Restricted Investment in Private Equity: The Volcker Rule\u27s Incursion Into Banking?

Investment in private equity originally came from individual investors and corporations. However, over the years institutional investors have become prominent in the investor pool with the hope of achieving risk adjusted returns. Banks have become significant sources of funds in the private equity market. Bank affiliate groups account for a significant share of the private equity activity as well as the banks’ own capital. A distinct feature of a leveraged buyout by a private equity firm as opposed to strategic buyouts and other transactions is the significant reliance on debt financing. Typically, shell companies with substantially no assets would be formed by the private equity firms to effect the buyout. A substantial portion of this buyout would be funded by investment banks or possibly commercial banks, issuing high yield debt and other related financial offerings. This structure makes the banks very crucial players in the buyout and exposes them directly to the risk of the upshot of the buyout. Private equity opens avenues for diversified and promising returns. But, investment in private equity, perceived as more risky and volatile as opposed to other publicly traded securities, is being viewed by the government as less favorable in the current market dynamics. The nature of these businesses being high leveraged, make them more likely to falter in a crisis, thus adding to the systemic risk of the investors. In 2007, the housing bubble burst and the economy took a hit, exposing a host of risky lending and investment practices. The banking sector was especially found at the center of the economic ruin. Banks involved in a variety of arenas outside the conventional commercial banking sphere became particularly critical in this economic situation. The regulators’ approach towards the banks has been censorious in various respects. Owing to the nature of private equity investment practice and the economic conditions of the US market, Section 619 of the Dodd Frank Act, known as the Volcker Rule, was proposed prohibiting banks from investing in proprietary trading and further banning investment in hedge funds and private equity, with the view that such funds can be alternative vehicles for proprietary trading. The regulatory agencies currently are in the process of formulating rules in connection with the new law. Having opened the floor for comment from various financial entities, experts, international organizations and individuals, the legislators have received mixed responses to the proposed rules. This paper critically examines the rules by putting forward different perspectives towards their implementation and effects