Implications of the Volcker Rule

Recently the US president proposed a rule “Banks no longer would be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit, unrelated to serving their customers.”

Mr Obama said that “While the financial system is far stronger today than it was one year ago, it’s still operating under the same rules that led to its near collapse”, the new rule named after former Federal Reserve Chairman Paul Volcker (a staunch advocate of prohibiting banks from engaging in proprietary trading solely for their own profit) would prohibit banks from owning or making investments in private-equity and hedge funds that “are unrelated to serving customers.” While financial institutions could still manage the assets on behalf of clients, they wouldn’t be able to invest in their own funds or those run by Private equity firms.

Since the proposal of this rule major banks have seen a fall in their stock prices by around 4% , if this rule is passed by the Congress the possible effects could be:

Private Equity Space:

  1. The industry would see many mergers and acquisitions with banks being forced to sell their private-equity units
  2. New players would be seen in the Private Equity market with the cash rich banks no more being there and a huge market share was occupied by them.
  3. Existing Private Equity firms would grow stronger
  4. Since huge loans were provided for LBOs by banks, this source of loans for LBOs may be interrupted resulting in a bit trouble for LBOs
  5. In a world where already the sources of capital for Private Equity are less, one source of capital would be removed

 Investment Banks:

  1. All major I-Banks may have to sell some private-equity businesses and stop investing in buyouts
  2. Plan to curb proprietary trading will cost all major I-Banks a huge fall in revenue next year. Goldman Sachs alone is estimated to have a $4.67 billion drop in earnings in 2011

Expert’s have various views about this rule:

David Viniar, Goldman’s chief financial officer, while calling the proposal “impractical” said that“You have global institutions around the world who are set up in a certain way and to put rules in place that roll back the financial system by 10 years I think is going to be a very, very hard thing to do”.

Steven Kaplan, a professor at the University Of Chicago Booth School Of Business said “Targeting private-equity investments by banks doesn’t go to the root of the problems that caused the financial meltdown”, “Private-equity investments did not cause the crisis,” Kaplan said. “It was their loans that went bad.”

However from the US Government side Austan Goolsbee, a member of Obama’s Council of Economic Advisers, said that the proposal was “not intended to get rid of asset management as a function.”