WASHINGTON — After more than three years, 18,000 comments and one whale of a scandal, regulators are closing in on a final Volcker Rule that is expected to be tougher than its first draft.
The controversial proprietary trading ban, enacted in the Dodd-Frank Act, has proved to be one of the financial reform law's most challenging provisions to implement, forcing five regulators to work together in a lengthy process that has frustrated everyone involved. While the concept of the provision is easy to understand — forcing commercial banks to stop taking risky bets with U.S. taxpayers' funds — the specifics have spurred confusion and discord.
"We are trying to be faithful to the intent of this rule, which is to eliminate short-term financial speculation in institutions that enjoy the protection of the safety net," said Janet Yellen, President Obama's nominee to succeed Federal Reserve Board Chairman Ben Bernanke, during her confirmation hearing on Nov. 14. "The devil here is in the details."
The specifics of a final rule are a closely guarded secret, but regulators are expected to strengthen the provision in an effort to ensure it would help avoid multibillion dollar trading losses like JPMorgan Chase & Co.'s "London Whale" episode, while also offering greater flexibility to allow banks to engage in market making activities. (The agencies have not yet scheduled a meeting to vote and release the final rule.)
Among other changes, the agencies are likely to increase the amount of information firms must keep track of for capital markets transactions, according to several former regulators with knowledge of the process.
"If it's going to be called a hedge, it's going to have to be clearly identified when they enter into the transaction and monitored on an ongoing basis," said Kathryn Dick, a former top official with the Office of the Comptroller of the Currency. "All of that will have to be documented throughout the life of the transaction."
Regulators are also expected to ease up on an exception to the proprietary trading ban for market making activities in order to avoid constraining markets where policymakers would still like banks to participate, including bond markets and certain derivative markets.
"There are aspects of the language in the proposal that would have made it difficult to do market making even with highly liquid equities for those banks that have equity investment activities," said Dick, now a managing director at Promontory Financial Group. "There needed to be some changes to the market making criteria in order for banks to continue to do traditional bank trading businesses."
A final rule would also likely relieve the compliance burden by offering financial institutions an additional year, pushing off the deadline until 2015. The rule is also expected to clarify what would be considered areas of ownership interest that could be kept.
The Exemptions of Volcker
By far the biggest battle over the Volcker Rule's implementation is the exception for market making, which bankers view as absolutely vital to preserving market liquidity. Many industry representatives said the regulators erred in their initial attempt at creating that carve out when they issued their initial proposal in October 2011.
"We believe the approach the agencies took were in some sense backwards," said Rob Toomey, managing director and associate general counsel of the Securities Industry and Financial Markets Association. "It was overly restrictive and it created hard lines that were going to be very hard to implement and that could have negative consequences to the overall functioning of the markets."
But Congress was vague in how regulators were to create the exemption, leaving them to decide how detailed they needed to be in defining its scope, including how it applied to various asset classes.
On the one hand, a simple rule may not fit well with certain underlying assets; on the other, if regulators offered a complete break-down of the exemption's possible applications, it could balloon a 300-page rule into more than 1,000 pages.
The balancing act is "very tough," said Dick. Regulators, she said, are "trying to reconcile how granular should they get... and put the right boundaries in place that they don't have to worry about this every single day and the roadmap will still be pretty clear for the industry."
Michael Krimminger, former general counsel of the Federal Deposit Insurance Corp., said he expects there to be "recognition of the importance of market making" by regulators in a final rule.
But the exact wording is still hanging in the balance — and will have a significant impact on bankers.
"An awful lot in Volcker can hang on a couple of words," said a former Federal Reserve Board official, who requested anonymity because the rule had not been released yet. "There are very small variables in terms of how you shape the hedging exemption or how you shape the market making exemption that can drive pretty dramatically different impacts both in terms of business practice and in terms of what kind of compliance programs you need to build."
Bankers are hoping the final rule will not be "hard-coded in criteria" like the first proposal and be more of "supervisory exercise," Toomey said.