Volcker, Inc.: How One Rule Became a Cottage Industry

WASHINGTON — Almost as soon as it was first suggested by former Federal Reserve Board Chairman Paul Volcker, the rule to ban banks from proprietary trading — enacted as part of the Dodd-Frank Act — has caused severe headaches for financial institutions.

But the so-called Volcker Rule has also spawned its own cottage industry for consulting firms, tech startups and lobbying groups that see it as a business opportunity.

"I spend a fair amount of my time of the Volcker Rule," said Ernie Patrikis, a partner at law firm White & Case and former general counsel at the New York Fed. "I have lunch with [chairman] Volcker periodically, from our days at the Fed. He knows I don't love the rule, but I thanked him for it because of the business it brought in. It's the gift that keeps on giving."

The Office of the Comptroller of the Currency — one of the five regulatory agencies that had to write and implement the Volcker Rule — estimated the cost of compliance at just under $1 billion when it conducted a cost-benefit analysis of the proposal back in 2011. A more recent estimate by Bernstein Research put that cost at closer to $8 billion to $10 billion annually.

More precise estimates of compliance costs are elusive. Banking industry trade groups don't keep track of compliance costs for their members and the bigger consulting firms with Volcker compliance practices declined to give specifics when asked for figures of how lucrative those practices are.

Tim Keehan, vice president and senior counsel at the American Bankers Association, said there are no firm figures on exact costs associated with the Volcker Rule, but said the OCC's estimate was likely merely "a starting point" and that compliance costs alone would be "billions."

Even if exact compliance costs are hard to pin down, for a rule that was not envisioned as a core element of financial reform, the Volcker Rule plays an outsized role. Thomas Vartanian, a partner at Dechert LLP and former OCC official, said that the Volcker Rule is one of the biggest compliance burdens in Dodd-Frank, in a league with derivatives regulation or the creation of the Consumer Financial Protection Bureau.

"The four parts of Dodd-Frank that have had the most significant impact on financial institutions are: the Volcker Rule; CFPB enforcement and its new consumer compliance examinations and rules; Title VII's revamping of the derivatives clearing process; and Title I's imposition of systemic stability regulation," he said. "They have all had an enormous impact on the compliance responsibilities of financial institutions, and therefore the cost that they are incurring to achieve that compliance."

The rule, as conceptualized by Volcker in a January 2010 op-ed in the New York Times, calls for a ban on proprietary trading as well as bank ownership of hedge or mutual funds. The idea is to prevent the banks from putting their capital at risk in order to speculate in the markets on their own "rather than in response to customer needs," Volcker said.

But while the Volcker Rule in concept is simple, the Volcker Rule in practice has turned out to be deeply complex. It took years for regulators to agree on the final rule, as the proposal was drafted, redrafted, and coordinated between the fiefdoms and bureaucracies of five separate federal agencies. And since the rule was finalized in 2013, the balkanized nature of the U.S. regulatory system has made further guidance rare and less concrete.

"There's so little guidance from the agencies, and there's so much uncertainty," Patrikis said. "I think the one thing that the Volcker Rule has proved is, we have too many regulatory agencies. It just doesn't work."

Volcker said as much himself. Speaking during a conference on Fed regulations at George Washington University on March 20, Volcker said the need to coordinate a simple concept across multiple agencies — and then to have lobbyists approaching each agency individually to achieve carve-outs for their clients — yielded an inherently weak structure.

"It's a perfect example of the way that the system is working," Volcker said. "Whatever happens, you'd better have a lobbyist on duty to get whatever little twist you can get so he justifies … his retainer from the bank. It's a lousy system. Think of the purity of the concept."

But the application of a pure and simple concept to complex markets and market participants was always bound to yield complicated results, Vartanian said. Because the Volcker Rule has an inherent subjectivity to it — defining which funds are prohibited and which are not, or what is allowed under a market making exception and what is speculation — compliance will likely be an ongoing issue for banks, not unlike anti-money laundering compliance.

"Compliance may be a moving target, depending on the assessment of the various different regulators evaluating it at the moment, and the quality of the resources allocated by the bank," Vartanian said.

Keehan said the comparison to anti-money laundering compliance is appropriate, and if anything Volcker compliance may be more complicated because it could potentially touch on such a broad variety of activities.

"It's going to be more complex than AML … at least until the rule gets more settled and we get a series of interpretations," Keehan said. "There's plenty more that they are going to have to do to provide clarity."

Kelvin To, founder of Data Boiler Technologies, thinks of Volcker compliance as a permanent and lucrative fact of life. He has developed an algorithmic program to identify and quarantine trades that run afoul of the rule. That kind of filter-based approach to compliance is important for banks to put in place because the Volcker Rule requires banks to have "internal controls reasonably designed to monitor compliance", which is a higher bar than simply looking out for obvious violations or examining them after-the-fact.

"People tend to look at is as … 'I just shouldn't do stupid things,' and it's more than that. It's way, way more than that," To said.

To said the program is designed to assess trades before they are executed to determine whether they violate the Volcker Rule's requirements by themselves or in concert with the bank's other positions, thus preventing both accidental and intentional violations. He envisions the program being a sort of financial utility for compliance, akin to central clearing managed by the Depository Trust and Clearing Corporation.

"Volcker Rule compliance is actually a race," To said. "There is bound to be a bad apple in the market, there are bound to be rogue traders. They game the system. Unfortunately, if I am a rogue trader, I use multiple approved strategies to … synthetically create trades that bypass the system. How are you going to stop that?"

For his part, Patrikis is seeking a carve-out in the Volcker Rule for banks that are looking to invest in public-private partnership funds that would finance infrastructure projects. In a March 3 letter to members of the House and Senate finance committees, Patrikis said infrastructure projects tend to require large institutional investors in order to get funded, but the Volcker Rule has effectively placed a restriction on banks' having controlling interests in those kinds of funds.

"It would be hard to see how such involvement would cause harm to the financial stability of the United States," Patrikis said. "To the contrary, one could argue that precluding banking organizations from participating could do just that given the amount of investment capital which banking organizations could raise for such projects."

That exemption, to date, has not gained traction among lawmakers, Patrikis said. But he is not alone in seeking clarification in the rule. Keehan said one of the downsides to the Volcker Rule as it was enacted in Dodd-Frank is that it was apparently written with the largest and most complex banks in mind, but was applied to banks of any size.

The Fed has asked Congress to clarify that the rule does not apply to community banks, but appeared to say it can do little without lawmakers' intervention.

The Fed has made some concessions on the rule. Late last year the agency voted to extend the deadline for the "covered funds" aspect of the rule from July 2015 to July 2016, and also said it intends to extend the deadline again to July 2017. But Keehan said the deadline to have compliance programs in place is still in effect for July of this year, which is exerting substantial pressure on banks.

The ABA is also asking regulators whether small banks would have to divest themselves of Community Development Funds because they are "funds of funds" and therefore violate the Volcker rule. Community development funds receive benefits under the Community Reinvestment Act, which was passed in 1977 to encourage lending to low- and moderate-income communities.

"It is ironic that the rule, which was intended for the largest banks ... because of the way that it's written, applies to every single bank," Keehan said. "I think we will continue to see a cottage industry of compliance crop up until you get the level of certainty you have in AML. There's every expectation that Volcker will be the same way."