US federal financial agencies approved and issued final regulations implementing Section 619 of the Dodd–Frank Act (commonly known as the Volcker Rule), which added a new section (Section 13) to the Bank Holding Company Act of 1956. This section contains prohibitions for banking companies on engaging in proprietary trading and on acquiring or retaining an ownership interest in or having certain defined relationships with a hedge fund or a private equity fund. The authors express their concern that certain securitization structures will fall under the scope of covered funds, given their broad definition, and thus create issues in the implementation of the final regulations for banking companies.

The Volcker Rule prohibits banking entities from engaging in proprietary trading and from making investments and conducting certain other activities with private equity funds and hedge funds. It also prohibits them from extending loans to or entering into any other transaction with covered funds (except on market terms) for which they act as sponsor, investment manager, or adviser. Covered funds broadly cover any issuer that does not fall into the definition of an investment company under the Investment Company Act of 1940.

The final regulation does not impose restrictions on most traditional consumer transactions involving asset-backed securities (ABSs). Certain structures have been specifically excluded, including loan securitizations, qualifying asset-backed commercial paper (ABCP) conduits, qualifying covered bond programs, and wholly owned subsidiaries of banking entities. But the authors point out that the definition of a covered fund is broad enough to encompass many securitization transactions and it might still affect certain collateralized loan obligations, ABCP conduits, and certain legacy transactions of banking entities.

The given time frame becomes critical because banking entities whose assets exceed $50 billion in gross trading assets were required to be reporting on defined parameters by 30 June 2014. Smaller banking entities have until 21 July 2015. Certain existing securitizations will be considered covered funds under the final regulations, and banks will need to arrange for their exit after the expiration of the compliance period. Given a bank’s current profile in engaging in securitization activities that are restricted under the rule, the required exits could have a substantial impact on banks’ balance sheets by the end of the compliance period.

The authors review the final regulations of the Volcker Rule and the impact they may have on securitization transactions.

Implementation of the Volcker Rule was not intended for securitization transactions per se, but many fall under the scope of the definition of covered funds. Many such issues will be identified during the implementation stage, which will hopefully be clarified by the regulators to preserve the spirit of the law. For example, the funding vehicle for a securitization transaction may not be wholly owned by the bank and instead may fall under the category of a covered fund. In addition, the implementation of the regulations will increase compliance costs for the financial sector, which has seen an increased supervisory focus in recent years to curb risky activities.