FDIC Approves Volcker Rule and Issues SPOE Strategy for Public Comment

unanimously approved a Final
that places restrictions on proprietary trading and interests in
private equity funds for banks, known as the Volcker Rule, and released
documentation detailing its “Single Point of Entry” (SPOE) strategy to resolve
large financial institutions.

The Volcker Rule

Bob Bean, Karl Reitz, Mike
Phillips and Greg Feder presented the final rule to the Board. Bean said
banking entities have a conformance period “of about two years” from the
statutory effective date to fully conform their activities and investments to
the requirements of the Final Rule. However, he noted that the conformance
period can be extended by the Federal Reserve Board (Fed) at their discretion.
Earlier this morning, the Fed unanimously approved an extension of the
conformance period to July 21, 2015.

Moving to a summary of the Final
Rule, Bean said it implements a new Section 13 of the Holding Company Act and places
prohibitions and limitations on the ability of banking entities to engage in
short-term proprietary trading of securities or derivatives for their own
account or to own, sponsor or have certain relationships with hedge funds and
private equity firms.

Proprietary Trading Exemptions
and Exclusions

The ban on proprietary trading
includes exemptions for underwriting, market-making and risk-mitigating

Under the exemption for
underwriting, if a banking entity acts as an underwriter for the distribution
of securities, the trading desk’s underwriting position must be related to that
distribution. However, the underwriting position “must be designed not to
exceed the reasonably accepted near-term demand of customers.” Bean noted that
determining customer demand is based on “historical demand and consideration of
current market factors.”

Under the exemption for
market-making related activities, the trading desk inventory “must be designed
not to exceed, on an ongoing basis, the reasonably expected near-term demand of
customers.” Additionally, a market-making desk may hedge the risk of its
market-making activities under this exemption “provided it is acting in
accordance with certain risk management procedures required in the Final Rule.”

Under the exemption for
risk-mitigating hedging, hedging activity must be designed to “demonstrably
reduce or significantly mitigate specific, identifiable risks of individual or
aggregated positions” of the banking entity. In addition, the Final Rule
requires the banking entity to conduct an analysis supporting its documented
hedging strategy and the effectiveness of hedges “must be monitored and, as
necessary, re-calibrated on an ongoing basis.” The Final Rule also requires
banking entities to document the hedging rationale for certain transactions
that present “heightened client risk.” It is also important to note that under
the Final Rule, a banking entity is allowed to hedge individual or aggregate
exposures, but is not be allowed to engage in micro-hedging.

Other exemptions from the
prohibition on proprietary trading include:

Trading in certain government obligations, including U.S.
government, agency, state and municipal obligations;

In limited circumstances, trading the obligation of a foreign
sovereign or its political subdivision;

Trading activities of foreign banking entities provided the
trading decisions and principal risks of foreign banking entities occur and are
held outside of the United States. Such transactions may involve U.S. entities
only under certain circumstances;

Trading on behalf of a customer in a fiduciary capacity; and

 Risk principal trades and activities of an insurance company
for its general or separate account.

The Final Rule also includes
clarifying exclusions to proprietary trading provided that certain requirements
are met, including:

Transactions solely as an agent, broker or custodian;

Transactions through a deferred compensation or similar plan;

Transactions to satisfy a debt previously contracted;

Transactions in certain repurchase and security lending

Transactions for the purpose of liquidity management in accordance
with a documented liquidity management plan;

Transactions in connection with certain clearing activities; and

Transactions to satisfy certain existing legal obligations.


Covered Funds

The Final Rule prohibits banking
entities from owning and sponsoring hedge funds and private equity funds
(covered funds). Under the rule, the definition of covered funds encompasses
any issuer that would be an investment company under the Investment Company
Act, excluding firms under Section 3c1 or 3c7. Additionally, the Final Rule
includes certain foreign funds and commodity pools in the definition covered
fund, but are defined “in a more limited capacity.”

The Final Rule specifically
excludes registered investment companies and business development companies
that are regulated by the Securities and Exchange Commission (SEC). Other
exclusions have been provided for certain foreign funds publicly offered
abroad, loan securitization, insurance company accounts, small business
investment company investments, public welfare investments, any issuer security
backed entirely by loans subject to certain asset restrictions and issuers in
conjunction with the FDIC receivership and conservatorship operations.

The Final Rule places the number
of limitations on permitted ownership interest in covered funds. In particular,
a banking entity must limit its total interest in each covered fund to no more
than three percent ownership interest and to no more than three percent of the
value of the entire covered fund. In addition, the aggregate of all interest a
banking entity has in covered funds may not exceed three percent of the banking
entity’s Tier One Capital. Finally, the banking entity must deduct the value of
all of its interest in covered funds and any related retained earnings, from
its regulatory capital calculations.

Compliance Requirements

The Final Rule includes
compliance requirements that vary based on the size of the banking entity and
the amount of covered activities it conducts. It requires banking entities to
establish an internal compliance program “reasonably designed” to ensure and
monitor compliance with the Final Rule. Larger baking entities with $50 billion
or more in total consolidating assets, must establish a more detailed
compliance program approved by the Board of Directors. The Board of Directors
and senior management are also responsible for “communicating an appropriate
culture of compliance and ensuring that appropriate policies regarding the
management of trading activities and covered fund activities or investments are
adopted to comply with the requirements of the Final Rule.”

Additionally, the CEO of a
banking entity must attest to its primary federal regulator that their
institution has processes to “establish, maintain, enforce, review, test and
modify the compliance program in a manner reasonably designed to achieve compliance
with the Final Rule.” Banking entities with total consolidated assets between
$10-$50 billion will be subject to minimum compliance requirements as set forth
in Section 20 of the Final Rule. Smaller banks engaging in modest activities
are subject to a more simplified compliance regime.

The Final Rule also requires
banking entities with “significant trading operations” to report certain
quantitative metrics related to their trading activities. These reporting
requirements will be phased in over a period of time based on the type and size
of the banking activities.

Board Statements

In a prepared statement, Chairman Martin
Gruenberg said the Final Rule more clearly defines
the type of trading activities that are exempt from the ban on proprietary
trading, highlighting the difficulty of defining the market-making and hedging
exemptions. He said the “heart” of the Final Rule remains the compliance
framework, which requires Boards of Directors, CEOs and other senior management
to approve compliance regimes and review their effectiveness on an ongoing
basis. Gruenberg also highlighted the exemption of smaller banking entities
from the Final Rule and the simplified compliance program for small banking
entities that engage in market making activities. In closing, he said the

Final Rule “preserves important, legitimate market making and hedging
activities,” while “achieving the statutory requirement of prohibiting
speculative trading and fund activities supported by the public safety net.”

a brief statement, Vice Chairman Thomas Hoenig announced his support for the
final rule, stating that it will mitigate the moral
hazard and “misaligned incentives” of large financial institutions that have
insured deposits. He acknowledged that the Volcker Rule is “highly complex,”
however, he pushed back against criticism of this complexity by noting that
systemically important financial institutions (SIFIs) are also highly complex.
In closing, he called the Volcker Rule a “necessary step” in ensuring that the
financial system is less vulnerable than it has been in the recent past and
thanked the staff for their hard work.

of the Currency Thomas Curry echoed Gruenberg’s remarks, saying the final rule
strikes the “right balance” and will make the financial system safer “while
preserving market liquidity, and continuing to allow banks to provide important
customer-oriented services.” He also said regulators have met the objective of
ensuring that the rule focuses on the largest financial institutions without
imposing “additional burdens” on community banks.

final regulations recognize that not all banking entities pose the same risk,
so a community bank that does not engage in any covered activity other than
trading in certain government obligations has no compliance obligations
whatsoever under the final regulations,” Curry said. “Community banks that
engage in additional covered activities will be subject to only minimal

closing, Curry stated that issuing the final rule is only the beginning of the
process, highlighting the importance of enforcing the Volcker Rule’s
restrictions and noting that the OCC will be “especially vigilant” in
developing a robust examination and enforcement program in 2014.

The Single Point of Entry Strategy

Art Murton presented the case for publishing
for the resolution of SIFIs. The
strategy would hold owners, creditors and culpable management accountable for
the failure of the firm while maintaining the stability of the U.S. financial
system, he said.



To implement the SPOE strategy,
the FDIC would be appointed receiver of only the top-tier U.S. holding company,
subsidiaries would remain open and operating. The FDIC would then organize a
“bridge financial company” into which it would transfer assets from the
receivership. Lawsuits would be apportioned according to the order of statutory
priority among the claims of the former equity holders and creditors, but
importantly, these claims would remain with the receivership.

The bridge financial company
would be run by an FDIC-appointed Board of Directors, CEO and “other key
managers from the private sector” to replace officers who have been removed as
part of the resolution process. The new management team would run the bridge
financial company under the FDIC’s oversight and enter into an “initial operating
agreement,” which would serve to “guide the operations of the company” and
require the formulation of a plan to resolve the company or companies under the
bankruptcy code “without risk of serious adverse affects on the financial
stability of the United States.”

Murton said the FDIC intends to
“maximize the use of private funding in a systemic resolution” and expects the
well-capitalized bridge financial company and its subsidiaries to attain
funding from “customary sources of liquidity in the private markets.” He noted
that market conditions could be such that private sources of funding might not
be immediately available and, in the intermediary, the Orderly Liquidation Fund
(OLF) would serve as a source of liquidity, and if needed, could facilitate
private-sector funding by providing guarantees. Alternatively funding could be
obtained directly through the OLF by issuing obligations fully secured by the
assets of the bridge financial company, he said. However, these obligations
would only be issued in “limited amounts for a brief transitional period.”

Once a valuation of the bridge
financial company is completed, claims and the receivership would be satisfied
through a securities or claims exchange whereby new debt, equity and possible
contingent securities would be issued. Murton said the FDIC’s goal is to limit
the time during which the bridge financial company operates and expects the
company to be ready to operate “within six to nine months.”

In his concluding remarks, Murton
noted that the Fed is expected to issue a proposed rule in the first quarter of
next year that would establish a long-term debt requirement for SIFIs, further
facilitating the above strategy.

Board Statements

In brief remarks, Gruenberg provided an
overview of Titles I and II of the Dodd-Frank Act, and said the FDIC is charged with resolving systemically important
financial institutions in a manner that “holds shareholders, creditors and
culpable management accountable for their failure while maintaining the
stability of the U.S. financial system.” He praised the formulation of the
strategy and said he is looking forward to public comments.

Hoenig expressed his support for releasing
the draft SPOE strategy, but noted that there are several “challenges” with its
implementation. He highlighted his interest in receiving comments on three “key
assumptions.” First, SPOE assumes that a bridge
financial company would be created by transferring sufficient assets from the
receivership to ensure a new company resulting from FDIC intervention is well
capitalized. Hoenig said this further assumes that the company has sufficient
equity and debt to cover all losses and has enough remaining assets to ensure
the new company is well capitalized after conversion. “If there is not
sufficient equity and debt, it is likely that the government would be required
to add necessary capital to avoid the systemic effects that result from a
failure,” Hoenig said.

Second, SPOE assumes that the
operating companies remain open through the crisis and if losses cannot be
fully absorbed by shareholders and creditors of the holding company, the
strategy assumes creditors of subsidiaries, potentially including uninsured
depositors, would be subject to a loss. Given current practice in the U.S. and
elsewhere, Hoenig said, and since Title II can be implemented only if the SIFIs
failure would have systemic consequences, it is likely the government would
again step in to assure an operating subsidiary does not fail.

Third, SPOE assumes that the parent
of an operating subsidiary is well capitalized and a SIFIs’ operations in
foreign jurisdictions would remain open and operating should a crisis occur. He
said the FDIC is working with foreign authorities to instill confidence in the
SPOE resolution strategy and to ensure that adverse reactions, such as
ring-fencing of funds, do not occur. However, he noted that while cross-border
cooperation has “increased significantly” since the onset of the crisis, it has
not been tested under crisis.

echoed many of Hoenig’s concerns, noting that issues pertaining to minimum long-term debt requirements, cross-border
contracts, and ring-fencing require more consideration and analysis. He also
said he will submit an appendix to the SPOE documentation for the record.


The Summary
and the proposed 2014
Corporate Operating Budget
were unanimously approved at the start of the
open meeting.



For an archived webcast of the open meeting,
please click here.