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News February 7, 2011 Issue

Volcker Rule Report Recommends Shape Of Rulemaking

As part of the sweeping financial reforms of last summer, banks were mostly banished from proprietary trading. No hedge funds, no private equity funds, only limited bona fide hedging by a bank and certain other lower-risk activities would be permitted.

It has not been effected yet, but the process has begun. What has been dubbed the "Volcker Rule," after former Federal Reserve chairman and current Obama Administration adviser Paul Volcker, will see a reduction in banking risk (and return) activity.

Federally insured bank deposits took the risk out of certain high-risk bank investing practices, but taxpayers were left holding the bag, said Volcker. To protect taxpayer funds and redirect banking to more "traditional" activity, Section 619 of the Dodd-Frank Act sets limits on hedging and other proprietary trading activity by banks.

In general, the Volcker Rule forbids banks from acting as principal "in order to profit from near-term price movements" except in limited trading circumstances, and from operating proprietary hedge or private equity funds. Banks – which include parent companies, certain bank holding companies, and any subsidiary or affiliate of such bank holding company – may engage on a limited basis in certain "riskier" activities. Those activities include market making, underwriting, hedging, transactions for customers or in government securities, and certain offshore activities.

Banks may organize and offer hedge and private equity funds, but only to the extent of establishing and initially capitalizing such funds sufficient to attract unaffiliated investors. Within a year after a fund’s launch, the bank must reduce its equity interest to not more than three percent of the fund’s total ownership interests. Not more than three percent of the bank’s Tier 1 capital may be devoted to such fund investments.

For non-bank financial companies supervised by the Federal Reserve Board – watch out anyone who presents enough of a systemic risk to warrant special FRB oversight – the Volcker Rule will not expressly prohibit or limit certain activities. It will however, levy the equivalent of "sin taxes" on them by imposing additional capital charges or other restrictions "to address the risks and conflicts of interest that the Volcker Rule was designed to address."

Section 619 also required the Financial Stability Oversight Council (FSOC) to recommend next steps to effect the prohibitions for banks. The FSOC’s report was released January 18, and its recommendations must be considered by the SEC, CFTC, and banking regulatory authorities as they promulgate implementing regulations, but are not controlling. Rules effecting the mandate must be adopted within nine months – that’s mid-October.

It’s anybody’s guess as to which way the final regulations will blow, but here’s what the FSOC report suggested.

To implement the rule, the FSOC said regulators should consider requiring banks to:

  • sell or wind down all impermissible proprietary trading desks;
  • implement a "robust compliance regime," complete with regular CEO attestations as to the effectiveness of the program;
  • test for potentially impermissible proprietary trading;
  • submit to supervisory review of trading activity that would distinguish permitted activities from impermissible proprietary trading;
  • create flags to identify customer-initiated trading to regulators;
  • divest impermissible proprietary trading positions and impose penalties when warranted; and
  • publicly disclose permitted exposure to hedge funds and private equity funds.

Regulation should consider prohibiting banks from:

  • investing in or sponsoring any hedge fund or private equity fund, except in connection with bona fide trust, fiduciary or investment advisory services provided to customers;
  • engaging in transactions that would allow them to "bail out" a hedge fund or private equity fund; and
  • operating similar type funds in an attempt to evade the intent of the rule.