Paul Volcker was the chairman of the Federal Reserve from 1979 to 1987. A period when United States experienced stagflation i.e. an environment where a region has high inflation coupled with high unemployment. Unlike the present situation (2020 – when inflation is low), Federal Reserve in the 1980s could not print money and inject it into the economy to bring down unemployment. At that time, printing money would have inflated asset prices, which would have led to even higher inflation. Despite strong political attacks and widespread protests in the history of the Federal Reserve, Paul Volcker decided to fight inflation (13.5%) by tightening monetary policies; in June 1981, the Federal Reserve hiked interest rates to about 20%. This move led to an even higher unemployment (over 10%). Despite the criticism, Volcker stood his ground. Volcker had dedication to absolute integrity and his “three verities” – stable price, sound finance, and good government. Over time, inflation gave in and price stability was achieved. Lastly, unemployment rate was brought down to 5%. I recommend Paul Volcker’s autobiography, Keeping at It: The Quest for Sound Money and Good Government, if you are interested to learn more about Volcker. Now that we know who Paul Volcker was and what he stood for, let’s talk about the Volcker rule.
As part of the Dodd-Frank act, the Volcker rule was set in place after the 2007-08 financial crisis. The Volcker Rule is a federal regulation that prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds, also called covered funds; The Volcker Rule aims to protect bank customers by preventing banks from making certain types of speculative investments. What does all this mean? Let me provide an example. Imagine you are the bank. Average Joe comes up to you and says he wants to take out a loan to buy his automobile or house. So, you tell Joe that you can give him the money, but he’d have to pay a 4% interest on that principal. That 4% interest is your profit. You can now re-invest that 4% profit, but wait – why stop at 4% profit? You notice that lending can only generate a sub-par 4% profit. However, if you re-invest that 4% profit into more riskier investments, you can rack in a lot more money. So, you start speculating and trading derivatives. This is precisely what happened in the financial crisis. You (bank) did not have any money left over when your speculative bets went south. The failure of your speculative bets not only compromised your financial status, but also compromised the investments of your customers who had accounts with you. So, the Volcker rule ensured that banks do not venture out in the speculative arena. Banks were asked to stick with meeting the needs of their customers, and not to have a conflict of interest between bank’s money (bank’s profits, investments, speculative bets, etc) and customers’ money.
In wake of the economic shutdown amid COVID-19 pandemic, on June 25, 2020, the Federal Deposit Insurance Commission (FDIC) officials said that the agency will loosen the restrictions from the Volcker Rule, and allow banks to easily make large investments into venture capital and similar funds. Furthermore, the banks will not have to set aside as much cash for derivatives trades between different units of the same firm. Originally, this requirement was put in place to ensure that if speculative derivative bets went wrong, banks would not get wiped out. The loosening of these requirements will certainly free up billions of dollars in capital for the industry.
It is important to note that on the same day (June 25, 2020), the Federal Reserve released the stress test results, which show that under the U- and W-shaped recovery scenarios, most firms remain well capitalized but several would approach minimum capital levels. Moreover, the Board is requiring large banks to preserve capital by suspending share repurchases, capping dividend payments, and allowing dividends according to a formula based on recent income.
This week, the corona-virus cases in the United States were on a rise, and states have paused or rolled back on their re-openings. The markets have realized that the economic recovery might take longer than expected. In addition to the 3 trillion dollars that the Federal Reserve injected into the economy (by buying treasure securities and corporate debt), banking regulations have been relaxed. Banks are now incentivized to invest in riskier investments as they chase higher returns. Additionally, banks are required not to pass down any money to the shareholders in form of dividends or share buybacks.
I suspect that this move of revoking Volcker rule and the Fed asking banks not to be shareholder friendly is in response to a record $2 trillion surge in cash that hit the deposit accounts of U.S. banks since the corona-virus first struck the U.S. in January (per FDIC data); The amount of money flowing into banks has no precedent in history: in April alone, deposits grew by $865 billion, more than the previous record for an entire year (source: CNBC). This goes to show that the fiscal and monetary stimulus to jump start the economy is now sitting at banks in form of cash. FDIC and the Federal Reserve noticed this clog, and thus are incentivizing banks to invest part of that cash into the economy. However, it will be up to the banks to decide if they want to spend that extra cash by investing in startups or derivatives. It’s all about risk-reward. Since there is abundant of free liquidity (near zero interest rates) and limited investment options available, I believe that banks are willing to take maximum risk in order to generate maximum profits. I suspect that we are setting the financial sector up for another 2007-08 type crisis in the future.
Hope you learned a little and found this blog post helpful. We talked about Paul Volcker, the Volcker Rule, banking regulations, Federal Reserve, and the setup for the next financial crisis. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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