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Relaxed Volcker covered fund rule portends more deregulation, says Fitch

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Fitch Ratings views the recent Notice of Proposed Rulemaking (NPR) issued by regulators to amend the Volcker Rule and relax limits on certain private equity (PE) and hedge fund investments, known as “covered funds” as indicative of loosening regulation and recalibration of post-crisis regulatory rules. While alternative investments can potentially deliver uncorrelated performance and superior long-term returns, they can also exhibit short-term earnings/valuation volatility, offer limited interim liquidity and put capital at risk for larger, systemic banks, especially in times of economic stress or during a market downturn.

Fitch views robust regulation and capital requirements as supportive of credit ratings; therefore relaxation would be viewed as a credit negative. With that said, any rating implications would depend on how individual US banks respond to the proposed relaxation of the covered fund investments rule. This proposal follows the August 2019 rule changes that eased compliance requirements regarding proprietary trading.

The proposal would allow banks to offer more products and services to ultra-high net worth individuals and more easily provide commercial banking services to funds. The NPR would also eliminate the requirement that foreign funds must be authorised to be sold in respective home jurisdictions and that they must be predominantly sold through public offerings.

The NPR also looks to simplify the treatment of loan securitisations and small business investment companies. The proposal would also relax the rules governing bank relationships with hedge funds and PE funds. Importantly, the caps limiting U.S. banks’ exposures to 3 per cent ownership of each covered fund and limiting covered fund investments to 3 per cent of Tier 1 capital would remain in place.

Hedge funds and PE funds are still largely restricted by the rules governing covered funds. For funds to qualify for exclusion, banks are still prohibited from proprietary trading and must adhere to specific disclosure and documentation guidelines. However, the proposal increases the investments excluded from the covered fund rule, facilitating investment in credit funds, venture capital funds, family wealth management vehicles and customer facilitation funds.

The most complex and interconnected banking entities, or global systemically important banks (GSIBs), significantly reduced their exposure to these types of investments to comply with the Volcker Rule, which was supportive of bank credit. Elevated balance sheet exposure to alternative investments was among the challenges banks faced during the financial crisis given investment underperformance, valuation volatility and reduced liquidity.

The NPR was approved by the Office of the Comptroller of the Currency and Federal Reserve and Federal Deposit Insurance Corp, which are seeking public comments until 1 April, 2020. Regulators are aiming to simplify and clarify the current regulation, which is often criticised as being overly broad and precluding banks from offering certain traditional commercial banking and asset management services as written.

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