Volcker Rule Update #2: Comment Period Extended; Analysis of the Hedging Exemption

The deadline for submitting comments regarding the proposed regulations implementing the Volcker Rule has been extended from January 13 to February 13. As we noted in our previous update on the Volcker Rule, the timeline was already very tight if regulators intended to meet the implementation deadline of July 2012, and this postponement only makes that timeline even tighter and less feasible.

Putting this logistical problem to a side, one major provision in the proposal we have yet to discuss in-depth is the exemption provided in the Volcker Rule for risk-mitigating hedging transactions. The current proposal would allow banks to maintain, purchase, or sell hedging positions with commercial deposits provided that these positions arise from and are related to specific risks involved in the bank’s other legitimate positions, contracts, or holdings. These other risks include market risk, counterparty/credit risk, currency/foreign exchange risk, and interest rate risk (among others). Additionally, the hedged positions taken by the bank must be “reasonably correlated” (or, to be more precise, reasonably negatively correlated) with the risks purportedly being mitigated.

Addressing some of the concerns that arose from the financial crisis directly, a bank cannot engage in a hedging transaction if the position would increase the bank’s exposure to an area of risk that did not exist prior to the transaction. Additionally, similar to the exemption in the Volcker Rule for market making, the proposal does not allow the exemption for hedging to apply if individuals at the bank involved in the transaction are rewarded (via increased compensation) for speculation involved in the hedged positions.

The proposal has been criticized for only requiring a “reasonable” correlation with the risk being hedged, as opposed to a complete or nearly complete correlation. For example, a bank that is exposed to risk in the corn market (due to loans to corn farmers) could take a hedged position against the price of corn, or it could take a different position that is reasonably correlated with the price of corn, such as the price of meat and/or the price of fuel, so long as the bank can justify the reasonableness of the correlation between the two. This vague language may make it particularly difficult for regulators to actually enforce the regulation against banks.