The Volcker Rule refers to a broad set of rules adopted under Dodd-Frank Title VI that attempts to reduce risk within banking institutions, stemming from mixing investment banking and commercial banking. The Volcker Rule consists of two major parts: rule preventing banking institutions from partaking in proprietary trading from their own funds and limiting banking institutions from investing in hedge funds or private equity funds.
Background
After the Global Financial Crisis (GFC), financial regulators began critiquing the riskier investments from banking institutions that caused the crisis. One major source of this risk involved banking institutions conducting proprietary investments in different kinds of funds, pooled assets, and other risky, high-profit investments. Until legislative efforts in the 1990s to repeal the Glass-Steagall Act, investment banking and commercial banking was required to be separated from each other. This prevented the kind of combination between consumer deposits and risky investments that contributed to the GFC. After the crisis, financial regulators in the U.S. and around the globe attempted to bring back some of the separations between investment and commercial banking. Since its enactment, the Volcker Rule has faced a variety of critiques, particularly about its effects on restricting capital and limiting bank profits. As a result, the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (EGRRCPA) loosened many of the restrictions of the Volcker Rule.
Prohibition on Proprietary Trading
This rule prevents banking institutions from making proprietary trades in most circumstances. The prohibition against proprietary trading applies not only to banks themselves but also to bank holding companies. Proprietary trading here is very broad, including almost all securities, derivatives, and futures. The rule allows for some exceptions for underwriting, market making activities, risk-mitigating hedging, U.S. government and limited foreign government obligations, and investing in foreign banking institutions. The exceptions in many circumstances require reporting and explanations for the applicability of the exceptions. Also, in all circumstances, the trading must not involve overly risky activity and must not create a conflict of interest.
The EGRRCPA added a major exception to the proprietary prohibition for smaller banking institutions. The Act allows banks to invest up to 5% of their assets in proprietary trading if the bank and their owners control less than $10 billion in assets.
Prohibition Against Investment in Covered Funds
This rule prevents banks from owning or entering into certain partnerships with “covered funds,” such as hedge funds and private equity funds. Title VI defines covered assets as any entity that is prevented from being an investment company by section 3(c)(1) or 3(c)(7) of the Investment Company Act. There are also a range of specific exceptions including for investing in covered funds that have a general purpose such as acquisition vehicles, joint ventures, foreign funds offered abroad, and some insurance accounts among others. This rule also has similar exceptions to the prohibition on proprietary trading that allow limited exceptions for investing in covered funds when the bank is organizing the fund, underwriting, hedging against risk, insurance activities, or for activities occurring completely outside the United States.
Compliance
The Volcker Rule also has an important compliance aspect that depends on the size of the bank. The main component of the rule requires an internal compliance program be created in each bank that ensures limits are followed, documentation is kept, and any reporting requirements be met. Large banks and those with large investment operations must meet higher compliance, prudential, and monitoring requirements. The Volcker Rule divided banks between smaller, mid-size, and larger size banks and could be triggered automatically if banks have a certain amount of assets. The EGRRCPA changed this by creating the $10 billion asset exception and raising the limit for mid size banks to $250 billion, reducing the amount of banks that fall under the heightened compliance requirements.
[Last updated in November of 2022 by the Wex Definitions Team]