Federal Agencies Announce Reforms to Volcker Rule

On Aug. 20, the Federal Deposit Insurance Corp. (the FDIC) and the Office of the Comptroller of the Currency (the OCC) approved amendments to the Volcker Rule, which restricts banking entities’ ability to engage in proprietary trading and to invest in equity interests of private (“covered”) funds. The FDIC and the OCC, along with the Securities and Exchange Commission (the SEC), the Commodity Futures Trading Commission (the CFTC) and the Board of Governors of the Federal Reserve System (the Fed), are the federal agencies responsible for implementing the Volcker Rule and coordinated the amendments. The FDIC released the text of the amendments, which will be published in the Federal Register upon adoption by the Fed, the SEC and the CFTC. The effective date of the reforms that would be implemented by the amendments is Jan. 1, 2020. The Volcker Rule was initially adopted by the five agencies in 2013 to implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Noteworthy changes under the August 2019 amendments include the following:

• The amendments create a rebuttable presumption that a banking entity that, together with its affiliates, has “limited trading assets and liabilities,” is compliant with the proprietary trading and covered fund prohibitions, and has no obligation to observe the rule’s requirements on demonstrating compliance. “Limited trading assets and liabilities” generally means trading assets and liabilities of less than $1 billion, as determined by averaging the gross sum of trading assets and liabilities over the four prior quarters.
  
  
• The amendments clarify the definition of “trading account” for purposes of the proprietary trading restriction and provide some latitude in using the definition for banks not subject to risk-based capital rules.

• A trading account is, generally, (i) an account used for short-term sales, (ii) an account used to buy or sell financial instruments that are covered positions and trading positions, or (iii) an account used to buy or sell financial instruments if the banking entity is engaged in derivatives or swap activities.
  
  
• Under the amendments, a banking entity that does not calculate risk-based capital ratios may elect to apply prong (ii) in determining the scope of its trading account and, if it so elects, would not be required to apply prong (i).

• The rebuttable presumption that a less-than-60-day position in a financial instrument is deemed to be for a trading account is reversed, so that a 60-day or longer position is deemed not to be for a trading account.
  
  
• Foreign exchange forwards and swaps and cross-currency swaps; matched customer-driven swaps; and instruments that hedge mortgage servicing rights are excluded from the definition of “proprietary trading.”
  
  
• The Volcker Rule exempts from proprietary trading restrictions certain specified underwriting and “market making” activities.

• The amendments introduce a new safe harbor under which a bank is deemed to satisfy the conditions for permitted underwriting and market-making activities if it maintains certain specified internal controls and oversight.
  
  
• The definition of “trading desk,” which is used in the underwriting and market-making provisions, is narrowed such that a unit must have certain specific characteristics and perform certain activities (such as implementing a business strategy and engaging in coordinated trading activity) in order to be considered a trading desk.

• Under Volcker, certain “risk-mitigating hedging activities” are exempt from the prohibition on proprietary trading. The amendment relaxes the conditions under which a bank may engage in such risk-mitigating hedging where the bank, together with its affiliates, has less than “significant trading assets and liabilities” (generally, less than $20 billion, as determined by averaging the gross sum of trading assets and liabilities over the four prior quarters).
  
  
• The amendments broaden somewhat the ability of foreign banks to engage in permitted trading activities without violating the prohibition on proprietary trading.
  
  
• Under Volcker, a bank may not acquire an “ownership interest” in a “covered fund” (generally, a private fund relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940). However, underwriting and market-making activities meeting certain criteria do not violate this prohibition, within quantitative limits. Under the current rule, with respect to a banking entity that (i) acts as a sponsor of a covered fund, (ii) is a “securitizer” (as defined under the securities laws) with respect to a covered fund or (iii) guarantees, assumes or insures the obligations of a covered fund, ownership interests in these covered funds count toward the quantitative limits. Under the amendments, the prong described in (iii) above has been deleted, suggesting latitude in a bank’s ability to guarantee the performance of a covered fund.
  
  
• Bank-owned life insurance (BOLI) is excluded from the prohibition on covered fund ownership. Under the current rule, a condition to the BOLI exception is that no bank that purchases the insurance participates in profits and losses associated with the policy other than in compliance-applicable “supervisory guidance” regarding BOLI. Under the amendments, “supervisory guidance” has been changed to “requirements.”
  
  
• Where a bank owns interests in a covered fund as an intermediary on behalf of a customer (that is not itself a banking entity) to facilitate the exposure of the customer to the profits and losses of a covered fund, the bank’s ownership will not run afoul of the prohibition on ownership of covered funds.
  
  
• Currently, an ownership interest in a covered fund is deemed not to be offered for sale to a resident of the U.S. only if it is sold pursuant to an offering that does not target U.S. residents. Under the amendment, the presumption is reversed; the ownership interest in a covered fund is deemed not to be offered to a U.S. resident only if it is not sold pursuant to an offering that does target residents of the U.S. in which the banking entity or any affiliate “participates.” (Generally, acting as a sponsor or an investment manager, or acting in a similar role, is deemed to constitute “participation” for this purpose.)
  
  

• A banking entity that is an insurance company may acquire ownership interests in covered funds for its general account or a separate account established by the insurance company as long as such ownership is compliant with state insurance laws and regulations. A further requirement to comply with other “written guidance” of the state insurance regulator has been deleted by the amendments.