Regulators Tinker With Volcker Rule to Help Community Banks

With the first major alteration to the Volcker rule, community banks will receive sought-after relief from a prohibition on certain types of debt securities. On Tuesday night, five federal agencies approved an interim final rule that allows them to retain their interests in collateralized debt obligations backed by trust preferred securities.

A trust-preferred security, with characteristics of both debt and equity, is created when a bank issues debt to a trust it created, and then sells its right to receive interest and principal payments to third-party investors. A TruPS-backed CDO is created when an investment bank purchases multiple trust-preferred securities, packages those securities into a single security, and issues new debt instruments based on that security to investors.

Prior to the financial crisis, many community banks invested in these financial instruments, and have held onto them in an effort to recoup losses. Unwinding them to comply with the Dodd-Frank Act's prohibition on proprietary trading by banks, would cost millions of dollars, according to the American Bankers Association.

The interim rule only applies to TruPS-backed CDOs issued by banks with less than $15 million in assets. To qualify for the exemption, the CDOs must have been established before May 19, 2010, with the bank's interest acquired on or before Dec. 10, 2013, the date final rules implementing the Volcker rule were issued. 

The interim final rule also clarifies that the relief for TruPS CDOs extends to activities of a qualifying bank as a sponsor or trustee for those securitizations. Banking entities may also continue to act as market makers in the CDOs. Regulators also released a non-exclusive list of issuers that meet the requirements of the interim final rule.

The interim final rule was approved by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission, and the Securities and Exchange Commission, the same agencies that issued final rules to implement the Volcker rule. The agencies will accept comments on the interim final rule for 30 days following publication in the Federal Register.  

CFTC Commissioner Scott O'Malia, a vocal critic of the prohibition on TruPS CDOs, praised the proposed rule. “When an unintended consequence of a regulation is discovered, it is imperative that it be expeditiously corrected to avoid unintentional harm to affected parties,” he said. “Broken rules must be fixed.”

ABA President Frank Keating, whose group sued regulators over the initial prohibition, praised “the regulators' speed and judiciousness” in revisiting the rule.

“Their action today should allow banks to avoid taking millions of dollars in unexpected and unnecessary write downs,” he said in a statement. “The inclusion of a list of issuers that meet the test of the interim final rule is also appreciated, and will help minimize the cost and compliance burden on affected banks.”

On Wednesday, the ABA announced it will drop its request for emergency relief in pending litigation over the Volcker Rule, but declined to stop the suit entirely.