The most eagerly awaited final rule in the history of financial regulation was delivered last week – 1,238 days since it became law and 764 days since being formally issued in proposed form.
Was the final Volcker rule worth the wait?
For foreign banks and custody banks, the answer is clearly yes. The expansion of the SOTUS exemption and the narrowing of the covered fund definition from the original version of the rule gave those banks most of what they wanted. For most of the US regional banks, it is largely a non-event. For universal and major investment banks, however, the answer will ultimately depend on how the rule will be interpreted, supervised, and enforced by regulators. Will the regulators use the discretion the new rule grants them in a pragmatic way or in a punitive fashion? It is really too early to know.
What is known though is that you no longer need “a lawyer and a psychiatrist” to comply with the rule’s trading provisions. Rather than prescribing what is or what is not a prop trade, the rule puts the onus on banks to prove that they are not prop trading and gives the regulators wide latitude to decide if the banks are meeting their burden of proof. The original rule draft had prescribed definitional lines – which is what the banks asked for at the time – but the lines drawn by the regulators were in all the wrong places. If applied, the original draft would have seriously impacted bank profitability and curtailed market liquidity (a concern we heard often from both the buy- and sell-side, and that is not necessarily alleviated in the final rule).
So, the final rule’s grant of supervisory discretion is welcome relief at this point, but the key is how the regulators will use their discretion. Banks with over $50 billion in trading assets and liabilities (13 firms) will have to start “proving their case” by reporting metrics on June 30, 2014. The following year, CEOs will have to start certifying that they have control processes in place to effectively comply with the rule. The name of the game is to “demonstrate” that the bank is not prop trading: the final rule and its preamble use the word in some form 145 times.
On covered funds, the rule takes a different approach. The rule tightens the definition of covered funds to better target hedge funds and private equity funds, in order to avoid capturing other types of vehicles. Most notably, the new definition excludes foreign public funds and certain loan securitization vehicles; this change creates parity between US and global funds (a big foreign win) and provides some relief for collateralized loan obligations. The rule did not, as had been hoped, alleviate the Super 23A restrictions.
In short, complying with the final rule seems manageable – but only if the regulators use their discretion wisely. Banks will need strong, well-documented processes to prove their case.
This Financial Services Regulatory Brief builds on our brief issued on December 11th. We discuss (a) key changes from the proposed version of the rule, (b) the regulation’s implementation and business impact, and (c) our view of what banks should now be doing.