When the finalized Volcker Rule hit earlier this month, we promised to cover the inevitable wrinkles emerging as banks wade through the rule’s 1,000 pages. It didn’t take long for one to surface. This week, the American Bankers Association (ABA) filed suit against regulators over a provision they believe bans community banks from holding certain collateralized debt obligations (CDOs). If left unchecked, ABA believes it could trigger losses at the smallest banks. It’s an all-too-perfect example of how complex regulations can carry unintended consequences contrary to regulators’ initial intent, and investors in community banks should likely keep a close eye on the situation. However, in our view, the rule shouldn’t much impact Financials or broader markets.
As a refresher, the Volcker Rule aims to create a “safer” financial system by banning banks from trading for profit in their own accounts, assuming (incorrectly) this practice led to 2008’s financial crisis. It targets a practice responsible for less than $20 billion in losses in the crisis and misses the $2 trillion in exaggerated and largely unnecessary write-downs that wreaked havoc stemming from the misapplication of mark-to-market accounting rules to illiquid, held-to-maturity assets. Though, it also doesn’t appear to make life too tough for US banks, considering most already adjusted business models to comply with Volcker.
Unintended consequences, however, can still create headaches. Last Tuesday, Utah-based regional bank Zions Bancorporation announced a $387 million write-down due to a provision of Volcker seemingly banning banks from owning CDOs backed by trust-preferred securities (TruPS). Many banks like holding these for their (formerly) easy accounting and regulatory treatment, and most don’t intend to sell them for profit—they largely hold them to maturity, collecting income along the way. In short, philosophically, the practice doesn’t seem to fit within Volcker’s scope. Yet, as Zions’ press release explained, they believe their holdings in TruPS-backed CDOs “will be considered disallowed investments” under Volcker, requiring them to reclassify these assets as “available-for-sale,” mark them to market value and sell them by July 2015.
According to the ABA, the kicker lies in Volcker’s definition of “ownership interest.” TruPS-backed CDOs naturally fall within the scope of banned “covered funds,” but ABA asserts that treating a stake “with no participation in profits and losses as a prohibited, equity-like ‘ownership interest’ … is not a logical outgrowth of the Proposed Rule.” In its filing, ABA claims the definition of “ownership interest” in the initial rule—the version released in 2011 for public comment—wouldn’t have encompassed banks’ stakes in TruPS-backed CDOs. However, the finalized rule contained an expanded definition that included some aspects of banks’ holdings, like receiving a share of the income.
ABA estimates more than 275 community banks will suffer a roughly $600 million capital hit if the interpretation stands as is, making them less likely to lend to consumers and small businesses relying on local community banks. After Zions’ announcement last week, community banks lobbied regulators to issue new guidance, ideally including an exemption for TruPS-backed CDOs, and regulators issued a statement attempting to clarify the confusion. Regulators acceded … sort of … by issuing a statement that basically instructed regional banks to go back and read the rule.
So the ABA filed an emergency motion asking the Federal Reserve, Federal Deposit Insurance Corporation and the Office of Comptroller of the Currency for a “stay pending review,” arguing the expanded definition wasn’t available for public comment and thus hastily adopted without a proper cost/benefit analysis.
How this shakes out is anyone’s guess. The language in question does imply if a bank’s stake in a covered fund meets any one of seven criteria, it’s an “ownership interest” because the seven are connected by “or,” not “and.” (Oh, legalese … ) But the unintended whack on community banks could inspire regulators to make some edits.
Whether or not the rule stands, though, its broader market impact is likely small—it’s isolated to community banks, which represent a fraction of all lenders. It isn’t great for these institutions, but per the ABA’s estimates, Zions accounts for more than half of the expected total losses. The rest are scattered among the other 274 banks. Some banks might still take larger hits, and investors should bear this in mind, but systemic risk appears next to nil. As does a 2008-style cascade of write-downs through the entire financial system if banks must more broadly mark other illiquid assets to market, considering many banks already hold the bulk of their securities as “for sale.” That means they’re already marked to market.
Overall, this is the latest instance of Dodd-Frank making life tougher on small banks. They’ve had the biggest compliance headaches so far, and it’s weighing on that segment of the industry. But what isn’t great for competition within banking, in this case, isn’t a big concern for Financials or stocks overall.