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  Issue 20 | Archive August 2014

U.S. Banks' Risk Targeting after Volcker

A paper by Jussi Keppo (National University of Singapore) and Josef Korte (Goethe University Frankfurt)

In a recently released working paper, RMI¡¯s affiliated researcher A/P Jussi Keppo (National University of Singapore) and Josef Korte (Goethe University Frankfurt) present early evidence on the Volcker Rule's preliminary effects on U.S. Bank Holding Companies.

In line with banks' public compliance announcements, the authors find that those Bank Holding Companies that are presumably most affected by the Volcker Rule already reduced their trading books relative to their total assets almost 3% more than other Bank Holding Companies. However, the Volcker Rule seems to have unintended consequences since they do not find corresponding effects on overall risk-taking. To keep their risk targets, the affected banks seem to use the remaining trading assets in speculation, not in the hedging of the banking business.

Four years after the enactment of the Dodd-Frank Act and motivated by several banks' self-declared compliance, Keppo and Korte analyze whether the Volcker Rule has already had an announcement or early compliance effect. The authors also investigate whether this compliance results in any of the intended effects on the affected banks' business models and risk-taking. They construct a comprehensive dataset of all Bank Holding Companies (BHC) in the United States covering a period from 2004 until 2013 on a quarterly basis. Employing accounting and regulatory data, the authors test for several changes in portfolios, risk-taking, and hedging, and also compare affected banks' trading books with hedge funds.

The paper presents several results. First, banks - on average - seem to reduce the size of their trading books relative to total assets after the passing of the Volcker Rule. More importantly, however, is that those Bank Holding Companies, which are presumably most affected by the Volcker Rule, show the strongest reduction of their trading books. The reduction of the trading books is sizable; the affected BHCs' average trading book before the passing of the Volcker Rule was around 10% of total assets and after that the affected BHCs reduced their trading books relative to their total assets almost 3% more than other BHCs. Moreover, when comparing with hedge funds the authors do not find a similar trend, instead hedge fund assets have been rising after the recent financial crisis and the passage of the Dodd-Frank Act. The reduction of banks' trading books is quite an intuitive reaction and also corresponds with the self-declared compliance announcements by banks affected by the Volcker Rule. Extending the model towards risk-taking of the institutions, the authors find weaker results. While overall bank risk has decreased after the enactment of the Volcker Rule, the authors do not find a pronounced effect on the BHCs that are particularly affected. If anything, affected banks seem to get riskier, but this is not significant. These findings imply that the Volcker Rule has so far not led to its intended consequences on banks' riskiness. Turning to the trading book performance, the authors first find that trading returns and volatility are largely unchanged after the Volcker Rule - if anything, affected banks seem to have lower and more volatile trading returns. Second, there might be trading that is wanted and, hence, permitted as an exemption from the Volcker Rule. In fact, the Volcker Rule explicitly stipulates, for instance, that trading accounts held for hedging purposes are permitted. If affected banks were increasingly using their trading accounts for hedging of banking book exposures, one would expect the correlation between trading and banking returns to strongly decrease - or at least to be negative after the introduction of the Volcker Rule. The authors test for this and find neither to be the case. Rather, while the correlation between trading and banking returns has decreased after the Volcker Rule became effective, the opposite is true for the most affected banks that even experienced a significant increase in the correlation.

Keppo and Korte interpret the results as evidence that banks started to comply with the Volcker Rule by reducing their trading portfolios. However, consistent with banks' risk targeting, this did not imply lower overall risk levels. The findings suggest that the banks use the remaining trading assets more in speculation and less in the hedging of their banking business. Possibly because of the increased trading speculation, the risk-taking has not increased in the banking book. Thus, while the banks might move towards compliance with the Rule, banks that relied on risk-taking through activities banned or limited by the Volcker Rule seem to use the remaining trading activities more in speculation, not in hedging. This should be expected since their risk-taking incentives have not changed. Apparently there are levels of risk that banks find optimal (whether they are from a societal perspective is a different question) and that they manage to sustain, at least so far, by decreasing hedging. If the reduction of banks' overall risk and trading account riskiness were essential targets of the Volcker Rule that should follow from banks' compliance, the paper's findings suggest that the Volcker Rule has so far not been very effective.

To be fair, the Volcker Rule is not yet fully implemented and will only be effective from 2015 onwards. Nevertheless, this paper highlights that banks do not necessarily need to change their risk targets. These findings have important implications for banking regulators, e.g., in the European Union, that are currently debating the introduction of proprietary trading bans. For instance, regulators might want to analyze the unintended consequences of the Volcker Rule in more detail, especially since its implementation might be expensive. After the Volcker Rule is effective one might observe a drop in banks' earnings due to its implementation costs. The falling profitability might, in turn, raise the banks' default probability.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)