Volcker Rule eases market-making while hedges face new scrutiny

Agencies set to sign off on ban

U.S. financial regulators, taking a landmark step in the five-year effort to rein in Wall Street, decided to curb some types of trading while largely freeing chief executives from personal responsibility in the final version of the Volcker rule.

The Federal Reserve, the Federal Deposit Insurance Corp. and three other agencies are set to sign off today on the proprietary trading ban, which has been contested by Wall Street banks JPMorgan Chase & Co., Goldman Sachs Group Inc. and their industry allies for more than three years.

Wall Street’s lobbying paid off in part. Regulators granted a broader exemption from the ban for banks’ market-making desks, on the condition that traders aren’t paid in a way that rewards proprietary trading, according to a draft of the final rule. The final version also exempts securities tied to foreign sovereign debt from the ban. At the same time, regulators gave banks less leeway for bets considered hedges for other risks.

“It prohibits risky proprietary trading while protecting economically essential activities like market-making,” Treasury Secretary Jacob J. Lew said last week. “Regulators have worked hard to find the right balance that protects our economy and taxpayers while also leaving room for well-functioning financial markets.”

Volcker’s Idea

The rule is named for Paul Volcker, the former Fed chairman credited with taming rampant inflation in the 1970s and who served as a top adviser to President Barack Obama. Volcker proposed the ban as a means of restoring stability to Wall Street following the 2008 financial crisis, arguing that banks that benefit from federal deposit insurance and discount borrowing shouldn’t be permitted to take risks that could trigger a taxpayer-funded government bailout.

The rule, enshrined by the Dodd-Frank Act of 2010, allows exemptions for market-making and some hedging, and defines limits for banks’ investments in private equity and hedge funds.

Bill Issac, a former FDIC chairman who is chairman of Cincinnati-based Fifth Third Bancorp, said the rule will pinch revenue and income at the biggest banks and some regional lenders, limiting their ability “to fulfill the full range of needs of their largest and most consequential customers.”

“These companies will turn elsewhere for these services, including foreign banks and non-regulated firms,” Isaac said in an e-mail.

Fine Print

With Wall Street banks having already shut proprietary trading desks in anticipation of the rule, its impact rests largely in the fine print -- how regulators address other banking activities, primarily market-making and hedging.

The final version set for approval by the Fed, FDIC, Securities and Exchange Commission, Commodity Futures Trading Commission and Office of the Comptroller of the Currency sets parameters for how banks may buy and sell financial products for clients and manage their own risks in the process.

Wall Street’s five largest firms had as much as $44 billion in revenue at stake on the outcome of just one part of the debate -- how market-making is defined and exempted -- according to data for the year ended Sept. 30. JPMorgan, the biggest U.S. lender by assets, had as much as $11.4 billion riding on the answer.

What follows are summaries of five of the rule’s major provisions:

Making Markets

The Volcker rule bans banks including Goldman Sachs and Morgan Stanley from trading to profit for their own accounts, while allowing them to continue making markets for clients. Distinguishing between those two practices has been one of the most difficult tasks for regulators.

In the final draft, the regulators eased the criteria banks must meet to qualify for the market-making exemption. To receive the exemption, a trading desk must both buy and sell contracts or enter into both long and short positions of those instruments for its own account.

The trades must not exceed, on an ongoing basis, the “reasonably expected near-term demands of clients.” Further, the final draft also requires that compensation arrangements not be designed to reward prohibited trading.

Bankers became concerned about the rule’s potential to ban big parts of their business almost immediately after Dodd-Frank was passed in 2010. The 2011 draft included a list of criteria to be met for trading to be exempted as market-making.

Industry lobbyists urged the exemption be widened, saying regulators needed to recognize that banks routinely buy and sell stocks, bonds and derivatives and build up inventories to help clients when they eventually place orders. Restricting those practices would hurt companies selling bonds, for example. Banks were joined by asset managers such as Vanguard Group Inc. and AllianceBernstein Holding LP in warning that a narrow exemption could unsettle markets.

Next page: Portfolio Hedging

Portfolio Hedging

In the final rule, regulators require banks to demonstrate on an ongoing basis that their trades hedge specific risks in order to win an exemption from the Volcker rule, according to the draft.

The banks must analyze and independently test that their hedges “may reasonably be expected” to reduce the identified risk, the draft says. Banks will need to show that a hedge “demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks,” according to the text.

The final rule requires banks to have an “ongoing recalibration of the hedging activity by the banking entity to ensure that the hedging activity” is not prohibited.

The hedging provision became central to the Volcker rule debate after JPMorgan lost $6.2 billion last year in bets on credit derivatives known as the London Whale. The trades, conducted in the U.K. by the bank’s chief investment office and nicknamed for their market impact, were described by JPMorgan executives as a portfolio hedge. The bank’s synthetic credit portfolio produced about $2.5 billion of revenue in the five years before 2012, according to a Senate subcommittee report on the bets.

Senator Carl Levin, the Michigan Democrat who leads the Permanent Subcommittee on Investigations, joined other Democrats and some regulators in pushing for a narrower definition of hedging after the JPMorgan trades. Daniel Tarullo, the Fed governor responsible for financial regulation, called the trades a “real world” case to be considered as the rule was drafted.

Three months after the losses were disclosed in 2012, JPMorgan Chairman and Chief Executive Officer Jamie Dimon told lawmakers that the Volcker ban “may very well have stopped parts of what this portfolio morphed into.”

Still, Wall Street pressed regulators to allow banks leeway in how they manage assets and liabilities with hedges. “An overly restrictive Volcker rule would curtail market liquidity, harm investors and dampen economic growth,” said Kenneth Bentsen, president of the Securities Industry and Financial Markets Association, Wall Street’s biggest lobby group, in a Dec. 5 e-mailed statement.

Sovereign Debt

The buying and selling of securities backed by a foreign sovereign will be permitted trading, according to the rule. That exemption includes securities issued by foreign central banks and applies to U.S. banks with overseas operations as well as foreign firms with affiliates in the U.S., according to the draft.

The initial Volcker rule draft drew international criticism for its reach into banks based overseas as well as for its impact on foreign sovereign debt markets.

The push-back started in late 2011 after the Volcker proposal exempted trading in U.S. government securities while covering debt issued by foreign countries. Officials from Canada, Japan and the U.K. sent letters to U.S. financial regulators and the Treasury Department saying the measure would harm their ability to fund governments.

Michel Barnier, the European Union’s financial services chief, complained to then-Treasury Secretary Timothy F. Geithner about the rule’s “extraterritorial consequences.” Canadian and Mexican bankers and government officials said the proprietary trading ban would violate the North American Free Trade Agreement’s guarantee that banks be allowed to deal equally in U.S. and Canadian debt obligations.

Fund Investments

The proprietary trading rule seeks to limit banks’ speculative bets in another way: by curbing their investments in private equity, hedge funds and commodity pools.

U.S. banks have already begun cutting their stakes, with further reductions needed to meet the law’s limit of 3 percent of Tier 1 capital invested in the funds. For example, Goldman Sachs cut its investment in such funds to $14.9 billion as of Sept. 30, down from $15.4 billion when Dodd-Frank was passed.

In an effort to limit the provision’s impact, bank representatives told regulators too many types of investments were included in the 2011 proposal. The draft restrictions went beyond traditional private equity and hedge funds, they said.

Bankers argued that using such a broad definition would capture investment vehicles used when loans are bundled into securities, as well as commodity pools and funds based overseas. In a February 2012 letter to regulators, lobbying groups for the largest banks called the covered funds definition the “most far-reaching flaw” in the proposal.

The draft makes clear that investments in commodity pools are restricted by the rule.

CEO Responsibility

Apart from the specific limits on bank investments and trading practices, the Volcker rule includes efforts at changing part of the culture of trading on Wall Street.

The approach was underscored by a speech in Washington last week by Lew, who said executives in charge of financial firms need to ensure that the “tone at the top” reflects a strong desire to prevent violating the rule.

Toward that end, the draft has a section entitled “responsibility and accountability,” that details how banks should set up compliance programs. They must have written procedures and be approved by the board of directors as well as the senior management of the bank, the draft said.

The board and top managers “are responsible for setting and communicating an appropriate culture of compliance,” the draft said.

The centerpiece of the governance changes is a requirement that CEOs “annually attest in writing” that the company has “procedures to establish, maintain, enforce, review, test and modify” the compliance program.

The wording will be a relief to Wall Street chiefs who were concerned that they would have to personally guarantee that their firms were in compliance with the rule, according to people familiar with the banks’ thinking. Executives already file a similar certification with the Financial Industry Regulatory Authority, a self-regulatory group for brokerage firms.

The certification wasn’t part of the Volcker rule when it was first proposed two years ago; it was added to send a signal that regulators weren’t bending to a massive lobbying campaign by financial firms, according to two officials familiar with the rule.

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