Statement on the Volcker Rule: Reducing Systemic Risk By Banning Excessive Proprietary Trading with Depositors’ Money

The recent financial crisis and subsequent events[1] show the dangers that can result when banks trade for their own accounts while disregarding their customers’ interests. During the financial crisis, U.S. taxpayers were forced to cover losses sustained by major financial institutions that resulted from speculative proprietary trading activities.[2]  While several factors combined to cause the financial crisis, proprietary trading by major financial institutions was a key contributor to that crisis.[3]  In particular, proprietary trading by deposit-taking institutions exposed a bank’s capital—and FDIC-insured deposits—to unacceptable risks and saddled taxpayers with massive losses.[4]

Moreover, proprietary trading by banks poses investor protection risks.  For example, as highlighted by Senator Merkley and Senator Levin, banks that engage in proprietary trading may gather information from their clients’ investment activities and exploit them.[5]  Indeed, banks have, in the past, created and marketed products that were secretly designed to fail;[6] or used client trading information against client interests.[7]

Today, the Commission in conjunction with several other financial regulators[8] implemented Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”),[9] also known as the “Volcker Rule,” by adopting an identical Final Rule.[10]  The rule implements a statutory mandate that prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund, subject to certain exemptions.[11]

The Final Rule adopted today prohibits proprietary trading by banking entities, with certain key exclusions and exemptions.[12]  For example, the rule covers exclusions for transactions relating to bona fide liquidity management purposes and exemptions for underwriting, market-making, and hedging activities.  The rule also prohibits banking entities from acquiring or retaining an ownership interest in, or sponsoring, a hedge fund or private equity fund, with certain exemptions.[13] More importantly, the Final Rule states that an exemption will not be available if the transaction, class of transactions, or activity would involve a material conflict of interest, high-risk assets and trading strategies, or pose a threat to the banking entity or the financial stability of the United States.[14]  The rule also requires banking entities to develop a compliance program designed to ensure and monitor compliance with Section 13 of the BHC Act and the Final Rule.[15]

Enforcement Mechanism

Today’s adoption of the Final Rule is an important step, but it is not the end of the process.  The success or failure of the Volcker Rule will depend on the manner in which banking entities comply with the letter and spirit of the rule, and on the willingness of regulators to enforce it.  Proactive, strong, and effective enforcement by the Commission is vital to investor protection and maintaining the stability of the U.S. financial system.  Section 13(e)(2) of the BHC Act authorizes the Commission to order any entity subject to its jurisdiction to terminate activities or investments that violate or function as an evasion of Section 13 of the Act.[16]  In addition, and more importantly, Section 13(e)(2) of the BHC Act provides that nothing in Section 13 limits the existing authority of the SEC.[17]

I also anticipate that the Commission will continue to work closely with other regulators.  This initiative has truly been a joint effort and thus, going forward, I would expect continuing coordination between the Commission and other regulators to ensure effective implementation and enforcement of the Final Rule.

Conclusion

Today’s adoption is a step forward in reining in speculative risk-taking by banking entities and preventing future crises.  In addition, I note that many industry participants have been asking for action on this matter --- and to have in place regulation that can provide certainty.  It is hard for any entity to move forward in an environment of regulatory limbo.  I am hopeful that the industry will move with energy and speed to comply with the Final Rule.

Although the passage of time can dim memories, we can never forget the crisis that brought our country to this moment.  Proprietary trading by financial institutions racked up huge losses and was one of the factors that forced American taxpayers to bail out the banking system.  That crisis destroyed financial institutions, caused significant investor losses, and obliterated the household wealth of average Americans.  By reining in excessive proprietary trading by deposit-taking institutions, the goal of the Volcker Rule is to restore integrity to the financial system and maintain the vibrancy of the U.S. financial market.

I want to specifically commend Chair White’s sustained and effective leadership, perseverance, and tremendous efforts in shepherding the Volcker Rule through the interagency rulemaking process.  These efforts brought this significant undertaking to completion. 

I also appreciate the commitment and professionalism of the SEC staff and its counterparts at the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, Commodity Futures Trading Commission, and the United States Department of Treasury during this process.

[*] The views expressed by Commissioner Luis A. Aguilar are his own and do not necessarily reflect the views of the U.S. Securities and Exchange Commission (“Commission” or “SEC”), his fellow Commissioners, or members of the staff.

[1] Proprietary trading by financial institutions also caused massive investor losses after the financial crisis.  For example, in May 2012, JPMorgan disclosed a $2 billion trading loss, and its shareholders witnessed the obliteration of about $30 billion of the bank’s market value.  See Justin O’Brien and Olivia Dixon, The Common Link in Failures and Scandals at the World’s Leading Banks, 36 Seattle U. L. Rev. 941, 945 (Winter 2013).  These and other events show that speculative trading by banks, if left unchecked, can cause serious damage to the U.S. economy and significant losses to U.S. investors.

[2] See Onnig H. Dombalagian, The Expressive Synergies of the Volcker Rule, 54 B.C. L. Rev. 469, 470 (Mar. 2013).

[3] See id.; Report of the Senate Committee on Banking, Housing, and Urban Affairs regarding The Restoring American Financial Stability Act of 2010, S. Rep. No. 111-176 at 9, 92 (2010), available at http://www.gpo.gov/fdsys/pkg/CRPT-111srpt176/pdf/CRPT-111srpt176.pdf; Testimony by Neal Wolin, Deputy Secretary of the Treasury, to the Senate Banking Committee (Feb. 2, 2010) (‘‘Major firms saw their hedge funds and proprietary trading operations suffer large losses in the financial crisis.  Some of these firms ‘bailed out’ their troubled hedge funds, depleting the firm’s capital at precisely the moment it was needed most.”).  In fact, due to the financial crisis, “eight million jobs were lost, more than seven million homes entered foreclosure, and $13 trillion in American household wealth vanished.”  See, e.g., Report of the Senate Committee on Banking, Housing, and Urban Affairs regarding The Restoring American Financial Stability Act of 2010, S. Rep. No. 111-176 at 228 (2010), available at http://www.gpo.gov/fdsys/pkg/CRPT-111srpt176/pdf/CRPT-111srpt176.pdf.

[4] See Statement of Thomas M. Hoenig, Vice Chairman FDIC, to the Committee on House Financial Services, Federal Reserve Bank and “Too Big To Fail” Banks, 2013 WLNR 15571877, (June 26, 2013) (“Extending the safety net to broker-dealer activities is unnecessary and unwise.  While trading and investment activities are important parts of the financial system, they operate more efficiently and safely without government protections.  Keeping them inside the safety net exposes the FDIC Deposit Insurance Fund and the taxpayer to loss.  Therefore, activities that should be placed outside the safety net and thus subject to market forces are: most derivative activities; proprietary trading; and trading for customer accounts, or market making.  Allowing customer trading makes it easy to game the system by ‘concealing’ proprietary trading as part of it.”); Thomas M. Hoenig and Charles S. Morris, Restructuring the Banking System to Improve Safety and Soundness, pp. 21-22 (Dec. 2012) (Proprietary trading has “little in common with core banking services and create risks that are difficult to assess, monitor, and control.”), available at http://www.fdic.gov/about/learn/board/Restructuring-the-Banking-System-05-24-11.pdf;

[5] Sen. Jeff Merkley and Sen. Carl Levin, The Dodd-Frank Act Restrictions on Proprietary Trading and Conflicts of Interest: New Tools to Address Evolving Threats, 48 Harv. J. on Legis. 515, 522-23 (Summer 2011).

[6] Id. at 523-25.

[7] See, e.g., In the Matter of Merrill Lynch, Pierce, Fenner & Smith Incorporated, Exchange Act Release No. 63760 (Jan. 25, 2011) (The Commission fined Merrill Lynch $10 million for misusing customer order information and for charging improper mark-ups and mark-downs on riskless principal trades), available at http://sec.gov/litigation/admin/2011/34-63760.pdf.

[8] These regulators are the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Commodity Futures Trading Commission.

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

[10] See Section 619 of the Dodd-Frank Act added new section 13 to the Bank Holding Company Act of 1956 (“BHC Act”) (codified at 12 U.S.C. 1851), which generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund, subject to certain exemptions.

[11] See 12 U.S.C. 1851.

[12] These exclusions include transactions in financial instruments under certain repurchase and reverse repurchase agreements and securities lending arrangements, securities acquired for bona fide liquidity management purposes, and transactions by a clearing agency or derivatives clearing organization in connection with clearing activities.  (Section __.3 of the Final Rule)  Moreover, the Final Rule permits a banking entity to engage in underwriting (Section __.4(a) of the Final Rule); market making-related activities (Section __.4(b) of the Final Rule); risk-mitigating hedging (Section __.5 of the Final Rule); trading in certain government obligations (Section __.6 of the Final Rule); trading on behalf of customers (Section __.6 of the Final Rule); trading by an insurance company for its general account (Section __.6 of the Final Rule); and trading solely outside of the U.S. by foreign banking entities (Section __.6 of the Final Rule).  The underwriting, market-making, and hedging exemptions prohibit compensation designed to reward or incentivize prohibited proprietary trading (Sections __.4 and __.5  of the Final Rule).

Section 13(d)(1)(H) of the BHC Act permits certain foreign banking entities to engage in proprietary trading that occurs solely outside of the United States and the Final Rule does not prevent a foreign banking entity from trading with any U.S. counterparty under that exemption.  The Final Rule focuses on the location of the principal risk of a foreign banking entity’s transactions but requires that decisions to enter into trades be made outside the United States.  (Section __.6(e) of the Final Rule).

[13] Section __.10 of the Final Rule.  The Final Rule, however, provides exemptions that permit a banking entity to acquire or retain an ownership in, or to sponsor, a covered fund in connection with underwriting or market making-related activities (Section __.11 of the Final Rule); risk-mitigating hedging activities (Section __.13 of the Final Rule); activities on behalf of customers (Section __.10 of the Final Rule); investments in small business investment companies and certain other investments designed to promote the public welfare (Section __.11 of the Final Rule); an insurance company acting for its general account (Section __.13 of the Final Rule); organizing and offering a covered fund (Section __.11 of the Final Rule); and covered fund activities that occur solely outside of the United States (Section __.13 of the Final Rule).

[14] Sections __.7 and __.15 of the Final Rule.  The Final Rule does not require banking agencies to provide written disclosures addressing potential conflicts of interest; however, at my request, the Final Rule now includes language stating that written disclosures may be appropriate in certain circumstances.

[15] Section __.20 of the Final Rule.

[16] Section __.21 of the Final Rule implements Section 13(e)(2) of the BHC Act.

[17] The SEC may rely on its inherent authority under applicable provisions of the federal securities laws to bring enforcement actions against entities that are subject to the Final Rule, including their officers, directors, and other affiliated parties for violations of law.  In particular, Section 13 of the BHC Act and the Final Rule do not limit the reach or applicability of the antifraud and other provisions of the federal securities laws—such as Section 17(a) of the Securities Act of 1933 or Sections 10(b) and 15(c) of the Securities Exchange Act of 1934—to banking entities.  Moreover, nothing in the Final Rule limits the SEC’s inherent examination and inspection authority over SEC-registered entities to ensure compliance with the Final Rule.

The Final Rule also requires the CEO of a banking entity to attest annually in writing to its regulator that the banking entity has in place a program reasonably designed to ensure compliance with the requirements of Section 13 of the BHC Act and the Final rule.  See Section __.20 and Appendix B of the Final Rule.  This requirement incentivizes the creation of appropriate “tone from the top” compliance programs, encourages management to adopt a culture of compliance, and ensures individual accountability.