Volcker Rule: Liquidity, Systemic Risk, and Financial Reporting Quality

Abstract

We investigate whether the market perceives the Volcker Rule as the right prescription for its stated objectives. Using a large and inclusive sample, we assess the market’s perception of the rule and its effectiveness using both the equity and credit default swap (CDS) market responses to the announcement of the rule. Our results show that the equity market response to the Volcker Rule announcement is positive while the credit default swap market response is negative, suggesting that the capital markets perceive the Volcker Rule as a positive regulatory measure. We conduct further analyses to determine whether or not there is a different market reaction based on systemic risk, liquidity, level of proprietary trading, and financial reporting quality. We find that banks with higher systemic risk, higher levels of proprietary trading, higher levels of illiquidity, and worse financial reporting quality are more likely to be negatively impacted by the Volcker Rule. We also examine banks’ characteristics before and after the announcement of the rule and find evidence that indicate a positive impact of the Volcker Rule.

Keywords: Volcker Rule, systemic risk, proprietary trading, liquidity

JEL Classification: G21, G28, M41, M48