NEW YORK (The Deal) -- One day after federal regulators changed a provision in the Volcker Rule responding to concerns by community banks, a bipartisan group of lawmakers on Wednesday urged U.S. government agencies to make another change to the more than 900 page measure that was approved by five agencies in December.
At a House Financial Services Committee hearing, top Democrats and Republicans urged regulators to revise a provision that hurts the ability of banks - big and small - to issue so-called Collateralized Loan Obligations, a form of loan that is made to businesses that are not considered investment grade. A number of high profile companies access the CLO market, including Sears Roebuck, SuperValu (SVU), J.C. Penney (JCP) and Rite Aid (RAD).
Under the Volcker Rule, CLO debt securities are treated as if they are equity securities, thereby making them ineligible to be held by banks. As a result, without any exemptions, over the next 18 months banks will have to divest or restructure up to $70 billion of CLO notes. Community bank executives have been telling regulators and lawmakers that CLOs are not systemically risky investments.
While most CLOs are held by the largest financial institutions, small banks have somewhere between $300 million and $1 billion in CLOs and, according to Elliot Ganz, the general counsel of the Loan Syndications and Trading Association, they will have to take a $30 million hit or more because of the change.
"That will be less money available to lend to their communities," said Ganz. Roughly 21 banks with assets of less than $25 billion own CLO securities. "If the price of CLO debt securities were to drop by only 10%, banks holding CLO debt securities would face potential cumulative losses of up to $7 billion, which losses would be driven solely by imposition of the rule."
Rep. Maxine Waters, the ranking Democrat on the panel, asked one witness whether he was "willing to work with us to address" concerns with CLOs. Rep. Jeb Hensarling, R.-Texas, the chairman of the panel, also raised concerns about the CLOs.
However, regulatory observers argued that while Democrats might be willing to exempt community banks from the CLO restriction, Republicans are seeking to provide an exemption for all banks, including the largest ones. A Senate bill introduced by Sen. Mark Kirk, R-Illinois, allows banks to keep their investments in CLOs as long as they were issued prior to Dec. 10, 2013.
This raised the ire of Securities Industry and Financial Markets Association CEO Ken Bentsen, who told The Deal that bifurcating the industry would be "nonsensical," adding that the CLO market is an important commercial funding market and to bifurcate it based on the size of an institution would hurt access to the loans. "Do you not want large banks to make loans?" he asked.
The bipartisan comments come after regulators late Tuesday, responding to small-bank complaints and a lawsuit launched by the American Bankers Association in December, revised a section of the Volcker Rule by providing a clearer means for financial institutions to keep Collateralized Debt Obligations that are backed by trust preferred securities. This was a big win for community banks, who otherwise would have had to almost immediately marked the assets to market value, producing an immediate hit to earnings. Charles Funk, CEO of $1.7 billion bank MidWestOne Financial Group in Iowa City, said his bank would have had to take a $1 million hit to earnings. Funk added that community banks overall would had to experience losses of at least $600 million.
Republican lawmakers also brought up concerns raised in a letter Hensarling sent to the Securities and Exchange Commission Monday that the Volcker Rule violates the law because the agency didn't conduct an economic analysis as is required by federal law in a statute known as the "administrative procedures act" or APA.
"What is the cumulative economic impact of all of these rules together going to be on the U.S. economy and individual Americans?" asked Rep. Scott Garrett, R-N.J. "Well, similar to the Volcker rule, no one really knows, especially the regulators who continue to thumb their nose up at the law and neglect to perform the appropriate economic analysis."
SIFMA's Bentsen told The Deal he would have liked to see regulators conduct a robust economic analysis before finalizing the Volcker Rule. However, he noted that three of the five regulators, the banking prudential regulators, that participated in writing the Volcker Rule are exempted from conducting cost-benefit analysis of rules.
However, he said SIFMA has "no plans" to file a lawsuit claiming that the regulators violated the APA because they didn't conduct an adequate cost-benefit analysis. Some other groups may file such a lawsuit, however.
Hensarling and Garret cited a 2011 D.C. appeals court decision that rejected an SEC proxy access rule for failing to conduct an economic analysis to back up the regulation. The SEC was one of five agencies to approve the Volcker Rule and any legal challenges by banks are likely to end up at the same court referenced by Hensarling and Garrett in their letter.
However, it is unclear whether the court will make a similar finding. The three-judge panel that rejected the SEC rule in 2011 was made up of Republican-appointed judges, and a recent move by Senate Democrats on Capitol Hill has made it easier for President Barack Obama to install nominees who are more likely to support the Volcker Rule.