Initial impact of the Volcker Rule

December 2015  |  FEATURE  |  BANKING & FINANCE

Financier Worldwide Magazine

December 2015 Issue

December 2015 Issue

The Dodd-Frank financial reforms have been on the radar of firms in the financial services industry for years. However, one of the most important and divisive components – the Volcker Rule – has only just come into full effect. First proposed in 2010, ostensibly the Volcker Rule was designed to shield banks’ customers from risky behaviour. Fundamentally, the Rule prohibits banks from engaging in two specific practices: firstly, proprietary trading, and secondly, entering into associations, through investment and relationships, with hedge and private equity funds. Under the auspices of the Rule, all banks required to achieve compliance had to submit their compliance manual and demonstrate to US regulatory authorities that they were compliant on 21 July 2015.

Colloquially named after Federal Reserve Chairman Paul Volcker, the aim of the Rule – Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act – is to bring commercial banking back in check. To that end, the Rule was designed to force banks to comply with perhaps the most significant new restriction on their activities since the Great Depression.

Some critics of the Rule (and there have been many detractors) have suggested that the rule will create a time warp effect in the financial services industry, in effect taking the banking system back to the ‘good old days’ during which institutions were able to make loans and take deposits – and do very little else in between.

There is also a belief that the final version of the Volcker Rule, introduced in 2014, is significantly tougher than many within the financial services industry expected, even though a considerable degree of lobbying was carried out by the banking sector to reduce its impact. Furthermore, the Rule has come in for additional criticism as some analysts believe that its layers of lengthy, vague and difficult terminology make enforcement difficult.

For many critics, the Volcker Rule has further muddied the waters of the financial services industry. It has, they argue, together with regulations regarding capital adequacy, qualified mortgages, risk retention, derivatives and liquidity, combined to increase compliance costs for companies and restrict the number of opportunities organisations have to generate a profit.

Although Dodd-Frank and the Volker Rule both had noble beginnings, the reality for regulators and financial institutions alike is that the task of distinguishing between the now prohibited activities and more legitimate financial operations has proved difficult. Consequently, during the lead-in period to the implementation of the Rule, compliance costs for financial institutions have ballooned. According to estimates from the Office of the Comptroller of the Currency the seven largest liquidity-providing banks in the US have collectively spent more than $400m in the last year in order to achieve compliance. Financial institutions in the US have been forced to create new, complex compliance systems in order to ensure that every single transaction is compliant with the new legislation. Given the level of activity at major banks, this has not been an easy task, particularly since every time a bank buys or sells a security it is in effect taking part in a proprietary trade – which is prohibited.

The implementation of the rule has also created difficulties for those institutions intending to expand their holdings of foreign currency in anticipation of increased demand. Going forward, regulators in the financial services sector will be required to take stock of a bank’s assets and liabilities, as well as their intentions. As a result of this additional scrutiny, regulators are now required to allocate additional time and resources to ensuring that financial institutions, and the market in general, are in a safe and stable condition.

For many critics, the Volcker Rule has further muddied the waters of the financial services industry.

Some commentators have also noted that the combined effect of Dodd-Frank and its higher operating costs has also served to restrict credit availability. Accordingly, it is likely that some trading may transfer to unregulated firms in the shadow banking sector, away from the prying eyes of regulators. Should the shadow banking sector prosper going forward, the task of solidifying the financial space and reducing risk could become more problematic.

Equally, financial firms including Goldman Sachs, J.P. Morgan Chase and Bank of America criticised the Rule, and drew support from Republican Congressmen who claimed that it could negatively impact the competitiveness of US financial institutions in the global market. According to the banks, the Volcker Rule was an attack on liquidity. Mr Volcker dismissed such claims as “nonsense”, given that the Rule does not apply to government securities, which provide the bulk of liquidity in the market.

The Rule has also been subject to a now abandoned lawsuit by smaller banks which claimed that implementation would force them to abandon their investments in trust-preferred securities, which have hybrid characteristics of debt and equity. The Rule, they also argued, would cost them a considerable amount of money in the long run.

There has also been opposition to the Rule from abroad. Earlier this year, Canada’s finance minister Joe Oliver told a New York securities conference that the rule violated the North American Free Trade Agreement (NAFTA). “I believe – with strong legal basis – that this rule violates the terms of the NAFTA agreement,” said Mr Oliver. “I hope the United States administration sees that changing the Volcker rule is in its own best interests and that of its biggest trading partner.” Previously, NAFTA members agreed not to extend their regulatory reach beyond their borders and to try to negotiate harmonised rules if cross-border regulation became necessary. Volcker’s critics argue that the Rule circumnavigates this agreement.

Given that criticisms of the act have been plentiful, and regulators have welcomed the Rule and its ban on proprietary trading, the early stages of implementation were always likely to be problematic. However, with a government intent on avoiding a repeat of the financial crisis of 2008, the industry’s protestations, and lawsuits, were always likely to fall on deaf ears. The memory of JP Morgan’s ‘London Whale’, for example, provided ample incentive to lawmakers of the need for tighter regulation of proprietary trading.

To that end, the Rule has been designed to prevent banks and financial institutions from making risky, speculative investments with their customers’ deposits. The aim of this process is to create greater demarcation between commercial and investment banking.

Given the scale and controversial nature of many of the features of the Dodd-Frank Act – which is 2300 pages long and made up of 16 provisions and 400 new regulations – its implementation has taken some time. There have been a number of delays over the course of the last five years. However, at the end of July the Volcker Rule was finally fully implemented and compliance with the regulation required. Though it arrived with little fanfare, there are likely to be a number of serious complications in its interpretation, exemptions and enforcement going forward.

Early stages

Five years after the Rule’s first introduction, and less than a year since its (more or less) full implementation, it is fair to say that there is still some degree of uncertainty about the Rule and the scale of the impact it is likely to have on the banking space. There have been some suggestions that the Rule may result in the ‘over lawyering’ of smaller banks as they are required to prove their compliance even though arguably it has little to no impact on them. To that end, the Federal Reserve Board, the FDIC and the OCC have issued a joint statement explaining that the Rule should not have much effect on the majority of banking entities with less than $10bn in total consolidated assets. The primary reason, generally speaking, is that the vast majority of smaller, community banks have little or no involvement in prohibited proprietary trading or investment activities in covered funds. In reality, however, it does appear that some smaller banks have been affected regardless.

Despite the consternation, by 21 July 2015 most banks were ready and had achieved some semblance of compliance with the Rule. Nine of the world’s largest banks had already been reporting their metrics to regulators since September of 2014 in preparation for the Rule’s full implementation. Banks have had plenty of time to achieve compliance, with most designing their own bespoke compliance programmes. For the larger and medium sized institutions more ‘enhanced’ programmes were required. Technology resources have played a role in establishing Volcker compliance, and will continue to do so. Clearly, the considerable amount of lead time between the release of the final plan and the implementation date of the Rule has been extremely useful for institutions. However, given the intricate nature of the Volcker Rule, there are still a number of organisations and smaller banks which fall under the purview of the Rule that may have only achieved partial or substandard compliance by the time it finally came into effect.

Though there have been calls for regulators to put forward additional guidance on compliance with the Rule, it was not particularly forthcoming before the implementation date, although some efforts have been made subsequently. In late September, the Securities and Exchange Commission issued a round of supplemental guidance to its list of frequently asked questions on Volcker Rule compliance. The latest updates, released on 25 September, address CEO attestation and compliance programme requirements for market making-related activities. FAQ 17 clarifies compliance requirements for market making and the identification of covered funds. FAQ 18 relates to CEO certification for prime brokerage transactions.

Despite the dearth of available regulatory guidance, a number of banks and financial institutions were able to achieve compliance with the Rule by using their own best judgement and implementing components of the Rule. The lack of clarity forced many banks to interpret aspects of the Rule for themselves and establish compliance programmes accordingly. Given the scope of many of the firms covered by the Rule, it can often be difficult for banks to know whether they are fully compliant; however, many firms have take it upon themselves to streamline and divest entire divisions, such as Goldman Sachs and JP Morgan Chase.


Given the considerable financial and time resources expended to comply with the Rule, one would expect non-compliance to be a dangerous tactic. Surprisingly, however, no punishments for non-compliance are listed in the wording of the Volcker Rule. That is not to say that companies will not be heavily fined for breaching their obligations. Given the recent trend for imposing substantial fines on financial institutions for malfeasance, it would behove firms to be mindful of their obligations and the merits of their compliance programmes. Though sanctions for non-compliance have not been explicitly expressed, they will no doubt be substantial.

The Rule itself only contains a minimal enforcement mechanism. If a bank engages in prohibited proprietary trading, it can be required to divest itself of the investment and restricted from future trading of that type. There is no separate punishment incorporated into the Rule for violations, despite suggestions that the Rule include its own schedule of civil penalties.

Moving forward

In the coming months it is likely that we will see additional issues being raised as financial institutions continue to come to terms with the scope of the Volcker Rule. Today, though many organisations have achieved a form of compliance, the Rule is still causing concern. As such it is important that the relevant US regulatory bodies continue to issue guidance and advice as required and requested. Organisations must continue to be nimble, adapting to the Rule and its implications for the market.

© Financier Worldwide


Richard Summerfield

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