On November 6, 2015, US banking regulators (the Office of Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board) issued instructions (“Instructions”) for banking entities on making regulatory capital adjustments for their investments in covered funds subject to the Volcker Rule. Both the Volcker Rule and the agencies’ risk-based regulatory capital rules require deductions for such investments but the regulations overlap, which could result in a larger deduction than necessary. The Instructions ensure that there are no such “double deductions” to regulatory capital for these investments.
The Volcker Rule and its regulations generally prohibit banking entities and affiliates from engaging in proprietary trading or sponsoring or acquiring ownership interests in certain private funds (“covered funds”). In addition, banking regulators have issued comprehensive rules on calculating the risk-based capital of banks and bank holding companies.
Under the Volcker Rule, a banking entity must deduct its entire investment in a covered fund from its Tier 1 capital, its “core capital,” composed primarily of the banking entity’s common stock.
Under the regulatory capital rules, an investment in a covered fund would be considered an “investment in the capital of an unconsolidated financial institution” (termed a “covered fund UFI” in the Instructions) and as such, the investment also could be subject to a deduction from a banking entity’s Tier 1 capital.
For those banking entities with permissible investments in covered funds under the Volcker Rule that potentially also would be subject to deductions from regulatory capital under the regulatory capital rules, the banking regulators provide the following Instructions:
- The banking entity first must calculate the amount of its investment in a covered fund that is subject to the regulatory capital deduction requirement contained in the Volcker Rule
- If the banking entity has an investment in a Volcker Rule covered fund, but the investment does not qualify as a covered fund UFI, then the banking entity must fully deduct the investment from its Tier 1 capital in accordance with the regulatory capital deduction requirement in the Volcker Rule
- However, if the banking entity has an investment in a Volcker Rule covered fund, and the investment does qualify as a covered fund UFI that is subject to a deduction from Tier 1 capital under the regulatory capital rules, the banking entity must first calculate and apply a deduction to its Tier 1 capital in accordance with the requirements of the regulatory capital rules (Step 1), and then calculate and apply an additional deduction to its Tier 1 capital in accordance with the regulatory capital deduction requirement in the Volcker Rule for any remaining investment in the covered fund not already deducted in Step 1.
Amounts deducted by the banking entity from Tier 1 capital pursuant to either the Volcker Rule or the regulatory capital rules may be excluded from the banking entity’s calculation of certain capital and leverage ratios under the regulatory capital rules.
As noted in previous blog posts, the financial regulators that promulgated the Volcker Rule (which include the banking agencies) also have been issuing guidance periodically in the form of Frequently Asked Questions (FAQ) that appear on each of the agencies’ websites.