One of the most controversial elements of the Dodd-Frank Act — a proposed ban on proprietary trading and limitations on private equity investments — is set to be unveiled by regulators in the coming days.
Bankers have anxiously awaited the so-called Volcker Rule, named after former Federal Reserve Board Chairman Paul Volcker, to see how regulators will define proprietary trading and craft certain exceptions allowed under the law.
American Banker, a sister publication of ASR has obtained a Sept. 30 draft memo outlining key specifics on the proposal.
The plan would broadly define proprietary trading, offer limited circumstances under which a bank could invest in a hedge or private-equity fund, and require banks to install internal controls to ensure compliance with the Volcker Rule. The Federal Deposit Insurance Corp. is set to issue the nearly 300-page proposal on Oct. 11. Other regulators are expected to act around the same time.
Following is a detailed guide to regulators' pending proposal:
Arguably one of the most contentious elements of the proposal is how regulators plan to define proprietary trading.
Under the proposal, regulators define such trading as "engaging in the purchase or sale of one or more covered financial positions as principle for the trading account of the banking entity."
Proprietary trading specifically would not include acting as an agent, broker, or custodian for an unaffiliated third party.
The rule would apply to any trading account that takes a position for the purpose of selling in the near-term. Regulators opted not to define "near-term" or "short-term" acknowledging the difficulty in ascertaining the purpose of a particular position.
Instead, the proposal would use a three-prong approach to define such an account. The first includes any account used by a firm to buy or take one or more several financial positions for the purpose of short-term resale; gain the benefit of short-term price movements; earn short-term arbitrage profits; or hedge one or more positions.
Secondly, any trading account used by a firm that is already subject to the Market Risk Capital Rules would be subject to the Volcker Rule. Lastly, any account used by a firm that is a securities dealer, swap dealer, or security-based swap dealer would qualify.
The proposal would provide some exclusions in what's defined as a trading account for certain positions that do not appear to involve the intent to engage in short-term trading. Those would include certain repurchases and reverse repurchase arrangements, securities lending transactions, positions taken for "bona fide" liquidity management purposes, as well as certain positions of derivatives clearing organizations or clearing agencies.
Exemptions to Proprietary Trading Ban
Under the original statute, banks are still allowed to engage in underwriting and market making-related activities.
In the proposal, regulators outline certain requirements that must be met to ensure activities, revenues and other trading activities fall into those exempted categories.
Additionally, the agencies added another exemption for risk-mitigating hedging. Like the other exceptions, banks must jump through certain hoops to ensure their activities are "truly" risk-mitigating hedging, including setting up an internal compliance program.
The proposal also sets up exemptions for certain government obligations, trading on behalf of customers, trading by a regulated insurance company or trading by certain foreign bank entities.
Other exemptions include transactions conducted by a banking entity as investment adviser, commodity trading advisor, trustee, or in a similar fiduciary capacity for the account of a customer where the customer, and not the banking entity, has beneficial ownership of the related position.
Hedge/Private Equity Fund Limits
The proposal also includes an entirely separate section detailing the types of relationships a bank is banned from having with hedge and private-equity funds.
Generally, a bank could not hold an "ownership interest" in, or sponsor, an investment fund covered by the proposal.
The types of private-equity and hedge funds subject to the ban would include issuers defined as an "investment company" in the 1940 Investment Company Act, although certain types of companies included in that earlier statute would be excluded.
The ban would also apply to commodity pools defined in the Commodity Exchange Act. The regulators could also include in the ban "any such similar fund" that they determine appropriate.
The proposal defines an "ownership interest" essentially as any equity investment or partnership that a bank holds in a covered fund. Other "similar interests" could be banned as well, such as a debt security if it "exhibits substantially the same characteristics as an equity or other ownership interest."
A bank could own an interest in an investment fund only if its share of the fund's profits is meant as performance compensation for the bank's serving as an investment or commodity trading advisor to the fund. Yet that exemption would come with its own restrictions.
In terms of prohibiting a bank from serving as a "sponsor" to a covered investment fund, the proposal would generally ban a bank from being a general partner or trustee, selecting directors and managers, or having a similar name of a covered fund.
Among other exemptions, a bank could be involved in organizing an investment fund covered by the rule under certain criteria related to traditional asset management and investment advisory businesses. Conditions would include, among others, that the bank provide "bona fide" trust and advisory services, and that the investment fund in question be only related to those services.
The proposal would also permit certain limited investments in a covered fund that a bank or one of its affiliates has organized. Yet that investment could not exceed 3% of the fund's total ownership interests, could not trigger more than 3% of the fund's losses and could not amount to more than 3% of the bank's tier 1 capital. A bank's total permitted investments in all covered funds could also not exceed 3% of its tier 1 capital.
Certain small business investment-related interests would also be allowed, as well as hedging activities meant to mitigate the bank's risk.
Compliance with Volcker Rule
The proposal would require any bank engaging in covered trading or fund activities to implement a program designed to ensure compliance with the proposal's many prohibitions and restrictions.
At a minimum, each program must include:
• Internal written policies and procedures designed to document and monitor proprietary trading and investments.
• A system of internal controls to monitor and identify potential areas of non-compliance, and to prevent the occurrence of prohibited activities.
• A management framework that delineates responsibility for compliance.
• Independent testing for the effectiveness of the compliance program.
• Training for trading personnel and managers to enforce the compliance program.
• Making and keeping records sufficient to demonstrate compliance with the rule, which banks must retain for at least five years, and provide to regulators upon request.
Banks that are engaged in broad, complex trading activities may also be required to implement a number of additional compliance standards outlined in Appendix C.
For example, their programs must:
• Specifically address the varying size and nature of activities conducted by different units of the bank, including the size scope and complexity of the risk of the individual activity or investment.
• Make senior management and intermediate managers accountable for effective implementation of the program, and ensure that the board of directors or CEO review its effectiveness.
• Facilitate supervision of the bank's covered trading activities by the agencies.
A bank is subject to these requirements if it engages in proprietary trading and has, together with its subsidiaries and affiliates:
• Trading assets and liabilities, on a global consolidated basis, of $1 billion or more, or 10% or more of its total assets.
• Either aggregate investments of $1 billion or more, or sponsors or advises one or more covered funds with total assets of $1 billion or more.
The closer a bank is to these thresholds, the higher the expectation from regulators that they should "generally include" the minimum standards in Appendix C, according to the proposal's preamble.
If a bank is not engaged in covered trading activities, it must ensure that its existing compliance policies and procedures include measures designed to prevent them from becoming engaged in such activities.
Finally, the proposal would specify that any bank that violates or evades the requirements of the Volcker Rule would be required to terminate the activity and, as relevant, dispose of the investment.