An Inside Peek at Volcker Rule Enforcement

By George Bollenbacher, Capital Markets Advisors

Originally published on TABB Forum 

The OCC’s recently published Volcker Rule examiners’ manual offers a look at how regulators are going to approach the rule’s enforcement. It looks like we should expect a good deal of confusion, and possibly some contention. 

After the final version of the Volcker Rule was published in December and banks began to prepare for the July 15, 2015, effective date, the only remaining question was how it would be enforced. That enforcement is up to the examiners of the various agencies. Recently, the Office of the Comptroller of the Currency (OCC) published a 26-page Volcker Rule examiners’ manual, which may be an inside peek into how the regulators are going to approach enforcement.

The Objectives 

Here are some of the objectives it sets for examiners:

• Assess the bank’s progress toward identifying the [banks] that engage in activities subject to the regulations. 
• Assess the bank’s progress toward identifying its proprietary trading. 
  • The bank must identify purchases and sales of financial instruments for specified short-term purposes. 
  • The bank must identify the trading desks (the smallest discrete unit of organization) responsible for the short-term trading identified above. Trading desks may span multiple legal entities or geographic locations. 
  • For each trading desk, the bank must determine on which permitted activities the desk will rely to conduct its proprietary trading. 
• Assess the bank’s progress toward identifying its ownership interests in covered funds. 
• Assess the bank’s progress toward identifying the covered funds that the bank sponsors or advises. 
• Assess the bank’s progress toward identifying its ownership interests in and sponsorships of entities that rely on one of the regulations’ exclusions from the definition of covered fund. 
• Assess the bank’s progress toward establishing a compliance program. 
• Assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies. 

Given the newness of the Volcker Rule, it is perhaps indicative that these objectives discuss a bank’s progress and plans, instead of its conformance. However, we should expect the instructions to move pretty quickly to assessing the bank’s conformance.

Specific Instructions 

Within the document, there are some specific instructions that are both pertinent and perhaps informative of the general approach. For example (these are only a small fraction of what the manual requires):

• Under a section entitled, Assess the bank’s progress toward reporting metrics as and when required, we see:Some banks may combine previously delineated trading desks into a single trading desk.
  • Multiple units with disparate strategies being combined into a single desk, however, could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level. 
• Under Assess the bank’s ability to calculate the required metrics we see:
  • This metric requires the bank to “tag” each trade as customer-facing or not. Inter-dealer trading typically does not count as customer-facing because a [bank] with trading assets and liabilities of $50 billion or more is not a customer unless the bank documents why it is appropriate to treat the counterparty as a customer. Trading conducted anonymously on an anonymous exchange or similar trading facility open to a broad range of market participants is customer-facing regardless of the counterparty. 
  • For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values. 
  • For comprehensive profit and loss (P&L) attribution, determine whether bank systems can segregate P&L into the required three categories: 
  • Determine whether the bank’s systems can report risk sensitivities on a sufficiently granular basis to account for a preponderance of the expected price variation in the trading desk’s holdings. 
• Assess the bank’s progress toward using the metrics to monitor for impermissible proprietary trading.
  • Determine whether the bank consistently applies, across its trading desks, methodologies for calculating sensitivities to a common factor shared by multiple trading desks (e.g., an equity price factor) so that these sensitivities can be compared across trading desks. 
• Assess the bank’s policy for reviewing activities and positions whose metrics indicate a heightened risk of impermissible proprietary trading. 
• Assess the bank’s progress toward identifying its market-making-related activities, market-maker inventory, and reasonably expected near-term demand (RENTD).
  • Assess the bank’s progress toward developing a process for measuring and documenting RENTD for each market-making desk. 
  • Demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with financial instruments in which the trading desk makes a market, including through block trades. 

• Assess the bank’s progress toward establishing and implementing an internal compliance program. 
• Assess the bank’s progress toward developing procedures and controls to continuously review, monitor, and manage risk-mitigating hedging activity to ensure that the bank meets the requirements of the risk-mitigating hedging exemption. Note that under the regulations the risk-mitigating hedging activity cannot be designed to:
  • reduce risks associated with – the bank’s assets or liabilities generally. 
  • general market movements or broad economic conditions. 
  • profit in the case of a general economic downturn. 
  • counterbalance revenue declines generally. 
  • arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the bank. 

• Assess the bank’s progress toward developing systems and processes to create and retain the hedging documentation for at least five years and in a manner that allows the bank to produce promptly those records to the OCC. 

There is much more in the manual than we have listed here, of course. But these excerpts can give us some insights into how the regulators are approaching the VR. For example:

• The regulators are aware of the opportunity, and perhaps desire, to obfuscate compliance with the rules. Several places in the instructions warn examiners to make sure that efforts are “meaningful,” particularly around the metrics.
• In most of the more difficult areas of the metrics – for example, the inventory aging and turnover categories – the instructions appear to offer no additional help. On the question of how to apply inventory aging and turnover, the instructions simply say:  For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values. (For options, value means delta-adjusted notional value; for other interest rate derivatives, value means 10-year bond equivalent value).  There is nothing about what to do if a bank opened a position, or opened and closed the position on the same day, which would result in a turnover ratio of ∞. Either the regulators haven’t identified these problems yet or don’t yet have an answer.
• The instructions don’t give any guidance on how examiners are to determine that a bank stands ready to buy or sell those instruments that trade infrequently or are new to the market. Here, again, the regulators may not have identified the uncertainty, or may not have an answer.

Overall, the instructions mostly parrot the rule itself, without clarifying many of the complexities and uncertainties around enforcement. If this is an indication of the preparations examiners will get for their very difficult tasks, we should expect a good deal of confusion, and possibly some contention. Thus it behooves banks to start a dialog now with their assigned examiners about how they will apply these instructions and what the results will be.