Winds of change blowing on Volcker rule

The Volcker rule has received another endorsement for a facelift.

A number of financial industry observers, including former Congressman Barney Frank, have called for adjustments to the Dodd-Frank Act's Volcker rule, which was frequently cited in the Treasury Department's financial industry regulatory recommendation report. The report, made public June 12, supported the ban on proprietary trading, or prop trading, for banks, but said significant amendments to the Volcker rule were needed to relieve some unnecessary compliance burdens and help improve market liquidity.

The proposal does not go as far as the Financial CHOICE Act, which calls for a repeal of the Volcker rule. Rather, the Treasury tried to strike a balance between too much and too little regulation when it comes to the Volcker rule, according to Schulte Roth & Zabel LLP Partner Joseph Vitale, who represents banks on regulatory matters.

"They're very practical recommendations," Vitale said in an interview. "In many instances, they represent a legitimate compromise between the positions taken by the Republicans and Democrats."

Many of the changes to the Volcker rule need legislative approval, and the current polarizing political environment of Congress gives little certainty to the passage of any major reform. However, some of the Treasury's recommendations on the Volcker rule received a nod of approval from Federal Reserve Chair Janet Yellen.

During a June 14 press conference, Yellen said she was pleased the report supported the prop trading ban, and said she would consider ideas for simplifying the rule. "Certainly, it's something we're quite open to looking at," Yellen said.

Yellen also noted that the Fed previously suggested exempting smaller banks from the Volcker rule. The Treasury has suggested that as well. The latest report recommended not applying the Volcker rule to banking organizations with $10 billion or less in total consolidated assets. The exemption would allow small institutions to focus on lending without devoting resources to Volcker rule requirements, according to the report.

The Treasury even recommended that banks crossing the $10 billion asset threshold be allowed to avoid the burden of the Volcker rule's prop trading requirements if their trading assets and liabilities total less than $1 billion and represent no more than 10% of total assets. Ropes & Gray LLP Partner Mark Nuccio, who advises institutions on the Volcker rule, said those sorts of exemptions would help relieve some regulatory burden for community banks and those who have little exposure to the trading business.

Overall, Nuccio said the Treasury took a nuanced approach with its Volcker rule suggestions and did not attack the regulation. "The proposal in the Treasury's report is a very thoughtful and sensible one," Nuccio said.

The Treasury also called for some regulatory relief for the banking entities that it said should remain subjected to the prop trading ban. For instance, the agency suggested eliminating the so-called purpose test, one of the three measures used to determine whether transactions constitute a prop trade.

To avoid the prop trading label under the purpose test, positions must be held for more than 60 days or the banking entity must determine that traders did not execute transactions just for a short-term benefit, such as a quick gain from price movement. The report said the 60-day part of the purpose test was too constricting and determining the intent of traders was too subjective.

The report included two potential opt-out provisions regarding the Volcker rule. The Treasury said that policymakers should consider allowing banking entities to opt out of the Volcker rule altogether if they are sufficiently well-capitalized with, say, a 10% non-risk-weighted leverage ratio capital.

"Such an institution should remain subject to trader mandates and ongoing supervision and examination to reduce risks to the safety net," the Treasury said in the report.

The Treasury had another opt-out recommendation involving the Volcker rule's market-making inventory rules. The Treasury suggested that policymakers should consider giving banks that meet certain conditions the opportunity to opt out of the provision that says market-making inventory must not exceed the reasonably expected near-term demand.

The Treasury said one approach is to allow a bank to opt out if it adopts "narrowly tailored trader mandates that ensure that its activities constitute market making" and comply with all the other conditions of the Volcker rule's market-making exemption. An alternative approach is to allow banks to opt out if they fully hedge "all significant risks" in their inventory, the Treasury said.

Schulte Roth & Zabel's Vitale said he does not think the Treasury's suggested mandates on the near-term opt-out provision were too onerous and said it is possible institutions would utilize it if they could.

Industry executives have said the Volcker rule's market-making reporting requirements are too complex. For instance during a March investor presentation, Morgan Stanley President Colm Kelleher said it is a "horrific" challenge to meet the current market-making inventory provisions.

The part of the Volcker rule that affects the largest number of banks is the provision that restricts investments into certain covered funds, said Milbank Tweed Hadley & McCloy LLP Partner Douglas Landy, who advises financial institutions on regulatory matters. The restrictions are intended to eliminate banks' incentive to bail out their funds, and prevent the entities from engaging in proprietary trading indirectly through the funds, the Treasury said.

But the Treasury's report also said the definition of covered funds is too complex and should not include venture capital. Allowing some bank investments into venture funds could help spur economic growth funding opportunities, the department said.

Before the Volcker rule was finalized, considerable debate was held about whether to make venture funds subject to the covered fund provision, Landy noted. He added that many of the Treasury's other recommendations had previously been suggested in industry group comment letters. However, Landy said it was fair to re-introduce those ideas because now the market has seen the impact of the rule.

"We've seen where the rule is overly conservative," he said. "We've also seen where the rule has caused harm."