Streamlined Volcker Rule could encourage some banks to take bigger risks

Recent changes to the Volcker rule by four federal regulators that were meant to simplify trading obligations of U.S. banks will instead open an opportunity for some banks to take more risk, creating a credit negative for the industry.

The final rule revisions, approved by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. on Aug. 20; the Commodity Futures and Trading Commission on Sept. 16; and the Securities and Exchange Commission on Sept. 18 aim to streamline and improve the efficacy of the complex trading requirements first adopted in 2013. However, particularly when lower interest rates are putting pressure on bank net interest margins, the changes have the potential to encourage some banks to take greater risks, creating a credit negative.

The revisions will not become final until they are also approved by the Federal Reserve Board. But we expect this will occur over the next couple of weeks. Once final, the revised rules will become effective Jan. 1 2020, but banks will have a year to comply.

By narrowing the rule's scope to exclude assets and liabilities held at fair value outside of the trading account — and by establishing a presumption that positions held for 60 days or longer are not considered proprietary trading — banks might increase risk-taking.

This is especially true for banks with combined U.S. trading assets and liabilities of less than $20 billion, excluding government and agency securities. This threshold includes most, if not all, community, regional and custodian domestic banks, as well as the U.S. operations of most foreign banks. Those banks’ compliance requirements would be reduced significantly under the revised rules.

Furthermore, a number of other recent regulatory tailoring initiatives have sought to lessen or eliminate the application of several other regulations to community and regional banks. We therefore believe those banks may have a freer hand to take advantage of the revised rule's narrower scope, looser compliance requirements and shifted burden of proof.

Conversely, while the largest U.S. banks — including Bank of America Corp., Citigroup Inc., The Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley and Wells Fargo & Co. — might also have opportunities to take additional trading and investment risks, their compliance requirements have not been appreciably reduced.

These banks remain fully subject to a number of other regulatory requirements that constrain such risk taking, most notably the Federal Reserve’s stress test; but also Basel III risk-based capital and liquidity requirements.

The Volcker Rule will continue to prohibit most forms of proprietary trading within the trading account. But a number of the changes should allow banks to enter hedging transactions, correct trading errors and manage their liquidity with less need to document and demonstrate that each individual transaction is not a proprietary trade.

The revised rules also simplify how banks can qualify for the reasonably expected near-term demand (RENTD) exemption. For market making and underwriting activities to be exempt from the ban on proprietary trading, a bank must demonstrate that its activity does not exceed RENTD.

In practice, this has been difficult to demonstrate. Under the revised rule, a bank will be presumed to have stayed within RENTD as long as its activity stays within internal limits set with consideration not only for risk, but also for the liquidity, maturity and depth of the market for the relevant types of instruments.

Although this could lead to increased risk-taking, the internal limits remain subject to ongoing review and oversight by a bank’s supervisor, which can also rebut the presumption of compliance if it determines that a trading desk is engaging in activity that is not designed to remain within RENTD.

Under the revised rule, only the largest banks would be required to maintain a compliance program that is reasonably designed to ensure compliance with RENTD exemption requirements: there is no required RENTD compliance program for other banks.

Similarly, the current rule mandates a detailed overall Volcker Rule compliance program for all banks with more than $10 billion in total assets, including enhanced minimum standards and CEO attestation. However, the revised rule would require most of this only for the largest banks, although even their enhanced minimum standards would be eliminated.

Banks with less than $1 billion in combined trading assets and liabilities would have no obligation to demonstrate compliance. While banks with between $1 billion and $20 billion in combined trading assets and liabilities would be required to have a simplified compliance program with no CEO attestation.

The rule would continue to require banks with combined trading assets and liabilities of more than $10 billion to submit a substantial amount of trade data to help the supervisors monitor compliance with the market-making exemption. While some of the required metrics were eliminated, others were added, reflecting the regulators' intention to improve the efficacy and relevance of the information being submitted.

We believe the availability of this information to supervisors becomes even more important now that more of the burden of proof for violations has shifted to the bank supervisors. However, smaller banks are not subject to this data requirement, which we think could make it more difficult for supervisors to effectively limit any increase in risk-taking at such banks.

Editor's note: This article originally appeared, in slightly different form, in an email to Moody's Investors Service’s clients.