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From Securities Regulation Daily, February 5, 2014

Lawmakers grill financial regulators on Volcker Rule

By Amanda Maine, J.D.

The heads of the country’s top financial regulatory agencies appeared before the House Financial Services Committee to answer questions about the implementation of the Volcker Rule. They were subject to a barrage of questions on many aspects of the rule, including its consistent application across different regulatory bodies, certain exemptions to the rule, the lack of a cost-benefit analysis, and concerns about putting the U.S. at a competitive disadvantage against countries that do not subject their banks to Volcker-type regulations.

Background. The Dodd-Frank Act requires the main financial regulators to implement the Volcker Rule, which prohibits U.S. bank holding companies and their affiliates from engaging in proprietary trading and from sponsoring hedge funds and private equity funds. The Federal Reserve, the SEC, the Comptroller of the Currency, the FDIC, and the CFTC jointly proposed the Volcker Rule in 2011 and 2012. After a great deal of public input and government outreach, the final rule was approved by the five agencies on December 10, 2013. The heads of the agencies testified today before House Financial Services Committee on the implementation of the Volcker Rule at a hearing titled “The Impact of the Volcker Rule on Job Creators.”

Coordination among regulators. Many lawmakers expressed their concern about how the Volcker Rule can be implemented in a consistent way by the five agencies. Although the regulators have set up a working group to coordinate their efforts, many members voiced their doubts that such a process would guarantee consistency in implementation. Rep. Edward R. Royce (R-Cal.) inquired why a coordinated implementation plan was not in place prior to the rule being finalized. Rep. Mick Mulvaney (R-S.C.) also expressed his concern with cross-agency consistency, wondering if there was a clear regime to resolve issues if one agency decreed that a certain trade was permissible but another agency deemed it otherwise.

The regulators acknowledged the members’ concerns, but emphasized that any given financial institution or bank holding company affiliate is under the jurisdiction of a primary regulator. SEC Chair Mary Jo White emphasized that the SEC is the primary regulator for Volcker Rule issues involving broker-dealers. Daniel Tarullo, a governor on the Federal Reserve Board, stated that all regulators have a statutory mandate for the oversight of particular entities and none are willing to fully cede interpretive authority. When pressed for why there is a need for a working group when agencies have absolute authority over the institutions they regulate, Tarullo said the input of the working group will be beneficial if the same kind of activity takes place in two different types of institutions, such as in a broker-dealer and in a national bank. The working group will help achieve consistency in these situations, according to Tarullo.

Tarullo was also asked if the working group’s interpretive process would be public and subject to public comment. Tarullo advised that generally applicable guidance should be made public. He noted, however, that because of concerns related to confidential proprietary information and business strategies, firm-specific inquiries about whether particular instruments fall into the Volcker Rule’s exception on market making will remain confidential.

Volcker Rule exemptions. In addition to the market maker exemption, the Volcker Rule also permits a banking entity to continue to engage in proprietary trading in U.S. government, municipal, and certain limited foreign sovereign obligations. A number of representatives on both sides of the aisle questioned why this exemption exists when there is no exemption from the Volcker rule for collateralized loan obligations (CLOs). Some members pointed out that a number of smaller, community-oriented banks will be forced to divest millions in CLOs if they are not granted an exemption from the Volcker Rule. Rep. Steve Stivers (R-Ohio) said that subjecting CLOs to the Volcker Rule was not Congress’ intent in drafting Dodd-Frank and that failure to address the issue could have a disruptive impact on the economy. Rep. David Scott (D-Fla.) echoed this sentiment, noting that financing from CLOs provides large amounts of money to small business and that those types of instruments were not the cause of the financial crisis which precipitated the need for legislation in the first place. Other members were concerned that an exemption would allow banks to trade in risky municipal and sovereign debt but not allow an exemption for CLOs traded by “main street” banks.

The regulators were sympathetic to the members’ concerns, noting that the working group will review and consider an exemption for CLOs. Tarullo also noted that most CLOs are made up exclusively of loans and are therefore not subject to the Volcker Rule. The agencies will address the remaining “arbitrage CLOs,” which consist of loans and other assets, he said. Many members pointed out that the agencies had recently approved grandfathering protection to trust-preferred securities collateralized debt obligations (TruPS CDOs) for smaller banks that would otherwise be forced to sell them off, and urged the agencies to approve similar protections for CLOs.

Economic analysis. Several Republican members of the committee chastised the regulators for not performing a rigorous cost-benefit analysis prior to finalizing the Volcker Rule. Committee Chair Jeb Hensarling (R-Tex.) cited research indicating the Volcker Rule would take $800 billion out of the economy. Rep. Ann Wagner (R-Mo.) said that the costs of the rule will dwarf its “highly speculative” benefits and repeatedly criticized the agencies for not doing a formal cost-benefit analysis. White maintained that while the SEC’s formal procedure for economic analysis was not used for the Volcker Rule, the SEC still used its guidance in helping draft the rule and the adopting release illustrates how the Commission evaluated the rule’s costs versus its benefits. Several representatives also lambasted the regulators for approving the rule with changes from the initial proposal when they felt a re-proposed rule would have been appropriate. White disagreed, noting that the original proposal was subject to two years of review, comment letters, and government outreach.

Competitive disadvantage. Many lawmakers expressed their fear that the Volcker Rule would put the U.S. at a competitive disadvantage to markets abroad. Rep. Bill Huizenga (R-Mich.) warned that other countries would not adopt a version of the Volcker Rule in order to attract business from the U.S. Tarullo acknowledged that immediately following the adoption of the Volcker Rule, there was not a lot of interest in the concept. However, he explained, in the intervening years, more foreign legislators and regulators have expressed support for adopting Volcker-style legislation. White recognized that regulatory arbitrage should be avoided, but countries such as the U.K., France, and Germany are moving toward adopting similar rules limiting proprietary trading by banks.

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