U.S. regulators will grant banks an exemption from Volcker Rule limits for collateralized debt obligations (CDOs)composed mostly of small-bank securities, according to a statementfrom regulators today.

The adjustment to the rule would allow banks to keep CDOs backedby trust-preferred securities (TruPS) established before May 19,2010, and obtained by Dec. 10, 2013, five financial agencies saidin a joint news release.

After regulators approved theVolcker Rule on Dec. 10, smaller U.S. banks said it could forcethem to take as much as $600 million in losses on certain CDOs heldby about 300 firms. U.S. regulators said they would considerexempting the securities and set tomorrow as the deadline.

“I understand the challenge that community banks face inmanaging new regulations, and by clarifying this exemption, we areworking to alleviate unnecessary regulatory burden,” saidComptroller of the Currency Thomas J. Curry, in a statement.

The exemption—granted by the OCC, Federal Reserve, FederalDeposit Insurance Corp., Securities and Exchange Commission, andCommodity Futures Trading Commission—gives grandfatheringprotection to CDOs as long as they meet thresholds ensuring theyare tied primarily to securities issued by banks with less than $15billion in assets. As a so-called interim final rule, it will beimplemented while the agencies also open a 30-day public-commentperiod.

Based on earlier objections from smaller banks, the AmericanBankers Association had sued to block implementation of the VolckerRule. Salt Lake City-based Zions Bancorporation—a holder of such CDOs—said it could loseabout $387 million under Volcker, a centerpiece of the 2010Dodd-Frank Act's overhaul of U.S. financial regulation.

“Our initial review of today's action by the regulators suggeststhat the Interim Final Rule provides a broad exemption for banksholding trust preferred securities from the original Volcker Rule,”ABA president Frank Keating said in a statement. “The ABA will beconducting a more comprehensive review of the amended language andwill announce a decision regarding the pending litigation on thisissue tomorrow.”

Zions owned $1.2 billion of bank-issued TruPS CDOs as of Sept.30, the most among all U.S. banks, according to analysts at SterneAgee & Leach Inc. About 3 percent of U.S. banks held similarCDOs and a sudden sale by Zions could disrupt the market, SterneAgee said.

CLOs Still Off-Limits

The regulators' exemption narrowly addresses CDOs, not thebanking industry's related complaint that Volcker could also forcelosses on certain collateralized loan obligations (CLOs). Severalindustry groups, including the Financial Services Roundtable andSecurities Industry and Financial Markets Association, have writtenletters to regulators warning of market disruptions if banks haveto sell off CLO ownership interests.

Hedge funds have gravitated to the $41.2 billion market in thesesecurities, which after losing most of their value in the 2008crisis have returned to almost 40 cents on the dollar in somecases, according to prices from JPMorgan Chase & Co.

Lawmakers from both parties had objected to making small bankssell off the securities. Senators Joe Manchin, a West VirginiaDemocrat, and Roger Wicker, a Mississippi Republican, introduced abill yesterday providing grandfathering protection for banks withless than $50 billion in assets. House Financial Services CommitteeChairman Jeb Hensarling, a Texas Republican, introduced a similarbill with Representative Shelley Moore Capito, a West VirginiaRepublican.

Industry representatives will testify before the House FinancialServices Committee tomorrow on the Volcker Rule's impact,concentrating much of their criticism on the CLO treatment,according to their prepared testimony.

“CLOs provide over $300 billion in financing to thousands ofbusinesses,” said David C. Robertson, a partner at TreasuryStrategies Inc., in testimony on behalf of the U.S. Chamber ofCommerce. He argued that Volcker was too broad in definingownership in CLOs that would be affected by the rule's limits.

“The regulators, acting without prior notice, far exceeded therequirements of the statute,” Robertson said. Banks could be forcedto restructure $70 billion in CLO debt, he said, which could createa “rush to liquidate.”

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