As Reform Talks Enter Final Day, Volcker Rule Likely to Get Tougher

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WASHINGTON — House and Senate conferees are expected Thursday to add language to the final regulatory reform bill that would strengthen a provision to ban proprietary trading and restrict investment in private-equity firms and hedge funds.

The committee is scheduled to wrap all remaining issues up by Thursday evening, including the Volcker Rule and another provision that would force banks to spin-off their swaps units.

The final Volcker provision was expected to be even tougher than a measure sought by Sens. Carl Levin, D-Mich., and Jeff Merkley, D-Ore. during debate on the Senate version of the bill.

Although the revised amendment was not finalized by late Wednesday, sources said it would further narrow the number of permitted activities under the Volcker Rule and prohibit transactions that create conflicts of interest.

"It's a very bad blow for the banks," said Doug Landy, a partner at Allen & Overy LLP. "To some extent most of them have resigned themselves to the proprietary trading issues. I think most banks have felt the unfettered investments in funds would be banned too, but they hoped they'd get something too. But the conflict-of-interest provision is a nightmare, because it conflicts with how banks operate and create products."

The debate over the Volcker Rule was delayed a day as the Senate continued to finalize its offer.

Senate Banking Committee Chairman Chris Dodd said late Wednesday that staff were hoping to finish a draft by Thursday morning.

Sources said they expect it to give banks some limited relief from the investment ban. Although an exact level was not yet set, sources said banks would be able to invest as much as 2% of the equivalent of their Tier 1 capital in a hedge fund or private equity firm. That was far less than changes sought by Sen. Scott Brown, R-Mass., who wanted to add a series of exemptions to the measure and allow up to 10% of investment.

Dodd said a final number was hard to determine.

"I can't come up with a number that doesn't work for me either substantively or politically," he said. "I've got both tracks that are in play and that's the job of the chairman here, to try to pull this together and get them lined up so the substance and the politics work. I'm not there yet."

While sources said Levin and others are not pleased about allowing any investment, many observers said a 2% level was too low to help banks.

"It's trivial," said Oliver Ireland, a partner at Morrison & Foerster. "It's so small, I don't see why you would want to do that."

But others said it may still allow some larger banks to invest in hedge funds and private-equity firms.

"It depends on the institution," said Satish Kini, a lawyer at Debevoise & Plimpton LLP. "For large institutions with lots of capital that may give them some room and for smaller institutions that may not. I don't know if lower than 2% is so small, it is effectively a bar."

Democrats were interested in reaching some kind of accord with Brown, one of only four GOP members who voted for the reform bill in the Senate. Democrats are likely to need Brown's vote to ensure the bill has the 60 votes necessary to move it to final passage.

"This has always been a bit of a balancing act," said Ed Mills, research analyst and vice president of financial policy research at FBR Capital Markets & Co. "There is the need to appease both sides of the spectrum. From the left you have Merkley and Levin pushing for as strong a rule as possible, and from the right or middle there is the need to keep 60 votes. It was clear Scott Brown was willing to be the 60th vote on cloture, so there was a need to allow him to limit this impact."

Also under discussion was how strict an investment adviser prohibition would be. Under the draft Merkley-Levin amendment, banks that serve as investment advisers would be banned from conducting affiliate transactions or cross-trading with firms they are assisting.

But lawmakers were negotiating whether that restriction should be watered down or lifted altogether.

In most other ways, however, the Senate conferees appeared to be strengthening the original Volcker Rule language included in the bill.

Under the revised provision, the prohibition on proprietary trading and curbs on investments would be statutory, rather than left to regulators to study and implement. The final language is also expected to give regulators some flexibility to implement the restrictions but prevent them from ignoring it entirely.

Senate conferees were also expected to further reduce the number of permitted activities from the original Merkley-Levin language and prohibit any transaction that creates a conflict of interest.

Under the provision, risk-mitigating hedging activities and underwriting derivatives to serve clients would still be permitted.

Since the Senate had not yet finalized its language on the Volcker Rule, it is unclear if the House will seek changes to it.

It also remained unclear on Wednesday if the added Volcker language could be used as a potential compromise to remove a measure added by Senate Agriculture Committee Chairman Blanche Lincoln that would force banks to spin off their derivatives units.

Some observers said the final Volcker language could be changed to deal with derivatives, potentially rendering the Lincoln provision moot.

Speaking with reporters during a break in conference, House Financial Services Committee Chairman Barney Frank made it clear the two provisions were related.

"Volcker also talks about activities not being in the bank," Frank said. "They don't completely match up, but there is some overlap."

Bank lobbyists have vigorously fought to remove the Lincoln amendment since it was added to the Senate regulatory reform bill last month. They argue it will cost firms millions of dollars to spin off their swaps desks.

They have received backup from federal regulators. Both Federal Reserve Board Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair warned that the provision could make the system riskier by forcing derivatives units underground or overseas, where they would not be regulated.

So far, at least, there has not appeared to be much sign that Lincoln wants to compromise. Still, Frank made it clear the issue is not resolved.

"It's a substantive problem for us," he said. "There is a difference of opinion. Many of the New Democrats and many of the New York people have some issues with Blanche Lincoln, and it is an issue that is now being discussed."

Conferees also agreed to a compromise on a provision from Rep. Jackie Speier, D-Calif., that would subject banks to a new statutory leverage ratio.

Under the agreement, the Fed would require any systemically important firm to maintain a debt to equity ratio of 15 to 1 if the systemic risk council determines the company poses a threat and that the imposition of a leverage limit would mitigate risk.

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