On December 10, 2013, the Office of the Comptroller of the Currency (“OCC”), the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the U.S. Securities and Exchange Commission (“SEC”), and the U.S. Commodity Futures Trading Commission (“CFTC”) issued jointly developed final regulations. By doing this, federal agencies implemented § 619 of the Dodd-Frank Act (Volcker Rule).
The main purpose of the Volcker Rule is to restrict the proprietary trading of certain securities, derivatives, commodity futures and options on these instruments that do not benefit the customers. The final regulations (the “Final Rule”) also set forth limits on investments in, and other relationships with, hedge funds or private equity funds.
The Final Rule is obligatory for the following banking entities: U.S. banks, their affiliates, non-U.S. banks with a branch or agency office in the United States and their affiliates. The Final Rule requires banks to develop and enforce governance and management frameworks to comply with the requirements of the Volcker Rule.
The Final Rule was published in the Federal Register on January 31, 2014, and became effective on April 1, 2014. According to the OCC Bulletin No. 2014-9, national banks (except certain limited-purpose trust banks), federal savings associations, and federal branches and agencies of foreign banks are required to follow the final regulations in all their activities and investments by the end of the conformance period, which the FRB has extended to July 21, 2015.
Compliance Provisions
The Compliance part of the Volcker Rule is included in Subpart D of the Final Rule, which generally requires banking entities to establish a compliance program with § 13 of The Bank Holding Company Act of 1956 (12 U.S.C. § 1841) (“BHC Act”) and the Final Rule itself, including written policies and procedures, internal controls, a management framework, independent testing of the compliance program, training, and recordkeeping. Compliance standards are set forth in Appendix A and Appendix B of Subpart D. Appendix A details the quantitative measurements. Appendix B details the enhanced minimum standards for compliance.
The Final Rule sets forth compliance requirements on the basis of the size of the bank and the scope of its activities. Banking entities fall into several categories with different compliance and reporting requirements, increasing with a rising level of assets, liabilities and trading activities (classification suggested by Sullivan & Cromwell LLP): (i) None (not engaged in trading activities); (ii) Light (consolidated assets less than $10 billion); (iii) Standard (small banks); (iv) Enhanced (large banks); (v) Enhanced with metrics (banks with trading assets and liabilities of at least $50 billion).
Criticism and Recommendations
The Volcker Rule is considered to be a complicated and challenging regulation for banks because of its strict requirements for data collection, aggregation and reporting. Moreover, the existing compliance and risk management programs must also comply with requirements of Dodd-Frank and Basel III at the same time. Banks must do a lot of work to adapt their technological and human resources infrastructures to the new requirements, while complying with existing standards.
The Volcker Rule is often criticized for its lack of “practicality” and unclear and excessively broad definitions and requirements. According to Kevin Petrasic, a partner at Paul Hastings Janofsky & Walker LLP, “…there is going to be a whole drama in the coming weeks and months on what the exemptions mean, how restrictive and what the enforcement posture is.” This may lead to mistakes in the development and enforcement of a compliance program under the Volcker Rule.
Another criticism focuses on the definition of proprietary trading and blurring the line between proprietary trading and legitimate market making, a practice in which banks hold securities with the purported plan to later sell them to a customer. This is no doubt the cornerstone of the Volcker Rule, which, according to other critics, “claims to establish a firewall between commercial lending and investment banks by preventing big banks from making proprietary trades for their own profit.” However, the estimates of this effect have changed over time. When the initial version of the rule was published, S&P considered that this “could wipe out billions in trading profits.” After the Final Rule was issued, S&P claimed the impact would most likely not be so dramatic.
Due to tight deadlines, banks have to decide quickly on the business level, which businesses and strategies to choose in the mid-term and long-term perspective and which derivatives and securities they want to trade. Implementation costs should be included in a bank’s financial models, which may affect the profitability of some businesses.
The other important recommendation is to ensure that the banks’ directors, management and officers understand the Volcker Rule and agree that notwithstanding the chosen strategy and business perspectives compliance should be the highest priority of the bank. The Volcker Rule imposes obligations on bank management to attest annually in writing to regulators that the bank complies with the Volcker Rule requirements. As mentioned, “there is a precedent for such certification — Sarbanes Oxley control reports — and FINRA compliance.”
The requirement of attestation is one of the Volcker Rule’s most crucial requirements. This requirement was not present in the initial version of the Volcker Rule, published in 2011, and most Wall Street firms actively lobbied against such a requirement. One of the counterarguments was that it is always difficult for a chief executive to know with a sufficient level of certainty that proprietary trading is in compliance with the rules. According to Joseph Grundfest, a professor of law and business at Stanford University and a former SEC commissioner, “the rule could lead banks to create a system of sub-certifications, in which business heads who report to the CEO, and possibly their subordinates, must sign off on the activities of their units.” Thus, it is highly recommended to develop and implement such a system and to increase the awareness of CEOs about everyday operations from the Volcker Rule perspective in the form of regular special reports.
Bank personnel play a key role in development, implementation and enforcement of the compliance program. Therefore, it is necessary to conduct a human resources audit together with relevant tests to evaluate, whether the bank still needs additional personnel and whether the existing staff possesses sufficient knowledge and skills.
Some authors recommend that banks “need to create a well-thought-out Volcker Rule implementation and monitoring plan, since numerous business units are all affected by the rule.” In addition, it would be helpful to have a detailed road map assigned to corresponding people who are responsible and tight deadlines. The banks should also have special project management teams in charge of management over all IT and organizational processes.
A strong compliance program must include compliance manuals for bank personnel, written in plain language. Such compliance manuals must be extremely detailed and foresee various possible scenarios. Clear and transparent compliance manuals must be self-explanatory and avoid any ambiguities and discrepancies. The process of developing and implementing compliance manuals is itself very useful, since it requires assessing existing resources and infrastructure. It is highly recommended that responsible bank officers take part in creating compliance manuals (as part of working groups and steering committees) together with external consulting firms, if any.
Apparently the regulatory agencies might also need to hire additional personnel and provide them with training. Therefore, in the first few months (during the transition period), there is a high risk of mistakes and errors by state agencies. Another issue is that the state agencies will have “wiggle room” to employ at their discretion. As mentioned by SEC Commissioner Daniel Gallagher, “…when our examiners come across a rule violation, whether egregious and intentional or peripheral and accidental, they are required to record such violations.” Therefore, the banks should be prepared for a careful and thorough review of any requests and decisions and should be ready to have open dialogue with state agencies, if necessary, to ensure that the actions of state agencies are legitimate and adequate.
The bank’s hedging strategy should also be analyzed and tested, including correlation analysis. The feasibility and the effectiveness of hedges should be monitored and adjusted on a permanent basis, if necessary. The bank is also required to document the hedging rationale for transactions that may entail increased compliance risks. According to some authors, the requirement to specify hedging “is a result of the London Whale episode, in which traders at JPMorgan Chase tried to reduce the bank’s exposure to certain hypothetical losses by taking on outsized risks in other categories that eventually cost the bank billions of dollars in losses and its reputation as a well-managed institution.”
The Volcker Rule may also affect the business of bank customers. Banks should notify their customers about potential adverse consequences. Due to strict requirements, quality and value of financial services may be decreased and some losses may be incurred for customers making business on derivatives and securities. Therefore, preparing and delivering alerts to clients is highly recommended.
The Volcker Rule will restrict banks’ ability to engage in private equity and hedge fund activities, as well as in proprietary trading, some of which may even be related to market making activities. The suggested measures and proposed steps may help banks to transform businesses and adjust operations in a timely and prompt manner, which may also increase competitive ability on the market and shareholder value in the long-term.