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The Volcker Rule’s Impact on Financial Institutions and Companies

 After several years of commentary, debate and resistance, the financial world is bracing for the imminent implementation of the Volcker Rule, a key component of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Simply put, the Volcker Rule alters the way many financial institutions in the U.S. operate in an attempt to regulate banking practices perceived by federal agencies as risky. At its core, the Rule tries to restrict banks from speculation and proprietary trading, forcing them to serve primarily as lending institutions providing capital to individuals and businesses.


Whether or not the Volcker Rule is capable of preventing financial calamities remains to be seen. Regulators believe new restrictions will protect the nation from the type of financial turmoil the economy experienced in 2008 – 2009. Major banks and financial institutions, on the other hand, see the Rule as an onerous set of regulations necessitating compliance obligations that severely limit liquidity and dull our country’s competitive edge in world financial markets.


Who does the Volcker Rule affect?


The Volcker Rule applies to banks with access to the Federal Reserve’s discount window and other government safety nets. These entities include federally insured, deposit-accepting banks and the institutions that own these banks, as well as credit unions. In light of the Rule’s recent finalization by government agencies charged with implementing it, affected institutions are entering the final portion of the Rule’s conformance period, during which banking entities must set in place internal compliance programs to ensure that their investment activities adhere to the new regulations.


What major changes does the Volcker Rule introduce?


The Rule seeks to prevent banking entities from taking unwarranted risks, especially with regard to federally insured deposits. To this end, it curtails banking entities from engaging in two specific practices: (1) proprietary trading, and (2) hedge and private equity fund activities. Essentially, the Rule seeks to separate the consumer lending arms of financial institutions from investment activities in an attempt to create a more transparent financial environment in which banks have fewer, if any, conflicting interests.


Proprietary Trading. The first category of activities the Rule prohibits, subject to some exceptions, is proprietary trading. This generally means that a banking entity cannot serve as the principal of its own trading accounts through which it purchases or sells financial instruments. Under the Volcker Rule, accounts qualify as “trading accounts” if their principal purpose is near-term sales or profit from short-term price movements, among other criteria.


Hedge and Private Equity Fund Activities. The second category of prohibited activities proscribes banking entities from serving as principals in transactions in which they directly or indirectly obtain or keep ownership interests in certain types of “covered funds.” These include private equity, venture capital, and hedge funds as defined by the Investment Company Act of 1940, as well as certain commodity pools under the Commodity Exchange Act and certain foreign funds that resemble U.S. covered funds.


This provision also prohibits banks from sponsoring covered funds. This means that banks cannot serve as general partners, managing members or trustees of covered funds. Banks also may not serve as operators of commodity pools with respect to covered funds, nor may they select or control the majority of a covered fund’s directors, trustees or management. Finally, banks cannot share names or variations of names with covered funds for commercial purposes. At their core, the second set of restrictions related to covered funds prohibits banks from indirectly accomplishing activities from which they are directly prohibited by the first category’s private trading restrictions.


Which aspects of the Volcker Rule’s restrictions may be problematic?


Even prior to its implementation, experts identified a host of troubling dimensions to the new Volcker Rule. Not least of all, the Rule limits the market-making activities through which financial institutions assist their customers. Banking entities may now be prohibited from maintaining large inventories of stocks, commodities, bonds and derivatives to facilitate trades for their customers—and proving that specified market-making activities are permitted under the Rule may prove costly. Experts also fear the Rule will impinge upon financial institutions’ ability to manage customers’ risk by effectively hedging their positions.  While there are carve-outs for both market-making and hedging, the sufficiency of these exclusions and exceptions, discussed below, is unclear.


Additional skepticism stems from the fact that it may be impossible to distinguish between forbidden proprietary trading practices and permissible market-making and hedging. This lack of clarity may prove disastrous for regulators and banking entities alike, for whom drawing clear distinctions between permitted and prohibited activities may remain challenging.


What are the major exceptions to the Volcker Rule’s restrictions?


As referenced above, the Rule provides exceptions that permit some level of market-making, underwriting and risk-mitigating hedging activity. With regard to market-making, banking entities will still be permitted to purchase and sell reasonable amounts of financial instruments on a limited basis, provided such activities demonstrate only the intention to meet the near-term demands of clients. Such market-making activity must also adhere to Volcker Rule–required compliance programs that de-incentivize prohibited proprietary trading by bank representatives.


With regard to covered funds, several types of funds are specifically excluded from the Final Rule’s prohibitions. These include foreign public funds, acquisition vehicles, bank-owned life insurance and public welfare investment funds, among others. There are also a number of specific activities that are excluded from the Rule’s prohibitions, including banking entities acting as agents, brokers, custodians or trustees for customers, or current or former employees (subject to certain limitations).


Exceptions to the Volcker Rule Exceptions. The exceptions in both categories are undercut, however, by umbrella prohibitions on trading and fund activity that may foreclose the very exceptions that are ostensibly permitted. Specifically, transactions and funds do not qualify for exemptions if such activity:


  • involves or results in conflicts of interest between the financial institution and its customers, clients or counterparties, without providing necessary disclosures;
  • directly or indirectly causes the banking entity to be exposed to high-risk assets; or 
  • threatens the banking entity’s safety or the United States’ financial stability


What type of compliance programs does the Volcker Rule require?


As referenced above, the Rule requires banking entities to monitor their own trading through internal compliance programs. While all compliance programs must meet reporting and documentation requirements, the scope and coverage of such programs vary based on the size of the entity and complexity of the banking activities involved. For example, all entities need to maintain proper records for monitoring, while only larger banking entities need to provide CEO attestation of compliance.


According to the Rule, banking entities at a minimum must implement compliance programs that include:   


  • written policies and procedures reasonably designed to ensure compliance with the final rules, including limits on underwriting and market–making; 
  • internal control systems;
  • clear compliance-related accountability;
  • audits and testing by independent sources;
  • additional documentation for covered funds;
  • necessary training programs; and
  • proper record keeping


Banking entities with $50 billion or more in total consolidated assets, foreign banking entities with U.S. assets of $50 billion or more and other specified entities must adopt enhanced compliance programs that go beyond the requirements outlined above. 


Such programs must ensure responsibility and accountability at the following levels:


  • chief executive officers—annual attestation in writing that banking entity has implemented processes reasonably designed to achieve compliance;
  • boards of directors—oversight of program adoption, all compliance-related matters and activities of senior management;
  • senior management—annual reports to board regarding compliance program’s effectiveness;
  • business line managers—implementation and enforcement at the trading desk level


How is the financial industry responding to the Volcker Rule?


Reaction to the Rule has generally been cool to say the least, with certain institutions taking decidedly drastic preemptive actions on the eve of the Final Rule’s implementation. Many banks reportedly fear that complying with new regulations may result in literally billions of dollars in costs merely to continue engaging in permissible activities under the Rule. Community banks may be hit particularly hard, with the American Bankers Associations alleging that such banks will suffer around $600 million in losses due to required divestitures. In the end, the Rule’s ultimate impact may depend on how closely banks are scrutinized with regard to the permissibility of trades and the extent to which some degree of speculation is tolerated.


Key takeaways

  •  Important Dates (timeline):
    •  April 2014. The Final Rule becomes effective April 1, 2014, with the conformance period extending until July 21, 2015.  
    • June 2014. Starting on June 30, 2014, entities with $50 billion or more in consolidated trading assets and liabilities must report quantitative measurements. 
    •  April 2016. Banking entities with between $25 and 50 billion in consolidated trading assets and liabilities will become subject to the Rule’s requirements on April 30, 2016. Banking entities with between $10 and $25 billion in assets will become subject to the requirements on December 31, 2016.  

  •  A good defense may be the best offense: Banking entities should immediately begin preparing compliance programs that adhere to the Final Rule.
  • Keep an eye out for lawsuits: Counsel and compliance officers should watch developments and monitor any potential legal challenges, which may affect implementation of the Rule.
  • Watch regulators: The ultimate impact remains to be seen and regulatory agencies should be watched closely to see how banking entities are treated in the post-Volcker Rule economy.


While some degree of uncertainty may be inevitable during the Volcker Rule’s implementation period, banking entities must be prepared to devote adequate resources to compliance. The extent to which test cases and litigation may help define the parameters of permissible activity under the rule may also depend on how aggressive regulatory agencies seek to enforce various components of the Rule. Without question, the Volcker Rule will impact banking activities in the near term, with banks striving to craft profitable operating models in what may prove to be a highly regulated environment.

[i] See Jake Zamansky, Wall Street Will Prepare Ways to Gut the Volcker Rule, Forbes (Dec. 17, 2013, 2:35 PM), http://www.forbes.com/sites/jakezamansky/2013/12/17/wall-street-will-prepare-ways-to-gut-the-volcker-rule/.

[ii]  See 12 U.S.C. § 1851, Final Rule, ATTACHMENT B, p. 26. http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a2.pdf

[iii] Id.

[iv] See Edvard Pettersson, Volcker Rule Block Request Dropped by Bankers Group, Bloomberg News (Dec 31, 2013 7:01 AM), http://www.bloomberg.com/news/2013-12-30/volcker-rule-block-request-dropped-by-bankers-group.html.