Does the government have a legal right to tell the banks what they can and cannot do with their own money? The Volcker Rule tries to do just that: banks are not allowed to engage in proprietary trading with their own capital. In this blog, we demonstrate an important justification for the Volcker Rule.

Banks occupy a unique place in the economy between investors and companies. In this role, banks are entrusted with private proprietary information of their clients and affiliates. This information is often material and sometimes adverse to the best interest of the clients. Conflicts of interest arise when executives become aware of opportunities to enter transactions for personal or bank profit which may also be detrimental to their banking clients. Examples of banking conflicts include creation, marketing, and sale of banking products such as new securities and bank loans when in possession of material, non-public, adverse information about their client firms, as well as banks’ roles in FX manipulation, LIBOR manipulation, the Enron and Madoff scandals, and banks’ severe trading losses such as London Whale trade. For more than 85 years, public policy through legislation has attempted to reign in the ensuing conflicts of interest to prevent this behavior.

The original motivation for the Glass-Steagall Act, which restricted banks from underwriting new securities, was in part to control these potential conflicts, specifically to prevent banks from using the material, non-public, information they acquire from the normal banking activities in underwriting new securities. For instance, if banks realize that a particular client is in danger of financial distress, they would have incentives to arrange for new security sales to the public and use the proceeds from those sales to pay off the bank loans.

The gradual weakening and subsequent repeal of the Glass-Steagall Act allowed commercial banks to acquire investment banking subsidiaries and allowed them to grow not only substantially in size but to also access even more information through more diverse banking activities. At the same time, proprietary trading became a major source of revenue for banks.

The subsequent financial crisis of 2008 exposed another glaring weakness of banking in the post-Glass-Steagall era. Banks had grown too big, too risky and too interconnected, many surpassing trillions of dollars in assets, interbank loans, and liabilities on and off balance sheet.   The sheer size, risk and interconnectedness of banking alone raised concerns about systemically important and too-big-to-fail banks. After numerous attempts to bring back Glass-Steagall failed, Congress attempted to contain systemic banking risk by passing the Volcker Rule in prohibiting proprietary trading, enacting consumer protection, and other ring-fencing and fire-wall provisions in the Dodd-Frank Act.

The source of the proprietary information that banks use to execute their proprietary trading programs is typically confidential. Banks do not disclose where and how they obtain this confidential information that helps them create billions of dollars of profits every year. In this paper we investigate one possible source of this information. Specifically, we investigate the importance of the private information banks acquire as part of their financial intermediary and financial advisory role for their client firms. Banks often attain insider status and become subject to insider trading reporting requirements and trading restrictions when they are hired to provide financial advice to their client firms. When banks become temporary insiders, they must also report all trades executed alongside other legal insiders.

Using this insider trading database, in an article forthcoming in Yale Journal on Regulation, we demonstrate that banks can and do access important, private, material information about their clients and trade on this information. On average, the inside information that banks acquire and trade on is highly valuable, allowing banks to earn more on 25% on their proprietary trades. Furthermore, we find that relaxation and elimination of the Glass-Stegall restrictions allowed banks to trade more frequently and earn greater amounts of abnormal profits. Since 2002, banks tend to trade and earn more than 40% abnormal profits from adverse information about their client firms.

Yet, the Volcker Rule is under attack. Legislation has been introduced aimed at repealing much of the Dodd-Frank legislation and eliminating the Volcker Rule altogether. Instead of repeal of the Volcker Rule we strongly urge that it be strengthened and enforced. Our research demonstrates that an important benefit of the Volcker Rule restrictions on proprietary trading is the elimination of incentives for investment bankers to profitably trade on material, non-public information about their clients to the detriment of their clients’ interests. Thus, we urge strong enforcement of the Volcker Rule to help contain some of the current conflicts of interest present in the banking system. Insider trading has been illegal for decades – it should not be condoned as a side benefit available to investment bankers.

This blog is based on the author’s recent Yale Journal on Regulation article, available here. S. Burcu Avci is a Post- Doctoral Research Scholar, Ross School of Business, University of Notre Dame Law School, South Bend, Indiana. Cindy A. Schipani is Merwin H. Waterman Collegiate Professor of Business Administration and Professor of Business Law, University of Michigan, Ann Arbor, Michigan. H. Nejat Seyhun is Jerome B. & Eilene M. York Professor of Business Administration and Professor of Finance, University of Michigan, Ann Arbor, Michigan.