Volcker Rule In Crosshairs

Terry Flanagan

With the stage set for five key agencies– the Federal Reserve, FDIC, SEC, OCC and CFTC – to formally vote on fortified Volcker Rule provisions on December 10, implementation of the rule will present steep challenges for banks.

“A new normal is taking shape for banks and financial institutions, as regulators are set next week to approve a beefed-up version of the Volcker rule prohibiting proprietary trading and other practices that put capital at risk,” said Douglas Landy, a partner in the Financial Regulations and Leveraged Finance groups at Milbank, Tweed, Hadley & McCloy and a former staff attorney at the Federal Reserve Bank of New York. “That includes investments in hedge funds and even hedging strategies by banks in the aftermath of the infamous London Whale.”

Landy represented more than two dozen foreign banks in 2012 in challenging Volcker during the SEC’s public comment period.

“The immediate question is precisely when implementation will begin,” he said. “Right now, the rule is set to take effect next July, which is actually not a lot of time for a multinational bank to put in place a cumbersome compliance mechanism to ensure it doesn’t accidentally slip into proprietary trading or some other forbidden activity. Banks will have to go through their entire portfolio to make sure they are in compliance with the letter of the final provisions, which is an especially daunting task for foreign banks.”

He added” “It appears that the Federal Reserve will issue a companion statement on that very subject, which will let banks know if they can get an extension on getting their portfolios in full compliance. This letter will be critical for banks. They will find out if they have to race to meet the July 2014 deadline or whether they may have additional time to get their operations up to the new standards.”

Risk-based metrics are most relevant for assessing Volcker Rule compliance. The goal is to eliminate proprietary risk taking. Identifying risk at the firm, book, product, or asset class level alleviates the need to individually validate each transaction and aligns rule implementation with regulator objectives.

“We anticipate that these metrics will be included in the final rule and hope regulators will emphasize them when evaluating bank trading activities,” said Sean Owens, director of fixed income and derivatives at Woodbine Associates.

Risk-based metrics are critical to the rule effectiveness. They allow for a clear distinction between market-making and hedging activities.

“It is important that we have a well-designed regulatory framework with proper incentives in place to prevent a breach of the system in the future,” said Owens. “In the case of the Volcker Rule, this means prudently assessing and monitoring bank trading risk on an ongoing basis. Tomorrow, we should have a much clearer picture how that will be done.”

Landy notes that banks will especially be focused on how the final rule affects covered bonds. “Banks use covered bonds, such as collateralized loan obligations and collateralized debt obligations, to fund themselves through securitizations and related transactions. Volcker could result in a fundamental change in how banks use many of their key funding mechanisms.”

The Volcker rule will also be closely looked at for how it relates to the international Basel III international regulatory framework for banks and to existing derivatives rule. “The existing international and domestic banking rules all have a bounce-on affect to one other and foreign institutions in particular face added layers of complexity to the rule,” Landy said.

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