THE VOLCKER RULE, MARKET-MAKING ACTIVITY, AND CONTRIBUTIONS TO SYSTEMIC RISK
The Volcker Rule, a major component of the Dodd-Frank Act, aimed to reduce structural conflicts of interest in the financial institutions whose deposits are insured by the Federal Government. It was argued that by eliminating proprietary trading, equity funds, and hedge funds from these institutions, there would be less systemic risk produced by these firms. A major criticism of the Volcker Rule has been that the fine line between proprietary trading (banned) and market-making transactions (not banned) will result in ambiguous enforcement and ultimately a decline in client-based market-making activity. Through a fixed-effect analysis of data from the financial institutions affected over the period leading up to and during implementation (2009-2014), this paper examines preliminary evidence of those two claims: that reductions in banned activities is correlated with reductions in market-making activity and has little correlation to reductions of systemic risk. This paper arrives at decidedly mixed results, with functional form greatly affecting the direction, magnitude, and statistical significance of the resulting correlation estimates.
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