The Volcker rule limits two main types of activities by large institutional banks. Banks are prohibited from engaging in proprietary trading activities and from owning interest in covered funds, generally defined as hedge funds and private equity funds. The rule is listed in Section 619 of the Dodd-Frank Act, and is part of the larger financial reforms contained in that legislation.
The rule was designed to prevent banks that receive federal and taxpayer backing in the form of deposit insurance and other support from engaging in risky trading activities. The rule was named after Paul Volcker, a former chair of the Federal Reserve Board.
Proprietary Trading Prohibited
The Volcker rule prohibits banks from engaging in proprietary trading activities. Proprietary trading is defined by the rule as a bank serving as a principal of a trading account in buying or selling a financial instrument. The regulations expand on the definition of what qualifies as a trading account and whether the trade involves a financial instrument.
The regulations define a trading account based upon three criteria: a purpose test for the account, the market risk capital rule test and the status test. The rules states that trades are presumed to be for the trading account of a bank if the bank held the position for 60 days.
Due to the broad definition of a trading account, certain trading activities are exempted from this prohibition, such as clearing activities, liquidity management, market making, hedging, trades to satisfy delivery obligations and trades through a profit sharing or pension plan of the bank. However, very strenuous compliance requirements are placed on these trading activities, which include internal controls and extensive documentation.
Prohibition on Covered Fund Investments
The Volcker rule further prohibits banks from having an ownership interest in a covered fund. The rule defines covered funds with a three-pronged test. A covered fund is exempt from the definition of an investment company as defined by the Investment Company Act of 1940, commodity pools with characteristics similar to hedge funds or private equity funds and foreign covered funds.
The rule sets forth a number of exceptions to these prohibitions, such as foreign public funds, wholly owned subsidiaries and joint ventures.
Extension of Deadlines for Compliance
Banks were supposed to liquidate their holdings in covered funds by July 2015. However, in December 2014, the Federal Reserve Board granted extensions to banks to get out of these positions until 2017, and until 2022 in some cases.
The banks argued that many of their positions were in illiquid investments on which they would have to take significant losses to exit. The banks stated that their ownership interests in hedge funds and private equity funds were at risk of losing substantial value if they were forced to liquidate them quickly.
FAQs
The Volcker Rule was part of the Dodd-Frank Act enacted into law by the Obama administration in 2010 as a response to the Global Financial Crisis. It prohibits banks from engaging in proprietary trading, or from using their depositors' funds to invest in risky investment instruments.
What is the 5 percent Volcker Rule? ›
A bank that does not have (and is not controlled by a company that has) more than $10 billion in total consolidated assets and does not have (and is not controlled by a company that has) total trading assets and liabilities of 5 percent or more of total consolidated assets is excluded from the Volcker Rule.
What is the purpose of the Volcker Rule in the Dodd Frank Act? ›
The objective of the Volcker Rule is to stop all proprietary trading (which is defined quite broadly) by commercial banks (such as HSBC) i.e. to cease any risky trading by banking institutions that has no benefit to its customers.
What activity does the Volcker Rule affect? ›
The Volcker rule generally prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.
What does the Volcker Rule prohibit? ›
The final rule prohibits banks from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account. The final rule also imposes limits on banks' investments in, and other relationships with, hedge funds or private equity funds.
Which two controls are required by the Volcker Rule? ›
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.
Does the Volcker Rule still exist? ›
On June 25, 2020, the Volcker Regulators relaxed part of the rules involving banks investing in venture capital and for derivative trading.
What is the final Volcker Rule? ›
The final rules permit a banking entity to continue to engage in proprietary trading in U.S. government, agency, state, and municipal obligations. They also permit, in more limited circ*mstances, proprietary trading in the obligations of a foreign sovereign or its political subdivisions.
What are covered funds under the Volcker Rule? ›
The Volcker Rule is a federal regulation that generally prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds, also called covered funds.
Does the Volcker Rule apply globally? ›
The Volcker Rule does apply to every foreign entity that directly or indirectly maintains a bank branch or agency in the United States, or controls a commercial lending company.
To subdue double-digit inflation, Chairman Volcker announced, in October 1979, a dramatic break in the way that monetary policy would operate. In practice, the new approach to monetary policy involved high interest rates (tight money) to slow the economy and fight inflation.
What is the Volcker Rule for permitted activities? ›
Permitted Proprietary Trading Activities
To recap, the Volcker Rule prohibits a banking entity from engaging in proprietary trading, which is defined to mean engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments.
How high did Paul Volcker raise interest rates? ›
Volcker slammed the brakes on the economy by raising interest rates to 20% — tough medicine to prove he was serious about getting inflation under control. "At some point this dam is going to break and the psychology is going to change," Volcker told the MacNeil/Lehrer NewsHour. It worked.
What activities are excluded from the proprietary trading restrictions? ›
Clarifying exclusions: The final rules clarify which activities are not considered proprietary trading, provided certain requirements are met, including trading solely as an agent, broker, or custodian; through a deferred compensation or similar plan; to satisfy a debt previously contracted; under certain repurchase ...
