Volcker Rule Could Cost Banks up to $4.3 Billion

Practical Law Legal Update 3-562-4647 (Approx. 4 pages)

Volcker Rule Could Cost Banks up to $4.3 Billion

by Practical Law Finance

Published on 26 Mar 2014 • USA (National/Federal)

The Office of the Comptroller of the Currency released a regulatory analysis of the Volcker Rule, estimating the total cost of compliance will be between $412 million and $4.346 billion.

On March 20, 2014, the Office of the Comptroller of the Currency released a regulatory analysis of the Volcker Rule, estimating the total cost of compliance (combined expenditures and estimated trading losses) will be between $412 million and $4.346 billion (for more information on the Volcker Rule, see Practice Note, Summary of the Dodd-Frank Act: The Volcker Rule). The analysis acknowledges three main sources of regulatory costs, which include:

Compliance expenditures by banking institutions.
Costs for banking institutions associated with retaining or divesting covered funds.
Non-monetized costs of compliance, which will add to the overall cost of the rule but are difficult to quantify.

The brunt of compliance expenditure costs are projected to be borne by the 46 largest banking institutions, with the seven largest of those banks incurring all expenditure costs of compliance in 2014, and roughly half of the compliance expenditures costs going forward. Cost of compliance expenditures generally consist of:

Reporting metrics.
Establishing an enhanced compliance program.
Establishing a core compliance program.

88% of estimated compliance expenditures (estimated to be between $402 million and $541 million) are associated with the market-making and underwriting exemptions, which allow banking institutions to engage in these activities to the extent that they are designed not to exceed the reasonably expected near-term demands of clients, customers or counterparties (RENTD). These cost estimates are based on estimated oversight costs for each trading desk located at a bank, which include:

1,100 trading desks at the 7 largest banks, which is estimated to cost at least $402 million in 2014 and at least $365 million per year, going forward.
491 trading desks at the next 39 largest banks, which will cost at least $176 million in 2015 and at least $167 per year, going forward.

In 2014, the OCC analysis states that the next largest costs associated with compliance expenditures for the Volcker Rule will be the cost of establishing reporting metrics, estimated to be $17.7 million, and the establishment of policies and procedures at the trading desk level, estimated to be $11 million. Data collection, enhanced compliance programs and renaming of covered funds are also expected to cost banks roughly $18.7 million.

However, the highest potential cost associated with the Volcker Rule is the combination of the cost of:

Raising Tier 1 capital so that banks may remain invested in permissible covered funds while adhering to capital requirements.
The required divestment of impermissible covered funds.

In order to remain invested in permissible funds, the OCC estimates that banks will need to spend $147 million in 2014 and $165 million in 2015 to raise the additional required capital. Additionally, banks must divest any impermissible holdings in covered funds, which will adversely impact the price of these funds. The OCC estimates the adverse affect on price due to decreased liquidity and demand to be 5.5% of the fund value, which translates into potential losses of $3.63 billion.

In addition, the OCC has identified various areas that will increase regulatory costs but that are difficult to value (non-monetized costs), as well as benefits that are similarly difficult to value. Non-monetized costs include, among others:

The exclusion of inter-dealer trading from RENTD. While exchange trading or other anonymous trading platforms may be included in RENTD, inter-bank trading and trading between a bank and another market-maker are not for "customer demand" and therefore not included. This exclusion will result in decreased liquidity, as inter-dealer trading has historically played a large role in increasing the volume of securities inventory held at a bank and banks will no longer be able to hold inventory in anticipation of these trades. Additionally, the exclusion could inhibit banks' ability to share risk when customers require large block trades; historically, dealers would be able to reallocate equity securities among different banking entities to reduce risk for any one bank. However, under the Volcker Rule, if banks cannot adjust their RENTD to accommodate risk sharing demands in a short enough time, the ability to share risk for these types of trades could disappear.
Decreased liquidity leading to increased bid-ask spreads.
Migration of risk. With increased regulation, there is a possibility that, in order to avoid burdensome regulations, banks and their customers will migrate their risky activities away to less regulated financial entities. Moreover, banks may see a shift in the risk profile of their own holdings, as certain types of securities are exempted from the ban on proprietary trading, such as securities issued by Fannie Mae or Freddie Mac (even though these securities may have a more volatile market price than other, prohibited securities).
Reduced ability to manage risks due to a narrower-than-requested liquidity management provision, which does not broadly allow asset-liability management, earnings management or scenario hedging.

Non-monetized benefits touted by the OCC include, among others:

Benefits associated with metrics reporting, including, among others, better knowledge of risk factor sensitivities, better knowledge of overall risk for each bank's trading portfolio and trading desk specific profit and loss attribution reports.
Reduced conflicts of interest between banks and their customers.
Improvement of core banking services that will promote competition, innovation and stability.
Increasing systemic stability by reducing risk and risky trades.

Volcker Rule Could Cost Banks up to $4.3 Billion | Practical Law