On December 10, 2013, five financial regulatory agencies approved rules implementing a portion of the Dodd-Frank financial sector reform law known as the Volcker Rule. Recall that the provision prohibits banks from trading securities and other financial instruments for their own account. It also bars them from owning or sponsoring hedge funds or private equity funds, referred to as covered funds.
The goal is to prevent banks from making risky bets with federally-insured (taxpayer-backed) deposits, an aim that received heightened support following the $6.2 billion ‘’London Whale’’ trading loss recorded by JPMorgan Chase & Co. (JPM - Free JPMorgan Stock Report) roughly a year ago. But bank regulators probably will still need to tweak the rules to make them workable.
The final rules provide exemptions for certain activities, like market making and trading government obligations, as long as they don’t involve a material conflict of interest or exposure to high-risk assets or trading strategies, and don’t pose a threat to the safety and soundness of the bank or the nation’s financial stability. The problem is that the exemptions, like what poses a threat to a bank’s safety, may be interpreted differently by the banks and their regulators.
One consequence of the Volcker Rule has raised the bank industry’s ire recently. It seems that certain debt securities held by banks, called collateralized debt obligations (CDOs) backed by trust preferred securities, are considered covered funds under the Volcker Rule. As a result, banks will be prohibited from treating them as long-term securities, which probably would require the banks to sell their existing holdings of the CDO securities. Under current accounting rules, they would have to adjust the value of (most likely write down) the CDO securities awaiting sale to their market value.
The writeoffs could be onerous. Already, Zions Bancorporation (ZION), a Utah-based bank with over $55 billion of assets, has indicated that it might mark down its CDO portfolio by an estimated $387 million, which would wipe out much of its earnings for 2013. Smaller banks, many that hoped to be exempt from such requirements, are especially concerned, since such charges could have a significantly greater negative impact on their bottom lines and equity capital at a time when capital requirements for banks are being raised. Bank regulatory agencies reportedly are taking another look at the issue. They could exempt small banks (with less than $15 billion of assets) from having to comply with the Volcker rule, or exempt the CDOs already on bank balance sheets.
Even aside from this issue, the tighter restrictions on trading activity appear likely to reduce bank revenues. Some believe Goldman Sachs (GS) would be hurt the most, since trading accounts for much of its revenues. Moreover, the added costs of complying with the new rules probably will boost the industry’s operating expenses. To offset the negative impact on earnings, banks may be inclined to raise the service fees they charge customers.
Meanwhile, ensuring compliance with the Volcker Rule could take some work. When engaging in hedging activity to offset the riskiness of a bank’s individual or aggregate trading positions, banks will be required to document their rationale for certain transactions, and to monitor and recalibrate the effectiveness of their hedges over time. CEOs of large banks would also be required to attest to their bank’s compliance with the rules. Training supervisors to monitor bank compliance with the Volcker rule is likely to take some time. It’s also unclear which of the five financial regulatory agencies that approved the Volcker Rule (The Federal Reserve Board, Federal Deposit Insurance Corporation, Commodity Futures Trading Commission, Office of the Comptroller of the Currency, and Securities and Exchange Commission) will take the lead in enforcing the rule.
The final version of the Volcker Rule becomes effective on April 1, 2014, but the Federal Reserve has extended the conformance period until July 21, 2015, and banks with between $10 million-$25 million in assets have until December 31, 2016 to comply. The bank industry is already moving to align their operations to the rule, but full compliance probably will take time.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.