Complete “Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulations” Case (KEL-703-PDF-ENG) from your Harvard Case Studies Course Pack.  Please answer the following questions specifically:

In the case:

1. In this case, at what state in its life cycle is the nonmarket issue of the “Volcker rule” (regulation of proprietary trading)?

2. Map out the interest and their potential influence.  

3. Propose a nonmarket strategy for a large bank to deal with the threat of the Volcker rule.  Make sure the strategy looks not only at the current stage of the issue but at future stages as well.

Additional questions:

4. Should banks be allowed to engage in proprietary trading? Why, or why not?

5. What are the interests and their potential influence for each side of the issue?  Who has the balance of influence?

6. Who are the banks’ opposition and allies?  What are the sources of strength of the banks’ opposition in terms of influencing legislation?  What are the sources of strength for the banks and its allies?

7. Should the banks support the Merkley-Levin amendment?  Why, or why not?

8. What are the banks’ general market strategies?  How does the nonmarket issue of proprietary trading relate to their strategy?

9. What should a bank’s nonmarket strategy look like here (both its strategy for the legislative and administrative phases of the issue)?  Is it likely to be successful?

Use the Case Study Guidelines under the “Start Here” tab as a guide on writing this.   Your paper should be a minimum of 5 pages (not including the cover sheet and references) and follow APA guidelines.

©2012 by the Kellogg School of Management at Northwestern University. This case was prepared by Professor Dylan Minor and
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DYLAN MINOR AND NICOLA PERSICO KEL703

The Volcker Rule:
Financial Crisis, Bailouts, and the Need for Financial Regulation

In 2007 worldwide credit markets tightened and international trade declined, resulting in
economic slowdowns around the world, stock market drops, and the potential collapse of large
financial institutions. Faced with the worst financial crisis since the Great Depression of the
1930s, governments and central banks around the world responded. In the United States alone,
government agencies committed trillions of dollars to loans, asset purchases, guarantees, and
direct spending to undertake fiscal stimulus, expansionary monetary policy, and bailouts of a
variety of private financial institutions.

The bailouts were especially controversial in the United States because public money was
used to protect private financial institutions and their wealthy executives while ordinary citizens
received no such protection. Elected officials were inundated with mail from angry constituents
denouncing the bailouts. This wave of outrage was seized upon by liberal activists, who launched
the Occupy Wall Street movement to protest growing economic and social inequality and to
advocate for greater economic fairness. Even on the opposite end of the political spectrum, the
conservative Tea Party movement sponsored protests and supported political candidates in favor
of reduced government spending and taxes to reduce the federal budget deficit and national debt.

On June 17, 2009, the Obama administration announced an “extraordinary response to a
historic economic crisis.”1

A New Foundation for Financial Regulation

President Obama’s proposal for preventing a reoccurrence of the financial crisis was
contained in a document called “Financial Regulatory Reform: A New Foundation.”2 The
proposal included five measures:

1. Consolidate regulatory agencies and create a new regulator to evaluate systemic risk.

1 Barack Obama, “Remarks on Regulatory Reform,” June 17, 2009, transcript and video, Washington Post,
http://projects.washingtonpost.com/obama-speeches/speech/23.
2 U.S. Department of the Treasury, “Financial Regulatory Reform: A New Foundation,” June 17, 2009, http://www.treasury.gov/
initiatives/Documents/FinalReport_web .

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THE VOLCKER RULE KEL703

2 KELLOGG SCHOOL OF MANAGEMENT

2. Implement additional regulation of financial markets.

3. Create a new consumer protection agency.

4. Introduce tools for financial crises, including a “resolution regime” that complements the
existing Federal Deposit Insurance Corporation (FDIC) authority to allow for orderly
winding down of bankrupt firms, as well as a proposal that the Federal Reserve receive
authorization from the Treasury for extensions of credit in “unusual or exigent
circumstances.”

5. Various measures aimed at increasing international standards and cooperation.

These proposals, which the Obama administration believed were sufficient to protect against
the need for future bailouts, became the basis for the financial reform law known as the Dodd-
Frank Act.

Public Reaction

Earlier that year, news of lavish bonuses paid to executives of bailed-out financial firms had
sparked popular indignation. In March 2009 the insurance company AIG, which had received
more than $170 billion in government bailout funds, had announced it would pay $165 million in
bonuses to managers of the business unit whose performance had sunk AIG and required it to be
bailed out.3 Ten days after the New York Times broke the news, with AIG under a barrage of
public criticism, an executive vice president of the business unit had resigned. In October 2009,
however, AIG again tried to pay out large bonuses. This time the U.S. Treasury Department
intervened to block the move.

These stories stirred powerful reactions in the media and among voters of both parties. This
reaction led the Obama administration and Congress to believe that stronger regulation not only
was politically feasible but also politically necessary. Accordingly, the administration started
exploring additional regulatory options, including one that had been proposed by Paul Volcker, a
respected former chairman of the Federal Reserve.

The Volcker Rule

What became known as the “Volcker rule” first had been proposed in a January 2009 report
cowritten by Volcker and the Group of Thirty, an international group of senior representatives of
academia and public and private sectors. The report recommended that “large, systemically
important banking institutions should be restricted in undertaking proprietary activities that
present particularly high risks.”4

Banks, unlike other financial entities, were insured by the FDIC. This insurance was a
guarantee that banks would be bailed out if they were in distress. With the downside risk of bad

3 Edmund L. Andrews and Peter Baker, “A.I.G. Planning Huge Bonuses After $170 Billion Bailout,” New York Times, March 14,
2009.
4 Group of Thirty, “Financial Reform: A Framework for Financial Stability,” January 15, 2009, http://www.group30.org/images/PDF/
Financial_Reform-A_Framework_for_Financial_Stability , p. 28.

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KEL703 THE VOLCKER RULE

KELLOGG SCHOOL OF MANAGEMENT 3

decisions being borne by the FDIC, banks might be lured into speculating for their own account;
if the speculation lost enough money to endanger the institution, the public (through the FDIC)
would bear the costs of the decision. This problem was known as moral hazard.

The solution for this moral hazard problem was to restrict banks from trading for their own
account. In Volcker’s words, “If you are going to be a commercial bank, with all the protections
that implies, you shouldn’t be doing this stuff. If you are doing this stuff, you shouldn’t be a
commercial bank.”5

The Volcker rule threatened to eliminate the banks’ proprietary trading revenues, or revenues
from trades that banks engaged in for their own—not their clients’—benefit. The proprietary
portion of trading revenues was difficult to quantify, but it was believed to be on the order of 10
percent of total trading revenues.6 At that figure, proprietary trading revenues in 2010 would have
exceeded $5.9 billion for the six largest American banks alone.7

Support

With public opinion firmly set against the bailouts and the financial industry, President
Obama announced his support for the Volcker rule in January 2010. In the same speech, he took
the opportunity to excoriate the financial industry:

[W]hat we’ve seen so far, in recent weeks, is an army of industry lobbyists from Wall
Street descending on Capitol Hill to try and block basic and common-sense rules of the
road that would protect our economy and the American people. So if these folks want a
fight, it’s a fight I’m ready to have.8

Voter support for tough action on Wall Street was overwhelming. The president’s position
was supported by Americans for Financial Reform (AFR), a public interest group that represented
the AARP, several large unions, the NAACP, MoveOn.org, and many others. The AFR started a
public campaign, including mass letter-writing to congressmen, in support of the Volcker rule.
The AFR was firmly opposed to proprietary trading: “Proprietary trading and private fund
investments are resulting in taxpayer-supported banks using cheap federal funds to gamble, not
lend to America’s struggling businesses and families.”9

The administration’s position was further strengthened when five former Secretaries of the
Treasury, four of whom had served under Republican presidents,10 wrote an open letter to the
Wall Street Journal supporting the Volcker rule.

5 John Cassidy, “The Volcker Rule,” The New Yorker, July 26, 2010.
6 Kate Kelly, “Banks Gear Up for a Battle,” Wall Street Journal, February 2, 2010.
7 Robert Lenzner, “Six Giant Banks Made $51 Billion Last Year; The Other 980 Lost Money,” Forbes, June 3, 2010.
8 Barack Obama, “Remarks on Financial Reform,” January 21, 2010, transcript, Washington Post, http://projects.washingtonpost.com/
obama-speeches/speech/167.
9 AFR, open letter to the H.R. 4173 Restoring American Financial Stability Act of 2010 Conference Committee, dated June 16, 2010.
10 President Barack Obama was a Democrat.

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THE VOLCKER RULE KEL703

4 KELLOGG SCHOOL OF MANAGEMENT

Opposition

Domestic banking institutions that would be subject to the Volcker rule were opposed to it for
a long list of reasons: the loss of proprietary trading revenue; the competitive disadvantage at
which U.S. banks would be placed relative to foreign banks; the burden of regulatory compliance
necessary to certify trades as nonproprietary; the regulatory ambiguity entailed by the definition
of “proprietary trade”; and the consequent uncertainty regarding enforcement.

The last two concerns were especially strong for small and community banks. Community
banks provided nearly 40 percent of the entire banking industry’s loans to small businesses,
which were crucial to job creation. Albert Kelly, American Bankers Association chairman-elect
and an Oklahoma community banker, described the potential impact of the Volcker rule (and, by
extension, the Dodd-Frank Act, to which the rule was appended) during Congress testimony
regarding community banks:

The Dodd-Frank Act will raise costs, reduce income, and limit potential growth, all of
which drives capital away from banking, restricts access to credit for individuals and
business, reduces financial resources that create new jobs, and retards growth in the
economy.11

The banks also raised a number of policy concerns about the Volcker rule, particularly
regarding interference with “market-making,” in which banks acted as counterparties for sellers
of, for example, purchased government debt or a bond issued by a corporation in hopes of
reselling it later. If market-making was deemed to be proprietary trading and banks were
prohibited from engaging in it, then the markets for corporate and government bonds might
become less liquid. This would result in the undesirable consequence of raising financing costs
for private and government entities.

The banks also argued that the ability to hedge—that is, to purchase securities that diversified
or attenuated the risk in a bank’s existing portfolio of loans—actually helped prevent default. If
hedging activities were deemed proprietary trading and thus forbidden by the Volcker rule, banks
would become more, rather than less, likely to fail.

Legislative Process

The Volcker rule was formally introduced on May 10, 2010, as an amendment to S. 3217, the
Senate version of the Dodd-Frank bill. The Merkley-Levin amendment, as it was called, explicitly
exempted the trading of government bonds for market-making, hedging, and underwriting. In
addition, the amendment included an “indeterminate” exception for any activities that federal
banking regulators deemed would promote “the safety and soundness of the banking entity.”

The amendment was intended to drive the $5 billion in “speculative profits” out of the
banking system while still permitting “good” financial activity. However, because the boundary
between market-making or hedging (good) and speculative (bad) activities was not well defined,
the amendment gave broad discretionary powers to the agencies charged with implementing the

11 John Soffronoff, “The Dodd-Frank Act: Size Matters,” Thomson Reuters News & Insight, April 30, 2012.

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KEL703 THE VOLCKER RULE

KELLOGG SCHOOL OF MANAGEMENT 5

Dodd-Frank Act. This need for discretion was widely accepted, as mentioned by Deputy Treasury
Secretary Neal Wolin at a February 2, 2010, hearing of the Senate Banking Committee:
“Certainly a lot of the detail would be left over to specific application in the rule-making process
or the advisory process.”12

A number of steps remained before the Merkley-Levin amendment could become law. First,
the amendment could be modified to gain support from additional lawmakers. Next, it would
need to be voted as part of S. 3217. Then the amendment would need to survive reconciliation
with the House version of the Dodd-Frank Act that had passed in December 2009 without a
Volcker-type provision.

Once the Merkley-Levin amendment became law, government agencies would be charged
with writing the regulations that would implement the letter and spirit of the law. The relevant
agencies included the Federal Reserve, the Securities and Exchange Commission, the FDIC, and
the Office of the Comptroller of the Currency. These agencies were run by political appointees
who had technical backgrounds, and their personnel was made up of civil servants. According to
administrative protocol, these agencies would first issue a notice of proposed rulemaking and
solicit comments from the public, which would help shape the regulations. These comments
would be regarded as influential insofar as they competently addressed specific technical issues.

Preparation Questions

1. In this case, at what stage in its life cycle is the nonmarket issue of the “Volcker rule”
(regulation of proprietary trading)?

2. Map out the interests and their potential influence. Is the Volcker rule likely to pass? Why, or
why not?

3. Propose a nonmarket strategy for a large bank to deal with the threat of the Volcker rule.
Make sure the strategy looks not only at the current stage of the issue but at future stages as
well.

12 Rebecca Christie, “U.S. May Give Regulators Room to Apply Volcker Rule (Update1),” Bloomberg Online, February 24, 2010.

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This document is authorized for use only by Ana Caceres in Advanced Auditing Theory and Application-7-1-19-1 taught by BUNNEY SCHMIDT, Keiser University from Jan 2020 to Jul 2020.

Case Study Analysis

Case study analysis gives students an opportunity to apply theory learned in the classroom to real world situations.  Case studies do not have discrete answers.  Rather, they challenge students to exercise their own business judgment in a supportive, educational environment.  Students test their knowledge by analyzing situations; defining problems or issues; evaluating alternatives and/or forming conclusions to resolve the problem or issue; and making recommendations.

Types of case study assignments:

Students may be asked to

· Prepare a case in advance, based on criteria developed by the instructor.  The case would then be used as a basis for discussion.

· Write a case analysis paper, based on criteria developed by the instructor.  The paper may be presented or reviewed by peers.

· Analyze a case that is threaded throughout the course.  As part of the learning process, students acquire knowledge during the course and apply that knowledge to different aspects of the case.

Case study analysis steps:

Cases used in the classroom vary from short vignettes to dense, multi page volumes.  It is the responsibility of the instructor to teach a process which, while useful in the classroom, can be applied to the real world after the student graduates.  Real world application of the steps used in case study analysis will vary from those found in the safety of the academia; employees will gather the information, found conveniently in an academic written case study, from a dynamic environment. 

Here are some recommended steps for successful case analysis:

1. Gain familiarity with the case situation.  This can be accomplished by reading the case several times.  Read the first time to appreciate the general story before you begin to form conclusions or make analysis.

2. Define the issue or problem.  To make an analysis or recommendation, one must first determine what the issue or problem is.  As in the real world, note there may be more than one problem in a case study analysis.  (You can appreciate the importance of this step if you ever took your car in because it was running rough and paid for several repairs because the mechanic didn’t correctly diagnose the problem in the beginning.)

3. Conduct your analysis.  What are the possible causes of the problem or issue?  What alternatives are possible given the facts presented?  This is the most time consuming step, and the step with the greatest variation. There may be many possibilities.  It might be helpful to list all solutions you can think of before focusing on the most useful or valid.  There is not necessarily a right answer, but there may be several alternatives that lead to varying outcomes.  The quality of analysis will depend upon application of theory learned in the classroom and through research. 

4. Make recommendations.  Choose the recommendation you believe to be the best, justify it, and develop it.  Recommendations may be made in the form of an action plan to solve the problem or issue.  Or, recommendations may involve the choice of the best alternative for resolving the issue or problem. Recommendations made must be thoroughly developed and supported. 

References:

ICFAI Center for Management Research. (nd). Learning with cases. Retrieved June 22, 2007 from

http://www.icmr.icfai.org/casestudies/learn_case.htm

.