The approval by the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) of the newly updated Volcker rule will ease compliance with the requirements that prevent banks from engaging in proprietary trading, and, in doing so, would enhance their role as market makers and aid market liquidity, according to Fitch Ratings.
The revamped Volcker rule — or Volcker 2.0 — reduces the onus on banks to prove that their trading activities are not proprietary in nature. In addition, and consistent with the aim to tailor regulatory rules, banks with between $1.0 billion and $20.0 billion in trading assets would be subject to a simplified compliance program, while community banks, defined as banks under $10.0 billion in assets with minimal trading assets and liabilities (under 5% of total assets) were already exempted from the Volker rule as part of the Economic Growth, Regulatory Relief, and Consumer Protection Act.
While most recent regulatory easing initiatives have been aimed at the smaller banks, Fitch views this change as more impactful for the larger banks. Relaxing the Volcker rule does not help smaller banks as they generally do not engage in the type of trading activities the regulations restrict.
The final rule changed in one important aspect from the original proposal. Under the initial proposal, the rule would have encompassed all of a bank’s fair-valued trading assets and liabilities — the so-called “accounting prong”. However, the final rule did not retain this test, which would have been more restrictive for banks and would have scoped-into over $400 billion of available-for-sale assets. Instead, the rule continues to define a trading account based on a modified version of the existing rule — as to whether there is a short-term trading intent — which is more subjective than the accounting-based test. The new rule also eliminates the presumption that trading positions held for 60 days or less constitutes prop trading, thereby freeing up some of the compliance burden associated with short-tenor trades.
Volcker 2.0 also provides more leeway for banks to effectively self-police their compliance with the rule as they will not be required to automatically notify supervisors when internal risk limits are exceeded. Previously, the rule required banks to promptly report limit breaches or increases to the regulators.
“Under the prior rule, banks were presumed guilty unless proven innocent. With Volcker 2.0, banks are more generally presumed to be innocent unless proven guilty” said Christopher Wolfe, Managing Director at Fitch Ratings.
The new rule also modifies the liquidity management exclusion from the proprietary trading restrictions, permitting banks to use a broader range of financial instruments to manage liquidity. It adds new exclusions for error trades, offsetting swap transactions, certain customer-driven swaps, hedges of mortgage servicing rights, and purchases or sales of instruments that do not meet the definition of trading assets/liabilities. It also eliminates the extra-territoriality reach of the rule for foreign banking entities covered fund activities, where the risk occurs and remains outside of the U.S.
The relaxation of the compliance burden potentially opens up some avenues for banks to engage in what can be viewed as proprietary trading, under the guise of legitimate market making or liquidity management. The original rule barred the execution of bank algorithmic trading strategies that only trade when market factors are favorable to the strategy’s objectives, or otherwise not qualify for the market-making exception. In Fitch’s view, the new rule could allow banks to re-engage in some algorithmic trading that previously did not comply and to some degree, more effectively compete in market-making activities against high frequency trading firms (HFTs).
Fitch views the general prohibition against proprietary trading as a positive from a ratings perspective. Thus, while there are no immediate rating impacts from these changes to the Volcker rule, we would negatively view any bank that increases directional trading activities that can be construed as proprietary trading or fails to self-police their trading activities appropriately. Moreover, given still heightened capital and liquidity standards, potentially including the finalised Basel Market Risk (FRTB) standard and compressed margins in trading businesses, any increase in perceived proprietary trading may not generate adequate returns on capital nor be reflected in better stock valuation.
“The regulators have opened the door for the larger U.S. banks to engage in selective risk taking, potentially with an eye toward enhancing market liquidity and levelling the playing field against HFTs” said Monsur Hussain, Senior Director at Fitch Ratings.
