WASHINGTON — The Volcker Rule has developed a reputation in the banking industry as one of the most vexing and resented post-crisis regulatory reforms.
The industry derides the proprietary trading ban enacted in the Dodd-Frank Act as costly, its standards vague and subjective, and its benefits few. The Trump administration has heard those concerns, and agencies have made efforts individually and together to reduce the compliance burden. But reforming a rule bound to a strict statute is not easy. Regulators must choose between subtle but expedient pin-prick changes or a more drastic overhaul that could take more time.
Treasury Secretary Steven Mnuchin explained at a conference in May what he sees as the main problem with the Volcker Rule: its subjectivity. He indicated that the rule could be simplified with a more objective distinction between in-house trades, which are banned, and permitted trades done on behalf of a client.
“The biggest problem with the Volcker Rule right now is, we all know that when you’re sitting in a room with two Bloombergs and a telephone and that’s all you do, that’s proprietary trading,” Mnuchin said. “But this should be relatively simple. If you’re sitting in a customer business and you’re doing customer trades and you’re facilitating the business … I think the right thing to conclude is that you’re acting within the context of the customer business.”
In its June regulatory blueprint, the Treasury Department said that, while the Volcker Rule doesn’t need to be scrapped entirely, a handful of critical areas require immediate attention. Specifically, the report called for changes to the definition of proprietary trading; changes to the compliance programs at the agencies; changes to the definition of covered funds; a carve-out for community banks; and greater coordination among bank regulators in their enforcement and enforcement guidance policies.
Timothy Keehan, vice president and senior counsel at the American Bankers Association's Center for Securities, Trust and Investments, said the industry’s expectation is that the regulators are taking a comprehensive look at the rule.
“The regulators want to take a look under the hood and see what they can do to make this Volcker vehicle run better,” Keehan said. “Now, the question is how much work the car needs … but I think they want to take a look at the engine itself and see if the engine needs repair.”
But Andy Green, managing director of economic policy at the Center for American Progress, said the statute itself is uncommonly specific in how it treats certain definitions and requirements related to the Volcker rule, meaning the regulators face constraints in their quest to loosen the terms of the rule.
“The statute is one of the most specific and binding parts of Dodd-Frank in general,” Green said. “The regulators don’t have unlimited flexibility.”
Green said those restrictions will likely lead the regulators to conclude that, at least as it pertains to some aspects of the rule that the Treasury objected to in its report, regulators have two choices in changing the effect of the rule.
“One is reopening the rule itself and attempting to do a new regulation that undoes some of the choices that ended up in the regulation,” Green said. “The second approach is leaving the regulation in place but lightening up the enforcement and implementation of that regulation. I think that is the more likely scenario for a variety of reasons.”
Mike Alix, a partner and the financial services consulting risk leader at PricewaterhouseCoopers, agreed that there are clear advantages — both in terms of expediency and flexibility — to making supervisory changes outside of formal rulemaking. But there are risks to such a move as well, such as inconsistency between agencies and the potential for legal challenges to supervisory changes that some parties think go too far.
“They can do it internally rather than publicly,” Alix said. “They can have their examination schedule, the scope of examination, the questions they ask, etc. That’s a bit risky — it’s always safer to do it within the formality of rulemaking.”
Among the changes outlined in the Treasury report are relatively straightforward, including the steps on how different agencies that enforce the rule interact with each other. (Regulators responsible for the rule including the banking agencies — Federal Reserve Board, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. — and the Securities and Exchange Commission and the Commodity Futures Trading Commission.)
The agencies could undertake those changes informally via some non-regulatory measure, like an interagency memorandum of understanding. But others, like the definitions of "proprietary trading" or "covered funds," would require a formal regulatory change.
The agencies have already started on a change to the rules aimed at either exempting or substantially reducing the Volcker Rule compliance burden for community banks, but that work may be rendered moot by the regulatory reform package moving though the Senate, which includes a carve-out from Volcker compliance for banks with less than $10 billion in assets.
The agencies also appear to be focusing their attention on addressing definitions of key terms as well as a provision known as “rebuttable presumption” that was baked into the existing Volcker regulations. That provision essentially puts the burden on the financial institutions to prove that a particular trade is within the confines of the Volcker rule, Keehan said, rather than putting the burden on the agencies to prove that it is not. Keehan said that provision has been especially troubling to banks.
“That goes into the head of a trader,” Keehan said. “You want to make it as objective as possible and not make it a psychological or speculative exercise. So to get rid of the rebuttable presumption I think goes a long way toward resolving that issue.”
Alix said that, even in those narrow areas — particularly as it pertains to the covered funds definition —the statute makes it challenging to offer the kind of relief that banks would likely prefer. A more generous interpretation would likely require legislative changes, which may not be forthcoming in the near term.
“Some of those things, particularly the covered funds stuff, would require congressional action,” Alix said. “But whatever they can do away from legislative action, they’re trying to do.”
Green said that regulators may run up against challenges particularly in revisiting the rebuttable presumption clause. The law says that proprietary trading is forbidden, while market making and hedging are allowed, he said, and it would be hard to construe the law in such a way that puts the onus on regulators.
“Rebuttable presumption really arises from the statute,” Green said. “Even if it’s not formally in the statute, it pushes in that direction. How much they could mess around with that within the regulation and not run afoul of what a court says? Debatable.”
The challenges of developing an interagency rule — even one where all five agencies are on the same page and agree on the principles at stake — are considerable, as evidenced by the uncommonly long time it took the Obama administration to develop the first proposed rule, which was published in December 2013, implementing the Dodd-Frank measure.
Thomas Vartanian, a partner at Dechert LLP and former regulator, said that what a new rulemaking implementing future reforms will look like will depend a great deal on which of the agencies takes the lead in crafting the actual regulatory language, and the extent to which the specifics are left to the agencies or are dictated from the top-down or bottom-up.
“In any interagency effort to write or rewrite a rule, the agency that has the power of the pen has a lot to say about how the rule ends up,” Vartanian said. “But it also depends on whether the policy goals are set from the top or bubble up from the staff.”
Alix said that, in this case, there is reason to believe that the agencies will have their ducks in a row to a greater extent than they did when they issued the rule initially under the Obama administration. Each has a few years of experience implementing the rule, he said, and have a better idea of where the pressure points are than they might have had at the outset.
“I think there is real promise for better cooperation and collaboration than there has been,” Alix said. “They will be constrained by their statutory authorities, but they will be better in terms of having a consensus view on what to do and divvying up among the various agencies responsibilities for doing it.”
Keehan agreed, saying he expected a proposal to emerge from the agencies “in the first part of next year.”
But Green said that regulators should keep an eye toward the supervisory value of the Volcker rule. He said they should not be taken in too deeply by the banks’ argument that the Volcker rule is too hard to comply with because it requires regulators to ascertain an individual trade’s intent.
He said banks know — and regulators can determine — whether a trade is meant to fulfill market-making or hedging goals, or short-term proprietary gains, and one of the regulatory advantages of the Volcker rule is that it requires the banks to keep track of what their traders are doing and why.
“Are there [traders] … engaged in moving the apples off the shelf so there aren’t a lot of spoiled apples there? Or are they engaged in putting a lot of apples in a warehouse out back because they think the price of apples is going to go up?” Green said. “That is a knowable thing, from looking at customer turnover, inventory — you can know that, and if you don’t know that, you have a big risk management problem.”