MBA Advocates Volcker Rule Changes to Improve CMBS Market Making

Certain changes to the Volcker Rule would better accomplish the rule’s public policy purposes–and protect a foundational element of commercial mortgage-backed securities liquidity–the Mortgage Bankers Association said in a letter to the Office of the Comptroller of the Currency.

The OCC has said the Volcker Rule was intended to promote the safety and soundness of banking entities by minimizing bank exposure to activities that could involve undue risk, but it acknowledged the final rule should be improved “both in design and application.”

In June a Treasury Department report found weaknesses in the Volcker Rule and its administration. It concluded the Volcker Rule “far overshot its mark” and said the rule spawned a “complex and burdensome” compliance regime. “Most important[ly], the rule has hindered both market making functions necessary to ensure a healthy level of market liquidity and hedging necessary to mitigate risk,” the Treasury Department report said.

The MBA letter called commercial mortgage-backed securities an important source of capital to support the infrastructure of multifamily housing, office buildings, retail stores and other commercial real estate.

“As securitized instruments, CMBS are more liquid than whole loans, which makes them attractive to many investors,” MBA President and CEO David Stevens, CMB, said. “Liquidity also facilitates the efficient transfer of risk, enabling CMBS investors to align their holdings with their respective risk appetites in changing risk environments.” 

Stevens noted a “foundational” element of CMBS liquidity is market making. “Market makers stand ready to buy and sell CMBS, providing liquidity even when there is not–at that time–a corresponding buyer or seller in the marketplace to take the other side of the transaction,” the letter said. “MBA is therefore concerned about the adverse impacts the Volcker Rule may have on banks’ market making activities, the corresponding impediment to CMBS liquidity and the resulting adverse impacts to commercial real estate financing.”

There is ample anecdotal evidence that the Volcker Rule has had significant adverse impacts on CMBS market making, MBA said. “For example, based on conversations with MBA bank members, we understand that banks have curtailed market-making activity,” the letter noted. “They report reducing the amount of balance sheet devoted to market making, resulting in a corresponding reduction in inventory of CMBS available for market making.”

Banks made these changes to manage their Volcker Rule compliance risk and to mitigate otherwise the impacts of uncertainty around Volcker Rule compliance, MBA noted. “Institutions’ extremely low tolerance for Volcker Rule compliance risk, together with an extremely high level of uncertainty as to what will be viewed as a violation, can naturally lead to a shrinking of the ability to make markets,” the letter said.

In addition, less market making activity and less inventory available for market making translates into less ability to absorb market flows, the letter said. This impairs CMBS liquidity, increases the risk of CMBS market volatility in a market downturn and has adverse effects on market flow.

“The Treasury Department has specifically identified problems with the design of the Volcker Rule, and the OCC acknowledges there is broad recognition that the design of the Volcker Rule should be improved. We agree,” the letter said. “We believe weakness in the current rule’s design is a key contributor to the potential adverse impacts described above–and that it also helps explain the difficulty regulators have had interpreting and applying the rule consistently.”

The Treasury Report said regulators’ existing approach to coordination has not worked and banks have had difficulty obtaining clear, consistent guidance as a result. “This is consistent with the experience of many MBA members,” the letter said. “For example, in some cases, we understand that one agency has found fault with activities and program elements that another agency had praised. As a result, our members find themselves exposed to substantial compliance risk without definitive guidance they can rely on to manage that risk. This outcome may stem, at least in part, from the design of the rule.”

Both market participants and regulators suffer because of this flawed design, MBA noted. “While there may be value in treating the symptoms by improving cross-agency coordination, we believe it is critical that the agencies address the underlying design root cause,” the letter said. “To do so, we recommend that the agencies shift the design of the rule in the direction of a principles-based regulation, for example, by providing banks additional flexibility and discretion, and substituting supervisory oversight and iterative processes for prescriptive restrictions and negative presumptions.”

At the same time, it may be appropriate to retain some bright lines, for example, to delineate institutions or activities that clearly are exempt from the rule’s provisions, or to specify other easing of the restrictions of the rule, the letter said.

“An indicator of design success would be that the agencies would be able to administer the rule with a high degree of consistency,” Stevens said. “Of course, the design choices should also support a rule that fulfills its purposes without undue adverse impacts, including adverse impacts on CMBS liquidity and markets.”