IMF Calls Volcker Rule Hard to Enforce and Threat to Liquidity

(Bloomberg) -- A U.S. regulation designed to prevent banks from making speculative bets is difficult to enforce and may drain liquidity from the country's banking system, according to the International Monetary Fund's top financial-risk official.

The U.S. imposed the so-called Volcker Rule, named after former Federal Reserve Chairman Paul Volcker, after the global financial crisis to discourage banks from taking on too much risk. Part of the Dodd–Frank Act, the regulation restricts federally insured banks from trading securities using their own funds, a practice known as proprietary trading.

Many congressional Republicans are critical of the Volcker Rule, which is a target of the Trump administration as it prepares to roll back provisions of Dodd-Frank. While the IMF has cautioned the U.S. against weakening its banking restrictions, it's fair for regulators to revisit the merits of the Volcker Rule, said Tobias Adrian, director of the International Monetary Fund's monetary and capital-markets department.

“It is a rule that's very difficult to enforce, because it's very difficult to distinguish between what are proprietary trades and what are client trades. So it's not clear how effective it is,” said Adrian, who took over the IMF role in January after serving as a senior research official at the Federal Reserve Bank of New York. He succeeded Jose Vinals, now chairman of Standard Chartered Plc.

Read more: A QuickTake explainer on the Volcker rule

There's also evidence the Volcker Rule has curbed the liquidity provided by dealer banks, which are relied on to keep markets functioning by matching buyers and sellers, Adrian said in an interview at the headquarters of the fund, where finance chiefs from 189 nations are gathering for the institution's annual spring meetings.

“It's important for the regulatory community to evaluate trade-offs, because regulations make the system safer. But they can also impact the ability of institutions to supply credit, to make markets, and that trade-off has to be carefully considered," said Adrian, a Frankfurt native who holds a doctorate from the Massachusetts Institute of Technology.

Strong Supporter

Paul Volcker remains a strong supporter of the rule, and said in a speech Wednesday that it should be kept in place.

To be sure, the IMF isn't open to rolling back all restrictions that reined in banks after U.S. financial crisis. In its semi-annual Global Financial Stability Report this week, the Washington-based fund cautioned the U.S. against “wholesale dilution or backtracking” on financial regulations, “particularly at a time when balance-sheet fundamentals are deteriorating for U.S. companies.”

Adrian said it's crucial for U.S. policy makers to maintain strong capital and liquidity requirements, and preserve changes that made it less risky to wind down cash-strapped banks. “I would not want to see us go back to a world with less capital,” he said.

But he said it's reasonable for policy makers to examine whether small banks have been unduly burdened by regulations. “Some of the regulations that might be primarily aimed at larger banks might be too complicated to implement for smaller institutions. There are ways of regulating those institutions in a simpler way that still make sure they're safe.”

Relative Calm

Adrian takes over the monetary department at a time of relative calm in global financial markets. Still, he knows the IMF will come under close scrutiny the next time there's a crisis.

“It's always difficult to make the right call. So what we focus on is to point out vulnerabilities or particular risks,” he said. “You could think of it as emphasizing structural vulnerabilities that could give rise to the next crisis. They might not.”

He pointed to China's credit growth as an example. “That's a vulnerability,” he said. “Historically it's a dangerous development.”

To contact the reporter on this story: Andrew Mayeda in Washington at amayeda@bloomberg.net.

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Randall Woods, Scott Lanman