Triumph of Risk Management Over Psychiatry: Revisions to the Volcker Rule

On May 30 the Federal Reserve Board, along with OCC, FDIC, SEC, and CFTC jointly published proposed revisions to tailor and simplify the Volcker rule which generally prohibits banks from engaging in proprietary trading and owning and investing in hedge funds and private equity funds. This proposal represents the “first effort” by the agencies to implement comprehensive Volcker rule reform. The proposal itself is quite dense, clocking in at 372 pages (plus an additional 120+ pages of SEC economic analysis) and containing 342 questions covering nearly all facets of the rule.

For many observers, the Volcker rule is a poster child of good regulatory intentions gone awry. The intent was to prevent traders from gambling with insured depositor money; the result has been concern in the trading room of market making and risk management activities like hedging being labelled ex post as “proprietary trading.” Prudent risk management requires firms to take  an ownership view on risks faced by the bank – and then to act on that view, for instance by taking on a hedge. This inability to cleanly separate benign and indeed desirable risk management from less benign and undesirable proprietary trading has been the core problem with implementing the original Volcker rule.

We believe the proposed revisions are a net positive for both banks and the agencies, and four themes stick out:

  1. Better aligns with the existing risk control practices of banks
  2. Increases flexibility for hedging
  3. Replaces subjective criteria (e.g. intent) with objective criteria
  4. Moves closer to an enforceable regulatory regime

While we view many of the developments as a net positive, there are certain proposed revisions that will likely have a limiting effect on the proposal’s practical impact. For example, the inclusion of CEO attestation for banks with “moderate” trading operations will ultimately prevent them from realizing the level of impact that is conceptually envisaged in the proposed revisions to streamline their compliance requirements. However, the inclusion of the CEO attestation is a critical component of the framework and has been cited by Fed Governor Lael Brainard as such, so we think it is unlikely to be removed from future proposals.

Finally, there are critical aspects of the rule for which we would have liked to see more concrete proposals, such as the definition of covered funds. We note, however, that the proposal seeks detailed feedback on this and many other aspects of the rule that didn’t have specific revisions proposed. This is an opening bid in what is likely to be a lengthy rulemaking revision process, and the industry should take seriously the solicitation for comment to help shape the final rule in a way that allows the original intent to be practically realized.


Triumph of Risk Management Over Psychiatry: Revisions to the Volcker Rule