Don’t Expect Eye-Popping Fines for Volcker Rule Violations

The adoption by five federal agencies of the Volcker Rule aimed at keeping banks from engaging in proprietary trading, is – to borrow a quote from Winston Churchill – the end of the beginning.

Getting the regulation adopted took over three years. But when it comes to sanctioning banks that violate the rule, don’t expect to see regulators rushing to bring the hammer down on offenders.

The Federal Deposit Insurance Corporation, the Federal Reserve, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission and the Securities and Exchange Commission worked together to reach a complex set of regulations. Many of the particulars of the nearly 50-page rule – and an additional 900 pages of explanations – show that much is open to interpretation.

The Volcker Rule was intended to prevent banks from “engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments.” It prohibits proprietary trading, where a bank uses its trading account to benefit from short-term movements in prices or engages in arbitrage transactions. The goal is to keep banks from executing transactions that can put the entire enterprise at risk.

But the rule contains a list of exemptions, including trades made for liquidity purposes and market-making activity for customers. Even hedging transactions are permitted, as long as they are “designed to reduce or otherwise significantly mitigate and demonstrably reduces or otherwise significantly mitigates specific, identifiable risks.”

Thus, a trade might be a permissible hedge to protect the bank against certain risks. But it could qualify as improper proprietary trading if it does not fall within an exception. The difference will depend on the particular circumstances of the trading and the relation to a bank’s overall securities positions, so there will be few if any bright lines to follow.

From an enforcement perspective, the heart of the Volcker Rule is the requirement that banks put in place extensive procedures to comply with the prohibition on proprietary trading. The agencies provided an appendix to the rule with more than 10 pages of detailed instructions to help banks meet the minimum standards to ensure that they adequately monitor trading.

The requirements include the adoption of written policies and procedures for dealing with trading activity; the commitment of adequate resources to oversight; the implementation of internal controls to limit how trading desks operate; and independent testing of the compliance program. Needless to say, this will impose significant costs on banks that engage in the types of transactions that could run afoul of the Volcker Rule.

To further bolster these measures, the agencies will require the chief executive to file an annual certification “that the banking entity has in place processes to establish, maintain, enforce, review, test and modify the compliance program.” This comes on top of the requirement in the Sarbanes-Oxley Act, which dictates that senior management must attest to the veracity of a company’s financial statements.

This puts more pressure on the chief executive to ensure that the bank is following the rule at the risk of being accused of making a false statement. That concern should filter through the ranks of a trading operation to avoid putting bank officers in an embarrassing situation.

The Volcker Rule itself contains only a minimal enforcement mechanism. If a bank engages in prohibited proprietary trading, it can be required to divest itself of the investment and restricted from future trading of that type. But there is no separate punishment incorporated into the rule for violations, despite suggestions that the rule include its own schedule of civil penalties.

In adopting the rule, the agencies instead stated that they would rely on their existing enforcement powers to address violations. The bank regulators can impose a penalty of $5,000 a day for a violation of any law or regulation, and as much as $1 million for a deliberate violation. The securities and commodities laws authorize similar civil penalties for intentional or reckless violations.

It remains to be seen whether established enforcement provisions will be used for Volcker Rule violations. The vagueness of the rule’s prohibition on certain types of proprietary trading will make it difficult to show that a trader knowingly violated it, or even acted recklessly, because it will be easy for an individual to claim ignorance.

A more likely path for enforcement is through the internal controls requirement imposed by the Volcker Rule on banks. Proof of an inadequate compliance program does not involve showing an intent to defraud, but only that the person or company failed to comply with corporate reporting requirements. This was the rule the S.E.C. used against JPMorgan Chase in the so-called London whale trading mess. But even that incident might not have violated the prohibition on proprietary trading because the traders contend that the trades were intended to mitigate the bank’s risk.

The near-term prospect of enforcement actions for violations of the Volcker Rule appears to be minimal. The Federal Reserve extended the implementation period to July 2015, and the compliance requirements will phase in for smaller banks. That reduces the chances of any bank being investigated for a violation until it has a compliance program in place.

More important, it will take time for the agencies to figure out what types of trading come close enough to the prohibition to even warrant an inquiry. The Volcker Rule relies primarily on banks to police themselves as part of their compliance programs. Questionable trades, therefore, may be quickly reversed before they are ever reported to the government. If the violation has already been remedied, that would obviate the need for an enforcement action.

By putting their faith in mandatory compliance programs, the agencies charged with enforcing the Volcker Rule seem to be relying on the threat of possible regulatory intervention to get banks to forgo questionable trading without having to resort to their enforcement powers.