Loosening of Volcker Rule Gives Banks Flexibility with Hedge, Private Equity Funds 

July, 2020 - Kevin Tran, Marc Adesso

On June 25, five federal regulatory agencies, including the federal banking agencies,[1] finalized changes to the Volcker rule that reduce margin requirements for derivatives trades and loosen restrictions on banking entities’ ability to invest in, sponsor or maintain certain relationships with hedge funds and private equity funds — known as “covered funds” under the Volcker rule. These changes, effective on October 1, 2020, follow modifications to the Volcker rule in 2019 that simplified proprietary trading restrictions.

Adopted following the 2008 financial crisis, the Volcker rule refers to section 13 of the Bank Holding Company Act, which was added by section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. (“Dodd-Frank Act”).[2]The law aimed to limit bank’s trading and investment activity that was deemed as risky by prohibiting them from using their own accounts for short-term proprietary trading and from acquiring ownership interests in covered funds (effectively, attempting to reinstitute the divide between commercial banking and more risky investment banking that existed under the Glass-Steagall Act).[3]Such speculative trading and investing activity by banks were also viewed as ultimately harmful to the financial system and a significant contributing factor to the crisis. To that end, regulators finalized the initial iteration of the Volcker rule in 2013 (and became effective on January 1, 2014), which generally prohibited any banking entity from engaging in proprietary trading or retaining an ownership interest in, sponsoring, or having certain relationships with covered funds, subject to certain exemptions that allowed for, among other activities, certain market-making, underwriting, hedging, trading and investment and investment advisor activities. In addition, the rule requires banking entities to submit periodic disclosures and develop and maintain internal compliance programs consistent with the extent to which it engages in activities covered under the Volcker rule.

Since its implementation, the Volcker rule has received wide criticism for being overly complex with broad restrictions on banking activities not intended to be captured by the statute. In implementing the Volcker rule, regulators were perceived to have an unnecessarily broad purview that increased compliance costs for banks, while simultaneously inhibiting access to capital and diminishing market liquidity. Further complicating the rule’s implementation were accusations that a robust cost-benefit analysis did not inform the development of the rule. Though few within the banking industry at the time argued that no regulation was needed, the sweeping changes ushered in by the Volcker rule led banks not only to curb activities clearly prohibited by the rule but also to stop providing certain services not otherwise explicitly prohibited under the rule due to fear of running afoul of the Volcker rule.

The modifications to the proprietary trading restrictions and disclosure requirements in August 2019 and the subsequent loosening of covered fund restrictions in June 2020 by the five federal regulatory agencies reflect an acknowledgment that the Volcker rule’s overly broad scope and the need to tailor the rule in a manner that addresses the activities the statute intended to limit. Although the August 2019 changes to the proprietary trading provisions were significant for banking entities,[4]loosening of covered fund restrictions likely will result in more impactful changes to banks. Among other changes, regulators intend for the final rule to streamline covered fund-related activities by (i) modifying the definition of “ownership interest” to exclude certain debt exposures to a covered fund, (ii) permitting certain low-risk transactions between a banking entity and a related covered fund, including intraday credit and payment, clearing and settlement transactions, (iii) broadening the scope of investment activities a banking entity would be permitted to conduct with respect to covered funds, such as investments in venture capital funds and long-term debt funds, and (iv) limiting the extraterritorial impact of the Volcker rule on foreign funds (i.e., funds offered by non-U.S. banks to non-U.S. individuals).

Among the changes described above, likely of particular interest to banking entities is the clear expansion of permissible activities related to covered funds. As intended under the Volcker rule, banking entities unwound many of their covered fund activities to comply. In addition, banking entities reduced engaging in activities that could otherwise be viewed as beneficial to the public, such as investing in funds dedicated to improving rural business opportunities or, more generally, development of services and products to benefit public welfare. The loosening of restrictions make it possible for banking entities to extend credit and provide other traditional banking services to related covered funds and removes barriers to banking entities investing in rural and low-income communities and providing small businesses with access to capital. For example, the modifications will permit banking entities to invest in, among other vehicles, venture capital funds.[5]Venture capital investing, by its nature, involves a high level of uncertainty and speculation as well as a high risk of failure involving significant variability in the outcomes of startup ventures and in the performance of venture capital portfolios. Given the breadth of venture capital funds captured under the Investment Company Act’s definition, the universe of funds that a bank could invest in is wide, including many funds that are exempt from regulation under the Investment Company Act itself. As a result, critics of the rollback claim that the changes unnecessarily increases risk to the U.S. banking system by removing safeguards that prevent banks from engaging in the types of risky behavior that contributed to the 2008 financial crisis. However, even with the changes, banks cannot engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or within the overall U.S. financial system. Furthermore, covered fund activities remain subject to robust risk-based capital requirements.

 

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