Credit Funds, Done Right, Can Be an Opportunity for Banks

Recent changes to the Volcker Rule, which become effective October 1, 2020, will permit banks and their affiliates (for convenience, “banks”) to sponsor credit funds, whose primary assets are loans and other debt instruments which the bank could hold directly.  The recent changes (the “Final Rule”) exempt credit funds from the Volcker Rule’s prohibition on sponsoring a covered fund.

The assets of the fund can include interest rate and foreign exchange derivatives, but only if they relate by their terms to the loans and other assets of the fund, and reduce the interest rate and foreign exchange risks of those assets.  Other derivatives, including commodity forward contracts, are prohibited.

The fund can own equity securities only if they are securities which the bank could hold directly and are received on customary terms in connection with loan transactions.  Examples might include a warrant that the fund receives as an equity kicker in a loan transaction, and which regulators expect will not exceed five percent of the value of the fund’s total investment in the borrower (or affiliated borrowers) at the time the loan is made.  Another example would be securities received to limit the fund’s losses on a troubled loan. 

The fund cannot engage in proprietary trading, as defined in the Volcker Rule, and cannot issue asset-backed securities.

The bank can acquire an ownership interest in the fund, but must treat the fund as an affiliate for purposes of the limitations on affiliate transactions imposed by sections 23A and 23B of the Federal Reserve Act.  This means, for example, that the bank may not be able to buy interests in the funds for its fiduciary accounts, or buy interests in the fund during an underwriting if an affiliate is a principal underwriter.

The bank cannot guarantee the obligations or performance of the fund or any borrower or other entity who receives a loan or other investment from the fund; must ensure that the fund complies with the safety and soundness standards that are applicable to the bank; and must disclose to investors (i) that losses will be borne solely by the investors, (ii) that the investor should read the fund documents before investing, (iii) that such investments are not insured by the FDIC and are not deposits, obligations of, or endorsed or guaranteed in any way by any banking entity, and (iv) the role of the bank and its affiliates and employees in sponsoring or providing services to the fund.

None of the activities of the fund can expose the bank to a high-risk asset or a high-risk trading strategy, a threat to the safety and soundness of the bank, or a material conflict of interest.  Conflicts of interest can be mitigated by disclosure or information barriers, but such steps are unlikely to be persuasive when viewed with 20-20 hindsight in a trouble situation.

Done right, credit funds can generate income from loan originations without increasing the size of the balance sheet.  Done wrong, banks could experience the kind of regulatory and financial problems that were encountered by some of the banks which sponsored real estate investment trusts in the 1970s.