The Volcker Rule was designed to curb big banks' ability to engage in risky and speculative securities trading activities in an effort to prevent future U.S. government bailouts of financial institutions deemed too big to fail. This rationale disappeared when Congress and regulators expanded the rule to include banks of all sizes. Under the final statute and regulations, a small community bank is subject to the same proprietary trading and hedge fund ownership restrictions as a holding company with over $1 trillion in assets. In addition, certain extensive and detailed recordkeeping requirements apply to banks with total assets far below any traditional notion of a large financial institution.
In our view, regulators responded to a perception that financial oversight was "too cold" in the run-up to the financial crisis by moving to a system that is "too hot" in their efforts to implement Dodd-Frank. Especially with respect to small and midsize banks, the regulatory pendulum has swung too far. Nevertheless, the compliance deadline is looming. We suggest that small and midsize banks take three immediate steps to implement a properly tailored Volcker Rule compliance program that is "just right" for their business objectives and compliance budgets.
First, study the Volcker Rule regulations carefully to understand which provisions actually apply to your institution. For example, a community bank with $5 billion in total assets must comply with the Volcker Rule's proprietary trading and hedge fund ownership restrictions, but is not subject to heightened recordkeeping requirements.
Second, consider whether it is genuinely important to engage in the activities permitted under the Volcker Rule, such as proprietary risk-mitigating hedging activities. Attempting to shoehorn your institution's activities within an exception will necessarily increase legal and compliance costs. If those costs, or the diversion of management resources necessary to comply with the Volcker Rule requirements, outweigh the value of the permitted hedging activities, discontinue them. This will allow you to implement a drastically scaled-back compliance program.
Third, reduce the burden of the Volcker Rule's compliance program mandate whenever possible. For example, if your institution has decided not to engage in any proprietary trading or hedge fund ownership activities, you may be able to satisfy the compliance mandate simply by adding appropriate Volcker Rule references to your existing compliance materials. If your institution does engage in permitted varieties of these activities, consider limiting the number of employees with the authority to do so.
The banking industry and even regulators are increasingly aware of the Volcker Rule's negative impact on smaller institutions. Shortly after the Volcker Rule regulations were issued at the end of last year, community banks sued the regulators for arguably including in the restrictions certain trust-preferred securities derivatives. This prompted federal agencies to issue an interim final rule clarifying that the derivatives were not included. Then, in a May 2014 speech, Federal Reserve Governor Daniel Tarullo suggested that policymakers reconsider the Dodd-Frank Act's burdens on small and midsize banks.
Current reform efforts may eventually lead to more proportional application of the Volcker Rule. In the meantime, small and midsize banks would be ill-advised to take a wait-and-see approach. Instead, they must understand the Volcker Rule and proactively design a compliance program that is consistent with their goals and budgets. The Volcker Rule does not need to be a compliance headache for your institution, but it will be if you do not begin planning now.
Anthony J. McFarland (partner), Brian R. Iverson (associate) and Annie T. Christoff (associate) are attorneys at Bass, Berry & Sims PLC. They recently authored an in-depth discussion of the Volcker Rule and other securities regulations in "Securities Laws for Banks," part of Bloomberg BNA's Banking Practice Portfolio Series.