The Volcker Rule: Banking and Investment Management M&A Catalyst?
Deloitte Insights video
While there is a lot of focus on what the Volcker Rule prohibits banking entities from doing, it does permit a number of activities such as market making, underwriting, engaging in risk-reducing hedging and transacting in government trading. It is also a challenge to the status quo, which may highlight merger and acquisition (M&A) opportunities in the financial services industry. Tune into this episode of Deloitte Insights to learn more.
It’s time for Insights, a video news production of Deloitte LLP. Now here’s your host, Sean O’Grady.
Sean O’Grady (Sean): Hello and welcome to Insights. The Volcker Rule is a section of the 2010 Dodd Frank Act named after former U.S. Federal Reserve Chairman, Paul Volcker. The Rule requires banking entities to curtail proprietary trading activities and investments in both hedge funds and private equity funds subject to certain limited exceptions. It is also a challenge to the status quo, which may highlight merger and acquisition opportunities in the Financial Services Industry. Here to discuss the Volcker Rule and its potential impact on M&A is Kim Olson, a Principal with Deloitte and Touche specializing in advising and delivering solutions to financial institutions on risk management, capital adequacy, internal controls, and regulatory compliance. And next to Kim is Jason Langan. Jay is a Partner in Deloitte and Touche’s M&A Transactions Services practice and the national M&A Industry Leader for Financial Services. Folks, thank you very much for joining us today. Kim, I’d like to begin with you and understand what is the Volcker Rule prohibiting.
Kim Olson (Kim): The Volcker Rule is prohibiting banking entities, which are defined as institutions that either accept federal deposit insurance and/or have access to the discount window, from effectively, Sean, doing two things. The first is engaging in proprietary trading and in simple layman’s terms that is where a bank uses its own account to conduct trading strategies basically that are aimed at trying to benefit from short-term price movements or speculate on short-term price movements. The second thing that it prohibits is banking entities from investing in and retaining investments in hedge funds and/or private equity funds, but there are certain limited exceptions to that.
You know, one thing that I want to point out, Sean, is that there is a lot of focus on what Volcker prohibits, but actually it also permits a number of activities, such as market making, underwriting, engaging in risk-reducing hedging, transacting in government trading. Those are all very important things that the Volcker Rule permits and in fact the Volcker Rule views these as vital transactions to the effective functioning of our markets. That said, while banking entities are allowed to do them, one thing that is really important is that they are not allowed to disguise basically those activities or prohibited activities as if they were permitted. Nor, if a banking regulator or a securities regulator determines that those activities are very high risk and/or would affect the safety and soundness of the institution, or the US Financial sector, those prohibited activities could be prohibited as well.
Sean: I want to take a second or two to go back to October of 2011 because there was a 298-page notice that proposed rulemaking on how to go about implementing the Volcker Rule that got a little bit of coverage in the press. And so I was wondering if you could flesh that out a bit more. What were some of the main points there?
Kim: Sure. So, that certainly made a splash in the market, not only because of its length but also within those 298 pages there were over a 400 questions that are put back to the industry for comment and consultation. Really boiled to its essence that the MPR what it’s trying to do, this is short for a notice of proposed rulemaking, what it is trying to do is put forward a compliance framework that is principles based, to help banks determine what are prohibited activities and what are permitted activities under Volcker. And, really sort of, if you were to take a broad brush kind of look at it, there are really three major components that one would need to think about.
The first thing that the MPR does is help to define the universe. Effectively, what is covered under Volcker. They give a three-pronged definition, part of that definition leverages the Basel market risk amendment, and what is included is trading activity there and basically creates the universe of those transactions that would be covered. Now, a couple of things on what is covered there. Really the presumption is that anything that is covered in that universe is prohibited, unless you can prove effectively that it is subject to an exclusion, that exemption criteria apply, and that the banking organization has the appropriate compliance regime.
The second component to think about is how a banking entity would then determine if some of those activities are permitted. Do the exclusions apply? Can they apply the exemption criteria for things such as market making and underwriting and hedging. And if so, one can determine that some of those would be permitted, the third component then would be the compliance regime, and here depending on size, effectively a banking organization may have to cover off on six different points, including having really robust internal controls, having policies and procedures, having independent testing basically that there is a compliance regime in place, and CEO review.
One of the things that I would say though that has really got the attention basically of the market is for organizations that have one billion in trading assets and over, they will be subject to calculation and reporting of quantitative metrics. And in fact, for institutions with five billion in trading assets and over, they would have to do 17 metrics, pretty much daily, reporting them monthly basically to show that those activities are consistent with the characteristics defined with what goes on in permitted activities. So, it is a pretty broad brush. It is a pretty intensive, if you will, framework that certain banking organizations would have to abide by.
Sean: Now sticking with that trading thread though, are there any conditions where private equity, hedge funds, they come back into play?
Kim : Yes, there are actually certain conditions wherein a banking entity is able to make those investments; there are a number of them. I think three to really focus on are as follows:
The first is that the bank must offer those funds or organize those funds, solely in connection with bona fide trust, fiduciary, and investment advisory activities, and solely to customers of such services. The second condition that has to be met is that the bank cannot guarantee or otherwise insure the fund or the performance of the fund and the fund cannot share the name of the banking entity.
And the third thing, which really has gotten a lot of play in the press, are that these investments must be de minimis, and they are subject to two hard quantitative limits. One is at the fund level. Basically the bank cannot own more than 3% of the fund after the first year. During the first year of its investment, it can own up to a 100%, but after that, it would have to reduce it to 3%. The second is an aggregate. All of these investments and hedge funds and private equity funds cannot exceed 3% of the Tier-I capital of the banking entity. If the banking entity can live in those parameters, it can then invest, basically, in hedge funds and private equity funds.
Sean: I would like to move the conversation over to Jay, because he has been standing by a little silently over there. So, my first question for you is, as a result of the Volcker Rule being put in, are you seeing any significant areas that are picking up in M&A activity?
Jason Langan (Jason): I think to couple to Kim’s point that the quantitative limits from a fund, or investment management perspective, is going to spur a lot of activity in private equity and hedge funds. We have seen some of that so far, more on the management buyout side, I think we will see more of that continue as the next 12 months unfold. And I also think, going back to Kim’s point earlier, I think the quantitative metrics around market making is going to have some folks consider potentially spinning off those operations if the compliance obligations are so stiff that it is not worth, or the ability to comply is so difficult, that it might be better off moving that operation outside of the banking environment.
Sean: And as the Volcker Rule has been weaving its way through organizations, are there any surprises that are coming your way?
Jason: I think I have two so far, Sean. I think the first one is that really nobody has been able to monetize proprietary trading business, and looking back trying to extend that on its own in some broker-dealer has a lot of complications – the largest being the capital requirements. So, I think that it kind of erodes any shareholder value in terms of being able to sell the business given the requirements from a capitalization perspective. Secondly, it is the inability of the sellers to properly market these assets. We are seeing a lot of struggle working with buy-side clients and getting quality data and quality analysis. I think the level of preparation given all that is going on with the regulatory changes and environmental changes for banks and securities firms, they have not had the time and resources dedicated to properly preparing seller and I think we are seeing a lot of bidders walking out of the process because they just can’t get the data they need to get comfortable with the asset.
Sean: Kim, do you have any thoughts on that as well.
Kim: I would like to sort of echo a point that you made earlier. Which is, effectively, as institutions, especially on the trading side go through what is permitted, if they start to find gray areas, I think they will beg the question – do you really want to be engaged in this business? Is the compliance too expensive for certain activities that you might have to de-conform. And I think you could potentially either see divestures or spinning off basically of those businesses as well.
Jason: Especially folks in the one and five billion dollar thresholds. That is going to be a lot of compliance headache; it might not be worth it. That is an asset people might be interested in buying , you know prop trading was not something that was very sellable. Market making and that more of a fee type of business, it has I think much more great of an appetite for buyers out there.
Sean: Let's walk down that path a little bit. What’s the profile of a seller?
Jason: I think the seller is somebody who is a bank that has diversified its operations over the last five to 10 years, and it is not just the top of the house. You look at mid-market banks, they have done a lot of different things, whether it is insurance advisory, investment management, fund sponsorship, prop trading, market makings. I think if somebody has A) has capital limitations, they need to raise capital outside of Volcker, and then you apply Volcker, and they are doing activities that aren’t permissible any longer and they have to divest.
Sean: And then on the other side of course what does a buyer look like. What is that profile.
Jason:Jason: The great thing about what’s being sold in Volcker is the limitations of who can own, mainly private equity aren’t there. They would be as a pure banking enterprise. So I think you will see both kind of corporate investment management complexes, be it buyers here especially folks in mutual fund management.
It expands their product offering, fills in some niches, gets some greater wallet share of the high net worth client and I think private equity can play in there. Interesting part of the private equity is that it is going to be interesting where they play. Do they play as a fund investment? Or they play at the corporate level and have a complementary service offering. We have seen a lot of similar activity in the marketplace today, not just offering private equity investments but may be offering a hedge product as well. It is going to be interesting to see where those assets get moved.
Sean: I would agree that it is going to be interesting where and I guess my last question is when, so what is the timeline surrounding the Volcker?
Kim: So, Sean that is a really interesting question. The statutory effective date is July 21, 2012. So that is the day banking entities are supposed to be ready to go. Now, there are a couple of complications that I think are important to think about.
The first is the final rule is not yet out. So, we have an MPR out. The comment period ends January 13, 2011, and I think one can imagine that there are going to be a number of comments that come back. So, it probably will take the regulatory agencies a bit of time to digest what has come back before they finalize basically the rule. Say that comes out in March, who knows exactly what it is going to come out. But that does not really leave a lot of time to adjust, basically, to the final requirements.
Another point that is also interesting to consider is that after the final effective date, banking entities have a two-year period with then which they can conform their activities. There is a bit of a question of what exactly do you have to have done by July 21, 2012. So, conforming your existing activities, does that mean things that are on the books and that you need to be able to show how you would get to the plan to be in conformance, or does that mean that you could actually engage in some proprietary trading if it were part of a strategy to conform their existing activities? Basically, I think the legal community has a number of different views about how to interpret that and it is not necessarily clarified in the MPR. So, I do know that folks are waiting to have the clarity on that.
Jason: I think it is interesting that the businesses that need to be divested are very profitable for the banks. So, I think there have been two schools of thought. One is to be a good corporate citizen and move it quickly. Others are, let's build capital and keep those profits and where we have to comply, we comply. We have seen different paths a lot of clients are taking in terms of how they want to comply with the rules.
Kim: But with that said, one last bit that I would like to add there though, is because it is a statutory effective day, banking organizations are thinking about “what would I have to do?” At a minimum, they would need to be able to say what would be permissible, what wouldn’t be permissible, what would be my plan to get where I need to go and what type of requirements do I need to think about or the changes basically to my compliance regime, to my infrastructure, to how I supervise my trading and my investments basically in funds. That is all work that needs to happen in the interim period and is something that is being focused on.
Sean: Clearly something to keep on the radar with all this elasticity and ambiguity.
Well folks thank you very much for joining us today. We have been talking about the Volcker Rule and its impact on M&A activity with Kim Olson, a Principal in Deloitte and Touche and Jason Langan, a Partner in Deloitte and Touche’s M&A Transactions Services practice.
If you would like to learn more about Kim, Jay or any of the topics discussed on today’s broadcast, you can find that information on our website at www.deloitte.com/insightsus. For all the good folks here at Insights, I am Sean O’Grady. We will see you next time.
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