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From Banking and Finance Law Daily, March 4, 2014

Industry groups argue for and against interim rule that implements exemption to Volcker Rule

By Colleen M. Svelnis, J.D.

Interested parties have begun to submit comment letters to the federal banking regulatory agencies in response to the interim final rule that was adopted by the federal bank, thrift, and commodities regulators creating an exemption to the Volcker Rule. The interim final rule was issued in response to financial industry complaints about the effect the Volcker Rule regulations will have on investments in collateralized debt obligations (CDOs) that are backed by trust preferred securities (TruPS). The interim rule will allow a bank to retain an interest in, or to sponsor, entities that issued affected CDOs, provided that:

  • the issuer was established before May 19, 2010;

  • the bank reasonably believes that the proceeds of the offering were invested primarily in qualifying collateral; and

  • the bank’s investment in the issuer was made before Dec. 10, 2013, or was acquired by a merger or acquisition.

TruPS are hybrid securities that have some characteristics of preferred stock and some characteristics of subordinated debt. They have been used as a way for community banks to raise capital. The dispute leading to the exemption in the interim final rule arose from the inclusion of CDOs backed by trust preferred securities within the investments that are banned by the Volcker Rule regulation. Banks, especially community banks, became concerned that they would be forced to re-categorize the CDOs as investments held for sale and eventually to sell the CDOs, both of which could be harmful to the institutions’ capital positions.

Exemption is flawed. Occupy the SEC, a working group that backed the passage of the Volcker Rule, submitted a comment letter to the agencies stating that it believes the TruPS exemption is flawed and should be eliminated because it leads to outcomes that run counter to the basic premise of the Volcker Rule. Under the Volcker Rule, banks are prohibited from sponsoring or having an ownership interest in a covered fund. The interim rule creates an exception for ownership interests in issuers of CDOs backed by TruPS. The letter states that this amendment would expose “toxic credit risks” throughout the economy.

Occupy SEC noted that community banks have been the primary purchasers of TruPS. As a result, the letter advises that the “high level of connectedness between TruPS CDO issuers and purchasers exacerbates the already troubling risk of contagion that these products represent.” A single default could, the letter warns, affect a number of firms in the banking industry. The exemption in the interim final rule could mean that all bank holding companies, not just community banks, “would be permitted to speculate in the commercial real estate market using money loaned to them by depositors and the Federal Reserve”. The letter asserts that there is no basis in Section 171 of the Dodd-Frank Act for the exemption in the interim final rule. Additionally, the group asserts that repealing it would lead to economic growth as banks would pursue safer and sounder alternatives for fundraising.

The letter points out that the amendment permits the purchase of a CDO interest as long as the banking entity “reasonably believes” that the offering proceeds received by the issuer were invested primarily in qualifying TruPS collateral. Occupy SEC admonishes that, by setting up a subjective reasonableness standard, enforcement of the restriction will be weak. Additionally, the group states that the agencies are setting a “dangerous precedent” by allowing this exemption. It will lead to other requests for further exemptions, which would erode the protections of the Volcker Rule.

Overlooked debt securities. In its letter, the American Bankers Association expressed its pleasure that the rule includes provisions “that expressly authorize banks to continue holding interests in collateralized debt obligations backed primarily by trust preferred securities that have been issued by banks with total assets of less than $15 billion.” The letter states that the interim final rule “substantially” addresses the negative impact the Volcker Rule would have on the banking industry and that the ABA believes the rule would provide “appropriate relief to ensure that these banks may hold these investments without unnecessary write-downs in bank earnings and/or capital.”

However, the ABA commented that the rule overlooks other debt securities held by banks that have been labeled as “covered funds” under the rule, including banks’ holdings of TruPS CDOs that are backed by insurance companies and real estate investment trusts. The ABA letter also states that banks appear to be required to divest the following investments by the end of the conformance period (July 10, 2015): (i) collateralized loan obligations (CLOs); (ii) re-securitized real estate mortgage investment conduits; (iii) tender option bonds; and (iv) auction rate securities.

The ABA has requested that the interim final rule be amended to permit banking entities to continue holding routine bank investments, consistent with the purposes and objectives of the Volcker Rule. Additionally, the ABA would modify the language of the definition of “ownership interest” in the final rule, provide clear and comprehensive examination guidance to banks in order to assist them in ascertaining permissible versus prohibited investments and in streamlining the legal and regulatory analysis required by providing:

  • a detailed community bank guide in the form of “frequently asked questions” (FAQ) that would meaningfully respond to common questions regarding compliance with the Final Rules;

  • a template for applying a Volcker Rule/Final Rules analysis to investment activity;

  • standards for due diligence, including their form and extent, regarding fund investments; and

  • guidance for working with internal and outside accountants, and how regulators will approach accounting–related issues.

Exemption should go further. In his comment letter, Rep. Stephen Lee Fincher (R-Tenn) noted that several TruPS are not exempt under the interim final rule resulting in losses in the banks’ 2013 financial statements that are unrelated to the performance of the individual TruPS, but solely attributable to the technical language in the Volcker Rule and interim final rule. Fincher requested “immediate relief to banks owning non-exempt TruPS by exempting all TruPS acquired prior to December 10, 2013, and issued prior to May 19, 2010, from the divestiture requirements of the Volcker Rule, in accordance with the original Congressional request to fix this problem in December.” The issues Fincher discussed in his letter include:

  • banks that own non-exempted TruPS that contain a significant amount of bank collateral but continue to be subject to Volcker divestiture requirements simply because the bank collateral composes less than 50 percent of the total collateral pool;

  • many of the non-exempted TruPS are labeled as “Insurance” TruPS—he asserts that there is still a significant amount of bank-issued collateral included in these issues; and

  • many of the non-exempted TruPS have been outstanding for 8-10 years and have experienced no collateral defaults, and contain 100 percent performing collateral.

MainStory: TopStory: VolckerRule

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