3. 1
Volcker rule
Limits on investments
The rule prohibits a banking entity from having an “ownership
interest” in, sponsoring, or having certain relationships with
hedge funds or private equity funds (termed “covered funds”).
Additional information about this aspect of the rule can be
found in Subpart C – Covered Fund Activities and Investments.
The rule is effective as of April 1, 2014. However, the
conformance period has been extended to July 21, 2015 — an
acknowledgment by regulators of the difficulty banking entities
face in complying with the rule.
Will your organization be ready? In this publication, we
highlight certain considerations you should be aware of as you
prepare to comply with the rule.
1
The federal agencies approving the rule include the Board of Governors of the Federal Reserve System, the Commodities Futures Trading Commission, the FDIC, the Office of the Comptroller of the
Currency, and the SEC.
2
See the final rule at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a1.pdf.
Introduction
BANKING ENTITIES DEFINED
“Banking entities” include insured U.S. depository
institutions; entities that control an insured depository
institution (for example, a bank holding company); a
foreign entity that is treated as a bank holding company
for purposes of Section 8 of the International Banking Act
of 1978 (i.e., because it has a U.S. branch or agency); and
affiliates or subsidiaries of the foregoing*
.
After four years of fervent public debate and intense regulatory
deliberation, Section 619 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act), known as the
Volcker rule (the rule), was approved by all five of the required
federal agencies on Dec. 10, 20131
. The rule — modified from
a proposal published in late 2011 — restricts a banking entity’s
trading activities and defines what is a permissible investment
for a banking entity. Coupled with the compliance challenges
and costs imposed by other parts of the Dodd-Frank Act, the
rule will create a significant hurdle for midsize and large banking
entities as they strive to regain historical levels of profitability.
Limits on trading activities
Subject to various exemptions, the rule prohibits banking
entities from engaging in proprietary trading — defined as
“engaging as principal for the trading account of the banking
entity in any purchase or sale of one or more financial
instruments.” Many of the terms in that definition are further
defined in Subpart B – Proprietary Trading Restrictions2
.
*
For purposes of the rule, the term “affiliate” has the same meaning as in Section 2(k) of the Bank
Holding Company Act of 1956. Namely, the term “affiliate” means any company that controls, is
controlled by, or is under common control with another company.
4. 2
Volcker rule
• A system of internal controls designed to monitor
compliance with the rule.
• A management framework that delineates responsibility and
accountability for compliance.
• Training for trading personnel and managers, as well as
other “appropriate” personnel.
• Records sufficient to demonstrate compliance with the rule
and retained for five years.
• Independent testing of the effectiveness of the compliance
program. The testing may be conducted by “qualified”
personnel of either the banking entity or an outside party.
• Domestic U.S. banking entities with total consolidated
assets of $50 billion or more.
• Foreign banking entities that have U.S. assets of $50 billion
or more for the preceding calendar year, including U.S.
subsidiaries, affiliates, branches and agencies.
• Banking entities that have been designated as enhanced by a
supervisory agency.
The additional requirements of an enhanced program address
the following areas:
• Trading desk (written policies)
• Robust analysis and quantitative risk management
• Authorized risks, instruments and products
• Hedging policies and procedures
• Explanation of the management of high-risk assets or
high-risk trading strategies
• Remediation of violations
3
Rule: Section 13 of the Bank Holding Company Act contains certain prohibitions and restrictions on the ability of a banking entity and nonbank financial company (supervised by the
Board of Governors of the Federal Reserve System) to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund.
Understanding the basics
Meeting the compliance requirements
Proprietary trading
Effective planning and careful implementation are critical to
meeting the compliance requirements of the rule. As described
below, compliance obligations are set based on the size and
volume of the banking entity’s relevant activities.
No formal requirement
Small, noncomplex banking entities that don’t engage in
proprietary trading or covered fund activities — other than
trading in U.S. government or agency obligations, or state and
municipal obligations — do not need to set up a compliance
program. However, a sound practice would be to update
investment or treasury policies.
Should these institutions engage in such activity, regulators will
expect a suitable compliance program to be developed.
Limited
Small entities with total consolidated assets of $10 billion or
less can implement a simplified compliance program. These
institutions are expected to modify their existing compliance
policies and procedures to describe their current trading
activities and controls, specifying how these comply with
Section 13 of the Bank Holding Company Act3
.
Standard
Entities with between $10 billion and $50 billion in total
consolidated assets must set up a compliance program that
satisfies nine requirements:
• Written policies and procedures reasonably designed to
document, describe, monitor and limit proprietary trading
activities, and activities and investments with respect to
covered fund activities.
5. 33
The largest entities will have to report on seven metrics —
down from the originally proposed 17 — to demonstrate
compliance. The metrics fall into three measurement categories:
risk management, source of revenue and customer-facing
activity measurements (see the accompanying chart).
The seven metrics must be reported for each calendar
quarter within 30 days of month end. For the largest
banking entities with $50 billion or more in trading assets
and liabilities, the metrics must be reported each month
within 10 days of month end, beginning January 2015.
For the largest banking entities, 7 metrics to demonstrate compliance.
Risk management
1. Risk and position limits and usage
2. Risk factor sensitivities
3. Value-at-Risk (VAR) and Stress Value-at-Risk (Stress VAR)
Source of revenue
4. Comprehensive profit and loss attribution (by existing positions,
new positions, and residual profit and loss other than that from existing
or new positions)
Customer-facing activity
5. Inventory turnover
6. Inventory aging
7. Customer-facing trade ratio (trade count-based and value-based)
The board of directors and senior management must adopt
the compliance program and ensure qualified management
oversight. The CEO must attest to the appropriate regulatory
agency that the entity in question has in place processes to
establish, maintain, enforce, review, test and modify the
compliance program in a manner reasonably designed to
achieve compliance.
Covered funds
An institution that invests in or sponsors a covered fund would
be expected to have a compliance program appropriate for the
size, scope and complexity of business activities undertaken.
Those entities with enhanced status are subject to the following
additional requirements:
• Identification of covered funds
• Identification of covered fund activities and investments
(mapping within organization)
• Explanation of compliance
• Description of monitoring activities for each organizational
unit to ensure compliance
• Internal controls
• Remediation of violations
6. Volcker rule
4
Trading assets and liabilities June 30, 2014 July 21, 2015 April 30, 2016 Dec. 31, 2016
$50 billion or more Quantitative metrics
Enhanced compliance
program
Between $25 billion and $50 billion
Full compliance program
for size and scale of
activities
Quantitative metrics
Between $10 billion and $25 billion
Full compliance program
for size and scale of
activities
Quantitative metrics
$10 billion or less
(modest activities)
Update existing compliance
program
$10 billion or less
(no activities)
Must be able to
demonstrate status
The Volcker rule: Timeline for implementation
Effective date of final regulation: April 1, 2014
7. 5
Conclusion
Even with the one-year extension granted for conformance,
the Volcker rule presents banking entities with a significant
challenge. 2014 regulatory strategies will need to be balanced
with the demands of enhanced compliance programs,
technology and process upgrades; and newly designed control
frameworks, reporting structures and internal audit programs;
Boards and senior management should begin by getting a clear
picture of what’s required of their institution and where they
are falling short of expectations. Organizations that succeed
will have the advantage on July 21, 2015, and beyond.
Contact
Nichole Jordan
National Banking and
Securities Sector Leader
T 212.624.5310
E nichole.jordan@us.gt.com
Jack Katz
Global Managing Partner
Financial Services
T 212.542.9660
E jack.katz@us.gt.com
Tariq Mirza
National Managing Director, Bank
Advisory and Regulatory Services
T 202.251.8677
E tariq.mirza@us.gt.com
Kenneth Goodwin
National Senior Manager,
Bank Advisory and
Regulatory Services
DFA/Volcker SME
T 212.542.9685
E kenneth.goodwin@us.gt.com