Eliminating Conflicts of Interest in Banks: The Significance of the Volcker Rule

Public policy has been focused on controlling the conflicts of interests in banks for the last eighty-five years with limited success. Banks have a unique place in the economy as intermediaries between investors and companies, allowing them to obtain significant private, proprietary information. Public policy is focused on trying to ensure that banks do not misuse this information for their own benefit to the detriment of their clients. This is a tough task.

In this Article, we focus our attention more specifically on proprietary trading. We exploit a unique dataset that allows us to observe the information banks receive and what they do with it. When banks are hired as investment advisers, they become temporary insiders, and they are required to report all transactions in their client firms’ stock to the SEC. Using this unique dataset, we analyze the kind of information banks acquire about their clients as part of their financial intermediary and advisory roles. Our data show that this information is highly valuable to banks. Specifically, banks have been able to earn more than 25% returns above market from proprietary trades on this information. Furthermore, after Glass-Steagall’s prohibitions against commercial banks engaging in investment banking activities were relaxed, this return on investment rose to a whopping 40%.

The Volcker Rule was enacted to aid in reducing systemic risks in the banking system and, among other purposes, to eliminate conflicts of interest that arise when banks profit at the expense of their clients. Scholars have previously argued that the Volcker Rule should be vigorously enforced to eliminate temptations to trade on material non-public information for banks’ benefit and against their client’s interest. We provide important empirical research for this proposition by showing that banks indeed trade on non-public information and earn higher than expected returns.