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What is the Volcker Rule and Who is Affected by It?

What is the Volcker Rule and who is affected by it?

The Volcker Rule, named for former Chairman of the Federal Reserve Paul Volcker, prevents banking entities from proprietary trading and from acquiring an ownership interest in or sponsoring a hedge fund or private equity fund. “Banking entities” includes any FDIC-insured bank, any company that controls an FDIC-insured bank, and any foreign banking organization that has U.S. banking operations. “Proprietary trading” means purchasing securities for one’s own account (as opposed to purchasing securities on a behalf of a customer). The rule is meant to prevent banks from engaging in short-term speculative investments.

The Volcker Rule was included in the Dodd-Frank Wall Street Reform and Consumer Protection Act as a response to the Great Recession and reflects the belief that banks that enjoy easier access to capital due to government support (such as the Federal Reserve Discount Window and FDIC-insured deposits) should not be able to use this capital to engage in trading activities that could result in the Federal Reserve or the FDIC then having to rescue them. To put it another way, while investing in stocks is appropriate for hedge funds and private equity funds, which are attempting to bring about large returns for wealthy investors who can withstand a loss, trading in stocks is not appropriate for banks investing money that is insured by the FDIC. There has been some debate whether these activities were a significant factor in bringing about the Great Recession. Former Treasury Secretary (and fellow triathlete) Timothy Geithner believes they were not, since the primary problem as far as banks were concerned was traditional mortgage loans.

The Volcker Rule has several exceptions. Government securities such as treasuries are exempted, since they are considered non-speculative and akin to holding cash. Trading on behalf of customers is permitted (i.e. filling orders), as is trading in connection with underwriting or market-making (though banks may hold only the amount of securities needed to meet the “reasonably expected near-term demands of customers”). The Volcker Rule also permits a certain amount of hedging activities that mitigate a “specific, identified exposure.”

There are five agencies responsible for the Volcker Rule: the Federal Reserve, the Federal Deposit Insurance Corp., the Comptroller of the Currency, the Commodity Futures Trading Commission, and the Securities and Exchange Commission. The Volcker Rule, which actually consists of several rules adopted by these agencies, became effective on April 1, 2014, and full compliance is required by July 21, 2015.

The compliance program necessary to ensure a banking entity is in compliance with the Volcker Rule will vary based on the size of the banking entity and the scope of activities conducted. Banking entities with significant trading operations will be required to establish a detailed program, to include independent testing and analysis, and their CEOs will be required to attest that the compliance program is reasonably designed to achieve compliance with the rule. The compliance and reporting requirements for smaller, less-complex institutions is more limited, and banking entities that do not engage in trading activities will not need to establish a compliance program at all. Please contact us for an evaluation of your Volcker Rule compliance program.