United States: Observation 1.1 On The Volcker Rule: Community Banks – Size Does Matter

Last Updated: December 27 2013
Article by Frank A. Mayer, III, Jonathan L. Levin and Walter Donaldson, II

This is the second in Pepper's series of client alerts dealing with specific effects of the 'Volcker Rule' on various market segments.

On December 10, 2013, after more than three years of intensive development, the Board of Governors of the Federal Reserve System (FRB), Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) adopted final regulations implementing the "Volcker Rule," added to the Bank Holding Company Act of 1956 by Section 619 of the Dodd-Frank Act, which prohibits banking entities and nonbank financial companies from engaging in proprietary trading and severely restricts their relationships with hedge funds and private equity funds. In taking this action, the agencies have caused a sea change in the way many financial institutions will conduct their operations.

This alert describes how the new regulations will affect banking entities1 with less than $10 billion in total consolidated assets (commonly called "Community Banks").

  • There will be a compliance burden on Community Banks.
  • There may be a capital charge on a Community Bank. 
  • §23A and 23B must be reviewed if transactions occur between the Community Bank and a covered fund, particularly collateralized debt obligations backed by trust-preferred securities.
  • Divestitures of trust-preferred securities may be a consequence of the Volcker Rule.

In the Bull's-Eye: Proprietary Trading and Covered Fund Relationships

Proprietary Trading. The regulations target trading activity engaged in by banking entities, which is prohibited when it involves the purchase or sale of financial instruments (i.e., securities, derivatives, commodity futures, or options) for short-term (usually less than 60 days) gain or hedging of other trading accounts, the purchase or sale of financial instruments treated as "covered positions and trading positions" under federal banking agency market risk capital rules, and the purchase or sale of financial instruments in connection with activities for which the banking entity is licensed as a dealer, swap dealer or security-based swap dealer.

Covered Funds. The regulations also target banking entity ownership and other relationships with covered funds. A "covered fund" is a hedge fund or private equity fund characterized by its being: (a) an issuer which is exempt from the Investment Company Act of 1940 because it does not propose to make a public offering of its securities and is beneficially owned by no more than 100 persons or is owned exclusively by "qualified purchasers;" (b) a commodity pool which is exempt from the Commodity Exchange Act because its participation units are not publicly offered and are owned by "qualified eligible persons;" or (c) a foreign-based entity owned by a U.S. banking entity that raises money to invest in securities for resale or otherwise trade in securities.

Outside the Bull's-Eye: Community Banks

Proprietary Trading. Few Community Banks engage in the types of trading activity targeted by the regulations. Regulatory officials have made clear that they intended to minimize the compliance burden on Community Banks. Trading in U.S. government, agency and GSE obligations, trading in state and municipal government obligations, and trading on behalf of customers as agent or fiduciary – the extent of trading activity at most Community Banks – are explicitly exempted from coverage. Also exempted are other trading activities often associated with Community Banks, including trading to satisfy debts previously contracted, trading through deferred compensation or pension plans, repurchase agreements, and securities lending transactions. Additionally, Community Banks can continue to purchase and sell securities for liquidity management purposes and to engage in risk-mitigating hedging activities.

Important caveat: For liquidity management – The banking entity must follow a written plan that specifies the covered securities, their trading circumstances and risks; eschews short-term profitmaking strategies; involves highly liquid securities; aligns amount with near-term funding needs; installs internal controls; provides for analysis and independent testing; and follows relevant regulatory requirements and guidance.

For Risk-Mitigating Hedging Activities. The banking entity must implement and enforce a written compliance program that documents hedging positions, techniques and strategies, installs internal controls and ongoing management procedures, and provides for analysis and independent testing to ensure demonstrable reduction or significant mitigation of specific, identifiable risks. The hedging activity must not create any significant new unhedged risk, must be continually recalibrated to avoid prohibited proprietary trading, and must not involve compensation of hedging personnel in any way that incentivizes prohibited proprietary trading. Additionally, the banking entity must keep for at least five years detailed records sufficient to demonstrate compliance with the regulations.

Important caveat: A banking entity may not rely on any exemption if the activity would result in a conflict of interest, result in exposure to high-risk assets or trading strategies, or threaten the safety and soundness of the entity or the financial stability of the U.S.

Covered Funds. Like proprietary trading, few Community Banks own, sponsor or invest in hedge funds or private equity funds. Again, federal regulators have stated that the regulations are not intended to cover the types of investment activities commonly carried on by Community Banks. Those activities, which are generally unrestricted by the regulations, include investing in covered funds where the banking entity acts solely as a non-owner agent, broker or custodian; acts as trustee for employee deferred compensation, stock-bonus, profit-sharing or pension plans; collects a debt previously contracted in the ordinary course of business; or otherwise acts as fiduciary for the account or on behalf of customers who are not covered funds themselves.

Easing the way further for Community Banks are certain other exemptions from the definition of covered fund, including an entity wholly or almost wholly owned by the banking entity, a joint venture of the banking entity with no more than 10 co-venturers that engages in a bank-permissible activity other than trading in securities, an account set up for the purchase of bank-owned life insurance (BOLI), a small business investment company (SBIC), a fund that invests in projects that promote housing services, jobs and general public welfare, and securitizations of residential or commercial mortgage-backed securities, automobile securitizations, credit card securitizations, as well as commercial paper backed by loans and other permissible assets. Community Banks also can hold interests in covered funds in order to share in profits as compensation for advisory and management services they provide to those funds. They also can organize and offer covered funds to their customers and their affiliates' customers in connection with trust, fiduciary, investment advisory, or commodity trading advisory services, subject to a 3 percent ownership limit and an aggregate limit of 3 percent of tier 1 capital after the first year. Additionally, as part of their risk-mitigating hedging activities, Community Banks can own interests in covered funds to the extent that their investments are designed to demonstrably reduce or significantly mitigate specific, identifiable risks in connection with compensation of their employees or their affiliates' employees who directly provide services to those funds.

Important caveats:

  • For risk-mitigating hedging investments, a banking entity must implement and enforce a special compliance program consistent with the standards listed above for risk-mitigating hedging activities under proprietary trading.
  • In calculating its regulatory capital, a banking entity must deduct the fair market value of its ownership interests in covered funds.
  • Certain transactions between a banking entity and a covered fund that are covered transactions under § 23A of the Federal Reserve Act (transactions with affiliates) are prohibited; all other transactions with covered funds are subject to the market terms requirement under § 23B; and reliance on any exemption is prevented when it would lead to the same adverse results as noted for proprietary trading.

Lighter Burden for Reporting and Compliance

While the reporting requirements that apply to larger banking entities are extensive and progressively more intrusive as the size of the entity grows, the regulations take a very different approach for Community Banks. Because banking entities with less than $10 billion in assets are typically uninvolved with covered activities and investments, they are freed from the reporting requirements applicable to larger entities. A Community Bank also is exempt from all compliance program requirements unless and until it commences any covered activity or investment. In that event, the terms, scope and detail of the compliance program need only be appropriate for the types, size, scope and complexity of such activities tailored to the Community Bank's business structure. Even then, the Community Bank need add to its existing policies and procedures only references to the provisions of the new regulations that are directly relevant to the particular covered activities it is conducting.

Compliance Deadline – Delayed

Technically, the regulations take effect on April 1, 2014. However, the Federal Reserve has extended the deadline for compliance until July 21, 2015 to allow banking entities to conform their activities and policies to the new regulatory requirements.

Pepper Points

Beware a dangerous, but presumably unintended, consequence – Under the new regulations, banking entities that hold collateral debt obligations (CDOs) backed by trust-preferred securities (TruPs) actually own "covered funds" that they suddenly are required to divest. Many Community Banks hold TruPs as a major component of capital, so will they now be forced to absorb significant capital charges when these CDOs are sold at a loss? FAQs just published by the banking agencies have failed to calm fears, and the banking industry has galvanized to demand corrective regulatory measures to avert a crisis.

The regulatory agencies have deliberately left much to the subjective judgment of bank examiners and agency officials. For example, even the chairman of the Federal Reserve has questioned how perfectly structured a hedge will need to be to qualify for the exemption from proprietary trading. As detailed and expansive as the new regulations may be, they leave wide room for interpretation and can be expected to evolve as banking models creatively adapt.


1. The regulations apply to "banking entities," which are defined as insured depository institutions (IDIs), companies that control IDIs (BHCs), including foreign banking organizations treated as BHCs, and affiliates and subsidiaries of IDIs and BHCs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Frank A. Mayer, III
Walter Donaldson, II
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