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Even before being implemented, a particular provision of the Volcker Rule is being challenged in the court. The American Bankers Association (ABA) has filed a lawsuit in the U.S. Court of Appeals for the District of Columbia Circuit over a provision that requires banks to sell their holdings in certain collateralized debt obligations (CDOs).

The ABA, which represents U.S. banks of all sizes and charters, stated that divesting these CDOs backed by trust-preferred securities will entail losses of approximately $600 million for the small community banks. Hence, the ABA seeks to block the provision before it impacts the banks’ capital position at the end of 2013.

While filing the lawsuit, the ABA stated that the regulators did not properly analyze the economic cost of this provision on small community banks and the impact of this decision on the banks’ capital levels. Further, the lawsuit alleges that the final version of the Volcker Rule approved by the regulators on Dec 10 was vastly different from the initial version on which public comments were invited.

The Volcker Rule was devised to prevent banks from owning more than 3% of any individual hedge fund or private equity fund. Further, it restricts banks from investing more than 3% of their total equity capital in private funds.

Though the banks have time till Jul 21, 2015 to divest CDOs, the way these will be recorded in the balance sheet needs to be changed by the end of fourth-quarter 2013. The banks will have to convert CDOs from “Held to Maturity” to “Available for Sale”, thereby leading to a one-time charge as well as an adverse impact on the capital ratios.

Consequently, many banks have announced their plans to abide by the provision. BankUnited Inc. (BKU - Analyst Report) plans to sell certain securities, while Zions Bancorp. (ZION - Analyst Report) and MBT Financial Corp. anticipate one-time write-down in the current quarter.

Prohibition of propriety trading through the implementation of the Volcker Rule will likely lead to further slowdown of top-line growth in many banks. With the ABA challenging the provision of Volcker Rule, major Wall Street banks including JPMorgan Chase & Co. (JPM - Analyst Report), Bank of America Corporation (BAC - Analyst Report) and The Goldman Sachs Group, Inc. (GS - Analyst Report) might follow suit.

Though Volcker Rule will hurt earnings as well as shareholders’ returns in the short term, from a broad perspective, it will enhance investors’ security and drive the economy toward sustainable growth.

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