Regulators incorporated many years of feedback from banks, legislators and Wall Street analysts when recently finalizing the Volcker rule, a mandate of the Dodd-Frank Act of 2009. However, it’s likely we have not seen the final word on this rule as key provisions of the proprietary trading ban will have a greater impact on smaller banks than regulators had anticipated.

When the Volcker rule was originally drafted, it was done so with systemically important financial institutions or large financial institutions with over $50 billion in assets in mind. The small-to-midsize banks (with assets less than $15 billion) were not a concern. The assumption was that a vast majority of these institutions did not participate in the activities in question. However, it is apparent now that regulators were wrong about the rule’s potential impact on small-to-midsize banks.

In fact, shortly after the final version debuted, the American Bankers Association filed a lawsuit against regulators related to the adverse impact the rule’s treatment of collateralized debt obligations backed by trust-preferred securities would have on small banks’ balance sheets, capital requirements and equity ratios. Regulators acted swiftly, issuing an interim final rule exempting all CDOs backed with Trups issued by banks with less than $15 billion of assets in mid-January.

The move indicates that regulators may be partial to changing the Volcker rule if too many small-to-midsize banks are adversely affected. Following the financial crisis in 2008-9, bank failures have decreased steadily. According to Federal Deposit Insurance Corp. data, there were 297 failures in 2009-10 combined; 92 in 2011; 51 in 2012; and 24 in 2013.

Regulators will want to avoid the perception that they are causing additional bank failures or endangering other small banks as a result of the final Volcker rule. The ABA has also yet to drop its lawsuit. Meanwhile, some small banks are still being adversely affected by the final rule due to the fact that the interim ruling did not exempt Trups CDOs issued by insurance companies. Federal Reserve governor Daniel Tarullo told lawmakers recently that regulators were mulling whether to further loosen the rule in regard to how it treats collateralized loan obligations.

Even though the regulators will try to provide relief, it is prudent for smaller banks to proactively reduce their exposure to the Volcker rule. Small banks cannot always count on regulators to come to their rescue and should take measures, similarly to the SIFIs, to reduce their exposure to the Volcker rule. Given the current fluid and somewhat inconsistent regulatory environment, it is prudent for small and midsize banks to act proactively. These financial institutions should define policies and procedures, particularly around liquidity management and capital issuance, to ensure compliance with the rule. This will help avoid any future penalties from regulators.  

It is considered best practice for small and midsize banks, to perform period assessments to measure and monitor their exposure, and to ensure that it has adequate policies and procedures in place to address any significant exposure.

The recent developments following the publication of the final Volcker rule prove that that we have not seen the final word on Dodd-Frank’s ban of proprietary trading. The rule will undergo further changes as its full impact, especially on smaller banks, becomes clearer. However, notwithstanding any further rule changes, it seems apparent that it is in their best interest for small banks to proactively take measures to prepare themselves for the Volcker rule, just like their larger counterparts.

Carlos Pereira and Thadi Murali are principal consultants in the banking, wealth and investment management practice at Capco U.S.