January 2014 Global Regulatory Network Executive Briefing Global Regulatory Network Global Stefan Walter stefan.walter@ey.com Americas Don Vangel donald.vangel@ey.com Marc Saidenberg marc.saidenberg@ey.com Ted Price ted.price@ey.com EMEIA Patricia Jackson pjackson@uk.ey.com Thomas Huertas thuertas@uk.ey.com John Liver jliver1@uk.ey.com Urs Bischof urs.bischof@ch.ey.com Marie-Hélène Fortesa marie.helene.fortesa@fr.ey.com Asia Pacific Keith Pogson keith.pogson@hk.ey.com Phil Rodd philip.rodd@hk.ey.com David Scott david.scott@hk.ey.com Japan Hidekatsu Koishihara koishihara-hdkts@shinnihon.or.jp US agencies agree on final Volcker Rule implications for banks On 10 December 2013, identical final rules implementing the so-called Volcker Rule (Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act) were promulgated by the five federal financial regulatory agencies responsible for implementing and enforcing the rule. 1 The final rules are effective 1 April 2014, although the Federal Reserve exercised its statutory authority to extend the date provided in the statute for conformance with the prohibitions and restrictions by one year, to 21 July 2015. This major Dodd-Frank Act milestone was reached after a nearly two-year rulemaking process during which the agencies assessed the approximately 18,000 comment letters submitted in response to the proposed rule and debated their different perspectives on the possible contours of a final rule. The Volcker Rule prohibits banking entities from proprietary trading and imposes substantial restrictions on their ownership or sponsorship of, and relationships with, certain covered funds, largely hedge funds and private equity funds. Importantly, with respect to proprietary trading, the final rule tightens the requirements for the hedging exemption to require that the hedge demonstrably mitigates a specific, identified exposure. More fundamentally, it leaves it to each of the five agencies to determine separately whether the entities they regulate are in compliance with the rule. That assessment will be based on their evaluations of required reporting by the regulated entities over which they have jurisdiction on seven sets of specified metrics and other information. The banks and their attorneys continue to analyze the detailed provisions of the final rule and the more than 900 pages of explanatory material that accompanied its issuance. As discussed further below, additional regulatory guidance regarding the scope of the covered funds provisions is expected to be issued by mid-january. However, the major implications of the rule for banks business models are clear. 1 The Board of Governors of the Federal Reserve System, The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.
Following are highlights of some of the key elements in the final regulation: Hedging exemption The rules require banking organizations to conduct correlation analyses for each exposure and its related hedges to support the hedging strategy, and to assess the appropriate calibration of the hedges on an ongoing basis. As noted above, the rules require that permissible hedges address a specific and identifiable risk and that they do not create additional risks. The final rule also imposes more stringent compliance, testing and monitoring requirements over hedging activities than did the proposed rule. Market-making and underwriting exemptions As in the proposed rule, the final regulation defines permissible market-making as principal trading activity required to meet the reasonably expected near-term demands of customers. Several of the required metrics to be reported, as discussed further below, are directed at assessing the nature of the relationship between trading and client demand. In addition, the exemption for positions held in connection with an underwriting must be related to expected customer demand for the instrument, and efforts must be made to dispose of the positions within a reasonable period of time. A key challenge will be for banks to assess what is reasonable customer demand under normal and stressed market conditions, including for positions that could become less liquid in periods of stress. How supervisors interpret market-making in more volatile conditions could be particularly important for the role that banking organization market-makers play in facilitating the market s adjustment to the Federal Reserve s scaling back of quantitating easing. Foreign bank exemptions for activity conducted solely outside the US (SOTUS). The final rule differs significantly from the proposal on this dimension. The proposal would have prohibited proprietary trading where the transaction in question was entered into outside of the US by a foreign bank if the trade touched the US in any of a number of ways, including if it cleared through a US exchange. Foreign bank commenters argued that the proposed approach was extra-territorial, and at odds with historical approaches to determining the locus of activities (which had generally relied on where decisions were made and risk booked). The final rule takes a risk-based approach to the SOTUS standard and generally does not apply to activity that does not involve decisions made, or risk booked, in the US. Clearing a trade through a US exchange or swap execution facility on an anonymous basis does not impact SOTUS status under the final rule. Sovereign debt The final rule, like the proposal, exempts from the general prohibition against proprietary trading activities that involve US Government, agency and municipal securities. However, in response to comments received, for foreign banks it also exempts trading in securities issued by the home country sovereign (and its political subdivisions) of those banks. Further, it permits foreign subsidiaries of US-domiciled banking entities excluding insured depository subsidiaries and their foreign branches to trade in the sovereign securities of host jurisdictions. Metrics and reporting There are seven sets of required metrics to be generated daily and reported monthly, down from 17 in the proposed rule. These requirements are to be phased in, beginning as of 30 June 2014 for banking entities with $50 billion or more in gross trading assets and liabilities (net of trading assets and liabilities of, or guaranteed by, the US or its agencies), 30 April 2016 for those with $25 billion or more, and, finally, year-end 2016 for those with $10 billion or more. For foreign banking organizations, gross trading assets and liabilities are to be measured for combined US operations only. While the number of required metrics has been reduced from 17 to 7, the level at which the metrics need to be produced is more clearly defined and granular. The proposed rule s definition of trading unit has been replaced with the term trading desk, which is the smallest discrete unit of organization of a banking entity that buys or sells financial instruments. This bottom-up reporting focus could have significant implications for many areas of compliance, ranging from metric production to the structure of the required compliance program. Global Regulatory Network Executive Briefing 2
For each trading desk, the required metrics include: risk positions, limits and limit usage; Value at Risk (VaR) and Stress VaR; risk factor sensitivities; comprehensive profit and loss attribution including from fees, commissions, spread and price changes; inventory turnover; inventory aging and the customer-facing trade ratio. A number of these metrics, such as P&L attribution, are also proposed under the Basel Committee s Fundamental Trading Book review to support banks designation of trading positions. 2 Banks may achieve synergies by addressing these US and international requirements in an integrated manner. Covered funds The final rule exempts certain funds that could have been covered by the literal language of the proposed rule, but which would not generally be considered hedge funds or private equity funds, such as wholly owned entities, joint ventures, foreign pension funds, insurance company separate accounts, bank-owned life insurance and certain securitizations backed by loans. In addition, it exempts foreign funds that would be registered investment companies if they were located in the US (e.g., UCITS). A banking entity generally may not own more than 3% of any covered fund nor have more than 3% of its Tier 1 capital invested in covered funds in the aggregate. However, for securitization vehicles subject to a risk-retention requirement, the investment limitation is the higher of 3% or the interest required to be retained. Further, for regulatory capital purposes, investments in covered funds must be deducted. However, a significant issue arose in that the final rule definition of covered fund investments appears to reach holdings of collateralized debt obligations (CDOs) backed by trust-preferred securities (TruPS), raising significant concerns, particularly among regional and community banks, about the possible need to write down such holdings. In response to these concerns and a 24 December petition to the US Court of Appeals for the DC Circuit by the American Bankers Association for an immediate stay of the agencies action, the agencies issued an interim final rule on 14 January 2014 grandfathering holdings of such CDOs where they reflect an interest in qualified TruPS that were established and issued before 10 May 2010, and where the banking organization held the interest in question before 13 December 2013. Compliance program Banking entities with $50 billion or more in total consolidated assets (foreign banks only need to consider total US consolidated assets) are required to have an enhanced compliance program, while other banking entities may adopt a standard program. In either case, the program must be reasonably able to identify, document, monitor and report on trading and covered funds activities; establish and enforce appropriate limits on relevant activities and investments; make senior management and others, as appropriate, accountable for implementing an effective compliance program; be overseen by the banking entities boards of directors; and be subject to periodic independent testing. Enhanced programs are required, among other things, to have detailed policies and procedures at the trading desk level covering each desk s mission, the instruments it is allowed to trade, the permitted uses of these instruments and attendant limits, including permitted hedging strategies. In addition, the CEO of a banking entity (or the most senior US executive for an in-bound foreign bank) must certify annually to the relevant regulatory agency that the entity has implemented a program designed to reasonably ensure compliance with the rule. The Burden of Proof Despite the somewhat reduced scope of the required metrics and reporting from that originally proposed, banks covered by the rule should not underestimate the implementation and compliance challenges ahead. For instance, the final rule does not require that income from bid-ask spreads be measured and reported separately from other sources as the proposed rule had done. However, the comprehensive P&L attribution and analysis for existing positions that the regulators will view as supporting evidence desk-by-desk of whether principal trading is compliant will still have to be further attributed to changes in specific risk factors and other applicable elements, such as cash flows, carry, changes in reserves and the correction, cancellation, or exercise of a trade. The metrics will not be used as a dispositive tool by the regulators, at least initially, but will be used to monitor patterns and identify activity that may warrant further review. Ensuring that there is sufficiently granular, complete and accurate data available daily to support that assessment is an immediate need. 2 Fundamental Review of the Trading Book Second Consultative Document, Basel Committee on Banking Supervision, October 2013. Global Regulatory Network Executive Briefing 3
In the end, the rule appears likely to create a compliance environment not markedly dissimilar from that applicable to anti-money laundering. That is, the question whether a banking organization is considered compliant will rely, in effect, on the subjective assessment by regulators of the output from the detailed reporting, accompanying analyses and the identification of potentially suspicious activity. Those determinations, in turn, will require enhanced due diligence and a robust know-yourtrading-desk policy to anchor the analysis, independent testing of the program, and senior management accountability for the effectiveness of the program. It also will entail management reporting that errs on the side of highlighting potential as well as actual compliance concerns. Finally, it is expected that the regulators will be developing guidance for examiners in the near future and will be gaining experience from the reporting during the period leading up to the July 2015 conformance date. During this period, some light should be shed on how the regulators will view the boundaries between permissible and impermissible trading under the final rule. However, banks must also be aware of the calls for vigorous enforcement from some in the official sector. As the regulators and industry gain experience with the implementation of the final rule, compliance expectations are likely to evolve over time. The development of inter-agency examinations guidance should help the agencies achieve a level of consistency in implementation, but some differences in interpretation can still be expected. Banking organizations should immediately begin to develop the required metrics and reporting and to analyze the output, both to enable constructive engagement with the regulators even as the latter are developing their views on supervisory oversight of the rule, as well as to ensure that they build what need to be data-driven compliance frameworks of policies, procedures, monitoring, testing and reporting on a sound and defensible foundation. Foreign banks should also, among other things, carefully evaluate the roles of US subsidiaries, offices and personnel in principal trading originated and booked outside the US. US regulators will assuredly look for clear evidence to support any SOTUS claims. For additional information, please contact: Donald T. Vangel Advisor, Regulatory Affairs, Financial Services Office donald.vangel@ey.com Randy Gonseth Partner, Volcker Rule Team Leader, Financial Services Office richard.gonseth@ey.com Global Regulatory Network Executive Briefing 4
Global Regulatory Network EY s Global Regulatory Network is an integral part of our Financial Services Office and enables EY to offer banks deep experience, leadership and insights on financial regulation. Our global regulatory services are led by an executive team of former senior regulators, including former Basel Committee Secretary General Stefan Walter. This team, supported by more than 100 other former regulators, drives EY s strategic outlook on global regulatory themes impacting global banks, including capital, liquidity, resolution and recovery planning, risk governance and other emerging topics in banking regulation. Stefan Walter was secretary general of the Basel Committee on Banking Supervision from 2006 to 2011. During this time, he was also a member of the Financial Stability Board. He has more than 20 years of international bank supervisory experience, including 15 years at the Federal Reserve Bank of New York. Don Vangel, Regulatory Advisor to the Office of the Chairman, joined EY after a 17-year career at the Federal Reserve Bank of New York, where he ultimately served as a Senior Vice President for Bank Supervision. Marc Saidenberg was a senior vice president and director of supervisory policy at the FRB of New York. He also represented the bank on the Basel Committee and served as co-chair of the committee s Working Group on Liquidity. He was actively involved in the development of the Basel III capital and liquidity standards, supervisory expectations for capital planning, liquidity risk management and RRPs. Ted Price was Deputy Superintendent at OSFI, Canada and a member of the Executive Committee. Ted served on the Senior Supervisors Group and the FSB SIE Working Group. Prior to joining OSFI, Ted held a number of senior roles at a global investment bank. Patricia Jackson is the former head of the Bank of England Regulatory Policy. She was the head of the Financial Industry and Regulation Division from 1995 to 2003 and was a member of the Basel Committee from 1995 to 2003. She chaired the global Quantitative Impact Studies to test the effect of Basel II and chaired the Calibration subgroup. Dr Tom Huertas is a former member of the FSA s Executive Committee. He also served as alternate chair of the European Banking Authority, as a member of the Basel Committee on Banking Supervision and as a member of the Resolution Steering Committee at the Financial Stability Board. John Liver s experience includes a number of regulatory roles with leading investment banks as well as the UK FSA and its predecessors. His roles include head of thematic supervision in the Investment Firms Division, head of Personal Investment Authority Supervision, overseeing the sales regulation of the life and pensions industry, and management roles in Investment Management Regulatory Organization s Enforcement and Supervision Departments. Urs Bischof is the former head of Risk Management of the Extended Executive Board of Switzerland s FINMA. His responsibilities included risk management supervision and oversight and prudential regulations, along with leadership roles with respect to Basel III, SIFI regulation, payments and clearing. Marie-Hélène Fortesa has extensive regulatory experience. Her posts have included leadership roles at the Autorité de Contrôle Prudentiel (French Prudential Supervisory Authority), the Association Française des Banques (French Banking Association) and INSEE (French National Institute for Statistics and Economic Studies), as well as senior roles at a leading investment bank. Keith Pogson, Phil Rodd and David Scott have extensive experience working with regulators across the Asia-Pacific region. Hidekatsu Koishihara is a former chief inspector and inspection administrator for the Japan Financial Services Agency. He also worked at the Ministry of Finance of Japan (MOF), Japan s former financial regulator, serving as the financial inspector at the Bank Bureau of MOF and Financial Inspection Division, and Minister s Secretariat of MOF. EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. 2014 EYGM Limited. All Rights Reserved. EYG no. EK0236 CSG/GSC2014/1262149 ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com