Loyola University Chicago School of Law, JD 2020
At the end of January, the Federal Reserve Board, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission (the “Agencies”) approved a notice of proposed rulemaking (“Proposed Rule”) to amend the “covered fund” provisions of section 13 of the Bank Holding Company Act, also known as the “Volcker Rule” (the “Rule”). The Volcker Rule is a regulation that generally prohibits banks from certain investment activities with their own accounts and limits their dealings with private equity and hedge funds, also known as “covered funds.”
The Rule in a Nutshell
The Rule was enacted in response to the 2008 financial crisis as a way to mitigate customer loss from banks making certain short-term investments. In August of last year, the Office of the Comptroller of the Currency voted to amend the Rule to clarify what types of securities trading was restricted. By restricting banks’ abilities to use their customers’ accounts for proprietary trading of securities, derivatives, and commodity futures, it prohibits banks from taking on too much risk by using accounts to increase profits. The debate over whether the Volcker Rule should extend to venture capital funds has been ongoing since its enactment.
Critics of the Volcker Rule worry that limitations on banks’ abilities to engage in trading would reduce overall liquidity because of a reduction in banks’ market-making power. The International Monetary Fund’s top risk official warned that these restrictions might significantly diminish liquidity in the bond market.
Generally, the Volcker Rule prohibits a banking entity from having ownership in a “covered fund” including an “investment company” under the Investment Company Act of 1940 but for the exclusions set forth in Section 3(c)(1) and (3)(c)(7) of the Act. The Rule implemented this prohibition and created a number of exclusions from the definition of a covered fund. One exclusion relates to issuers of asset-backed securities that meet the requirements of the “Loan Securitization Exclusion.” The Proposed Rule would exempt a fund whose assets consist solely of (1) loans; (2) debt instruments; (3) and other assets that are related or incidental to holding, acquiring, or selling such loans or debt instruments; and (4) certain interest rate or foreign exchange derivatives.
The proposed changes would weaken the overall reach of the Rule. Under the new version of the Rule, venture capital investments are no longer covered. Chair Jay Clayton of the Securities and Exchange Commission said that enacting these amendments could “facilitate capital formation, improve competition and market efficiency along an number of dimensions, and do so without increasing risks to investors.” Clayton points to the ability of banks to now extend financing to start-ups and medium-sized businesses through qualifying venture capital funds, which could benefit the financial system by improving the flow of financing and allowing banking entities to compete effectively with other sources of financing.
The namesake of the Volcker Rule, Paul Volcker, passed away late last year. Consumer advocates have since expressed concern that the latest amendments to the Rule might permit risky behavior by banks, and that it undermines the Rule’s objectives by opening more loopholes for taxpayer-backed banks to engage in substantial proprietary trading.
Dissenters warn of possible consequences
Some key players in the regulatory and rulemaking space have been vocal about their concerns over the changes proposed. SEC Commissioner Allison Herren Lee said the revision “ignores … risk-reducing public policy” and according to CFTC Commissioner Dan Verkovitz, is “driven by complaints from the very banks the rule is intended to make safer.” Maxine Walters, House Financial Services Committee Chair accused regulators of “working overtime to weaken a regulation” that is designed to protect taxpayer money from risky investments by bigger banks.
The biggest question is what the FDIC is signaling by backing these revisions. If a bank is to fail because of its excessive-risk taking, the FDIC is empowered to trigger Dodd-Frank’s Title II to liquidate a large, complex financial company that is close to failing. Some analysts warn that banks have barely even begun to implement the Volcker Rule, and that we haven’t experienced a full credit cycle to test its effectiveness in an economic downturn.
In the interim, comments on the proposed rules are due April 1, 2020. The full text of the proposed amendments can be found here.