WASHINGTON — The American Bankers Association has decided to drop its lawsuit against the final Volcker Rule, saying regulators have already addressed some of the potential damage from the regulation.

The trade group said Wednesday it will continue to work with regulators to prevent other possible harm that small banks might suffer as a result of the rule, which banned proprietary trading and restricted investments in hedge funds.

"We believe the best opportunity to pursue successful resolution of these issues is to constructively engage with the regulators without the chilling impediment of pending litigation, particularly in light of their recent public statements expressing a desire to address the Volcker Rule's unintended consequences," Frank Keating, the president of the ABA, said in a press release.

At issue is how the Volcker Rule treats collateralized debt obligations backed by trust-preferred securities as well as the regulation's impact on collateralized loan obligations. The ABA filed suit late last year against the Volcker Rule, noting that many small and regional banks would be forced to take writedowns on Trups-backed CDOs in the fourth quarter because they could no longer be "held to maturity" under accounting rules. Regulators were caught off guard by the problem because the Volcker Rule does not technically take effect until July 2015.

The regulators scrambled to release an interim final rule last month that exempted all CDOs backed by Trups issued by small banks. While the solution left some banks still facing substantial losses, the fix covered most affected institutions.

Left unchanged, however, was the Volcker Rule's treatment of CLOs, which banks have continued to protest. Federal Reserve Board Gov. Daniel Tarullo said last week that the issue was at "the top of the list" to be addressed by an interagency working group implementing the Volcker Rule.

Keating cited those words in his statement, saying industry officials are hopeful regulators will address the problem on their own.

"The Volcker Rule was never intended to classify Trups, CLOs or other debt instruments as hedge funds," said Keating. "As a result of the agencies' unduly broad definition, many investments made by banks of all sizes will no longer be allowed. These are traditional banking assets, not the trading instruments the Volcker Rule was designed to capture. We look forward to sitting down with regulators to work out a solution to this issue."

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