Banks’ Suit Tests Limits of Resisting Volcker Rule

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The American Bankers Association says that 275 smaller banks, like Zions Bancorporation of Salt Lake City, will suffer under a provision of the Volcker Rule.Credit Kim Raff/The Salt Lake Tribune

The banks have fired their first salvo in what could soon turn into a war of litigation over the Volcker Rule.

As expected, the American Bankers Association, an industry trade group, filed a motion in federal court on Tuesday in Washington seeking to quickly suspend one part of the Volcker Rule, which was officially completed two weeks ago.

The trade group claims 275 small banks will suffer an imminent $600 million hit to capital and make them less likely to lend to consumers and businesses.

Though the current dispute centers on an obscure and complex investment product, the association’s lawsuit could become an early test of how much the industry can successfully push back against the Volcker Rule. The rule was devised to stop regulated banks from speculatively trading with their depositors’ money and other funds in an effort to avoid some of the problems that led to the bank bailouts in the wake of the 2008 financial crisis.

Banks have long been lobbying to shape or water down the Volcker Rule. After much delay, five federal agencies approved the final rule this month, bolstering some provisions, but leaving others open to loopholes.

The lawsuit is an indication of how far banks may be willing to go to challenge regulators in court even if the total dollars at issue are relatively few. And ironically, the first legal assault is being brought on behalf of smaller banks, not big Wall Street firms like Goldman Sachs or JPMorgan Chase, which had until recently engaged in some of the speculative trading that the Volcker Rule mainly targeted.

Even before the Volcker Rule became law, some were predicting Wall Street would head to court to oppose provisions it did not like, like a measure that would curtail the ability of banks to engage in portfolio hedging, a type of trading that critics say goes beyond normal hedging of positions for either the benefit of clients or mitigating the bank’s own risk.

At the heart of the bankers’ group lawsuit are instruments called collateralized debt obligations, the instruments that helped stoke the financial crisis. The final Volcker Rule contained language that, to many in the industry, seemed to prohibit banks from holding C.D.O.’s.

The banking association says the Volcker Rule unfairly targets a special type of C.D.O. held by smaller banks. These instruments are made up of so-called trust-preferred securities, a cross between a bond and a stock that banks issued to increase their capital.

Crucially, accounting rules have shielded banks from taking a full hit on these soured investments. But, now, the banks could lose that shield if the Volcker Rule forces them to offload the C.D.O.’s. As a result, the banking association argues that the banks might have to take big write-downs in the next few weeks that would substantially dent their capital.

It’s too soon to say how the litigation will play out and whether the trade group will be successful in getting a quick stay of the measure, especially because bank regulators issued guidance last week that had sought to allay some of the banking industry’s concerns that the Volcker Rule amounted to a blanket ban on trust-preferred C.D.O.’s.

A spokesman for the Federal Reserve, one of three regulatory agencies sued by the industry group along with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, said that the regulators need to review and confer on the lawsuit before commenting.

Banks have until July 21, 2015, to divest themselves of risky assets under the Volcker Rule, but can get an extension from the Fed if necessary.

The issue of whether the Volcker Rule intended to force banks to divest themselves of trust-preferred C.D.O.’s has been gathering momentum ever since Zions Bancorporation, a regional lender based in Salt Lake City, said on Dec. 16 that it was taking a $387 million fourth-quarter charge to write down the value of its portfolio of the securities, and was also reducing its regulatory capital levels after changing its accounting treatment for those securities.

Audit firms have been telling some bank clients that without more specific guidance from the regulators, banks cannot avoid writing down the C.D.O.’s, potentially forcing the banks to absorb capital hits by the end of the year.

In the lawsuit, the American Bankers Association contends regulators did not do a proper analysis of the “economic costs” of the provision on small banks and how a decision to require banks to get rid of an investment in the C.D.O.’s would affect their balance sheets.

A common litigation tactic is to argue that regulators failed to do a proper cost-benefit analysis of a rule before enacting it. So the success of this line of argument by the trade group could be used by other trade groups considering challenging other portions of the 71-page Volcker Rule and its more than 800-page preamble.

The lawsuit also argues the final version of the Volcker Rule, as approved by the regulatory agencies on Dec. 10, was substantively different from the initial version that regulators sought public comment on two years ago. The lawsuit claims the portion of the rule governing prohibited investments never suggested that the C.D.O.’s would be included.

But in their proposed rule, issued in 2011, regulators invited financial firms and others to give their feedback on how the rule might affect C.D.O.’s. Comment letters submitted by the banking association do not appear to show any special concern about how the Volcker Rule might affect C.D.O.’s. In fact, in arguing for an exemption for credit funds, the association went out of its way to show that such funds were different from C.D.O.’s.

One resolution may be for the regulators to devise more specific guidance that would give the banks’ auditors the ability to decide which C.D.O.’s they can hold and which they have to sell.