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Federal Reserve Issues Proposal on Bank Trading

Source: WSJ - Alan Zibel, Scott Patterson

Posted on 11 Oct 2011

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The Federal Reserve on Tuesday proposed regulations outlining how banks should restructure their operations to comply with a new ban on risky speculative bets.

The Dodd-Frank financial-overhaul law passed last summer seeks to prevent banks from putting themselves at risk by prohibiting so-called proprietary trading. Regulators have spent months working out the details of the regulations, which also restrict most relationships with hedge funds and private-equity funds.

The limits on banks' activities were included in a provision of the Dodd-Frank law named for former Federal Reserve Chairman Paul Volcker. During the debate over the financial law, Mr. Volcker contended that excessive risk-taking in banks' "proprietary" trading businesses could threaten the overall financial system in the future.

The proposal is also expected to be approved by the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency and is expected to be considered by the Securities and Exchange Commission on Wednesday.

It includes exemptions that allow such trading in some cases. Comments are due on the proposal by Jan. 13 and the rules are expected to be effective next year.

The proposal "provides commentary intended to assist banking entities in distinguishing permitted market-making-related activities from prohibited proprietary trading activities," the Fed said in a statement.

Some Republicans on Capitol Hill, however, say the new rules will put U.S. banks at a disadvantage compared with their international counterparts.

And industry groups warn the rule will lead to higher costs for U.S. companies.

Banks already say that the cost of complying with these rules will be expensive. And they are likely to fight a provision of the rule that bans them from using affiliates outside the U.S. to make proprietary trades.

The proposal is designed to prohibit trades designed to make a quick profit, but provide exemptions to underwrite and make markets in securities and to hedge risks. Regulators have also set up a thorough compliance program to make sure that banks don't make proprietary trades under the guise of

Critics, however, warn that the hedging exemption is overly broad, saying it could allow banks to make the type of bets the rule aimed to prevent. That's because a bank might define the risk to its portfolio broadly, such as the risk of a recession.

In addition to the FDIC and Fed, the rules need to be approved by the Office of the Comptroller of the Currency, Securities and Exchange Commission and Commodity Futures Trading Commission.
Proprietary-trading desks at banks have functioned like hedge funds, making bets on stocks, commodities and other assets, often using borrowed

money to do so. A report by the Government Accountability Office in July said stand-alone proprietary trading accounted for $15.6 billion in revenue at the six largest bank holding companies for the 13 quarters from June 2006 to December 2010. However, proprietary trading accounted for $15.8 billion in losses, during the financial crisis wiping out the gains of the previous 4 1/2 years.

The Volcker rule already has triggered major changes at large U.S. banks. Several institutions shut down trading desks that made bets with the firm's own capital. Many traders moved to smaller firms that aren't subject to the rule.

The Fed said the proposal requires banks with big trading operations to report "certain quantitative measurements" to assist regulators in identifying some activities that could be exempt. The proposal also limits these reporting requirements for smaller banks, as part of an effort to reduce the burden on smaller institutions.