[Federal Register Volume 63, Number 115 (Tuesday, June 16, 1998)]
[Proposed Rules]
[Pages 32766-32768]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-15934]
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Proposed Rules
Federal Register
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This section of the FEDERAL REGISTER contains notices to the public of
the proposed issuance of rules and regulations. The purpose of these
notices is to give interested persons an opportunity to participate in
the rule making prior to the adoption of the final rules.
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Federal Register / Vol. 63, No. 115 / Tuesday, June 16, 1998 /
Proposed Rules
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FEDERAL RESERVE SYSTEM
12 CFR Part 250
[Miscellaneous Interpretations; Docket R-1016]
Applicability of Section 23A of the Federal Reserve Act to Loans
and Extensions of Credit Made by a Member Bank to a Third Party
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Notice of proposed rulemaking.
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SUMMARY: Section 23A of the Federal Reserve Act restricts the ability
of a member bank to fund its affiliates through direct investments,
loans, or certain other transactions (covered transactions). Section
23A deems transactions between a member bank and a nonaffiliated third
party as covered transactions between the bank and its affiliate to the
extent that proceeds of the transactions are used for the benefit of or
transferred to the affiliate. The Board is proposing to grant two
exemptions from section 23A for certain loans and extensions of credit
made by an insured depository institution to customers that use the
proceeds to purchase certain securities from or through the depository
institution's registered broker-dealer affiliate. The first exemption
would apply when the affiliate is acting solely as a broker or riskless
principal in the securities transaction. The second exemption would
apply when the extension of credit is made pursuant to a pre-existing
line of credit that was not established for the purpose of buying
securities from or through an affiliate. The Board proposes to grant
these exemptions from section 23A to permit customers to gain more
flexible use of the services of insured depository institutions and
their registered broker-dealer affiliates, while still ensuring that
the credit transactions are conducted in a manner that is consistent
with safe and sound banking practices.
DATES: Comments must be submitted on or before July 21, 1998.
ADDRESSES: Comments, which should refer to Docket No. R-1016, may be
mailed to Jennifer J. Johnson, Secretary, Board of Governors of the
Federal Reserve System, 20th Street and Constitution Avenue, N.W.,
Washington, D.C. 20551. Comments addressed to Ms. Johnson also may be
delivered to the Board's mail room between 8:45 a.m. and 5:15 p.m. and
to the security control room outside of those hours. Both the mail room
and the security control room are accessible from the courtyard
entrance on 20th Street between Constitution Avenue and C Street, N.W.
Comments may be inspected in Room MP-500 between 9:00 a.m. and 5:00
p.m. weekdays, except as provided in section 261.12 of the Board's
Rules Regarding Availability of Information.
FOR FURTHER INFORMATION CONTACT: Thomas M. Corsi, Senior Counsel (202/
452-3275), Pamela G. Nardolilli, Senior Counsel (202/452-3289), or
Satish M. Kini, Senior Attorney (202/452-3818), Legal Division; or
Molly S. Wassom, Deputy Associate Director, Banking Supervision and
Regulation (202/452-2305), Board of Governors of the Federal Reserve
System. For the hearing impaired only, Telecommunications Device for
the Deaf (TDD), Diane Jenkins (202/452-3254).
SUPPLEMENTARY INFORMATION:
Background
Restrictions of Section 23A
Section 23A of the Federal Reserve Act, originally enacted as part
of the Banking Act of 1933, is designed to prevent the misuse of a
member bank's resources through ``non-arm's length'' transactions with
its affiliates.\1\ To achieve this purpose, section 23A establishes
both quantitative limits and qualitative restrictions on transactions
by a member bank with its affiliates. The statute places limits on
``covered transactions'' between a member bank and any single affiliate
to no more than 10 percent of the bank's capital and surplus and limits
aggregate covered transactions with all affiliates to no more than 20
percent of the bank's capital and surplus.\2\ Covered transactions
include extensions of credit, investments, and certain other
transactions that expose the member bank to risk. Section 23A also
requires that credit exposures to an affiliate be secured by
collateral, the amount of which is statutorily defined.\3\
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\1\ 12 U.S.C. 371c. Although section 23A originally applied only
to member banks, Congress has since applied the section to insured
nonmember banks and savings associations in the same manner as it
applies to member banks. See 12 U.S.C. 1828(j); 12 U.S.C. 1468.
\2\ ``Capital and surplus'' has been defined by the Board as
tier 1 and tier 2 capital plus the balance of an institution's
allowance for loan and lease losses not included in tier 2 capital.
12 CFR 250.242.
\3\ 12 U.S.C. 371c(c).
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In addition to regulating direct transactions between a bank and
its affiliates, section 23A deems any transaction between a member bank
and any person to be a transaction between a member bank and an
affiliate to the extent that the proceeds of the transaction are ``used
for the benefit of, or transferred to,'' that affiliate.\4\ This
provision of the statute, commonly referred to as the ``attribution
rule,'' is designed to prevent an evasion of the quantitative limits
and collateral requirements of section 23A through the use of a third
party that serves as a conduit for the flow of funds from the bank to
its affiliates.\5\
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\4\ 12 U.S.C. 371c(a)(2). Section 23A defines an affiliate to
include ``any company that controls the member bank and any other
company that is controlled by the company that controls the member
bank.'' 12 U.S.C. 371c(b)(1).
\5\ See A Discussion of Amendments to Section 23A of the Federal
Reserve Act Proposed by the Board of Governors of the Federal
Reserve System 36 n.1 (September 1981) (attached as an appendix to
correspondence from Chairman Paul Volcker to the Chairman and
Ranking Members of the House and Senate Committees on Banking,
Housing and Urban Affairs, October 2, 1981).
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Both the Board and Board staff have taken the position that, by
means of the attribution rule, section 23A applies to loans made by a
bank to a third party, where the proceeds of the loans are used to
purchase various types of assets from the bank's affiliate.\6\ In
transactions in which a bank provides funds to a borrower to finance
the purchase of assets from an affiliate of the bank, the Board and its
staff have been concerned that the affiliate's need for cash or need
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to sell assets may improperly influence the bank's decision to extend
credit.
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\6\ See, e.g., Letter from J. Virgil Mattingly, General Counsel
of the Board, to Ms. Charla Jackson (August 26, 1996) (crop-
production loan to farmer who leases farm land from a bank's
affiliate is covered by section 23A); F.R.R.S. para. 3-1146.5 (bank
loan to finance a prospective purchaser's acquisition of an
affiliate covered by section 23A); F.R.R.S. para. 3-1167.3 (bank
loan to finance the purchase of shares issued by an affiliate deemed
a covered transaction subject to section 23A).
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Section 23A also gives the Board broad authority to grant
exemptions from the statute's restrictions. Specifically, the statute
permits the Board to exempt transactions or relationships, by
regulation or by order, if such exemptions are ``in the public interest
and consistent with the purposes of this section.'' \7\
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\7\ 12 U.S.C. 371c(e)(2).
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Section 20 Operating Standards and Application of Section 23A
In August 1997, the Board revised the prudential limitations
governing the activities of section 20 subsidiaries of bank holding
companies and adopted Operating Standards to replace the existing
firewalls.\8\ One of the firewalls had prohibited a bank holding
company and its subsidiaries (other than the underwriting subsidiary)
from knowingly extending credit to customers to purchase (a) a bank-
ineligible security underwritten by a section 20 subsidiary during the
period of the underwriting or for 30 days thereafter, or (b) a bank-
ineligible security in which the section 20 subsidiary makes a market.
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\8\ See 62 FR 45295, 45307 (1997) (codified at 12 CFR 225.200).
Section 20 subsidiaries are companies that underwrite and deal in,
to a limited extent, bank-ineligible securities. A bank-ineligible
security is a security in which a member bank may not underwrite or
deal.
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In place of this firewall, the Board adopted Operating Standard #
6, which prohibits a bank from knowingly extending credit to a customer
to purchase bank-ineligible securities that a section 20 subsidiary is
underwriting or has underwritten within the past 30 days. The Operating
Standard, however, allows an extension of credit to be made by a bank
to a customer to purchase securities from a section 20 affiliate during
the underwriting period, pursuant to a pre-existing line of credit not
entered into in contemplation of the purchase of affiliate-underwritten
securities. Operating Standard #6 does not otherwise prohibit a bank
from lending to a customer to purchase securities from a section 20
affiliate.
At the same time that it adopted the Operating Standards, the Board
affirmed that section 23A would apply to the types of credit
transactions that Operating Standard #6 does not prohibit to the extent
that the proceeds of the transactions would be used for the benefit of,
or transferred to, an affiliate. Several commenters on the Board's
proposal to adopt the Operating Standards raised concerns about the
compliance and economic burdens associated with applying section 23A to
the extensions of credit now permitted under Operating Standard #6.\9\
The commenters argued that these burdens would cause banks to avoid
making the types of loans permitted by the new Operating Standard,
thereby minimizing the practical effect of eliminating the firewall. In
response, the Board stated that it would consider whether an exemption
from section 23A for those transactions to which the Operating Standard
does not apply would be appropriate.
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\9\ For example, commenters noted that a bank making a loan for
the purchase of securities from its section 20 affiliate would need
to monitor (1) whether the stocks being purchased by its customers
were issues in which its section 20 affiliate was making a market,
(2) the appropriate amount of collateral, (3) the length of time the
collateral would need to be posted, and (4) whether there was room
for the loan under the bank's section 23A quantitative limit on
covered transactions.
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Proposal
The Board is proposing to grant two exemptions from the
quantitative limitations and collateral restrictions of section 23A for
certain loans and extensions of credit made by an insured depository
institution, the proceeds of which are used to buy securities from a
registered broker-dealer affiliate of the depository institution. The
first proposed exemption from section 23A would apply when an insured
depository institution lends to its customers for the purpose of
purchasing third-party securities through a registered broker-dealer
affiliate that is acting solely as broker (but not as principal) in the
securities transaction with the customer or as riskless principal in
the transaction with the customer.\10\ In such circumstances, the
customer would be purchasing securities through the depository
institution's affiliated broker-dealer, which would be acting only on
an agency or agency-equivalent basis, and the seller of the securities
would be required to be a nonaffiliated third-party. The exemption
would be applicable even if the broker-dealer affiliate of the insured
depository institution retained part of the loan proceeds as a
brokerage commission or, in the case of a riskless principal
transaction, a mark-up for effecting the securities transaction.
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\10\ ``Riskless principal'' is the term used in the securities
business to refer to a transaction in which a broker-dealer, after
receiving an order to buy (or sell) a security for a customer,
purchases (or sells) the security for its own account to offset a
contemporaneous sale to (or purchase from) the customer. A broker-
dealer acting as a riskless principal is not obligated to buy (or
sell) a security for its customer until after the broker-dealer
executes the offsetting purchase (or sale) for its own account. See,
e.g., 12 CFR 225.28(b)(7)(ii); The Bank of New York Company, Inc.,
82 Fed. Res. Bull. 748 (1996). Accordingly, riskless principal
transaction are an alternative means for executing buy or sell
orders on behalf of customers in a manner equivalent to an agency
transaction.
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The second proposed exemption would apply to extensions of credit
that are made pursuant to a pre-existing line of credit, the proceeds
of which are used to purchase securities from or through an affiliate
that is a registered-broker dealer. Under the proposed exemption, the
extensions of credit must be made by an insured depository institution
pursuant to a pre-existing line of credit that (1) was not entered into
in contemplation of the purchase of securities from or through an
affiliate, and (2) is either unrestricted or the extension of credit is
clearly consistent with any restrictions imposed. (For example, if the
customer had a pre-existing line of credit limited to purchases of
rated securities from an unaffiliated party, then the exemption would
not apply to an extension of credit used to purchase unrated securities
from or through an affiliate.) In determining whether the line of
credit is truly pre-existing, examiners will consider the timing of the
line of credit, the conditions imposed on the line of credit, and
whether the line of credit has been used for purposes other than the
purchase of securities from an affiliate.
The Board believes that the two proposed exemptions from the
restrictions of section 23A are consistent with the purposes of the
Federal Reserve Act. The exemptions would pose minimal risk to insured
depository institutions. Under the first exemption, there is negligible
risk that loans made would be used as a source of funding from an
insured depository institution to its affiliates. The exemption may be
used only when the depository institution's broker-dealer affiliate
acts as a broker or riskless principal in a securities transaction.
Accordingly, the securities being sold through the registered broker-
dealer would not be carried in the inventory of the broker-dealer or an
affiliate, and the loan proceeds, which would be initially transferred
to the affiliate to purchase the securities, would be transferred in
turn to the seller of the securities, which also would not be an
affiliate of the insured depository institution.
The second exemption also presents little opportunity for a
depository institution to benefit its affiliates. In circumstances in
which there is a pre-existing line of credit that has been established
for a purpose other than buying securities from or through an
affiliate, there is little risk that the
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depository institution either will be using a credit transaction to
direct money to its affiliates in violation of section 23A or will ease
its credit standards to benefit its affiliate.
The Board also believes that the proposed exemptions from section
23A are consistent with the public interest. The two exemptions would
provide greater convenience to customers to gain more flexible use of
the services of insured depository institutions and their registered
broker-dealer affiliates, while still ensuring that the safety and
soundness concerns of section 23A are met. In addition, the exemption
that applies to pre-existing lines of credit would alleviate the
compliance burdens associated with applying section 23A to extensions
of credit that were not made in contemplation of a purchase of
securities from a depository institution's section 20 affiliate.
Regulatory Flexibility Act Analysis
The Board certifies that adoption of this proposal is not expected
to have a significant economic impact on a substantial number of small
business entities within the meaning of the Regulatory Flexibility Act
(5 U.S.C. 601 et seq.). Many small bank holding companies do not have
registered broker-dealer affiliates. Many small banking organizations,
therefore, would not be affected by the proposed rule.
In addition, the proposed rule would create an exemption from
section 23A of the Federal Reserve Act for bank holding companies and
insured depository institutions that have registered broker-dealer
affiliates. Accordingly, the proposal may be expected to alleviate
(rather than increase) compliance for affected small bank holding
companies and their affiliates.
Paperwork Reduction Act
The Board has determined that the proposed rules do not involve the
collection of information pursuant to the provisions of the Paperwork
Reduction Act of 1995, 44 U.S.C. 3501 et seq.
List of Subjects in 12 CFR Part 250
Federal Reserve System.
For the reasons set forth in the preamble, the Board proposes to
amend 12 CFR part 250 as follows:
PART 250--MISCELLANEOUS INTERPRETATIONS
1. The authority citation for part 250 continues to read as
follows:
Authority: 12 U.S.C. 78, 248(i) and 371c(e).
2. Section 250.244 is added to read as follows:
Sec. 250.244 Exemption from section 23A of the Federal Reserve Act for
certain loans and extensions of credit made by an insured depository
institution to a third party to purchase securities from an affiliate.
(a) Section 23A of the Federal Reserve Act (12 U.S.C. 371c) shall
not apply to a loan or extension of credit by an insured depository
institution to any person other than an affiliate if--
(1) The terms of the loan or extension of credit are consistent
with safe and sound banking practices; and
(2) The proceeds of the loan or extension of credit are used to
purchase securities through an affiliate that is a broker-dealer
registered with the Securities and Exchange Commission, where
(i) The affiliate is acting solely as broker (but not as principal)
in the securities transaction or as riskless principal in the
securities transaction; and
(ii) The securities are not issued or sold by companies that are
affiliates of the insured depository institution.
(b) This grant of exemption is applicable to a loan or extension of
credit even if a portion of the proceeds are used by a borrower to pay
brokerage commissions or, in the case of riskless principal
transactions, mark-ups to the affiliate.
3. Section 250.245 is added to read as follows:
Sec. 250.245 Exemption from section 23A of the Federal Reserve Act for
certain extensions of credit by an insured depository institution to a
third party made pursuant to a pre-existing line of credit.
Section 23A of the Federal Reserve Act (12 U.S.C. 371c) shall not
apply to an extension of credit by an insured depository institution to
any person other than an affiliate if--
(a) The proceeds of the extension of credit are used to purchase
securities from or through an affiliate that is a registered broker-
dealer; and
(b) The extension of credit is made pursuant to, and consistent
with any conditions imposed in, a pre-existing line of credit that was
not established in contemplation of the purchase of securities from or
through an affiliate.
By order of the Board of Governors of the Federal Reserve
System, June 10, 1998.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 98-15934 Filed 6-15-98; 8:45 am]
BILLING CODE 6210-01-P