On December 10, 2013, five financial regulatory agencies approved the implementation of the Volcker Rule, a long-awaited regulatory item for US banks. It was originally proposed by former Federal Reserve chairman Paul Volcker, who argued that speculative trading played a significant role in exacerbating 2007’s global financial crisis. The rule therefore restricts a bank from engaging in speculative activity that does not benefit its customers.
As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the rule prohibits US banks from executing short-term proprietary trades for their own accounts in securities, derivatives and commodity futures, as well as options of those instruments. Banks are also prohibited from having active trading relationships with hedge funds and private equity funds.
Customer deposits that could have previously been used to trade on behalf of the banks’ own accounts are now definitively separated from such trading activity – the Volcker Rule prevents excessive risk-taking that could adversely impact banks’ customers, but aims to leave market liquidity and institutional competitiveness unaffected. There are 4 main types of trade that are therefore exempt from the Volcker Rule: market-making, risk-related hedging, underwriting, and liquidity management. Such exemptions will allow a bank to still perform its key fundamental roles in financial markets, namely transforming money, risk and maturities.
Banks have until July 21 of this year to be in compliance of the rules on proprietary trading activity, and until July 21 of 2016 to conform relationships with funds that were in place before 2014.
Compliance requirements for US banks
In anticipation of the July enforcement date, banks are implementing an enhanced culture of compliance that requires establishing clear policies on trading and fund-related activities. For example, compensation for employees must not reward or encourage proprietary trading.
In terms of risk management, firms are now required to report substantially more about their risk exposures on a regular basis, including risk and position limits, risk factor sensitivities, value at risk (VaR), comprehensive profit and loss attribution, inventory turnover and many other metrics.
The impending implementation of the rule has also encouraged innovation in risk monitoring and compliance systems. Data Boiler Technologies in Boston, for example, has created tailored solutions specifically to meet the Volcker Rule’s requirements. According to its founder and president Kelvin To, Data Boiler has developed trade monitoring systems that seek to prevent prohibited trades (rather than having to remedy cases after the fact), dynamic forecast systems to ensure inventory levels are suitable across various market scenarios, and several other patented products.
The Office of the Comptroller of the Currency has indicated that the Volcker Rule will cost US national banks up to $4.3bn as they will have to sell at a loss those investments deemed “restricted” by the rule.
How banks have responded
The Volcker Rule has already effected changes in banking strategy – several banks that were engaged in hedge fund and private equity business before the financial crisis decided to sell off those units in order to be in compliance. Regulators have also asserted that the rule’s final version will require banks to provide more information in order to verify if a specific trade is classified as a hedge. This was due principally to the $6.2bn loss suffered by JP Morgan in 2012 as the result of a trade falsely classified as a “portfolio hedge” by bank executives. JP Morgan CEO Jaime Dimon has since conceded that such losses may not have arisen had the Volcker Rule been in place at the time.
Foreign banks will also be affected as a result of the legislation on the US financial system. Canada’s largest banks, for example, will be required to add further and costlier compliance systems on the basis that they have operations within the US. However, if the bank trades entirely outside of the US, and solely with non-US counterparts, then Volcker does not apply.
Lobbying by Canada’s senior officials has been fairly successful in pushing back against some of the potential negative consequences that the Volcker Rule would create for Canadian banks. One such example is an exemption of the rule for government bonds – initially, federal and provincial government bond trading was to come under the Volcker Rule’s mandate, but Canadian authorities have since managed to successfully persuade the Fed to reconsider the impact this would have on the Canadian financial system.