The Impact of Volcker Rule on Bank Profits and Default Probabilities.

Abstract

Volcker rule restricts U.S. banks’ trading activities. We analyze the impact of the rule by using two stochastic control models that we calibrate to a sample of U.S. banks. The first model considers a bank’s earnings from its banking and trading books separately. The second model attempts to improve the first model by considering the bank’s earnings through recapitalization.

Banks trade to hedge their cash flows and to increase their value through alpha generating trading strategies. If a bank’s trading alpha and its correlation between trading and banking cash flows are both zero then it is optimal for the bank not to trade at all.

According to our models and sample data, more than 99% of the trading value comes from alpha bets and, thus, hedging has only a small positive impact. Further, trading explains about 1% of the banks’ equity value and the banks could lose almost that value due to the Volcker rule. We estimate a simple worst-case scenario by solving how much the banks should raise their loan rates to compensate the value decrease from the Volcker rule. This loan rate increase is on average about 1 basis point. Finally, the Volcker rule may raise default probability up to 15% and by 0.24% on average.