BY EDWIN LEWIS
In December the Federal Reserve and other federal bank regulators, the Securities Exchange Commission and the Commodity Futures Trading Commission adopted the Volcker Rule final regulations under the Dodd-Frank Act of 2010. The Volcker Rule represents a major change from prior law on how banks may trade stocks and other speculative investments for their own account.
A little history is important here to understand the “why” of Volcker and its impact on banks that have depositor funds insured by the Federal Deposit Insurance Corp. In a nutshell, the rule reinstates provisions of the Glass-Steagall Act of 1933. Glass-Steagall ended a bank”™s ability to speculate in stocks with depositors”™ money, a major cause of the stock market crash of 1929. If you wanted to trade stocks after Glass-Steagall, you had to go to a broker, not a bank.
That worked just fine until 1999 when Congress passed the Gramm-Leach-Bliley Act, which repealed Glass-Steagall in part and allowed banks to get back into the speculative investment business. Graham-Leach-Bliley became proof of the philosopher George Santayana”™s advice that “Those who cannot remember the past are condemned to repeat it.” Then-President Clinton said the law would stimulate “greater innovation and competition in the financial services industry” and its removal of barriers to competition “will enhance the stability of our financial services system.” Many blame the repeal of Glass-Steagall on the global financial crisis of 2008.
The Volcker Rule prevents speculative investment (“proprietary trading”) by a depository bank for its own account, but permits investments for the purpose of hedging risks of the bank, and investments related to “making a market” for the securities of a bank customer. There are additional exemptions and exemptions from the exemptions in the law. Suffice it to say the rule is so complicated that the regulators added 800-plus pages of explanation to it. Lurking behind the rule are civil and criminal penalties.
The Volcker Rule presents a major challenge to bank leadership: the general counsel, the chief compliance officer and senior risk management, as well as bank boards of directors, the CEO and CFO and senior management and auditors. The regulators themselves have the task of defining their approach to compliance standards, best practices and points of examination, and preparing to enforce. Some bank requirements begin in April and June this year, so time is of the essence. Many banks have prepared for the rule.
How may a bank successfully comply on a timely basis? I”™ve outlined my view of a basic approach:
1. Bank leadership must have a clear understanding of all aspects of the rule and the implications for the bank. This seems obvious, but I”™ve seen companies start off with basic misconceptions of a law, leading to serious violations. The rule is nuanced in several respects and bank leadership needs to know how to spot the issues and ask the right questions. For example, market-making for bank clients is OK as long as no proprietary trading is incented in connection with the market-making. Also, exemptions to the rule do not apply if there is a conflict of interest, material exposure to high risk assets or a threat to the safety and soundness of the bank. General counsel and compliance management must take the lead in grasping both a big picture and detailed understanding of the rule, and illuminating the board and management (and the auditors) in the meaning and effect of the rule. Ambiguities should be discussed with the regulators.
2. Which brings me to the role of the board of directors to set a strong compliance emphasis for the bank. The board, as with any important compliance issue, must make it abundantly clear to all management that they will be held accountable for the organization”™s compliance with the rule. The rule also gives the board specific oversight responsibilities for development of the compliance program required by the rule and described below.
3. The general counsel, the chief compliance officer and risk management must communicate well and work in harmony on all issues relating to the rule. They must coordinate all compliance activities including training, monitoring and testing. Bank policies must be updated, including violation reporting procedures.
4. Training protocol is important. The general counsel, chief compliance officer, chief should design and implement an effective continuous training program for Volcker compliance for all levels of the bank, including the board of directors.
5. Once the powers that be have a good grasp of the rule, then there must be an exhaustive due diligence of bank operations to identify all activities that may be affected by the rule. I”™ve seen many instances where the leadership of a large business does not have a complete understanding of the operations of the business, including subsidiaries, joint venture partners and affiliates. This becomes exponentially more complicated if there are overseas operations.
6. General counsel and compliance management also need to alert all other relevant areas of the bank to the new rule and how it affects the bank. This may include vendors, joint venture partners, outside auditors and other pertinent “outsiders.”
7. General counsel and compliance management must guide the bank to develop and implement procedures to “establish, maintain, enforce, review, test and modify” the bank”™s program to comply with the Volcker Rule.
8. The law requires that the bank”™s CEO attest in writing that the bank has developed and implemented a Volcker Rule compliance program. This is similar to the Sarbanes-Oxley and the FINRA certification requirements. The regulators have also pronounced that the board of directors and senior management “are responsible for setting and communicating an appropriate culture of compliance” with the rule and “ensuring that appropriate policies regarding the management of trading activities” are adopted. General counsel and the chief compliance officer must work with the CEO to develop such a program and oversee the attestation process. They must work with the bank board and senior management to facilitate their compliance as well. The Director and Officers liability insurance policy must be reviewed to confirm coverage of the attestation activity.
9. The rule specifies that banks must keep appropriate documentation and make it available to the regulators so they may confirm bank compliance with the rule. The general counsel and the chief compliance officer should also develop and oversee the process.
10. Under the rule, banks with significant trading must monitor, measure and report to the regulators certain trading metrics. General counsel and the chief compliance officer must review this process as well.
11. Outside auditors will also have a say in evaluating compliance and must be brought into the picture.
12. If the bank is publicly traded, then general counsel and the chief compliance officer must make sure that rule-related compliance disclosures are properly reported.
13. The rule is subject to interpretation during examination and enforcement, so the general counsel and the chief compliance officer should maintain a continuous and open dialogue regarding the regulators”™ examination protocols and best practices and their enforcement posture.
14. General counsel and the chief compliance officer should keep a look-out for additional guidance from the regulators, including items in their web pages, Federal Register and press releases. They should also subscribe to the regulators”™ e-notices.
The points I”™ve outlined should present a good start for effective compliance with the Volcker Rule and to bring a bank into the new Glass-Steagall Era.
Edwin Lewis is a lawyer and former general counsel and chief compliance officer for global public companies. He is counsel to the executive director of the Pace University Lubin Center for Global Governance, Reporting and Regulation and member of the Lubin M.B.A. program faculty. He can be reached at elewis@pace.edu.
