The Volcker Rule and Community Banks

Regulators approval on December 10, 2013 of the final version of the Volcker Rule (the “Final Rule”) was widely reported by the media last week with the possible effects and impact thereof continuing to be widely discussed this week. Why would a seemingly obscure rule, over 900 pages in length, dealing with banks’ trading practices garner so much publicity and attention?

The answer undoubtedly lies in the reason for the rule and the perceived “evil” it is designed to remedy.

At its core, the Final Rule is aimed at preventing banks from using customers’ money to make profit for themselves. The perception (primarily of politicians and the mainstream media) is that banks took too much and too many trading risks which resulted in losses that were as a major cause of the financial crisis in 2007-2008. So, the Final Rule is designed to reduce risk taking by banks and the resultant financial losses caused thereby (or at least it’s so believed). Presto! “Greedy” banks practice of taking trading risks will be hemmed in and the world will be better and safer.

But what impact does the Final Rule have on community banks? Here are some important takeaways:

• A community bank will have no compliance obligations if its trading is limited to transactions involving U.S. government, agency, state or municipal obligations all of which are exempt from the Final Rule. So, trading in U.S. Treasury obligations, GSE agency obligations, municipal obligations and FDIC obligations can continue free of the restriction contained in the Final Rule. By limiting trading to these types of obligations, a community bank can sidestep the Final Rule.
• The Final Rule also contains exemptions from restrictions for trading (i) in agent/broker/custodian accounts; (ii) as a trustee or in a fiduciary capacity on behalf of customers or (iii) in risk mitigating hedging activities.
• If a community bank manages its liquidity through trading activities covered by the Final Rule it will need to adopt, if it has not already, an appropriate liquidity management plan. The Final Rule specifies what must be included in a bona fide liquidity management plan.
• The Final Rule prohibits a banking entity from having an ownership interest in what are defined as “covered funds” unless an exception applies. Very few community banks invest in covered funds. Certain entities, including wholly owned subsidiaries and joint ventures are not considered covered funds under the Final Rule. Also exempt from the definition of a covered fund is any issuer of securities backed entirely by loans subject to 2 certain asset restrictions. However, if a community bank holds investments in asset backed securities that do not comply with these restrictions, those instruments will have to be divested.
• Finally, one area of concern relates to banks holding collateralized debt obligations (CDOs) (including CDOs backed by trust preferred securities) which it did not organize and offer. Those will have to be divested in accordance with the time frames set out in the Final Rule.

The American Bankers Association (ABA) in a letter to regulators this week addressed this last point by stating that the Final Rule could have “unintended negative consequences” for banks with investments in trust preferred securities. The ABA letter noted that divesting these obligations in accordance with the Final Rule could cause banks to suffer “unexpected hits to earnings and even to capital”. The ABA urged regulators to take action on this ASAP. So, how “final” the Final Rule is remains to be seen.

On a lighter note, some facts about the Final Rule:

• 4 The number of times Paul Volcker met with President Obama to discuss the Final Rule
• 200 The number of lawyers at Jones Day (a New York law firm) said to be charged with studying the rule so as to advise their Wall Street clients
• 18,000 The number of comments on the Final Rule submitted to regulators during its formative stages.

The foregoing is not intended to be legal advice, but rather, to provide accurate information regarding banking law and regulatory matters. For more information, please contact any member of our banking practice group: James A. Rapp ( jrapp@srnm.com ), William M. McCleery, Jr. ( wmccleery@srnm.com ), Michael A. Bickhaus ( mbickhaus@srnm.com ), Ted Niemann ( tniemann@srnm.com ), Alok Patel ( apatel@srnm.com ), or Joseph Ott ( jott@srnm.com ) at (217) 223-3030 or visit us on the web at www.srnm.com. We invite and welcome all questions and comments.