Volcker Study Paves Way for New Bank Rules

NEW YORK ( TheStreet) -- The U.S. Treasury Department's Financial Stability Oversight Council issued a much-awaited study on the Volcker rule on Tuesday that will allow other regulators to begin the rulemaking process.

Wall Street firms have been wringing their hands over how far the rule will go in handcuffing their operations and lobbying against a narrow provision. Last month, the Securities and Exchange Commission held a series of meetings with representatives from Goldman Sachs ( GS), Morgan Stanley ( MS), JPMorgan ( JPM), Citigroup ( C) and Bank of America-Merrill Lynch ( BAC) to discuss implementation of the rule, which seeks to limit risk-taking at large financial institutions which receive federal protection.

Also known as Section 619, the Volcker rule expressly prohibits federally insured banks from hosting "proprietary trading" groups, which trade capital from a firm's balance sheet for profit. All of the big banks have wound down their proprietary trading divisions or moved traders into other areas where they can trade for clients instead.

But there are questions about other business lines, like market making and hedging, which received special exemptions from the Volcker provision, but present an opportunity for regulatory arbitrage.

"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," the FSOC said in its report.

The study has been closely watched by Wall Street as a catalyst for the rulemaking process, which can now move forward at the Securities and Exchange Commission and Commodity Futures Trading Association. The agencies have three months to implement specific rules and processes banks must follow.

The process of identifying what trades are proprietary will be incredibly difficult, and the FSOC report suggested leaving much of the leg work to banks. The council suggested that the agencies require banks to implement a "robust compliance regime" with internal reviews that must be signed off on by the CEO, as well as "quantitative analysis" to determine whether activities fall under the category of proprietary trading.

In addition to the self-policing, the FSOC suggests that regulators require a "mechanism" that will help regulators ensure that trades are initiated by clients. It also suggests enforcing "legal sanctions as appropriate" when violations occur.

Separately, the FSOC also outlined suggestions for risk-retention on loan securities, on a "too big to fail" provision that limits the market share of large banks and on an authority to oversee nonbank financial firms.

-- Written by Lauren Tara LaCapra in New York.

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