The Volcker Rule seems like a well-intentioned attempt to prevent banks from taking risks that are ultimately paid for by depositors and taxpayers.
Nonetheless, as the final Volcker Rule and banks' reactions to it begin to take shape, it should be increasingly clear that the Rule shifts risk around as much as it actually reduces it.
A case in point is how banks invest in funds that primarily own corporate loans (otherwise known as collateralized loan obligations, or "CLOs"). The Volcker Rule generally prohibits banks from owning (investing in) CLOs unless the CLO limits its investments only to corporate loans. CLOs that also invest in bonds or other securities are off limits.
While this rule may seem to limit bank risk taking, it may actually to do the opposite.
Overconcentration in Loans
By preventing banks from investing in CLOs that have securities, the Volcker Rule undermines the ability of banks to invest in diversified CLOs. Banks thereby may face a higher risk of overconcentrating their exposures to loans. And since CLOs that buy securities are off limits to banks, CLO managers might instead replace securities with loans that are even riskier than bonds to qualify for bank ownership, a point highlighted by the Financial Times' Tracy Alloway. There are also some legitimate concerns about investors already piling too strong into corporate loans. Unfortunately, the Volcker prohibition may artificially increase the demand for loans from CLOs seeking to be sold to banks.
Entrenched CLO Managers
Risk taking by banks may also be increased by the ways in which they may skirt the Volcker Rule prohibition on investing non-compliant CLOs. Despite "ownership" widely being understood to mean investing in equity, under the Volcker Rule bank ownership of a CLO includes investing in CLO debt that allows the investor to replace the CLO manager. Accordingly, removing the ability of CLO debtholders to replace the manager seems to allow a bank to invest in a CLO that otherwise would be off limits. Doing so, however, could help to create CLOs with managers that are less accountable to investors.
Favoring Passive Over Managed CLOs
Another way to get around any limitations on CLO investment is to invest in a CLO structured as a passively-managed fund (under Rule 3a-7 of the Investment Company Act). Managers of passively-managed funds cannot trade the CLO's assets and must rely on the loans' cash flows to pay investors. Managed CLOs, on the other hand, are more nimble and permit the manager to buy and sell in response to market valuations of loan assets. While trading may cause its own problems, it does not seem wise for the Volcker Rule to effectively create an exception for banks that invest in CLOs that cannot sell their assets to cut losses.
The fact that a law has unintended consequences does not mean it should be repealed. But the fact that the financial crisis was more of a demonstration of how safe--as opposed to risky--CLOs truly are draws into question the need to tinker with how banks invest in CLOs in the first place.