The proposed Volcker rule in the US could pose a threat to covered bond structures in countries where these involve a separate asset owner or guarantor, even if the impact appears unintentional, according to Allen & Overy, the ASF, and UK RCBC.

Paul Volcker and Barack Obama

The industry bodies made comments in this vein in submissions to a consultation that ended on Monday, with scores of comments sent to US regulatory agencies. The proposal would implement Section 619 of the Dodd-Frank Act and is officially called Proposed Rule: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationship with, Hedge Funds and Private Equity Funds.

Nicole Rhodes, consultant counsel, Allen & Overy, told The Covered Bond Report that the Volcker rule could have far-reaching consequences for covered bond structures that involve a separate vehicle that owns cover pool assets transferred to it by an issuer and provides a guarantee backed by those assets to the bondholders.

Such a potential outcome stems from one of two main prongs to the Volcker rule, which Rhodes said is often talked about as only being about restrictions on proprietary trading but also sets out other restrictions, which could present covered bond specific challenges.

Nicole Rhodes, A&O

“It’s that second limb in particular where potential issues come up for arrangements involving separate vehicles,” she said.

The crux of the issue is a broad definition of what the Volcker Rule calls a “covered fund” and restrictions on activities and relationships between a banking entity, also broadly defined, and such a fund. Lawton Camp, partner at Allen & Overy, said that the definition of a banking entity is expansive enough so that a non-US banking organisation with a branch or agency in the US will be viewed as a banking entity under the Volcker Rule.

“The issue surrounds how the definitions work,” he said. “One of the principal ideas behind Volcker was to stop banks from investing in hedge funds and private equity funds, so they created this definition of ‘covered fund’”.

“If you are a banking entity there are severe restrictions on investing a covered fund.”

In a submission to the Volcker consultation filed on Monday, the UK Regulated Covered Bond Council focuses on the effect of the proposed rule on UK covered bond arrangements and its concerns that “as currently drafted and in the absence of clarification, the Proposed Rule may interfere with and effectively restrict aspects of existing UK covered bond structures where such transactions involve a relevant banking entity”.

It said that such an outcome would not be justified, would not reflect the legislative intention behind Section 619 of the Dodd-Frank Act, would have a negative and disproportionate effect on UK banks, and would give rise to potential conflicts with the legislative framework applying to Regulated Covered Bonds in the UK.

Covered bond issuance in other jurisdictions could also be negatively affected by the proposed Volcker Rule, according to the UK RCBC and American Securitization Forum (ASF).

“It should be noted that the issues identified under the Proposed Rule in respect of UK covered bond structures would also be relevant in principle in respect of covered bond structures used in certain other EU jurisdictions (e.g. The Netherlands and Italy) and certain non-EU jurisdictions (e.g. Canada, Australia and New Zealand),” said the UK RCBC.

In its own submission the ASF spoke more generally of the implications for covered bonds of the proposed Volcker regulations, which it said can be interpreted as hindering or even preventing non-US banks that are subject to the Volcker Rule from engaging in covered bond issuance or similar secured bank funding. The ASF went on to focus on covered bond structures that utilise special purpose vehicles.

Camp said that the consequences of the Volcker Rule for covered bonds could go beyond mortgage-backed issuance under certain type of structures, such as those used in the UK and France.

Lawton Camp, A&O

“For example, French law covered bonds issued by a société de crédit foncier [SCF]) and collateralised entirely by ECA [Export Credit Agency] loans may be impacted by the broad reach of the Proposed Rule,” he said. “The SCF could be viewed as a ‘covered fund’.

“As a result, unless certain exemptions are clarified and broadened, the Volcker Rule could restrict a regulated French bank from issuing covered bonds in France.”

Broad definitions unwelcome

The UK RCBC states that its key concerns arise mainly from the wide definition of a covered fund and that it is not sufficiently clear that asset pool owners in UK covered bond structures would not come under the definition as proposed.

It notes that section 619 of the Dodd-Frank Act sets out certain restrictions on activities and relationships between banking entities – including certain non-US banks – and covered funds, an “Ownership Restriction” and a “Super 23A Restriction”.

The UK RCBC and ASF submissions suggest that if the wide definition of a covered fund is followed through then it is not clear that asset pool owners or special purpose entities would not be considered to fall within the scope of the definition of a covered fund. In this regard, the RCBC’s submission also refers to the relevance of certain foreign equivalency provisions and discussions about revising the terms of certain exemptions under the US Investment Company Act of 1940.

In light of this, the ASF in its submission said that the proposed Volcker regulations should be clarified so that special purpose entities whose sole function is to operate as collateral devices as part of a covered bond offering or other secured general recourse bank funding arrangements “be excluded from the definition of ‘covered fund’ for all purposes under the Volcker Rule”.

The UK RCBC said that in the absence of clarification, the possibility of an asset pool owner in a UK covered bond structure being considered a covered fund “has the potential to create significant issues for the UK covered bond market given the wide restrictions contemplated by the Volcker Rule”.

Certain “points of connection” between a bank issuer and the asset pool owner” may be prohibited, it said.

These include features of the UK covered bond framework such as a bank issuer making term advances to the asset pool owner under an intercompany loan agreement, the proceeds of which advances will be used for specified purposes, including to purchase the collateral pool from the bank issuer; and a bank issuer’s right to repurchase certain assets from the asset pool owner.

“Moreover,” said the UK RCBC, “such an outcome may result in certain arrangements which are expressly permitted (and indeed required) by the UK covered bond legislative framework (including the use of Asset Pool Owners in general) being restricted under the Volcker Rule, effectively putting relevant issuers in a position of being subject to conflicting laws.

“From a policy perspective, it would seem appropriate for the UK authorities to regulate the structure to be used in the context of UK Regulated Covered Bond transactions (as they have done), but the rationale for the application of a conflicting US law in this regard is unclear.”

In addition to calling for asset pool owners to not be considered covered funds, the UK RCBC said that the former should similarly be exempt from the definition of a “banking entity”.

“In the absence of this clarification, the activities of Asset Pool Owners may be restricted to the extent that such activities may be construed to fall within the widely cast proprietary trading restriction and/or within the range of restricted activities and transactions vis-à-vis covered funds,” it said.

Hopes a ‘ridiculous’ situation can be avoided

The UK RCBC submission makes clear its perspective that the potential implications for UK and certain other covered bonds are largely unintentional, with Allen & Overy’s Rhodes also making this point.

“There’s nothing that would suggest that covered bond arrangements are targeted by Volcker, which is all about hedge fund and private equity fund exposure and what regulators consider to be too much risk in that regard,” she said. “I hold out some hope that because these covered bond structures do not seem to be a targeted type of arrangement in principle, that the comments made as part of the consultation and the potential issues in this regard will be factored in.”

A more narrow definition of a covered fund and the scaling back of the Super 23A provision would go some ways to ensuring that non-US covered bond arrangements are not adversely affected by the Volcker Rule, according to Rhodes.

Another market participant believes that the US authorities have had little time to consider the extraterritorial impact of the Volcker Rule proposals, and expects that super 23A will either have to be gotten rid of or significantly scaled back.

“In addition, covered funds need to be just hedge funds and private equity funds, not every fund that was ever created,” he said.

In the absence of such changes the Volcker Rule could lead to the “ridiculous” situation where certain covered bond transactions in Europe will not be possible, with banks likely to resist, he said.