Dodd-Frank: The Volcker Vortex

by King & Spalding
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In its simplest form, the Dodd-Frank Act's Volcker Rule prohibits U.S. bank holding companies and their affiliates from engaging in "proprietary trading" and from sponsoring hedge funds and private equity funds. While the original idea was straightforward – to prevent speculative, excessively risky activity by insured depository institutions – drawing a clear line between proprietary trading and permissible market-making activity has proven much more difficult than many had anticipated.

The final Volcker Rule was approved by the Commodity Futures Trading Commission, Federal Reserve Board, Federal Deposit Insurance Corporation, Comptroller of the Currency and the Securities and Exchange Commission on December 10, 2013, after they worked for about three years to craft a workable rule. The 71-page Volcker Rule includes an 892-page preamble that explains the reasoning behind the regulators' decisions and addresses thousands of comments received after the original proposal was published in 2011.

While much of the Volcker Rule had been thoroughly debated, commented on, and edited before the publication of the final edition on December 10, a new provision prohibiting banks from keeping investments in collateralized debt obligations backed by hybrid securities called trust preferreds, or TRuPs, ignited an immediate controversy. Community banks which would otherwise hold TruPS CDOs to maturity would have to mark them as available for sale, negatively impacting their balance sheets and reducing the amount of credit that could be extended to small and large businesses.

In response, House Financial Services Committee Chairman Jeb Hensarling (R-TX) and Financial Institutions and Consumer Credit Subcommittee Chairman Shelley Moore Capito (R-WV) sent a letter to the regulators expressing concern with the treatment of TruPS CDOs under the Volcker Rule. In addition, the duo introduced legislation last month to clarify that the Volcker Rule will not require banking institutions to divest their ownership in TruPS CDOs that were issued before the date of the final Volcker Rule.

In the Senate, Senators Joe Manchin (D-WV) and Roger Wicker (R-MS) introduced similar legislation last week and sent a letter to financial regulators in December demanding they take action to protect community banks. While other legislation has been introduced to fix the Volcker Rule, these other bills would apply to all banks and other types of securities including collateralized loan obligations (not just TruPs).

As a result of the collective political pressure, the five regulators on January 14 agreed to change a key provision in the rule to allow banks to retain certain types of TruPS-backed CDOs. However, the securities must have been issued before May 19, 2010 (when Dodd-Frank passed), and the bank in question must have acquired the interest in the securities before Volcker was unveiled in December.

While good news for many community banks, lawmakers and industry executives remain concerned that the complexity of the Volcker rule, the lack of regulatory coordination, and the potential for disparate regulatory treatment will restrict capital, reduce liquidity and undermine activities beneficial to the economy such as market-making and hedging. At a minimum, regulators should consider giving particular markets or products additional time to comply in order to lessen the potential negative market impacts
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-J.C. Boggs

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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