One of the main governmental responses to the 2008 crisis was the Dodd-Frank Wall Street Reform and Consumer protection act. This act includes changes such say “say on pay” which requires shareholder approval on executive compensation and empowering the SEC by allowing it to exercise judgment on proxy voting and protecting the customer by capping interchange fees in banks with over 10 billion in assets. However the most important part of this reform is likely to be the Volcker Rule.
Named after Paul Volcker, the Volcker Rule is essentially a reincarnation of the Glass Steagall act. This rule prohibits deposit taking institutions from directly engaging in proprietary trading or speculation, this is also done by the prohibition of over 3% ownership in any given hedge fund or private equity fund. One point of view is that this reduces the market risk of retail institutions and shifts it to the investment banks, the theoretical subsequent result being that there is less market-making and a less efficient system that disrupts allocation of capital throughout the economy. Before the rule, banks held securitized assets on their balance sheets for weeks which would put them at risk of swings in the products value. In practice however investment banks will now take a much more cautious approach as they would now be using borrowed money from the retail banks.
An example of what we should expect to see if more risk reduction is taking place is a more cautionary approach by investment banks. At the next booming period we will be able to juxtapose investment banks before and after the Volcker Rule. The norm so far has been to create securitized mortgages and hold in the bank’s balance sheets typically for a couple of weeks until they could be sold, this was the “warehouse” function of banks in the securitization process. If a more cautionary approach is taken, a reduction in the “warehouse” aspect of securitization will take place and there will be a greater incentive to directly link buyers and sellers beforehand. This could be an indication that the previous system was run on moral hazard of investment banks not bearing their own risks.
Although there are claimants that this rule will greatly cripple markets, by crippling access to liquid, if the investment opportunities are truly there, then other industries will be able to pick up the slack without putting as much risk on the consumer(lets not forget how much money companies are sitting on today). Without citizens bearing the risk it’s probable that risk-taking will be reduced and the dropping of standards would not occur without sufficient reason. This bearing of risk will likely result in a demand for greater transparency, the benefit will be a decline in cloudy activities, such as shadow banking.