The Senate is now considering a set of exemptions to the Volcker Rule that would allow the asset management divisions of banks to continue business as usual when it comes to investing client money in hedge funds and private equity. The Senate finance regulatory reform bill under debate on Capitol Hill this week contains a prohibition on such funds that, if left as is, would severely curtail the way the asset management division of a bank can invest.
It is a less-examined prohibition than the one against proprietary trading, but one with a potentially greater impact on the banking industry, according to a study that the law firm Shearman & Sterling released on June 8.
The current wording in the Volcker Rule – which may change significantly before Congress presents a finished bill to the White House – says banks that use federal deposit insurance would not be able to sponsor or invest in hedge funds and private equity funds.
"The bank would not be able to have its name on a fund, or act as a general partner on the fund, so it would have to sell or spin off the general partner interest," says Brad Sabel, co-leader of Shearman & Sterling's Financial Recovery & Reform Advisory Group. It is common for large banks to pool client assets into discretionary managed accounts for efficiency and cost-effectiveness, just as it is common for a bank to hold stakes in funds for portfolio diversification.
While the Volcker Rule contains such broad wording that most banks are hesitant to comment on exactly how it might affect their business, the Shearman & Sterling study says it appears that the prohibition against sponsorship of a hedge fund or a private equity fund – or any fund not regulated, as mutual funds are, by the Investment Company Act of 1940, which regulates mutual funds – would prevent several scenarios common within financial institutions. The bank could not serve as a general partner, managing member, or trustee of a fund, according to Shearman & Sterling. Nor could it select or control a majority of the directors, trustees or management of a fund, or share the same name, or variation of name, with a fund.
"If you're an investment advisor in a separate subsidiary outside a bank, but affiliated with a bank, you would have to get someone else to manage any hedge fund or private equity fund you set up," says Sabel. There has been some lack of clarity as to whether an investment manager in that position could serve as an advisor to the fund; that might depend on the advisor’s role. Sabel, however, believes that banks might return to the pre-Gramm-Leach method of engaging in the funds business, which was to outsource management and sponsorship but act as advisors. If a new law actually passes with the fund prohibition intact, asset management companies not affiliated with banks, as well as foreign asset managers with no U.S. operations might stand to benefit, as U.S. financial institutions would have to outsource the sponsorship and management of funds.
While the Volcker Rule is aimed at limiting the risks that banks can take with their own capital, the broad wording has produced what might turn out to be unforeseen consequences. Sabel is concerned that the prohibitions against funds and proprietary trading, especially combined with Sen. Blanche Lincoln’s rules on pushing derivatives dealing out of bank and stricter prudential limitations, could have the effect of causing companies not subject to Fed umbrella supervision to become much bigger in securities and derivatives dealing.
“This movement could cause the shadow banking system to develop again, which is generally considered one of the major reasons for the financial crisis,” he says. There is also the concern that investors expect the banks that organize and sponsor funds to hold large stakes in their own funds as evidence that they have “skin in the game" and therefore will invest wisely.
“The rule wasn’t intended to affect the asset management function,” says Tim Ryan, president and CEO of the industry group the Securities Industry and Financial Markets Association, which has made recommendations to Congress on financial reform and continues to do so. "I think the definition sweeps in a lot of entities that are not really hedge funds or private equity funds."
Among SIFMA’s recommendations are that the wording of the Volcker Rule be amended so that it establishes clearer definitions of which bank activities are affected. The wording should state that this prohibition on asset management does not apply to those acting as fiduciaries or custodians of client assets or that co-invest in a fund at a minimal level, says Ryan.