Don’t call it a rollback. A slate of reforms for the always controversial Volcker rule that were proposed this week doesn’t retreat from the Dodd-Frank Act rules as much as some in the banking sector might wish for.
Fed Vice Chairman for Supervision Randal Quarles referred to the effort as “an important milestone in comprehensive Volcker rule reform,” albeit “not the completion of our work.”
Continuing recent efforts to chip away at the Dodd-Frank Act, the Federal Reserve Board voted unanimously on May 30 to seek public comment on a proposal to simplify and tailor compliance requirements relating to the rule.
Enacted as a response to the financial crisis, the Volcker rule declares that proprietary trading—the practice of a financial institution engaging in trading activities with its own money—is generally not an appropriate line of business for a federally insured commercial bank.
The rule prohibits covered banking entities from engaging in proprietary trading and from retaining an ownership interest in hedge funds or private equity funds.
Exempted from the prohibition, and subject to conditions, are certain activities: trading in U.S. government, agency, and municipal obligations; underwriting and market-making-related activities; risk-mitigating hedging activities; trading on behalf of customers; trading for the general account of insurance companies; and foreign trading by non-U.S. banking entities.
Since regulations implementing the Volcker rule were finalized in December 2013, spreading oversight among five federal agencies, critics say the complexity of the rule has created compliance uncertainty for banks.
“The agencies responsible for implementing the rule see many opportunities to simplify it and improve it in ways that will allow firms to conduct appropriate activities without undue burden and without sacrificing safety and soundness,” Chairman Jerome Powell said. “The proposal will address some of the uncertainty and complexity that now make it difficult for firms to know how best to comply and for supervisors to know that they are in compliance.”
Powell, prior to the vote, added that the proposal “is faithful to both the text and the spirit of the law.”
“We have had almost five years of experience in applying the Volcker rule,” he added. “The agencies responsible for implementing the rule see many opportunities to simplify and improve it in ways that will allow firms to conduct appropriate activities without undue burden and without sacrificing safety and soundness.”
“Our goal is to replace overly complex and inefficient requirements with a more streamlined set of requirements. This proposed rule will tailor the Volcker rule’s requirements by focusing the most comprehensive compliance regime on the firms that do the most trading. Firms that do more modest amounts of trading will face fewer requirements.”
“Quarles is certainly using his bully pulpit to put forward the issues that he and his staff at the Fed are interested in, including Volcker.”
Doug Landy, Financial Services Regulation Attorney, Milbank
The proposed changes were jointly developed by all five agencies responsible for administration of the Volcker rule—the Federal Reserve Board, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.
Specifically, the proposed changes would:
Tailor the rule’s compliance requirements based on the size of a firm’s trading assets and liabilities, with the most stringent requirements applied to firms with the most trading activity;
Provide more clarity by revising the definition of “trading account” in the rule, in part by relying on commonly used accounting definitions;
Clarify that firms that trade within appropriately developed internal risk limits are engaged in permissible market making or underwriting activity;
Streamline the criteria that apply when a bank seeks to rely on the hedging exemption from the proprietary trading prohibition;
Limit the impact of the Volcker rule on the foreign activity of foreign banks; and
Simplify the trading activity information that banks are required to provide to the agencies.
Other changes include:
Creating categories of banking entities based on the size of their trading assets and liabilities that would be used to tailor certain requirements of the rule;
Revising and better defining terms relevant to proprietary trading activity; and
Amending the rule’s annual CEO attestation requirement.
The proposal would also focus “on quantitative, bright-line rules where possible to provide clarity regarding prohibited and permissible activities.”
Comment will be accepted for 60 days after the proposal’s publication in the Federal Register.
“By focusing the application of the rule on those firms with the highest levels of activity covered by the statue, and by clarifying and simplifying the compliance regime, we can promote safety and soundness while reducing unnecessary burdens,” Quarles said prior to the vote.
During a debate on the rule proposal, Powell pointed out that roughly 95 percent of the trading assets in the U.S. financial system are held by a handful of institutions with more than $10 billion in assets under their control (the actual number is 18). They are, therefore, the institutions that do, and will, face the most stringent requirements of the Volcker rule.
“That provides a good, sound basis for understanding why we think it is so important to tailor application for the very large number of firms who have quite small levels of trading assets,” he said.
Powell’s overarching question: “If you work at a trading desk at one of those larger firms, how does this proposal affect you? How does your life change from the standpoint of this proposal?”
“The goal of the proposal is not to restructure how banking entities conduct their trading operation, but to clarify which activities, exactly, are permitted on the trading desk and which activities are prohibited,” answered Kevin Tran, supervisory financial analyst for the Fed. “In that sense, the proposal would help banks operate their trading desks in a more efficient manner.”
Another question from Powell: “We are going to let the banking entities set their own position limits for underwriting and market-making activities. How do we get comfortable with the idea of letting the banks set these position limits themselves?”
“Staff believes that the existing requirements for underwriting and market making have been very prescriptive and, as a result, could inhibit otherwise permissible trading activities,” answered Greg Frischmann, counsel for the Board of Governors of the Federal Reserve System. “This proposal would provide these firms with greater flexibility to engage in these permissible activities in ways that are consistent with the statute. The agencies, however, will closely review these limits and the process by which they are established on an ongoing basis.”
“The proposal provides that you are only eligible for this presumption that trading within risk limits is permissible if you have set your limits appropriately,” he added. “The firms will have a strong incentive to set these limits in an appropriate manner when they know that the agencies will be reviewing those limits on an ongoing basis.”
The proposed rule would recognize that small asset size is not the only indicator of reduced proprietary trading risk, Quarles explained. It would group firms that remain subject to the rule based on the risk arising from their trading activity.
Specifically, the proposal includes three tiers of firms based on trading activity levels, with the resulting compliance requirements tailored based on level of trading activity. Firms with “limited trading activity,” defined as less than $1 billion of trading assets and liabilities, would be presumed to comply with the Volcker rule.
Lael Brainard, a member of the Fed’s Board of Governors, also supported the proposal.
“The premise of the Volcker rule is compelling,” she said. “Banks should not engage in speculative trading activity for which the federal safety net was never intended. Since the Volcker rule was enacted, banks have closed their stand-alone proprietary trading desks and substantially reduced the overall market and liquidity risk profile of their trading books. It is hard to see compelling evidence that the Volcker rule has materially disrupted liquidity provisions in key markets.”
Nevertheless, experience with its implementation “suggests that the interagency rule has turned out to be needlessly cumbersome in practice,” she added. “The application of the Volcker rule to firms with little trading activity results in compliance costs without a commensurate benefit to financial stability.”
The compliance mechanism developed by the agencies to distinguish between proprietary trading, on the one hand, and underwriting and market making, on the other hand, has been difficult to implement and supervise in practice, Brainard added.
“Rather than requiring banking institutions to undertake specific quantitative analyses prescribed by the regulators, the proposed revisions would require banking institutions to establish internal risk limits to achieve the principle of not exceeding the reasonably expected near-term demands of customers, subject to supervisory review,” she said, adding that “the requirement of CEO attestation is critical for this to work.”
Subsequent to the Fed’s vote, there were both cheers and jeers for the initiative.
“Let’s call it like it is,” said Sen. Jeff Merkley (D-Ore.), a co-author of the Volcker rule. “This is a massive giveaway to the biggest banks. Our small, local community banks don’t want to run hedge funds with their customers’ money. This is a brazen attempt by big bank CEOs and their Trump-appointed allies to reopen the Wall Street casino, less than 10 years after the passage of financial reform.”
“These are not small, technical changes,” he added. “These are massive rewrites to make it easier for Wall Street banks to engage in the same types of risky bets that brought down our economy in 2008. This is a backdoor attempt to roll back financial reform laws without going through Congress, and every American who wants to hold Wall Street accountable and avoid a repeat financial crisis should be deeply alarmed.”
A more positive review comes from John Berlau, a senior fellow for the Competitive Enterprise Institute, which supports free market solutions. He blamed the Volcker rule for worsening the steep decline in initial public offerings and number of companies on U.S. stock exchanges.
“It is another impediment to growing companies going public because it creates uncertainty about banks’ ability to buy shares to engage in ‘market making’ for these firms,” he says. “If regulators clarify that a bank’s buying of shares to create a market for publicly traded firms is exempt from the law’s ban on ‘proprietary trading,’ that would help entrepreneurs access capital and middle-class investors access wealth.”
Along with the current reform proposal, other efforts to scale back or eliminate the Volcker rule and similar regulations will undoubtedly continue.
Late last month, for example, the Economic Growth, Regulatory Reform, and Consumer Protection Act became law. The legislation included measures to exempt banks with less than $10 billion in assets and small trading books from the Volcker rule.
“As a result, the proposal before us today, and the regulation more broadly, quite appropriately no longer applies to those firms,” Quarles said of how that law connects to the Fed’s proposal.
Expect more of this to come.
“Quarles is certainly using his bully pulpit to put forward the issues that he and his staff at the Fed are interested in, including Volcker,” says Doug Landy, a financial services regulation attorney at the Milbank law firm.
On the agenda for those with a focus on bank regulations, he says, are stress test transparency and frequency, having more narrowly calculated liquidity rules, providing relief for small- and medium-sized banks on current liquidity rules, and making “living will” rules and resolution plans simpler and less frequent.
“There is a theme running through them, which is they provide targeted relief, especially in complying with a set of complex and overlapping rules,” Landy says. “They do not roll them back to provide substantive relief, instead they are saying, ‘Let’s make the rules work better and be easier to comply with; let’s make reporting easier.’ ”
In essence, regulators and legislators are saying, “let’s run a regulatory cost benefit analysis using the evidence we have from the close to eight years since Dodd-Frank has passed and decide where can we target changes,” he adds.