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Feds Enact Tough Volcker Rule Curbing Risky Trades

One provision requires big banks to divest 100% of their investments in most other hedge funds and private equity businesses they own a stake in by July 2015. However, they may be given some additional time to cash out of some of these firms.

Bank investments in funds with capital allocated to mortgage-backed securities will likely be permitted to continue owning a 5% stake in those investments, as part of an effort to comply with another statutory requirement that banks have "skin in the game" when it comes to securitized residential loans they issue.

Beyond the one-year extension granted Tuesday, the Fed can provide two more one-year extensions until July 2017 to allow large financial institutions to divest most of their hedge fund and private equity investment. The agency could also give banks an additional five years to comply if the funds are illiquid, bringing the potential compliance date for these funds to 2022. Funds would need to apply for these extensions.

Nevertheless, Fed General Counsel Scott Alvarez warned that, even with the extension, the industry should immediately begin coming into compliance with the rules. "All institutions will be expected to make a good faith effort to bring all their activities and investments into conformance by the compliance date," he said.

Big banks will continue to be permitted to "sponsor" or set up funds for private investors. However, a major provision in the regulation requires big banks to cut their holdings in these hedge funds and private equity funds they launch for their clients down to 3% within a year of setting up those funds. Banks must also keep their hedge fund investments, under this exception, to less than 3% of their so-called Tier 1 common capital -- the capitalization banks are required to keep on hand to make sure they have enough to cover all their financing activities.

A Fed staffer noted that a bank can't bailout any of these funds, pointing to a provision that was included in response to efforts during the height of the financial crisis in 2008 by now-defunct Bear Stearns to bail out hedge funds it operated. Investors must also be notified in advance and the fund can't be named after the bank, he added.

Some agency members raised concerns about whether the rule would interfere with banks' market making obligations to provide liquidity to investors particularly in times of stress, such as during the flash-crash that rattled the markets in 2010. Big banks provide this liquidity by buying, selling and holding securities and anticipating future customer demands.

As an example, Fed Governor Jeremy Stein questioned at the agency's open meeting whether a bank in its role as market maker would be permitted to help a hedge fund client unwind a large, illiquid position if the fund got into financial trouble and the wind-down required a period of several months. He said the job could be particularly problematic given the Volcker Rule's stipulation that market making risks are "not to exceed the reasonably expected near-term demands of clients."

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