Regulators' Questions Underscore Struggle to Craft Volcker Rule

WASHINGTON — A proposal implementing the so-called Volcker Rule has given the banking industry more questions than answers — literally.

The official version of the proposal, released by regulators on Tuesday, requests public comment on nearly 400 questions, from basic definitions to the potential costs of complying with the rule to the impact on various financial players. Although the industry lamented that regulators went too far when the proposal was leaked by American Banker last week, the questions effectively leave the regulators wide latitude to substantially revise a future final rule.

"It signals that they haven't taken a fixed position on a lot of things, so there is still room for discussion with them," said Dwight C. Smith, a partner with Morrison & Foerster.

In anticipation of a flood of comments, regulators are giving the public the maximum 90 days to comment on the nearly 300-page proposal.

Speaking at the meeting of the Federal Deposit Insurance Corp. board, Acting Comptroller of the Currency John Walsh quipped that one could argue that the comment period has been open for some time already, as drafts of the proposal have already been leaked.

"Unfortunately, though, I think the leakiness of this particular rule writing process has not been limited to the last few weeks," Walsh said Tuesday at the Federal Deposit Insurance Corp. board meeting. "There have been a number of occasions over the months where there were discussions and I think leaks of parts of the proposal that I think were aimed at influencing its outcome."

Walsh said the rule is long and complex, and added that regulators made the right decision to allow the full 90 days for comment.

"Hopefully the response to the numerous questions for comment will also help reduce the likelihood of any unintended consequences that may arise from the proposed regulatory framework," said Thomas Curry, an independent member of the FDIC board and the nominee to succeed Walsh.

The proposal includes 394 specific questions focusing on three general topics: proprietary trading; private equity and hedge fund investments; and compliance.

Kevin Petrasic, a partner with Paul, Hastings, Janofsky & Walker LLP, said the regulators appear to be struggling with the same issue Congress wrestled with, which is how to define these activities.

"I'm sure there are a number of reasons for the questions, one of which is try to build a strong record to defend whatever the final rule is," Petrasic said. "At the same time, there is clear recognition that the regulators are doing their best to try to define the parameters by the way that they asked the questions."

While people may disagree with particular aspects of the rule, Petrasic said the regulators are going about it in the right way by giving people as much opportunity as possible to weigh in, and highlighting the obvious questions.

Such questions included: what exactly is proprietary trading? Why is one kind of activity proprietary trading while another similar activity is not? What is the basis for the distinction, and is that difference something that's reducing risk-taking in the banking industry?

The proposal generally bans an institution from making direct investments through its own trading account. But the agencies sought feedback on whether their proposed definition for "trading account" — which would include accounts used by the bank for short-term trading, those subject to certain market risk capital rules and accounts used by a bank for securities or swaps dealing — was sufficient.

"Is the proposed rule's definition of trading account effective? Is it over- or under-inclusive in this context?" the regulators said "What alternative definition might be more effective in light of the language and purpose of the statute?"

The agencies also sought the public's reaction to how the proposal defined activities which would be allowed under the proprietary trading ban, including certain permitted market-making activities.

"Is the proposed rule's approach to implementing the exemption for permitted market making-related (i) appropriate and (ii) likely to be effective?" the regulators said. "If not, what alternative approach would be more appropriate or effective?"

When it came to risk-mitigated hedging activities, the agencies asked for feedback on whether the proposed hedging exemption would be effective, and what impact it would have on the risk management activities of a bank and its clients.

"Does the proposed approach sufficiently articulate the types of risks that a banking entity typically hedges? Does the proposal sufficiently address application of the hedging exemption to portfolio hedging strategies?" the regulators asked. "If not, how should the proposal be changed?"

They also asked whether the proposed rule's exemption of certain investment adviser, commodity trading advisor, trustee or similar fiduciary transactions effective? And should any other similar types of fiduciary relationships be specified in the rule?

"What are the mechanics of the particular trading activity and how does it qualify as being on behalf of customers?" they asked. "Are there certain requirements or restrictions that should be placed on the activity, if permitted by the rule, to prevent evasion of the prohibition on proprietary trading?"

Thomas Pax, a partner with the law firm Clifford Chance in Washington, said he was concerned that the proposal lays out such a detailed compliance framework when there are still many open questions about the substance of the rule.

"I guess what I would hope we would see as we go through the comment period now is that it goes a lot farther into being definitive about the scope of the rule, particularly now when you see what they're requiring in terms of compliance," Pax said. "I don't see how you can set this kind of compliance program in place and have it be meaningful if you don't give the institutions clear guidance on what's being prohibited or not."

Regulators have asked financial firms whether reporting requirements should be phased in gradually, as proposed, or whether an alternative approach would be more effective; what role the Office of Financial Research could or should play in receiving and analyzing banks' quantitative measurements; whether the proposal provides enough time to implement the record-keeping requirements; and whether a firm should be exempt from providing quantitative measurements if it can demonstrate that the information wouldn't be useful for that trading unit.

Regulators also asked some basic business questions about the activities that would be covered by the rule.

For example, they asked banks to describe the typical trading activities of a bank with less than $1 billion in trading assets and liabilities, and how complex those activities are. They also asked banks to explain how their trading activity might be categorized under the proposed definition, and which categories would be most helpful in distinguishing prohibited proprietary trading from permitted activities.

They also asked banks for input that would help them refine certain requirements.

"The rule affects lots of different kinds of operations, and does so in different ways, so they need to be able to drill down on each of those," Smith said.

In a statement issued after the FDIC vote, the president of the American Bankers Association said the "exceedingly high" number of questions in the proposal shows how frustrated regulators have become as they try to translate the Volcker concepts into reality.

"We anticipate that this rule will be continually adjusted and reformed as regulators respond to unintended consequences," ABA President Frank Keating said. "Unfortunately, the resulting uncertainty will have an enduring and negative impact on the banking industry and the customers we serve."

Americans for Financial Reform, a coalition of national and local organization pushing for Wall Street reform, said the vagueness of the rule and the hundreds of questions it includes underlines the fact that regulators are still in the midst of crafting the final product.

"Some of the questions they pose show pressures to weaken the rule even further, to the point of total uselessness," Lisa Donner, the group's executive director, said in a press release. "Instead, we call on the regulators to revise the rule so that it accomplishes the goal of producing a safer financial system, and one that serves the real economy instead of preying on it."

With so many questions, however, regulators may have a difficult time seeing the forest for the trees, Petrasic said.

"I think the challenge for the regulators is going to be to step back at some point and say does this make sense?" he said. "Are all these components achieving the goal that Congress highlighted in terms of reducing risk-taking by proprietary trading? So I think that's going to be the big challenge: how do you distill all this information?"