WASHINGTON (MNI) – Following is the text of the letter sent Monday
by former Federal Reserve Chairman Paul Volcker to U.S. banking
regulators in response to their request for comments on the Volcker
Rule, which prohibits a banking entity from engaging in proprietary
trading and from acquiring or retaining an ownership interest in or
sponsoring a hedge fund or private equity fund:

Subject: Prohibitions and Restrictions on Proprietary Trading and
Certain Interests in, and Relationships with, Hedge Funds and Private
Equity Funds.

This letter sets out my comments on your proposed rules
implementing the portion of the Dodd-Frank legislation restricting
proprietary trading and investment in hedge and equity funds by U.S.
banking organizations. I have attached a more lengthy statement
reviewing the policy considerations compelling the legislation and
dealing with concerns about the impact on markets and competition,
points that are sometimes lost amid the intense lobbying efforts on
detailed implementation.

I cannot help but be impressed by the success the regulatory
agencies so far in reaching agreement on the preliminary rule and by
your confidence that the regulation can and will be successfully
implemented. I am also certain that simplicity and clarity are
challenging objectives, which for full success, require constructive
participation by the banking industry. As I have suggested elsewhere,
there should be a common interest in an approach that, to the extent
feasible, is consistent with the banks’ broader internal controls and
reporting systems.

My sense is that success is strongly dependent on achieving a full
understanding by the most senior members of the bank’s management,
certainly including the CEO, and the Board of Directors, of the
philosophy and purpose of the regulation. As the rules become effective,
periodic review by the relevant supervisor with the Boards and top
management will certainly be appropriate, as a key part of the usual
examinations process or otherwise.

The necessary understanding should be reflected in both the culture
of the bank and in the written internal controls applicable to trading
activities and to relations with hedge and equity funds that have an
element of bank sponsorship and investment. Obviously, those controls
must be consistent with the specifics of the regulation restricting
proprietary trading.

At the other end of the process is the need for a set of “metrics”
designed to reveal evidence of deliberately concealed and recurring
proprietary trading. I know much effort has been made in that area.
While I am not familiar with all the details, I do emphasize its
importance.

I understand that such measures as trading volume, and its relation
to size of the trading “book”, the volatility of earnings from trading,
the extent to which those earnings are generated by pricing spreads
rather than changes in price, the origination of trades (i.e. from
customer initiative) and the close alignment of “hedging” transactions
with the composition of the trading positions will be essential tools
for supervisors and management to monitor the trading activities of
firms.

To the degree those metrics can be made consistent with the banks’
internal reporting and control systems, both management control and
simplicity will be greatly facilitated.

I realize that between those two requirements — management
commitment and ex-post measurement of performance — lies the thorny
issue of guidance with respect to defining the character of “market
making” for customers. Clearly, we know what it does not mean. Holding
substantial securities in a trading book for an extended period
obviously assumes the character of a proprietary position, particularly
if not specifically hedged. Various arbitrage strategies, esoteric
derivatives, and structured products will need particular attention, and
to the extent that firms continue to engage in complex activities at the
demand of customers, regulators may need complex tools to monitor them.
There may well be occasions when a customer oriented purchase and
subsequent sale extending over days cannot be more quickly executed or
hedged. But substantial holdings of that character should be relatively
rare, and limited to less liquid markets. Flagrant, intentional
violation of the general restrictions should be evident from review of
well designed metrics and “ad hoc” examinations (and should, of course,
also be identified by a bank’s internal controls).

My understanding is that only a very few very large banking
organizations engage in continuous “market making” on any significant
scale. Clearly, it is those institutions that will require the attention
of the regulatory authorities. I also understand that the lawful
restrictions do extend to all banking organizations, including community
and regional banks normally inactive. The management of those
institutions must understand the nature of the restrictions. However,
consistent with effectively administering the law, oversight and
reporting of those institutions may be less intrusive than that
appropriate for active trading operations. For small banks, infrequent
transactions with customers who may not have easy access to fluid public
markets may at time lead to rather longer holding periods – subject to
the review of the customer relationship and relevant record keeping.
More generally, when or if there is demonstrably clear understanding and
enforcement by management of the principles, detailed rules may be less
necessary and oversight less intensive.

I need not add that I continue to follow with interest your efforts
to assure meaningful and effective execution of the law and fidelity to
the important considerations of public policy that the law is intended
to enforce.

–end of text–

** Market News International Washington Bureau: 202-371-2121 **

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