Under the Economic Growth, Regulatory Reform and Consumer Protection Act, depository institutions and their holding companies with less than $10 billion in assets are excluded from the prohibitions of the Volcker Rule. Accordingly, institutions under $10 billion may, so long as consistent with general safety and soundness concerns, engage once again in proprietary trading and in making investments in covered funds.
Neither EGRRCPA nor the proposed rule, however, addresses the impact on an institution when it goes over $10 billion in assets, either as a result of organic growth or via merger. The proposed rule does not even apply the tests on a quarter-end or other reporting period basis, much less an average balance or consecutive quarter requirement. The proposing release notes that they believe that insured depository institutions “regularly monitor their total consolidated assets” for other purposes, and therefore do not believe this ongoing test requirement would impose any new burden.
The Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA) provided significant regulatory relief for community banks, including broad relief from the Volcker Rule’s prohibition on proprietary trading and investments in covered funds. As previously discussed, Section 203 of EGRRCPA provided an exemption from the Volcker Rule for institutions that are less than $10 billion and whose total trading assets and liabilities are not more than 5% of total consolidated assets. The exemption provides complete relief from the Volcker Rule by exempting such depository institutions from the definition of “banking entity” for purposes of the Volcker Rule.
On December 21, 2018, the financial regulatory agencies invited public comments on a proposal to implement the EGRRCPA changes to the Volcker Rule. The proposed rule provides that an insured depository institution is exempt from the Volcker Rule if “it has, and every company that controls it has, total consolidated assets of $10 billion or less and total trading assets and trading liabilities, on a consolidated basis, that are 5% or less of total consolidated assets.” While the proposed rule is not yet effective, the Federal Reserve has previously confirmed that it would not enforce the Volcker Rule in a manner inconsistent with EGRRCPA, so the proposed rule is effectively already in place.
Based on September 30, 2018 call report data, this change to the Volcker Rule exempted approximately 97.5% of the 5,486 U.S. depository institutions. (The actual number is probably slightly less, as some of those exempted depository institutions are affiliated with larger and/or foreign banks, each of which would remain subject to the Volcker Rule.) Of note, the $10 billion asset threshold is by far the most relevant determinant of the eligible relief. Based on that call report data (which necessarily excludes any trading assets and liabilities held by a parent company), only 0.15% of depository institutions had trading assets equal to at least 5% of their total assets (and only 0.16% of the institutions had trading assets equal to 3% or more of their total assets).
While few community banks ever engaged in proprietary trading before the Volcker Rule, EGRRCPA still provides meaningful relief from the compliance obligations of the Volcker Rule, the risk of inadvertently being deemed to engage in proprietary trading, or the prohibition from investing in covered funds (or the need to ensure that vehicles that were invested in qualified for an exemption from the covered fund definition).
As of the end of August 2018, two key provisions of The Economic Growth, Regulatory Relief, and Consumer Protection Act (aka the Crapo bill, S.2155, or increasingly, EGRRCPA) have become effective: the increase in the small bank holding company policy statement threshold and the increase in the expanded examination cycle threshold. Before looking at those provisions, I have to acknowledge the fabulous Wall Street Journal story by Ryan Tracy, “Can You Say EGRRCPA? Tongue-Twister Banking Law Confuses Washington.” Personally, I’m now leaning towards “egg-rah-sip-uh.”
On July 6, 2018, the federal banking agencies released an Interagency statement regarding the impact of the Economic Growth, Regulatory Relief, and Consumer Protection Act that provided guidance as to which provisions were immediately effective versus which provisions would require further regulatory action. Included in this guidance was confirmation that the banking regulators would immediately implement EGRRCPA’s changes to the Volcker Rule, freeing most institutions with total assets of less than $10 billion from the constraints of the Volcker Rule. The regulators noted that they “will not enforce the final rule implementing section 13 of the BHC Act in a manner inconsistent with the amendments made by EGRRCPA to section 13 of the BHC Act.”
Unfortunately, two of the more significant areas of regulatory relief for community banks, the respective increases in thresholds for the small bank holding company policy statement and the expanded examination cycle were not granted such immediate effectiveness. While EGRRCPA required the Federal Reserve to act on the expansion of the policy statement within 180 days, anyone familiar with the deadlines set forth in the Dodd-Frank Act for regulatory action would not be holding their breath.
Small Bank Holding Company Policy Statement Expansion. On August 30, 2018, the Federal Reserve published an interim final rule implementing the revisions to the small bank holding company policy statement. The Federal Reserve’s small bank holding company policy statement generally exempts such institutions from the requirement to maintain consolidated regulatory capital ratios; instead, regulatory capital ratios only apply at the subsidiary bank level. The small bank holding company policy statement was first implemented in 1980, with a $150 million asset threshold. In 2006, it was increased to $500 million, and in 2015, it was increased to $1 billion. Section 207 of EGRRCPA called for the Federal Reserve to increase the threshold to $3 billion, and the interim final rule implements this change.
On March 14, 2018, the Senate passed, 67-31, the Economic Growth, Regulatory Relief and Consumer Protection Act, or S. 2155. While it may lack a catchy name, its substance is of potentially great importance to community banks.
The following summary focuses on the impact of the bill for depository institutions with less than $10 billion in consolidated assets. The bill would also have some significant impacts on larger institutions, which could, in turn, affect smaller banks… either as a result of competition or, perhaps more likely, through a re-ignition of larger bank merger and acquisition activity. However, we thought it was useful to focus on the over 5,000 banks in the United States that have less than $10 billion in assets.
Community Bank Leverage Ratio
Section 201 of the bill requires the federal banking regulators to promulgate new regulations which would provide a “community bank leverage ratio” for depository institutions with consolidated assets of less than $10 billion.
The bill calls for the regulators to adopt a threshold for the community bank leverage ratio of between 8% and 10%. Institutions under $10 billion in assets that meet such community bank leverage ratio will automatically be deemed to be well-capitalized. However, the bill does provide that the regulators will retain the flexibility to determine that a depository institution (or class of depository institutions) may not qualify for the “community bank leverage ratio” test based on the institution’s risk profile.
The bill provides that the community bank leverage ratio will be calculated based on the ratio of the institution’s tangible equity capital divided by the average total consolidated assets. For institutions meeting this community bank leverage ratio, risk-weighting analysis and compliance would become irrelevant from a capital compliance perspective.
Volcker Rule Relief
Section 203 of the bill provides an exemption from the Volcker Rule for institutions that are less than $10 billion and whose total trading assets and liabilities are not more than 5% of total consolidated assets. The exemption provides complete relief from the Volcker Rule by exempting such depository institutions from the definition of “banking entity” for purposes of the Volcker Rule.
Accordingly, depository institutions with less than $10 billion in assets (unless they have significant trading assets and liabilities) will not be subject to either the proprietary trading or covered fund prohibitions of the Volcker Rule.
While few such institutions historically undertook proprietary trading, the relief from the compliance burdens is still a welcome one. It will also re-open the ability depository institutions (and their holding companies) to invest in private equity funds, including fintech funds. While such investments would still need to be confirmed to be permissible investments under the chartering authority of the institution (or done at a holding company level), these types of investments can be financially and strategically attractive.
Expansion of Small Bank Holding Company Policy Statement
Section 207 of the bill calls upon the federal banking regulators to, within 180 days of passage, raise the asset threshold under the Small Bank Holding Company Policy Statement from $1 billion to $3 billion.
Institutions qualifying for treatment under the Policy Statement are not subject to consolidated capital requirements at the holding company level; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans or subordinated debt, to finance growth.
Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. This investment choice could range anything from real estate properties to developing a line of pro drones (see https://letsflywisely.com/professional-drones/). Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.
Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth. This expansion of the small bank holding company policy statement would significantly increase the ability of community banks to obtain significant efficiencies of scale while still providing enhanced returns to its equity holders.
Institutions engaged in significant nonbanking activities, that conduct significant off-balance sheet activities, or have a material amount of debt or equity securities outstanding that are registered with the SEC would remain ineligible for treatment under the Policy Statement, and the regulators would be able to exclude any institution for supervisory purposes.
Section 214 of the bill would specify that federal banking regulators may not impose higher capital standards on High Volatility Commercial Real Estate (HVCRE) exposures unless they are for acquisition, development or construction (ADC), and it clarifies what constitutes ADC status. The HVCRE ADC treatment would not apply to one-to-four-family residences, agricultural land, community development investments or existing income-producing real estate secured by a mortgage, or to any loans made prior to Jan. 1, 2015.
In facing Congressional and industry backlash related to the effect of the Volcker Rule on TruPS CDOs, federal regulators were expected to choose between two options. Door 1 was to provide an exemption for TruPS CDOs held by all institutions. Door 2 was to provide an exemption only for TruPS CDOs held by banks with less than $15 billion in assets, consistent with the Collins Amendment to Dodd-Frank.
The regulators chose neither door, instead opening Door 3: the regulators have exempted TruPS CDOs for all institutions, so long as the TruPS CDO primarily holds TruPS of banks with less than $15 billion in assets. It will likely take a few days for the full analysis to come in, but I would expect that this has the effect of exempting all TruPS CDOs, as the CDO structure was primarily used in conjunction with private offerings of TruPS by smaller financial institutions.
The Interim Final Rule, issued on January 14, 2014, adds a new Section __.16 to the Volcker Rule, effective on April 1, 2014 (the same effective date for the Volcker Rule generally). Section __.16 provides that the “covered funds” prohibition of the Volcker Rule do not apply to investments in a CDO if:
the CDO was established prior to May 19, 2010 (the grandfather date for Tier 1 treatment for TruPS);
the bank reasonably believes the offering proceeds of the CDO were used to invest primarily in TruPS issued by banks with less than $15 billion in assets (the Collins Amendment threshold); and
the bank acquired the TruPS CDO on or before December 10, 2013 (the date the final Volcker Rule was approved by the regulators).
According to a story in the American Banker (subscription required), the federal banking regulators are looking at exempting all existing collateralized debt obligations backed by trust-preferred securities from compliance with the Volcker Rule.
From a technical perspective, it seems likely that the regulators would effect such an exemption by excluding the debt tranches of CDO’s backed by TRuPS from the definition of an “ownership interest” under the Volcker Rule, thereby allowing continued ownership by banking entities. Whether the revision is limited to existing TRuPS CDO’s or all is likely largely irrelevant, as the elimination of preferred capital treatment for Trust Preferred securities has eliminated the creation of new TRuPS CDO’s.
As previewed by the regulators’ late Christmas gift, the regulators are considering limiting the relief to banking entities with less than $15 billion in total assets. Without getting into the merits of whether its appropriate to treat TRuPS CDO investments differently based on the size of the institution with the investment, it seems that limiting the relief to banking entities with less than $15 billion could also limit the effectiveness of such relief. To the extent larger financial institutions still need to dispose of their TRuPS CDO investments (by July 2015, but potentially earlier in light of accounting treatment), it could still unsettle TRuPS CDO markets, widening market losses for community banks. While not impacting regulatory capital levels, this could still represent a GAAP hit for community banks that seems inconsistent with the Collins amendment and the regulators general statements that the Volcker Rule is not intended to impact community banks.
In a late Christmas present (or perhaps it was just delayed in delivery), the federal banking agencies and the SEC (although apparently not the Commodity Future Trading Commission) announced they would be reviewing whether it would be appropriate to exempt CDOs backed by Trust Preferred Securities from the Volcker Rule’s ban on covered funds.
The agencies have stated that they intend to address the matter no later than January 15, 2014, and believe that, consistent with GAAP, any actions taken in January 2014 should be effective in addressing year-end financial statements so long as such actions are taken before the issuance of such financial statements.
In the statement released by the regulators, the agencies emphasize the grandfathering of TRuPS provided by the Dodd-Frank Act for institutions with consolidated assets of less than $15 billion, and suggest that action to revise the Volcker Rule may be appropriate to avoid “consequences that are inconsistent with the relief Congress intended to provide community banking organizations.” Whether this foreshadow only partial relief of the impact of the Volcker Rule on CDOs backed by TRuPs, namely only to those institutions with less than $15 billion in total consolidated assets, remains to be seen.
The greatest weakness in the FAQ, and a generally nasty side-effect of issuing final Volcker Rules shortly before calendar (and thus fiscal) year-ends, is whether accounting firms will force institutions to recognize unrealized market losses, based on an inability to hold the investment to maturity. This question will ultimately be answered by the accounting firms, although still subject to second guessing by the banking regulators. The tone and style of the December 19, 2013 FAQ suggests that the regulators are continuing to explore the issue, and intend to take advantage of the delayed compliance deadline of July 2015, to reach more conclusive determinations. Whether this ambiguity is sufficient for institutions to appropriately determine they maintain the requisite intent to hold the securities through maturity will be a judgement call for institutions and their accountants.
Without providing definitive answers, the FAQ does indicate that the banking regulators do not believe that bank investments in CDOs backed by TRuPS portfolios are universally prohibited by the final Volcker Rule. Rather, they point to two specific areas for further analysis in determining the Volcker Rule’s applicability to any particular investment.
On December 10, 2013, the final Volcker Rule was adopted by the federal banking regulators, the SEC, and the CFTC to implement Section 619 of the Dodd-Frank Act. The Volcker Rule generally prohibits banking entities from engaging in “proprietary trading” and making investments and conducting certain other activities with “private equity funds and hedge funds.”
One unintended consequence appears to be the treatment of Collateralized Debt Obligations (CDOs) backed by Trust Preferred Securities (TRUPs) as “covered funds” under the Volcker Rule. As a covered fund, banking entities of all sizes will no longer be able to own TRUPs CDOs as of July 21, 2015. Moreover, because of this obligation to divest by July 21, 2015, banks are no longer able to say they will hold such investments to maturity and therefore will not be able to split out their other than temporary impairment between credit losses and market losses. Any market losses in the CDO security (which is currently reflected only in other comprehensive income) will be reported as a loss through Tier 1 capital. Banks holding TRUPs-backed CDO’s are encouraged to reach out to their accountants to discuss the potential accounting impact.
Warren Interviews AGs for Consumer Protection Agency
Reports this week indicate that Elizabeth Warren, who is interim head of the U.S. Consumer Financial Protection Bureau, has interviewed four Democratic state attorneys general to be her permanent successor. The four AGs reportedly in the running are Tom Miller of Iowa, Lisa Madigan of Illinois, Roy Cooper of North Carolina and Martha Coakley of Massachusetts. The bureau is scheduled to officially start work on July 21. Under the Dodd-Frank Wall Street Reform Act, which President Obama signed in July, the bureau must have a Senate-confirmed director to perform certain functions such as the supervision and regulation of non-bank financial firms.
House Republicans Release Top Line Budget Numbers
With President Obama set to release his FY 2012 budget on February 14, House Republican leaders on Thursday announced they would seek $32 billion in spending cuts from the resolution currently funding the government. Republicans framed their proposal as cutting $74 billion from President Obama’s 2011 budget request. However, because Obama’s budget was never approved by the last Congress, the cuts would actually be made against a continuing resolution now funding the government. That resolution is to expire on March 4, and if lawmakers do not agree on another short-term measure or one funding the government for the rest of the year, they risk a government shutdown. The spending ceiling announced by House Budget Committee Chairman Paul Ryan (R-WI) represents a $58 billion cut in non-security discretionary funding. While details of the specific department cuts were not announced on Thursday, the House Appropriations Committee next week will release its bill detailing the specific department budgets based on the spending ceiling. Reports indicate that the Democratic majority in the Senate is opposed to the House Republican budget cuts.
TARP Program Breaks Even with Fifth Third Bank Repayment
On Thursday, the Treasury Department announced that Fifth Third Bank has now fully repaid its $3.4 billion in TARP loans and that total repayments and other income from programs within TARP (approximately $243 billion) have nearly surpassed total disbursements under those programs (approximately $245 billion). The Treasury Department also announced that current estimates indicate that bank programs within TARP will ultimately provide a profit of nearly $20 billion to taxpayers.
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