What does the Volcker Rule teach us about risk?

When Congress passed the Dodd-Frank financial reform bill in 2010, one of the law’s crucial components was known as the “Volcker Rule.” Named after former Federal Reserve chairman Paul Volcker, the rule is designed to stop banks that accept federally insured deposits from making speculative bets with the money.

Banks will often engage in what is called “proprietary trading.” This means that they invest in the short term to take advantage of rapid price movements.

Such bets were quite common prior to the financial crisis, and some believe that they helped to precipitate it by making the system as a whole less stable. The problem with speculative trading is that when such bets go wrong, banks and their customers suffer for it. When the banks are dealing with federally insured deposits, taxpayers also end up on the hook for the losses.

In a letter sent to regulators last year, Volcker himself defended the rule.

“The basic public policy set out by the Dodd-Frank legislation is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services,” he wrote.

The final approval of the Volcker Rule illustrates the importance of lenders limiting their risk to maintain their own health and that of the overall system. These are the same principals that make risk assessment software so crucial. When faced with a business or a consumer that is seeking a loan, banks must make sure that the borrower is credit worthy. It is this sense of caution that should be reflected in all banking practices.

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