GARP Master Class - Morrison & Foerster · • Dodd-Frank overview and status report ... • Resolution planning • Recovery planning • Stress testing • Other capital planning

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October 2012

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Agenda • Dodd-Frank overview and status report • Systemic regulation and oversight • Title VII in brief • Volcker Rule


Overview and Status Report

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Rulemaking Progress


Rulemaking progress (cont’d) ADOPTED • Durbin Amendment • Creation of new agencies/functions:

• Financial Stability Oversight Council • Office of Financial Research • Office of Insurance Oversight • Consumer Financial Protection Bureau

• Dissolution of Office of Thrift Supervision

• Collins Amendment • Investment Adviser Registration • Living Wills • Say on Pay • Whistleblower Incentives and

Protections

PENDING • Securitization Reform • Designation of Nonbank SIFIs • Derivatives Reform • Volcker Rule • Credit Agency Rating Reform • Capital Requirements • Mortgage Origination and Servicing • Enhanced Prudential Supervision

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• Many of the most important issues have not been addressed, including, for example:

• Designation of entities that are systemically important • Resolution of Volcker Rule • Derivatives provisions • Securitization and mortgage related provisions

DFA – Open Issues


Systemic Regulation and

Oversight

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Systemic regulation • What has changed in financial services regulation?

• SIFI regulatory scheme for BHCs • Systemic (“connectivity”) regulatory authorities • An expanded and enterprise-level resolution scheme for important financial

services firms • A regulatory scheme for “risky” activities across classes of financial institutions • Consolidated and focused consumer regulatory regime • A new class of nonbank financial institutions (nonbank SIFIs) that is subject to

Federal, bank-focused financial supervision (FRB)

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SIFI regime • The elements of the SIFI regulatory regime

• Enhanced supervisory and prudential standards (sections 115 and 165)

• Comprehensive early action, enforcement and resolution authority (sections 121, 165(d), 162, 166 and 172; Title II)

• More intrusive reporting requirements (section 116 and 161) • Activities standards and limitations (sections 120, 163, 164 and

173) • Nonbank SIFI organization and regulation (section 167) • Regulation of systemically important payments clearance and

settlement facilities (Title VIII)


Capital Plans • Stated Purposes

• Maintenance of tier 1 common equity at 5% over upcoming two years • Basis for measuring permissible capital distributions

• Contingent Requirements • Financials • Capital policy • Impact of expected changes to business • Stress test results


Capital Plans (cont’d) • Purposes in execution

• To evaluate the quality of capital and vulnerability of capital to a wide range of stress scenarios

• Required applications • Regulatory capital planning • Basel II/III – now a factor for all banks • Resolution planning • Recovery planning • Stress testing • Other capital planning

• Primary driver: projected credit losses • Application of macro-prudential assumption at portfolio or loan level • Internal credit risk rating capability • Earnings, growth and planned capital infusions


Capital Plans (cont’d) • Content in execution

• Comprehensive capital forecasting including all exposures • Stress testing scenario issues

• A single-path capital plan is based on a number of baseline assumptions that seem most reasonable to management at the time

• What if one or more key assumptions are wrong? • Multiple paths need to be evaluated to understand the downside exposure of

capital to stress scenarios • Three-to five-year projections • Concise, dashboard-level summary reporting content, followed by “high-level”

detail.


Capital Plans (cont’d) • Board duties

• Regulatory requirements • Annual review of “robustness” of planning process • Periodic review of capital goals • Approval of planned capital actions

• As a practical matter, review and approve • Risk limits • Strategic plans and directions • Major assumptions • Results of planning and testing exercises


Contingency Funding Plans • Legal Purpose

• Sufficient highly liquid and unencumbered assets to meet funding needs over 30 days.

• “Highly liquid” • “Unencumbered”

• Note overlap with Basel III requirements


Contingency Funding Plans (cont’d) • Purpose in execution

• To evaluate the availability of and access to liquid resources, and vulnerability to stress scenarios

• Both on-balance sheet liquidity and off-balance sheet (credit lines) • Required applications

• Liquidity stress testing required for all insured financial institutions • March 2010 Interagency Policy Statement on Funding and Liquidity Management

• Basel III liquidity ratios • Other expected liquidity metrics

• Net non-core funding dependence • Brokered deposits/total deposits • Funding concentration metrics • Loan/deposit ratio


Contingency Funding Plans (cont’d) • Content

• Four formal components • Quantitative assessment • Event management process • Monitoring • Testing

• Key considerations • Early warning signs • “Liquidity stress event management team” • Identifying and accessing “alternative funding sources”


Contingency Funding Plans (cont’d) • Board duties

• Annually, approve CFP and review annually • Annually, establish liquidity risk limits • At least semi-annually, board to determine whether bank managed in accordance

with liquidity risk plan • In a liquidity event, oversight will escalate as conditions deteriorate


Resolution and Liquidation • Resolution planning

• U.S. requirements – rapid and orderly liquidation under bankruptcy code • First plans filed on July 2

• Orderly Liquidation Authority • Criteria • FDIC appointed as receiver • $50 billion line of credit

• OLA institutions not synonymous with SIFIs • Non-SIFI could, at the time, present material risk • SIFI could be resolved in bankruptcy


Resolution Plans • Deadlines – three tiers

• July 1, 2012 – already submitted • July 1, 2013 • December 31, 2013

• Agency review • 60 days • Iterative review • Credibility standard


Stress Testing • Capital stress testing

• Legal basis • Data • Assumptions

• Liquidity stress testing • Legal basis • Data • Assumptions


Stress Testing • October 9, 2012, the OCC, FDIC and Federal Reserve approved

stress testing requirements for all insured depository institutions with total consolidated assets of $10b or more

• The Federal Reserve also published final stress test rules for Board-run and company-run stress test requirements for banking organizations with total consolidated assets of $50b or more

• Effective dates differ—generally banks will have until September 2013


Stress Testing • The final rules address the following: • Stress test scenarios: banking agency will provide at least three

economic stress scenarios to run • Stress test methodologies: rules describe the government provided

inputs or scenarios and the required outputs that must be generated • Required reports and publication of results: covered companies and

banks will be subject to different reporting requirements and deadlines and to disclosure requirements


Integration • Three-point program

• Single point of responsibility and accountability for all planning and testing • Responsibility typically would rest with CRO

• Planning and testing on one analytical program • Govern, direct, and coordinate planning and testing activities under one

management-level committee • Typically, the risk management committee

• Role of in-house counsel • Single lawyer responsible for advice on all planning and testing requirements • Sufficiently senior to obtain support from others in legal department not ordinarily

involved in planning and compliance – e.g., capital markets • Scorecard for all board and senior management actions • Timeline


Title VII Overview


Title VII Overview • Objectives of Title VII

• Reduce systemic risk posed by the swaps market to the U.S. financial system • Increase transparency of the swaps market, particularly as to both pre and post

execution pricing • Enhance the integrity of the swaps market and improve the conduct of major

market participants


• Regulates products • Swaps • Security-based swaps (SBSs)

• Regulates entities • Swap dealers • Security-based swap dealers • Major swap participants (MSPs) • Major security-based swap participants • Derivatives Clearing Organizations (DCOs) • Swap Execution Facilities (SEFs) • Swap Data Repositories (SDRs)

• Splits regulation between CFTC and SEC • CFTC regulates swaps, swap dealers and major swap participants • SEC regulates security-based swaps, security-based swap dealers and major security-based

swap participants • For convenience, we will generally use the CFTC terminology to refer to both

categories, unless we note otherwise

Title VII Overview (cont’d)


Status of Rulemaking • Critical building blocks of the Title VII regulatory regime have been

jointly adopted by the CFTC and SEC • Entity Definitions (adopted in April and published in May 2012) covering definitions

of swap dealer, security-based swap dealer, major swap participant, major security-based swap participant and eligible contract participant (referred to as the Entity Definitions)

• Product Definitions (adopted in July 2012, and published August 2012) covering definitions of swap and security-based swap

• However, still awaiting final action by the U.S. Treasury regarding the exemption of FX forwards and FX swaps for certain purposes

• Publication of Product Definitions triggered a host of compliance dates under the CFTC’s Title VII regulations, but will not have a similar effect with respect to the SEC’s Title VII regulations


• With the publication of the Product Definitions, registration for swap dealers and major swap participants is to become mandatory before year end

• Once this registration requirement occurs, many other Title VII rules adopted by the CFTC will begin to take effect at that time or shortly thereafter, including:

• Real-time Reporting for Credit and Interest Rate Swaps • General Recordkeeping and Reporting for Credit and Interest Rate Swaps • Various Internal Business Conduct Standards for swap dealers and MSPs • External Business Conduct Standards • Position Limits for physical commodity-based futures and swaps for spot

months and, for legacy agricultural commodities, non-spot months (CFTC recently provided temporary no-action relief from certain aggregation requirements under its position limit rules)

• Also under CFTC’s rules, FCMs will be required in November 2012 to implement the LSOC method for segregating customer initial margin posted for cleared swaps

Status of Rulemaking (cont’d)


• SEC is taking a different approach to Title VII rulemaking • It appears that no registration requirements will be imposed until all substantive

Title VII rulemaking by SEC is complete • Two of the CFTC’s Commissioners (Sommers and O’Malia) indicated they

had hoped that the CFTC would proceed in a similar fashion • SEC’s substantive rulemaking has lagged significantly behind the CFTC’s

• In some cases, the SEC is yet to publish a proposed rule on matters that the CFTC has long since published proposed rules on or even proceeded to adopt final rules

• For example, as yet no SEC proposed rule on: • margin requirements for OTC swaps or capital for non-bank registrants • cross border application of SEC’s Title VII regulation

• Even where SEC has published proposed rules, the timeline for finalizing these rules is unclear

Status of Rulemaking (cont’d)


Extraterritorial Guidance • CFTC is also working to finalize guidance and compliance relief

relating to the cross-border application of Title VII and the CFTC’s Title VII rules

• In late June, CFTC issued: • Proposed Guidance regarding the application of its Title VII rules beyond the

U.S. borders, and • Proposed Exemptive Order to permit delayed compliance with certain Title VII

requirements for foreign entities • Comment period for Exemptive Order closed on August 13, 2012, and

comment period for Proposed Guidance closed on August 27, 2012 • Extensive comments were submitted by many groups and market participants

• Following the applicable comments periods, • Proposed Guidance could be finalized in October 2012, but many issues will

need to be resolved and finalization could take longer, and • Proposed Exemptive Order could be finalized in October 2012


• Proposed Guidance attempts to address cross-border matters by: • distinguishing between “Entity-level” requirements and “Transaction-level” requirements of

Title VII • defining who is a U.S. Person for cross-border purposes • considering how Title VII should apply to foreign branches, subsidiaries and affiliates of U.S.

Persons, as well as how guaranties by U.S. Persons might impact these considerations • contemplating, in the case of some Entity-level requirements, potential “Substituted

Compliance” based on comparably robust home country regulation

• The Proposed Guidance is already attracting a significant adverse reaction from the international banking and financial regulatory community

• Proposed Exemptive Order supplements the Guidance by allowing delayed compliance for certain (but not all) Entity-level requirements

• Primarily for non-U.S. swap dealers/MSPs who by complying with the order may delay some compliance until July 2013

• However, U.S. swap dealers/MSPs who comply can delay their compliance with some Entity-level requirements until January 1, 2013. Additional relief is also afforded foreign branches of U.S. swap dealers and MSPs.

Extraterritorial Guidance (cont’d)


• As expected, the Proposed Guidance and Proposed Exemptive Order have garnered extensive substantive comments from foreign and international regulators, industry groups and major market participants

• Many commenters have raised fundamental issues, such as: • The Proposed Guidance and Proposed Exemptive Order exceeding the extraterritorial

authority granted under Dodd-Frank and existing case law • The failure of this effort to be sufficiently coordinated with G-20 efforts as had been

contemplated, creating significant risk of inconsistent and duplicative regulations, market fragmentation and disruption and regulatory arbitrage rather than harmonization

• The inappropriateness of issuing guidance rather than going through a formal rulemaking process, which imposes more rigorous procedures and cost-benefit standards

• Unintended compliance disparities that will result between U.S. and non-U.S. swap dealers • Need for general delay in registration and compliance dates to allow sufficient time to resolve

issues, finalize guidance and then structure businesses accordingly



• In addition, commenters have raised numerous specific comments and issues about aspects of both the Proposed Guidance and the Proposed Exemptive Order, including

• Lack of clarity in the U.S. Person definition (which differs from the SEC’s Regulation S definition)

• Aggregation requirements for swap activities of affiliated non-U.S. persons • Treatment of inter-affiliate transactions and, in particular, the use of non-U.S. affiliate

“conduits” • Treatment of non-U.S. counterparties that are guaranteed by a U.S. Person • Treatment of non-U.S. branches (i.e., commenters argue these should be treated as any other

non-U.S. person) • Permitting substituted compliance for “Transaction-Level” requirements • Simplify and expand approach to recognizing substituted compliance • A renewed call for “Limited Designation” if a foreign swap dealer conducts its U.S. swap

activities through its U.S. based affiliate • Request to clarify how Proposed Exemptive Order and Proposed Guidance affect NFA

registration process and to eliminate resulting confusion and inconsistencies • Permit delayed and substituted compliance for certain reporting and recordkeeping

requirements (such as daily trade records requirement) • Expanding emerging markets exception to branches of non-U.S. swap dealers



Compliance and Registration Deadlines • Whenever registration does occur, each newly registered swap dealer or

MSP will face a host of other regulatory compliance dates • The registration process has been delegated to the NFA and will be

conducted as follows • Registration will be made on a provisional basis, by filing forms 7-R, 8-R, finger

print cards and compliance documentation, and paying required filing fees • A registrant will need to include with its application to NFA materials demonstrating

its ability to comply with any “4(s) Implementing Regulations”, which consist of: • Capital and Margin (Section 4s(e)); Reporting and Recordkeeping (Section

4s(f)); Daily Trade Reporting (Section 4s(g)); Business Conduct Standards (Section 4s(h)); Documentation Standards (Section 4s(i)); Duties (Section 4s(j)); CCO Designation (Section 4s(k)); and Segregation Requirements for Uncleared Swaps (Section 4s(l))

• Compliance will be demonstrated on a rolling basis, so that as compliance dates occur a registrant will need to supplement its application to show its ability to comply with those additional 4(s) Implementing Regulations for which compliance is then required


Entity Definitions • Swap dealers and MSPs are two of the most heavily regulated new

entities established by Title VII. The statutory definitions for these entities provide:

• Swap Dealer: Any person who– • Holds itself out as a swap dealer; • Makes a market in swaps; • Regularly enters into swaps with counterparties as an ordinary course of

business for its own account; or • Is commonly known in the trade as a dealer or market maker in swaps

• Major Swap Participant: Any person who is not a dealer and– • Maintains a substantial position in swaps, excluding positions held for hedging

or mitigating commercial risk; • Outstanding positions create substantial counterparty exposure that could

have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or

• Is a highly leveraged financial entity that maintains a substantial position in swaps and is not subject to a Federal banking agency’s capital requirements


• CFTC and SEC have jointly adopted rules and provided guidance in an effort to clarify these statutory definitions:

• For swap dealers, the regulations and guidance include: • A three-step process to be followed in determining swap dealer status • Importance of the “dealer-trader” distinction in this analysis-this is a concept long

used by the SEC in regulating securities broker-dealers • Exclusion of some hedging activities from the “dealer” determination • Further description of what types of activities will be considered “market making” • Clarification of the exclusion for swaps executed in connection with loan

originations, though this exclusion is only available to insured depository institutions

• Expansion and phasing in of the “de minimis” exemption

Entity Definitions (cont’d)


• For MSPs, the regulations and guidance include: • Definitions of “major swap participant” and “major security-based swap participant”

focus on the market impacts and risks associated with that person’s swap and security-based swap positions. (Note that “swap dealer” and “security-based swap dealer” definitions focus on activities)

• Major participants generally must follow the same statutory requirements that apply to swap dealers and security-based swap dealers since their activities could pose a high degree of risk to the U.S. financial system generally.

• MSP: Any person who is not a dealer and– • Maintains a substantial position in swaps, • Outstanding positions create substantial counterparty exposure that could have serious adverse effects on the financial stability of the US banking system or financial markets; or

• Is a highly leveraged financial entity that maintains a substantial position in swaps and is not subject to federal bank capital requirements

Entity Definitions (cont’d)


Product Definitions • On July 6, 2012, the SEC approved the Product Definitions on a

unanimous vote of the SEC Commissioners. On July 10, 2012, the CFTC held an open meeting at which it approved the final Product Definitions in a 4-1 vote of the Commissioners (with Commissioner Chilton voting against the final rules).

• Title VII generally bifurcates regulation of the OTC derivatives markets, with the CFTC having jurisdiction over “swaps” and the SEC having jurisdiction over security-based swaps (“SBS,” and with “swaps,” “Title VII Instruments”).

• The SEC and CFTC share jurisdiction over “mixed swaps.” • The CFTC also has regulatory and enforcement authority over

“security-based swap agreements” (“SBSAs”), but the SEC has antifraud and certain other authority over SBSAs.


• Title VII defines a “swap” broadly to include transactions involving a purchase, sale, payment or delivery that is dependent on the occurrence, nonoccurrence, or extent of occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence

• This broad scope raised concerns regarding the status of a number of different types of products and instruments, and the final definitions include guidance regarding quite a number of products that are excluded from the definitions provided certain conditions are met. In the next series of slides, we will outline the treatment of a number of these products.

• The final rules also establish a process by which parties may request a joint interpretation from the CFTC/SEC regarding whether a particular OTC derivative or type of derivative that is subject to Title VII of Dodd-Frank should be treated as a swap, SBS or mixed swap.

Product Definitions (cont’d)


• Key exclusions from the swap/SBS definition: • Consumer Transactions: certain consumer transactions primarily for personal,

family or household purposes were excluded, including real estate transactions, mortgages, personal service transactions and interest lock and caps related to such transactions

• Commercial Transactions: those involving customary business or commercial arrangements, such as employment, sales, servicing, or distribution, business combinations, and equipment, inventory and IP transfers or leases, and many commercial finance arrangements

• Forward Contracts on Physical Commodities: consistent with longstanding distinction between forward contracts and futures contracts, with helpful clarification regarding bookouts, embedded optionality and other common commercial terms, such as requirement, output and evergreens

• Forward Contracts on Securities: confirmed MBS TBA transactions are covered • Participation Agreements: excluded both LSTA true sale participations and LMA

risk participations • Insurance Products: provided a safe harbor based on either being an “Enumerated

Product” or satisfying a “Product Test”

Product Definitions (cont’d)


Compliance Issues • Swap dealers and MSPs face a significant array of regulatory and

compliance burdens, including • External Business Conduct Standards • Internal Business Conduct Standards • Real time Reporting and General Recordkeeping and Reporting • Trading Documentation Requirements • Clearing Documentation and Processing Requirements • Margining and Collateral Segregation Requirements • Capital Requirements

• As noted earlier, the precise compliance dates for these are complex and, given the uncertainty over the required registration date for swap dealers and MSPs, somewhat uncertain


• Even assuming the most delayed registration deadline, swap dealer and MSP registrations face major compliance issues and challenges such as:

• Policies and procedures: developing the required policies and procedures to demonstrate compliance with all “4s Implementing Regulations”

• Supervision and CCO compliance: demonstrating that a strong supervisory system is in place, with skilled supervisory personnel along with a qualified CCO, is likely to be a critical item assessed by the NFA

• Training programs: internal training programs regarding policies and procedures are likely to be assessed by the NFA

• IT and related infrastructure: the ability to comply with the required policies and procedures will demand extensive IT and infrastructure development by registrants

Compliance Issues (cont’d)


• External and internal business conduct standards and recordkeeping and reporting are requiring prospective registrants to devote considerable resources to be ready to comply with these requirements

• External Business Conduct Standards • General standards include:

• Verification of counterparty status • KYC and institutional suitability requirements • Disclosure obligations relating to material risks, characteristics and conflicts of

interest • Daily mark-to-market values • Clearing Documentation • Trading Documentation

• Additional standards apply to interactions with Special Entities



• To comply with external business conduct standards, swap dealers and MSPs will need to implement enhanced due diligence procedures prior to executing transactions with swap counterparties

• In addition to establishing policies and procedures, swap dealers and MSPs will need to alter and supplement counterparty documentation in order to comply with external business conduct standards

• To facilitate this documentation process, ISDA together with its membership have developed a suite of documents and an implementation system

• Referred to as the ISDA August 2012 DF Protocol • Result of months of work and negotiation among ISDA and sell and buy side

representatives • Though not a solution to all external business conduct requirements, it is

intended to help regulated entities address many of the due diligence and documentation challenges they face as a result of these requirements



• Internal Business Conduct Standards • CFTC final rules:

• Requires registrants to adopt risk management programs • Requires that swap documentation with counterparties address certain matters, including

payments netting, events of default and termination, transfers, governing law • Complying with the new Internal Business Conduct Standards will present many new

challenges, including addressing: • Changes In Communications Between Swap Dealers and Third Parties • Communications Involving Research Analysts • Communications Involving Research Reports • Relationship Between Clearing and Business Trading Units • Role of the Chief Compliance Officer • Required Annual Compliance Report • Reporting and Recordkeeping for Swap Dealers-Trade and Marketing Data • Reporting and Recordkeeping for Swap Dealers-Governance Data • Duties of Swap Dealers • Required Risk Management Program for Swap Dealers (including a new products policy) • Diligent Supervision Requirement



• Recordkeeping and Reporting • The requirements include:

• General recordkeeping and reporting requirements • Real-time public reporting requirements • Requirements to maintain “daily trade records”

• Under the CFTC’s rules: • General recordkeeping and reporting requirements mandate the reporting of “creation

data” and “continuation data” relating to swaps • Creation data consist of

• Primary economic terms data (“PET”) and • Confirmation data (i.e., all of the terms of the swap as confirmed by the parties)

• Continuation data consist of information arising during the term of a swap, such as: • Valuation data • Changes to previously reported economic terms

• Real-time public reporting requirements mandate that certain economic data be reported to SDRs “as soon as technologically practicable” so that the SDR can then publicly disseminate that information

• Daily trade recording requirements mandate that a swap dealer maintain records that are sufficient to permit comprehensive and accurate trade reconstruction and identifiable and searchable by transaction and counterparty, including both pre-execution and post-execution information



• Trading Documentation • Rules very recently adopted by CFTC • Require documentation to address

• Confirmation timing and practices • Portfolio reconciliation • Portfolio compression • Trading document requirements • End-user documentation requirements

• CPO and CTA compliance issues • By expanding “commodity interests” to include swaps and removing the 4.13(a)(4) exemption

from CPO registration, the CFTC has triggered a complex and in some cases unanticipated compliance challenge for many pooled investment vehicles and their advisors

• The securitization industry and other key financial market participants are struggling with the potential risk that entities that previously were not faced with potential CPO registration might now technically have to concern themselves with this possibility

• No-action and other relief are being sought by various groups and market participants



Volcker Rule

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Volcker Interplay • The Volcker Rule prohibits (with some exceptions) “proprietary

trading.” • Proprietary trading means:

• Engaging as principal • For the trading account • Of the “covered banking entity” • In the purchase or sale of one or more “covered financial positions.”

• A “covered financial position” includes a swap. • A “covered banking entity” includes an insured depository institution and

any affiliates or holding companies. • A trading account is an account in which positions are held in order to

realize gains from short-term price appreciation. • Generally, positions held for 60 days or less are deemed to be traded

positions and are subject to Volcker restrictions. • Positions held for more than 60 days generally are exempt

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What is Prohibited? • Proprietary trading

• Covered financial position • Trading account

• In or sponsoring hedge funds or private equity funds • Section 3(c)(1) of Investment Company Act • Section 3(c)(7)

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What Trading is Permitted? • Underwriting • Market-making • Risk-mitigating hedging transactions • Trading in U.S. government and U.S. government agency securities • Trading outside the United States • Some thoughts on proprietary trading

• Note that scope of Volcker prohibition differs from the scope of the Lincoln provision, requiring separate compliance with each provision. For example, • Lincoln focuses only on “swaps” as defined Title VII, while Volcker focuses on a

broader range of trading transactions • Volcker, however, looks at trading only in a “proprietary account” while Lincoln

looks at all swaps (subject to safe harbored activities)

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Proprietary Trading–Compliance and Reporting Requirements Specific Requirements for Certain Banking Entities

(“Appendix A Banking Entities”) All banking entities that have consolidated worldwide trading

assets and liabilities equal to or greater than $1 billion, measured on an average gross sum basis as determined on the last day of each of the four prior calendar quarters, will be subject to detailed and extensive reporting and recordkeeping requirements for those trading activities (Section 7 and Appendix A requirements), depending on the nature and level of trading activity

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Proprietary Trading Rules–Compliance and Reporting Requirements

Specific Requirements for Appendix A Banking Entities These reporting and recordkeeping requirements are tiered as

follows: Banking entities that have consolidated worldwide trading assets

and liabilities equal to or greater than $1 billion but less than $5 billion will be required to maintain records and report on their market-making related activities

Banking entities that have consolidated worldwide trading assets and liabilities equal to or greater than $5 billion, however, will be required to maintain records and report on all covered trading activity

This information is required for each “trading unit” of the reporting banking entity

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Specific Requirements for Appendix A Banking Entities Scope of reporting

$1-$5 billion banking entities: 8 data points for market making activities

$5 billion + banking entities: 17 data points for market-making activities, 5 data points for other permitted trading

Frequency of calculation and reporting Calculation: every trading day Reporting: monthly -- reports due 30 days after calendar month’s

end or as other requested by supervisory agency

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Specific Requirements for Appendix A Banking Entities Quantitative reporting and recordkeeping requirements

Risk management measurements Source-of-revenue measurements Revenue-relative-to-risk measurements Customer-facing activity measurements Payment of fees, commissions and spreads measurements

Further, all Appendix A banking entities are Appendix C banking entities (although not necessarily vice-versa), and therefore are subject to compliance management requirements specifically impacting their trading activities

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Proprietary trading • Appendix C Trading Compliance Program Requirements

• Internal policies and procedures • Identification of trading accounts • Identification of trading units and organizational structure • Description of missions and strategies • Trader mandates • Description of risks and risk management processes • Hedging policies and procedures • Explanation of compliance • Remediation of violations

• Written internal controls • Assure consistency with mission, strategy and risk mitigation • Must address, at a minimum, (i) authorized risks, instruments and products,

(ii) risk limits, (iii) robust analysis and quantitative measurements, and (iv) surveillance of program effectiveness

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• Appendix C Trading Compliance Program Requirements • Responsibility/accountability

• Corporate governance • Trader mandates • Management procedures • Business line managers • Senior management responsibilities • Board of directors/CEO responsibilities

• Independent testing • Not less than annually • Evaluation of program adequacy/effectiveness, written policies and

procedures, internal controls and management procedures • Training • Recordkeeping

Proprietary trading (cont’d)

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• Specific compliance requirements apply to Tier 3 entities (Appendix C requirements) • Internal policies and procedures

• Identification of covered funds • Identification of asset management units/organization • Description of sponsorship activities • Description of investment activities • Remediation of violations

• Written internal controls • Investment monitoring • Relationship monitoring • Surveillance of program effectiveness

Covered funds

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• Appendix C requirements • Responsibility/accountability

• Corporate governance • Management procedures • Business line managers • Senior management responsibilities • Board of directors/CEO responsibilities

• Independent testing • Not less than annually • Evaluation of program adequacy/effectiveness, written policies and procedures,

internal controls and management procedures • Training • Recordkeeping

Covered funds (cont’d)

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• Investments in SBICs and related investments • Related investments include funds designed primarily to promote public welfare, or

qualified IRC section 47/state historic tax credit investments

• Risk-mitigating hedging activities • Investments made in connection with obligations/liabilities of the banking entity (i)

taken when acting for a customer to facilitate customer exposure to profits/losses of covered fund, or (ii) directly connected to compensation of employee directly provided advisory services to a covered fund

• Such investments are designed to reduce specific risks to the banking entity related to such obligations/liabilities


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• Investment in or sponsorship of a covered fund by a banking entity solely outside of the United States if: • Banking entity not directly/indirectly controlled by U.S. banking entity • Activity is conducted pursuant to BHCA Section 4(c)(9) or 4(c)(13) • Interests in the fund are not offered or sold to a U.S. resident • Activity occurs solely outside of the U.S.


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Covered funds (cont’d) • Loan Securitizations

• Allows owner/sponsorship of covered fund that is an issuer of asset-backed securities, assets of which are solely comprised of: • Loans • Directly related contractual rights or assets • Interest rate and foreign exchange derivatives that materially relate to terms of

underlying loans/contractual rights or assets and are used for hedging purposes with respect to issuer

• Bank-owned life insurance (BOLI) separate accounts

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Funds–Other Permissible Activities

Other Permitted Covered Funds/Activities Joint ventures/operating company investments Acquisition vehicles “Securitizer” and “originator” credit risk retentions of asset-backed

securities issuers under Securities Exchange Act section 15G Liquidity management subsidiaries Qualified ABS issuers Covered fund ownership interests acquired DPC, subject to

compliance with agency disposition periods Covered fund ownership interests acquired/held in compliance with

Federal Reserve Board’s Volcker Rule conformance periods

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Covered Funds–Limits on Banking Entity Relationships

Absolute prohibition on banking entity Section 23A covered transactions with covered funds

“Super 23A” prohibition applies to any covered fund to which a banking entity acts as investment manager, investment adviser, or sponsor

Super 23A does not prohibit otherwise-permitted acquisitions or retentions of covered fund ownership interests under the organize/offer or other covered fund exceptions

Prime brokerage transactions with covered funds are conditionally exempted

But, limited to covered funds in which a covered fund managed, sponsored or advised by the banking entity has taken an ownership interest

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Covered Funds–Limits on Banking Entity Relationships

Application of Federal Reserve Act Section 23B to banking entity relationships with covered funds

Applies to any covered fund to which a banking entity acts as investment manager, investment adviser, or sponsor

Banking entity and its affiliates are treated as a “member bank” for Section 23B purposes

Permitted prime brokerage transactions are subject to Section 23B limitations

This is MoFo. 66

Covered Activities–Prudential Limitations

Otherwise permissible proprietary trading or fund ownership/sponsorship activity is forbidden if it would: Result in a material conflict of interest between the banking

entity and its clients Result, directly or indirectly, in a material exposure for the

banking entity to high-risk assets or high-risk trading strategies

Pose a threat to the safety and soundness of the banking entity

Pose a threat to the financial stability of the U.S.

This is MoFo. 67


Material Conflicts of Interest: Activities or transactions that would involve or result in the banking

entity’s interests being “materially adverse” to client, customer or counterparty interests, unless: Banking entity makes “clear, timely and effective disclosure” of

conflict and Disclosure is made “explicitly and effectively” in a manner that

allows client/customer/counterparty to “negate or substantially negate” any materially adverse effect

or Banking entity has information barriers that are reduced to writing in

specified written policies and procedures. Compliant information barriers, however, do not permit transactions creating conflicts that have materially adverse effect on client/customer/counterparty

This is MoFo. 68


High-Risk Asset: Asset or group of related assets that if held by banking entity would significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail

High-Risk Trading Strategy: Trading strategy that if conducted by banking entity would significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail

Threat to the safety and soundness of the banking entity

Threat to the financial stability of the U.S.

This is MoFo. 69


Financial agencies may require banking entities that violate or seek to evade requirements of Volcker Rule or implementing regulations to restrict, limit or terminate activity or dispose of investment

Such action may be taken upon finding of “reasonable cause” upon notice and opportunity for a hearing

Standard enforcement powers

This is MoFo. 70

Compliance and reporting • Structure of Required Compliance Program

• The proposed rules would create compliance and reporting requirements to assure that (i) covered banking entities comply with the substantive requirements of the Volcker Rule and implementing regulations, and (ii) the financial regulatory agencies can monitor and supervise such compliance

• These requirements broadly include: • A compliance program that is reasonably designed to assure and monitor

compliance with proprietary trading and covered fund activities and investments • Reporting and recordkeeping requirements for covered trading and covered

fund activities

This is MoFo. 71

• Structure of Required Compliance Program • Certain banking entities that are actively and substantially engaged in trading

activities would be subject to more stringent and detailed compliance and reporting requirements that are imposed on a tiered basis, depending on the quantitative level of these activities

• All of these requirements, by all accounts, will be costly and burdensome for many banking entities to implement

Compliance and reporting (cont’d)

This is MoFo. 72

• Compliance Program – Required Minimum Elements for all Banking Entities (Section 20) • Internal written policies and procedures • System of internal controls • Management framework that clearly delineates responsibility and accountability for

Volcker Rule compliance • Independent testing of compliance program effectiveness • Training for trading personnel/managers and other appropriate personnel • Making/keeping records sufficient to demonstrate compliance, which must be

provided to a banking entity’s regulatory agency on request and maintain for a period of not less than 5 years


This is MoFo. 73

• Compliance Program – Enhanced Requirements for Certain Banking Entities (Section 20 and Appendix C) • Affected banking entities (“Appendix C banking entities”) are:

• Those that engage in proprietary trading and have total worldwide trading assets and liabilities of either (i) equal or greater than $1 billion, or (ii) 10% or more of total assets, measured on a average gross sum basis as determined on the last day of each of the four prior calendar quarters.

• Those that invest in or have relationships with covered funds where (i) aggregate investments in covered funds, or (ii) average total assets of covered funds sponsored or advised by the banking entity, are equal or greater than $1 billion, measured as of the last day of each of the four prior calendar quarters


This is MoFo. 74

• Enhanced Requirements for Appendix C Banking Entities • Significantly more detailed requirements for covered trading activities, covered fund

activities or investments • Program requirements • Internal policies and procedures • Internal controls • Accountability requirements • Independent testing • Training • Recordkeeping

• These requirements are similar but not identical for proprietary trading and covered fund activities (and therefore are discussed separately below)


This is MoFo. 75

• Compliance Program – Conditional Exclusion • Conditional exclusion for banking entities “to the extent” not engaged in “activities

or investments prohibited or restricted” by the proprietary trading or covered fund rules • Existing compliance policies and procedures must be designed to prevent the

banking entity from engaging in covered activities, and require a banking entity to develop the required compliance program before engaging in covered activities

• Some questions regarding the practical impact and utility of this conditional exclusion • Trading in exempted instruments • Investment portfolio purchases • Impact of high risk activities/systemic risk requirements


Documents

GARP Master Class - Morrison & Foerster · • Dodd-Frank overview and status report ... • Resolution planning • Recovery planning • Stress testing • Other capital planning