CDO’s Comprised of Small-Bank Securities Exempted from Volcker Rule

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), commonly called the Volcker rule, prohibited banking entities from engaging in proprietary trading, or acquiring, retaining, or sponsoring any equity, partnership, or other ownership interest in a hedge fund or a private equity fund. Drafted in response to fears stemming from the economic downturn of 2009, the Volcker Rule limited the ability of banks to participate in what was deemed highly risky market activities.  In effect, the rule would require banks to divest themselves of all collateralized debt instruments (“CDOs”), and so when governmental agencies adopted this rule on December 10, 2013, there was some pushback from those in the banking industry.

Smaller banks in particular have expressed opposition to the Volcker rule, as its implementation would most likely force smaller banks to take up to $600 million in losses on CDOs held by about 300 firms. These smaller banks are especially susceptible to losses in the event that they are forced to restructure the money tied up in the CDOs, which could create a rush to liquidate. Governmental agencies gathered in early 2014 to consider the implications of this rule for smaller banks and developed an interim final rule to exempt certain behavior in response to this issue. The interim rule served as the basis for the final rule that has since been implemented. Agency officials have justified the exemption with the need to alleviate unnecessary regulatory burden on smaller banks.

Under this new exemption, banking entities are permitted to retain an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. For certain CDOs to fall within the scope of the rule and to be eligible for retention by banks, they must be backed by trust-preferred securities established before May 19, 2010, and must be obtained by December 10, 2013, the effective date of the final rule. The exemption also requires that the CDOs be tied to securities issued by banks with less than $15 billion in assets, therefore limiting its scope to smaller banks that may be more affected by the Volcker rule.

Creating the exemption may solve some of the issues with the Volcker rule that could plague smaller bank. It is unclear, however, if the exemption has been applied broadly enough. Other financial instruments, like collateralized loan obligations (“CLOs”), create similar issues if banks are forced to sell off all CLO holdings. In upcoming discussions of governmental agencies, critics of this narrow application may be interested to see if these rulemakers react to comments from the banking industry and introduce additional rules that would apply the exemption on a wider basis.