Regulators Improve the Volcker Rule

27 Aug 2019
Read Time 4 mins
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Volcker Rule

Recently, the board of the FDIC approved a number of changes to the Volcker Rule after releasing a set of proposed changes in May of 2018 and considering public comments.  While some have suggested the changes significantly alter the effectiveness of the rule, the changes that were approved by the FDIC broadly represent improvements that reduce the complexity of complying with the rule while maintaining the statutory ban on proprietary trading and supporting the ability of large banks to serve the capital markets needs of savers and investors.  In this post, we place the recent changes in context and discuss how they have improved the Volcker Rule.

In order to put the recent changes into perspective, it is important to understand a few things about large banks and the Volcker Rule.  First, members of the Financial Services Forum do not engage in proprietary trading, which means trading in the short-term for their own benefit without facilitating customer activities or hedging their own risks.  Financial Services Forum members do engage in trading activity to serve the needs of their customers, such as pension funds, and support deep and liquid capital markets.  As a result, the Volcker Rule is a compliance exercise that should be designed to fulfill the statutory mandate without creating unnecessary burdens and costs.

Second, appointees of both Democratic and Republican administrations have long recognized that the original version of the Volcker Rule was excessively complex and burdensome.  In particular, former Federal Reserve Governor Daniel K. Tarullo remarked: “Several years of experience have convinced me that … the Volcker Rule is too complicated.  Achieving compliance under the current approach would consume too many supervisory, as well as bank resources.  He continued, ”It may be having a deleterious consequence on market making, particularly for some less liquid securities.”  It is worth noting that in the past few years, the evidence that the Volcker Rule is having a deleterious impact on market liquidity has been steadily mounting.  We called attention to this issue in a May 2018 blog post, shortly after the Volcker Rule changes were proposed.  In addition, recent research from the government’s Office of Financial Research also suggests that the Volcker Rule has reduced market liquidity.

The changes to the Volcker Rule will reduce unnecessary complexity by providing much-needed clarity while also supporting the safety and soundness of large banks as they support deep and liquid capital markets.

Two specific changes are worth highlighting: the improvement to the trading account definition and the improvement to the liquidity management provisions of the rule.

A key problem with the rule from its inception has been the overly complicated and subjective definition of the “trading account” that determines the scope of the Volcker Rule.  The original rule defined the trading account with respect to three overlapping and subjective criteria that required banks to divine the intent of each trade.  This approach to defining the scope of the Volcker Rule was inherently problematic, an issue that was widely recognized by regulators.  In particular, Governor Tarullo said: “I think the hope was that, as the application of the rule and understanding of the metrics resulting from it evolved, it would become easier to use objective data to infer subjective intent. This hasn’t happened, though. I think we just need to recognize this fact and try something else.”

The revised trading account definition represents a significant improvement that objectively clarifies and appropriately focuses the scope of the rule.  Moreover, to the extent that some assets are not included in the revised definition, that is because those assets support long-term investments, customer trades, or hedging transactions, and are not related to proprietary trading.

The original Volcker Rule also contained a provision to ensure that banks could engage in liquidity management.  Liquidity management is a key banking activity that supports bank safety and soundness by ensuring that banks have sufficient liquid assets across a range of currencies to meet short-term demands for cash from depositors and other short-term liability holders as they arise.  While the intent of the original liquidity management provision was wholly appropriate, it did not allow banks to conduct certain activities that are part and parcel of prudent liquidity management.  The revised rule now permits a wider range of liquidity management activities that will support safer and sounder banks.  Everyone should applaud regulators for making changes that will improve the safety and stability of the banking sector.

As originally implemented, the Volcker Rule was a complex regulation that created unnecessary burdens that did not fully support safe-and-sound banking practices and impeded the ability of large banks to serve their clients and support liquid markets.  Time and objective experience proved to regulators that these problems were real and that changes were needed.  The changes that were recently made to the Volcker Rule are a step in the right direction that will reduce unnecessary burdens and improve compliance while helping large banks meet the needs of their customers and support liquid capital markets in a safe-and-sound manner.

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