Volcker Rule

An investment bank can do two very different things with money. It can arrange deals for clients and charge a fee. Or it can trade with its own capital and keep the profit.

The second one is called proprietary trading. It is where a bank's interests can part company with its clients'.

After the global financial crisis of 2008, the United States decided the two should not sit in the same place. The Volcker Rule is the piece of law that separates them. It segregates banking from proprietary trading and asset management.

It is not a standalone statute. It is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which brought American investment banks back under tight regulation after two decades of very fast growth.

Why does an Indian merchant banking paper teach an American rule? Because India made the same choice much earlier, by a different route. A merchant banker here does not take deposits at all, and the Banking Commission Report of 1972 recommended keeping merchant banks structurally apart from commercial banks — expressly based on the American Glass-Steagall Act of 1933.

What the workbook says, exactly and no more (Chapter 2, section 2.1.2). After the exponential growth of investment banks in the US over 1990 to 2007 and the subsequent global financial crisis in 2008, investment banks were brought under tight regulation again with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The Act sought to regulate investment advisers, derivative markets and the functioning of credit rating agencies. Specific to investment banking, it sought to regulate them by segregating banking from proprietary trading and asset management (through the Volcker Rule), and by providing for regulatory supervision for capital adequacy, quantitative limits and other restrictions.

That is the whole of the workbook's treatment. It gives no percentage, no threshold and no capital figure for the Volcker Rule itself. The only numbers in the passage are years, and the quantitative limits are mentioned without being quantified. Do not supply a figure for this rule from anywhere else.

The arc it closes. The American separation of commercial and investment banking has been made and unmade several times, and the workbook lays the sequence out:

Read top to bottom, the Volcker Rule restores in substance what the repeal of Glass-Steagall gave up eleven years earlier.

Why the rule bites on investment banks specifically. The workbook explains what a US investment bank is. Merchant banks in the United States have evolved into investment banks: along with all the functions of a merchant bank, investment banks also risk their own capital and aim to earn profits from their proprietary trading activities. In the United States commercial banks and investment banks have been separated in terms of both the sources of capital and the allowed activities. Proprietary trading and asset management are precisely the two activities a pure merchant bank does not have — which is why those are the two the Volcker Rule targets.

The Indian parallel, which the workbook draws itself. Merchant banks differ from commercial banks in that they do not take deposits from individuals or businesses. The Banking Commission Report of 1972 asserted the need for merchant banking services to be provided by public sector banks and, based on the Glass-Steagall Act of 1933, recommended a separate structure for merchant banks so as to separate them from commercial banks and financial institutions. SBI set up its merchant banking division in 1972 on that recommendation. India's modern version of the same instinct is the Strategic Business Unit requirement — which ring-fences a merchant banker's non-SEBI-regulated work rather than its trading book.

Illustrative figures. The workbook gives no Volcker Rule numbers, so the split below only applies its description of what each kind of firm does.

Vidarbha Capital Ltd is a SEBI-registered merchant banker whose parent is a scheduled commercial bank.

India never had to write a Volcker Rule, because the separation was built into the structure. The Banking Commission Report of 1972 recommended exactly that, citing Glass-Steagall, and SBI opened its merchant banking division as a separate division in the same year. Vidarbha Capital Ltd holds a merchant banker registration; its parent holds a banking licence; and the Rs 26 crore trading book belongs to neither of those two activities.

Now the American mirror. Hudson Meridian Inc is a US bank holding company with a deposit-taking bank inside it. Converted at an illustrative Rs 85 to the dollar purely so the scale is comparable:

Under the Volcker Rule the last two lines cannot sit alongside the deposit-taking bank. Banking is segregated from proprietary trading and asset management, so roughly Rs 3,698 crore of revenue has to be pushed out of the banking entity or given up.

The practical exam point is the direction of travel. The United States separated, then merged, then separated again — 1933, 1999, 2010. India separated once, in 1972, and stayed separated. The Rs 85 exchange rate above is an assumption used only to make the two tables comparable; it is not a workbook figure.

Chapter 2 (Introduction to the Merchant Banking) is 15% of the paper, and the Volcker Rule appears in section 2.1.2 (Evolution of International Merchant Banking), in the paragraph on how the United States regulated investment banks after 2008. The chapter's second learning objective is the merchant banking scenario in the Indian and international market, so this material is squarely examinable.

The questions are association questions, not calculations. The Volcker Rule is part of which Act — the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010. What does it segregate — banking from proprietary trading and asset management. Which Act differentiated commercial banks from investment banks and prevented depositories from underwriting — Glass-Steagall, 1933. Which Act replaced it — the Financial Modernisation Act 1999. Which Act created the SEC — the Securities Exchange Act, 1934. Learn the list of years, because that is what the paper tests.

• The Volcker Rule is a limb of Dodd-Frank, not a separate Act. Dodd-Frank is 2010; the workbook gives the Volcker Rule no date of its own.
• It segregates banking from proprietary trading and asset management. Both, not only trading.
• The workbook gives no figure for it. It mentions quantitative limits without quantifying them, so any percentage in an answer option did not come from this chapter.
• Glass-Steagall was relaxed in 1997 and repealed in 1999. Two dates, two different events, one paragraph.
• 1933 is Glass-Steagall; 1934 is the Securities Exchange Act and the SEC. Adjacent years, different jobs.
• Dodd-Frank also covered investment advisers, derivative markets and credit rating agencies. The Volcker Rule is only its investment-banking-specific limb.
• Do not read the Volcker Rule into Indian law. India's separation comes from the Banking Commission Report of 1972 and from the fact that a merchant banker does not take deposits. The workbook names the American rule as international context; no SEBI regulation adopts it.
• Proprietary trading is an investment banking activity, not a merchant banking one. That is why the rule is about investment banks.