The Financial Stability Oversight Council (FSOC), the US supervisory body created by the Dodd-Frank Act, has unveiled tough new guidelines to ensure banks do not engage in proprietary trading and limit their investment in the hedge funds or private equity funds.
Section 619 of the act, widely associated with its chief advocate, ex-Federal Reserve head Paul Volcker, banned banks from principle trading activities, with a few business practices such as those relating to market making and asset management being excepted. It also limited investment in funds that have unacceptable risk profiles to 3% of a bank's capital. The FSOC guidance will be used by the regulatory agencies responsible for designing the Volcker rule framework to help distinguish between permitted and banned activity.
The emphasis of the proposals is on banks to develop robust internal controls and programmatic compliance regimes and to use quantitative analysis based on revenue, revenue-to-risk, inventory and customer flow metrics to identify proprietary trading activity. The FSOC also recommends that banks create a mechanism to identify trades initiated by customers. Under the guidelines, bank CEOs must public attest to the effectiveness of their own supervisory regimes.
Agencies are to be guided by five principles in their rulemaking. Regulations should: prohibit improper proprietary trading activity; be flexible enough to cope with new products and business practices; be applied consistently; provide clarity as to what is and isn't proprietary trading; and be robust to cope with different asset classes.
Once rules are in place agencies are recommended to supervise banks' operations to ensure compliance and terminate any activity that is found to be in breach of the Volcker Rule. The Dodd-Frank Act, which was signed into law on 21 July 2010, determined the principles of the Volcker Rule but the rules which bring it into effect will be set by major financial regulatory bodies; the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and the Commodity Futures Trading Commission.
Responding to the announcement, Tim Ryan, CEO of sell-side trade body the Securities Industry and Financial Markets Association, said, “Regulators will need to strike the right balance between banning those activities deemed to be proprietary trading and those that are permitted activities under the Volcker Rule. The ability of financial institutions to make markets for different kinds of financial instruments is crucial to market liquidity and capital formation, which fuels economic growth and job creation.”
A number of banks have already shut down or spun out their proprietary trading operations pre-empting implementation of the rule. In September 2010 investment bank J.P. Morgan confirmed that it would be moving its proprietary trading desks for equity, emerging markets and structured credit to its asset management division and on 11 January 2011 Morgan Stanley said that its in-house quantitative proprietary trading unit, Process Driven Trading will be separated from the rest of the bank in 2012. Goldman Sachs and Bank of America Merrill Lynch are both reported to have plans to adapt their current operations in line with new regulation.