Nearly four years after the Dodd-Frank Act passed, the Volcker rule has finally made its long-awaited passage.
This news was first published on Dialogue Online
Named after former Federal Reserve chairman Paul Volcker, the rule was signed off by five regulators – the Commodity Futures Trading Commission (CFTC), the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Comptroller of the Currency and the Securities and Exchange Commission – last December, limiting US-registered banks from engaging in proprietary trading and investment in private equity and hedge funds. The rule is set to kick in July 2015.
Plans to ban prop trading have been in the works since the financial crisis, where banks’ trading of complex financial instruments – for profit rather than for clients – was criticised for leaving them holding excessive risk and highly leveraged balance sheets.
Many banks have since closed down propriety trading desks, but the Volcker rule, which is nearly 900-pages long, also has tighter rules for market making and hedging and requires comprehensive compliance programs, with “detailed policies, limits, governance processes, independent testing and reporting” to be in place.
For the largest banks, the chief executive officer must also certify to regulators that the bank has a compliance programme in place.
Rob Toomey, managing director and associate general counsel at the Securities Industry and Financial Markets Association (SIFMA), says banks began drafting their compliance plans as soon as Volcker was passed in December.
“Right after the rule came out, firms started to look into what they needed to do,” Toomey says. “It’s a very complex rule and within a firm it implicates a number of disciplines from compliance to risk to trading. All that needs to be integrated.”
Many banks have established task forces around Volcker to get their compliance regimes in place. “I don’t think we’ll fully understand what is required until people get deeper into it. It’s an evolving thing.”
Banks have been required to report seven key quantitative metrics that would allow regulators to pick up any discrepancies: risk and position limits and usage; risk factor sensitivities; value-at-risk and stress VaR; comprehensive profit and loss attribution; inventory turnover; inventory aging; and customer facing trade ratio for each of its trading desks.
The largest entities, with equal or more than US$50 billion assets and liabilities worldwide, will be required to report the metrics from 30 June 2014. Smaller banks with US$25 billion or more or US$10 billion or more aren’t required to report until 30 April 2016 and 31 December 2016 respectively.
Sean Owens, director at consulting and research firm Woodbine Associates, says some required metrics are currently captured through the banks’ risk management functions, but others aren’t. Coupled with the compliance programme needed, banks have a “huge undertaking” ahead.
The changes touch every area of the business. “Compensation agreements can incentivise proprietary trading, for example,” Owens says. “It changes how people conduct their business. The bank needs to lay out different policies and procedures and from there educate people on how they can operate within the new framework.”
There has been concern that the Volcker rule will have unintended consequences due to the fragmented nature of its development across regulators. The law didn’t task any one agency or agencies collectively with the interpretation, examination, supervision or enforcement of the final regulation.
SIFMA’s Toomey says organisations are worried about how regulators would interpret requirements for compliance. “There is a desire for the five regulators to come to consistent approaches.
“We may have some clarity in the coming days on how they are going to do that, but that’s a bit concern as people get knee-deep into compliance and performance.”
A task force has already been created by the five agencies to oversee the Volcker rule’s implementation. Last week, speaking to the US House Committee on Financial Services , CFTC acting chair Mark Wetjen said the commission was actively looking into the possibility of additional enforcement steps.
“Although compliance requirements under the Volcker rule do not take effect until July 2015, the CFTC is exploring now whether to take additional steps including whether to adopt formal procedures for enforcement of the rule,” he said.
Wetjen did not give details on additional measures being looked at by the CFTC, but said the task force would address jurisdictional issues that are expected to arise due to the number of regulators involved in developing the rule.
Last month, the Europe Commission released its equivalent of the Volcker Rule, also banning deposit-taking banks from engaging in certain proprietary trading activities. It expects the rules to be approved by the Parliament and Council by June 2015.
In its proposal on banking structural reform, the Commission outlined the steps it plans to limit proprietary trading activity, saying the activity is highly risky, while offering limited benefits to bank clients or the wider economy.
The most controversial aspect is a move to shift market-making activities into legally separate subsidiaries in some cases. The rule is designed to prevent banks from getting around the ban on prop trading by engaging in “hidden” trading activities, which could become too risky.
Andrew Olmem, a partner at Washington-based law firm Venable, says the European Union’s plans to introduce Volcker-like regulation could potentially have an impact in the US.
“Institutions with significant operations in the US and the UK can have a regulation overlap depending on how foreign regulations interpret similar prohibitions,” he says. “Banks may have to face two separate obligations, go through each of the requirements and take the most stringent from each of them.”
Olmen says people aren’t talking about the potential effects in detail yet, as the European legislative process is in its early stages.
The industry believes undiscovered complexities will appear as people dive further into the requirements, Toomey says. “We don’t know what they’ll be; we don’t know how it will be resolved, but we want to make sure there is a consistent approach from the regulators.”