As we predicted in Observation 1.0, the inevitable waves of Volcker Rule guidance and interpretation have begun.
- A set of frequently asked questions, developed jointly and adopted in substantively identical form by the federal banking agencies (the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB) and the Federal Deposit Insurance Corporation (FDIC)), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), (the “Interagency FAQs”) has just been published.
- Since we understand that examiners will be assessing institutional progress during the conformance period, it is critical that covered banks review the Volcker Rule Interim Examination Procedures contemporaneously issued by the OCC.
- The securities market also has begun to adapt to the new regulatory framework by developing instruments designed to sidestep Volcker Rule prohibitions.
The Interagency FAQs cover six topics on which the banking industry has sought clarification, though the order in which they appear may differ among the agencies.
- The agencies endeavor to explain the requirements applicable during the conformance period that runs until July 21, 2015, with the FRB reserving the authority to extend annually until July 21, 2017 for particular banks. Generally, banking entities are required to make good-faith efforts aimed at fully conforming their activities to the Volcker Rule by the deadline. Stand-alone proprietary trading operations must be promptly terminated or divested, and prohibited investments and activities are not to be expanded during the conformance period. The deduction from tier 1 capital of permitted investments in covered funds is given as an example of how the requirement is not mandatory until the end of the conformance period. It is also noted that certain metrics reporting by the largest banking entities will be in effect before the conformance deadline.
- The agencies note that the Volcker Rule excludes an issuer that is a registered investment company (RIC) from the definition of a covered fund, including its development in a seeding period before it becomes an RIC. Correspondingly, they determine that an issuer that will become an excluded foreign public fund will be treated during its seeding period the same as an issuer that will become an excluded RIC, on the condition that the seeding period is conducted according to a carefully documented written plan.
- The agencies make clear that the exclusion of loan securitizations from the definition of a “covered fund” includes servicing assets that constitute rights or other assets designed to assure the servicing or timely distribution of proceeds to holders and that are related to the purchasing and holding of the loans, subject to certain requirements. Any servicing asset that is a security must be a cash equivalent or received in lieu of debts previously contracted.
- The agencies address the quantitative measurement reports required from banking entities valued at more than $50 billion, explaining that the measurements must be taken daily beginning July 1, 2014 and that the July metrics must be reported by September 2, 2014, the day after Labor Day.
- The agencies remain steadfast in their opposition to a banking entity sharing its name, the name of any affiliate, or any derivative of such name with a covered fund that it organizes and offers. The standard is the avoidance of customer confusion, whether in the fund’s name itself or in any marketing or promotional materials, that would lead to the assumption that the banking entity or any of its affiliates guarantee, assume or otherwise insure fund obligations or performance.
- The agencies reiterate the definition of “trading desk” as the smallest discrete unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or any affiliate. A trading desk will operate at the level at which profit and loss of traders is attributed, and it may serve more than one legal entity and book its trades and positions in different affiliates. In cases in which more than one affiliated entity is involved, careful records must be kept of all financial exposures. Metrics are to be calculated at the level of the entire desk (not for each subset of positions booked at the various component entities) and must be reported to each agency having jurisdiction over every entity involved.
Pepper Point: While the Interagency FAQs are helpful in some respects, too often they simply parrot or rephrase statutory and regulatory language without offering meaningful clarification. Continued pressure on the agencies for more pointed interpretation will need to be applied as banking entities manage the specifics of their own activities.
Volcker Rule Interim Examination Procedures
On June 12, 2014, the OCC published interim procedures for examiners to assess banks’ progress in developing a framework to comply with the Volcker Rule. These examination procedures are designed to help bank examiners work with banks to determine whether they have business activities or investments that are subject to the regulations and, if so, to assure progress is being made during the conformance period to achieve full compliance by the July 21, 2015 deadline.
Principal objectives of the Volcker Rule Interim Examination Procedures include:
- Assessing progress toward identifying activities subject to the regulations
- Assessing progress toward establishing a compliance program
- Assessing plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies.
- Assessing progress toward timely reporting of proprietary trading metrics
- Assessing progress toward using metrics to monitor for impermissible proprietary trading
- Assessing progress toward identifying market-making-related activities, market-maker inventory, and reasonably expected near-term demand
- Assessing progress toward establishing a compliance program for permitted market-making-related activities
- Assessing progress toward establishing a compliance program for underwriting activity
- Assessing progress toward establishing a compliance program for risk-mitigating hedging activity and satisfying documentation requirements.
- Assessing plan for conforming asset management and sponsorship activities
- Assessing plan for conforming securitization activities involving a securitization vehicle that is a covered fund
- Assessing plan for conforming underwriting and market-making activities in covered funds
- Assessing progress in ensuring compliance with the de minimis ownership limits on investments in covered funds relevant to the permitted asset management, securitization, underwriting, and market-making activities
- Assessing plan for conforming hedging activities using covered funds
- Assessing plan for divesting nonconforming investments in covered funds.
- Assessing overall progress in taking necessary actions to meet the requirements of Volcker Rule regulations within the conformance period.
The OCC has announced its intention to supplement the interim procedures during the conformance period with in-depth procedures designed to enable examiners to test compliance on an ongoing basis.
Pepper Point: Though meant for examiners, the interim procedures are a valuable tool for understanding the areas of concern to the regulators. In addition, the procedures provide a simplified primer on the requirements of the Volcker Rule and contain a useful glossary of terms integral to the foundation of this emerging field. We expect the other federal banking agencies to issue substantially similar examination procedures.
Two new developments emerged last month representing concerted efforts by banks and the securities market to adapt to the investment prohibitions under the Volcker Rule.
- Keying on the exemption from the covered fund ownership prohibition granted to joint ventures between a banking entity and no more than 10 unaffiliated participants, a large securities affiliate of a major bank sold bonds to a joint venture trust, thus potentially avoiding its traditional, but Volcker-prohibited, role of acting as bond issuer.
Pepper Point: The new structure has not yet received approval from regulators, and survives only during the conformance period ending in July 2015. However, the industry hopes that the positive effect on the municipal bond market derived from enabling banks to retain their long-term bond holdings will promote a favorable regulatory result.
- Collateralized loan obligations (CLOs) are targeted by the Volcker Rule as prohibited investments if certain types of equity securities are part of their securitized asset pool. While the effective date of this prohibition for CLOs that have been held since 2013 has been extended to July 21, 2017, a number of large banks have worked with the Clearing House to develop a customizable template for a supplemental indenture that restructures a CLO to remove impermissible securities and achieve compliance with the Volcker Rule. Reportedly, this template has already been used in at least eight transactions.
Pepper Point: Although losses will not result from CLOs maturing before the extended 2017 deadline, according to banking industry research, the numbers show that the majority of losses will be in CLOs maturing after 2017. Without further regulatory action to exempt CLOs more broadly (an outcome that appears unlikely), covered banks have a relatively limited window to develop a comprehensive strategy for restructuring or divestment.
A Publication of Pepper Hamilton LLP
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