Volcker Rule

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The Volcker Rule is the nickname of Section 619 of the Dodd-Frank Act. Proposed by former Federal Reserve Chairman Paul Volcker, it prohibits banks and their affiliates from proprietary trading as well as owning or sponsoring hedge funds and private equity funds. The rules were addressed in a joint proposal by the Securities and Exchange Commission, the U.S. Department of the Treasury and the Federal Reserve Board in October 2011.[1] In January 2012, the CFTC approved its own version of the Volcker Rule. The regulators had expected to publish the final rules by July 2012, followed by a two-year implementation phase-in, but such rules have been delayed.

The consortium of regulators have planned meetings on December 10, 2013, to consider the final rules. According to press reports, one major change from the proposed rules, and a big reason for the delay in putting out final rules, has been the rules regarding hedging. At issue is the concept of "portfolio hedging," or large-scale trades designed to mitigate risk but which could give banks a loophole allowing them to engage in proprietary trading, as was the case with JPMorgan's "London Whale." The revised version of the rule reportedly will not permit portfolio hedging, disappointing the banks who had lobbied regulators to retain language allowing portfolio hedging.[2]

For more information on the contents of the proposed rules, additional news, and links to comment letters and research papers on the Volcker Rule, visit the Volcker Rule page in MarketsReformWiki.

Background

The Volcker Rule was approved by the U.S. Senate in May 2010, and would have banned U.S. banks from trading with their own capital and running hedge funds.[3] It is named after former Federal Reserve Chairman Paul Volcker. By the time it was included in the final draft of Dodd-Frank, the Volcker Rule had softened a bit. The legislation will allow banks to invest in private-equity and hedge funds, although they will be limited to providing no more than 3 percent of the fund’s capital. They also cannot invest more than 3 percent of their Tier 1 capital.[4] Regulatory agencies such as the FDIC, Treasury Department, Federal Reserve and CFTC, however, would be tasked with creating the framework for and implementation of the rule.

President Barack Obama introduced the rule in January 2010 with Volcker standing beside him. Because it was after the House had already passed its version of financial reform, the Volcker rule was included in the Senate package only, guided through the chamber by Senate Banking Committee Chairman Christopher Dodd. [5]

A Bloomberg report out in late June 2010, citing a person close to Volcker, said the former Federal Reserve Chairman was disappointed with what he considered to be a diluted final version of the rule that bears his name. Initially, the Volcker rule would have banned banks from running private-equity and hedge funds but last minute congressional negotiations aimed at winning Republican support led to a compromise that allows banks to invest up to 3% of their capital in such funds. Volcker was said to be content with language that bans banks from trading with their own capital.[6]

Volcker said in a statement released June 28, 2010 that the bill agreed upon by congressional negotiators provides a constructive legal framework for reform of the financial system. He said that among the bill's provisions "are strong restraints on proprietary trading by commercial banking organizations, a point that has been of particular interest to me."[7]

Financial Firms Express Concern About Rule

Soon after the passage of Dodd-Frank, banks and other financial institutions began a lobbying effort to water down or repeal the Volcker Rule.

In June 2011, Goldman Sachs - whose business is weighted toward trading - released an estimate of at least $3.7 billion in annual revenue would be lost under the new regime. One big area of concern for Goldman is that regulators who are interpreting the Volcker Rule will severely limit the amount of time a bank can hold a security or derivative.[8]

Other banks including Bank of New York Mellon Corp. and State Street Corp. also lobbied to stop the rule from going into effect. The banks were concerned that it might curtail their asset-management activities, since many of their funds could be considered hedge funds.

In January 2011, many of the big investment banks on Wall Street testified to Congress against the Volcker rule opposing the notion that prohibits any banking activity that doesn't directly service the customer. These activities include proprietary trading, investment banking advisory services as well as hedge fund or private equity involvement. Experts believe that even if Volcker does not succeed, the banking and speculative industry will experience much stricter markets. [9]

In September 2012, several trade and lobbying associations, including the American Bankers Association and SIFMA, have called for an outright repeal of the Volcker Rule.[10]

The London Whale

In April 2012, a trader and risk manager in JPMorgan's London office, Bruno Iksil (aka the "London Whale" due to the size of his trading book) caused a loss of over $6.2 billion on a large position in the credit default swaps market. [11][12]

The losses led to a reconsideration of the Volcker Rule, as Iksil's trading was done under the guise of "portfolio hedging" - trading activity designed to lower a firm's overall risk profile. The final Volcker Rule purportedly addresses portfolio hedging and sets strict guidelines on which activities may be considered bona fide hedges. According to Treasury Secretary Jack Lew, “the rule prohibits risky trading bets like the ‘London Whale’ that are masked as risk-mitigating hedges.” [13]

Final Rules Delayed

In November 2013, U.S. Treasury Secretary Jack Lew urged federal agencies to finish writing the rule by the end of 2013.[14] However, around the time she was confirmed as the new chair of the Federal Reserve, Janet Yellen indicated the board was weighing extensions in the compliance date for the Volcker Rule.[15]

On December 18, 2014 the Federal Reserve gave banks until 2017 to meet a provision in the Volcker rule that bans them from using their own money to invest in hedge and private equity funds. The Fed had earlier announced the delay until 2017 for collateralized loan obligations (CLOs), which banks use to shift the credit risk in leveraged loans off their balance sheet and sell it to others. [16] [17]

References

  1. SEC Jointly Proposes Prohibitions and Restrictions on Proprietary Trading. SEC.
  2. Volcker Rule Won't Allow Banks to Use 'Portfolio Hedging'. WSJ.com.
  3. Volcker Sidelined as Obama Reshapes Advisory Panel. Bloomberg.
  4. Biggest Wall Street Revamp Since 1930s Approved. Bloomberg Businessweek.
  5. Volcker Rule Under Attack as Lawmakers Seek Loophole. Bloomberg.
  6. Volcker Said to Be Unhappy With New Version of Rule. Bloomberg.
  7. Volcker Said to Be Unhappy With New Version of Rule. Bloomberg.
  8. Goldman lobbying hard to weaken Volcker rule. Reuters.
  9. Wall Street Takes Aim at Volcker Rule. The Street.
  10. Even After ‘Whale’ Losses, Bankers Hammer Volcker. Wall Street Journal.
  11. From 'Caveman' to 'Whale'. Wall Street Journal.
  12. JP Morgan trader 'London Whale' leaves London. The Guardian.
  13. Lew Says Volcker Rule to Prevent Repeat of London Whale Bets. Bloomberg.
  14. Pressure Builds to Finish Volcker Rule on Wall St. Oversight. NY Times DealBook.
  15. Yellen says Fed will weigh compliance extension for Volcker rule. Reuters.
  16. Fed delays Volcker rule restriction on fund ownership. Reuters.
  17. Fed Gives Banks More Time to Sell Private-Equity, Hedge Fund Stakes. The Wall Street Journal.