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Volcker Rule Changes: The Good, Bad and Ugly

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Welcome back to Human Capital! I’m Melanie Waddell in Washington. This week we’re checking in with Gail Bernstein, general counsel for the Investment Adviser Association, on how the recent decision by the FDIC and OCC to “simplify and tailor” banks’ proprietary trading via changes to the Volcker Rule directly impacts investment advisors and asset managers. 

To be sure, the Aug. 20 modifications — which set new compliance parameters and put limits on banks’ market-making activities — are getting mixed reviews. Dennis Kelleher, president and CEO of Better Markets, calls them a “weakening” of the Volcker Rule ban on proprietary trading by banks that will give Wall Street “its biggest victory since the 2008 financial crisis.”

House Financial Services Committee Chairwoman Maxine Waters, D-Calif., chalked up the revisions as carrying out President Donald Trump’s “reckless deregulatory agenda,” stating the changes “could potentially leave taxpayers at risk of having to once again foot the bill for unnecessary and burdensome bank bailouts.”

FDIC Chairwoman Jelena McWilliams argued when the final changes passed that simplifying the post-crisis Volcker Rule, ushered in by the Dodd-Frank Act in 2010, was needed, as Volcker has been “the most challenging to implement” for regulators and the industry. “Distinguishing between what qualifies as proprietary trading and what does not has proven to be extremely difficult,” she said.

What’s the Volcker Rule? Former President Barack Obama proposed the Volcker Rule in January 2010, to recognize former Fed Chairman Paul Volcker’s “aggressive pursuit” of prohibiting banking entities from engaging in proprietary trading and from owning or controlling hedge funds or private equity funds.

Proprietary trading by Wall Street’s biggest banks and derivatives dealers “generates enormous profits, huge margins and the biggest bonuses,” Kelleher maintains.

Excessive proprietary trading can lead to banks’ failure and “incentivizes bankers to make the biggest bets because they get to use other people’s money (from taxpayer-backed deposits) and keep the winnings but shift any losses to the bank and taxpayers,” Kelleher says.

Kelleher cites Morgan Stanley’s loss of more than $9 billion on a single bet in December 2007 along with JPMorgan’s loss of more than $6 billion in 2012 from its so-called ‘London Whale’ trades.

But FDIC’s McWilliams argues that banks doing “relatively little trading are required to go through substantial compliance exercises to ensure that activities that have long been considered traditional banking activities do not run afoul” of the Volcker Rule.

The final rule includes a host of changes, and becomes effective on Jan. 1, 2020, with a compliance date of Jan. 1, 2021.

The revised rule applies a three-tiered compliance regimen based on an entity’s trading activity, with the most heavily regulated being entities with $20 billion or more in consolidated trading assets and liabilities.

“Banking entities,” explains IAA’s Bernstein, are banks and their affiliates, including investment advisors or asset managers that have a bank “in the corporate family.”

Funds that are affiliates of a bank are considered “banking entities” and subject to the Volcker Rule, she continued, which “created some rather strange situations, including that a mutual fund (registered investment company) wouldn’t be able to make short term investments” and that “covered funds, if they were considered affiliates of a bank, wouldn’t be able to make short-term investments.”

The final rule addressed an IAA concern: “That the proposed accounting prong under the so-called trading account definition — which is part of the proprietary trading prohibition — was too broad and would sweep in instruments that weren’t even covered by the earlier definition,” Bernstein relays.

This proposed prong, she said, was “rejected in favor of remaining focused on the idea of short-term intent and now making it clear that a financial instrument held for 60 days or longer will presumptively not be considered short-term.”

What’s next? IAA wants the Volcker agencies to treat U.S. registered funds and foreign public funds the same, and to exclude both of them from the “banking entity” definition in the next proposal. Also, the Securities and Exchange Commission, Federal Reserve Board and Commodity Futures Trading Commission must approve the FDIC’s Aug. 20 changes.

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