May 5, 2014
Collateralized Loan Obligations (CLOs), Structure, Use, and
Implementation of the Volcker Rule
A collateralized loan obligation (CLO) is one way to fund
debt through a trust that issues securities. Recent
rulemaking to implement Section 619 (the Volcker Rule) of
the Dodd-Frank Act focused attention on bank participation
in CLOs. This article provides a general overview of the
CLO structure; with a particular focus on CLOs that have
been used by banks to fund commercial debt, and discusses
regulatory policies of CLOs in relation to the Volcker Rule.
Some policymakers are concerned that the December 2013
final regulation for the Volcker Rule may create unintended
hardship for banks that own interests in CLOs originated
prior to the issuance of the rule. There is proposed
legislation (H.R. 4167) designed to address these concerns.
General Definition and Structure of a CLO
CLOs are a subset of the more general category of
collateralized debt obligations (CDOs). In a CDO, a trust is
formed to hold debt. The debt might be loans or bonds, and
thus there are CLOs for loans and CBOs for bonds. The
difference between a CLO and a CBO is that bonds are
generally more easily transferrable than loans because
bonds are designed to be marketable securities whereas
most loans are not. However, there can be robust secondary
markets for some forms of loans, such as mortgages,
although the liquidity of such secondary markets is
sensitive to market conditions. A second potential
difference between CLOs and CBOs is that several banks
may use the CLO structure to coordinate combined lending
to a single borrower (such as loan participations or loan
syndicates), which can complicate the transfer of loans to
the trust or the decoupling of the loan from the lender.
Because of this potential coordinating role, CLOs are often
associated with commercial lending.
CDOs can be funded by issuing obligations (securities) that
are collateralized by the debts (loans or bonds) held in the
trust. This is the basic structure of many classes of
securities, including such CLOs as asset-backed securities
(ABS), mortgage-backed securities (MBS), student loan
asset-backed securities (SLABS), and commercial
mortgage-backed securities (CMBS). For more
information, see CRS Report R43345, Shadow Banking:
Background and Policy Issues, by Edward V. Murphy.
Although lenders might use the trust structure to fund loans
by selling securities to third parties through securities
markets, the structure can also be used to coordinate loans
among several lenders that then buy back some or all of the
securities from the transaction.
Types of CLOs of Immediate Concern
Although the term CLO is a broad term that includes many
kinds of asset-backed securities, the current policy
discussion is focused on a narrower class. Banking
regulation in the United States had historically limited the
geographic reach of depository banks, and thus the trust
structure has been a common structure to coordinate
commercial lending in a growing economy and to facilitate
the use of securities markets to supplement depository
lending. The next two sections will illustrate these two (of
many) uses of collateralized lending.
First, the use of the trust structure as a bank coordinating
mechanism can be illustrated with a hypothetical example.
A regional business, such as a food truck, might have a line
of credit and other relationships with a regional bank. As
the business grows, it may desire to expand to additional
cities not served by its current lender. A regional bank
might offer to coordinate with other regional banks, rather
than surrender the food truck company to a larger bank.
One convenient coordinating device for such a loan
package is a trust, in which the loans from various banks
are pooled, yet the banks themselves retain much of the
interest in the loan pool by retaining most of the securities
issued by the trust. Technically, such securities would be
obligations of the trust collateralized by the loans held by
the trust (CLO). The food truck example is a caricature, but
it is a useful reminder that the trust structure is neither
particularly innovative, nor the exclusive territory of the
Second, the CLO structure can be used to allow securities
markets to supplement bank lending (so-called leveraged
loans). A lead bank can form a trust to pool loans. The
trust can issue debt and equity securities (obligations) to
fund the loans, which are collateralized by the loans in the
pool (CLO). In some areas of finance, the term CLO is
industry jargon for business loans funded in this fashion.
Banks might retain some of the interest in the loans, but
mutual funds, hedge funds, insurance companies, and other
investors may also participate. Figure 1 shows recent
trends in the share of CLOs as investors in commercial
loans. 1 Other investor groups include mutual funds, hedge
funds, insurance companies, and other investors.
See page 6 of “Risk Retention for CLOs,” November 2013, by Oliver
Wyman, available at
www.crs.gov | 7-5700
Collateralized Loan Obligations (CLOs), Structure, Use, and Implementation of the Volcker Rule
Banks retain interest in the CLO arrangement in both the
food truck example and in the leveraged lending example.
However, if the trusts that are used as coordinating devices
for CLOs are considered risky investment funds, then banks
may have to divest themselves of such assets because of the
Figure 1: Share of CLOs as Investors in Leveraged
The Volcker Rule and CLOs
In addition to prohibiting proprietary trading by banking
organizations, the Volcker Rule also prohibits certain
relationships between banks and risky investment firms.
Financial regulators issued a final regulation in December
2013 that included definitions for the prohibited business
relationships and for the class of prohibited investment
funds. For more information, see CRS Report R43440, The
Volcker Rule: A Legal Analysis, by David H. Carpenter and
M. Maureen Murphy.
The final Volcker Rule prohibits bank ownership of many
kinds of CLO securities because the trusts in the CLO
structure are defined as prohibited investment funds. The
December 13 rule prohibits bank ownership of obligations
from CLOs if the security includes rights similar to
ownership rights (elements of equity rather than pure debt).
Intended or not, the rule generally requires banks to divest
themselves of CLOs that they used to coordinate
commercial lending with other banks, not just CLOs that
are used to finance third-party lending.
Source: “Risk Retention for CLOs,” November 2013,
by Oliver Wyman, available at
The final Volcker Rule affects current and future CLO
structures. Going forward, banks may be able to construct
CLO structures to comply with the Volcker Rule by not
retaining the kinds of equity interests prohibited by the
December rule. However, the regulation also requires
banks to divest themselves of CLO interests that they
already possess by the conformance date. Banks that have
used the CLO structure as a coordinating device have
argued that they should be exempt from the general CLO
rule, or have their current interests grandfathered, or the
time they have to conform extended.
Active CLO Legislation
There is current legislation, H.R. 4167, to exempt from the
Volcker Rule bank ownership of certain debt interests in
CLOs originated before January 31, 2014. The bill defines
a CLO as an asset-backed security secured primarily by
commercial loans. The bill states that participation in
removal of the trustee for cause cannot be the lone indicator
of ownership interest to designate a security as an
ownership interest rather than debt. The bill effectively
would extend the conformance period of many existing
CLO structures. H.R. 4167 passed the House but has not
been acted upon by the Senate.
For more information, see CRS Report R43440, The
Volcker Rule: A Legal Analysis, by David H. Carpenter and
M. Maureen Murphy , CRS Report R43345, Shadow
Banking: Background and Policy Issues, by Edward V.
Edward V. Murphy, firstname.lastname@example.org, 7-6201
www.crs.gov | 7-5700