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Community banks should prepare for the implementation of the Volcker Rule regulations, which limits banks’ trading and investment activities.

How Community Banks Can Prepare for the Volcker Rule

  • 12/27/2013

Update: On January 14, 2014, the bank regulators permitted the retention of TruPS CDOs if the following qualifications are met:

  1. the TruPS CDO was established, and the interest was issued, before May 19, 2010;
  2. the banking entity reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in qualifying TruPS collateral; and
  3. the banking entity’s interest in the TruPS CDO was acquired on or before December 10, 2013, the date the agencies issued final rules implementing section 619 of the Dodd Frank Act.

The rule defines qualifying TruPS collateral as any trust preferred security or subordinated debt instrument that was:

  1. issued prior to May 19, 2010, by a depository institution holding company that as of the end of any reporting period within 12 months immediately preceding the issuance of such trust preferred security or subordinated debt instrument had total consolidated assets of less than $15 billion; or
  2. issued prior to May 19, 2010, by a mutual holding company.

Also on January 14, 2014, the banking regulators (OCC, FDIC, and FRB) issued a non-exclusive listing of 86 TruPS CDOs that they will recognize as meeting the criteria for retention. TruPS CDOs not included on this listing require further analysis to determine if impairment charges on those holdings are required to be recognized at December 31, 2013.

How Community Banks Can Prepare for the Volcker Rule

On December 10, 2013, final regulations were released for the “Volcker Rule,” the provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that aims to prevent banks from engaging in speculative trading activity and limit their investments in hedge funds or private equity funds.

“Since the regulations have been issued, most of the media attention has focused on the need for relief or an exemption for community banks, so they can avoid impairment charges for their year-end reporting,” says Todd Sprang, a financial institutions principal with CliftonLarsonAllen. “We are hoping this will still happen, but it seems unlikely,” he warns.

Community banks usually avoid impairment charges on certain securities by asserting it is more likely than not that they won’t need to sell those securities prior to maturity. However, the issuance of these regulations prior to December 31 requiring sale of certain securities prior to maturity negates that assertion. With year-end Call Reports due at the end of January, Sprang suggests that community banks take the following steps in the event they are forced to comply with these regulations.

Determining impermissible investments

There has been a significant focus on trust-preferred securities (TruPS) collateralized debt obligations (CDOs) due to the amount of potential impairment charges related to these investments. However, they are not the only investments within your current portfolio that may be subject to the divestiture requirements of the Volcker Rule.

You need to work with your investment advisor in the next two weeks to identify which investments are considered ownership interests in covered funds (i.e., impermissible investments). Based on what we currently understand, single-issuer TruPS are exempt from the divestiture requirements.

The following investments will generally also be exempt:

  • Residential mortgage-backed securities (RMBS)
  • Commercial mortgage-backed securities (CMBS)
  • Auto securitizations
  • Credit card securitizations
  • Asset-backed commercial paper

The following investments will require deeper analysis to determine whether they are exempt:

  • Certain CDOs (including TruPS CDOs)
  • Certain collateralized loan obligations
  • Certain non-agency collateralized mortgage obligations
  • Re-Real estate mortgage investment conduits (Re-REMICs)
  • Other non-agency securitization vehicles

Determining market value

If the impermissible investment is a level 1 or 2 measurement in the fair value hierarchy, fair value measurement is straightforward. If it is a level 3 measurement (common for TruPS CDOs) due to the significance of unobservable inputs, then continue to use your current fair value measurement process.

However, you should monitor the trading levels for level 3 impermissible investments, because an increase in trading volume due to Volcker Rule compliance-related divestitures could be sufficient to warrant future level 1 or 2 measurement.

Recording impairment charges

Once you’ve determined the number of impermissible investments and their fair market value, the next step is to recognize the related impairment charge. This equals the entire amount by which the amortized cost exceeds fair value on a security-by-security basis at December 31, 2013. It is triggered by the fact that, at year-end, it is more likely than not that banks will be required to sell the impermissible investment prior to maturity.

As a result, any impermissible investments are no longer eligible for held-to-maturity (HTM) classification. Impermissible investments will need to be classified as either available-for-sale (AFS) or Trading.

Future classification

If the fair value of those investments continues to decline, impermissible investments that continue to be held as AFS or are reclassified from HTM to AFS may require additional impairment charges through the income statement in future periods.

Classifying these investments as Trading will allow subsequent increases and decreases in fair value to be recorded through the income statement in future periods. Consult with your tax advisor to discuss the potential tax implication if you are considering reclassifying investments to Trading.

How we can help

CliftonLarsonAllen representatives can help if you have any questions about the implications of the Volcker Rule on your community bank. We will continue to monitor this matter and provide additional implementation information as applicable.