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.
"We don't know how they are going to come out. The fact that we are so far down the road and so late in getting this done is indicative of how difficult it is and how difficult it has been for the agencies," he said.
For now, regulators have only offered assurances that they are "close" to finishing a final Volcker Rule by the end of the year, a target date set by the Obama administration for the bulk of remaining rules under Dodd-Frank.
"We have to get this done, and when we get it done, our goal is not to be as tough as possible, or as lenient as possible," said Treasury Secretary Jack Lew in an interview with CNBC on Nov. 12. "It's to get as close to right as possible….Inevitably, we might err a little, in one way or the other. If I had to choose, I would err on just being a little bit on the tough side."
Still, regulators have been predicting the Volcker Rule's imminent finalization for more than a year, leaving persisting skepticism that they can meet the year-end deadline.
"I don't think anybody is talking to anybody," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc. "All of the agencies are sort of in meltdown mode. They're not talking and they've agreed not to talk."
Even before Dodd-Frank was signed into law on July 21, 2010, it was clear that regulators were going to have a tough time crafting the Volcker Rule.
Congress added the provision, named for former Fed Chairman Paul Volcker, late in the financial reform debate, and certain aspects of it, including its controversial exemptions, were added at the 11th hour during negotiations over the law.
Yet it has become a symbolic cornerstone of President Obama's regulatory reform agenda and a stalking horse for the debate over "too big to fail," even though critics note that proprietary trading had little to do with the financial crisis.
Regulators' first problem was each other. The law required the Fed, OCC, FDIC, Securities and Exchange Commission and Commodity Futures Trading Commission to work together to craft a final rule. But bridging the different missions and various views represented on some of the agencies' boards into a coherent rule was an almost impossible task.
They have also faced two other major challenges: defining proprietary trading in a matter that was consistent with the law's intent while still addressing ambiguities and unintended consequences; and addressing intervening events that have spurred increased scrutiny of the drafting of the rule.
"The longer you wait, the more things happen that they need to reflect and recalibrate how to position the final rule," said the former Fed official.
The Financial Stability Oversight Council offered its first look at the Volcker Rule in January 2011, offering an 81-page study and a set of recommendations.
Some saw it as a hopeful sign. Across the board, regulators among the 10 voting members of the council had agreed to keep the rule simple, yet firm; to apply metrics to monitor banks and to identify areas were activities had been expanded into by institutions; and to be sensitive to varying asset classes.
"It lead me to believe that we would have a rule out very quickly, and it would be a pretty straightforward rule that would be relatively easy to implement," said Dick. "What we ended up with was a proposed rule, of course, that was very complicated, quite specific in certain areas and a lot of narrative and questions that would suggest that regulators weren't in agreement at all on how that rule should be implemented."
But the October 2011 plan demonstrated just how far the agencies were going to have to go.
More than 400 questions had been included in a proposal, which many in the industry saw as overly prescriptive, making it crystal clear how hard it would be for policymakers to come up with specific regulatory language that reconciled the different views of the five agencies involved.
During an interagency ruling, it is often easier to pose a question then to resolve a disagreement among two or three regulators. By asking outside commenters to weigh in, regulators could forestall brokering an agreement on any particular issue. Yet that method is unavailable to them in a final rule.
"The proposal appears to have almost no filtering in the questions that were posed by the regulators," said Krimminger. "It seems to be much more a product of wide disagreements about how to do this, so everybody asked their questions."
By posing so many queries, however, regulators were also taking another risk. If a final rule does not closely adhere to a proposal, it is easier to file a legal challenge.
"The proposed rule wasn't a proposal — it was a concept release," said Petrou. "I don't see how the administrative process has been served by going from something with all of those questions to a final rule without any comment on the massive decisions that will need to be made to make a final rule out of the questions."
Others agree, suggesting that policymakers' initial proposal was far less than a formal, specified plan by regulators in how they intended to apply the rule to financial institutions. They said it was similar to a conceptual discussion found in an advanced notice of proposed rulemaking by regulators, and represented a hope that the industry would provide answers that the agencies were struggling to find.
"My read of the questions was, 'We can't agree what this rule needs to look like so we're going to ask the industry a lot of questions and hope that somebody gives us an answer we can all agree on,'" said another former regulator who spoke on condition of anonymity. "It's probably self-evident that didn't occur, because its two years later and we still don't have a final rule."
The questions sparked more than 18,000 comment letters that likely helped foment more debate and disagreement between the regulators, as each now had supporting evidence to represent their various positions.
While the banking agencies — the FDIC, OCC and Fed — largely appeared to come to an agreement between themselves about the scope of a final rule, reaching consensus with the SEC and CFTC has proved problematic. At times during the past two years, the agencies have appeared close to a final finish, only to be drawn back to the debating table by either the SEC or CFTC.
"There was earlier, a year ago even, a great deal of agreement on conceptual issues, but turning conceptual issues into statutory language is a long road," said Krimminger, now a partner at Cleary Gottlieb Steen & Hamilton.
JPMorgan Chase's $6.2 billion trading loss known as the London Whale, which occurred in May 2012, also presented more challenges. Since then, Congress has pressured regulators to ensure that a final Volcker Rule would have prevented such trades.
The losses effectively forced regulators to re-calibrate the final regulation.
"One of the key mandates to the staff from all the five agencies working on the final rule has been to ensure that London Whale, in substantive and procedural terms, couldn't happen again," Fed Gov. Daniel Tarullo said Friday in a Q&A session at a conference on shadow banking, according to Bloomberg News.
Tarullo said the London Whale was a "real-world case" that allowed the agencies to road test the Volcker Rule.
Even now, however, how close regulators are to signing off on a final rule remains a mystery. The banking agencies are reportedly weighing issuing a final rule themselves, leaving the CFTC to issue its own, different regulation.
But industry sources view that scenario as unlikely and top Treasury officials have already warned it would be dangerous.
"We think a joint rule is optimal," said Mary Miller, the Treasury undersecretary for domestic finance who has been responsible for coordinating the interagency efforts on the rulemaking, on March 4. "To have a different rule developed by a banking regulator and a securities regulator would not be helpful to the market... That requires a significant amount of coordination and discussion to think about how they can all work together. And that process takes time — it has taken time."