Taming Volcker

Author: John Crabb | Published: 29 May 2018
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Bankers’ counsel have spoken exclusively to IFLR about the Rule’s future and how it may need to be toned down

It has been one of the buzzwords of the financial sector in the US ever since its inception almost 10 years ago. Section 619 of the Dodd-Frank Act, generally referred to as the Volcker Rule, continues to be at the forefront of the banking regulation conversation.

Although Dodd-Frank, which loosely aims to repair the US financial system and end the concept of too-big-to-fail, came into effect in 2010, shortly after the financial crisis, the Obama-era Volcker Rule contained within it was only fully implemented on July 21 2015 following significant delays.

Named after its creator – former Federal Reserve chairman Paul Volcker, who led the US economic recovery following the financial crisis – the Volcker Rule is a US federal regulation that aims to prevent banks from making the kind of risky speculative investments using their own accounts. This practice is widely believed to have contributed to the 2008 financial crisis.

In recent years, the Republican administration has been trying to remove the restrictions that the Rule puts on banking entities from engaging in proprietary trading, and limits a banking entities' investment in hedge funds and private equity funds of a certain size.

Last year, the Department of the Treasury issued a number of reports outlining suggestions to the financial industry, and in the June report entitled 'A Financial System That Creates Economic Opportunities Banks and Credit Unions' outlined its specific intentions for Volcker with substantial amendments. While not an exact replica of the report, subsequent proposals have gathered bipartisan support in the ensuing months and some form of change seems increasingly likely as various attempts to alter progress through both chambers of Congress.

Unsurprisingly, it has been at the centre of much debate since it was originally enacted, with recent calls to reduce its scope of application including for smaller, non-systemic banks. The House passed a bill to this effect on April 25, which would leave only 10 US banks under the Rule's remit if approved.

William Galvin, chief securities regulator for the Commonwealth of Massachusetts, has warned that weakening the Rule could lead the sector on a dangerous path reminiscent of the 2008 financial crisis. "These changes may increase profitability for some firms and banks in the short term, but they will increase risks for the economy and for investors, savers, and taxpayers," he told IFLR.

With this in mind, IFLR ran a survey on the future of the Volcker Rule. In association with Morrison & Foerster, the poll surveyed leading in-house bankers' counsel and asked them to share their views on the Rule and proposed changes going forward. The survey covered areas from proprietary trading to covered funds, resulting in some fascinating results.

The key takeaway from the research is that while the market doesn't want to see the Volcker Rule abandoned, in its current form it is overly complicated and needs to be simplified in line with other examples of modern financial regulation.

It is not immediately clear how the complexity of the Rule can be simplified, but the results suggest that it is necessary (see question 1). As many as 80% of respondents agree with Randal Quarles, the Fed's vice chairman for supervision, that the regulation implementing the Volcker Rule is 'an example of a complex regulation that is not working well'.

The Volcker Rule was written in the aftermath of the 2008 financial crisis. Prior to that, many banks had drifted away from the purpose that they were supposed to be fulfilling, and instead of providing financial services to the world at large, they were seen to be focusing solely on their own agenda. Instead of providing services to businesses and to customers, they are trading for their own accounts, which was not really the intention.

"I understand why the Rule was written, and while I don't disagree with the premise, it became a bit of a monster when they tried to actually write it," says one in-house counsel at a major US bank. "I think it could be written a lot more simply than the way it was done initially."

1. According to the Fed’s vice chairman for supervision, Randal Quarles, the regulation implementing the Volcker Rule is 'an example of a complex regulation that is not working well’. To what extent do you agree with this view?

2. Looking at Quarles’ previous statement. What do you think is the primary cause of this?

3. Legislators are considering making the Federal Reserve the primary Volcker Rule regulator instead of continuing with the current system, in which numerous regulatory agencies are primarily responsible. To what extent do you think this centralisation of authority would be helpful?

Simplify or die

The Rule was approved by five implementing agencies before passing into law: the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission (SEC).

As laid out in the agencies' joint Final Rule, the regulation:

'generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (covered fund), subject to certain exemptions'.

It also provides that:

'A nonbank financial company designated by the Financial Stability Oversight Council (FSOC) for supervision by the Board (while not a banking entity under section 13 of the BHC Act) would be subject Volcker Rule matters: to additional capital requirements, quantitative limits, or other restrictions if the company engages in certain proprietary trading or covered fund activities.'

This is only a brief snapshot of a Rule that runs to more than 900 pages in total.

Another in-house counsel, the chief Volcker compliance officer at a US bank, says that if the Rule's intent was to prohibit proprietary trading, which it has mitigated, then it is working well. "With respect to some of the finer points of implementation like metrics it is not working that well, but that does not necessarily warrant an indictment of the entire Rule," he says.

"I don't think it should be relaxed or strengthened, I think it should be better defined. That is what a lot of the firms are looking for, so when we talk about intents with respect to market making or mitigating hedging, that is a nightmare for a compliance officer to discern," he adds.

The community view
One of the concerns that the market has for the Volcker Rule is how it applies to smaller, often community, banking institutions which don’t hold the assets required to be captured under the remit of Volcker regulation. Respondents suggested that the Rule has consequences that were not, or should not, have been intended. It isn’t certain if the Rule is actually keeping banks from making unwise investments, but compliance is hampering smaller institutions in particular which don’t necessarily have that kind of risk on the books. The regulation itself is unclear and is impacting those that aren’t intended to be or should not be impacted, particularly if the extra territorial effect is factored in.

Jerry Ernst, chief executive office of Horizon Community Bank in Arizona, says that the Volcker Rule is aligned so that insured depositor’s funds should not be used for highly speculative ventures due to the potential to cause failures.

"As a community bank, we have no proprietary funds and all of our risk is in our loan portfolio, save market and rate risk which exist in our plain vanilla bond portfolio," he says. "Although I may feel differently were I in a large institution and felt competitive pressures, the Rule is overly complex as even though we have no such activities, our regulators require us to add a policy on the matter to come into perceived compliance from their perspective."

He adds: "I do not think right now is the time for relaxing regulation in this area significantly, but would be in agreement with those that think this Rule could be rewritten for better clarity and ease of compliance, including exempting banks that do now own or invest in hedge funds."

4. Under the Volcker Rule, a banking entity is prohibited from acquiring or retaining as principal an ownership interest in a covered fund or acting as a sponsor of a covered fund. The definition of banking entity is broad and covers not only banks but also their affiliates and subsidiaries. Should it be amended?

Michael Alix, financial services advisory risk leader at PricewaterhouseCoopers, says that there is no doubt that the rules will be redefined to address some of the biggest concerns that have been raised about the Volcker Rule.

"How exactly that is done remains in doubt, but it will all be in the direction of making it easier to comply and making it easier to know what you need to do to be in compliance with the law," he says. "There is broad acceptance that a limitation on trading designated purely for proprietary trading will remain in place, but how that limitation is designed and enforced is in question."

The survey's second question asked those who agreed with Quarles' previous statement that the Rule was overly complex, and that some aspects of the Rule specifically were problematic. The options included compliance burdens associated with trading activity and determining which trading activity is permitted and which is not, burdens associated with funds activities and determining which funds activities are permitted and which are not and the extent to which the Volcker Rule may apply to transactions or activities involving parties or personnel outside the US. The result was resoundingly the combination of the three, with almost three-quarters of respondents suggesting that all of the answers were applicable.

Another respondent, a Volcker control officer at a major foreign bank, says that while he is uncertain how US domiciled banks handle compliance, his own bank puts a lot effort in to the compliance programme, which is a significant burden.

"When we demonstrate compliance, we also need to demonstrate routine spending ready to buy and sell, and also out position if they to monitor them, so a lot of different reports need to be generated, all of this monthly governance is a compliance burdens," he says.

In March of this year, the House Financial Services Committee approved a bill by a vote of 50 to 10 which has proposed naming the Federal Reserve as the primary Volcker Rule regulator instead of continuing with the current system, in which numerous regulatory agencies are primarily responsible. The poll asked to what extent they thought that this centralisation of authority would be helpful in the overarching theme of simplifying the Rule (see question 3): 64% of respondents felt it would be a good idea, with 28% suggesting that the current system has created gridlock and confusion.

Having five regulators is difficult, says another respondent from the private sector. The current system of five regulators is demanding and is creating problems, suggest results. If the banks spend all this time trying to figure out if something is prohibited, and they ask the regulators – but they don't know the answer – and then the five have to agree on what the answer is, that is cumbersome. If the Fed ends up as the default regulator because they have more experience, they regulate those banks and holding companies already and have the necessary perspective.

It is not a given that the Fed should take the reins, but it has become unwieldy for the market to interface with the five regulators in the interest of assisting how the implementation is working. From the regulators' perspective, none of the five can take an action without agreement or consent of the other four. "They are out of harmony with each other and that is a nightmare. All you have to do is look at any two regulatory institutions in the US that are required to work together, and multiply it by an extra factorial," says the Volcker control officer.

Just take metric reporting as an example: there is no need to report metrics to different regulators and then answer five questions. There can be an agreement, but an agreement is not always easy to reach. "It will definitely be less stressful if contact points are reduced to one, but that doesn't necessarily mean that I agree that it is the right choice," says the overseas control officer. "In some instances, the OCC plays a more active role in interacting with the US office, who knows if the Fed is necessarily the correct choice."

It is not that the market desperately wants the Fed as a regulator, but more that it recognises that having five different agencies subject to implementing the Rule has been and would continue to be problematic.

Quarles too pointed out that firms and industry participants ask questions of the regulators, and receive different answers, which is by no means a good thing. "Concentrating the oversight responsibility for the Rule with the Federal Reserve makes an enormous amount of sense, because not only is it is a single regulator but it the one that has the resources and reach to deal with the Rule's application," says Alix.

This question was not clear cut, however, with 36% respondents suggesting it would not help simplify matters. One respondent implies that it depends on how the bank operates in the US: for instance, his bank has a federal licence so its primary regulator is the OCC. "We are subject to OCC regulation on basically all the activity that we have in the US, whether it is credit regulations or something else, the OCC is our supervisor," he says.

He adds: "So it does mot simplify things for us to say well, for everything except for the Volcker Rule, the Fed is your supervisor. It would be adding another layer for me."

5. A covered fund under the Volcker Rule is an entity that (i) relies on section 3(c)(1) or 3(c)(7) of the Investment Company Act; (ii) is a commodity pool whose operator relies on CFTC Rule 4.7 (and certain similar pools); or (iii) a foreign fund that either relies on section 3(c)(1) or 3(c)(7) with respect to US investors or satisfies other criteria. Should it be amended?

6. The Volcker Rule contains several exclusions from the covered fund definition, including exclusions for wholly-owned subsidiaries, joint ventures, certain loan securitisations, and registered investment companies. If the covered fund definition remains unchanged, do you think exclusions or additional exclusions should be amended?

7. The Volcker Rule permits banking entities to engage in certain permitted activities with respect to covered funds that the banking entity owns or sponsors, such as acting as an investment adviser to a fund or acting as an underwriter or market-maker to a fund. Are amendments to these permitted activities or additional permitted activities needed?

Volcker 2.0

It is expected that within the next few weeks the five authorities in charge of Volcker will present their joint effort to revamp it, which has been dubbed Volcker 2.0. Predicted measures within the proposals will blunt the edges of Volcker considerably. To this end, the survey looked specifically at the definitions and stipulations of covered funds, or hedge funds and private equity funds, and proprietary trading, when a bank or firm makes an investment for its own gain rather than the commission it would gain from its clients.

Under the Volcker Rule, a banking entity is prohibited from acquiring or retaining as principal an ownership interest in a covered fund or acting as a sponsor of a covered fund. The definition of banking entity is broad and covers not only banks but also their affiliates and subsidiaries – question four asked if it should be amended, and 64% agreed that it should be narrowed in its scope. Close to half of this group felt that it would be useful to narrow the definition to apply only to banks that are systemically important to the US financial system, while the rest see fit to narrow the definition to apply only to US banks and their US affiliates and subsidiaries.

One respondent suggests amends to include banks and bank holding companies and affiliates in the US and foreign banking organisations, looking closely at how expansively it covers a foreign banking organisation which doesn't touch the US.

This issue has tended to be statutory, it is not a regulatory issue, and is likely to be addressed through the legislation that is currently working its way through Congress. It is not uncertainty about what a banking entity is per se, but that what they capture in the banking entity includes institutions for which the Volcker Rule really shouldn't apply.

The definition too, of covered funds, has been found to be overly complicated (see question 5). A covered fund under the Volcker Rule is an entity that (i) relies on section 3(c)(1) or 3(c)(7) of the Investment Company Act; (ii) is a commodity pool whose operator relies on CFTC Rule 4.7 (and certain similar pools); or (iii) a foreign fund that either relies on section 3(c)(1) or 3(c)(7) with respect to US investors or satisfies other criteria.

The rebuttal presumption
One aspect of the Rule that has caused significant consternation is the so-called rebuttable presumption (see question 10), with more than 90% of respondents suggesting that it should be amended in one way or another.

The five regulatory agencies are likely to propose amendments to the rebuttable presumption contained in the current regulations, under which the purchase or sale of a financial instrument by a banking entity is presumed to be for its trading account (and for purposes of short-term profits or similar purposes) if the banking entity holds the related financial risk for fewer than 60 days.

One US in-house counsel went as far as to call the rebuttable presumption ridiculous, and says it should be eliminated. "If they want to keep it, drop it from 60 days to one or two," he says. "Taking it for what it is worth, if you want to make a quick buck and you think you know better than the market you are going bet on an economic number, a Fed rate, something like a war starting or not starting. You are not going to take a position and leave it open for 59 days, that is ludicrous."

In your open position report, he continues, you are going to have defend why you made the trade. Two months is an absolute eternity in trading, rendering the process almost pointless.

"If you really want to do intra-day trading, you are going to be questioned. Why were you trading intra-day, why were you trading 500 eurodollars in the morning and then punched out 500 eurodollars at midday after the inflation number came out? That is the kind of stuff that compliance officers and trading supervisors look at, we won’t consider 59 days."

8. If the Volcker Rule’s covered fund provisions are completely repealed, would your banking entity revert to the practices that the Rule currently either prohibits or limits?

More than three-quarters of the poll's respondents felt that the definition should be simplified, with the majority suggesting means to narrow the categories of funds that fall within the definition. A further 15% suggested that they are eliminating certain higher cost products but view the cost as only one element in determining if a product is in the best interest of the client.

This technical regulation is used to define what a covered fund is in relation to bringing in private equity funds and hedge funds. "We tend to use more laymen terms, and rules that are closer to the industry, than use difficult to understand legal terms to define some like this," says the overseas control officer.

"It should be more laymen in this sense. Making it more layman is the difficult part, private equity funnels, hedge fund, there must be some tax definitions – even that or sticking to the legal rules. Of course it will be more up to the regulators themselves to strike a balance," he explains.

The policy objective was aimed at hedge funds and private equity funds. The actual definition has been seen to bring in more than what was intended and create some confusion. It is a highly contested issue, but if a way was found to simply say that banking entities should not be permitted to invest more than a certain amount in hedge funds or in private equity, this could address the concern.

The Volcker Rule permits banking entities to engage in certain permitted activities with respect to covered funds that the banking entity owns or sponsors, such as acting as an investment adviser to a fund or acting as an underwriter or market-maker to a fund; and also contains several exclusions from the covered fund definition, including exclusions for wholly-owned subsidiaries, joint ventures, certain loan securitisations, and registered investment companies.

Questions six and seven of the survey looked at whether these two aspects of the Rule as it applies to covered funds should be amended. If the covered fund definition remains unchanged, 69% of respondents think exclusions or additional exclusions should be amended, while a small proportion think exclusions are necessary because the current definition applies to entities that should not be considered covered funds.

While several of the respondents feel that one or more of the permitted activities should be amended to broaden or clarify the reach, 39% argue that the current permitted activities strike the right balance.

The covered fund exemption is in some ways similar to the proprietary trading exemption, says the overseas legal counsel. It is a problematic exemption because it is counterintuitive. Many banks operate under a global universal banking model, which as an entity that operates outside the US it is difficult to adopt to. "Whatever entities may relate to the US, we can adopt this exemption, but it is counterintuitive. They all have their pros and cons," he adds.

Nicely linking to the underlying thread that the Rule needs to be simpler, the counsel adds: "How to operate under those exemptions, that is quite unclear."

9. Market participants have expressed concern over the complexity of the Volcker Rule’s definition of proprietary trading, which generally applies when a banking entity engages as principal for its trading account in the purchase or sale of a financial instrument. Which of the following do you think would be the most helpful change to the definition of proprietary trading?

10. The Volcker Rule regulatory agencies may amend the rebuttable presumption contained in the current regulations, under which the purchase or sale of a financial instrument by a banking entity is presumed to be for its trading account (and for purposes of short-term profits or similar purposes) if the banking entity holds the related financial risk for fewer than 60 days. Which of the following possible changes do you think makes the most sense?

Acting prop-er

The final section of our survey looked at proprietary trading, and whether it too could be simplified to help with compliance. Market participants have expressed concern over the complexity of the Volcker Rule's definition of proprietary trading (see question 9), which generally applies when a banking entity engages as principal for its trading account in the purchase or sale of a financial instrument. Thirty percent of respondents do not think that the definition needed to be changed at all.

A Volcker compliance officer at a US bank does not think that it is enforceable, and that it is extremely difficult to get into a traders head when they have any element of digression. Once you get an option in your books, while you rely on their services, you are in a variable positions that require you to hedge.

"Whenever you are hedging some non-money instrument, which every single interest rate instrument is, then you have to rebalance your hedges," he says. "So, unless the trader has a perfectly prescribed hedging program that is basically automated, then there is digression."

From a compliance perspective, it is hard to judge. In a legitimate instance the trader could have been leaving leave the position open because they wanted to stay short, so what will the regulator do, police down to the minute, or put every second in the procedures, he asks.

"You can't, you would have to automate hedging completely and there is no way you can do that. It is unwieldy, and it is a very slippery slope to try and find it," he says. "If it is designed to prohibit proprietary trading and that is what it is doing then, then what is wrong?"

Another respondent, who in this instance feels that proprietary trading should be defined with respect to the amount of market risk that a banking entity takes in connection with a given transaction, says that it goes back to the original idea of what the Rule is really trying to accomplish. "What we are really trying to do is discourage banks from taking on market risk on to their own books," he says. "The focus on that I think really goes to the heart of the regulation."

11. Many believe that market making activity by dealers has decreased significantly in recent years. To the extent that such reduction in market-making activity is a result of the Volcker Rule’s requirements for permitted market-making activity, how do you think the exemption for permitted market making activities should be changed?

12. Regulators are reportedly examining potential amendments to the RENTD requirement, which forms part of not only the exemption for permitted market-making activities but also the exemption for permitted underwriting activities. Which of the following potential changes makes the most sense?

Obviously the rule here applies to trading activities, and it is about the intent of each trait. When talking about reform, the direction should be more about the volume of limits that should give when banks come to trading activities. "While straightforward, it is important to limit excess. Market risk will play a very important role, to the extent that it would come to play in position limits," says the overseas counsel.

One explanation for this outcome of the survey is that it could be that Volcker Rule compliance officers who would interpret this as the application of the reasonably expected near term demands (RENTD), and if you have more positions than you have demands that is proprietary trading. However, this technical problem with the RENTD calculation and the way it has to be established is burdensome.

Regulators are also reportedly examining potential amendments to the RENTD requirement (see question 12), which forms part of not only the exemption for permitted market-making activities, but also the exemption for permitted underwriting activities.

Question 12 surveyed the suggested amendments, asking if the regulatory agencies should clarify that a purchase or sale need only be reasonably consistent with observable customer demand patterns and, in the case of new asset classes or markets, with reasonably expected future developments based on client relationships. It also asks if they should clarify that dealers may make individualised assessments of anticipated customer demand based on their expertise and experience in the markets or if they should expressly recognise that that illiquid and low volume markets require dealers to take a longer and broader view than dealers in liquid markets.

Fixty-six percent of respondents suggested that all three were necessary amendments to clarify the RENTD requirement, with the third option, the recognition that illiquid and low volume markets require a different stance, taking most of the rest.

The question is how to do it, transacting in liquid market and liquid markets can be very different. The regulators, when they come out with their proposal, will have considered this and studied that the desirability of making it easier for dealers to transact within the Volcker Rule in less liquid markets.

There are several things that are happening here, and it can be simpler to comply by making it clearer what is, or what is not, a proprietary trade, in the same way as it is to say what is or what is not a covered fund, says Alix.

"It is clarification and relaxation, and the relaxation would be to allow people to do transactions that would otherwise be thought of as proprietary. In the context of being inconsistent about what constitutes a trade for underwriting market making, or hedging, and what is not, they should look at the effects of that issue of differences and market liquidity," he explains.

In an illiquid market it is not as easy to tell by using holding period or transaction history what is proprietary versus what it not. Attempts to be consistent in the application of the changes can make it more likely that you will have a clear idea in a liquid market if a transaction is a proprietary transaction or an underwriting hedging, or market making transaction. Underwriting and hedging is really more of a market making issue not underwriting.

RENTD is one of the areas that banks tend to pay a lot of compliance out of, as it needs to calculated quarterly in the bank. The Rule never defined what a sufficient RENTD is, what is insufficient RENTD, or what is meant by the near term, says another US counsel. "It is meant to be a quantitative measure, but there is no guidance as to how the quantitative measures are calculated. The content itself is good but we need more guidance as to what we mean by RENTD and how to calculate it."

From a market and regulatory respective and from a bipartisan perspective, the Volcker Rule is probably one of the easiest conceptual changes that could be made coming out of the change in the leadership in Washington. If these suggesed changes are made there will be a lot of savings throughout the industry, as well as clarity, without need for a material change in the underlying risk that the Volcker Rule is trying to address.

 


 

 

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