Significant Revisions of the Volcker Rule

Nathan S. Brownback and V. Gerard Comizio are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank publication by Mr. Brownback and Mr. Comizio.

This week, the Board of Governors of the Federal Reserve System (the “Board”), the Federal Deposit Insurance Corporation (the “FDIC”), and the Office of the Comptroller of the Currency (the “OCC”) each issued a Notice of Proposed Rulemaking (“the Notice”) proposing a number of changes to the Volcker Rule.

In summary, as described in more detail below, the Notice proposes significant changes to the Volcker Rule’s proprietary trading restrictions, a new tiered system of compliance, and a streamlined set of compliance metrics. In contrast, the Notice proposes few specific proposals for regulatory relief from the covered fund limitations and prohibitions; it primarily focuses on seeking public comment on the covered fund provisions—71 questions focus on them—but also reaffirms existing FAQs and guidance regarding the interaction of the Volcker Rule definitions of “covered fund” and “banking entity.” The existing FAQs and guidance provide some regulatory relief from the potential inclusion, in certain circumstances, of registered investment companies and foreign public funds (during their permissible seeding periods), and foreign excluded funds—none of which are covered funds—in the definition of “banking entity” under the Volcker Rule. With respect to these and other issues, the Notice requests comment on at least 342 questions related to the Volcker Rule, its scope and operations—a seemingly high number of questions for a proposed rulemaking of this type.

In introducing a new tiered compliance system, the Notice would place greater regulatory emphasis on banking entities with the largest trading operations and provide new regulatory relief for those that engage in less trading. Further, the notice would loosen the proprietary trading account restrictions to permit more short term trades by eliminating the current subjective purpose test for a banking entity’s holdings of financial instruments, which includes a rebuttable presumption that holding financial instruments for less than 60 days constitutes proprietary trading, with an objective test based on fair value accounting treatment of the relevant financial instrument. Finally, the Notice would provide foreign banking entities with increased flexibility and authority to make proprietary trades and invest in covered funds outside the United States.

The Notice follows an August 2017 OCC notice requesting public comment on potential revisions to the Volcker Rule (the “RPI”). In the RPI, the OCC asked how the Volcker Rule “should be revised to better accomplish the purposes of the statute … [and for suggestions on] improvements in the ways the final rule has been applied and administered to date.” It requested public comment on aspects of the Volcker Rule that impose higher regulatory costs than is justified by their reductions in undue bank risk from exposure to proprietary trading and fund investments; it also posed a number of questions related to the operation of the Volcker Rule.

The Notice addresses some industry concerns about the Volcker Rule, including some of the issues raised in comment letters on the RPI and some aspects of the Volcker Rule discussed in the Treasury Department’s June report evaluating the impact of the Dodd-Frank Act and its implementing regulations on banks and credit unions.

The Notice is detailed, and we expect to issue further memoranda covering the impact of its specific provisions in more depth.

Key Provisions of the Notice

The key provisions of the Notice include:

Volcker Rule Compliance

  • The Notice would introduce a new tiered compliance regime composed of three tiers of compliance requirements, all based on the size of a banking entity’s “trading assets and liabilities” (“TALs”):
    • Banking entities with “significant” TALs (that is, $10 billion or more) would be subject to a “comprehensive compliance program that would be tailored to reflect the requirements of the statute”;
    • Banking entities with “moderate” TALs (at least $1 billion, but less than $10 billion) would be required to incorporate Volcker Rule compliance into their general compliance policies and procedures; and
    • Banking entities with “limited” TALs (less than $1 billion) would be presumed to be in compliance with the Volcker Rule, absent Agency findings to the contrary in an examination or otherwise, and would have no ongoing duty to demonstrate compliance;
  • The Notice would also reduce the overall number of metrics required to be reported, streamline the reporting process, and limit metrics reporting requirements to banking entities in the top compliance tier; that is, those with significant TALs only;

Proprietary Trading

  • The Notice would revise the definition of “trading account” for purposes of the proprietary trading provisions, removing the subjective purpose test and its rebuttable presumption that holding a financial instrument for less than 60 days constitutes proprietary trading, and replacing it with a test based on accounting status—that is, if a financial instrument is “recorded at fair value on a recurring basis under applicable accounting standards”—designed by the Volcker Rule Agencies to capture derivatives, trading securities, and available-for-sale securities;
  • The Notice would expand the liquidity management exclusion from proprietary trading;
  • The Notice would establish a presumption that the purchase or sale of a financial instrument by a banking entity does not exceed reasonably expected near-term demand, or “RENTD,” (and thus violate limits on proprietary trading activities permitted under the underwriting and market-making exemptions) as long as the banking entity establishes, implements, maintains, and enforces underwriting and market-making internal risk limits;
  • The Notice would reduce the impediments to permitted risk-mitigating hedging under the proprietary trading provisions;
  • The Notice would expand the applicability of permitted proprietary trading activity for foreign banking entities’ trading outside the United States (the “TOTUS” exemption) by removing certain requirements of the exemption, including the requirement that financing of relevant activities take place outside the United States; and

Covered Funds

  • While the Notice proposes few major changes to the current covered fund prohibitions, it addresses the following:
    • The Notice would extend the no-action relief issued in July 201712 with respect to the inadvertent inclusion in the definition of “banking entity” of foreign excluded funds controlled by non-U.S. banking entities (while requesting public comment on resolving the issue more permanently);
    • The Notice would affirm the Volcker Rule FAQ response in which the Volcker Rule Agencies indicated that they would not treat RICs or foreign public funds as banking entities during their permissible seeding periods;
    • The Notice would remove the requirement that a banking entity include the value of ownership interests a banking entity holds in a covered fund that the banking entity does not organize and offer against its aggregate fund limit and capital charge;
    • The Notice would expand the ability of a banking entity to acquire a covered fund interest as a hedge; and
    • The Notice would expand the applicability of foreign banking entities’ covered fund investments solely outside the United States (the “SOTUS” exemption) by removing certain requirements of the exemption, including the requirement that financing of relevant activities take place outside the United States.

Other observations

Some important observations and takeaways on the Notice include:

  • The Notice does not implement Volcker Rule-related changes adopted pursuant to the new financial services deregulatory law, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “EGRRCPA”);
    • However, Board staff indicates that the Notice is not inconsistent with the EGRRCPA, and
    • The Volcker Rule Agencies indicate they will not enforce the current Volcker Rule in a manner inconsistent with the statutory changes;
  • The Notice is in its preliminary stages: it poses 342 questions to the public, inviting comment letters that will help the Volcker Rule Agencies refine the Notice into a final rule;
  • The Notice addresses certain (but by no means all) longstanding industry comments and concerns regarding the Volcker Rule, focusing largely on the proprietary trading and compliance aspects of the Volcker Rule; and
  • The Notice does not completely ignore the Volcker Rule’s covered fund provisions—some 71 questions relate to them—but at this stage, it suggests few changes to the covered fund provisions, instead requesting public comment on:
    • Amending the definition of a “covered fund” as it is in the current version of the Volcker Rule (the Notice refers to the current definition as the “base” covered fund definition), including, potentially, by amending the base definition such that it does not capture funds with certain characteristics that make them distinct from hedge funds and private equity funds;
    • Expanding currently available exclusions for foreign public funds, securitizations, and joint ventures;
    • Adopting new exclusions such as an exclusion for family wealth management vehicles and, potentially, rather than the change to the base covered fund definition discussed above, a new exclusion for funds with certain characteristics that make them distinct from hedge funds and private equity funds; and
    • Allowing the exclusions from the definition of “covered transaction” in Section 23 of the Federal Reserve Act to apply in the context of the Volcker Rule’s Super 23A provisions.

Action Plan for Clients Impacted by the Volcker Rule

Financial services organizations should note that, for now, the most important changes to the Volcker Rule in the Notice focus on (1) reducing compliance requirements by, among other things, eliminating the enhanced compliance regime of Appendix B, creating a tiered system for compliance, and permitting the folding of Volcker compliance requirements into banking entities’ general policies and procedures, (2) removing the subjective “purpose test” from the proprietary trading provisions by replacing the purpose prong of the trading desk definition with an objective rule based on accounting treatment, and eliminating the 60-day rebuttable presumption, and (3) expanding the ability of foreign banking entities to make proprietary trades and invest in covered funds outside the United States pursuant to the TOTUS and SOTUS exemptions.

As such, the Notice addresses some, but by no means all, industry concerns regarding the Volcker Rule. This is particularly true as relates to the current scope of the general prohibition on covered fund investments, which currently includes within its scope, among other things, all funds exempt under either Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. The Notice appears to be a work in progress, and, with 342 questions posed for public comment, is likely to go through further iterations before it evolves into a final rule. Therefore, it is critical for financial services organizations subject to the Volcker Rule or otherwise affected by it to closely examine the Notice to (1) evaluate the aspects of the Notice that most impact their business lines, (2) assess all questions posed in the Notice that may impact them and their business, consult counsel, and consider providing comments on the Volcker Rule to the Agencies. It appears likely that the Volcker Rule Agencies intend to make further changes to the Notice in the coming months after careful consideration of public comments.

The complete publication, including footnotes, is available here.

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