JPMorgan Loss Illustrates Difficulties of Adopting the Volcker Rule

When Troy Paredes, a commissioner on the Securities and

Exchange Commission, addressed the audience at the “SEC Speaks” event in

Washington D.C. earlier this year, he provided some insight into the

difficulties of crafting the banking industry regulations against proprietary

trading known as the Volcker Rule.

“The notice of proposed rulemaking is lengthy, dense, and

complex and asks hundreds of questions,” he said.

Intended to reign in risky trading by banks, the new rules

laid out as part of the Dodd-Frank Act prohibit proprietary trading by banks

and their affiliates, aside from hedging and market-making. The blurred lines

of constantly evolving financial instruments and strategies, however, has made

for a convoluted adoption process, one filled with the sort of vagaries that

executives and their compliance departments dread.

On May 10, the already contentious rulemaking became even

more so when JPMorgan Chase revealed that nearly $3 billion and counting was lost

on a bad trade. It was precisely the type of transaction, according to some

legislators, that the Volker Rule was designed to prevent.

Details are still emerging about the ill-fated strategy. The

headlines, however, have feasted on how one of the nation's most respected

banks led by a well-regarded CEO rumored to be under consideration for the

Secretary of the Treasury post, failed to heed the lessons of the 2008 market

collapse.

“The headlines seem to be turning more toward Jamie Dimon

than the regulations,” says Peter Wallison, co-director of American

Enterprise Institute's program on financial policy studies, and former general

counsel of the Treasury Department. “The issue isn't what's going to happen to

Dimon,  but what the government has been

requiring the rest of us to do through the Dodd-Frank Act and, in particular,

the Volcker Rule.”

Yet exactly what the proposed regulations require banks to

do is hardly clear. A problem flagged by the JPMorgan debacle is that there is

no clear-cut answer to whether the bank's actions would have, or would not

have, violated either the intent or language of the Volcker Rule in its current

form.

“In broad terms, if

you are hedging your aggregate risks, in a portfolio sense, that would be

permissible under the Volcker Rule and that makes it very difficult to say

what's hedging and what's not,” says Darrell Duffie, a finance professor at

Stanford University.

“The fact is that proprietary trades and hedges look very

much alike and you don't really know which is which until you really look at

all of the facts and circumstances surrounding the transaction,” Wallison says.

“Regulators trying to adopt a rule or regulation that implements the Volcker Rule

are having a great deal of trouble because it is extremely hard to draw a

bright line, in writing at least, between something that is either a hedge or

an impermissible proprietary trade. Determining a proprietary trading effort or

a hedge requires a lot of work, including talking to the trader and asking what

he did and why he did it. You can't do that with a rule.”

Before JPMorgan's loss, indications were that banks would

get the benefit of the doubt.  “There was

a consensus earlier this year that ambiguities about how the Volcker Rule

should be implemented would be resolved in favor of financial institutions,”

says Mike Stocker, a New York-based partner at law firm Labaton Sucharow.

“Bankers had some reason to be optimistic, as the industry had launched a

massive lobbying effort targeting, among other things, the scope of exemptions

for hedging and market-making.”

The scrutiny on JPMorgan's position, however, “has injected

more uncertainty into the rulemaking process, and markets don't like

uncertainty—especially about practices that have long been a huge source of income

for banks,” Stocker says.

Volcker Rule ambiguity is giving the financial services

industry other compliance-related headaches, as well.  “Everybody is waiting for the actual rules

under Volcker, so that compliance systems can be put in place in accordance

with them,” says James Fanto, Professor of Law at Brooklyn Law School. “But

even with the rules, I suspect that it will not always be easy to draw the line

between legitimate hedging and ‘speculation.' Given that risk management is

such a critical part of banking and is strongly supported by regulators, it

would be hard to imagine a scenario that would ever prohibit legitimate

hedging.  We can't simply pretend that

all the useful inventions of finance do not exist, especially if they should be

offered to and used by clients.”

“The issue isn't what's going to happen to Dimon, but what the government has been requiring the rest of us to do through the Dodd-Frank Act and, in particular, the Volcker Rule.”

—Peter Wallison,

Co-Director of Financial Policy Studies Program,

American Enterprise Institute

Last month, in advance of Congressional hearings and a July

deadline for final regulations, the Federal Reserve Board announced a two-year

conformance period before enforcement of the Volcker Rule would begin. During

that time, entities “should engage in good faith planning efforts, appropriate

for their activities and investments, to enable them to conform their

activities” and investments to the requirements of Section 619 and final rules by no later than the conformance period, according to the Fed stated.

“Volcker Czar”

The vague nature of “good faith,” although intended to aid

financial entities, adds to the confusion of how to wind down forbidden

investments, given that the definition of what those are exactly is a matter of

debate.  Adding to the challenge is

whether the five regulatory agencies involved, each with their own priorities

and sense of what's important, may differ on what constitutes “good faith” and

the degree of leniency they are willing to offer.

“Conformance will be painful for the banks as it will likely

mean reduced revenues and potentially significant impacts to certain

businesses. However, from an execution standpoint, the action plan should be

more straightforward and the actions owned by the business,” says Dan Ryan, chairman

of PricewaterhouseCoopers' Financial Services Regulatory Practice. “Compliance,

on the other hand, will be a very complex process and will require significant

teamwork among the business unit, finance, risk, operations, IT, legal, and compliance

to both design and execute. “

CONFORMANCE CLARIFIED

Below is an excerpt from the Federal Reserve Board's clarification of the Volcker Rule conformance period:

Section 13 of the BHC Act generally provides that, unless the period for

conformance is extended by the board, a banking entity must conform its activities and

investments to the prohibitions and requirements of that section and any final

implementing rules no later than 2 years after the statutory effective date of section 13.

The effective date of section 13 is July 21, 2012.

As noted in the issuing release for the Conformance Rule and the legislative

history of section 13, the conformance period for banking entities is intended to give

markets and firms an opportunity to adjust to the prohibitions and requirements of that

section and any implementing rules adopted by the agencies. Consistent with this

purpose and the statute, the Conformance Rule provides each banking entity with a

period of 2 years after the effective date of section 13 (i.e., until July 21, 2014) in which

to fully conform its activities and investments to the prohibitions and requirements of

section 13 and the final implementing rules, unless that period is extended by the board

(the “conformance period”). The Conformance Rule also provides a non-bank financial

company supervised by the board with 2 years after the date the company becomes a

non-bank financial company supervised by the board to comply with any applicable

requirements of section 13 of the BHC Act, including any applicable capital requirements

or quantitative limitations adopted thereunder, unless that period is extended by the

board.

Under the Conformance Rule, all proprietary trading activity conducted by each

banking entity must conform to the prohibitions and requirements of section 13 of the

BHC Act and any final implementing rules by no later than the end of the conformance

period. Similarly, all activities, investments and transactions with or involving a covered

fund, including a covered fund organized and offered or sponsored by the banking entity,

must conform to section 13 of the BHC Act and final implementing rules by no later than

the end of the relevant conformance period.

During the conformance period, every banking entity that engages in an activity

or holds an investment covered by section 13 is expected to engage in good-faith efforts,

appropriate for its activities and investments, that will result in the conformance of all of

its activities and investments to the requirements of section 13 of the BHC Act by no later

than the end of the conformance period. This includes evaluating the extent to which the

banking entity is engaged in activities and investments that are covered by section 13 of

the BHC Act, as well as developing and implementing a conformance plan that is as

specific as possible about how the banking entity will fully conform all of its covered

activities and investments with section 13 of the BHC Act and any final implementing

rules by July 21, 2014, unless that period is extended by the board. These good-faith

efforts should take account of the statutory provisions in section 13 of the BHC Act as

they will apply to the activities and investments of the banking entity at the end of the

conformance period as well as any applicable implementing rules adopted in final by the

primary financial regulatory agency for the banking entity. Good-faith conformance

efforts may also include complying with reporting or recordkeeping requirements if such

elements are included in the final rules implementing section 13 of the BHC Act and the

agencies determine such actions are required during the conformance period.

Source: Federal Reserve.

“Our recommendation has been that firms appoint a ‘Volcker

Czar' to both lead the design and compliance process development and then have

accountability and responsibility for Volcker compliance once the rules go live,”

Ryan says.

There is also the matter of how weaning off proprietary

trading can be accomplished on investments with a lengthier time horizon or

commitment, such as private equity funds. What rights and requirements will banks

face? How can they effectively extract themselves from these positions, and are

they barred from still entering into such arrangements during the conformance

period?

“One thing we have been hearing lately is that banks would

be responsible for testing or somehow saying that the bank— or broker dealer or

whatever entity it is— is in compliance with the Volcker Rule,” says a

corporate lawyer who, due to a potential client conflict, asked not to be named.

The problems continue for those faced with the challenge of

recordkeeping and reporting, the lawyer says. Simply put, infrastructure can't

easily scale and accommodate a moving target. Even if 99 percent of what will

be required is defined, that 1 percent of uncertainty could derail a roll-out

during the conformance period.

Even as banks await a final rule, Kim Olson, a principal

with Deloitte & Touche who leads the firm's service offering covering the

Volcker Rule, sees both specific criteria and conceptual guidance already in

place to distinguish between permissible and disallowed trades. There should

not be “supersized and concentrated types of trades that trigger or create

material exposure to high risk” and there should not be “lots of upside or

downside with respect to a particular hedge, she says”

Duffie is

hopeful that JPMorgan's losses won't add unnecessary drama and that a cautious

process will continue to unfold. “To their credit, the agencies charged with

implementing the statute have decided to take more time and try to get it right

rather than just simply going forward with the proposal they came out with last

year,” he says. “Better to have a delayed rule that works, rather than one that

is on time and doesn't work.”

Wallison, however, expects politics to play a major role in shaping

both the Volcker Rule and Dodd-Frank in general.

“Nobody in power in Washington is going to want to open up

the Dodd-Frank Act now,” he says. “It's not going to happen. I'm afraid what we

will see are regulators continuing to struggle with coming up with a rule.”