Volcker Rule Finalized

Here's what's in the much-anticipated final version of the Volcker Rule, designed to increase oversight of securities trading.

Wall Street faces intrusive new government oversight of trading after U.S. regulators issued what they billed as a stricter Volcker rule today, imposing restrictions designed to prevent blowups while leaving many of the details to be worked out later.

The Federal Reserve, the Federal Deposit Insurance Corp. (FDIC), and three other agencies are set to sign off today on the proprietary trading ban, which has been contested by JPMorgan Chase & Co., Goldman Sachs Group Inc., and their industry allies for more than three years. Agencies were proceeding with plans to release the rule in Washington even as a snowstorm forced the federal government to close.

Wall Street’s lobbying paid off in part. Regulators granted a broader exemption for banks’ market-making desks, on the condition that traders aren’t paid in a way that rewards proprietary trading, according to the final rule released today. The regulation also exempts some securities tied to foreign sovereign debt. At the same time, regulators gave banks less leeway for bets considered hedges for other risks.

“This provision of the Dodd-Frank Act has the important objective of limiting excessive risk-taking by depository institutions and their affiliates,” Fed Chairman Ben Bernanke said today in a statement. “The ultimate effectiveness of the rule will depend importantly on supervisors, who will need to find the appropriate balance while providing feedback to the board on how the rule works in practice.”

The Fed gave banks a delay until July 21, 2015 to comply with rule. Beginning June 30, 2014, banks with $50 billion in consolidated assets and liabilities must report quantitative information about their trading.

The rule is named for Paul Volcker, the former Fed chairman credited with taming rampant inflation in the 1970s and who served as a top adviser to President Barack Obama. Volcker, 86, proposed the ban as a means of restoring stability to Wall Street following the 2008 financial crisis, arguing that banks that benefit from federal deposit insurance and discount borrowing shouldn’t be permitted to take risks that could trigger a taxpayer-funded government bailout.

The rule, enshrined by the Dodd-Frank Act of 2010, allows exemptions for market-making and some hedging, and defines limits for banks’ investments in private equity and hedge funds. The version issued today is 71 pages long, with an additional 850-page preamble.

“Nobody went to jail after the Wall Street meltdown,” said Jim Antos, a Hong Kong-based analyst at Mizuho Securities Asia Ltd. in Hong Kong. “And maybe, the particular way they’re wording this ensures that nobody is ever going to go to jail. You’re getting diplomatic immunity and you don’t even have to be a foreign diplomat. Fantastic.”

The biggest U.S. banks slid in pre-market trading. JPMorgan Chase & Co. declined 0.4 percent to $56.28 at 8:56 a.m. in New York, and Bank of America Corp. shares fell 0.3 percent to $15.53. Goldman Sachs Group Inc. slid 0.7 percent to $166.45 and Morgan Stanley fell 0.2 percent to $30.32.


Fine Print

With Wall Street banks having already shut proprietary trading desks in anticipation of the rule, its impact rests largely in the fine print—how regulators address other banking activities, primarily market-making and hedging.

The rule by the Fed, FDIC, Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and Office of the Comptroller of the Currency sets parameters for how banks may buy and sell financial products for clients and manage their own risks in the process.

Wall Street’s five largest firms had as much as $44 billion in revenue at stake on the outcome of just one part of the debate—how market-making is defined and exempted—according to data for the year ended Sept. 30. JPMorgan, the biggest U.S. lender by assets, had as much as $11.4 billion riding on the answer.

Here are summaries of five of the rule’s major provisions:


Making markets. The Volcker rule bans banks, including New York-based Goldman Sachs and Morgan Stanley, from trading to profit for their own accounts, while allowing them to continue making markets for clients. Distinguishing between those two practices has been one of the most difficult tasks for regulators.

In the final rule, regulators eased the criteria banks must meet to qualify for the market-making exemption. To receive the exemption, a trading desk must both buy and sell contracts or enter into both long and short positions of those instruments for its own account.

The trades must not exceed, on an ongoing basis, the “reasonably expected near-term demands of clients.” The rule instructs banks to determine that demand based on historical data and other market factors. Further, the rule requires that compensation arrangements not be designed to reward prohibited trading.

Bankers became concerned about the rule’s potential to ban big parts of their business almost immediately after Dodd-Frank was passed in 2010. The 2011 draft included a list of criteria to be met for trading to be exempted as market-making.

Fed Governor Daniel Tarullo said the rule had been “simplified somewhat, particularly by reducing the number of metrics that will be used in the reporting and analysis of trading data.”

Industry lobbyists urged the exemption be widened, saying regulators needed to recognize that banks routinely buy and sell stocks, bonds, and derivatives and build up inventories to help clients when they eventually place orders. Restricting those practices would hurt companies selling bonds, for example. Banks were joined by asset managers such as Vanguard Group Inc. and AllianceBernstein Holding LP in warning that a narrow exemption could unsettle markets.

Portfolio hedging. In the final rule, regulators require banks to demonstrate on an ongoing basis that their trades hedge specific risks in order to win an exemption from the Volcker rule.

The banks must analyze and independently test that their hedges “may reasonably be expected” to reduce the identified risk, the draft says. Banks will need to show that a hedge “demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks,” the rule says.

The final rule requires banks to have an “ongoing recalibration of the hedging activity by the banking entity to ensure that the hedging activity” is not prohibited.

The hedging provision became central to the Volcker rule debate after JPMorgan lost $6.2 billion last year in bets on credit derivatives known as the London Whale. The trades, conducted in the U.K. by the bank’s chief investment office and nicknamed for their market impact, were described by JPMorgan executives as a portfolio hedge. The bank’s synthetic credit portfolio produced about $2.5 billion of revenue in the five years before 2012, according to a Senate subcommittee report on the bets.

Bart Chilton, a Democratic CFTC commissioner who said Nov. 20 that he planned to vote against the rule because it was too weak, said today that it had been strengthened enough since to win his support.

“The language has been solidified tightly to avoid loopholes,” Chilton said in a statement. “When people say this version of the Volcker rule will stop circumstances like the London Whale, this ongoing recalibration provision is exactly what will help avoid similar debacles.”

Senator Carl Levin, 79, the Michigan Democrat who leads the Permanent Subcommittee on Investigations, joined other Democrats and some regulators in pushing for a narrower definition of hedging after the JPMorgan trades. Tarullo, the Fed governor responsible for financial regulation, called the trades a “real world” case to be considered as the rule was drafted.

Three months after the losses were disclosed in 2012, JPMorgan Chairman and Chief Executive Officer Jamie Dimon, 57, told lawmakers that the Volcker ban “may very well have stopped parts of what this portfolio morphed into.”

Still, Wall Street pressed regulators to allow banks leeway in how they manage assets and liabilities with hedges. “An overly restrictive Volcker rule would curtail market liquidity, harm investors, and dampen economic growth,” said Kenneth Bentsen, president of the Securities Industry and Financial Markets Association, Wall Street’s biggest lobby group, in a Dec. 5 e-mailed statement.


Sovereign debt. The buying and selling of securities backed by a foreign sovereign will be permitted trading under certain circumstances, according to the rule. That exemption includes securities issued by foreign central banks and applies to U.S. banks with overseas operations as well as foreign firms with affiliates in the U.S.

The initial Volcker rule draft drew international criticism for its reach into banks based overseas as well as for its impact on foreign sovereign debt markets.

The push-back started in late 2011 after the Volcker proposal exempted trading in U.S. government securities while covering debt issued by foreign countries. Officials from Canada, Japan, and the U.K. sent letters to U.S. financial regulators and the Treasury Department saying the measure would harm their ability to fund governments.

Michel Barnier, the European Union’s financial services chief, complained to then-Treasury Secretary Timothy F. Geithner about the rule’s “extraterritorial consequences.” Canadian and Mexican bankers and government officials said the proprietary trading ban would violate the North American Free Trade Agreement’s guarantee that banks be allowed to deal equally in U.S. and Canadian debt obligations.

Regulators also allowed more flexibility for overseas banks. They will be exempt from the ban for trades accounted for outside the U.S. so long as their employees deciding to buy and sell contracts are also located outside the country. The final rule also frees overseas banks from the ban for trades they conduct on U.S.-based exchanges and clearinghouses, and for trades they have with foreign operations of U.S. banks.


Fund investments. The proprietary trading rule seeks to limit banks’ speculative bets in another way: by curbing their investments in private equity, hedge funds, and commodity pools.

U.S. banks have already begun cutting their stakes, with further reductions needed to meet the law’s limit of 3 percent of Tier 1 capital invested in the funds. For example, Goldman Sachs cut its investment in such funds to $14.9 billion as of Sept. 30, down from $15.4 billion when Dodd-Frank was passed.

Regulators granted broader exemptions for some types of funds. Under the final rule, joint ventures, issuers of asset-backed securities, and wholly-owned subsidiaries are among exempt funds.

In an effort to limit the provision’s impact, bank representatives told regulators too many types of investments were included in the 2011 proposal. The draft restrictions went beyond traditional private equity and hedge funds, they said.

Bankers argued that using such a broad definition would capture investment vehicles used when loans are bundled into securities, as well as commodity pools and funds based overseas. In a February 2012 letter to regulators, lobbying groups for the largest banks called the covered funds definition the “most far-reaching flaw” in the proposal.


CEO responsibility. Apart from the specific limits on bank investments and trading practices, the Volcker rule includes efforts at changing part of the culture of trading on Wall Street.

The approach was underscored by a speech in Washington last week by Treasury Secretary Jacob J. Lew, who said executives in charge of financial firms need to ensure that the “tone at the top” reflects a strong desire to prevent violating the rule.

Toward that end, the rule has a section entitled “responsibility and accountability,” which details how banks should set up compliance programs. They must have written procedures that are approved by the board of directors as well as the senior management of the bank, according to the rule.

The board and top managers “are responsible for setting and communicating an appropriate culture of compliance,” the rule said.

The centerpiece of the governance changes is a requirement that CEOs “annually attest in writing” that the company has “procedures to establish, maintain, enforce, review, test, and modify” the compliance program.

The wording will be a relief to Wall Street chiefs who were concerned that they would have to personally guarantee that their firms were in compliance with the rule, according to people familiar with the banks’ thinking. Executives already file a similar certification with the Financial Industry Regulatory Authority, a self-regulatory group for brokerage firms.

The certification wasn’t part of the Volcker rule when it was first proposed two years ago; it was added to send a signal that regulators weren’t bending to a massive lobbying campaign by financial firms, according to two officials familiar with the rule.


Supervisory Focus

In the end, after hundreds of pages outlining numerous what-if’s, exemptions, and special circumstances, the rule reiterates that banks will now have to prove to supervisors that they are adhering to the overriding principle that Volcker and Obama put forward in 2010 as a way to prevent another financial meltdown.

According to documents released by the Fed, the rule prohibits “any transaction or activity” exposing banks to high-risk assets or strategies “that would substantially increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States.”

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