Recent revisions to the Volcker Rule will bring significant changes to existing legislation that will affect how banking institutions can engage in the private markets. Originally part of the 2010 Dodd-Frank Act, these updates will allow banks to have greater involvement with certain types of private market funds, particularly VC and private debt. To help you understand more about the subject, we’ve compiled some frequently asked questions on the history and implications of the Volcker Rule.
What is the Volcker Rule?
The Volcker Rule is a specific portion of the Dodd-Frank Wall Street Reform and Consumer Protection Act (often simplified as the Dodd-Frank Act) that was intended to reduce risks to taxpayers and the world economy. The goal was to prevent banks from engaging in several risky behaviors that helped lead to the Global Financial Crisis (GFC).
Key elements of the Volcker Rule:
- Banks were prohibited from engaging in proprietary trading
- Banks were prohibited from owning or investing in a hedge fund or private equity fund
- The rule limited the liabilities that the largest banks could hold
What is proprietary trading?
Proprietary trading, or prop trading for short, is when a firm or bank uses its own money to invest in securities instead of using a client’s money. Often, banks will invest on behalf of their clients, earning money on fees or commissions, but returning most of the profits to the client. When a bank engages in prop trading it uses its own money—and therefore stands to reap all of the profits or losses—which makes it riskier for the bank and those whose deposits support the bank.
How did the Volcker Rule affect banks’ involvement in hedge funds and private equity?
A key aspect of the original language in the Volcker Rule was to regulate banks’ exposure to so-called “covered funds,” defined broadly in the rule as “hedge funds and private equity funds.”The rule limited how much banks could invest in private equity, allowing for a maximum of 3% of their Tier 1 capital (considered core capital, or the primary source of funding for a bank). To put that in perspective, Goldman Sachs’ private equity assets represented 19% of its Tier 1 capital at the end of 2012, which was before the rules implementing the Dodd-Frank legislation were in place.
As originally implemented, “covered fund” included a variety of private market fund strategies beyond what PitchBook (and many other industry professionals) would define as “Private Equity,” including VC and private debt funds.
What is the historical context for the Volcker Rule?
A recent timeline of major events related to the Volcker Rule
The Financial Services Modernization Act of 1999 was passed, repealing the Glass-Steagall Act
Global Financial Crisis started
US Federal Reserve Chairman Paul Volcker proposed federally insured banks be banned from many forms of short-term trading
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed
The Volcker Rule is housed in a new section 13
of the Bank Holding Company Act of 1956
Rule changes begin to take effect
The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) is passed, limiting compliance requirements for smaller banks
Additional amendments built off of EGRRCPA are implemented
The SEC issued a proposal for additional changes to the Volcker Rule
The SEC announced that new amendments would be adopted
2020 (October 1)
The final rule takes effect, lifting certain restrictions on how banks can invest in the private markets
In 1933, following the Wall Street Crash of 1929 and subsequent bank runs, the Glass-Steagall Act
was passed to separate commercial and investment banking. In addition to changing how banks could be structured, the new laws sought to limit how banks could use depositors’ money.
Sixty-six years later, The Financial Services Modernization Act of 1999 (also known as the Gramm-Leach-Bliley Act) was passed, repealing the long-standing Glass-Steagall Act. This change ushered forth widespread consolidation across the financial industry, resulting in fewer banks controlling greater assets.
In 2007, risky trading practices and a collapse in the United States housing bubble led to the Global Financial Crisis. Afterward, sentiment swung back in favor of separating traditional banking from relatively riskier types of trading or investing. In the wake of the GFC, the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted, one section of which included the Volcker Rule.
Why is the Volcker Rule in effect?
The Volcker Rule was made to place additional guardrails around how banks seek profits, and also to limit risk. Due to the important role that banks play in the economy, lawmakers sought to safeguard against potential future financial crises by implementing new regulations.
What are the upcoming changes?
The new 2020 rule change outlines three explicit objectives related to covered funds, stating that it:
- “clarifies and simplifies compliance with the implementing regulations”
- “refines the extraterritorial application of section 13 of the BHC Act”
- “permits additional fund activities that do not present the risk section 13 was intended to address”
In other words, these changes are said to make it easier for banks to comply with the Dodd-Frank Act regulations while enabling them to engage in types of investing that were previously prohibited but weren’t intended to be.
When will the changes take effect?
The SEC announced in June 2020 that new amendments would be adopted, with the final rule taking effect October 1, 2020.
For more complex analysis on the implications of planned modifications to the Volcker Rule, download the analyst note.