[Federal Register Volume 66, Number 92 (Friday, May 11, 2001)]
[Rules and Regulations]
[Pages 24229-24233]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-11608]


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FEDERAL RESERVE SYSTEM

12 CFR Part 250

[Miscellaneous Interpretations; Docket No. R-1104]


Application of Sections 23A and 23B of the Federal Reserve Act to 
Derivative Transactions With Affiliates and Intraday Extensions of 
Credit to Affiliates

AGENCY: Board of Governors of the Federal Reserve System.

[[Page 24230]]


ACTION: Interim rules with request for public comments.

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SUMMARY: The Board of Governors of the Federal Reserve System is 
adopting on an interim basis rules to address the application of 
sections 23A and 23B of the Federal Reserve Act to credit exposure 
arising out of derivative transactions between an insured depository 
institution and its affiliates and intraday extensions of credit by an 
insured depository institution to its affiliates. The rules require 
institutions to adopt policies and procedures reasonably designed to 
monitor, manage, and control credit exposures arising out of the 
transactions and clarify that the transactions are subject to section 
23B.

DATES: The interim rules are effective January 1, 2002. Comments must 
be submitted on or before August 15, 2001.

ADDRESSES: Comments should refer to Docket No. R-1104 and should be 
sent to Ms. Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, NW., 
Washington, DC 20551 (or mailed electronically to 
[email protected]). Comments addressed to Ms. Johnson 
also may be delivered to the Board's mail room between the hours of 
8:45 a.m. and 5:15 p.m. weekdays and, outside of those hours, to the 
Board's security control room. Both the mail room and the security 
control room are accessible from the Eccles Building courtyard 
entrance, located on 20th Street, NW., between Constitution Avenue and 
C Street, NW. Members of the public may inspect comments in Room MP-500 
of the Martin Building between 9 a.m. and 5 p.m. weekdays.

FOR FURTHER INFORMATION CONTACT: Pamela G. Nardolilli, Senior Counsel 
(202/452-3289), or Mark E. Van Der Weide, Counsel (202/452-2263), Legal 
Division; Michael G. Martinson, Associate Director (202/452-3640), or 
Heidi W. Richards, Assistant Director (202/452-2598), Division of 
Banking Supervision and Regulation; Board of Governors of the Federal 
Reserve System, 20th Street and Constitution Avenue, NW., Washington, 
DC 20551.

SUPPLEMENTARY INFORMATION:

Background

    Sections 23A and 23B of the Federal Reserve Act are intended to 
limit the risks to an insured depository institution (``institution'') 
from transactions with its affiliates.\1\ Sections 23A and 23B also 
limit the ability of an institution to transfer to its affiliates the 
subsidy arising from the institution's access to the Federal safety 
net.
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    \1\ Section 23A originally was enacted as part of the Banking 
Act of 1933 and applied only to banks that were members of the 
Federal Reserve System. Congress amended the Federal Deposit 
Insurance Act in 1966 to extend section 23A to insured nonmember 
banks. 12 U.S.C. 1828(j). In 1989, Congress further extended the 
coverage of section 23A to insured savings associations. 12 U.S.C. 
1468. Congress enacted section 23B of the Federal Reserve Act as 
part of the Competitive Equality Banking Act of 1987, and has 
subsequently expanded its scope to cover the same set of depository 
institutions as are covered by section 23A.
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    Section 23A achieves these goals in three major ways. First, it 
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 percent of 
the institution's capital and surplus, and the aggregate amount of 
covered transactions with all affiliates combined (including financial 
subsidiaries of the institution) to no more than 20 percent of the 
institution's capital and surplus. Covered transactions include 
purchases of assets from an affiliate, extensions of credit to an 
affiliate, guarantees issued on behalf of an affiliate, and certain 
other transactions that expose an institution to an affiliate's credit 
or investment risk.
    Second, the statute requires all covered transactions between an 
insured depository institution and its affiliates to be on terms and 
conditions that are consistent with safe and sound banking practices, 
and prohibits an institution from purchasing low-quality assets from 
its affiliates. Finally, the statute requires that an insured 
depository institution's extensions of credit to affiliates and 
guarantees issued on behalf of affiliates be appropriately secured by a 
statutorily defined amount of collateral.
    Section 23B protects an insured depository institution by requiring 
that transactions between the institution and its affiliates be on 
market terms; that is, on terms and under circumstances that are 
substantially the same, or at least as favorable to the institution, as 
those prevailing at the time for comparable transactions with 
unaffiliated companies. The market terms requirement of section 23B 
applies to any covered transaction (as defined in section 23A) with an 
affiliate as well as a broad range of other transactions, such as a 
sale of securities or other assets to an affiliate and a contract for 
the payment of money or furnishing of services to an affiliate.
    The Gramm-Leach-Bliley Act (``GLB Act'') requires the Board to 
adopt, by May 12, 2001, final rules under section 23A to ``address as 
covered transactions credit exposure arising out of derivative 
transactions between [insured depository institutions] and their 
affiliates and intraday extensions of credit by [insured depository 
institutions] to their affiliates.''\2\ The Board is adopting the 
interim final rules explained below pursuant to the amendments to 
section 23A contained in the GLB Act.
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    \2\ GLB Act section 121(b)(3) (codified at 12 U.S.C. 371c(f)(3).
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Explanation of Interim Rules

A. Derivative Transactions

    Derivative transactions between an insured depository institution 
and its affiliates generally arise either from the risk management 
needs of the institution or the affiliate. Transactions arising from 
the bank's needs typically arise when an institution enters into a swap 
or other derivative contract with a customer but chooses not to hedge 
directly the market risk generated by the derivative contract or is 
unable to hedge the risk directly because the institution is not 
authorized to hold the hedging asset. In order to manage the market 
risk, the institution may have an affiliate acquire the hedging asset. 
The institution would then do a ``bridging'' derivative transaction 
between itself and the affiliate maintaining the hedge.
    Other derivative transactions between an insured depository 
institution and its affiliate are affiliate-driven. An institution's 
affiliate may enter into an interest-rate or foreign-exchange 
derivative with the institution in order to accomplish the asset-
liability management goals of the affiliate. For example, an 
institution's holding company may hold a substantial amount of 
floating-rate assets but issue fixed-rate debt securities to obtain 
cheaper funding. The holding company may then enter into a fixed-to-
floating interest-rate swap with its subsidiary insured depository 
institution to reduce the holding company's interest-rate risk.
    Insured depository institutions and their affiliates that seek to 
enter into derivative transactions for hedging (or risk-taking) 
purposes could enter into the desired derivatives with unaffiliated 
companies. Institutions and their affiliates often choose to use each 
other as their derivative counterparties, however, in order to maximize 
the profits of and manage risks within the consolidated financial 
group.
    The Board believes that derivative transactions between an insured 
depository institution and an affiliate are subject to section 23B 
under the

[[Page 24231]]

express terms of the statute.\3\ The Board has not ruled on the 
question of whether derivative transactions between an insured 
depository institution and its affiliates are covered transactions 
under section 23A.
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    \3\ In addition to applying to covered transactions as defined 
in section 28A, the market terms requirement of section 23B applies 
broadly to, among other things, ``[t]he payment of money or the 
furnishing of services to an affiliate under contract, lease, or 
otherwise.'' 12 U.S.C. 371c-1(a)(2)(C). Institution-affiliate 
derivatives generally involve a contract or agreement to pay money 
to the affiliate or furnish risk management services to the 
affiliate.
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    Derivative transactions between an insured depository institution 
and an affiliate resemble section 23A covered transactions in many 
respects. Such transactions may expose institutions to the credit risk 
of their affiliates. Although the typical institution-affiliate 
derivative transaction does not create current credit exposure for the 
institution at the inception of the transaction, an institution may 
incur current credit exposure to an affiliate during the term of a 
derivative transaction and nearly always faces some amount of potential 
future exposure on such a transaction. The credit exposure on a 
derivative transaction with an affiliate poses a risk to the safety and 
soundness of the bank that is similar in many respects to the risk 
posed by a loan to an affiliate, and may be more volatile and 
indeterminate than the credit exposure created by a loan.
    Determining the appropriate treatment for derivative transactions 
under section 23A is a complex and important endeavor. In light of the 
complexities of the subject matter and in light of the May 12, 2001, 
statutory schedule in the GLB Act, the Board is taking the following 
two steps to address institution-affiliate derivative transactions 
under sections 23A and 23B. First, the Board is publishing this interim 
rule, which (i) requires, under section 23A as amended by the GLB Act, 
that an institution establish and maintain policies and procedures 
reasonably designed to manage the credit exposure arising from the 
institution's derivative transactions with affiliates and (ii) 
clarifies that institution-affiliate derivative transactions are 
subject to the market terms requirement of section 23B. The policies 
and procedures must at a minimum provide for monitoring and controlling 
the credit exposure arising from the institution's derivative 
transactions with each affiliate, and all affiliates in the aggregate, 
and ensuring that the institution's derivative transactions with 
affiliates comply with section 23B. In addition, the interim rule 
defines the term ``derivative transaction'' to mean any derivative 
contract covered by the Board's capital adequacy guidelines (which 
includes most interest-rate, currency, equity, and commodity derivative 
contracts) and any similar derivative contract, including credit 
derivative contracts.
    Second, the Board has included provisions in the proposed 
Regulation W issued concurrently with this interim rule to address 
further the credit exposure associated with derivative transactions. 
Regulation W proposes a set of questions on measures in addition to 
those contained in this interim rule that could be applied to 
institution-affiliate derivative transactions under section 23A. In 
connection with this interim rule and proposed Regulation W, the Board 
solicits public comment on the most appropriate treatment under section 
23A of the credit exposure arising from derivative transactions.
    As noted above, regardless of how the Board ultimately decides to 
address credit exposure on derivative transactions between an 
institution and an affiliate under section 23A, these transactions are 
subject to the market terms requirement of section 23B. Accordingly, 
each institution should have in place credit limits on its derivatives 
exposure to affiliates that are at least as strict as the credit limits 
the institution imposes on unaffiliated companies that are engaged in 
similar businesses and are substantially equivalent in size and credit 
quality. Similarly, each institution should monitor derivatives 
exposure to affiliates in a manner that is at least as rigorous as it 
uses to monitor derivatives exposure to comparable unaffiliated 
companies. In addition, each institution should price, and require 
collateral in, derivative transactions with affiliates in a way that is 
at least as favorable to the institution as the way the institution 
would price, or require collateral in, a derivative transaction with 
comparable unaffiliated counterparties.
    Although the Board continues to explore and analyze the complex 
issue of how best to address institution-affiliate derivative 
transactions under section 23A, the Board has not made a determination 
at this time that the credit exposure arising from such derivatives 
ought to be made subject to all the requirements of section 23A. The 
Board continues to collect information regarding the derivatives 
practices of insured depository institutions and asks for additional 
data on such practices in order to assist the Board in determining 
whether the approach set forth in the interim rule would suffice to 
prevent institutions from incurring material credit exposure to 
affiliates on derivative transactions. It appears that several of the 
larger insured depository institutions that participate in the 
derivatives markets increasingly manage credit risk arising from 
derivatives exposure to financial institutions by requiring such 
counterparties to post collateral. The Board understands that these 
institutions generally require full collateralization of their current 
credit exposure (i.e., positive net mark-to-market values recalculated 
daily based on the previous day's exposures) on derivative transactions 
with financial institutions above a relatively small threshold amount.
    The Board requests information regarding (i) how institutions 
currently measure, monitor, and limit derivatives credit exposure to 
unaffiliated companies; (ii) whether institutions include an estimate 
of potential future exposure in their measurement of credit exposure to 
unaffiliated derivatives counterparties and, if so, how institutions 
estimate potential future exposure on a derivative transaction; (iii) 
in what circumstances and to what extent institutions require 
unaffiliated counterparties to post collateral to secure derivatives 
credit exposure; (iv) what types of collateral institutions accept to 
secure derivatives credit exposure (and what haircuts are used for the 
various collateral types); (v) how often institutions mark to market 
(and require additional collateral with respect to) their derivative 
transactions with unaffiliated counterparties; (vi) how institutions 
price derivative transactions with unaffiliated counterparties; and 
(vii) how large the uncollateralized derivatives credit exposures are 
that institutions have to unaffiliated companies.
    After a more complete review and analysis of the credit risk 
mitigation practices of insured depository institutions participating 
in the derivatives markets and of the public comments received on this 
interim rule and Regulation W, the Board may decide to subject credit 
exposure on institution-affiliate derivatives to some or all of the 
requirements of section 23A.

B. Intraday Extensions of Credit

    As noted above, the GLB Act requires the Board to address as 
covered transactions under section 23A the credit exposure arising from 
intraday extensions of credit by insured depository institutions to 
their affiliates. Depository institutions regularly provide transaction 
accounts to their affiliates in conjunction with providing

[[Page 24232]]

payment and securities clearing services. As in the case of 
unaffiliated commercial customers, these accounts are occasionally 
subject to overdrafts during the day that are repaid in the ordinary 
course of business. The Board has not to date ruled on whether these or 
other types of intraday credit extensions are covered transactions 
under section 23A or are subject to the market terms requirement of 
section 23B.
    Existing business practices indicate that the potential risk 
reduction benefits afforded by full application of the requirements of 
section 23A to intraday credit exposures may not justify the costs to 
banking organizations of implementing these requirements at this time. 
Intraday overdrafts and other forms of intraday credit extensions are 
generally not used as a means of funding or otherwise providing 
financial support for an affiliate. Rather, these credit extensions 
typically facilitate the settlement of transactions between an 
affiliate and its customers when there are mismatches between the 
timing of funds sent and received during the business day. Although 
some risk exists that such intraday credit extensions could turn into 
overnight funding of an affiliate, this risk may be sufficiently remote 
that application of the strict collateral and other requirements of 
section 23A would not be warranted for the intraday credit exposure. 
Moreover, mandating that banks collateralize intraday exposures could 
require banks to measure exposures across multiple accounts, offices, 
and systems on a global basis and to adjust collateral holdings in real 
time throughout the day. The Board is concerned that few banks 
currently have these capabilities and that they would be very costly to 
implement.
    As with institution-affiliate derivative transactions, the Board is 
taking a two-step approach to addressing intraday credit extensions by 
an institution to an affiliate under sections 23A and 23B. First, the 
Board is publishing this interim final rule. The interim rule (i) 
requires, under section 23A, that institutions establish and maintain 
policies and procedures reasonably designed to manage the credit 
exposure arising from the institution's intraday extensions of credit 
to affiliates and (ii) clarifies that intraday extensions of credit by 
an insured depository institution to an affiliate are subject to the 
market terms requirement of section 23B. The policies and procedures 
must at a minimum provide for monitoring and controlling the 
institution's intraday credit exposure to each affiliate, and all 
affiliates in the aggregate, and ensuring that the institution's 
intraday credit extensions to affiliates comply with section 23B.
    Second, the Board has proposed in Regulation W an alternative 
approach that would subject certain intraday credit extensions to 
section 23A. The Board specifically invites public comment on whether 
the Board's final rule on intraday credit extensions under section 23A 
should reflect the approach taken in this interim rule, the approach 
set forth in proposed Regulation W, an approach that more fully 
subjects intraday credits to section 23A, or another approach.

C. Delayed Effective Date

    The GLB Act authorizes the Board to delay the effective date of its 
final rule under section 23A on derivative transactions and intraday 
credit extensions ``for such period as the Board deems necessary or 
appropriate to permit banks to conform their activities to the 
requirements of the final rule without undue hardship.'' \4\ Pursuant 
to this authority, the Board has determined to delay the effective date 
of these interim final rules until January 1, 2002, to allow 
institutions an appropriate amount of time to put in place the policies 
and procedures required by the rules. The delayed effective date also 
will provide the Board with an opportunity to revise the interim rules 
to reflect public comments as necessary.
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    \4\ 12 U.S.C. 371c(f)(3)(B).
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Regulatory Flexibility Act

    In accordance with section 3(a) of the Regulatory Flexibility Act 
(5 U.S.C. 603(a)), the Board must publish an initial regulatory 
flexibility analysis with this rulemaking. The rules implement 
provisions of section 121 of the GLB Act that require the Board to 
adopt final rules under section 23A of the Federal Reserve Act to 
address as a covered transaction the credit exposure arising out of 
derivative transactions between insured depository institutions and 
their affiliates and intraday extensions of credit by institutions to 
their affiliates.
    The interim rules require insured depository institutions to 
establish and maintain policies and procedures regarding their 
derivative transactions with affiliates and intraday credit extensions 
to affiliates. The policies and procedures required by the rules are 
necessary to ensure that institutions conduct these activities in a 
safe and sound manner and to enable the Board to execute properly its 
supervisory function. These requirements apply to all insured 
depository institutions, regardless of size, engaged in these 
activities. The Board believes that institutions that engage in these 
activities, in most cases, already have policies and procedures in 
place to manage the risks of these activities.
    The Board specifically seeks comment on the likely burden that the 
interim rules will impose on insured depository institutions that 
engage in derivative transactions with affiliates or extend credit on 
an intraday basis to affiliates.

Administrative Procedure Act

    The provisions of these rules are effective on January 1, 2002, on 
an interim basis. Pursuant to 5 U.S.C. 553, the Board finds that it is 
impracticable to issue these rules in proposed form and that there is 
good cause to issue these rules as interim final rules due to the fact 
that the GLB Act requires the Board to adopt final rules addressing the 
credit exposure arising from derivative transactions between 
institutions and affiliates and intraday extensions of credit from 
institutions to affiliates by May 12, 2001. The Board is seeking public 
comment on all aspects of the interim rules and will amend the rules as 
appropriate after reviewing the comments.
    Subject to certain exceptions, 12 U.S.C. 4802(b)(1) provides that 
new regulations and amendments to regulations prescribed by a Federal 
banking agency that impose additional reporting, disclosure, or other 
new requirements on an insured depository institution must take effect 
on the first day of a calendar quarter that begins on or after the date 
on which the regulations are published in final form. In accordance 
with this provision of the Administrative Procedure Act, these interim 
rules do not become effective until January 1, 2002.

Paperwork Reduction Act

    The Board has determined that the interim rules do not involve a 
collection of information pursuant to the provisions of the Paperwork 
Reduction Act of 1995 (44 U.S.C. 3501 et seq.).

Plain Language

    Section 722 of the GLB Act requires the Board to use ``plain 
language'' in all proposed and final rules published after January 1, 
2000. In light of this requirement, the Board has sought to present its 
interim rules in a simple and straightforward manner. The Board invites 
comments on whether there are additional steps the Board could take to 
make the rules easier to understand.

List of Subjects in 12 CFR Part 250

    Federal Reserve System.

[[Page 24233]]


    For the reasons set out in the preamble, the Board amends 12 CFR 
part 250 as follows:

PART 250--MISCELLANEOUS INTERPRETATIONS

    1. The authority citation for part 250 is revised to read as 
follows:

    Authority: 12 U.S.C. 78, 248(i), 371c(f) and 371c-1(e).

    2. Section 250.247 is added to read as follows:


Sec. 250.247  Application of sections 23A and 23B of the Federal 
Reserve Act to derivative transactions between insured depository 
institutions and their affiliates.

    (a) Derivative transactions between an insured depository 
institution and its affiliates are subject to the market terms 
requirement of section 23B(a)(1) of the Federal Reserve Act (12 U.S.C. 
371c-1(a)(1)).
    (b) An insured depository institution must establish and maintain 
policies and procedures reasonably designed to manage the credit 
exposure arising from its derivative transactions with affiliates in a 
safe and sound manner. The policies and procedures must at a minimum 
provide for:
    (1) Monitoring and controlling the credit exposure arising from the 
institution's derivative transactions with each affiliate and all 
affiliates in the aggregate; and
    (2) Ensuring that the institution's derivative transactions with 
affiliates comply with section 23B.
    (c) For purposes of this regulation, derivative transactions 
include any derivative contract listed in paragraphs A. III. E. 1. a. 
through d. of appendix A to 12 CFR part 225 and any similar derivative 
contract, including credit derivative contracts.

    3. Section 250.248 is added to read as follows:


Sec. 250.248  Application of sections 23A and 23B of the Federal 
Reserve Act to intraday extensions of credit by insured depository 
institutions to their affiliates.

    (a) Intraday extensions of credit by an insured depository 
institution to its affiliates are subject to the market terms 
requirement of section 23B(a)(1) of the Federal Reserve Act (12 U.S.C. 
371c-1(a)(1)).
    (b) An insured depository institution must establish and maintain 
policies and procedures reasonably designed to manage the credit 
exposure arising from its intraday extensions of credit to affiliates 
in a safe and sound manner. The policies and procedures must at a 
minimum provide for:
    (1) Monitoring and controlling the credit exposure arising from the 
institution's intraday extensions of credit to each affiliate and all 
affiliates in the aggregate; and
    (2) Ensuring that the institution's intraday extensions of credit 
to affiliates comply with section 23B.

    By order of the Board of Governors of the Federal Reserve 
System, May 3, 2001.

    Dated: May 3, 2001.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 01-11608 Filed 5-10-01; 8:45 am]
BILLING CODE 6210-01-P