More than three years after the passage of Dodd-Frank, one of its centerpieces is finally here – but it may not have been worth the wait.
On December 10, 2013, a final version of the long anticipated and hotly debated Volcker Rule was approved by the Department of the Treasury, the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission. The Rule, which was meant to curtail bank risk, is commonly referred to as a ban on proprietary trading whereby a financial institution uses the institution’s money to trade for the institution’s benefit. This so-called ban, however, is subject to a number of exceptions: for example, exclusions for trading in foreign government debt, spot commodities trading, market-making, and, most importantly, risk-mitigating hedging. Additionally, despite approval of the final rule, exclusions from the definition of ownership interests in “covered funds” are being granted. (“Covered funds” under the Rule are funds that banking entities may not sponsor or own interests in; the rationale is that banks should not even indirectly engage in proprietary trading.) In response to a lawsuit brought by the American Bankers Association, banks recently won a concession by the regulators regarding the treatment of certain collateralized debt obligations backed by trust-preferred securities (“TruPS-backed CDOs”); on January 14, 2014, the agencies issued a supplemental interim final rule, specifying that the Rule’s covered fund restrictions do not apply to a banking entity’s ownership of an interest in, or sponsorship of, any issuer of TruPS-backed CDOs (if certain conditions are met). Bankers and regulators are gearing up for another fight with regard to the Rule’s treatment of collateralized loan obligations (“CLOs”). The Rule is scheduled to go into effect on April 1, 2014.
The Rule’s most significant exception to the ban on proprietary trading is that for hedging, which is commonly used by banks to increase stability and profitability by minimizing risk. The basic idea of a hedge is to take an investment position to counter the risk of another position. For example, if one was investing in an oil company, one might hedge against the risk of oil price fluctuations by investing in airline stocks, which would be expected to rise if the price of oil–a major component of jet fuel–decreased. One of the chief concerns of many proponents of a strong rule against proprietary trading was that almost anything could be considered or framed as a hedge against something else, and could therefore fall under the exception. Many pointed to JP Morgan’s $6 billion “London Whale” loss as an example of how, because almost anything can be represented as a hedge, “a bank’s risk may actually increase due to the interconnected nature of proprietary trades being permitted as “hedges.” In response, regulators tightened the proposed exception for risk-mitigating activities in the final Rule. In lieu of more specifically defining such activities, however, the Rule prescribes implementation of an internal compliance program and production of new documents that put the onus on the banking institutions to explain in detail why an activity is risk-mitigating as opposed to risk-creating.
According to the final Rule, risk-mitigating hedging activities are only permitted if the bank maintains an internal compliance program “reasonably designed” to ensure compliance with the Rule, which, among other things, must include:
- “written policies and procedures regarding the positions, techniques, and strategies” permissible for hedging, including “documentation indicating what positions, contracts, or other holdings” particular trading desks may use, as well as permissible position and aging limits;
- procedures for ongoing “monitoring, management, and authorization”;
- analysis and testing (including correlation analysis) designed to ensure that the permissible positions, techniques, and strategies reduce or “otherwise significantly mitigate” the “specific, identifiable risk(s) being hedged”; and
- correlation analysis showing that the permissible positions, techniques, and strategies actually do reduce or significantly mitigate that specific, identifiable risk.
Additionally, the Rule requires that a permitted hedging activity not give rise “to any significant new or additional risk that is not itself hedged contemporaneously” and is subject to “ongoing recalibration” by the banking entity to ensure compliance. Further, the compensation arrangements of employees performing risk-mitigating hedging must not be designed to “reward or incentivize” prohibited proprietary trading.
The Rule also outlines the required documentation of permitted risk-mitigating hedging activities. At the time of a purchase or sale made in reliance on the hedging exemption, the banking entity must document:
- the “specific, identifiable risk(s)” the transaction is designed to reduce;
- the “specific risk-mitigating strategy” the transaction is designed to fulfill; and
- the trading desk or other business unit responsible for the hedge.
The banking entity must retain these records for at least five years after their creation, in a form allowing prompt production of the records upon request.
Compliance with these provisions clearly involves a significant amount of work to be undertaken by bank entities seeking to manage risk. Given the vast portfolio of trading positions and complexity of the hedges at major banks, smart bankers and financial experts will most likely be able to classify most activities as risk-mitigating hedges. But it seems likely that much more effort will be directed – at the expense of efforts devoted to actually making smart financial decisions – to justifying those decisions by directing and manipulating the correlation analyses and records outlining the specific, identifiable risks and risk-mitigating strategies. Given that there has been no real evidence that proprietary trading was a cause of the most recent financial crisis, more time, effort, and money may be spent on regulation of and compliance with the Volcker Rule than its effect will warrant. In other words, the Volcker Rule may be more trouble than it’s worth.