The Volcker rule stakes a claim for being among the most controversial and maligned creations of the Dodd-Frank Act. It was pitched as a remedy for the bad behavior by banks—before, during, and after the financial crisis of 2008.
The rule, named for former Federal Reserve Chairman Paul Volcker, is a ban on proprietary trading by federally insured banks that should otherwise be standard depository institutions rather than dip their toes into the world of Wall Street and its hedge funds.
Proponents sing its praises as a necessary remedy for keeping banks simple and risk averse. Critics, however, see the rue as a massive compliance burden for all banks, especially community banks that are, in effect, punished for the bad moves of their larger brethren even though they had no role in the global economic meltdown.
The Volcker rule, once fiercely guarded by progressives, now faces reforms that have started to garner bipartisan support.
After achieving bipartisan support by the House Committee on Financial Services, H.R. 4790, the Volker Rule Regulatory Harmonization Act moved onto the House Rules Committee. It held an initial hearing on April 13. The bill was enacted by the full House by a 300-104 vote on Friday; 78 Democrats voted in favor along with a majority of Republicans.
If passed by the Senate (and signed by President Trump), the bill would amend Section 619 of the Dodd-Frank Act, which enacted the Volcker rule, to streamline the regulatory authority over the rule by granting the Federal Reserve the exclusive rulemaking authority and providing for sole examination and enforcement authority by an entity’s primary federal regulator.
Currently multiple agencies—the Office of the Comptroller of the Currency, Federal Reserve, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and Commodity Futures Trading Commission—jointly oversee the rule and its enforcement.
The bill stipulates that community banks will be exempt from the Volcker rule if they do not have, and are not controlled by, an entity with $10 billion or more in total consolidated assets and total trading assets or trading liability that are more than 5 percent of total consolidated assets.
Among the complaints with the rule is that it harms the important role of banks buying and selling securities on behalf of their customers, a practice known as “market making.”
Market making, critics say, is crucial to the modern financial system, in which companies raise funds by selling equity, bonds, notes, and commercial paper. The argument is that by acting as intermediaries between buyers and sellers, banks hold prices down. Corporations that issue debt to pay for capital investments, research and development, payroll, or new workers all depend on market makers to hold down the cost of credit.
“Although the drafters of the Volcker rule have acknowledged the key role that market making plays in ensuring deep, liquid capital markets, and as a result attempted to exempt market-making activities from prohibition on proprietary trading, the final rules implementing the Volcker rule create uncertainty for market participants, as there is no easy bright-line test to distinguish between the banned proprietary trading” and permissible market making,” reads a Republican policy statement. “Further, proprietary trading played no role in precipitating the financial crisis or making it worse, and proponents of the Volcker rule have never successfully explained how banning depository institutions from engaging in proprietary trading or investing in hedge funds and private equity makes the financial system less risky.”
Unfortunately, the GOP wrote, “the uncertainty and complexities involving the final rules make it difficult for banks to buy or sell securities for their own inventory in anticipation of client demand, because managing inventory can look like proprietary trading, subjecting the firm to regulatory sanctions and monetary penalties.”
“From its inception, the Volcker rule has been a solution in search of a problem. It seeks to address activities that had nothing to do with the financial crisis. The practical effect has been to undermine financial stability, rather than to preserve and protect it.”
Pete Sessions (R-Texas), Chairman, House Rules Committee
Another oft-cited complaint is the complexity of the 932-page rule, not the least of which is multi-agency oversight and the challenge of accurately defining the nuances of the rule’s definition of proprietary trading versus market making.
“From its inception, the Volcker rule has been a solution in search of a problem,” said Pete Sessions (R-Texas), chairman of the House Rules Committee, at last week’s hearing on the bill. “It seeks to address activities that had nothing to do with the financial crisis. The practical effect has been to undermine financial stability, rather than to preserve and protect it.”
The bill, he said, “provides community banks much-needed relief from the rule’s burdensome compliance obligations.”
Speaking in opposition to the bill was Rep. Jim McGovern (D-Mass.): “I wish there was more diversity in the legislation we have to consider,” he said. “It seems that all we do is chip away at oversight of our financial industries, and I worry that we are going back to the risky old days that led to the financial crisis and almost destroyed our entire economy.”
Rep. French Hill (R-Ark.), as a guest of the Rules Committee, was point man for defending the rule proposal.
“The structure of this rule has curtailed market-making activities that are critical for reducing costs on investors, homebuyers, and credit card users,” he said. “Market making is crucial because it provides liquidity for stocks, bonds, notes, and commercial paper, which companies rely upon when they raise capital, when they securitize important things like mortgages or credit card receivables.”
“The current Volcker rule framework is untenable,” he argued, adding, “relying on input from five different regulatory agencies with disparate statutory missions has resulted in confusion and inefficiencies. Hundreds of questions are pending before the Interagency Volcker Working Group, because it has yet to reach a consensus on how to answer them.
French explained that the new rule consolidates rulemaking for the Volcker rule with the Federal Reserve Board of Governors, the regulator traditionally charged with administering the Bank Holding Company Act. Other agencies will still have a role as the primary federal regulator for a covered entity that is charged with sole examination and enforcement authority for the Volcker rule.
Rep. Maxine Waters (D-Calif.) wasn’t buying the defense of the bill. It would provide a blanket exemption from the Volcker rule for 98 percent of the nation’s banks, based on the threshold of consolidated assets, she argued.
Most community banks do not engage in prohibited trading activities and therefore have no compliance obligations under the rule, she said. The rule, by specifying an exemption, could give community banks the thumbs up to begin speculative trading instead of focusing on the traditional business of banking. “It also makes community banks prime targets for hedge fund salesmen,” she said.
“If we truly want to decrease regulatory burdens for community banks that engage in permitted trading activity, we should be looking at other ways to accommodate them, such as by creating a presumption of compliance with the Volcker rule that doesn’t open a loophole,” Waters said. “Instead the bank would delegate sole rulemaking authority to the Federal Reserve, which could choose to consult or not consult with the other regulators.
“This would unreasonably cut the FDIC out of any future rule changes even though it is the regulator charged with protecting deposit insurance against the very risky speculative activities the Volcker rule was designed to prevent. It could also cut the OCC (Office of the Comptroller of the Currency) out of the rulemaking process even though it oversees institutions that account for approximately 40 percent of bank holding company trading revenues.”
Hill focused on the proposed legislation as a means to combat Volcker’s complexity.
“If you are a community bank and you hold municipal bonds over a weekend, or for five days, that you bought for a customer but are going to sell in the future, is that proprietary trading? Or is that making market in a local security that is perfectly appropriate and perfectly legal under the safety and soundness rules of banking? That’s the kind of thing that has created confusion,” he said.
“The problem with a ‘presumption of compliance’ in the real world is that no matter what is written down on the piece of paper, the bank will need to go through all of the compliance features anyway,” Hill added. “In reality, they won’t get the presumption. I know it may say that on paper, but the rule is still the rule. You will still need to demonstrate to your primary regulator that you are in compliance and you will get a question in that exam process to prove you are in compliance. You will still be investigated to the letter of the law to make sure that your presumption is, in fact, true.”
As for the move away from a multi-agency oversight, Hill defended the proposal to streamline the hierarchy. “You could maybe argue that the Fed is the first among equals here, but they are consulting with the other agencies, which are absolutely enforcing the rule over the institutions they are responsible for.”
The Federal Reserve, should it receive added authority, may have its own plans for reforming the Volcker rule.
During a March speech at the Institute of International Bankers’ annual Washington conference, Vice Chairman for Supervision Randal Quarles detailed some of the Fed’s highly anticipated initiatives. A focus of the speech was the Dodd-Frank Act’s Volcker rule and continuing efforts to scale back the ban on proprietary lending by federally insured banks.
“I believe the regulation implementing the Volcker rule is an example of a complex regulation that is not working well,” Quarles said. “We have to ask how to improve the framework of the implementing regulation to make it more workable and less burdensome in practice from both a compliance and supervisory perspective.”
“I think we all can agree that the implementing regulation is exceedingly complex,” he added. “As one example of specifics, among many, the statute and implementing regulation’s approach to defining ‘market making-related activities’ rests on a number of complex requirements that are difficult or impossible to verify objectively in real time. As a result, banks spend far too much time and energy contemplating whether particular transactions or positions are consistent with the Volcker rule.”
The Federal Reserve, he said, is actively working with other regulators to engage in a rulemaking process and develop a proposal for public comment that would make material changes to the Volcker rule regulations.
It should be clearer and more transparent what is subject to the Volcker rule’s implementing regulation and what is not, Quarles said. The definition of key terms like “proprietary trading” and “covered fund” should be as simple and clear as possible.
“It should not be a guessing game or require hours of legal analysis of complex banking and securities regulations to determine if a particular entity is a covered fund,” he said.
In August 2017, the OCC also opened a public comment period that seeks proposed changes to the rule.
Specifically, the OCC invited input on ways to tailor the rule’s requirements and clarify key provisions that define prohibited and permissible activities.