The Volcker Rule: A User's Manual

MacroAndCheese's picture


The Volcker Rule, named for the former Chairman of the Federal Reserve credited with taming inflation in the early 1980s, is a specific section of the Dodd-Frank Act that was signed into law on July 21, 2010.  Although the Dodd-Frank Act is now law, the Volcker Rule is not slated to be implemented until July 21, 2012, on the two-year anniversary of the original bill.
This entry provides a brief overview of the Volcker Rule and its key statutes, including what entities are impacted, which bank trading activities will be prohibited, the measures that will be required for compliance, and the implementation timeline.   This explanation frequently references the original document itself, with specific citations sourced with the relevant page(s) provided in parentheses.  The original document can be found here:



What is the Volcker Rule?


The Volcker Rule (“VR”) is an addendum to the “Dodd-Frank Wall Street Reform and Consumer Protection Act.”  The VR runs 298 pages.  Its intent is to prohibit commercial banks from engaging in “proprietary trading” according to a limited, prescribed definition (see below).  The VR does not prohibit banks from trading altogether, although it will require banks to document all trades that are not “exempted,” and to demonstrate that these trades follow procedures as mandated.  The VR will be overseen by five separate government entities, including the Federal Reserve, SEC, CFTC, FDIC, and OCC (Office of the Comptroller of the Currency.)



What is the Dodd-Frank Act?


The Dodd-Frank Act (“DFA”) was enacted to carry out financial reform measures in response to the financial crisis and recession of 2007-2009.  The intent of the bill was to reform the financial system, including some consolidation of regulatory agencies, consumer protection measures, broader supervision of the financial system by the Federal Reserve, and increased supervision of hedge funds.  The Volcker Rule was added to the DFA at the request of President Barrack Obama.



What institutions are affected by the VR?


All banking institutions in the United States and their affiliates, including overseas bank branches, would be bound by the VR.  In addition, the VR would cover all foreign banks maintaining operations in the United States.  Non-bank financial institutions such as hedge funds or insurance companies would not be affected.  Brokerages and investment banks would also not be subject to the VR, although the largest of the investment banks such as Goldman Sachs and Morgan Stanley agreed to become banking institutions during the financial crisis and would now be covered.



What is the VR definition of “proprietary trading?”


The VR definition is as follows:


“Proprietary trading means engaging as principal for the trading account of the covered banking entity in any purchase or sale of one or more covered financial positions.  Proprietary trading does not include acting solely as agent, broker, or custodian for an affiliated third party.” (p. 390)


The VR goes on to provide a specific definition of “trading account,” namely an account that trades for “short-term resale; benefitting from…short-term price movements; realizing short-term arbitrage profits; and hedging…positions.”  The VR adds that positions held for 60 days or less will be generally deemed to be “trading” positions.  This definition effectively allows banks to maintain “investment accounts” for longer-term investments.  However, the VR permits regulators to designate any account as a “trading account” as they see fit.


The VR also defines “covered position” in a very specific manner, namely “(A) a security, including an option on a security; (B) a derivative, including an option on a derivative; (C) a contract of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.”  The definition specifies that loans, commodities, and foreign exchange are excluded from the VR (p. 394). 



What activities are not “covered financial positions” and are therefore acceptable?


In addition to loan, commodity, and foreign exchange transactions, the VR also permits trading in government securities (including agencies, securities issued by individual states and cities, etc.), underwriting and market-making provided the transactions are affiliated with specific customer needs, and any trade in which the bank is acting as agent (broker) rather than as principal.



Does the VR impose other restrictions besides proprietary trading?


Yes, under the VR, US banks will not be allowed to own interests in hedge funds exceeding 3% of the total value of the equity, and will not be allowed to sponsor hedge or private equity funds.


The VR also prohibits transactions that represent a material conflict of interest between the bank and its clients, bank exposure to high-risk assets or trading strategies, or activities that jeopardize the “safety and soundness of the covered banking entity,” or the “financial stability of the United States.” (p.411)  None of backstop restrictions are defined in detail and are subject to the judgment of federal banking agencies.



How will banks comply with the VR?


Banks will be responsible for monitoring of and compliance with the VR.  As stated in the VR, the banks’ “written policies and procedures must clearly articulate and document a comprehensive explanation of how the mission and strategy of each trading unit, and its related risk levels, comply with this part.” (p. 487)  Additionally, banks are required to identify which activities are “covered,” and if so, to document in detail how covered transactions are being properly managed and monitored in accordance with the VR.



Why is compliance with the VR considered to be complicated?


Applying the VR in many cases is straightforward.  It will be possible for banks to trade US treasury bonds for their own account, for example, but not securities such as stocks or stock options.  However, due to the complexity of financial instruments and to the comprehensive nature of bank market-making activity, compliance will be challenging.


To distinguish market-making from proprietary trading, for example, regulators will apply five specific factors in making their determination.  These factors are:


  1. Risk-Management
  2. Source-of-Revenues
  3. Revenue Relative to Risk
  4. Customer-Facing Activity
  5. Payment of Fees, Commissions, and Spreads


The definitions and descriptions run 14 pages of the VR (pp. 450-464).  The application of these factors is quantitative in nature and requires extensive measurement and record-keeping on an ongoing basis.  Since regulators will be applying these rules to banking activities, the banks themselves will of course need to make their determination in the same manner.



What are the compliance measures to be implemented by banks?


As detailed in Appendix C of the VR, a minimal bank compliance program “requires that banking entities establish, maintain, and enforce an effective compliance program, consisting of written policies and procedures, internal controls, a management framework, independent testing, training, and recordkeeping.” (p.479)  Appendix C lays out in considerable detail what will be required and runs 23 pages, from pp. 479-502.  The VR holds senior and intermediate management accountable for the effective implementation of the program, and requires that the bank’s board of directors and CEO review the program for efficacy.



What is the VR timeline?


As mentioned, the VR implementation date is July 21, 2012.  Banks will be required to implement a full compliance program capable of monitoring all banking activities by that date.  However, there will be a two-year conformance period by which banks will be expected to bring their activities within compliance.  In other words, banks will have a two-year grace period during which they can bring their operations to conformity.  In addition, at the discretion of the Federal Reserve, individual banks may be granted three one-year extensions beyond the initial grace period.  Full implementation by all banks much be achieved by July 21, 2017.

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Matt's picture

"If we switch to the gold standard, the world will follow within 12 months" hmm, the last time things went from Fractional Reserve back to a proper gold standard, it only took what, two years to destroy all the banks and create a depression? (Andrew Jackson, 1836-37 I believe).

 Let's hope that if Ron Paul does manage to become President and create a gold standard, he figures out a form of implementation that doesn't cause a massive collapse.

billsbest's picture

<a href="">Ron Paul Says "Nein!" to a Lew Lehrman International Gold Standard!</a>

Everybodys All American's picture

Goldman and Morgan Stanley are not bank holding co's in reality and will just go back to being investment banks as they should to avoid the Volcker Rule. Wait and see.

Further,if they really want fix the problems with banks then break all of these banks into smaller regional banks much as AT&T was broken apart when they were a monopoly. That will go a long way to managing this insanity. OF course Obama will not do it because he has Eric Holder for attorney general who may as well be a fatboy.

Hey, I may have just come up with a great idea. Political fatboys. What kid wouldn't want an Eric Holder or Nancy Pelosi fatboy in their bedroom? </sarcoff>

MacroAndCheese's picture

Amen, break 'em up or make 'em pay insurance.  But prop trading?  Fuggedaboutit.  Useless, expensive distraction.

williambanzai7's picture

I guess we can fantasize, but in the end we are going to have to wait for the big kahuna to hit.

williambanzai7's picture

They can't have their cake and eat it too...but that won't stop them from trying? All those healthy European Banks that were supposed to beat them into the ground with global competition seem to be doing really spectacular.

11b40's picture

...and don't forget the Japanese bankers who were going to buy America.

williambanzai7's picture

In fairness to them, they got caught up in our hype. Now they are completely off the radar.

The biggest banks are emerging in China.

W10321303's picture

Simply put. This does not restore capitalism = Long-term investment that produces Long-term value. It does not punish the corporatists for their on-going frauds. It does not limit the size of 'entities' to a point where price discovery becomes tantamount. Increase the corporate tax rate to 50% or more and put some 'Banksters' in jail. You will see a lot more Capitalism.

Downtoolong's picture

The VR will be overseen by five separate government entities, including the Federal Reserve, SEC, CFTC, FDIC, and OCC

Yea, that's going to work out just great.


Matt's picture

298 pages for one rule, which is overseen by 5 seperate regulators? Holy Beaurucractic bloat, batman!

williambanzai7's picture

Let me give you a friendly pointer.

It's not good enough to just cut and paste SEC releases on ZH. The readers expect analysis and depth beyond the canned garbage delivered by the Pornography Commission.

Perhaps a good way to start would be to provide a summary of what the Occupy Wall Street comment letter delivered this week says.

Basically it says in so many extremely well written words that the Volcker Rule, or current mutation thereof, has been rendered a verbose watered down piece of Wall Street lobbied garbage; a magnificent loophole ridden example of regulatory capture. 


I have read many of these letters during the span of my career and I will tell you that the people who wrote this know what they are doing and talking about.

Do a google search and read the accolades.

MacroAndCheese's picture

Sorry William but you and your friends at Occupy the SEC don't know what you're talking about.  In fact they get it wrong right up front, on page 3, in their very first sentence:

"Proprietary trading by large-scale banks was a principal cause of the recent financial crisis, and, if left unchecked, it has

 the potential to cause even worse crises in the future, "  They go on to finger CDOs "and other instruments" that were "at the heart of the financial crisis."

By the Volcker Rule definition of proprietary trading--and by virtually anyone's who has actually, like, worked on Wall Street--CDOs, CLOs, and all the other CxOs have nothing to do with proprietary trading.  Certainly the Volcker Rule does not prohibit the trading of CDOs etc.

No bank prop desk would be caught dead with that stuff, it's all far too illiquid.  In fact the Volcker Rule draws a line at 60 days in terms of what defines a prop holding period, and good luck holding that stuff for less even in good times.

It's obvious to anyone from the Street that all the nuclear waste was created miles away from proprietary trading desks.  That's why I wrote this post, William, so people like you can know what you're talking about to avoid red herring arguments and address the real issue, which is the Volcker Rule does nothing to protect us from the next financial calamity.

Maybe I can offer you a little friendly advice:  Stop gluing human heads onto apes and learn about what you're bashing, so that at least you're bashing it for the right reasons.




williambanzai7's picture

As a securities lawyer, my first inclination, before writing a piece on it would be to analyze it to death. Frankly, I am happy to have put that life behind me and I decided early last week to spare myself the exercise. But I continue to appreciate analytics to recitation.  I don't mean to be snooty, but I really don't think we should be toeing the Wall Street party line on these matters.

As for the bashing, I know enough to know a piece of regulatory swiss cheese and convoluted obfuscation when I see it. That is the basic design parameter of Barney Frank's magnum opus and the Volcker Rule.

I have a better idea. Lets chuck the rule and break up the TBTF banks so we don't have to worry about it. Afterall the VR and derivatives regulation were supposed to placate the break-up the TBTF banks crowd, who in the end somehow wound up getting pickpocketed. 

As for my friends at Occupy Wall Street, I would say at a minimum that piece of work goes a very long way towards refuting those who say they all know nothing about Wall Street except how to defecate on cruisers. Evidently, they know how to assiduously defecate in rule making proceedings as well.

Lastly, I have zero confidence that this quagmire will be competently enforced.


11b40's picture

Thank you, WB7.  I just posted the link to this in the comments section of Chris Whalen's latest contribution (?).

OWS has been relatively quiet lately, but not in hibernation.  Just wait until the weather warms up.  It will be a long, hot summer....and for all the mainstream critics who have tried so desparately to put down the movement with their disparaging remarks about lack of focus and not knowing what their goals were, I suggest they stay tuned and learn.

Last fall was only a warm up to the main event, which I predict will occur Labor Day at the BAC corporate headquarters in Charlotte...about 3 blocks from the Democratic National Convention.  Do you remember Chicago in the summer of '67?

williambanzai7's picture

I know what's been simmering. I ignore all the punditry about what OWS is and is not. They are fixated with trying to classify and define. Those who think the collective public disgust that is at the core was a passing fad are in for a rude awakening.

MacroAndCheese's picture

Amen on that.  It's all about TBTF.  Prop trading is a side show and great for sound-bite quick cures.  JPM, BAC, C are $2 trillion.  We have no investment banks, they've been legislated out of existence.  The Volcker Rule is an annoying, expensive, idiotic distraction written by politicians more interested in sound bites than our future.

williambanzai7's picture

What irritates me the most is how they have collectively mastered the regulatory bait and switch and misdirection technique. It is much easier to get what they want in a back room. Hence all those deferred decisions and blue ribbon studies.

They complain about too much government and then they devise rules that require armies of revolving door fools to unenforce them.

Whatever happened to the bright red line.

falak pema's picture

...Whatever happened to the bright red line...

They forgot it in Iraq, or in Afghanistan, or in Vietnam or in Korea on 38 th parallel. In fact the red line was last used in Korea. After that there were no red lines and misdirection from Tonkin onwards became party line. Tovarich!

Regulatory capture and institutional bypass. Even legal trespass. Finally, macabre farce of TSA, Guantanamolese-NDAA. Now dodge the bullet of criminal chase. Use Apache techniques to wipe all trace.

The financialese will appear to repeal G-S repeal. All the while the printalese will unveil the real biflationese.

What the system needs is more flexilese and maximum forgetsquidimpeachalese. The Volcker symphony release is scheduled for July.

williambanzai7's picture

Are you with the SEC, the FDIC or the BDSM ;-)

falak pema's picture

I think I'll apply for the creation of a new bureaucracy; asswipealese : the only way to clean out the debt without losing your cool or your jewels. 

I'll make a fortune with TPTB.