WASHINGTON — Regulators are hoping to release an interim final rule next week designed to satisfy banker demands to change a provision of the Volcker Rule that threatens to force smaller institutions to take millions of dollars in write-offs.

While the situation is fluid and the exact form of relief could change, regulators are considering exempting all existing collateralized debt obligations backed by trust-preferred securities from compliance with the Volcker Rule, say people with the knowledge of the deliberations. Such a move would likely stem the banker anger that erupted after regulators said such CDOs were covered by the controversial regulation, and may spur the American Bankers Association to drop its lawsuit over the issue.

Observers called this a savvy solution, allowing regulators to preserve the Volcker Rule's treatment of such CDOs from now on while avoiding the market fallout that would result from changing the accounting treatment for existing Trups-backed obligations.

"It would be a classic Washington response," says Ed Mills, a financial policy analyst at FBR Capital Markets. "The industry gets the win that they needed. While there may be tough language to deal with this on an ongoing basis, that language could be meaningless because the market's just not there."

Because this is such a fast-developing story, American Banker offers the following Frequently Asked Questions to sort through what happened and the likely ways the issue could play out.

What's the basic problem?

At issue is whether banks are required to shed CDOs made up of Trups and how quickly. Under the final Volcker Rule issued in early December, regulators said that certain Trups-backed CDOs would be covered.

That has sparked several banks to announce plans to write down or sell such assets immediately, some at a substantial loss, despite the fact that the Volcker Rule does not go into effect until July 2015.

The problem is one of accounting. If these CDOs are covered by the Volcker Rule, banks can no longer treat them as available-to-maturity securities and must instead mark them as available-for-sale, either selling them or taking significant writedowns in the process. Importantly, banks would have to change the accounting treatment for their fourth-quarter filings, which are due at the end of January.

How many banks are affected and how much money are we talking about?

At least 300 institutions could be hurt by the Volcker Rule if it is left unchanged, according to ABA estimates that rely on data from the Federal Deposit Insurance Corp. In its lawsuit, the trade group said the provision could trigger roughly $600 million in losses.

The individual impact, however, varies considerably. Zions Bancorp. (ZION) in Salt Lake City said last month it would take a $387 million loss, while BankUnited (BKU) in Florida recognized a loss of $1.4 million on the sale of one portfolio of CDOs (while simultaneously announcing a $3.8 million gain on the sale of private-label re-securitized real estate mortgage investment conduits also prompted by the Volcker Rule.)

For other institutions, the cost may be more severe. Cam Fine, president of the Independent Community Bankers of America, says he knows of at least two banks, one in Mississippi and another in Texas, whose executives have told them they will "go down if this rule is enforced."

Did regulators intend this result?

No. By almost every account, senior level regulators never recognized what would happen by including Trups-backed CDOs under the Volcker Rule, including the potential losses that would have to be recognized immediately. Indeed, the agencies had provided repeated assurances to Congress that the Volcker Rule would not significantly affect community banks — a claim that now appears untenable.

Regulators were unprepared for the backlash from small banks and their trade group representatives, as well as the intense, bipartisan interest from members of Congress in the issue. The agencies have been frantically working to fix the issue ever since.

"They got caught with their pants down and they're trying to pull them up," says Fine.

What have regulators done?

The agencies' first effort came Dec. 19, when regulators released a Frequently Asked Questions designed to clarify which CDOs were covered by Volcker. The release specified that banks might be able to restructure their investments so that they were exempt from the ban.

But the release was a disaster, regulators acknowledge privately. Instead of clarifying the issue, it just confused matters further. It also created political problems. The Volcker Rule was never designed to go after small banks, and yet the final rule appeared to do just that. Although Congress was leaving for Christmas break, lawmakers and their staff began hammering the agencies over the problem.

The ABA, meanwhile, filed a lawsuit on Dec. 24 seeking an emergency court ruling by Dec. 31 stopping the Volcker Rule from going into effect.

As a result, the regulators issued another release on Dec. 27 saying that they were considering whether to exempt Trups-backed CDOs from the Volcker Rule, with a final decision due by Jan. 15. The release included a specific mention of the accounting issues, suggesting banks should wait to decide treatment for the fourth quarter until regulators clarify the situation.

Was that enough?

Yes and no. The second regulatory statement allowed the ABA to drop the demand for a court ruling by Dec. 31 because it relieved pressure from bank auditors to have a decision by yearend. But the lawsuit is pending in two different courts, with an appeals court requiring the regulators to make a responsive filing by Jan. 17.

What are regulators going to do?

They are still figuring that part out. Behind the scenes, the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency appear particularly adamant about finding a solution that makes the issue — and the lawsuit — go away.

Broadly speaking, there are at least two options the agencies have entertained. One is to exempt existing Trups-backed CDOs for all institutions with less than $15 billion of assets. Such a cutoff would be consistent with the Collins Amendment, a provision of the Dodd-Frank Act that said Trups no longer count as Tier 1 capital but which grandfathered existing securities for smaller banks. But there are legal questions about whether the regulators are allowed such an asset cutoff under the Volcker Rule.

The other approach would be to exempt all existing Trups-backed CDOs, regardless of the size of the bank that owns them. That solution is more likely to quell any remaining criticism surrounding the issue as there is little to no issuance currently of new Trups-backed CDOs.

It's also possible regulators could try another option, but time is running out. Regulators hope to resolve the issue next week, well before the Jan. 15 cutoff they gave themselves.

Would the ABA drop the lawsuit?

That depends on what regulators actually do. For now, the trade group is optimistic that the agencies will act appropriately.

"When I saw that Dec. 27 statement, it seemed to me they are creating a logical avenue to resolve this without going to the courts," says Wayne Abernathy, executive vice president for financial institutions policy and regulatory affairs for the ABA. "It's one thing if you are trying to get regulators to back down off of something they intended. But I'm convinced they didn't intend to have this impact. It's just a matter of finding something that works."

It is clearly in regulators' interest to solve the problem quickly. The longer the issue hangs out there, the more likely Congress or the courts will step in.

"They don't want this open sore festering and having every banking association in Washington D.C. going to Congress pressuring them to fix this thing," says Fine. "Regulatory agencies are smarter than that. Why pick a fight over this?"


Rob Blackwell is the Washington Bureau Chief for American Banker.