Regulators update Volcker, swaps and rate-cap rules

WASHINGTON — Regulators approved three rules Thursday that tied up loose ends from the Trump administration’s deregulatory push of the past few years and were embraced by the banking industry.

Five financial regulatory agencies clarified the meaning of "covered funds" under the Volcker Rule. Meanwhile, the Federal Deposit Insurance Corp. gave certain banks more flexibility to exchange swaps among affiliates for risk management purposes, and it followed the Office of the Comptroller of the Currency's lead in addressing the so-called Madden problem that involves federal preemption as applied to interest rates.

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Bloomberg News

The rules "will allow banks to further support the economy at this challenging time for the nation" without compromising financial stability, said Rob Nichols, president and CEO of the American Bankers Association.

All three rules were voted on at a public meeting of the four-member FDIC board, which most of its members attended in person even as many events in Washington have been conducted virtually during the coronavirus pandemic.

The agencies’ Trump-appointed regulators — FDIC Chairman Jelena McWilliams, acting Comptroller Brian Brooks and Consumer Financial Protection Bureau Director Kathy Kraninger — appeared in person and voted in favor of the rules. Martin Gruenberg, the board's lone Democrat appointee, voted against all three rules via videoconference.

Volcker Rule clarification

In January, the Federal Reserve, the FDIC and the OCC proposed an update of the Volcker Rule to clarify how the agencies determine exceptions to the Dodd-Frank Act provision that largely banned banks from investing in private-equity firms and hedge funds. The proposed rule expanded allowable investments to include venture capital funds, family wealth management firms and other vehicles.

On Thursday, the FDIC board and the Federal Reserve Board approved the changes, and the OCC, Commodity Futures Trading Commission and the Securities and Exchange Commission said they too had approved the rule, which will take effect in October.

Though largely unchanged from the proposal, the rule made changes in one area of regulation related to foreign funds, with regulators citing the possibility of redundant compliance obligations for foreign funds controlled by other banking entities.

“In certain circumstances, some foreign funds that are not ‘covered funds’ may be subject to the implementing regulations as ‘banking entities’ if they are controlled by a foreign banking entity, and thus could be subject to more onerous compliance obligations than are imposed on similarly situated covered funds, even though the foreign funds have limited nexus to the United States,” Doreen Eberly, director of risk management supervision at the FDIC, wrote in a memo to the agency’s board.

According to the memo, the final rule would exempt a purchase from a qualifying foreign fund from the Volcker Rule's requirements “if any acquisition of an ownership interest in, or sponsorship of, the qualifying foreign excluded fund by the foreign banking entity meets the requirements for permitted covered fund activities and investments solely outside the United States,” she wrote in the memo.

The rule also changed how regulators determine whether a public welfare fund qualifies as covered or exempted in the context of the Community Reinvestment Act, saying that the Volcker Rule’s covered fund provision would explicitly exclude funds whose investment from banks qualifies for CRA activity.

Swaps-related rule

Meanwhile, the FDIC finalized changes proposed last September on the requirements governing how and when banks are permitted to conduct margin swaps among their affiliates. Currently, banks must put aside a certain amount of collateral to conduct interaffiliate derivatives trades, effectively freezing up about $40 billion across the financial system, according to industry estimates.

The final rule, which regulators say was adopted to allow banks to use interaffiliate margin swaps for “internal risk management purposes,” contains two revisions from the proposed version last fall.

First, it introduced a limit on the initial margin swap of 15% of the covered swap entity’s Tier 1 capital. “This rule would protect the Deposit Insurance Fund by preventing banking organizations from transferring significant levels of risk to [insured depository institutions] while also facilitating prudent risk management through interaffiliate swaps,” McWilliams said in prepared remarks at the board meeting.

The finalized swap rule also tweaked the proposal to make it more consistent with how the agencies approach other parties not typically subject to the rule.

“By this revision, a covered swap entity would be required to collect initial margin from an affiliate at such times and in such forms and such amounts (if any) that the covered swap entity determines appropriately addresses the credit risk posed by the affiliate and the risks of its non-cleared swaps with the affiliate,” Eberly wrote in another staff memo to the FDIC board.

'Madden problem' fix

The FDIC also approved a rule that followed on the heels of the OCC’s solution to the 2016 decision by the 2nd U.S. Circuit Court of Appeals in Madden v. Midland Funding LLC, finalized in May. The FDIC’s final rule, which applies to state nonmember banks, reaffirmed the doctrine of “valid when made,” which generally holds that the interest rate on loans bought and sold across state lines preempt state and local rate caps.

“The final rule supports longstanding regulatory safety and soundness principles by ensuring the enforceability of the interest rate terms of loans made by state banks following the sale, assignment, or transfer of the loans,” McWilliams said in prepared remarks, adding that the absence of a fix would raise “significant safety and soundness concerns for financial institutions that may be unable to sell loans to manage liquidity and capital on their balance sheets.”

The final rule introduced few changes from the proposal outside of technical adjustments for sake of clarification, according to agency staff.

The “valid when made” doctrine has recently come under fire from consumer advocates, who claim the principal allows predatory lenders to partner with financial institutions through so-called rent-a-bank schemes and sidestep state interest rate restrictions. Banks and other lenders, in the meantime, had said that Madden’s ambiguity short-circuited the ability of financial firms to buy and sell loans confidently in the Second Circuit's jurisdiction.

Gruenberg voted against the FDIC’s proposed Madden fix Thursday, arguing that the rule may have the effect of restricting the regulator's ability to crack down on rent-a-bank relationships.

“The practical import of today’s rulemaking is to further insulate high-cost loans made through these very partnerships between nonbanks and bank relationships from legal challenge,” he said in prepared remarks. “It should not go unnoticed that much of the current ongoing litigation in this area involves attempts by state authorities to rein in nonbanks that have partnered with banks to seek to evade state interest rate laws.”

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