The Volcker Rule
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The Volcker Rule was actually proposed by Paul Volcker who was the former chairman of the United States Federal Reserve and an American economist where he restricted all the banks in the United States from entering into certain types of speculative investments which could not add any benefits to their customers. It will further be realized that on January 2010 President Obama publicly endorsed this rule which applied to the varied financial institutions in US. Volcker extended to argue that American banks had previously entered into such speculative activities which happened to be the key drivers to the financial crisis that occurred between 2007 and 2010. It will be documented that the rule is in most cases taken to refer to a ban on proprietary trading practiced by the commercial banks where their deposits have turned out to be utilized to trade on their bank’s account (Garcia, Carpenter & Murphy, 2011).
These trading restrictions are actually placed on all financial institutions in the United States. Studies extend to reveal that the Volcker rule disconnects investment banking, propriety trading and private equity financial sections from the lending arms of their customers. Banks are therefore not permitted to concurrently enter into creditor and advisory roles with their clients. The main aim of the Volcker Rule is to reduce the conflicts of interest that seem to be stuck between banks and clients by separating the different forms of business practices that financial institutions usually employ. In the discussion presented, the Volcker rule will extend to limit several risky banking activities. In addition, the reasons necessitating delay of its implementation will also be examined.
The legislation truly situates several substantive restrictions regarding the bank activities as dictated by the Volcker Rule. Basically this proposed rule has two fundamental separate rules which include a ban on both private equity activities and some hedge fund and the property trading prohibition. These two restrictions originate from the view of the congress that the banks have in fact moved beyond the traditional deposit taking and lending into new business lines that disclose the undesirable risks towards insured deposits. According to the views of many scholars the Volcker Rule appears to be controversial due to the fact that the prohibited activities provide little evidence on whether they were some of the key drivers for financial crisis. Certainly, some scholars argue that the profitability of hedge fund, propriety trading and private equity activities are essentially very significant in offsetting the massive losses of the banks from traditional loan portfolios and mortgages. Generally this rule really applies to the entire banking entities such as thrifts, SLHCs, BHCs, banks among others. The prohibitions also expand to apply to the United States operations revolving around its foreign banks. It will be documented that the nonbank financial corporations that are usually standardized under the new-fangled systemic risk management are precisely not affected by the Volcker rule. As a result the Congress has reacted by ensuring that the Federal Reserve purely imposes quantitative limits and supplementary capital requirements on them so as to mitigate the perceived risks that are inherent in private equity, hedge funds and proprietary trading activities.
According to Liaw (2006), propriety trading prohibition requires that the Volcker Rule forbids any banking entity from selling and buying any derivative, security or some other financial instruments mainly for its trading account which is truly opposed to the customers’ accounts. Based on the rule, proprietary trading is meant to refer to the process of engaging as the principal in respect to the trading account of a banking entity that is covered during the sale or purchase for a covered financial position. On the other hand a trading account is taken to refer to any account that is utilized by a banking entity that is covered so as to acquire several covered financial positions primarily for short term price movement, arbitrage profits or resale and also for hedging a position. It will be noted that a trading account expands to capture in covered financial position, commodity and foreign exchange derivatives by the banking entity as dictated by the market risk capital regulation and some other transactions which the banking entity enters. This is where you need to do my homework.
It will be realized that some transactions are generally ruled out from the ban regarding proprietary trading. They include customer transactions, hedging or authentic risk mitigating activities, transactions in government sponsored enterprise or United States securities and transactions in relation with market making r underwriting activities (Liaw, 2006). The transactions also include the selling and buying of securities in framework of an insurance company and the proprietary trading carried out by a non-United States restricted banking entity that takes place outside US.
The Volcker Rule bans private equity activities and hedge funds by ensuring that the rule forbids all banking entities from retaining or acquiring any partnership, equity or some other related ownership interest or supporting any private equity and hedge funds. Based on the legislation, the terms private equity fund and hedge fund incorporates any issuer exempt that stems from the registration in the form of an investment company. A banking entity will only sponsor hedge fund if it acts as the managing member or general partner of the fund, controls or selects directors, officers, trustees and employees or is involved in the management of the shares or funds similar to the hedge funds.
It will be noted that despite the extensive capacity of the ban there are some fundamental exemptions that permit the banking entities in the United States to offer and organize hedge funds only if the banking entity meets the requirements listed below (Volcker Rule, n.d.). The banking entity should provide an authentic trust, investment advisory services and fiduciary to the fund. It should also offer and organize the hedge fund merely to the customers and simply in relation with the trust provisions and related services. The banking entity should reveal that the losses incurred will be borne solely by the willing investors, should not permit any ownership interest that may stem from the employees or directors who are not directly engaged in offering services to the hedge fund and should avoid some of the transactions that are specified in the exhaustive affiliate regulations in the Federal Reserve Act relating the fund (Volcker Rule, n.d.). Even though the exemption stipulated in the Volcker Rule may pave way for most of the banking entities to allocate considerable resources to hedge fund in the future, several larger financial institutions in US presently go beyond the 3% thresholds.
As discussed above, Volcker Rule actually restricts both the hedge and private equity funds and proprietary trading activities. It is thus held that the Congress and the Obama Administration feared that most of the banking entities could make use of the private fund investments as a technique to carry out proprietary trading hence generating a loophole in the ban of the Volcker Rule regarding proprietary trading. As a result, the Volcker Rule prohibits a banking entity in its view of acquiring and retaining any form of ownership interest or else in sponsoring a private equity fund (Tarbert and Radetsky, 2011). According to the Volcker’s Rule the term ownership is actually extensive and seems to have been construed broadly by the various regulators to capture in any carried interest and the initial capital investments. On the other hand sponsorship widens to incorporate any banking entity operating as the fund’s managing member or general partner and have an additional authority to control and elect various parties within the entity. Private equity fund is one among the important statutory terms in this rule. According to Dodd-Frank private equity fund includes any entity which can be categorized as an investment company as stipulated in the Investment Company Act that was enacted in 1940. Tarbet and Radetsky (2011) argues that private equity funds in most cases are set up in manner that depend on the provisions so as to circumvent registration with the SEC as required in the Investment Company Act. Based on the Volcker Rule, private equity funds are essentially identified fundamentally by reference to what many refer to be unreal. However Dodd-Frank allows regulators to develop and identify a certain criteria for categorizing any similar funds as private equity funds under the consequent rulemakings.
The Volcker rule precisely specifies when a banking entity should begin engaging in activities related to market making. It will be realized that based on the proposed regulations, proprietary prohibition does not actually apply if the sale or purchase for the covered financial position is prepared in relation with the market making activities of the covered banking entity. Based on the Volcker Rule then the market making activities of a banking entity are only allowable on the condition that the banking entity abides by the by the requirements listed below. Firstly, the banking entity ought to institute an internal compliance program which obey the rules and requirements stipulated within the proposed regulations and that the trading desk of the banking entity should refrain from any action of either selling or buying any covered financial position that is meant for its account on a continuous or regular basis.
Secondly, the banking entity is required to be a registered dealer so as to trade on the specific financial instrument which it intends to make a market for or else exempted from registration. The market making activities of the trading desk ought to be calculated in a way that does not go beyond the rationally expected short term demands of customers, clients and counterparties. In addition, the market making activities of the trading desk of the banking entity should be designed in way that generates revenues mainly from asks or bid spreads, commission, fees or any other income which is not attributed to the hedging or appreciation regarded to the covered financial position. Finally, the compensation arrangements of the banking entity that are meant for the people who carry out the market making activities must be designed in way that does not offer rewards to any proprietary risk taking (Fein, 2011).
It will be noted that a banking entity is supposed to engage in any market making activities such as hedging on the condition that the covered financial position decreases the precise risk in connection to the related aggregated or individual positions and further captures all the requirements regarding permitted risk extenuating activities in hedging as summarized within the proposed regulations (Nguyen, 2012). The Volcker rule extends to capture in some exceptions that revolve around the market making activities. The rule as a result spots out several factors so as to distinguish the proprietary trading activities that are prohibited from those market making activities that are permitted with no indication of their comparative importance.
The forbidden proprietary trading activities can be distinguished in case where the trading practice in which the trading unit mainly creates revenues which stems from the price movements attached to the retained principal risks and positions other than revenues from the customers. Another factor that distinguishes the two activities is in case where the trading practice in which the trading unit does not perform its transactions by using a trading system which intermingles with the other orders or mainly with banking customers for the market making desk so as to offer liquidity services or when the trading unit holds principal positions that are in excess of rationally anticipated customer demands. According to the proposed regulations, the two activities can further be distinguished in cases where the trading practice in which the trading unit happens to consistently pay rather than earning spreads, commissions or fees and the utilization of compensation incentives that are directed to the employees of a specific trading activity which mainly recompense proprietary risk-taking (Wallison, 2013).
The essence that revolves around the job of a market maker is mainly to offer liquidity through quoting the relevant prices to the customers and also to respond astutely to the risks that are acquired as the customers attempt to act towards the quoted prices. It will be recognized that a single trade can generally subject the market maker to various risks. It is further held that a victorious market maker usually makes the exact choices regarding the risks he or she prioritizes to address, the sequence to follow and the necessary instruments required. The most favorable choices are those that are geared at minimizing the volatility of one’s portfolio while at the same time maximizing the quantity of the bid offer spread that is captured over time. This implies that market making clearly entails risk mitigation other than the elimination of risks (Investments & Kriz, 2012). The proposed rule as a result establishes considerable uncertainty that revolves around the risks and optimization process thereby reducing the readiness of the market makers to offer liquidity.
Broker dealers and regulated banking entities are known to be among the largest providers of services related to the market making. The continued existence of a competitive and robust field for all the banking entities that are ready to offer liquidity is fundamental for building a secondary market support in favor of investments like municipal and corporate bonds. It will be comprehended that without the projected secondary market liquidity sources that are provided by the market makers then the risks associated with the ownership of bonds would increase making most of the investors to increase the borrowing costs attached to the issuers which in turn leads to a serious impairment of the capital formation.
As soon as the financial reform law which was necessitated by Dodd-Frank came out, the provisions stipulated in the Volcker Rule clearly defined risk mitigating activities as the trades that were mainly designed to minimize the precise risks that banking entity may face in connection to its contracts, positions or other holdings of the entity. (Eisinger, 2012, April 18). Risk management is essentially designed to address rationally foreseeable risks. It will be realized that the risk managers also focus on some of the risks that actually have the potential to devastate movements in the assets portfolio that may necessitate collapse of the key financial institutions or lead to insolvency of an extremely leveraged sovereign entity. To alleviate these risks the banking entities are required to routinely examine their balance sheets to avoid such outlying scenarios. Other banking entities extend to carry out tests related to the financial and macroeconomic market scenarios as ordered by the Federal Reserve so as to make sure that the financial institutions have a forward looking and robust capital planning processes (Schapiro, 2011). The Volcker rule also extends to address on the issue of underwriting. As discussed above, the proprietary trading prohibition does not apply to the sale or purchase involving a covered financial position carried out by a banking entity in association with its prevailing underwriting activities. Based on the proposed rule, covered financial positions are usually supposed to be made in association with the underwriting activities only if the requirements listed below are satisfied (Petrasick, 2011).
The banking entity should have an internal compliance program that is fully established so as to ensure that the subject activities become underwriting activities. It is also required that the covered financial positions are actually supposed to be securities. The sale or purchase is influenced exclusively in association with securities distribution in which the banking entity that is covered must act as an underwriter and the underwriting activities should be geared at generating income. It will be realized that the Volcker Rule does not go beyond the Glass-Steagall provisions as it entails exceptions for market making, hedging and underwriting. It is thus evidently true under the Glass-Steagall insured banks are not able to deal or underwrite in cases of fixed income securities unlike in the Volcker Rule where the banks can engage underwriting activities (Glass-Steagall and the Volcker Rule, 2012).
Like the other provisions that are within the legislation, Volcker Rule only comes into operation as soon as the regulators release the final rules that help in implementing it. Given the considerable and potentially disruptive effects the targeted prohibitions may contain, the Congress gave the Council a period of six months to end up the initial study so as to issue recommendations regarding on how they can the Volcker Rule in the best way possible. It will be realized that there was some delay in the implementation of the Volcker rule due to several reasons. The difference that stuck between making markets and proprietary trading, underwriting and hedging is tremendously hard to define clearly, particularly based in the regulatory language which actually explains why the regulators delayed in implementing the Volcker Rule. Another cause of the delay is assumed to have originated from the lack of transparency in writing the rule and the continued disagreements between the regulators. It is also argued that the delay in implementation might have been caused by the departure of Mary Schapiro in December 2012 as she was the chairman of the Securities and Exchange Commission. The members who remained faced a partisan split that made the rulemaking to become difficult. (Hopkins, 2012, November 30).
The Volcker Rule actually helps in risk prevention and on the other hand it can lead to reduced profits. This proposed rule was actually mandated through the Dodd-Frank Act 2010 which happened to be subject of complaints for many banking entities claiming that it was potentially harmful and confusing. It was named under Paul Volcker who was the Chairman of Federal Reserve by then and was mainly intended to prevent the banking entities from putting the money of the depositors at risk. The contemporary proposed rule prohibits the financial institutions from proprietary trading but sets some exceptions for trades attached to hedging risk and market making activities. It also extends to limit the investments of the banks in hedge and private equity funds. The Standard & Poor actually approximated that Volcker Rule was capable of cutting the profits realized by the major United States banks by almost twice if the regulators would take a strict standpoint on prohibiting proprietary trading. It is good to document that Dodd-Frank proceeds to charge five regulators which include the commission for the Securities and Exchange, Federal Reserve Board, commission for Commodity Futures Trading, corporation for the Federal Deposit Insurance and the Comptroller Currency office to write regulations that help in implementing the rule.
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Wallison, P. J. (2013). Bad history, worse policy: how a false narrative about the financial crisis led to the Dodd-Frank Act. Washington, D.C.: American Enterprise Institute for Public Policy Research.