On December 10, 2013, the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the Commodity Futures Trading Commission (Agencies) issued the final rule (Final Rule) implementing the “Volcker Rule” requirements of section 13 (section 13) of the Bank Holding Company Act (BHC Act), which were added by section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Final Rule is effective April 1, 2014, but banking entities generally have until July 21, 2015, to conform their activities to the Final Rule.
The Final Rule includes broad exemptions for banking entities that are regulated insurers. Part I of this memo sets out key takeaways for insurers. Part II summarizes the Final Rule’s main provisions. Part III focuses on the Final Rule’s treatment of banking entities that are regulated insurers. Part IV focuses on the Final Rule’s reporting and compliance program requirements, and Part V highlights that, for purposes of the Volcker Rule capital requirements and quantitative limits, the Agencies may be considering treating nonbank systemically important financial institutions (SIFIs) that are not banking entities (e.g., Prudential Financial, Inc. (PFI)) differently from SIFIs that are banking entities
- Key Takeaways
- Regulated insurers that are banking entities generally qualify for broad exemptions from the Volcker Rule (for both proprietary trading and covered fund activities), but any insurance holding company (IHC) or IHC subsidiary that is a banking entity, but not a regulated insurer, would not qualify for such exemptions.
- An insurer that is a banking entity will need to assess the extent to which it and its affiliates are subject to the Super 23A Restrictions, and to implement appropriate compliance programs for activities subject to section 13.
- The broad definition of covered funds may require that banking entities divest a variety of pre-Volcker securitizations, which could result in investment opportunities for real-money buyers such as insurers.1
- Collateralized loan obligations, consumer asset-backed securities (ABS), and loan-based securitizations will continue to be the focus of banking entities’ non-agency securitization activities.
- The Final Rule may result in changes to some non-agency securitizations, since wherever possible bank underwriters and their client sponsors will prefer to distribute ABS that are not covered funds and hence qualify for investment by banking entities. For example, some market-value CLOs may seek to rely on the Final Rule’s exemption for qualifying loan securitizations. Issuers of non-qualifying ABS may be required to pay a premium to compensate for the less liquid nature of such securities vis-a-vis qualifying ABS.
- The Main Provisions of the Final Rule. The Final Rule:
- covers any banking entity, meaning, subject to limited exceptions, (i) an insured depository institution, (ii) any foreign bank operating a branch or agency in the U.S., and (iii) any affiliate of (i) or (ii). An affiliate is defined as any company that controls, is controlled by, or is under common control with another company2 and includes non-bank affiliates such as insurers and finance companies;
- imposes limitations on the short-term proprietary trading (Proprietary Trading Restriction) of financial instruments by any banking entity; and
- prohibits or limits a banking entity’s sponsoring or having an ownership interest (Ownership Restriction) in, or certain relationships with (Relationship Restriction), private funds meeting the definition of “covered fund.” Under the Final Rule, a “covered fund” means:
- an issuer that would be an investment company under the Investment Company Act of 1940 (1940 Act) but for exemptions under sections 3(c)(1) or 3(c)(7) of that Act. These exemptions are generally available to privately offered companies whose securities are beneficially owned by 100 or fewer persons or owned exclusively by qualified purchasers,
- certain commodity pools, and
- certain foreign funds.
- Treatment of Banking Entities That Are Regulated Insurers
Exemption from the Proprietary Trading Restriction. If a banking entity is a regulated insurer, the Final Rule provides an exemption3 for proprietary trading activity in the general account or in a separate account4 of the insurer, provided that:
- the insurer (or an affiliate) purchases or sells the financial instruments solely for the insurer’s general account or a separate account established by the insurer,
- the purchase and sale is conducted in compliance with, and subject to, the insurance company investment laws and regulations of the State or jurisdiction in which such insurance company is domiciled (collectively, “insurance regulation”), and
- the appropriate Federal banking agencies (after consultation with the Financial Stability Oversight Council (FSOC) and relevant State insurance commissioners) have not jointly determined that a particular insurance regulation is insufficient to protect the safety and soundness of the banking entity, or the financial stability of the United States.
Exemption From the Ownership Restriction. If a banking entity is a regulated insurer, the Final Rule provides an exemption5 permitting such insurer (or affiliate) to sponsor, or to acquire and retain an ownership interest in, covered funds, provided:
- the insurer (or affiliate) acquires and retains the ownership interest solely for the insurer’s general account or one or more of its separate accounts,
- the acquisition and retention of the ownership interest is conducted in compliance with, and subject to, insurance regulation, and
- the appropriate Federal banking agencies (after consultation with the FSOC and relevant State insurance commissioners) have not jointly determined that a particular insurance regulation is insufficient to protect the safety and soundness of the banking entity, or the financial stability of the United States.
Limitations on Exemptions. The exemptions that a regulated insurer enjoys from the Proprietary Trading Restriction and Ownership Restriction are subject to overriding limitations that prohibit a banking entity from engaging in an activity or investment if the activity or investment involves a material conflict of interest with customers, clients or counterparties or in a material exposure to high-risk assets or high-risk trading strategies, or if the activity or investment would pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.6 Material conflicts of interest may be addressed (i) through timely and effective disclosure or in some cases through the use of (ii) information barriers that are memorialized in written policies and procedures.7
Certain BOLI and COLI Separate Accounts Are Not Covered Funds. The Final Rule also (a) permits insurers that are banking entities to sponsor bank owned life insurance (BOLI) and corporate owned life insurance (COLI) separate accounts (i.e., separate accounts that rely on a section 3(c)(1) or section 3(c)(7) exemption from the 1940 Act in private placements of life insurance), and (b) allows banks and corporations (that are banking entities) to invest in BOLI and COLI separate accounts, respectively. Specifically, the Final Rule provides that generally a “covered fund” does not include separate accounts so long as either:
- no banking entity other than the insurance company that establishes the separate account participates in the account’s profits and losses; or
- the separate account is used solely for the purpose of allowing one or more banking entities to purchase qualifying BOLI.8
To qualify for this treatment, the BOLI separate account must be used solely for the purpose of allowing one or more banking entities to purchase a life insurance policy for which the banking entity or entities is beneficiary, provided that no banking entity that purchases the policy may:
- control the investment decisions regarding the underlying assets or holdings of the separate account; or
- participate in the profits and losses of the separate account other than in compliance with applicable supervisory guidance regarding bank owned life insurance.9
Relationship Restrictions. The Final Rule generally prohibits a banking entity that, directly or indirectly, serves as investment manager, investment adviser, commodity trading advisor, or sponsor to a covered fund, or that organizes and offers a covered fund, or that retains an ownership interest in certain covered funds,10 as well as any affiliate of such banking entity, from entering into a transaction with the covered fund, or with any other covered fund that is controlled by such covered fund, that would be a “covered transaction” as defined in section 23A of the Federal Reserve Act, as if such banking entity were a member bank and the covered fund were an affiliate thereof (so-called “Super 23A Restrictions”).11 Covered transactions include certain loans and extensions of credit to a covered fund, guarantees of a covered fund’s obligations, or a credit exposure to a covered fund arising from a derivatives transaction.12
- Reporting Obligations and Compliance Program
Reporting. If a regulated insurer is a banking entity with significant trading activities, and the insurer’s activities are limited to permitted activities, then the banking entity may, but is not required to, meet the reporting requirement with respect to trading metrics.
Compliance Program. The extent of compliance program requirements that a banking entity must meet depends on the entity’s total consolidated assets as well as whether the entity conducts significant trading activities. The Agencies “expect [banking entities that are] insurance companies to have appropriate compliance programs in place for any activities subject to section 13.”13 The scope of the compliance program with respect to an insurance company would appear to depend, among other things, on the Agencies’ view of the extent to which the insurer is in fact conducting any activity that would be subject to section 13 of the BHC Act.
- Regulatory Capital and SIFIs. The Final Rule requires a banking entity to deduct the greater of 1) historical cost, plus earnings, and 2) fair market value of all qualifying de minimis covered fund investments made by the entity from the entity’s tier 1 capital. Under BHC Act section 13, nonbank financial companies designated by the FSOC as SIFIs that engage in proprietary trading activities or make investments in covered funds may be subject by the appropriate Agency or Agencies to additional capital requirements and quantitative limits. The Agencies noted that two of the three companies currently designated by the FSOC for supervision by the FRB are affiliated with insured depository institutions (American International Group, Inc. and General Electric Capital Corporation, Inc.) and are therefore currently banking entities for purposes of section 13 of the BHC Act. Interestingly, the FRB staff indicated that it “is exploring whether the third entity [(i.e., PFI)] engages in any activity that would be subject to section 13 of the BHC Act, and will propose action consistent with that section if appropriate and applicable.” The fact that the Agencies refrained, at least preliminarily, from applying to PFI capital requirements with respect to its proprietary trading and investments in covered funds suggests that, for purposes of the Volcker Rule capital requirements and quantitative limits, the Agencies are considering treating SIFIs that are not banking entities differently from SIFIs that are banking entities.