In a win for Wall Street banks, the latest effort to overhaul the post-crisis Volcker Rule is reportedly moving toward a narrower and clearer definition of what types of trades are prohibited.
Regulators appointed by President Donald Trump took a first stab last year at toning down Volcker’s trading limits, which were meant to prevent bankers from threatening the financial system. However, bankers blasted the revamp, arguing it might make it even harder for firms to buy and sell securities. In response to that criticism, the watchdogs are now focused on erasing the 2018 proposal’s centerpiece — known among regulators as the “accounting prong” that would have determined which trades are banned.
A less onerous method embedded in the original Volcker has become the favored replacement for the accounting test. Senior officials at the five federal agencies revising Volcker reportedly met April 16 to discuss the new direction. The change would be an unmistakable victory for megabanks, which have been lobbying to weaken Volcker ever since its inclusion in the 2010 Dodd-Frank Act.
The original rule was meant to prevent lenders with federally backed deposit insurance from suffering huge trading losses, as they did before the 2008 financial crisis. Named for its advocate, former Federal Reserve Chairman Paul Volcker, the rule prohibits proprietary trading — the practice of banks betting on markets with their own capital. Transactions are perfectly fine if they’re executed on behalf of clients.
But detractors say confusion over which short-term trades pass muster has made banks too cautious, prompting a retrenchment from certain assets that — according to much-debated research — could dry up liquidity when markets are under stress.
Getting Wall Street relief from Volcker has been a top priority for Treasury Secretary Steven Mnuchin and other administration officials. While it’s unclear how soon that will happen, re-writing last year’s proposal could delay the process by months.
In their 2018 proposal, known as Volcker 2.0, the Fed and other agencies sought to give more certainty over which trades are permitted by introducing the accounting prong. It would have forced banks to apply accounting standards to certain transactions, and if the firms experienced sharp enough gains or losses, the trades would be presumed to be violating Volcker.
Banks ripped the idea — with Goldman Sachs Group Inc. leading the charge. The firm, in an October 2018 letter to the Fed, called the proposal “highly problematic” because it could rope in a lot of transactions not even outlawed by the existing version of Volcker.
In recent discussions, regulators have weighed dumping the accounting measure and relying more heavily on something known as the market-risk capital prong, the people said. That method, which is already in Volcker, prohibits trades involving financial instruments that are generally held for sale in the short term. The change would probably be appealing to banks because it’s based on rules they already have to follow.
The bottom line: Compliance under the market-risk capital test would be less burdensome because lenders would no longer have to make subjective calls about their intentions with each trade. Whether Wall Street trading books would swell is harder to predict.
In their current re-write, officials are also seeking to ease constraints on banks’ investments in private equity and hedge funds, the people said, an area largely ignored in the 2018 proposal. The Fed, which is leading the effort, might relax restrictions on foreign lenders’ investment funds, and it could give U.S. banks more leeway to provide credit to certain funds, according to the people.
The five agencies responsible for the rule — the Fed, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., Securities and Exchange Commission and Commodity Futures Trading Commission — are also working to streamline the data that’s supposed to be reported to regulators under Volcker, the people said.
A new Volcker proposal to replace last year’s version — an effort one agency head joked could be called Volcker 2.1 — would push back a final overhaul of the trading rule. Still, several officials including Treasury Department counselor Craig Phillips, who has led that agency’s work on regulatory policies, have openly suggested a re-proposal may be necessary.
Even when proposing Volcker 2.0 in 2018, Fed Vice Chairman for Supervision Randal Quarles said regulators might not be done with the job, calling it “an important milestone in comprehensive Volcker rule reform, but not the completion of our work.”
The plan for revising Volcker, which was named for former Federal Reserve Chairman Paul Volcker, is a significant win for banks that have long argued the original rule was overly complex and costly to comply with.
The proposal maintains Volcker’s ban on proprietary trading, in which banks invest for their own profits rather than on behalf of customers. But it would remove an important assumption that positions held by lenders for fewer than 60 days are proprietary and make it easier for banks to determine whether trades are prohibited. Regulators also want to give firms more leeway to take advantage of exemptions in Volcker that permit trades that hedge market risk and are done for market-making purposes.
“The proposal seeks to simplify and tailor the 2013 final rule,” SEC Chairman Jay Clayton said at a public meeting in Washington. “I strongly encourage all interested parties to comment on the many questions proposed in the release and I look forward to commentator input about implementing the Volcker Rule in a more effective way.”
Clayton and Republican SEC Commissioners Michael Piwowar and Hester Peirce voted to advance the proposal. Kara Stein and Robert Jackson Jr., both Democratic commissioners, opposed it.
“The objective behind this proposal is straightforward: simplifying and tailoring the Volcker Rule in light of our experience with the rule in practice,” said Randal Quarles, the Fed’s vice chairman of supervision and point man on bank regulation. “This is a goal that is shared among all five agencies and among policymakers at those agencies with many different backgrounds.”
The revisions aren’t just a rollback, Quarles said, calling them “the fruit of long and shared experience” and not “assumptions of a few recently appointed individuals.”
Quarles said the plan was a “best, first effort” at simplifying the rule, indicating that further tweaks may be coming.
“I view this proposal as an important milestone in comprehensive Volcker Rule reform, but not the completion of our work,” Quarles said.
The proposal would remove an assumption that positions held by lenders for fewer than 60 days are proprietary trades. And it would scrap a part of the test for determining whether a trade is proprietary, replacing it with new criteria based on how the bank accounts for the trades, according to the summary.
The plan also sets up a tiered system for compliance based on a bank’s trading assets and liabilities, with the most stringent requirements applying to companies with $10 billion or more, according to the summary.
Regulators are also proposing to make it easier to take advantage of exemptions, such as one that gives broad flexibility to execute trades that serve as hedges against potential losses. Banks now have to submit documentation to prove they are hedging, requirements they say are unreasonable.
The proposal broadens exemptions banks can seek for underwriting and market-making to permit activities “designed not to exceed reasonably expected near-term demand of clients, customers, or counterparties,” according to the summary. In a key shift from the current rule, the proposal will let banks set their own risk limits for market-making and underwriting activity. Regulators will be able to review the limits on an ongoing basis.
It also seeks to ease the impact of the rule on foreign banks’ operations outside the U.S.
The volcker rule, named for former Fed Chairman Paul Volcker, banned what’s known as proprietary trading – the practice of banks investing for their own benefit rather than buying or selling securities to fulfill requests from customers. It also restricted lenders’ ability to invest in hedge funds and private-equity firms.
The rule is meant to bar banks with federally-backed deposit insurance from suffering out-sized losses by restricting their ability to bet with their own capital. Financial firms have said the rule is unnecessarily complex and almost impossible to adhere to.
Volcker Rule, the controversial proprietary trading ban, enacted in the Dodd-Frank Act, proved to be one of the financial reform law’s most challenging provisions to implement, forcing five regulators to work together in a lengthy process that frustrated everyone involved. While the concept of the provision is easy to understand – forcing commercial banks to stop taking risky bets with U.S. taxpayers’ funds – the specifics spurred confusion and discord.
Regulators’ first problem was each other. The law required the Federal Reserve (Central Bank), Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to work together to craft a final rule. But bridging the different missions and various views represented on some of the agencies’ boards into a coherent rule became a onerous task.
They also faced two other major challenges: defining proprietary trading in a manner that was consistent with the law’s intent while still addressing ambiguities and unintended consequences; and addressing intervening events that spurred increased scrutiny of the drafting of the rule.
The biggest battle over the Volcker Rule’s implementation centered around the exception for market making, which bankers view as absolutely vital to preserving market liquidity – including for bond markets and certain derivative markets. Many industry representatives said the regulators erred in their initial attempt at creating that carve out when they issued their initial proposal in October 2011.
But Congress was vague in how regulators were to create the exemption, leaving them to decide how detailed they needed to be in defining its scope, including how it applied to various asset classes.
The “Volcker Rule” finally went into effect on April 1, 2014, with banks’ full compliance required by July 21, 2015 — although the Federal Reserve has since set procedures for banks to request extended time to transition into full compliance for certain activities and investments.
The Volcker Rule prohibits banks from using their own accounts for short-term proprietary trading of securities, derivatives and commodity futures, as well as options on any of these instruments. The rule also bars banks, or insured depository institutions, from acquiring or retaining ownership interests in hedge funds or private equity funds, subject to certain exemptions.