Dodd-Frank Act Two-Year Anniversary
Five takeaways on Dodd-Frank’s impact on the Volcker Rule
As we approach the two-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), it’s worth pausing for a moment to take stock of how it has already influenced the financial services and banking industries, and what may lie ahead. Today, its full impact remains to be seen – financial services institutions are still grappling with the enormity and complexity of the 2,300-page law. And regulators from numerous federal agencies are still writing many of the rules that are anticipated to affect different corners of the industry, which may contribute to uncertainty.
At the same time, after two years its impact has become clearer. For example, a cornerstone of the Dodd-Frank Act is a rule, proposed by Former Federal Reserve Chairman Paul A. Volcker, designed to mitigate future systemic risks. Section 619 of the law, commonly referred to as the Volcker Rule, bars banking entities (that receive federal deposit insurance and/or have access to the discount window) from engaging in proprietary trading in which they use their own capital to assume “principal” risk to benefit from near-term price movements. It also forbids certain fund activities, such as investing in or sponsoring hedge and private equity funds (although certain exemptions could apply). The Volcker Rule becomes effective July 21, 2012, which prohibits banking entities from engaging in new proprietary trading and covered funds activities. But they have two years – until July 21, 2014 – to conform existing activities to comply with the prohibitions.
A Final Rule that sets forth the compliance requirements for the Volcker Rule has not been released. In April 2012, the agencies issued guidance for the conformance period, which states that banking entities should engage in “good faith” compliance efforts. As part of such efforts, they must evaluate the extent to which they are engaged in covered activities and investments. Plus, they must develop and implement a conformance plan “that is as specific as possible” to fully comply and conform their covered activities and investments before July 21, 2014. Yet, many banking entities are still left with questions over how “good faith” will be interpreted in complying with the requirements, how to distinguish permitted activities from proprietary or covered investments, and steps they need to take fully comply.
For financial services executives working to understand where they should be focusing when it comes to the Volcker Rule, here are five important observations.
The Volcker Rule is here to stay. The real question is how stringent will it be?
In April 2012, some banking entities thought there might be a softening of the Volcker Rule. But recent industry, political, and regulatory events suggest that the requirements could be as stringent as those proposed in the Notice of Proposed Rulemaking (NPR) released on October 11, 2011 – or even more so. Banking entities are still left wondering about not just when the requirements will be released, but just how hardened and forceful they will be. They’re also asking other questions regarding what constitutes a “good-faith effort” when it comes to complying with the requirements, and how that will be enforced. The pace at which banking entities are developing conformance plans to bring their activities and investments into compliance and the relative specificity of the plans differs across the industry. For some, specific actions will be predicated on the Final Rule.
Banking entities need a clear understanding of all activities in their trading universe
Do banking entities really understand what could be deemed proprietary trading in light of the Volcker Rule? The statute allows them to engage in so-called permitted activities, such as market-making, underwriting, and risk-mitigating hedging. While those activities are undertaken for very different purposes and intents than proprietary trading, they can actually take on similar characteristics. This could leave banking entities and traders in a bit of a quandary if they don’t know – and can’t distinguish – their permitted activities from prohibited proprietary ones. Some banking entities are further ahead than others by applying the proposed exemption criteria set forth in the NPR to assess whether their trading activities would be considered permitted. But if they don’t know, or can’t identify, proprietary trading activities, regulators may assume they’re not making a good-faith effort to stop new proprietary activities. Without a clear view of these activities, banking entities could find it more difficult to comply with the rules.
Banking entities will need to develop quantitative measurements to identify trading activity
Banking entities will eventually need to scrutinize their trading unit levels to figure out how to distinguish between permitted and prohibited trading activities. Metrics are likely to be a fundamental part of helping them achieve this objective. Calculating these metrics will depend on data, their risk management system, and their reporting ability. The Volcker Rule proposes that banking entities with more than $5 billion in trading assets and liabilities will have to produce 17 metrics, while institutions between $1 billion to $5 billion will have to produce eight metrics. Since entities have varying abilities in producing needed data, determining some of these metrics could prove challenging.
Additionally, banking entities will need to implement appropriate oversight and accountability, independent testing, recordkeeping, and training for traders and other relevant employees. All of this means that banks will need to think hard, provide adequate resources, conduct thorough analyses, and dedicate themselves to developing and implementing the most effective compliance regime for their trading platform.
The Volcker Rule will likely change how trading is conducted within banking entities
The NPR points out that banking entities must have specific policies and procedures in place that detail what can be traded, how it can be hedged, what risks can be taken, and how traders are compensated. Not only will these policies and procedures require diligence and hard work to write up, but they are anticipated to change how trading is conducted within a banking entity. Additionally, banking entities will need to design controls to monitor and identify potential areas of noncompliance.
Who will oversee compliance of the Volcker Rule within covered banking entities?
A number of banking entities have established steering committees, which seek to assess the NPR’s impact and their compliance readiness. The big question is: Who will oversee Volcker Rule compliance on an ongoing basis? Compliance will likely require personnel with deep experience and skill sets in the quantitative, risk, finance, legal, and compliance areas, robust information technology systems, and effective and efficient operations. Banking entities will need to create a structure and management framework that articulates the role and responsibilities of those overseeing compliance. This will be essential as they move forward on the Volcker Rule.
Because there’s a lot more to know about the Dodd-Frank Act, these takeaways are presented as part of a series of issue-focused insights into the impact of this legislation. Deloitte has released in-depth look at the law’s potential implications in other areas such as compensation, stress testing, consumer protection, derivatives, and living wills. For more information, please visit us at Financial Regulatory.
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