Your daily source for regulatory news, analysis, and opinion

Implementing the Volcker Rule’s Backstop Provisions

Following the last financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which defines and limits the activities of certain financial firms. The Act’s goal is to reduce the likelihood of the financial markets collapsing, often referred to as systemic risk. To further that goal, Congress called for a rule banning proprietary trading by commercial banks. In response, federal agencies passed the Volcker Rule, which bans commercial banks from participating in speculative trading, and limits the business relationships commercial banks can have with hedge funds and private equity firms.

ThinkstockPhotos-495812922The majority of activities prohibited by the Volcker Rule are explained through specific, detail-oriented tests. However, according to a recent article by two associates at the law firm Davis Polk & Wardell, the Volcker Rule has two, often-overlooked, catchall provisions that create uncertainty for market participants and regulators alike.

The authors, Jai Massari and Gabriel Rosenberg, claim that the Volcker Rule’s use of both specific and broad provisions may actually inhibit regulators’ ability to enforce the rule effectively and create uncertainty for market participants. They argue that using broad, catchall language as a backdrop to specific provisions robs regulators of needed flexibility, increases the likelihood of legal challenges to the rules, and creates the potential for a rocky relationship between regulators and industry participants. Despite their criticisms, Massari and Rosenberg propose ways for regulators to use the catchall provisions in a way that minimizes their potential negative effects.

According to Massari and Rosenberg, Dodd-Frank merely provides a broad mandate to regulate systemic risks, and crafting specific rules to implement this mandate is a difficult task. The authors describe two approaches taken by regulators in enacting the specifics of Dodd-Frank: a descriptive approach and a prescriptive approach. The descriptive approach re-states the overarching broad mandate and uses a qualitative process to determine which institutions or activities pose systemic risk. The prescriptive approach uses “detailed, specific, and data-driven rules” to identify clearly firms and activities that create systemic risk. In other words, a descriptive approach uses broad language and allows regulators tremendous flexibility in application, while the prescriptive approach sets out specific, measurable guidelines explaining which activities are prohibited.

The authors recognize that each approach has its costs and benefits. The descriptive approach provides flexibility to regulators, but creates uncertainty for market participants, who do not always know ahead of time which activities are prohibited. On the other hand, the prescriptive approach provides certainty to market participants, but does not give regulators flexibility to reign in left out or newly emerged risks. Massari and Rosenberg argue the Volker Rule splits the difference, layering descriptive regulations on top of prescriptive rules. They contend that although this approach would seem to take advantage of the strengths of each, it actually accentuates the defects of both.

According to Massari and Rosenberg, the descriptive layer of the Volcker Rule supplements the prescriptive rules laid out in 882 pages of text, by adding 10 pages that the authors consider to be the Volcker Rule’s “backstop” provisions. The provisions add that even if an activity would be permitted under the other terms of the Volcker Rule exemptions, it “is nonetheless prohibited if it would ‘result, directly or indirectly, in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.’”

Massari and Rosenberg argue that this descriptive layer actually makes the Volcker Rule more susceptible to legal challenges on the grounds that the rule is too vague. A statute that places an entity’s property at risk without clearly explaining the forbidden activities can be invalidated as unconstitutionally vague. Although the Volcker Rule has yet to come under such an attack, other provisions of Dodd-Frank that were enacted in a descriptive manner have been challenged as unconstitutionally vague.

Additionally, Massari and Rosenberg contend that the combination does not provide the advantage of flexibility typical of descriptive rules. For example, some banking activities were accidently covered by Volcker Rule’s prescriptive provisions. However, because the descriptive provisions can only be used as an additional enforcement mechanism, regulators cannot use the provisions to allow the inadvertently prohibited activities.

Finally, Massari and Rosenberg argue that the backstop of the Volcker Rule has the potential to chill the relationship between regulators and market participants because the industry views the descriptive provisions as a way to impose after-the-fact liability for activities that market participants did not know were prohibited.

To mitigate the shortcomings of the Volcker Rule’s combined proscriptive and descriptive approach, Massari and Rosenberg propose that regulators apply the backstop provisions in only a prospective manner. Additionally, they urge regulators, as they gain a greater understanding of the market realities, to give more nuanced and detailed guidance about the ways in which the backstop will be used in practice. Even though Massari and Rosenberg argue that the backstop provisions of the Volcker Rule are not ideal, they propose ways to use it as an effective regulatory mechanism.

Tagged: , , ,