United States

The Volcker Rule and its implications on the banking industry

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Banking regulators gathered at an FDIC board meeting on Oct. 11, 2011, and released a 298-page proposal entitled "Prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private-equity funds," otherwise known as the Volcker Rule. With the arrival of the Volcker rule, named after former Federal Reserve Chairman Paul Volcker who pioneered the rule, some significant restrictions on the proprietary trading activities of the banking industry in the United States will come to pass. The proposed Volcker rule will prohibit U.S. banks from conducting any proprietary trading or trading for their own profits by engaging in the trading of securities, derivatives and other financial instruments. It will also limit U.S. banks to a maximum 3 percent position or stake in their investments in hedge funds and private-equity funds. The Volcker Rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). Several groups from the industry are working on the final details, including representation from the Federal Reserve, Securities and Exchange Commission, FDIC, CFTC and the Treasury Department. The proposal includes 350 questions that the regulators would like interested parties to weigh in on. Public commentary on the Volcker Rule will be allowed through Jan. 13, 2012.

The Volcker Rule comes as a direct response from the Federal Government to the 2007 – 2009 financial crises. The primary objective will be to prevent the banking industry from engaging in risky type trading for their own profits. A U.S. bank would no longer be able to focus on proprietary trading, but rather they would have more of a customer focus. It appears that the largest banks, Goldman Sachs Group Inc., Bank of America Corp., and JPMorgan Chase & Co. would be impacted by the Rule the most.

The proposal is quite lengthy and may be difficult for both banks to comply with and regulators to enforce. Frank Keating (chief executive of the American Bankers Association) said in the following statement: "Only in today's regulatory climate could such a simple idea become so complex, generating a rule whose preamble alone is 215 pages, with 381 footnotes to boot. How can banks comply with a rule that complicated, and how can regulators effectively administer it in a way that doesn't make it harder for banks to serve their customers and further weaken the broader economy?"

Exemptions to the Rule
The Volcker Rule does have its exemptions and one notable one that has garnered a lot of controversy lately deals with hedging portfolio risk. Hedging is designed to mitigate the risk from trading activities that a bank engages in. A hedging transaction would offset whatever risky transaction the bank enters into as a safeguard. The original language in an earlier draft defined hedging as trades that were tied to specific bets. However, that language has now changed in the new proposal and suggests that the hedging activity could apply on a portfolio basis. There is a fear that the line between what is considered hedging and proprietary trading will be blurred if the language includes hedging on a portfolio basis. This would mean that a bank would continue to be able to enter into hedging activities on a large-scale basis, and potentially hedge against the aggregate risk of one or more trading desks. Opponents of portfolio hedging believe that this would undermine the spirit of the Volcker Rule and provide the loophole that Wall Street is looking for. Proponents, on the other hand, believe that an inability to hedge portfolios would create new risks and significantly increase the costs of hedging.

Another exemption would be for banks that are market makers for their customers. Market makers need to be able to provide liquidity in the market by having the ability to buy or sell on behalf of their customers. There are seven criteria that banks would have to meet in order to utilize this exemption:

  1. Must confine revenue to fees, commissions and the spreads between bid and ask prices, rather than income from market value appreciation
  2. Must have a comprehensive compliance program
  3. Must engage in bona-fide market making activity
  4. Market making activities must be designed to not exceed the reasonably expected near-term demands of its clients
  5. Must follow the proper registration rules under federal commodity and securities laws
  6. Must have compensation practices in place to prevent undue risk-taking
  7. Must ensure that hedging transactions are related to the market making activity

There are also restrictions proposed by the Volcker Rule that would extend offshore. Transactions that are affected outside of the United States must meet four criteria to meet the exemption from the Volcker Rule:

  1. The transaction is conducted by a bank not organized under U.S. laws.
  2. No party to the transaction is a U.S. resident.
  3. No bank employee involved in the transaction is physically located in the United States.
  4. The transaction is executed wholly outside the United States.

There is concern in the banking industry that complying with the Volcker Rule could place domestic banks at a disadvantage compared to their foreign competitors because foreign competitors will not have the same restrictions in their home countries.

Other exemptions exist for trading in certain government obligations, trading on behalf of customers, investing in SBICs and public interest investments, trading for the general account of insurance companies, and organizing and offering a covered fund (including limited investments in such funds).

Other aspects of the Volcker Rule
Also on the table is the possible deletion of the original requirement that CEOs would have to pledge that their respective firms are not engaging in any proprietary trading activities.

The Volcker Rule also aims to raise the level of transparency in the financial sector. There is a stipulation in the proposed rule that would have all banks report their portfolio holdings to a central repository. Regulators would then have more information about how much risk these banks were taking on in an ongoing effort to thwart any significant threats to the entire financial system.

Todd E. Rosen, CPA, Director, RSM US LLP, 212.372.1715

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