The Volcker Rule and Venture Capital

It is rare that new pools of capital become accessible on an overnight basis. The Volcker Rule’s covered funds section was updated on October 1, 2020, to allow banks to invest in venture capital funds once again. This was the first time this had happened since 2008. We will discuss how we arrived at this point, what it means for venture capital, and what fund managers should consider due to this policy shift.

Volcker rule and venture capital

After the 2008 global financial crisis, policymakers were concerned that banks invested their own capital in financial products that may lose value and expose depositors to losses or cause bank failure. Policymakers believed such a failure would disrupt the financial system. Their reaction? Outlaw it.

The Volcker Rule prohibits banks from proprietary trading or investing in covered funds, including venture capital funds. The first Volcker Rule covered the fund’s section, which went into effect on April 1, 2014, missed the mark. The financial crisis was not triggered by prior bank investments and venture capital funds connections. A bank’s assets and income streams would be more diverse if it could invest in qualified venture capital funds. This benefits the bank and the financial system as a whole.

This will help small enterprises and start-ups create jobs and expand the economy. By boosting the flow of funding to small firms and start-ups, these banking entity investments can help the broader financial system.

Understand Venture Capital

Venture capital (VC) is a type of private equity and financing provided by investors to startups and small firms that are thought to have long-term growth potential. Well-to-do individuals, investment banks, and other financial institutions are common venture capital sources.

Role of venture capital in a company

Venture capitalists are required because they help to smooth out the creative destruction process and help businesses change themselves from chaotic organizations to well-oiled ones. Therefore, venture capitalists have an important role to play in molding the economic futures of countries around the world. It is often stated that venture capitalists bridge the gap between the public and private sectors. However, while many governments actively fund new businesses, the bureaucracy and red tape involved in official decision-making often suppress startup funding and the incubation process.

What is the Volcker Rule?

The Volcker Rule is a federal regulation that prevents banks from engaging in certain investment activities with their own funds and restricts their transactions with hedge funds and private equity funds, often known as covered funds.

The goal of the Volcker rule

The Volcker Rule originated in 2009 when economist and former Federal Reserve Chair Paul Volcker recommended a piece of legislation in reaction to the growing financial crisis (and after the nation’s top banks had significant losses from their proprietary trading units). The goal was to safeguard bank clients by prohibiting banks from engaging in certain types of speculative activities that worsened the crisis.

Essentially, it prevents banks from trading securities, derivatives, and commodity futures, as well as options on any of these products, on their own accounts (client funds). Volcker ultimately sought to re-establish the distinction between commercial and investment banking. This distinction existed previously but was legally abolished in 1999 as a result of a partial repeal of the Glass-Steagall Act.

Why did angel investors criticize the Volcker rule?

There has been widespread criticism of the Volcker Rule from many angel investors. The US Chamber of Commerce asserted in 2017 that the Volcker Rule’s costs outweigh its advantages and that a cost-benefit study was never conducted. It was claimed at the FEDS that the Volcker Rule would lower liquidity as banks’ market-making activities would be limited. Also, the International Monetary Fund (IMF) has claimed that enforcing restrictions to avoid speculative bets is extremely difficult.

How does the Volcker rule work?

To understand how the Volcker Rule Works, one must comprehend the Glass-Steagall Act of 1933. Glass-Steagall was part of the 1933 Banking Act. It classified banks as depository or investment institutions.

An investment bank can utilize its money to trade securities and make other risky bets. They can’t take deposits, open checking or savings accounts, or do anything else like a commercial bank.

All retail banking is done through a depository institution. Notably, they can accept customer deposits and pay interest. The FDIC insures banks. i.e., In the event of a bank failure, consumers will be paid up to $250,000 per account.

Implications and Exceptions of Volcker rule for VC funds

To invest in venture capital funds, a bank must still adhere to conflicts of interest, investment risk, and soundness restrictions. The regulations are tighter if the bank sponsors a venture fund, which means it is a general partner or controls a majority of directors or managers. Also, In June 2020, regulators decided to exempt venture capital funds from the definition of covered funds, allowing banks to invest in eligible VC funds.

The Final Rule exempts an issuer that fits the definition of a venture capital fund in 17 C.F.R.(Code of Federal Regulations) as defined under the Current Rule.

If a fund meets the criteria listed below, banks may invest.

• The fund does not trade proprietary.
• If a bank owns a stake in the fund:
  • No conflict of interest between the bank and its clients.
  • It won’t expose the bank to a high-risk asset or trading method.
  • It will not jeopardize the bank’s safety or the US financial stability.
  • It will follow all banking rules and laws.
• There is no guarantee, assumption, or insurance of the fund’s performance.
• If the bank is a sponsor/advisor:
  • It will give current and potential investors formal Volcker Rule disclosures.
  • It will ensure the fund’s actions are safe and sound.
  • It will be treated as a covered fund under Section 23A[7].

Venture capital covered funds in Volcker rule

A cover fund under Volcker Rule is defined as the following:

• The private fund exemptions that most hedge funds, private equity funds, and venture capital funds rely on in the Investment Company Act (ICA)
• Does not comply with the rules of the Commodity Futures Trading Commission (CFTC).
• The ICA’s Section 3(c)(1) or Section 3(c)(7) foreign funds with respect to U.S. investors, or meet additional requirements.

Venture Capital Fund Under The SEC Regulations

Under SEC regulations, a private fund must meet all of the following criteria to qualify as a venture capital fund:

• The organization to meet its investors that it is pursuing a strategy of venture capital.
• Capital contributions (including uncalled capital commitments) that are not “qualified investments” are not held in excess of 20% of the total capital contributions.
• Leverage, including guarantees, will not exceed 15% of total capital contributions or last more than 120 days;
• Make sure only to issue securities that don’t give holders the ability to withdraw their money.
• In addition, it is not registered as an investment firm with the ICA.
• There is no business development company status for this company.
• Volcker rule exclusion and Volcker rule

Future of the Volcker rule

In one study released in June 2017, the Treasury said it supports the Volcker Rule’s prohibitions on proprietary trading and recommended significant revisions to it. The study recommends exempting banks with assets under $10 billion from the Volcker Rule. The Treasury also advised simplifying and refining the definitions of proprietary trading and covered funds, as well as loosening the rules to allow banks to better hedge their risks.

Based on the Treasury’s recommendations, the Office of the Comptroller of the Currency (OCC) has spearheaded efforts to amend the Volcker Rule since June 2017. It’s unclear when any proposed adjustments would take effect, although it might be months or years. Regulators released a Volcker rule provision in June 2020, allowing lenders to invest in venture capital funds and other assets. Hence the Volcker rule requirements meet the needs.

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