The Perils of a Middle Road to Regulating Systemic Risk: The Volcker Rule’s Risk Backstop Provisions
Written By: Jai R. Massari & Gabriel D. Rosenberg
The Dodd-Frank Act, enacted after the global financial crisis, requires U.S. financial regulators to define and regulate systemically risky firms and activities—a truly Sisyphean task. In this Essay, we identify two paths regulators have taken: a “descriptive approach,” which involves restating the Congressional mandate as regulatory text and creating a qualitative, bespoke process for the identification of systemic risks; and a “prescriptive approach,” which involves adopting detailed, specific, and data-driven rules that clearly delineate firms or activities that do, or do not, pose systemic risk. Each of these approaches has benefits and drawbacks—most notably the tradeoff between ex ante certainty of application (prescriptive approach) and flexibility (descriptive approach). We then describe a third approach—implemented in the Volcker Rule—of layering a broad descriptive prohibition onto a set of detailed, prescriptive rules. This middle, “backstop” approach is a tempting way for regulators to capture the benefits of both the descriptive and prescriptive approaches. However, we argue, in practice the backstop approach accentuates the drawbacks of each of the descriptive and prescriptive approaches, rather than their benefits, resulting in ex ante uncertainty while tying the hands of regulators. We therefore suggest that regulators avoid the temptation of the backstop approach when seeking to identify systemically risky firms or activities, but we also provide suggestions for minimizing these adverse outcomes should regulators nonetheless choose this approach.
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