Volker Rule Becomes Effective On April 1, 2014: The Orchestrated Banker’s Loopholes!

OCC Money Currency

Description: Final Regulations:


On December 10, 2013, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission issued jointly developed final regulations to implement section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the Volcker Rule. The final regulations were published in the Federal Register on January 31, 2014, and become effective on April 1, 2014.

National banks (other than certain limited-purpose trust banks), federal savings associations, and federal branches and agencies of foreign banks (collectively, banks) are required to fully conform their activities and investments to the requirements of the final regulations by the end of the conformance period, which the FRB has extended to July 21, 2015.


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The final regulations

  • prohibit banks from engaging in short-term proprietary trading of certain securities, derivatives commodity futures, and options on these instruments for their own accounts.
  • impose limits on banks’ investments in, and other relationships with, hedge funds and private equity funds.
  • provide exemptions for certain activities, including market making-related activities, underwriting, risk-mitigating hedging, trading in government obligations, insurance company activities, and organizing and offering hedge funds and private equity funds.
  • clarify that certain activities are not prohibited, including acting as agent, broker, or custodian.
  • scale compliance requirements based on the size of the bank and the scope of the activities. Larger banks are required to establish detailed compliance programs and their chief executive officers must attest to the OCC that the bank’s programs are reasonably designed to achieve compliance with the final regulations. Smaller banks engaged in modest activities are subject to a simplified compliance program.


Rothschild Czar Hairy Reed Working Against U.S. Citizens
Rothschild Czar Hairy Reed Working Against U.S. Citizens

Even the dumbest banker can get around the Volcker rule. The regulators started with a weak statute, and managed to make it weaker. It’s as though they want to avoid offending the banks.

It took years of work and thousands of pages of banker whinges to achieve this dubious result in the final implementing regulations. (This article eschews specific cites to the rules. For more detail, see my article behind a paywall at http://www.taxanalysts.com.)

The statute itself, section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA), is weak and has large exemptions called permitted activities.

But in the new Volcker regulations, the five agencies charged with enforcement widened the scope of escape from the rule by creating open-ended administrative exclusions. As the sponsors of the Volcker rule, Sens. Levin and Merkley, argued, there is no statutory authority for these exclusions.

Beyond that, all of the Volcker rule loopholes are highly dependent on unenforceable standards and self regulation by the banks. We know how well self regulation worked.

hole in the wall

The loopholes—administrative and statutory—read like a catalogue of the dangerous activities that the DFA should have prohibited but did not. So herewith, a list of the loopholes in the final rule:

Spot commodities trading (administrative exclusion). All commodities derivatives are subject to the prop trading ban, but the physicals are exempt under the final rule. Modern banking is not a Lillian Hellman play in which northern bankers finance southern cotton crops.

Banks engage in transactions called “leasing oil” or “printing oil” in which they pretend to own an oil company’s inventory so it can dress up its financials with an off-balance-sheet loan. The oil is temporarily sold to the bank and then sold back to the company—like an oil repo. Yes, the bank and the oil company are consenting adults, but the transaction is thought to contribute to market manipulation.

Why are the regulators encouraging banks to continue to meddle in the commodities markets? The commodities bubble engineered by the Fed has been a worldwide disaster. The regulators’ excuse is that the statute does not prohibit it, but they are giving big banks the green light to continue to mess with prices of commodities for which they have no business need.

hole in the wall

Repos (administrative exclusion). Repos, reverse repos and securities loans are excluded from the concept of trading account. There are no practical limits on repos in the final rule—not a peep about collateral or haircuts—except that the contracts have only two parties.

The regulators’ defense for the repo exclusion was not just weak and conflicted—the Fed is anxious to shore up the repo market–but oblivious to the risks of these transactions. Repos and securities loans can be used for arbitrage and short sales. They can be used to create the effect of total return swaps and synthetic forward contracts. A lot of betting can occur within these secured loans.

Yet the nearly 900-page preamble states that repos aren’t a problem because it is not intended that there be price changes in the collateral. Not making this up.

Of course, if there were price fluctuations in the collateral, and there had been a fair amount of rehypothecation, all hell would break loose, like it did in 2008. According to the Financial Stability Board in Basel, small changes in value can have horrible contagion effects when collateral has been rehypothecated and leverage multiplied.

Um, gee, didn’t repos and excessive dependence on the shadow banking system for short-term finance get us in the trouble we are in? The most that can be said for the administratively created repo exclusion is that perhaps the Volcker rule is not the ideal vehicle to address the repo problem. Banks should not be broker/dealers, which typically use overnight repo finance. The Volcker rule is not an adequate substitute for Glass-Steagall.

hole in the wall

Liquidity management (administrative exclusion). Banks could put all their relatively safe holdings in this bucket (dealing in Treasuries is statutorily excluded). Liquidity management is anything a bank says it is, as long as liquid securities are involved and the bank has a written plan.

There no prohibition on trading in the plan, but the regulators want the compensation, trading activity and frequency to be directed toward the stated goal of liquidity management. This requires a compliance mechanism on the part of the bank. The liquidity management plan would be highly dependent on models which were shown not to be reliable in the 2008 meltdown.

hole in the wall


Derivatives clearing (administrative exclusion). JP Morgan has been called a $76 trillion derivatives clearing operation with a $2 trillion bank attached. The regulators created an administrative exclusion from the Volcker rule to leave this systemically dangerous activity alone. Derivatives creation is about where it was before the meltdown.

The Dodd-Frank Act’s wishful thinking about making derivatives safer really shows here. The DFA requires that derivatives be cleared but does not create clearinghouses. Now, by centralizing liability and standing in for the parties to a derivative contract, a clearinghouse itself becomes too big to fail. And clearinghouses have had to be bailed out in recent history.

Declining Value Of Rothschild's Dollar
Declining Value Of Rothschild’s Dollar

Many private clearinghouses exist. They are undercapitalized private clubs of big banks and big players that want to trade with each other. The final Volcker regulation excuses derivatives trading by a bank that operates a clearinghouse, and also by a bank that is acting as a clearing member.

If derivatives clearing was some wonderful, riskless, neutral act that did not involve a bank taking a position in a derivative contract or a referenced asset, there would be no need for this exclusion. Banks wanted to be able to buy and sell to establish reference prices. If clearing and settlement transactions are risk reduction transactions, then they should have been put under hedging as a permitted activity.

hole in the wall

Underwriting (statutorily permitted activity). Underwriting also includes secondary market offerings. Although the regulation calls for inventory to be proportionate to customer need, anticipatory accumulation of inventory is permitted, as is block positioning. It’s a short leap from accumulation of inventory to prop trading, as more than one commentator on the proposed rules admitted.

hole in the wall

Market maker (statutorily permitted activity). On the one hand, only a few banks act as market makers. On the other, the ones that do are the giant, systemically dangerous ones.

The regulators tried to impose market maker definitional standards that are honored in the breach every day by designated market makers. A bank must routinely stand ready to buy or sell securities to which it has financial exposure. It must be willing and able to provide quotes and participate through all market cycles.

Algos are not qualified for the market maker exemption. But a bank doesn’t have to be an actual registered market maker to take advantage of the market maker exemption. Are the bank supervisors going to ring up the banks every day to see if they’re really providing executable quotes on the stuff in their trading books?

hole in the wall

Compensation. The regulators punted, like they always do. They rebuffed suggestions that compensation for market making and underwriting be limited to spread, fees and commissions. Compensation must not be designed to reward prop trading, but if some of the gains make their way to traders who have done a good job serving customers or managing risk, so be it, according to the final rule.

hole in the wall

Hedging (statutorily permitted activity). To the regulators’ credit, they tightened this one. A hedge must mititgate an identified risk and be regularly tested for efficacy. Hedges don’t eliminate risk; they replace one risk with another risk that is more bearable.

Why wasn’t the hedging exemption hooked up to the GAAP standard? GAAP hedges must demonstrate a high degree of efficacy in offsetting changes in the fair value of an asset. Every three months, or whenever reporting is required, hedge effectiveness has to be tested using a reasonable method. If the hedge is ineffective, it had better be part of a documented dynamic hedging strategy that is continuously repositioned (ASC 815-20-25).

It’s not clear how bank supervisors are going to monitor the correlation between the hedges and the trading accounts, especially when the rule accepts that hedges will often be in different legal entities. Americans for Financial Reform argued that the hedging exemption would permit arbitrage.

What restrictions? There are no penalties for violation of the Volcker rule—no disgorgement of profits, either. Regulators can tell banks not to do some things, set quantitative limits and impose additional capital requirements. The regulators did not use their power to create sanctions, creating a presumption that things have to get really out of hand before action will be taken.

The statute contains sweeping, vague restrictions that say all bets are off if banks are doing things like putting the US financial system at risk. The biggest banks are putting the US financial system at risk every day the permitted trading activities occur inside federally insured banks. And the administrative exclusions are not subject to these statutory restrictions.

spanky bucks

The statute prohibits an otherwise permitted activity that creates a material conflict of interest with a client, causes the bank to hold high-risk assets or undertake a high-risk strategy, or threatens the safety and soundness of the bank itself or the U.S. financial system. None of this is adequately spelled out in the final rule, which perfunctorily reiterates the statute.

Under the statute, a conflict of interest has to be material. If a bank is on the other side of a transaction with a customer, that does not create a conflict of interest per se. Not making this up—the bankers howled that their customers are not widows and orphans (whose funds they nonetheless may be managing). If there is a conflict, the bank has to tell the customer soon enough for the latter to do something about it, effectively excusing conflicts.

hole in the wall

Hedge funds and private equity funds (statutorily permitted activity). JP Morgan Chase and Goldman Sachs are the largest sponsors of hedge funds. Under the statute, big banks can continue to sponsor and manage lightly regulated investment funds.

Banks can’t put their name on the fund—but the big banks have known brands–and have to tell investors they will not absorb losses. They can’t own huge equity interests, and their aggregate interests in investment funds are subtracted from Tier 1 capital. They can’t sell assets to their own funds, and transactions with them have to be at arm’s length.

But banks and fund managers can have profits interests that pay a large chunk of trading profits. As Occupy the SEC pointed out, these compensation arrangements fly in the face of the regulators’ designs for trading desk compensation.

Banks can’t offer prime brokerage to their own funds, but they can offer it to unrelated funds. This permission cements to codependent relationship banks as that prime brokers have with hedge funds. Bank lending relative to assets is currently low for the very largest banks. Banks have $2 trillion more in deposits than they have in loans. Surely they can find someone engaged in more productive activity to lend to than hedge funds?

hole in the wall

Accounting treatment. The regulators seem not to have understood that the holdings for which divestiture is required under the Volcker rule were not all in banks’ marked trading books. They seem to have forgotten that in the heat of the meltdown, accounting authorities on both sides of the Atlantic gave banks permission to value beaten-down securities based on cash flows and move them to their investment books to avoid recognition of reality (FASB staff position FAS 157-4 and ASC 325-40-35-10A).

That’s what the dustup over Zions Bank’s charge was about. The Utah community bank had a disproportionately large holding of TruPS CLOs held in its investment book, which it had to move to its available for sale book and mark to market for impending sale (ASC 320-10-35). Most TruPS are issued by community banks and held by other community banks, so they have contagion risk as well as risk to capital.


This is being done now to save money because of the retiring Baby Boomers

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