Financial Regulatory Forum

Small banks await regulatory fix on Trust Preferred Securities portion of the Volcker rule for capital decisions

By Guest Contributor
January 24, 2014

By Bora Yagiz, Compliance Complete

NEW YORK, Jan. 24 (Thomson Reuters Accelus) - Banks that have relied over the years on a special type of assets to fulfill their capital requirements may soon have to restructure their investment portfolios to bring it in line with the Volcker rule limiting risky trading by banks. At stake is the treatment of the Trust Preferred Securities (TRuPS), whose inclusion as “investments in entities referred to as covered funds” such as collateralized loan obligations and collateralized debt obligations, would oblige banks to divest them in compliance with the Volcker rule.

The intent behind the complex Volcker rule is clear. It is aimed at limiting the exposure of banks to certain type of “covered funds” such as hedge funds or private equity funds to 3 percent, and to prevent them from engaging in proprietary trading, namely, trading with their customers’ funds for their own short term gains rather than trade on their clients’ behalf. It is, therefore, a rule to make banks’ investments less risky and more transparent.

The rule does not target any specific instrument for capital purposes, but its possible ban on TRuPs would give contradictory regulatory signals regarding the capital calculations for some 300 small banks, most of which have less than $500 million under assets.

The U.S. banks have been able to benefit from a regulation created by the Federal Reserve in 1996. The U.S. regulator permitted bank holding companies to fulfill 25 percent of their core capital requirements with the TRuPS, thereby allowing them to dodge the more restrictive forms of capital stipulated by the Basel Committee.

According to the U.S. Government Accountability Office, 10 percent of all BHC Tier 1 capital consisted of TRuPS as of December 2010. This is a relatively high ratio, given that few TRuPs have been issued since the financial crisis.

The mechanics behind a TRuP is straightforward. A bank creates a trust that issues preferred shares to investors –TRuPs. These 30-year instruments are backed by the debt issued by the bank, and essentially have a hybrid nature with both preferred stock and subordinated debt characteristics for regulatory capital and tax purposes. The debt interest payments of the bank are tax deductible, while the dividends paid by the trust are considered Tier 1 capital. At redemption, similar to bonds, TRuPs pay their original face value.

Unlike their larger counterparts that have easy access to capital markets on their own, small banks were able to participate in the TRuPs market only through collateralized debt obligations (CDOs) — essentially, vehicles pooling together various types of non-mortgage debt assets and dividing them in tranches.

When TRuPs (and their CDOs) proved in the financial crisis to be less resistant to loss than previously thought, they fell out of regulatory favor. Certain features they carry, such as early callable optionality, a 5-year deferral of dividend payments, and a lump-sum redemption at expiration, as well as erroneous assumptions used in their modeling (for example, missing highly correlated dimensions of risks) meant that they were more like debt than high-quality capital.

The so-called Collins Amendment of the Dodd-Frank Act fixed this in 2010 by prohibiting large banks from carrying TRuPs as part of their Tier 1 capital, and it gave them a three-year phase-out period ending in January 2016. This, coupled with the dim prospects of recovery in their value, resulted in most of the large banks divesting of their TRuPs. Those banks that did not, such as Citigroup, and BBVA Compass, have relatively low amounts of TRuPs in their held-to-maturity portfolios. Zions Bancorp, a relatively sizable bank with $54 billion in assets, stated that it is ready to take a one-time charge of $387 million, when it has to move them from its held-to-maturity to available-for-sale portfolio.

Crucially, the amendment allowed the smallest banks (with less than $500 million in assets) to grandfather TRuPs and continue issuing them. Medium-sized banks (with assets more than $500 million but less than $15 billion) were also able to keep old TRuPs in their books but could not issue newer ones.

If the TRuPs were to be banned altogether, small banks holding them would likely be finding themselves between rock and a hard place. On the one hand, in contradiction with the Collins Amendment, these instruments would no longer be eligible as capital. On the other hand, banks would have to recognize immediate write-downs of any of these securities with a fair value less than their carrying value, either by moving them from a held-to-maturity classification to an available-for-sale classification or by recognizing an other-than-temporary impairment in conformity with the GAAP rules.

The American Bankers Association (ABA) trade group estimated the write-down figure to be around $600 million on combined holdings of $3.5 billion. Another estimate put the figure at $500 million. The high estimates are based on the depressed prices that TRuPs fetch on the current market.

ABA has been vocal about the possible ban of the TRuPs, arguing that the banking entities that invested in pooled TRuPS would be burdened unfairly since they do not pose the kind of systemic risk the Volcker rule is intended to address. Despite assurances from the regulators that banks need not sell these securities until July 2015, when the Volcker rule becomes effective, the association has filed a lawsuit in the DC Court of Appeals about the issue. Regulators have until January 17, 2014 to respond.

“I can’t think of any alternative possible exclusion or exemption banks could technically rely on,” said Charles Horn, a partner with Morgan Lewis, when asked about banks’ legal recourses.

The regulators have proposed the holders of TRuPs CDOs to restructure. “That’s easier said than done,” said Chris Cole, Senior Vice President at Independent Community Bankers of America. “It will require obtaining the consent of different groups of investors holding the CDO with potentially conflicting interests in such a restructuring.”

There are also legal hurdles. Most of the TRuPs CDOs were established based on sections 3(c)1 and 3(c)7 of the Investment Company Act, which make them covered funds by definition. Restructuring them otherwise may be too cumbersome.

Cole remained upbeat about the prospects of a regulatory solution, however, saying that he is “convinced that the regulators will be able to come up with an answer in the next few days, averting a possible crisis for the community banks.”

In the meantime, U.S. Sen. Mark Kirk of Illinois and six other Republicans introduced legislation regarding the Volcker Rule’s treatment of debt interests in TRuPS. The legislation intends to remove CDOs backed by TRuPS issued before December 10, 2013 out of the rule’s scope.

Even if the U.S. regulators decide to exclude the TRuPS (and their CDOs) from the definition of covered funds, banks holding them mayl face yet another challenge, from the international Basel Committee’s of bank regulators. The committee’s recently approved amendment for risk-weightings for banks’ equity investments in funds may duly prompt the U.S. regulators to make a more conservative revision in the risk-weightings of TRuPs.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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