Under the Volcker Rule, banks can no longer own, invest, or sponsor hedge funds, private equity funds, or any proprietary trading operations for their own profit. The Volcker Rule prevents financial firms from using deposits that are insured by the FDIC to run hedge funds and private equity funds.
The Rule also limits the liabilities that the largest banks could hold. This limitation is intended to reform former investment banks, like Goldman Sachs and Morgan Stanley. These banks changed into commercial banks during the financial crisis just so they could take advantage of taxpayer-funded bailouts. It also seeks to protect depositors in the largest retail banks, like JP Morgan Chase and Citi.
The Volcker Rule was designed to prevent large banks from becoming too big to fail. This means that the failure of the bank would devastate the economy, requiring that it must be bailed out with taxpayer funds.
When Banks Can TradeThe Volcker Rule allows some trading when it's necessary for the bank to run its business. For example, banks can engage in currency trading to offset their own holdings in foreign currency. They may also do some similar kinds of trading to offset interest rate risk. Banks are still allowed to trade on behalf of their customers, with their customers' funds and approval. Sometimes, this means the investment requires some "skin in the game." In that case, banks can invest up to 3% of their own capital.
Why the Volcker Rule Is NeededThe Volcker Rule seeks to undo the damage done when the Glass-Steagall Act was repealed. Glass-Steagall was simple -- it separated investment banking from commercial banking. Under Glass-Steagall, investment banks were privately-run, small companies that helped corporations raise capital by going public on the stock market, or issuing debt. They charged high fees, were small, and not regulated. Commercial banks were stodgy, safe places where depositors could put their money and gain a little interest. They could take out loans at regulated interest rates. However, commercial banks made money despite thin profit margins because they had access to lots and lots of capital in the depositors' funds.
Banks lobbied to repeal Glass-Steagall so they could be competitive internationally. When retail banks (like Citi) started trading with derivatives like an investment banks, it meant the CEOs could now put the vast reserves of depositors' funds to work -- without much regulation.
Furthermore, they could do so knowing that the Federal government protected commercial banks in a way investment banks were not. Commercial bank deposits were protected by the FDIC. Banks could borrow money at a cheaper rate than anyone else. This is called the LIBOR rate, and it is just a hair above the Fed funds rate.
These advantages gave the banks with an investment banking arm an unfair competitive advantage over boring community banks and credit unions. As a result, these banks bought up older ones, and became too big to fail. This added another advantage -- the banks knew the Federal government would bail them out if anything went wrong. Banks had the taxpayers as a safety net in two ways -- as depositors, and as a source of bailout funds. This is known as a moral hazard, in that bank stockholders and managers won if things went well, but taxpayers lost if things didn't.
Impact of the Volcker RuleIn response to the Volcker Rule, Goldman Sachs reduced its risk-taking in 2011. That's when the bank closed Goldman Sachs Principal Strategies, a division that traded equities, and the Global Macro Proprietary Trading desk, which made risky trades with bonds, currencies and commodities.
Goldman has also reduced investments in private equity and hedge funds to 3% or less of each fund. That's a good thing, because these investments made Goldman report its second quarterly loss since going public in 1999. (Source: Bloomberg, "MF Global’s Collapse Exposes Prop-Trading Risk That Volcker Wants to Curb," October 31, 2011)
Why Is It Called the Volcker Rule?The Volcker Rule was proposed by former Federal Reserve Chairman Paul Volcker while he was the chair of President Barack Obama's economic advisory panel from 2009-2011. Volcker was known for being courageously aggressive enough, while Fed Chairman, to raise the Fed funds rate to uncomfortable levels to starve double-digit inflation. Although this helped cause the 1980-1981 recession, it was successful.
Volcker's credibility was needed to overcome intense lobbying by the banking industry, which does not want to see these restrictions imposed. It's estimated that the Rule will cost banks $10 billion to implement. (Updated April 4, 2013)