It was always unlikely that any tinkering with the Volcker rule—no matter how well-intentioned—would move forward without a skirmish or two.
From its enactment, battle lines have been drawn to protect and insulate what many consider a centerpiece of the Dodd-Frank Act.
Despite smooth sailing before the Board of Governors of the Federal Reserve last week, amid a discussion on scaling back some of the rule’s requirements, similar enthusiasm was predictably unlikely, especially when you consider that five regulatory agencies—each with their own political bent and industry outlook—kicked around the proposed changes.
On May 30, the Federal Reserve Board voted unanimously 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.
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.
The revisions would also create 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.
“If we want to make sure bankers don’t gamble with taxpayer money, we should make sure they’re not getting paid to gamble with taxpayer money. Rolling back the Volcker rule while failing to address pay practices that allow bankers to profit from proprietary trading puts American investors, taxpayers, and markets at risk. That is a risk that I cannot accept.”
SEC Commissioner Robert Jackson
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. Any changes must also be approved by those agencies.
Since regulations implementing the Volcker rule were finalized in December 2013, critics have complained that the complexity of the rule creates compliance uncertainty. In recent months, there has been growing momentum, capped by recently passed legislation, to exempt banks with less than $10 billion in assets from the rule.
On June 4, Rostin Behnam, the Commodity Futures Trading Commission’s lone Democratic commissioner, was the first regulator to publicly challenge the rule changes. His objections, however, were not enough to prevent the proposal before the Commission from moving forward.
“My biggest concern is that our action today will encourage a return to the risky activities that led to the financial crisis, and perhaps further consolidate trading activity into a few institutions,” Behnam said. “Simply put, we are trying to make things clearer and easier for banking entities. My concern is that we are missing the mark here. In fact, we are actually further complicating the Volcker rule and calling it simplification.”
Where once there was one set of rules for all banking entities, there will now be three categories of banking entities with different rules for each, Benham explained. These categories, broadly speaking, group institutions by “significant trading assets and liabilities,” “moderate trading assets and liabilities,” and “limited trading assets and liabilities.”
“When we have determined what bucket each bank is in, there is still a safety valve that will allow regulators to move the entity into a different bucket,” Benham added.
He supported the idea that regulators have some flexibility in their categorical groupings, but raised other concerns.
The expansion of what constitutes risk-mitigating hedging activities “potentially provides a method to evade oversight,” Behnam said. “At the CFTC, we need to think very carefully about how the definition of hedging activity in the proposal compares to our definitions of hedging activity in the context of other critical rules like the de minimis threshold or position limits.”
“I also find that I am a little befuddled as to exactly what a presumption of compliance is, at least in the context of this rule,” Benham added. “It seems clear to me from the rule that the idea is not that a bank with limited trading assets and liabilities is actually any less likely to violate the Volcker rule by engaging in prohibited proprietary trading. Instead, the idea behind today’s rule is to reduce the impact of the Volcker rule’s restrictions on banks below the $10 billion threshold.”
That may be a laudable goal and the right result, “but it also is one that ultimately may require a statutory change,” he added. “What we should not be doing is presuming compliance for entities that we don’t think are any more likely to be compliant than other entities that do not receive the presumption.”
Behnam chastised participating regulators for failing to provide ample time to review the proposal. “My office received a near final draft for review five days before the agencies began voting on these rules,” he said. “I first received a partial draft three weeks before voting began. Worse, I was blocked from the process. I was told in no uncertain terms that the document we were seeing had been negotiated by the agencies (including the CFTC, without my input), and that essentially what I was seeing was a fait accompli.”
That sense of “mission accomplished” didn’t deter other critics, notably on the Securities and Exchange Commission, from voicing their own discontent. During a June 5 open meeting, SEC Commissioner Robert Jackson echoed Behnam’s disappointment.
“The Commission today joins several other agencies in rolling back protections designed to keep banks from speculating with taxpayer money—more commonly known as the Volcker rule,” he said. “Weakening these protections gives banks more leeway to do the kind of risky trading for which we should be ever more watchful.”
“To the degree that it was already difficult for regulators to distinguish market-making activity from prohibited proprietary trading, I worry that these changes will muddy the waters even further, giving bank lawyers new ways to hide risky bets,” Jackson added.
A “clear, common-sense reason” for opposing the proposed revisions is that “there is a simple way to prevent people from doing something,” Jackson said. “Don’t pay them to do it.”
“If we want to make sure bankers don’t gamble with taxpayer money, we should make sure they’re not getting paid to gamble with taxpayer money,” he added. “Rolling back the Volcker rule while failing to address pay practices that allow bankers to profit from proprietary trading puts American investors, taxpayers, and markets at risk. That is a risk that I cannot accept.”
“Whatever one thinks of Wall Street’s most talented traders, they can be expected to follow the money,” Jackson added. “There is evidence that, since the adoption of the Volcker Rule in 2013, much of the riskiest trading on Wall Street has moved to private funds. One concern about our vote today is that weakening Volcker will bring that trading back to firms with taxpayer backing. If we want to make sure this risk-taking is not subsidized by taxpayers, we should prohibit those firms from paying traders on the basis of their proprietary profits.”
Commissioner Kara Stein—who, like Jackson, is a Democrat—had similarly harsh words for the proposed amendment to the Volker rule.
“The proposed amendment could increase moral hazard risks related to proprietary trading by allowing dealers to take positions that are economically equivalent to positions they could have taken in the absence of the 2013 final rule,” she said.
Stein declared that “it is imperative” to understand what happened in recent decades, and “what drove such historic government intervention in the financial system.”
The original rule was focused on reducing conflicts of interest between banks and their customers and to promote competition, Stein said. The proposal to amend it “runs in the opposite direction.”
“The proposed amendment is actually aimed at making it easier for banks to take on greater leverage and risk,” she added. If adopted, it “would help undo the framework that has helped avoid another financial crisis. I believe that, overall, this proposal cleverly and carefully euthanizes the Volcker rule.”
Among other things, the proposal would allow banks to more easily classify any trade as a hedge, regardless of whether it effectively and demonstrably offsets risk, Stein claimed. Also, under the proposal, some of the requirements related to documentation and ongoing correlation analysis would no longer be required for certain hedges.
The more relaxed the hedging requirement, the more incentive the bank has to engage in speculative trading while classifying the trading as ‘hedging,’” Stein said. “This change could increase moral hazard and conflicts of interest to the extent that banking entities engage in more risky trading. … Why are we opening the door to more speculative trading by banks?”
Despite the arguments, Republicans on the SEC—Chairman Jay Clayton, Commissioner Michael Piwowar, and Commissioner Hester Peirce—voted in the affirmative and advanced the proposal for public comment.