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Volcker Rule

Goldman Sachs did not violate the Volcker Rule (and $1 billion is a drop in the bucket anyway)

By Hal S. Scott

Here’s the secret about that secret Goldman Sachs team that made headlines this week: It’s not really doing anything wrong.

Bloomberg News reported that the investment bank is sidestepping the so-called Volcker rule by having a group within the firm, with $1 billion of assets under management, make risky “hedge fund” type investments.

Take this story with a large grain of salt. The Volcker Rule, enacted by Congress, prohibits proprietary trading but also permits market-making and long-term investment. Market-making is important to the economy because it supplies liquidity for investments.  Without liquidity issuers of debt and equity would have to pay more for their funds because investors with less liquid investments would face more risk.  Banks are also allowed to invest their excess funds in longer-term investments.  As for any investor, it is prudent to diversify a portfolio with investments of different types, with some investments more risky than others.

The problem comes in deciding what is proprietary trading rather than market-making or investing.  When it comes to market-making, regulators want to make sure the positions are temporary, that inventory is being accumulated to dispose of in relatively short order.  On the other hand, when it comes to investment, the same regulators want to make sure the position is for the longer term, not a position that is designed to profit by short-term price movements.  Of course, in both these permitted cases, the firm has its capital at risk, as it does in the case of proprietary trading.  So if you can only have relatively short positions for market making and relatively long positions for investment, the real impact of the Volcker rule is to prohibit intermediate investment, a very questionable policy.  And even some intermediate risk might be permitted if the financial institution can rebut the presumption, based on all the facts and circumstances, that its position was taken essentially to make a short-term profit.  And intermediate risk would also be allowed if incurred in connection with a third proprietary trading exemption for hedging, the issue in the JP Morgan whale case.

But there is no Volcker Rule at the moment. Its implementation through regulation is in proposal stage and the proposal is being thoroughly revised in response to a raft of commentary—so there is nothing Goldman violated.  Secondly, the proposed rule allows long-term investments, those over 60 days, risky or not, because such longer term investments are not regarded as being in a “trading account.” Third, $1 billion sounds like a lot of money but it is a drop in the bucket of Goldman’s $950 billion in assets at the end of third quarter 2012.  Goldman has stated that the investments in question were long-term, so Goldman was just complying with the proposed rule, and really not risking that much of its money.

Much more troublesome than the story, however, is the rule itself. Once in effect, its only net impact might be to ban positions of intermediate term in some but not all cases.

Hal S. Scott is Harvard Law School’s director of the Program on International Financial Systems (PIFS) and director of the Committee on Capital Markets Regulation (CCMR). He is an independent director of Lazard Ltd. and a past governor of the American Stock Exchange.


Statement on Implementation of the Volcker Rule

WASHINGTON, November 1, 2012—Section 619 of the Dodd-Frank Act, often referred to as the Volcker Rule, is designed to strengthen the financial system and constrain the level of risk undertaken by banking entities that benefit from FDIC-insurance on customer deposits and access to the Federal Reserve’s discount window. The challenge to regulators in implementing the Volcker Rule is to prohibit the proprietary trading that Congress intended to limit, while allowing banking organizations to continue to engage in investments not intended to profit from short-term price movements, and in three forms of other permissible activities: hedging, market making and underwriting.

Proposed Rule

The Proposed Rule generally takes a flexible approach in determining whether an investment is intended to profit from short-term price movements. According to the Proposed Rule, “In considering the purpose for which a covered financial position is acquired or taken and evaluating whether such position is acquired or taken for short-term purposes, the Agencies intend to rely on a variety of information, including quantitative measurements of banking entities’ covered trading activities, supervisory review of banking entities’ compliance practices and internal controls, and supervisory review of individual transactions.”

Alternatively, the Proposed Rule applies a more rigid approach to interpreting the three forms of permissible activities, in order to ensure that they will not be used to disguise proprietary trading. In order for a proprietary trade to qualify for any of the exemptions, seven criteria specific to each exemption must be satisfied. The Proposed Rule sets forth at great length the criteria and the attendant compliance program. The criteria are designed to identify all instances of prohibited proprietary trading in an otherwise permitted activity.

Alternative Proposal

We do not believe that it is possible to define with precision the line between proprietary trading and the three permissible activities. Either one risks too limited or too broad a definition of proprietary trading. A too limited definition would not prevent the trading that Congress sought to prevent, while a too broad interpretation would prohibit activities Congress sought to allow.

We recommend that an approach similar to the flexible approach used with respect to investments be used to determine whether the purpose of a trade is hedging, market making or underwriting. We propose that the Proposed Rule set forth guidelines for making this determination. These guidelines, while recognizing that some “customers” or “market-making trades” may give rise to excessive positions over a more extended period, would enable management and supervisors to determine a pattern of proprietary (or speculative) positions. Metrics should be developed to assist in that determination. Ultimately it would be up to bank supervisors, working with their supervised institutions, to judge whether trades outside the guidelines were permitted given the circumstances under which they occurred.

Bank supervisors would monitor risk limits and controls and over time the guidelines could be further refined based on experience. We agree with Chairman Volcker that “success is strongly dependent on achieving a full understanding by the most senior members of the bank’s management, certainly including the CEO, and the Board of Directors, of the philosophy and purpose of the regulation. As the rules become effective, periodic review by the relevant supervisor with the Boards and top management will certainly be appropriate, as a key part of the usual examinations process or otherwise.”[1]

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The Committee on Capital Markets Regulation is an independent and nonpartisan 501(c)(3) research organization dedicated to improving the regulation of U.S. capital markets. Thirty-three leaders from the investor community, business, finance, law, accounting and academia comprise the Committee’s membership. The Committee co-Chairs are Glenn Hubbard, Dean of Columbia Business School, and John L. Thornton, Chairman of the Brookings Institution. The Committee’s Director is Professor Hal S. Scott, Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School.

For Further Information:

Hal S. Scott
Committee on Capital Markets Regulation

Jennifer M. Grygiel
Executive Director for Public Affairs & Communications
Committee on Capital Markets Regulation
(617) 384-5364

[1] Letter from Paul Volcker to the Fed. Deposit Ins. Corp., Sec. & Exch. Comm’n, Bd. of Governors of the Fed. Reserve Sys., Office of the Comptroller of the Currency and Commodity Futures Trading Comm’n 2 (Feb. 13, 2012).


Hedging Under the Volcker Rule

WASHINGTON, June 20, 2012—Debate continues around the proposed regulations to implement the Volcker Rule, most lately around its provisions related to permitted hedging activities. As the Committee on Capital Markets Regulation (CCMR) has commented in the past, the proposed regulations should be appropriately constructed to address activities that are specifically permitted under Dodd-Frank, including market-making, underwriting and hedging.

Following the recent JPMorgan (JPM) trading losses, some have called for tightening or even removing the provisions for portfolio hedging that are incorporated in the proposed regulations. Dodd-Frank permits hedging on aggregated positions but critics suggest this should not be interpreted to allow hedging on a portfolio basis. Despite the JPM losses, however, CCMR believes that portfolio hedging should in general be permitted.

Portfolio hedges are crucial for banks to reduce overall volatility and risk. Overly restricting hedging would actually increase bank risk, the very outcome the critics themselves seek to avoid. Suggestions that portfolio hedges need to be correlated to individual underlying positions are both unworkable and overlook the reality that banks seek to hedge their overall mix of assets, and potential movements across an entire portfolio, rather than single movements of individual assets. Furthermore, correlations evolve over time and hedging is a dynamic process.

JPM’s trade began as a hedge against a deterioration in credit conditions. However, early in 2012, JPM tried to offset its hedge position in a way that, according to JPM Chairman and CEO Jamie Dimon, “created new and potentially larger risks.” Dimon himself said the strategy to offset the hedge was “flawed, complex, poorly reviewed, poorly executed and poorly monitored.” Whether or not the resulting positions would, at some point, have been prohibited under the Volcker Rule, the initial purpose of the trade was to reduce risk to the bank and, when properly executed, hedges serve a critical role in risk management.

JPM’s losses should thus turn our focus to the regulators’ challenge in defining permitted activities under Volcker. The agencies proposing regulations to implement the Volcker Rule acknowledged: “the delineation of what constitutes a prohibited or permitted activity…often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice.” That the proposed regulations go on for 298 pages is further evidence of the difficulty of this task. Instead of attempting to draw bright lines around permitted activities including hedges, perhaps a better approach would be a more collaborative one where regulators in their supervisory capacity work together with the firms they oversee to examine overall positions and determine whether they are permissible.

If regulators restrict banks’ flexibility in their hedging strategies, they will leave banks unable to mitigate entity-wide risks. As a result banks will likely reduce lending, which would have a substantial impact on the real economy. Recent studies on hedging suggest that banks (like JPM) that used credit derivatives for hedging were able to maintain a higher level of lending during the financial crisis. Perhaps even more alarming though, banks that cannot hedge will become much riskier. Moreover, U.S. banking entities will be at a competitive disadvantage to domestic and international competitors who continue to have the flexibility to hedge against the risks that they deem appropriate.

This is not to say that some changes may need to be made as a result of the JPM experience. In particular, regulators should focus on guiding banks to improve internal risk management policies and procedures, and possibly consider qualification requirements for directors on a board’s risk committee, and they should also address any inadequacies in their own oversight of banks.  Reporting and central clearing of credit derivatives—the products at the center of the JPM trades—will also bring greater transparency to the market, ensure appropriate collateralization and consistent pricing, and minimize any systemic consequences of similar future events.

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Jacqueline McCabe testifies before the House Oversight and Government Reform Committee in a hearing entitled “The SEC’s Aversion to Cost-Benefit Analysis”

***Media Advisory***


WASHINGTON, April 17 2012—Jacqueline C. McCabe, Executive Director for Research of the Committee on Capital Markets Regulation, testified before the TARP, Financial Services and Bailouts of Public and Private Programs Subcommittee of the House Oversight and Government Reform Committee today, warning that inadequate cost benefit analysis by regulators rulemaking under Dodd-Frank risks successful legal challenges and/or litigation delays which will cause economic harm.

Ms. McCabe recapped a recent study by the Committee on cost-benefit analysis in 192 orders, proposed rules and final rules issued by 15 government agencies pursuant to Dodd-Frank: “…we believe many of the rules under Dodd-Frank could be subject to successful challenge in court. It would be an unfortunate outcome if, after the Dodd-Frank rulemaking process has run its course for several years, important rules are invalidated because of inadequate analysis. Even if such rules are not eventually invalidated, prolonged uncertainty around their fate threatens to hamper economic activity.”

With regard to the recently issued SEC Internal Guidance on Economic Analysis in SEC Rulemakings she said that “We are pleased that the SEC has recognized the need to consider the overall economic impact of its rules, including both SEC rulemaking pursuant to Congressional mandates, as well as entirely discretionary SEC rulemaking… The SEC acknowledges that this approach will provide the most complete evaluation of a rule’s economic effect, particularly because in many cases it is difficult to distinguish between mandatory and discretionary aspects of a rule.”

She also addressed recent CFTC Internal Guidance, which is contrary to the SEC’s Internal Guidance on the issue of discretion: “The SEC’s approach to this issue of discretion stands in contrast to that taken by the CFTC. In staff guidance issued by the CFTC General Counsel and Chief Economist last May, the CFTC advised its staff that if rulemaking provisions under Dodd-Frank  ‘merely replicate the statutory provisions the Commission is required to promulgate without the exercise of discretion, then cost-benefit considerations may not be a factor in the promulgation of the rule.’”

Ms. McCabe concluded that “…in calling for better cost-benefit analysis as part of the rulemaking process, we are not suggesting that the Dodd-Frank rulemaking process should be sidetracked or delayed. Many provisions of Dodd-Frank are crucial to ensuring the safety and soundness of our financial markets, and thus should be made effective as soon as possible.” However, “Rules needed to protect the financial system can be put in jeopardy by the failure to conduct a cost-benefit analysis that can withstand judicial scrutiny.  We commend the new direction the SEC has taken on this issue and would hope other agencies would follow suit.”

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The text of today’s letter appears below.

For further information please visit:

Contact Information:

Jacqueline C. McCabe

Hal Scott
617-384-5364 Continue Reading…

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Financial Stability Board Roundtable Speech by Hal Scott: A Medium Term (5-10 Year) Vision for the Financial Stability Board

Committee Director Hal S. Scott gave the following speech in his capacity as the Co-Chairman of the Council on Global Financial Regulation.

Financial Stability Board Roundtable

Mexico City, April 13, 2012

A Medium Term (5-10 Year) Vision for the Financial Stability Board


Hal S. Scott, Nomura Professor of International Financial Systems,
Harvard Law School and Co-Chairman of the Council on Global Financial Regulation

Thank you for inviting me to speak to you today. I feel I am participating in a meeting of great importance to the future of the global financial system—to put the Financial Stability Board on an enduring organizational footing.

I am speaking in my capacity as the Co-Chairman of the Council on Global Financial Regulation. The Council was formed in 2010 with the objective of providing government officials and regulators with independent recommendations, analysis and commentary on issues relating to international financial regulatory coordination. The Council is composed of fifteen individuals, representing eleven different nationalities, who are experienced in financial regulatory matters and who have committed to act independently of any institutions with which they are or have been affiliated. None of the Council’s members presently hold any position in any governmental or financial regulatory body.

As you may know, this Council a year ago this month – in April 2011 – issued a report titled “Practical Measures for Strengthening International Financial Regulatory Coordination.” That Report focused in large part on the mandate, capacity and governance of the Financial Stability Board. We took that as our focus because of a belief that effective international coordination in the financial field is essential to healthy financial markets and global growth. Moreover, the Council in its Report took the view that the FSB should be a central and enduring part of the global financial institutional architecture. We offered what we believed were practical measures for strengthening the coordinating function of the FSB. Our thinking today remains in line with our April Report, but the Council has gone beyond it and in the spirit of offering constructive ideas for discussion is pleased to present today some additional thoughts with respect to development and implementation of standards. Our goal is less to be definitive, than to contribute ideas to a creative process of thinking as to the future of the Financial Stability Board.

The 2008 financial crisis made us painfully aware of the vulnerability of the global financial system. While the subprime crisis was centered in countries that experienced housing bubbles, the collapse of the bubble affected financial institutions globally that were exposed to declines in housing assets or that had financial exposures to institutions that did have housing asset exposure. While Asian and Latin American financial institutions were relatively unscathed, their economies were affected by the recessionary conditions that beset their Western trading partners. The G20 was relatively quick to realize that the financial crisis required not just a national but a coordinated global response. This was not only because of the widespread effects of the crisis and the interdependence of global financial institutions, but also to avoid regulatory inconsistencies, protectionist responses, gaps and arbitrage. The need for a coordinated global response was important background for the conversion of the Financial Stability Forum to the Financial Stability Board (FSB) in April 2009. As 2008 and its aftermath recede from memory and economic conditions stabilize, there is an unfortunate but understandable tendency for such coordination to yield to the more immediate interests of national policy makers and regulators, and local politics. This tendency needs to be resisted by further strengthening the role of the FSB.

I will discuss this morning my view that the FSB’s activities over the next five to ten years should have two main areas of focus. First, the FSB should monitor, identify and address national regulations that are in conflict with each other or with international standards set by international standard setting bodies, where such conflicts pose a significant risk to the financial system. At the moment, the regulation of derivatives and of proprietary trading by banks require particular attention in this regard.

Second, the FSB should identify high-risk regulatory gaps at the national and international level, for example, as they have done with shadow banking. The FSB must identify the relevant international organization that should address these regulatory gaps, or, where no existing organization can fill this role, itself coordinate the necessary national action. I will then turn to capacity issues of the FSB regarding organization, governance and funding.

Regulatory Inconsistency

Let me begin with the role of the FSB in dealing with regulatory inconsistency where the inconsistency creates a problem for the stability of the global financial system. The FSB must identify potential and existing regulatory divergences of this kind. This will require the FSB to institute a regular process to monitor G20 members’ regulations, as well as the standards set forth by international standard setting bodies. As the CGFR suggested in its April 2011 report, the FSB should encourage G20 member governments routinely to provide the FSB with proposed national financial regulatory measures that have cross-border implications, so that the FSB may coordinate a period of consultation among other G20 members prior to implementation. That process is intended to identify potential regulatory divergences before they come into effect and will facilitate collaboration between national authorities.

But the FSB must also play a role in identifying important inconsistent policies and regulations that are adopted, particularly if they create conflicts, and formulate plans for resolving them. The so-called regulatory dialogues, which perform this function bilaterally, need to be systematized and in many subject areas become multilateral. The FSB should maintain a thorough detailed database comparing key regulations and make this database open to the public. The FSB has taken steps in this direction, for example, by publishing on its website national and regional responses to a survey conducted by the FSB Implementation Monitoring Network regarding progress of these nations and regions toward implementing G20 recommendations. This information should be kept current, and should be presented in a manner that allows for easy comparison of regulations across jurisdictions.

Completeness of Implementation

Although not the main focus of my remarks, I should also mention that beyond monitoring inconsistent policy and regulation among countries, the FSB should also monitor the completeness of implementation of policies in areas where it has formulated an action program. This is necessary to make sure we can detect problems that go beyond looking only at “law on the books.” The CGFR has made two recommendations to make this process effective: the FSB should conduct or oversee a review of domestic laws which limit information-sharing across jurisdictions, and the FSB together with the International Monetary Fund (IMF) should develop a standardized framework for the G20 peer review process. The FSB’s Standing Committee on Standards Implementation has already developed such a framework for monitoring the implementation of international standards, which includes mechanisms for information gathering, evaluation and assessment and publication of results. Going forward the FSB and the IMF must clarify and formalize their respective responsibilities on multilateral surveillance.

The FSB should also strengthen and formalize the basis on which international standard setting bodies collaborate among themselves. Because these entities have distinct areas of technical competence, they are generally well-positioned to identify divergent cross-border regulations in a particular area. The FSB must work with these entities to coordinate their standards across sectors. These issues will be the topic of Olin Wethington’s address in the next panel.


The need to deal with significant inconsistencies is especially evident in the area of derivatives reform, which the G20 has identified as an area of priority. At the initiative of the FSB, a working group led by representatives of the Committee on Payment and Settlement Systems (CPSS), the International Organization of Securities Commissions (IOSCO) and the European Commission was formed in April 2010 to make recommendations on the implementation of the G20 derivatives reform. In October 2010, the FSB issued a report on “Implementing OTC Derivatives Market Reforms” which contained 21 recommendations regarding practical issues authorities might encounter in implementing the goals of the G20. The FSB issued its first implementation progress report in April 2011, where it expressed concern over whether many jurisdictions would meet the G20’s end-2012 deadline. The FSB issued a second report in October 2011, with an even more detailed assessment of progress. The FSB’s OTC Derivatives Working Group will continue to monitor implementation of derivatives reform as the end-2012 deadline approaches.

Unfortunately, divergence in derivatives regulation has begun to emerge, for example, in U.S. and E.U. regulation of clearinghouses. Both the U.S. and proposed E.U. regimes will permit their home-country institutions to participate in a foreign clearinghouse only if the regulation of that foreign clearinghouse is equivalent to that of the regulation of clearinghouses in the home country. These equivalence determinations are primarily designed to avoid regulatory arbitrage but the cure could be worse than the bite. It would be highly inefficient and risky, and perhaps even unworkable, to split central clearing of derivatives geographically. Where a trade has a U.S. and E.U. counterparty, where would the trade be cleared if equivalence were deemed lacking by both the U.S. and E.U.? Note that if one party found equivalence and the other did not, all trading would migrate to the location that did not find equivalence (since this venue would be acceptable to the party that found this location was equivalent). Such trading migration would likely not be acceptable, thus further underscoring the necessity of coordinated action.

The solution, of course, is to make sure each side finds equivalence, but this requires that there be minimum divergence in regulatory approach. Ensuring this outcome is complicated by different timetables for implementation of regulation, the U.S. being ahead of the E.U. This underscores the need for the FSB to encourage compatible timetables in implementation of regulation. And as for the substance, the FSB, or the OTC Derivatives Working Group as coordinated by the FSB, must be involved in the areas where the risk of divergence is highest, for example regarding margin requirements and other measures of protection for the clearinghouse, including capital requirements for members, ownership and governance restrictions, and clearinghouse access to a central bank discount window.

The U.S. and E.U. have also diverged in the proposed treatment of non-financial derivatives counterparties. The proposed European Market Infrastructure Regulation offers a more generous end-user exemption than the end-user exemption in the Dodd-Frank Act. The end-user exemption in the Dodd-Frank Act exempts only derivatives activity by a non-financial end-user for hedging purposes, whereas the E.U. proposal exempts any derivatives activity by a non-financial end-user up to a certain unhedged threshold. This threshold has yet to be determined. Thus it is likely that for a substantively similar derivatives transaction, non-financial end-users in the E.U. would not have to clear the transaction with a clearinghouse or report the transaction to trade repositories, while the same transaction in the U.S. would require both clearing and reporting. The FSB should have an active role in resolving these problems and others like it.

Unilateral Regulation Outside the G20 Framework

While significant inconsistencies in regulation can arise in the implementation of the G20 reform agenda, they can also arise when countries pursue reforms outside the agenda that impact the interest of other countries. This suggests that the FSB may need to play a role in restraining such action, even when undertaken by prominent members. Here I have in mind the impact of the Volcker Rule and Vickers Commission recommendations on the rest of the world.

The Volcker Rule bans proprietary trading and certain investments in hedge or private equity funds by U.S. banking organizations; this is not part of the G20 agenda nor has it so far been proposed or adopted by any other G20 member, to my knowledge. The Volcker Rule will not only limit the activities of U.S. banking organizations, it will also limit the activities of foreign banks operating in the U.S. In addition, it may prevent foreign banks outside the U.S. from investing in funds that are sold to U.S. residents. And most notably, it grants U.S. banking organizations an exemption for trading U.S. government but not foreign government debt, a discrimination that will be hard to fix by regulation. The Vickers Commission proposes splitting insured deposit retail banking activities and wholesale banking activities of U.K. banks into separate ring-fenced affiliates with the intent that the U.K. public safety net would cover only the retail bank. Unlike the Volcker Rule, the Vickers Commission proposal does not apply to foreign banks operating in the U.K. through branches although it has urged foreign supervisors to encourage their banks to operate in the U.K. in subsidiary rather than branch form. Nonetheless, the Vickers Commission could have substantial international repercussions. Suppose the U.K. wholesale bank were to fail with significant impact on foreign counterparties. Could or should the U.K., which was the home country supervisor of the failing wholesale bank, walk away from any financial responsibility just because the wholesale bank did not take insured deposits? The general point is that the FSB may have to police countries adopting policies outside the G20 consensus that significantly impact other countries.

Regulatory Gaps

In addition to resolving significant inconsistencies, a second main focus for the FSB in the coming five to ten year period should be in addressing gaps in financial regulation that create potential sources of systemic risk, across nations and regions. The FSF, pre-cursor to the FSB, was created in 1997 in part to serve an early warning function in future economic crises. An important part of identifying potential future crises will be to understand where the regulatory shortcomings lie. In many instances, these gaps exist outside the traditional banking industry, the principal focus of the FSB.

Shadow Banking

Regulation of the shadow banking system is an important gap, which is currently being addressed by the FSB. The shadow banking system, which the FSB has broadly defined as “credit intermediation outside the regular banking system,” encompasses such diverse activities as money market funds, securitization, securities lending and repo transactions, among others. It introduces significant benefits to market participants as a source of funding and liquidity. At the same time though, it is subject to “runs” similar to traditional bank short-term funding, and can thus be a source of systemic risk—this was a major problem with respect to the money market funds during the crisis. In addition, as the G20 noted in its report last November, the relatively unregulated status of the shadow banking system can create opportunity for regulatory arbitrage. At the G20’s request, the FSB created a Task Force on Shadow Banking to help identify the role and risks of the shadow banking system, and to set out approaches for effective monitoring and to prepare, where necessary, additional regulatory measures to address risks posed by the system. The FSB issued a report in October of 2011 that sets forth 11 specific recommendations for monitoring and enhancing regulation of shadow banking and the G20 has called on the Task Force to draft rules and regulations for the shadow banking industry by year-end.

In addition to shadow banking, there are other areas where the G20 has suggested the FSB should address gaps in regulation. For example, the G20 identified the need to integrate financial consumer protection policies into regulatory and supervisory frameworks, and endorsed the FSB’s report on consumer finance protection and the high level principals the FSB developed along with the Organisation for Economic Co-operation and Development (OECD). The G20 has also called upon the FSB to undertake ongoing monitoring and reporting on compensation practices, to identify gaps in implementation of the FSB principals and standards on compensation. The FSB has also been tasked with developing principles on credit ratings and in coordinating the preparation of recommendations for a global legal entity identifier. Addressing gaps in regulation will be an important role of the FSB. In addressing these gaps, the FSB should set priorities, focusing on areas where the potential for systemic risk is the greatest.

Another serious area of concern is the supervision and resolution process for important financial organizations operating across borders. The FSB has been very active in stepping into the action gap in this area. Its “Key Attributes of Effective Resolution Regimes for Financial Institutions” sets forth the principal features that should be part of all national resolution regimes. The Key Attributes also include requirements for information sharing between national authorities, institution-specific cross-border crisis management groups and institution-specific cooperation agreements between home and host authorities. The Key Attributes were endorsed by the G20 in November 2011 and the 29 financial institutions designated as G-SIFIs by the FSB and the Basel Committee on Banking Supervision (BCBS) are required to meet the resolution planning requirements by the end of 2012.

Capacity of the FSB

I would now like to discuss some key issues relating to making the FSB a “fully enduring organization,” as the G20 formulated the objective at the Cannes Summit. It goes without saying that its endurance will require that it be successful in fulfilling its mission, parts of which I have already discussed.

With this objective in mind, the work of the Council in recent months has concentrated on exploring and considering the various possible frameworks which have been used for different international organizations and which may also be appropriate for the FSB. When I say “framework,” our attention and research has particularly focused on three features which are central to any organizational structure—(i) its legal identity and corporate capacity; (ii) its governance process; and (iii) the primary sources of funding for its operation and staffing.

I think it would be helpful to briefly summarize the Council’s research in which we have examined these three features in 13 different international organizations.

Legal Identity and Capacity

On the topic of legal identity and capacity, let’s begin with the FSB. The FSB is a unique body among the various international organizations which the Council has researched. At present, the FSB does not possess its own legal identity and its charter is essentially an informal memorandum of understanding for cooperation among its member signatories. In fact, Article 16 of the FSB Charter states that the document “is not intended to create any legal rights and obligations.” The FSB effectively operates as an arm or extension of the BIS, and its actions or decisions evolve from political consensus rather than legal or statutory powers.

In contrast, most other international organizations today fall into one of three categories.

First are organizations which employ a traditional corporate structure under the laws of a particular jurisdiction, typically where their head office is located. This has been the preferred approach of the multilateral development banks such as the European Bank for Reconstruction and Development (EBRD), the Asian Development Bank (ADB) and the African Development Bank (AfDB) as well as the Bank for International Settlements (BIS). And, although the shareholders of these organizations include governments or national monetary institutions, these entities typically have customary corporate constitutional documents and share capital structures.

The second category would include organizations which are established by inter-governmental agreement or treaty. In these cases, the relevant constitutional document under which the organization is formed generally states that the organization is granted legal identity and capacity by the governments which are party to the inter-governmental agreement or treaty. Hence, for example, Article IX of the Articles of Agreement of the IMF states that the Fund “shall possess full juridical personality including the capacity to contract, acquire and dispose of immovable and movable property and institute legal proceedings.” The IMF’s Articles goes on to require that signatory states take the necessary action “within their territories” to give effect to the organization’s legal identity. Other examples of these types of organizations include the World Bank, OECD, Association of Southeast Asian Nations (ASEAN), the International Labour Organization (ILO) and the World Trade Organization (WTO).

Finally, the third category of organization would involve a type of international association.” Two examples are the International Association of Insurance Supervisors (IAIS) and IOSCO. In both cases, the organizations have specific statutory authority for their existence in the jurisdiction in which they are located – in the case of the IAIS, under the Swiss Civil Code, and in the case of IOSCO under a Spanish law recognizing “public utility associations.”

It is important to note an over-arching principle in all three of these categories and which is a feature shared by all the organizations we examined. Specifically, in each case (with the exception of the IMF and the World Bank which were created by intergovernmental agreements), there is a legal basis for the identity and capacity of the entity which arises from the legal jurisdiction in which it is physically located. In this way, an organization can expect to have certainty under the laws of the place where it is physically located so that it can engage in its business with the rights and privileges as well as responsibilities of the laws governing commercial or related types of activities. This covers a wide range of matters including, for example, engaging in real or personal property transactions, staffing and employment, intellectual property protection and, if necessary, judicial review for the enforcement of rights or redress of grievances arising in the place where the organization is operating.

This legal basis and the certainty it can afford may arise under existing corporate law or under express statutory authority. In the case of Swiss-based organizations, this can also be accomplished under what is referred to as a “headquarter agreement” through which the Swiss Federal government recognizes the legal identity of the organization and confers certain immunities and privileges under the Federal “Host State Act” (Federal Act on Privileges, Immunities and Facilities of 22 June 2007).

In terms of the future of the FSB, of these various options, the easiest path would be for the FSB to establish itself as a separate legal entity in Switzerland – a jurisdiction with the experience and precedent for hosting international organizations. The FSB Secretariat is already located in Switzerland and, as mentioned, Swiss law expressly offers a legal framework for giving an existing international organization a separate legal identity without the more difficult process of constituting a body through an international treaty or inter-governmental agreement. As mentioned, this can be accomplished under either existing statutory authority for associations as well as through “headquarter agreements” through which the legal identity of the FSB would be recognized. Both of these approaches should be explored with Swiss counsel and the staff of the FSB, taking into account the continuation of links with the BIS while keeping in mind the goal of optimizing the independence of the FSB not only vis-a-vis the BIS but in more general terms. Separation from the BIS will serve to differentiate its role from that of traditional central banks and thereby be capable of speaking to a wider audience and coordinating with a broader range of participants in financial regulatory matters.


Turning now to the topic of governance, the FSB presently has a distinct and informal approach, albeit with structures which are drawn from more formal governance methods found in public and private bodies. Specifically, the FSB’s present governance structure consists of the Plenary, a Steering Committee, a Chairperson and the FSB Secretariat. The Plenary, whose representatives are governors of central banks and other international institutions, is the decision-making body of the FSB and its decisions are taken informally by consensus. The Plenary, with the help of standing committees and working groups approves the work program of the FSB, decides its membership and adopts reports, standards and recommendations. The Steering Committee, whose composition is decided by the Plenary, meets at least four times each year and provides operational guidance between the Plenary meetings to carry forward the directions of the FSB. The Chairperson, the principal spokesperson of the FSB, is appointed by the Plenary from FSB members for a term of three years renewable once. Finally, the Secretariat is directed by the Secretary General who is appointed by the Plenary at the proposal of the Chairperson. The Secretariat supports the activities of the FSB, ensures the effective communication to Members and manages the financial, material and human resources allocated to the FSB.

The other international organizations we have examined share what are broadly similar governance structures which are similar to private corporations. In brief, member states or institutions are represented by a board of directors or governors or a council which meets and take decisions at annual or bi-annual meetings or conferences. A secretariat or executive board with permanent members oversees the day-to-day work of the organization and is often assisted by a number of committees and sub-committees. At the head of each organization is typically a managing director, director-general or president, often assisted by deputy managing directors or vice-presidents.

In terms of voting, there are three distinguishable voting procedures employed by the organizations we have reviewed: consensus; simple majority; and higher majority. The constitutional documents of the IMF, the BIS, the ILO, the IAIS, the EBRD, the ADB and the AfDB all include provisions for voting generally to be carried out on a simple majority basis, but prescribe higher levels of majority for certain matters, often relating to the constitution of the organization itself or for capital funding issues. For example, the statutes of the BIS require a two-thirds majority to authorize any increase or reduction of share capital, the cancellation of shares, the election of its Board of Governors or any amendments to the Statutes themselves.

Notwithstanding formal voting procedures, decision-making in international organizations is also often an informal and consultative process in which decisions are taken in a consensual fashion with recourse to formal voting only where no consensus can be reached. This approach is at the heart of the present governance method at the FSB. However, as it evolves towards a more enduring organization, the Council believes that the FSB should introduce greater formality, regularity and transparency in it decision-making process. These features are hallmarks of well-run public and private organizations which enjoy the support of their members or shareholders, and their introduction in the context of a more enduring status for the FSB should enhance the credibility of the organization’s decision-making process.


In completing my overview of other international organizations, I should also speak briefly about funding. The FSB, under its present structure, is an extension of the BIS and has funding arrangements which are dependent on budgetary allocations from the BIS. In considering the alternatives, the international organizations we investigated obtain their funding from essentially two sources.

The first method is through voluntary contributions of members. All of the organizations we researched obtain a portion of their funding in this way. This can be structured either through the issuance of share capital or through a dues-based system, and the amount of contributions may be equal across all members (e.g. ASEAN) or vary according to the size of a member’s economy (e.g. OECD).

The second method is what can be loosely described as private or profit-based funding. This includes private capital raising methods such as bond issuances or borrowing facilities. And in the case of international organizations engaged in lending or other commercial activities, funding may be provided by the revenues generated by such activities.

Finally, the funding framework for the BIS also suggests a type of “endowment” method of funding as this institution has specific reserve funds which are funded by an annual percentage of the BIS’s net profits and thereby provides a supplemental source of revenue for the institution.

In the Council’s view, and as we have previously recommended, the FSB should develop a funding approach that transitions away from primary reliance on the BIS to a more independent and sustained approach – at the same time taking into consideration the benefits of a continued relationship with the BIS. The alternative approaches for funding an organization like the FSB with limited capacity for profit-making activity are narrow and, hence, most likely to depend on dues-based contributions from member organizations. The level of these contributions may also be set so as to provide for an “endowment” reserve fund, similar to the BIS, which could facilitate the independence and stability of the FSB’s funding resources. A difficult question will also be the share allocation among member organizations – specifically, whether dues based funding should be equal across all members or vary according to certain criteria related to the size of the member’s economy. As the initial budget of the FSB may be modest, a simpler equal-sharing approach among members may be most attractive at the outset.


As we have discussed, the FSB’s key mission should be to coordinate financial regulatory policies of the G20 that have the greatest importance to the stability of the global financial system. This requires making the FSB a more enduring organization. We have also considered the options to accomplish this, focusing on three central features of any organizational structure – legal identity and capacity, governance and funding. While each of these topics offers alternatives and complexities, I would like to conclude by noting that these three areas are inter-connected for our purposes today. Legal identity is the starting point. Effective governance requires a legal identity to be in place. Both are necessary for fund raising operations and professional staffing. In short, these three features will be at the heart of any enduring organization because, in our view, it is the prudent and effective combination of these features which will offer an organizational foundation to ensure the effectiveness, independence and objectivity of the FSB in its future work.

Thank you again for inviting me to speak to you today.

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The Committee releases a comment letter to the OCC, FDIC, Federal Reserve, SEC and the CFTC regarding Prohibitions and Restrictions on Proprietary Trading

Re: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 76 Fed. Reg. 68,846 (OCC Docket ID OCC-2011-0014, OCC RIN 1557 – AD44; Fed Docket No. R-1432, Fed RIN 7100 – AD82; FDIC RIN 3064 – AD85; SEC Release No. 34 – 65545, File No. S7-41-11, SEC RIN 3235 – AL07); Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships with, Hedge Funds and Covered Funds (CFTC RIN 3038 – AD05).

Dear Mr. Walsh, Ms. Johnson, Mr. Stawick, Mr. Feldman, and Ms. Murphy:

The Committee on Capital Markets Regulation (Committee) appreciates the opportunity to comment on the Office of the Comptroller of the Currency (OCC), Federal Reserve Board (Board), Federal Deposit Insurance Corporation (FDIC) and Securities and Exchange Commission’s (SEC) notice of proposed rulemaking, [1] and the Commodity Futures Trading Commission’s (CFTC, and together with the OCC, the Board, the FDIC, and the SEC, the Agencies) separate but substantially similar notice of proposed rulemaking,[2] regarding prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds under Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).[3]

Since 2005, the Committee, composed of 32 members, has been dedicated to improving the regulation of U.S. capital markets. Our research has provided an independent and empirical foundation for public policy. In May 2009, the Committee released a comprehensive report entitled The Global Financial Crisis: A Plan for Regulatory Reform, which contains fifty-seven recommendations for making the U.S. financial regulatory structure more integrated, more effective, and more protective of investors in the wake of the financial crisis of 2008.[4] Since then, the Committee has continued to make recommendations for regulatory reform of major areas of the U.S. financial system.

We believe that Section 619 of Dodd-Frank as well as the Proposed Rules introduce great potential for harm to our banks and financial markets more broadly, without any clear evidence of their risk-mitigating benefits. As a result, and as the Committee has stated in the past,[5] we strongly encourage the Agencies to interpret the proprietary trading ban as narrowly as possible to limit the damage that will result.

Section 619 of Dodd-Frank adds a new Section 13 to the Bank Holding Company Act of 1956, which generally prohibits banking entities from engaging in proprietary trading or from acquiring or retaining certain interests in or relationships with hedge funds or private equity funds. The rule provides for numerous exceptions to the ban on proprietary trading, including for market-making, underwriting, hedging activities, acting on behalf of customers, trading in certain government obligations, certain trading by regulated insurance companies, and others. The Proposed Rules seek to define these exemptions, which admittedly is an extremely complex and difficult task. Defining the exemptions too narrowly would arguably impede the objectives of the Proposed Rules. Defining too broadly, however, could seriously limit core banking and capital market functions, permitted by Congress, that are critical to the smooth functioning of our financial markets.

In its attempt to strike this balance, the Agencies have drafted 298 pages of a proposed regulation which ultimately raises more questions and concerns than it answers (in addition to the nearly 400 specific questions posed). Paul Volcker himself said: “It’s much more complicated than I would like to see.”[6] We know that the Agencies are working diligently with market participants to understand their concerns over the Proposed Rules’ wide-reaching effects, both intended and unintended, and over the aspects of the Proposed Rules where further clarity is needed. We strongly encourage the Agencies to continue in this dialogue. Because the Proposed Rules will result in fundamental changes to the way U.S. and certain non-U.S. banks conduct business, at tremendous cost, the Committee urges the Agencies to implement the rule with the utmost care.

Following are several significant concerns the Committee has with respect to the Proposed Rules:

1.   The Proposed Rules go well beyond the language and intent of Section 619 and limit proprietary trading and fund investments at tremendous cost.

To begin, it bears reiterating that there is no evidence that short-term proprietary trading investments or hedge fund and private equity fund investments were the major source of losses during the credit crisis.[7] In fact, one Wall Street firm estimates that more than 95% of U.S. bank losses during the credit crisis can ultimately be traced back to bad lending or investment decisions.[8] The investment losses include portfolio investments in real estate backed securities, an activity, like lending, which can continue under the Volcker Rule.[9] The recent U.S. Government Accountability Office (GAO) report found that during the period from mid-2006 through December 2010, stand-alone proprietary trading and fund investment revenues were generally a small percentage of total revenues at the six largest U.S. bank holding companies: proprietary trading revenues ranged from a low of about 0.2% to a high of about 3.1% of combined quarterly revenues for all activities at the bank holding companies,[10] while revenues from hedge fund and private equity fund investments represented between approximately .08% to 3.5% of combined revenues.[11] Furthermore, proprietary trading revenues were relatively flat over the period of the study.[12] The GAO report admittedly used a narrow definition of “proprietary trading,” looking only at the activity of stand-alone proprietary trading desks at the bank holding companies. The definition and sample may account for their estimate of the small impact on financial firms. On the other hand, the GAO report did not analyze the profitability of the proprietary trading activity, nor did it challenge the diversification benefits such trading provides.

At the same time, the enormous cost of the Proposed Rules is widely acknowledged. The Proposed Rules will result in significant costs for banks, including lost revenues following the shuttering of remaining proprietary trading desks at certain banks that had been active and successful traders,[13] and enormous compliance and recordkeeping costs. In addition, the Proposed Rules will result in increased transaction costs and liquidity constraints that will be felt across the financial industry. While these increased transaction costs would benefit banks, such benefits may be offset by the expected decline in market-making, underwriting and hedging activities that the Committee believes will result if, by reason of an overbroad series of regulations, the Agencies cause a contraction in the integrated business units that support these activities. While it is admittedly difficult to quantify the full impact of the Proposed Rules, recent estimates are staggering. The Institute of International Finance suggests the Volcker Rule may depress bank earnings by $3.5 – $4 billion per year.[14] Bernstein Research analyst Brad Hintz estimates that it will result in a reduction of fixed income revenues of between 20% and 25%.[15] Moody’s characterized the Proposed Rules as a “credit negative” for bondholders of Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase and Morgan Stanley.[16]

Impact on Liquidity and Transaction Costs

While non-bank financial institutions not subject to the Proposed Rules may eventually take on all or a portion of the trading activity in which banks can no longer engage, or other forms of intermediation may emerge, thus returning liquidity to the market and reducing transaction costs, it is not likely such a shift would occur in the short-term, and furthermore, it is uncertain whether such a shift will fully offset banks’ diminished trading activity. Following implementation of the Proposed Rules, there will be a dramatic reduction in liquidity in assets that banks can no longer trade and, as a result, bid-ask spreads and transaction costs will increase. The Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce estimates that the Proposed Rules “will impose at least a five basis point increase in bid-ask spreads”[17] and suggests the spreads could actually be many times greater. This total increase, measured over the nearly $8 trillion corporate bond market, will be enormous. Overall “incremental transaction costs for investors and financing costs for U.S. companies could total into the tens of billions of dollars.”[18]

Compliance and Recordkeeping Costs

The Proposed Rules’ lengthy, detailed compliance and reporting requirements will also result in significant cost. For the 2,096 national banks, for example, in its September 2011 report, the OCC estimated these annual costs would reach nearly $1 billion.[19] Significant infrastructure investments will have to be made and internal controls put in place to quantitatively monitor all transactions. These added compliance burdens will be incurred at a time when banks are already facing the challenges of a weak economy.

2.   As currently drafted, the Proposed Rules will unnecessarily limit banking and capital market functions that Dodd-Frank specifically permits.

The Agencies themselves acknowledge that “the delineation of what constitutes a prohibited or permitted activity…often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice.”[20] At the same time, the Agencies recognize that financial services including “underwriting, market making, and traditional asset management services, are important to the U.S. financial markets and the participants in those markets, and the Agencies have endeavored to develop a proposed rule that does not unduly constrain banking entities in their efforts to safely provide such services.”[21] The Proposed Rules’ approach to identifying permitted and prohibited activities must be narrowed and revised so that it is flexible enough to accommodate differences in the structure and business of each firm.


Distinguishing between market-making and speculative proprietary trading poses significant challenges. This is because, as Darrell Duffie notes: “Market making is inherently a form of proprietary trading.”[22] The Agencies acknowledge that “Market-making related-activities…sometimes require the taking of positions as principal, and the amount of principal risk that must be assumed by a market maker varies considerably by asset class and differing market conditions.”[23] Duffie goes on to suggest: “In order to provide significant immediacy to its customers, a market maker requires substantial discretion and incentives regarding the pricing, sizing, and timing of trades. It must also have wide latitude and incentives for initiating trades, rather than merely reacting to customer request for quotes, in order to properly risk manage its positions or to prepare for anticipated customer demand or supply.”[24]

The Proposed Rules suggest seven criteria for examining positions to determine whether they represent bona fide market-making. The Proposed Rules’ implementation of the requirement that market-making activities should not exceed reasonably expected near term demand of clients, customers, and counterparties must be revised. First, while Section 619 makes clear that these activities may be with clients, customers or counterparties, the Proposed Rules focus on demand of customers. They must be clarified to reflect that this demand can come from other dealers or future customers, for example. Furthermore, while Section 619 says market-making activities are permitted to the extent they “are designed not to exceed the reasonably expected near term demands of clients, customers or counterparties,”[25] the Proposed Rules seem to tighten this standard and require that “anticipatory buying or selling activity is reasonable and related to clear, demonstrable trading interest of clients, customers, or counterparties.”[26]

In addition, if a bank makes a market in relatively illiquid instruments, or a bank is entering a new market, the concept of “near term demand” must be implemented to supply flexibility and to acknowledge market differences. A market-maker may also need to hold significant inventory for example to accommodate potential block trade requests. Under the current, narrow market-making exemption, it is likely banks will reduce their inventory in many asset classes, resulting in decreased liquidity and increased transaction costs, bid-ask spreads and volatility. Traders will be hesitant to make markets in assets where there is questionable ability to sell them in the near term. Furthermore, should a bank feel compelled to sell certain assets at an inopportune time to avoid being viewed as holding a proprietary position, this could have extremely negative, destabilizing impact–for example, if a bank were forced to sell its assets in a fire sale during a period of market crisis.

The final criterion in the Proposed Rules for a determination of market-making activity sets forth quantitative measurements (or “metrics”) that banks’ market-making activities must meet to be eligible for exemption. We believe metrics can be an appropriate and a potentially valuable tool in analyzing investments. However, we note that the application of metrics to activities at different firms may produce very different results. It is critical to recognize that such different results may all reflect legitimate market-making activities. For example, one bank may be more aggressive than its peers when it is looking to move into a new line of business. As a result, it may find it acceptable to make less profit on these new trades, resulting in a different result under the quantitative measurements than the results of its peer firms. However, these low-priced trades may very well be bona fide market-making. The Agencies (or potentially the Board, as discussed further below) should consider the results of the quantitative measurements on a case-by-case basis, looking horizontally across all business units in each firm. Any use of metrics must ensure that the specific characteristics of an individual firm are not overlooked in a rigid application of the rules.


Again, to assist in identifying permitted hedging activities, the Proposed Rules approach this process with a test applying seven criteria. However, the criteria seem to suggest a belief on the part of the Agencies that hedging should be more precise a practice than it generally is, not producing excess profit or loss. Alliance Bernstein notes: “Given…the emphasis…on avoiding profit or loss on positions taken by market makers, intermediaries are not going to be able to place great confidence in the use of hedging as a means of staying within the exemption.”[27] Furthermore, when determining whether hedging activity is permissible, Agencies must acknowledge that hedging may take place horizontally across business units within a firm (and, thus, may take place in a different legal entity from the underlying positions being hedged). In addition, the criterion which requires that “the transaction be reasonably correlated…to the risk or risks the transaction is intended to hedge or otherwise mitigate”[28] could inadvertently prohibit certain types of hedging activity altogether. For example, scenario hedges, which are meant to mitigate the risk of unlikely “tail” events and thus do not exhibit such correlation,[29] would likely be prohibited under the Proposed Rules. The Proposed Rules should be revised to avoid such unintended consequences.


Similar to its approach with market-making and hedging, the Proposed Rules contain seven criteria to assist in identifying bona fide underwriting activities. We would encourage the Agencies to revisit the third criteria, that “the transaction must be effected solely in connection with a distribution of securities for which the banking entity is acting as an underwriter”[30] (emphasis added). The inclusion of the word “solely” will inadvertently prohibit some complex underwritings that banks may undertake.

Government Securities

The question of whether U.S. government debt should be treated differently from foreign government debt has been raised by numerous commentators including the United Kingdom, Japanese and Canadian governments. We encourage the Agencies to consider this issue further, particularly with respect to foreign banks with U.S. branches that are subject to the Proposed Rules and that would no longer be able to trade in the United States in their own government debt. Ideally, we believe the Agencies should use their authority under paragraph (d)(1)(J) of Section 619 to exempt all foreign sovereign debt, whether held by U.S. or foreign banks. The potential risk introduced by banks holding such debt on their balance sheet would be addressed through Basel risk-weightings.

In addition, the U.S. government obligation exemption under the Proposed Rules is narrowly defined, and excludes state and local agency securities. This is a narrower approach than that taken under the Securities Exchange Act of 1934 or by any banking regulation (including under the Glass-Steagall Act itself). Excluding agencies will result in an inconsistent application of the exemption across different jurisdictions; the Municipal Securities Rulemaking Board cites the “extremely divergent ways” in which different states “organize and empower their subdivisions, municipalities, agencies, authorities, instrumentalities and districts” and concludes that “[t]wo issues of securities with identical terms and provisions, and with identical risk profiles, and which otherwise would exhibit the identical trading behavior, would be treated in completely different ways under the Volcker Proposal….”[31] In their current form, the Proposed Rules would prohibit banking entities from trading in over half of the municipal bonds outstanding.[32] Institutional investors are generally less active in municipal markets, thus proprietary trading desks and market makers play a more significant role in providing liquidity.[33] We encourage the Agencies to further review this exemption, and unless there is clear evidence that the current approach will result in a corresponding reduction in risk, it should be revised accordingly.

Prohibition on Fund Investments

The Proposed Rules prohibit banks from acquiring or retaining ownership interest in, or sponsoring, “covered funds.”[34] In an attempt to define “covered funds,” the Agencies have incorporated definitions from the Investment Company Act of 1940. The result is an extremely over-inclusive definition that captures many types of entities beyond the hedge funds and private equity funds that the legislative history of Section 619 makes clear that Section sought to cover. Prohibiting such investments impacts not only the banks, but also the funds themselves, many of which are managed by third party asset management firms and which will suffer from this shrinkage of their client base. SIFMA wrote: “It is difficult to overstate the time, effort and expense banks will have to commit to identifying, monitoring and conforming thousands of entities in their ownership structures that in no way resemble hedge funds or private equity funds.”[35] In particular, we note the prohibition extends to registered, publicly-offered non-U.S. funds (including non-U.S. exchange-traded funds, where this ban would result in U.S. banks being left unable to serve as market-makers in this asset class), commodity pools (which could include U.S. mutual funds that hold futures positions), credit funds (which are economically identical to loans), certain asset-backed securities issuers, and certain repackagings of municipal securities, among other entities. We urge the Agencies to address this issue and to appropriately exempt from the definition of “covered funds” those entities that bear no resemblance to the hedge funds and private equity funds covered by Dodd-Frank.

In addition, Dodd-Frank exempts regulated insurance companies trading for their general accounts from both the proprietary trading and hedge fund and private equity fund restrictions, while the Proposed Rules take a narrower approach and permit only proprietary trading by insurance companies. The Agencies do not provide any explanation as to their narrower approach, which is contrary to the intent behind the provision, as summarized by Senator Merkley: “The Volcker Rule was never meant to affect the ordinary business of insurance… These activities, while definitionally proprietary trading, are heavily regulated by State insurance regulators, and in most cases do not pose the same level of risk as other proprietary trading.”[36] Numerous commenters have raised this issue, and we urge the Agencies to revise the Proposed Rules accordingly.

High Risk Assets

Dodd-Frank requires the Agencies to issue regulations that implement Section 619’s prohibition on activities that “would result, directly or indirectly, in a material exposure by the banking entity to high-risk assets or high-risk trading strategies.”[37] The definitions provided in the Proposed Rules are too vague and broad to be meaningful. “High-risk assets” are defined as “an asset or group of assets that would, if held by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail” and “high-risk trading strategy” is defined as “a trading strategy that would, if engaged in by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail.”[38] We would encourage the Agencies to propose a more specific definition. Such a definition should take into account the public policy behind the Proposed Rules.

Subsidiaries of Banking Entities

The prohibitions of the Proposed Rules also apply to “subsidiaries” of banking entities, as defined in Section 2 of the BHC Act.[39] Section 2 offers a three-part test in identifying subsidiaries. The first two factors are objective—whether the parent owns 25% or more of a class of voting securities of the subsidiary, and whether the parent controls the election of a majority of the directors of the subsidiary. The third factor however is subjective—whether “the Board determines, after notice and opportunity for hearing, that the [parent] company directly or indirectly exercises a controlling influence over the management or policies of the bank or company.”[40] This third factor requires analysis of the facts and circumstances of each particular situation, and introduces uncertainty as to whether certain subsidiaries will be covered by the definition. We believe that this particular factor should not be included in the identification of subsidiaries for purposes of the Proposed Rules, and instead, a clear and objective definition based on the first two factors should be used. Such an objective approach is consistent with the Board’s approach in defining “control” in its proposed rules on Enhanced Prudential Standards and Early Remediation Requirements.[41]

3.   The Proposed Rules raise concerns over extra-territoriality and a lack of international coordination.

As discussed above, the inability of foreign banks with U.S. branches to trade in the United States in their own sovereign debt could result in these banks shuttering their U.S. branches. The Canadian Office of the Superintendent of Financial Institutions has called for an exemption to permit at least foreign banks to trade in their own sovereign debt, and warns that “a failure to include these additional exemptions at least for banking entities whose parent bank is located outside of the U.S. would undermine the liquidity of government debt markets outside of the U.S. and could significantly impede the ability of foreign banks to efficiently manage their liquidity and funding requirements at an enterprise-wide level.”[42]

In addition, foreign banks will be prohibited from investing in funds that are offered or sold to U.S. residents even if the foreign bank makes that investment from outside the United States. The Proposed Rules provide an exemption to permit foreign banks to invest in covered funds “so long as such activity occurs solely outside the United States”[43] (the Offshore Exemption), which exemption the Agencies say is aimed specifically to limit the extraterritorial application of the covered fund restrictions on foreign banks. However, as noted by several commentators including the Japanese government and the Institute of International Bankers, whether a fund has been offered or sold to U.S. investors may be difficult if not impossible to determine (for example, where investors include omnibus accounts or other arrangements with intermediaries serving as the shareholder of record), thus preventing foreign banking entities from investing in these funds. There is no reason why the Proposed Rules should (as they do) take the approach that any U.S. investor in a fund “taints” that fund, even if the investing bank had noting to do with any sale to a U.S. person; rather, the intent behind the Offshore Exemption was to prohibit foreign banks from offering sponsored hedge fund and private equity fund investments to U.S. persons.[44] Mark Standish testified: “[T]hese fund restrictions represent an extraordinary and unprecedented extraterritorial expansion of U.S. banking regulation into the core prudential regulation of the non-U.S. activities of international banks by their home country regulators.”[45]

Besides the effects on foreign banks, the narrow Offshore Exemption will also impact U.S. asset managers unaffiliated with any banking entity. These asset managers will either be forced to exclude foreign banks from investing in their funds, or will need to ensure that no U.S. investors are present in such funds (including U.S. tax exempts, which commonly invest in offshore funds). We encourage the Agencies to modify the Offshore Exemption to explicitly permit foreign banks investing in funds that they do not sponsor or advise, even if those funds are offered or sold to U.S. residents.

Finally, the application of the Proposed Rules’ compliance program on foreign banks would be duplicative and extremely burdensome and runs the real risk that foreign jurisdictions will take a similar approach with respect to U.S. operations. We urge the Agencies to consider the suggestions of The Norinchukin Bank that “foreign banks should be exempted from reporting requirements if the U.S. authorities are able to utilize monitoring information gathered by the authorities in their home countries…”[46] and that such requirements should potentially be limited to the U.S.-based subsidiaries or branches of these foreign banks.[47]

We note that Mr. Volcker, in his testimony before the Senate in February of 2011, said “[S]urely a strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multi-national banks and active financial markets.”[48] However, no other country has since followed suit. The United Kingdom will follow an approach recommended by the Vickers Commission and will separate and “ringfence” their retail and wholesale banking operations from each other. This approach is far less restrictive than the absolute prohibitions of the Volcker Rule, as it does not prohibit proprietary trading and investments in funds; it just requires their separation from a retail bank. The fact that U.S. banks will exist under a much more onerous regime than foreign ones does not bode well for the competitiveness of U.S. banks and argues strongly for the understanding that the Proposed Rules should be more precisely tailored to prohibit only the specific activities that Section 619 encompasses.

4.   The Proposed Rules raise significant logistical issues, including the roles and potential overlapping jurisdiction of multiple agencies and issues with the timing of implementation.

Dodd-Frank requires “coordinated rulemaking” among the five regulators who have issued the Proposed Rules, however, it does not clarify the division of responsibility among them. The Proposed Rules say that each Agency should have supervisory, examination and enforcement authority over the legal entities over which it has rulemaking authority but this will be difficult to implement in practice. In modern banking structures, trades and their hedges may be conducted across multiple legal entities and jurisdictions; similarly quantitative metrics as prescribed with respect to the market-making exemption are also measured across multiple legal entities. If a bank’s U.S. corporate credit market-making desk buys both a bond and a related credit default swap, the bond might be held in its U.S. broker-dealer, the credit default swap in a separate legal entity (soon to be registered as a securities-based swap dealer), and the desk might hedge the position with a futures position at its futures commission merchant. Thus, a single trade could be held across multiple legal entities that fall under the jurisdiction of different regulators. Such an arrangement of multiple enforcers seems unduly complicated and likely to lead to conflict, inconsistency and confusion. Instead, the Board, which is the primary enforcer of the Bank Holding Company Act and the single regulator that currently looks across banks’ entire global businesses regardless of legal entity, should be given initial authority to supervise the implementation of the Proposed Rules. The Board can then determine whether an activity should be delegated to one of the other Agencies for further examination or enforcement.

Furthermore, while the Proposed Rules generally have a two-year conformance period, the compliance and recordkeeping requirements of the Proposed Rules will take effect this coming July. Considering that the initial comment period for the Proposed Rules ends on February 13 and that the Proposed Rules themselves pose hundreds of questions and significant further work needs to be done by the Agencies and market participants before the rules can be finalized, it seems premature for banks to begin building their compliance and reporting infrastructures until the specific requirements are finalized. SIFMA rightly concludes: “it was not the intent of Congress that banks would be left scrambling to erect massive compliance structures within the span of a few short weeks.”[49] We urge the Agencies to delay the compliance and recordkeeping deadlines until these requirements have been finalized.

Further, we urge that the Agencies repropose the Proposed Rules once they have had the opportunity to review, and reflect, the numerous comments and suggestions that governments, the industry and market practitioners have raised.

5.   Lack of Cost-Benefit Analysis.

Finally, we note that further cost-benefit analysis is critical in light of the ruling this past July by the U.S. Court of Appeals for the D.C. Circuit in Business Roundtable v. SEC.[50] Although the five different Agencies each have their own standards and internal practices for economic analysis of proposed rules,[51] the Proposed Rules contain virtually no quantitative analysis other than providing estimated paperwork burdens. The OCC’s assertion “that this proposed rule will not result in expenditures by state, local, and tribal governments, or by the private sector, of $100 million or more in any one year”[52] is not plausible, and we encourage the OCC to provide further explanation as to how this conclusion was reached. If the Proposed Rules are to withstand judicial scrutiny, robust analysis of the broader impact of the Proposed Rules must be undertaken.

Thank you for considering our comments. Please do not hesitate to contact us at (617) 384-5364 if we can be of any further assistance.

Respectfully submitted,

Hal S. Scott, Director

[1] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 76 Fed. Reg. 68,846 (proposed Nov. 7, 2011) [hereinafter Proposed Rules].

[2] Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Covered Funds, 17 C.F.R. Part 75 (proposed Jan. 2012).

[3] Dodd-Frank Wall Street Reform and Consumer Protection Act § 619, Pub. L. No. 111-203 (2010) [hereinafter Dodd-Frank].

[4] Comm. on Capital Mkts. Reg., The Global Financial Crisis: A Plan For Regulatory Reform (May 2009),

[5] Letter from the Comm. on Capital Mkts. Reg. to Timothy F. Geithner, Chairman, Fin. Stability Oversight Council 2 (Nov. 5, 2010),

[6] Rachel Armstrong, Paul Volcker Says Volcker Rule Too Complicated, Reuters, Nov. 11, 2011,

[7] Not all members of the Committee agree on the lack of contribution of proprietary trading to the financial crisis.

[8] Goldman Sachs Group, Inc., Goldman Investment Research, United States: Financial Services 5 (Jan. 22, 2010).

[9] See Proposed Rules, supra note 1, at 68,857 (defining the term “trading account” to which the proprietary trading ban applies).

[10] U.S. Gov’t Accountability Office, Proprietary Trading: Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented 16 (July 2011) [hereinafter GAO Report].

[11] Id. at 23.

[12] Id. at 14.

[13] Note that while the GAO report suggested proprietary trading was a small part of firm revenues over the period studied, the GAO report used a narrow definition of “proprietary trading” and furthermore, it presented aggregate data measured across six firms with differing degrees of proprietary trading activity.

[14] Inst. of Int’l Fin., The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework 23 (Sept. 2011),

[15] Katie Little, Which Banks Would the Volcker Rule Affect?, CNBC Stock Blog (Oct. 11, 2011),

[16] Rachel Kakouris & John Balassi, IFR-Investors Warn of Volcker Rule Liquidity Concerns, Reuters, Nov. 18, 2011,

[17] Letter from the Ctr. for Capital Mkts. Competitiveness of the U.S. Chamber of Commerce to Jennifer J. Johnson, Sec’y, Bd. of Governors of the Fed. Reserve, Robert E. Feldman, Exec. Sec’y, Fed. Deposit Ins. Corp., Elizabeth M. Murphy, Sec’y, Sec. & Exch. Comm’n, and Office of the Comptroller of the Currency 7 (Dec. 15, 2011) [hereinafter CCMC Letter].

[18] Id.

[19] Memorandum from the Office of the Comptroller of the Currency, Impact Analysis of Proposed Rule to Implement the Volcker Rule 10 (Sept. 7, 2011).

[20] Proposed Rules, supra note 1, at 68,849.

[21] Id.

[22] Darrell Duffie, Market Making Under the Proposed Volcker Rule 3 (Jan. 16, 2012),

[23] Proposed Rules, supra note 1, at 68,869.

[24] Duffie, supra note 22, at 4.

[25] Dodd-Frank § 619.

[26] Proposed Rules, supra note 1, at 68,871.

[27] Letter from Peter Kraus on behalf of AllianceBernstein to Fed. Deposit Ins. Corp., Sec. & Exch. Comm’n, Bd. of Governors of the Fed. Reserve Sys., and Office of the Comptroller of the Currency 6 (Nov. 16, 2011).

[28] Proposed Rules, supra note 1, at 68,875.

[29] Joint Hearing Before the Subcomm. on Capital Mkts. and Gov’t Sponsored Enterprises and the Subcomm. on Fin. Institutions and Consumer Credit of the H. Comm. on Fin. Servs., 112th Cong. 6 (Jan. 18, 2012) (written Testimony of Securities Industry and Fin. Mkts. Ass’n) [hereinafter SIFMA Testimony].

[30] Proposed Rules, supra note 1, at 68,866.

[31] Letter from the Municipal Securities Rulemaking Board to the Office of the Comptroller of the Currency, Bd. of Governors of the Fed. Reserve Sys., Fed. Deposit Ins. Corp., and Sec. & Exch. Comm’n 7 (Jan. 31, 2012).

[32] A Critical Analysis of the Potential Impact of the Volcker Rule on Municipal Bonds, Clients and Friends Memo (Cadwalader, Wickersham & Taft LLP), Dec. 12, 2011, at 2,

[33] U.S. Municipal Strategy Special Focus, Citigroup Global Markets (Citigroup), Nov. 20, 2011, at 1,

[34] Proposed Rules, supra note 1, at 68,851-68,852.

[35] SIFMA Testimony, supra note 29, at 8.

[36] 156 Cong. Rec. S5896 (daily ed. July 15, 2010) (statement of Sen. Jeff Merkley).

[37] Dodd-Frank § 619.

[38] Proposed Rules, supra note 1, at 68,894.

[39] Id. at 68,945.

[40] Bank Holding Company Act § 2(a)(2)(C).

[41] Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 614 (proposed Jan. 5, 2012).

[42] Letter from Julie Dickson, Superintendent, Office of the Superintendent of Fin. Insts. Canada to Fed. Deposit Ins. Corp., Sec. & Exch. Comm’n, Bd. of Governors of the Fed. Reserve Sys., and Office of the Comptroller of the Currency 3 (Dec. 28, 2011).

[43] Proposed Rules, supra note 1, at 68,852.

[44] 156 Cong. Rec. S5897 (daily ed. July 15, 2010) (statement of Sen. Jeff Merkley)..

[45] Examining the Impact of the Volcker Rule on Markets, Businesses, Investors and Job Creation: Joint Hearing Before the Subcomm. on Capital Mkts. and Gov’t Sponsored Enterprises and the Subcomm. on Fin. Institutions and Consumer Credit of the H. Comm. on Fin. Servs., 112th Cong. 8 (Jan. 18, 2012) (written Testimony of Mark Standish on behalf of the Institute of Int’l Bankers).

[46] Letter from The Norinchukin Bank to the Fed. Deposit Ins. Corp., Sec. & Exch. Comm’n, Bd. of Governors of the Fed. Reserve Sys., Commodity Futures Trading Comm’n, and Office of the Comptroller of the Currency 10 (Jan. 25, 2012).

[47] Id. at 12.

[48] Hearing Before the S. Comm. on Banking, Hous. & Urban Affairs, 111th Cong. 3 (Feb. 2, 2010) (written Testimony of Paul Volcker).

[49] SIFMA Testimony, supra note 29, at 11.

[50] Bus. Roundtable v. Sec. and Exch. Comm’n, 647 F.3d 1144, 1148 (D.C. Cir. 2011).

[51] CCMC Letter, supra note 17, at 3.

[52] Proposed Rules, supra note 1, at 68,939.

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Little to celebrate on Dodd-Frank’s birthday

Financial Times
By Hal S. Scott

America’s Dodd-Frank act is one year old on Thursday. The act made some useful corrections in the regulation of American financial markets, but it has failed to respond effectively to the root causes of the financial crisis and its impact on the global financial system. In the short term, it has hindered economic recovery. Worse, in the longer term, it has actually made future crises more likely, while potentially damaging the international competitiveness of America’s financial institutions.

The crisis resulted from a housing bubble fuelled by loose monetary policy and excessive risky lending by over leveraged banks, encouraged by pro-housing financial regulation. Yet Dodd-Frank did not rectify the low underwriting standards of Fannie Mae and Freddie Mac, and failed to reverse the low levels of capital that Basel has required banks to hold for mortgages. Its creation of a Financial Stability Oversight Council to monitor systemic risk—a ten-headed hydra of largely independent agencies—will not be effective.

As the crisis developed, plunging housing prices created a contagious liquidity problem, only headed off by heroic policies of the Federal Reserve, the Federal Deposit Insurance Corporation and the US Treasury. Yet Dodd-Frank has now crippled the ability of these same agencies to respond in the same way to future crises. The Fed can no longer lend to individual companies, as it did to AIG. More importantly it can no longer establish emergency liquidity facilities without the written agreement of the secretary of the Treasury, who may in the future be a hostage to America’s new “anti-bail-out” consensus.

The FDIC, meanwhile, can no longer guarantee deposits above a new $250,000 limit after the end of 2012, or guarantee senior debt, without a joint resolution of Congress. Due to earlier legislation relating to the financial crisis, the Treasury also can no longer use its economic stabilisation fund to guarantee money market funds. As a result, at a whiff of a new crisis, liquidity will dry up in a flash.

Dodd-Frank did at least insist that systemically important financial institutions hold more capital, while banks hold at least as much capital as required under the original Basel I requirements. Yet the most important reforms on increased capital were left to the Basel Committee, whose record is weak. While Basel III has required more capital, there remains the more difficult (if not impossible job) of setting accurate risk weights against which to measure this capital.

One of the great myths of Dodd-Frank is that the new orderly liquidation authority of the FDIC to resolve non-banks will avert future crises. But if important financial institutions are taken over by the FDIC, it is already too late—runs will already be in progress; at best losses can be minimised in resolution. Worse, Dodd-Frank takes away from FDIC its previous power to keep troubled banks alive through open-bank assistance and makes it difficult to preference short-term creditors in any resolution, powers that may be needed to curb runs.

Dodd-Frank does make some needed corrections in regulation by requiring central clearing of over-the-counter derivatives, more disclosure to investors in securitised loans, more transparency about rating agency methodology and more emphasis on consumer protection. Yet the introduction of these so-called Volcker rules were in truth uncalled for. The crisis had nothing to do with proprietary trading or investment in private funds. Prohibiting these activities deprives US banks of diversification opportunities, and makes them uncompetitive with foreign banks.

This massive revamp of American regulation creates uncertainty for now, and, with Basel III, significant costs in the future, with uncertain benefit. The political debate that produced it was shaped by the popular desire to avoid bail-outs of irresponsible financial institutions. The record shows, however, that these bail-outs worked, and were profitable for taxpayers. Any future shortfalls could be met by taxes on financial institutions or, in the case of deposit insurance, by an increase in premiums. Taxpayers need not be put at risk. In the future bubble-induced crises will, unfortunately, continue. Yet, following the new rules introduced a year ago, containing them will sadly now be more difficult than ever.

The writer is professor of international financial systems at Harvard Law School and director of the committee on capital markets regulation

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Hal S. Scott testifies before the U.S. House of Representatives Committee on Financial Services in a hearing entitled “Financial Regulatory Reform: The International Context”

Hal Scott Urges Narrow Application of Volcker Rule to Allow Bank Market Making, Hedging, other Dodd-Frank Permitted Activities

In his testimony this afternoon to the House Financial Services Committee, Hal S. Scott, Director of the Committee on Capital Markets Regulation and the Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School, is urging the U.S. to adopt a five-point approach to the financial regulatory rulemaking process to both protect the global capital markets and enhance the global competitiveness of U.S. markets.

His points:

  • A sufficiently narrow approach to defining Proprietary Trading under the Volcker Rule will avert effectively denying to banks several key risk control activities permitted under Dodd-Frank
  • U.S. initiatives that clash with E.U. initiatives on derivatives trading should be set aside for now so U.S. rules can be defined in concert with the E.U.
  • The long, full phase-in time for revised capital requirements provided under Basel should be used in order to minimize the differential impact of these requirements on different banks in different countries.
  • Systemically important firms should designated on a global basis—only where there is agreement among countries about which firms should be designated – and the U.S. national process should be tightly coordinated with the work of the Financial Stability Board—the body created by G-20 leaders in 2009 to help develop global economic governance.
  • The US should continue to work with the FSB to achieve an approach to the resolution of failed firms this is as internationally coordinated as possible.

Prof. Scott’s central emphasis on the global competitive strength of U.S. capital markets, which CCMR quarterly studies have shown has been deteriorating over the past five years. Links to his written Congressional testimony today, as well as the latest CCMR competitiveness study, both are available at the CCMR Web site.

For Further Information Contact:

Hal Scott
617 384-5364

Tim Metz
Hullin Metz & Co. LLC
(646) 495-5136 Continue Reading…

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Hal S. Scott testifies before the U.S. House of Representatives Committee on Financial Services in a hearing entitled “Promoting Economic Recovery and Job Creation: The Road Forward”





JANUARY 26, 2011


  • Sound regulatory implementation of the Dodd-Frank Act is vital to economic growth and maintaining America’s competitiveness. President Obama should not leave the financial system behind in his new initiatives in these areas.
  • The rulemaking process is a massive undertaking in which over 200 new rules are being implemented in one year, completely revamping the regulation of our financial system. This is too fast a timetable to do the job correctly. It does not permit adequate public input and is devoid of meaningful cost-benefit analysis.

Recommendations for Dodd-Frank Regulatory Implementation

1.     Congress should urge the President to require OMB to comment on the adequacy of cost-benefit analysis of the independent financial agencies in promulgating new rules, e.g., the CFTC, FDIC, Federal Reserve, and SEC. Congress should require by statute that all these agencies engage in cost-benefit analysis.

2.     Congress should encourage the financial agencies to report on progress toward meeting statutory deadlines and permit the missing of deadlines if truly justified.

3.     Congress should encourage the financial agencies to make proposed and issued rules available to the public promptly.

4.     Congress should give the financial agencies the resources they legitimately need to implement Dodd-Frank.

Needed Changes in the Dodd-Frank Act

1.     Do not require the Federal Reserve to get advance Treasury Secretary approval for emergency lending.

2.     Narrowly define “proprietary trading” under the Volcker Rule to include only “trading activities set up with segregated capital and separate teams of personnel that do not interact with customer businesses or rely on customer deposits.”

3.     The Congress, not the Federal Reserve, should fund the activities of the Bureau of Consumer Financial Protection and should urge the President to promptly nominate a director of the new agency.

4.     Fundamental structural reform of the regulatory system is needed, beyond the creation of the Financial Stability Oversight Council.

5.     The ban on the use by the government of credit ratings in formulating regulations should be somewhat relaxed by providing that the government cannot unduly rely on such ratings.

Continue Reading…

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The Committee releases a comment letters to the Financial Stability Oversight Council regarding the the Volcker Rule

Re: Public Input for the Study Regarding the Implementation of the Prohibitions on Proprietary Trading and Certain Relationships With Hedge Funds and Private Equity Funds, 75 Fed. Reg. 61,758 (Docket No. FSOC-2010-0002)

Dear Chairman Geithner:

The Committee on Capital Markets Regulation* appreciates the opportunity to comment on the Financial Stability Oversight Council’s request for public input regarding the study on the implementation of the restrictions on proprietary trading (the Volcker Rule) in § 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[1]

Since 2005, the Committee on Capital Markets Regulation (Committee) has been dedicated to improving the regulation of U.S. capital markets. Our research has provided an independent and empirical foundation for public policy. In May 2009, the Committee released a comprehensive report entitled, The Global Financial Crisis: A Plan for Regulatory Reform (Report), which contains 57 recommendations for making the U.S. financial regulatory structure more integrated, more effective, and more protective of investors in the wake of the financial crisis of 2008.[2] Since then, the Committee has continued to make recommendations for regulatory reform of major areas of the U.S. financial system.[3]

As Hal S. Scott, Director of the Committee, explained in testimony before the Senate Committee on Banking, Housing, and Urban Affairs,[4] proprietary trading was not a source of systemic risk that precipitated the financial crisis of 2008, nor did it create significant inherent conflicts of interest between banks and their customers. Instead, it helped banks service the needs of their customers, diversify their businesses, and compete with foreign banks. Proprietary trading also had several substantial benefits for the financial markets, such as increasing liquidity, improving price discovery, and promoting market efficiency. The Committee urges the Council to recognize these benefits by narrowly implementing the ban on proprietary trading. The comments below provide specific guidance on several important foundational elements and exceptions to the rule.

Foundational Elements

1.     “Proprietary trading.”[5] This is the key definition that will influence the application of all of the implementing regulations. We propose that proprietary trading be defined narrowly by being limited to trading activities set up with segregated capital and separate teams of personnel that do not interact with customer businesses or rely on customer deposits. This approach will ensure it does not cover activities that are driven by or in response to customer needs, requests, or orders.

2.     “Selling in the near term.” Under the Dodd-Frank Act, a “trading account”[6] used for proprietary trading is defined to be used principally with the intent to “sell[] in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” This implies that the motives of the banking entity when initially acquiring the security or instrument are highly relevant in determining whether impermissible proprietary trading is occurring. The phrase “near term,” however, is also used in the exception allowing for market making “for the reasonably expected near term demands of clients.”[7] The phrase need not be defined the same way in both places. Although there is an important temporal aspect in both uses, the regulators should take care not to define the term in such a way as to prohibit either long-term investments or market making.

3.     “Material conflict of interest,”[8] “material exposure,”[9] “high-risk assets,”[10] and “high-risk trading strategies.”[11] These terms are designed to enable rule makers to prohibit trading that would technically fall within a statutory exemption but otherwise is inconsistent with the asserted purposes of the Volcker Rule.[12] In defining these terms, they should set high thresholds, so that only activities harmful to customer interests and those that pose a systemic risk, the stated purposes behind § 619, are prohibited.[13]


Notwithstanding the general restriction on proprietary trading, § 619(d)(1) specifies a number of permitted activities and, through subsection (d)(1)(J), gives the agencies the authority to specify “[s]uch other [exceptions] as the appropriate…[agencies] determine, by rule,…would promote and protect the safety and soundness of the banking entity and the financial stability of the United States.” We encourage them to narrow the effect of the rule by using this authority because a narrow ban will increase the safety and soundness of banks and the U.S. financial system.

1.     Transactions involving U.S. government or agency obligations.[14] The first exception to the general ban on proprietary trading allows banking entities to trade obligations of the U.S. government, agencies, states, or political subdivisions.[15] Rule makers should broaden this exemption, under the authority in § 619(d)(1)(J) to create new permitted activities, to include trading in securities issued by foreign governments. A foreign branch of a U.S. bank and a U.S. branch of a foreign bank should both be permitted to trade in government debt issued by any government in any currency. Such activities are not inherently risky and in any event the risk will be supervised. This approach will ensure there is fairness and consistency in implementation of the new rules.

2.     Transactions in connection with underwriting or market-making-related activities “to the extent that any such activities…are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.”[16] This is an important carve-out in the Rule, as rule makers must define what types and level of trading activity in any one security are necessary to rise to the level of permissible customer order facilitation or market-making. Implementing this exception requires an understanding that it is not always possible to trace every trade back to an instruction from a specific client. Banking entities try to accommodate their clients’ needs even if it requires buying something from a client that may not be able to be resold immediately. That service, of providing a price for an asset and taking risk away from a client, is a core function of a banking entity and should not be discouraged.

3.     “Risk-mitigating hedging activities.”[17] This is another important carve-out that requires banking entities to demonstrate their intent to reduce risk, rather than make a near-term profit, when acquiring a security.[18] Once again, this term should be defined in a way that ensures a banking entity has the broadest flexibility to manage and hedge risk with a broad array of financial instruments. In the event a dealer buys an asset from a client that cannot immediately be resold, it may hedge with something that approximates but does not exactly match the risk of the asset until it can find a buyer. This type of hedging activity, which enables a dealer to service its clients, should be allowed. Also, hedges should be able to be justified on an individual position level or on a portfolio level, so long as they exist to reduce “specific risks”[19] of those risky “positions, contracts, or other holdings”[20] a banking entity deems it necessary and appropriate to hedge. Related to this, a hedge also need not be a short position, because long positions are often valuable for mitigating certain risks.

4.     Transactions “on behalf of customers.”[21] Although legislators narrowed this exception in the conference process, we believe it should be expanded by regulators under the rulemaking authority provided by § 619(d)(1)(J), discussed above, to include all transactions that facilitate customer relationships. The provision should permit any trade that is customer-initiated or based upon a banks’ accommodation for a customer, even if the bank creates a bespoke security in response to anticipated customer needs. If banks are to continue providing valuable financial products and services to customers, then they must be able to have the broadest flexibility to accommodate and facilitate customer needs and demands. Moreover, if banks cannot provide these services then those activities may migrate to more lightly regulated institutions, an outcome the Council may want to avoid.

5.     “Investments in SBICs, public welfare investments, or investments in qualified rehabilitation or certified historic structure projects.”[22] Although these instruments are rarely traded by banks, rule makers should clarify that investments in them do not constitute proprietary trading, regardless of holding period, intent, or purpose. This is because of their illiquid and long-term nature, along with the fact that they support important governmental objectives.

6.     “Transactions by a regulated insurance company (and its affiliates) for its general account.”[23] This exemption, for banking entities that may have affiliated insurance entities, should be clarified to allow for all trading activities, so long as they comply with state insurance laws and are necessary to conduct the ordinary business of insurance.

Thank you for considering our comments. Please do not hesitate to contact us at
(617) 384-5364 if we can be of any further assistance.

Respectfully submitted,

R. Glenn Hubbard, Co-chair

John L. Thornton, Co-chair

Hal S. Scott, Director

* Not every member of the Committee is in favor of the approach taken by this letter.

[1] 75 Fed. Reg. 61,758 (Oct. 6, 2010); Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 619 [hereinafter Dodd-Frank Act]. All subsections of § 619 referenced in this letter are references to subsections of § 13 of the Bank Holding Company Act of 1956 as amended by § 619 of the Dodd-Frank Act.

[2] Comm. On Capital Mkts. Reg., The Global Financial Crisis: A Plan For Regulatory Reform (May 2009),

[3] See Letter from the Comm. on Capital Mkts. Regulation to Christopher Dodd, Chairman, Richard Shelby, Ranking Member, S. Comm. on Banking, Hous. & Urban Affairs and Barney Frank, Chairman, Spencer Bachus, Ranking Member, H. Comm. on Fin. Servs. (Mar. 4, 2010) (proposing a comprehensive approach to reducing systemic risk from over-the-counter derivatives); see also Letter from the Comm. on Capital Mkts. Regulation to Christopher Dodd, Chairman, Richard Shelby, Ranking Member, S. Comm. on Banking, Hous. & Urban Affairs, and Barney Frank, Chairman, Spencer Bachus, Ranking Member, H. Comm. on Fin. Servs. (June 14, 2010).

[4] Prepared Written Testimony of Hal S. Scott before the S. Comm. on Banking, Hous. & Urban Affairs (Feb. 4, 2010). This testimony did not necessarily represent the views of the Committee.

[5] Dodd-Frank Act § 619(h)(4).

[6] Id. § 619(h)(6).

[7] Id. § 619(d)(1)(B).

[8] Id. § 619(d)(2)(A)(i).

[9] Id. § 619(d)(2)(A)(ii).

[10] Id.

[11] Id.

[12] This might include highly leveraged hedges (options, futures, or other derivatives) in an illiquid market where the bank has publicly been very bullish and doing a substantial flow business.

[13] See Dodd-Frank Act § 619(b)(1).

[14] Id. § 619(d)(1)(A).

[15] Id. It also includes investments in small business investment companies registered with the SEC.

[16] Id. § 619(d)(1)(B).

[17] Id. § 619(d)(1)(C).

[18] Id.

[19] Id.

[20] Id.

[21] Id. § 619(d)(1)(D).

[22] Id. § 619(d)(1)(E).

[23] Id. § 619(d)(1)(F).

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