In order to regulate banks, curtailing them from engaging in activity deemed excessively risky, the U.S. Congress included the Volcker Rule as part of the Dodd-Frank legislation in July 2010. As a result, if a bank wants to accept government guarantees (FDIC insurance), the bank must do two things: 1) eliminate any potential conflicts of interest and 2) curb what the government considers risky behavior. Previously, banks had been afforded wide latitude by the regulators to utilize their capital in all trading activities—now the scope of trading activities that banks can engage in on their own behalf is greatly limited.
The rationale that drove regulators to pass the Volcker Rule is clear, but the interpretation and implementation of the rule by financial institutions is incredibly complex. A great deal of compliance and legal oversight is now required to perform some of the most basic and essential banking functions. For example, it remains perfectly legal for a banking institution to buy and sell securities as long as it engages in market making activities—but in order to make a market, the bank needs to maintain a liquid inventory in a given security. This requires a great deal of discretion. If a regulator determines that a bank is intentionally holding too large of an inventory of a given security, this could be considered proprietary trading.
In addition to the general restriction on proprietary trading, this controversial rule introduced guidelines concerning the governance of covered funds owned by U.S. banks and their affiliates. The regulatory agencies began enforcing these regulations on July 22, 2015.
In order to conform to the covered funds regulations, a bank must first determine what covered funds are under its purview. Once complete, the bank must take steps to conform to the regulations by selling off assets classified as covered funds that are not exempt from the regulation. The most illiquid instruments will need to be sold by July 21, 2017.
Next, the bank will need to create a process to monitor covered fund trading activity for all new transactions. In order to implement such a control process, the bank will need to create a database of its covered funds and cross-reference all new trading activity against this list. If a new trade is executed with a covered fund, it will need to be either cancelled or confirmed with the bank’s legal and compliance departments as allowable under one of the Volcker covered funds’ exemptions.
In parallel with identifying all covered funds under its domain, a bank must also enhance its compliance programs to supervise trading activity with covered funds. The scale of these programs will vary with the size of the overall banking institution. The scope of the enhancements can simply be an update to the bank’s compliance policies and procedures documentation or—for the largest global banks—it may require building robust Volcker-specific compliance programs that call for a CEO to sign off on a yearly attestation that the bank is in full compliance with the Volcker Rule regulation.
As new processes such as the mandatory compliance program are implemented, inefficiencies are likely to occur. The operational burden of these new Volcker-specific processes may be quite intensive and expensive to implement, requiring many of the large investment banks to hire additional staff to manage the new workflows.
Although the Volcker Rule has left an immediate and visible impression on the financial industry, its full impact may not be felt for some time. Currently, banks are no longer trading on their own behalf. Without access to an internal market for trading and the ability to conduct proprietary trading, a bank’s funding cost may increase as well. This, in turn, may lead to higher costs for its clients. The operational burden that banks are carrying will surface through inefficiencies and increased costs at an organizational level. The goals of the Volcker Rule were crystal clear—the repercussions are less clear and may be quite far-reaching. Industry participants, including the regulators, may have to wait several years to fully recognize all of its effects.