Volcker Rule Includes New Compliance Requirements for Banks

Federal regulators have finally unveiled their proposal for the Volcker Rule, a linchpin of the Dodd-Frank Act that would restrict proprietary trading by many financial firms and require expansive new compliance programs for banks to monitor and report on their trading activity.

The 298-page plan, presented last week by the Federal Deposit Insurance Corp. and the Securities and Exchange Commission, foremost prohibits banks from “trading on their own account,” to deter them from making risky investments such as what led to the financial crisis in 2008. (The proposal also contains a series of exemptions for when proprietary trading is acceptable.)

The proposal also calls for banks to establish an internal compliance program to monitor suspicious activities at trading desks. Member banks with significant trading activity would be required to collect measurable data and submit them to the supervisory agencies. That data would be used by regulators to identify trading violations. 

The second component of the proposed rule attempts to restrict banks and their affiliates from investing, sponsoring, or making transactions with hedge funds or private equity funds for their own accounts, unless exempted by the rule. Banks' total ownership of these funds is limited to 3 percent of their total Tier 1 assets (the combination of equity capital and retained earnings). In the FDIC draft, the agency seeks comments for 394 specific issues during the 90-day comment period ending Jan. 13, 2012.

The Volcker Rule's prohibitions are set to take effect next July, whether or not regulations are finished and adopted by then.

The proposal met a flurry of criticism from both inside and outside of the banking industry. Opponents called it vague and overly cumbersome; some lawyers say the proposal raised far more questions than it answered.

“While the original idea behind the Volcker Rule may have been a simple one—to limit the exposure of federally insured deposit institutions to the more aggressive investment behavior typically associated with hedge funds and private equity firms—the nearly 300-page proposal is just more evidence that the regulators have found it a challenging task to establish workable guidelines governing this type of behavior,” says Caleb Boggs, a partner at law firm Blank Rome.

Others say the proposal suggests that the regulators may be more willing to compromise in the final draft of the rule. “My initial observation was it is an interesting situation that they are asking 394 questions in a 298-page proposal. It shows the seriousness of the agencies to address issues in the proposal and come up with a workable solution to put the concepts in practice,” says Kevin Petrasic, partner at law firm Paul Hastings. For example, the FDIC asked if the deadlines set by the agencies are realistic, and whether banks want a gradual, phased-in approach to implement the different sections of the rule rather than all at once.

“My initial observation was it is an interesting situation that they are asking 394 questions in a 298-page proposal. It shows the seriousness of the agencies to address issues in the proposal and come up with a workable solution to put the concepts in practice.”

—Kevin Petrasic,

Partner,

Paul Hastings

The FDIC proposed several exemptions to the restrictions on proprietary trading, including those for activities related to market making, underwriting, risk-mitigating hedging, and customer transactions. At the same time, trading of certain instruments are excluded from the ban, such as debt notes from the U.S. government, its agencies, and its sponsored enterprises, as well as debt vehicles of state and local government. The exemptions are also subject to “backstop limitation,” meaning they are withdrawn if the transactions could cause conflicts of interest between a bank and its clients, subject the bank to unreasonable risk, or threaten the safety of the bank and the U.S. financial system.

Comply to Play

Banks engaged in the permitted trading activities need to establish a compliance program to monitor and to supervise trading activities. The minimum requirement is for banks at least to have internal written policies and procedures to describe, monitor, and ensure activities comply with the statute. An internal control function is needed to identify potential non-compliance areas and to prevent unauthorized trading activities.

The proposal also calls for independent testing of program effectiveness by qualified personnel and training for program participants; documents related to the program must be kept for at least five years. The proposal also says that compensation for traders must be structured to discourage risk-taking activities, and mandates that traders in the compliance program outline the risk limits, types, and hedging policies of the institution.

OVERVIEW OF PROPOSED RULE

The excerpt below provides a brief overview of the Volcker rule proposal:

In formulating the proposed rule, the Agencies have attempted to reflect the structure of section 13 of the BHC Act, which is to prohibit a banking entity from engaging in proprietary trading or acquiring or retaining an ownership interest in, or having certain relationships with, a covered fund, while permitting such entities to continue to provide client-oriented financial services. However, the delineation of what constitutes a prohibited or permitted activity under section 13 of the BHC Act often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice. The Agencies appreciate that while it is crucial that rules under section 13 of the BHC Act clearly define and implement its requirements, any rule must also preserve the ability of a banking entity to continue to structure its businesses and manage its risks in a safe and sound manner, as well as to effectively deliver to its clients the types of financial services that section 13 expressly protects and permits. These client-oriented financial services, which include underwriting, market making, and traditional asset management services, are important to the U.S. financial markets and the participants in those markets, and the Agencies have endeavored to develop a proposed rule that does not unduly constrain banking entities in their efforts to safely provide such services. At the same time, providing appropriate latitude to banking entities to provide such client-oriented services need not and should not conflict with clear, robust, and effective implementation of the statute's prohibitions and restrictions. Given these complexities, the Agencies request comment on the potential impacts the proposed approach may have on banking entities and the businesses in which they engage. In particular, and as discussed further in Part VII of this Supplemental Information, the Agencies recognize that there are economic impacts that may arise from the proposed rule and its implementation of section 13 of the BHC Act, and the Agencies request comment on such impacts, including quantitative data, where possible.

In light of these larger challenges and goals, the Agencies' proposal takes a multi-faceted approach to implementing section 13 of the BHC Act. In particular, the proposed rule includes a framework that: (i) clearly describes the key characteristics of both prohibited and permitted activities; (ii) requires banking entities to establish a comprehensive programmatic compliance regime designed to ensure compliance with the requirements of the statute and rule in a way that takes into account and reflects the unique nature of a banking entity's businesses; and (iii) with respect to proprietary trading, requires certain banking entities to calculate and report meaningful quantitative data that will assist both banking entities and the Agencies in identifying particular activity that warrants additional scrutiny to distinguish prohibited proprietary trading from

otherwise permissible activities. This multi-faceted approach, which is consistent with the implementation and supervisory framework recommended in the Council study, is intended to strike an appropriate balance between accommodating prudent risk management and the continued provision of client-oriented financial services by banking entities while ensuring that such entities do not engage in prohibited proprietary trading or restricted covered fund activities or investments.

In addition, and consistent with the statutory requirement that the Agencies' rules under section 13 of the BHC Act be, to the extent possible, comparable and provide for consistent application and implementation, the Agencies have proposed a common rule and appendices. This uniform approach to implementation is intended to provide the maximum degree of clarity to banking entities and market participants and ensure that section 13's prohibitions and restrictions are applied consistently across different types of regulated entities.

Source: FDIC Volcker Rule Proposal.

In addition, banks with more than $1 billion in trading assets and liabilities and that are engaged in permitted market-making activities will also have to collect data and provide regulators with quantitative metrics for supervision purposes, although those metrics have yet to be identified.

“[Regulators] estimated the time required for banks to implement the rule to be more than 1.8 million hours. Banks will have to use a lot of resources just to do the compliance work,” Petrasic says. He adds that banks with high volume of trading activities will have more difficulty collecting the relevant data, increasing the time needed to fulfill the requirement.

Another issue banks and regulators may encounter is the complexity in deciphering the data. Petrasic says even if some data is inconsistent, that does not necessary signify prohibited trading activities. “Banks can put this [data mining] in place, but will this data be useful to regulators?” he asks.

As part of the Volcker Rule, banking regulators are also proposing rules to restrict banks from investing, sponsoring, or entering into transactions with hedge funds or private equity funds. That ban also includes a series of exempted activities, such as: transactions that are for the purposes of asset management, hedging, foreign activity by foreign banks, loan securitizations, investment in a small-business investment company, joint ventures, acquisitions, wholly-owned subsidiaries  engaged in liquidity management, funds that are organized for asset-backed issuers, and bank and corporate-owned life insurance policies.

Bank ownership of such funds won't be allowed to exceed more than 3 percent of their total assets, calculated by combining equity capital and retained earnings. The complexity of the rule continues as each fund is governed by different permissible activities' guidelines which banks must satisfy prior to sponsoring the different types of funds.

For example, banks are permitted to sponsor and own asset-management funds only if: they are engaged in bona fide trust or commodity trading advisory services;

the covered funds are organized in connection with bona fide trust; and the banks have clear written disclosures to investors that these funds are not insured by the FDIC—and those are just three criteria, among many more that are too elaborate to list here. Bank-owned funds are also subject to the compliance program requirement similar to that of proprietary trading.

“This poses a fairly significant shift in the aspect of banks' line of businesses,” Petrasic says.

During the comment period, he expects to see a high volume of remarks on the timing of the rule, compliance program requirements, the different exemptions, and the businesses of hedge funds and private equity funds currently owned by banks.