Volcker Rule a regulatory beast in need of taming
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Over the past few months, there has been a steady drumbeat of calls from regulators and legislators to change the Volcker Rule, the prohibition on bank risk-taking adopted as part of the Dodd-Frank Act in 2010.

The essential strictures of the Volcker Rule are well known: U.S. banking entities and foreign banking entities with a U.S. presence are prohibited from engaging in proprietary trading or investing in (or “sponsoring”) hedge funds and private equity funds. From those two tenets sprung a long, tortured debate that has spanned virtually every aspect of the Volcker Rule, from how to write the implementing regulations, to how to interpret those regulations and now, finally, to how to change those regulations.


To begin, the statutory Volcker Rule tasked five federal agencies — the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Office of the Comptroller of the Currency (OCC) — with jointly writing and issuing implementing regulations.


The requirement for consensus among five different agencies, each of which had different views and supervised different classes of entities and activities, resulted in a rule-writing process that dragged on, notoriously, for nearly three-and-a-half years as it “fueled internal wrangling” among regulators. 

The final regulations, issued in December 2013, immediately set off another round of industry hand-wringing as market participants began the lengthy process of digesting the rule and implementing its mandatory compliance programs. What seemed straightforward in theory was anything but in reality.

For example, the final regulations used the concept of “covered funds” as a proxy for the statute’s reference to hedge funds and private equity funds, incorporating by reference a legal definition that dragged into the rule’s scope a wide range of entities that no market participant had thought of as a hedge fund or private equity fund.

The concept of legitimate “market-making-related-activities,” exempted from the statutory proprietary trading ban but left undefined, was especially unwieldy as implemented, requiring regulators to essentially read the minds of traders to determine their subjective intent. In the years since the final regulations were issued, as those regulators began the process of examining compliance with the Volcker Rule, they increasingly realized that market participants had a point: as former Federal Reserve Governor Tarullo put it just before leaving his post earlier this year, “the Volcker Rule is too complicated.”

Which brings us to the recent calls for reform. A brief recap: In June, the House of Representatives passed the Financial CHOICE Act of 2017, which, should it become law, would repeal the Volcker Rule in its entirety. Days later, the Treasury Department released the first in what is slated to become a series of reports examining the U.S. financial regulatory system.

The report recommended a number of regulatory improvements surrounding the Volcker Rule, including better tailoring its applicability to smaller entities, working to improve interagency coordination among the five regulatory agencies and clarifying and simplifying essential aspects of both the proprietary trading and covered fund prohibitions.

Later in June, acting Comptroller of the Currency Keith A. Noreika noted in congressional testimony that, “[t]he Volcker rule provides a practical example of how conflicting messages and inconsistent interpretation can exacerbate [the] regulatory burden by making industry compliance harder and more resource intensive than necessary.”

Even Federal Reserve Chair Janet Yellen acknowledged before the House Financial Services Committee that the recommendations in the Treasury Department’s report were “very useful,” even if on a few points she had a different view. 

From there, action for change became more concrete: In late July, the Federal Reserve issued two separate releases on the Volcker Rule, one of which signaled a willingness to reexamine how the Volcker Rule applies to certain, completely offshore funds held by foreign banks, long a sticking point among foreign market participants.

On July 28, the Financial Stability Oversight Council “discussed potential improvements to the Volcker Rule,” one day after Treasury Secretary Steve Mnuchin testified to Congress that “we [wouldn’t] object” if Congress were to repeal the Volcker Rule. Finally, on Aug. 2, the OCC officially requested public comment on how the Volcker Rule should be revised “to better accomplish the purposes of the statute” in such a way that would “decreas[e] the compliance burden on banking entities and foster economic growth.” 

What do these developments really mean, and how much of this, if any, will become reality? One noteworthy development is that regulators themselves have finally begun to give voice to the exact contentions that banks have spent years espousing — that the Volcker Rule is overbroad, unwieldy and difficult to interpret and enforce and that it imposes disproportionate compliance obligations on smaller and foreign institutions whose activities do not pose the type of risks that the Volcker Rule was meant to guard against. 

Given this recent groundswell of support for reform, right now is an appropriate time to revisit the Volcker Rule. The five agencies now have several years of reported trading metrics, examination data and bank attestations behind them. What were once theoretical objections — that the Volcker Rule’s definition of market-making would be too difficult to apply and that “compliance under the current approach would consume too many supervisory, as well as bank, resources” — have now been borne out in practice, and any review of the Volcker Rule can make use of this data and experience.

There is at least one other way regulators may ease the burden of the Volcker Rule — through simply taking a lighter approach to enforcement. This isn’t to suggest that regulators should ease the rigor of their examinations or take any possibility of enforcement off the table, but rather the hope that agencies will acknowledge that large swaths of the Volcker Rule are difficult (if not impossible) to interpret with any certainty, and that banks that have spent countless millions of dollars in a good faith effort to achieve compliance should not be punished for taking reasonable stances with which an examiner might disagree.

We suspect that anything the industry argues for will be framed by opponents as yet another giveaway to large banks. But it shouldn’t be a foregone conclusion that anything that might make the lives of banks’ compliance staff easier must necessarily come at the expense of safety and soundness. There is a middle ground that both respects the statutory prohibitions of the Volcker Rule and tailors its application to market participants in a more straightforward, risk-based manner. 

One final point: In the short term, any changes will likely have the effect of increasing compliance burdens rather than reducing them; and banks’ internal policies and procedures will have to be rewritten in response to any potential reforms.

However, we will hopefully end up with a more sensible rule that, in the long run, is easier to implement and enforce and has less of a chilling effect on market liquidity.

Douglas Landy is a partner in the New York office of Milbank, Tweed, Hadley & McCloy and a member of the firm’s Leveraged Finance Group. James Kong is an associate in the New York office of Milbank, Tweed, Hadley & McCloy and a member of the firm’s Leveraged Finance Group.

The views expressed by contributors are their own and not the views of The Hill.