Balance-Sheet Risk Management Hedging Programs under the Volcker Rule

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1 Balance-Sheet Risk Management Hedging Programs under the Volcker Rule With the implementation of the Volcker Rule, the question arises as to the impact of the rule on balancesheet risk management ( BSRM ) hedging programs. The Volcker Rule s proprietary trading ban is a prohibition on certain short-term speculative trading. It generally bans using derivatives principally for the purpose of: (1) short-term resale; (2) benefitting from short-term price movements; (3) realizing short-term arbitrage profits; or (4) hedging positions relating to any of the above. If a banking entity is using derivatives for these purposes, the Volcker Rule only permits certain types of trading activity if a compliance program is implemented. As explained in this white paper, trades executed in BSRM hedging programs are not executed for the above purposes prohibited by the Volcker Rule. As a result, BSRM hedging transactions are typically not proprietary trading nor should the BSRM programs themselves be required to implement a compliance regime. Background The Volcker Rule was enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ). 1 Although the Volcker Rule is complex, it generally prohibits or limits banking entities from making certain types of speculative investments, specifically: engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account; or owning, sponsoring, or having certain relationships with hedge funds or private equity funds, referred to as covered funds. 2 Although short-term proprietary trading is generally forbidden, the Volcker Rule contains exceptions for certain types of permitted activities, including market making, underwriting, hedging and trading in certain government obligations. 3 Banking entities engaging in permitted types of proprietary trading must implement a compliance program to ensure compliance with the regulations. 4 The nature and scope of a financial institution s compliance obligations vary according to several factors, including the absolute size of a financial institution s assets and the size of its trading assets and liabilities. All entities are required to be compliant by July 21, U.S.C U.S.C. 1851; 12 CFR Part U.S.C. 1851(d); 12 CFR Part CFR Part 44

2 While financial institutions should evaluate all trading and ownership activities for compliance with the Volcker Rule, this white paper specifically considers the impact of the rule s proprietary trading ban on Balance Sheet Risk Management (BSRM) hedging programs. Please note that the opinions expressed herein are not intended to be relied upon as legal advice nor an analysis of a financial institution s particular activities, and should not replace your own counsel s legal advice. Overview of BSRM Hedging Programs Many community and regional financial institutions operate BSRM hedging programs, which are typically designed to hedge against interest rate risk arising from a financial institution s portfolio of assets and liabilities. While there are several different measures of interest rate risk, the most common and easiest to understand are net interest income (NII) simulations and economic value of equity (EVE) analysis, using interest rate shocks or ramps to assess and quantify interest rate risk. NII simulations are a measure of short term interest rate risk, focused on NII impacted by movements in all interest rates over a short time horizon, usually 12 to 24 months, while EVE can be thought of as a longer term measure of interest rate risk. Changes in value of assets and liabilities, given various rate scenarios, will uncover interest rate risk positions not always readily apparent. An asset-sensitive financial institution for both NII and EVE would be expected to benefit from rising rates, as assets re-price faster and higher than liabilities, and produce more interest income than interest expense. This same financial institution would experience more interest expense than interest income in a falling rate environment. The opposite would be true for a liability-sensitive financial institution for both NII and EVE. It is also possible and often the case that a financial institution is asset-sensitive by one measure (say NII) but not by the other (say EVE), but this only highlights the need to deploy appropriate strategies to mitigate the identified risk and not inadvertently create risk in a different area. 2

3 For financial institutions that are liability sensitive, the above chart shows the underlying hedged items and approaches that are most commonly used to become more asset-sensitive. While any of these approaches can lead to an appropriate transaction, some offer less complexity and less likelihood of any P&L impact, and are therefore generally considered first. A series of questions about the availability of potential underlying hedged items takes shape, as follows: Does the financial institution intend to take out short term fixed rate advances from the FHLB, now or in the future? If not, would the financial institution renew or take out new longer term floating rate advances, now or in the future? Does the financial institution have any other indexed funding, such as indexed deposits, or will it have them in the future? Pay-fixed swaps against these underlying hedged items are commonly encountered, and lend themselves to simple, cash flow hedge accounting, with little to no ineffectiveness possible. If not, the conversation could just as easily focus on hedging new or existing fixed rate loans or fixed rate securities, swapping them back to a floating rate under the fair value hedge accounting model. 3

4 The same can be said for financial institutions that are asset sensitive, but a different set of underlying hedged items would be considered. The above chart shows the items and approaches that are most commonly used, to become more liability sensitive, and simultaneously convert some future earnings into current period earnings. The path of least accounting resistance, would have the financial institution first consider whether there are floating rate loan pools, based on LIBOR or fed funds for example, that can be easily hedged using a receive-fixed swap in a cash flow hedging relationship. A similar case can be made to look at hedging floating rate securities that are non-callable. A look at the other side of the balance sheet reveals other items that can be hedged, including fixed-rate FHLB advances, brokered CDs, or other fixed rate liabilities. While moving to fixed rate liabilities require a change in the accounting approach used, there are still appropriate receive-fixed swap transactions that can be executed using the fair value hedge accounting model. 4

5 Prohibition Against Proprietary Trading Overview of the Volcker Rule Under the Volcker Rule, a banking entity generally is prohibited from engaging in proprietary trading. With certain exemptions from the definition of proprietary trading outside of the scope of this white paper, the Volcker Rule defines proprietary trading as engaging as principal for the trading account of the banking entity in the purchase or sale of one or more financial instruments. 5 A financial instrument is defined to include securities, options on securities, derivatives and options on derivatives, futures contracts and options on future contracts. 6 Loans, spot physical commodities and spot foreign exchange transactions are not included within the definition of a financial instrument. 7 The Volcker Rule establishes three separate tests where a trade can be considered as being for the financial institution s trading account: 1) the purpose test; 2) the market risk capital test; and 3) the dealer status test. Because a community and regional financial institution generally will not be subject to the market risk capital rule and dealer status test, this white paper focuses its analysis on the application of the Volcker Rule s purpose test to community and regional financial institutions BSRM hedging programs. 8 The purpose test provides that the purchase or sale of a financial instrument will be considered for the financial institution s trading account, and thus a proprietary trade, if the principal purpose of such trade falls within one of the following four categories: 1) short-term resale; 2) benefitting from actual or shortterm price movements; 3) realizing short-term arbitrage profits; or 4) hedging positions related to any of the three categories above. 9 A common characteristic of these four categories is that all are principally for 5 12 U.S.C. 1851; 12 C.F.R. Part 44.3(a). This white paper will use financial institution as a shorthand reference for banking entity C.F.R. Part 44.3(a) C.F.R. Part 44.3(c). 8 Under the market risk capital rule, if a banking entity, or an affiliate of a banking entity, is an insured depository institution, bank holding company or savings and loan holding company and calculates riskbased capital ratios under the market risk capital rule, a trade that is both a covered position and a trading position is considered to be for a trading account under the Volcker Rule. 12 C.F.R. Part 44.3(b)(1)(ii). Under the dealer status test, any account used by a banking entity that is a securities dealer, swap dealer, or security-based swap dealer to acquire or take positions in connection with its dealing activities is considered to be for the banking entity s trading account. 12 C.F.R. Part 44.3(b)(1)(iii). Community and regional financial institutions generally do not trigger these tests and, thus, analysis of these tests is beyond the scope of this white paper C.F.R. Part 44.3(b)(1)(i). 5

6 the purpose of selling in the near term or with the intent to resell to profit from short-term price movements. 10 Consequently, the purpose test primarily is concerned with determining the short-term intent of a trade. The Volcker Rule establishes a rebuttable presumption that a trade is presumed to be for the financial institution s trading account if the financial institution either holds a financial instrument for fewer than sixty days from the date of purchase or sale of the financial instrument or substantially transfers the risk of the financial instrument within sixty days of the trade. 11 A financial institution may rebut this presumption by using all relevant facts and circumstances to demonstrate that the purpose of the trade was not for any of the four categories within the definition of a trading account. 12 Importantly, the sixty-day presumption is not a safe harbor. Trades held for sixty days or more from the date of purchase or sale of the financial instrument still can fail the purpose test and trades executed within 60 days of the date of purchase or sale of the financial instrument can rebut the presumption of short-term intent. 13 Rather, the sixty-day presumption is intended to act as a reference point only. The preamble to the Volcker Rule reinforces this position by providing that [t]he Agencies proposed this presumption primarily to provide guidance to banking entities that are not subject to the market risk capital rules or are not covered dealers or swap entities and accordingly may not have experience evaluating short-term trading intent. 14 If a financial institution engages in proprietary trading, it must develop a compliance program monitoring the financial institution s proprietary trading. 15 Importantly, a financial institution that does not engage in these activities is not required to implement a compliance program until such time prior to when the financial institution begins engaging in these activities. 16 Thus, community and regional financial institutions that do not engage in proprietary trading are not required to implement a compliance program by July 21, Rather, a community and regional financial institution will only be required to implement a compliance program under the Volcker Rule when the financial institution prepares to begin proprietary trading. 10 Federal Register, Vol. 79, No. 21, Friday, January 31, 2014, pg C.F.R. Part 44.3(b)(2) C.F.R. Part 44.3(b)(2). 13 The preamble to the Volcker Rule specifically identifies 1) an unexpected increase in the financial instrument s volatility and 2) a need to liquidate the instrument to meet unexpected liquidity demands as examples of short-term trades which may rebut the 60-day presumption. Federal Register, Vol. 79, No. 21, Friday, January 31, 2014, pg Federal Register, Vol. 79, No. 21, January 21, 2014, pg C.F.R. Part 44.20(a) C.F.R. Part 44.20(f) A banking entity that does not engage in activities or investments pursuant to subpart B [proprietary trading] or subpart C [covered fund activities]... may satisfy the requirements of this section by establishing the required compliance program prior to becoming engaged in such activities or making such investments.... 6

7 Application of the Volcker Rule to BSRM Programs A traditional BSRM hedging program should not be considered as proprietary trading under the Volcker Rule because these programs do not involve the use of derivatives principally 1) for the purpose of shortterm resale; 2) to benefit from short-term price movement; 3) to realize arbitrage profits; or 4) to hedge positions related to any of the three other categories. 17 Instead, these derivative products are designed to insulate the financial institution s interest-rate risk arising from a mismatch between its assets and liabilities. Simply put, these programs are risk mitigation strategies rather than short-term, profit-driven trading strategies. Even in the event that a financial institution is forced to terminate a BSRM hedging swap prior to sixty days after entering into the swap, this situation does not automatically mean that the purpose test has been violated and the financial institution is engaging in proprietary trading. As stated above, a financial institution may rebut this presumption by using all relevant facts and circumstances to demonstrate that the purpose of the trade was not for any of the four categories within the definition of a trading account. 18 Examples of documentation that a financial institution may use to demonstrate the purpose of the trade include, but are not limited to, referring to the financial institution s internal hedging program policy and analyzing the financial institution s current composition of its portfolio. Thus, a traditional BSRM hedging program does not implicate the short-term, profit-driven intent necessary to trigger the purpose test. 19 Because a traditional BSRM hedging program does not violate the purpose test and a regional or community financial institution is not subject to the market capital risk rule and the dealer status test, a community and regional financial institution s BSRM hedging program is not for its trading account. Under the Volcker Rule, the purchase or sale of a financial instrument must be for a financial institution s trading account in order to be considered proprietary trading. Since a BSRM hedging program does not meet the definition of a trading account, these trades are not considered proprietary trading and the Volcker Rule should not apply. As such, these financial institutions should be exempt from the requirement to implement a compliance program by July 21, Rather, such a financial institution will only be required to implement a compliance program prior to when it expects to actually begin engaging in proprietary trading. 17 Because many TruPS have been excluded from the definition of a covered fund, this white paper focuses its analysis on the applicability of the proprietary trading prohibition to BSRM hedging programs C.F.R. Part 44.3(b)(2) U.S.C. 1851(h)(6); 12 C.F.R. Part 44.3(b)(1)(i) C.F.R. Part 44.20(f). 7

8 About the Authors Carla Bennett Carla is a member of Chatham s real estate and global sponsors teams working as a derivatives regulatory advisor. Prior to joining Chatham, Carla practiced law at Duane Morris LLP as a commercial litigator. Previously, she played basketball professionally in Madeira, Portugal and for the Minnesota Lynx. Carla graduated from Drake University with a B.A. in Journalism and Mass Communication and holds a law degree, magna cum laude, from the University of Notre Dame. Christopher Bender Chris is a member of the Global Regulatory Solutions team where he serves as a Regulatory and ISDA Advisor. Prior to joining Chatham, Chris was an attorney at Duane Morris LLP where he was a member of the Real Estate Practice Group. Chris also interned for the Massachusetts Office of the Attorney General after his first year of law school. Prior to attending law school, Chris worked as a Research Associate at the Georgetown University Health Policy Institute. Chris earned a B.S. from Cornell University, a Master of Public Policy from the Georgetown University Public Policy Institute and received his law degree from The University of Pennsylvania Law School. Transactions in over-the-counter derivatives (or swaps ) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions