The Volcker Rule: Great Expectations For Regulating Risk

http://blogs.orrick.com/securities-litigation/files/2012/10/iStock_000019591329XSmall-200x150.jpgOn Tuesday, December 10, five federal regulatory agencies, the Federal Reserve, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller and the Commodity Futures Trading Commission, jointly released the long awaited and hotly contested “Final Rules Implementing the Volcker Rule.”   The Rules and supplement, together more than 900 pages long, are already generating comment and controversy for their complexity and severity—or lack thereof, depending on who you ask.  The Rules become effective on April 1, 2014 with final conformance expected by July 21, 2015.

A Product of Hard Times

Paul Volcker, an economist, former Federal Reserve Chairman and former chairman of the Economic Recovery Advisory Board, initially proposed a (seemingly) simple rule restricting certain risk-taking activity by American banks in a 3-page letter to President Obama in 2009.  Speculative activity, for example, proprietary trading, was believed to have contributed to the “too big to fail” position that the nation’s largest banks found themselves in at the height of the Financial Crisis in 2008 and 2009.  The Volcker rule thus proposed prohibiting banks from engaging in short-term proprietary trading on their own account.  It also proposed limiting the relationships that banks could have with hedge funds and other private equity entities.  Not long after its proposal, the rule was made into law in Section 619 of the 2010 Dodd-Frank Wall Street Reform Act, to take effect upon the issuance of implementing regulations.  

Drafting of the Rules has been a lengthy and contentious process.  The first study and recommendations concerning the rule were released in January 2011 by the Financial Stability Oversight Counsel; an initial draft and summary of the Rules was leaked on October 5, 2011.  Since then the Rules have gone through multiple revisions and generated more than 18,000 comment letters submitted to the agencies.  Events such as JP Morgan Chase’s “London Whale” trading losses prompted further revisions and delay.  The agencies were forced to request multiple deadline extensions while facing an increasingly complex task; in his opening statements on December 10, Federal Reserve Governor Daniel K. Tarullo compared the Rules to Dickens’ Jarndyce v. Jarndyce.

A Tale of Two Risks

The Rule have three components, all designed to limit the risks that depositary institutions can expose themselves to (in contrast to those they may take on their customers’ behalf):  1) a prohibition on proprietary trading, 2) a prohibition on owning or sponsoring “covered funds” (i.e. hedge funds and private equity funds) and 3) compliance and reporting requirements.  The most significant controversy stemming from the release comes from the numerous exceptions to the two trading and investment prohibitions.

First and foremost among the exceptions, the banks may engage in certain proprietary trading activity if they are market-making, underwriting a transaction, hedging to mitigate risk or trading in U.S. government bonds and certain foreign sovereign bonds.  The Rules also exempt trading activities of foreign banks as long as the trading decisions and principal risk occurs outside of the U.S.  The most vocal critics of the Rules argue that it is difficult or impossible to completely distinguish or quantify market-making and hedging from a truly speculative long or short position—the Rules seemingly are trying to force a bright line solution to a very grey problem.  To compensate, banks will be required to analyze and support all excepted trading activities.  For example, for a given hedging strategy, “[a bank] needs to identify the positions being hedged with sufficient specificity, so that at any point in time, the specific financial instrument positions or components . . . can be clearly identified.”  As a result of the specificity now required in order to execute a hedge strategy, the Rules may practically eliminate portfolio hedging as a viable risk management strategy.

Second, the Rules’ ban on principal ownership of covered funds exempts wholly-owned subsidiaries, joint ventures, acquisition vehicles, SEC-registered investment companies, certain foreign funds and loan securitizations, among other things.  The exemptions from investments in covered funds are generally considered quite broad, making this part of the final Rules significantly more lenient and less burdensome than the proprietary trading restrictions.

In the near term, Compliance will become a key player within the banks as they navigate the Rules’ many shades of grey.  The first requirements under the Rules come into effect on June 30, 2014 when big banks—with $50 billion or more in trading assets and liabilities—must begin reporting certain quantitative measurements relating to risk positions, sensitivities, stress analysis and product inventory.  As a result of the lengthy drafting process, many large banks have had the time and opportunity to be proactive about changes required under Volcker—particularly the reporting requirements which are effective first.

The effectiveness of the Rules is likely to be determined by two factors.  First, by how vigorously the banks are willing to take advantage of the exceptions, particularly those pertaining to the grey areas of market-making and risk hedging.  And, second, by the regulatory agencies’ aggressiveness and effectiveness in enforcing the law to curb risk-taking activity.