The Volcker Rule Joyce M. Hansen, Deputy General Counsel and Senior Vice President, Federal Reserve Bank of New York

1. The Volcker RuleJoyce M. Hansen, Deputy General Counsel and Senior Vice President, Federal Reserve Bank of New York American Bar Association, Section of International Law 2011 Spring Meeting April 6, 2011

2. Outline • Highlights II. Purpose III. Statute IV. FSOC Study • Key challenges The views reflected in this presentation are solely those of the presenter, and do not represent the views of the Federal Reserve Bank of New York or the Federal Reserve System.

3. I. Highlights • Volcker Rule: Section 619 of the Dodd-Frank Act • Prohibit proprietary trading • Acquire or retain …ownership or sponsorship of hedge or private equity fund • Statute calls for interagency rulemaking, to be preceded by a Financial Stability Oversight Council (FSOC) study • Promote safety and soundness of banking entities • Limit transfer of Federal subsidy • Reduce conflicts of interest • Limit activities having caused undue risk

4. Highlights • FSOC Study published in January 2011 • Recommends, for prop trading, comprehensive supervisory approach, including: • Programmatic compliance regime • Analysis and review of quantitative metrics • Recognizes challenges in implementation • Rulemaking due in October 2011

5. Financial Stability Oversight Council Establishment and Membership • Established on July 21, 2010 • Membership • Voting members • Secretary of the Treasury (serves as Chair) • Federal Reserve Chairman • Director of the Bureau of Consumer Financial Protection • Comptroller of the Currency • Chairman of the SEC • Chairperson of the FDIC • Chairperson of the CFTC • Director of the Federal Housing Finance Agency • Chairman of the National Credit Union Administration Board • Independent member having insurance expertise

6. Financial Stability Oversight Council • Nonvoting members • Director of the Office of Financial Research • Director of the Federal Insurance Office • State Banking Commissioner • State Securities Commissioner • State Insurance Commissioner

7. Financial Stability Oversight Council Purposes of the Council • Identify risks to U.S. financial stability that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies (“BHCs”) or nonbank financial companies (“NBFCs”), or that could arise outside the financial services marketplace • Promote market discipline, by eliminating expectations on the part of shareholders, creditors and counterparties of such companies that the Government will shield them from loss in the event of failure • Respond to emerging threats to the stability of the U.S. financial system

8. Financial Stability Oversight Council Duties of the Council • Determining which NBFCs are systemically important and require supervision by the Federal Reserve • Identifying systemically important financial market utilities (“FMUs”) and payment, clearing and settlement activities • Making recommendations to the Federal Reserve and to primary financial regulatory agencies for heightened prudential standards • Collecting information and facilitating information sharing • Recommending supervisory priorities • Monitoring the financial services marketplace and financial regulatory developments • Identifying gaps in regulation • Providing a forum for agency discussion and resolution of agency jurisdictional disputes • Preparing a written report and testifying annually before Congress

9. II. Purpose “The basic point is that there has been, and remains, a strong public interest in providing a ‘safety net’ –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions.” Testimony of Paul Volcker before the Senate Banking Committee, 2/2/10

10. II. What is the purpose of the Volcker Rule? • Recently released FSOC Study: • Separate federal support for the banking system from speculative trading activity with the banking entity’s own capital; • Reduce potential conflicts of interest between a banking entity and its customers; and • Reduce risk to banking entities and nonbank financial companies designated for supervision by the Board

11. III. Statute: two main components of the rule • Ban proprietary trading by banking entities* a. Subject to permissible activity exemptions, including i. Underwriting ii. Market making • Hedging b. Subject to “backstop” provisions i. Material conflicts of interest ii. Material exposure to high risk assets iii. Safety and soundness iv. Financial stability 2. Ban investing in or sponsoring hedge funds or private equity funds by banking entities (subject to permissible activities and backstop provisions) * Banking entities are insured DIs, BHCs, FBOs, and any affiliate or subsidiary

12. III. Proprietary trading: the statutory definition • What is proprietary trading? • “engaging as a principal for the trading account…in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative or contract” or any other financial instrument that the agencies define by rule • What is the trading account? • “any account used for acquiring or taking positions in securities and instruments…principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements)” and other accounts that the agencies define by rule

13. III. Proprietary trading definition: some matters of coverage • Investing versus proprietary trading. Senator Merkley: • “The term ‘trading account’ is intended to cover an account used by a firm to make profits from relatively short-term trading positions, as opposed to long-term multi-year investments.” • “Linking the prohibition on proprietary trading to trading accounts permits banking entities to hold debt securities and other financial instruments in long-term investment portfolios.” • How to define “trading account”? • FSOC Study: possibilities include (1) accounting standards; (2) market risk capital rules • Note “other accounts” language

14. III. Permitted activities • Underwriting • Market making • Hedging • Trading on behalf of customers • Trading in U.S. Treasuries, Agencies, and Municipals • Insurance company general account exemption • Activities of foreign banking organizations • Other activities that the agencies determine by rule would promote and protect safety and soundness and financial stability

15. III. Prohibited – Material Conflicts & High Risk Activities However, no class of transactions or activity will be exempt if agencies determine they: • Involve or result in “material conflict of interest”; • Result in “material exposure” to “high-risk assets or high-risk trading strategies”; • FSOC Study: possibility – assets whose values cannot be externally priced or whose risk cannot be adequately hedged • Pose a threat to safety and soundness; or • Pose a threat to financial stability of the U.S.

16. III. Fund investment and sponsorship: the statutory definitions • May not “acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund” • What is “sponsoring”? • Serving as GP, managing member or trustee • Selecting or controlling majority of directors, trustees or management of fund • Sharing name with fund • What is a “hedge fund” or a “private equity fund”? • Defined by reference to Investment Company Act exemptions on which such funds generally rely • However: may pick up entities not traditionally thought of as hedge funds or private equity funds  FSOC Study: venture capital funds • Similar funds defined by rule

17. III. Fund investment and sponsorship: permitted activities May organize and offer a private equity fund or hedge fund if: • In connection with provision of “bona fide trust, fiduciary, or investment advisory services” to “customers”; • No investment other than a “de minimis investment”; • Banking entity does not guarantee or assume risk of the fund and makes disclosures to fund investors of this; • No name sharing and restricted employee investment What is a “de minimis investment”? • May provide seed capital to (up to 100%) or make a de minimis investment in a fund, but must reduce to <= 3% of the total ownership interests of a fund within 1 year after establishment (Board may extend for 2 additional years) and • Investments must be “immaterial” to the banking entity, but in no case may aggregate of all interests > 3% of Tier 1 capital of the banking entity • Deduction of investments from capital

18. III. Application of the Volcker Rule to activities thatare not per se prohibited • Banking entity permitted activities may still be subject to prudential limitations: • Agencies “shall” adopt rules imposing “additional capital requirements and quantitative limitations, including diversification requirements” regarding even permitted activities if “appropriate to protect safety and soundness of the banking entities engaged in such activities” • Nonbank financial companies – activities not prohibited, but may be limited: • Nonbank financial companies supervised by the Board shall be subject to “additional capital requirements for and additional quantitative limits” with regard to proprietary trading and fund activities

19. IV. FSOC Study: proprietary trading • Implementation considerations: • Relatively easy to prohibit segregated proprietary trading units – “bright line”; harder to prevent proprietary trading that occurs away from such units • “Certain classes of permitted activities – in particular, market making, hedging, underwriting, and other transactions on behalf of customers – often evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives.” • “Broadly gauged restrictions on prop trading may deter permitted market-making, hedging and underwriting activities. However, more loosely defined restrictions are likely to provide an opportunity for prohibited proprietary trading.”

20. IV. FSOC Study • Proprietary trading commingled with client transactions • Inventory required for market-making or underwriting could also be used to conduct prop trading • Accumulation of inventory in anticipation of customer demand can resemble prop trading • Banking entities can engage in impermissible prop trading through inconsistent or incomplete hedging of client transactions The amount of risk required for permitted activities varies considerably by business model

21. IV. Core Recommendations – Four Parts • FSOC recommends development of: • Programmatic compliance regime • Policies & procedures, internal controls, independent testing & CEO attestation • Analysis and reporting of quantitative metrics • May include revenue, revenue-to-risk, inventory and customer-flow metrics • Supervisory review and oversight • Periodic review, testing & ongoing monitoring of trading activities • Review of quantitative metrics for red flags • Enforcement procedures for violations • Still subject to study

22. IV. Programmatic Compliance Regime • Policies describe mission & strategy of each trading unit, ensuring internal controls & supervisory reviews are attuned to specific conditions of each trading unit. • Policies may include description of: • Mandate of each unit / profit center • Articulation of levels & types of risk necessary to execute profit center mission, including rationale for why such risks are appropriate • Description of how revenues are generated and risks are managed • Description of clients served and activity typical of client base • Enumeration of trading activities & list of approved products • Firms will also develop program of controls to ensure risks taken are appropriate and consistent with articulated Volcker Rule policies and procedures.

23. IV. Programmatic Compliance Regime (cont.) • Leverages & potentially strengthens existing control framework used to understand & manage trading risks • Controls may include: • Establishment of authorized risks, instruments and products • Procedures to analyze revenues to discern key drivers of P&L • Risk limits to ensure that risk-taking is appropriately constrained in a way that disallows prohibited activities. • Firms may also be required to: • Establish recordkeeping & reporting to facilitate internal & supervisory monitoring • Conduct independent testing of compliance regime • Have CEOs attest to ongoing effectiveness of compliance regime

24. IV. Analysis & Reporting of Quantitative Metrics • Firms provide supervisors with regular metrics that assist in identifying potential impermissible activities. Data used to: • Highlight trends or incidents that may suggest violations have occurred • Facilitate comparisons across banking entities, market segments, or trading strategies to inform and strengthen supervisory process • FSOC identified four “promising” categories of metrics: • Revenue-Based Metrics: Facilitate comparison of daily revenues with historical trends and similar data for other banks • Revenue-to-Risk Metrics: Measure revenue generated per unit of risk; Premise  permitted activities likely have greater revenue-to-risk ratios • Inventory Metrics: Premise  market maker that retains risk in excess of customer demand may hold impermissible proprietary position • Customer-Flow Metrics: Evaluate volume of customer-initiated orders against trader-initiated orders; Premise  significant trader-initiated order volume may suggest proprietary activity

25. IV. Supervisory Review & Oversight • Supervisory review likely to be ultimate lynchpin in effective implementation. • FSOC recommends Agencies incorporate the following components as part of supervisory oversight: • Periodic review and testing of internal controls and procedures • Ongoing supervisory monitoring and review of trading activities • Frequent communication with trading personnel • Review of quantitative metrics for red flags

26. IV. Enforcement Procedures for Violations • Statute provides for divestiture process, but doesn’t appear to limit other types of enforcement actions • Study provides no specific recommendations, recommends further study

27. IV. Strengths to FSOC Study Approach • Avoids “one-size-fits-all” approach (on a number of dimensions) • Leverages, and potentially strengthens, internal control infrastructure already used to monitor and manage risks • Avoids “bright line” definitions, reducing opportunities for “gaming” • Programmatic approach puts onus on firms • Metrics may facilitate horizontal comparisons

28. V. Key Challenges • Definitional challenges (“trading account”; “proprietary trading”; scope of permitted activities) • Development of metrics • Coordinating supervisory activities across Agencies • Resource issues

29. VI. Conformance • Effective date: earlier of (i) final rules + 12 months or (ii) July 21, 2012 • Conformance period: effective date + 2 years (July 2014) • Subject to possibility of three separate one year extensions by the Board • Subject to possibility of one further five year extension by the Board for “illiquid funds” where contractual obligation exists on 5/1/2010 • Board issued final conformance rules in February 2011 • Sections 225.180-182 of Regulation Y