Bates Research - 12-27-13

The “Volcker Rule”

Post by Director Greg Kyle

On December 10, five U.S. regulators agreed to formally impose trading restrictions on U.S. banks.  The 900-plus-page “Volcker Rule”, part of the Dodd-Frank Act, is designed to put certain restrictions on proprietary trading and investments in hedge funds and private equity funds.  The rule is designed to protect banks, shareholders and taxpayers from potentially large losses due to certain trading activities.

According to one of the regulators, the CFTC (Commodity Futures Trading Commission), the “Volcker Rule” or Section 619 of the Dodd-Frank Act will generally prohibit two activities of banking entities:

It prohibits federally insured depository institutions, bank holding companies, and their subsidiaries or affiliates (banking entities) from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for a banking entity’s own account, subject to certain exemptions.

It prohibits owning, sponsoring, or having certain relationships with a hedge fund or private equity fund, subject to certain exemptions.

The aforementioned exemptions include municipal bonds, U.S. Treasuries and GSE securities (i.e. Fannie Mae, Freddie Mac).  Market making, underwriting and certain risk-mitigating hedging activities are considered as exempt as well.

Small and mid-sized banks may be impacted in the next two quarters as regional banks look to unload portfolios that may not be allowed when the Act comes into effect in April 2014.  Zions Bancorp has already announced  that it will sell some of its CDO (collateralized debt obligation) securities and take a $387 million after-tax charge to comply with the new rule. Other regional banks will likely undertake similar actions.

There is much that is open to interpretation in the new law and it will take time to assess the full impact of the 954 page rule on larger bank revenues and earnings, as the Act is applied.  One example of uncertainty in the Act is that banks will still be allowed to pursue market-making related activities provided they do not “exceed the reasonably expected near term demands of clients, customers, or counterparties.”  However, how “reasonable” will be defined or the time period for “near term” is not clearly identified.

Over the coming months we will likely see further clarifications from regulators and commentary from the banks on the impact of the new rules on revenue, earnings and capital at risk.

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