cdos

Regulators cave quickly in first Volcker Rule battle

January 6, 2014: 1:19 PM ET

A rule meant to limit bank trading would have also banned a risky complicated type of debt. What's so bad about that?

The Federal Reserve are among the regulators who decided to roll back a provision of the Volcker Rule.

The Federal Reserve, along with other regulators, is close to rolling back a provision of the Volcker Rule that banks didn't like.

FORTUNE -- Round one goes to the banks.

Later this week, regulators are expected to finalize a rule that will allow banks to continue to hold a complicated, risky structured bond that was set to be banned by the Volcker Rule.

The fight started a few weeks ago from an unlikely source. In mid-December, Salt Lake City-based Zions Bancorp said it was being forced to take a $387 million loss, more than the bank had earned in any single year since 2007. The reason: Volcker.

MORE: Sloan on Volcker: Complexity trumps common sense

A few years ago, Zions had bought a type of collateralized debt obligation that was backed by trust preferred securities (TruPs), which are a type of debt that are issued by banks and insurance companies. Volcker classifies TruPs-backed CDOs as hedge funds, which are banned under the rule.

Zions had lost a bunch of money on the investment, but it had never told its investors that. Accounting rules allow banks to delay recognizing losses on investments they promise to hold to maturity. Now that TruPs CDOs were set to be banned under Volcker, Zions could no longer promise they would be held until they were paid back, forcing the bank to take the loss that was there all along.

Bankers, nonetheless, cried foul. In late December, the American Banking Association sued to halt the Volcker Rule from going into effect, saying it was unfairly punishing Zions and hundreds of other small banks that had bought TruPs CDOs. Almost immediately, regulators announced they were reviewing TruPs and the Volcker Rule. And now it looks likely regulators will exempt the securities.

The retreat from regulators is understandable. The purpose of the Volcker Rule was to deter banks from making risky trades with their own money. TruPs CDOs are not actually hedge funds, or a proprietary trade. As Zions said, it planned to hold the CDOs to maturity, and that makes them more like many other bonds that banks buy and are still allowed to hold under Volcker. And they are largely held by small banks, not the large banks that threatened the economy in the financial crisis. So, not the types of things that the Volcker Rule was set up to limit.

MORE: You may be saving too much for retirement

But that doesn't mean banning TruPs CDOs is a bad thing. TruPs are a type of debt that is sold by banks and other financial firms and bought by other banks and financial firms. Didn't the financial crisis teach us that the system was too interconnected? Making it harder for banks to hold TruPs (they can still own them outside of CDOs) would help to limit that interconnectedness.

TruPs CDOs are not as risky as subprime CDOs, which are what caused the biggest losses during the financial crisis. But they are structured bonds. And they are certainly not risk-free. Zions, after all, lost nearly $400 million on them.

The Volcker Rule will deliver unintended consequences. Not all of those will be bad, though. Opportunity missed.

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