A midsize Bank’s musings on the Volcker Rule impact

A midsize Bank’s musings on the Volcker Rule impact

Written By Tally Ferguson, SVP, Director of Market Risk Management, Bank of Oklahoma

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The Volcker rule’s prohibition on trading activity came into effect last July. Surprisingly, the rule does not stop at trading activity! Banks with little or no trading may be tempted to let this historic moment pass unceremoniously. If they buy or sell securities, hedge with derivatives, or manage customer money, they ignore the rule at their peril! As of September 30, 2015, the U.S. boasted nearly 70 bank holding companies with assets between $10 and $50 billion. Of these, five reported trading assets and liabilities of at least $500 thousand. These likely have solid Volcker compliance programs. Thirty midsize holding companies reported no trading account

assets. These need program, but they might not recognize it. Their program is probably easy to compile, and an ounce of prevention is worth a pound of regulatory cure. That leaves 34 midsize holding companies with a small level of trading assets but assets ranging from $11 to $42 billion. These Probably have a Volcker rule program in place, but likely to have under-estimated the impact of the rule Figure 1 illustrates this breakdown. This article offers no value to the five that must surely have a strong compliance program. It offers perspective and food for thought for the 64 other midsize holding companies.

COMFORMANCE PERIOD ENDS

Passed in July, 2010, the Volcker rule gave banks five years to come into conformance with the rule – enough time to get a college degree, but not enough to digest the rule’s implications.

The FFIEC issued regulatory guidance on the rule in December, 2013. Banks built programs, but unexpected consequences continue to surface.

What is trading?

The Volcker Rule prohibits financial institutions from “trading” “financial instruments.” Broadly, “financial instruments” comprise securities, derivatives and futures. “Trading” involves purchasing and selling for short term gains from price movements. Hedging such transactions is also trading. The rule presumes any position closed or mitigated within 60 days is trading. The sixty day safe harbor applies to any security, derivative or future. Consider the following examples of “trading” post Volcker rule that banks did not manage like trading activities before. (1) investment portfolio manager rebalances after a bond rally and sells a security bought within 60 days. (2) mortgage servicing rights manager fine tunes his coverage by closing out part of a swap transaction entered two months earlier. (3) Matched book swaps trader takes in a customer interest rate swap and matches it with a dealer immediately. The Volcker rule permits each of these, but it requires documentation to prove rule conformance. With Volcker, we are guilty until proven innocent. Vive la revolckerution.

UNEXPECTED CONSEQUENCES?

Let me discuss three unexpected consequences of the Rule. First, Risk Mitigating hedging became harder to support. In the May 3-4 Risk America’s conference, I will share a mortgage servicing rights example to illustrate how high the analytical and documentation bar is. I will also offer a low-tech but effective solution to avoid these requirements. For this article, I offer several broad examples for banks to consider. The inset describes what the Volcker rule considers risk mitigating hedging.   Note the risks hedged must be specific and identifiable. “Hedging interest rate risk” is not specific. The risk protected by an anticipatory hedge may be hard to identify. The second bullet of the inset requires hedges to be specific to a position. This requirement makes Macro-hedging difficult to defend. As an example, fine tuning net interest income at risk with interest rate swaps can involve opening and closing derivative positions within 60 days. That becomes trading. To show that activity is permissible under Volcker, the ALM desk must document the hedge activity as follows:

  • Identify the risk(s) of the hedged positions, contracts, or other holdings of the banking entity that the purchase or sale is designed to reduce;
  • Describe the specific risk-mitigating strategy that the purchase or sale is designed to fulfill; and
  • Distinguish the trading desk or other business unit that is establishing and responsible for the hedge.
  • Create and retain records that show the hedge complies with the risk mitigating hedge requirements. Regulators can ask for this analysis for up to five years, and banks mush promptly produce such records.

As I will illustrate in the May 3-4 Risk America’s conference, records showing hedge compliance are extensive. They must demonstrate correlation analysis, and independent testing designed to ensure that the positions, techniques and strategies that may be used for hedging.  They must be specific to the risks identified at the outset of the hedge. These requirements will change the way you document balance sheet hedges and my change your balance sheet hedging strategies.

A second unexpected consequence pertains to transactions entered into for the benefit of customers. I use mirrored customer trades as an example. Many mid-size banks offer corporate clients help with managing their interest rate risk. The classic fixed for floating interest rate swap lets borrowers make fixed-rate credit facilities out of floating rate loans. With this swap, the borrower pays the bank a fixed rate and receives floating. Banks seeking to keep the floating rate structure immediately offsets (“mirrors”) the client swap with a derivatives dealer, paying fixed and receiving floating. As Robespierre would be quick to point out, “immediately” is less than 60 days, making these transactions trading transactions. How can banks continue this business? Is it excluded as brokerage activity? Exempted as for the benefit of customer? Exempted as market making? Should banks rebut the presumption that such activity is trading? Perhaps at the Risk America’s conference, we will find hints at answers to these questions. Likely, precedence will be set over time.

Finally, consider one last unexpected consequence. Many of the mid-size banks that reported few or no trading account assets reported trust accounts under management. With custody of securities accounts come potential for trade errors. Consider a customer that asks the custodian to sell $100,000 in bonds. In error, the bank purchases the $100,000 in bonds. The bank now owns $200,000 in bonds. Upon identifying the error, it will sell the position and lock in the loss or gain from the error. Assuming the banks internal controls are reasonably effective, they will find and correct the error within 60 days. If not, the bank has considerably bigger problems than Volcker Rule documentation.   Because the bank in this example purchased and sold $100,000 of bonds within 60 days, the transaction is presumed trading. This could be an intriguing opportunity to rebut the presumption of trading. Minimally, the bank should document the error to leave a clear audit trail that a customer trade, not a speculative whim, set this set of transactions in motion.

What is Risk mitigating hedging?

Activity that:

  • Reduces or mitigates one or more specific, identifiable risk related to identified positions, contracts or holdings.
  • Bases risk reduction on facts and circumstances of the identified underlying and hedging positions, contracts or holdings
  • Does not initially give rise, to any significant new or additional risk not hedged contemporaneously
  • Does not compensate hedgers for gains in value of underlying or hedge

FINAL THOUGHTS?

Arguably, the Volcker Rules ushered in the most significant change to trading activity in the United States since Glass Steagall. Though six years old this June, the rule has been effective for only one. Regulators continue to solidify their standards. The broad definition of trading, combined with the presumption of guilt leads to unexpected consequences of which midsize banks might not be aware. Assessing these situations with timely documentation can mitigate the impact of these unexpected consequences.