Uncertainty lingers in recent exception to Volcker Rule
Photo by Patrik Jones

In a joint press release issued on January 15, 2014, five federal agencies indicated their approval of an interim final rule to permit banking entities to retain interests in collateralized debt obligations backed primarily by trust preferred securities (“TruPS CDOs”).  These interests would have otherwise been prohibited under the new Volcker Rule, which prohibits certain investments by banks and is found in Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The interim final rule comes just weeks after the agencies’ approval of the Volker Rule on December 10, 2013.

With the hope of avoiding the need for future bailouts of the financial system, the Volker Rule prohibits an insured depository institution and its affiliates from engaging in “proprietary trading,” from acquiring or retaining any equity, partnership, or other ownership interest in a hedge fund or private equity fund, and from sponsoring a hedge fund or a private equity fund. Essentially, the Volcker Rule is intended to limit profit-seeking proprietary trading at commercial banks by essentially banning these banks, which accept federally insured deposits, from making speculative bets with that money.

So, preventing banks from taking unreasonable risk with customer money, isn’t this a good thing? Well, according to critics, the issue with the Volker Rule is that, in strict application, the rule would capture a substantial amount of legitimate activity conducted by banks, activity that is essential to growing jobs and small businesses. In this regard, the American Bankers Association took specific issue with the Volcker Rule provisions that would force banks to rid themselves of TruPS CDOs, arguing that such provisions are against the spirit of the rule since banks that invested in TruPS CDOs “do not pose the kind of systemic risk the Volcker rule is intended to capture” and are “facing unexpected and precipitous write-downs on these investments that are not justified by any safety and soundness concern.”

In the run-up to the financial crisis, some banks issued trust-preferred securities, which have characteristics of both debt and equity, to raise capital. Some of those securities were then packaged into CDOs and sold to banks and other financial institutions, i.e. TruPS CDOs. These securities lost much of their value during the financial crisis, and banks that invested in them have been holding on to them in the hope that they will recover in value. The Volcker Rule, if left unchanged, would have forced banks not only to sell those securities but also to recognize the losses on them.

In issuing the interim rule, the regulators have sought to balance the spirit of the Volker Rule with the need for banks to engage in legitimate types of trading. Among other exemptions provided, the interim final rule permit the retention of an interest in or sponsorship of covered funds such as a TruPS CDO by banking entities if the following qualifications are met:

  • the TruPS CDO was established, and the interest was issued, before May 19, 2010;
  • the banking institution reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in Qualifying TruPS Collateral; and
  • the banking institution’s interest in the TruPS CDO was acquired on or before December 10, 2013, the date the agencies issued final rules implementing Section 619 of the Dodd-Frank Act.

While the rapidity with which the regulators responded to industry-wide concerns demonstrates the regulators’ intent to cooperate with industry stakeholders, it might also show a more reactionary approach to implementing final rules under other controversial Dodd-Frank Act provisions, which have taken them years to write. If this is the case, the full impact of the Volker Rule, and other controversial Dodd-Frank Act provisions not yet finalized, will continue to remain an uncertainty.