The Volcker Rule, named after the former Federal Reserve Chairman Paul Volcker, was a part of the famous Dodd Frank act which was passed in response of the 2008 financial crisis in order to avoid any such financial crisis in future. The bill requires all the investment banks coming under Volcker rule to mandatorily comply with Volcker rule.
As per the Volcker Rule the Investment banks are prohibited from the short term Proprietary Trading of the securities, OTC derivatives (Futures, Options etc.) under the bank’s own account for the benefit of the banks customers and are expected to submit certain Metrics/Quantitative measurements on regular basis and keep record of all applicable transactions and reports for a period of 7 years.
Volcker Rule Coverage:
Under the Volcker Rule, a “banking entity” is defined broadly and includes
FDIC – Insured Depository Institution
Companies that control an FDIC insured depository institution;
Any company that is treated as a bank holding company for purposes of sec 8 of the International Banking Act of 1978;
Any affiliate or subsidiary of the above
Includes any non-U.S. bank with a U.S. branch or agency office.
Objectives of Volcker Rule:
To reduce the systemic risk to the USA financial markets by limiting the high-risk speculative activities of the Banks
Protect US Financial market stability in order to avoid any other financial crisis
Prevent US customers’ or taxpayers’ money to be used for speculative or proprietary trading by the investment banks and hedge funds
It focuses on refraining the banks from the activities using depositors’ money which can expose them to high risks and create a situation of instability within themselves or in the entire US financial system.
It prohibits banks from undertaking speculative activities and investments (to be specific involve in proprietary trading of securities) using customers’ funds
It mainly consists of two general prohibitions which are ‘Covered Funds Prohibition’ and ‘Proprietary Trading Prohibition’
It prohibits Investment banks or Banks to invest or have certain relationships with hedge funds or private equity funds (Covered Funds)
Impact on Banks:
The Volcker rule requirements impact the investment banks or financial entities in the following ways:
Investment Activities – Due to restrictions imposed by Volcker Rule, banks have to reduce proprietary trading and investments in private equity, hedge funds and other speculative businesses
Regulator Reporting – Banks have to submit the required reports to the regulators as a part of regulatory requirement to adhere to Volcker rules
Risk and Compliance– Investment Banks and Financial Entities have to re-align their entire Risk and Compliance department and revise trading policies, processes in order to comply with Volcker rules. Also proper risk management processes need to be introduced to avoid any rogue trading by any specific trader in order to generate exorbitant profit through unfair means.
Technology upgrade and investment – Investment Banks and Financial Entities have to invest more funds to upgrade their IT system in order to comply with Volcker rule regulatory requirements.