Moving the ball forward on instituting new rules to govern how Wall Street does business in order to lower risk, promote transparency and protect the American public, federal regulators last week advanced the so-called Volcker Rule, which is part of the larger Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Volcker Rule, which was originally proposed by U.S. economist and former Federal Reserve Chairman Paul Volcker, prohibits a bank or institution that owns a bank from engaging in proprietary trading that isn’t at the behest of its clients, and from owning or investing in a hedge fund or private equity fund. It also limits the liabilities that the largest banks can hold (see NGI, Oct. 11, 2010).

Last Wednesday the Securities and Exchange Commission (SEC) — by a unanimous vote — advanced the Volcker Rule, one day after the Federal Deposit Insurance Corp. (FDIC) added to the rule’s momentum by requesting public comment on implementation.

However, the path forward for the specific rule is anything but smooth as no less than five regulators — the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission (CFTC), the Federal Reserve Board, the SEC and the FDIC — must weigh in.

Calling the rule “one of the most challenging financial regulatory provisions ever written,” PwC analysts Gary Meltzer and Dan Ryan said the rule deals with highly technical complex legal matters crossing banking, capital markets and investment management rules.

“The proposal has been anxiously awaited because it is the type of legislation where a definition or phrase interpreted one way or the other can have significant impact,” Meltzer and Ryan wrote in a research note. “While on its own [the Volcker Rule] would be a worthy study for Talmudic scholars, complicate this with five agencies having to write the rules and you have geometric expansion of complexity.”

According to Meltzer and Ryan, provisions in Dodd-Frank stipulate that the three banking agencies, the SEC and CFTC are to consult and coordinate with each other to ensure consistent application and interpretation of the rules they issue. The three banking agencies are to issue their rules jointly.

Specifically, the Volcker Rule would prohibit insured depository institutions, bank holding companies and their subsidiaries or affiliates (banking entities) from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for a banking entity’s own account, subject to certain exemptions. It also prohibits the owning or sponsoring of a hedge fund or private equity fund, subject to certain exemptions.

The FDIC noted that the rule also prohibits banking entities from entering into any transaction or engaging in any activity that would:

The proposal, which will be issued jointly with the Federal Reserve Board, the Office of the Comptroller of the Currency and the SEC, clarifies the scope of the Act’s prohibitions and, consistent with statutory authority, provides certain exemptions to these prohibitions. The FDIC said it anticipates that the CFTC will issue a comparable proposal in the near future.

“We have a number of rules that we’ll be voting on in the upcoming months,” a CFTC spokesman told NGI. “The Volcker Rule is one of them, but we have a number of rules and packages on our plate, which are probably ahead of that.”

The proposed rule would require banking entities to establish an internal compliance program that is designed to ensure and monitor compliance with the statute’s prohibitions and restrictions, and implementing regulations. The internal compliance program would be subject to oversight by the banking entity’s board of directors and appropriate federal supervisory agency, the FDIC said. The proposal also requires banking entities with significant trading operations to report to the appropriate federal supervisory agency certain quantitative measurements designed to assist the federal supervisory agencies and banking entities in identifying prohibited proprietary trading in the context of exempt activities.

Of note, transactions in certain instruments, including obligations of the U.S. government or a U.S. government agency, the government-sponsored enterprises, and state and local governments, are exempt from the statute’s prohibitions. Activities exempted include market making, underwriting and risk-mitigating hedging. The statute also permits banking entities to organize and offer a hedge fund or private equity fund subject to a number of conditions, including permitted de minimis investments in such funds subject to limitations.

The proposed rule also includes regulatory commentary intended to assist banking entities in distinguishing permitted market making-related activities from prohibited proprietary trading activities. It also includes a number of elements intended to reduce the burden of the proposal on smaller, less-complex banking entities.

The FDIC said comments on the proposal will be received through Jan. 13.

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