Originally published February 1, 2005
Securitization structures typically involve transfers of assets between a bank and its subsidiaries and may also involve other transactions with entities that control the bank or are under common control with the bank. Consequently, in structuring a transaction or investing in asset-backed securities it is important to consider the applicability of Sections 23A and 23B of the Federal Reserve Act, as amended by the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 and regulations promulgated thereunder.1 Taken together, the purpose of these provisions is to limit risks the banking system that may arise through transactions between a bank and its affiliates and to limit the ability of a bank to transfer to its non-bank affiliates the subsidy arising from the bank’s access to the discount window and the federal regulatory safety net. Generally speaking, these provisions limit a bank’s ability to support its affiliates but not the ability of a bank to receive support from its affiliates.2
Section 23A of the Federal Reserve Act regulates affiliate transactions in three major ways. First, the statute limits the aggregate amount of an insured depository institution’s "covered transactions" with any single affiliate (other than a financial subsidiary of the institution) to no more than 10% of the institution’s capital and surplus and limits the aggregate amount of covered transactions with all affiliates to no more than 20% of the institution’s capital and surplus.3 Second, it requires that all covered transactions between a member bank and any of its affiliates be on terms and conditions that are consistent with safe and sound banking practices. Third, it requires that a member bank’s extensions of credit to its affiliates and guarantees issued on behalf of its affiliates be appropriately secured by a statutorily prescribed amount of collateral.4 Section 23B of the Federal Reserve Act provides that "covered transactions" and certain other transactions between a bank and its "affiliates" must be on the terms and under circumstances, including credit standards, that are substantially the same as, or at least as favorable to the bank as, those that the bank would in good faith offer to non-affiliated companies. Through a non-evasion provision, Section 23A covers transactions that do not individually violate the enumerated restrictions but that in the aggregate do so.
Derivative contracts, synthetic loans and synthetic securitizations are not explicitly addressed as "covered transactions" in Section 23A or 23B. However, Federal Reserve Regulation W treats certain credit derivatives as "covered transactions" for purposes of Section 23A of the Federal Reserve Act and also requires that derivative transactions between banks and their affiliates (other than depository institutions) be subject to the requirements of Section 23B of the Federal Reserve Act that transactions with affiliates be on market terms.5 For purposes of Regulation W, derivatives are defined by reference to the capital guidelines of the federal banking regulatory agencies contained at 12 C.F.R. Part 225, App.III.E.l.a – d.6
Regulation W requires banks to establish and maintain policies and procedures that are reasonably designed to manage the credit exposure arising from their derivative transactions with their affiliates and also requires banks to impose credit limits on their derivative exposure to affiliates that are at least as strict as the credit limits that they impose on unaffiliated companies that are engaged in similar businesses and are substantially equivalent in size and credit quality as the affiliated counterparties."7 Such policies and procedures must at a minimum provide for monitoring and controlling the credit exposure arising from the bank’s derivative transactions with each of its affiliates and with all of its affiliates in the aggregate (including by imposing appropriate credit limits, mark-to-market requirements and collateral requirements) and ensuring that the bank’s derivative transactions with affiliates comply with Section 23B of the Federal Reserve Act.8 In the adopting release for Regulation W the Federal Reserve has stated that it views market terms for derivatives among major financial institutions as requiring daily marks to market and two-way collateralization above a relatively small exposure threshold.9
Regulation W also treats as "covered transactions" credit derivatives that are the functional equivalent of a bank’s guarantee of an affiliate’s obligations.10 Such derivatives include credit default swaps between a bank and a non-affiliate that protect against defaults on reference assets that include obligations of an affiliate. They also include total return swaps in which a nonaffiliated counterparty receives payments based on the total return of an obligation of an affiliate of the bank.11 Regulation W does not specify the basis for calculating the covered amount of derivative transactions for purposes of determining compliance with the concentration limits and the collateralization requirements of Section 23A, but the Federal Reserve has stated that it would generally expect the covered transaction amount for a credit derivative to be the notional principal amount of the derivative.12 It also does not address the pro-rationing of exposure to an affiliate’s obligations where such obligations represent only a portion of the pool of reference assets with respect to which credit protection is being provided or the use of hedging transactions with third parties to allow a bank to reduce the amount of covered transactions implicated by its use of credit derivatives. In addition, Regulation W does not provide an exception for credit derivatives in which affiliate obligations represent a small portion of the underlying reference assets. However, the Federal Reserve has stated in the adopting release that it intends to interpret Regulation W in such a way as to treat a credit derivative as a covered transaction only to the extent that the derivative provides credit protection with respect to obligations of an affiliate of the bank.13
The Federal Reserve has stated that it expects to issue a proposed rule that would invite public comment on how to treat as "covered transactions" under Section 23A of the Federal Reserve Act certain derivative transactions that are the functional equivalent of a loan by a bank to an affiliate or the functional equivalent of an asset purchase by a bank from an affiliate.14 This rulemaking action does not appear to have taken place, but the bank regulatory agencies appear to have adopted positions to address concrete, circumstances for example. However, the general instructions to Form FR Y-8 state that a credit exposure arising from a derivative transaction between an insured depository institution and an affiliate is not subject to the quantitative limits and collateral requirements of Section 23A, but that a credit derivative between an insured depository institution and a nonaffiliate in which the insured depository institution protects the nonaffiliate from a default on or decline in value of an obligation of an affiliate of the insured depository institution is covered under Section 23A as a guarantee by the insured depository institution on behalf of an affiliate.15
Endnotes
*Mr. Nolan is a Partner of Goodwin Procter LLP, resident in New York City.
1 12 U.S.C. §§ 371c, 371c-1. These provisions have been made generally applicable to savings associations (with some additional limitations) through the Home Owners Loan Act, 12 U.S.C. § 1468(A)(l). They are also applicable to non-member insured banks pursuant to Section 18(j)(l) of the FDI Act, 12 U.S.C. § 1828(1)(1). The OTS previously adopted a regulation, codified at 12 C.F.R. §563.41, which implements Sections 23A and 23B as they apply to savings associations. The Federal Reserve has recently promulgated Regulation W (discussed below in Section IV.B.), which consolidates the Federal Reserve’s positions on a variety of transactions between banks and their affiliates, including derivatives transactions, intraday extensions of credit by banks to affiliates, the use of bank-issued general purpose credit cards to purchase goods and services from affiliates of a bank and purchases of loans by banks from their affiliates.
2 The prohibition of management interlocks does not prevent officials of a bank from acting as officers of an SPV that has been established in connection with a securitization as it only relates to individuals acting as managers of two or more unaffiliated depository institutions and/or depository institution holding companies. See 12 C.F.R. Part 26, Part 348 & Part 563f.
3 See 12 U.S.C. §371c(a)(1), 37lc(e)(3); 12 C.F.R. § 223.13. Capital and surplus of a member bank consists of Tier 1 capital and Tier 2 capital.
4 See 12 U.S.C. §371c(c).
5 12 C.F. R. §223.33. Although Regulation W does not apply to savings associations, the OTS has promulgated a regulation that incorporates all applicable provision and exceptions prescribed by Regulation W, provides guidance concerning the relationship between Regulation W and certain additional provisions under section 1l(a)(1) of the Home Owners Loan Act and imposes certain restrictions under section 11(a)(4) of the Home Owners Loan Act. 12 C.F.R. part 563.574.
6 12 C.F.R. §223.3(l). These include swaps, forwards, options and other similar contracts on an interest rate, currency, equity or commodity.
7 See 12 C.F.R. § 223.33(a).
8 See 12 C.F.R. § 223.33(b).
9 See "Transactions Between Member Banks and Their Affiliates", 67 Fed. Reg. 75,588 (Dec. 12, 2002). This is consistent with the Federal Reserve’s supervisory guidance. See, e.g., "Application of Market Risk Capital Requirements to Credit Derivatives", SR 97-18 (GEN) (June 13, 1997) (requiring certain banking organizations to measure daily value-at-risk for covered positions located in the trading account and for foreign exchange and for all commodity positions).
10 See "Transactions Between Member Banks and Their Affiliates", 67 Fed. Reg. 75,588 (Dec. 12, 2002). This position is consistent with the Federal Reserve’s earlier position that the use of derivatives in such types of transactions raise important supervisory issues. See "Supervisory Guidance for Credit Derivatives", SR Letter 96-17 (GEN) (Aug. 12, 1996).
11 See 12 C.F.R. § 223.33(c).
12 See "Transactions Between Member Banks and Their Affiliates", 67 Fed. Reg. 75,588 n.143 (Dec. 12, 2002).
13 See "Transactions Between Member Banks and Their Affiliates", 67 Fed. Reg. 75,588 (Dec. 12, 2002).
14 See "Transactions Between Member Banks and Their Affiliates",67 Fed. Reg. 75,588 - 75,889 (Dec. 12, 2002).
15 See "Line Item Instructions for The Bank Holding Company Report of Insured Depository Institutions’ Section 23A Transactions with Affilliates" (form FR Y-8) (June 2003).
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