FORGING A BRAVE NEW WORLD: REMODELING U.S.
BANKING REGULATIONS AFTER THE CRISIS
Jacopo Crivellaro
I.
INTRODUCTION
The financial crisis of the past five years inspired the American Congress to enact the Wall Street Reform
and Consumer Protection Act (“Dodd-Frank Act”) with the intent of radically reforming the financial and
corporate regulatory system. The demise of leading financial institutions and the unprecedented outlay of
public funds to save the financial economy from collapsing have paved the way for the more substantial
reform of the banking industry since the Glass-Steagall Act of 1933, itself a product of the Great
Depression. In particular, the Volcker Rule (Section 619 of the Dodd Frank Act)1 and the Regulations
proposed by the Treasury, Federal Reserve, Federal Deposit Insurance Corporation (“FDIC”) Securities
and Exchange Commission (“SEC”) and the Commodities and Futures Trading Commission (“CFTC”)
seek to restrict banks from engaging in proprietary trading and from sponsoring, acquiring or retaining an
ownership interest in a private fund as well as engaging in covered transactions with these affiliated
funds.
The Volcker Rule seeks to reduce the risk appetite of banks shifting the hazard of transactions to
institutions which do not benefit from federal support. In essence, banks will be prevented from abusing
the advantages of deposit insurance and access to emergency lending facilities to invest in speculative
short-term trading or private fund investments which are not related to their customer’s business.2
According to its architect, former Chairman of the Economic Recovery Advisory Board Paul Volcker:
[the Rule] “is designed to deal with the problem of too big to fail and the related moral hazard that looms
so large as an aftermath of the emergency rescues of financial institutions, bank and non-bank, in the
midst of the crises.”3
The breadth of the Volcker Rule proposed regulations, and the regulatory burdens they impose on
international ‘banking entities’ has raised the concern of non-U.S. actors. Moreover, the rule’s extraterritorial effect and the limitation on U.S. banks from dealing in foreign financial products has the
potential to gravely compromise foreign capital and financial markets.
1
Dodd-Frank Wall Street reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010)
adopted as Section 13 of the Bank Holding Company Act.
2
Donna M. Parisi, In the Eye of the Beholder: The Volcker Rule Proposal and What it Means, Practising Law
Institute, Understanding Financial Products 2012, Feb. 6-7, 2012, 1928 PLI/Corp 49.
3
Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies: Hearing Before the
S. Comm. On Banking, Housing and Urban Affairs, 111th Cong. 1 (2010)(statement of Paul Volcker, Chairman of
President’s Economic Recovery Advisory Board).
1
II.
VOLCKER RULE PROPOSED REGULATIONS – PROHIBITION ON
PROPRIETARY TRADING
The proposed regulations4 apply to ‘covered banking entities’5 including non-U.S. ‘bank holding
companies’.6 These entities are prohibited from engaging as principals in the purchase or sale of a
covered financial position (effectively, engaging in proprietary trading).7 A series of exceptions permit
trading in particular instruments (U.S. government and agency obligations) and in particular activities
(underwriting, market-making, risk-mitigating hedging, trading on behalf of customers, trading outside
the U.S. by non-U.S. banking entities).
The impossibility to dissect large financial institutions into smaller banks whose failure would not
systemically imperil the economy, persuaded the Obama administration to favor a transactional rather
than structural regulation of banking activities. Thus, rather than restricting investment activities for
commercial banks on an entity basis as the Glass-Steagall Act had done, the Volcker rule seeks to prohibit
banks from undertaking particular transactions. Yet, restricting investment activities depending on the
nature of the transaction necessarily relies on definitions and a high degree of regulatory sophistication.
The difficulty of drawing a bright line to discriminate between permissible and impermissible market
making or illegitimate risk-mitigating hedging has raised concerns that this standard has not been met.
Moreover, the possibility of concealing principal-trading as trading on behalf of customers has been
voiced as a substantial loophole in the regulatory scheme, as well as a weakness of the undue reliance on
definitions.
From an international perspective, the Volcker Rule restriction on proprietary trading has been heatedly
criticized. First, the instrument-based exception for U.S. Government obligations does not apply to
foreign Government bonds. Secondly, the exception for trades undertaken outside the U.S. by non U.S.
banking entities is perceived as unduly restrictive.
A. Foreign Sovereign Debt Bonds
U.S. Treasury Bonds were exempted from the application of the Volcker rule because of the long-lasting
commitment of domestic financial institutions in the Treasury bond market, and because of the
insignificant banks losses reported by their exposure to Treasury bonds during the crisis. Thus, there
seemed little reason to disrupt the practice when it could potentially hinder the liquidity of the U.S.
government debt market.
However, a similar reasoning was not adopted for foreign sovereign debt. No distinction was drawn
between the nationality of the foreign debt, and a blanket-wide exemption prevents banks from
4
Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge
Funds and Private Equity Funds (proposed Oct. 11 and 12, 2011) (to be codified at 12 C.F.R. pts. 44, 248 & 351 &
17 C.F.R. pt. 255) (the Proposed Regulations), available at http://www.occ.gov/newsissuances/newsreleases/2011/nr-occ-2011-126a.pdf.
5
Defined as ‘any insured depository institution’ (banks chartered under U.S. law whose deposits are insured by the
FDIC)
6
As defined by Section 8 of the International Banking Act of 1978 (non-U.S. banks that have a U.S. branch or
agency or control a commercial lending company).
7
A covered financial position is defined as a long, short, synthetic or other position in a security, derivative, contract
of sale of commodity for future delivery or option.
2
undertaking proprietary trades on the London gilt market or Japanese Government Bonds for example.
Restricting U.S. banks from trading in foreign government securities might gravely affect the liquidity of
these markets. In some cases, U.S. banking entities operate as primary dealers in non-U.S. sovereign bond
markets and there are not financial institutions present which might readily replace that activity.8 A
decrease in the demand of foreign sovereign bonds will raise borrowing costs for governments and may
exacerbate troubles for the European countries already impacted by the sovereign debt crisis.9
The federal agencies may expand the current exceptions to the proprietary trading prohibition only if so
doing would promote and protect the financial stability of the U.S..10 A less liquid market for international
sovereign debt would affect the global economy indirectly, with the impact on U.S. financial stability
which can only be speculative. Thus, the statutory authority for regulators to craft such an exception may
be questionable. Moreover the bankruptcy of MF Global Holdings, a New York based financial
derivatives broker heavily invested in the European bond market, highlights how sovereign debt holdings
may not be as safe as expected.
Perhaps, concerns for trading in foreign debt securities may be assuaged if restrictions on the nationality
of the bonds were introduced (i.e. only bonds of G20 countries) or if only bonds which could qualify as
Federal Reserve Bank collateral were accepted.
Alternatively, U.S. banks may continue to invest in foreign sovereign securities as long-term investments
(rather than for speculative proprietary trading). Furthermore, it may be possible for U.S. banks to
continue trading on foreign government securities insofar as their activity constitutes legitimate marketmaking. Yet, this would require a substantial commitment of U.S. banks given the onerous reporting
obligations triggered by the market-making exception. Thus, the Japanese Bankers Association has filed
comments urging clarity in the definition of market making and a relaxation of regulatory burdens for
U.S. banks involved in the market making of foreign sovereign debt.11
B. Trading outside the U.S. by non-U.S. banking entities
The Volcker Rule exempts non-U.S. banks from engaging in proprietary trades if performed by non-U.S.
entities primarily engaged in business outside the U.S. and the transaction occurs “solely outside the
United States.” The territorial restriction is met only if (a) the trading entity is organized under non-U.S.
law, (b) no party to the transaction is a resident of the U.S., (c) no personnel involved in the transaction is
physically located in the U.S., and (d) the transaction is executed “wholly outside of the United States.”
The exception embodies the twin purposes of the Volcker Rule: financial stability for U.S. banks without
unduly affecting non-U.S. banks in their foreign dealings.
8
Testimony of Mark Standish on Behalf of The Institute of International Bankers Before the U.S. House of
Representatives Subcommittee on Financial Institutions and Consumer Credit Subcommittee on Capital Markets and
Government Sponsored Enterprises Committee on Financial Services “Examining the Impact of the Volcker Rule on
Markets, Businesses, Investors and Job Creation” (Jan. 18, 2012) available at
http://financialservices.house.gov/UploadedFiles/HHRG-112-BA-WState-MStandish-20120118.pdf.
9
Bank of Canada Comments to the Volcker Rule, (Feb. 13, 2012) http://www.bankofcanada.ca/wpcontent/uploads/2012/02/volcker_rule_130212.pdf.
10
Dodd-Frank Act § 619(d)(1)(J); BHC Act § 13(d)(1)(J).
11
Japanese Bankers Association Comments to the Volcker Rule, (Jan. 13, 2012) http://www.sec.gov/comments/s741-11/s74111-69.pdf.
3
The rigidity of the territorial restriction - with a trade prohibited if it implicates minimal contacts with
U.S. personnel or banking entities – has been harshly criticized. Rather than the geographic bright line
rule, the International Institute of Bankers (“IIB”) proposed focusing on a standard of where the risk of
the activity is located and where the ultimate mind and management for the relevant trading activity
rests.12 This would allow financial transactions which have minimal or insignificant ties with the U.S..
Insofar as the Volcker Rule seeks to safeguard the stability of the U.S. financial markets, the blanket rule
against U.S. marginal links appears over-extensive. In many cases, ancillary U.S. links are chosen
because of legitimate business concerns (i.e. to take advantage of time hour differences) or the stability of
the underlying financial sector, without necessarily transferring the risk of the transaction to the U.S.
entity.13 In these cases, a restriction on permissible non-U.S. proprietary trading with limited U.S. links
will restrict the flow of capital without a comparative benefit of increased stability to the financial sector.
A rigid enforcement of the current rule would significantly affect the dynamics of financial transactions,
reducing the appeal of the U.S. as an international financial center. Insofar as U.S. firms are restricted in
their operations worldwide, the impact on global liquidity might undermine rather than promote the safety
and soundness of U.S. banking. On the other hand, a less restrictive policing of the Volcker Rule in its
territorial nexus would raise innumerable questions of where the line is to be drawn.
III.
VOLCKER RULE PROPOSED REGULATIONS – PROHIBITION ON
INTERESTS IN PRIVATE FUNDS
The second limb of the Volcker Rule restricts a banking entity from acquiring or retaining any ownership
interest in, or sponsoring a covered fund, whether directly or indirectly.14 A “covered fund” is an issuer
that would be an investment company for the purposes of the Investment Company Act of 1940 but for
the exceptions of Sections 3(c)(1) or 3(c)(7). This includes both private equity funds and hedge funds.
“Similar funds as the appropriate agencies may determine” may also be included within the ambit of the
rule. This provision has been read to include commodity pools as defined by the Commodity Exchange
Act of 1936 and foreign issuers which would be considered “covered funds” if they offered securities
under the laws, or to residents of the U.S. Essentially, this encompasses private funds (private equity or
hedge funds) which would otherwise avoid categorization as “covered funds” merely by limiting their
offerings of securities to non U.S. residents.
The rule does not restrict banks from an acquiring or retaining an interest in the fund when operating in
good faith as a fiduciary, custodian, broker or agent for an unaffiliated third party. Moreover, there is a de
12
Institute of International Bankers, Comments to the Volcker Rule (May 10, 2011)
http://www.sec.gov/comments/df-title-vi/prohibitions/prohibitions-41.pdf.
13
Institute of International Finance, Comments to the Volcker Rule (Feb. 10, 2012)
http://www.iif.com/regulatory/comment/article+1046.php. The IIB Report suggests non-U.S. affiliates of
international banks should be permitted to trade in (1) U.S. securities and other assets, and in derivatives with U.S.
reference assets and (2) on U.S. exchanges and/or with U.S. counterparts. Moreover, non-U.S. banking entities
should be permitted to use U.S. agents and brokers insofar as the principal risk for the transaction is not shifted to
the U.S. IIB Comments, supra.
14
Ownership interest is broadly defined to include any equity, partnership or similar interest whether it is entitled to
voting rights or not, and including any derivative of such interest.
4
minimis exception for investments which comprise in the aggregate less than 3% of the bank’s Tier 1
Capital as and do not exceed 3% of the outstanding ownership interest of the fund.
A. Definition of “Covered Fund”
As currently worded the scope of the private fund exemption appears worryingly over-extensive. It affects
foreign non-U.S. registered investment funds which are not what the Volcker Rule seeks to target because
of their potentially deleterious effect on the economy.15 Retail funds and SICAV in Europe, Public Funds
in Canada would all be encompassed by the current regulations – prohibiting investments by U.S. banks
and conversely, prohibiting their marketing to American investors. This will hinder the development of
these funds as both U.S. and non-U.S. financial firms with asset management activities will have to
rebrand their non-U.S. covered funds and will often be forced to severely restrict their holdings.16
B. Transactions outside the United States
Investments by non-U.S. banks in “covered funds” are permissible insofar as no ownership interest in the
fund is offered for sale or sold to a resident of the U.S. and the activity occurs solely outside of the U.S..
Similar to the proprietary trading exception, the geographical standard is extremely demanding.
Moreover, requiring that no personnel be located in the U.S. for the transaction is seen as both an
excessive precaution and an inefficient safeguard.17
IV.
VOLCKER RULE PROPOSED REGULATIONS – TRANSACTIONS WITH
COVERED FUNDS
The Volcker Rule also restricts banks that serve as investment managers, investment advisors, commodity
trading advisors or banks that organize and offer a covered fund from entering in transactions with the
covered fund, insofar as these transactions would be defined as a “covered transaction” for the purposes
of Section 23A of the Federal Reserve Act. Thus, banks are prohibited from loaning to an affiliated
covered fund, investing in securities issued by an affiliated covered fund (and similarly accepting
securities from an affiliated fund as collateral for the loan) and derivative transactions that cause the bank
to have a credit exposure to the affiliated covered fund.
Concerns are voiced that the agencies should clarify whether the prohibition restricts covered transactions
by non-U.S. banks with affiliated funds outside the U.S.18
15
William J. Sweet. Jr., Dodd-Frank Rulemaking: Volcker Rule and SIFI Proposals Commentary and Insight,
Practising Law Institute, A Guide to Financial Institutions 2012, Mar. 6, 2012, 1936 PLI/Corp 75.
16
The IIB Comments, suggest banking entities should be able to invest in non-U.S. private funds that invest in
portfolio companies, securities or assets globally (including in the U.S.) and utilize U.S. advisers insofar as
ownership interests in the fund are not sold to U.S. residents, and the decision to acquire to retain an ownership
interest is made by the bank’s management and reviewed outside the U.S.. IIB Comments, supra.
17
In fact, the Volcker Rule’s position conflicts with traditional securities regulation in which the presence of U.S.
intermediaries does not affect the categorization of the transaction as non-U.S. based insofar as the securities are not
offered to U.S. recipients. Donna M. Parisi, In the Eye of the Beholder: The Volcker Rule Proposal and What it
Means, Practising Law Institute, Understanding Financial Products 2012, Feb. 6-7, 2012, 1928 PLI/Corp 49.
18
European Banking Federation, Comments to the Volcker Rule, (Feb. 13, 2012) http://www.sec.gov/comments/s741-11/s74111-192.pdf.
5
V.
VOLCKER RULE PROPOSED REGULATIONS – IMPACT ON NON-U.S.
BANKS
Regardless of the soundness of the economic policy choices advanced; regardless of whether limiting
proprietary trading in banks and investments in private funds will significantly improve the stability of the
banking sector without compromising economic recovery,19 the Volcker Rule raises serious concerns for
non-U.S. banking entities. Compliance and reporting burdens are extreme especially when applied to nonU.S. bank foreign subsidiaries.20 In fact, non-U.S. banking entities with minimal U.S. contacts (even just
a single branch or entity) would be subject to the prohibitions on proprietary trading or private fund
investments, or if otherwise permitted to pursue the transaction “outside the United States” are subject to
onerous record keeping and reporting obligations.
Restrictions on U.S. banks substantially impede investments in foreign financial instruments. Justifying
these limitations with the need for greater financial stability seems unrealistic. Prohibiting U.S. banks
from accessing certain financial markets or investing in particular instruments appears protectionist, and
often also places U.S. banks at a comparative disadvantage with foreign banks which are not so
restricted.21
Insofar as the American regulatory approach seeks to shape global banking regulation its success will
depend on coordination with other regulators.22 However, the discomfort expressed by foreign regulatory
agencies for the unilateral regulatory framework is an unwelcome indicator and the inevitable risk of a
“go it alone”[sic] approach.23
The Proposed Volcker Rule Regulations were released in October 2011 and have received an
overwhelming number of responses in the comment period. The Volcker Rule was scheduled to take
effect on July 21, 2012, with a two year grace period before the rule becomes fully operational. Initially,
banks were encouraged to comply with the rule as soon as practicable reserving the two year period to
19
Charles K. Whitehead, The Volcker Rule and Evolving Financial Markets, 42 Harvard Business Law Review 39
(2011)(suggesting the Volcker Rule will increase funding costs for the corporate debt market and hinder the
development of the private equity business); Darrell Duffie, Market Making under the Proposed Volcker Rule, Rock
Center for Corporate Governance, Working Paper Series No. 106, at 5, (the Volcker Rule will hamper “efficient
price discovery, lowering the quality of information about economic fundamentals that is revealed by the markets.”)
20
David M. Lynn, The Volcker Rule: Compliance Considerations, Practising Law Institute: Global Capital Markets
& the U.S. Securities Laws 2012, Apr. 25, 2012, 1951 PLI/Corp 49; Institute of International Finance, Comments,
supra: [the burden is] “disproportionate and unwarranted for activities that occur outside the U.S.”
21
J.P. Morgan Cazenove, Global Investment Banks: Regulatory Arbitrage Series: OW European Over US IBs 24
(2011) https://mm.jpmorgan.com/stp/t/c.do?i=5930E-12&u=a_p*d_558208.pdf*h_-2igf3ms ; Institute of
International Finance, Comments, supra, the restriction not only puts U.S. banks at a “competitive disadvantage …
but will greatly limit such institutions’ participation in these global financial markets at a time when restoring and
deepening liquidity is essential to economic recovery”; Ryan K. Brissette, The Volcker Rule’s Unintended
Consequences, 15 North Carolina Banking Institute 231, 252 (2011).
22
Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies: Hearing Before the
S. Comm. On Banking, Housing and Urban Affairs, 111th Cong. 1 (2010).
23
Masamichi Kono, Vice Commissioner for International Affairs Financial Services Agency, Government of Japan,
and Kenzo Yamamoto, Executive Director Bank of Japan, (Dec. 28, 2011); Julie Dickson, Superintendant, Office of
the Superintendant of Financial Institutions, Government of Canada, December 28, 2011; British Bankers’
Association, Comments to the Volcker Rule, http://www.sec.gov/comments/s7-41-11/s74111-364.pdf (suggesting
the Volcker Rule ignores the primary role for home state regulators to address prudential matters); Margrethe
Vestager, Danish Minister for Economic Affairs and President of ECOFIN, Comments to the Volcker Rule,
http://www.sec.gov/comments/s7-41-11/s74111-456.pdf
6
clarify and fine tune the complexities present in the regulation. However, given the widespread opposition
the Agencies have clarified that they will not insist on compliance until July 2014 and the promulgation
of the Final Rule itself has been delayed until the end of the year.24 It is also likely that the outcome of the
presidential elections will influence the ultimate policy choices taken by the federal agencies.
As a side note, it is worth remembering that even if the Rule were to be validly promulgated the finality
of the regulation is not necessarily guaranteed. In the recent case of Business Roundtable v S.E.C. federal
courts have displayed an unexpected willingness to scrupulously review federal financial and corporate
regulation and vacate rules where they fall short of Congressional standards.25
VI.
CONCLUSION
The Volcker Rule as currently proposed by the five regulatory authorities responsible for financial and
banking institutions in the U.S. is an ominous shadow looming in the imminent future of non-U.S. banks
with American branches or affiliates. Together with the Foreign Account Tax Compliance Account, the
rule furthers an expansive notion of American financial regulation in the hope of preventing future crises.
Whether this will be effective will ultimately depend on the willingness of non-U.S. banks and foreign
regulatory agencies to overcome concerns for the breaches of comity because of the overarching goal of
worldwide financial stability.
24
Shahien Nasiripour, Fed Extends Volcker rule deadline, Financial Times, Apr. 19, 2012,
http://www.ft.com/intl/cms/s/0/ffc56a56-8a4d-11e1-93c9-00144feab49a.html; Final Volcker rule expected by yearend - Treasury official, Reuters Regulatory News, Aug. 21, 2012 http://in.reuters.com/article/2012/08/21/volckertimeline-idINL2E8JL4CB20120821.
25
Business Roundtable v. S.E.C., 647 F.3d 1144, Fed. Sec. L. Rep. (CCH) P 96358 (D.C. Cir. 2011).
7