U.S. banks are seeking to limit the reach of the Volcker Rule by challenging its definition of what it means to own a hedge fund or private-equity fund.
The opening gambit was made by the American Bankers Association (ABA), the industry’s biggest lobbying group, which said in a federal lawsuit filed last month on behalf of community banks that regulators had defined too broadly what it means to have an ownership stake. A week later, four other organizations, including the Financial Services Roundtable, sent a letter to bank-supervisory agencies making the same point.
Regulators, who spent more than two years writing the rule, defined ownership widely to capture all economic interests a firm might have in restricted funds. The ABA said it should be narrower, focusing only on equity, and that buying debt a fund sells doesn’t qualify as ownership. If the industry succeeds in getting the definition narrowed, that could allow banks to have ties to funds the rule intended to outlaw.
“Wall Street can create any kind of instrument that can look like debt on paper but act and feel like equity,” said Matthew Dunn, a director at Deloitte & Touche LLP. “So without a wide-cast net for ownership, they could skirt the rule’s ban by structuring funds that they control and benefit from, but technically don’t own.”
The Volcker Rule, the part of the 2010 Dodd-Frank Act named after former Federal Reserve Chairman Paul A. Volcker, was designed to curb the ability of banks to make risky bets with their own money. It limits ownership stakes in hedge funds and private-equity funds to 3 percent.
The definition of ownership covered about $3.5 billion of collateralized debt obligations backed by trust-preferred securities, or TruPS CDOs, that are held by banks, according to the Dec. 24 lawsuit. On Dec. 31, the four lobbying groups, which represent major financial firms, said the definition also would cover holdings by banks of $70 billion in collateralized loan obligations (CLOs), securities that pool corporate and consumer loans.
More than 275 banks will be forced to divest their TruPS CDOs and record $600 million of losses, the ABA said. These lenders bought bonds and not the equity in the CDOs, so that doesn’t make them owners, the group said in its lawsuit.
Like other securitizations, TruPS CDOs pool assets and sell slices to investors seeking different levels of risk. The assets in this case are hybrid bonds banks sold before the 2008 financial crisis. TruPS were popular because they counted as capital until Dodd-Frank put a stop to that practice.
In a joint statement last month, after the lawsuit was filed, the Fed and three other agencies that wrote the Volcker Rule said they would review and decide by Jan. 15 whether it’s “appropriate and consistent” with Dodd-Frank “not to subject” TruPS CDOs to the ban. The Volcker Rule, which focuses on big banks, doesn’t specifically mention TruPS CDOs or community lenders. The Dodd-Frank ban on TruPS grandfathered banks with less than $15 billion in assets.
While granting an exemption could lead the ABA to withdraw its lawsuit, it might not be enough to stop the industry’s attack on the definition of ownership.
Elliot Ganz, executive vice president and general counsel of the Loan Syndication & Trading Association, which represents firms that market and invest in corporate loans, said his New York-based group is considering a separate lawsuit.
Forcing banks to sell their CLO investments in the next two years could hurt prices and cause losses, according to Ganz. CLOs are caught in the ban because debt holders can force a change of management at a CLO, one of the Volcker Rule's definitions of an ownership stake. The four lobbying groups, which also include the Securities Industry & Financial Markets Association and the Structured Finance Industry Group, challenged that logic in their letter.
“Why should banks dump their sensible investments?” Ganz said in an interview.
His organization didn’t rush to sue like the ABA because there wasn’t an immediate loss for holders of CLOs, which are mostly marked to market prices on balance sheets, he said. Many banks hold TruPS CDOs in an account that allows them to ignore market values as long as they keep the securities to maturity.
The controversy over the definition of ownership erupted when Zions Bancorporation, a Salt Lake City-based lender with $55 billion in assets, said on Dec. 16 that it would take a hit of $387 million on its TruPS CDO holdings because the Volcker Rule would force their sale within two years. Zions’ $1.2 billion portfolio is the highest among banks, according to figures compiled by brokerage firm Sterne Agee & Leach Inc.
While exempting such CDOs from the rule would undermine the ABA lawsuit, it wouldn’t preempt others, said Matthew Albrecht, a bank credit analyst at Standard & Poor’s in New York.
“The political ammunition behind the lawsuit is community banks, so if people discover more elements harming community banks, they’ll use that for new legal challenges,” Albrecht said. “This is a big, complicated rule with lots of unknown implications. There will be more lawsuits when people understand more of the 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.
The regulators are aware that the definition of ownership is under attack and are prepared to defend it, according to a person familiar with their discussions who asked not to be identified because the matter is private. Narrowing the definition could give banks the leeway to circumvent the rule by structuring funds with little equity and controlling them through debt ownership, the person said.
The Volcker Rule’s restriction on hedge-fund ownership complements its ban on proprietary trading by not giving banks the ability to use outside entities to do the same kind of risky trading. The rule exempts investing in funds that only buy loans, such as securitizations of mortgages.
CLOs aren’t excluded because most of them buy a small amount of securities in addition to loans. Regulators say that by eliminating the bond holdings, CLOs could gain exemption from the rule without any change to the definition of ownership.
Regulators attempted to draw a line between pure debt holders and other types of involvement, according to Robert Maxant, a partner at Deloitte. A simple creditor buys a bond, which pays a fixed interest and returns the principal at maturity. CLOs, CDOs, and other structures give their creditors additional economic benefits depending on how the underlying assets perform, as well as control over how they’re managed. Those are akin to ownership, which the regulators are trying to capture in the Volcker Rule, Maxant said.
“Banks could keep attacking the ownership element,” Maxant said. “Regulators will keep defending it because they don’t want banks to do proprietary trading through funds.”