Federal regulators vote next week on a confidential and controversial 205-page draft proposal of the Volcker Rule - the government's proposed ban on prop trading and limitations on private equity investments by banks. American Banker obtained on Wednesday evening a 9/30 draft memo outlining key specifics on the proposal.   The plan would broadly define proprietary trading, offer limited circumstances under which a bank could invest in a hedge or private-equity fund, and require banks to install internal controls to ensure compliance with the Volcker Rule. The FDIC is set to issue the nearly proposal on 10/11, and other regulators are expected to act around the same time. Detailed Guide to Regulators' Pending Proposal: Proprietary Trading: As proposed, regulators would define prop trading as "engaging in the purchase or sale of one or more covered financial positions as principle for the trading account of the banking entity."  It specifically wouldn't include acting as an agent, broker, or custodian for an unaffiliated 3rd party. The rule would apply to any trading account that takes a position for the purpose of selling in the near-term - which was not defined.  Instead, the proposal would use a 3-prong approach to define such an account.

1. Any account used by a firm to buy or take one or more several financial positions for the purpose of short-term resale;  gain the benefit of short-term price movements; earn short-term arbitrage profits;  or hedge one or more positions.
2. Any trading account used by a firm that is already subject to the Market Risk Capital Rules would be subject to the Volcker Rule.
3. Any account used by a firm that is a securities dealer, swap dealer, or security-based swap dealer would qualify.

The proposal would provide some exclusions in what's defined as a trading account for certain positions that do not appear to involve the intent to engage in short-term trading.  Those would include certain Repos and Reverse Repos, securities lending transactions, positions taken for "bona fide" liquidity management purposes, as well as certain positions of derivatives clearing organizations or clearing agencies. Exemptions to Proprietary Trading Ban. Under the original statute, banks are still allowed to engage in underwriting and market making-related activities.  As proposed, certain requirements must be met to ensure activities, revenues and other trading activities fall into those exempted categories.  Additionally, the agencies added another exemption for risk-mitigating hedging.  Like the other exceptions, banks must jump through certain hoops to ensure their activities are "truly" risk-mitigating hedging, including setting up an internal compliance program. The proposal also sets up exemptions for certain government obligations, trading on behalf of customers, trading by a regulated insurance company or trading by certain foreign bank entities. Other exemptions include transactions conducted by a banking entity as investment adviser, commodity trading advisor, trustee, or in a similar fiduciary capacity for the account of a customer where the customer, and not the banking entity, has beneficial ownership of the related position. Hedge/Private Equity Fund Limits. There's a separate section detailing the types of relationships a bank is banned from having with hedge and PE funds.  Generally, a bank could not hold an "ownership interest" in, or sponsor, an investment fund covered by the proposal.  Funds subject to the ban would include issuers defined as an "investment company" in the 1940 Investment Company Act, although certain types of companies included in that earlier statute would be excluded. Commodity pools would also be banned , and regulators could include in the ban "any such similar fund" that they determine appropriate. An "ownership interest" essentially would be any equity investment or partnership that a bank holds in a covered fund.  Other "similar interests" could be banned as well - e.g, a debt security if it "exhibits substantially the same characteristics as an equity or other ownership interest." A bank could own an interest in an investment fund only if its share of the fund's profits is meant as performance compensation for the bank's serving as an investment or commodity trading advisor to the fund. Yet that exemption would come with its own restrictions. "Sponsorship" Limitations. The proposal would generally ban a bank from being a general partner or trustee, selecting directors and managers, or having a similar name of a covered fund.  Among other exemptions, a bank could be involved in organizing an investment fund covered by the rule under certain criteria related to traditional asset management and investment advisory businesses.  Conditions would include, among others, that the bank provide "bona fide" trust and advisory services, and that the investment fund in question be only related to those services. Certain limited investments in a covered fund that a bank or one of its affiliates has organized would be permitted, but the investment could not exceed 3% of the fund's total ownership interests, could not trigger more than 3% of the fund's losses and could not amount to more than 3% of the bank's tier 1 capital.  A bank's total permitted investments in all covered funds could also not exceed 3% of its tier 1 capital.  Certain small business investment-related interests would also be allowed, as well as hedging activities meant to mitigate the bank's risk. Compliance with Volcker Rule. Any bank engaging in covered trading or fund activities would be required to implement a program designed to ensure compliance with all prohibitions and restrictions.  At a minimum, each program must include:

• Internal WSP's designed to document and monitor prop trading and investments.
• System of internal controls to monitor and identify potential areas of non-compliance, and to prevent the occurrence of prohibited activities.
• Management framework that delineates responsibility for compliance.
• Independent testing of the compliance program.
• Training for trading personnel and their managers.
• 5-Year retention of records.

Additional compliance standards may be necessary for banks engaged in broad, complex trading activities. For additional information, go to:   American Banker, 10/5/11]