Research note. The Volcker Rule as structural law: implications for cost-benefit analysis and administrative law

Research note by John Coates


In response to the 2008 financial crisis the US Congress introduced the “Volker Rule” – a novel law generally barring banking organizations from proprietary trading and investing in hedge and private equity funds. Before implementing the Volcker Rule, US governmental agencies are required by administrative law to follow specified notice-and-comment procedures, and courts have a role in enforcing an obligation that agencies not be “arbitrary” in finalizing regulations. Many continue to advocate that the financial agencies also use quantified cost-benefit analysis in doing so. In principle, ad law requirements should help the public evaluate the impact of the Rule and hold agencies accountable in exercising their discretion and delegated authority in choosing among ways to implement a legislative requirement. However, in a forthcoming article in a symposium issue of the Capital Markets Law Journal that focuses on the Volcker Rule, I build on prior work published in the Yale Law Journal and Law and Contemporary Problems to argue that the effects of a structural law such as the Volcker rule and its implementation by agencies cannot be reliably or precisely quantified, and courts err when they attempt to force agencies to do so under the guise of review for procedural regularity or substantive rationality.

Structural laws as a technique in the finance and banking sector

Structural laws are designed to shape behavior not only or primarily through direct commands but indirectly, by creating “structures” that will organize, constrain and channel actively the activity of their addressees. Examples include laws creating regulatory agencies and giving them discretion to supervise or regulate private actors, laws creating quasi-public corporations, clearinghouses, or other organizations, such as stock exchanges, as well as laws establishing common standards, markets or networks, or even physical structures, such as nodes of the Internet. Rather than banning undesirable behavior, as ordinary laws do, structural laws attempt to encourage desirable behavior banning, taxing or otherwise channeling activities, including activities that be unobjectionable in some contexts or if conducted by some entities. Consistent with their name, structural laws structure the economy, thereby facilitating market-enhancing regulation.

A review of the history of law and regulation of the finance sector shows that structural laws have long been used to regulate and constrain Anglo-American banking, financial institutions, and capital markets.  Initially included in bank charters, legal structures were reinforced by custom, legislation and, in the twentieth century, increasingly through regulation. Indeed, the tradition of structural laws in finance extends much farther back in time than the Glass-Steagall Act, to which the Volcker Rule has been unfavorably (but unfairly) compared, and includes activities limits on the Bank of England and the two early Banks of the United States, geographic restrictions on all US banks prior to the late twentieth century, and activities limits on holding companies reflected in the Bank Holding Company Act.

Administrative law as a tool for constraining government agencies

Alongside these banking laws, another set of structural laws grew in importance in the 20th century: administrative law – the body of statutes and court doctrines channeling and controlling the use of delegated law-making power by government officials and agencies.  To control and improve the functioning of agencies, Congress adopted a number of legal constraints, including the Administrative Procedures Act, which together with an assertive judiciary gives private actors the ability to challenge regulation in court.  To this list, cost-benefit analysis (CBA) has been increasingly advanced – in advocacy, in Congress, and in court – as an additional tool for improving financial regulations, and holding financial regulatory agencies accountable to the public.

CBA requirements call for regulatory agencies to consider or even quantify all regulatory costs and benefits before exercising their rulemaking authority and finalizing regulations, even when Congress has mandated those regulations. At its best, CBA involves thorough analysis and quantitative measurement of variety of factors and diverse data, building on existing knowledge and experience as a basis for making forward-looking predictions about the effect and consequences of a particular rule. CBA has been widely used in non-financial contexts – such as environmental and safety regulation – and generally if not universally viewed as having improved regulatory output in those domains.

The Volcker rule – legal nature and goals

The article then turns to the Volcker Rule.  That Rule has complex ambitions, but in general terms is an attempt to reduce the risk and improve the governance of US “banking entities” – essentially deposit-taking banks and companies controlling or affiliated with banks – by channeling them into the most basic and traditional core functions of banking – financial intermediation and lending – and away from two types of speculation – trading for the account of the bank and indirect investments through unregulated collective investments funds.  By prohibiting banks from engaging in these activities the Volcker Rule functions as a structural law, and is aimed at changing the banks’ organizational culture, as well as the structural connections between banks and other, riskier components of the capital markets.  By pushing out core elements of bonus-culture conventional on trading floors, it aims to reduce the powers of traders within banks, and so restore stability and boredom to banking.

The Volcker Rule, needless to say, is not without its critics, who argue that it imposes vast compliance burdens on small banks and prevents large banks from providing liquidity to crucial capital markets.  But one thing that both its advocates and its opponents would have to agree upon is that the Volcker Rule is an innovation.  The structures it seeks to impose on the financial markets are distinct from those imposed by prior laws.  It is not simply a repeat of the Glass-Steagall Act, nor is it attempting to recreate the effects of other prior laws.  It is, in sum, an important and novel structural law.

Implications of understanding the Volcker rule as a novel structural law

The bottom-line of the foregoing analysis has implications for administrative law, and particular for those with ambitions for the financial regulatory agencies to conduct CBA on important new regulations, such as the Volcker Rule.  As noted above, quantified CBA requires data for assessment, as a basis for making forward-looking predictions about the effects of a rule.  Yet by definition no such data exists for any important and novel structural law, such as the Volcker Rule.  Controversy and wide disagreement exists about even basic inputs to a quantified CBA of the Volcker Rule, such the costs and frequency of financial crisis.  In sum, any CBA of the Volcker Rule would be highly contestable and sensitive to modelling assumptions.  It would not add materially to qualitative judgments about the Rule’s likely effects that could be made with greater speed and more transparency in a conventional regulatory rulemaking process.  If administrative law is to add to the public benefits of financial regulation, at least for the large category of innovative structural laws, tools other than CBA are needed.  Those could include, for example, greater flexibility from Congress to the agencies to conduct experiments, or even mandates to do so, given likely opposition from industry participants, or at least to attach sunsets to significant regulatory changes (both regulatory and deregulatory) and coupling extensions of the changes to the outcomes of detailed retrospective reviews.

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John Coates is the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School, and Research Director of the Center on the Legal Profession.

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