On Monday, the US Treasury Department issued a fairly detailed report ("A Financial System That Creates Economic Opportunities – Banks and Credit Unions") of proposed changes to financial regulation primarily stemming from the Dodd-Frank Act. While the report itself was much broader in scope, significant attention focused on "improving the Volcker Rule."
By way of background, Section 619 of the Dodd-Frank Act, referred to as the Volcker Rule, prohibits banking entities (defined to include banks and their affiliates and holding companies) from engaging in proprietary trading and limits a banking entities' investment in certain hedge funds and private equity funds. In January 2014, five federal financial regulators (the Federal Reserve, the FDIC, the OCC, the CFTC and the SEC) jointly adopted final rules implementing the Volcker Rule, and banking entities have been required to comply with most provisions since July 2015.
Treasury's report is clear that banks with access to FDIC deposit insurance and the Federal Reserve's discount window "should not engage in speculative trading for their own account," but it criticizes the Volcker Rule's design and implementation which "far overshot the mark." Changes to both scope and operation of the Volcker Rule "are necessary to clarify the rule's prohibitions, reduce unnecessary compliance burdens and promote market making and other economically important activities." While the report is critical of both proprietary trading and the covered fund restrictions in the rule, more attention is focused on revisions to the former.
Beginning on page 71 of Treasury's report, specific recommendations for revisions to the Volcker Rule are discussed. Many of them can be accomplished by regulation and without legislative action.
Following terminology associated with the House's Financial CHOICE Act, the report proposes a Volcker Rule "Off-Ramp" for highly capitalized banks. Noting that increased capitalization can effectively mitigate risks posed by proprietary trading, the report supports the position that highly capitalized banks, referencing the 10 percent leverage ratio proposed by the Financial CHOICE Act, should be permitted to "opt out of the Volcker Rule altogether."
Additional recommended changes include:
Small bank exemption. Exempting from the rule in its entirety banking organizations with $10 billion or less in total consolidated assets. "The relatively small risk that these institutions pose to the financial system does not justify the compliance burden of the rule, and the risk posed by the limited amount of trading that banks of this size could engage in can easily be addressed through existing prudential regulation and supervision."
Limited activity exemption. Exempting from the rule's proprietary trading restrictions banking organizations, regardless of their size, with less than $1 billion in trading assets and trading liabilities provided their trading assets and trading liabilities represent 10 percent or less of total assets.
Revised scope of enhanced compliance requirements. In response to the rule's "progressively more stringent requirements based on a banking entity’s size and involvement in covered activities," triggering enhanced compliance requirements for banking entities with $10 billion or more in consolidated trading assets and liabilities rather than the current trigger of $50 billion in total consolidated assets.
Foreign fund exemption. Exempting foreign funds owned or controlled by foreign affiliates of US or foreign banks from the definition of banking entity, and thus from the scope of the Volcker Rule.
Simplification or elimination of subjective proprietary trading tests. Revising or eliminating the "purpose test" for determining whether trading activity is proprietary trading and eliminating the presumption that positions held for less than 60 days constitute proprietary trading. The report notes that two of the three proprietary trading tests, namely the "market risk capital rule test" and the "status test," are linked to objective calculations and thus are more workable from a compliance perspective. In contrast, the purpose test requires a subjective assessment of trader intent and the 60-day presumption leads to excessive conservatism by banking entities unwilling to contradict the presumption even if short term trades of less than 60 days would not otherwise satisfy the test.
Increased market making flexibility. Giving banking entities flexibility in determining inventory of securities needed for market making and the ability of opt out of the "reasonably expected near term demand" or RENTD requirement entirely if the banking entity is fully hedged against "all significant risks arising from its inventory of that instrument." In making these recommendations, the report noted difficulties in forecasting demand and the belief that market making generally "does not pose the same risks as speculative proprietary trading."
Simplified hedging exemption. Monitoring interest rate, credit, market and other risks as part of standard business practice and hedging accordingly, rather than instituting a specific Volcker Rule hedging compliance program and satisfying the associated documentation requirements. In making this recommendation, the report noted that "[t]he Volcker Rule appropriately exempts risk-mitigating hedging transactions from the proprietary trading prohibition" but the compliance requirements are "unnecessarily burdensome."
Improved coordination among regulators. Mandating increased consistency and coordination among the five agencies responsible for enforcing the Volcker Rule. "The regulators' existing approach to coordination has not worked and, as a result, banks have had difficulty obtaining clear, consistent guidance. These agencies should ensure that their interpretive guidance and enforcement of the Volcker Rule is consistent and coordinated."
Limited definition of covered funds. Adopting a simple definition of a covered fund focused on the characteristics of hedge and private equity funds (the actual focus of Section 619 of the Dodd-Frank Act) rather than reliance on reference to the Investment Company Act. In making this recommendation, the report states that the current definition is overly broad and encompasses funds that are not hedge or private equity funds. It is possible such a change would clarify the inapplicability of the rule to certain CDO and other fund structures.
Extension of a covered fund’s seeding period. Extending the current seeding period for new funds from one to three years.
Allowing certain affiliated transactions with covered funds. Restoring the allowance for certain transactions between a banking entity and its covered funds that are otherwise permitted by Section 23A of the Federal Reserve Act between a bank and other affiliates.
Relaxation of fund naming restrictions. Allowing sponsored funds to share a name with banking entities other than the insured bank itself.
Find out more about the recommendations for revisions to the Volcker Rule by contacting:
Christopher N. Steelman