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4 Steps to Volcker Compliance: A Bank's Guide to Regulatory Change

| FinReg

By John Sampson and Michael Barnes, Ernst & Young

Originally published on TABB Forum 

Volcker Rule compliance requires a thorough inventory of funds and entities with specific explanations as to why they are or are not covered funds under Volcker. But banks that install a precise compliance program should be able to operate efficiently in the new environment. Here are 4 steps to Volcker compliance and 9 tips to consider along the way. 

On Dec. 10, 2013, banks awoke to the release of the final Volcker Rule — impacting how they operate, the investments that they make and the services that they provide. Banks no longer have the freedom to organize and provide services once permitted during the days of the Gramm-Leach-Bliley Act. Instead, they’ve been prescribed a dose of stringent regulation, significantly changing the world in which they can operate by impacting their abilities to own and to provide services to funds and other subsidiaries. Fortunately, a well-designed, thoughtfully implemented Volcker-compliant program will allow banks to manage their funds successfully in the new landscape.


The Volcker Rule restricts both banks’ ownership in funds and their ability to enter into transactions with funds. Banks with more than US$10 billion in consolidated assets must have a detailed fund compliance plan in place by July 22, 2015. In the interim, banks must have a conformance period plan that addresses the required actions that need to occur between now and July 22, 2015, to ensure they’re compliant with the Volcker Rule. Banks can apply to the Federal Reserve to extend the conformance period for illiquid funds.


Ownership interest 

The Volcker Rule significantly restricts banks from owning hedge funds or private equity funds — which necessitates clarity related to the definition of ownership of hedge funds and private equity funds. Unfortunately, the Volcker Rule is complex and requires detailed analysis. The Volcker Rule constructs a complex, layered approach for banks to define ownership and prohibited funds. There are eight ownership characteristics that attempt to capture the “economic sense” of ownership by mainly focusing on participation in the potential upside and economic downside of the entity. These characteristics maintain a logic sequence that captures ownership.

The definition of funds would be relatively straightforward except for the Volcker Rule’s 14 distinct exceptions. While these traps are at times exasperating, they can also represent important avenues for reducing the Volcker Rule’s impact. A bank’s Volcker Rule funds’ compliance program must analyze its entities using these traps to determine the Volcker Rule’s applicability.


The Volcker Rule limits a bank’s ability to provide services to covered funds through Sections 23A and 23B of the Federal Reserve Act, which are written to limit a bank’s transactions with affiliates and to ensure arm’s-length pricing on transactions between the bank and its affiliates. Under the Volcker Rule, a bank can only provide certain “prime brokerage” services to “sponsored-covered” funds in which another bank-covered fund has made an investment. This new restriction is colloquially referred to as the “Super 23A” restriction and will present new obstacles to banks that provide prime brokerage, administration or custodial services to funds that they also manage.

Compliance program 

The Volcker Rule has specific compliance program requirements, and it requires the individual business managers to take responsibility for compliance. The Volcker Rule compliance program requires a thorough inventory of funds and entities with specific explanations as to why they are or are not covered funds under Volcker. There must be specific procedures and controls regarding the monitoring of entity ownership interest, disposition plans, transactions with covered funds and remediation in the event of a Volcker violation. Finally, the chief executive officer (CEO) must annually attest that the bank has a reasonably designed compliance program to comply with the Volcker Rule for banks with more than US$50 billion in consolidated assets.

The Compliance Path 

Compliance with the Volcker Rule for covered funds can be initiated through the following four distinct steps:

  • Step 1: Banks need to survey their entities and the services that they provide them.
  • Step 2: Banks need to categorize entities and services as permissible under the Volcker Rule, or as impermissible, thus necessitating changes to become permissible.
  • Step 3: Banks need to conform existing entities to the Volcker Rule by disposing of, or transforming, the entities and/or services.
  • Step 4: Banks need to implement a Volcker Rule compliance program to ensure that entities and services comply with the Volcker Rule going forward.


The goal of surveying is threefold. Banks need a complete inventory of all funds, entities and activities that the Volcker Rule could cover. The second goal is to identify which funds or entities the bank owns under the Volcker Rule and which transactions are entered into with those funds and entities. The final goal is to collect sufficient information to determine if the identified entities and activities are covered funds or transactions under the Volcker Rule, or qualify for an exemption.

Generally, Volcker Rule-covered funds are bank entities that would require registration under the Investment Company Act of 1940 (40 Act), if they were offered in the US, except for the exemptions provided by Sections 3(c)(1) and 3(c)(7). In addition to hedge and private equity funds, banks used these exemptions to establish a joint venture, acquisition, securitization and countless other entities in order to avoid 40 Act registrations. Until the Volcker Rule, there was little consequence of 3(c)(1) or 3(c)(7) categorization. As a result, banks may have difficulty in ascertaining exactly which entities are 3(c)(1) and 3(c)(7), and why the entities are qualified for those exemptions. Banks must ask themselves if that’s the right exemption to use, or if it was the most expedient. This assessment could be an overwhelming task, but must be performed or the banks risk divesting permissible assets.

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Figure 1: Survey Characteristics 

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The flowchart above illustrates the start of the decision process. The Volcker Rule considers an entity “guilty until proven innocent,” so each step of the process requires careful consideration and documentation.

Compounding the surveying problem is the Volcker Rule’s broad definition of ownership interest, which includes investing in certain debt securities. Under the Volcker Rule, an ownership interest either:

  • Has an equity or ownership interest.
  • Has the right to remove the entity’s management or investment adviser.
  • Has the right to receive a share of income from the entity.
  • Has the right to receive the underlying assets after other investors have been redeemed.
  • Has the right to receive the excess spread between the payments on the entity’s underlying assets and the amounts due to investors.
  • Provides that the interest payable by the entity could be reduced based upon losses in the underlying assets.
  • Receives interest in a pass-through basis or determined by the performance of the underlying asset.
  • Represents a synthetic right to receive any of the above.

The Volcker Rule ownership definition includes investing in structured debt securities. Identifying covered funds poses issues because of the different exemptions. Conceptually, banks should easily identify 3(c)(1) and 3(c)(7), but the final Volcker Rule contains at least 14 different exemptions, including:

  • Would be able to use another exemption from the 40 Act registration, such as (3(c)(5) or Securities and Exchange Commission (SEC) Rule 3a-1.
  • Is a foreign public fund (retail undertakings for collective investments in transferable securities [UCITS]).
  • Is a joint venture.
  • Is a wholly owned subsidiary.
  • Is an acquisition vehicle.
  • Is a foreign pension or investment company.
  • Is a vehicle established to hold bank-owned life insurance.
  • Is a loan securitization.
  • Is a qualifying asset-backed commercial paper conduit.
  • Is a qualifying covered bond.
  • Is a small business investment company (SBIC) or public welfare fund.
  • Is a registered investment company.
  • Is the entity of a separate account at an insurance company.
  • Is an issuer in relation to a Federal Deposit Insurance Corporation (FDIC) receivership.

As one can see, these exceptions to the Volcker Rule contain considerable conditions.

These exemptions are powerful, as they allow many in-the-course-of-ordinary-business entities, such as equipment-leasing vehicles, to avoid capture under the Volcker Rule. The downside is that a bank needs a robust survey when it begins to examine its Volcker Rule entities and activities.


Banks can use the survey results to categorize their entities and activities under the Volcker Rule. The Volcker Rule will clearly affect some entities and activities, such as true hedge funds and private equity funds. The Volcker Rule will leave other entities and activities unscathed, such as registered investment companies. The most difficult category is when there are multiple possible Volcker Rule categories for a single fund. This category requires extensive analysis and thought about how to re-categorize entities and activities to maximize the strategic value to the bank and its balance sheet.


Conformance requires taking existing prohibited entities and activities and bringing them into conformance with the Volcker Rule. The options are to dispose or to transform. Many banks probably will reduce the size of their hedge fund and private equity investments due to the conflicts between retaining the incentive and management fees and the limits on the 3% investment amount.

Transformation requires creative thinking. Despite its draconian consequences, the Volcker Rule’s exemptions, its treatment of foreign banks, a captive insurance company’s ability to own covered funds, and the continuance of the merchant banking exemption provide opportunities to re-categorize entities and activities in order to conform to the Volcker Rule. Time spent reviewing the survey results and the Volcker Rule will be time well spent.

Conformance is the toughest step in this plan. Entities and activities will need to be terminated and/or restructured, which could result in the uprooting of people and operations. The Volcker Rule will alter flexibility in future operations. The decisions around Volcker Rule entities and activities are difficult and carry far-reaching consequences.

Compliance Program 

The conformance period deals with how banks will become fund compliant with the Volcker Rule by July, 22, 2015. Banks must consider how they will operate in this new regulatory world going forward, knowing that future Volcker Rule compliance requires a robust program. Business managers are the first line of defense, but the compliance program touches risk, accounting, legal and compliance, before finally arriving at the CEO and the board. The Volcker Rule requires strict compliance going forward.

Figure 2: Volcker Rule compliance program 

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The Volcker Rule requires meticulous documentation. Banks need to maintain an inventory of entities and transactions and their Volcker Rule status. The Volcker Rule presumes transactions and entities are impermissible unless proven otherwise.

Volcker Rule funds’ compliance involves all areas of a bank. The first line of defense is the business managers who own the compliance responsibilities. The Volcker Rule emphasizes this responsibility by requiring CEO certification in large banks. The second line of defense is the business support functions – e.g., compliance, finance and accounting – which oversee the compliance programs and ensure that managers follow required procedures. The third line of defense is internal audit that periodically, and at least annually, reviews and tests the effectiveness of the Volcker Rule compliance program. All of this is overseen by the board of directors, who manage Volcker Rule compliance and ensure that the bank allocates sufficient resources to Volcker Rule compliance. The Volcker Rule sets out extremely prescriptive compliance procedures so that a risky venture won’t slip through the process.

There is life in Volcker Rule fund compliance dystopia. Banks that read the Volcker Rule carefully and install a precise, thoughtful compliance program should be able to operate efficiently in the new environment. Nonetheless, as management explores the Volcker Rule in depth, it should remember the following nine considerations:

  1. You are not alone. Private equity and venture technology partnerships may have to be converted into direct investments. Joint ventures may have to limit the number of investors contractually. All banks and investment managers that have banks as their investors in hedge and private equity funds face Volcker Rule issues. Addressing these issues will require flexibility and ingenuity. Investment managers, which are already under pressure to increase asset size, should be willing to examine alternative structures in order to retain investments.
  2. Show that you get it. Regulators want to see that the regulated respect the regulations. Those institutions that install a thorough Volcker Rule compliance program will influence events as they move forward. Those that don’t will be negatively impacted.
  3. Lead from the top. Volcker Rule compliance is a tough task which will require difficult firm-wide and personnel decisions. If the CEO and the board lead and get involved, the company will follow. Volcker Rule compliance will be quicker and cheaper for banks than if Volcker Rule compliance is another regulatory chore imposed by the regulators.
  4. Interact with the regulators. The Volcker Rule represents the collective ideas of Governors of the Federal Reserve, Office of the Comptroller of the Currency, FDIC, the SEC and the Commodity Futures Trading Commission. The five agencies may have a difficult time making decisions as they seek to avoid regulatory arbitrage. Nonetheless, the more interactions that management has with its regulators, the more the regulators will appreciate the efforts that bank management is making, and subsequent decisions will be easier.
  5. Embrace change. You can be certain that just as you near a point of comfort with your Volcker Rule funds project, someone will raise another costly, frustrating point. Volcker compliance will be a long, expensive, challenging process. Don’t get discouraged.
  6. Leverage existing efforts. As a consequence of regulatory efforts such as Form ADV, Form PF, Form CPO-PQR and the Alternative Investment Fund Managers Directive, banks have collected much information that is directly transferable to the Volcker Rule. In the early stages of the Volcker Rule effort, it is important to identify and leverage this work.
  7. Talk with your peers. The Volcker Rule is uncharted territory. All banks are in the same position and facing the same challenges. Frequent discussions with peer institutions will shed light on emerging best practices, or address an issue and find a solution.
  8. Consult wisely and often. The Volcker Rule is an interesting mix of legal and operational issues. Banks that seek advice often from the proper places will have a better chance of succeeding.
  9. In uncertainty there may be prosperity. Volcker Rule compliance will necessitate the sale and restructuring of funds and the transfer of activities to third parties. As these events unfold, banks that get in front of them will have opportunities to facilitate these transactions. Banks can use their own Volcker Rule experiences to help others, particularly private equity and hedge fund managers looking for new investors, and asset-backed securities issuers looking to initiate additional transactions.

The state of uncertainty is never a pleasant place to be. The key to getting out of it is individual proactive efforts that make the situation better. If banks lead the initiative in framing the actuality of Volcker Rule fund compliance, they can better control the outcome.