SRC Insights: Second Quarter 2002

Proposed Regulation W: New Guidance on Affiliate Transactions

by William L. Gaunt, Assistant Vice President

In May 2001, the Board of Governors of the Federal Reserve System (the Board) announced three actions designed to strengthen and simplify regulation of banks' transactions with their affiliates. First, the Board proposed and asked for comment on new Regulation W to implement sections 23A and 23B of the Federal Reserve Act. Section 23A restricts loans by a bank to an affiliate and asset purchases by a bank from an affiliate. Section 23B requires that transactions between a bank and its affiliates be on market terms.

In its second action, the Board issued interim final rules, which became effective January 1, 2002, that place restrictions on inter-affiliate derivative transactions and intraday extensions of credit between banks and their affiliates. The comment period on both of these actions closed on August 15, 2001.

In the third action, the Board issued final rules granting several exemptions from sections 23A and 23B relating to loans and to purchases of assets.

The final Regulation W is not expected before mid-2002 at the earliest because of the large number of comments received and the complexity of the issues. Until Regulation W is finalized, all previously issued valid Board interpretations and staff opinions regarding sections 23A and 23B, together with the interim final rules on derivative transactions and intraday credit, will remain in full force and effect.

This article points the reader to some of the larger issues posed by the new affiliate transaction rules, provides a timetable for implementation of the new regulations and guides the reader to where the regulations and related information can be found.

New Regulation W - Why is it Needed?
Sections 23A and 23B of the Federal Reserve Act are key statutory protections against a bank incurring losses from its transactions with its affiliates. In effect, sections 23A and 23B restrict the ability of a bank to transfer to its affiliates the subsidy stemming from the bank's access to federal deposit insurance.

The adoption of a comprehensive, unified regulation implementing sections 23A and 23B is appropriate for several reasons. The new regulatory framework established by the Gramm-Leach-Bliley Act (the GLB Act) emphasizes the need for sections 23A and 23B to isolate banks from potential losses incurred by the newly permitted affiliates under the GLB Act. Also, the adoption of a comprehensive, unified regulation would simplify the interpretation and application of sections 23A and 23B, ensure that the statute is consistently interpreted and applied, and minimize burden to the extent consistent with the statute's goals.

Key Elements of Proposed Regulation W
Regulation W would replace the existing framework of Federal Reserve interpretations and informal staff guidance with an organized, category by category approach to sections 23A and 23B. It would consolidate the numerous findings by the Board that deal with how sections 23A and 23B apply to bank transactions and also make various changes to the existing rules. Certain of these changes are required by the GLB Act while others reflect an updated look at affiliate transactions including several proposed exemptions for specified transactions.

Some key issues addressed in proposed Regulation W are:

credit exposure on intraday credit extensions by banks to their affiliates;
credit exposure on derivative transactions between banks and their affiliates;
new exemptions;
treatment of financial subsidiaries;
the so called "250.250" exemption permitting a bank to purchase loans from an affiliate;
valuation of a bank's investments in and acquisitions of affiliates;
collateralization of a bank's investment in debt securities (including commercial paper) of an affiliate; and
application of sections 23A and 23B to U.S. branches and agencies of foreign banks.

Due to the broad scope of the proposed changes, as illustrated by the 120-page proposal and request for comment, this article will address only the first four issues in the above list.

Interim Final Rules on Intraday Credit and Derivatives
On January 1 of this year, in an action related to the issuance of proposed Regulation W, "interim final" rules required by the GLB Act became effective. These rules place restrictions on inter-affiliate derivative transactions and regulate intraday extensions of credit between banks and their affiliates. The designation "interim final" for the rules covering derivatives and intraday credit transactions stems from the fact that the rules became effective January 1, 2002 and will remain in place until further notice from the Board. In all likelihood, the rules will be adjusted in the future to reflect the comments solicited from the banking community, hence the "interim" designation. After the Board has considered the comments on the regulation and declares the final regulation effective, the derivative and intraday credit rules will become a part of Regulation W to create a single comprehensive regulation.

Intraday Credit. The interim final rules require that the bank have established policies and procedures for intraday credit. At a minimum, the bank must monitor and control its intraday credit exposure to each affiliate and all affiliates in the aggregate and ensure that extensions of intraday credit comply with section 23B (e.g., ensure that the risk management process for intraday credit is no less rigorous than the process that the bank employs for such transactions with third parties). These policies and procedures must be in place by January 1, 2002 for the exemption to apply.

Proposed Regulation W further provides that an intraday extension of credit is not subject to the quantitative limits or collateral requirements of section 23A if the credit extension arises in connection with the performance by a bank, in the ordinary course of business, of securities clearing and settlement transactions or payment transactions (for example, wire transfers, check clearing, and ACH transactions) on behalf of an affiliate. In other words, the intraday credit must not be intended to fund the affiliate, and the bank must have no reason to believe that the affiliate will have difficulty repaying the extension of credit in the ordinary course of business.

Finally, all intraday credit extensions that exist at the end of the bank's business day in the United States would become subject to section 23A at that time since they are no longer intraday extensions of credit but become overnight extensions of credit.

Derivative Transactions with Affiliates. Determining the appropriate treatment for derivative transactions under section 23A is a complex endeavor. Accordingly, the Board's interim final rule addressed only those provisions required to be implemented under the GLB Act, while the Regulation W proposal included requests for comment on a number of major issues related to derivative transactions. The interim final rules require that institutions adopt policies and procedures to monitor, manage and control credit exposures resulting from derivative transactions with their affiliates. At a minimum, the policies and procedures must provide for monitoring and controlling the credit exposure arising from the bank's derivative transactions with each affiliate and all affiliates in the aggregate and ensure that the bank's derivative transactions with affiliates comply with section 23B.

Final Rules on Exemptions from Section 23A
In its third action dealing with affiliate transactions, the Board issued final rules effective June 11, 2001 that provide for three exemptions from section 23A. The first of these exemptions exempts from section 23A's "attribution rule" loan proceeds used by unaffiliated bank customers to purchase securities or other assets from or through an affiliate of the bank. The Board has confirmed that section 23A does not apply to extensions of credit by a depository institution to customers that use the loan proceeds to purchase a security or other asset through an affiliate of the depository institution, so long as the affiliate is acting exclusively in an agency or brokerage capacity, and the affiliate retains no portion of the loan proceeds. The Board has also specifically exempted from section 23A that portion of the loan that the affiliate might retain as a market-rate brokerage commission or agency fee for processing the transaction.

A similar exemption applies to extensions of credit by a depository institution to a nonaffiliate to enable the nonaffiliate to purchase securities through a registered broker-dealer affiliate of the institution that is acting exclusively as riskless principal in the securities transaction.

The second exemption exempts from the "attribution rule" extensions of credit by a bank to an unaffiliated customer who uses the proceeds to purchase securities from the inventory of a broker-dealer affiliate of the bank if the loan is made pursuant to a preexisting line of credit not entered into in contemplation of the purchase of securities from the affiliate.

The Board also released an interpretation that expands an insured depository institution's ability to purchase from an affiliated, registered broker-dealer securities that have a ready market and prices that can be verified from a reliable independent source. This exemption was first proposed in 1998, and the final exemption reflects the industry comments on the original proposal. For a securities purchase to be exempt from section 23A, several conditions must be met. Among other conditions, the security must (i) have a "ready market"; (ii) be eligible for a State member bank to purchase directly; (iii) not be a low-quality asset; (iv) not be purchased during an underwriting or within 30 days of an underwriting if an affiliate is an underwriter of the security, unless the security is an obligations of or fully guaranteed by the United States or its agencies; (v) have a price quoted routinely on an unaffiliated electronic service that provides indicative data from real-time financial networks; and (vi) not be issued by an affiliate (with certain exceptions). In addition, the price paid by the insured depository institution should be at or below the current market quotation for the security and the size of the transaction should not be so large as to cast material doubt on the appropriateness of relying on the current market quotation for the security.

Treatment of Financial Subsidiaries
With respect to a bank, the old definition of "affiliate" in sections 23A and 23B specifically did not apply to a company that is a subsidiary of the bank, with certain exceptions. This definition was consistent with the scope of activities of bank subsidiaries, which historically were permitted to engage only in activities that the parent bank could conduct. Today, some subsidiaries of banks engage in activities impermissible for the banks themselves and, with the passage of the GLB Act, financial subsidiaries have an even broader array of powers beyond permissible banking activities. Accordingly, the GLB Act also amended the Federal Reserve Act so that sections 23A and 23B would apply to transactions between a bank and its so-called financial subsidiaries.

Under the GLB Act and under proposed Regulation W, a financial subsidiary of a bank is considered an "affiliate" of the bank for purposes of sections 23A and 23B and, with certain limited exceptions, any covered transactions between a bank and its financial subsidiaries must comply with the same quantitative, collateral, and other restrictions imposed by sections 23A and 23B on other affiliates. The GLB Act also establishes other special rules for financial subsidiaries, which are described in more detail in the proposed Regulation W.

However, in passing the GLB Act, Congress recognized that banks need to have some flexibility in conducting transactions with subsidiaries. Therefore, the GLB Act provided that the 10 percent restriction on covered transactions with any individual affiliate does not apply to transactions between a bank and any of its individual financial subsidiaries. However, the aggregate amount of the bank's covered transactions with all affiliates, including its transactions with its financial subsidiaries, would be subject to the aggregate 20 percent threshold.

Conclusion
This article only touches upon some of the many issues that are presented by proposed Regulation W and the related rulemaking for affiliate transactions. All of the rules were published in the Federal Register on May 11, 2001 and can be found on the Board's website External Link .

It is likely that the final Regulation W will change from its proposed form as a result of the numerous comments received by the Board from the banking industry. Bankers and their advisors should be prepared to adjust to the requirements of Regulation W once it is issued in final form.

In the interim, depository institutions should direct any questions on the application of sections 23A and 23B and the final interim rules to their primary federal banking regulator. Institutions supervised by the Federal Reserve Bank of Philadelphia should direct questions to the examiner-in-charge of an ongoing supervisory event, the institution's central point of contact at the Reserve Bank, or an officer or manager in Community, Regional, and Global Supervision.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

SRC Insights: Second Quarter 2002

Proposed Regulation W: New Guidance on Affiliate Transactions

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