On April 20, 2017, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a Consent Order to Deutsche Bank AG after finding deficiencies in the bank’s Volcker Rule compliance program, imposing a civil money penalty of $19.71 million. This is the first time that the Federal Reserve has found a violation of the Volcker Rule, which requires banking entities with total assets greater than $10 billion to establish compliance programs reasonably designed to ensure and monitor compliance with Volcker Rule requirements.
While proprietary trading activities are prohibited under the Volcker Rule, there are two main exemptions that allow depository banks and their affiliates to trade or underwrite financial instruments without being in violation: (i) the underwriting exemption and (ii) the market-making exemption. In order for a bank that is subject to the Volcker Rule to avail itself of these exemptions, its trading desks must make sure that their trading activities are designed not to exceed the reasonably expected near-term demands (“RENTD”) of clients, customers and counterparties. The Federal Reserve found Deutsche Bank AG to be in violation of the Volcker Rule pertaining to its RENTD methodologies under the market-making exemption.
Under the market-making exemption, RENTD is considered when setting risk and position limits for (i) market-making inventory, (ii) products used to manage risk in connection with market-making activity, (iii) risk factors relating to overall exposure of the trade desk’s portfolio, and (iv) inventory holding periods. RENTD methodologies are used to create these limits and provide evidence that a trading desk’s positions are correlated to customer activity and are estimates of future customer demand.
Market-making RENTD has been a challenge for banks to capture since the data that is necessary to make these estimates had never been collected by most banks before the Volcker Rule, and the data itself is complex and can span multiple trading systems depending on the size of the bank. For example, the market-making exemption applies to trades with “customers” only. Therefore, trading desks must bifurcate trades that will use the market-making exemption into customer and noncustomer trades for historical data purposes. Additionally, the market-making RENTD estimation is done on a trade-by-trade basis, making compliance even more complex.
In issuing its Consent Order, the Federal Reserve determined that Deutsche Bank AG failed to establish a compliance program reasonably designed to ensure and monitor compliance with Volcker Rule requirements, finding the following:
- Significant gaps existed across key aspects of the bank’s Volcker Rule compliance program, including within policies and procedures, the management framework, and internal controls, causing deficiencies in the bank’s independent testing efforts.
- Significant weaknesses existed in the bank’s demonstrable analyses showing that its proprietary trading is not to exceed the reasonably expected near-term demands of its clients, customers and counterparties, which is required for permitted market-making activities. Additionally, the bank did not subject trading desks to this methodology and thus did not allow for sufficient review and challenge by internal control groups.
- The bank’s metrics reporting and monitoring process suffered from weaknesses that, together with the absence of sufficient internal controls, limited the bank’s ability to adequately monitor trading activity to detect impermissible proprietary trades.
The Consent Order requires an increase in senior management oversight and enhanced internal controls and the Volcker Rule compliance program. With regard to these two main areas of focus, the bank will need to submit a written plan that is acceptable to the Federal Reserve within sixty (60) days of the Consent Order. At a minimum, the plan must include the following:
Senior Management Oversight
- Actions that senior management will take to maintain effective oversight of actions taken by the bank to correct deficiencies.
- Clearly defined roles, responsibilities and accountability regarding compliance for the bank’s management, compliance personnel and internal audit staff.
- Measures to ensure that management decisions related to key processes and controls are made in a timely manner.
- Measures to ensure adequate resourcing, implementation and maintenance of the bank’s independent risk management control functions.
- Measures to ensure the implementation, maintenance and effective operation of Volcker Rule governance forums and identification and resolution of issues (along with proper documentation).
- Measures to ensure that Volcker Rule compliance issues are appropriately escalated to senior management.
Internal Controls and Volcker Rule Compliance
- Measures to implement complete, accurate and internally consistent policies and procedures governing the bank’s compliance with the Volcker Rule, including desk-level policies and procedures that clearly define desk trading activities, financial instruments, and applicable exceptions or exclusions to the proprietary trading restrictions.
- Internal controls necessary to ensure adequate review and challenge of the bank’s compliance with the Volcker Rule, including enhanced policies, controls and documentation.
- Enhanced internal controls to ensure proper monitoring and surveillance of trading activity to identify trades that potentially violate the Volcker Rule.
- Improved independent testing guidelines.
- Measures to improve metrics reporting and monitoring functions to enable more granular analyses and more timely identification and resolution of issues.