Volcker ruleA complex compliance challenge

2014

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Volcker rule

Limits on investmentsThe rule prohibits a banking entity from having an “ownership interest” in, sponsoring, or having certain relationships with hedge funds or private equity funds (termed “covered funds”). Additional information about this aspect of the rule can be found in Subpart C – Covered Fund Activities and Investments. The rule is effective as of April 1, 2014. However, the conformance period has been extended to July 21, 2015 — an acknowledgment by regulators of the difficulty banking entities face in complying with the rule.

Will your organization be ready? In this publication, we highlight certain considerations you should be aware of as you prepare to comply with the rule.

1 The federal agencies approving the rule include the Board of Governors of the Federal Reserve System, the Commodities Futures Trading Commission, the FDIC, the Office of the Comptroller of the Currency, and the SEC. 2 See the final rule at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a1.pdf.

Introduction

BANKING ENTITIES DEFINED“Banking entities” include insured U.S. depository institutions; entities that control an insured depository institution (for example, a bank holding company); a foreign entity that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 (i.e., because it has a U.S. branch or agency); and affiliates or subsidiaries of the foregoing*.

After four years of fervent public debate and intense regulatory deliberation, Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), known as the Volcker rule (the rule), was approved by all five of the required federal agencies on Dec. 10, 20131. The rule — modified from a proposal published in late 2011 — restricts a banking entity’s trading activities and defines what is a permissible investment for a banking entity. Coupled with the compliance challenges and costs imposed by other parts of the Dodd-Frank Act, the rule will create a significant hurdle for midsize and large banking entities as they strive to regain historical levels of profitability.

Limits on trading activitiesSubject to various exemptions, the rule prohibits banking entities from engaging in proprietary trading — defined as “engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments.” Many of the terms in that definition are further defined in Subpart B – Proprietary Trading Restrictions2.

*For purposes of the rule, the term “affiliate” has the same meaning as in Section 2(k) of the Bank Holding Company Act of 1956. Namely, the term “affiliate” means any company that controls, is controlled by, or is under common control with another company.

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Volcker rule

• A system of internal controls designed to monitor compliance with the rule.

• A management framework that delineates responsibility and accountability for compliance.

• Training for trading personnel and managers, as well as other “appropriate” personnel.

• Records sufficient to demonstrate compliance with the rule and retained for five years.

• Independent testing of the effectiveness of the compliance program. The testing may be conducted by “qualified” personnel of either the banking entity or an outside party.

• Domestic U.S. banking entities with total consolidated assets of $50 billion or more.

• Foreign banking entities that have U.S. assets of $50 billion or more for the preceding calendar year, including U.S. subsidiaries, affiliates, branches and agencies.

• Banking entities that have been designated as enhanced by a supervisory agency.

The additional requirements of an enhanced program address the following areas:• Trading desk (written policies) • Robust analysis and quantitative risk management• Authorized risks, instruments and products• Hedging policies and procedures• Explanation of the management of high-risk assets or

high-risk trading strategies• Remediation of violations

3 Rule: Section 13 of the Bank Holding Company Act contains certain prohibitions and restrictions on the ability of a banking entity and nonbank financial company (supervised by the Board of Governors of the Federal Reserve System) to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund.

Understanding the basics

Meeting the compliance requirementsProprietary tradingEffective planning and careful implementation are critical to meeting the compliance requirements of the rule. As described below, compliance obligations are set based on the size and volume of the banking entity’s relevant activities.

No formal requirement Small, noncomplex banking entities that don’t engage in proprietary trading or covered fund activities — other than trading in U.S. government or agency obligations, or state and municipal obligations — do not need to set up a compliance program. However, a sound practice would be to update investment or treasury policies.

Should these institutions engage in such activity, regulators will expect a suitable compliance program to be developed.

Limited Small entities with total consolidated assets of $10 billion or less can implement a simplified compliance program. These institutions are expected to modify their existing compliance policies and procedures to describe their current trading activities and controls, specifying how these comply with Section 13 of the Bank Holding Company Act3. Standard Entities with between $10 billion and $50 billion in total consolidated assets must set up a compliance program that satisfies nine requirements: • Written policies and procedures reasonably designed to

document, describe, monitor and limit proprietary trading activities, and activities and investments with respect to covered fund activities.

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The largest entities will have to report on seven metrics — down from the originally proposed 17 — to demonstrate compliance. The metrics fall into three measurement categories: risk management, source of revenue and customer-facing activity measurements (see the accompanying chart).

The seven metrics must be reported for each calendar quarter within 30 days of month end. For the largest banking entities with $50 billion or more in trading assets and liabilities, the metrics must be reported each month within 10 days of month end, beginning January 2015.

For the largest banking entities, 7 metrics to demonstrate compliance.

Risk management1. Risk and position limits and usage2. Risk factor sensitivities 3. Value-at-Risk (VAR) and Stress Value-at-Risk (Stress VAR)

Source of revenue4. Comprehensive profit and loss attribution (by existing positions, new positions, and residual profit and loss other than that from existing or new positions)

Customer-facing activity5. Inventory turnover 6. Inventory aging 7. Customer-facing trade ratio (trade count-based and value-based)

The board of directors and senior management must adopt the compliance program and ensure qualified management oversight. The CEO must attest to the appropriate regulatory agency that the entity in question has in place processes to establish, maintain, enforce, review, test and modify the compliance program in a manner reasonably designed to achieve compliance.

Covered fundsAn institution that invests in or sponsors a covered fund would be expected to have a compliance program appropriate for the size, scope and complexity of business activities undertaken. Those entities with enhanced status are subject to the following additional requirements:

• Identification of covered funds• Identification of covered fund activities and investments

(mapping within organization)• Explanation of compliance• Description of monitoring activities for each organizational

unit to ensure compliance• Internal controls • Remediation of violations

Volcker rule

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Trading assets and liabilities June 30, 2014 July 21, 2015 April 30, 2016 Dec. 31, 2016

$50 billion or more Quantitative metricsEnhanced compliance

program

Between $25 billion and $50 billionFull compliance program

for size and scale of activities

Quantitative metrics

Between $10 billion and $25 billionFull compliance program

for size and scale of activities

Quantitative metrics

$10 billion or less

(modest activities)Update existing compliance

program

$10 billion or less

(no activities)Must be able to

demonstrate status

The Volcker rule: Timeline for implementationEffective date of final regulation: April 1, 2014

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Conclusion

Even with the one-year extension granted for conformance, the Volcker rule presents banking entities with a significant challenge. 2014 regulatory strategies will need to be balanced with the demands of enhanced compliance programs, technology and process upgrades; and newly designed control frameworks, reporting structures and internal audit programs; Boards and senior management should begin by getting a clear picture of what’s required of their institution and where they are falling short of expectations. Organizations that succeed will have the advantage on July 21, 2015, and beyond.

ContactNichole JordanNational Banking and Securities Sector LeaderT 212.624.5310E nichole.jordan@us.gt.com

Jack KatzGlobal Managing Partner Financial ServicesT 212.542.9660E jack.katz@us.gt.com

Tariq MirzaNational Managing Director, Bank Advisory and Regulatory Services T 202.251.8677E tariq.mirza@us.gt.com

Kenneth Goodwin National Senior Manager, Bank Advisory and Regulatory Services DFA/Volcker SMET 212.542.9685E kenneth.goodwin@us.gt.com

Content in this publication is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information on the issues discussed, consult a Grant Thornton LLP client service partner or another qualified professional.

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