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Will Softening of Volcker Rule Prove Beneficial for Banks?

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On May 30, the Federal Reserve along with other key financial regulatory bodies took another step toward easing the stringent regulations related to the Volcker Rule imposed on banks post 2008-financial crisis.

The three-member Federal Reserve Board unanimously approved the proposals aimed at simplifying and improving the Volcker Rule that prevents banks from engaging in certain types of speculative investments with a view to curb their risk-taking ability. The changes have been opened to a 60-day public comment period, post which, regulators will put it to final vote before the changes can take effect.

Some major Wall Street banks such as JPMorgan Chase (JPM - Free Report) , Goldman Sachs (GS - Free Report) and Bank of America (BAC - Free Report) closed the day 2.3%, 1.3% and 1.8% higher, respectively.

Volcker Rule – A Brief Recap

The Volcker Rule prohibits banks or insured depository institutions from conducting proprietary trading, i.e., the practice of banks investing to pocket profits for themselves rather than buying or selling securities to fulfill customers’ demands. Also, it barred them from acquiring or retaining ownership interests in hedge funds or private equity funds.

The Volcker Rule had attracted widespread criticism at the very outset. The banks have been complaining of the complexity and claimed the rule to be vague. Further, in 2017, the U.S. Chamber of Commerce had put forth its views over the negative impacts of rule on liquidity and that the costs associated with it outweigh benefits.

Key Changes Proposed by Regulators

Firstly, the regulators have categorized the banks in three divisions, depending on their level of trading activity. Strict compliance measures have been reserved for those with “significant trading assets and liabilities” or more than $10 billion in trading assets.

The second category concerns companies with trading assets between $1 billion and $10 billion and those will benefit from reduced compliance requirements. Finally, in the last category, banks with trading assets lower than $1 billion will be subject to the lowest level of compliance requirements.

Further, the regulators have allowed banks to determine their own risk limits for underwriting activities and market making. However, the companies with significant trading assets and liabilities would still be required to have a comprehensive internal compliance program.

Also, the proposal stands to remove the assumption that positions held by lenders for less than 60 days are proprietary trades. It would even discard some parts of a test that determines whether a trade is proprietary and replace it with new criteria based on how the bank accounts for the trades.

Banks will also be freed from the elaborate documentation requirements for hedging activities under certain conditions.

On the other side, foreign banks stand to benefit greatly from a major change proposed in the rule. Under the existing rule, foreign banks are allowed to engage in proprietary trading only if it occurs outside the United States. However, per the proposal, the exemption will expand to trades initiated outside the country but should go through a U.S. branch or affiliate or is financed by one.

Would Rolling Back of the Rule be a Boon for Banks

"The specific elements of this proposal are drawn from experience-the shared experience of all five responsible agencies and of policymakers at those agencies with wide and varied backgrounds during the four years that the Volcker rule regulations have been in force," said Randal K. Quarles, the Board's Vice Chairman for Supervision.

These changes are expected to have a positive effect on the safety and soundness of the financial system and greatly reduce fixed costs for the financial institutions. Further, the banks can now freely engage in hedging activities in limits they consider risk-free that might help them counter risk in other parts of their businesses.

Moreover, the changes in the Volcker Rule might help to improve lending as banks are likely to benefit from better liquidity position.

Last week also there were reasons for banks to rejoice. Trump signed a bill which raised the SIFI threshold significantly, freeing large number of banks from strict oversight by the Federal Reserve, higher capital requirements, annual stress tests and the need to produce "living wills". Such easing of regulations coupled with the corporate tax reform and rising interest rates are likely to give solid boost to banks’ profitability and lead their stocks to touch all-time highs.

Easing of regulations might leave behind some loopholes that banks seek to exploit. Therefore, the regulators are expected to continue to strictly supervise banks’ activities and keep them on the right track to avoid another crisis.

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