Priyanka Sondur, TCS Financial Solutions

Today, Wall Street faces a 4.3 billion dollar challenge as it will be forced to implement the Volcker rule, which imposes curbs to prevent a financial meltdown. With this Rule, banks may be forced to focus on their core business lines while minimizing systemic risks and ensuring and enforcing other forms of reform.

On December 10, 2013, The Federal Reserve, Federal Deposit Insurance Corporation and three other agencies formally adopted the Final Rules, implementing section 619 of the Dodd – Frank Wall Street Reform and Consumer protection act. The Rule, which was initiated by former Federal Reserve Chairman, Paul Volcker, in response to the 2007-2008 financial crises, will prohibit banks (financial institutions) from:

  • Engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account
  • Owning, sponsoring or having beneficial relationships with hedge fund/private equity managers

The Rule attempts to reduce risk and banking instability by restricting US banks from taking part in proprietary and speculative trading by imposing strict frameworks to justify exemptions for certain activities like market trading, underwriting, hedging, trading in government obligations and organizing and offering a hedge or private equity fund. The Final Rules limit these exemptions if they involve a conflict of interest, an exposure to high-risk assets or trading strategies and are a threat to the safety and stability of the banking and financial system in the US.

Banks, in short, will not be allowed to invest in funds that have not been registered with the SEC and from partaking in hedging activities that do not have a definite, identified risk. This will lead to a number of changes in a bank’s investment and hedging strategies.

What do the Rules say?

The Final Rules have defined and identified the characteristics of prohibited and permitted activities and investments.

Proprietary Trading Prohibition:

The Rule prohibits proprietary trading by banking entities; however, there are exemptions for:

  • Underwriting:

    Banking entities that act as underwriters for distribution of securities and the trading desk’s underwriting position being related to that distribution are exempt as long as the position does not exceed the reasonably expected demands of customers.

  • Market making and related activities:

    A trading desk is required to purchase and sell one or more financial instruments; however, they would need to be designed such that they do not exceed the expected demands of customers based on historical demand and market factors. The market-making desk can hedge the risks of its market-making activity only if it is in accordance with risk management procedures that are a requirement under the final Volcker rules.

  • Risk-mitigating hedging:

    A banking entity would be required to conduct analyses to support its hedging strategy and be able to evaluate its effectiveness and recalibrate the strategy. Under the Rules, financial institutions would be required to record their transactions in real-time and identify the hedging rationale for certain transactions that could present a compliance risk.

  • Trading in government obligations:

    A financial institution can continue to engage in proprietary trading only under a US government, agency, state and municipal obligations. They are also permitted, in limited circumstances, to engage in proprietary trading in obligation to a foreign sovereign and/or its political subsets.

  • Trading activities of foreign banking institutions:

    The Rules do not prohibit trading by foreign banking entities, so long as the trading decisions and principal risks are held outside of the United States. Transactions could involve US institutions but only under specific circumstances.

Covered Fund Prohibitions:

The Rules, as stated earlier, prevent financial institutions from owning or sponsoring hedge and private equity funds, which are referred to as “covered funds”. Under the Final Rules, the definition of covered funds was clarified and it included any issuer that is an investment company. However, the Rule excludes covered funds of certain entities with more general corporate purposes, for example, wholly owned subsidiaries, joint ventures, SEC-registered investment companies and business development companies.

Compliance Requirements and how the rule will affect information technology

The Rules hand out compliance requirements based on the size and amount of activity conducted by a bank, to reduce the burden on smaller entities. Banks will be required to set up an internal program designed to ensure and monitor compliance with the final Rules. Banks that do not engage in activities specified under the Rules do not have such compliance program requirements. The program will aim to monitor compliance activities as well as ensure that the trading bans and restrictions defined under the Rule are complied with.

The program will require larger financial institutions to establish a detailed compliance dictate, which would include the requirement of the CEO’s attestation while smaller banks will require a simplified compliance program. The entities would be required to maintain documentation so that agencies can monitor their activities in case of evasion. Banks that perform significant trade operations need to be able to report quantitative measurements, which are designed to monitor these activities. The requirement would be calibrated depending on the type and size of firms’ trading activities.

Implementing these compliance programs under the Volcker rule regulation embodies significant changes to the banking IT infrastructure, data processing and record-keeping procedures. New, internal banking policies will need to be developed to document, describe and track trading and investment fund activities. Controls will have to be set up such that they will be able to detect and record areas of non-compliance and submit to the regulating agencies on request. The biggest challenge of such a system is that it would have to be able to differentiate between those activities that are permitted and those that are prohibited. Many financial regulations have been implemented in recent years that have pushed banks to add new controls, but with the Rule, which came into effect on 1st April 2014, the number of changes to be implemented has now become more urgent. These include the need to improve data quality, reducing end-user developed applications and spreadsheets and improving front-office systems.

Impact of Volcker Rule on investment banks, hedge and private equity funds

With the Volcker Rule now law, investment banks and securities dealers are the most affected. Brian Moynihan, CEO of Bank of America Corporation, released a statement that ending trading activities under the Volcker Rule costs the banks near USD 500 million of revenue per quarter. Stephen Hoopes of IBIS World opines that the Volcker Rule is anticipated to further harm both revenue and profit for large investment banks. He notes that a number of large banks have already witnessed losing some of their best traders to hedge funds. Hoopes, however, also opines that the general increase in corporate profits and the improving US economy can more than make up for the negative trends related to the Rule.

The impact on the hedge fund and private equity industry is not as severe. With banks being restricted from speculative activity, non-banking institutions now have access to a wider market with lower competition. The firms that remain after the implementation of the Rule are expected to gain huge profits. IBIS world reports that, over the next five years, the revenue for the private equity, hedge funds & investment vehicles industry will increase at an annualized rate of 3.8% to USD 107.7 billion.

A Rule surrounded by skepticism

Since the ruling, many commentators have been writing about the lack of necessity for such a Rule. The biggest criticism being that far from stabilizing the economy, the implementation of this rule would send it into a tailspin.

The ultimate goal of the Rule is to build financial institutions and also prevent any future crisis. To minimize the need for the government to act as a safety net during a crisis, regulars will need to create tools that:

  • Internalize the cost that arises during a crisis, including insurance
  • Introduce more supervision of banks through capital requirements
  • Limit the sort of activities that banks can do

The Volcker Rule only addresses the third component, and for the market to stay stable only three will have to work in tandem. Banks diversified their income streams by introducing more business lines in the hope of making the financial system more stable. However, there is no evidence to back up such a claim. In fact, as per financial theory, the risk to an individual firm should be recorded separate to that of the broader market. The economic crisis was a result of a market-wide risk which increased as banks exposed themselves to more risk through diversification. A very real concern of the implementation of this Rule is its inability to differentiate between proprietary trading and the legitimate function a financial institution should partake in to remain profitable. While some activities are clearly defined as proprietary trading there are significant questions surrounding activities related to market making and hedging of risks. Regulators will have to keep a close eye on how banks change now that the Rule is implemented.

Conclusion

The final rules came into effect on April 1, 2014. The Federal Reserve Board has extended the conformance period until July 21, 2015. Recently, the Federal Reserve gave banks two more years to divest their collateralized loan obligations (CLOs) that fall under the Volcker rule. (CLOs are used by banks to remove loans from their balance sheets by selling the exposure as some form of securitization.) Beginning June 30, 2014, banking entities with USD 50 billion or more in consolidated trading assets and liabilities will be required to report quantitative measurements. Banking entities with at least USD 25 billion, but less than USD 50 billion in consolidated trading assets and liabilities, will be subject to this requirement on April 30, 2016. The same Rule comes into effect on December 21, 2016, for those with at least USD 10 billion, but less than USD 25 billion, in consolidated trading assets and liabilities.

A major concern for banks is that compliance with the new regulations will cost them billions of dollars just to continue to engage in permissible activities under the Rule. The Rule’s ultimate impact will depend on how closely the banks are scrutinized with regards to permissible trades and the tolerance limit to speculation. Financial institutions should begin preparation of compliance programs in adherence to the Final Rule. The Rule will have a huge impact on banking activities in the near future as banks work to carve out new profitable operating models in what will now be a high regulated and scrutinized environment.


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