The Dodd-Frank Act was enacted on July 21, 2010 after intense debate within the investment banking industry and the political realm in Washington D.C. to address the consequences of the “Lehman Shock” and other lessons learned from the 2008 financial crisis that affected the world economy.1 One area that congress did not consider in depth during the legislative process of the Dodd-Frank Act was the effect the act would have on foreign banking organizations. However, with the global economy evermore integrated today, any regulation or change to the financial system in the U.S. would have transnational implications. Hence, there are several provisions, most notably, the Volcker Rule that have extraterritorial consequences in the Dodd-Frank Act that foreign banks should consider.
This rule was named after the former Federal Reserve Chairman Paul Volcker, who promoted the rule to reduce the risk created by financial institutions taking on risk as a principal investor. This rule applies to all financial institutions. Regarding the overview of the rule, the proposed interagency rules issued in October of 2011 are very complex and have raised many questions.2 The proposal received over 17,000 comments, including extensive comments from foreign banks, their trade associations, and foreign governments. The basic prohibitions, which are subject to exceptions, apply to banking entities. It does not allow proprietary trading or investing in covered hedge funds and private equity funds for banking entities. A “banking entity” consists of U.S. banks, bank holding companies including foreign banks with U.S. bank subsidiaries, foreign banks with U.S. branches, and any affiliate of these entities, including insurance and securities affiliates of foreign banks.3 Banking entities functioning solely in trust or fiduciary capacity such as trading or investing as trustee on behalf of trust customers are exempt from this rule.
On the prohibition of proprietary trading, the Volcker Rule prohibits taking positions as principal in trading account in securities, derivatives, futures, options or any other security or financial instrument as provided by rule. Moreover, trading account used to hold positions for short-term resale, benefiting from short term price movements, or realize short-term arbitrage profits are not allowed in the Volcker Rule.4 This prohibition is not based on the type of instrument however: the financial instrument can be held, as long as it is not held for proprietary trading. Permissible financial positions in a trading account include loans, commodities, foreign exchange (but not foreign exchange forwards, which are treated as derivatives), U.S. government and U.S. government agency securities, and investment in small business investment companies. In the current proposal, there is no comparable exemption for sovereign debt of other countries and this is a huge issue criticized by foreign governments and banks.5) This is an example that when the Dodd-Frank Act was legislated, it did not consider in depth, the foreign or global consequences of the Act.
Permissible transactions in the Volcker Rule include transactions as agent for customers, underwriting or market-making activities, and risk mitigating hedging activities. All these permissible activity’s burden is on the bank to show compliance with exemptions. For Foreign banks, trade executed “wholly outside” the U.S. is exempt.6 In order to meet the conditions, the foreign bank must conduct the majority of its business and banking activities outside the U.S. and must not be controlled by a banking entity organized under U.S. law. Also, the counterparty to the trade cannot be a U.S. resident and no personnel directly involved in the trade should be located in the U.S. Moreover the transaction must be executed “wholly outside” the U.S. while the entity conducting the trade must be in compliance with currently applicable foreign bank regulations for its activities. For foreign banks, the concerns of the Volcker Rule should be that the prohibition does apply to U.S. branches and agencies, U.S. bank subsidiaries and U.S affiliates of the foreign bank.7 The use of U.S. facilities to execute trade may also take the exemption away since exchanges in the U.S are not permitted. This means that the foreign bank’s U.S. offices or affiliates cannot be involved in transactions as a broker or intermediary to facilitate the trade. The exemption for foreign banks is also conditional on adherence by the banks with certain safety and soundness standards, called “Prudential Backstops.”
Overall, these newly proposed regulations would create many burdens for foreign banks. The requirements include liquidity requirements, debt-to-equity ceiling, early remediation provisions, stress testing requirements, risk management requirements, intermediate holding companies for large scale U.S. operations etc. that was not explained in depth in this article. It will take close cooperation and integration of governance of the banks worldwide to successfully implement the new provisions in the Dodd-Frank Act.
David Skeel, The new financial deal: understanding the Dodd-Frank Act and its (unintended) consequences 58 (John Wiley & Sons, 2010). ↩
Chen Zhou, Are banks too big to fail? Measuring systemic importance of financial institutions, 6 Int’l J. Cent. Bank 229, 231 (2010). ↩
Charles K. Whitehead, The Volcker Rule and Evolving Financial Markets., 1 Harv. Bus. L. Rev. 11-19 (2011). ↩
Matthew Richardson, Roy Smith, and Ingo Walter, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance 191 (John Wiley & Sons, 2010). ↩
Charles K. Whitehead, The Volcker Rule and Evolving Financial Markets, 1 Harv. Bus. L. R. 39, 51, 71–73 (2011 ↩
Id. at 15 ↩