SEC Passes Volcker Rule By 3 To 2

December 11, 2013

On December 10, 2013, final rules were issued to implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Volcker Rule"). Essentially, the rules prohibit certain short-term proprietary trading by subject banks. Moreover, those banks are now limited as to the nature and extent of their investments in and relationships with hedge funds or private equity funds. 

Except, you know, the hand of compromise is all over this Volcker Rule and as you plow through the hundreds of pages of text, you come across all sorts of exemptions, exclusions, and carve-outs. Some things apply to the big boys and not the small fry. Some things apply to the whales but not always or only subject to certain circumstances. Good luck trying to figure out what is and isn't exactly covered.  

BrokeAndBroker offers its readers the full-text of the Securities And Exchange Commission's ("SEC's") press release announcing the new rules and the attendant statements of the SEC's Chair and four commissioners.  For serious investors and industry participants, this is an excellent opportunity to better understand the politics of regulation and the likely bases for appeals that will inevitably impede the initial efforts to implement the Volcker Rule. I have appended quotes from each of the public statements to afford you a brief sample of the nature of the Chair's and each commissioner's perspective.

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Press Releases

Public Statements

U.S. banks and their affiliates will no longer be able to engage in short-term proprietary trading of securities, derivatives, and other financial instruments for their own account.  In carrying out this prohibition, the final rule has benefited from a consideration of commenter views on unintended market impacts, particularly with respect to liquidity in off-exchange markets, while preserving an appropriate separation between prohibited proprietary trading and activities permitted by the statute, and taking meaningful steps to prevent evasion. 

U.S. banks and their affiliates also will be restricted in how the covered funds they sponsor may be organized and offered.  In addition, firms that sponsor or advise a covered fund will be barred from, for example, purchasing assets from the fund or extending credit to it.  At the same time, the rule preserves the ability of U.S. banks and their affiliates to engage in certain activities with covered funds that the statute allows, such as asset management on behalf of customers. 

Consistent with the statute, the final rule also would limit otherwise permitted activities if they involve a material conflict of interest; a material exposure to high-risk assets or high-risk trading strategies; or a threat to the safety and soundness of the banking entity or to the financial stability of the United States. 
Although the passage of time can dim memories, we can never forget the crisis that brought our country to this moment.  Proprietary trading by financial institutions racked up huge losses and was one of the factors that forced American taxpayers to bail out the banking system.  That crisis destroyed financial institutions, caused significant investor losses, and obliterated the household wealth of average Americans.  By reining in excessive proprietary trading by deposit-taking institutions, the goal of the Volcker Rule is to restore integrity to the financial system and maintain the vibrancy of the U.S. financial market. 
Some have argued that this rule will unnecessarily restrict the provision of financial services to the American families and businesses that currently rely on banks to provide them.   These concerns are belied by the fact that families and businesses received those services from numerous and diverse financial services providers during the period when the Glass-Steagall Act was in effect, and the US economy grew to be the strongest in the world.  In addition, Congress did not simply re-adopt the Glass-Steagall Act.  Rather, it decided to restore and provide new protections to cover activities like derivatives trading, while still permitting banks to provide certain customer-centered financial services.  However, these permitted activities, such as market making and underwriting, are to be subject to restrictions and limitations intended to ensure that they do not give rise to significant risks to the banking entities or the financial system.  
From the very beginning, the Volcker Rule has been a solution in search of a problem, a common situation throughout the Dodd-Frank Act.  To quote former Treasury Secretary Geithner, "If you look at the crisis, most of the losses that were material for the weak institutions - and the strong, relative to capital - did not come from [proprietary trading] activities.  They came overwhelmingly from what I think you can describe as classic extensions of credit."[4]  Paul Volcker himself explained, "[P]roprietary trading in commercial banks was there but not central" to the financial crisis.[5]  When asked by the New York Times in 1923 why he wanted to climb Mount Everest, George Mallory famously replied, "Because it's there."[6]  That may or may not be a compelling reason to climb the world's tallest mountain, although I'll note that Mallory and his climbing partner disappeared during their 1924 Everest expedition, and his body wasn't discovered for 75 years.  

Even in the era of never letting a serious crisis go to waste, however, the mere fact that proprietary trading makes a segment of our policy establishment nervous[7] surely is not sufficient justification to potentially destroy the market-making system central to the liquidity and proper functioning of our capital markets.  Years from now, I fear, financial historians will marvel at how the Dodd-Frank Act forced regulators to proactively disadvantage American financial institutions as well as the strength and integrity of our capital markets to address such tangential - at best - matters as conflict minerals, resource extraction, and proprietary trading, but gave a complete pass to the main cause of the financial crisis -- decades worth of disastrous federal housing policy.
Common sense, as well as good government, dictates that, at a minimum, an agency knows what is in the rule and have a basic understanding of the potential impact the rule will have.  Unfortunately, the Volcker Rule being adopted today fails to meet both those fundamental principles.  Indeed, if we cannot satisfy ourselves with how the rule will work, the public is unlikely to have such confidence either.     

The rule proposal was more than 500 pages long, asked approximately 1,300 questions, and the Rulemaking Agencies received over 18,000 comment letters.  The common rule text spanned approximately 120 pages.  The length of the common rule text, the volume of questions, and the number of comment letters attest to the importance and complexity of this rulemaking.