Economic Effects of the Volcker Rule: Restrictions on Banking Activity and Their Consequences for Economic Growth and Stability

The Volcker Rule—a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act—restricts commercial banks from trading securities for their own accounts and limits their ability to affiliate with hedge funds and private-equity firms. The rule is intended to limit risk in the financial system by restricting institutions that are supported by public institutions from taking on risk that may ultimately be borne by taxpayers. This essay uses economic theory to examine the justification for such a rule, whether the rule is likely to be effective, and the additional economic effects that may arise from having the rule in place. The research in this essay suggests that the rule is unlikely to limit risk in the way that its supporters hope, because it attempts to work around, rather than address, a fundamental source of risk in the financial system: the moral hazard that results from public institutions providing support to banks and their creditors, which creates incentives for banks to assume more risk than they would otherwise.