Volcker: are the big fish back?

It looks likely the Volcker Rule, which restricts banks’ investment in private equity to 3 percent of tier one capital, will be revised. The five agencies responsible for its oversight have committed to a review while the Treasury department has drawn up proposals that would make it less onerous.

While the rule is not directed at private fund firms themselves, it affects some of what were, historically, key investors – big banks. Since the Volcker Rule banks have decreased their exposure to the asset class: JPMorgan’s One Equity Partners has spun out; Credit Suisse sold off its Customised Fund Investment Group, Strategic Partners secondaries business and Global Infrastructure Partners Group; and Citigroup offloaded Citi Venture Capital International. Certain amendments or a repeal could, therefore, re-open the lines of investment from big banks.

While everyone agrees on the need for review, no one agrees on how the rule should change. pfm runs down who has said what, what the different recommendations are and analyzes the proposals which will have an impact on the industry.

Take five

There are five federal agencies charged with overseeing the Volcker Rule – the Federal Reserve, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Commodities Futures Trading Commission and the Office of the Comptroller of the Currency. This means any rewrite will likely be a long, drawn-out process as they reach attempt to reach a consensus. But there is evidence the big five are – to varying degrees – committed to reform.

In a July report to Congress, the SEC said there was not yet enough evidence to say whether the Volcker Rule has helped or hurt financial markets and, by extension, whether modifications will or will not make things better. “Although the SEC’s report might be seen at first glance as casting doubt on whether the Treasury’s proposed changes are really needed, the SEC’s study deserves credit for highlighting this scientific conclusion,” says Peter Island, professor of economics at Boston College.

The Federal Reserve board released guidelines in July that eased some of the restrictions imposed by the rule. The likely new chairman, Jerome Powell, said in September he was confident there would be a five-agency rule on a “less burdensome Volcker.” At the same time, chairman of the CFTC, Christopher Giancarlo, said he was “confident Volcker would be revised.”

The OCC held a public consultation on the effectiveness of the rule, after comments from its acting head, Keith Noreika, that the rule provides a “practical example” of how conflicting messages and inconsistent interpretation can “exacerbate the regulatory burden by making industrial compliance harder and more resource intensive than necessary.”

The FDIC has remained silent, but has committed to the five-agency review.

A sixth body, the Treasury, has also weighed into the argument, calling for the Volcker Rule to be amended. In its June paper, A Financial System That Creates Economic Opportunities, it said it “recommends significant changes to the Volcker Rule, including changes to the statute, regulations and supervision.”

There is clearly appetite for a change to the Volcker Rule, but given that the interagency administrative framework requires changes to be unanimous, it is not likely to be a quick process, even before the lawmarkers get involved.

“Changes should occur at a Congressional level, and there is some bipartisan recognition that a deregulatory fine-tuning of the Volcker Rule is in order,” Charles Horn, partner at Morgan Lewis, says.

But Congress is likely to focus on pushing through other key pieces of reform, such as taxation

If the changes do materialize, it may be time to dust off the contacts book. The banks might be back.

The proposals that would affect private fund managers

Area of regulation: Definition of a covered fund

Change proposed by: Treasury, Federal Reserve

What do they want? One of the main criticisms of the Volcker Rule is that it is vague and its method of defining a covered fund has “captured issuers that were not intended to be covered.” In its consultation, the
Office of the Comptroller of the Currency asked whether this definition should be replaced with one that focuses on characteristics specific to hedge funds or private equity funds such as investment strategy and fee structure.

Industry impact: This redefinition would leave private equity within the scope of the Volcker Rule, which has not pleased bankers. The chief executive of the American Bankers Association, Rob Nichols, said refining the definition of a covered fund to only include those engaged primarily in short-term proprietary trading would be more in keeping with the rule’s aim of ensuring stability in the financial markets.

Nichols said banks should be able to invest in more vehicles including venture capital funds which “provide programs for various areas of public welfare.” He said applying the rule to these funds is “alien to the purpose of the statute.”

Chances of change: The rhetoric suggests private equity will remain within the scope of the rule, but the private funds management lobby, which has been campaigning against the Volcker Rule since its inception, is powerful.

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Area of regulation: Extending the seeding period

Change proposed by: Federal Reserve, Treasury

What do they want? Reform of a kind has already materialized. In July, the Fed said banks can apply for an additional two years to make seeding investments in private equity or hedge funds. Seeding refers to a banking entity putting initial equity into a new fund to attract investors. Under Volcker, banks are not allowed to own more than 3 percent of an investment that is more than one year old, meaning they may need to reduce their stakes in private equity funds a year after inception.

Industry impact: The additional two years will give firms additional time to stand up and to establish the track record needed to attract investors, the US Treasury says.

Chances of change: Currently banks must meet certain criteria if they are to be granted an extension to the holding period in a new investment. However, banks continue to hold non-Volcker compliant private equity portfolios. Morgan Stanley’s is worth around $2.2 billion, while Goldman Sachs’ private equity and real estate portfolio is worth almost three times more, $7.7 billion, and the regulators have shown no sign of initiating any serious enforcement action against them. The Fed has given banks four extensions to comply with the 2017 deadline, the last being five years. Even if the rules are not changed formally, this implies there will be few consequences for banks that hold onto their portfolios for longer than is technically allowed.