Volcker Rule (§ 619)
The legislation places a number of substantive restrictions on the activities of banks*—one of the most important of which is the so-called “Volcker Rule,” named after former Federal Reserve Chairman Paul Volcker, who initially proposed it. The Volcker Rule is actually two separate rules: (1) a prohibition on proprietary trading, and (2) a ban on certain hedge fund and private equity activities. These controversial restrictions, discussed further below, stem from Congress’s view that banks and thrifts have moved too far beyond traditional lending and deposit-taking into other business lines that present undesirable risks to insured deposits. The Volcker Rule is particularly controversial because many believe there is little evidence that the prohibited activities played a factor in the financial crisis. Indeed, some have cited the profitability of proprietary trading and hedge fund and private equity activities as critical in offsetting banks’ massive losses from mortgages and other traditional loan portfolios.
The Volcker Rule will apply to all “banking entities,” a term that includes banks, thrifts, BHCs, SLHCs, and their affiliates. The prohibitions will also apply to the US operations of foreign banks. Nonbank financial companies regulated under the new systemic risk regime are technically not subject to the Volcker Rule, but Congress has directed the Federal Reserve to impose additional capital requirements and quantitative limits on them to mitigate the perceived risks inherent in proprietary trading and hedge fund and private equity activities.
Prohibition on Proprietary Trading (§ 619)
The Volcker Rule prohibits any banking entity from buying and selling any security, derivative, or other financial instrument for its “trading account,” as opposed to the accounts of customers. Certain transactions are, however, generally excluded from the ban on proprietary trading, including:
- customer transactions
- transactions in connection with underwriting or market-making activities
- bona fide risk-mitigating or hedging activities
- buying and selling of securities in the context of an insurance business
- transactions in US government or government-sponsored enterprise securities
- proprietary trading by a non-US controlled banking entity that occurs outside the United States
Ban on Hedge Fund and Private Equity Activities (§ 619)
The Volcker Rule also prohibits banking entities from acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring any hedge fund or private equity fund, subject to certain exceptions. Under the legislation, the terms “hedge fund” and “private equity fund” include any issuer exempt from registration as an investment company under section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (Investment Company Act). The relevant regulators may also include “similar funds” through rulemaking. A banking entity “sponsors” a hedge fund or private equity fund if it serves as the general partner or managing member of the fund, selects or controls (or has employees, officers, directors, or agents who constitute) a majority of the directors, trustees, or management of the fund, or shares the same or a similar name with the fund. The prohibition will not apply to any non-US controlled banking entity if the interests in a given fund are not offered or sold to US residents.
Despite the expansive scope of the ban, a key exception will allow US banking entities to organize and offer private equity or hedge funds if a number of requirements are met—specifically, if the banking entity:
- provides bona fide trust, fiduciary, or investment advisory services to the fund;
- organizes and offers the fund only to customers and only in connection with the provision of trust or related services;
- does not make, acquire, or retain an interest other than a seed investment in the fund and satisfies each of the following two requirements:
- within one year of the fund’s establishment, the banking entity’s investment is reduced to 3% or less of the total ownership interest in the fund
- the aggregate of all the banking entity’s investments in private equity and hedge funds is 3% or less of the banking entity’s Tier 1 capital;
- avoids certain transactions specified in the detailed affiliate rules of the Federal Reserve Act with respect to the fund;
- does not guarantee, assume, or insure the fund’s obligations or performance;
- does not share the same or a similar name with the fund;
- does not allow an ownership interest by any director or employee not directly engaged in providing services to the fund; and
- discloses that losses will be borne solely by investors.
Although this exemption will make it possible for banking entities to devote significant resources to hedge fund and private equity activities in the coming years, some of the larger financial institutions in the United States currently exceed both of the 3% thresholds. The major form of relief Congress has granted these banking entities is the potentially lengthy time frame for the Volcker Rule’s implementation.
Implementation Period (§ 619)
Like many other provisions in the legislation, the Volcker Rule comes into force only when the regulators issue final rules implementing it. However, given the significant and potentially disruptive impact the prohibitions might have, Congress has given the Council six months to complete an initial study and issue recommendations on how best to implement the Volcker Rule. Within nine months after the study or within two years of the enactment of the legislation, the Federal Reserve and other regulators will consider the Council’s findings and issue their final, coordinated regulations making the Volcker Rule officially “effective.” Nevertheless, “effective” does not really mean immediately effective, because Congress has given banking entities two years after the rules are issued to comply with the Volcker Rule. Furthermore, the Federal Reserve and other regulators at their discretion may issue up to three one-year extensions to individual banking entities. Additional extensions of up to five years are available in connection with commitments to funds considered “illiquid.” As a practical matter, therefore, forced divestments under the Volcker Rule could take place anywhere from approximately three to possibly 12 years after the enactment of the legislation. Even with the potential for a lengthy divestment period, however, the Volcker Rule is a radical alteration of the bank regulatory landscape—particularly for the nation’s largest financial institutions.