Volcker Rule Under Attack as Lawmakers Seek Hedge Fund Loophole

Senate negotiators will probably offer changes today that would soften the Volcker rule by allowing banks to sponsor hedge funds and invest their own money, within limits, alongside that of clients.

The compromise, designed to win the support of at least three Republican senators, comes as lawmakers struggle to reach agreement on financial reform this week. To appease Democrats in favor of stronger regulation, negotiators also plan to make it harder for regulators to undermine the rule, according to lobbyists and congressional aides involved in the discussions.

“There’s pressure from both sides to toughen and to soften the Volcker rule, and politics is the art of compromise,” said Lawrence Kaplan, an attorney at Paul Hastings Janofsky & Walker LLP in Washington. “Running a hedge fund wasn’t the problem, and this way they’re saying all of it wasn’t bad, you just can’t use too much of your capital on it. Politics is the art of saying ‘we made it tougher’ without making it really tough.”

As approved by the Senate last month, the Volcker rule, named after former Federal Reserve Chairman Paul Volcker, would ban U.S. banks from trading with their own capital and running hedge funds. It has been the target of last-minute lobbying by banks including Bank of New York Mellon Corp. and State Street Corp. The two banks are concerned that their asset-management activities would be curtailed, since many of their funds could be considered hedge funds although they don’t engage in risky bets, people familiar with the banks’ arguments said.

‘Wide Net’

Scott Brown, the Massachusetts senator who was among four Republicans voting in favor of the Senate bill, is pushing for changes that would benefit Boston-based State Street and BNY Mellon, those people say. The efforts to exempt the custodian banks and their asset-management units would also help Goldman Sachs Group Inc. and JPMorgan Chase & Co., the people say.

“The proposed Volcker rule casts an unnecessarily wide net,” BNY Mellon said in an e-mailed statement. “It would prohibit traditional activities that our clients expect from us and create a competitive disadvantage relative to other less regulated asset managers.”

President Barack Obama introduced the rule in January with Volcker standing beside him. Because it was after the House had already passed its version of financial reform, the rule was included in the Senate package only, guided through the chamber by Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat.

Levin, Merkley

Senators Carl Levin of Michigan and Jeff Merkley of Oregon, also Democrats, proposed an amendment that would eliminate some wiggle room for regulators to soften the ban. While the amendment didn’t make it into the Senate bill, parts of it will be included in the changes Senate negotiators offer today, Dodd told reporters yesterday.

Bank lobbyists are also pushing to let firms invest a limited amount — 2 percent to 5 percent of their capital — in hedge funds or private-equity funds. Levin and Merkley oppose this so-called de minimis investment option, according to the people familiar with the negotiations.

The current version of the Volcker rule bans “sponsoring” of hedge funds and private-equity funds. Sponsoring is defined as “serving as a general partner, managing member or trustee.” Banks cannot appoint a majority of a fund’s directors or managers and cannot give their name to it.

“I hope and anticipate that Congress will negotiate a strong bill,” Volcker said in an e-mailed message, declining to comment on the ongoing talks and prospects for the rule.

Citigroup, JPMorgan

Even in its current form, the Volcker rule could be interpreted as allowing banks to keep running their hedge funds as long as they divest their stakes, according to some lobbyists and congressional staffers. That understanding has led some banks to expand their businesses. Citigroup Inc. plans to raise more than $3 billion for its private-equity and hedge funds, people with direct knowledge of the plan said last week.

JPMorgan, the second-largest U.S. bank by assets, operates the world’s biggest hedge fund, according to the 2009 rankings of AR magazine, an industry trade publication. The New York- based firm’s hedge funds had $50 billion of assets under management as of Jan. 1, the magazine reported in March. Goldman Sachs’s hedge funds, which ranked ninth on the list, had $21 billion.