US regulators are considering whether to re-propose amendments to the Volcker rule, to tackle industry alarm that a change intended to soften it might end up making it tougher.
The Volcker rule bars deposit-taking banks from engaging in speculative proprietary trading and contains criteria for assessing whether a trade is speculative. Amendments proposed by the five regulatory agencies in May 2018 were designed to ease the application of the regulation and included a new ‘accounting prong’ to clarify how to identify speculative intent.
But market participants fear this prong would broaden the number of trades captured well beyond the original rules completed in December 2013.
“If the accounting prong goes through as proposed, it will wipe away all the regulatory benefits,” says Hugh Conroy, a partner at Cleary Gottlieb Steen & Hamilton. “It will increase the scope of Volcker, at least on the trading side, and increase compliance costs.”
The accounting prong is intended to replace a ‘short-term intent prong’ in the 2013 rule, which assumes trades held for less than 60 days are speculative unless the bank can provide evidence to rebut the assumption. Instead, all instruments recorded at fair value would be considered part of the trading account for Volcker rule purposes. This far-reaching definition would encompass not only trading securities, but also items reported as available-for-sale securities, which could capture derivatives hedges and liquidity reserves.
If the accounting prong goes through as proposed, it will wipe away all the regulatory benefitsHugh Conroy, Cleary Gottlieb Steen & Hamilton
Sources say regulators were struck by the level of criticism from the industry, and are now mulling whether to produce a new draft to avoid drawing in large numbers of holdings that are not speculative in nature. This would mean opening up a fresh round of consultation before the rule is finalised.
“It appears that the agencies are thinking about the rule and really trying to dig into the comments,” says Conroy.
A much bigger prong
A response submitted by the Bank Policy Institute in October 2018 suggested as much as $400 billion in bonds (excluding government or government-backed debt, which is exempt from the rule) currently classed as available-for-sale could be dragged into banks’ Volcker trading books by the accounting prong. Most of these securities would be held in the banks’ liquidity buffers, and they include between 10% and 15% of outstanding non-agency asset-backed securities.
“If the accounting prong were adopted, banking entities would face a choice between re-designating positions as hold-to-maturity, which would reduce a firm’s flexibility to respond to changing conditions, or divesting them, which could materially increase the costs to consumers of financing these loans,” warned BPI senior associate general counsel Gregg Rozansky in the response.
Meanwhile, the eight largest US banks hold derivatives contracts with a gross notional value of around $2.4 trillion for purposes other than trading, according to regulatory filings.
Scott O’Malia, chief executive of the International Swaps and Derivatives Association, wrote in a comment letter: “The accounting test, as proposed, picks up all derivatives entered into for any purpose and regardless of the period of time that the derivative is held.”
Both the BPI and Isda urged the agencies not to introduce the accounting prong, with the BPI proposing a modified version of the short-term intent prong that would exclude securities with a residual maturity of less than 60 days at issue or purchase. Isda wants all derivatives entered into as a hedge for either liabilities or investments in subsidiaries to be exempt, along with an expanded exemption list for derivatives that can be considered liquidity risk management tools.
“The presumption of guilt needs to be changed,” sums up Adam Gilbert, global regulatory leader for financial services advisory at PricewaterhouseCoopers, referring to the Volcker rule’s tendency to presume trades are proprietary unless banks can prove otherwise.
As presented, last May’s Volcker proposal resembled an advanced notice of proposed rulemaking than a finished proposal, with almost 350 detailed questions. It could take months for regulators to rewrite the accounting prong and finalise other aspects of the rule, such as the prohibition on investing in private equity and hedge funds.
“The agencies are thinking about it in groups internally and trying to formulate their respective priorities,” says Conroy. “But we understand they probably are not yet sitting in the five-agency huddle and hashing out the final rule.”
With this in mind, banks would like to see aspects of the Volcker proposal – such as changes to the rules governing the measurement of real expected near-term client demand (the way of demonstrating trades are on behalf of clients, not proprietary) – finalised as soon as possible, says Conroy. There was sufficient detail in the proposal and enough questions asked for these changes to be made without a re-proposal, he adds.
Volcker had a hefty cost tag associated with compliance and a lot of that has already been invested. Can it be dialled back? Yes, probably, but it’s tough to do that nowAdam Gilbert, PricewaterhouseCoopers
“Advocates for the industry are saying that if you need to finalise pieces of this that you all agree on, please do so now – even if it’s just half the proposal,” he says. “We are urging them to do that because we don’t want to lose momentum and miss out on the additional flexibility embedded in this proposal.”
A speedy re-proposal of the whole text seems unlikely for a variety of reasons. Interagency rulemaking is always a fraught process – any changes would need sign-off from the Fed, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission.
At present, the SEC and CFTC are hobbled by the US government shutdown. Congress is now dominated by the Democrat party which originally passed the Volcker legislation, and could always direct the agencies to focus on something else in order to preserve what Democrat lawmakers see as their legacy.
Meanwhile, the Fed is focusing on implementing the Crapo Act and a series of other proposals, including the stress capital buffer and a recalibration of the leverage ratio for large banks.
Nor is there any sense among regulators that they need to move quickly with the Volcker proposal. PwC’s Gilbert notes the rule has weaned firms off proprietary trading anyway. Banks have built Volcker teams and dedicated substantial resources to compliance; their focus is not on finding flexibility in the rule.
“Volcker had a hefty cost tag associated with compliance and a lot of that has already been invested. Can it be dialled back? Yes, probably, but it’s tough to do that now,” Gilbert says.