Earlier today, December 10, 2013, the Federal Reserve Board, the FDIC, the OCC, the SEC, and the CFTC approved the final version of the joint interagency Volcker Rule (the "Rule"). The text of the Rule, the preamble, and related materials are available here.

Digesting the nearly one thousand pages of rule text and explanation will require some time, but community banks should be aware that they are not wholly exempt from the Rule.

Indeed, a bank can avoid the establishment of a compliance program for proprietary trading only if its trading is limited to government, agency, State, and municipal obligations.  If a bank of any size trades for its own account in order to manage liquidity or to hedge against other risks, then a compliance program is necessary.  Moreover, the compliance requirements for hedging may be so onerous as to preclude such trading by all but the largest banks.

Exceptions in the Rule permit several kinds of trading and private equity- and hedge fund-related activity that are likely to encompass most community bank activities that could be subject to the Rule. Many of the exceptions are, however, conditional – meaning that many community banks will have to review whether their current liquidity management and other policies satisfy the prerequisites for the exceptions. The Federal Reserve has provided some guidance for community banks that is available here. This alert relies in part on this guidance. Although compliance with the Rule is not required until July 21, 2015, community banks should give the matter prompt attention in order to ensure that any problematic activities can be wound down without haste.

Banks may recall that the proposed version of the Volcker Rule that was released in October 2011 would effectively have required every bank, even those not engaged in any activity covered by Volcker, to have a policy for compliance with the requirements in the proposal. The final Rule is not so dramatic, but it will require a bank to review any trading or any investment in a private equity fund or hedge fund in order to determine whether and how the Rule applies.

To review the basics from the perspective of a bank, "proprietary trading" that is prohibited by the Rule means the purchase or sale of financial instruments for a bank's own trading account. A trading account at a bank is any account used to purchase or sell: (i) financial instruments principally for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging any of these positions; or (ii) financial instruments that are covered by the market risk capital rule and that are trading positions, where the bank uses the market risk capital rule to calculate risk-based capital ratios. "Private equity funds" and "hedge funds" that banks may not sponsor or own are funds in which there are either no more than 100 shareholders or in which all of the shareholders are "qualified purchasers" (in broad terms, very wealthy individuals or institutional investors).

Important points in the Rule for community banks (but not the only points) include the following:

Proprietary Trading

  • Government, agency, State, or municipal bonds or other obligations. The Rule exempts trading in these securities entirely from the proprietary trading ban. The specific instruments covered by the exemption are (i) obligations of, or issued or guaranteed by, the United States; (ii) obligations, participations, or other instruments of, or issued or guaranteed by, a U.S. government agency, Ginnie Mae, Fannie Mae, Freddie Mac, a Federal Home Loan Bank, Farmer Mac, or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971; (iii) State or municipal bonds or other obligations; and (iv) an obligation of the FDIC or an entity formed by or on behalf of the FDIC either in its corporate capacity to dispose of assets acquired by the FDIC or as conservator or receiver.
  • Liquidity management. The Rule permits trading as part of a liquidity management program subject to the following conditions:
    • The bank has a written liquidity plan that identifies the securities that may be traded, the circumstances in which they may be traded, and the amount, types, and risks of these securities.
    • The securities are not to be purchased and sold for the purpose of short-term resale or benefitting from short-term price movements.
    • The securities are highly liquid and must not be expected to generate appreciable short-term gains or losses.
    • The amounts held are consistent with near-term funding needs.
    • The bank provides independent testing and establishes internal controls and an analytic framework that ensures that the securities are held for liquidity management purposes.

A bank's primary federal regulator may impose additional requirements.

  • Fiduciary transactions. A bank acting as trustee or other fiduciary may trade financial instruments for the account of, or on behalf of a customer, provided that it does not have or retain any beneficial ownership of the instruments.
  • Riskless principal transactions. A bank may purchase or sell financial instruments in a transaction in which, after receiving a customer's order to purchase or sell an instrument, the bank purchases or sells the instrument for its own account to offset a contemporaneous sale to or purchase from the customer.
  • Risk-mitigating hedging. Trading to hedge against specific risks is allowed but is subject to the following conditions that may be impractical for some banks:
    • The bank has established and implements, maintains and enforces an internal compliance program, including written policies and procedures (which in turn must include documentation requirements and position and aging limits), internal controls and ongoing monitoring, and analysis and independent testing to establish that the trades in fact reduce risk.
    • Trading is conducted in accordance with the policies, procedures, and controls and is designed to reduce one or more specific risks. Additionally, the trades may not give rise to significant new or additional risk that is not contemporaneously hedged and must be subject to continuing review.
    • Compensation arrangements for the traders are designed not to reward or incentivize prohibited proprietary trading.

Extensive documentation requirements also apply.

Hedge Funds and Private Equity Funds

  • Traditional ownership interests and investments. The definitions of private equity and hedge funds in the proposed Volcker Rule swept so broadly as to potentially cover investments that regulators have long approved in various entities and funds and that are not associated with what are commonly regarded as the activities of hedge funds or private equity funds. The Rule clarifies that several types of investments are not covered by the prohibition, including wholly owned subsidiaries, joint ventures, acquisition vehicles, foreign pension or retirement funds, insurance company separate accounts (including BOLI), public welfare investment funds, and any entity formed by, or on behalf of, the FDIC to facilitate the disposal of assets acquired in the FDIC's corporate, conservatorship, or receivership capacity. Nevertheless, a bank should be aware that conditions apply to certain of these investments; for example, investments in joint ventures are not covered by the rule only so long as the ventures have 10 or fewer unaffiliated co-venturers.
  • Asset-backed securities, commercial paper, and derivatives. Similarly, as originally proposed, the Volcker Rule might have prohibited investments in various asset-backed securities. The Rule clarifies that investments in many of these securities, including most asset-backed securities and commercial paper backed by conforming asset-backed commercial paper conduits, are permissible. Not all asset-backed securities avoid designation as a covered fund, however, and a bank with any interests in non-traditional asset-backed securities should review its holdings with care. Similarly, some investments in derivatives are permitted, while others are not.
  • Collateralized debt obligations and collateralized loan obligations. According to the Federal Reserve, unless a bank has acted as the securitizer or asset manager for CDOs or CLOs, investments in these instruments may have to be unwound.

Conclusion

Although neither Congress nor the banking regulators view the Volcker Rule as focused on community banks, any community bank that engages in almost any form of proprietary trading or investment in a fund that is permitted by the Rule must review its current policies, procedures, and business practices to ensure that it does not run afoul of the Rule, even if unintentionally.  Given the lead time often necessary to change policies or practices, this review should take place by early next year.