Feds Enact Tough Volcker Rule Curbing Risky Trades

WASHINGTON, D.C. (The Deal) -- After more than two years under consideration, five federal regulators on Tuesday approved the landmark Volcker Rule, the measure that seeks to prohibit big banks from making short-term speculative proprietary derivatives and stock investments.

The rule is also fashioned to force those financial institutions to cash out most of their hedge fund and private equity investments in the coming years.

The Volcker Rule was required by the Dodd-Frank Act, enacted in the wake of the 2008 financial crisis.

The final measure, which weighs in at over 950 pages, was approved at open meetings held Tuesday by two federal agencies -- the Federal Reserve and the Federal Deposit Insurance Corp. -- and closed meetings held by the nation's securities regulators, theSecurities and Exchange Commission, the Commodity Futures Trading Commission and Office of the Comptroller of the Currency. Despite the measure's approval all around, oneFDICcommissioner, Thomas Hoenig, said he would have preferred to see large banks broken up instead.

The rule -- named after former Fed chairman Paul Volcker whose idea inspired the regulation -- seeks to limit big banks' propensity for risk taking in the wake of the 2008 economic crisis and is, on balance, more stringent than the roughly 300-page proposal regulators introduced in October 2011. Yet it provides some relief for certain trades and wasn't as tough as some lawmakers and regulators would have liked.

President Barack Obama said in a statement that the U.S. financial system will be safer because "we fought to include this protection in the law."

Volcker, for his part, issued a statement saying the rule is a "significant part of the larger on-going effort to rebuild a strong banking system fully capable of and attentive to meeting the critical financial needs of businesses and individuals." He added that bank supervisors will need to be "equipped and alert" in detecting and dealing with problems as they arise.

The former Fed chairman touched on a key potential weakness in the regulation. Because a great deal of the burden is placed on bank and securities regulators to identify and limit prohibited trades, some are concerned about whether the five agencies responsible for overseeing the regulations will be able to enforce the restrictions.

"Implementation here, more than with most rules, is probably going to be key. Our supervisors are going to have to navigate pretty carefully," said Federal Reserve Governor Daniel Tarullo.

The Fed, one of the agencies involved, extended the deadline for complying with the rule to July 21, 2015, from July 21, 2014.

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."

Stein observed: "It's market making economically speaking, but it's unusually big and maybe a longer term position that needs to be worked off."

A Fed staffer said that the task would qualify under the market making exemption but that the bank would have to make sure to follow its pre-set limits on market making risks. Going beyond those limits would require that management make a conscious decision to breach those limits temporarily and probably should not be done without input from the bank's primary regulator. "The implementation of how it gets worked out by the firm would depend on the limit structure they imposed on themselves as market makers," the staffer said.

One SEC Republican member, Dan Gallagher, went a step further and dissented in a statement, arguing that the final rule will discourage big banks from their "market-making" obligations to provide liquidity to investors particularly in times of stress. "What we face is the prospect of banning the market making practices so central to our capital markets in order to make sure we capture every last activity that could potentially be characterized as proprietary trading," he said.

The 2011 proposal and the final rule had many differences. One key change: Bank CEOs at financial institutions with more than $50 billion in assets must attest in writing that their firms have set up processes to ensure that the institution is in compliance with the trading prohibitions. While tougher than the original proposal, critics had sought more restrictive language that would have had CEOs certify that there is no speculative proprietary trading at the firm at all. Nevertheless, even the weaker measure may have a chilling effect on banks, as executives will be less willing to allow some trading activity because there can be personal liability involved if anything goes wrong.

The final rule is also tougher when it comes to how banks can hedge their risks. The new stricter wording comes after JPMorgan Chase's (JPM) so-called London Whale credit derivatives trade last year amassed losses in excess of $5.8 billion. Instead of allowing banks to hedge their risks on a "macro" or "portfolio basis," as was initially proposed, banks can hedge their risk if they can demonstrate that the trades "demonstrably reduce or otherwise significantly mitigate one or more specific, identifiable risks." Hedging of generalized risks based on models will be prohibited, as will bets on the direction of the economy or trades tied to general revenues or expectations of losses.

Nevertheless, the stronger wording isn't likely to appease some critics on the left who would have preferred to have banks justify each hedge on a trade-by-trade basis, an approach they said they believe would eliminate any chance that banks engage in risky speculative trades for their own accounts. On the other side, some raised concerns about the provision's restrictiveness, arguing it would make it tougher for a bank to hedge its risks.

Not all Republicans opposed the rule: One GOP FDIC member, Hoenig, suggested it didn't go far enough. Hoenig said he worries it can be "gamed," adding that he would like to see large financial institutions split their commercial banking units from their investment banking businesses as part of an effort to ensure that firms don't have access to the government safety net when engaging in risky speculative trading.

Foreign governments were given some exemptions for trading of their sovereign debt. The initial version only provided relief for proprietary trading by big U.S. banks of U.S. Treasury securities. Many foreign governments were outraged by the provision because of concerns that it would result in a reduction in liquidity of trading of their sovereign debt.

The final rule allows "in more limited circumstances" proprietary trading of non-U.S. foreign debt, such as Canadian and Japanese debt. U.S. banks can trade foreign sovereign debt if they qualify as a primary dealer for trading of that debt or they are using it for legitimate hedging.

Nevertheless, legal experts said they expect banks will find an opening for lawsuits, arguing that regulators violated the Administrative Procedures Act and did not give them enough time to comment on key changes to the rules. Kevin Petrasic, partner at Paul Hastings LLP, noted that bank lobby groups could challenge the rule, arguing that it isn't valid because there was a split among the agencies over how to write the rules.

Even though the agencies unified in approving a collective rule, some SEC and CFTC commissioners did push for stronger restrictions than those sought by bank regulators. But it's unclear how far the disagreement went and whether it could help a legal challenge.

A challenge to the Volcker Rule is likely to end up at the U.S. Court of Appeals for the D.C. Circuit. Challengers may be more wary about filing suit after an Obama nominee for the court, Patricia Millett, was confirmed by the Senate Tuesday afternoon in a vote of 56-38, within the context of a new congressional system that prohibits filibusters on presidential nominations and federal judge positions.

Millett's confirmation shifts the balance of power at the court: Of the active judges that carry a heavier workload, five are Democratic appointments and four are Republican.

-- Written by Ronald Orol and Bill McConnell in Washington

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