The “Volcker Rule”: Proposals to Limit “Speculative” Proprietary Trading by Banks
Released: 2010-06-30T00:00:00

Introduction

In 1933, during the first 100 days of President Franklin D. Roosevelt's New Deal, the Securities Act of 1933 and the Glass-Steagall Act (GSA) were enacted, setting up a pervasive regulatory scheme for the public offering of securities and generally prohibiting commercial banks from underwriting and dealing in those securities. GSA prohibited affiliations between banks (which, for the purposes of this report, means bank-chartered depository institutions, that is, financial institutions that hold federally insured consumer deposits) and securities firms (which are commonly referred to as "investment banks" even though they are not technically banks and do not hold federally insured consumer deposits); further restrictions on bank affiliations with non-banking firms were enacted in Bank Holding Company Act of 1956 (BHCA) and its subsequent amendments, eliminating the possibility that companies owning banks would be permitted to take ownership or controlling interest in insurance companies, manufacturing companies, real estate companies, securities firms, or any other non-banking company. As a result, distinct regulatory systems developed in the United States for regulating banks, on the one hand, and securities firms on the other.

Banks are institutions of limited power; they may only engage in the activities permissible pursuant to their charter, which generally limits them to the "business of banking" and all powers incidental to the business of banking. Included in these activities restrictions are certain limitations on their ability to engage in proprietary trading, that is, investing as principal, rather than at the behest or for the benefit of customers, for the bank's own account. In addition to activity restrictions, banks are subject to capital standards, affiliation restrictions, management interlocking restrictions, and many other standards; they are subject to regular examinations to ensure they are being well-managed, conducting business in a safe and sound fashion, and complying with numerous consumer protection and other laws; and federal banking regulators have a full range of strong and flexible enforcement tools, such as prompt corrective action powers, to rectify problems that are found during examinations.

One of the benefits of being a bank, and thus being subjected to heavy, expensive regulation, is access to what is referred to as the "federal safety net," which includes the Federal Deposit Insurance Corporation's (FDIC's) deposit insurance, the Federal Reserve's discount window lending facility, and the Federal Reserve's payment system.

The regulation and oversight of securities firms are very different from that of banks. Securities firms may be primarily regulated by the Securities and Exchange Commission (SEC) at the federal level, or they may not be regulated directly at the federal level at all, which often is the case for hedge funds, private equity firms, and special purpose vehicles (SPVs). Rather than regulating for safety and soundness, the SEC's regulatory regime is predominately built around registration, disclosure of risk, and the prevention and prosecution of insider trading and other forms of fraud. SEC-regulated firms generally are not subject to capital and liquidity standards or to regular safety and soundness examinations. And aside from a general prohibition on accepting federally insured consumer deposits, securities firms generally are not subject to activity restrictions, as are banks. As a result, these institutions generally do not have access to the federal safety net.

While there are two distinct regulatory systems, the distinguishing lines between the traditional activities engaged in by commercial and investment banks became increasingly difficult to discern as a result of competition, financial innovation, and technological advances in combination with permissive agency and judicial interpretation. Beginning in the late 1970s, the Board of Governors of the Federal Reserve System (FRB), as the primary regulator for bank holding companies (BHCs), and the Office of the Comptroller of the Currency (OCC), as the primary regulator for national banks, issued a series of regulations and orders, liberally interpreting the limitations imposed on the activities of commercial banks through laws such as the GSA and the BHCA. The result was the incremental expansion of the types and levels of securities activities permissible for BHCs and financial subsidiaries of banks. The Gramm-Leach-Bliley Act of 1999 (GLBA) continued this trend by repealing two of the four sections of the GSA and the BHCA and by establishing the financial holding company (FHC) structure, which permits commercial banks and full-service investment banks (as well as insurance companies) to coexist under common control.

In the wake of the Great Recession of 2008, there have been calls to reexamine the activities that should be permissible for commercial banks in light of the fact that they receive governmental benefits through access to the federal safety net. Some have called for the reenactment of the repealed provisions of the GSA, which is discussed in greater detail in another CRS report.

While neither the House- nor the Senate-passed version of H.R. 4173 , the comprehensive financial regulatory reform proposals of the 111 th Congress, includes provisions that would reenact the GSA, both bills do propose curbs on "proprietary trading" by banking institutions. The bills would limit the ability of commercial banking institutions and their affiliated companies and subsidiaries to engage in trading unrelated to customer needs and investing in and sponsoring hedge funds or private equity funds. Such an approach has been referred to as the "Volcker Rule," having been urged upon Congress by Paul Volcker, former Chairman of the FRB and current Chairman of the President's Economic Recovery Advisory Board.

This report briefly discusses the permissible proprietary trading activities of commercial banks and their subsidiaries under current law. It then analyzes the Volcker Rule proposals under both the House- and Senate-passed financial reform bills. Appendix A , Appendix B , and Appendix C of the report provide the full legislative language from both bills.

Current Restrictions on Proprietary Trading

Pre-GLBA

The OCC and the FRB are empowered to implement, enforce, and, by extension, interpret (by regulation, guidance, or order) the subtleties and ambiguities of the GSA and the BHCA. For several decades after the enactment of the GSA, banks did not attempt to expand beyond traditional banking activities to a significant degree. This trend began to change in the 1970s. High inflation, coupled with a consumer movement to interest-bearing accounts and investment products, such as money market funds offered by securities firms, reduced the profitability of traditional bank products. Corporate consumers also began moving to securities firms for short-term lending (e.g., through the commercial paper market), which, for some, was less expensive than borrowing directly from banks. Facing lower profits and stiffer competition from securities firms, banks began seeking approval from regulators to engage in a greater universe of securities activities. Additionally, regulators may have become less cautious as time passed after the Great Depression.

Beginning in the 1970s and 1980s, requests for approval to engage in a greater universe of securities activities were largely granted by the OCC and the FRB, and, in most cases, have been approved by courts. By the time that the GLBA was enacted in 1999, the FRB had authorized certain BHCs and their subsidiaries to underwrite and deal in an array of bank-ineligible securities, including municipal bonds, commercial paper, mortgage-backed securities and other consumer-related securities, corporate debt securities, and corporate equity securities. In addition to underwriting and dealing activities, the FRB also approved other securities activities such as the provision of investment advice, the brokering of securities, and others. The FRB promulgated the list of permissible nonbanking activities at 12 C.F.R. § 225.28(b). With respect to securities-related activities, the regulation includes two distinct categories: (1) agency functions for customers and (2) transactions as principal (i.e., for the company's own account, often referred to as "proprietary trading"). In the latter category are the following: (1) "[u]nderwriting and dealing in government obligations and money market instruments"; (2) "[i]nvesting and trading activities" in certain swaps, futures, options, foreign exchange, and other derivative contracts; and (3) "buying and selling bullion and related activities." The FRB requires banks to adhere to a number of limitations and conditions, largely spelled out in regulation, in order to engage as principal in each of these three categories.

Post-GLBA

After GLBA, commercial banks were provided the authority to make proprietary investments in a broader array of securities, but to do so, they generally must either be organized as an FHC or the bank itself must establish a financial subsidiary. The permissible proprietary activities vary for FHCs and financial subsidiaries, so they are addressed in turn.

Financial Holding Companies

The GLBA introduced the FHC, a separate form of BHC for companies wishing to expand beyond the business of banking and closely related activities to a broader array of financial services. The GLBA permits FHCs to engage in and own companies engaging in (1) activities that are "financial in nature or incidental to such financial activity" or (2) activities that are "complementary to a financial activity" and do "not pose a substantial risk to the safety and soundness of the depository." The GLBA listed certain activities as "financial in nature," including all the nonbanking activities which had already been authorized for BHCs. The GLBA empowered the FRB, in coordination with the Secretary of the Treasury, to issue orders or regulations supplementing that list.

Merchant Banking Investments. Under the GLBA and rules promulgated jointly by the Secretary of the Treasury and the FRB, FHCs with a securities affiliate or an insurance affiliate with an investment adviser affiliate may engage in what is referred to as merchant banking activities, under certain conditions. Merchant banking means to "directly or indirectly and as principal or on behalf of one or more persons, ... acquire or control any amount of shares, assets or ownership interests of a company or other entity that is engaged in any activity not otherwise authorized for the financial holding company." FHC merchant banking investments must be "part of a bona fide underwriting or merchant or investment banking activity." Additionally, the interests must only be held on a temporary basis and, in general, no longer than 10 years. Under the regulation, the shares in such investments may be acquired by any subsidiary of the FHC other than a depository institution subsidiary. If assets other than debt or equity securities are involved, they must be "held or promptly transferred to a portfolio company." "Portfolio company," in this context, is merely the term used for the company to which these assets must be transferred. Depository institution subsidiaries of the FHC may not routinely manage the portfolio company. There also are restrictions designed to prevent the FHC from routinely managing or operating the portfolio company. For example, executive officers of the holding company and of certain subsidiaries of the holding company, including its securities broker and depository institution subsidiaries, may not serve as executive officers of the portfolio company. Despite these restrictions, however, there is a provision which permits an FHC to routinely, but on a temporary basis, manage a portfolio company; this may occur "only when intervention by the financial holding company is necessary or required to obtain a reasonable return on the financial holding company's investment in the portfolio company upon resale or other disposition of the investment, such as to avoid or address a significant operation loss or in connection with a loss of senior management at the portfolio company." The FRB's prior approval is not generally required for an FHC to engage in merchant banking activities unless the proposed investment will result in the aggregate carrying value of all merchant banking investments to exceed a certain level.

Merchant Banking Investments Through a Private Equity Fund . An FHC also may make merchant banking investments though a private equity fund that makes investments in nonfinancial companies, provided the private equity fund meets certain qualifications and the FHC's investments comply with requirements for merchant banking. "Private equity fund" is defined, for this purpose, as a company "formed for the purpose of and is engaged exclusively in the business of investing in shares, assets, and ownership interests of financial and nonfinancial companies for resale or other disposition." The private equity company must not be an operating company; no more than 25% of its equity may be held by the FHC or any of its officers, directors, employees or principal shareholders; its term must be no longer than 15 years; and it must not have been formed to evade the merchant banking restrictions on FHCs. If an FHC makes investments through a private equity fund, the investments will generally be subject to a 15-year limitation rather than the 10-year limit that would apply if the FHC were to make direct investments. If an FHC controls a private equity fund, the FHC may not routinely operate the private equity fund.

Federal Reserve Act (FRA) §§ 23A, which imposes limitations on "covered transactions" between a bank and its affiliates, and 23B, which requires certain transactions to be on market terms, apply to transactions between an FHC and its subsidiaries and the private equity fund only if control exists.

The regulations presume control for applicability of sections 23A and 23B if the FHC controls more than 15% of the private equity firm's total equity. This presumption may be rebutted with contrary evidence presented to the FRB or by showing the existence of any one of the following presumptions against control: (1) none of the FHC's officers, directors, or employees serves as a director or trustee of the firm; (2) another person or entity holds more of the total equity of the firm than does the FHC and no more than one of the FHC's officers, directors, or employees serves as a director or trustee of the firm; (3) another person or entity controls more than 50% of the voting shares of the firm and the officers, directors, or employees of the FHC do not constitute a majority of the directors or trustees of the firm.

On June 22, 2000, the FRB issued guidance on FHCs' equity investments and merchant banking activities. This guidance focuses on sound policies and practices, including board of directors oversight; limits on and controls with respect to types and amounts of investments; periodic reviews of investments and of the component elements of the investment process; assessment of possible investment performance under various circumstances; internal controls adopted to types of investments; exit strategies; and capital allocation based on risk. There are also guidelines on transactions involving the portfolio company which are not subject to the FRA §§ 23A and 23B. FHCs are urged to

have systems and policies in place to monitor transactions between the holding company, or a non-depository institution subsidiary of the holding company, and a portfolio company ... [to] assure that the risks of these transactions, including exposures of the holding company on a consolidated basis to a single portfolio company, are reasonably limited and that all transactions are on reasonable terms, with special attention paid to transactions that are not on market terms.

Financial Subsidiaries of State- and Federally Chartered Banks

Since the GLBA, not only may banks affiliate with securities firms within the FHC structure, national banks and state-chartered banks also may, subject to certain conditions, own or control financial subsidiaries that may engage in many of the same securities activities permissible for FHCs. Specifically, the GLBA authorized national banks to control or hold an interest in financial subsidiaries which could engage in "activities that are financial in nature or incidental to financial activity," as well as "activities that are permitted for national banks to engage in directly (subject to the same terms and conditions that govern the conduct of the activities by a national bank)." It also provided authorization for state-chartered banks to control or hold interests in subsidiaries engaging "in activities as principal that would only be permissible for a national bank to conduct through a financial subsidiary."

In general, financial subsidiaries may conduct any other activities authorized for FHCs with exceptions for (1) underwriting insurance or annuities, except for certain grandfathered activities primarily related to credit insurance; (2) developing or investing in real estate; and (3) merchant banking or insurance portfolio investing. There is also a provision permitting the Secretary of the Treasury to designate additional activities as financial in nature, in coordination with the FRB, based on the same standards as are applicable to the FRB when adding to the list of financial activities under the BHCA.

For a national bank to hold a financial subsidiary that is engaging in proprietary financial activities as principal, rather than in an agency capacity, the bank and all of its depository institution affiliates must be well capitalized; there must be OCC approval; the bank must have a satisfactory rating under the Community Reinvestment Act; the assets of all financial subsidiaries of the bank must not exceed the lesser of $50 billion or 45% of the assets of the bank; and the largest banks must adhere to additional requirements. State-chartered, federally insured banks have similar authority, provided that the bank and all of its insured depository institution affiliates are well capitalized and well managed.

Financial Regulatory Reform: How House and Senate Versions of H.R. 4173 Treat the "Volcker Rule"

Volcker Testimony

Testifying before the Senate Committee on Banking, Housing, and Urban Affairs on February 2, 2010, Chairman Paul Volcker urged the committee to prevent commercial banking institutions, beneficiaries of taxpayer-subsidized deposit insurance and emergency liquidity, from continuing to engage in sponsoring and investing in hedge funds and private equity funds and "trading unrelated to customer needs and continuing banking relationships." These activities he identified as "essentially proprietary and speculative activities." Although he provided no definitions in his testimony, he made it clear that he believed that any definitional problems could be overcome by providing regulators "broad" and "specific" authority to define "hedge fund" and "private equity fund" and that regulators could use it to prevent the emergence of "a new breed of bank-based funds that in all but name would function as hedge or equity funds." He was equally optimistic about the ability of Congress and the regulators to deal with the dangers of "proprietary trading." He indicated that he thought that there are means available by which regulators could identify, and eliminate, speculative proprietary trading by bank fund managers not only because of the potential risks for the institutions but also because of possible conflicts with the interests of their customers. He described "proprietary trading," at least in terms of any sizeable volume, as being conducted by only "a handful of large commercial banks"—"maybe four or five in the United States and perhaps a couple of dozen worldwide."

House Provision

H.R. 4173 , as passed by the House of Representatives, addresses proprietary trading only in the context of certain companies—financial holding companies that have been determined to be systemically significant by the Financial Services Oversight Council and, therefore, subjected to stricter prudential standards. Section 1117(a) of the measure provides authority for the Board of Governors of the Federal Reserve System (FRB) to ban proprietary trading by financial holding companies that have been subjected to stricter standards upon determining that such trading "poses an existing or foreseeable threat to the safety and soundness of such company or to the financial stability of the United States." The bill defines "proprietary trading" as "the trading of stocks, bonds, options, commodities, derivatives, or other financial instruments with the company's own money and for the company's own account." The bill allows the FRB broad power to make exemptions to the ban. Not only may the FRB exempt proprietary trading determined to be "ancillary to other operations," such as making a market in securities, hedging risk, and determining the market value of the company's assets, the FRB may, through regulation, exempt any other type of proprietary trading.

Senate Provision

Section 619 of the Senate-passed version of H.R. 4173 , which is included in the Conference Base Text of H.R. 4173 , requires the federal banking agencies to engage in a joint rulemaking to prohibit "proprietary trading" and investing in hedge funds or private equity funds by covered entities, that is, federally insured depository institutions, bank holding companies, companies treated as bank holding companies, and their subsidiaries. Before the banking agencies conduct the rulemaking to prohibit proprietary trading and investment in hedge funds, however, the Financial Stability Oversight Council, which is substantively similar to the House bill's Financial Services Oversight Council, must conduct a study. The Council consists of nine presidentially appointed voting members; it is chaired by the Secretary of the Treasury; and, pursuant to other sections of the legislation, it possesses substantive powers relating to systemic risk and regulation of financial companies. The study must be completed within six months of enactment of this legislation and is to be geared to assessing the potential implications and effect of the specifications of section 619 with respect to a list of factors, including taxpayer costs; household and business burdens; spread of the federal safety net to non-depository institutions; risk to the financial system; and safety and soundness of the institutions. On the basis of that study, the Council is required to "make recommendations" regarding the substantive prohibitions and definitions of section 619. The joint rulemaking by the banking regulators is required to "reflect any recommendations or modifications made by the Council."

Subsection 619(b) of the bill requires the federal banking agencies to prohibit proprietary trading by insured depository institutions, companies directly or indirectly controlling insured depository institutions, companies treated as bank holding companies, and any of their subsidiaries (covered entities). Subsection 619(a) defines "proprietary trading" as follows:

... purchasing or selling, or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments ... for the trading book (or such other portfolio as the Federal banking agencies may determine) of such institution, company, or subsidiary ... and ... subject to such restrictions as the Federal banking agencies may determine, does not include purchasing or selling or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of customer relationships, including risk-mitigating hedging activities related to such a purchase, sale, acquisition, or disposal. § 619(a)(2)

Subsection 619(b)(2) provides exceptions for the following types of obligations, provided the "investment ... is otherwise authorized by Federal law," and subject to any conditions imposed "on the conduct of investments" by the appropriate federal banking agency:

(i) obligations of the United States or any agency of the United States, including obligations fully guaranteed as to principal and interest by the United States or an agency of the United States;

(ii) obligations, participations, or other instruments of, or insured by, the Government National Mortgage Association, the Federal National Mortgage Association, or the Federal Home Loan Mortgage Corporation, including obligations fully guaranteed as to principal and interest by such entities; and

(iii) obligations of any State or any political subdivision of a State.

Subsection 619(c)(1) requires the federal banking agencies to engage in a joint rulemaking procedure to prohibit the covered entities "from sponsoring or investing in a hedge fund or a private equity fund." Subsection 619(a)(1) defines "hedge fund" and "private equity fund" as "a company or other entity that is exempt from registration as an investment company pursuant to section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 50a-3(c)(1) or 80a-3(c)(7)), or a similar fund, as jointly determined by the appropriate Federal banking agencies."

Under subsection 619(a)(3), "sponsoring" a hedge fund or a private equity fund includes "serving as a general partner, managing member, or trustee," "selecting ... a majority of the directors," or "sharing ... the same name or a variation of the same name" as the fund. Subsection 619(d)(1) provides exceptions from the prohibition on sponsoring or investing in a hedge fund or private equity fund for any "investment otherwise authorized under Federal law that is ... an investment in a small business investment company ... or designed primarily to promote the public welfare, as provided in" 12 U.S.C. § 24(Eleventh). There are also exceptions for investments permitted under sections 4(c)(9) and 4(c)(13) of the Bank Holding Company Act, provided they are conducted solely outside the United States by a company not controlled directly or indirectly by a company organized under the laws of the United States or of a state.

Subsection 619(e) prohibits covered entities that serve as investment managers or advisers to hedge funds or private equity funds from engaging in certain transactions with those funds and requires other specified transactions with them to be on market terms.

Subsection 619(f) requires the FRB to "adopt rules imposing additional capital requirements and specifying additional quantitative limits for nonbank financial companies supervised by the … [FRB] under section 113 [of the Senate legislation] that engage in proprietary trading or sponsoring and investing in hedge funds and private equity funds." Excepted from these rules is a list of investments that includes U.S. obligations, obligations issued by the federal housing government-sponsored enterprises (housing GSEs), obligations of small business investment companies; state and local obligations; and obligations designed to promote the public welfare.

All of the requirements for rulemaking, regarding both proprietary trading and investments in hedge and private equity funds, are specifically subjected "to the recommendations and modifications" of the Council under subsection 619(g). Subsection (g) requires the Council to complete a study of the foregoing provisions assessing a number of factors. On the basis of that study, the Council is authorized to

make recommendations regarding the definitions ... and the implementation of [the] provisions ... including any modifications to the definitions, prohibitions, requirements, and limitations contained therein that the Council determines would more effectively implement the purposes of this section and ... make recommendations for prohibiting the conduct of the activities described ... above a specific threshold amount and imposing additional capital requirements on activities conducted below such threshold amount.

Although there are certain express exceptions to section 619's prohibitions, unlike other banking laws, section 619 does not contain a specific provision delegating broad exemptive power to the regulators. It appears that, in lieu of delegating such authority to the regulators, section 619 provides the Council with some flexibility to modify the parameters of the law both by requiring the rulemaking to "reflect" Council recommendations and by including, in each of the substantive provisions defining prohibitions, language subjecting the prohibition "to the recommendations and modifications of the Council." The Committee Report accompanying the bill takes a broad view of the dangers in permitting banking firms to engage in these risky activities and a narrow view of the authority of the Council to substantially alter the prohibitions of section 619.

Subsections 619(g)(1)(A) and (h) present a timetable for implementation: (1) the Council is to complete its study no later than six months after the bill is enacted; (2) the regulators are to issue final rules no later than nine months after completion of the Council study; and (3) effective two years after these rules are promulgated, insured depository institutions, companies controlling depository institutions, companies treated as bank holding companies, and subsidiaries of these institutions may not retain investments or relationships prohibited under the regulations, unless a company applies for and receives an extension. Extensions may be given one year at a time for a maximum of three years for any one company.

In addition to the § 619 provisions, § 989 of the Senate-passed bill requires the Government Accountability Office to conduct a study and issue a report on "the risks and conflicts associated with proprietary trading" engaged in by banks, BHCs, FHCs, subsidiaries of BHCs and FHCs, and "any other entity, as the Comptroller General of the United States may determine." This study and report requirement also was included as part of the Conference Base Text of H.R. 4173 .

The Conference Report: Section 619

Banking Entities May Not Engage in Proprietary Trading or Hed ge Fund Ownership or Sponsorship; Nonbanking Financial Compan ies Subject to FRB Supervision May Do So With Capital and Quantitative Limits . Subsection (a) of section 619 of the Conference Report contains an outright prohibition on proprietary trading by and ownership of interests in or sponsorship of hedge funds or private equity funds by a "banking entity." Subsequent provisions of the bill, however, provide exceptions to this. "Banking entity" is defined in subsection (h) to mean any FDIC-insured depository institution, company controlling an insured depository institution, company treated as a bank holding company for purposes of the International Banking Act of 1978, and any affiliate or subsidiary of such entity. The exact language provides a broad prohibition. It reads: "a banking entity shall not … engage in proprietary trading, or … acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund." There are, however, certain exceptions, some transitional and others designated as permitted activities under subsection (d) of the legislation.

Rather than subjecting nonbank financial companies supervised by the FRB to a prohibition on proprietary trading and hedge fund ownership or sponsorship, the legislation authorizes the regulators to issue rules subjecting such companies to additional capital and quantitative limits on such activities unless the activity has been identified as a permitted activity under section (d) and has not been subjected to capital and quantitative requirements for safety and soundness purposes.

Definitions. Subsection 619(h) sets forth definitions of various terms, in some cases providing a degree of discretion to the regulators to expand the reach of the prohibitions and limitations. For example:

A "hedge fund" or a "private equity fund" is defined as "an issuer that would be an investment company … but for sections 3(c)(1) or 3(c)(7) of [the Investment Company Act of 1940] …, or such similar funds as the … [appropriate regulatory agencies] may by rule … determine ."

"Proprietary trading" is "engaging as principal for the trading account of the banking entity or nonbank financial company supervised by the Board in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on or any such security, derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate … agencies …may, by rule … determine. "

Some definitions are substantially similar to those in the Senate bill (e.g., "nonbank financial company" and "sponsor"). In addition, there are two new definitions: "trading account" and "illiquid fund." "Trading account" is defined to mean "any account used for acquiring or taking positions in the securities and instruments described [under the definition of "proprietary trading"] … principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any other accounts as the appropriate … agencies … may, by rule … determine." "Illiquid fund" is defined in subsection 619(h)(7) as a hedge fund or private equity fund that "as of May 1, 2010, was principally invested in, or was invested and contractually committed to principally invest in, illiquid assets such as portfolio companies, real estate investments, and venture capital investments; and …[which] makes all investments pursuant to, and consistent with, an investment strategy to principally invest in illiquid assets."

Council Study and Coordinate d Joint Rulemaking . Subsection (b) of section 619 requires the Financial Stability Oversight Council to complete a study not later than six months after enactment and make recommendations to the regulators on implementation. The Conference Report, thus, appears to provide the Council less power than the Senate-passed bill, because it limits the Council to recommending how implementation may be geared to (1) promote banking entity safety and soundness; (2) limit inappropriate transfers to "unregulated entities" of the federal subsidies embodied in FDIC deposit insurance and FRS liquidity programs; (3) "protect taxpayers and consumers and enhance financial stability" by minimizing risky activities by banking entities; (4) reduce conflicts of interest between customer interests and the self-interest of the covered entities; (5) limit unduly risky activities of the covered entities; (6) accommodate insurance company investment authority while safeguarding both affiliated banking entities and the financial stability of the United States; and (7) devise appropriate timing for divestiture of illiquid assets affected by implementation of section 619.

Subsection (b) requires the federal banking regulators and the SEC and CFTC to conduct joint rulemaking and to adopt these rules no later than nine months after the Council completes its study. The regulators must coordinate the regulations for safety and soundness and elimination of the possibility of advantaging or disadvantaging some companies. Subsection (c) specifies that final rules are to become effective 12 months after they are issued or two years after enactment. In general, banking entities will be given two years to divest nonconforming activities.

Di vestiture of Nonconforming Activities. Subsection (c) addresses divestiture of nonconforming activities. Divestiture of nonconforming activities is generally required within two years of enactment subject to certain exceptions. The FRB is to issue rules on the divestiture provisions within six months of enactment. Additional capital and other restrictions, including margin requirements, on ownership interests in or sponsorship of hedge funds or private equity funds by banking entities are to be implemented by rules promulgated within the context of the joint rulemaking. The two-year divestiture requirement may be extended under certain circumstances: (1) the FRB may approve extensions for one-year periods not to exceed three additional years, and (2) if a contractual obligation in effect on May 1, 2010, requires a banking entity to take or retain its ownership interest in, or provide additional capital to, an illiquid fund, the entity may apply to the FRB for an extension which may be granted for no more than five years; divestiture would be required at the end of the five years or on the contractual date—whichever is earlier.

Permitted Activities . Subsection (d) identifies exceptions to the blanket prohibitions of subsection 619(a) by listing permitted activities and setting conditions under which those activities may be conducted. It excludes from permitted activities any transaction or class of activities, otherwise permitted, that would involve or result in a material conflict of interest; a material exposure by the banking entity to "high-risk assets or high-risk trading strategies" as defined by the regulators; or a threat to safety and soundness of the banking entity or to the financial stability of the United States. It provides standards by which the regulators may set further limits or conditions on these activities and includes authority for the regulators to add to the list of permitted activities. The regulators may impose additional capital and quantitative limits as "appropriate to protect the safety and soundness of banking entities engaged in such activities." Among the conditions specified for conducting these activities are that the activity must (1) be permitted under other federal or state law; (2) be subjected to restrictions as determined by the appropriate federal regulators; and (3) not involve or result in a material conflict of interest, expose the banking entity to "high-risk assets or high-risk trading strategies," or threaten safety and soundness of the banking entity or the financial stability of the United States. Subject to those conditions, the exceptions or permitted activities are:

Organizing and Advising Hedge or Private Equity Funds in Connection with Fiduciary or Trust Services . Subsection (d)(1)(G) authorizes banking entities to organize and offer private equity or hedge funds only if (1) the banking entity provides "bona fide trust, fiduciary, or investment advisory services"; (2) the fund is offered only in connection with trust, fiduciary, or investment advisory services to "persons that are customers of such services of the banking entity"; (3) the banking entity retains only a de minimis interest in the funds; (4) the banking entity and its affiliates engage in no transaction with the fund that would be designated as a covered transaction under FRA section 23A and other transactions with the fund are conducted only on terms specified in FRA section 23B, as if the banking entity were a member bank, and the fund an affiliate of that bank; (5) the banking entity does not guaranty the obligations of the hedge fund or private equity fund; (6) the banking entity does not share a name with the hedge fund or private equity fund; (7) no director or employee of the banking entity, other than a director or employee directly engaged in providing investment advisory or other services to the hedge fund or private equity fund, takes or retains an interest in the fund; and (8) the banking entity takes certain steps to assure the investors in the hedge fund or private equity fund that losses of the fund will be borne solely by its investors. Government and GSE Obligations . Subsection (d)(1)(A) authorizes the purchase and sale of U.S. obligations; obligations of federal agencies; obligations of Ginnie Mae, Fannie Mae, Federal Home Loan Banks, Farmer Mac, and Farm Credit System institutions; and obligations of any state or political subdivision of a state. Market Making Activities . Subsection (d)(1)(B) authorizes the "purchase, sale, acquisition, or disposition of securities and various instruments which the regulators have determined by rule to fall within the definition of "proprietary trading" under subsection (h)(4), provided the transactions are "in connection with underwriting or market-making related activities, to the extent that … [such transactions] are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties." Risk Mitigating Hedging Activities . Subsection (d)(1)(C) authorizes "risk-mitigating hedging activities" that are related to "positions, contracts, or other holdings of the banking entity and are designed to reduce specific risks in connection with and related to such holdings. Small Business Investment Company Investments . Subsection (d)(1)(E) authorizes specified small business investment company investments and investments qualified as rehabilitation expenditures with respect to qualified rehabilitated building or certified historic structure as defined in section 47 of the Internal Revenue Code or similar state historic tax credit program. Insurance Company Portfolio Investments. Subsection (d)(1)(F) authorizes the "purchase, sale, acquisition, or disposition of securities and other instruments" which the regulators have determined by rule to fall within the definition of "proprietary trading" under subsection (h)(4) if the transactions are "by a regulated insurance company directly engaged in the business of insurance for the general account of the company by any affiliate of such regulated insurance company, provided that such activities by any affiliate are solely for the general account of the regulated insurance company." The transactions must also comply with applicable law, regulation, or guidance, and there must be no determination by the regulators that a relevant law, regulation, or guidance is insufficient to protect the safety and soundness of the banking entity or the financial stability of the United States. Proprietary Trading by Foreign Companies Conducted Outside the United States . Subsections (d)(1)(H) and (I) authorize investments permitted under sections 4(c)(9) and 4(c)(13) of the Bank Holding Company Act, provided they are conducted solely outside the United States by a company not controlled directly or indirectly by a company organized under the laws of the United States or of a state. Other Investments . Subsection (d)(1)(J) provides the regulators with authority to permit "[s]uch other activity … by rule, … [as] would promote and protect the safety and soundness of the banking entity and the financial stability of the United States." De Minim i s Investments by Banking Entities in Hedge Funds and Private Equity Funds. Subsection 619(d)(4) permits banking entities, subject to certain limitations, to make and retain a "de minimis investment" in a hedge fund or private equity fund or to make an initial investment in a hedge fund or private equity fund that the banking entity organizes. Among the limitations is a requirement to seek unaffiliated investors to reduce, within one year (subject to a possible extension for two more years), the banking entity's initial investment to the prescribed de minimis amount, as defined in subsection (d)(4). A de minimis investment must be (1) "not more than 3 percent of the total ownership interests of the fund," (2) "immaterial to the banking entity, as defined by rule" and (3) such that the aggregate investment of the banking entity in all such funds does not exceed 3 percent of its Tier 1 capital. There is also a requirement that a banking entity's aggregate outstanding de minimis or initial investments in hedge funds or private equity funds organized by the banking entity, including retained earnings, must be deducted from assets and tangible equity of the banking entity and the amount of the deduction to "increase commensurate with the leverage of the hedge fund or private equity fund."

Limitation on Relationships with Hedge Funds and Private Equity Funds . Under subsection 619(f), a banking entity serving as "an investment manager, investment advisor, or investment sponsor to a hedge fund or private equity fund" or a banking entity which organizes and offers a hedge fund or private equity fund in connection with fiduciary or trust services as specified in subsection (d)(1)(G) or any affiliates thereof may enter into a transaction with the fund which would be a covered transaction under FRA section 23A if the banking entity and affiliate were a member bank and the fund were an affiliate thereof. In addition, any transaction between the banking entity and the fund must comply with Section 23B of the FRA as if the banking entity were a member bank and the fund, an affiliate, thereof. The FRB may permit a banking entity to enter into a prime brokerage transaction with any hedge fund or private equity fund in which a hedge fund or private equity fund managed, sponsored, or advised by the banking entity or nonbank financial company has an ownership interest under certain conditions. The banking entity must be in compliance with all of the conditions under which a banking entity may organize and advise a hedge fund or private equity fund in connection with fiduciary or trust services under subsection (d)(1)(G). Moreover, the banking entity's chief executive officer must provide an annual, and updated as necessary, written certification of compliance. The FRB must have determined that the primary brokerage agreement is consistent with the safe and sound operation of the banking entity; moreover, the prime brokerage transaction is subject to FRA section 23B as if the counterparty were an affiliate of the banking entity. Additional capital charges or other restrictions for nonbank financial companies are to be covered by rules issued by the appropriate regulators in the prescribed joint rulemaking proceedings.

Anti-Evasion Provision. Subsection (e) authorizes the appropriate regulator, having reasonable cause to believe that a banking entity or a nonbank financial company supervised by the FRB, is engaged in activities functioning as an evasion of section 619, or in violation of section 619, to order, subject to notice and opportunity for a hearing, termination of the activity and disposition of the investment. This subsection also requires the regulators to issue internal control and recordkeeping rules to insure compliance with section 619.

Rules of Construction. Subsection 619(g) provides three rules of statutory construction for interpreting section 619: (1) the prohibitions and restrictions of section 619 apply, except as provided in the section, notwithstanding the existence of other provisions of law authorizing such activities; (2) nothing in section 619 is to "be construed to limit the ability of a banking entity or nonbank financial company … to sell or securitize loans in a manner otherwise permitted by law"; and (3) nothing in section 619 is to "be construed to limit the inherent authority of any Federal agency or State regulatory authority under otherwise applicable provisions of law."

Future Prospects: Rulemaking and Mandated Study

While the Conference Committee was at work, there appeared to be some apprehension within the financial services industry about the reach of § 619, the imprecision of its definitions and prohibitions, and its implementation. Some concerns may have been allayed by the Conference Report's final version of section 619. For example, there are specific provisions providing for (1) distinct treatment for insurance company portfolio investments; (2) the ability of banking entities and non-financial companies determined to be systemically important to sponsor hedge fund and private equity funds that are limited to customer investments; (3) conditions under which bank investments in hedge funds and private equity funds may be permitted; and (4) phase-in periods. Although the outlines of a new regulatory framework for proprietary trading and hedge fund operations of banking entities and other systemically important companies are fully outlined in the legislation, the actual reach and practical effect of the provisions await the clarifying hand of the regulators. To illustrate, subsection (d)(1)(C) authorizes banking entities to engage in "risk-mitigating hedging activities" related to "positions, contracts, or other holdings of the banking entity that are designed to reduce specific risks to a banking entity in connection with and related to such positions, contracts or other holdings." It delineates no parameters for these hedging activities. With this and other provisions of the bill, there is likely to be an intensive rulemaking process wherein virtually every possible interpretation of the statutory language will be subjected to a full airing.

It also might be noted that a related provision of the legislation provides clear indication that Congress will continue to monitor the scope of investment activities permitted to banking concerns. Section 620 of the Conference Report gives the federal banking agencies 20 months to study and report on investment and other activities that banking entities may conduct under federal and state law. The agencies are to evaluate and make recommendations on (1) types of activities or investments; (2) associated risks; (3) risk mitigation activities; (4) safety and soundness concerns; (5) potential negative effects of each activity with respect to banking entities and the U.S. financial system; (6) whether each activity or investment is appropriate for banking entities; and (7) any necessary additional restrictions.

Appendix A. Text of H.R. 4173 § 1117, as Passed by the House

SEC. 1117. RESTRICTION ON PROPRIETARY TRADING BY DESIGNATED FINANCIAL HOLDING COMPANIES.

(a) In General- If the Board determines that propriety trading by a financial holding company subject to stricter standards poses an existing or foreseeable threat to the safety and soundness of such company or to the financial stability of the United States, the Board may prohibit such company from engaging in propriety trading.

(b) Exceptions Permitted- The Board may exempt from the prohibition of subsection (a) proprietary trading that the Board determines to be ancillary to other operations of such company and not to pose a threat to the safety and soundness of such company or to the financial stability of the United States, including—

(1) making a market in securities issued by such company;

(2) hedging or managing risk;

(3) determining the market value of assets of such company; and

(4) propriety trading for such other purposes allowed by the Board by rule.

(c) Rulemaking Authority- The primary financial regulatory agencies of banks and bank holding companies shall jointly issue regulations to carry out this section. (d) Effective Date- The provisions of this section shall take effect after the end of the 180-day period beginning on the date of the enactment of this title. (e) Proprietary Trading Defined- For purposes of this section and with respect to a company, the term 'proprietary trading' means the trading of stocks, bonds, options, commodities, derivatives, or other financial instruments with the company's own money and for the company's own account

(d) Effective Date- The provisions of this section shall take effect after the end of the 180-day period beginning on the date of the enactment of this title.

Appendix B. Text of H.R. 4173 § 619, as Passed by the Senate, and Which Is Included as Part of the Conference-Base Text of H.R. 4173

SEC. 619. RESTRICTIONS ON CAPITAL MARKET ACTIVITY BY BANKS AND BANK HOLDING COMPANIES.

(a) Definitions- In this section —

(1) the terms `hedge fund ' and `private equity fund ' mean a company or other entity that is exempt from registration as an investment company pursuant to section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) or 80a-3(c)(7)), or a similar fund, as jointly determined by the appropriate Federal banking agencies;

(2) the term `proprietary trading '—

(A) means purchasing or selling, or otherwise acquiring or disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments by an insured depository institution, a company that controls, directly or indirectly, an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), and any subsidiary of such institution or company, for the trading book (or such other portfolio as the Federal banking agencies may determine) of such institution, company, or subsidiary; and

(B) subject to such restrictions as the Federal banking agencies may determine, does not include purchasing or selling, or otherwise acquiring or disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of customer relationships, including risk-mitigating hedging activities related to such a purchase, sale, acquisition, or disposal; and

(3) the term `sponsoring ', when used with respect to a hedge fund or private equity fund, means —

(A) serving as a general partner, managing member, or trustee of the fund;

(B) in any manner selecting or controlling (or having employees, officers, directors, or agents who constitute) a majority of the directors, trustees, or management of the fund; or

(C) sharing with the fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name.

(b) Prohibition on Proprietary Trading-

(1) IN GENERAL- Subject to the recommendations and modifications of the Council under subsection (g), and except as provided in paragraph (2) or (3), the appropriate Federal banking agencies shall, through a rulemaking under subsection (g), jointly prohibit proprietary trading by an insured depository institution, a company that controls, directly or indirectly, an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), and any subsidiary of such institution or company.

(2) EXCEPTED OBLIGATIONS-

(A) IN GENERAL- The prohibition under this subsection shall not apply with respect to an investment that is otherwise authorized by Federal law in —

(i) obligations of the United States or any agency of the United States , including obligations fully guaranteed as to principal and interest by the United States or an agency of the United States ;

(ii) obligations, participations, or other instruments of, or issued by, the Government National Mortgage Association, the Federal National Mortgage Association, or the Federal Home Loan Mortgage Corporation, including obligations fully guaranteed as to principal and interest by such entities; and

(iii) obligations of any State or any political subdivision of a State.

(B) CONDITIONS- The appropriate Federal banking agencies may impose conditions on the conduct of investments described in subparagraph (A).

(C) RULE OF CONSTRUCTION- Nothing in subparagraph (A) may be construed to grant any authority to any person that is not otherwise provided in Federal law.

(3) FOREIGN ACTIVITIES- An investment or activity conducted by a company pursuant to paragraph (9) or (13) of section 4(c) of the Bank Holding Company Act of 1956 (12 U.S.C. 1843(c)) solely outside of the United States shall not be subject to the prohibition under paragraph (1), provided that the company is not directly or indirectly controlled by a company that is organized under the laws of the United States or of a State.

(c) Prohibition on Sponsoring and Investing in Hedge Funds and Private Equity Funds-

(1) IN GENERAL- Except as provided in paragraph (2), and subject to the recommendations and modifications of the Council under subsection (g), the appropriate Federal banking agencies shall, through a rulemaking under subsection (g), jointly prohibit an insured depository institution, a company that controls, directly or indirectly, an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), or any subsidiary of such institution or company, from sponsoring or investing in a hedge fund or a private equity fund.

(2) APPLICATION TO FOREIGN ACTIVITIES OF FOREIGN FIRMS- An investment or activity conducted by a company pursuant to paragraph (9) or (13) of section 4(c) of the Bank Holding Company Act of 1956 (12 U.S.C. 1843(c)) solely outside of the United States shall not be subject to the prohibitions and restrictions under paragraph (1), provided that the company is not directly or indirectly controlled by a company that is organized under the laws of the United States or of a State.

(d) Investments in Small Business Investment Companies and Investments Designed To Promote the Public Welfare-

(1) IN GENERAL- A prohibition imposed by the appropriate Federal banking agencies under subsection (c) shall not apply with respect an investment otherwise authorized under Federal law that is —

(A) an investment in a small business investment company, as that term is defined in section 103 of the Small Business Investment Act of 1958 (15 U.S.C. 662); or

(B) designed primarily to promote the public welfare, as provided in the 11 th paragraph of section 5136 of the Revised Statutes (12 U.S.C. 24).

(2) RULE OF CONSTRUCTION- Nothing in paragraph (1) may be construed to grant any authority to any person that is not otherwise provided in Federal law.

(e) Limitations on Relationships With Hedge Funds and Private Equity Funds-

(1) COVERED TRANSACTIONS- An insured depository institution, a company that controls, directly or indirectly, an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), and any subsidiary of such institution or company that serves, directly or indirectly, as the investment manager or investment adviser to a hedge fund or private equity fund may not enter into a covered transaction, as defined in section 23A of the Federal Reserve Act (12 U.S.C. 371c) with such hedge fund or private equity fund.

(2) AFFILIATION- An insured depository institution, a company that controls, directly or indirectly, an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), and any subsidiary of such institution or company that serves, directly or indirectly, as the investment manager or investment adviser to a hedge fund or private equity fund shall be subject to section 23B of the Federal Reserve Act (12 U.S.C. 371c-1) as if such institution, company, or subsidiary were a member bank and such hedge fund or private equity fund were an affiliate.

(f) Capital and Quantitative Limitations for Certain Nonbank Financial Companies-

(1) IN GENERAL- Except as provided in paragraph (2), and subject to the recommendations and modifications of the Council under subsection (g), the Board of Governors shall adopt rules imposing additional capital requirements and specifying additional quantitative limits for nonbank financial companies supervised by the Board of Governors under section 113 that engage in proprietary trading or sponsoring and investing in hedge funds and private equity funds.

(2) EXCEPTIONS- The rules under this subsection shall not apply with respect to the trading of an investment that is otherwise authorized by Federal law —

(A) in obligations of the United States or any agency of the United States , including obligations fully guaranteed as to principal and interest by the United States or an agency of the United States ;

(B) in obligations, participations, or other instruments of, or issued by, the Government National Mortgage Association, the Federal National Mortgage Association, or the Federal Home Loan Mortgage Corporation, including obligations fully guaranteed as to principal and interest by such entities;

(C) in obligations of any State or any political subdivision of a State;

(D) in a small business investment company, as that term is defined in section 103 of the Small Business Investment Act of 1958 (15 U.S.C. 662); or

(E) that is designed primarily to promote the public welfare, as provided in the 11 th paragraph of section 5136 of the Revised Statutes (12 U.S.C. 24).

(g) Council Study and Rulemaking-

(1) STUDY AND RECOMMENDATIONS- Not later than 6 months after the date of enactment of this Act, the Council —

(A) shall complete a study of the definitions under subsection (a) and the other provisions under subsections (b) through (f), to assess the extent to which the definitions under subsection (a) and the implementation of subsections (a) through (f) would —

(i) promote and enhance the safety and soundness of depository institutions and the affiliates of depository institutions;

(ii) protect taxpayers and enhance financial stability by minimizing the risk that depository institutions and the affiliates of depository institutions will engage in unsafe and unsound activities;

(iii) limit the inappropriate transfer of Federal subsidies from institutions that benefit from deposit insurance and liquidity facilities of the Federal Government to unregulated entities;

(iv) reduce inappropriate conflicts of interest between the self-interest of depository institutions, affiliates of depository institutions, and financial companies supervised by the Board, and the interests of the customers of such institutions and companies;

(v) raise the cost of credit or other financial services, reduce the availability of credit or other financial services, or impose other costs on households and businesses in the United States ;

(vi) limit activities that have caused undue risk or loss in depository institutions, affiliates of depository institutions, and financial companies supervised by the Board of Governors, or that might reasonably be expected to create undue risk or loss in such institutions, affiliates, and companies; and

(vii) appropriately accommodates the business of insurance within an insurance company subject to regulation in accordance with State insurance company investment laws;

(B) shall make recommendations regarding the definitions under subsection (a) and the implementation of other provisions under subsections (b) through (f), including any modifications to the definitions, prohibitions, requirements, and limitations contained therein that the Council determines would more effectively implement the purposes of this section; and

(C) may make recommendations for prohibiting the conduct of the activities described in subsections (b) and (c) above a specific threshold amount and imposing additional capital requirements on activities conducted below such threshold amount.

(2) RULEMAKING- Not earlier than the date of completion of the study required under paragraph (1), and not later than 9 months after the date of completion of such study —

(A) the appropriate Federal banking agencies shall jointly issue final regulations implementing subsections (b) through (e), which shall reflect any recommendations or modifications made by the Council pursuant to paragraph (1)(B); and

(B) the Board of Governors shall issue final regulations implementing subsection (f), which shall reflect any recommendations or modifications made by the Council pursuant to paragraph (1)(B).

(h) Transition-

(1) IN GENERAL- The final regulations issued by the appropriate Federal banking agencies and the Board of Governors under subsection (g)(2) shall provide that, effective 2 years after the date on which such final regulations are issued, no insured depository institution, company that controls, directly or indirectly, an insured depository institution, company that is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 (12 U.S.C. 1841 et seq.), or subsidiary of such institution or company, may retain any investment or relationship prohibited under such regulations.

(2) EXTENSION-

(A) IN GENERAL- The appropriate Federal banking agency for an insured depository institution or a company described in paragraph (1) may, upon the application of any such company, extend the 2-year period under paragraph (1) with respect to such company, if the appropriate Federal banking agency determines that an extension would not be detrimental to the public interest.

(B) TIME PERIOD FOR EXTENSION- An extension granted under subparagraph (A) may not exceed —

(i) 1 year for each determination made by the appropriate Federal banking agency under subparagraph (A); and

(ii) a total of 3 years with respect to any 1 company.

Appendix C. The Conference Report: Section 619