PUBLIC STATEMENTS & REMARKS

Statement of Chairman Heath P. Tarbert in Support of Further Revisions to the Volcker Rule

January 30, 2020

Several months ago, I supported a rulemaking addressing the proprietary trading provisions of the Volcker Rule[1] and laid out my views as CFTC Chairman as well as someone who has witnessed the rule’s implementation over the last decade.[2]  The proposal before the Commission today focuses on the other side of the Volcker Rule: the prohibition on activities related to private equity and hedge funds (the “covered funds” provisions).

Although this part of the Volcker Rule has only limited implications for the CFTC and the derivatives markets that our agency regulates,[3] I have voted for the proposal because it represents a more accurate reading of the law Congress actually passed.[4]  With this proposal, however, the Volcker Rule is laid bare and several inherent flaws become all the more apparent.  At the same time, the good news is that, if the proposal is adopted, the Volcker Rule will no longer be applied to investments Congress never intended to be included, such as credit funds, venture capital funds, customer facilitation vehicles, and family wealth management vehicles.  The proposal also contains important modifications to several existing exclusions from the covered funds provisions—for foreign public funds, loan securitizations, and small business investment companies.  In these ways, the proposal moves toward addressing the over-breadth of the covered fund definition and related requirements.

Origins of the Covered Funds Prohibition

The Volcker Rule was intended to address two concerns with banking organizations: conflicts of interest and excessive risk taking.  I think proprietary trading raises legitimate concerns on both counts.  Trading for a bank’s[5] own account presents a potential conflict when buying and selling for customer accounts alongside it.  And there is little question that large-scale trading operations can create risks for a bank that directly or indirectly benefits from deposit insurance and discount window access.[6]  While the Volcker Rule has been poorly implemented, I believe the proprietary trading restrictions were at least well-intended.[7]

I unfortunately cannot say the same for the attendant prohibition on activities related to “private equity and hedge funds.”  It is worth noting that, before the politicization of the rule, Chairman Volcker did not even propose this part of the ban, and instead focused solely on proprietary trading.  In fact, he appeared disappointed to see the covered funds provisions in the bill.  He noted: “I’d write a much simpler bill.  I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance.”[8]  It is hard to argue with such a common-sense approach.

Flaws in the Covered Funds Provisions

There are several inherent flaws with the so-called covered funds side of the Volcker Rule:  (1) it represents a politicization of prudential supervision; (2) it does not address purported risks of non-banking activities; (3) it paradoxically reinforces conflicts of interest; and (4) it has been overly complicated and full of loopholes for lawyers.  In many ways, the proposal today would correctly implement what the statutory Volcker Rule actually says; it cannot fix the law’s fundamental problems, but it can bring us a step closer to reasonable implementation.

1. Politicizing Prudential Supervision

    The proposal correctly acknowledges that Congress chose its words carefully.  The law refers to “private equity and hedge funds.”[9]  The congressional record includes a number of instances where congressional intent is explicitly stated regarding the desire of Congress to exempt investments by banks in venture capital funds.  For example, on the day the Senate passed the Dodd-Frank Act, the very namesake of the law, Senator Chris Dodd, stressed that “properly conducted venture capital investment will not cause the harms at which the Volcker rule is directed.”[10]  During the initial implementation of the Volcker Rule, regulators largely ignored this rather inconvenient language.  Yet it is there.

    Congress offered no reason for why venture capital funds were explicitly excluded.  But I can make an educated guess:  venture capital funds are viewed by the public—and rightly so—as incubators for entrepreneurship in our country.[11]  Venture capital generally has a good reputation relative to private equity and hedge funds.  In fact, now some legislators at least have been transparent about their motives.  For example, the recently proposed legislation, Stop Wall Street Looting Act of 2019,[12] takes aim at a very specific corner of the financial industry:  private equity funds.  Notably, the restrictions in that bill do not apply to venture capital funds.  At least here the political purpose is clear on its face; it does not hide behind a prudential rationale.

    Banning activities related to private equity and hedge funds may make good political sense to some.  Being less controversial, however, has nothing to do with whether something is less risky for our banking system.[13]  Indeed, while venture capital funds play a critical role in our economy, the high returns they typically generate are correlated with the risks they take in concentrating their investments in yet-unproven start-ups.  There is little or no evidence that participation in venture capital funds is less risky than investments in private equity and hedge funds.  And hence the congressional choice to exclude them was political, not prudential.  We should not kid ourselves.

    2. Inconsistent Treatment of Non-Banking Risks

      The exclusion of venture capital is just the tip of the iceberg.  Congress had every chance to address the so-called merchant banking authority that had been added to the Bank Holding Company Act when the Glass-Steagall Act was repealed.[14]  Under that authority, banks can invest in commercial companies far outside the field of financial services.  Supervisors have largely restricted the ability of banks to go beyond activities that are “financial in nature” or “closely related to banking” because the government cannot adequately supervise such risk taking.  Under the theory that a bank is simply holding a commercial company as a financial investment as opposed to part of its operations, the merchant banking authority allowed large banks to buy all sorts of companies—either outright or through funds.[15]  While the Volcker Rule restricted banks from investing in companies through private equity or hedge funds, Congress left the merchant banking authority fully intact, even though it is entirely inconsistent from a risk standpoint.

      The end result has been that banks can continue to make investments (even 100% controlling investments) in all sorts of commercial enterprises directly.  The irony is that making investments directly in commercial companies is far more risky than the diversification benefits that come with making those investments indirectly through private equity or hedge funds.  From a risk standpoint, therefore, Congress’s approach to the Volcker Rule makes little sense.  It is simply hard to see how American taxpayers are better protected under this approach.

      3. Misalignment with Investors                                                  

        Reducing conflicts of interest was the other key goal of the Volcker Rule.  But the covered funds restrictions get this issue backwards.  The Volcker rule actually does not ban sponsorship of private equity and hedge funds.  Rather, Congress has allowed banks to organize and offer covered funds to their customers, but only if the bank’s interest in those funds is de minimis, i.e., three percent or less.  Customers who invest in these funds want to know the bank has “skin-in-the-game.”  That is, rather than just paying management fees, investors want to know that the fund sponsor has invested its own capital alongside theirs.  In many private equity and hedge funds, the sponsor commits up to 10% of its own capital in each fund to prove its interests are aligned with those of its investors.  With private funds, skin-in-the-game largely mitigates any potential conflicts.[16]  Yet the Volcker Rule cuts in the opposite direction, significantly reducing banks’ “skin in the game” and leading to questions about whether Congress carefully assessed conflicts and investor protection when adding the covered funds provisions.

        4. Full Employment  . . .  for Lawyers

          A final flaw is that the ban on private equity and hedge fund activities has become a game of legal charades.  It has made many Wall Street law firms wealthier, while doing little with respect to the risk portfolios of banks.  That is because Congress took a legalistic approach to defining what a private equity or hedge fund is—at the same time being over-inclusive and under-inclusive.[17]

          Specifically, rather than defining “private equity or hedge fund” as they are commonly understood, the Volcker Rule defines a “covered fund” to include an issuer that would be an “investment company” under the Investment Company Act of 1940 (“1940 Act”) but for Section 3(c)(1) or Section 3(c)(7) of the 1940 Act[18] and certain commodity pools under the Commodity Exchange Act.[19]  These exclusions from the “investment company” definition are the principal ones relied upon by private equity and hedge funds, but many other investment companies also rely on these exclusions, including venture capital funds.  Thus, the Volcker Rule’s treatment of covered funds is overly inclusive.  At the same time, it has created a cottage industry for lawyers to devise ways of restructuring investments to fit into one of the many other exclusions from the definition of “investment company” in Section 3(c) of the 1940 Act (e.g., the exemption in Section 3(c)(5)).  Together with the vagueness and subjectivity present in the proprietary trading provisions,[20] the Volcker Rule is a gift that keeps on giving for lawyers.

          A Modest Step Forward

          While I support these further refinements to the Volcker Rule, I cannot help but ask whether the proposal is ultimately tilting at windmills.  The flaws of the Volcker Rule as enacted by Congress remain.  However, we can at least avoid erroneously applying the Volcker Rule to investments to which Congress clearly did not intend.  While venture capital funds do not necessarily provide less risky alternatives to hedge fund and private equity investments, increased bank financing and investments will likely have a positive impact on economic growth and encourage entrepreneurial ventures.  This improvement, while modest, nevertheless aligns with the CFTC’s strategic goals and core values as it enhances the regulatory experience and provides clarity for market participants.

          Finally, I am pleased that the proposal requests comment on whether to clarify the scope of the exclusion for public welfare investments, including as it relates to rural business investment companies and qualified opportunity zone funds.  I look forward to the views of commenters on these issues, as I believe avoiding restrictions on opportunity zones, for example, will allow money from the banking sector to flow into many of our inner cities and underdeveloped communities.

           

          [1] See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 84 Fed. Reg. 61,974 (Nov. 14, 2019).

          [2] See Chairman Heath Tarbert, “Statement in Support of Revisions to the Volcker Rule” (Sept. 16, 2019), https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement091619.

          [3] The proposed rulemaking will generally have limited implications for the CFTC because “covered funds” is defined to be hedge funds and private equity funds.  Although certain commodity pools are included in the definition of covered funds, these entities are limited in scope in terms of what is being proposed in the proposed rulemaking.  However, the proposed rulemaking will expand the ability of banks to engage in a limited set of covered transactions with covered funds.  Among other things, this expansion will allow futures commission merchants to provide clearing services to their covered fund customers.  The proposed expansion follows a March 29, 2017 no-action letter issued by the Division of Swap Dealer and Intermediary Oversight to a futures commission merchant regarding clearing-related services provided to covered funds.

          [4] The Volcker Rule is contained in Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”).  Public Law 111-203, 124 Stat. 1376 (2010), https://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf.

          [5] I use the term “bank” here in the colloquial sense to refer to a modern financial holding company and its constituent subsidiaries, including insured depository institutions and non-bank subsidiaries.

          [6] That said, I generally believe that appropriate capital, leverage, and liquidity requirements—when combined with a robust risk management framework and culture inside each institution—will do far more to lower the risk profile of banks than ill-founded and artificial distinctions between permitted and prohibited activities that are found in laws like the Volcker Rule.  In this respect, at least the Glass-Steagall Act had an elegant simplicity to it—distinguishing between traditional banking and non-banking services such as securities underwriting and insurance that had been generally well understood for decades. 

          [7] I have called the Volcker Rule “among the most well-intentioned but poorly designed regulations in the history of American finance.”  Heath Tarbert, supra note 2.

          [8] James B. Stewart, “Volcker Rule, Once Simple, Now Boggles,” N.Y. Times (Oct. 21, 2011), https://www.nytimes.com/2011/10/22/business/volcker-rule-grows-from-simple-to-complex.html?pagewanted=1.

          [9] See Section 13(a)(1)(B) of the Bank Holding Company Act of 1956, as added by Section 619 of the Dodd-Frank Act.

          [10] 156 Cong. Rec. S5904-S5905 (July 15, 2010) (colloquy between Senator Dodd and Senator Boxer stating that the statute’s prohibitions should not extend to venture capital funds).

          [11] See, e.g., Ilya A. Strebulaev and Will Gornall, “How Much Does Venture Capital Drive the U.S. Economy?” Stanford Business (Oct. 21, 2015), https://www.gsb.stanford.edu/insights/how-much-does-venture-capital-drive-us-economy.

          [12] H.R. 3848—116th Congress (2019-2020).

          [13] There are other examples of how the Volcker Rule mismeasures risk.  See, e.g., Norbert J. Michel, “It’s Time to Just Kill the Volcker Rule,” The Heritage Foundation (June 6, 2018), https://www.heritage.org/markets-and-finance/commentary/its-time-just-kill-the-volcker-rule (“In fact, commercial lending typically creates more liquidity risk than securities trading.  Regularly traded securities generally have many buyers, whereas individual commercial loans have no buyers.  It is comparatively easy to exit a securities position, whereas it is virtually impossible to sell off a commercial loan that is going south.”).

          [14] See Bank Holding Companies and Change in Bank Control, 65 Fed. Reg. 80735 (Dec. 22, 2000) (implementing provisions of the Gramm-Leach-Bliley Act that permitted a financial holding company to engage in merchant banking activities).

          [15] The merchant bank authority authorizes a financial holding company, either directly or indirectly through a non-bank subsidiary, to acquire or control any amount of shares, assets, or ownership interests of a company or other entity that is engaged in any activity not otherwise authorized for the financial holding company under section 4 of the Bank Holding Company Act.  12 C.F.R. § 225.170.

          [16] This is a major difference between proprietary trading, where conflicts naturally arise, and investing in private equity and hedge funds.

          [17] The congressional definition includes most venture capital funds, which is why Senators and Congressmen felt compelled to add various colloquies to the legislative history. 

          [18] Section 3(c)(1) of the 1940 Act excludes from the definition of “investment company” funds whose securities are sold privately to less than 100 purchasers.  Section 3(c)(7) exempts from the definition of “investment company” funds whose securities are sold privately only to “qualified purchasers.”  Funds excluded by these provisions nonetheless remain subject to the 1940 Act requirements relating to “pyramiding” of investment company structures found in Section 12(d) of that statute.

          [19] Section ___.10(b) of the Volcker Rule.  See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5536 (July 31, 2014).

          [20] See Douglas J. Elliot, “The Volcker Rule and its Impact on the U.S. Economy,” Brookings Institute (Jan. 18, 2012), https://www.brookings.edu/testimonies/the-volcker-rule-and-its-impact-on-the-u-s-economy/ (“Operationalizing the arbitrary and subjective distinctions created by the Volcker Rule forces regulators to peer into the hearts of bankers. The proposed rules are inevitably very complex, as regulators make an honest effort to obtain enough information to guess the intent behind investment actions.”); and Peter Wallison, “The Volcker Rule Is Fatally Flawed,” Wall Street Journal (Apr. 10, 2012), https://www.wsj.com/articles/SB10001424052702303815404577333321275373582 (“Calls for ‘simplification’ of the Volcker Rule are profoundly misguided.  The circle can’t be squared.  The Volcker rule is complex because Dodd-Frank requires the regulators to make distinctions . . . that simply can’t be made by the blunt instrument of regulation.”).