Comment Text:
DEPARTMENT OF THE TREASURY February 13, 2012
Office of the Comptroller of the Currency
12 CFR Part 44
Docket No. OCC-2011-0014
RIN: 1557-AD44
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
12 CFR Part 248
Docket No. R-1432
RIN: 7100-AD82
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 351
RIN: 3064-AD85
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 255
Release No. 34-65545; File No. S7-41-11
RIN: 3235-AL07
COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 75
RIN: 3038-AD05
Subject: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds.
This letter sets out my comments on your proposed rules implementing the portion of the Dodd-Frank legislation restricting proprietary trading and investment in hedge and equity funds by U.S. banking organizations. I have attached a more lengthy statement reviewing the policy considerations compelling the legislation and dealing with concerns about the impact on markets and competition, points that are sometimes lost amid the intense lobbying efforts on detailed implementation.
I cannot help but be impressed by the success the regulatory agencies so far in reaching agreement on the preliminary rule and by your confidence that the regulation can and will be successfully implemented. I am also certain that simplicity and clarity are challenging objectives, which for full success, require constructive participation by the banking industry. As I have suggested elsewhere, there should be a common interest in an approach that, to the extent feasible, is consistent with the banks’ broader internal controls and reporting systems.
My sense is that success is strongly dependent on achieving a full understanding by the most senior members of the bank’s management, certainly including the CEO, and the Board of Directors, of the philosophy and purpose of the regulation. As the rules become effective, periodic review by the relevant supervisor with the Boards and top management will certainly be appropriate, as a key part of the usual examinations process or otherwise.
The necessary understanding should be reflected in both the culture of the bank and in the written internal controls applicable to trading activities and to relations with hedge and equity funds that have an element of bank sponsorship and investment. Obviously, those controls must be consistent with the specifics of the regulation restricting proprietary trading.
At the other end of the process is the need for a set of “metrics” designed to reveal evidence of deliberately concealed and recurring proprietary trading. I know much effort has been made in that area. While I am not familiar with all the details, I do emphasize its importance.
I understand that such measures as trading volume, and its relation to size of the trading “book”, the volatility of earnings from trading, the extent to which those earnings are generated by pricing spreads rather than changes in price, the origination of trades (i.e. from customer initiative) and the close alignment of “hedging” transactions with the composition of the trading positions will be essential tools for supervisors and management to monitor the trading activities of firms.
To the degree those metrics can be made consistent with the banks’ internal reporting and control systems, both management control and simplicity will be greatly facilitated.
I realize that between those two requirements – management commitment and ex-post measurement of performance – lies the thorny issue of guidance with respect to defining the character of “market making” for customers. Clearly, we know what it does not mean. Holding substantial securities in a trading book for an extended period obviously assumes the character of a proprietary position, particularly if not specifically hedged. Various arbitrage strategies, esoteric derivatives, and structured products will need particular attention, and to the extent that firms continue to engage in complex activities at the demand of customers, regulators may need complex tools to monitor them. There may well be occasions when a customer oriented purchase and subsequent sale extending over days cannot be more quickly executed or hedged. But substantial holdings of that character should be relatively rare, and limited to less liquid markets. Flagrant, intentional violation of the general restrictions should be evident from review of well designed metrics and “ad hoc” examinations (and should, of course, also be identified by a bank’s internal controls).
My understanding is that only a very few very large banking organizations engage in continuous “market making” on any significant scale. Clearly, it is those institutions that will require the attention of the regulatory authorities. I also understand that the lawful restrictions do extend to all banking organizations, including community and regional banks normally inactive. The management of those institutions must understand the nature of the restrictions. However, consistent with effectively administering the law, oversight and reporting of those institutions may be less intrusive than that appropriate for active trading operations. For small banks, infrequent transactions with customers who may not have easy access to fluid public markets may at time lead to rather longer holding periods – subject to the review of the customer relationship and relevant record keeping. More generally, when or if there is demonstrably clear understanding and enforcement by management of the principles, detailed rules may be less necessary and oversight less intensive.
I need not add that I continue to follow with interest your efforts to assure meaningful and effective execution of the law and fidelity to the important considerations of public policy that the law is intended to enforce.
Paul A. Volcker
