How to Make Sure the Volcker Rule Survives in Court

Dec. 10 (Bloomberg) -- Vocal opposition from banks didn’t stop U.S. financial regulators from approving the so-called Volcker rule, which bans proprietary trading.

Yet the real threat to the rule never came from Wall Street. It is coming from the courts. Unless regulators can defend the rule based on principles of economics, it could go down in flames.

For a long time, courts gave financial regulators a free hand. The statutes that confer authority on those regulators are broad, and courts never felt themselves qualified to second-guess agencies with the technical expertise and the experience to understand the arcana of finance.

All this changed in 2011, when the U.S. Court of Appeals for the District of Columbia Circuit struck down a regulation issued by the Securities and Exchange Commission that required corporations to allow shareholders to provide the names of their nominees for director positions on proxy materials. The court held that the regulation was invalid because the SEC didn’t prove that the benefits of the regulation -- improving corporate governance and hence corporate profit -- exceeded the cost the rule would add to proxy contests.

The decision shocked financial regulators. The SEC, unlike the Environmental Protection Agency and other nonfinancial regulators, had never been required to perform cost-benefit analyses of its rules. Nor had the Commodity Futures Trading Commission or the Federal Reserve.

And while a later decision signaled that the court might go easier on a core financial regulation such as the Volcker rule - - as opposed to a regulation touching on corporate governance -- it remains unclear what a court will think when the Volcker rule enters its sights. It appears quite likely that the Chamber of Commerce, which brought the earlier actions, will challenge the Volcker rule as well. Meanwhile, Republican Senators Mike Crapo and Richard Shelby have introduced a bill to require financial regulators to use cost-benefit analysis even when courts don’t force them to.

The financial regulators are in a panic because, never having done so, they don’t know how to do a cost-benefit analysis of a financial regulation. Nor does the academic literature supply a formula or protocol.

To remedy this, the two of us invited top financial economists and legal scholars to a conference at the University of Chicago Law School, and asked them how financial agencies should conduct cost-benefit analysis.

To understand the answer, let’s take a look at the Volcker rule. It bans banks from using their own money to speculate in the securities markets, but also includes exceptions, allowing banks to buy very safe securities, as well as securities that hedge other risks they take, and to “make markets” for their clients, among other things. The theory behind the rule is that it will reduce the exposure of banks to risks that could cause them to go bankrupt, thus saving the taxpayer the cost of bailing them out and (if taxpayers fail to do so) avoiding potential damage to the entire financial system.

How do we quantify the expected costs and benefits of the rule? On the cost side, it deprives banks of the profit from their proprietary trading operations. This amount can be easily estimated based on the profit banks have made from proprietary trading in the past and are making today. Indeed, the banks themselves have estimated that their lost profit from the Volcker rule will be small. The broader costs to the economy beyond the lost profit are likely to be small, too; the lost profits themselves approximate the social cost of the regulation.

The benefits of the rule are harder to calculate. The most important one is the reduction of the risk that the bank will fail and cause an economic crisis, as well as the reduction in the losses the taxpayer will end up absorbing if the bank is bailed out. The magnitude of those losses can be estimated from the losses resulting from banks’ proprietary trading operations at the height of the financial crisis in 2008, a cost that was absorbed by taxpayers through the Troubled Asset Relief Program.

The Volcker rule only produces this benefit -- the elimination of the loss -- when a financial crisis occurs, and so the benefit must be discounted by the probability of a financial crisis, which itself can be estimated from historical data. To this must be added the chance that the banks’ losses will themselves trigger a crisis, multiplied by the losses such a crisis would entail for the economy. Again, these numbers can be estimated based on historical data, such as that collected by Carmen Reinhart and Kenneth Rogoff in their book “This Time Is Different.” The net effect is the monetary benefit of the Volcker rule; it passes a cost-benefit analysis only if that benefit exceeds the cost to profits.

We suspect that given the admitted small loss to the banks, the Volcker rule easily passes this test. But we stand ready to be proved wrong: The goal of such analyses is precisely to make assumptions explicit and allow policy to move from the sphere of ideological conflict to scientific calculation.

We have (obviously) simplified a difficult analysis. There are other relevant, though less important, costs and benefits that need to be addressed. Furthermore, the regulators will need to make some strong assumptions, and a great deal of work will be necessary to analyze historical data.

But this analysis of financial regulations should be a lot easier than the cost-benefit studies already conducted by other regulators, who must, for example, make valuations of the costs of being alive (as opposed to being killed in a car accident), avoiding headaches and enjoying wildernesses, and must estimate the impact of carbon on global warming without any comparable historical data. These cost-benefit analyses are acceptable because they provide more information than doing nothing at all, and they discipline the agencies by requiring them to use consistent assumptions across regulations.

Indeed, financial regulators already use a kind of intuitive cost-benefit analysis; they just don’t tell us what it is. For example, the Federal Deposit Insurance Corp. charges premiums to banks for deposit insurance based on its estimate of the risk that a bank will go bust and the cost when that happens.

Financial regulators also determine capital adequacy rules based (presumably) on their sense that excessively weak rules will threaten the financial system by allowing banks to build up too much leverage, while excessively strict rules will threaten economic growth by stifling loans.

They don’t tell us their numbers; perhaps they don’t think carefully enough about what they are. Cost-benefit analysis would require them to think carefully and disclose their assumptions. This would make regulations and their rationales transparent. That would satisfy the courts, and be good for the country as well.

(Eric A. Posner, a professor at the University of Chicago Law School, is a co-author of “The Executive Unbound: After the Madison Republic” and “Climate Change Justice.” E. Glen Weyl is an assistant professor in the economics department at the University of Chicago.)

To contact the writers of this article: Eric A. Posner at E. Glen Weyl at

To contact the editor responsible for this article: Katy Roberts at