Pub. 5 2014 Issue 1

www.wvbankers.org 18 West Virginia Banker Background The “Volcker Rule” was proposed by Paul Volcker, former Chairman of the Federal Reserve Board, to reduce or eliminate speculative investment activities of banks and their affiliates. Following passage of the Glass-Stegall Act in 1932 and the Banking Act in 1933, commercial banks would gather deposits to make loans while investment banks would engage in the underwriting, sale, and trading of securities. The rampart intended to protect commercial banking from investment banking gradually eroded and was essen- tially removed in 1999 with enactment of the Gramm-Leach-Bliley Act. Volcker and others attributed partial blame for the 2008 financial crisis to the repeal of Glass-Stegall. The Volcker Rule was incorporated into the Dodd Frank Act of 2010 (DFA) as Section 619. Federal regulatory agencies, including the prudential bank regulators, Securities Exchange Commission, and Commodity Futures Trading Commis- sion proposed regulations to implement Section 619 starting in October 2011. The challenge for the rule makers was to imple- ment the restrictions of 619 while trying to preserve market making and hedging activities integral to commercial banking. Following 18,000 comments the final regu- lations were adopted in 2013. Key Provisions The objective of Section 619 and imple- menting regulations was to reduce the risk level for institutions that either directly or indirectly benefit from Federal depos- it insurance. In the broadest terms, the regulations prohibit proprietary trading, where the bank’s equity is at risk, limit investments in hedge funds and private equity funds, and require establishment of separate, robust compliance programs to manage the risk. Trading Activities The final rule prohibits proprietary trad- ing, or trading for the bank’s own account. Because trading is an essential component, underwriting and market making activities are also limited. The new rules provide certain exemptions for both underwriting and market making. For underwriting, the exemption permits a bank to carry an inventory of securities or financial instru- ments to satisfy the reasonably expected near-term demand for the securities being The Volcker Rule and Community Banks By Richard C. Donovan issued. For market making, the inventory must not exceed the reasonably expected demand considering daily volumes and market factors. In other words, underwrit- ing and market making activities may be exempted when the securities held by the bank are limited to levels needed to fulfill those roles. Another exemption to trading permits banks to engage in risk-mitigation hedging activities. Hedging must be risk-mitigat- ing in both purpose and effect. A bank would be allowed to hedge individual risk exposures or aggregate exposures on a loan portfolio segment for example. In contrast, a bank would be prohibited from loosely defined “macro” hedges, such as the infamous “London Whale” episode where a trader was hedging against weak- ening U.S. economy. Covered Funds The final rules prohibit banks from sponsoring or investing in hedge funds or private equity funds, collectively covered funds. However, a bank may, within limits, invest in covered funds organized and offered by the bank. A bank is limited to 3% ownership interest in any, one fund and an overall limit of 3% of Tier 1 capital in the aggregate. Excluded from covered funds are entities having general corporate purposes, such as a subsidiary, or joint venture. While mortgage backed securi- ties issued by the government sponsored entities are exempt, some commenters have observed that an exemption for other collateralized loan obligations may be questionable. Compliance It is no surprise that compliance is a key component of the new rules. Banks engaged in activities covered by the regulation are expected to have a robust, comprehensive, separate compliance program for Section 610. Banks over $50 billion in assets would be required to have the most robust programs, while those between $10 and $50 billion would be sub- ject to the minimum requirements. Banks less than $10 billion in assets can meet the compliance requirements by integrating any requirements into existing policies and procedures. Community Bank Issues Trading Activities Trading activities include buying and selling securities, as well as hedging