Fed Gives Deutsche Bank, UBS Five-Year Breather On Illiquid Fund Volcker Compliance

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Deutsche Bank (NYSE:DB), UBS (NYSE:UBS) and Silicon Valley Bank (SVB) now have five more years to dispose of their illiquid fund investments, after the Federal Reserve formally granted these banks an extension under Volcker Rule provisions. Under the Volcker Rule, U.S.-based banks and domestic arms of all foreign banks are prohibited from investing more than 3% of their own cash in hedge funds and private-equity funds past a deadline of July 2017. While most banks have been able to slash their stakes in relevant funds in a timely manner to comply with the requirement, a chunk of investments locked up in illiquid funds poses a problem to total compliance. This is because unwinding these funds quickly would trigger losses for the banks, and in many cases a timely stake sale is also not possible due to lock-in period requirements.

The Fed’s extension will let Deutsche Bank, UBS and SVB reduced their stake in these illiquid funds in an orderly manner. Notably, the regulator granted similar leeway to Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) last December. 

See the full Trefis analysis for Goldman Sachs |  Morgan StanleyJPMorganCitigroup | Bank of America

In the aftermath of the economic downturn of 2008, the U.S. sought to reform the excessive risk-taking attitude of the country’s banking sector by implementing the Dodd–Frank Wall Street Reform and Consumer Protection Act. One of the key rules adopted under the Act, which went into effect in early 2014, was the Volcker Rule, which spelled out the restrictions on all speculative investments by banks that do not directly benefit consumers. The Volcker Rule restricts banks from indulging in proprietary trading activities, limits the amount of its own cash that a bank can invest in private-equity funds or hedge funds to 3%, and also imposed limits on the liabilities that can be held by the largest U.S. banks as well as the U.S.-based operations of foreign banking giants.

Over the years, all banks in the U.S. – especially the largest ones with significant investment banking operations – worked towards compliance with the Volcker Rule by shuttering their proprietary trading units and slashing their investments in relevant funds. The largest banks, however, ran into a problem with their investments in illiquid funds that come under the purview of the Volcker Rule. As a bulk of the investments in these funds had been negatively impacted by lower valuations since the downturn, reducing their stake would result in losses for the banks. And even if the investments had improved in value, the illiquid nature of these funds would result in sizable mark-downs if the banks attempted to sell them quickly in order to meet the July 2017 deadline.

While UBS and Deutsche Bank do not disclose their total outstanding investments in applicable illiquid U.S. funds, we believe that the figure is likely around a few hundred million dollars for each of them. The Fed’s acceptance of the request for illiquid funds means that the banks can pace their divestment over the next five years – until July 2022. As a result, investment revenues for these banks will not be hurt by losses which would have accompanied expedited sales. In fact, the overall improvement in market conditions should help revenues from these investments rise steadily until the banks dispose of them, and the banks will likely book sizable profits from these investments over coming years.

We include these investments for Deutsche Bank in our analysis as a part of the bank’s ‘Loan Products and Other Revenues’ for the investment banking division. Higher realized gains on the sale of these investments will boost these revenues – the impact of which on the bank’s share price estimate can be understood by modifying the chart below.

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