The Volcker Rule’s covered fund provisions have not received the attention they deserve. Like the more well-studied proprietary trading rule, the covered funds rule restricts bank investments in the name of limiting their risk-taking and mitigating their contribution to systemic risk. As with proprietary trading, legislators and regulators faced a decision with covered funds on how to define those bank activities that would be off-limits. However, unlike with prop trading, Congress, and federal regulators subsequently, chose to define the scope of the covered funds rule largely by reference to an existing statute.
In a recent short article just published in The Capital Markets Law Journal (an earlier ssrn draft is available here), I examine this decision by Congress and federal regulators. In crafting the statutory provision and the final rule respectively, Congress and federal regulators chose to apply the covered funds rule to bank investments in entities that would otherwise be investment companies but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This importation from the Investment Company Act – in what I call a trans-statutory cross reference – has profound consequences.
A first cut
Using Investment Company Act exemptions to set the scope of the covered funds rule has advantages. The Investment Company Act exemptions set boundaries that have already been defined by regulators and market expectations. These particular trans-statutory cross references work to circumscribe bank investments in, and sponsorships of, a wide range of entities. Congress appears to have concluded that private equity and hedge fund investments posed inordinate risks for banks and the government safety net. Since those two types of funds typically use those two Investment Company Act exemptions, the trans-statutory cross references seem to accomplish Congress’s intended purposes. A range of other entities also use these two exemptions, but the five federal regulators that promulgated the final rule ultimately carved many of those entities out. Still, many non-real-estate-related securitization vehicles would be covered by the rule.
On the other hand, prohibiting banks from investing in particular exempted funds does not necessarily mean that banks will move their money to safer locales. Many real estate securitizations, for example, are not covered by the rule. Banks could move capital to other exempted funds or even restructure existing investments to fall under other Investment Company Act exemptions not covered by Volcker. More on this in a moment.
When securities law serves banking law purposes
Stepping back from its immediate market consequences: the trans-statutory cross references at the heart of the covered funds rule highlights the ways in which the Investment Company Act, in particular, and securities regulation, more broadly, can and cannot regulate effectively the systemic risk posed by banks and other financial institutions. In other words, the tools of securities relation are in some ways aligned and in some ways mismatched with the purposes of prudential regulation. The trans-statutory cross references exacerbate Volcker’s problems of under- and over-inclusiveness in limiting the risk-taking of banks. The portions of the Investment Company Act most useful for systemic risk are its restrictions on leverage, which are somewhat unique in the pantheon of securities laws and function most similarly to banking rules.
Trans-statutory cross references can delegate power from one agency to another
Volcker’s trans-statutory cross references have not only policy but also political implications. By using a securities law to define the scope of a banking law, the covered funds rule effectively transfers critical policymaking functions from one group of agencies (banking regulators) to another (the SEC). This has potentially profound implications given the differing statutory missions, cultures, and personnel of those agencies. Securities regulators also face different interest groups and have different institutional pressure points compared to their banking counterparts.
How the SEC will wield this power to define the scope of a banking law remains to be seen. Some commentators have doubts as to the SEC’s interest and ability to pursue systemic risk regulation alongside its traditional investor protection role. The covered funds rule will provide one test of the SEC’s resolve. Banking industry interest will likely now focus on other Investment Company Act exemptions. SEC decisions to narrow or expand other Investment Company Act exemptions – particularly Section 3(c)(5) or Rule 3-a-7 – now have cascading consequences by virtue of Volcker’s covered fund provisions. After Volcker, banks and other parties in securitization markets may seek to structure securitizations to rely on one of these other exemptions. Efforts to narrow these exemptions will likely meet strong opposition from banks and the securitization industry. In considering whether to narrow or enlarge these exemptions, the SEC must now consider not only whether investors in collective investment funds are protected. It must also consider the effects on bank risk-taking and systemic risk.
A larger lesson
The political dynamics outlined in my paper point to lessons for policymakers considering using trans-statutory cross references in the future. Trans-statutory references may take power from one regulatory body and give it to another. In the case of the covered fund rules, power over prudential rules was, perhaps unintentionally, delegated to a securities regulator. This works well if the statutory drafters trust the agency from whom power was taken less or trust the agency to whom power was given more. It works if the concern is to check potentially overzealous pursuit of policy objectives by the traditional regulator or to remedy potential shirking by a captured body. However, trans-statutory cross references may fail if the newly empowered regulator works at cross purposes to the statute it now has authority over. Trans-statutory cross references reflect a lesson that is old but one that bears repeating nonetheless: technical drafting decisions can have outsized and unintended political consequences, particularly with respect to the most important question of all – who decides policy going forward.
Cross-posted at Columbia's Blue Sky Blog.