Securities Regulation Daily SEC, CFTC, and bank regulators vote to propose further easing of Volcker Rule
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Thursday, January 30, 2020

SEC, CFTC, and bank regulators vote to propose further easing of Volcker Rule

By Richard A. Roth, J.D. and Mark S. Nelson, J.D.

The Fed, other banking regulators, and the SEC and CFTC will propose further amendments to the Volcker Rule regulation that are intended to exempt from the rule activities that do not present relevant risks and ease the compliance burden on financial institutions that are engaging in covered activities.

Based on regulatory experience in enforcing the Volcker Rule since it was adopted in 2013, the Federal Reserve Board and other financial regulators plan to propose rule amendments they believe will simplify compliance and enforcement without giving rise to the types of risks the rule was intended to prevent. As described by the Fed’s staff memorandum, the Volcker Rule "prohibits any banking entity from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a covered fund." However, the current regulation has an unnecessary international reach and applies to banking activities that present little or no risk, the agencies believe.

The Office of the Comptroller of the Currency, SEC, and CFTC are expected to propose comparable changes to their rules.

The Fed memo lists six intended effects of the proposal:

  1. The effects of the rule on foreign funds offered by foreign banks to foreign persons would be limited.
  2. Intraday credit, payment, settlement, and clearing transactions between a bank and covered funds it advises or sponsors would be permitted.
  3. Rule provisions on foreign public funds, loan securitizations, and small business investment companies would be simplified.
  4. Banks would be able to invest in or sponsor credit funds, venture capital funds, customer facilitation funds, and other funds that do not present the risks the rule was intended to address.
  5. Credit exposures to covered funds usually would be considered not to be ownership interests in the fund.
  6. Parallel investments by a bank and a sponsored covered fund would not be treated as covered activities.

Extraterritorial effect. The staff memo says that, under the current rule, foreign funds that are organized and offered outside the United States may be treated as covered funds because they are affiliated with a U.S. bank. This would subject the funds to proprietary trading and other restrictions imposed by the Volcker Rule.

The proposed amendment would correct this unintended effect by excluding qualified foreign funds from the rule’s coverage.

Low-risk transactions. The current rule prevents banks from engaging in some transactions that otherwise are permitted by Section 23A of the Federal Reserve Act (12 U.S.C. §371c). The memo says the proposed amendments would change that ban to permit transactions that Section 23A would allow without limit, including intraday credit extensions; the extension of credit that is fully secured by U.S. Treasury securities; and transactions related to payment, clearing, and settlement services provided to the fund.

Covered fund exclusions. The proposed amendments would simplify the eligibility criteria for covered fund exclusions that benefit foreign public funds, loan securitizations, and small business investment funds. The staff memo says this would make it easier for banks to use, and comply with, the exclusions.

Permitted funds. According to the memo, the current rule could prevent banks from owning or sponsoring some types of funds that do not present the types of risk the Volcker Rule is intended to address. The proposal would allow banks to own or sponsor:

  • Credit funds—funds that make loans; invest in debt securities or other assets related to acquiring, holding, servicing, or selling loans; and qualifying interest rate or foreign exchange derivatives.
  • Venture capital funds—funds that invest in small business and startup businesses, but only to the extent the bank would otherwise be permitted to invest in the businesses. Only investments in funds defined as "venture capital funds" by SEC rules would be permitted, and proprietary trading by the funds would be prohibited.
  • Family wealth management funds—Traditional banking and asset management services could be provided to qualified wealth management funds that are owned by members of a single family and up to three other closely related persons.
  • Customer facilitation funds—Some restrictions in the current rule would be eliminated to allow a bank to provide banking or financial services to a customer within a fund structure rather than directly. However, the bank would not be permitted to guarantee the fund’s performance, and it would not be permitted to have more than a 0.5-percent ownership interest in the fund.

Ownership and investment limits. The proposed rule would clarify the rule’s definition of "ownership interest" and the way a bank must calculate its fund investment limit and the capital deduction that results from ownership.

Parallel investments. Under the current rule, parallel investments by a bank and a covered fund might be deemed essentially to be investments in that fund, the memo says. Also, there is a limit on the amount of such an investment the bank is permitted to make. The proposal would provide that a bank would not need to include as a parallel investment any investment that otherwise is permitted by applicable laws and by safety and soundness standards.

Fed meeting statements. At the Fed meeting, Chair Jerome H. Powell and Vice Chair for Supervision Randal K. Quarles issued statements supporting the proposal. Both opined that it would simplify compliance and enforcement without increasing risk. At the FDIC meeting, Chairman Jelena McWilliams expressed the same sentiment and included stronger criticisms of the current rule’s complexity.

However, Governor Lael Brainard disagreed with parts of the proposal. While she said she agreed with the aspects that related to foreign funds, she said that other proposed changes would weaken the rule and allow banks to engage in activities that should be banned. Brainard pointed specifically to the proposal’s provisions that would allow banks to invest in or sponsor venture capital funds and credit funds and that would lift restrictions on parallel investments.

FDIC board member Martin J. Gruenberg agreed with Brainard, saying he would vote against the proposal. Gruenberg said, "It would severely weaken the restrictions on relationships between banks and covered funds. It would reintroduce the types of high-risk investments and activities that contributed to the financial crisis."

SEC divided over venture funds. The proposal drew a similar lack of unanimity from commissioners at the SEC and CFTC. Voting at both agencies largely followed political lines.

SEC Chairman Jay Clayton endorsed the proposal, as did CFTC Chairman Heath Tarbert. For Clayton, adoption of the proposed Volcker Rule changes may address some of the concerns startups have about locating adequate funding. "I believe permitting banking entities to extend financing to start-ups and small and medium-sized businesses through qualifying venture capital funds could benefit the broader financial system by improving the flow of financing to these businesses, while allowing banking entities to compete more effectively with non-bank sources of financing," said Clayton. "Particularly important to me, the proposal could allow banking entities with a presence in and knowledge of the areas where venture capital and other types of financing are less readily available—i.e., ‘between the coasts’—to provide critical financing to businesses in those areas, as they have traditionally done."

But SEC Commissioner Allison Herren Lee characterized the latest proposal as step towards "effective repeal of the Volcker Rule." According to Lee, the proposal would allow two significant expansions: "It would broaden the categories of private funds in which banks can invest—most notably by including venture capital and credit funds. And, it would allow banks to evade certain investment restrictions by permitting a greater degree of ‘parallel investment’ alongside covered funds, thus allowing exposure to these often high-risk holdings."

With respect to venture capital funds, Lee questioned the proposal’s rational for allowing banks to invest in these inherently risky funds. She also questioned the proposal’s use of the SEC’s definition of venture capital fund, which she said could give the SEC inordinate power over banks’ risk taking even though the SEC is not a prudential regulator. She also noted that securities market participants have already called on the SEC to expand the scope of its definition.

SEC Commissioners Elad Roisman and Hester Peirce added their support for what they view as a targeted proposal. "While our preference in amending the Volcker Rule might have been simply to lean on the ‘DELETE key,’ we recognize the legislative mandate and appreciate the more surgical and careful approach reflected in this proposal."

CFTC Commissioner Dan Berkovitz, much like Lael Brainard of the Fed, agreed that changes to fix unintended consequences of the Volcker Rule may provide appropriate relief, but he dissented from the proposal because it "goes much further than reasonably necessary and appears to create substantial loopholes without effectively analyzing the potential risks." According to Berkovitz, the proposal will have little impact on derivatives markets regulated by the CFTC (Chairman Tarbert also made that point). Berkovitz, however, said he still opposes the weakening of the broader Dodd-Frank Act curbs on risk taking by banks. CFTC Commissioner Rostin Behnam likewise dissented, making one of the same points Berkovitz did about how this second set of revisions targets interests in covered funds after regulators eased provisions on proprietary trading late last year.

Outgoing SEC Commissioner Robert Jackson had not issued a public statement on the latest Volcker Rule proposal as of publication. Jackson has announced plans to leave the SEC in February.

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