Changes to the Volcker Rule and the Venture Capital Exception

By: Colby Trace, RBFL Student Editor

Everybody wants to blame the financial industry in times of financial crisis, and the flames only get fanned when banks need to be bailed out from what is viewed as their own risky behavior with taxpayer dollars, as was the case in the financial crisis of 2008. The Volcker Rule is a modern codification that reflects the idea that banks should not be gambling with their depositor’s money. The sentiment comes from a strong intuition; why should banks be allowed to seek upside for themselves via risky investments while their depositors or insurers take on the potential losses? This intuition is also embedded in the history of U.S. financial regulation. The Banking Act of 1933 was passed in the wake of the Great Depression and contained what came to be known as Glass-Steagall, a set of provisions that separated commercial banking from investment banking in an attempt to curb the amount of risk in the banking system. Over time, the teeth of these provisions were dulled, and they were eventually repealed in 1999.

Less than a decade after this repeal, another financial crisis was in full swing, and once again banking activity was scrutinized. Many viewed it as the primary driver of the economic collapse. In response to the crisis, the Dodd-Frank Wallstreet Reform and Consumer Protection Act was passed and contained a set of provisions that partially resurrected the ghost of Glass-Steagall, known as the Volcker Rule. The Volcker Rule essentially prevents banking entities from proprietary trading and from making large investments in or sponsoring “covered funds” such as private equity and hedge funds, with several enumerated exclusions. Once again, the idea is to prevent banks from taking on too much risk by not allowing them to engage in investment activities which are purely for their own benefit and which shift potential risk to their depositors or insurers.

While curbing risk sounds like a great idea in the abstract, in practice it is a balancing act. Banks are a vital source of capital, and they need some freedom to invest their funds to foster economic activity. The Fed recognizes this and in January 2020, proposed a set of changes to the Volcker Rule. The rule changes were finalized by five federal agencies on June 25, 2020 and included tweaks and additions to what can be excluded from the definition of a covered fund. Among these new exclusions are venture capital funds (VC funds).

Given the economic downturn caused by the ongoing pandemic, allowing banks to invest in VC funds looks like it may provide some stability to the capital pool and incentivize the funds to distribute capital where they otherwise wouldn’t have. Combined with the provisions that stop banks from guaranteeing VC funds’ investments, it looks like this new exception could foster private capital infusion at a time when it is very much needed. But, where does this leave the Volcker Rule with respect to its original purpose? At the time the changes were proposed, Chairman Jerome Powell acknowledged that the purpose of the Volcker Rule is still to stop banks from engaging in risky investment behavior with their taxpayer insured deposits and that this goal is an important one. Presumably, this is an important objective because allowing investment with insured funds is thought to be a source of systemic risk. Yet, at their heart, VC investments are inherently risky. Up to 30% fail completely. Even though banks are not allowed to insure the losses of the VC funds, any completely failed venture will still reflect as total loss of the bank’s portion of investment in that venture. The inclusion of VC funds in the new exclusions, then, may suggest attitudes about the risks of banks and their speculative investments are shifting.

 

Sources:

  1. Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 12 C.F.R. § 248, https://www.federalregister.gov/documents/2020/07/31/2020-15525/prohibitions-and-restrictions-on-proprietary-trading-and-certain-interests-in-and-relationships-with
  2. Jason Katz and Timothy Lavender, The Final Volcker Rule: Implications for Venture Capital, JD Supra, https://www.jdsupra.com/legalnews/the-final-volcker-rule-implications-for-45283/#:~:text=The%20Final%20Volcker%20Rule%20will,startups%2C%20thus%20encouraging%20capital%20formation.
  3. Chair Jerome H. Powell, Statement on Volcker Rule Covered Funds Proposal and Control Framework Final Rule 1, https://www.federalreserve.gov/aboutthefed/boardmeetings/files/powell-opening-statement- 20200130.pdf
  4. Investopedia, The Volcker Rule, https://www.investopedia.com/terms/v/volcker-rule.asp#:~:text=The%20Volcker%20Rule%20is%20a,funds%2C%20also%20called%20covered%20funds.
  5. Investopedia, The Glass Steagall Act, https://www.investopedia.com/terms/g/glass_ steagall_act.asp
  6. Deborah Gage, The Venture Capital Secret: 3 out of 4 Startups Fail, The Wall Street Journal, https://www.wsj.com/articles/SB10000872396390443720204578004980476429190#:~:text=The%20common%20rule%20of%20thumb,of%20venture%2Dbacked%20businesses%20fail.

 

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