Banking & Finance
The Volcker Rule—Compliance Program Requirements for Foreign Banking Entities
Congress enacted the Volcker Rule in an effort to restrict proprietary trading and investments (and sponsorships) in certain funds primarily by U.S. banking entities as a result of the financial crisis that consumed the better part of the late 2000s. However, the rule also places substantial burdens on foreign banking entities to the extent they have branches or operations located in the U.S., or are doing business with U.S. persons.1 As a result, foreign banking entities may be required to adopt substantial compliance procedures tailored to the Volcker Rule, and in certain instances, senior management of a foreign banking entity will even have to attest on an annual basis that his or her organization is in compliance with the Volcker Rule.
The definition of a banking entity
2 under the Volcker Rule is broad and many entities, which may not consider themselves banks or banking entities, are likely to be impacted by the Volcker Rule. Additionally, the definition does not distinguish between a domestic and foreign entity. Subject to enumerated exceptions, a “banking entity” is defined as (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any company that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978; and (iv) any “affiliate” or subsidiary of any of the foregoing entities. An affiliate is defined as any company that controls, is controlled by, or is under common control with another company.3 For example, a foreign bank in Asia may not have any U.S.-based operations or do business with any U.S. residents. Nonetheless, if the Asian bank is affiliated with any entity that meets the definition of a banking entity in (i) - (iii) above, the Asian bank would also be considered a banking entity, and thus be covered by the Volcker Rule absent any other enumerated exceptions or exemptions.
Critically, an entity affiliated with a banking entity will need to examine its relationship with the banking entity, and the nature of its business, to determine whether the Volcker Rule will apply to its activities. If an entity is defined as a banking entity under the Volcker Rule, it will need to determine whether it is required to adopt a compliance program and the scope of the compliance program. The degree to which a banking entity is required to adopt compliance procedures will depend largely on: (1) the size of the banking entity; and (2) the extent to which the banking entity engages in either permitted proprietary trading or covered fund (“Covered Fund”) activities.4
In this Client Alert, we summarize the relevant aspects of the final rules (“Final Rules”) that implement the Volcker Rule with respect to the compliance program requirements for:
For further information please contact
Matt Kluchenek +1 312 861 8803 matt.kluchenek @bakermckenzie.com
Mike Sefton +1 312 861 2884 michael.sefton @bakermckenzie.com
In This Issue:
Conclusion and Effective Dates
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• U.S.-based operations of foreign banking entities; and
• non-U.S. operations that may be affected by, or covered by, the Volcker Rule to the extent that the foreign banking entity is doing business in the U.S. or with U.S. persons.
Under the Final Rules, certain foreign banking entities (and banking entities generally) will be required to adopt a compliance program reasonably designed to ensure and monitor compliance with the Volcker Rule. The degree to which a foreign banking entity is required to adopt a compliance program varies based on the foreign banking entity’s size and the activities in which it engages.
Foreign Banking Entities Not Engaged in Covered Activities and Foreign Banking Entities with Consolidated Assets of $10 Billion or Less
First, a foreign banking entity that does not engage in any covered activities (permitted proprietary trading or Covered Fund activities) is not required to establish a compliance program until such time that it does engage in such activities.5 Second, a banking entity with total consolidated assets of $10 billion or less reported over the last two previous years that is engaged only in underwriting, market making, hedging, or Covered Fund activities, may amend its existing compliance program by including appropriate references to the Volcker Rule and the Final Rules.6 Changes to an existing compliance program are expected to take into account the banking entity’s “activities, size, scope and complexity.”7
The categories above do not distinguish between foreign-based and U.S.-based operations or assets. Thus, if a foreign banking entity believes it may fall within the requirements for no compliance program or a simplified compliance program, it would need to examine its activities compared to the Final Rules. The examination may require in-depth analysis as certain activities that would otherwise be covered activities may be exempt or excluded because the entity is a foreign banking entity.8 While potentially time consuming, determining whether a foreign banking entity’s activities are covered by the Volcker Rule and the Final Rules in the first place may save the banking entity from enacting significant compliance procedures.
Standard Compliance Program for other Foreign Banking Entities
Foreign banking entities that are not otherwise exempt, will be required to implement a compliance program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions on proprietary trading and Covered Fund activities required by the Volcker Rule and the Final Rules.9 The terms, scope and detail of the compliance program are required to be tailored to the foreign banking entity’s business. Thus, a foreign banking entity with significant U.S.-based operations, or branches located in the U.S., will generally be expected to have more thorough and robust procedures in comparison to a foreign banking entity that does not have branches located in the U.S. or other U.S.-based operations.
Additional members of the Baker & McKenzie Volcker Rule team:
John J. Conroy, Jr. +1 312 861 8171
Daniel L. Goelzer +1 202 835 6191 daniel.goelzer @bakermckenzie.com
Ricardo S. Martinez +1 212 626 4002 ricardo.martinez @bakermckenzie.com
Creighton R. Meland +1 312 861 2990 creighton.meland @bakermckenzie.com
Ira A. Reid +1 212 891 3976 ira.reid @bakermckenzie.com
Lloyd M. Winans +1 212 626 4515 lloyd.winans @bakermckenzie.com
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Regardless of the size of a foreign banking entity’s operations or its U.S. presence, a Volcker Rule standard compliance program must, at a minimum, address:
• written policies and procedures reasonably designed to document, describe, monitor and limit (to the extent necessary) both trading activities covered by the Volcker Rule which could be considered proprietary trading, and activities and investments related to Covered Funds;
• internal monitor controls reasonably designed to monitor compliance with, and prevent violations of, the Volcker Rule and the Final Rules;
• a management framework delineating responsibilities and accountability for compliance with the Volcker Rule and the Final Rules, in addition to including appropriate managerial review of trading activity (including risk management), Covered Fund participation and activity, compensation and other issues addressed in the Volcker Rule and the Final Rules;
• independent testing and auditing that may be conducted by the banking entity’s own qualified personnel or outside qualified personnel;
• ongoing training for trading personnel, managers and other appropriate persons to effectively implement and enforce the compliance program; and
• recordkeeping responsibilities requiring records, sufficient to demonstrate compliance with the Volcker Rule and the Final Rules, be kept for no less than 5 years.10
Implementing the standard compliance program will require substantial costs and expense to ensure and monitor compliance. Notably, the standard compliance program is not simply procedures that must be adopted by the foreign banking entity, but rather, the Final Rules require that the foreign banking entity takes steps to actively monitor any covered activities, ensure accountability, test the compliance program on a routine basis and document the foreign banking entity’s covered activities, including the reliance on any exemptions. The requirements set forth above are minimums and the Final Rules do not provide a safe harbor or any other assurances of what steps a foreign banking entity may take to ensure that it sufficiently complies with the Volcker Rule. Overall, adopting the standard compliance program may result in significant costs to a foreign banking entity. However, depending on the extent to which the foreign banking entity may engage in permitted proprietary trading or Covered Funds activity, additional compliance procedures will be required.
Additional Documentation for Covered Funds
Any foreign banking entity with $10 billion or more in consolidated assets reported over the prior two years will also be required to document its Covered Fund activities and maintain records concerning these activities.11 The records required for Covered und activities primarily concern ensuring that foreign banking entities document their permitted activities and their reliance on any exemptions and the basis for such exemption. The Covered Fund recordkeeping requirements are generally the same for domestic and foreign banking entities except that §75.20(e)(4) requires domestic banking entities that maintain investments of $50 million or more in foreign public funds to keep additional records.
Reporting and Recordkeeping Requirements under Appendix A
Foreign banking entities engaged in permitted proprietary trading may be required to report certain metrics, or trading data, to the appropriate Agency as well as keep certain records related to such proprietary trading.12 Whether a foreign
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banking entity is subject to the reporting and recordkeeping requirements depends on the amount of trading assets utilized in U.S.-based operations.13
The Final Rules provide that if a foreign banking entity’s U.S. trading assets exceed a certain threshold then the foreign banking entity must report the metrics to its relevant Agency on a regular ongoing basis as well as be subject to additional recordkeeping requirements.14 U.S. trading assets are determined by measuring the average gross sum of trading assets and liabilities of the combined U.S.-based operations of the foreign banking entity (including all subsidiaries, affiliates, branches and agencies operating, located or organized in the U.S.) as of the last day of each quarter for the previous four consecutive quarters.15 The threshold amounts where reporting will be required are: (a) $50 billion beginning on June 30, 2014, (b) $25 billion beginning on April 30, 2016, and (c) $10 billion beginning on December 31, 2016.
The reportable metrics, which are set forth in Appendix A to the Final Rules, relate to the type of proprietary trading permitted under the Volcker Rule--i.e., market making activity, hedging/risk management and underwriting. By monitoring these metrics, the Agencies believe they will be in a better position to identify permitted market marking-related activities and distinguish such activities from prohibited proprietary trading, and identify certain trading activities resulting in material exposure to high-risk assets or high-risk trading strategies.16
Appendix A sets forth seven specific metrics that must be addressed. They are:
1. Risk Management Measurements
• Risk and Position Limits and Usage
• Risk Factor Sensitivities
• Value-at-Risk and Stress VaR
2. Source of Revenue Measurements
• Comprehensive Profit and Loss Attribution
3. Customer-Facing Activity Measurements
• Inventory Turnover
• Inventory Aging
• Customer Facing Trade Ratio
Although the reporting requirements may consist of only seven metrics, each metric requires numerous calculations described in Appendix A and must be calculated as of each trading day.17 For foreign banking entities with $50 billion or more in U.S. trading assets, metrics will need to be reported on a monthly basis within 30 days from the end of the month beginning on June 30, 2014. Beginning in January 2015, such information will need to be reported within 10 days from the end of the month.18 For foreign banking entities with $10 billion to $50 billion in U.S. trading assets, metrics will need to be reported on a quarterly basis within 30 days from the end of the quarter.19 Reporting for foreign banking entities with at least $25 billion in U.S. trading assets will begin on April 30, 2016. Reporting for foreign banking entities with at least $10 billion in U.S. trading assets will begin on December 31, 2016.20
If a foreign banking entity that may be subject to reporting is not already using these metrics for its own risk management purposes, then it should begin doing so. Foreign banking entities that may already utilize these metrics for their own
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purposes should also review Appendix A carefully to ensure that they are calculating the metrics in the manner prescribed by regulators to ensure that their metrics are not questioned or receive unnecessary scrutiny.
Finally, the Final Rules provide that the Agencies will review the data collected and may revise the collection requirement (presumably the particular metrics and/or the frequency of calculation and reporting), as needed, based on a review of the data collected prior to September 30, 2015.21
Enhanced Compliance Program
The Final Rules also require that certain banking entities adopt an enhanced compliance program with more stringent requirements. Specifically, foreign banking entities may be required to adopt additional compliance procedures specified in Appendix B to the Final Rules in the following circumstances:
• the foreign banking entity engages in permitted proprietary trading and is required to report proprietary trading based on the amount of its U.S. trading assets;
• the foreign banking entity has total U.S. assets as of the previous calendar year end of $50 billion or more (including any subsidiary, affiliate, branch and agency of the foreign banking entity operating, located or organized in the U.S.); or
• The applicable Agency notifies the foreign banking entity that it must adopt the additional compliance procedures.
The enhanced compliance program is based on the six tenets required for the standard compliance program described above, namely: (1) written policies and procedures; (2) internal controls; (3) management framework and accountability; (4) independent testing; (5) ongoing training, and (6) recordkeeping.22 The enhanced compliance program contains all six of the foregoing requirements, but in most cases, in greater detail than the standard compliance program.
Since the enhanced compliance program requirement is triggered primarily as a result of a foreign banking entity’s proprietary trading activities, not surprisingly, much of the enhanced compliance program is dedicated to documenting and monitoring permitted proprietary trading activities. For proprietary trading activities, the comprehensive enhanced compliance program addresses the following:
• trading desks;
• risks and risk management processes;
• authorized risks, instruments and products;
• analysis and quantitative measurements; and
• trade practices and any reliance on the use of exemptions permitted by the Volcker Rule and the Final Rules; and
• remediation for violations.23
Each of the items set forth above will require specificity in a foreign banking entity’s enhanced compliance program. Using trading desks as an example, the enhanced compliance program must include, among other things, “a mapping for each trading desk to the division, business line or other organizational structure,” and,
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[T]he type and amount of risks allocated by the banking entity to each trading desk to implement the mission and strategy of the trading desk, including an enumeration of material risks resulting from the activities in which the trading desk is authorized to engage (including but not limited to price risks, such as basis, volatility and correlation risks, as well as counterparty credit risk). Risk assessments must take into account both the risks inherent in the trading activity and the strength and effectiveness of controls designed to mitigate those risks;24
The requirement above is merely one of twelve enumerated requirements relating to trading desks. Although a foreign banking entity’s proprietary trading activities may trigger the enhanced compliance program, Appendix B also contains procedures for monitoring a foreign banking entity’s Covered Fund activities.25 Generally, the compliance procedure requirements for Covered Fund activities are similar to those for proprietary trading insofar as the foreign banking entity must monitor and document its investments in Covered Funds and ensure that any investments fall within the limitations of the Volcker Rule and the Final Rules. The enhance compliance program also must include procedures as to how it will respond to violations of the Volcker Rule and Final Rules in its Covered Fund activities.26
Management Responsibility and Accountability
The enhanced compliance program also requires a foreign banking entity have a management framework in place reasonably designed to ensure that:
• appropriate personnel are responsible for the effective implementation and enforcement of a compliance program;
• a clear reporting line with a chain of responsibility is delineated; and
• the compliance program is reviewed periodically by senior management.27
The enhanced compliance program must be approved by the banking entity’s board of directors, an appropriate committee of the board, or equivalent governing body, and senior management.28 Business line managers and senior management must be identified and procedures must be in place to determine compensation arrangements for those involved in proprietary trading to ensure they are not receiving any incentivized or performance-based compensation.29
The enhanced compliance program also requires in the case of foreign banking entities, that the most senior officer responsible for the U.S. operations of the foreign banking entity attest on an annual basis to the appropriate Agency that the entity has in place:
• processes to establish, maintain, enforce, review, test and modify [the enhanced compliance program] in a manner reasonably designed to achieve compliance with the [Volcker Rule and the Final Rules.]30
Generally, the enhanced compliance program addressing management responsibilities seeks to ensure that there is a culture of compliance from the top down. Nonetheless, if an Agency believes that a foreign banking entity has violated the Volcker Rule, undoubtedly, one of the first documents that the Agency will request is a copy of the enhanced compliance program to determine who was responsible for implementing and monitoring compliance. As a result, foreign banking entities will need to ensure that the enhanced compliance
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program is tailored to its business taking into account what the foreign banking entity realistically will, and will not, do as part of its U.S. operations.
While foreign banking entities consider their daunting responsibilities under the Volcker Rule, they will need to examine their current U.S. operations and as a result, may even engage in re-structuring certain aspects of their business to minimize the effects of the Volcker Rule. Foreign banking entities should engage in this internal examination, but at the same time, they must be mindful of the Final Rules’ “anti-evasion” provisions.31
The Final Rules provide that Agencies may order a foreign banking entity to terminate any activity or dispose of any investment, if the Agency believes that a violation of the Volcker Rule or the Final Rules has occurred, or the foreign banking entity, “acts in a manner that functions as an evasion of the requirements of the [Volcker Rule or the Final Rules].”32 Determining whether a particular function of the foreign banking entity should occur through its U.S. operations is necessary, but at the same time, a delicate approach is necessary to ensure that any change in operations is not simply implemented to evade the reach or jurisdiction of the relevant Agency.
Conclusion and Effective Dates
For foreign banking entities engaged in any covered activities, the Volcker Rule will require substantial compliance procedures be adopted and implemented through the standard compliance program. For foreign banking entities engaged in proprietary trading and meeting the appropriate asset-based thresholds, an even more substantial enhanced compliance program will be required along with the reporting of metrics concerning its permitted proprietary trading. Undoubtedly, significant costs will be expended implementing compliance programs and foreign banking entities should already be reviewing their operations and assessing their compliance with the Volcker Rule.
The Final Rules will become effective April 1, 2014. However, banking entities will not be required to comply with the Final Rules until July 21, 2015. During the conformance period, a banking entity must engage in good faith efforts to enable the banking entity to conform its activities to the requirements of the Final Rules by July 21, 2015.
The Federal Reserve has stated that a banking entity with stand-alone proprietary trading operations is expected to promptly terminate or divest those operations. Initial deadlines for reporting will be rolling with banking entities with $50 billion in U.S. assets beginning on June 30, 2014; $25 billion in U.S. assets beginning on April 30, 2016; and $10 billion beginning on December 31, 2016. ________________________
1 The Volcker Rule was enacted in 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and is codified as Section 13 of the Bank Holding Company Act, 12 U.S.C. §1851.
2 See §75.2 (c)(1).
3 12 U.S.C. §1841(k).
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4 See §75.20 of the Final Rules implementing the Volcker Rule. Citations to the Final Rules are as they appear in U.S. Commodity Futures Trading Commission (CFTC) Regulations. Uniform final rules have also been adopted by the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), the U.S. Securities and Exchange Commission (SEC) and the Office of the Comptroller of the Currency (OCC) (collectively, including the CFTC, the “Agencies”). Covered Fund is defined in §75.10(b).
5 See §75.20(f)(1).
6 See §75.20(f)(2).
8 For example, see the foreign fund exemption permitting certain covered fund activities outside the United States described in §75.13(b).
9 See §75.20(a).
10 See §75.20(b)(1)-(6).
11 See §75.20(e).
12 See §75.20(d).
13 See §75.20(c)(2) and (d)(2).
14 See §75.20(c) and (d).
16 See CFTC’s Federal Register Release for Final Rules, at 809.
17 See Final Rule Appendix A §III.B.
18 See §75.20(d)(3).
20 See §75.20(d)(2).
21 See Final Rule Appendix A §I.
22 See Final Rule Appendix B.
23 See Final Rule Appendix B.
24 Final Rules Appendix B §II.A.
25 Final Rules Appendix B §II.B.
27 Final Rules, Appendix B §III.
31 See §75.21