The Volcker Rule
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the ―Dodd-Frank Act)
The Dodd-Frank Act is intended to strengthen the financial system and constrain risk taking at banking entities.
Section 619 of the Dodd-Frank Act, also known as the Volcker Rule, is a key component of this effort.
The Volcker Rule prohibits banking entities, which benefit from federal insurance on customer deposits or access to the discount window, from engaging in proprietary trading and from investing in or sponsoring hedge funds and private equity funds, subject to certain exceptions.
The proprietary trading provisions prohibit a banking entity from engaging in trading activity in which it acts as a principal in order to profit from near-term price movements.
The hedge fund and private equity fund provisions generally prohibit a banking entity from investing in, or having certain relationships with, any fund that is structured under exclusions commonly used by hedge funds and private equity funds under the Investment Company Act of 1940 (the Investment Company Act).
However, to ensure that the economy and consumers continue to benefit from robust and liquid capital markets and financial intermediation, the Volcker Rule provides for certain ―permitted activities that represent core banking functions such as certain types of market making, asset management, underwriting, and transactions in government securities.
These permitted activities – in particular, market making, hedging, underwriting, and other transactions on behalf of customers – often evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives, and it will be important for Agencies to carefully weigh all characteristics of permitted and prohibited activities as they design the Volcker Rule implementation framework.
These permitted activities are subject to a prudential ―backstop that prohibits such activity if it would result in a material conflict of interest, material exposure to high-risk assets or high-risk trading strategies, a threat to the safety and soundness of the banking entity, or a threat to the financial stability of the United States.
For nonbank financial companies that are supervised by the Board, the Volcker Rule does not expressly prohibit or limit any activities.
Instead, the Volcker Rule requires that the Board adopt rules imposing additional capital charges or other restrictions on such companies to address the risks and conflicts of interest that the Volcker Rule was designed to address.
Since the enactment of the Dodd-Frank Act, a number of banking entities have shut down, or announced plans to shut down, their operationally distinct, dedicated proprietary trading operations and hedge fund and private equity fund businesses that were a source of losses during the crisis.
While these actions have reduced proprietary trading activity, impermissible proprietary trading may continue to occur, including within permitted activities that are not organized solely to conduct impermissible proprietary trading.
As Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, explained in his testimony to the Senate Banking Committee when he urged adoption of this provision:
- What we can do, what we should do, is recognize that curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services.
Recurrent pressures, volatility and uncertainties are inherent in our market-oriented, profit-seeking financial system.
By appropriately defining the business of commercial banks ... we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek.
AGENCIES: Office of the Comptroller of the Currency, Treasury (“OCC”); Board of Governors of the Federal Reserve System (“Board”); Federal Deposit Insurance Corporation (“FDIC”); and Securities and Exchange Commission (“SEC”).The Dodd-Frank Act was enacted on July 21, 2010.
Section 619 of the Dodd Frank Act added a new section 13 to the Bank Holding Company Act of 1956 (“BHC Act”) (codified at 12 U.S.C. 1851) that generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund(“covered fund”), subject to certain exemptions.
New section 13 of the BHC Act also provides that a nonbank financial company designated by the Financial Stability Oversight Council (“FSOC”) for supervision by the Board (while not a banking entity under section 13 of the BHC Act) would be subject to additional capital requirements, quantitative limits, or other restrictions if the company engages in certain proprietary trading or covered fund activities.
Section 13 of the BHC Act generally prohibits banking entities from engaging as principal in proprietary trading for the purpose of selling financial instruments in the near term or otherwise with the intent to resell in order to profit from short-term price movements.
Section 13(d)(1) expressly exempts from this prohibition, subject to conditions, certain activities, including:
• 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.
Section 13 of the BHC Act also generally prohibits banking entities from acquiring or retaining an ownership interest in, or sponsoring, a hedge fund or private equity fund.
Section 13 contains several exemptions that permit banking entities to make limited investments in hedge funds and private equity funds, subject to a number of restrictions designed to ensure that banking entities do not rescue investors in these funds from loss and are not themselves exposed to significant losses from investments or other relationships with these funds.
Section 13 of the BHC Act does not prohibit a nonbank financial company supervised by the Board from engaging in proprietary trading, or from having the types of ownership interests in or relationships with a covered fund that a banking entity is prohibited or restricted from having under section 13 of the BHC Act.
However, section 13 of the BHC Act provides that these activities be subject to additional capital charges, quantitative limits, or other restrictions.
The Agencies are adopting the final rule to implement section 13 of the BHC Act with a number of changes to the proposal, as described further below.
The final rule adopts a risk-based approach to implementation that relies on a set of clearly articulated characteristics of both prohibited and permitted activities and investments and is designed to effectively accomplish the statutory purpose of reducing risks posed to banking entities by proprietary trading activities and investments in or relationships with covered funds.
The final rule has been designed to ensure that banking entities do not engage in prohibited activities or investments and to ensure that banking entities engage in permitted trading and investment activities in a manner designed to identify, monitor and limit the risks posed by these activities and investments.
For instance, the final rule requires that any banking entity that is engaged in activity subject to section 13 develop and administer a compliance program that is appropriate to the size, scope and risk of its activities and investments.
The rule requires the largest firms engaged in these activities to develop and implement enhanced compliance programs and regularly report data on trading activities to the Agencies.
The Agencies believe this will permit banking entities to effectively engage in permitted activities, and the Agencies to enforce compliance with section 13 of the BHC Act.
In addition, the enhanced compliance programs will help both the banking entities and the Agencies identify, monitor, and limit risks of activities permitted under section 13, particularly involving banking entities posing the greatest risk to financial stability.
The Agencies have designed the final rule to achieve the purposes of section 13 of the BHC Act, which include prohibiting banking entities from engaging in proprietary trading or acquiring or retaining an ownership interest in, or having certain relationships with, a covered fund, while permitting banking entities to continue to provide, and to manage and limit the risks associated with providing, client-oriented financial services that are critical to capital generation for businesses of all sizes, households and individuals, and that facilitate liquid markets.
These client-oriented financial services, which include underwriting, market making, and asset management services, are important to the U.S. financial markets and the participants in those markets.
At the same time, providing appropriate latitude to banking entities to provide such client-oriented services need not and should not conflict with clear, robust, and effective implementation of the statute’s prohibitions and restrictions.
As noted above, the final rule takes a multi-faceted approach to implementing section 13 of the BHC Act. In particular, the final rule includes a framework that clearly describes the key characteristics of both prohibited and permitted activities.
The final rule also requires banking entities to establish a comprehensive compliance program designed to ensure compliance with the requirements of the statute and rule in a way that takes into account and reflects the banking entity’s activities, size, scope and complexity.
With respect to proprietary trading, the final rule also requires the large firms that are active participants in trading activities to calculate and report meaningful quantitative data that will assist both banking entities and the Agencies in identifying particular activity that warrants additional scrutiny to distinguish prohibited proprietary trading from otherwise permissible activities.
As a matter of structure, the final rule is generally divided into four subparts and contains two appendices, as follows:
• Subpart A of the final rule describes the authority, scope, purpose, and relationship to other authorities of the rule and defines terms used commonly throughout the rule;
• Subpart B of the final rule prohibits proprietary trading, defines terms relevant to covered trading activity, establishes exemptions from the prohibition on proprietary trading and limitations on those exemptions, and requires certain banking entities to report quantitative measurements with respect to their trading activities;
• Subpart C of the final rule prohibits or restricts acquiring or retaining an ownership interest in, and certain relationships with, a covered fund, defines terms relevant to covered fund activities and investments, as well as establishes exemptions from the restrictions on covered fund activities and investments and limitations on those exemptions;
• Subpart D of the final rule generally requires banking entities to establish a compliance program regarding compliance with section 13 of the BHC Act and the final rule, including written policies and procedures, internal controls, a management framework, independent testing of the compliance program, training, and recordkeeping;
• Appendix A of the final rule details the quantitative measurements that certain banking entities may be required to compute and report with respect to certain trading activities;
• Appendix B of the final rule details the enhanced minimum standards for programmatic compliance that certain banking entities must meet with respect to their compliance program, as required under subpart D.
Proprietary Trading Restrictions
Subpart B of the final rule implements the statutory prohibition on proprietary trading and the various exemptions to this prohibition included in the statute.
The final rule contains the core prohibition on proprietary trading and defines a number of related terms, including “proprietary trading” and “trading account.”
The final rule’s definition of proprietary trading generally parallels the statutory definition and covers engaging as principal for the trading account of a banking entity in any transaction to purchase or sell specified types of financial instruments.
The final rule’s definition of trading account also is consistent with the statutory definition.
In particular, the definition of trading account in the final rule includes three classes of positions.
First, the definition includes the purchase or sale of one or more financial instruments taken principally for the purpose of short-term resale, benefitting from short-term price movements, realizing short-term arbitrage profits, or hedging another trading account position.
For purposes of this part of the definition, the final rule also contains a rebuttable presumption that the purchase or sale of a financial instrument by a banking entity is for the trading account of the banking entity if the banking entity holds the financial instrument for fewer than 60 days or substantially transfers the risk of the financial instrument within 60 days of purchase (or sale).
Second, with respect to a banking entity subject to the Federal banking agencies’ Market Risk Capital Rules, the definition includes the purchase or sale of one or more financial instruments subject to the prohibition on proprietary trading that are treated as “covered positions and trading positions” (or hedges of other market risk capital rule covered positions) under those capital rules, other than certain foreign exchange and commodities positions.
Third, the definition includes the purchase or sale of one or more financial instruments by a banking entity that is licensed or registered or required to be licensed or registered.
Who is Paul A. Volcker?
Mr. Volcker was born on September 1927 in Cape May, New Jersey.
He earned a bachelor of arts degree, summa cum laude, from Princeton in 1949, and a master of arts degree in political economy and government from the Harvard University Graduate School of Public Administration in 1951.
From 1951 to 1952, he was Rotary Foundation Fellow at the London School of Economics.
Mr. Volcker’s experience with the New York Fed began when he worked as a research assistant in the research department during the summers of 1949 and 1950.
He returned to the New York Fed as an economist in the research department in 1952, and became a special assistant in the securities department in 1955.
Two years later, he resigned to become a financial economist at Chase Manhattan Bank.
In 1962, he joined the Treasury as Director of the Office of Financial Analysis, and in 1963 he was appointed Deputy Undersecretary for Monetary Affairs.
In 1965, he rejoined Chase Manhattan as vice president and director of forward planning.
From 1969 to 1974, he was Undersecretary of the Treasury for Monetary Affairs.
His five-and-a-half-year tenure covered a period of rapid change in international and domestic financial affairs.
After leaving the Treasury, Mr. Volcker became senior fellow at the Woodrow Wilson School of Public and International Affairs at Princeton University for the 1974-75 academic year.
He was named chairman of the Board of Governors of the Federal Reserve System by President Carter, and was sworn in on August 6, 1979. He served until August 11, 1987.
February 6, 2009: President Barack Obama signed an executive order establishing the new Economic Recovery Advisory Board.
The Board will provide an independent voice on economic issues and will be charged with offering independent advice to the President as he formulates and implements his plans for economic recovery.
Paul Volcker is the Chairman.