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Five agencies released a final rule Tuesday that would ban proprietary trading by banks and limit their investment in hedge and equity funds.
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Cheat Sheet: Regulators Release Specifics on the Final Volcker Rule

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WASHINGTON Five federal agencies unveiled a highly anticipated final rule on Tuesday after taking three painstaking years to craft a ban that would prohibit banks from gambling with U.S. taxpayer dollars.

In more than 71 pages, banking and securities regulators detailed precisely how they planned to strike a balance between banning proprietary trading while providing banks with the flexibility to continue to engage in certain market-making activities.

The controversial ban, enacted in the Dodd-Frank Act, has proved to be one of the financial reform law's most challenging provisions to implement, forcing the five agencies to work together in a lengthy process that has frustrated everyone involved.

The Federal Deposit Insurance Corp. and Federal Reserve Board were the first agencies to approve the final Volcker Rule on Tuesday morning, despite a brief snowstorm that shuttered the government. By mid-day, the other three agencies involved the Securities and Exchange Commission, Office of the Comptroller of the Currency and the Commodity Futures Trading Commission had also approved the rule.

Following are how regulators tackled various issues in the final rule:

Proprietary Trading

Although the final rule bans proprietary trading, it carves out several exemptions, including one to allow banks to engage in trades that are designed to buffer against losses in a portfolio of assets, known as "portfolio hedging."

Financial institutions typically use hedges to help manage risks that often come from trading with clients. But it's widely acknowledged that matching one-for-one is often difficult to attain, thus banks have used portfolio hedging to manage a broader swath of risks.

In the final rule, the agencies specified that exemptions would be applied to hedging activity that is "designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity."

Going forward, banks will be required to document each transaction, explaining the rationale for "certain transactions that present heightened compliance risk." The provision is designed to prevent trading losses like the $6.2 billion fallout from JPMorgan Chase's infamous "London Whale."

Financial institutions will also be required to keep a close eye on the effectiveness of their hedges, and monitor and recalibrate as necessary on an ongoing basis, regulators said. Firms will be required to analyze its hedges along with performing a correlation analysis for each trade.

The final rule will allow banks to trade on behalf of their customers in a "fiduciary capacity or in riskless principal trades and activities of an insurance company for its general or separate account."

'Market Making'

Regulators also granted institutions some discretion in figuring out whether certain trades are permissible as market-making activities. In drafting the final rule, regulators sought to avoid constraining markets where policymakers would still like banks to participate with the caveat of ensuring firms' acted in accordance with certain risk-management procedures.

Regulators have largely agreed market making is a good thing, but they have faced a challenge in defining such activities, where banks buy, sell and hold securities to fulfill demands by clients.

In prescribing the language, U.S. agencies put some boundaries on the exemption, specifying a "firm's trading desk's inventory in these types of financial instruments would have to be designed not to exceed, on an ongoing basis, the reasonably expected near-term demands of customers."

Firms will be required to demonstrate in their analysis "historical customer demand" and provide the current inventory of financial instruments they hold.

Banks had been critical of how regulators tightly defined market-making, claiming by doing so it would hurt their ability to serve clients and negatively impact the overall functioning of the markets.

Covered Funds

The final rule prohibits banks from owning and sponsoring private equity funds referred to as covered funds. The definition of a covered fund includes any issuer that could be an investment company. It also includes certain foreign funds and commodity pools.

The final rule excludes, however, certain covered funds such as wholly-owned subsidiaries, joint ventures, and acquisition vehicles, as well as Securities and Exchange Commission-registered investment companies.

Regulators also set a cap on the amount of investment that a banking entity may hold up to 3%. It also established the aggregate value of all ownership interests of the banking entity not to exceed 3% of the Tier 1 capital requirement.

CEO Certification

Under the final rule, bank executives of the largest firms will now be required to certify annually that their firm is in compliance with the regulation. Executives from smaller sized entities that are engaged in modest activities would be subject to a much more simplified compliance regime.

Regulators added the so-called "CEO attestation" to the final rule as a means to heighten accountability at firms by forcing top executives to be aware of the kinds of trades happening inside their institution.

Banks will now have to maintain documentation so that the "agencies can monitor their activities for instances of evasion."

The requirement was not envisioned in the initial plan even though the Financial Stability Oversight Council, an interagency group headed by the Treasury secretary, had recommended it as part of a study undertaken ahead of the release of the 2011 proposal.

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Comments (1)
If only the technologists were at the table we might have gotten a realistic Volker rule, one that is implementable.

The Financial System is a "system" a huge, almost indescribable interconnected web of computers and networks. Financial institutions are huge technology factories. We have already exceeded the capacity of the "system" to absorb more incremental change of regulation. This on top of the crumbling infrastructure of the financial system and the Rube Goldberg legacy technology each financial institution lives with day by day.

We see the dysfunction every day in market shutdowns, stolen credit card portfolios, failed IPOs, swaps trades that overwhelm regulators computer capacity, false starts on trade audit trails, inability to aggregate data for systemic risk analysis because regulators failed to define data formats, inability to aggregate risk for each financial institution because of incompatible data across business silos, etc. etc. etc.

The only way the new information demands of the Volker rule i.e. not exceeding customer near term demands, or explaining trades that heighten compliance risk, can be implemented effectively is through technology. This, in turn, will require new stochastic methods for estimating client trading demand and correlations of each hedged trade. The volume is too huge and the speed of trading to fast to expect any of this to be done manually.

The feel good at-a-boy back slapping of regulators will surely be replaced by the reality of unintended consequences. I for one would not like to be the CEO signing off on the "attestation" provision under the Volker Rule requirements.
Posted by Allan Grody | Wednesday, December 11 2013 at 7:13AM ET
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