While you were getting that pair of socks you always wanted, the government got an unexpected Christmas present: the first lawsuit seeking to nullify a portion of the Volcker rule, which regulators just finalized a few weeks ago. And the lawsuit was not filed by JPMorgan Chase or Goldman Sachs, but the American Bankers Association, which is the trade group for small and mid-sized banks. The ABA objected to a part of the rule that would force legitimate accounting on losses garnered in the wake of the financial crisis. The suit represents an important and early test of financial reform—and you can trust that the Wall Street behemoths are watching closely to see whether regulators will have the spine to defend a rule they spent years writing. So far, the early signs are not promising.
Under the Volcker rule, banks are restricted from holding certain “covered funds” in their long-term portfolios, including collateralized debt obligations, or CDOs. There’s good reason to do so: CDOs, which take the riskiest parts of other securities and re-package them to allegedly make them safe, nearly blew up Citigroup. After the housing bubble collapsed, CDOs derived from mortgage-backed securities became almost worthless, creating hundreds of billions in losses at Citi, and leading to multiple government bailouts. The covered funds provision would force banks like Citi away from assuming such high-risk financial exposures. It goes hand in hand with the main goal of the Volcker rule, to limit profit-seeking proprietary trading at commercial banks.
As many CDOs remain worthless today, the rule would force some banks to realize losses on current holdings. In fact, this whole dust-up is mostly about one bank. Zions Bancorp, a regional bank out of Salt Lake City, Utah, announced two weeks ago that it would have to sell off a series of CDOs before the Volcker rule takes effect in July 2015, leading to a projected loss of $387 million, more than the annual earnings of the bank over any of the last five years. These losses were going to surface sooner or later, but the old accounting rules allowed Zions to basically hide them on their books by classifying CDOs as “hold to maturity.” The Volcker rule eliminates the ability for Zions to maintain this ruse, and so the bank said it would relabel the CDOs as “available for sale,” forcing a write-down to fair-market value.
In other words, the old accounting rules prevented investors from discovering the true financial health of the bank. As a way to flush out accounting fictions, the Volcker rule serves an important purpose; this certainly would have prevented Citigroup from continuing to amass the CDOs that led to the bank’s near-collapse. Zions doesn’t come out a loser in this scenario; it already lost, by purchasing lots of risky assets that eventually failed.
Nevertheless, Zions didn’t want to air its dirty laundry for all to see; realizing the loss would impact investor perceptions and its stock price. Plus, it would have to raise more capital to make up for the losses-masquerading-as-capital on its balance sheet. So it got its lobbyists at the American Bankers Association to whine about the situation. That led to the Christmas Eve lawsuit, seeking an immediate injunction against the part of the rule that would force the accounting changes.
In the complaint, the ABA charges that the new accounting rules would cause $600 million in realized losses by around 275 community and regional banks. But as the financial reform group Better Markets pointed out, Zions has already announced a $387 million write-down, almost two-thirds of the total. The remaining losses would average out to less than $1 million per community or regional bank. While lobbyists claim the losses would force a reduction in lending, outside of Zions it really wouldn’t have much of an impact.
But because community banks exist in every Congressional district and Federal Reserve Bank region in America, they tend to have influence in Washington. Senators from both parties asked regulators to revisit the rule and provide relief for community banks. And last week, the Federal Reserve, on behalf of the banking regulators, released some guidance about the new rules. It reminded banks that “the Final Rules provide a number of express exclusions” from whether CDOs have to be classified as covered funds, and therefore jettisoned. The guidance basically provided a road map for community banks to delay their realized losses until at least 2015, and even afterward. For example, the guidance suggested that the banks could create a specific plan to contort them into something that could acquire an exemption.
The guidance wasn’t good enough for the ABA, which filed its lawsuit anyway. But it is bad news that the immediate impulse from banking regulators was to accommodate the banks, and help them avoid having to do something they didn’t want to do. Since every observer expects further sparring and litigation over the Volcker rule, particularly from the Wall Street titans, this is a worrying sign. Banks never raised an objection to the treatment of CDOs in the thousands of comment letters they wrote in the years leading up to the Volcker rule’s publication. But a few days of grumbling led regulators scrambling for an after-the-fact adjustment. It defies logic that regulators would bend over backwards to save one community bank from having to reveal their losses. If they can’t stand up to Zions Bancorp, how will they do with Goldman Sachs or JPMorgan Chase?
In response to the suit, regulators have already temporarily postponed the provision in question until January 10. But they have until today to formally respond. They could hold firm, and refuse to modify the rule for the benefit of Zions and any other bank relying on accounting tricks to hide losses. Indeed, the ferocity with which lobbyists have engaged on the CDO issue suggests that there could be other losses lurking on bank balance sheets that Volcker rule provisions may ferret out. That would be a very good thing, which would restore confidence in the industry over the long term, and prevent future calamities.
But if the regulators capitulate, then you can basically toss the Volcker rule out the window. Banks have already delayed and diluted financial reform through a constant assault of lobbying and litigation. The Volcker rule was one of the few provisions that gained strength through the rule-writing process. A cascade of concessions during implementation would give little hope that any financial reform can get the proper regulatory follow-through.