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1. 1 | PERSPECTIVES The Volcker Rule - Are You Ready? The Volcker Rule - Are You Ready? WHAT IS THE RULE? On December 10, 2013, five U.S. financial regulatory agencies1…
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  • 1. 1 | PERSPECTIVES The Volcker Rule - Are You Ready? The Volcker Rule - Are You Ready? WHAT IS THE RULE? On December 10, 2013, five U.S. financial regulatory agencies1 adopted a final rule implementing Title VI of the Dodd-Frank Wall Street Reform and Consumer Protection Act commonly referred to as “The Volcker Rule (the “Final Rule”). The Final Rule became effective on April 1, 2014, and impacted institutions are required to be in full compliance by July 21, 2015. The “Volcker Rule” generally prohibits a banking entity and its affiliates from: »» Engaging in proprietary trading; »» Acting as a principal, directly or indirectly, and acquiring or retaining any ownership interest in, or sponsoring, a covered fund. A banking entity is defined as either an insured depository institution, a company that controls an insured depository institution, a company treated as a bank holding company under the International Banking Act of 1978, or an affiliate or subsidiary of one of the above. PROPRIETARY TRADING As expected, the Final Rule prohibits proprietary trading by a banking entity in most securitized products. Proprietary trading is defined as engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments. A trading account is, in turn, broadly defined to mean an account used by a bank to make short-term trades, and by default, presumes that any security held on a bank’s balance sheet for less than 60 days is being held in the bank’s trading account, unless the bank can demonstrate otherwise. While these definitions would appear to encapsulate virtually all forms of trading activity that banks engage in, the Final Rule does contain several exemptions that would not be considered prohibited proprietary trading. 1 The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board, The Securities Exchange Commission (SEC), The Commodity Futures Trading Commission (CFTC) and Comptroller of the Currency.
  • 2. 2 | PERSPECTIVES The Volcker Rule - Are You Ready? Notably, the following activities would be allowed under the Final Rule: Market making – The Final Rule allows for market making activities provided that the trading desk that establishes and manages the financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in those types of financial instruments for its own account, in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instrument. Underwriting – The Final Rule permits the banking entity to act as an underwriter2 for a distribution of securities with its trading desk having positions related to such distribution. For the purpose of this exemption, both members of the underwriting syndicate and selling group members can qualify as underwriters. The underwriting position must be designed not to exceed reasonably expected near term demands of client, customers or counterparties. Hedging – The Final Rule specifies that hedging must be for risk mitigation purposes and cannot give rise, at the inception of the hedge, to any significant new or additional risk that is not itself hedged contemporaneously. The Final Rule allows for portfolio hedging, but banks cannot use macro hedging to protect against the broader market or economic risk or to increase risk taking. Banks will have to provide a detailed history to show correlation when entering into hedges and also to justify the level and types of trading inventory. Key requirements of hedging exemption rule include: »» Bank must have detailed internal compliance procedures; »» Transaction must mitigate one or more specific risks, not general risk; »» Hedge and underlying position should be reasonably correlated; »» Hedge cannot lead to material exposure risk that is not hedged; »» Hedge is subject to monitoring; »» Compensation cannot be tied to proprietary trading; and, »» Banks must maintain detailed documentation. Acting as an agent or broker for a customer – The Final Rule allow banking entities to use their own funds to purchase or sell financial instruments when acting on behalf of their customers rather than on behalf of themselves or retain a beneficial ownership of the financial instruments. Activities of an insurance fund under its separate or general account – The Final Rule specifically and broadly exempts the purchase, sale, acquisition or disposition of securities and other instruments by a regulated insurance company engaged in the business of insurance for the general account of the company. Likewise, separate accounts managed and maintained by insurance companies as part of the business of insurance are generally customer-driven and do not expose the banking entity to gains and losses on the value of assets held in the separate account, although the banking entity may be treated as the owner of the assets for certain purposes. Unlike the general account of the insurance company, separate accounts are managed on behalf of specific customers, similar to a bank managing a trust or fiduciary account. Foreign banking entities eligible for the exemption – In order to be eligible for the foreign trading exemption, the banking entity must not be directly or indirectly controlled by a banking entity that is organized under the laws of the United States or of one or more States. In addition to the banking entity, any relevant personnel making the decision to purchase or sell as principal cannot be located in the United States and no financing for the banking entity’s ownership or sponsorship is provided, directly or indirectly by any U.S. affiliate of the banking entity. Furthermore, any transaction including investment or sponsorship arising from risk-mitigating hedging related to an ownership interest is not accounted for as principal directly or indirectly on a consolidated basis by any branch or U.S. affiliate of the banking entity. 2 The terms “distribution” and “underwriter” are defined in Final Rule §_.4 (a)(3) and §_.4(a)(4), respectively.
  • 3. 3 | PERSPECTIVES The Volcker Rule - Are You Ready? Exclusion of repurchase agreement and securities lending agreements – Repurchase, reverse repurchase agreements and securities lending agreements are generally exempt from the definition of proprietary trading under the Final Rule. However, the Agencies will monitor these transactions to ensure this exclusion is not used to engage in prohibited proprietary trading activities. For example, the collateral or position that is being financed by the repurchase or reverse repurchase agreement may not be exempt and involve impermissible proprietary trading. Furthermore, proprietary trading is not prohibited across all products. Banking entities can continue to trade as a principal for the following asset classes: »» US government obligations; »» Debt issued or guaranteed by the GSEs, including agency MBS and the STACR deals; »» Municipal bonds; and, »» Any loans, including mortgage whole loans or other consumer and commercial receivables. COVERED FUNDS Along with restrictions on proprietary trading, the Volcker Rule generally restricts a bank from acquiring, owning, or sponsoring a covered fund subject to certain thresholds. A covered fund is broadly defined to include investment vehicles that either limit the number of investors in the fund or that obtain capital from qualified investors that meet certain net worth or income thresholds – including, most hedge funds and private equity funds. However, the current definition is broad so that other types of vehicles, including some types of securitizations, may ultimately be classified as a covered fund. The Final Rule provides the following exclusions from being defined as a covered fund: »» Foreign fund related exclusions: ›› Foreign Public Funds ›› Foreign Pension or Retirement Funds »» Structured product vehicle exclusions: ›› Issuing Entities for Asset-Backed Securities ›› Qualifying Asset-Backed Commercial Paper Conduits ›› Entity Owning a Pool of Loans / Assets for the Benefit of Covered Bonds »» Insurance vehicle exclusions: ›› Bank-Owned Life Insurance ›› Insurance Company Separate Accounts »» Joint venture and acquisition vehicle exclusions: ›› Wholly Owned Subsidiaries ›› Joint Ventures between a Banking Entity / Affiliates and Unaffiliated Persons ›› Acquisition Vehicles »» Public benefit vehicle exclusions: ›› SBICs and Public Welfare Investment Funds ›› Registered Investment Companies and Excluded Entities ›› Issuers in Conjunction with the FDIC’s Receivership or Conservatorship In the global environment that financial institutions operate in today, appropriately classifying and supporting covered fund interests will pose a material challenge.
  • 4. 4 | PERSPECTIVES The Volcker Rule - Are You Ready? and covered fund activities and investments set forth in the Final Rule. The compliance program must include written policies and procedures that are appropriate for the types, size, complexity and risks of the related activities conducted by the banking entity. Key dates in the adoption timeline are included below: COMPLIANCE TIMELINE A banking entity must develop and provide for the continued administration of a compliance program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions on proprietary trading April 1,2014 Effective date of Final Rule June 30,2014 Reporting of quantitative metrics ($50bn in trading assets and liabilities) July 21, 2015 Conformance period ends July 21, 2016-22? Extension of conformance period(s)* *Potential extension of conformance period »» Potentially two additional one-year “general” extensions. »» Additionally potential five-year extension for “illiquid” funds (for obligations existing as of May 1, 2010). COMPLIANCE PROGRAM REQUIREMENTS Minimum Compliance Program In order to comply with the minimum requirement, a banking entity needs to develop a minimum compliance program which includes the following: »» Written policies and procedures designed to document, describe, monitor and limit trading activities in accordance with the rule; »» System of internal controls reasonably designed to monitor compliance; »» Management framework that delineates responsibility and accountability for compliance; »» Independent audit and testing of compliance program effectiveness; »» Staff training program; and, »» Records demonstrating compliance retained for no less than five years. Enhanced Compliance Program In addition to the minimum compliance standards, banks that are required to report quantitative metrics and have $50 billion or more in assets must have an enhanced compliance program with key components to include the following: »» Policies and procedures governing trading desks including instruments and risk levels; »» Descriptions of risk management processes; »» Internal controls to monitor and enforce risk limits; »» Policies and procedures on hedging instruments and strategies; »» Analytics and quantitative measurement of trading activities including back-testing; »» Description and documentation of covered fund activities and investments; »» Compliance monitoring of the Final Rule and documentation on exemptions; and, »» Remediation of violations.
  • 5. 5 | PERSPECTIVES The Volcker Rule - Are You Ready? Quantitative Measurement Reporting In order to effectively monitor its trading activities, a banking entity needs to develop and report the following quantitative measurements: »» Risk and Position Limits and Usage »» Risk Factor Sensitivities »» VaR and Stress VaR, Trading P&L Attribution »» Comprehensive Profit and Loss Attribution »» Inventory Turnover »» Inventory Aging »» Customer Facing Trade Ratio The Final Rule does not provide any prescriptive definition of the above measurements; instead it is general guidance such that it is flexible enough to be tailored specifically to the activities of each trading desk. Calculation guidance provided in Appendix A3 ensures that a similar approach is being used across all the trading desks within a banking entity. Reporting requirements of the quantitative measurements to the agencies will be determined based on the size of each bank’s consolidated trading assets and liabilities. Banks holding in excess of $50 billion in consolidated trading assets and liabilities have a threshold date to report as of June 30, 2014; banking entities with trading assets and liabilities between $25 billion and $50 billion have a threshold date to report as of April 30, 2016; and, banking entities between $10 billion and $25 billion of trading assets and liabilities are subject to a threshold date to report of December 31, 2016. Other Compliance Matters »» The banking entity must adopt a written compliance program approved by the board of directors, an appropriate committee of the board, or equivalent governance body, and senior management. »» The CEO of the banking entity is required to annually attest in writing that their organization has the procedures to establish, maintain, enforce, review, test and modify the compliance program in a manner reasonably designed to achieve compliance with the Final Rule. »» Independent testing of the effectiveness of the compliance program must occur with a frequency appropriate to the size (no less than annually), scope, and risk profile of the banking entity’s trading and covered fund activities or investments. »» Banking entities must provide adequate training to personnel involved in activities governed by the Final Rule or those involved in its compliance. »» Banking entities must create and retain records sufficient to demonstrate compliance and support the operations and effectiveness of the compliance program. 3 Section .20(d) Reporting and Recordkeeping Requirements Applicable to Trading Activities.
  • 6. 6 | PERSPECTIVES The Volcker Rule - Are You Ready? CONCLUSION What emerges from the Final Rule is that nearly all organizational units will be involved in its compliance. »» For the front office there is accountability in terms of trading desks, technology and staff. Risk and revenue related metrics including correlation and back-testing requirements will expand the scope for risk management. In addition, risk and authorization limits must be developed. »» Interpreting rule requirements, the rigor of ongoing compliance monitoring and the need for evaluation and investigation suggest a prominent role for legal and compliance functions. »» In order for banking entities to utilize any of the exemptions described in the Final Rule, data must be captured and stored with business and technology units needing to collaborate in regards to gathering, saving and monitoring all the quantitative metrics. »» A centralized corporate governance function must be in place to establish processes around the identification of violations and escalation policies, as well as, monitoring overall compliance with the rule including the independent testing function. Given the wide reach of the Final Rule, impacted entities of any size should be currently assessing the impact to their organization and working towards full compliance. In order to delineate between market-making and proprietary activities, as well as capture metrics such as profit and loss attribution and inventory turnover, a few short term initiatives an entity can assess are: »» Enhancing the data quality across business and trading desks thus allowing for a standardized approach with aggregating information and metrics. »» Using trading and sales systems to capture daily turnover across all asset classes and derivatives. The process must be automated and there will be a need to move away from customized desk tools and develop cross-business and cross-desk applications. »» Aggregating the reporting and documenting of trading activities for both internal compliance monitoring and bank examinations needs.
  • 7. 7 | PERSPECTIVES The Volcker Rule - Are You Ready? AS ILLUSTRATED IN THE CHART BELOW, NAVIGANT CAN ASSIST IN ALL ASPECTS OF ADOPTING THE VOLCKER RULE: VOLCKER RULE CATEGORY VOLCKER RULE REQUIREMENT Operational Gap Analysis/Remediation Compliance Program Design & Implementation Policy and Procedure Development Regulatory Exam Response Support Risk Assessment Data Integrity and Capture Quantitative Measurement Developement Independent Testing Program Design Implementation Independent Model Validation and Model Governance Policies Training Program Design/Outsourcing Project Management Staff Augmentation NAVIGANT SERVICE OFFERING Policy and Procedures Compliance Support Quantitative Measures Corporate Governance » What constitutes a trading desk » New product approval process » Document hedging/trading strategies, customer/counterparty relationships, risk management process and staff compensation arrangements. » Facilitate regulatory examination » Recordkeeping » Independent testing » Identify, document, monitor and report permitted activities and potential areas of noncompliance » Development of quantitative measurements based upon general definitions provided » Model validation » Reporting » Risk limits and authorization levels » Corporate governance including escalation and remediation of violations » Training program HOW NAVIGANT CAN HELP Creating a fully compliant infrastructure and reporting framework that adheres to the Volcker Rule requires coordination across business units and significant allocation of resources to standardize data, documentation and processes. Navigant has extensive experience in all aspects of the Volcker Rule including personnel that have worked in the private and public sectors in trading, securitizations, investments, hedging, risk management, data management, technology, valuation, project management and accounting/audit. This experience affords our personnel with an in-depth understanding of the intent and application of the requirements along with a practical view into developing a compliance and corporate governance program.
  • 8. 8 | PERSPECTIVES The Volcker Rule - Are You Ready? © 2014 Navigant Consulting, Inc. All rights reserved. 00003026 Navigant Consulting is not a certified public accounting firm and does not provide audit, attest, or public accounting services. See navigant.com/licensing for a complete listing of private investigator licenses. To discuss how Navigant can assist your organization, please contact the following individuals: Paul Noring Managing Director pnoring@navigant.com 202.973.6550 Pete Barbera Director pbarbera@navigant.com 202.973.6540 Sudip Chatterjee Director sudip.chatterjee@ncacf.com 646.227.4301 Raman Mandapaka Director raman.mandapaka@navigant.com 202.973.6572 Patrick DellaValle Associate Director patrick.dellavalle@ncacf.com 202.481.8348
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