In a letter to the SEC on the proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act, the Senate co-authors of the provisions said that the Volcker Rule is intended to be a modern version of the Glass-Steagall Act. In the letter, Senators Carl Levin (D-MI) and Jeff Merkley (D-OR) urged the SEC and banking agencies to eliminate unjustified exclusions and exemptions, such as proposed hedging exemptions related to bank investments in private funds. Rather than creating exemptions that place activities entirely outside the Volcker restrictions, the final regulations should, if standards for designating a new permitted activity are met, use that mechanism to address the activities at issue.
The Senators also said that the final regulations should apply capital charges and conduct-based restrictions to ensure that banks engaging in permitted activities are not taking undue risks. These tools, which regulators should not ignore, could be used to reduce risk when banks engage in securitizations or other complex financial transactions in which regulators have no reliable risk analysis.
Moreover, the final regulations should better align competitive interests with compliance interests. Disclosure of risk modeling and asset portfolios should be used as a tool to prevent evasion of the Volcker restrictions and reward compliance. Investors and customers, including mutual funds and pension funds, should be able to see a bank’s metrics and evaluate whether the bank is engaging in high risk activities. And trading partners should know the risks that their counterparties pose to them. Disclosure can make compliance and financial stability a competitive strength, reasoned the Senators, as it realigns bank management incentives away form dangerous risk taking and towards serving clients.
The proposed regulations fail to address the issue of seed funds, said the Senators, despite clear statements of congressional intent that they do so. The regulations need to clarify that either the bank must locate other investors from the fund’s inception so that it stays within the three percent limit or provide additional limits on the initial capital investment to carry out Dodd-Frank’s intent. The Senators suggested that the final regulations establish a clear limit on the amount of seed funds that a bank may provide to a new fund, adding that a maximum amount of $10 million would be sufficient for a fund to build a track record to attract other investors. In addition, the final regulations should prohibit any investment that would exceed the statutory three percent limit one year after a new fund is established.
The Senators also urged that the final regulations require the directors and CEO of the bank to make an annual assessment and sign a certification of the effectiveness of the bank’s internal controls and policies to implement the Volcker Rule. They believe that the annual assessment and certification would facilitate regulatory oversight and encourage effective implementation by encouraging the tone at the top, which the Senators described as one of the more powerful ways to change the culture of a firm.
The proposed regulations set forth principles and then direct banks to figure out for themselves what is and what is not proprietary trading., said the Senators, an approach they described as putting ``the fox in charge of designing the hen house.’’ They suggested that the final regulations should provide clear guidance through rebuttable presumptions based on asset classes of which activities fall within the scope of a permitted activity and which do not. In the Senators’ view, this approach would enhance consistency across the banking sector and enable banks to structure their operations with increased comfort that they are complying with the Volcker Rule.
This approach would also lower the regulatory burden by allowing for the streamlining of compliance requirements for activities covered by the presumptions, said the Senators, while at the same time enhancing the ability of regulators to indentify and focus on risky activities and violations.
The Senators also said that the proposed definition of trading account is far too narrow to carry out the intent of the Volcker Rule. Although the proposed regulations set out to capture trading positions taken to lock-in short term types of arbitrage, they said the regulations take an overly narrow view of ``short term,’’ defining it as a period of 60 days or less. The Senators urged that the final regulations extend coverage to accounts where positions are taken for up to one year. Using an overly narrow time period would invite gamesmanship, they warned, and defeat the intent of Dodd-Frank.
Moreover, the raft of exclusions from the definition of trading account for a variety of transactions, such as repurchase agreements and trades in actual commodities, are ill-advised and should be stricken. These exclusions are not contemplated by Dodd-Frank and would create new complexities.
Similarly, the proposed exclusion from the trading account for transactions undertaken to manage liquidity needs is highly troubling, said the Senators, since it has no statutory basis and would add enormous complexity to the definition of trading account. Liquidity management is already the subject of upcoming Basel Committee and Dodd-Frank proposed rules to reduce risks.
Thus, the Senators suggested coordinating the two sets of rules so that liquidity management transactions are undertaken in low risk, conflict-free ways. For example, a well-designed implementing regulation could create incentives for banks to use liquidity management transactions that involve the trading of government securities, which is a low-risk activity already permitted by the Volcker provisions.
Another troubling exclusion with no statutory basis is the one from the definition of trading account for positions taken in the course of acting as a derivatives clearing organization. It was unclear why positions taken by a registered derivatives clearing organization in the course of its clearing operations would be less in need of monitoring than other positions undertaken by a bank. While derivatives clearing organizations are subject to special rules related to carrying out their duties, that is no reason to exclude their trading operations from review for proprietary trading, high risk activities, or conflicts.
Another weakness of the proposed regulations, in the view of the Senators, is their failure to address the issue of underwriting versus market making. They urged regulators to clarify that when a bank is trying to sell clients financial instruments that it originated, rather than facilitating a secondary market for client trades in previously existing financial products, its activities should be analyzed in the context of permitted underwriting activities rather than permitted market making activities.