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From Banking and Finance Law Daily, December 19, 2013

Unintended consequences in Volcker Rule discussed by industry, Congress; regulators respond

By Stephanie K. Mann, J.D.

According to the Financial Services Roundtable (FSR), a provision in the Volcker Rule finalized by regulators last week will result in negative, unintended consequences, requiring some banks to experience significant losses, which could reduce new lending. FSR sent a letter to the regulators—Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Securities and Exchange Commission, and Commodity Futures Trading Commission—urging them to take immediate action to remedy this provision.

The Fed, FDIC, and OCC subsequently issued a brief set of frequently asked questions and answers that attempts to help banks determine how to handle the potential problem with trust preferred securities—hybrid securities that have some characteristics of preferred stock and some characteristics of subordinated debt. The concern is that investments in collateralized debt obligations backed by trust preferred securities are covered funds under the Volcker Rule.

Negative impact on bank capital. “The covered fund provisions of the final Volcker rule are being interpreted to bar the ownership of trust preferred securities funds after July 2015. This interpretation already has depressed the value of these investments and, based upon applicable accounting standards, may cause a number of banks to record sizable losses in the fourth quarter of this year,” said the letter. “This, in turn, will have a negative impact on bank capital and reduce new lending and other activities by FSR members, just as our economy is starting to show some signs of recovery.”

In order to prevent this negative impact, the FSR urges the regulators to issue interpretive guidance that permits firms that hold such obligations to continue to record them at book value rather than marking them to market. It also encourages them to review the treatment of these obligations under the rule as the underlying credit quality of these securities has improved significantly since the financial crisis.

The American Bankers Association also sent a letter to the federal regulators urging them to immediately address the unintended consequences of the Volcker Rule in order to protect community banks and mid-size banks.

Congressional point of view. Senators Joe Manchin (D-WVa), Mark Kirk (R-Ill), and Roger Wicker (R-Miss) also sent a letter to the federal regulators in order to ensure community banks are protected from the broad brush of federal regulation. According to the senators, due to a technical oversight in the Volcker Rule, which was intended to protect the economy from risky bets by large banks, community banks fear that they would have to write off hundreds of millions of dollars in capital in just a couple of weeks. In addition, if the rule is not addressed immediately, the banks would be required to sell securities at depressed values. This oversight would not only severely punish community banks, but it would also undermine the U.S. economy and financial stability.

The letter, in part, states: “The purpose of the Volcker Rule was to ensure that the trading activities of the big banks do not undermine the U.S. economy and financial stability, not to punish community banks. In finalizing the Volcker Rule, regulators have wisely sought to ensure that these community banks, which had nothing to do with the actions that necessitated the Volcker Rule in the first place, were not negatively impacted. Unfortunately, that cannot be said about the treatment of pools of trust-preferred securities owned by community banks.

Regulatory guidance. CDOs backed by trust preferred securities might not be covered funds, the banking regulatory agencies’ guidance says, depending on the structure of the specific CDO and the interest held by the specific bank. To begin with, a CDO might be excluded from the definition of covered fund under a relevant Investment Company Act exemption. If so, it could retain that exclusion at the end of the conformance period.

Even if the CDO currently is a covered fund, it could be restructured during the conformance period so that divestiture would not be necessary, the FAQs continue.

The FAQs also suggest that banks evaluate CDOs to determine whether they constitute ownership interests. Factors to be considered include whether the bank: can participate in the selection of the CDO’s directors or investment advisor; has the right to share in the CDO’s income, gain, or profits; has a right to the assets underlying the CDO after all other interests are paid in full; or enjoys any of several other incidents of ownership.

If a bank’s interest in the CDO is not an ownership interest in a covered fund, it would not fall under the Volcker Rule.

Companies: American Bankers Association

MainStory: TopStory FinancialStability VolckerRule SecuritiesDerivatives

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