The Volcker Rule – American banks to face hurdles from summer 2012
What sort of scenario will face American banks, when implementation of the Volcker Rule, segregating retail banking business from risky investments, takes effect in summer 2012? And why are foreign banking competitors also less than impressed with the planned new legislation? This first, in a series of articles, will discuss the important changes being foreshadowed in this planned legislation.
As part of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the US Congress adopted a ban on proprietary trading for commercial banks and their affiliates. Additionally, it restricted investment in hedge funds and private equity by commercial banks and their affiliates. These measures have become generally known as the so-called "Volcker Rule", named after the well known economist and former director of the Federal Reserve bank.
The legislation, as a reaction to the causes of the financial crisis, seeks to create a dividing line between commercial banking and depositary functions, which are insured, from a bank's investment activities. In this regard, it is reminiscent of the so-called Glass-Steagall Act from 1933, which was phased out only thirteen years ago.
A flood of commentary from Wall Street
Implementation of the "Volcker Rule" is supposed to go into effect this July. In October of last year the SEC (Securities and Exchange Commission) and three other federal agencies released proposed regulations (over 300 pages!) that would implement the Volcker Rule in practice.
Last week saw the expiration of a deadline stipulated by regulators for banking industry and public comment on the proposed regulations. And news reports suggest there have been an enormous number of complaints lodged, from an assortment of Wall Street banks, trade groups (such as SIFA, the Securities Industry and Financial Markets Association) and also from the insurance industry, whom it is claimed, hope to avoid being including as targets of the regulations.
A great deal of commentary and objection has also come from foreign banks. Why the foreign interest? Because the regulations will not just affect U.S. banks or institutions. Subject to certain exemptions, the "Volcker Rule" will affect the proprietary trading and private fund activities by "banking entities."This definition includes any foreign banks which maintain a U.S. branch or agency office and by any of the foreign bank's affiliates.
Exemptions to the “Volcker Rule” are overridden in the event that the respective activity results in a material exposure by the bank to high risk assets or high risk trading strategy. Also in cases when such activity would involve a material conflict of interest between the bank and its clients or counterparties or if such activity poses a threat to the safety or soundness of the bank or to the financial stability of the United States.
What will be prohibited?
First and foremost, the Volcker Rule prohibits commercial banks from proprietary trading in equity and debt securities, derivates, commodity futures, options and other investment vehicles designated by the Securities Exchange Commission. This prohibition affects trades aimed at disposing of an acquired security within a relatively short time frame and making a profit as a result of its short-term change in market value.
At the same time, this prohibition does not encompass trade in some excluded types of securities, such as government bonds. The rule also doesn’t apply to activities associated with introduction of securities to the market, market-maker activities, trades executed on behalf of clients or insurance companies or to transactions aimed at hedging other risks borne by the bank.
Restrictions on hedge fund investments
Banks will be generally prohibited from acquiring an ownership interest in, acting as a sponsor to, or having certain other relationships with a hedge fund or a private equity fund unless certain exemptions are met.
An “ownership interest” is taken to mean not only equity shares or partnership interests but also any interest that holds voting rights, rights to share in a covered fund’s profits and losses or the ability to earn a return based on performance of such fund’s investments.
A bank will be deemed a “sponsor” of a covered fund in several cases. For example if it serves as a general partner, managing member, trustee or commodity pool operator of a covered fund. Or alternately, if it selects or controls a majority of the directors, trustees or management of such covered fund or if it shares the same name or variation of a name, with the covered fund, for the corporate or marketing purposes.
One permitted exemption is that the bank will in general be permitted to sponsor or hold an ownership interest in the covered fund if such ownership interest does not exceed 3% of the total outstanding ownership interests of such fund and the total investments in all covered funds by such bank does not exceed 3% of its Tier 1 capital.
Strict parameters for foreign banks
Another permitted exemption concerns foreign banks. However, any entity striving to be considered a foreign bank must conform to strict parameters. Only entities organized under foreign law and controlled solely by entities organized under foreign law may be awarded this designation. Alternately, they may be deemed a “qualifying foreign banking organization” under Federal Reserve Board regulations, or considered to be in compliance with certain other requirements ensuring that the foreign bank’s business is conducted outside the United States, as measured by income, assets and revenues.
Many foreign banks have already expressed a concern that they may not be able to fulfil these conditions if they have extensive US operations. But even in the event of successful compliance with this strict conditions, the banks are also required to ensure that no ownership interest in the covered fund will be offered for sale to a U.S. resident and that no subsidiary, affiliate or employee of the bank that is involved in the sale or offer of the ownership interest is physically located in or incorporated in the United States.
Additionally, the Volcker Rule regulations also impose obligations on the banks with respect to their compliance programs if they engage in covered fund activities or investments. And even if the bank does not engage in such activities, it will be obliged to ensure its compliance policies include steps to prevent it becoming involved in such covered fund activities and investments.