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Canadian banks warn that the proposed U.S. Volcker rule could violate NAFTA.Getty Images/iStockphoto

Canada's Big Five banks have sent a stern letter to U.S. regulators, warning that proposed rules designed to limit the risks major financial institutions take may violate the two countries' free trade agreement.

The banks say the legislation in question – known as Volcker rule – will also have serious, unintended consequences in the Canadian mutual fund market if changes aren't made.

U.S. regulators introduced the Volcker rule as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was drafted in the aftermath of the financial crisis. The key initiative was to limit the amount of risk banks take with client funds. Under the Volcker rule, U.S. deposit-taking banks are prevented from investing client money in hedge funds or private equity funds, and other speculative investments, in order to boost profit.

However, the Canadian banking sector argues the changes have unfair consequences for Canada, according to the joint letter sent Thursday by Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada and Toronto-Dominion Bank.

Most importantly, they argue that Canadian banks deserve an exemption to continue operating their own mutual funds, which they say are safe investments. Exemptions have already been made to allow banks in the U.S. and other countries to invest in and operate mutual funds, but the current proposal fails to expressly exclude Canadian mutual funds from what the rule calls a "covered fund" – hedge funds, private equity funds and certain similar funds.

Canadian banks are affected by the Volcker rule because they each have U.S. branch networks or capital-markets operations. The lack of an exemption for Canadian banks appears to be an oversight, albeit a serious one that has the banks worried if it isn't changed.

"Differing treatment between U.S. Public Funds and Canadian Public Funds directly contravenes NAFTA national treatment obligations," the letter says, referring to the North American free-trade agreement.

"U.S. banks will be able to continue to offer, sell, sponsor and maintain significant ownership interests in U.S. Public Funds globally without regard to the Volcker Rule, while banks that sponsor [Canadian mutual funds]will be unable to escape its restrictions no matter how limited their transactions with U.S. persons may be."

The letter is one of several sent by Canadian organizations recently to U.S. regulators about the changes. The Office of the Superintendent of Financial Institutions sent a letter warning the changes would have a detrimental impact on Canada.