The volcker rule prohibits banks from proprietary

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The Volcker Rule prohibits banks from "proprietary trading", meaning transactions conducted purely for their own gain, rather than to serve clients. It was intended to prevent banks from gambling with deposits insured by the federal government. Regulators see big "portfolio hedges", designed to protect against broad risks such as an economic downturn or a rise in interest rates, as risky proprietary trading in disguise and so ban them. It is like Glass-Steagall in that both try to limit the activities of banks beyond taking deposits and providing loans in order to limit the risks (and potential costs
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to the government). Glass-Steagall prevented commercial banks from entering into the investment banking and brokerage industries, while Volcker prevents investment in securities under the banks’ own names. ii. What are its possible unintended and undesirable consequences? It may limit "market-making", whereby banks keep a supply of securities on hand, so that they can sell them to a customer on demand, or buy them from one even when they do not have another client lined up to pass them on to. Without the liquidity banks provide in this way, pension funds and insurers would find it harder, more time-consuming and more expensive to buy and sell bonds and other financial instruments. The rule alleviates this worry somewhat by allowing banks to buy securities to meet "reasonably expected" demand from customers. In practice banks will probably respond by making markets for a narrow range of securities that already trade frequently, and thus might reasonably be expected to do so in future. Meanwhile, the securities that now change hands less frequently are likely to be shunned, making them even harder to trade. The rule forces banks to tie each hedge to the risks of specific positions they have taken. Yet there are few perfect hedges that match each position, so banks often resort to big "portfolio hedges", designed to protect against broad risks such as an economic downturn or a rise in interest rates. The rule may unintentionally bar small banks, which are largely exempted from its strictures, from investing in financial instruments that currently form a big part of their capital. iii. Which kind of security is exempt and why? Government bonds are exempted from the rule to prevent it from raising the cost of government borrowing and to funnel funds to government bonds. E. Read “Big Insurers Need to be Watched” (19.1) and “Roadkill in the Fed’s race to regulate shadow banking”(19.2) and answer the following: Note: During the Crisis, the government bailed out, for the first time, some nonbank financial institutions, arguing that their failure would have threatened the stability of the financial system. This became official policy under Dodd-Frank, which gave regulators the authority to designate financial institutions (both bank and non-bank) as ‘systemically important’ (SIFIs); institutions so designated would then be subject to “stringent regulation” by the Fed.
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