Bankers May Have to Sue Over Volcker Rule (Update 1)

Updated from 11:35 a.m. ET with comment from Kevin Petrasic, a partner in the Global Banking and Payments Systems practice of Paul Hastings in Washington.

NEW YORK (TheStreet) -- The three-year Volcker Rule Saga may not be close to being settled.

The Wall Street Journal reported Monday night that the American Bankers Association was "threatening legal action" over regulators' complicated set of final regulations issued on Dec. 10.

The Volcker Rule -- named after former Federal Reserve chairman Paul Volcker -- is part of the Dodd-Frank bank reform legislation of 2010, and is meant to ban "proprietary trading" by banks.  After an initial set of rules was proposed by the Fed and other bank regulators in October 2011, the finalized rules clarified many of exceptions, to allow banks with broker/dealer subsidiaries to maintain inventories of securities and to make hedge trades to protect from losses on those securities. 

The idea of the Volcker Rule is to make sure banks don't "gamble," while enjoying the advantage of gathering deposits insured by the Federal Deposit Insurance Corp.

The regulations implementing Volcker are long and complicated, and "the only certainty is that waves of agency guidance and interpretations will fill the coming months and years," according to the first of two "observations on the Volcker Rule" published this month by Pepper Hamilton LLP.

One of the items that received some clarification in the final set of Volcker regulations is requirement for banks not to invest in "covered funds," which include many collateralized debt obligations (CDOs) backed by trust preferred securities.

Following a "preliminary assessment" of the final Volcker regulations, Zions Bancorporation (ZION) of Salt Lake City on Dec. 16 said it had determined that "substantially all" of its investments in trust preferred collateralized debit oblations (CDOs) would be disallowed under Volcker. The company said it would record a fourth-quarter other-than-temporary impairment charge of $629 million on the transfer of disallowed held-to-maturity securities to held-for-sale.  The bank also said it had until July 21, 2015 to sell the trust preferred CDOs, "unless, upon application, the Federal Reserve grants extensions to July 21, 2017."

It would appear that Zions made a very responsible decision to get the worst of Volcker out of the way immediately, rather than surprise some of its investors down the line.

KBW analyst Collyn Gilbert wrote in a note to clients on Dec. 16 that there were two community banks under her firm's coverage that could see relatively large losses from the sale of securities springing from the Volcker Rule. 

The Federal Reserve, FDIC and the Office of the Comptroller of the Currency made an attempt to curb the uproar among community bankers last Thursday when it released its FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule.  In the FAQ, the regulators said banks could evaluate their CDOs backed by trust preferred securities to determine if they "could be restructured during the conformance period to avail itself of another exclusion or exemption under the Investment Company Act."

But the ABA didn't buy it, releasing a letter the same day in which the organization's CEO Frank Keating said "ABA is dismayed that the regulators have not found a resolution to address the disruptive consequences of the Volcker Rule on community banks. Community banks were reassured that the Volcker Rule wouldn't affect them, as they pose no conceivable systemic risk, but they have found out otherwise -- and with only two weeks before the end of the year. The consequences of this unexpected bureaucratic bombshell are millions of dollars in losses that will undermine affected banks' ability to serve their customers and communities."

In Pepper Hamilton's second observation of the Volcker Rule, the firm agreed that there was "a dangerous, but presumably unintended, consequence -- under the new regulations," that could force community banks to sell CDOs backed by trust preferred securities.  The firm also said the the "FAQs just published by the banking agencies have failed to calm fears, and the banking industry has galvanized to demand corrective regulatory measures to avert a crisis."

Being required to sell assets of a certain class will obviously distress the market for the CDOs in question.

The regulators "may be creating artificial holes in these comunity banks that will have to be filled by other types of capital," according to Frank Mayer, a partner in Pepper Hamilton's Financial Services Practice Group in Philadelphia.

According to the Journal, two community banks acted as petitioners in a court complaint filed by the ABA Monday, which may give the ABA legal standing to sue the regulators.

Mayer thinks the complicated issues over Volcker need to be worked out "in the executive branch and Congress," rather than in the courts. 

"They could put a moratorium on enforcing the rule. Maybe the FDIC or OCC could work on enforcement pending clarification on whether this type of structure is indeed a covered fund," he says. 

Kevin Petrasic, a partner in the Global Banking and Payments Systems practice of Paul Hastings in Washington, also sees the Volcker Rule as a major problem for smaller banks. 

"The ultimate irony is that this rule that was touted as going after the big banks is hurting the small banks, not only becsause of the uncertainty but because they have to evaluate their investment portfolios.  If it is determined that their [CDOs backed by trust preferred securities] are subject to the Volcker rule, they will be taking a huge capital hit," Petrasic says.

"There are two options for the industry: a legal challenge or going to Capital Hill to get it addressed.  But as soon as you open one part of the Volcker Rule for discussion, you're taking a significant risk that everything becomes fair game," Petrasic adds.

And that could mean more unintended consequences for community banks.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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