Federal regulators released an interim final regulation late Tuesday designed to fix a problem with the Volcker Rule that would have caused hundreds of banks to take writedowns on certain assets.

The agencies' solution would exempt from the Volcker Rule all collateralized debt obligations backed by trust-preferred securities that were issued by banks with less than $15 billion of assets. Although that ostensibly helps just smaller institutions, the new rule is worded in such a way that many large banks holding Trups-backed CDOs will also benefit.

Left out of the fix, however, are collateralized loan obligations, which also run afoul of the Volcker Rule and are held by many banks.

The Trups CDO issue has already sparked a lawsuit from the American Bankers Association and multiple bills in Congress as policymakers race to correct the problem. It was not immediately clear if regulators' move would cause the ABA to drop the lawsuit, but the trade group signaled it is considering it.

"Our initial review of today's action by the regulators suggests that the interim final rule provides a broad exemption for banks holding trust-preferred securities from the original Volcker Rule," Frank Keating, the association's president, said in a statement to American Banker. "The ABA will be conducting a more comprehensive review of the amended language and will announce a decision regarding the pending litigation on this issue tomorrow."

Others were taking a more cautious approach.

"We asked the regulators to respond quickly to our appeal to fix their flawed interpretation of CDOs/Trups and they have responded," said Cam Fine, CEO of the Independent Community Bankers of America. "Now our bankers have more certain guidance as to the balance sheet impact on their banks. We will wait to hear from our members as to whether this fully addresses their concerns with this matter."

Regulators' solution is novel, even if it is complicated to understand.

At issue was whether Trups-backed CDOs should be covered by the Volcker Rule. Under the final rule issued last month, such assets were captured by the Dodd-Frank Act provision, leaving many banks scrambling to determine the proper accounting treatment. As a result, many warned they would have to take writedowns, likely at a significant loss, in their fourth-quarter filings.

Regulators had essentially two options to fix the problem: they could exempt all existing Trups-backed CDOs, or just create a carve out for institutions with less than $15 billion of assets.

The interim final rule issued Tuesday does the latter — but with a twist. It effectively exempts any Trups CDO in which the trust-preferred security was issued by a bank with less than $15 billion of assets. By keying off the issuer of the Trups — as opposed to the owner — the interim final rule will additionally benefit any larger bank that owns CDOs backed by Trups issued by smaller ones. In practical terms, that is likely to be most affected institutions, according to sources with knowledge of the matter.

The result is that regulators can simultaneously claim to have provided a fix to the problem for most institutions while also maintaining the $15 billion asset threshold.

That line in the sand is very important for any potential legal challenge to the Volcker Rule. Under the Dodd-Frank Act, Trups no longer count as Tier 1 capital. But the regulatory reform law grandfathered all Trups owned prior to May 19, 2010, by banks with less than $15 billion of assets.

In the interim final rule issued Tuesday, regulators used that date and asset cutoff as the legal basis for granting a carve out even though it was contained in a different part of Dodd-Frank from the Volcker Rule.

Whether lawmakers will be satisfied with the solution remains to be seen. House Republicans had been urging regulators to carve out all existing Trups CDOs, while Democrats had been pushing for an exemption only for smaller institutions.

Strangely, this may be the rare case where regulators did both at the same time.

Regulators said the change was needed to insure the Volcker Rule, designed to target the largest institutions, did not inadvertently damage small banks.

"Today's interim final rule is intended to clarify the impact on community banks of language in the Volcker rule relating to trust preferred securities," said Comptroller of the Currency Thomas J. Curry in a statement. "I understand the challenge that community banks face in managing new regulations, and by clarifying this exemption, we are working to alleviate unnecessary regulatory burden on this important group of financial institutions."

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.