By Arthur Midianga
On June 25, 2020, the Federal Deposit Insurance Corporation (FDIC) Board of Directors discussed several topics related to amendments of regulatory guidelines covering the Volcker Rule, Swap Margin Rule, and Interest Rate Rule.
The final rules will provide more clarity for financial institutions and produce better alignment with existing rules that promote better risk management. Amendments to the Volcker Rule will include modifications to existing exclusions while adopting some new exclusions from the “covered funds” definition. Next, the Swap Margin Rule will equip covered swap entities with flexibility regarding the internal allocation of collateral to facilitate prudent risk management, while also protecting safety and soundness. Lastly, the Interest Rate will allow state-chartered banks or insured branch of a foreign banks to charge a higher interest rate on the commercial paper rate.
Volcker “Covered Funds” Provision Final Rule – Effective as of October 1, 2020
The Volcker Rule, implemented in 2014, generally prohibits banking entities from engaging in proprietary trading, and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with, a hedge or private equity fund.
The FDIC, Federal Reserve Board of Governors, Office of the Comptroller of the Currency (OCC), Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CTC) are issuing a final rule to modify and clarify the covered funds provision of the Volcker Rule to simplify compliance with implementing regulations, refining the extraterritorial application of Section 13 BHC Act, and permitting additional fund activities that do not present the risk Section 13 was intended to address. Under the final rule, activities of certain funds that are organized outside of the U.S. and offered to foreign investors (qualifying foreign excluded funds) would be exempt from the restrictions of implementing regulations. Accordingly, the rule codifies an existing policy statement by the federal banking agencies (the OCC, Board, and FDIC) addressing potential issues related to a foreign banking entity controlling qualifying foreign excluded funds. The final rule presents modifications to several existing exclusions from the covered funds provisions which include:
- Revision of certain restrictions in the foreign public funds’ exclusions to closely align the provision with the exclusion for similarly situated US-registered investment companies.
- Permitting loan securitizations excluded from the definition of covered fund to hold a small amount of non-loan assets, consistent with past industry practice.
- Revision of exclusion of small business investment companies.
In addition, the final rule adopts several new exclusions from the “covered fund” definition:
- Establishes a new exclusion for funds that extend credit to permit the same credit-related activities that banking entities can engage in directly.
- Exclusion for venture capital funds to ensure banking entities can indirectly facilitate this investment activity to the same degree as banking entities.
- Two exclusions for family wealth management and customer facilitation vehicles to provide flexibility for banking entities to provide advisory and other traditional banking services through a fund structure.
The final rule permits established, codified categories of limited, low-risk transactions between a banking entity and a related fund, including riskless principal transactions, also allowing a banking entity to engage in certain transactions with related funds in connection with payment, clearing and settlement activities. This will provide an express safe harbor for senior loans and senior debt, and provides clarity about the types of creditors’ rights considered in the scope of definition of ownership interest.
Amendment to Swap Margin Rule – Effective as of August 31, 2020
In 2015, the FDIC, the Federal Reserve Board of Governors, the OCC, the Federal Housing Finance Agency (“FHFA”), and the Farm Credit Administration (the “Agencies”) issued a final rule requiring banks and other entities that engage in swap activities (“covered swap entities”) to exchange initial and variation margin with their counterparties for swaps that are not centrally cleared. Since the implementation of this rule, regulators have observed banking organizations using inter-affiliate swaps for internal risk management purposes by transferring derivatives exposure to a centralized risk management function. The largest firms have made significant progress in implementing resolution strategies designed to recapitalize subsidiaries as protection against the types of affiliate failures envisioned under the rule.
The final rule is designed to provide covered swap entities with flexibility regarding the internal allocation of collateral to facilitate prudent risk management, while also protecting safety and soundness. Under this new rule, a covered swap entity is not required to collect initial margin from affiliates when the aggregate amount of such initial margin is less than 15% of the covered swap entities’ Tier 1 capital. This also protects the Deposit Insurance Fund by preventing banking organizations from transferring significant levels of risk to insured depository institutions. In addition, the rule also amends the requirement for covered swap entities by; (1) facilitating the transition away from interbank offered rates (“IBORS”) and other interest rates expected to be discontinued; (2) adding an additional initial margin compliance period for certain smaller counterparties. The rule does not amend the requirement that a covered swap entity exchange initial and variation margin with unaffiliated counterparties.
Federal Interest Rate Rule for State-Chartered Banks and Insured Branches of Foreign Banks – The final rule will go into effect 30 days after its publication in the Federal Register and is applicable to all state-chartered banks and insured branches of foreign banks
In 1980, Congress enacted the Depository Institutions Deregulation and Monetary Control Act (“DIDMCA”) which created Section 27 of the Federal Deposit Insurance Act, authorizing state banks to charge interest at a rate that is permissible in the state where the bank is located.
Based upon recent court decisions that have raised significant uncertainty regarding the longstanding application of Section 27 to state banks operating across state lines, the FDIC final rule clarifies the valid interest rate for a loan is determined when the loan is processed. The final rule allows a state-chartered bank or insured branch of a foreign bank to charge interest of up to the greater of 1% more than the rate on 90-day commercial paper rate, or the rate allowed by the law of the state where the bank is located. Furthermore, interest on a loan permissible under section 27 will be determined as of the date the loan was made. Interest on a loan permissible under section 27 would not be affected by changes in state law, the commercial paper rate after the loan was made, or the sale, assignment, or other transfer of the loan, in whole or in a part.
The final rule does not address separate questions regarding the issue of a “true lender” in a lending arrangement between banks and third parties, and preserves that state’s ability to opt out of coverage under Section 27 in accordance with Section 524 of DIDCMA.
Key Benefits of the New Rules:
– Volcker “Covered Funds” Provision Rule
- Facilitates capital formation by providing banking entities with greater flexibility in sponsoring funds that provide loans to companies (allowing investments in qualifying venture capital funds) so that banking entities can build a diverse portfolio by allocating more resources across an array of long-term investments in a broader range of geographic areas, industries, and sectors.
- Protects safety, soundness and financial stability by not allowing banks to engage in any activity that is not currently permissible if conducted on their balance sheets, and limits banks’ exposure by including additional protections that restrict the ability to conduct certain transactions with covered funds.
- Provides greater clarity and certainty about permitted activities, which will improve the supervision and implementation of the Volcker Rule. Clarifies the existing foreign public fund exclusion, with the intention of providing a consistent treatment between US-registered investment companies and their foreign equivalents.
-Swap Margin Rule
- Facilitates prudent risk management by allowing banking organizations the ability to use inter-affiliate swaps to centralize the risk management of derivative exposures by modifying the requirement that a covered swap entity collects initial margin from affiliates.
- Protects the Deposit Insurance Fund by preventing banking organizations from transferring significant levels of risk to insured depository institution subsidiaries.
- Maintains key safeguards by requiring covered swap entities to exchange variation margin with affiliates to reflect the change in value of each party’s obligations over the life of each contract.
–Federal Interest Rate Rule
- Codifies longstanding FDIC guidance through formal rulemaking processes to provide the public with an opportunity to comment.
- Addresses marketplace uncertainty regarding the enforceability of the interest rate terms of a loan agreement following a bank’s assignment of a loan to non-bank.
- Promotes safety and soundness by giving certainty to banks that sell loans into the secondary market as a way to meet deposit withdrawal demands.
- Supports the stability of the nation’s financial system by ensuring that the FDIC can satisfy its statutory duty as conservator or receiver to maximize the return on sale or disposition of assets and minimize the loss to the Deposit Insurance Fund.
As the rules will be implemented in the second half of 2020, it will provide greater clarity while maintaining prudent risk management standards to support the financial system. The amendments support a changing risk environment and specifies components for institutions to ensure they are in compliance with regulations.