Leaked Volcker Draft Leaves Questions (Update 1)

Volcker story update with additional commentary

NEW YORK ( TheStreet) -- A leaked draft of federal regulators' proposed set of regulations to implement the Volcker Rule sheds light on the coming fight between lawmakers and the industry before the rules are finalized at year-end.

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act -- signed into law by President Obama last July -- the Volcker Rule prohibits bank holding companies from engaging in most forms of proprietary trading while severely limiting banks' investments in private equity funds and hedge funds. The rule was proposed by the president and supported by former Federal Reserve Chairman Paul Volcker.
Paul Volcker

Investment banks Goldman Sachs ( symbol) and Morgan Stanley ( symbol) are facing a major upheaval to their business models, as the firms have relied on private trading as a profit center over recent years.

Other large holding companies, including Bank of America ( symbol), JPMorgan Chase ( symbol), Wells Fargo ( symbol) and Citigroup ( symbol) will also be affected as they eliminate most proprietary trading, while facing mounting pressures on revenues in other areas, including narrowing interest rate spreads in the wake of the Federal Reserve's "Operation Twist", reduced fees on credit cards and checking account overdrafts, and a significant reduction in the interchange fees the banks charge merchants to process debit card purchase transactions.

In January, before the Federal Reserve issued its draft proposal to implement the Volcker Rule, JPMorgan Chase's Europe Equity Research group, estimated that the average decline in earnings per share for "a normal year" for Goldman and Morgan Stanley from the rule's "limits on 'pure' proprietary trading alone," would be 14%, with possible revenue declines of 15% for Citigroup and 14% for Bank of America, depending on how the regulator's final rule would restrict banks' market making activities.

At that time, the potential limiting of market-making activity based around the regulatory interpretation of "expected near team demands of clients, customers, or counterparties" was at the center of debates among regulators and the banking industry.

A key question -- according to JPMorgan analyst Kian Aboulhossein -- was how regulators would interpret the terms "near term" when used in the context of "trading accounts" and "market making permitted activities." The analyst said that if the new rules wouldn't allow banks to hold securities inventories for long periods, "trading activities were likely to be impacted materially."

Kevin L. Petrasic -- a partner in the Paul Hastings Global Banking practice in the firm's Washington, D.C. office -- said that the leaked draft made public by the American Banker was "a draft of a draft," which "suggests that we're looking at a 60-day safe harbor" for a regulatory definition of "near term" as it applies to the Volker Rule's exception for market making activities.

Petrasic emphasized that "there is a lot of debate between a number of agencies, with significant issues that are being struggled with." In the leaked draft, there are over 100 questions that regulators need to resolve before the final "Notice of Proposed Rulemaking" is issued.

Regulators have their work cut out for them, with "Congress looking over the shoulder of the agencies," according to Petrasic, who said that "regardless of what happens here, by law, the statute is supposed to be in place by next July." While this may seem like a long period, Petrasic says it is not, since "it will take a long time to implement and test" the systems banks will put in place to comply with the new rules.

Petrasic said that "there does seem to be an appreciation that market making is an important activity for banks. I think the challenge is trying to figure out how to preserve what are clearly important activities that banks engage in and distinguish them from the proprietary trading banned by the Volcker Rule." Banks will be seeking more clarity on key definitions, since they "could be required to put in place complicated compliance mechanisms just to prove a negative."

With the Dodd-Frank act leaving the regulators a thankless task in interpreting what on the surface seems like a simple ban from proprietary trading, amid the current anti-Wall Street hysteria, Petrasic said there was increased "scrutiny of all of the authors of the laws, as well as other policy makers."

"The market making and underwriting activities permitted by the rule are critical to the way our system works," he said. Frank A. Mayer, III -- a partner in the Financial Services Practice Group of Pepper Hamilton LLP - said that the leak of the draft rule proposal "could be construed as a trial balloon to gauge industry reaction," adding that the joint rulemaking by all the federal regulators "is good, rather than having different approaches taken by different regulators."

Mayer said that the regulators are focused on making sure that deposit-taking banks are "only engaging in truly functional risk mitigation" in their trading activities.

Mayer also tied-in the Volker Rule with the recent lawsuits against Bank of New York Mellon ( BK) alleging that the bank defrauded clients in foreign currency exchange transactions, saying that regulators "will let a deposit-taking institution be a fiduciary, but they are going to be watching very closely."

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.