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Vedder Thinking | Articles Q&A: The Volcker Rule and Its Implications for Regional and Community Banks


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After a lengthy development period, section 619 (the Volcker Rule) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was finally adopted on December 10, 2013. Since the release of the proposed rule more than three years ago, the financial services industry has been concerned about the burden of complying with the proprietary trading restrictions in the Volcker Rule and the potential effects of those restrictions on the competitiveness of U.S. banks. Many larger banks started work early on in anticipation of the compliance requirements set forth under the Volcker Rule, but there is some uncertainty about how great a regulatory burden falls on the nation's "main street" banks.

In this article, Daniel O'Rourke and Juan M. Arciniegas discuss the Volcker Rule and its relevance to banking entities with less than $10 billion in total consolidated assets. Dan is a Shareholder in the Financial Institutions group and focuses his practice on bank regulatory matters, and Juan is a Shareholder in the Investment Services group and concentrates his practice on derivatives and structured products. Their discussion on the topic will uncover some thoughts on what community and regional banks should consider as they determine whether—and the extent to which—the Volcker Rule applies to them.

Dan: Juan, give us a 50,000-foot view of the Volcker Rule. What is it and what is its purpose?

Juan: The Volcker Rule was named after Paul Volcker, a former U.S. Federal Reserve Chairman, who argued that proprietary trading by large financial institutions was a major contributing factor to the financial collapse in 2007-2008. He also argued that if the U.S. economy required an institution to be bailed out by the federal government, then such institution should not place taxpayers' money at risk by trading in certain markets.

Congress included the Volcker Rule as part of the Dodd-Frank Act, which amended Section 13 of the Bank Holding Company Act of 1956. At the broadest level, the legislation prohibits banking entities from

  • engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account; or
  • owning, sponsoring or having certain relationships with hedge funds or private equity funds, referred to as "covered funds."

Today, almost five years after the Dodd-Frank Act was signed into law, implementation remains a work in progress. In particular, it is not 100 percent clear whether the Volcker Rule will affect banks with less than $10 billion in total consolidated assets—and it is even less clear how the Volcker Rule will impact a bank's hedging activity.

Dan: What is "proprietary trading" and how is it defined in the Volcker Rule?

Juan: The Volcker Rule generally prohibits banking entities from engaging in "proprietary trading."

Proprietary trading, as defined in the rule, means "engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments." Thus, compliance with the Volcker Rule depends on whether the account for which the trade is placed satisfies the definition of "trading account" and whether the trade involves a "banking entity" and a "financial instrument."

Dan: Could you break that down into its component parts?

Juan: The restrictions on proprietary trading set forth in the Volcker Rule apply to institutions that meet the criteria of "banking entities" as defined under the Volcker Rule. This includes

  • any insured depository institution;
  • any company that controls an insured depository institution;
  • any foreign entity that is treated as a bank holding company for purposes of section 8 of the International Banking Act of 1978 (i.e., because it has a U.S. branch or agency); and
  • any affiliate or subsidiary of any such entity.

Excluded from the definition of "banking entity" are

  • any covered fund that is not itself a "banking entity" under the definition set out above;
  • any portfolio company held under a bank holding company's merchant banking authority; and
  • the Federal Deposit Insurance Corporation (FDIC) acting in its corporate capacity or as conservator or receiver under the Federal Deposit Insurance Act or Title II of the Dodd-Frank Act.

Under the Volcker Rule, the term "financial instrument" includes

  • a security, including an option on a security;
  • a derivative, including an option on a derivative; and
  • a contract of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.

A "derivative" is defined to include swaps, security-based swaps, purchases and sales of nonfinancial commodities for deferred shipment or delivery that are intended to be physically settled, foreign exchange swaps and forwards, retail commodity transactions, and standardized contracts for certain commodities under Section 19 of the Commodity Exchange Act.

The definition of "financial instrument" excludes loans, defined broadly to include any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative; spot foreign exchange; and spot physical commodities.

Dan: What about "trading account"?

Juan: The Volcker Rule provides a functional definition of "trading account," which means an account that satisfies any one of three criteria: a "purpose test," a "market risk capital rule test," or a "status test."

  • Purpose Test: A trading account includes any account used by a banking entity to buy or sell a financial instrument principally for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging a position resulting from any of the foregoing trading activities.
  • Market Risk Capital Rule Test: If the banking entity or any affiliate is an insured depository institution, bank holding company or savings and loan holding company and calculates risk-based capital ratios under the U.S. market risk capital rule, a trading account includes accounts used to buy or sell one or more financial instruments that are both market risk capital rule-covered positions and trading positions (or hedges of other market risk capital rule-covered positions).
  • Status Test: If the banking entity is licensed or registered (or required to be licensed or registered) to engage in the business of a securities dealer, swap dealer or security-based swap dealer, a trading account includes any account used by a banking entity to purchase or sell financial instruments for any purpose to the extent the financial instruments are purchased or sold in connection with activities that require the banking entity to be so licensed or registered.

The rule does not expressly define what constitutes a banking entity "engaging as principal" in a transaction. The Adopting Release does, however, indicate that "the combination of references to engaging as principal and to a trading account in the Volcker Rule focuses on an entity's incurring risks of profit and loss through taking ownership of securities and other instruments."

Dan: That all seems rather complex. Is there an easier way to distinguish trading subject to Volcker from other trading activity?

Juan: Agreed Dan, it really is complex. It’s not unusual for banks to execute transactions within their own account, but not all trading is subject to Volcker. The key is to determine the purpose and intent behind the trading activity.

To help in distinguishing between trading subject to Volcker and permissible proprietary trading, the rule incorporates a rebuttable presumption which indicates that purchases or sales of a financial instrument are for a short-term trading account if they are held for fewer than 60 days. The Volcker Rule also expands the presumption to cover the purchase or sale of any financial instrument (regardless of holding period) if the acquiring banking entity "substantially transfers" the risk of that financial instrument within 60 days of the purchase or sale. The Adopting Release indicates that this expansion was intended to cover basis trades.

The presumption of proprietary trading applies unless the banking entity can demonstrate, based on all relevant facts and circumstances, that it did not purchase or sell the financial instrument principally for the short-term purposes cited in the definition of "short-term trading account." To reduce the costs and burdens of rebutting the presumption, regulators will allow banking entities to rebut the presumption for a group of related positions; however, the Volcker Rule does not provide any specific procedure for rebutting the presumption.

Dan: Did the rule provide for any exclusions or exemptive relief?

Juan: There are a number of exclusions and exemptions from the rule, some of which are easy to apply and to analyze, others not so much. For regional and community banks, there are two that come to mind.

First, the Volcker Rule permits banks to purchase or sell a financial instrument if the bank is acting as what's called a "riskless principal." The way this works is that the bank must first have a customer-driven order to purchase or sell a financial instrument which it then may contemporaneously offset through a purchase or sale of the same financial instrument through its own account. Any transaction conducted pursuant to this exemption must be customer-driven and must not expose the bank to gains or losses as principal on the value of the traded instrument.

This exemption would apply to a customer hedging program, often referred to as a "back-to-back" program. For every customer transaction, the bank will typically enter into an identical trade in the interdealer market to offset the risk—resulting in a riskless principal transaction.

Second, the Volcker Rule also permits banks to engage in trades designed to reduce the specific risks that the banks' individual or aggregated positions, contracts or other holdings create—known as the risk-mitigating exemption. Banking entities seeking to engage in permitted risk-mitigating hedging activity must establish, implement, maintain and enforce an internal compliance program, including robust, detailed hedging policies and procedures designed to prevent prohibited proprietary trading in this context.

Dan: So what does this mean for regional and community banks? Do they have a Volcker Rule issue?

Juan: The Federal Reserve Board, the FDIC and the OCC issued a joint statement explaining that the Volcker Rule should not have much effect on most banking entities with less than $10 billion in total consolidated assets. The primary reason, generally speaking, is that the vast majority of community banks have little or no involvement in prohibited proprietary trading or investment activities in covered funds.

The regulators said that, generally, "a community bank is exempt from all of the compliance program requirements" under the Volcker Rule, so long as it does not engage in activities covered by the Volcker Rule.

Dan: So assume a bank does engage in activities covered by Volcker. Can you talk a little bit about how a community bank can be compliant with Volcker?

Juan: For those community banks that do engage in one or more covered activities, the compliance program requirements can be met by simply including references to the relevant portions of the Volcker Rule within the community bank’s existing policies and procedures to address just the activities that the community bank actually conducts.

A community bank that does not engage in any covered activity, but decides to do so in the future is expected to adjust its existing policies and procedures to include only appropriate references before it starts activities covered by Volcker.

Dan: That seems rather straightforward. But just to be clear, are these compliance requirements the same across all sizes of community banks?

Juan: Great question, Dan. No they are not. The compliance obligations I just mentioned apply only to community banks below $10 billion in total consolidated assets. For banks larger than that, the compliance program is substantially different.

Dan: Is there a deadline by which banks must be compliant?

Juan: All banks and banking entities subject to U.S. prudential banking rules must conform prohibited proprietary trading activities to the Volcker Rule by its effective date of July 21, 2015. Given how minimal the compliance burdens are on community banks under $10 billion, this should not be a grueling task.