Volcker Fix Leaves Some Small Banks Out in the Cold

WASHINGTON — Regulators' attempt to carve out an exemption for small banks from a key part of the Volcker Rule satisfied most institutions that feared getting swallowed up in the Dodd-Frank Act provision, but left others still vulnerable to the regulation and facing significant losses.

In their interim final regulation issued this week, the regulators said it would carve out collateralized debt obligations backed by trust-preferred securities that were issued by banks with less than $15 billion of assets. By most estimates, that exclusion covers the majority of institutions seeking to avoid massive writedowns.

But it did not help all affected institutions. For example, Hardin County Bank in Savannah, Tenn., holds a $500,000 CDO that is not eligible for the regulatory exemption because the Trups backing it were issued by insurance companies, not banks.

"This was a good win for banks, but there are still going to be losses booked because of the Volcker Rule," said Ashley Dennis, the bank's chief financial officer. "Whether it was issued by a bank holding company or an insurance company, it's still the same type of security. I don't think there should be a distinction based on who issued it, especially if it is still performing."

As a result of the Volcker Rule, Dennis said the $415 million-asset bank expects to take a roughly $125,000 writedown on the security, equal to approximately 11% of the institution's quarterly net income. The hit comes despite the fact that the security continues to perform and the bank had intended to hold it until maturity, according to Dennis.

"They have never missed an interest payment," Dennis said. "It is still fully performing."

It is unclear how many other institutions may be in the same boat. Wayne Abernathy, the executive vice president for financial institutions and regulatory affairs for the American Bankers Association, said the trade group has heard from at least six other institutions facing a similar concern. But Abernathy cited figures that said there were only 20 CDOs backed by Trups issued by insurance companies.

Still, he said that even one community bank taking such a hit was a problem.

"Does the Volcker Rule intend to impose penalties on community banks that invested in insurance company-issued CDOs?" Abernathy said. "I don't see anything in the Volcker Rule that suggests that its purpose was that a community bank should take a $125,000 hit on an insurance-debt investment."

The situation may help explain why the ABA has yet to drop its lawsuit against the regulators. The trade group sued in late December, asking a court for emergency action before banks had to file their fourth-quarter earnings. It said in a statement Wednesday that it was dropping the request for emergency relief, but had yet to decide if it would stop the lawsuit entirely. The ABA said it was seeking more input from members on whether institutions may still face substantial harm from the Trups-related provisions of the Volcker Rule.

Regulators, meanwhile, appear unlikely to come to Hardin County Bank's aid. In their interim final rule addressing the Trups CDO issue, they said they were exempting bank-issued Trups that were covered by the Collins Amendment, a provision in the Dodd-Frank Act that said trust-preferred securities could no longer count as Tier 1 capital. Importantly, the measure grandfathered all Trups issued by banks with less than $15 billion of assets.

"Regulators tied their fix to the Collins amendment—that's where they felt their legal authority lay — and that's why the insurance Trups were left out," said Karen Thomas, senior executive vice president of government relations and public policy for the Independent Community Bankers of America, who said the trade group was still examining the impact of the interim final rule.

Jaret Seiberg, a policy analyst with Guggenheim Securities, agreed that "there are going to be some banks where this matters, yet it's hard to believe that regulators are going to be able to do anything about it."

"I don't think there is any real good prospects for help beyond what came out already," he said.

Some regulators privately believe their hands are tied. They were caught off guard by the backlash to the final Volcker Rule because they did not realize banks would have to recognize losses on their Trups-backed CDOs by the end of the fourth quarter. Because the Volcker Rule does not go into effect until July 2015, they thought there would be adequate transition time.

But due to accounting rules, banks could no longer hold such securities as held-to-maturity, instead reclassifying them as available-for-sale. Such a move would force them to either recognize the current market value of the CDO or sell the security off. Banks that held such CDOs effectively had to either write down the assets or sell them at a probable loss.

Although regulators wanted to correct the issue, they worried that simply exempting all Trups-backed CDOs would open them up to further legal liability. Under the Administrative Procedures Act, regulators cannot act in an "arbitrary or capricious manner" in writing a rule. Regulators worried that granting a broad exemption — even if it was designed to help many banks — could open them up to charges they acted in that way.

Their primary fear is how large banks and other holders of collateralized loan obligations — which are also covered by the Volcker Rule — will act. The agencies fear that holders of CLOs will file a lawsuit, arguing that they should have received the same exemption from the Volcker Rule that holders of CDOs did.

Institutions that hold CLOs and trade groups are already lobbying Congress for a similar exemption.

"I would note that the relief issued yesterday by the agencies is certainly welcome relief for some, but it has not resolved the very serious issues regarding collateralized loan obligations that, left unresolved, will affect the cost of credit to Main Street businesses that benefit from that market," said Ken Bentsen, president and chief executive of the Securities Industry and Financial Markets Association, during a hearing on the Volcker Rule on Wednesday.

Collateralized loan obligations act similarly to a bond issuance and typically are made up of midsize and large commercial loans. Many see no reason why regulators should have included them under the Volcker Rule, since they are generally used to diversify risk.

"There is no rationale to punish a bank for holding a CLO," Seiberg said. "CLOs are important tools to expand credit availability."

But since most holders of CLOs are big banks — unlike Trup CDOs, many of which are owned by smaller institutions — the issue has not garnered the same level of political momentum.

Lawmakers may also come to the rescue when it comes to CLOs. Rep. Maxine Waters, the top Democrat on the House Financial Services Committee, suggested that just as both political parties were able to agree CDOs needed to be addressed, the same was true for CLOs.

"Just as we were able to do that, I think that we're able to work with regulators on some of the other issues that are being identified, such as the CLO issue," she said.

Still, many observers expect that if Congress or the regulators don't act, a bank or trade group will file a lawsuit on the CLO issue at some stage. If and when they do, the interim final rule regarding Trups CDOs will be closely scrutinized to see if regulators acted arbitrarily in crafting that exemption.

By then, however, it will be far too late for Ashley Dennis and Hardin County Bank. With fourth-quarter filings due by the end of the month, her hope is that the ABA, ICBA and others will continue to press the issue with regulators.

"Don't give up," she said. "The fight's not over. I think there needs to be more work to see how many banks own the trust-preferreds not issued by a bank. I can't imagine we're the only one."

— Victoria Finkle contributed to this article.