Financial Regulatory Reform Update

Welcome to PwC's Financial Regulatory Reform Update where we update you on the latest developments relating to financial services regulatory reform.

October 11, 2011

Nip the shoots of arbitrary power in the bud, is the only maxim which can ever preserve the liberties of any people.
- John Quincy Adams

Two things are infinite: the universe and human stupidity; and I'm not sure about the universe.
- Albert Einstein

Leaked Volcker Rule Proposal -- Coverage, Compliance and Complexity

While not the Pentagon Papers, the 205-page Confidential Staff Draft of the Volcker Rule Proposal that was leaked and posted on the American Banker's website this week marks either another singular aspect to the Volcker Rule's controversial history or a new stage in agency transparency -- bet on the former. Technically, what was leaked was a draft Preamble to the proposed rule implementing the Volcker provision of Dodd-Frank. What was not leaked was the language of the Proposed Rule including several important Appendices. The purpose of a Preamble is to provide an explanation of the proposed rule -- which the Volcker Preamble does with a high degree of granularity. Caveats due are that the rule language (which was not leaked) governs and the Agencies could do some last-minute tweaking. The FDIC Board is scheduled to take up the proposal on October 11th and the SEC the next day on October 12th. The rest of the story should be available electronically after the FDIC meeting.

Framework of the Proposal

The so-called Volcker Rule is Section 619 of Dodd-Frank which added a new Section 13 to the Bank Holding Company Act (BHC Act) that generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund subject to certain exemptions. "Banking entity" is defined to include any insured depository institution and its parent company and any foreign bank that has US branches or agencies and any affiliate or subsidiary of any of the foregoing. "Hedge fund" and "private equity fund" are defined as an issuer that would be an investment company under the Investment Company Act of 1940 but for Section 3( c) (1) or 3( c)(7) of that Act or any similar funds.

Five regulatory agencies are charged with implementing the Volcker rule in regulation, including: the Federal Reserve Board (FRB), Office of the Comptroller of the Currency (OCC), FDIC, SEC and CFTC (the Agencies). The Agencies have proposed to implement a common rule and appendices. This uniform approach to implementation is intended by the Agencies to provide the maximum degree of clarity to banking entities and market participants and ensure that the prohibitions and restrictions are applied consistently across different types of regulated entities.

The Proposal includes a framework that: (i) describes the key characteristics of both prohibited and permitted activities; (ii) requires banking entities to establish a comprehensive programmatic compliance regime designed to ensure compliance with the requirements of the statute and proposed rule in a way that takes into account and reflects the unique nature of a banking entity’s businesses; and (iii) with respect to proprietary trading, requires certain large banking entities to calculate and report meaningful quantitative data to assist in identifying particular activity that warrants additional scrutiny to distinguish prohibited proprietary trading from otherwise permissible activities.

A Multi-Faceted Approach

The Agencies describe their approach as "multi-faceted" and consistent with the implementation and supervisory framework recommended in the Financial Stability Oversight Council (FSOC) Report. As a matter of structure, the proposal is generally divided into four subparts and contains three appendices, as follows:

  • Subpart A of the proposal describes the authority, scope, purpose, and relationship to other authorities of the rule and defines terms used commonly throughout the rule;
  • Subpart B of the proposal prohibits proprietary trading, defines terms relevant to covered trading activity, establishes exemptions from the prohibition on proprietary trading and limitations on those exemptions, and requires certain banking entities to report quantitative measurements with respect to their trading activities;
  • Subpart C of the proposal prohibits or restricts acquiring or retaining an ownership interest in, and certain relationships with, a covered fund, defines terms relevant to covered fund activities and investments, as well as establishes exemptions from the restrictions on covered fund activities and investments and limitations on those exemptions;
  • Subpart D of the proposal generally requires banking entities to establish an enhanced compliance program regarding compliance with the proposal, including written policies and procedures, internal controls, a management framework, independent testing of the compliance program, training, and recordkeeping;
  • Appendix A of the proposal details the quantitative measurements that certain banking entities may be required to compute and report with respect to their trading activities;
  • Appendix B of the proposal provides commentary regarding the factors the Agencies propose to use to help distinguish permitted market making related activities from prohibited proprietary trading;
  • Appendix C of the proposal details the minimum requirements and standards that certain banking entities must meet with respect to their compliance program, as required under subpart D.
  • In addition, the FRB’s proposal also contains a subpart E, to which the provisions of the FRB’s Conformance Rule under section 13 of the BHC Act will be recodified from their current location in Regulation Y.

The proposal includes a bracketed period for public comment ending December 16th -- suggesting a 60-day comment period based on a yet to be determined date coincident with approval by all of the agencies. The proposal asks scores of questions on every aspect, in particular, with respect to the scope of key definitions, prohibitions, exemptions and reporting and recordkeeping. A date to keep in mind is July 21, 2012 when compliance programs as prescribed and certain reporting and recordkeeping requirements become effective.

Proprietary Trading Restrictions

Some highlights:

  • The proposal defines proprietary trading generally as engaging as principal for the trading account of a banking entity in any transaction to purchase or sell certain types of financial positions. The proposal also defines the term “covered financial position.” This term is used throughout to define the scope of financial instruments subject to the prohibition on proprietary trading. Consistent with the statutory language, such covered financial positions include positions (including long, short, synthetic and other positions) in securities, derivatives, commodity futures, and options on such instruments, but do not include positions in loans, spot foreign exchange or spot commodities.
  • The proposal’s definition of trading account includes (I) positions taken principally for the purpose of short-term resale, benefitting from short-term price movements, realizing short-term arbitrage profits, or hedging another trading account position, (ii) with respect to a banking entity subject to the Market Risk Capital Rules, the definition includes “covered positions” under those capital rules, other than certain spot foreign exchange and commodities positions; and (iii) includes all positions acquired or taken by certain registered securities and derivatives dealers in connection with their activities that require such registration or notice. Exclusions from the trading account definition include certain repurchase and reverse repurchase arrangements or securities lending transactions, positions acquired or taken for bona fide liquidity management purposes, and certain positions of derivatives clearing organizations or clearing agencies.
  • The proposal implements the statutory exemptions for underwriting and market making related activities and provides a number of requirements that must be met in order for a banking entity to rely on the applicable exemption. These requirements support and augment other parts of the proposal’s approach to implementing the prohibition on proprietary trading, including the compliance program requirement and the reporting of quantitative measurements, in order to assist banking entities and the Agencies in identifying prohibited trading activities.
  • The proposal also implements the statutory exemption for risk-mitigating hedging and contains a number of requirements that must be met in order for a banking entity to rely on the exemption. For certain transactions that present heightened compliance risks, banking entities are required to document, at the time the transaction is executed the hedging rationale.
  • The proposal describes permitted trading on behalf of customers and identifies three categories of transactions that would qualify for the exemption: (i) transactions conducted by a banking entity as investment adviser, commodity trading advisor, trustee, or in a similar fiduciary capacity for the account of a customer where the customer, and not the banking entity, has beneficial ownership of the related positions; (ii) riskless principal transactions; and (iii) transactions conducted by a banking entity that is a regulated insurance company for the separate account of insurance policyholders, subject to certain conditions.
  • Finally, the proposal describes permitted trading outside of the United States by a foreign banking entity. The proposed exemption clarifies when a foreign banking entity will be considered to engage in such trading pursuant to section 4(c)(9) of the BHC Act. The exemption also clarifies when trading will be considered to have occurred solely outside of the United States, as required by the statute, and provides a number of specific criteria for determining whether that standard is met.
  • A banking entity must comply with proposed Appendix A’s reporting and recordkeeping requirements only if it has, together with its affiliates and subsidiaries, trading assets and liabilities the average gross sum of which (on a worldwide consolidated basis) is, as measured as of the last day of each of the four prior calendar quarters, equal to or greater than $1 billion. Proposed Appendix B contains a detailed commentary regarding identification of permitted market making related activities and distinguishing such activities from trading activities that constitute prohibited proprietary trading.

Covered Fund Activities and Investments

Some highlights:

  • The proposal explains the universe of entities that would be considered a “covered fund” and, thus, subject to the general prohibition. The definition of ownership interest explicitly excludes from the definition “carried interest” whereby a banking entity may share in the profits of the covered fund solely as performance compensation for services provided to the covered fund by the banking entity Other definitions are included for the terms “prime brokerage transaction,” “sponsor,” and “trustee.”
  • The proposal permits a banking entity to acquire and retain, as an investment in a covered fund, an ownership interest in a covered fund that the banking entity organizes and offers pursuant to or for which it acts as sponsor, for the purposes of (i) establishing the covered fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors, or (ii) making a de minimis investment in the covered fund in compliance with applicable requirements.
  • In implementing the covered funds provisions, the Agencies also have interpreted or defined terms contained in the three principal exemptions related to covered fund activities by a banking entity: (i) the exemption for organizing and offering covered funds; (ii) the exemption for investment in a covered fund in the case of risk-mitigating hedging; and (iii) the exemption for covered fund activities outside of the United States.
  • The proposal also implements in part the rule of construction contained in section 13(g)(2) of the BHC Act, which permits the sale and securitization of loans and clarifies that a banking entity may acquire and retain an ownership interest in, or act as sponsor to, a covered fund that is an issuer of asset-backed securities, the assets or holdings of which are solely comprised of: (i) loans; (ii) contractual rights or assets directly arising from those loans supporting the asset-backed securities; and (iii) a limited amount of interest rate or foreign exchange derivatives that materially relate to such loans and that are used for hedging purposes with respect to the securitization structure.
  • The Agencies have proposed to permit three activities at this time under exemptive authority. These activities involve acquiring and retaining an ownership interest in, or acting as sponsor to, certain bank owned life insurance (“BOLI”) separate accounts, investments in and sponsoring of certain asset-backed securitizations, and investments in and sponsoring of certain entities that rely on the exclusion from the definition of investment company in section 3(c)(1) and/or 3(c)(7) of the Investment Company Act) but that are, in fact, common corporate organizational vehicles.
  • The proposal requires a banking entity engaged in covered fund activities and investments to comply with (i) the internal controls, reporting, and recordkeeping requirements and Appendix C of the proposal, as applicable and (ii) such other reporting and recordkeeping requirements as the relevant supervisory Agency may deem necessary to appropriately evaluate the banking entity’s compliance with subpart C.

PwC will be providing more in-depth reviews of the Volcker proposal once final regulatory language is available.

The Federal Reserve Board Releases Its Report on its Horizontal Review of Incentive Compensation Practices at Large Banking Institutions

To foster implementation of improved compensation practices, in late 2009, the Federal Reserve initiated a multi disciplinary, horizontal review of incentive compensation practices at 25 large, complex banking organizations. One goal of this horizontal review was to help complete its understanding of the range of incentive compensation practices across firms and categories of employees within firms. The second, more important goal was to guide each firm in implementing the interagency guidance on Incentive Compensation proposed by the Federal Reserve in 2009 and adopted by the other Federal Banking Agencies in 2010.

As explained in more detail in the Federal Reserve's report, every firm in the review made progress in developing practices and procedures that internalize the principles in the interagency guidance into the management systems in each firm. The Fed notes that many of these changes are already evident in the actual compensation arrangements of firms. For example, senior executives now have more than 60 percent of their incentive compensation deferred on average, higher than illustrative international guidelines agreed by the Financial Stability Board, and some of the most senior executives have more than 80 percent deferred with additional stock retention requirements after deferred stock vests. The Fed states also that based on its review firms are now attentive to risk-taking incentives for large numbers of employees below the executive level—at many firms thousands or tens of thousands of employees— which was not the case before the beginning of the horizontal review, when most firms paid little attention to risk-taking incentives, or were attentive only for the top employees.

Yet, in the Fed's view, every firm also needs to do more. As oversight of incentive compensation moves into the regular supervisory process, the Federal Reserve will continue to work to ensure progress continues both in the implementation of the firms’ plans and in the risk appropriate character of actual compensation practices.

Effective Incentive Compensation Design

The Report notes that all firms in the horizontal review have implemented new practices to balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks. The most widely used methods for doing so are risk adjustment of awards and deferral of payments.

  • Risk adjustments make the amount of an incentive compensation award for an employee take into account the risk the employee’s activities may pose to the organization. An example of a leading-edge practice that is now used by a few firms is including in internal profit measures used in incentive compensation awards a charge for liquidity risk that takes into account stressed conditions.
  • Deferring payout of a portion of incentive compensation awards can help promote prudent incentives if done in a way that takes into account risk taking, especially bad outcomes. Almost all firms now use vehicles for some employees that adjust downward the amount of deferred incentive compensation that is paid if losses are large. However, the Fed stated that most firms still have work to do to implement such arrangements for a larger set of employees and to more closely link such reductions to individual employees’ actions, particularly for employees below the senior executive level.

Progress in Identifying Key Employees

All firms in the horizontal review have made progress in identifying the employees for whom incentive compensation arrangements may, if not properly structured, pose a threat to the organization’s safety and soundness. Slightly more than half of the firms have identified groups of similarly compensated employees whose combined actions may expose the organization to material amounts of risk. However, some firms are still working to identify a complete set of mid- and lower-level employees and to fully assess the risks associated with their activities.

Changing Risk-Management Processes and Controls

All firms in the horizontal review have changed risk-management processes and internal controls to reinforce and support the development and maintenance of balanced incentive compensation arrangements. Risk-management and control personnel are engaged in the design and operation of incentive compensation arrangements of other employees to ensure that risk is properly considered.

Progress in Altering Corporate Governance Frameworks

All firms in the horizontal review have made progress in altering their corporate governance frameworks to be attentive to risk-taking incentives created by the incentive compensation process for employees throughout the firm. The role of boards of directors in incentive compensation has expanded, as has the amount of risk information provided to boards related to incentive compensation.

PwC's Experts on Compensation Practices are preparing an analysis of the Study that will be made available in the near future.

Treasury Secretary Timothy Geithner Presents Recommendations of the FSOC at House and Senate Oversight Hearings

In delivering his Report on the first year of the Financial Stability Oversight Council (Council), Treasury Secretary Timothy Geithner presented several Council recommendations to the Chairmen and Ranking Members of the House Financial Services Committee and Senate Banking Committee

First, the Secretary testified that the Council emphasizes the importance of further actions to strengthen the financial position of the core of the U.S. financial system, particularly the largest institutions. Toward this objective, regulators will gradually phase in, over a period of several years, the much tougher standards for capital and liquidity the U.S. has negotiated with the other major financial systems around the world. The Council's report also "draws attention to new market structures and financial products, such as exchange traded funds and structured notes, where we have seen very rapid growth and innovation."

In the Secretary's words a "robust financial system should encourage and foster innovation, but not at the expense of overall financial stability."

Second, the Council recommends reforms to strengthen a number of key funding markets in the United States, markets that were a critical source of vulnerability in the crisis. The most important of these recommendations are directed at the tri-party repo markets and the money market funds. The essence of these recommendations is to make the tri-party repo markets and money funds themselves less vulnerable to the classic dynamic in which an abrupt rush for the exits forces a damaging spiral of asset sales, deleveraging and broader contagion.

Third, the Council recommends reforms to the housing finance system. Specifically, it recommends action to establish national standards for the mortgage servicing market, in order to better align incentives and help reestablish confidence in the integrity of the housing market.

Fourth, the Council emphasizes the importance of closer cooperation and coordination in the implementation of financial reforms, both here in the United States and around the world. The Secretary stated that as "we act to contain risk in the United States; we want to minimize the chances that it simply moves to other markets around the world, ultimately endangering our own system. The most important challenges we face in building a level playing field lie in the design of new capital standards and liquidity rules for the largest institutions and reforms to the derivatives markets."

Although the Secretary emphasized that the U.S. financial system today is much stronger than it was before the crisis, he said work is not complete. To preserve the gains achieved and to reduce both the risk of and the damage from future crises, the U.S. must continue to implement financial reform, pass comprehensive housing finance reform, and move forward with the other recommendations of the Council. The Administration will do this with a balanced approach, weighing the benefits of regulation against the costs of excessive restraint. The U.S. needs to move at a pace that fully recognizes the fragility of the global economic recovery, phasing in reforms over time so that we limit the risks to growth.

As we move forward, the Secretary encouraged Congress to strengthen our capacity to continue repairing our financial system which includes making sure that qualified people are in place to run the financial agencies. "And it requires that Congress provide sufficient funding for enforcement agencies to do their jobs in today’s complicated and challenging financial environment. If we leave the agencies responsible for enforcement underfinanced, then we will leave the American consumers, investors, and businesses that depend on our financial system more vulnerable.".

Financial Stability Board -- Consultation Paper -- Understanding Financial Linkages: A Common Data Template for Global Systemically Important Banks

According to the Financial Stability Board (FSB), in the recent crisis, the lack of timely, accurate information proved very costly. The current data architecture lags well behind the forces driving increased complexity and globalization of financial systems, institutions and markets. Importantly, there are major gaps in information on the globally active financial institutions that play a key role in the international financial system. There is little consistent information on the major bilateral linkages between such institutions, as well as on their interactions with other key financial institutions and markets across the world. As a consequence, there is a poor understanding of the global financial network which continues to hamper policy responses.

Mandate to FSB from G-20

To bridge these information gaps and complement the policy efforts underway to address the risks posed by global systemically important financial institutions, and as part of a wider initiative to enhance information in response to the crisis, the G-20 finance ministers and central bank governors called on the FSB in November 2009 to improve data collection and sharing in this area, in close consultation with the IMF.

The specific mandate was to take forward the following recommendations, spelled out in the joint IMF/FSB Report to the G-20 on Information Gaps.

Recommendation 8: The FSB to investigate the possibility of improved collection and sharing of information on linkages between individual financial institutions, including through supervisory college arrangements and the information exchange being considered for crisis management planning. This work must take due account of the important confidentiality and legal issues that are raised, and existing information sharing arrangements among supervisors.

Recommendation 9: The FSB, in close consultation with the IMF, to convene relevant central banks, national supervisors, and other international financial institutions to develop by end-2010 a common draft template for systemically important global financial institutions for the purpose of better understanding the exposures of these institutions to different financial sectors and national markets. This work should be undertaken in concert with related work on the systemic importance of financial institutions. Widespread consultation would be needed, and due account taken of confidentiality rules, before any reporting framework can be implemented.

FSB Working Group

To take this forward, the FSB set up a working group chaired by Aerdt Houben, Director of Financial Stability at De Nederlandsche Bank, composed of financial stability and statistical experts from national authorities and international institutions. In line with the mandate, the working group has developed preliminary proposals for a new common data template that aims to address the key gaps identified during the crisis and to provide the authorities with a stronger framework for assessing potential systemic risks.

The FSB indicated that the initial work has focused on preparing proposals for a common template to be completed by global systemically important banks (G-SIBs). The number of banks which are asked to report the proposed common data template will ultimately be decided by the FSB in consultation with the Basel Committee on Banking Supervision (BCBS) and the national authorities. Banks judged as globally systemically important will be asked to complete the new template. Other large internationally active banks may also be asked to complete the template, to improve the understanding of key linkages within the global financial system. As such, while the BCBS’ term of G-SIBs is used throughout the consultation paper (for simplicity), the final set of banks reporting the proposed data template may be somewhat larger than that identified by the BCBS as G-SIBs. Moreover, national or regional authorities may also consider collecting similar data for banks that they judge to be systemically important domestically.

Parallel work to develop improved data on large non-bank financial institutions is underway in some areas, such as insurance, hedge funds and data reporting to trade repositories, and will commence shortly in others. The preliminary proposals are described in the Consultation Paper. In a number of places the proposals are not fixed, but encompass a range of options. For example, there is agreement that additional information should be collected on the maturity structure of assets and liabilities to improve the assessment of liquidity and funding risks. But the question of how maturities should be categorized also remains open at this stage.

Seeking Input on the Template

Recognizing that data collection is costly, and that there is a cost-benefit balance to be struck, the FSB welcomes additional input from interested parties (such as banks, debt and equity investors in banks, IT system providers, analysts and academics) on the issues and questions set out in the consultation document. This feedback will be drawn on in deepening the cost-benefit analysis and in narrowing down the range of options to develop a final data template. As production of the template is taken forward subsequently, the working group will undertake further piloting and consultation on the detailed proposals. The template will also be introduced in a series of incremental steps that will provide reporting institutions with time to meet the new requirements.

Without prejudice to other regional or national initiatives, the ultimate objective of this international project is to develop a data framework that facilitates monitoring of key interlinkages among the major global banks in a consistent manner, whilst at the same time ensuring maximum synergies between the various sources of information used for statistical, supervisory and macroprudential analysis in order to strictly minimize any duplication of system maintenance and efforts. It is against this background, that national authorities and the FSB are considering storing and pooling the template data collected nationally on a harmonized basis in a central hub, proposed to be hosted by the BIS.

The proposed new common template aims at integrating two types of datasets (official statistics and public disclosures) by delivering a high-quality internationally consistent set of data on the exposures and funding of the G-SIBs, as well as on the key bilateral linkages between institutions that form the central hub to the international financial network. To lower reporting costs and to improve the value to users, a further goal is to secure as much consistency as possible between the common template and existing datasets (also taking into account planned enhancements) such as the BIS International Banking Statistics (IBS), and national flow of funds and sector balance sheet data.

Senator Tim Johnson and Congressman Barney Frank Write SEC, CFTC and Banking Agencies on Derivatives Regulation

Senator Tim Johnson, Chairman of the Senate Banking Committee and Rep. Barney Frank, Ranking Member of the House Financial Services Committee, recently wrote to the CFTC, SEC and bank regulators regarding derivatives regulatory reform implementation. The legislators urged the agencies to coordinate their rulemakings with each other and underscored the international implications of U.S. regulatory efforts. They recommended that regulations be "sequenced in a logical, coordinated manner that encourages compliance and market competition." They recommended that the agencies "avoid opportunities for regulatory arbitrage that could increase systemic risk and reduce the competitiveness of U.S. firms abroad." The letter notes specifically that "Congress generally limited the territorial scope of Title VII to activities within the United States." It then reflects concerns that proposed regulations on margin, clearing, trading, registration and the treatment of foreign subsidiaries "raise questions" about consistency with this intent. The letter also urges the agencies to coordinate closely with international counterparts and to protect the ability of derivatives end users and pension funds to use derivatives in a cost effective manner.