Is the Volcker Rule Unworkable?

WASHINGTON — Regulators' proposal to implement the Volcker Rule is overly long, complex and may be impossible to comply with.

Those, in a nutshell, were the early reviews given to a 200-plus page draft preamble to the proposal published by American Banker.

"We're dismayed there are over 200 pages just in the preamble, which suggests that the details of the regulation itself are going to be some multiples of that," said Wayne Abernathy, the director of regulatory affairs and financial institutions policy at the American Bankers Association. "The question that comes to mind is: How does any banking institution comply with it and how does any regulator actually implement it effectively?"

The Federal Deposit Insurance Corp. is due to vote on the plan Tuesday, but its early release was stirring up buzz within the banking industry, with some suggesting that certain parties were hoping to prevent further changes to the plan.

"Someone is trying to influence the debate and to ensure that the official rules come out sooner rather than later," said a banking attorney who asked not to be identified.

The Volcker Rule, which was first suggested by former Federal Reserve Board Chairman Paul Volcker, was made law in the 2010 Dodd-Frank Act. It generally bans banks from putting their own capital at risk through trading, and severely limits their involvement with hedge funds and private-equity entities. Yet the law also allowed for several exemptions, including trading done expressly on behalf of customers.

According to the leaked draft, which was dated Sept. 30 and could be different from the final proposal released by regulators, proprietary trading would be defined as "engaging in the purchase or sale of one or more covered financial positions as principle for the trading account of the banking entity." But trades made by an institution acting as an agent or broker for an unaffiliated third party, as well as hedging activities for lowering bank risk, would generally not be banned.

The document also broadly defines the types of ownership interests in or sponsorship of hedge funds or private-equity funds that would no longer be allowed. But it would provide exemptions for certain "de minimis" investments generally less than 3% of a fund's ownership, and less than 3% of a bank's Tier 1 capital, as well as investment activities related purely to asset management and advisory services done for customers.

But regulators also left significant leeway to change parts of the plan, listing dozens of questions in the proposal.

Some observers said that suggests the plan is just the opening salvo in what is expected to be a long battle over the final rule.

"I don't think the proposal goes much beyond what the statute said. There is some specificity in it as far as examples either for investments or the types of trading operations that are not permissible," said Dwight Smith, a partner at Morrison and Foerster. "But there are a lot of questions and it looks like the agencies are asking a lot of questions. So it's part of a dialogue back and forth in which the agencies need more input from the industry. They can't get that input without putting something out there."

Yet even though no regulation has formally been instituted, some impact of the "Volcker Rule" has already been felt. Some large institutions, having seen the writing on the wall, have already closed or spun off some of their trading activities.

"The institutions have reduced the capital allocated to those activities, gotten out of the activities, or moved them into asset management businesses. That is also true of pure proprietary trading — what I call embedded hedge funds, where there is no client interface," said Tim Ryan, the president and chief executive officer of the Securities Industry and Financial Markets Association. "That has gone the same way as private equity: it has either been shut down, the people have been told to go out and they've left and formed hedge funds or they've moved the business into the asset management business where there is very little bank capital."

But he added that firms have been less committal with other trading activities where the effect of the Volcker Rule is less clear, such as when companies acting on behalf of a client will hold a trading asset on their balance sheet temporarily during a transaction. The outcome of the rule-writing process may ultimately determine whether banks expand or shed those activities, he said.

"The third piece is where you're basically on a trading desk and you're providing support to clients," Ryan said. "Arguably under Volcker you need to watch closely what you're doing because if your hold period is for too long or you're taking too much risk, then you could be in violation of Volcker as opposed to just supporting clients."

Smith said the length of the proposal could be all some banks need to decide to downsize their trading operations.

"I'm not sure it's going to have much effect either way, although for some institutions the length and complexity may be somewhat discouraging," he said. "That might just generally be an inducement to cut back on what they may be doing."

But Gregory Lyons, a partner at Debevoise & Plimpton LLP, said despite reports of banks closing the door on proprietary trading, there are others holding out hope that the rulemaking process allows for enough flexibility for them to preserve a vestige of such operations.

"There are certainly many institutions that are still looking to retain those portfolio investment companies and those prop trading operations in some fashion," he said. "Many [institutions] have taken some initial steps, but as far as how they really want to operate going forward many are waiting."