United States: Observation 1.1.1 On The Volcker Rule: Community Banks – Compliance

Last Updated: January 13 2014
Article by Frank A. Mayer, III and Jonathan L. Levin

On December 10, 2013, the federal banking agencies jointly issued final regulations to implement the "Volcker Rule," added to the Bank Holding Company Act by Section 619 of the Dodd-Frank Act, to prohibit banking entities and nonbank financial companies from engaging in proprietary trading and severely restrict investments in covered funds. As we noted in the first Pepper Point in Observation 1.1 on the Volcker Rule: Community Banks – Size Does Matter, the regulations appear to treat banking entities holding collateral debt obligations (CDOs) backed by trust preferred securities (TruPS) as owning "covered funds," which they must divest. This result was a surprise to the community banking community. When Congress enacted the Administrative Procedure Act and the Regulatory Flexibility Act, among the policy goals was elimination of surprises.

Did the Federal Banking Agencies Comply with the Regulatory Flexibility Act?

The Regulatory Flexibility Act (RFA) applies to rules published in the Federal Register pursuant to 5 USC 553(b) or any other law for which the agency provides notice and opportunity for public comment. Agency means an agency as defined in 5 USC 551(1). While there are exemptions1 and emergency rules,2 they should be inapplicable to the Volcker rulemaking process.

The RFA requires agencies to consider the economic impact of actions on small entities when promulgating regulations. The RFA was enacted because Congress was concerned about regulations that were unduly burdensome for small entities since regulations can adversely affect competition, discourage innovation and entrepreneurship, restrict improvements in productivity, and require small entities to comply with regulations that eradicate problems not caused by them.

Did Community Banks Cause the Great Recession?

The major goals of the RFA are to: (i) increase agency awareness and understanding of the impact of their regulations on small entities; (ii) require that agencies communicate and explain their findings to the public; (iii) encourage agencies to use flexibility and to provide regulatory relief to small entities; and (iv) provide a level playing field to allow small entities to compete.

The RFA requires a regulatory flexibility analysis if a rule will have a significant economic impact on a substantial number of small entities. The agency should perform a threshold analysis to determine the economic impact of a proposed rule, and the RFA requires an agency certification to be published in the Federal Register along with an explanation of the factual basis for the certification. An Initial Regulatory Flexibility Analysis (IRFA) provides a description of the nature of the impact; description of reasons action is being considered; statement of objectives and legal basis for the rule; description of the number of small entities to which the proposed rule will apply; description of the projected reporting, recordkeeping, and other compliance requirements; identification of relevant federal rules that may duplicate, overlap, or conflict with the proposed rule; and a description of alternatives.

A Final Regulatory Flexibility Analysis (FRFA), which must be published and cannot be waived, requires: (i) a discussion of the comments received, the alternatives considered and the rationale for the final rule; (ii) a statement of the need for and objectives of the rule; (iii) a summary of the significant issues raised by public comments in response to the IRFA, a summary of the agency's assessment of such issues and a statement of any changes made in the proposed rule as a result of such comments; (iv) a description and an estimate of the number of small businesses to which the rule will apply or an explanation of why no such estimate is available; (v) a description of the projected reporting, recordkeeping and other compliance requirements of the rule; (vi) a description of the steps the agency has taken to minimize the significant economic impacts on small entities consistent with the stated objectives of applicable statutes, including a statement of the factual, policy and legal reasons for selecting the alternative adopted in the final rule, and the reasons for rejecting each of the other significant alternatives; and (vii) a response to any comments filed by the Small Business Administration Chief Counsel for Advocacy in response to a proposed rule and a detailed statement of any changes made in response to the comments.

Have the Federal Banking Agencies Met the Requirements of the RFA?

It appears from the Volcker rulemaking record that the unintended consequence of deeming TruPS as a "covered fund" was not vetted through the RFA process. Because the proposed rule did not fully define certain key terms, the problem did not surface until the final rule laid out specific elements that would cause an ownership interest in TruPS-backed CDOs to be prohibited. There is clear indication that the agencies did not intend this consequence, given that they have consistently advocated for alleviation of the regulatory burden on community banks and expressly found the regulations to have no significant economic impact on smaller banking entities.

If allowed to stand, this unexpected result of the Volcker Rule is potentially calamitous, since many community banks count TruPS-backed CDOs as a significant part of their Tier 1 capital.

In an effort to block enforcement of the regulation, the American Bankers Association (ABA) together with several community banks brought a court action on December 24, 2013, seeking a temporary restraining order (TRO) against the federal banking agencies. On December 27 the agencies issued a joint statement acknowledging their recent awareness of this problem and announced that they are reviewing whether or not to subject these instruments as prohibited investments. The agencies are committed to address the matter by January 17, which is critical in light of the affected banking entities' reporting requirements. In response, the ABA has withdrawn its request for a TRO, though the underlying claim is still pending before the court.

While the current situation3 is undeniably troubling, any future course of action should await the imminent agency response.

We foresee several possible outcomes. Besides reaffirming the current regulatory setup, which we consider highly unlikely, the agencies could choose to exempt TruPS-backed CDOs from the definition of covered funds when such instruments are held by banking entities with less than $15 billion in total assets. That would align the regulations with the Collins Amendment (Section 171) of the Dodd-Frank Act, which allows community banks of that size to continue to count TruPS issued before May 10, 2010 as Tier 1 capital. Alternatively, the agencies might exempt these instruments for banking entities of any size, recognizing that the Collins Amendment will prevent banking entities with more than $15 billion in assets to count TruPS as Tier 1 capital after 2015. The agencies might adopt an even broader exemption covering other types of CDOs. In any event, we expect the real challenge for the agencies to be how to define the limits of any exemption so as to combat abuse while achieving the desired relief.

Pepper Points:

What are the consequences of noncompliance?

As the Volcker Rule currently stands, any community bank that engages in an activity or makes an investment in violation of the Volcker Rule or acts in a manner that functions as an evasion of the Volcker Rule shall, upon discovery, promptly terminate such activity and, as relevant, dispose of the "covered fund."

The Volcker Rule provides the federal banking agencies with authority to take any action permitted by law to enforce compliance, "including directing the banking entity to restrict, limit or terminate any or all activities [under the Volcker Rule] ... and dispose of any investment." Please note that this provision was revised from the proposed rule to remove an opportunity for a "hearing" and it applies to "any and all activities" as opposed to "the activity" that is the subject of a violation (as was the case in the proposed rule). See Preamble to Volcker Rule at pg. 855-856.

The federal banking agencies also note in the Preamble to the Volcker Rule that they may rely on their inherent authorities under otherwise applicable provisions of banking, securities and commodities laws to bring enforcement actions against banking entities, their officers and directors, and other institution-affiliated parties for violations of law. See Preamble to Volcker Rule at pg. 858.

As a compliance reminder, the Volcker Rule currently requires community banking entities with total consolidated assets of $10 billion or less that engage in covered proprietary trading or "covered fund activities" to satisfy the compliance program requirement by including appropriate Volcker Rule-specific references in their existing compliance policies and procedures.


1. Exemptions include rulemakings involving military or foreign affairs functions; matters relating to agency management or personnel; matters relating to management of public property, loans, grants, benefits, or contracts; interpretive rules, general statements of policy, or rules where notice and comment are impracticable, unnecessary, or contrary to public interest.

2. Agency head may waive or delay completion of the Initial Regulatory Flexibility Analysis, if timely compliance is impracticable; but must publish the reasons for finding an emergency.

3. Nearly two dozen Democratic lawmakers, led by Rep. Maxine Waters, D-Calif., the ranking member on the banking panel, are warning that a more limited change is warranted for banks with less than $15 billion in assets, citing a provision in the Dodd-Frank Act that addressed treatment of TruPS for small banks.

"For many small banks, ability to pool via a CDO structure was a prerequisite for issuance of TruPS, and we appreciate that regulators have taken that into account as they review whether they can provide guidance to restructure TruPS CDOs such that banks may be able to continue to hold them," Waters and the other Democrats wrote in a letter Tuesday.

'Consistent with Section 171 of the Dodd-Frank Act, we believe regulators have the authority to exempt banks with less than $15 billion in assets from the requirement to divest of TruPS CDOs, providing important relief to the community banking sector.'

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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