Federal banking regulators are relaxing provisions within the Volcker Rule, a key part of the Dodd-Frank Act, which regulated banks much more heavily following the role the industry played in sparking the Great Recession.
The Volcker Rule prevents banks from participating in proprietary trading -- that is, investing their own funds instead of client assets in stocks, derivatives, options, or other financial instruments. The Volcker Rule also generally prohibits banks from taking an ownership stake in a covered fund, such as a hedge fund or private equity firm. Banks with under $10 billion in assets were excluded from the Volcker Rule last year, so this week's news was a big win for large bank stocks, which surged following the news (although the gains would prove short-lived when the Federal Reserve released results of its latest bank stress test).
The new Volcker Rule will go into effect Oct. 1, according to the U.S. Office of the Comptroller of the Currency. Let's take a deeper look at the changes and why this helps bank stocks.
The specific changes
While the covered fund definition was intended to stop banks from getting tied too heavily to a hedge fund or private equity fund, it also prevented banks from investing in other types of funds. The definition was so broad, according to the final rule, that some bank loans to covered funds could be defined as an ownership interest.
The amended rule would allow banks to invest in most venture capital funds that do not engage in proprietary trading, credit funds, and family wealth management and customer facilitation vehicles.
Additionally, federal regulators eased capital requirements on swap trades made between subsidiaries within the same banking organization. Banks will often swap out interest rates (fixed to floating or vice versa) on certain liabilities and assets in order to hedge against interest rate volatility. Under the current Volcker Rule, banks have to maintain margin, or collateral, for those trades, even those made within its own organization. Under the amended rule, they will not have to maintain that margin. However, if the margin under the old or current rule would have exceeded 15% of a division's tier 1 capital, initial margin would still be required.
Why this is good for banks
The easing of the margin requirements is expected to free up $40 billion of capital at banks. Unlike most companies, banks must hold regulatory capital to guard against unexpected loan losses. But that capital stands still, not generating any kind of return. So any time capital is freed up, it is generally expected that banks will boost profits, because they can deploy that capital into loans or securities or some other mechanism that can generate returns.
Being able to invest in venture capital firms is another way banks can hopefully diversify their revenue streams without taking on too much risk. Venture capital firms often invest in start-ups and small businesses that are usually too early or too risky for banks to directly extend credit to. But by investing in venture capital firms, which make a pool of investments in start-ups, banks can now indirectly extend credit to start-ups -- something regulators believe is a positive for the economy -- and reap the returns, which can be very attractive when a start-up makes it big. The private markets are also another way to hedge risk, granted that banks don't get too heavily involved.
A much better regulatory landscape
It's hard to see it now as they face potentially heavy loan losses as a result of the coronavirus pandemic, but banks have received a lot of nice regulatory relief in recent years, including multiple rollbacks of the Dodd-Frank Act. This should position the industry much better for when the economy stabilizes and the pandemic subsides.