Volcker Rule

Volcker Rule prohibits banks from using customer deposits for their own profits in trading operations. They can't own, invest in, or sponsor hedge funds, private equity funds, or other trading operations. In general, it prohibits banking entities from engaging in proprietary trading.

Some in the industry like these rules while others don't; many have expressed strong opinions on these rules. The original proposed rule has been diluted significantly over the years and the final rules that are yet to come (probably in 2021) provide for various exemptions. While rule making is a complicated task in itself, the compliance and enforcement of it is quite another. In its current stage, compliance requires complicated data analysis, proper understanding of business situations and careful interpretation - a poisonous mixture, the antidote of which is in terms of additioal cost to organisations in terms of resources, technology and training manpower (all of these could have been replaced with plain honesty, which is quite an elusive virtue).

One thig is for sure: simplfying Wall Street is a complicated affair.

Banks are depository institutions. They are licensed to borrow money from depositors in the form of saving bank accounts, checking accounts, fixed deposits, etc., and lend it to needy individuals and companies, and in the process make some money for themselves through differential interest rates. Without any regulations, banks can as well use the customer deposited money and trade in various markets (equity, bond, FX, commodity, etc.) for higher profits. The question is: Is this correct?. The answer is a clear no. banks are licensed to act as intermediaries i.e. borrow money from those who have surplus and lend it to those who have deficit, along with providing certain other financial services to their clients to earn non-interest income. If in this process it loses money due to NPA (Non-Performing Assets), the customers who deposited the money are protected, to a certain extent, through deposit insurance, usually provided by a government backed insurance company, the subscription for which is mandatory for all banks in the system.

If the banks take excessive risk from trading clients' money and make a lot of profits, then such profits are not distributed to the clients. Instead, the clients get only the interest amount that is promised to them. The profits goes to the management, shareholders and probably employees. Alternatively, if the bank incurs losses due to the trading activities, who bears the losses?. The bank may simply declare itself bankrupt, its capital will be used to pay-off all liabilities and if it is not sufficient then customers will have to bear the losses, anything over and above the deposit insurance level. That means, the bank can simply play the trading game with someone else's money, wherein the profits goes to its pocket but losses go to the account of the clients. This is certainly not correct. Therefore, regulation need to be there to prevent banks from using customer deposits for trading activities. The Volcker regulation addresses this issue.

Let's consider another scenario where banks can use their capital to trade in markets, also known as proprietary trading. The customers of banks should not be concerned about this. Should they?. Well! the issue is that if the banks lose their money (i.e. their capital) then it may not be solvent to continue its business. If there are NPA's, then who will bear the losses? The NPA losses may be due to bad credit decisions or poor judgement on part of the bank's management, the consequences of which should not be suffered by the customers. The banks may declare themselves bankrupt and the losses are usually borne by the government from tax payers money, as no government can afford to have a banking system in which depositors lose their hard-earned savings. Therefore, the banks should not be allowed to trade with their money also. Proper regulation should be there to ensure that this does not happen. The Volcker regulation, along with Basel regulation, addresses this issue.

It is a part of the Dodd-Frank Act. the rules have been developed by the following five federal financial regulatory agencies.
  1. Securities and Exchange Commission
  2. Federal Reserve
  3. Commodities and Futures Trading Commission
  4. Federal Deposit and Insurance Corporation
  5. Office of the Comptroller of the Currency (a division of the Treasury Department)
These exemptions are necessary because banks need to trade for providing certain financial services to their customers. Let's consider the following. Banks are the designated primary dealers (or market makers) for government securities. They provide vital liquidity to both the short-term and long-term government bond markets. As a part of this activity, banks may have to keep some inventory of various government bonds. This inventory can be either from its own capital or from customer deposits. It is neither possible nor necessary to distinguish the source of the money for this trading activity. Therefore, the Volcker rule provides exemption for both market making and trading of government securities.

Banks also provide market making for equity and non-government bonds. The market making activity in government bonds is different from that of market making in non-government bonds and other instruments - to start with, the risks and requirements are different. Therefore, a blanket exemption for market making is not provided for this activity. Instead, an exemption is provided based on a concept called as RENTD, which is discussed in a separate section below in this article.

Large banks undertake traditional banking activities alongside providing other financial services including investment banking. One of the core functions of investment banking is underwriting of shares, bonds, and other hybrid securities. Previously, investment banking services were provided by pure investment banks. After the repeal of Glass-Steagall Act, banks are allowed to do investment banking business. During the financial crisis of 2008, pure investment banks such as Goldman Sachs and Morgan Stanley were allowed to convert themselves into banks to receive TARP funds (Troubled Assets Relief Program funds). [TARP funds are provided from tax payers money. Only banks were allowed to receive it and hence investment banking divisions had to convert themselves into banks to receive it.]. Underwriting is critical to the capital markets. Investment Banking divisions of banks are active underwriters and thus this function is exempted from Volcker rule.

Banks offer products such as Spot FX, FX Forwards, FX Options and Currency Swaps to their clients. Both exporters and importers use these products to hedge their foreign exchagne risk. Spot FX requires trading by the banks in the FX market on behalf of their clients and derivative FX requires the bank to hedge the resultant risk, which means that bank will have to trade in the FX market. These trading activities are ancilliary to the service that the banks are providing and hence cannot be construed as proprietary trading or trading of client's money. Therefore, they are excluded from the Volcker rule.

Most banks try to sell products created by other financial service providers, such as insurance products of insurance companies, mutual funds of mutual fund companies, hedge funds of hedge fund companies, structured products of investment banks, etc. They do this to earn some extra income. There is no risk from this activities and hence they are exempted from the Volcker rule.

RENTD (Reasonably expected near-term demand)
One of the contentious issues of Volcker rule pertains to market making activity carried out by banks. There is a thin line between market making activity and proprietary trading. Often, market making requires maintenance of inventory. For example, let's consider a situation in which a trader purchases a bond to fulfill an expected purchase order from a client. The client order did not materalize and hence the trader sells the bond back in the market and makes a profit in this transaction. Is this proprietary trading or market making? It depends on whether there was indeed an expected client order. The trader could have done proprietary trading in disguise of market making, thereby violating the Volcker rule. How should banks comply with the regulation in these situations. The answer to this is the RENTD requirement, wherein the bank should demonstrate that there was a resonable expected near-term demand, on whose basis the transaction was undertaken.

Initially, the rules were based on the concept of "demonstrable analysis standard". In 2018, the rules were amended to "risk-limit based presumption of compliance" method. Along with other changes, the current Volcker rules are commonly referred to as Volcker 2.0.

Currently, proprietary trading as defined in the Volcker Rule is permitted only under specific exemptions, including market-making activities. In order to rely on the market making exemption, a banking entity must meet a number of requirement. The following are a few of them. The objective of the above compliance program, and in particular, the required limits, is to identify trading activity that may constitute impermissible proprietary trading. Banks are required to formulate their RENTD methodology and implement the limits. This is easier said than done, as there is subjectivity involved with regard to "reasonable limits".

All of the above requires data analysis, skilled manpower and robust internal controls.

Exempted Banks
Not all banks come under the Volcker rule. Banking entites with total consolidated trading assets and liabilities of at least $20 billion will have to fully comply with Volcker rule. For smaller banks, the following are the exemptions.
Effective Date of the final rules
Though the Volcker rule is currently active, there have been many amendments to it over the years with various effective dates. The commission has brought about additional rules at various times during this decade and has drafted the final rules for industry comments and suggestions. The final rules are commonly referred to as Volcker 2.0, have an effective date of January 1, 2020 though compliance is not required until January 1, 2021.


Updation History
First updated on 7th April 2020