On Regulatory Responses to the Recent Crisis: An Assessment of the Basel Market Risk Framework and the Volcker Rule

Banks around the world suffered huge trading losses in the recent crisis. In response, the Basel Committee on Banking Supervision (2011a) provides a revised framework to determine the minimum capital requirements for their trading portfolios. Moreover, the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) imposes certain restrictions on the composition of the trading portfolios of U.S. banks through the ‘Volcker Rule.’ Our paper assesses the effectiveness of the Basel framework and the Volcker Rule in preventing banks from taking substantive tail risk in their trading portfolios without capital requirement penalties. We find that the Basel framework is ineffective in preventing banks from doing so, but that the Volcker Rule is beneficial in that it partially mitigates this ineffectiveness. We also suggest two alternatives to the Basel framework and discuss the impact of the Volcker Rule if either one of them is adopted.