The Dodd-Frank Wall Street Reform and Consumer Protection Act still includes a watered-down version of the Volcker Rule and the Lincoln Amendment, both of which seek to limit deposit-taking banks’ engagement in riskier activities, often involving derivatives, such as proprietary trading and swap dealing.

(Click here for the complete text of the Act. Section 619 starts on page 660, Section 716 on page 734.)

The Volcker Rule, originally formulated by former Federal Reserve chairman Paul Volcker last year, is the idea that deposit-taking banks should be forbidden from proprietary trading, or investing in hedge funds or private equity funds.

In the form in which it appears in Section 619 of this Act, the Rule is expressed in an extremely convoluted way over 30 pages, with many exceptions and exceptions to exceptions. It is likely to take a long time before lawyers and regulators arrive at a working understanding of how the prohibition will operate.

However, some key points are:

- Banks will be forbidden from proprietary trading in any securities or derivatives or having any ownership in hedge funds or private equity funds, except for the exceptions in the Act

- Non-bank financial companies supervised by the Federal Reserve Board will bear higher capital requirements for such activities, except for the exceptions in the Act

- The Financial Stability Oversight Council will have six months to “study and make recommendations on implementing the provisions of this section”

- After that the federal banking agencies, SEC and CFTC will have nine months to “consider the findings of the study... and adopt rules to carry out this section”

- Those regulators must make the rules in a coordinated way, but each will make rules for the entities it regulates

- The section will come into effect not later than one year after the rules are adopted or two years after the Act is enacted, whichever is earlier

- After the section becomes effective, banks and finance companies will have a further two years to comply

- Further extensions may be granted on application if the bank is bound by contract

- The banking agencies, SEC and CFTC will set higher capital rules and quantitative limits for these investments, if they deem it necessary. The Act does not set these higher capital rules in detail

- The following activities are permitted (in other words, are exceptions to the general prohibition) as long as they are otherwise legal and do not breach any restriction set by regulators:

a) trading in US Treasury and federal agency bonds, including those of Ginnie Mae, Fannie Mae and Freddie Mac, and of state and municipal bonds

b) trading of any security or instrument “in connection with underwriting or marketing-making-related activities, to the extent that any such activities... are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties”

c) “risk-mitigating hedging activities” designed to reduce the bank’s risk

d) trading on behalf of customers

e) investments in companies under the Small Business Investment Act and various other specific exemptions

f) trading by an insurance company for its general account

g) “organizing and offering a private equity or hedge fund, including serving as a general partner”, as long as the bank provides trust, fiduciary or investment advisory services to the fund, it is offered to the bank’s customers, the bank keeps only a ‘de minimis’ share of the equity, it does not guarantee the fund’s performance, it does not let the fund use its name, only bank employees directly involved in serving the fund can invest in it

h) other activities that the regulators decide would “promote the safety and soundness of the banking entity”

i) selling and securitising loans

- Banks can invest in private equity and hedge funds they have organised to start them off, but must within one year reduce their holding to the ‘de minimis’ level of no more than 3% of the fund’s equity. All a bank’s investments of this kind put together must not exceed 3% of its Tier 1 capital. All such investments will be deducted from capital for capital adequacy purposes “and the amount of the deduction shall increase commensurate with the leverage” of the fund.

- The following activities are forbidden, despite the above exceptions

a) things that would cause a “material conflict of interest” (to be defined by the regulators when they make the rules) between the bank and its clients or counterparties

b) things that would expose the bank to “high risk” assets or trading strategies (to be defined by the regulators)

c) things that would threaten the bank’s safety and soundness or the financial stability of the US

- Banks will be allowed to act as prime brokers to their own funds, subject to certain conditions

Lincoln makes it

The Act also includes a version of the Lincoln Amendment put forward by Senator Blanche Lincoln. The original intent was to make deposit-taking banks move their swaps trading desks into separately capitalised affiliates, to ensure that they were ringfenced and could not end up absorbing any government rescue funds.

After last minute changes during the frenzied negotiations to amalgamate the Senate and House bills, a softened version of this provision is contained in Section 716 of the Act, which covers nine pages.

Much to the relief of the big banks, all swaps activity used to hedge risks for the bank can now stay within the bank. So, it appears, can swaps activity in foreign exchange and interest rate risks, as well as credit default swap activity, as long as it is cleared by a clearing house.

Again, the law is expressed in concentric spirals of references to other paragraphs, but the essence seems to be that:

- “Swaps entities” may not be bailed out with federal money, with effect from two years after the Act becomes law

- Swaps entities are dealers or major participants in swaps or security-based swaps that are registered under the Commodity Exchange Act or Securities Exchange Act

- Swaps entities does not include insured depository institutions that are major participants in swaps or security-based swaps. Presumably this means that banks are only swaps entities if they are dealers in swaps, not just major participants. So banks that are major participants in swaps may still be bailed out.

- Despite the prohibition on swaps entities being bailed out, banks can remain eligible for bailout funds if they own affiliates which are swaps entities

- Banks can also remain eligible for bailout funds if they confine their swap or security-based swap activities to these permitted activities:

a) hedging and other similar risk-mitigating activities directly related to their activities

b) dealing in or participating in swaps “involving rates or reference assets that are permissible for investment by a national bank” under the paragraph Seventh of section 5136 of the Revised Statutes of the United States. This is a long paragraph but this provision has been interpreted to mean currency and interest rate swaps are acceptable. Ironically, the original paragraph Seventh banned banks from dealing in securities or stock for its own account. It is not entirely clear what the status of equity-related swaps would be.

c) dealing in credit default swaps as long as these are cleared by a clearing house.

- Existing transactions are not prohibited, nor are those made during the transition period

- The transition period will be set by regulators, but may be up to two years, during which time the banks must divest the swaps entity, cease those activities or make the swaps entity an affiliate

- When setting the transition period, regulators will weigh the potential impact of the change on the bank’s lending and capital formation against the risks of allowing it to keep the swaps business

- If any FDIC-insured swaps entity, or any systemically important firm, becomes insolvent as a result of swaps activity, its swaps positions can be terminated or transferred, and no taxpayer funds can be used to prevent it going into receivership if the failure results from the swap activity

- Taxpayer funds will not be used to secure orderly liquidation of less important firms that get into difficulties

- Any government funds spent on winding down swaps entity will be recovered from that entity’s assets or through “assessments, including on the financial sector”

- The Financial Stability Oversight Council can, by a two thirds majority, vote to stop individual swaps entities receiving federal assistance

Jon Hay +44 207 779 8372 jhay@fow.com

Mareen Goebel +44 207 779 8358 mgoebel@fow.com