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1 | PERSPECTIVES The Volcker Rule - Are You Ready?
The Volcker Rule - Are You Ready?
WHAT IS THE RULE?
On December 10, 2013, five U.S. financial regulatory agencies1
adopted a final
rule implementing Title VI of the Dodd-Frank Wall Street Reform and Consumer
Protection Act commonly referred to as “The Volcker Rule (the “Final Rule”). The
Final Rule became effective on April 1, 2014, and impacted institutions are required
to be in full compliance by July 21, 2015.
The “Volcker Rule” generally prohibits a banking entity and its affiliates from:
»» Engaging in proprietary trading;
»» Acting as a principal, directly or indirectly, and acquiring or retaining any
ownership interest in, or sponsoring, a covered fund.
A banking entity is defined as either an insured depository institution, a company
that controls an insured depository institution, a company treated as a bank holding
company under the International Banking Act of 1978, or an affiliate or subsidiary of
one of the above.
As expected, the Final Rule prohibits proprietary trading by a banking entity in
most securitized products. Proprietary trading is defined as engaging as principal
for the trading account of the banking entity in any purchase or sale of one or
more financial instruments. A trading account is, in turn, broadly defined to mean
an account used by a bank to make short-term trades, and by default, presumes
that any security held on a bank’s balance sheet for less than 60 days is being held
in the bank’s trading account, unless the bank can demonstrate otherwise. While
these definitions would appear to encapsulate virtually all forms of trading activity
that banks engage in, the Final Rule does contain several exemptions that would
not be considered prohibited proprietary trading.
1 The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board, The Securities Exchange Commission (SEC), The Commodity Futures
Trading Commission (CFTC) and Comptroller of the Currency.
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Notably, the following activities would be allowed under the
Market making – The Final Rule allows for market making
activities provided that the trading desk that establishes and
manages the financial exposure routinely stands ready to
purchase and sell one or more types of financial instruments
related to its financial exposure and is willing and available
to quote, purchase and sell, or otherwise enter into long
and short positions in those types of financial instruments for
its own account, in commercially reasonable amounts and
throughout market cycles on a basis appropriate for the
liquidity, maturity, and depth of the market for the relevant
types of financial instrument.
Underwriting – The Final Rule permits the banking entity to
act as an underwriter2
for a distribution of securities with its
trading desk having positions related to such distribution.
For the purpose of this exemption, both members of the
underwriting syndicate and selling group members can
qualify as underwriters. The underwriting position must be
designed not to exceed reasonably expected near term
demands of client, customers or counterparties.
Hedging – The Final Rule specifies that hedging must be for
risk mitigation purposes and cannot give rise, at the inception
of the hedge, to any significant new or additional risk that is
not itself hedged contemporaneously. The Final Rule allows
for portfolio hedging, but banks cannot use macro hedging
to protect against the broader market or economic risk or
to increase risk taking. Banks will have to provide a detailed
history to show correlation when entering into hedges and
also to justify the level and types of trading inventory. Key
requirements of hedging exemption rule include:
»» Bank must have detailed internal compliance procedures;
»» Transaction must mitigate one or more specific risks, not
»» Hedge and underlying position should be reasonably correlated;
»» Hedge cannot lead to material exposure risk that is not hedged;
»» Hedge is subject to monitoring;
»» Compensation cannot be tied to proprietary trading; and,
»» Banks must maintain detailed documentation.
Acting as an agent or broker for a customer – The Final Rule
allow banking entities to use their own funds to purchase
or sell financial instruments when acting on behalf of their
customers rather than on behalf of themselves or retain a
beneficial ownership of the financial instruments.
Activities of an insurance fund under its separate or general
account – The Final Rule specifically and broadly exempts
the purchase, sale, acquisition or disposition of securities
and other instruments by a regulated insurance company
engaged in the business of insurance for the general
account of the company. Likewise, separate accounts
managed and maintained by insurance companies as part
of the business of insurance are generally customer-driven
and do not expose the banking entity to gains and losses on
the value of assets held in the separate account, although
the banking entity may be treated as the owner of the assets
for certain purposes. Unlike the general account of the
insurance company, separate accounts are managed on
behalf of specific customers, similar to a bank managing a
trust or fiduciary account.
Foreign banking entities eligible for the exemption – In
order to be eligible for the foreign trading exemption, the
banking entity must not be directly or indirectly controlled
by a banking entity that is organized under the laws of the
United States or of one or more States. In addition to the
banking entity, any relevant personnel making the decision
to purchase or sell as principal cannot be located in the
United States and no financing for the banking entity’s
ownership or sponsorship is provided, directly or indirectly
by any U.S. affiliate of the banking entity. Furthermore, any
transaction including investment or sponsorship arising from
risk-mitigating hedging related to an ownership interest is
not accounted for as principal directly or indirectly on a
consolidated basis by any branch or U.S. affiliate of the
2 The terms “distribution” and “underwriter” are defined in Final Rule §_.4 (a)(3) and §_.4(a)(4), respectively.
3 | PERSPECTIVES The Volcker Rule - Are You Ready?
Exclusion of repurchase agreement and securities lending
agreements – Repurchase, reverse repurchase agreements
and securities lending agreements are generally exempt
from the definition of proprietary trading under the Final
Rule. However, the Agencies will monitor these transactions
to ensure this exclusion is not used to engage in prohibited
proprietary trading activities. For example, the collateral or
position that is being financed by the repurchase or reverse
repurchase agreement may not be exempt and involve
impermissible proprietary trading.
Furthermore, proprietary trading is not prohibited across
all products. Banking entities can continue to trade as a
principal for the following asset classes:
»» US government obligations;
»» Debt issued or guaranteed by the GSEs, including agency
MBS and the STACR deals;
»» Municipal bonds; and,
»» Any loans, including mortgage whole loans or other
consumer and commercial receivables.
Along with restrictions on proprietary trading, the Volcker
Rule generally restricts a bank from acquiring, owning, or
sponsoring a covered fund subject to certain thresholds.
A covered fund is broadly defined to include investment
vehicles that either limit the number of investors in the fund
or that obtain capital from qualified investors that meet
certain net worth or income thresholds – including, most
hedge funds and private equity funds. However, the current
definition is broad so that other types of vehicles, including
some types of securitizations, may ultimately be classified
as a covered fund. The Final Rule provides the following
exclusions from being defined as a covered fund:
»» Foreign fund related exclusions:
›› Foreign Public Funds
›› Foreign Pension or Retirement Funds
»» Structured product vehicle exclusions:
›› Issuing Entities for Asset-Backed Securities
›› Qualifying Asset-Backed Commercial Paper Conduits
›› Entity Owning a Pool of Loans / Assets for the Benefit of
»» Insurance vehicle exclusions:
›› Bank-Owned Life Insurance
›› Insurance Company Separate Accounts
»» Joint venture and acquisition vehicle exclusions:
›› Wholly Owned Subsidiaries
›› Joint Ventures between a Banking Entity / Affiliates and
›› Acquisition Vehicles
»» Public benefit vehicle exclusions:
›› SBICs and Public Welfare Investment Funds
›› Registered Investment Companies and Excluded Entities
›› Issuers in Conjunction with the FDIC’s Receivership or
In the global environment that financial institutions operate
in today, appropriately classifying and supporting covered
fund interests will pose a material challenge.
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and covered fund activities and investments set forth in the
Final Rule. The compliance program must include written
policies and procedures that are appropriate for the types,
size, complexity and risks of the related activities conducted
by the banking entity. Key dates in the adoption timeline are
A banking entity must develop and provide for the
continued administration of a compliance program
reasonably designed to ensure and monitor compliance
with the prohibitions and restrictions on proprietary trading
Effective date of
($50bn in trading
assets and liabilities)
July 21, 2015
July 21, 2016-22?
*Potential extension of conformance period
»» Potentially two additional one-year “general” extensions.
»» Additionally potential five-year extension for “illiquid” funds (for obligations existing as of May 1, 2010).
COMPLIANCE PROGRAM REQUIREMENTS
Minimum Compliance Program
In order to comply with the minimum requirement, a banking
entity needs to develop a minimum compliance program
which includes the following:
»» Written policies and procedures designed to document,
describe, monitor and limit trading activities in
accordance with the rule;
»» System of internal controls reasonably designed to monitor
»» Management framework that delineates responsibility
and accountability for compliance;
»» Independent audit and testing of compliance program
»» Staff training program; and,
»» Records demonstrating compliance retained for no less
than five years.
Enhanced Compliance Program
In addition to the minimum compliance standards, banks
that are required to report quantitative metrics and have $50
billion or more in assets must have an enhanced compliance
program with key components to include the following:
»» Policies and procedures governing trading desks including
instruments and risk levels;
»» Descriptions of risk management processes;
»» Internal controls to monitor and enforce risk limits;
»» Policies and procedures on hedging instruments and strategies;
»» Analytics and quantitative measurement of trading
activities including back-testing;
»» Description and documentation of covered fund activities
»» Compliance monitoring of the Final Rule and
documentation on exemptions; and,
»» Remediation of violations.
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Quantitative Measurement Reporting
In order to effectively monitor its trading activities, a banking
entity needs to develop and report the following quantitative
»» Risk and Position Limits and Usage
»» Risk Factor Sensitivities
»» VaR and Stress VaR, Trading P&L Attribution
»» Comprehensive Profit and Loss Attribution
»» Inventory Turnover
»» Inventory Aging
»» Customer Facing Trade Ratio
The Final Rule does not provide any prescriptive definition
of the above measurements; instead it is general guidance
such that it is flexible enough to be tailored specifically to
the activities of each trading desk. Calculation guidance
provided in Appendix A3
ensures that a similar approach is
being used across all the trading desks within a banking entity.
Reporting requirements of the quantitative measurements
to the agencies will be determined based on the size of
each bank’s consolidated trading assets and liabilities. Banks
holding in excess of $50 billion in consolidated trading assets
and liabilities have a threshold date to report as of June
30, 2014; banking entities with trading assets and liabilities
between $25 billion and $50 billion have a threshold date
to report as of April 30, 2016; and, banking entities between
$10 billion and $25 billion of trading assets and liabilities are
subject to a threshold date to report of December 31, 2016.
Other Compliance Matters
»» The banking entity must adopt a written compliance
program approved by the board of directors, an
appropriate committee of the board, or equivalent
governance body, and senior management.
»» The CEO of the banking entity is required to annually
attest in writing that their organization has the procedures
to establish, maintain, enforce, review, test and modify
the compliance program in a manner reasonably
designed to achieve compliance with the Final Rule.
»» Independent testing of the effectiveness of the
compliance program must occur with a frequency
appropriate to the size (no less than annually), scope, and
risk profile of the banking entity’s trading and covered
fund activities or investments.
»» Banking entities must provide adequate training to
personnel involved in activities governed by the Final Rule
or those involved in its compliance.
»» Banking entities must create and retain records sufficient
to demonstrate compliance and support the operations
and effectiveness of the compliance program.
3 Section .20(d) Reporting and Recordkeeping Requirements Applicable to Trading Activities.
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What emerges from the Final Rule is that nearly all
organizational units will be involved in its compliance.
»» For the front office there is accountability in terms of
trading desks, technology and staff. Risk and revenue
related metrics including correlation and back-testing
requirements will expand the scope for risk management.
In addition, risk and authorization limits must be
»» Interpreting rule requirements, the rigor of ongoing
compliance monitoring and the need for evaluation
and investigation suggest a prominent role for legal and
»» In order for banking entities to utilize any of the
exemptions described in the Final Rule, data must be
captured and stored with business and technology units
needing to collaborate in regards to gathering, saving
and monitoring all the quantitative metrics.
»» A centralized corporate governance function must be
in place to establish processes around the identification
of violations and escalation policies, as well as,
monitoring overall compliance with the rule including the
independent testing function.
Given the wide reach of the Final Rule, impacted entities
of any size should be currently assessing the impact to their
organization and working towards full compliance. In order
to delineate between market-making and proprietary
activities, as well as capture metrics such as profit and loss
attribution and inventory turnover, a few short term initiatives
an entity can assess are:
»» Enhancing the data quality across business and trading
desks thus allowing for a standardized approach with
aggregating information and metrics.
»» Using trading and sales systems to capture daily turnover
across all asset classes and derivatives. The process must
be automated and there will be a need to move away
from customized desk tools and develop cross-business
and cross-desk applications.
»» Aggregating the reporting and documenting of trading
activities for both internal compliance monitoring and
bank examinations needs.
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AS ILLUSTRATED IN THE CHART BELOW, NAVIGANT CAN ASSIST IN ALL
ASPECTS OF ADOPTING THE VOLCKER RULE:
VOLCKER RULE REQUIREMENT
Operational Gap Analysis/Remediation
Compliance Program Design & Implementation
Policy and Procedure Development
Regulatory Exam Response Support
Data Integrity and Capture
Independent Testing Program
Independent Model Validation and
Model Governance Policies
Training Program Design/Outsourcing
NAVIGANT SERVICE OFFERING
» What constitutes a trading desk
» New product approval process
» Document hedging/trading strategies,
customer/counterparty relationships, risk
management process and staff compensation
» Facilitate regulatory examination
» Independent testing
» Identify, document, monitor and report permitted
activities and potential areas of noncompliance
» Development of quantitative measurements
based upon general definitions provided
» Model validation
» Risk limits and authorization levels
» Corporate governance including escalation and
remediation of violations
» Training program
HOW NAVIGANT CAN HELP
Creating a fully compliant infrastructure and reporting
framework that adheres to the Volcker Rule requires
coordination across business units and significant allocation
of resources to standardize data, documentation and
processes. Navigant has extensive experience in all aspects
of the Volcker Rule including personnel that have worked
in the private and public sectors in trading, securitizations,
investments, hedging, risk management, data management,
technology, valuation, project management and
accounting/audit. This experience affords our personnel with
an in-depth understanding of the intent and application of
the requirements along with a practical view into developing
a compliance and corporate governance program.
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