Ring-fencing Wall Street
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Alok Sheel and Meeta Ganguly
The Volcker Rule is a landmark in regulatory reform. But it will have to stand the test of another crisis to prove its efficacy.
On December 10, the much acclaimed "Volcker rule" was finalised by five US regulators — the Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Commodity Futures Trading Commission. The rule was part of the Dodd Frank Act, which was passed in the wake of the global financial crisis. There are similar initiatives in the UK (Vickers Commission) and the EU (Liikanen Report). While the latter two are yet to be translated into legislation, the hotly contested but crucial rule-writing process for the Volcker Rule has been completed after three long years of deliberation.
The genesis of these three initiatives in key financial jurisdictions lies in the attempts to reinstate a Glass-Steagall-type firewall — which was in existence in the US since 1933, but repealed in 1999 by the Clinton administration — between deposit-based and investment banking. Glass-Steagall restricted commercial banks, which had access to deposit insurance and liquidity buffers from the central bank, from underwriting or dealing in securities, and investment banks from accepting deposits. Like Glass-Steagall, the Volcker Rule is part of a slew of measures designed to maintain financial stability by insulating the critical economy-wide payments system from the kind of classic bank runs that haunted major advanced economies right up to the Great Depression, necessitating large taxpayer bailouts.
This firewall was successful in preventing major bank runs in the post-war period until it was overtaken by financial innovation and "light touch regulation", which is based on disclosure rather than control. In retrospect, it is unsurprising that the collapse of this firewall led to the buildup of systemic risk in the financial system that boiled over with the run on Lehman Brothers, a systemically important, large investment bank.
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