Volcker rule impact may hit in 2022

The 'Volcker Rule's' impact on private equity may not be felt until 2022, and its main effect could be to reduce banks' co-investment in alternative vehicles.

The US government’s so-called Volcker Rule, which will limit the amount of capital a bank can invest in its own private equity funds, is unlikely to make its mark on the industry until 2020.

After spending days reconciling two separate financial reform bills, Congress on Friday agreed to cap a bank’s co-investment in its own private equity funds to no more than 3 percent of the total commitments of the fund. Banks will also only be allowed to invest a total of 3 percent of its tier 1 capital ratio in its own private equity, hedge fund and real estate funds.

However, the industry might not feel the regulatory pinch until 2022, according to legal and industry professionals.

Congress last week ruled that the newly created Financial Stability Oversight Council study the issue for six months before recommending regulations on how to implement the Volcker rule. The Federal Reserve and Securities and Exchange Commission, among other federal agencies, will then have another nine months to review those recommendations and make their suggestions. At most the government will have two years from the time President Barack Obama signs the bill into law (expected before 4 July) to recommend how the Volcker rule will be implemented.

A lot depends on how regulators impose the transition period [for banks] but implementation of the Volcker rule could be anything from four to 12 years.

Kevin Petrasic

Kevin Petrasic, counsel at Paul Hastings’ banking and financial institution practice, said the government has also given itself a lot of flexibility on timing.

In addition to the two years the government has allowed itself to come up with regulations, banks have been allowed a two year “transition” period to implement changes, together with the possibility of three one-year extensions. After that time, the Federal Reserve has the right to give banks operating “illiquid funds” – such as private equity – a further five years  to comply with the new regulations, meaning the longest available transition period would be 12 years.

“A lot depends on how regulators impose the transition period [for banks] but implementation of the Volcker rule could be anything from four to 12 years,” Petrasic said.

Once implemented, the rule could have a significant effect on co-investment in bank-sponsored private equity funds. The likes of Morgan Stanley and Goldman Sachs have often invested up to 20 percent of the total commitments of their own alternative funds, but under the new rules that would be restricted to 3 percent – with a bank-wide cap on co-investment equivalent to 3 percent of its tier 1 capital ratio.

We cannot let ourselves forget what happened in October of 2008 and all the events leading up to that. We have to keep our eyes on the ball. I hope political support continues.

Sheila Bair

According to industry sources, as of 31 March, Morgan Stanley had invested the equivalent of 9 percent of its almost $50 billion of tier 1 capital in its own hedge fund, private equity and real estate funds, while Goldman Sachs had invested roughly 22 percent, with $15.4 billion of equity invested in such vehicles against a tier 1 capital reserve of $69.4 billion.

There is still uncertainty as to whether existing funds operated by banks are affected by the new rules, or whether they will be exempt under “grandfather rights”. However, given the typical 10-year life of many private equity funds, vehicles launched prior to this legislation are likely to have been liquidated or be in the process of being liquidated by the time the Volcker rule comes into force.

Sheila Bair, chairman of the US banking regulator, the Federal Deposit Insurance Corporation and one of the federal agencies that will be able to write the regulations implementing the Volcker rule, said the government had to “hold the course” and must resist lobbying to soften the rules.

She told Reuters: “We cannot let ourselves forget what happened in October of 2008 and all the events leading up to that. We have to keep our eyes on the ball. I hope political support continues.”