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Darrell Duffie: How Should We Interpret the Volcker Rule?

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Darrell Duffie: How Should We Interpret the Volcker Rule?

A scholar proposes alternative capital requirements for banks to eliminate potential unintended consequences of financial reform.

When the Dodd-Frank financial regulations became law in 2010, the reforms were put in place to promote safety and soundness within the U.S. financial system and lower the risk of future financial crises. However, the government's interpretation of one of those reforms, "the Volcker Rule," could have unintended and adverse consequences for the U.S. economy, says Professor Darrell Duffie of Stanford GSB.

Duffie, the Dean Witter Distinguished Professor of Finance at Stanford, details these potential consequences and proposes an alternative solution in an analysis submitted January 17 to the responsible agencies. They include the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission. The agencies are taking open comments from experts on the Volcker Rule until February 13. They will finalize their interpretations of the rule by July 12 when the Dodd-Frank reform legislation takes effect.

Duffie reveals a host of potential outcomes from the agencies' current regulatory interpretation, which would effectively reduce the quality and capacity of market-making services that banks now provide to U.S. investors by discouraging market makers from significantly increasing their risk levels in order to handle large imbalanced requests to buy and sell. This would limit an important source of liquidity for financial transactions and create less efficient markets and higher capital-raising and borrowing costs for homeowners and corporations. Duffie argues that it would also eventually lead to the migration of market making outside the banking sector, with potentially bad effects on financial stability.

"These consequences would potentially hurt economic growth at a time when we can least afford it," observes Duffie. "However, we're in a position now to make adjustments in the agencies' interpretation of the Volcker Rule so as to allow effective market making while maintaining low systemic risk through high capital and liquidity requirements for banks engaged in these activities."

Market makers provide immediacy by selling assets to investors that wish to buy them, and buying assets from investors that want to sell. The agencies' proposed restrictions would substantially discourage market makers from doing so, except for trades with predictable risks and predictable profits from bid-ask spreads. The bigger or riskier trades requested by investors would often be shunned by market makers, leading to thinner markets and more price volatility.

Duffie warns that under the proposed rule interpretation, some banks may exit the market-making business altogether, while others may significantly reduce the amount of capital that they devote to market making. This would contribute to higher trade execution costs for investors; greater difficulty in obtaining liquidity; higher borrowing costs for corporations, homeowners, and governments; and higher costs of equity capital for firms issuing common shares.

Duffie suggests that non-bank providers of market-making services would fill some or all of the lost market-making capacity, with unpredictable impacts on financial stability. "These non-bank firms would be outside of the bank regulatory framework," says Duffie. "Our experience with non-bank broker-dealers in the last crisis was not a happy one. Further, Dodd-Frank does not allow individual non-bank market makers to access lender-of-last resort financing from the Federal Reserve," says Duffie. His report points to the relevance of lender-of-last-resort liquidity provided by the European Central Bank during the current Eurozone debt crisis.

As an alternative, Duffie recommends establishing rigorous capital and liquidity requirements for market makers, combined with effective supervisory monitoring, with the objective of ensuring that banks have abundant capital and liquidity to cover their market-making risks. These requirements should continue to be strengthened as deemed appropriate by regulators to robustly protect the Deposit Insurance Fund and the soundness of the financial system.

Duffie cites the work of Stanford GSB finance colleagues Anat Admati, Peter DeMarzo, and Paul Pfleiderer in their paper with economist Martin Hellwig of Germany's Max Planck Institute, regarding why high capital requirements should not lead banks to cut back inefficiently on their provision of banking services.

After being approached to prepare an analysis of the Volcker Rule for the Securities Industry and Financial Markets Association (SIFMA), Duffie declined consulting fees in lieu of SIFMA's charitable contribution of $50,000 to the Michael J. Fox Foundation for Parkinson's Research.

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