Eight bold regulatory predictions on the direction of U.S. Banking and Fintech regulation in light of the election results.
1. The era of “outside the law” Federal regulation is over. Critics of the CFPB (exclusively Republicans) have criticized and challenged the agency’s structure and tactics. These challenges include criticism of the agency’s broad jurisdiction and rulemaking power as an unconstitutional delegation by Congress of its legislative power. Members of Congress and private litigants have assailed the CFPB’s reliance on enforcement actions instead of true rulemaking as undercutting due process and basic fairness. Republicans have been united in believing that the agency’s existence and actions violated the Constitution, the agency’s grant of power under Dodd-Frank and the Administrative Procedures Act. Increasingly, the courts have dealt the agency significant setbacks. This author believes that Director Cordray only persisted in his aggressive pursuit of policy goals because he believed that pursuit was blessed by the Obama Administration and the Democratic Party. Whatever one thinks of President-Elect Trump and his incoming administration, we can be certain that it will not support or defend an aggressive pursuit of policy goals even when that pursuit is perceived to exceed the scope of the law. If a CFPB official decides to pursue such an enforcement action will be doing so without political cover. As a result, I believe the CFPB will not bring enforcement actions unless the law and the facts clearly support that decision. This is a major change of direction for the agency. Once the agency is limited to strictly enforcing the law and promulgating only regulations that comply with the Administrative Procedures Act, it will be able to obtain many fewer settlements (and for much lower amounts) than it was able to do before when it enforced standards that it essentially made up on the spot.
2. Director Cordray will either resign or be fired by the President. The extent of the anger and resentment towards Director Cordray by Republicans in Congress cannot be overstated. I suspect President Trump does not have a strong personal opinion on the matter, but his advisors are close to Congressional leaders and I think there is zero chance that Republicans will not give the Director what they see as his long-overdue comeuppance. A recent District Court opinion supports the Constitutional authority of the President to fire the Director, but I think President Trump will not hesitate to articulate a “for cause” basis to fire the Director under Dodd-Frank if the Director were to contest the President’s power to fire him at will.
On September 10, 2015, a divided Second Circuit appeals court held in Berman v. Neo@Ogilvy LLC, that an employee who reports wrongdoing internally to management is considered a “whistleblower” under the Dodd-Frank Act, thereby strengthening retaliation protections for employee whistleblowers.
There has been a history of tension between the Dodd-Frank statutory definition of “whistleblower” and the applicability of the Dodd-Frank anti-retaliation provisions to employees who report suspected misconduct internally. The Act defines a “whistleblower” as “any individual who provides…information relating to a violation of the securities laws to the Commission…” However, section 78u-6(h)(1)(A)(iii) of the Act prohibits retaliation against “a whistleblower” who makes disclosures “required or protected” by the Sarbanes-Oxley Act. The U.S. Securities and Exchange Commission’s regulations interpret the term “whistleblower” to include for retaliation purposes employees who report or disclose potential wrongdoing either internally or to the SEC (SEC Rule 21F-2(b)(1)). This has led to a Circuit split among federal courts as to whether or not Dodd-Frank protects against retaliation only if the whistleblower reports the wrongdoing to the SEC, or if its protections also extend to whistleblowers who report misconduct internally to management.
In facing Congressional and industry backlash related to the effect of the Volcker Rule on TruPS CDOs, federal regulators were expected to choose between two options. Door 1 was to provide an exemption for TruPS CDOs held by all institutions. Door 2 was to provide an exemption only for TruPS CDOs held by banks with less than $15 billion in assets, consistent with the Collins Amendment to Dodd-Frank.
The regulators chose neither door, instead opening Door 3: the regulators have exempted TruPS CDOs for all institutions, so long as the TruPS CDO primarily holds TruPS of banks with less than $15 billion in assets. It will likely take a few days for the full analysis to come in, but I would expect that this has the effect of exempting all TruPS CDOs, as the CDO structure was primarily used in conjunction with private offerings of TruPS by smaller financial institutions.
The Interim Final Rule, issued on January 14, 2014, adds a new Section __.16 to the Volcker Rule, effective on April 1, 2014 (the same effective date for the Volcker Rule generally). Section __.16 provides that the “covered funds” prohibition of the Volcker Rule do not apply to investments in a CDO if:
- the CDO was established prior to May 19, 2010 (the grandfather date for Tier 1 treatment for TruPS);
- the bank reasonably believes the offering proceeds of the CDO were used to invest primarily in TruPS issued by banks with less than $15 billion in assets (the Collins Amendment threshold); and
- the bank acquired the TruPS CDO on or before December 10, 2013 (the date the final Volcker Rule was approved by the regulators).
According to a story in the American Banker (subscription required), the federal banking regulators are looking at exempting all existing collateralized debt obligations backed by trust-preferred securities from compliance with the Volcker Rule.
From a technical perspective, it seems likely that the regulators would effect such an exemption by excluding the debt tranches of CDO’s backed by TRuPS from the definition of an “ownership interest” under the Volcker Rule, thereby allowing continued ownership by banking entities. Whether the revision is limited to existing TRuPS CDO’s or all is likely largely irrelevant, as the elimination of preferred capital treatment for Trust Preferred securities has eliminated the creation of new TRuPS CDO’s.
As previewed by the regulators’ late Christmas gift, the regulators are considering limiting the relief to banking entities with less than $15 billion in total assets. Without getting into the merits of whether its appropriate to treat TRuPS CDO investments differently based on the size of the institution with the investment, it seems that limiting the relief to banking entities with less than $15 billion could also limit the effectiveness of such relief. To the extent larger financial institutions still need to dispose of their TRuPS CDO investments (by July 2015, but potentially earlier in light of accounting treatment), it could still unsettle TRuPS CDO markets, widening market losses for community banks. While not impacting regulatory capital levels, this could still represent a GAAP hit for community banks that seems inconsistent with the Collins amendment and the regulators general statements that the Volcker Rule is not intended to impact community banks.
In a late Christmas present (or perhaps it was just delayed in delivery), the federal banking agencies and the SEC (although apparently not the Commodity Future Trading Commission) announced they would be reviewing whether it would be appropriate to exempt CDOs backed by Trust Preferred Securities from the Volcker Rule’s ban on covered funds.
The agencies have stated that they intend to address the matter no later than January 15, 2014, and believe that, consistent with GAAP, any actions taken in January 2014 should be effective in addressing year-end financial statements so long as such actions are taken before the issuance of such financial statements.
In the statement released by the regulators, the agencies emphasize the grandfathering of TRuPS provided by the Dodd-Frank Act for institutions with consolidated assets of less than $15 billion, and suggest that action to revise the Volcker Rule may be appropriate to avoid “consequences that are inconsistent with the relief Congress intended to provide community banking organizations.” Whether this foreshadow only partial relief of the impact of the Volcker Rule on CDOs backed by TRuPs, namely only to those institutions with less than $15 billion in total consolidated assets, remains to be seen.
On December 19, 2013, the Federal Reserve, FDIC and OCC issued an Interagency FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule. While roundly criticized by most trade associations and others following the industry as constituting “Frequently Asked Questions Without Answers,” the FAQ does provide additional potential insight on whether banks will ultimately need to dispose of their investments in CDOs backed by TRuPS portfolios (as well as other CDOs).
The greatest weakness in the FAQ, and a generally nasty side-effect of issuing final Volcker Rules shortly before calendar (and thus fiscal) year-ends, is whether accounting firms will force institutions to recognize unrealized market losses, based on an inability to hold the investment to maturity. This question will ultimately be answered by the accounting firms, although still subject to second guessing by the banking regulators. The tone and style of the December 19, 2013 FAQ suggests that the regulators are continuing to explore the issue, and intend to take advantage of the delayed compliance deadline of July 2015, to reach more conclusive determinations. Whether this ambiguity is sufficient for institutions to appropriately determine they maintain the requisite intent to hold the securities through maturity will be a judgement call for institutions and their accountants.
Without providing definitive answers, the FAQ does indicate that the banking regulators do not believe that bank investments in CDOs backed by TRuPS portfolios are universally prohibited by the final Volcker Rule. Rather, they point to two specific areas for further analysis in determining the Volcker Rule’s applicability to any particular investment.
On December 10, 2013, the final Volcker Rule was adopted by the federal banking regulators, the SEC, and the CFTC to implement Section 619 of the Dodd-Frank Act. The Volcker Rule generally prohibits banking entities from engaging in “proprietary trading” and making investments and conducting certain other activities with “private equity funds and hedge funds.”
One unintended consequence appears to be the treatment of Collateralized Debt Obligations (CDOs) backed by Trust Preferred Securities (TRUPs) as “covered funds” under the Volcker Rule. As a covered fund, banking entities of all sizes will no longer be able to own TRUPs CDOs as of July 21, 2015. Moreover, because of this obligation to divest by July 21, 2015, banks are no longer able to say they will hold such investments to maturity and therefore will not be able to split out their other than temporary impairment between credit losses and market losses. Any market losses in the CDO security (which is currently reflected only in other comprehensive income) will be reported as a loss through Tier 1 capital. Banks holding TRUPs-backed CDO’s are encouraged to reach out to their accountants to discuss the potential accounting impact.
Throughout 2012 a series of roundtable discussions were held in order to assess the current diversity programs and polices in place within the financial industry. As a result of these talks, six financial agencies: the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Consumer Financial Protection Bureau, and the Securities and Exchange Commission (the “Agencies”), proposed a set of diversity and inclusion standards. These standards, titled the “Proposed Interagency Policy Statement Establishing Joint Standards for Assessing the Diversity Policies and Practices of Entities Regulated by the Agencies and Request for Comment” (the “Policy Statement”), were published on October 25, 2013, with the 60-day comment period to end on December 24, 2013. This Policy Statement helps to implement a part of the Dodd-Frank Act, which requires each financial agency to establish an Office of Minority and Women Inclusion, and assign a director who is responsible for all agency matters relating to diversity in management, employment, and business activities.
What the Proposed Standards Will Do
The proposed Policy Statement sets out uniform standards for regulated entities in four key areas: (1) organizational commitment to diversity and inclusion; (2) workforce profile and employment practices; (3) procurement and business practices and supplier diversity; and (4) practices to promote transparency of organizational diversity and inclusion. The Agencies advise that each standard will be tailored to the regulated entity’s size and other relevant characteristics such as total assets, number of employees, geographic location, and community characteristics. Entities that are affected by the Policy Statement include financial institutions, investment banking firms, mortgage banking firms, asset management firms, brokers, dealers, financial services entities, underwriters, accountants, investment consultants, and providers of legal services.
On May 29, 2013, the Consumer Financial Protection Bureau (CFPB) issued a final rule amending the Ability-to-Repay (ATR) and Qualified Mortgage (QM) rules it issued on January 10, 2013. Within this final rule are two new categories of small creditor QMs. The first, for small creditor portfolio loans, was adopted exactly as proposed alongside the January ATR rule and permits small creditors in all markets to make portfolio loans that are QMs even though the borrower’s DTI ratio exceeds the general QM 43% cap. As a reminder, small creditors for these purposes are those with less than $2 billion in assets at the end of the preceding calendar year that, together with their affiliates, made 500 or fewer covered first-lien mortgages during that year.
The second new QM is a welcome even if only temporary category of balloon mortgages. Unlike the small creditor portfolio QM, this interim QM was not an express part of the so-called “concurrent proposal” issued in January. This is simply but significantly a QM that meets all of the existing rural balloon-payment QM requirements except the controversial limitation that the creditor operate primarily in “rural” or “underserved” areas.
As written, the new balloon QM category expires two years after the ATR rules take effect on January 10, 2014. The CFPB characterizes this two-year window as a “transition period” useful for two purposes: (1) it will give the CFPB time to consider whether its definitions of “rural” and “underserved” are in fact too narrow for the needs of the rural balloon-payment QM rule and (2) it will give creditors time to “facilitate small creditors’ conversion to adjustable-rate mortgage products or other alternatives to balloon-payment loans.” The CFPB took pains to argue that Congress “made a clear policy choice” not to extend QM status to balloon mortgages outside of rural and underserved areas, and the agency reiterated its belief that adjustable-rate mortgages pose less risk to consumers than balloons: “The Bureau believes that balloon-payment mortgages are particularly risky for consumers because the consumer must rely on the creditors’ nonbinding assurances that the loan will be refinanced before the balloon payment becomes due. Even a creditor with the best of intentions may find itself unable to refinance a loan when a balloon payment becomes due.” For these reasons, creditors may expect future CFPB scrutiny intended to bury, not save, balloon mortgages. (more…)
Community bank lenders have responded to the CFPB’s Ability-to-Repay and Qualified Mortgage rules with questions about adjustable-rate mortgages (ARMs), balloon-payment qualified mortgages, and non-standard mortgage refinances. The CFPB’s implementation of Dodd-Frank’s balloon-payment qualified mortgage concept, for example, turns on a narrow definition of the types of lenders that qualify to make such loans. ARMs may be a viable alternative to balloon mortgages, but these loan products pose compliance and operational risks of their own. Finally, lenders may still be considering the types of transactions that qualify for the special “non-standard mortgage” refinancing exemption from the general Ability-to-Pay rule.
For a uniquely focused discussion on making these types of loans in light of the CFPB’s new mortgage regulations, join attorneys John ReVeal and Barry Hester for the latest installment of Bryan Cave’s webinar partnership with compliance training leader BAI Learning & Development. This free presentation will be held on Wednesday, May 8, from 3-4 pm Eastern. More information and registration are available here. Participants should walk away with a solid roadmap for managing existing portfolio balloons and ARMs now and for originating these types of mortgages once the CFPB’s rules take effect in 2014.