The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System (collectively, the banking agencies) issued interagency guidance on November 6 that clarifies the relationship between their regulatory capital rule and the capital treatment of certain private funds, known as covered funds, under the Volcker Rule.1 The guidance ensures that covered fund investments by banking entities that result in capital deductions pursuant to the Volcker Rule will not be double counted if deductions for the same investment would also be required pursuant to the banking agencies’ capital rule. The release includes a step-by-step deduction methodology as well as information about how banking organizations should report capital deductions taken pursuant to the Volcker Rule.
Capital Deduction Background
Under the Volcker Rule, for purposes of compliance with applicable regulatory capital requirements, a banking entity generally must deduct from its Tier 1 capital the greater of the fair market value or historical cost (plus any earnings received) of its investments in covered funds, including any amounts paid to obtain a restricted profit interest in the covered fund. Although it is not entirely clear from the text of the final rule, this deduction is generally understood to apply only to those investments in covered funds held pursuant to an exemption under Section __.11 of the final rule, which includes the exemptions for organizing and offering a covered fund in connection with an asset management business or a securitization, and the exemptions for underwriting and market making in covered funds. The Volcker Rule capital deduction went into effect July 21. For certain legacy covered funds that were in place prior to December 31, 2013, the agencies intend to delay implementation of the capital deduction until July 21, 2017.
The text of the final rule did not address how the Volcker Rule capital deduction interacts with other regulatory capital requirements that apply to banking organizations. However, the commentary acknowledged that the capital deduction required for investments in covered funds does not perfectly align with the deduction and risk-weighting requirements imposed by the banking agencies’ regulatory capital rule. It went on to state that the banking agencies expected to propose steps to reconcile the two rules.2 The interagency guidance appears to be the banking agencies’ approach to accomplishing this reconciliation.
Deduction Methodology in the Interagency Guidance
Under the regulatory capital rule, a banking organization’s “investment in the capital of an unconsolidated financial institution” (UFI) may be subject to a deduction from Tier 1 capital. If a banking organization holds such an investment, and it is also an investment in a covered fund for purposes of the Volcker Rule, there appears to be overlapping capital requirements for the investment that could require the investment to be deducted from Tier 1 capital under each rule, resulting in double counting. The interagency guidance clarifies that such investments should be deducted only once from the banking organization’s Tier 1 capital.
The banking agencies included a specific methodology to ensure that the banking organization takes the appropriate deductions under each rule. In effect, the methodology gives a banking organization credit toward the required Volcker Rule capital deduction for any deduction taken from common equity Tier 1 capital or additional Tier 1 capital under the regulatory capital rule with respect to an investment that is an investment in both a UFI and a covered fund. Any remaining investments in covered funds that would be required to be deducted pursuant to the Volcker Rule capital deduction must still be deducted accordingly. The methodology also clarifies that deductions taken pursuant to this part of the capital rule and the Volcker Rule are excluded not only from the numerator but also from the denominator of the relevant capital ratios.
Reporting and Compliance
The interagency guidance reiterates that a banking organization should be able to demonstrate to its primary federal regulatory agency that it is in compliance with the Volcker Rule and that all covered fund investment amounts have been deducted from Tier 1 capital. To that end, the guidance indicates the particular regulatory reports and line items in which banking organizations should report the capital deductions of investments made in covered funds. These reports and line items vary depending on the type and size of the banking organization in question and are listed in more detail in the interagency guidance.
1 The full text of the interagency guidance can be found here.
2 The commentary to the final rule also helpfully clarified that the Volcker Rule does not require a non-U.S. banking entity that invests in a covered fund to deduct the value of its investment from Tier 1 capital calculated under applicable home country capital standards. Any U.S. subsidiary of such a banking entity that is separately required to calculate and report Tier 1 capital under U.S. capital rules would still be subject to the deduction for its own investments in covered funds.
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Capital Deduction Background
Under the Volcker Rule, for purposes of compliance with applicable regulatory capital requirements, a banking entity generally must deduct from its Tier 1 capital the greater of the fair market value or historical cost (plus any earnings received) of its investments in covered funds, including any amounts paid to obtain a restricted profit interest in the covered fund. Although it is not entirely clear from the text of the final rule, this deduction is generally understood to apply only to those investments in covered funds held pursuant to an exemption under Section __.11 of the final rule, which includes the exemptions for organizing and offering a covered fund in connection with an asset management business or a securitization, and the exemptions for underwriting and market making in covered funds. The Volcker Rule capital deduction went into effect July 21. For certain legacy covered funds that were in place prior to December 31, 2013, the agencies intend to delay implementation of the capital deduction until July 21, 2017.
The text of the final rule did not address how the Volcker Rule capital deduction interacts with other regulatory capital requirements that apply to banking organizations. However, the commentary acknowledged that the capital deduction required for investments in covered funds does not perfectly align with the deduction and risk-weighting requirements imposed by the banking agencies’ regulatory capital rule. It went on to state that the banking agencies expected to propose steps to reconcile the two rules.2 The interagency guidance appears to be the banking agencies’ approach to accomplishing this reconciliation.
Deduction Methodology in the Interagency Guidance
Under the regulatory capital rule, a banking organization’s “investment in the capital of an unconsolidated financial institution” (UFI) may be subject to a deduction from Tier 1 capital. If a banking organization holds such an investment, and it is also an investment in a covered fund for purposes of the Volcker Rule, there appears to be overlapping capital requirements for the investment that could require the investment to be deducted from Tier 1 capital under each rule, resulting in double counting. The interagency guidance clarifies that such investments should be deducted only once from the banking organization’s Tier 1 capital.
The banking agencies included a specific methodology to ensure that the banking organization takes the appropriate deductions under each rule. In effect, the methodology gives a banking organization credit toward the required Volcker Rule capital deduction for any deduction taken from common equity Tier 1 capital or additional Tier 1 capital under the regulatory capital rule with respect to an investment that is an investment in both a UFI and a covered fund. Any remaining investments in covered funds that would be required to be deducted pursuant to the Volcker Rule capital deduction must still be deducted accordingly. The methodology also clarifies that deductions taken pursuant to this part of the capital rule and the Volcker Rule are excluded not only from the numerator but also from the denominator of the relevant capital ratios.
Reporting and Compliance
The interagency guidance reiterates that a banking organization should be able to demonstrate to its primary federal regulatory agency that it is in compliance with the Volcker Rule and that all covered fund investment amounts have been deducted from Tier 1 capital. To that end, the guidance indicates the particular regulatory reports and line items in which banking organizations should report the capital deductions of investments made in covered funds. These reports and line items vary depending on the type and size of the banking organization in question and are listed in more detail in the interagency guidance.
1 The full text of the interagency guidance can be found here.
2 The commentary to the final rule also helpfully clarified that the Volcker Rule does not require a non-U.S. banking entity that invests in a covered fund to deduct the value of its investment from Tier 1 capital calculated under applicable home country capital standards. Any U.S. subsidiary of such a banking entity that is separately required to calculate and report Tier 1 capital under U.S. capital rules would still be subject to the deduction for its own investments in covered funds.
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Sidley Banking and Financial Services Practice
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Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.