At a time when banks are facing a tough operating backdrop, the Federal Reserve’s approval to the overhauling of Volcker Rule is a positive catalyst. Earlier this week, the central bank became the last of the five banking agencies to give its consent to simpler provisions.
Other four regulators – the Commodity Futures Trading Commission (“CFTC”), the Federal Deposit Insurance Corp. (“FDIC”), the Office of the Comptroller of the Currency (“OCC”), and the Securities and Exchange Commission (“SEC”) – had already given green signal to the changes.
The revamped regulatory requirements have been simplified, providing more flexibility to banks on restricted trading activities.
The Fed said in a statement, “The revisions continue to prohibit proprietary trading, while providing greater clarity and certainty for activities allowed under the law.” These changes will become effective Jan 1, 2020, with a compliance date of Jan 1, 2021.
Volcker Rule – A Brief Recap
The Volcker Rule (part of Dodd Frank Act) prohibits banks or insured depository institutions from conducting proprietary trading, i.e. the practice of financial firms investing to pocket profits rather than buying or selling securities to meet customers’ demands. Also, it barred these companies from acquiring or retaining ownership interests in hedge funds or private equity funds.
The Volcker Rule had drawn widespread criticism at its very inception. Banks, including JPMorgan JPM, Goldman Sachs GS and Morgan Stanley MS, have been complaining of its complexity and claimed the rule to be vague. Notably, these banks have gradually moved away from proprietary trading operations.
Further, in 2017, the U.S. Chamber of Commerce put forth its views over the negative impact of the rule on liquidity, and stated that the costs associated with it outweigh benefits.
Notably, in July 2018, the FDIC, OCC, Federal Reserve Board, SEC and CFTC unanimously published proposed changes in provisions aimed at simplifying the Volcker Rule that prevents banks from engaging in certain types of speculative investments, with a view to curb their risk-taking abilities.
Depending on the size of a bank's trading assets and liabilities, the rule’s compliance measures have been tailored, with the strictest requirements for the ones with high levels of trading activities. Also, a proprietary trading ban has been eased, which prevents banks from making short-term investments using their own capital.
Further, regulators have allowed banks to determine their own risk limits for underwriting activities and market making. Nevertheless, the companies, with significant trading assets and liabilities, will still be required to have a comprehensive internal compliance program.
Moreover, the final rule removes the assumption that positions held by lenders for less than 60 days are proprietary trades. It would even discard some parts of a test that determine whether or not a trade is proprietary, and replace it with a new criteria based on how the bank accounts for the trades.
Banks will also be freed from the elaborate documentation requirements for hedging activities under certain conditions. The revamped rule further simplifies trading activity-related information to be provided to the agencies.
Moreover, foreign banks stand to benefit greatly from a major change in the rule. Under the existing rule, foreign banks are allowed to engage in proprietary trading only if it occurs outside the United States. However, per the new regulation, the exemption will expand to trades initiated outside the country but should go through a U.S. branch or affiliate or be financed by one.
Will Revamped Rule be Beneficial for Banks?
The final rule is anticipated to greatly lower fixed costs for banks. Also, banks can now freely engage in hedging activities in limits they consider risk-free that might help counter risk in other parts of their businesses.
Further, the revamped Volcker Rule might help improve lending as banks are likely to benefit from better liquidity positions.
However, easing of regulations might leave behind some loopholes that banks seek to exploit. So, the regulators are expected to maintain a strict supervision on banks’ activities, and keep them on the right track to avoid another crisis.
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