WASHINGTON — Federal regulators’ joint proposed Volcker Rule would bifurcate the municipal bond market, increase costs to issuers, reduce investor liquidity, and create new business challenges for firms, two broker-dealer groups are telling House panels in written testimony.
The Volcker Rule, mandated by the Dodd-Frank Act, would prohibit banks from trading on a proprietary basis and restrict their investments in hedge funds and private equity.
The Securities and Exchange Commission and banking regulators released a joint proposal in November for implementing the rule. They asked for public input on more than 1,000 questions and directed comments to be submitted by Feb. 13. The proposed rule would take effect on July 21, but banks would have a two-year period in which to modify their activities and investments to conform to it.
The joint proposal would exempt from the Volcker Rule state and local obligations and market making.
However, the Bond Dealers of America warned members of the House Financial Services Committee’s panels on capital markets and on financial institutions in its written testimony that the rule “is too narrow, complex and ultimately unworkable for the exceptions to be meaningful.”
Both the BDA and the Securities and Industry Financial Markets Association said the proposed rule would bifurcate the muni market because the only bonds that would be exempted would be those issued by states, counties, cities and other units of general government.
Bonds issued by turnpike authorities, water and sewer districts, school districts and housing authorities would not be exempt.
“These latter bonds would face a much diminished market as bank-affiliated broker dealers would not be able to purchase them or sell them from their inventory,” BDA wrote in testimony it planned to submit to the panels.
As a result, issuers of these bonds would facer higher costs because there would be fewer investors and investors would demand higher returns to compensate for lower liquidity, it said.
SIFMA executive vice president Ken Bentsen, agreed. “We’re concerned that the regulators might be taking too narrow a view with respect to the muni exemption,” he said in an interview Tuesday.
The rule he said would result in “very much a bifurcated market with no apparent gain to safety and soundness.”
Bentsen warned compliance with the rule would be inconsistent from state to state because of the different definitions of state entities as opposed to state agents. “Some states treat conduit issuers differently than other states,” he said.
“We believe that the proposed rule should be amended to allow all state and local government bonds, including those of agencies and instrumentalities to be exempt from the Volcker Rule,” BDA wrote.
Both groups also are concerned that, under the joint proposed rule, tender option bonds would be included in the definition of a “covered fund” like a hedge fund.
TOBs are common investment vehicles in the municipal market that allow state and local governments to issue debt at reasonable interest rates. A bond is deposited in a trust and provides the underlying credit for variable rate bonds that are sold to investors. Investors can, at specified intervals, put or tender the bonds. But because the trusts that hold the underlying bonds would be considered covered funds under the joint proposal, banks could no longer set up trusts and would have to divest themselves of their existing interests, according to the two groups.
“Because the underlying asset in the trust is a state or local bond, we believe that the TOB arrangement should be exempted from the definition of covered fund,” BDA said. “TOB arrangements are transparent, the trusts generally have bonds of a single issuer and there is no 'tranching.’”
“We believe tender option bonds can and should be treated as municipal securities,” said Bentsen.
Bentsen also warned the joint proposal would not exempt interest rate swaps.
“If you end up with too onerous a rule in terms of compliance and enforcement requirements, it could cause firms to pull back from the swaps market and that would just remove capacity of an important risk management tool that issuers use,” he said.
In addition, the market making exemption will be virtually useless because the term has not been defined for fixed-income securities, BDA wrote, noting it has asked the SEC for such a definition to no avail.
“Moreover, the seven criteria in the proposed rule are very complicated and rely heavily on commentary in appendices,” BDA wrote.” A firm simply will not know with certainty when it engages in a trade where a regulator will, at some later point in time, judge whether or not the trade met the seven criteria and the commentary in the appendices. Consequently, firms will err on the side of caution and liquidity will be lost.”
