[Federal Register Volume 67, Number 239 (Thursday, December 12, 2002)]
[Rules and Regulations]
[Pages 76560-76617]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-30634]



[[Page 76559]]

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Part III





Federal Reserve System





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12 CFR Parts 223 and 250



Transactions Between Member Banks and Their Affiliates; Final Rules and 
Proposed Rule

  Federal Register / Vol. 67, No. 239 / Thursday, December 12, 2002 / 
Rules and Regulations  

[[Page 76560]]


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FEDERAL RESERVE SYSTEM

12 CFR Part 223

[Regulation W; Docket No. R-1103]


Transactions Between Member Banks and Their Affiliates

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board of Governors of the Federal Reserve System (Board) 
is adopting a final rule (Regulation W) to implement comprehensively 
sections 23A and 23B of the Federal Reserve Act and provide several new 
exemptions consistent with the purposes of the statute. The final rule 
combines statutory restrictions on transactions between a member bank 
and its affiliates with numerous Board interpretations and exemptions 
in an effort to simplify compliance with sections 23A and 23B.

DATES: The final rule is effective April 1, 2003.

FOR FURTHER INFORMATION CONTACT: Pamela G. Nardolilli, Senior Counsel 
(202/452-3289), or Mark E. Van Der Weide, Counsel (202/452-2263), Legal 
Division; or Michael G. Martinson, Associate Director (202/452-3640), 
or Molly S. Wassom, Associate Director (202/452-2305), Division of 
Banking Supervision and Regulation; Board of Governors of the Federal 
Reserve System, 20th Street and Constitution Avenue, NW., Washington, 
DC 20551. For users of Telecommunications Device for the Deaf (``TDD'') 
only, contact 202/263-4869.

SUPPLEMENTARY INFORMATION:

Introduction

    Sections 23A and 23B of the Federal Reserve Act are important 
statutory provisions designed to protect against a depository 
institution suffering losses in transactions with affiliates. They also 
limit the ability of a depository institution to transfer to its 
affiliates the subsidy arising from the institution's access to the 
Federal safety net. Sections 23A and 23B apply, by their terms, to 
banks that are members of the Federal Reserve System (``member 
banks''). Other Federal law subjects insured nonmember banks and 
insured thrifts to sections 23A and 23B in the same manner and to the 
same extent as if they were member banks.
    Although sections 23A and 23B each explicitly grant the Board broad 
authority to issue regulations to administer the section,\1\ the Board 
has never issued a regulation fully implementing either section. 
Instead, depository institutions seeking guidance on how to comply with 
the statute have relied on a series of Board interpretations and 
informal staff guidance. Institutions have increasingly sought guidance 
from the Board on section 23A issues in recent years as a result of the 
increasing scope of activities conducted by modern financial holding 
companies and the growing complexities of the U.S. financial markets.
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    \1\ 12 U.S.C. 371c(f), 371c-1(e).
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    On May 11, 2001, the Board issued a proposed Regulation W to 
implement comprehensively sections 23A and 23B.\2\ The Board decided to 
issue such a rule for several reasons. First, the new regulatory 
framework established by the Gramm-Leach-Bliley Act (``GLB Act'') \3\ 
emphasizes the importance of sections 23A and 23B as a means to protect 
depository institutions from losses in transactions with affiliates. In 
addition, adoption of a comprehensive rule would simplify the 
interpretation and application of sections 23A and 23B, ensure that the 
statute is consistently interpreted and applied, and minimize burden on 
banking organizations to the extent consistent with the statute's 
goals. Finally, issuing a comprehensive proposed rule allowed the 
public an opportunity to comment on Board and staff interpretations of 
sections 23A and 23B, many of which were adopted without the benefit of 
public comment.
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    \2\ 66 FR 24186, May 11, 2001.
    \3\ Pub. L. 106-102, 113 Stat. 1338 (1999).
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    Among other things, the GLB Act required the Board to adopt final 
rules, by May 12, 2001, to address under section 23A credit exposure by 
a member bank to its affiliates on derivative transactions and intraday 
credit extensions. The Board issued interim final rules to fulfill this 
statutory mandate on May 11, 2001 (concurrently with proposed 
Regulation W). The interim final rules became effective January 1, 
2002. The Board also sought public comment as part of the Regulation W 
rulemaking process on how these types of transactions should be treated 
under section 23A.
    The Board received approximately 120 public comments on the 
proposed Regulation W and the interim final rules on derivative 
transactions and intraday extensions of credit. Commenters included 3 
Members of Congress, 75 banking organizations, 20 trade associations 
representing the banking or financial services industry, 5 state 
banking departments or other governmental agencies, 9 law firms or 
individuals, and several other organizations. Nearly all the commenters 
supported the Board's decision to issue Regulation W and the interim 
rules but opposed or raised concerns about one or more aspects of the 
regulations.
    The Board has carefully reviewed and analyzed the issues raised by 
commenters and has decided to issue a final Regulation W that is 
substantially similar to the proposed rule. The Board has modified the 
proposed rule in many important respects, however, to reflect the 
concerns of commenters and further analysis by the Board. The final 
rule supersedes any Board interpretations or staff opinions of sections 
23A and 23B that are inconsistent with the rule. In a separate 
rulemaking concurrent with the issuance of final Regulation W, the 
Board is rescinding its existing interpretations of and exemptions from 
section 23A contained in part 250 of title 12 of the Code of Federal 
Regulations because all such interpretations and exemptions are 
included within Regulation W.
    The Board expects each depository institution with affiliates that 
is subject to sections 23A and 23B to implement policies and procedures 
to ensure compliance with the final rule.

Background

    As noted above, sections 23A and 23B by their terms limit the risks 
to a member bank from transactions with affiliates and limit the 
ability of a member bank to transfer its Federal subsidy to affiliates. 
Section 23A achieves these goals in four major ways. First, it limits a 
member bank's ``covered transactions'' with any single ``affiliate'' to 
no more than 10 percent of the bank's capital stock and surplus, and 
transactions with all affiliates combined to no more than 20 percent of 
the bank's capital stock and surplus. ``Covered transactions'' include 
purchases of assets from an affiliate, extensions of credit to an 
affiliate, investments in securities issued by an affiliate, guarantees 
on behalf of an affiliate, and certain other transactions that expose 
the member bank to an affiliate's credit or investment risk. A member 
bank's ``affiliates'' include, among other companies, any companies 
that control the bank, any companies under common control with the 
bank, and certain investment funds that are advised by the bank or an 
affiliate of the bank.
    Second, the statute requires all transactions between a member bank 
and its affiliates to be on terms and conditions that are consistent 
with safe and sound banking practices. Third, the statute prohibits a 
member bank from

[[Page 76561]]

purchasing low-quality assets from its affiliates. Finally, section 23A 
requires that a member bank's extensions of credit to affiliates and 
guarantees on behalf of affiliates be appropriately secured by a 
statutorily defined amount of collateral.
    Section 23B protects a member bank by requiring that certain 
transactions between the bank and its affiliates occur on market terms; 
that is, on terms and under circumstances that are substantially the 
same, or at least as favorable to the bank, as those prevailing at the 
time for comparable transactions with unaffiliated companies. Section 
23B applies this restriction to any covered transaction (as defined in 
section 23A) with an affiliate as well as certain other transactions, 
such as (i) any sale of assets by the member bank to an affiliate; (ii) 
any payment of money or furnishing of services by the member bank to an 
affiliate; and (iii) any transaction by the member bank with a third 
party if an affiliate has a financial interest in the third party or if 
an affiliate is a participant in the transaction.
    Section 23A originally was enacted as part of the Banking Act of 
1933, and the restrictions of section 23A applied only to member banks. 
Since 1933, Congress has amended the statute several times, including a 
comprehensive revision in 1982.\4\ Congress also amended the Federal 
Deposit Insurance Act (``FDI Act'') in 1966 to apply section 23A to 
insured nonmember banks in the same manner and to the same extent as if 
they were member banks.\5\ In addition, Congress revised the Home 
Owners' Loan Act (``HOLA'') in 1989 to apply section 23A to insured 
savings associations in the same manner and to the same extent as if 
they were member banks.\6\ Congress enacted section 23B of the Federal 
Reserve Act as part of the Competitive Equality Banking Act of 1987,\7\ 
and has subsequently expanded its scope to cover the same set of 
depository institutions as are covered by section 23A. Consequently, 
sections 23A and 23B now apply to all insured depository institutions 
and uninsured member banks.
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    \4\ Garn-St Germain Depository Institutions Act of 1982, Pub. L. 
No. 97-320, Sec.  410, 96 Stat. 1515 (1982) (codified at 12 U.S.C. 
371c).
    \5\ Pub. L. 89-485, Sec.  12(c), 80 Stat. 242 (1966) (codified 
at 12 U.S.C. 1828(j)).
    \6\ Financial Institutions Reform, Recovery, and Enforcement Act 
of 1989, Pub. L. 101-73, Sec.  301, 103 Stat. 342 (1989) (codified 
at 12 U.S.C. 1468(a)).
    \7\ Pub. L. 100-86, Sec.  102, 101 Stat. 552, 564 (1987) 
(codified at 12 U.S.C. 371c-1).
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    The GLB Act amended the Federal Reserve Act in 1999 so that 
sections 23A and 23B would apply to transactions between a bank and its 
``financial subsidiaries.'' Section 23A, as amended by the GLB Act, 
defines a financial subsidiary as any subsidiary of a bank that would 
be a financial subsidiary of a national bank under section 5136A of the 
Revised Statutes of the United States. Section 5136A of the Revised 
Statutes generally defines a financial subsidiary as a subsidiary of an 
insured depository institution that engages in activities that are not 
permissible for national banks to engage in directly (unless national 
banks are authorized by the express terms of a Federal statute to own 
or control the subsidiary).\8\ The GLB Act provides that a financial 
subsidiary of a bank, unlike most other subsidiaries of a bank, is 
considered an ``affiliate'' of the bank for purposes of sections 23A 
and 23B. The GLB Act also establishes certain special rules under 
section 23A for financial subsidiaries.
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    \8\ See 12 U.S.C. 24a(g).
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Explanation of Final Rule

I. Format of Regulation

    Regulation W provides users with a single, comprehensive reference 
tool for complying with and analyzing issues arising under sections 23A 
and 23B.\9\ The regulation restates the statutory definitions, 
restrictions, and exemptions, and also includes Board interpretations 
of the sections. Commenters agreed that including the statutory 
provisions in the rule would make understanding and using the rule 
easier.
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    \9\ The regulation implements sections 23A and 23B of the 
Federal Reserve Act. The regulation does not contain or implement 
statutory or regulatory restrictions on transactions between member 
banks and their affiliates that may be applicable under other 
provisions of law, including those that may apply to member banks 
subject to prompt corrective action under section 38 of the FDI Act 
(12 U.S.C. 1831o).
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    The regulation first provides, in subpart A, a comprehensive 
glossary of the terms used in the regulation and the statute. The 
regulation then sets forth, in subpart B, the principal restrictions 
and requirements imposed by section 23A. Next, in subpart C, the 
regulation discusses the appropriate valuation and timing principles 
for covered transactions. Subpart D discusses the appropriate treatment 
under section 23A for transactions with financial subsidiaries, bank-
affiliate derivative transactions, and certain bank-affiliate merger 
and acquisition transactions. Subpart E sets forth available exemptions 
from certain of the requirements of section 23A. Subpart F lays out the 
operative provisions of section 23B. Subpart G discusses the 
application of sections 23A and 23B and the rule to U.S. branches and 
agencies of foreign banks. Subpart H contains the Board's miscellaneous 
interpretations of the statute.
    The regulation also includes examples illustrating how several of 
the rule's provisions would apply in particular circumstances. The 
examples included in the rule are considered part of the rule and 
compliance with an example, to the extent applicable, would constitute 
compliance with the rule. Each example included in the rule illustrates 
only the scope and application of the particular topic addressed by the 
example and does not illustrate any other topic or issue that may arise 
under the rule.

II. Scope of Regulation

    As noted above, although sections 23A and 23B apply by their terms 
only to member banks, the FDI Act subjects insured nonmember banks to 
the restrictions of sections 23A and 23B as if they were member banks. 
In order to clarify how sections 23A and 23B applied to each type of 
bank, the proposed Regulation W applied by its terms to member banks 
and insured nonmember banks. The Federal Deposit Insurance Corporation 
(``FDIC'') objected to the scope of the proposed rule and urged the 
Board to amend the rule so that it would not apply by its terms to 
insured nonmember banks. The Board has decided to revise the rule to 
apply by its terms only to member banks. Notwithstanding this 
restriction of the scope of Regulation W, insured nonmember banks must 
comply with the rule as if they were member banks.\10\
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    \10\ Accordingly, an insured nonmember bank also may take 
advantage of Regulation W's exemptions as if it were a member bank.
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    As noted above, HOLA subjects insured savings associations to 
sections 23A and 23B as if they were member banks. HOLA also imposes 
several restrictions on transactions between an insured savings 
association and certain of its affiliates that are not contained in 
section 23A \11\ and provides the Office of Thrift Supervision 
(``OTS'') with authority to impose additional restrictions on 
transactions between an insured savings association and its 
affiliates.\12\ In light of the stricter regulatory regime governing 
transactions between an insured savings association and its affiliates 
and in light

[[Page 76562]]

of a request by the OTS that Regulation W not specifically cover such 
institutions, the final rule (like the proposed rule) does not apply by 
its terms to insured savings associations. The Board notes, however, 
that because insured savings associations are subject to sections 23A 
and 23B as if they were member banks, insured savings associations must 
comply with Regulation W as if they were member banks.\13\ Moreover, 
any parallel regulation adopted by the OTS to govern transactions with 
affiliates must be at least as strict on insured savings associations 
as Regulation W is on member banks.
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    \11\ HOLA prohibits an insured savings association from (i) 
making loans or extending credit to any affiliate unless that 
affiliate is engaged solely in activities that the Board has 
determined to be permissible under section 4(c) of the Bank Holding 
Company Act (12 U.S.C. 1843(c)); and (ii) investing in securities 
issued by any affiliate other than shares issued by a subsidiary. 12 
U.S.C. 1468(a)(1).
    \12\ 12 U.S.C. 1468(a)(4).
    \13\ Accordingly, an insured savings association also may take 
advantage of Regulation W's exemptions as if it were a member bank.
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III. Definitions--Subpart A

    Subpart A of Regulation W sets forth definitions of the terms used 
in sections 23A and 23B and the rule. Terms that are defined in the 
regulation as they are defined in the statute generally are not 
discussed below. Material terms that the Board proposes to define or 
clarify for purposes of the regulation are discussed below.
A. Definition of Affiliate (Sec.  223.2)

1. Investment Funds Advised by the Member Bank or an Affiliate of the 
Member Bank (Sec.  223.2(a)(6))

    Section 23A includes as an affiliate any company that is sponsored 
and advised by the member bank or any of its affiliates.\14\ Section 
23A also includes as an affiliate any investment company for which the 
member bank or its affiliate serves as an investment advisor, as 
defined in the Investment Company Act of 1940 (``1940 Act'').\15\ The 
proposed regulation included these provisions and also included as an 
affiliate any investment fund--even if not an investment company for 
purposes of the 1940 Act--for which the member bank or an affiliate of 
the bank serves as an investment advisor, if the bank or an affiliate 
of the bank owns or controls more than 5 percent of any class of voting 
securities or similar interests of the fund.\16\
    A number of commenters expressed opposition to this proposal. 
According to these commenters, the proposal would violate the careful 
statutory framework established by Congress for determining which 
investment funds are affiliates of banks. In addition, these commenters 
claimed that there is little potential for conflicts of interest, and 
no evidence of abuse, in transactions between banks and unregistered 
funds. One commenter urged the Board to deem an unregistered investment 
fund to be an affiliate of a bank only if the bank or an affiliate 
controls the fund.
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    \14\ 12 U.S.C. 371c(b)(1)(D)(i).
    \15\ 12 U.S.C. 371c(b)(1)(D)(ii).
    \16\ As noted above, proposed Regulation W applied by its terms 
to ``banks,'' and the final rule applies by its terms only to member 
banks. Nevertheless, to make comparisons of the proposed and final 
rules easier for readers, the remainder of this preamble discusses 
the proposed rule as if it applied only to member banks.
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    The Board has determined to adopt this proposal. Most investment 
funds that are advised by a member bank (or an affiliate of a member 
bank) are affiliates of the bank under section 23A because the funds 
either are investment companies under the 1940 Act or are sponsored by 
the member bank (or an affiliate of the member bank). In some 
instances, however, the member bank or its affiliate may advise but not 
sponsor an investment fund that is not an investment company under the 
1940 Act. Although such a fund would not fit within the statutory 
definition of affiliate, section 23A also authorizes the Board to 
determine, by regulation or order, that any company is an affiliate of 
a member bank if the company has ``a relationship with the member bank 
or any subsidiary or affiliate of the member bank, such that covered 
transactions by the member bank or its subsidiary with that company may 
be affected by the relationship to the detriment of the member bank or 
its subsidiary.''\17\
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    \17\ 12 U.S.C. 371c(b)(1)(E).
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    The Board believes that the advisory relationship of a member bank 
or affiliate with an investment fund presents the same potential for 
conflicts of interest regardless of whether the fund is an investment 
company under the 1940 Act.\18\ An investment fund typically escapes 
from the definition of investment company under the 1940 Act because it 
(i) sells interests only to a limited number of investors or only to 
sophisticated investors; or (ii) invests primarily in financial 
instruments that are not securities.\19\ The Board does not believe 
that the private nature or investment strategy of a fund should have a 
substantial effect on the fund's affiliate status under section 23A 
because these factors do not alter the conflicts of interest presented 
in the advisory relationship between the member bank or its affiliate 
and the fund.\20\
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    \18\ In fact, a member bank may face greater risk from the 
conflicts of interest arising from its relationships with an 
investment fund that is not registered as an investment company 
under the 1940 Act because the 1940 Act restricts transactions 
between a registered investment company and entities affiliated with 
the company's investment advisor. See 15 U.S.C. 80a-17.
    \19\ The term ``investment company'' in the 1940 Act does not 
include a company that is owned by qualified persons or by no more 
than 100 persons, provided that the company does not engage in a 
public offering of its securities. See 15 U.S.C. 80a-3(c)(1), (7). 
The term also generally does not include investment funds that are 
engaged primarily in investing in financial instruments other than 
securities. See 15 U.S.C. 80a-3(a)(1).
    \20\ The Board also believes that investment funds organized 
outside the United States for which a member bank or affiliate 
serves as investment advisor are affiliates of the bank for purposes 
of section 23A. See Letter dated July 24, 1990, from J. Virgil 
Mattingly, Jr., General Counsel of the Board, to Anne B. McMillen. 
The term ``investment company'' in the 1940 Act does include 
investment funds organized under the laws of a non-U.S. 
jurisdiction.
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2. Financial Subsidiaries (Sec. Sec.  223.2(a)(8) and 223.3(p))

    Congress amended section 23A in 1982 to provide that subsidiaries 
of a member bank are not affiliates of the bank under the statute. 
Congress adopted this approach on the premise that subsidiaries of a 
member bank generally are consolidated with the bank and engage only in 
those activities that the bank itself could engage in directly, and 
hence that such a subsidiary was more like a department of the bank 
than a separate company. In order to prevent evasions of section 23A, 
the 1982 amendments gave the Board explicit authority to treat as an 
affiliate of a member bank any subsidiary if the relationship between 
the bank and the subsidiary could affect transactions between the 
companies to the detriment of the bank.\21\
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    \21\ 12 U.S.C. 371c(b)(2)(A).
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    In 1997, in light of the expanding powers of subsidiaries of banks, 
the Board relied on this statutory authority to issue for comment a 
proposal to extend section 23A to transactions between a member bank 
and a subsidiary of the bank engaged in activities not permissible for 
the bank to engage in directly. The Board took no final action on this 
proposal in light of Congressional consideration of financial 
modernization legislation. In 1999, the GLB Act authorized banks to own 
``financial subsidiaries'' that engage in activities not permissible 
for the parent bank to conduct directly, such as underwriting and 
dealing in bank-ineligible securities. The GLB Act also amended section 
23A to define a financial subsidiary of a bank as an affiliate of the 
bank and, thus, subjected transactions between the bank and a financial 
subsidiary to the limitations of sections 23A and 23B.
    Section 23A, as amended by the GLB Act, defines a financial 
subsidiary as a subsidiary of any bank (state or national) that is 
engaged in an activity

[[Page 76563]]

that is not permissible for national banks (other than a subsidiary 
that Federal law specifically authorizes national banks to 
control).\22\ Proposed Regulation W defined financial subsidiary by 
repeating the definition of the term in section 23A. The proposed rule 
also noted that many state banks have authority to engage in activities 
that would not be permissible for national banks and sought comment on 
how to apply the section 23A definition of financial subsidiary to 
state banks. In addition, the proposal requested comment on whether to 
exempt from the definition of financial subsidiary any subsidiary of a 
bank that engages solely in agency activities.
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    \22\ Specifically, section 23A defines a ``financial 
subsidiary'' as ``any company that is a subsidiary of a bank that 
would be a financial subsidiary of a national bank under section 
5136A of the Revised Statutes of the United States.'' 12 U.S.C. 
371c(e)(1). Section 5136A, in turn, defines a financial subsidiary 
as any company that is controlled by one or more insured depository 
institutions, other than (i) a subsidiary that engages solely in 
activities that national banks are permitted to engage in directly 
or (ii) a subsidiary that national banks are specifically authorized 
to control by the express terms of a Federal statute (other than 
section 5136A), such as an Edge Act corporation or a SBIC. 12 U.S.C. 
24a(g)(3). Section 5136A also generally prohibits a financial 
subsidiary of a national bank from engaging in insurance 
underwriting, real estate investment and development, or merchant 
banking activities. 12 U.S.C. 24a(a)(2).
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    a. Subsidiaries of state banks.--Commenters offered a wide variety 
of alternative ways for the Board to apply the statute's definition of 
financial subsidiary to state banks. One set of commenters (including 
the Conference of State Bank Supervisors and the American Bankers 
Association) asked the Board to define a financial subsidiary of a 
state bank to include only those subsidiaries that are engaged in 
activities that the parent state bank could not engage in directly. 
Another set of commenters argued that the Board should define a 
financial subsidiary of a state bank to include only those subsidiaries 
subject to section 46 of the FDI Act; that is, those subsidiaries that 
are engaged in principal activities that may only be conducted by a 
national bank through a financial subsidiary (currently, only 
subsidiaries engaged in underwriting and dealing in bank-ineligible 
securities). Other commenters advocated for a complete exemption for 
all subsidiaries of a state bank. Over 30 commenters--the largest 
number of commenters on any issue raised by the proposed rule--urged 
the Board to define financial subsidiary to exclude those subsidiaries 
of state banks that are engaged in grandfathered securities investment 
activities under section 24(f) of the FDI Act.\23\
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    \23\ 12 U.S.C. 1831a(f). Section 24(f) of the FDI Act permits 
state banks that had lawfully made certain liquid equity investments 
in 1990-91 to continue to engage in such equity investment 
activities so long as such equity investments do not exceed an 
amount equal to the bank's capital.
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    The Board believes that the literal terms of section 23A provide 
that a subsidiary of a state bank that engages in an activity that is 
not permissible for national banks to conduct directly is a financial 
subsidiary of the state bank (unless Federal law specifically 
authorizes national banks to control such a subsidiary). This 
conclusion holds regardless of whether the activity (i) is permissible 
for the state bank to conduct directly; (ii) is an agency or principal 
activity; (iii) was approved by the FDIC under section 24 of the FDI 
Act; or (iv) was conducted by the subsidiary before the enactment of 
the GLB Act.
    The final rule defines financial subsidiary in this manner but also 
contains exemptions for two classes of subsidiaries of state banks. 
First, the final rule exempts any subsidiary of a state bank that 
engages in activities that the parent state bank may engage in directly 
under Federal and state law.\24\ In the Board's view, if a state bank 
has authority under applicable law to conduct an activity directly in 
the bank, section 23A normally should not apply to transactions between 
the bank and a subsidiary engaged in the activity. In these 
circumstances, the bank could conduct the activity directly in the bank 
and fund the activity free of section 23A. The Board is aware of no 
material supervisory reason to create a disincentive for the bank to 
conduct such a bank-permissible activity through a subsidiary if the 
bank has determined--for tax, liability, or other reasons--that the 
activity is most safely and efficiently conducted through a subsidiary. 
This approach is consistent with the spirit of the GLB Act and with the 
Board's 1997 rulemaking on subsidiaries of member banks.
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    \24\ For purposes of applying this exemption, a state bank may 
directly engage in an activity under Federal law if Federal law does 
not prohibit the state bank from directly engaging in the activity. 
If, on the other hand, Federal law prohibits a state bank from 
directly engaging in an activity--such as equity investment (see 12 
U.S.C. 1831a(c) and (f))--a subsidiary of a state bank that engaged 
in the activity could not qualify for this exemption.
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    Second, the final rule exempts any subsidiary of a state bank that 
engages in activities that the subsidiary was legally conducting before 
issuance of final Regulation W. Among other things, this exemption 
would remove from the definition of financial subsidiary those 
subsidiaries of state banks that are engaged in the limited, 
grandfathered securities investment activities authorized under section 
24(f) of the FDI Act. The Board does not believe that this exemption 
would apply to a significant number of other material subsidiaries of 
state banks. The exemption would be appropriate, however, so as not to 
impose a hardship on the existing business operations and structures of 
state banks.\25\
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    \25\ Neither of these exemptions would be available for any 
subsidiary of a state bank that engages in principal activities that 
the GLB Act requires a national bank to conduct in a financial 
subsidiary, such as underwriting and dealing in bank-ineligible 
securities. Section 46 of the FDI Act explicitly provides that such 
subsidiaries of a state bank are to be treated as section 23A 
affiliates of the bank. 12 U.S.C. 1831w.
    The GLB Act authorizes the Board and the Treasury Department to 
determine jointly, on or after November 12, 2004, that financial 
subsidiaries may engage in merchant banking activities. GLB Act 
Sec.  122. If the Board and Treasury were to make such a 
determination, the merchant banking subsidiaries of banks would be 
section 23A financial subsidiaries under the final rule.
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    As noted above, some commenters argued that the only section 23A 
financial subsidiaries of state banks are those subsidiaries that are 
subject to section 46 of the FDI Act. The Board does not believe that 
this argument is convincing. Although section 46 of the FDI Act 
specifically notes that sections 23A and 23B apply to transactions 
between a state bank and a section 46 subsidiary, section 46 does not 
change the definition of financial subsidiary contained in section 23A 
or, by its terms, limit the coverage of section 23A's financial 
subsidiary provisions to only section 46 subsidiaries.
    Several commenters also argued that the Board should exempt any 
subsidiary of a state bank (other than a section 46 subsidiary) 
approved by the FDIC under section 24 of the FDI Act. Section 24 of the 
FDI Act prevents a subsidiary of an insured state bank from engaging in 
any principal activity that is not permissible for a subsidiary of a 
national bank unless (i) the FDIC has made a determination that the 
activity would pose no significant risk to the Federal deposit 
insurance funds; and (ii) the state bank remains in compliance with the 
capital guidelines of its appropriate Federal banking agency.\26\ As 
noted above, the final rule contains an exemption for any subsidiary of 
a state bank that engages in activities permissible for the parent 
state bank to conduct directly. Accordingly, the principal effect of 
granting an exemption for section 24 subsidiaries would be to exempt 
from section 23A transactions between a state bank and

[[Page 76564]]

its section 24 subsidiaries engaged in activities the parent bank may 
not conduct directly. Such subsidiaries would include those engaged in 
equity investment (which Federal law prohibits insured state banks from 
engaging in) \27\ or real estate investment and development (in those 
states that do not permit state banks to conduct such activities 
directly).
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    \26\ 12 U.S.C. 1831a(d).
    \27\ Federal law generally prohibits insured state banks from 
making equity investments of a type or in an amount that is not 
permissible for national banks. See 12 U.S.C. 1831a(c) and (f).
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    Commenters argued that various considerations support granting an 
exemption for section 24 subsidiaries that conduct activities not 
permissible for their parent state bank. First, commenters contended 
that section 24 of the FDI Act and the FDIC's regulations thereunder 
establish a reasonably comprehensive system for protecting insured 
state banks that engage, or propose to engage, in principal activities 
not permissible for national banks. In this regard, the FDIC's section 
24 regulations impose restrictions on transactions between a state bank 
and many types of section 24 subsidiaries (including subsidiaries 
engaged in real estate investment and development).\28\ In addition, 
the FDIC has approved only a few hundred section 24 subsidiaries since 
Congress added section 24 to the FDI Act in 1991, and the FDIC has 
received very few requests under section 24 in the past couple of 
years. Finally, a large majority of section 24 subsidiaries represent a 
small part of the capital of their parent state banks, and section 24 
subsidiaries have not to date materially affected the safety and 
soundness of state banks.
---------------------------------------------------------------------------

    \28\ See 12 CFR 362.4(b)(5) and (d).
---------------------------------------------------------------------------

    The Board believes that there are important reasons, however, not 
to include in the final rule an exemption for section 24 subsidiaries 
that engage in activities their parent bank may not conduct directly. 
First, Congress provided a definition of financial subsidiary in 
section 23A that, by its terms, covers section 24 subsidiaries.\29\ In 
addition, coverage of section 24 subsidiaries that engage in activities 
not permissible for their parent bank (and, by definition, activities 
not permissible for national banks) is consistent with an important 
purpose of the GLB Act--constraining the ability of a bank to transfer 
the subsidy arising from the bank's access to the Federal safety net to 
affiliates engaged in activities that the bank cannot conduct directly.
---------------------------------------------------------------------------

    \29\ Some commenters argued that section 24 subsidiaries engaged 
in real estate investment and development or equity investment are 
not section 23A financial subsidiaries because (i) section 23A 
defines a financial subsidiary as a subsidiary that ``would be a 
financial subsidiary of a national bank under section 5136A of the 
Revised Statutes'' and (ii) section 5136A prohibits financial 
subsidiaries of national banks from engaging in real estate 
investment and development and merchant banking. The Board finds 
this argument unpersuasive. Although section 5136A prohibits 
financial subsidiaries of national banks from engaging in real 
estate investment and development or equity investment, a subsidiary 
engaged in such activities would meet the terms of the financial 
subsidiary definition in section 23A and section 5136A.
---------------------------------------------------------------------------

    Furthermore, the activities conducted by many section 24 
subsidiaries, including in particular real estate investment and 
development, increase the risk profile of their parent bank and 
historically have caused significant losses to the Federal deposit 
insurance funds.\30\ Although section 24 subsidiaries have not to date 
imperiled their parent banks, banks have been operating in a favorable 
economic environment since Congress enacted section 24 of the FDI Act. 
Moreover, the section 24 restrictions imposed by the FDIC are not as 
comprehensive as those in section 23A \31\ and could be removed or 
relaxed by the FDIC at any time.\32\ Furthermore, although the Board 
could revoke any exemption granted to section 24 subsidiaries if the 
exemption were to have adverse safety and soundness consequences, such 
a future revocation may be difficult to effect because it would come at 
a time when state banks are least able to comply with the requirements 
of section 23A. For these reasons, the final rule does not contain an 
exemption for section 24 subsidiaries of a state bank that engage in 
activities their parent bank may not conduct directly.
---------------------------------------------------------------------------

    \30\ As noted above, Congress expressed specific concern in the 
GLB Act about real estate investment and development by prohibiting 
the financial subsidiaries of national banks from engaging in these 
activities. 12 U.S.C. 24a(a)(2). It is also worth noting that, 
because the final rule includes an exemption for subsidiaries of a 
state bank engaged in activities that the parent state bank could 
engage in directly, the principal beneficiaries of a separate 
exemption for section 24 subsidiaries would be subsidiaries of a 
state bank engaged in activities that state or Federal law has 
determined are too risky to be conducted directly in the bank.
    \31\ The FDIC's restrictions, among other things, do not (i) 
include a 10 percent quantitative limit on covered transactions 
between the bank and any single section 24 subsidiary; (ii) restrict 
the ability of a bank to finance a third party's purchase of assets 
from a section 24 subsidiary of the bank; or (iii) treat a purchase 
of assets from a section 24 subsidiary or the issuance of a 
guarantee or letter of credit on behalf of a section 24 subsidiary 
as covered transactions.
    \32\ In many past cases, the FDIC required state banks to deduct 
from tier 1 capital the full amount of their equity investments in 
most section 24 subsidiaries (including real estate investment and 
development subsidiaries). Consistent with the interagency capital 
rule on nonfinancial equity investments adopted on January 25, 2002, 
however, the FDIC now requires that state banks deduct from tier 1 
capital between 8 percent and 25 percent of an equity investment in 
most section 24 subsidiaries. See 12 CFR part 325, Appendix A, Sec.  
II.B.6.ii. The FDIC retains authority under the nonfinancial equity 
investment capital rule to apply a higher capital charge on these 
investments, but the FDIC has not chosen to do so at this time.
---------------------------------------------------------------------------

    b. Agency subsidiaries of national banks and state banks.--Section 
23A's definition of financial subsidiary does not exclude subsidiaries 
of banks that are engaged solely in agency activities.\33\ As a result, 
insurance agency subsidiaries of national banks that operate outside a 
town of 5,000, for example, are financial subsidiaries of their parent 
banks under the statute.
---------------------------------------------------------------------------

    \33\ Some commenters argued that agency subsidiaries of state 
banks cannot be financial subsidiaries under section 23A because (i) 
the only section 23A financial subsidiaries of state banks are 
subsidiaries that qualify as financial subsidiaries under section 46 
of the FDI Act and (ii) agency subsidiaries cannot qualify as 
financial subsidiaries under section 46. For the reasons discussed 
above, the Board does not believe that this argument is convincing.
---------------------------------------------------------------------------

    A large number of commenters urged the Board to exclude 
subsidiaries engaged in agency activities from the definition of 
financial subsidiary. The Board has decided to exempt from the 
definition of financial subsidiary any subsidiary of a national bank or 
state bank that would be considered a financial subsidiary solely 
because the subsidiary engages in insurance agency activities that are 
not permissible for the parent bank. The Federal banking agencies have 
had significant experience in supervising insurance agency subsidiaries 
of banks, and such subsidiaries do not pose the kind of threat to bank 
safety and soundness that section 23A was designed to prevent. In 
addition, because insurance agency subsidiaries are not capital-
intensive, they require little funding from the parent bank and, hence, 
stand to benefit less from the subsidy implicit in the Federal safety 
net than would a subsidiary engaged in activities as principal. Under 
the final rule, therefore, subsidiaries of banks engaged in insurance 
agency activities or agency activities permissible for the bank to 
engage in directly are not section 23A financial subsidiaries.
    The Board does not believe that it is appropriate at this time to 
grant an exemption for all subsidiaries engaged exclusively in agency 
activities because defining what constitutes an agency activity is 
problematic, and some agency activities involve significant risk. In 
the unusual circumstance where a subsidiary of a bank conducts a non-
insurance agency activity that is not permissible for the bank to 
conduct directly, the bank may request that the Board grant a specific 
exemption for the subsidiary.

[[Page 76565]]

    The Board notes that it retains discretion under section 23A to 
determine, by regulation or order, that any subsidiary of a member bank 
(even a subsidiary that qualifies for a regulatory exemption from the 
definition of financial subsidiary) is an affiliate of the bank if the 
relationship between the bank and the subsidiary is such that covered 
transactions between the bank and the subsidiary may be affected by the 
relationship to the detriment of the bank.\34\
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    \34\ 12 U.S.C. 371c(b)(1)(E) and (b)(2)(A). As discussed below 
in part III.A.6. of this preamble, Sec.  223.2(a)(12) of the final 
rule also authorizes the appropriate Federal banking agency for a 
depository institution to determine by order that a subsidiary of 
the institution is an affiliate.
---------------------------------------------------------------------------

    c. Subsidiaries of thrifts.--Although section 23A applies by its 
terms only to member banks, HOLA subjects every thrift to section 23A 
``in the same manner and to the same extent as if the [thrift] were a 
member bank.''\35\ As noted above, section 23A defines a financial 
subsidiary as ``any company that is a subsidiary of a bank that would 
be a financial subsidiary of a national bank.'' Because all ``member 
banks'' under section 23A are also ``banks'' under section 23A, and 
because HOLA subjects every thrift to section 23A as if the thrift were 
a ``member bank,'' one could read the financial subsidiary definition 
in section 23A as covering any subsidiary of a thrift that would be a 
financial subsidiary of a national bank.
---------------------------------------------------------------------------

    \35\ 12 U.S.C. 1468(a).
---------------------------------------------------------------------------

    On the other hand, the OTS argued that thrifts generally are not 
``banks'' under section 23A and, hence, that thrifts do not have 
financial subsidiaries under section 23A. The OTS also pointed out 
that, although the GLB Act contains explicit and detailed provisions 
(unrelated to section 23A) regarding financial subsidiaries of national 
banks and state banks, the GLB Act does not contain any explicit 
reference to financial subsidiaries of thrifts. In addition, HOLA 
already contains numerous provisions that protect thrifts in their 
transactions with subsidiaries. For example, HOLA requires thrifts to 
deduct from their capital all investments in, and extensions of credit 
to, any subsidiary engaged in activities that are not permissible for 
national banks.\36\ HOLA also prohibits a thrift from investing more 
than 3 percent of its assets in service corporation subsidiaries.\37\ 
The Board further notes that there is little empirical evidence to date 
that subsidiaries of thrifts have had a material adverse effect on the 
safety or soundness of their parent thrifts since becoming subject to 
heightened Federal regulation in 1989.
---------------------------------------------------------------------------

    \36\ 12 U.S.C. 1464(t)(5); 12 CFR 559.3(j)(2) and part 567.
    \37\ 12 U.S.C. 1464(c)(4)(B).
---------------------------------------------------------------------------

    In light of the statutory ambiguities, the protections contained in 
HOLA, and a request by the OTS that the final rule not treat 
subsidiaries of thrifts as financial subsidiaries, the final rule does 
not address financial subsidiaries of thrifts.

3. Companies Held Under Merchant Banking or Insurance Company 
Investment Authority (Sec.  223.2(a)(9))

    The GLB Act amended the Bank Holding Company Act (``BHC Act'') to 
permit bank holding companies (``BHCs'') and foreign banks that qualify 
as financial holding companies (``FHCs'') to engage in merchant banking 
and insurance company investment activities.\38\ If a FHC owns or 
controls more than 25 percent of a class of voting shares of a company 
under the merchant banking or insurance company investment authority, 
the company is an affiliate of any member bank controlled by the FHC by 
operation of the statutory definitions contained in section 23A. The 
GLB Act also added paragraph (b)(11) to section 23A, which creates a 
rebuttable presumption that a company is an affiliate of a member bank 
for purposes of section 23A if the bank is affiliated with a FHC and 
the FHC owns or controls 15 percent or more of the equity capital of 
the company pursuant to the FHC's merchant banking or insurance company 
investment authority.\39\
---------------------------------------------------------------------------

    \38\ GLB Act Sec.  103(a); 12 U.S.C. 1843(k)(4)(H) and (I).
    \39\ GLB Act Sec.  121(b)(2). As noted above, this rebuttable 
presumption applies only if the affiliated FHC owns or controls 15 
percent or more of the company's equity capital under the new 
merchant banking or insurance company investment authorities. The 
Board notes, however, that under existing Board precedents a BHC may 
not own any shares of a company in reliance on section 4(c)(6) or 
4(c)(7) of the BHC Act where the holding company owns or controls, 
in the aggregate under a combination of authorities, more than 5 
percent of any class of voting securities of the company.
---------------------------------------------------------------------------

    The regulation includes within the definition of ``affiliate'' any 
company subject to this rebuttable presumption. The regulation also 
provides a definition of equity capital, identifies three situations or 
``safe harbors'' where the statute's presumption would be deemed to be 
rebutted, and clarifies the application of the presumption to private 
equity funds. The Regulation W provisions that implement the statutory 
presumption are substantially identical to those contained in the 
Board's merchant banking rule.\40\
---------------------------------------------------------------------------

    \40\ See 12 CFR 225.176(b).
---------------------------------------------------------------------------

    The statute does not provide a definition of equity capital. The 
regulation defines equity capital roughly in accordance with the GAAP 
definition of stockholders' equity. Equity capital includes a company's 
preferred stock, common stock, capital surplus, retained earnings, and 
accumulated other comprehensive income, less treasury stock.\41\ The 
definition of equity capital also makes clear that any other account of 
the company that constitutes equity should be included in the company's 
equity capital. Accordingly, the Board retains its authority on a case-
by-case basis to require a holding company to treat a subordinated debt 
investment in a company as equity capital of the company for purposes 
of applying the 15 percent presumption.
---------------------------------------------------------------------------

    \41\ Although the proposed rule only explicitly included 
perpetual preferred stock in a company's equity capital, the final 
rule includes all forms of preferred stock. The Board believes that 
any instrument in the form of equity should be treated as equity 
capital for purposes of Regulation W.
---------------------------------------------------------------------------

    The regulation also provides three specific regulatory safe harbors 
from the 15 percent presumption. These safe harbors apply in situations 
where the holding company owns or controls more than 15 percent of the 
total equity of the company under the merchant banking or insurance 
company investment authority (thereby triggering the statutory 
presumption) and less than 25 percent of any class of voting securities 
of the company (thereby not meeting the statutory definition of 
control). The three situations are substantially identical to those 
listed in the Board's merchant banking regulation.\42\
---------------------------------------------------------------------------

    \42\ See 12 CFR 225.176(b)(2) and (3).
---------------------------------------------------------------------------

    The first exemption applies where no director, officer, or employee 
of the holding company serves as a director (or individual exercising 
similar functions) of the company. The second exemption applies where 
an independent third party controls a greater percentage of the equity 
capital of the company than is controlled by the holding company, and 
no more than one officer or employee of the holding company serves as a 
director (or individual exercising similar functions) of the company. 
The third exemption applies where an independent third party controls 
more than 50 percent of the voting shares of the company, and officers 
and employees of the holding company do not constitute a majority of 
the directors (or individuals exercising similar functions) of the 
company.\43\
---------------------------------------------------------------------------

    \43\ For purposes of these safe harbors, the rule provides that 
the term ``holding company'' includes any subsidiary of the holding 
company, including any subsidiary bank of the holding company. 
Accordingly, if a director of a subsidiary bank or nonbank 
subsidiary of a FHC also serves as a director of a portfolio 
company, the first safe harbor, for example, would be unavailable.

---------------------------------------------------------------------------

[[Page 76566]]

    These safe harbors do not require Board review or approval. 
Moreover, the safe harbors are not intended to be a complete list of 
circumstances in which the 15 percent presumption may be rebutted. The 
regulation also provides, consistent with the GLB Act, that a holding 
company may rebut the presumption with respect to a portfolio company 
by presenting information to the Board that demonstrates, to the 
Board's satisfaction, that the holding company does not control the 
portfolio company. The Board notes that a company that qualifies as an 
affiliate under the 15 percent presumption and under another prong of 
the regulation's definition of affiliate cannot avoid affiliate status 
through a rebuttal of the 15 percent presumption (either by qualifying 
for one of the three regulatory safe harbors or by obtaining an ad hoc 
rebuttal of the presumption from the Board).
    A FHC generally is considered to own or control only those shares 
or other ownership interests that are owned or controlled by itself or 
by a subsidiary of the holding company. The rule clarifies that, for 
purposes of applying the presumption of affiliation described above, a 
FHC that has an investment in a private equity fund (as defined in the 
Board's merchant banking rule) will not be considered indirectly to own 
the equity capital of a company in which the fund has invested unless 
the FHC controls the private equity fund (as described in the Board's 
merchant banking rule).

4. Partnerships (Sec.  223.2(a)(4) and (10))

    The proposed rule generally deemed partnerships for which the 
member bank or an affiliate of the bank serves as a general partner to 
be an affiliate of the bank. Several commenters expressed concern that 
this interpretation of section 23A would eliminate bank funding of 
legitimate commercial and community development transactions. This 
concern of commenters is unwarranted. Although partnerships for which a 
member bank serves as a general partner are on the section 223.2(a) 
list of entities that generally are affiliates, such partnerships 
typically will be excluded from the definition of affiliate in section 
223.2(b) as subsidiaries of their parent bank. The Board traditionally 
has considered the general partner interest in a limited partnership to 
be a separate class of voting securities of the partnership. 
Accordingly, a limited partnership would be considered an operating 
subsidiary of a member bank (that is, a subsidiary of a member bank 
that is not a section 23A affiliate of the bank) in the typical 
circumstances where the member bank owns or controls more than 25 
percent of the general partner interests in the partnership and the 
partnership is not a financial subsidiary of the bank.
    The final rule amends the proposed rule on general partners in one 
respect to prevent evasion. The proposed rule defined as an affiliate 
of a member bank any partnership if the member bank or an affiliate of 
the bank causes any officer or employee of the bank or affiliate to 
serve as a general partner of the partnership (unless the partnership 
is an operating subsidiary of the bank, as discussed above). The final 
rule expands the proposed rule to provide that a partnership also will 
be considered an affiliate of the member bank if the bank or an 
affiliate of the bank causes any director of the bank or affiliate to 
serve as a general partner of the partnership (unless the partnership 
is an operating subsidiary of the bank).

5. Subsidiaries of Affiliates (Sec.  223.2(a)(11))

    In the proposal, the Board invited public comment on whether to add 
to the definition of affiliate any company controlled by an investment 
fund that is an affiliate of the member bank. A few commenters objected 
to this proposal on the grounds that it would have little section 23A 
benefit and would require banks to implement complex monitoring and 
aggregation systems.
    The Board has decided to accord affiliate status to any company 
controlled by an investment fund affiliate of a member bank. The 
conflicts of interest that exist between a member bank and any 
investment fund that it or its affiliate advises also would appear to 
exist between the bank and a portfolio company controlled by the fund. 
A member bank would have an incentive to provide financial assistance 
to such a portfolio company in order to enhance the returns of the 
investment fund affiliate of the bank. As a result, covered 
transactions between the member bank and such a portfolio company may 
be affected by the control relationship between the investment fund and 
the portfolio company to the detriment of the bank.
    The Board also has determined, more broadly, to deem an affiliate 
any company controlled by another affiliate of the member bank. This 
regulatory position is consistent with the long-standing view of Board 
staff. Although section 23A by its terms defines as affiliates most 
subsidiaries of an affiliate of the member bank, there are a few 
exceptions to the rule. In addition to covering subsidiaries of 
investment fund affiliates, this action will make clear, for example, 
that subsidiaries of interlocking directorate affiliates (Sec.  
223.2(a)(4)) and sponsored and advised affiliates (Sec.  223.2(a)(5)) 
also are treated as affiliates of the member bank. Again, the control 
relationship between such statutory affiliates and their subsidiaries 
may affect covered transactions between the member bank and such 
subsidiaries to the detriment of the bank.

6. Companies Designated by the Appropriate Federal Banking Agency 
(Sec.  223.2(a)(12))

    As noted above, section 23A authorizes the Board to determine that 
any company that has certain relationships with a member bank or an 
affiliate of the bank is itself an affiliate of the bank. Unlike the 
proposed rule, final Regulation W provides that these determinations 
may be made by the Board or by the appropriate Federal banking agency 
for the relevant depository institution (under authority delegated by 
the Board). The Board believes that this delegation of authority should 
enhance the ability of the Federal banking agencies to protect 
depository institutions in their transactions with associated 
companies. A depository institution may petition the Board for review 
of any such affiliate determination made by the institution's 
appropriate Federal banking agency under the general procedures 
established by the Board for review of actions taken under delegated 
authority.\44\
---------------------------------------------------------------------------

    \44\ See 12 CFR 265.3.
---------------------------------------------------------------------------

7. Certain Joint Venture Companies (Sec.  223.2(b)(1)(iii))

    As noted above, under the terms of section 23A, subsidiaries of a 
member bank generally are not treated as affiliates of the bank, even 
if they would otherwise qualify as affiliates.\45\ The statute contains 
two specific exceptions to this general rule: ``Financial 
subsidiaries'' of a member bank and ``bank'' subsidiaries of a member 
bank are treated as affiliates of the parent

[[Page 76567]]

bank. As also noted above, the statute provides that the Board may 
determine that other subsidiaries of a member bank should be treated as 
affiliates in appropriate circumstances.\46\
---------------------------------------------------------------------------

    \45\ See 12 U.S.C. 371c(b)(1)(A) and (b)(2)(A). Section 23A 
defines a subsidiary of a specified company as a company that is 
controlled by the specified company. Under the statute, a company 
controls another company if the first company owns or controls 25 
percent or more of a class of voting securities of the other 
company, controls the election of a majority of the directors of the 
other company, or exercises a controlling influence over the 
policies of the other company. 12 U.S.C. 371c(b)(3) and (4).
    \46\ 12 U.S.C. 371c(b)(2)(A).
---------------------------------------------------------------------------

    Pursuant to this authority, the Board proposed that two additional 
classes of subsidiaries of a member bank should be treated as 
affiliates: (i) Certain joint venture companies; and (ii) employee 
benefit plans. This section of the preamble discusses joint venture 
companies; the following section addresses employee benefit plans.
    First, the proposed regulation provided that any subsidiary of a 
member bank in which an affiliate of the bank directly owns or controls 
25 percent or more of any class of voting securities would be 
considered an affiliate of the bank. For example, under the proposed 
rule, a joint venture company that is 50 percent owned by a BHC 
directly and 50 percent owned by one of its subsidiary member banks, 
would be treated as an affiliate of the bank.
    One commenter objected to this provision in light of the fact that 
such joint venture companies and their investors are supervised by the 
Federal banking agencies. The Board does not believe that supervision 
of the joint venture company or the affiliated investor is sufficient 
to protect the member bank. Although such a joint venture company 
qualifies as a subsidiary of the member bank under section 23A because 
the bank owns more than 25 percent of the company's voting stock, an 
affiliate's substantial direct interest in the company creates the 
potential for conflicts of interest that may endanger the bank. The 
Board notes that, with the limited exception of sister banks, Congress 
did not exempt entities from the definition of affiliate under section 
23A because of their supervisory status.\47\
---------------------------------------------------------------------------

    \47\ Several other commenters asked that the final rule not 
exclude joint venture subsidiaries of a bank so long as the bank 
owns more than 50 percent of the voting securities of the joint 
venture company. The Board declines to adopt this position because, 
notwithstanding the bank's controlling voting interest in the 
subsidiary, the bank's less-than-100 percent interest and the 
affiliate's substantial direct interest in the company may provide 
the bank with inappropriate incentives to support the company.
---------------------------------------------------------------------------

    The Board has determined to modify the joint venture rule in 
several respects. The proposed rule only treated a subsidiary of a 
member bank as an affiliate of the bank if one or more affiliates of 
the bank directly owned or controlled 25 percent or more of any class 
of voting securities of the joint venture. The final rule, however, 
treats a subsidiary of a member bank as an affiliate if one or more 
affiliates of the bank, or one or more controlling shareholders of the 
bank, directly control the joint venture. The Board intends this 
expansion of the joint venture exclusion to cover situations where an 
affiliate exercises direct control over the joint venture through a 
manner other than ownership of voting securities (for example, through 
majority interlock or ownership of nonvoting securities). This 
expansion also covers situations where a controlling natural person 
shareholder or group of controlling natural person shareholders of the 
member bank (who, as natural persons, are not themselves section 23A 
affiliates of the bank) exercise direct control over the joint venture 
company.
    This regulatory treatment of certain bank-affiliate joint ventures 
as affiliates does not apply to joint ventures between a member bank 
and any affiliated insured depository institutions. For example, if two 
affiliated member banks each own 50 percent of the voting common stock 
of a company, the company would continue to qualify as a subsidiary and 
not an affiliate of each bank (despite the fact that an affiliate of 
each bank owned more than 25 percent of a class of voting securities of 
the company). Such a special rule for joint ventures between a member 
bank and affiliated insured depository institutions is consistent with 
the purpose behind the sister-bank and affiliated-bank exemptions 
contained in section 23A. The Board does not believe that transactions 
between a member bank and a company that is wholly owned by the member 
bank and its affiliated insured depository institutions generally pose 
material risks to the safety and soundness of the shareholding 
institutions or to the Federal deposit insurance funds. The Board would 
retain authority to treat such joint ventures as affiliates under 
section 23A on a case-by-case basis.

8. Employee Benefit Plans (Sec.  223.2(b)(1)(iv))

    The second proposed regulatory exception to the general rule that 
subsidiaries of a member bank are not treated as affiliates of the bank 
relates to employee benefit plans. Board staff traditionally has taken 
the position that most employee stock option plans, trusts, or similar 
entities that exist to benefit shareholders, members, officers, 
directors, or employees of a member bank or its affiliates (``ESOPs'') 
should be treated as affiliates of the bank for purposes of sections 
23A and 23B. In most cases, the ESOP's share ownership or the 
interlocking management between the ESOP and its associated member bank 
or BHC exceeds the statutory thresholds for determining that a company 
is an affiliate. Some institutions have argued, however, that ESOPs 
should be considered subsidiaries of the member bank and therefore 
exempt from coverage. The proposed rule provided that the ESOP of a 
member bank or an affiliate of the bank cannot itself avoid 
classification as an affiliate of the bank by also qualifying as a 
subsidiary of the bank.
    Although one commenter supported the proposed rule's approach to 
ESOPs, several commenters objected to the approach. These commenters 
principally argued that (i) ESOPs are regulated by the Department of 
Labor and transactions between a bank and an associated ESOP are 
adequately governed by ERISA; (ii) Congress has expressed support for 
ESOPs; (iii) regulating bank-ESOP transactions under section 23A would 
prevent banks from effectively using ESOPs to compensate employees and 
would put banks at a competitive disadvantage to nonbank firms; and 
(iv) treating ESOPs as affiliates of their associated bank may prevent 
some banks from establishing ESOPs because third-party lenders to an 
ESOP generally require the employer to guarantee the loan and ESOPs 
often would have no collateral to pledge for the bank guarantee other 
than unacceptable affiliate-issued securities.
    Notwithstanding these considerations, the Board believes that the 
relationship between a member bank and its or its affiliate's ESOP 
generally warrants coverage by sections 23A and 23B. In the past, banks 
have made unsecured loans to their ESOPs or their affiliates' ESOPs or 
have guaranteed loans to such ESOPs that were made by a third party. 
These ESOPs, however, generally have no means to repay the loans other 
than with funds provided by the bank. In addition, the issuance of 
holding company shares to an ESOP that is funded by a loan from the 
holding company's subsidiary bank could be used as a vehicle by the 
bank to provide funds to its parent holding company when the bank is 
unable to pay dividends or is otherwise restricted in providing funds 
to its holding company.

9. Securitization Vehicles and Other Special Purpose Entities 
(``SPEs'')

    In the proposal, the Board sought comment on whether additional 
clarification is necessary in the area of securitizations. The Board 
specifically requested comment on the question of whether 
securitization SPEs should in any circumstances be deemed to be 
affiliates of the member bank involved

[[Page 76568]]

in the securitization. The Board received a significant amount of 
comment on this issue. Commenters uniformly recommended that the Board 
not treat SPEs as affiliates of any bank associated with the 
securitization. Due to the complexities of this issue and the pending 
proposal by the Financial Accounting Standards Board (``FASB'') on the 
consolidation of SPEs,\48\ the Board is deferring at this time any 
rulemaking with respect to the relationships between member banks and 
SPEs.
---------------------------------------------------------------------------

    \48\ FASB Proposed Interpretation, Consolidation of Certain 
Special-Purpose Entities, an Interpretation of ARB No. 51 (June 28, 
2002).
---------------------------------------------------------------------------

    The Board reminds banking organizations that any company sponsored 
and advised on a contractual basis by a member bank or an affiliate of 
the bank is an affiliate of the bank under the express terms of section 
23A and the final rule. The legislative history of the statute suggests 
that such ``sponsored and advised'' companies would include, at a 
minimum, any company that receives investment advice and administrative 
services on a contractual basis from a member bank, whose trustees or 
managers are selected by the bank, and that has a name similar to that 
of the bank. The Board expects that member banks, at a minimum, would 
treat companies meeting or substantially meeting these three indicia of 
sponsorship and advice as affiliates under section 23A.
B. Other Definitions (Sec.  223.3)

1. Capital Stock and Surplus (Sec.  223.3(d))

    Under section 23A, the quantitative limits on covered transactions 
are based on the ``capital stock and surplus'' of the member bank.\49\ 
The proposed regulation included a definition of capital stock and 
surplus that the Board previously adopted as an interpretation of 
section 23A.\50\ Under this definition, capital stock and surplus is 
the sum of the member bank's tier 1 capital and tier 2 capital and the 
balance of the bank's allowance for loan and lease losses not included 
in its tier 2 capital. This definition employs familiar concepts 
contained in the Federal banking agencies' capital adequacy 
guidelines,\51\ and is consistent with the lending limits applicable to 
national banks \52\ and the Board's Regulation O, which limits lending 
to a member bank's insiders.\53\
---------------------------------------------------------------------------

    \49\ 12 U.S.C. 371c(a)(1).
    \50\ See 61 FR 19805, May 3, 1996.
    \51\ See, e.g.,12 CFR part 225, appendix A.
    \52\ 12 CFR 32.2(b).
    \53\ 12 CFR 215.2(i).
---------------------------------------------------------------------------

    The final rule, consistent with a discussion in the preamble to the 
proposed rule, alters the definition of capital stock and surplus in 
one regard. The National Bank Act requires a national bank, ``in 
determining compliance with applicable capital standards,'' to deduct 
from its capital the aggregate amount of any outstanding equity 
investments, including retained earnings, of the bank in all its 
financial subsidiaries.\54\ The FDI Act imposes the same capital 
deduction requirement on insured state banks that establish financial 
subsidiaries.\55\ In determining compliance with the quantitative 
limits of section 23A, a bank is required by statute to include in its 
covered transactions any equity investments (excluding retained 
earnings) of the bank in its financial subsidiaries. It would be unfair 
to compel a bank to include such investments in its covered transaction 
amount (the numerator of the fraction in section 23A's quantitative 
limits) but to exclude such investments from capital stock and surplus 
(the denominator of the fraction). Accordingly, the final rule 
explicitly permits a member bank with a financial subsidiary to add 
back to its section 23A capital stock and surplus the amount of any 
investment in a financial subsidiary that counts as a covered 
transaction and is required to be deducted from the bank's capital for 
regulatory capital purposes.
---------------------------------------------------------------------------

    \54\ 12 U.S.C. 24a(c)(1).
    \55\ 12 U.S.C. 1831w(a)(2).
---------------------------------------------------------------------------

2. Control (Sec.  223.3(g))

    Section 23A provides that a company or shareholder shall be deemed 
to have control over another company if, among other things, such 
company or shareholder controls in any manner the election of a 
majority of the ``directors or trustees'' of the other company.\56\ 
Regulation W expands this prong of the control definition to conform it 
to the control definition contained in the Board's Regulation Y by 
adding that control also exists when a company or shareholder controls 
the election of a majority of the ``general partners (or individuals 
exercising similar functions)'' of another company. This expansion of 
the control definition is intended to ensure that banking organizations 
understand that a company or shareholder would be deemed to control 
another company (including a partnership, limited liability company, or 
other similar organization) under section 23A if the company or 
shareholder controls the election of a majority of the principal 
policymakers of such other company.
---------------------------------------------------------------------------

    \56\ 12 U.S.C. 371c(b)(3)(A)(ii).
---------------------------------------------------------------------------

    The regulation also includes two additional presumptions of control 
that are similar to presumptions contained in Regulation Y. First, a 
company will be deemed to control securities, assets, or other 
ownership interests controlled by any subsidiary of the company.\57\ 
Second, a company that controls instruments (including options and 
warrants) that are convertible or exercisable, at the option of the 
holder or owner, into securities, will be deemed to control the 
securities.\58\
---------------------------------------------------------------------------

    \57\ See 12 CFR 225.2(e)(2)(i).
    \58\ See 12 CFR 225.31(d)(1)(i). The proposed rule referred to 
``securities'' (rather than ``instruments'') that are convertible 
into other securities. The final rule refers more generically to 
convertible ``instruments'' to clarify that the convertibility 
presumption applies regardless of whether the right to convert 
resides in a financial instrument that technically qualifies as a 
``security'' under section 23A or the Federal securities laws.
---------------------------------------------------------------------------

    One commenter asked the Board to clarify that a company or person 
may rebut the convertibility presumption of control. The Board agrees 
with this position and has amended the final rule to provide that, as 
under Regulation Y, this presumption is rebuttable. Commenters also 
suggested that the convertibility presumption should apply only to 
convertible instruments that are immediately convertible, or 
convertible within a short time frame, into the underlying securities. 
Consistent with the Board's interpretations of the parallel Regulation 
Y provision, the Board declines to adopt this approach. Establishment 
of any kind of regulatory safe harbor for warrants, options, and other 
convertible instruments that cannot be exercised or converted for some 
short period of time is likely to facilitate evasion of the 
presumption. A company or person that wishes to rebut this presumption 
based on the specific features of a convertible instrument should 
present their arguments to the Board for a case-by-case decision.
    The final rule supplements the control presumptions contained in 
proposed Regulation W with one additional rebuttable presumption. The 
final rule provides that a company or shareholder that owns or controls 
25 percent or more of the equity capital of another company controls 
the other company unless the company or shareholder demonstrates 
otherwise to the Board based on the facts and circumstances of the 
particular case. This rebuttable presumption is similar to a 
presumption applied by the Board under the control provisions of the 
BHC Act.\59\ Such a presumption of control is particularly appropriate 
in the section

[[Page 76569]]

23A context because a BHC, for example, may have incentives to divert 
the resources of a subsidiary bank to any company in which the holding 
company has a substantial financial interest, regardless of whether the 
holding company owns any voting securities of the company.
---------------------------------------------------------------------------

    \59\ See, e.g., 12 CFR 225.143 (Board Policy Statement on 
Nonvoting Equity Investments).
---------------------------------------------------------------------------

3. Covered Transaction (Sec.  223.3(h))

    The restrictions of section 23A do not apply to every transaction 
between a member bank and its affiliates. The section only applies to 
``covered transactions'' between a member bank and its affiliates. The 
statute defines a covered transaction as (i) an extension of credit to 
an affiliate; (ii) a purchase of or investment in securities issued by 
an affiliate; (iii) a purchase of assets from an affiliate; (iv) the 
acceptance of securities issued by an affiliate as collateral for an 
extension of credit to any person; and (v) the issuance of a guarantee, 
acceptance, or letter of credit on behalf of an affiliate.\60\ Among 
the transactions that generally are not subject to section 23A are 
dividends paid by a member bank to its holding company, sales of assets 
by a member bank to an affiliate, an affiliate's purchase of securities 
issued by a member bank, and many service contracts between a member 
bank and an affiliate. This section of the preamble discusses whether 
certain classes of transactions between a member bank and an affiliate 
are covered transactions for purposes of section 23A.
---------------------------------------------------------------------------

    \60\ 12 U.S.C. 371c(b)(7).
---------------------------------------------------------------------------

    a. Confirmation of a letter of credit issued by an affiliate (Sec.  
223.3(h)(5)).--As noted, section 23A includes as a covered transaction 
the issuance by a member bank of a letter of credit on behalf of an 
affiliate. The proposed regulation provided that a member bank's 
confirmation of a letter of credit issued by an affiliate is also a 
covered transaction.
    One commenter noted staff's traditional position that certain 
confirmations of a documentary letter of credit issued by an affiliate 
are not covered transactions and asked the Board to clarify that such 
confirmations would not be treated as covered transactions under 
Regulation W.\61\ The Board has decided to reverse the staff position 
on this issue and to treat all confirmations of a letter of credit 
issued by an affiliate as a covered transaction. Under the current law 
applicable to letters of credit, when a bank confirms a letter of 
credit, it assumes the risk of the underlying transaction to the same 
extent as if it had issued the letter of credit.\62\ Accordingly, the 
rule treats confirmations of a letter of credit issued by an affiliate 
in the same fashion as issuances of a letter of credit on behalf of an 
affiliate.
---------------------------------------------------------------------------

    \61\ See Letter dated May 5, 1981, from Robert E. Mannion, 
Deputy General Counsel of the Board, to Andrew T. Moore, Jr.; see 
also Letter dated July 17, 1980, from Robert E. Mannion, Deputy 
General Counsel of the Board, to Baldwin B. Tuttle.
    \62\ See U.C.C. 5-107(2).
---------------------------------------------------------------------------

    b. Credit enhancements supporting a securities underwriting.--The 
Board has confirmed previously and hereby reconfirms that section 23A's 
definition of guarantee would not include a member bank's issuance of a 
guarantee in support of securities issued by a third party and 
underwritten by a securities affiliate of the bank.\63\ Such a credit 
enhancement would not be issued ``on behalf of'' the affiliate. In 
addition, although the guarantee does provide some benefit to the 
affiliate (by facilitating the underwriting), this benefit is indirect. 
Accordingly, the proceeds of the guarantee would not be transferred to 
the affiliate for purposes of the attribution rule of section 23A.\64\ 
Of course, section 23B would apply to the transaction and, where an 
affiliate was issuer as well as underwriter, the transaction would be 
covered by section 23A because the credit enhancement would be on 
behalf of the affiliate.
---------------------------------------------------------------------------

    \63\ See 62 FR 45295, Aug. 27, 1997.
    \64\ See 12 U.S.C. 371c(a)(2).
---------------------------------------------------------------------------

    c. Cross-guarantee agreements and cross-affiliate netting 
arrangements (Sec.  223.3(h)(5)).--Board staff has confirmed previously 
that a cross-guarantee agreement among a member bank, an affiliate, and 
a nonaffiliate in which the nonaffiliate may use the bank's assets to 
satisfy the obligations of a defaulting affiliate is a guarantee for 
purposes of section 23A.\65\ The Board believes that such cross-
guarantee arrangements among member banks and their affiliates should 
be subject to the quantitative limits and collateral requirements of 
section 23A.
---------------------------------------------------------------------------

    \65\ See Letter dated Aug. 6, 1993, from J. Virgil Mattingly, 
Jr., General Counsel of the Board, to Richard Lasner.
---------------------------------------------------------------------------

    Similarly, the Board understands that some member banks have 
entered into or are contemplating entering into cross-affiliate netting 
arrangements (``CANAs''). These include arrangements among a member 
bank, one or more affiliates of the bank, and one or more nonaffiliates 
of the bank, where a nonaffiliate is permitted to deduct obligations of 
an affiliate of the bank to the nonaffiliate when settling the 
nonaffiliate's obligations to the bank. These arrangements also would 
include agreements where a member bank is required or permitted to add 
the obligations of an affiliate of the bank to a nonaffiliate when 
determining the bank's obligations to the nonaffiliate.
    These types of CANAs expose a member bank to the credit risk of its 
affiliates because the bank may become liable for the obligations of 
its affiliates. Because the exposure of a member bank to an affiliate 
in such an arrangement resembles closely the exposure of a member bank 
when it issues a guarantee on behalf of an affiliate, the final rule 
explicitly includes such arrangements in the definition of covered 
transaction. Accordingly, the quantitative limits of section 23A would 
prohibit a member bank from entering into such a CANA to the extent 
that the netting arrangement does not cap the potential exposure of the 
bank to the participating affiliate(s).
    Several commenters urged the Board to withhold judgment on CANAs 
until standardized documentation is developed by the industry. These 
commenters advised that CANAs are of many types and, therefore, that 
the Board should not adopt a fixed rule for all CANAs. One commenter 
encouraged the Board to clarify in particular that CANAs that do not 
make the bank liable for the obligations of its affiliates or otherwise 
cause any detriment to the bank are not covered transactions. By only 
addressing the CANAs described above, the rule only treats CANAs as 
covered transactions in situations where the member bank may become 
liable for the obligations of its affiliates. The Board intends to 
monitor industry developments in this area and will revisit this aspect 
of Regulation W or issue further interpretive guidance on CANAs as 
warranted.
    d. Keepwell agreements.--Banking organizations have asked for 
guidance on the question of whether a ``keepwell'' agreement should be 
considered a guarantee for purposes of section 23A. In a keepwell 
agreement between a member bank and an affiliate, the bank typically 
commits to maintain the capital levels or solvency of the affiliate. 
The credit risk incurred by the member bank in entering into such a 
keepwell agreement is similar to the credit risk incurred by a member 
bank in connection with issuing a guarantee on behalf of an affiliate. 
As a consequence, keepwell agreements generally should be treated as 
guarantees for purposes of section 23A and, if unlimited in amount, 
would be prohibited by the quantitative limits of section 23A.

4. Extension of Credit (Sec.  223.3(o))

    Although section 23A includes a ``loan or extension of credit'' to 
an affiliate as a covered transaction, the statute does not define 
these terms. The

[[Page 76570]]

regulation defines ``extension of credit'' to an affiliate to mean the 
making or renewal of a loan to an affiliate, the granting of a line of 
credit to an affiliate, or the extending of credit to an affiliate in 
any manner whatsoever, including on an intraday basis. The regulation 
also provides a nonexhaustive list of transactions that the Board deems 
to be extensions of credit to an affiliate, including an advance to an 
affiliate by means of an overdraft, cash item, or otherwise; a lease 
that is the functional equivalent of an extension of credit to an 
affiliate;\66\ an acquisition of a note or other obligation of an 
affiliate, including commercial paper or other debt securities issued 
by an affiliate; and any increase in the amount of, extension of the 
maturity of, or adjustment in the interest rate term or other material 
term of an extension of credit to an affiliate.\67\ The final rule also 
includes a sale of Federal funds to an affiliate on the list of 
examples. This position reflects the long-standing view of the Board 
about the nature of Federal funds transactions.\68\
---------------------------------------------------------------------------

    \66\ The Board would consider a full-payout, net lease 
permissible for a national bank under 12 U.S.C. 24(Seventh) and 12 
CFR part 23 to be the functional equivalent of an extension of 
credit.
    \67\ A floating-rate loan does not become a new covered 
transaction whenever there is a change in the relevant index (for 
example, LIBOR or the member bank's prime rate) from which the 
loan's interest rate is calculated. If the member bank and the 
borrower, however, amend the loan agreement to change the interest 
rate term from ``LIBOR plus 100 basis points'' to ``LIBOR plus 150 
basis points,'' the parties have engaged in a new covered 
transaction.
    \68\ See 12 CFR 250.160.
---------------------------------------------------------------------------

    In addition to these examples, the final rule specifies that other 
similar transactions that result in an affiliate owing money to a 
member bank are extensions of credit by the member bank to the 
affiliate. This aspect of the definition of extension of credit is 
consistent with the definition of the same term in Regulation O and 
would cover, among other things, situations where an affiliate fails to 
pay on a timely basis for services rendered to the affiliate by the 
member bank.
    As noted, the regulation provides that a member bank's purchase of 
a debt security issued by an affiliate is an extension of credit by the 
bank to the affiliate for purposes of section 23A.\69\ Several 
commenters objected to this interpretation of the statute and argued 
that a purchase of an affiliate's debt securities is a ``purchase of or 
investment in securities issued by an affiliate'' for purposes of 
section 23A, and that such a purchase cannot also then be an 
``extension of credit'' for purposes of section 23A. Other commenters 
criticized this position on the grounds that (i) it often would not be 
feasible (due to negative pledge covenants) for the bank to obtain 
collateral for the security after the terms of the security are fixed 
at inception; and (ii) requiring collateral for purchases of debt 
securities but not for purchases of equity securities is perverse.
---------------------------------------------------------------------------

    \69\ This position is consistent with the Board's long-standing 
view. See 37 Federal Reserve Bulletin 960 (1951).
---------------------------------------------------------------------------

    The Board does not find any of these objections persuasive. 
Although the Board is aware that section 23A's definition of covered 
transaction separately includes a member bank's purchase of securities 
issued by an affiliate and a member bank's loan to an affiliate, the 
fact that a holder of debt securities expects repayment of principal 
upon maturity makes debt securities closely resemble loans for purposes 
of section 23A and the statute's objective of protecting the member 
bank. There is nothing in the text or legislative history of section 
23A that indicates that a particular transaction may be slotted only 
into one category of covered transaction.
    Although the Board recognizes the incongruities of requiring 
collateral for debt investments by a member bank in an affiliate but 
not equity investments by a member bank in an affiliate, this is an 
unalterable aspect of the statutory framework. The prevalence of these 
incongruities, moreover, is constrained by the limited ability of 
member banks to make equity investments. Importantly, the Board's 
action on this matter removes an incongruity more likely to occur--
treating differently under section 23A two transaction forms (loans and 
debt securities) that are substantially equivalent from a credit risk 
perspective.
    For all these reasons, therefore, Regulation W provides that a 
member bank that buys debt securities issued by an affiliate has made 
an extension of credit to an affiliate under section 23A and must 
collateralize the transaction in accordance with section 23A's 
collateral requirements. As discussed below, the final rule provides an 
exemption from the collateral requirements in situations where a member 
bank purchases an affiliate's debt securities from a third party in a 
bona fide secondary market transaction.\70\
---------------------------------------------------------------------------

    \70\ See part IV.B.5. of this preamble.
---------------------------------------------------------------------------

5. Low-Quality Asset (Sec.  223.3(v))

    Two provisions of section 23A restrict a member bank's ability to 
engage in transactions with affiliates that involve low-quality assets. 
First, the statute prohibits a member bank from purchasing a low-
quality asset from an affiliate unless the bank performs an independent 
credit evaluation and commits to purchase the asset before the 
affiliate acquires the asset.\71\ Second, the statute prohibits a 
member bank from counting a low-quality asset toward section 23A's 
collateral requirements for credit transactions with an affiliate.\72\
---------------------------------------------------------------------------

    \71\ 12 U.S.C. 371c(a)(3).
    \72\ 12 U.S.C. 371c(c)(3).
---------------------------------------------------------------------------

    Section 23A defines a low-quality asset to include (i) an asset 
classified as ``substandard,'' ``doubtful,'' or ``loss,'' or treated as 
``other loans especially mentioned,'' in the most recent report of 
examination or inspection by a Federal or State supervisory agency (a 
``classified asset''); (ii) an asset in nonaccrual status; (iii) an 
asset on which payments are more than thirty days past due; or (iv) an 
asset whose terms have been renegotiated or compromised due to the 
deteriorating financial condition of the obligor.\73\ The Board notes 
that any asset meeting one of the above four criteria, including 
securities and real property, is a low-quality asset.\74\
---------------------------------------------------------------------------

    \73\ 12 U.S.C. 371c(b)(10).
    \74\ The Federal banking agencies generally consider non-
investment grade securities to be classified assets. See, e.g., 
``Uniform Agreement on the Classification of Assets and Appraisal of 
Securities Held by Banks' (May 7, 1979); Federal Reserve Commercial 
Bank Examination Manual Sec.  2020.1. Assets identified by examiners 
through the Shared National Credit and International Country 
Exposure Review Committee processes also should be considered 
classified assets for purposes of section 23A.
---------------------------------------------------------------------------

    The regulation broadens the definition of low-quality asset in 
three ways. First, the regulation provides that an asset identified by 
examiners as an ``other transfer risk problem'' (``OTRP'') is a low-
quality asset.\75\ Such assets represent credits to countries that are 
not complying with their external debt-service obligations, but are 
taking positive steps to restore debt service through economic 
adjustment measures, generally as part of an International Monetary 
Fund program. Although OTRP assets are not considered classified 
assets, examiners are instructed to consider these assets in their 
assessment of a bank's asset quality and capital adequacy.\76\
---------------------------------------------------------------------------

    \75\ No commenter objected to this provision of the proposed 
rule.
    \76\ See Federal Reserve Commercial Bank Examination Manual 
Sec.  7040.1.
---------------------------------------------------------------------------

    Second, the regulation reflects the increasing use by financial 
institutions of their own internal asset classification systems. A 1998 
Board study of the 50 largest U.S. banks demonstrated that all use 
internal loan classifications, and a substantial proportion of such

[[Page 76571]]

institutions have relatively advanced internal rating systems.\77\ 
There is considerable variance in how large banks rate performing 
assets; however, banks are required to use the same categories employed 
by the Federal banking agencies for rating classified assets.
---------------------------------------------------------------------------

    \77\ William F. Treacy & Mark S. Carey, Credit Risk Rating at 
Large U.S. Banks, 84 Federal Reserve Bulletin 897 (1998).
---------------------------------------------------------------------------

    Because examinations may be twelve months apart--eighteen months 
for smaller banks--these internal classification systems may cause a 
bank to regrade an asset long before its next examination. Accordingly, 
the rule includes within the definition of low-quality asset not only 
assets classified during the last examination but also assets 
classified or treated as special mention under the institution's 
internal classification system (or assets that received an internal 
rating that is substantially equivalent to classified or special 
mention in such an internal system).
    Several commenters objected to this aspect of the proposed rule. 
They argued that the statute provides a highly articulated definition 
of low-quality asset that should not be supplemented by the Board. They 
also cautioned that the rule would penalize banks with careful internal 
classification systems and would create perverse incentives for banks 
to avoid internally classifying bad assets. The Board acknowledges 
these concerns but believes that the rule is consistent with the text 
and intent of section 23A and that the supervisory benefits of the rule 
would outweigh any adverse effects. The purchase by a depository 
institution from an affiliate of assets that have been internally 
classified raises potentially significant safety and soundness 
concerns.
    The Board shares the concern of commenters that this provision of 
the rule may induce companies to avoid or defer reclassification of an 
asset in order to allow its sale to an affiliated depository 
institution, but believes that such evasions can be addressed through 
the examination process. The Board expects companies with internal 
rating systems to use the systems consistently over time and over 
similar classes of assets and will view as an evasion of section 23A 
any company's deferral or alteration of an asset's rating to facilitate 
sale of the asset to an affiliated institution.
    Finally, the proposed rule defined low-quality asset to include 
foreclosed property designated ``other real estate owned'' (``OREO''), 
until it is reviewed by an examiner and receives a favorable 
classification. One commenter criticized this interpretation and 
represented that OREO is often good collateral collected from a bad 
borrower. This commenter further advised that a bank should be allowed 
to purchase OREO from an affiliate if the bank uses the OREO as 
premises.
    The final rule contains an expanded version of the proposed rule's 
OREO provision. The final rule defines as a low-quality asset any asset 
(not just real estate) that is acquired in satisfaction of a debt 
previously contracted (not just through foreclosure) if the asset has 
not yet been reviewed in an examination or inspection. In the Board's 
experience, property acquired from a borrower in default is often of 
such poor quality that its ownership poses the same risk to the bank as 
a classified loan. In response to the concerns expressed by the 
commenter, the Board notes that, under the rule, if a particular asset 
is good collateral taken from a bad borrower, the asset should cease to 
be a low-quality asset upon examination.

6. Member Bank (Sec.  223.3(w))

    As discussed above, although proposed Regulation W applied by its 
terms to all ``banks,'' the final rule applies by its terms to all 
``member banks.'' Consistent with section 1 of the Federal Reserve Act, 
the final rule defines ``member bank'' to mean ``any national bank, 
State bank, banking association, or trust company that is a member of 
the Federal Reserve System.''
    The definition of member bank in the regulation also states that 
most subsidiaries of a member bank are to be treated as part of the 
member bank itself for purposes of sections 23A and 23B. The only 
subsidiaries of a member bank that are excluded from this treatment are 
financial subsidiaries, insured depository institution subsidiaries, 
certain joint venture subsidiaries, and ESOPs--companies that are 
deemed affiliates of the member bank under the regulation. This 
treatment of subsidiaries reflects the fact that the statute typically 
does not distinguish between a member bank and its subsidiaries, and 
all the significant restrictions of the statute apply to actions taken 
by a member bank ``and its subsidiaries.'' Defining the term ``member 
bank'' as described above and using the term ``member bank'' wherever 
the statute says ``member bank and its subsidiaries'' makes the 
regulation shorter and easier to understand. The definition also should 
help to remind member banks that certain subsidiaries should not be 
treated as part of the member bank for purposes of the statute.

7. Obligations of, or Fully Guaranteed as to Principal and Interest by, 
the United States or Its Agencies (Sec.  223.3(z))

    Section 23A accords special treatment to extensions of credit 
secured by ``obligations of the United States or its agencies'' or 
``obligations fully guaranteed by the United States or its agencies as 
to principal and interest'' (collectively, ``U.S. government 
obligations''). First, the statute imposes the lowest collateral 
requirement, 100 percent of the loan amount, on extensions of credit 
secured by U.S. government obligations.\78\ Second, the statute 
provides an exemption for extensions of credit fully secured by U.S. 
government obligations.\79\
---------------------------------------------------------------------------

    \78\ 12 U.S.C. 371c(c)(1)(A)(i) and (ii).
    \79\ 12 U.S.C. 371c(d)(4)(A) and (B).
---------------------------------------------------------------------------

    The proposed rule did not provide guidance as to what financial 
instruments qualify as U.S. government obligations. Several commenters 
asked the Board to clarify that U.S. government obligations for section 
23A purposes would include, at a minimum, all the obligations 
identified in the Board's Regulation A as eligible to serve as 
collateral for advances by Federal Reserve Banks to member banks under 
section 13(8) of the Federal Reserve Act.\80\ The final rule provides 
this clarification, which is consistent with staff's long-standing 
position under section 23A. The final rule also indicates that U.S. 
government obligations do not include mortgage loans insured by the 
Federal Housing Administration or the Veterans Administration because 
the backing of the U.S. government for these loans is not a full and 
unconditional guarantee of the principal and interest of the underlying 
mortgage loans. This exclusion also is consistent with staff's 
traditional interpretation of section 23A.
---------------------------------------------------------------------------

    \80\ See 12 CFR 201.108(b). Section 13(8) of the Federal Reserve 
Act authorizes Federal Reserve Banks to make advances to member 
banks secured by, among other things, U.S. government obligations 
eligible for purchase by a Federal Reserve Bank under section 14(b) 
of the Federal Reserve Act. 12 U.S.C. 347. The description of U.S. 
government obligations in section 14(b) of the Federal Reserve Act 
is virtually identical to the description of U.S. government 
obligations in section 23A. See 12 U.S.C. 355.
---------------------------------------------------------------------------

8. Purchase of Assets (Sec.  223.3(dd))

    The proposed rule defined a purchase of an asset as the acquisition 
of an asset in exchange for cash or any other consideration, including 
an assumption of liabilities. The preamble to the proposed rule 
indicated the Board's view that merging an affiliate with and into a 
member bank generally would constitute a purchase of assets by the bank 
from the affiliate. Consistent with

[[Page 76572]]

the preamble to the proposed rule, the final rule also provides that 
the merger of an affiliate into a member bank is a purchase of assets 
by the bank from the affiliate if the bank assumes any liabilities of 
an affiliate or pays any other form of consideration in the 
transaction.

9. Securities (Sec.  223.3(ff))

    Section 23A defines ``securities'' to mean ``stocks, bonds, 
debentures, notes, or other similar obligations.''\81\ Because of the 
ambiguous nature of this definition, the Board generally has looked to 
the Federal securities laws for guidance in determining which financial 
instruments should be considered securities for purposes of section 
23A. In light of the similarities between commercial paper and 
debentures and notes and the countervailing fact that the Securities 
Exchange Act of 1934 excludes some forms of commercial paper from its 
definition of security,\82\ the regulation clarifies that commercial 
paper is a security for purposes of section 23A.\83\
---------------------------------------------------------------------------

    \81\ 12 U.S.C. 371c(b)(9).
    \82\ See 15 U.S.C. 78c(a)(10).
    \83\ As noted above in part III.B.4. of this preamble, the Board 
considers a member bank's investment in commercial paper issued by 
an affiliate to be both an investment in securities issued by an 
affiliate and an extension of credit to an affiliate.
---------------------------------------------------------------------------

    One commenter on the proposed rule asked the Board to indicate 
whether annuities are securities for purposes of section 23A. The Board 
would consider annuities that are securities for purposes of the 
Federal securities laws to be securities for purposes of Regulation W.

10. Voting Securities (Sec.  223.3(jj))

    Section 23A uses both the terms ``voting shares'' and ``voting 
securities.'' To remove ambiguity and enhance regulatory consistency, 
Regulation W replaces all statutory uses of the term ``voting shares'' 
with the term ``voting securities'' and defines ``voting securities'' 
to have the same meaning as ``voting securities'' in Regulation Y.\84\
---------------------------------------------------------------------------

    \84\ See 12 CFR 225.2(q).
---------------------------------------------------------------------------

IV. General Provisions of Section 23A--Subpart B

    Subpart B of the regulation sets forth the principal restrictions 
of section 23A, including the quantitative limits, the safety and 
soundness requirement, the collateral requirement, and the prohibition 
on the purchase of low-quality assets. This subpart also includes 
section 23A's attribution rule, which provides that any transaction 
with a nonaffiliate will be considered a transaction with an affiliate 
to the extent that the proceeds of the transaction are used for the 
benefit of, or transferred to, that affiliate. In addition, subpart B 
incorporates previous Board and staff interpretations of these 
provisions, and a few new interpretations of these provisions. These 
interpretations of the statute are discussed below.
A. Quantitative Limits (Sec. Sec.  223.11 and 223.12)
    Section 23A(a)(1) provides that a member bank may engage in a 
covered transaction with an affiliate only if, upon consummation of the 
proposed transaction, the aggregate amount of the bank's covered 
transactions (i) with any single affiliate would not exceed 10 percent 
of the bank's capital stock and surplus and (ii) with all affiliates 
would not exceed 20 percent of the bank's capital stock and 
surplus.\85\ Sections 223.11 and 223.12 of the regulation set forth 
these quantitative limits. The quantitative limits of Regulation W 
(consistent with section 23A) only prohibit a member bank from engaging 
in a new covered transaction if the bank would be in excess of the 10 
or 20 percent threshold after consummation of the new transaction. The 
regulation (consistent with section 23A) generally does not require a 
member bank to unwind existing covered transactions if the bank exceeds 
the 10 or 20 percent limit because its capital declined or a 
preexisting covered transaction increased in value.
---------------------------------------------------------------------------

    \85\ 12 U.S.C. 371c(a)(1).
---------------------------------------------------------------------------

    Section 23A(a)(1)(A) states that a member bank ``may engage in a 
covered transaction with an affiliate only if * * * in the case of any 
affiliate,'' the aggregate amount of covered transactions of the bank 
would not exceed 10 percent of the capital stock and surplus of the 
bank. The proposed rule interpreted this limitation to prevent a member 
bank from engaging in a new covered transaction with an affiliate if 
the aggregate amount of covered transactions between the bank and any 
affiliate (not only the particular affiliate with which the bank 
proposes to engage in the new covered transaction) would be in excess 
of 10 percent of the bank's capital stock and surplus after 
consummation of the new transaction. Several commenters argued that 
this reading of the 10 percent limit is inconsistent with the statutory 
language of section 23A and existing bank practices. These commenters 
urged the Board to interpret the 10 percent limit to prohibit a bank 
from engaging in a covered transaction with an affiliate only when the 
aggregate amount of covered transactions between the bank and that 
affiliate would exceed 10 percent of the bank's capital.
    The Board believes that both the interpretation of the 10 percent 
limit set forth in the proposed rule and the interpretation advocated 
by commenters are consistent with the statutory language. In light of 
the numerous other existing safeguards in sections 23A and 23B, 
including in particular the 20 percent quantitative limit and the 
collateral requirements, and the other supervisory tools available to 
the Federal banking agencies, the Board has determined to adopt the 
interpretation advocated by commenters in the final Regulation W. 
Notwithstanding this more liberal interpretation of the 10 percent 
limit, the Board strongly encourages member banks with covered 
transactions in excess of the 10 percent threshold with any affiliate 
to reduce those transactions before expanding the scope or extent of 
the bank's relationships with other affiliates.
    Another commenter asked the Board to clarify in section 223.11 that 
transactions between a bank and a financial subsidiary of the bank are 
not subject to the 10 percent limit of section 23A. Although proposed 
Regulation W made this point in the section of the rule relating to 
financial subsidiaries, the Board agrees that clarity would be enhanced 
if the final rule also made this point in the section of the rule that 
sets forth the 10 percent limit. Accordingly, section 223.11 of the 
final rule states that transactions between a member bank and its 
financial subsidiary are not subject to the 10 percent limit.
B. Collateral Requirements (Sec.  223.14)
    Section 223.14 of the regulation sets forth the collateral 
requirements established by section 23A(c) for loans and extensions of 
credit to an affiliate, and guarantees, acceptances, and letters of 
credit issued on behalf of an affiliate (collectively, ``credit 
transactions''). As a general matter, section 23A requires any credit 
transaction by a member bank with an affiliate to be secured with a 
statutorily prescribed amount of collateral. The required collateral 
varies from 100 percent of the value of the credit extended (when the 
collateral is a deposit account or U.S. government obligations) to 130 
percent of the credit extended (when the collateral is stock, leases, 
or certain other ``real or personal property'').\86\
---------------------------------------------------------------------------

    \86\ 12 U.S.C. 371c(c)(1).
---------------------------------------------------------------------------

1. Deposit Account Collateral (Sec.  223.14(b)(1)(i)(D))

    Under section 23A, a member bank may satisfy the collateral 
requirements

[[Page 76573]]

of the statute by securing a credit transaction with an affiliate with 
a ``segregated, earmarked deposit account'' maintained with the bank in 
an amount equal to 100 percent of the credit extended.\87\ The proposed 
regulation clarified that, to satisfy the statute's ``segregated, 
earmarked'' requirement, the account must exist for the sole purpose of 
securing the credit extended and be so identified.
---------------------------------------------------------------------------

    \87\ 12 U.S.C. 371c(c)(1)(A)(iv).
---------------------------------------------------------------------------

    Numerous commenters asked the Board to remove this regulatory gloss 
and explicitly state that banks may satisfy the collateral requirements 
of section 23A by (i) using a single deposit account to collateralize 
one or more covered transactions with one or more affiliates or (ii) 
entering into a cross-collateralization agreement with one or more 
affiliates under which all of such affiliates' deposit accounts are 
pledged as collateral for all of such affiliates' credit transactions 
with the bank. According to these commenters, such collateral 
arrangements are a common, safe, and efficient means of satisfying the 
letter and spirit of the collateral requirements of section 23A.
    The Board has analyzed the claims of these commenters and has 
decided not to require a member bank accepting deposit account 
collateral to establish a separate segregated, earmarked deposit 
account to secure each covered transaction with an affiliate. The Board 
recognizes that such a strict reading of the ``segregated, earmarked'' 
requirement is not required by the statute and would impose a 
substantial compliance burden on member banks that engage in a 
significant number of covered transactions with affiliates. Moreover, 
in some circumstances, using an omnibus deposit account for multiple 
affiliates and multiple covered transactions may have prudential 
advantages for the member bank as compared to using separate deposit 
accounts for each outstanding covered transaction.
    Although the final rule does not include the proposed regulatory 
gloss, the Board expects that member banks that secure covered 
transactions with omnibus deposit accounts will take steps to ensure 
that such accounts fully secure the relevant covered transactions. Such 
steps might include substantial overcollateralization or the use of 
subaccounts or other recordkeeping devices to match deposits with 
covered transactions. In addition, as required by the final rule, to 
obtain full credit for any deposit accounts taken as section 23A 
collateral, member banks must ensure that they have a perfected, first 
priority security interest in the accounts.
    Several commenters asked the Board to replace the ``segregated, 
earmarked'' requirement for deposit accounts with a requirement that 
banks have a perfected, first priority security interest in the 
accounts. These commenters explained that, although the ``segregated, 
earmarked'' requirement made sense before the adoption of revised 
Article 9 of the Uniform Commercial Code, the revised Article 9 has 
rendered segregation and earmarking of a deposit account legally 
irrelevant to ensuring that a bank has a perfected, first priority 
security interest in the account. Despite the revisions to Article 9, 
the final rule maintains the ``segregated, earmarked'' requirement 
because it is required by the plain language of section 23A and because 
segregating and earmarking deposit account collateral is a prudent 
practice even under revised Article 9.

2. Ineligible Collateral (Sec.  223.14(c))

    The purpose of section 23A's collateral requirements is to ensure 
that member banks that engage in credit transactions with affiliates 
have legal recourse, in the event of affiliate default, to tangible 
assets with a value at least equal to the amount of the credit 
extended. The statute recognizes that certain types of assets are not 
appropriate to serve as collateral for credit transactions with an 
affiliate. In particular, the statute provides that low-quality assets 
and securities issued by an affiliate are not eligible collateral for 
such covered transactions.\88\
---------------------------------------------------------------------------

    \88\ 12 U.S.C. 371c(c)(3) and (4)
---------------------------------------------------------------------------

    The proposed rule provided that intangible assets (as defined by 
generally accepted accounting principles (``GAAP'')), including 
servicing assets, are not acceptable collateral to secure credit 
transactions with an affiliate. Several commenters supported the 
proposed rule's categorical exclusion of intangible assets. A larger 
number of commenters argued, however, that banks should be permitted to 
use certain intangible assets as section 23A collateral, in particular 
assets, such as servicing assets and purchased credit card 
relationships, that count as capital under the Board's capital adequacy 
guidelines.
    The final rule retains the categorical exclusion of intangible 
assets.\89\ In the Board's view, intangible assets are particularly 
hard to value, and a member bank may have significant difficulty in 
collecting and selling such assets in a reasonable period of time. The 
Board believes that these reasons justify the exclusion of intangible 
assets from the types of collateral eligible to satisfy the 
requirements of section 23A. The Board notes that the identifiable 
intangible assets that are not deducted from capital under the capital 
adequacy guidelines (namely, servicing assets and purchased credit card 
relationships) are limited quantitatively in the extent to which they 
count as capital.\90\ The Board is willing to consider requests, on a 
case-by-case basis, to permit particular types of intangible assets to 
serve as section 23A collateral, and has amended the proposed rule to 
allow for such ad hoc exceptions to the categorical exclusion.
---------------------------------------------------------------------------

    \89\ The final rule, however, does not define intangible assets 
by reference to GAAP. Upon further review, the Board has determined 
that the GAAP definition of intangible asset may be underinclusive 
for section 23A purposes. If a member bank has doubts as to whether 
a particular asset is an intangible asset, the bank should consult 
with Board staff.
    \90\ See 12 CFR part 225, appendix A, Sec.  II.B.1.d-e.
---------------------------------------------------------------------------

    In addition, the proposed rule provided that guarantees and letters 
of credit are not eligible collateral for section 23A purposes. Several 
commenters argued that the rule should permit banks to satisfy the 
collateral requirements of section 23A with letters of credit. These 
commenters stated that letters of credit are less likely to fluctuate 
in value than many other types of eligible section 23A collateral, 
represent senior claims on banks, are not subject to an automatic stay 
in bankruptcy, involve lower administrative costs than most other types 
of collateral, convey an immediate right to cash rather than a possibly 
illiquid piece of collateral, and are recognized under the net capital 
rule of the Securities and Exchange Commission (``SEC''). Other 
commenters argued that banks should be allowed to use guarantees to 
comply with section 23A's collateral requirements. These commenters 
noted that the Board's capital adequacy guidelines recognize the value 
of guarantees as a credit risk mitigation device.
    The final rule continues to provide that guarantees and letters of 
credit are not acceptable section 23A collateral.\91\ Letters of credit 
and guarantees are not balance sheet assets under GAAP and, 
accordingly, would not constitute ``real or personal property'' under 
section

[[Page 76574]]

23A. Moreover, section 23A(c) requires that credit transactions with an 
affiliate be ``secured'' by collateral. A credit transaction between a 
member bank and an affiliate supported only by a guarantee or letter of 
credit from a third party would not appear to meet the statutory 
requirement that the credit transaction be secured by collateral. Of 
course, the Board could grant an exemption that would permit guarantees 
or letters of credit to count as collateral or to serve as a 
replacement for collateral. The Board has decided not to do so at this 
time because guarantees and letters of credit often are subject to 
material adverse change clauses and other covenants that allow the 
issuer of the guarantee or letter of credit to deny coverage. Moreover, 
in the Board's view, there is a particularly significant risk, 
highlighted by recent events, that a member bank may have difficulty 
collecting on a guarantee or letter of credit provided by a 
nonaffiliate on behalf of an affiliate of the bank.
---------------------------------------------------------------------------

    \91\ The final rule also provides that instruments ``similar'' 
to guarantees and letters of credit are ineligible collateral. For 
example, in the Board's view, a member bank cannot satisfy section 
23A's collateral requirements by purchasing credit protection in the 
form of a credit default swap referencing the affiliate's 
obligation.
---------------------------------------------------------------------------

    As noted above, section 23A prohibits a member bank from accepting 
securities issued by an affiliate as collateral for an extension of 
credit to an affiliate. The proposed rule clarified that securities 
issued by the member bank itself also are not eligible collateral to 
secure a credit transaction with an affiliate. Most commenters 
supported the exclusion of bank-issued equity securities but urged the 
Board to permit banks to take their own debt securities as section 23A 
collateral. These commenters pointed out that bank deposits (another 
form of bank liability) count as a preferred form of collateral under 
section 23A and that selling or retiring bank-issued debt securities 
would provide real benefit to the bank upon foreclosure.
    The Board has determined to modify the proposed rule to address 
these comments. Under the final rule, equity securities issued by the 
lending member bank, and debt securities issued by the lending member 
bank that count as regulatory capital of the bank, are not eligible 
collateral under section 23A. If a member bank were forced to foreclose 
on a credit transaction with an affiliate secured by such securities, 
the bank may be unwilling to liquidate the collateral promptly to 
recover on the credit transaction because the sale might depress the 
price of the bank's outstanding securities or result in a change in 
control of the bank. In addition, to the extent that a member bank is 
unable or unwilling to sell such securities acquired through 
foreclosure, the transaction would likely result in a reduction in the 
bank's capital, thereby offsetting any potential benefit provided by 
the collateral.

3. Perfection and Priority (Sec.  223.14(d))

    To ensure that a member bank has good access to the assets serving 
as collateral for its credit transactions with affiliates, the final 
regulation provides (as did the proposed rule) that a member bank's 
security interest in any collateral required by section 23A must be 
perfected in accordance with applicable law. This requirement is 
consistent with court decisions on the issue \92\ and ensures that the 
member bank has the legal right to realize on the collateral in case of 
default, including a default resulting from the affiliate's insolvency 
or liquidation. Commenters supported this provision.
---------------------------------------------------------------------------

    \92\ See Fitzpatrick v. FDIC, 765 F.2d 569 (6th Cir. 1985).
---------------------------------------------------------------------------

    For similar reasons, the final rule requires (as did the proposed 
rule) that a member bank either obtain a first priority security 
interest in the required collateral or deduct from the amount of 
collateral obtained by the bank the lesser of (i) the amount of any 
security interests in the collateral that are senior to that obtained 
by the bank or (ii) the amount of any credits secured by the collateral 
that are senior to that of the bank. For example, if a member bank 
lends $100 to an affiliate and takes as collateral a second lien on a 
parcel of real estate worth $200, the arrangement would only satisfy 
the collateral requirements of section 23A if the affiliate owed the 
holder of the first lien $70 or less (a credit transaction secured by 
real estate must be secured at 130 percent of the amount of the 
transaction). Commenters also supported this provision. At the request 
of a commenter, the final rule includes an example of how to compute 
the section 23A collateral value of a junior lien.

4. Unused Portion of an Extension of Credit (Sec.  223.14(f)(2))

    Section 23A requires that the ``amount'' of an extension of credit 
be secured by the statutorily prescribed levels of collateral. Board 
staff traditionally has advised that a member bank that provides a line 
of credit to an affiliate must secure the full amount of the line of 
credit throughout the life of the credit. That is, staff has not viewed 
section 23A as permitting a member bank to satisfy the collateral 
requirements of the statute by securing only the portion of a credit 
line that has been drawn down by the affiliate. In an acknowledgment 
that this treatment may be too strict for some lines of credit, the 
proposed rule provided that the collateral requirements of section 23A 
would not apply to the unused portion of an extension of credit to an 
affiliate so long as the member bank does not have any legal obligation 
to advance additional funds under the credit facility until the 
affiliate has posted the amount of collateral required by the statute 
with respect to the entire used portion of the extension of credit.\93\ 
In such credit arrangements, securing the unused portion of the credit 
line is unnecessary from a safety and soundness perspective because the 
affiliate cannot require the member bank to advance additional funds 
without posting the additional collateral required by section 23A.
---------------------------------------------------------------------------

    \93\ This proposed treatment would not apply to guarantees, 
acceptances, and letters of credit issued on behalf of an affiliate, 
which must be fully collateralized at inception.
---------------------------------------------------------------------------

    Numerous commenters endorsed this provision of the proposed rule, 
and the final rule maintains the provision.\94\ The Board notes that, 
if a member bank voluntarily advances additional funds under such a 
credit arrangement without obtaining the additional collateral required 
under section 23A to secure the entire used amount (despite its lack of 
legal obligation to make such an advance), the Board would view this 
action as a violation of the collateral requirements of the statute.
---------------------------------------------------------------------------

    \94\ The final rule uses the terms ``used'' and ``unused'' in 
place of the proposed rule's ``drawn'' and ``undrawn'' to conform to 
more standard regulatory usage. See, e.g., Schedule RC-L to the bank 
Call Report.
---------------------------------------------------------------------------

5. Purchasing Affiliate Debt Securities in the Secondary Market (Sec.  
223.14(f)(3))

    As described above, the rule treats a member bank's investment in 
the debt securities of an affiliate as an extension of credit by the 
bank to the affiliate that is subject to section 23A's collateral 
requirements. In the preamble to the proposed rule, the Board sought 
comment on whether the rule should permit member banks in certain 
circumstances to purchase debt securities issued by an affiliate 
without satisfying the collateral requirements of section 23A. In 
particular, the Board invited comment on whether it should require 
section 23A collateralization in circumstances where a member bank 
purchases an affiliate's debt securities (i) from a third party in a 
bona fide secondary market transaction or (ii) pursuant to a registered 
public offering document or a private placement memorandum in an 
offering in which the affiliate receives significant participation from 
third parties. A large number of commenters expressed

[[Page 76575]]

support for the first of the proposed exemptions; only a few commenters 
advocated for (and one commenter criticized) the second proposed 
exemption.
    The Board has decided to adopt the first of the two exemptions 
described above. When a member bank buys an affiliate's debt securities 
in a bona fide secondary market transaction, the risk that the purchase 
is designed to shore up an ailing affiliate is reduced. Moreover, any 
purchase of affiliate debt securities that qualifies for this exemption 
would remain subject to the quantitative limits of section 23A and the 
market terms requirement of section 23B. In analyzing a member bank's 
good faith under this exemption, the Board would expect examiners to 
look at the time elapsed between the original issuance of the 
affiliate's debt securities and the bank's purchase, the existence of 
any relevant agreements or relationships between the bank and the third 
party seller of the affiliate's debt securities, any history of bank 
financing of the affiliate, and any other relevant information.
C. Prohibition on the Purchase of Low-Quality Assets (Sec.  223.15)
    Section 223.15 of the regulation restates the statute's general 
prohibition on the purchase by a member bank of low-quality assets from 
an affiliate.\95\ Several commenters on the proposed rule argued that 
the Board should exempt a bank's purchase of low-quality assets from an 
insured sister bank. These commenters stated that the cross-guarantee 
provisions in section 5(e) of the FDI Act eradicate any concern about 
low-quality asset transactions between sister banks.\96\
    The Board has consulted with the other Federal banking agencies on 
this matter and has determined not to grant the requested exemption for 
several reasons. First, when Congress added the sister-bank exemption 
to section 23A in 1982, it specifically and affirmatively left sister 
banks subject to the prohibition on the purchase of low-quality 
assets.\97\ When Congress added the cross-guarantee provisions to the 
FDI Act in 1989, it did not amend the sister-bank exemption in section 
23A to permit a member bank to buy low-quality assets from a sister 
bank. In light of such evidence of Congressional intent, the Board 
should not exempt a member bank's purchase of low-quality assets from a 
sister bank in the absence of compelling evidence that the exemption 
would be in the public interest.
---------------------------------------------------------------------------

    \95\ 12 U.S.C. 371c(a)(3). Section 23A does not prohibit an 
affiliate from donating a low-quality asset to a member bank, so 
long as the bank provides no consideration for the asset.
    \96\ See 12 U.S.C. 1815(e).
    \97\ See 12 U.S.C. 371c(d)(1).
---------------------------------------------------------------------------

    The Board does not believe that such compelling evidence exists. 
Importantly, the FDI Act's cross-guarantee provisions would only assist 
the FDIC to recoup losses in the event of the failure of a sister bank, 
and would not ensure that sister banks continue to operate in a safe 
and sound manner as going concerns. Moreover, the FDI Act's cross-
guarantee provisions would not apply to all sets of section 23A sister 
banks. For example, the cross-guarantee provisions would not apply to 
section 23A sister banks if the sister banks were not subsidiaries of a 
BHC or a thrift holding company.\98\ Finally, the cross-guarantee 
provisions would not prevent sister banks from using the requested 
exemption to transfer low-quality assets back and forth among 
themselves to escape examination.
---------------------------------------------------------------------------

    \98\ See 12 U.S.C. 1813(w), 1815(e)(1) and (9), and 1841(c)(2).
---------------------------------------------------------------------------

    The proposed rule provided an exception, based on a long-standing 
staff interpretation, to the general prohibition on purchasing low-
quality assets from an affiliate.\99\ The exception allowed a member 
bank that purchased a loan participation from an affiliate to renew its 
participation in the loan, or provide additional funding under the 
existing participation, even if the underlying loan had become a low-
quality asset, so long as certain criteria were met. The proposed rule 
provided this exception because these renewals or additional credit 
extensions may enable both the affiliate and the participating member 
bank to avoid or minimize potential losses. It would be inconsistent 
with the purposes of section 23A to bar a member bank from using sound 
banking judgment to take the necessary steps (consistent with the 
criteria established in the rule) to protect itself from harm in such a 
situation.
---------------------------------------------------------------------------

    \99\ See Letter dated Aug. 10, 1984, from Michael Bradfield, 
General Counsel of the Board, to Margie Goris.
---------------------------------------------------------------------------

    Under the proposed rule, the exception was available only if the 
underlying loan was not a low-quality asset at the time the member bank 
purchased its participation and the proposed transaction would not 
increase the member bank's proportional share of the credit facility. 
The member bank also had to obtain the prior approval of its board of 
directors for the transaction and provide its appropriate Federal 
banking agency with 20 days' prior notice of the transaction.
    Commenters expressed support for preserving this exemption in 
Regulation W but asked the Board to soften three of the conditions to 
the exemption. Several commenters argued for the removal of the ``no 
increase in the bank's share'' requirement on the ground that lead 
banks involved in a credit restructuring often are required to 
repurchase participations previously sold to smaller banks, thereby 
increasing their proportionate share of the problem credit. Another 
commenter recommended that banks be allowed to increase their share of 
a problem credit by 5-10 percent.
    Commenters also criticized the board of directors' approval 
requirement on the grounds that it is time consuming and that renewals 
of problem credits are not sufficiently important to require board-
level attention in most cases. Commenters offered several alternatives, 
including approval by an executive committee of the bank's board of 
directors, approval by senior bank management, approval under the 
bank's normal approval process for restructuring problem credits, and 
approval by bank management under policies adopted by the bank's board 
of directors.
    Moreover, commenters expressed significant opposition to the 20 
days' prior notice requirement. They asked the Board to remove the 
requirement or replace it with an after-the-fact notice requirement. 
According to these commenters, speed is often of the essence in workout 
situations, and there is no evidence that this exemption has been 
abused by banks in the nearly twenty years that it has been available.
    Under proposed Regulation W, this restructuring exemption only 
applied when a member bank renewed a participation in a loan originated 
by an affiliated depository institution. Some commenters expressed a 
view that the exemption should be expanded to permit a bank to renew a 
participation in a loan originated by any affiliate (not just an 
affiliated depository institution). According to these commenters, such 
an expansion of the exemption would enhance a bank's ability to protect 
itself from troubled borrowers by restructuring loans.
    In response to these comments, the Board has decided to revise the 
rule in several respects. First, the final rule contains a 20 days' 
post-consummation notice requirement in replacement of the proposed 
rule's 20 days' prior notice requirement. Second, the final rule 
permits a member bank to increase its proportionate share in a 
restructured loan by 5 percent (or by a higher percentage with the 
prior approval of

[[Page 76576]]

the bank's appropriate Federal banking agency). Third, the final rule 
expands the scope of the exemption to include renewals of 
participations in loans originated by any affiliate of the member bank 
(not just affiliated depository institutions). Fourth, the final rule 
softens the board of directors' prior approval requirement as follows. 
For renewals of loans originated by a nondepository affiliate of the 
member bank, the renewals must be approved, consistent with current 
practice, by the entire board of directors of the bank. For renewals of 
loans originated by depository institution affiliates of the member 
bank, however, the rule provides several different ways to comply with 
the requirement. The member bank may obtain the prior approval of the 
entire board of directors, of an executive committee of the board of 
directors, or of selected senior management officials (so long as, in 
the case of approvals by management officials, the board of directors 
of the member bank establishes policies and procedures for such 
renewals, any approvals by bank management are consistent with such 
policies and procedures, and the board of directors periodically 
reviews the policies and procedures and any approvals by management). 
The Board believes that the conditions to the exemption contained in 
the final rule should be sufficient to ensure that any exempted problem 
loan restructurings do not pose a safety and soundness risk to the 
member bank.
D. Attribution Rule (Sec.  223.16)
    Section 23A provides that any transaction between a member bank and 
any person is deemed to be a transaction with an affiliate to the 
extent that the proceeds of the transaction are used for the benefit 
of, or transferred to, that affiliate.\100\ For example, a member 
bank's loan to a customer for the purpose of purchasing securities from 
the inventory of a broker-dealer affiliate of the bank would be a 
covered transaction under section 23A. This ``attribution rule'' was 
included in section 23A to prevent a member bank from evading the 
restrictions in the section by using intermediaries and to limit the 
exposure that a member bank has to customers of affiliates of the bank. 
The proposed regulation restated this provision and provided several 
exemptions from the attribution rule.
---------------------------------------------------------------------------

    \100\ 12 U.S.C. 371c(a)(2).
---------------------------------------------------------------------------

1. In General

    Commenters offered a few general suggestions on the scope of 
section 23A's attribution rule. Several commenters recommended that the 
Board include a ``bona fide, ordinary course transactions'' exemption 
to the attribution rule, similar to the exemption that the Board 
adopted in Regulation O.\101\ In addition, a number of commenters 
contended that the attribution rule should not apply to transactions 
where the bank does not know, or have reason to know, that the proceeds 
are transferred to or used for the benefit of an affiliate. Some of 
these commenters argued that the purpose of the attribution rule is to 
prevent sham transactions, not to prevent an affiliate from receiving 
unintended or accidental benefits from bank action. A few commenters 
even asked the Board to remove all the particular exemptions from the 
attribution rule included in Regulation W because, in the view of these 
commenters, the exemptions create the negative implication that all 
other transactions with third parties in which money flows to an 
affiliate are covered.
---------------------------------------------------------------------------

    \101\ See 12 CFR 215.3(f).
---------------------------------------------------------------------------

    The Board has decided not to include any such general exemptions 
from the scope of the attribution rule in final Regulation W. The Board 
considers an exemption for transactions where the member bank does not 
know, or have reason to know, that the proceeds will flow to an 
affiliate as too broad in light of the important place of section 23A 
in the bank regulatory framework. The Board is not willing to make the 
applicability of the attribution rule contingent in all cases on 
subjective factors such as a member bank's knowledge of the purpose of 
a transaction or on such ambiguous, though objective, factors such as a 
member bank's reason to know of the purpose of a transaction.
    The Board also does not believe that a Regulation O-like exemption, 
for transactions by a member bank with a third party the proceeds of 
which are used by the third party in a bona fide transaction to acquire 
goods or services from an affiliate of the member bank, would be 
appropriate in the context of section 23A. Regulation O's exemption 
meshes well into that rule's underlying statutory scheme because 
sections 22(g) and 22(h) of the Federal Reserve Act do not generally 
cover asset purchases from an insider; section 23A, on the other hand, 
generally does restrict asset purchases from an affiliate. Moreover, 
Regulation O's exemption reflects an underlying policy concern not to 
discourage qualified business owners from serving as management 
officials of banks. This sort of concern is not present in the section 
23A context.

2. Agency and Riskless Principal Transactions (Sec.  223.16(b) and 
(c)(1-2))

    Concurrently with proposed Regulation W, the Board issued a final 
interpretation that exempted from section 23A a loan from a member bank 
to a nonaffiliate who uses the loan proceeds to purchase securities 
from a broker-dealer affiliate of the bank acting exclusively as a 
riskless principal.\102\ Proposed Regulation W also included this 
exemption and sought additional public comment on its terms. Numerous 
commenters recommended extending the riskless principal exemption to 
include assets other than securities and selling affiliates other than 
broker-dealers. These commenters did not provide specific information 
to the Board about other asset classes that are routinely purchased and 
sold on a riskless principal basis. In light of this absence of 
evidence, the Board declines at this time to expand the riskless 
principal exemption to include other assets or other affiliates.
---------------------------------------------------------------------------

    \102\ 66 FR 24226, May 11, 2001.
---------------------------------------------------------------------------

    Unlike the final interpretation and proposed Regulation W, final 
Regulation W contains a definition of ``acting exclusively as a 
riskless principal.'' The definition generally tracks language in 
Regulation Y and provides that, for purposes of Regulation W, a company 
acts exclusively as a riskless principal if the company, after 
receiving an order to buy (or sell) a security from a customer, 
purchases (or sells) the security in a secondary market transaction for 
its own account to offset a contemporaneous sale to (or purchase from) 
the customer.\103\
---------------------------------------------------------------------------

    \103\ See 12 CFR 225.28(b)(7)(ii).
---------------------------------------------------------------------------

    Several commenters stated that Regulation W should clarify that a 
loan from a bank to a nonaffiliate who uses the loan proceeds to 
purchase assets through an affiliate of the bank acting solely as an 
agent is not subject to the attribution rule. Concurrently with the 
issuance of proposed Regulation W, the Board issued a final 
interpretation of section 23A confirming, with some conditions, this 
view.\104\ The Board has decided to include this interpretation within 
the text of Regulation W to advance the goal of making the regulation a 
single, comprehensive source for the Board's views on sections 23A and 
23B.
---------------------------------------------------------------------------

    \104\ 66 FR 24226, May 11, 2001.
---------------------------------------------------------------------------

    The final rule clarifies one of the conditions to both the agency 
and riskless principal exemptions. Under the final interpretations 
adopted in May

[[Page 76577]]

2001, neither of these exemptions was available to a member bank if the 
asset purchased by the nonaffiliate was sold ``out of the inventory 
of'' any affiliate of the bank. The Board is concerned that users of 
the regulation may read the ``out of the inventory'' language so 
narrowly as to allow a member bank to use these exemptions in 
situations where the asset purchased by the nonaffiliate was sold as 
principal by an affiliate of the bank that did not have an inventory of 
the sold asset. Whether the selling affiliate has accumulated an 
inventory of the asset sold to the nonaffiliate is not important from 
section 23A's perspective; what matters is whether the asset purchased 
by the nonaffiliate was sold as principal by an affiliate of the member 
bank. The final rule replaces the ``out of the inventory'' standard 
with an ``as principal'' standard to remove this ambiguity. 
Accordingly, under the final rule, these two exemptions are not 
available if the asset purchased by the nonaffiliate was sold as 
principal (other than as riskless principal) by an affiliate of the 
member bank.

3. Preexisting Lines of Credit (Sec.  223.16(c)(3))

    Concurrently with proposed Regulation W, the Board issued a final 
interpretation that exempted from section 23A an extension of credit by 
a member bank to a nonaffiliate who uses the credit to purchase 
securities underwritten by or otherwise sold as principal by a broker-
dealer affiliate of the bank, if the extension of credit is made 
pursuant to a preexisting line of credit not entered into in 
contemplation of transactions with an affiliate of the bank.\105\ 
Proposed Regulation W also included this exemption and sought 
additional public comment on its terms. Commenters requested that the 
Board expand the exemption to cover purchases of any asset from any 
affiliate. In the view of these commenters, an extension of credit 
pursuant to a general purpose, preexisting line of credit should be 
exempt from the attribution rule regardless of the type of asset being 
purchased by the customer. Final Regulation W's version of this 
exemption is substantially identical to the one contained in the May 
2001 final interpretation (and proposed Regulation W). The Board may 
expand the exemption in the future, however, after it acquires 
additional supervisory experience with its use.
---------------------------------------------------------------------------

    \105\ 66 FR 24226, May 11, 2001.
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4. General Purpose Credit Cards (Sec.  223.16(c)(4))

    a. Proposed rule and public comments.--Section 23A's attribution 
rule, by its terms, covers an extension of credit by a member bank to 
an individual who uses the proceeds to purchase a product or service 
from an affiliate of the bank. Proposed Regulation W exempted from the 
attribution rule an extension of credit by a member bank to a 
nonaffiliate pursuant to a general purpose credit card in such a 
situation. The proposed rule defined a general purpose credit card as a 
credit card issued by a member bank that is widely accepted by 
merchants that are not affiliates of the bank (such as a Visa card or 
Mastercard) if less than 25 percent of the aggregate amount of 
purchases with the card are purchases from an affiliate of the 
bank.\106\ Under the proposed rule, extensions of credit to 
unaffiliated borrowers pursuant to special purpose credit cards (that 
is, credit cards that may only be used or are substantially used to buy 
goods from an affiliate of the member bank) remained subject to the 
attribution rule.\107\
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    \106\ The proposed rule also required that a general purpose 
credit card be eligible for use to purchase products or services 
from nonaffiliates of the card-issuing bank. The Board has deleted 
this requirement from the final rule because of its redundance on 
the ``widely accepted'' condition.
    \107\ As noted above, most special purpose credit card banks 
comply with section 23A by selling their receivables or establishing 
a segregated, earmarked deposit account to collateralize their 
receivables at the end of each day.
---------------------------------------------------------------------------

    The Board proposed this exemption because the funding benefit 
received by the member bank's affiliate from the use of general purpose 
credit cards by unaffiliated borrowers is likely to be minimal, and a 
member bank's decision to issue a general purpose credit card (and make 
loans pursuant to such a credit card) to an unaffiliated borrower 
likely would be based on independent credit standards unrelated to any 
possible affiliate transaction.
    Commenters strongly supported inclusion of an exemption for 
extensions of credit to nonaffiliates pursuant to a general purpose 
credit card, but a large number of commenters criticized the rule's 
definition of general purpose credit card.\108\ These commenters 
contended that the 25 percent limit in the definition of general 
purpose credit card would impose substantial monitoring and 
recordkeeping burden on banks. Some of these commenters also alleged 
that the limit is not needed for safety and soundness given that the 
card must be widely accepted by merchants and given the virtual 
impossibility of a bank using credit card transactions to assist a 
troubled affiliate. These commenters argued that the possibility that 
customers may use a widely accepted credit card to buy goods from a 
nonaffiliate should ensure that credit is granted on market terms, and 
pointed out that credit card transactions expose the bank to the credit 
risk of thousands or millions of individual unaffiliated credit card 
customers and do not directly expose the bank to the credit risk of any 
affiliate.
---------------------------------------------------------------------------

    \108\ Many commenters urged the Board to expand the exemption 
for general purpose credit cards to cover other forms of general 
revolving consumer debt, including home equity lines of credit, 
overdraft lines on checking accounts, and margin loans.
---------------------------------------------------------------------------

    Several commenters made suggestions about how the Board should 
modify, or clarify the application of, the quantitative limit in the 
definition of general purpose credit card. A couple of commenters 
believed that the rule should raise the 25 percent limit to 50 percent. 
In addition, several commenters asked the Board to provide banks with a 
cure period if they exceed the limit and requested that the Board 
provide guidance as to whether banks must do continuous or only 
periodic compliance checks with the limit.
    b. Final Rule.--The Board continues to believe that the definition 
of general purpose credit card should include the 25 percent limit. If 
more than 25 percent of the purchases effected through a credit card 
are purchases of products and services from affiliates of the card-
issuing bank, the bank has significant incentives to relax its credit 
underwriting standards to facilitate the sale of goods and services by 
its affiliates. The Board believes that a limit should be placed on the 
ability of a bank to use the Federal safety net to subsidize the 
financing of the sales activities of affiliates of the bank.
    The final rule contains several adjustments to ease the burden of 
complying with the general purpose credit card exemption. First, the 
final rule provides several different methods for a member bank to 
demonstrate that its credit card meets the 25 percent test. For a 
member bank that has no commercial affiliates (other than those 
permitted for a FHC under section 4 of the BHC Act), the bank would be 
deemed to satisfy the 25 percent test if the bank has no reason to 
believe that it would fail the test.\109\ Such a member

[[Page 76578]]

bank would not be obligated to establish systems to verify strict, 
ongoing compliance with the 25 percent test. For a member bank that has 
commercial affiliates (beyond those permitted for a FHC under section 4 
of the BHC Act), the bank would be deemed to satisfy the 25 percent 
test if (i) the bank establishes systems to verify compliance with the 
25 percent test on an ongoing basis and periodically validates its 
compliance with the test; or (ii) the bank presents information to the 
Board demonstrating that its card would comply with the 25 percent 
test.\110\
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    \109\ A member bank could use this method of complying with the 
25 percent test even if, for example, the bank's FHC controls, under 
section 4(a)(2), 4(c)(2), or 4(k)(4)(H) of the BHC Act, several 
companies engaged in nonfinancial activities.
    \110\ One way that a member bank could demonstrate that its card 
would comply with the 25 percent test would be to show that the 
total sales of the bank's affiliates are less than 25 percent of the 
total purchases by cardholders.
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    The final rule adopts a stricter compliance standard for member 
banks with commercial affiliates because banks with commercial 
affiliates typically are the banks whose credit cards are used 
substantially to purchase goods or services from affiliates. The Board 
believes that the stricter standard for member banks with commercial 
affiliates will help constrain the mixing of banking and commerce by 
limiting the ability of such banks to use the Federal safety net to 
subsidize the commercial activities of their affiliates.
    Second, the final rule provides member banks that fall out of 
compliance with the 25 percent test a three-month grace period to 
return to compliance before extensions of credit under the card become 
covered transactions. Third, the final rule gives member banks that are 
required to validate their ongoing compliance with the 25 percent test 
a fixed method, time frames, and examples for computing compliance.
    The Board does not expect that member banks whose cards fail to 
meet the terms of the general purpose credit card exemption would be 
compelled to discontinue the cards. Most banks that issue special 
purpose credit cards historically have complied with section 23A by 
selling their credit card receivables to an affiliate at the end of 
each day.\111\ Under such arrangements, which also would be permissible 
under final Regulation W, the bank does not provide continuous 
financing for its commercial affiliates; rather, it obtains funding 
from outside sources on a daily basis for its affiliate-related 
credits. Member banks that issue VISA cards and Mastercards that fail 
to satisfy the 25 percent test would be able to use the same mechanisms 
to comply with section 23A as do banks that currently issue special 
purpose credit cards.
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    \111\ As discussed below, the Board has not historically treated 
intraday credit extensions as covered transactions under section 
23A. Section 223.42(l) of the final Regulation W provides a fairly 
comprehensive exemption for intraday extensions of credit.
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V. Valuation and Timing Principles Under Section 23A--Subpart C

    Subpart C of the regulation sets forth the rules that member banks 
must use to calculate the value of covered transactions for purposes of 
determining compliance with the quantitative limits and collateral 
requirements of section 23A. This subpart also sets forth several rules 
that member banks must employ to determine when a transaction becomes 
or ceases to be a covered transaction.
A. Credit Transactions With an Affiliate (Sec.  223.21)

1. Valuation (Sec.  223.21(a))

    The proposed regulation provided generally that a credit 
transaction between a member bank and an affiliate initially must be 
valued at the amount of funds provided by the member bank to, or on 
behalf of, the affiliate plus any additional amount that the bank could 
be required to provide to, or on behalf of, the affiliate. The final 
rule supplements the proposed rule by providing that the section 23A 
value of a credit transaction between a member bank and an affiliate is 
the greater of (i) the principal amount of the credit transaction; (ii) 
the amount owed by the affiliate to the member bank under the credit 
transaction; or (iii) the result produced by application of the formula 
set forth in the proposed rule.
    The first prong of the final rule's valuation formula for credit 
transactions (``the principal amount of the credit transaction'') 
likely would determine the valuation of a transaction in which a member 
bank purchased a zero-coupon note issued by an affiliate. The Board 
believes that a member bank should value such an extension of credit at 
the principal, or face, amount of the note (that is, the amount that 
the affiliate ultimately must pay to the bank) rather than the amount 
of funds initially advanced by the bank. For example, assume a member 
bank purchased from an affiliate for $50 a 10-year zero-coupon note 
issued by the affiliate with a face amount of $100. The proposed rule's 
valuation formula permitted the member bank to value this transaction 
at $50--the amount provided to the affiliate by the bank in the 
transaction. The final rule requires the member bank to value this 
transaction at $100.
    The second prong of the final rule's valuation formula for credit 
transactions (``the amount owed by the affiliate'') likely would 
determine the valuation of a transaction in which an affiliate fails to 
pay a member bank when due a fee for services rendered by the bank to 
the affiliate. This prong of the valuation formula is not intended to 
include within section 23A's quantitative limits, however, items such 
as accrued interest not yet due on a member bank's loan to an affiliate 
or credit exposure of a member bank to an affiliate on a derivative 
transaction that is not the functional equivalent of a credit 
transaction (unless and until the affiliate defaults in making a 
required payment to the bank on a settlement date).
    Member banks will be able to determine the section 23A value for 
most credit transactions under the third prong of the rule's valuation 
formula. Under this prong, for example, a $100 term loan is a $100 
covered transaction, a $300 revolving credit facility is a $300 covered 
transaction (regardless of how much of the facility the affiliate has 
drawn down), and a guarantee backstopping a $500 debt issuance of the 
affiliate is a $500 covered transaction.\112\ Several commenters 
contended that the unused portion of a line of credit should not count 
toward the quantitative limits of section 23A, especially not if the 
bank is only conditionally obligated to advance additional funds. In 
the Board's view, the entire amount (both the used and unused portions) 
of a line of credit or other loan commitment counts toward a member 
bank's quantitative limits under section 23A regardless of whether the 
line of credit contains a ``material adverse change'' clause or any 
other provision that is intended to relieve the bank of its funding 
obligation under certain conditions. This position is consistent with 
the treatment of commitments under the Board's capital adequacy 
guidelines and is particularly appropriate in the section 23A context 
because of the risk that a member bank may not use every contractual 
escape hatch available to avoid funding a troubled affiliate.\113\
---------------------------------------------------------------------------

    \112\ These examples are included in the text of the final rule.
    \113\ See 12 CFR part 225, appendix A, Sec.  III.D.2.
---------------------------------------------------------------------------

    Under section 23A and the regulation, a member bank has made an 
extension of credit to an affiliate if the bank purchases from a third 
party a loan previously made to an affiliate of the bank. The rule 
provides a different valuation formula for these indirect credit 
transactions. For these credit transactions, the member bank must value 
the transaction at the price paid by the bank for the loan plus any

[[Page 76579]]

additional amount that the bank could be required to provide to, or on 
behalf of, the affiliate under the terms of the credit agreement.
    For example, if a member bank pays a third party $90 for a $100 
term loan that the third party previously made to an affiliate of the 
bank (because, for example, the loan was at a fixed rate and has 
declined in value due to a rise in the general level of interest 
rates), the covered transaction amount is $90 rather than $100.\114\ 
The lower covered transaction amount reflects the fact that the member 
bank's maximum loss on the transaction is $90 rather than the original 
principal amount of the loan. For another example, if a member bank 
pays a third party $70 for a $100 line of credit to an affiliate of 
which $70 had been drawn down by the affiliate, the covered transaction 
amount would be $100 (the $70 purchase price paid by the bank for the 
credit plus the remaining $30 that the bank could be required to lend 
under the credit line).
---------------------------------------------------------------------------

    \114\ The final rule includes this example of the valuation of 
indirect credit transactions.
---------------------------------------------------------------------------

    Although a member bank's purchase of, or investment in, a debt 
security issued by an affiliate is considered an extension of credit to 
an affiliate under the regulation, these transactions are not valued 
like other extensions of credit. The valuation rules for purchases of, 
and investments in, the debt securities of an affiliate are set forth 
in section 223.23 of the rule, which is discussed below in part IV.C. 
of this preamble.

2. Timing (Sec.  223.21(b)(1))

    The proposed regulation also made clear that a member bank has 
entered into a credit transaction with an affiliate at the time during 
the day that the bank becomes legally obligated to make the extension 
of credit to, or issue the guarantee, acceptance, or letter of credit 
on behalf of, the affiliate. This timing rule represented a departure 
from the industry practice of complying with section 23A only with 
respect to overnight positions. This timing rule also clarified that a 
covered transaction occurs at the moment that the member bank executes 
a legally valid, binding, and enforceable credit agreement or 
guarantee, and does not occur only when a member bank funds a credit 
facility or makes payment on a guarantee.
    Many commenters objected that forcing banks to keep track of 
extensions of credit to an affiliate on an intraday basis would present 
serious compliance burdens for banks. These commenters believed that 
banks would have little trouble ensuring that credit transactions 
satisfy the collateral requirements of section 23A or the market terms 
requirement of section 23B at the intraday time of the transactions. 
According to these commenters, however, banks currently record loans 
and measure loan exposures at the end of each business day, and 
requiring intraday loan amount tracking would impose a significant cost 
on banks.
    The Board has decided to retain proposed Regulation W's general 
timing rule for credit transactions. The burden of the timing rule 
should be significantly mitigated, however, by the exemption for 
intraday extensions of credit in section 223.42(l) of the 
regulation.\115\ The Board further notes that the burden of the timing 
rule should be lessened by the fact that Regulation W, consistent with 
section 23A, only requires a member bank to compute compliance with its 
quantitative limits when the bank is about to engage in a new covered 
transaction. Accordingly, Regulation W does not require a member bank 
to compute compliance with the rule's quantitative limits on a 
continuous basis.
---------------------------------------------------------------------------

    \115\ As discussed in more detail below in part VII.L. of this 
preamble, however, the intraday credit exemption generally applies 
only to extensions of credit that a member bank expects to be 
repaid, sold, or terminated by the end of its U.S. business day. 
Hence, the final rule generally requires a member bank to ensure its 
intraday compliance with section 23A when making a loan to an 
affiliate during the day that the bank expects to remain outstanding 
and on its books overnight.
---------------------------------------------------------------------------

3. Credit Transactions With Nonaffiliates That Become Affiliates (Sec.  
223.21(b)(2))

    Banks sometimes lend money to, or issue guarantees on behalf of, 
unaffiliated companies that later become affiliates of the bank. The 
proposed regulation provided that credit transactions with a 
nonaffiliate become covered transactions at the time that the 
nonaffiliate becomes an affiliate of the member bank. Specifically, the 
proposed rule required that a member bank (i) ensure that any such 
credit transaction satisfies the collateral requirements of section 23A 
promptly after the nonaffiliate becomes an affiliate; and (ii) include 
the amount of any such transaction in the aggregate amount of the 
bank's covered transactions for purposes of determining whether any 
future covered transactions would comply with the quantitative limits 
of section 23A. The proposal did not require a member bank to reduce 
the amount of its covered transactions with any affiliate at the time 
the nonaffiliate becomes an affiliate.\116\
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    \116\ The proposed rule also set forth a stricter set of 
compliance rules, which are discussed below, for situations in which 
a member bank entered into a credit transaction with a nonaffiliate 
``in contemplation of '' the nonaffiliate becoming an affiliate.
---------------------------------------------------------------------------

    Many commenters criticized this approach. They contended that loans 
to a nonaffiliate that later becomes an affiliate should be eternally 
exempt from the quantitative limits and collateral requirements of 
section 23A because the loans were made on arm's-length terms at 
inception and the terms of the loans would not change when the 
nonaffiliate becomes an affiliate. Several of these commenters argued 
that the proposed rule's approach to these loans is highly burdensome, 
especially for banking organizations that have a significant equity 
investment business (where new companies are constantly becoming, and 
ceasing to be, 15 percent-owned portfolio company affiliates). 
According to these commenters, banks currently treat these loans as 
grandfathered, and the proposed rule's approach would put banks and 
their merchant banking affiliates at a serious disadvantage to 
nonregulated lenders and their venture firm affiliates. Other 
commenters contended that the ``prompt'' collateral requirement would 
be burdensome because it may be difficult to obtain collateral if the 
new affiliate is less than wholly owned or has other debt outstanding 
with negative pledge covenants.
    The Board continues to subscribe to the general approach of the 
proposed rule in these situations. Although commenters may be correct 
in asserting that transactions with a nonaffiliate would be on market 
terms and would stay on market terms after the nonaffiliate becomes an 
affiliate, section 23A requires more than that covered transactions 
with affiliates be on market terms. Section 23A supplements the market 
terms requirement of section 23B with, among other things, quantitative 
limits and collateral requirements. If the Board did not treat credit 
transactions with a nonaffiliate as covered transactions at the time 
that the nonaffiliate becomes an affiliate, a member bank could incur 
uncollateralized exposure to affiliates well beyond the 20 percent 
aggregate quantitative limit in section 23A.\117\
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    \117\ Although the lending limits applicable to national and 
State member banks would apply to these credit transactions at 
inception, these lending limits permit loans to a single corporate 
group in amounts up to 50 percent of the bank's capital stock and 
surplus. 12 CFR 32.5(d). The lending limits also would cease to 
apply to these credit transactions after the nonaffiliate becomes an 
affiliate. 12 CFR 32.1(c)(1).

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[[Page 76580]]

    The Board agrees, however, that relief from the collateral 
requirements of section 23A would be appropriate in certain 
circumstances. Accordingly, the final rule exempts credit transactions 
from the collateral requirement in situations where the member bank 
entered into the transaction with the nonaffiliate at least one year 
before the nonaffiliate became an affiliate of the bank. In such 
circumstances, it is unlikely that the member bank engaged in the 
transaction with the nonaffiliate in anticipation of the nonaffiliate 
becoming an affiliate of the bank. The Board advises member banks, 
however, that such transactions must comply with the market terms 
requirement of section 23B.
    As noted above, in cases where the member bank entered into the 
credit transaction with the nonaffiliate ``in contemplation of'' the 
nonaffiliate becoming an affiliate of the bank, the proposed rule 
imposed a more strict set of requirements. In these cases, the proposed 
rule required the member bank, at or before the time the nonaffiliate 
becomes an affiliate, (i) to ensure compliance with the collateral 
requirements of section 23A and (ii) to reduce the aggregate amount of 
its covered transactions with affiliates if necessary so as not to 
exceed the quantitative limits of section 23A.
    Although commenters did not object to the proposed rule's stricter 
approach to ``in contemplation'' transactions, some commenters argued 
that the ``in contemplation'' standard in the rule is too vague. 
Several of these commenters believed the ``in contemplation'' standard 
should be replaced with a more objective standard that focuses on 
whether the nonaffiliate has entered into a binding agreement under the 
terms of which the nonaffiliate would become an affiliate or whether 
there has been a publicly announced transaction in which the 
nonaffiliate would become an affiliate. Other commenters contended that 
the Board should clarify that a transaction will be deemed ``in 
contemplation of'' a nonaffiliate becoming an affiliate only if the 
bank personnel involved in approving the transaction were aware of 
negotiations concerning the nonaffiliate's future affiliation with the 
bank. According to these commenters, any other formulation would 
require a banking organization to disseminate broadly throughout the 
firm prospective merger information (in contravention of good 
securities law compliance policies).
    The Board does not believe that the above-described circumstances 
constitute a complete set of the situations in which a member bank 
might make a loan to a nonaffiliate ``in contemplation of'' the 
nonaffiliate becoming an affiliate of the bank. To provide some clarity 
to banking organizations, however, the final rule specifies that a 
transaction between a member bank and a nonaffiliate is presumed to be 
``in contemplation of'' the nonaffiliate becoming an affiliate if the 
bank enters into the transaction with the nonaffiliate after the 
execution of, or commencement of negotiations designed to result in, an 
agreement under the terms of which the nonaffiliate would become an 
affiliate.
    The exemption from the collateral requirements discussed above does 
not apply to ``in contemplation'' transactions. If a member bank 
engages in a credit transaction with a nonaffiliate in contemplation of 
the nonaffiliate becoming an affiliate of the bank, the bank must 
ensure that the transaction complies with the collateral requirements 
of the rule at the time the nonaffiliate becomes an affiliate 
(regardless of whether a year elapsed between the inception of the 
credit transaction and the nonaffiliate becoming an affiliate).
B. Asset Purchases From an Affiliate (Sec.  223.22)
    Regulation W provides that a purchase of assets by a member bank 
from an affiliate initially must be valued at the total amount of 
consideration given by the bank in exchange for the asset. This 
consideration can take any form, and the regulation makes clear that it 
would include an assumption of liabilities by the member bank. The 
regulation also indicates that an asset purchase remains a covered 
transaction for a member bank for as long as the bank holds the asset, 
and that the value of the covered transaction after the purchase may be 
reduced to reflect amortization or depreciation of the asset, to the 
extent that such reductions are consistent with GAAP and are reflected 
on the bank's financial statements.
    The final rule, like the proposed rule, also clarifies that certain 
asset purchases by a member bank from an affiliate are not valued in 
accordance with the general asset purchase valuation formula. First, if 
the member bank buys from one affiliate a loan to a second affiliate, 
the bank must value the transaction as a credit transaction with the 
second affiliate under section 223.21 of the final rule.\118\ Second, 
if the member bank buys from one affiliate a security issued by a 
second affiliate, the bank must value the transaction as an investment 
in securities issued by the second affiliate under section 223.23 of 
the final rule.\119\ Third, if the member bank engages in a 
constructive asset purchase described in section 223.31 of the final 
rule, the bank must value the transaction under that section.\120\
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    \118\ The valuation rule for credit transactions is discussed 
above in part V.A. of this preamble.
    \119\ The purchase by a member bank of a security issued by an 
affiliate is discussed below in part V.C. of this preamble.
    \120\ These transactions are discussed below in part VI.A. of 
this preamble.
---------------------------------------------------------------------------

    The final rule (unlike the proposed rule) also sets forth a special 
valuation rule for a member bank's purchase of a line of credit or loan 
commitment from an affiliate. A member bank initially must value such 
asset purchases at the purchase price paid by the bank for the asset 
plus any additional amounts that the bank is obligated to provide under 
the credit facility.\121\ The Board has crafted this special valuation 
rule to ensure that there are limits on the amount of risk a company 
can shift to an affiliated bank. Without the rule, a company would be 
able to transfer substantial amounts of unfunded obligations to an 
affiliated bank in a manner that barely affected the bank's 
quantitative limits under section 23A.
---------------------------------------------------------------------------

    \121\ A member bank would not be required to include unfunded, 
but committed, amounts in the value of the covered transaction if 
(i) the credit facility being transferred from the affiliate to the 
bank is unconditionally cancelable (without cause) at any time by 
the bank; and (ii) the bank makes a separate credit decision before 
each drawing under the facility.
---------------------------------------------------------------------------

    Under the regulation, in contrast with credit transactions, an 
asset purchase from a nonaffiliate that later becomes an affiliate 
generally does not become a covered transaction for the purchasing 
member bank. If a member bank purchases assets from a nonaffiliate in 
contemplation of the nonaffiliate becoming an affiliate of the bank, 
however, the asset purchase becomes a covered transaction at the time 
the nonaffiliate becomes an affiliate. In addition, the member bank 
must ensure that the aggregate amount of the bank's covered 
transactions (including any such asset purchase from the nonaffiliate) 
would not exceed the quantitative limits of section 23A at the time the 
nonaffiliate becomes an affiliate.
    The regulation provides several examples designed to assist member 
banks in valuing purchases of assets from an affiliate.

[[Page 76581]]

    Several commenters requested confirmation that if a bank receives 
an encumbered asset from an affiliate, it is not forever a covered 
transaction in the amount of the encumbrance. The Board has modified an 
example in the regulation to clarify that a member bank's receipt of an 
encumbered asset from an affiliate ceases to be a covered transaction 
when, for example, the bank sells the asset.
C. Purchases of and Investments in Securities Issued by an Affiliate 
(Sec.  223.23)
    Section 23A includes as a covered transaction a member bank's 
purchase of, or investment in, securities issued by an affiliate. 
Proposed Regulation W required a member bank to value a purchase of, or 
investment in, securities issued by an affiliate (other than a 
financial subsidiary of the bank) \122\ at the greater of the bank's 
purchase price or carrying value of the securities.\123\ Under the 
rule, a member bank that paid no consideration in exchange for 
affiliate securities would nevertheless have to value the covered 
transaction at no less than the bank's carrying value of the 
securities.\124\ In addition, under the rule, if the member bank's 
carrying value of the affiliate securities increased or decreased after 
the bank's initial investment (due to profits or losses at the 
affiliate), the amount of the bank's covered transaction would increase 
or decrease to reflect the bank's changing financial exposure to the 
affiliate, but could not decline below the amount paid by the bank for 
the securities.
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    \122\ The valuation rule for investments in securities issued by 
a financial subsidiary is discussed below in part VI.B.2. of this 
preamble.
    \123\ Staff traditionally advised member banks to value a 
purchase of securities issued by an affiliate at the purchase price 
paid by the bank for the securities.
    \124\ Carrying value refers to the amount at which the 
securities are carried on the GAAP financial statements of the 
member bank.
---------------------------------------------------------------------------

    A number of commenters objected to this valuation formula and 
offered alternatives. Several commenters argued that investments in an 
affiliate's securities should be valued at the lower of purchase price 
or carrying value. Under this formula, a contribution of affiliate 
securities to a bank would be valued at zero, and the bank would be 
permitted without limit to reduce the covered transaction amount for a 
purchase of affiliate securities as the value of the securities 
declined. These commenters justified their formula's treatment of bank 
investments in a declining affiliate by pointing out that a bank's 
capital would be reduced to reflect the decline in value of the 
affiliate's securities and by noting that their approach more 
accurately reflects the bank's actual remaining financial exposure to 
the affiliate.
    Under the commenters' proposed formula, a bank's section 23A value 
for an investment in affiliate securities also would not increase as 
the value of the securities increased. These commenters argued that an 
increase in the value of an investment does not create additional risk 
of loss for the investor and that there is no justification for 
restricting section 23A lending as an affiliate increases in financial 
strength. One of these commenters contended that the proposed 
regulation's valuation rule is inconsistent in increasing the section 
23A value of an investment as the affiliate prospers but not decreasing 
the section 23A value of the investment as the affiliate declines.
    Other commenters argued that investments in an affiliate's 
securities always should be valued at the purchase price or, at a 
minimum, that a contribution of affiliate securities initially should 
be valued at zero.
    The Board has determined to adopt the valuation rule contained in 
the proposed regulation. The Board continues to believe that several 
important considerations support the general carrying value approach of 
this valuation rule. First, the approach is consistent with GAAP, which 
would require a bank to reflect its investment in securities issued by 
an affiliate at carrying value throughout the life of the investment, 
even if the bank paid no consideration for the securities. Second, the 
approach is supported by the terms of the statute, which defines both a 
``purchase of'' and an ``investment in'' securities issued by an 
affiliate as a covered transaction. The statute's ``investment in'' 
language indicates that Congress was concerned with a member bank's 
continuing exposure to an affiliate through an ongoing investment in 
the affiliate's securities.
    Third, amendments to section 23A made by the GLB Act support the 
approach. The GLB Act defines a financial subsidiary of a bank as an 
affiliate of the bank, but specifically provides that the section 23A 
value of a bank's investment in securities issued by a financial 
subsidiary does not include retained earnings of the subsidiary. The 
negative implication from this provision is that the section 23A value 
of a bank's investment in other affiliates includes the affiliates' 
retained earnings, which would be reflected in the bank's carrying 
value of the investment under the rule.
    Finally, the carrying value approach is consistent with the 
purposes of section 23A--limiting the financial exposure of banks to 
their affiliates and promoting safety and soundness. The valuation rule 
requires a member bank to revalue upwards the amount of an investment 
in affiliate securities only when the bank's exposure to the affiliate 
increases (as reflected on the bank's financial statements) and the 
bank's capital increases to reflect the higher value of the investment. 
In these circumstances, the valuation rule merely reflects the member 
bank's greater financial exposure to the affiliate and enhances safety 
and soundness by reducing the bank's ability to engage in additional 
transactions with an affiliate as the bank's exposure to that affiliate 
increases.
    As noted above, this valuation rule also provides that the covered 
transaction amount of a member bank's investment in affiliate 
securities can be no less than the purchase price paid by the bank for 
the securities, even if the carrying value of the securities declines 
below the purchase price. Although this aspect of the valuation rule is 
not consistent with GAAP, using the member bank's purchase price for 
the securities as a floor for valuing the covered transaction is 
appropriate for several reasons. First, it ensures that the amount of 
the covered transaction never falls below the amount of funds actually 
transferred by the member bank to the affiliate in connection with the 
investment. In addition, the purchase price floor limits the ability of 
a member bank to provide additional funding to an affiliate as the 
affiliate approaches insolvency. If the regulation were to value 
investments in securities issued by an affiliate strictly at carrying 
value, then the member bank could lend more funds to the affiliate as 
the affiliate's financial condition worsened. As the affiliate 
declined, the member bank's carrying value of the affiliate's 
securities would decline, the section 23A value of the bank's 
investment likely would decline, and, consequently, the bank would be 
able to provide additional funding to the affiliate under section 23A. 
This type of increasing support for an affiliate in distress is 
precisely what section 23A was intended to restrict.
    The regulation provides several examples designed to assist member 
banks in valuing purchases of and investments in securities issued by 
an affiliate.

[[Page 76582]]

D. Posting Securities Issued by an Affiliate as Collateral (Sec.  
223.24)

1. General Valuation Rule (Sec.  223.24(a) and (b))

    Section 23A defines as a covered transaction a member bank's 
acceptance of securities issued by an affiliate as collateral for a 
loan or extension of credit to any person or company.\125\ This type of 
covered transaction has two classes: one in which the only collateral 
for the loan is affiliate securities; and another in which the loan is 
secured by a combination of affiliate securities and other collateral. 
Section 23A does not explain how these different types of covered 
transactions should be valued for purposes of determining compliance 
with the quantitative limits of the statute.
---------------------------------------------------------------------------

    \125\ 12 U.S.C. 371c(b)(7)(D). This covered transaction only 
arises when the member bank's loan is to a nonaffiliate. Under 
section 23A, the securities issued by an affiliate are not 
acceptable collateral for a loan or extension of credit to any 
affiliate. See 12 U.S.C. 371c(c)(4). Moreover, if the proceeds of a 
loan that is secured by an affiliate's securities are transferred to 
an affiliate by the unaffiliated borrower (for example, to purchase 
assets or securities from the inventory of an affiliate), the loan 
should be treated as a loan to the affiliate. The loan must then be 
secured with collateral in an amount and of a type that meets the 
requirements of section 23A for loans by a member bank to an 
affiliate.
---------------------------------------------------------------------------

    As a general rule, Regulation W values covered transactions of the 
first class, where the credit extension is secured exclusively by 
affiliate securities, at the full amount of the extension of credit. 
This approach reflects the difficulty of measuring the actual value of 
typically untraded and illiquid affiliate securities, and 
conservatively assumes that the value of the securities is equal to the 
full value of the loan that the securities collateralize. This position 
also reflects the traditional advice given by Board staff on this 
issue. Regulation W contains an exception to the general rule where the 
affiliate securities held as collateral have a ready market. In that 
case, the transaction may be valued at the fair market value of the 
affiliate securities. The exception grants relief from staff's 
traditional position in those circumstances where the value of the 
affiliate securities is independently verifiable by reference to 
transactions occurring in a liquid market.\126\
---------------------------------------------------------------------------

    \126\ In either case, the transaction must comply with section 
23B; that is, the member bank must obtain the same amount of 
affiliate securities as collateral on the credit extension that the 
bank would obtain if the collateral were not affiliate securities.
---------------------------------------------------------------------------

    Regulation W values covered transactions of the second class, where 
the credit extension is secured by affiliate securities and other 
collateral, at the lesser of (i) the total value of the extension of 
credit minus the fair market value of the other collateral or (ii) the 
fair market value of the affiliate securities (if the securities have a 
ready market). Until 1999, staff advised member banks to value this 
class of covered transactions at the total amount of the extension of 
credit. In January 1999, the staff modified its position on mixed 
collateral loans to permit member banks to value these transactions in 
a manner similar to the rule.\127\
---------------------------------------------------------------------------

    \127\ See Letter dated January 21, 1999, from J. Virgil 
Mattingly, Jr., General Counsel of the Board, to Bruce Moland. This 
letter set forth an opinion of Board staff that, for purposes of 
applying the quantitative limits in section 23A, such mixed-
collateral loans should be valued at the lesser of (i) the total 
amount of the loan less the fair market value of nonaffiliate 
collateral (if any) or (ii) the fair market value of the affiliate's 
securities that are used as collateral.
---------------------------------------------------------------------------

    The Board believes that where a loan is secured by securities of an 
affiliate and other collateral, it is reasonable to reflect the fair 
market value of the other collateral in determining whether, and to 
what extent, the loan should count toward the member bank's section 23A 
quantitative limits. Under the rule's method of calculation for mixed-
collateral loans, if a loan is fully secured by nonaffiliate collateral 
with a fair market value that equals or exceeds the loan amount, then 
the loan would not be included in the member bank's quantitative limits 
for purposes of section 23A.\128\ If the loan is not fully secured by 
other collateral, then the maximum amount that the member bank must 
count against its quantitative limits is the difference between the 
full amount of the loan and the fair market value of the nonaffiliate 
collateral.
---------------------------------------------------------------------------

    \128\ The Board notes, however, that section 23A requires a loan 
by a member bank that is secured with any amount of an affiliate's 
securities to be consistent with safe and sound banking practices. 
12 U.S.C. 371c(a)(4).
---------------------------------------------------------------------------

    The approach taken in Regulation W, however, is different from that 
of the 1999 interpretation in two respects. First, although the 1999 
interpretation allowed member banks to use the fair market value of the 
affiliate securities as an upper limit on the value of the transaction 
regardless of the liquidity of the affiliate securities, the regulation 
only allows member banks to use the value of the affiliate securities 
as an upper limit if the affiliate securities have a ready market. The 
Board is concerned that a member bank could understate the market value 
of affiliate securities that do not have a ready market in order to 
shrink the size of the covered transaction. Second, the regulation's 
ready market requirement replaces an implicit condition of the 1999 
interpretation that only a small amount of the total collateral could 
be affiliate securities. The valuation rule in Regulation W applies 
regardless of the amount of affiliate collateral.\129\
---------------------------------------------------------------------------

    \129\ One commenter asked for clarification that a member bank 
may use the higher of the two valuation options for these 
transactions if, for example, the bank does not have the procedures 
and systems in place to verify the fair market value of affiliate 
securities. The Board has adjusted the language of the rule to 
clarify that a member bank may choose to use the higher valuation 
option.
---------------------------------------------------------------------------

    Commenters did not criticize the proposed rule's general valuation 
formulas for these covered transactions, and the general formulas 
contained in the final rule are substantially identical to those in the 
proposal. Commenters did, however, suggest several new exemptions for 
this type of covered transaction: (i) Transactions in which the 
affiliate securities serving as collateral meet the (d)(6) exemption 
and (ii) transactions in which the affiliate securities serving as 
collateral represent less than 50 percent of the total collateral. The 
final rule does not include either of these suggested exemptions. In 
the Board's view, a loan by a member bank that is secured by affiliate 
securities could be used to provide indirect financing to an affiliate 
and exposes the bank (albeit secondarily) to the credit risk of an 
affiliate regardless of whether the affiliate securities are traded in 
a liquid market or constitute a minority of the total collateral for 
the loan.

2. Exemption for Shares Issued by an Affiliated Mutual Fund (Sec.  
223.24(c))

    In connection with the proposed rule, the Board specifically sought 
comment on whether to exempt from section 23A loans to third parties 
secured by affiliate-issued mutual fund shares. A large number of 
commenters advocated granting this exemption and offered the following 
principal arguments in support of their position: (i) The bank is not 
funding an affiliate in these transactions; (ii) although section 23A 
includes as a covered transaction a loan to a third party 
collateralized by affiliate securities, the purpose of including this 
covered transaction was to prevent evasion, and evasion is implausible 
when the collateral taken by the bank is affiliate-issued mutual funds; 
(iii) tracking these loans can be very burdensome as many of the loans 
are small and the value of the mutual fund collateral changes daily; 
(iv) the assets of an affiliated mutual fund generally are shares of 
nonaffiliates, which could otherwise serve as collateral for the loan 
without creating a covered transaction under section 23A; and (v) 
mutual funds

[[Page 76583]]

are highly regulated, their shares are highly liquid and can only be 
purchased at their daily net asset value, and mutual funds are required 
by law to have boards of directors that are largely independent of the 
bank and its affiliates.
    In the proposal, the Board asked for comment on five potential 
conditions to the availability of this exemption: (i) The borrower does 
not use the proceeds of the loan to purchase shares of the affiliated 
mutual fund; (ii) the borrower is not an executive officer of the 
member bank or its affiliates; (iii) the price of the mutual fund 
shares is quoted routinely in a widely disseminated news source; (iv) 
the shares of the mutual fund are widely held by the public; and (v) 
the member bank and its affiliates do not own in the aggregate more 
than 5 percent of the shares of the mutual fund. A few commenters 
recommended that the Board drop all five of these conditions. Other 
commenters specifically endorsed or specifically objected to particular 
conditions.
    One commenter supported the use of proceeds condition, but other 
commenters objected to the condition because the use of loan proceeds 
is hard to monitor and control. Several commenters expressed opposition 
to the executive officer condition. Many of them noted that Regulation 
O already comprehensively regulates bank lending to executive officers. 
A number of other commenters expressed a willingness to support the 
condition if it were modified to cover only executive officers that are 
subject to Regulation O restrictions.
    A few commenters supported the pricing mechanism condition. One 
commenter opposed the condition on the grounds that major newspapers 
only report on large mutual funds, and even small mutual funds are 
liquid (and must redeem shares upon request at all times) and have 
prices quoted on internet sites and in other news sources. Several 
commenters asked the Board to widen this condition to explicitly permit 
mutual fund price quotes to be obtained from Morningstar, Lipper, 
Bloomberg, fund supermarket websites, or any other unaffiliated, real-
time, electronic pricing system.
    Some commenters expressly supported the widely held condition. 
Several other commenters criticized the condition. These commenters 
noted that the daily redemption requirement to which mutual funds are 
subject should satisfy any liquidity concerns that the Board may have. 
They advised that concentrated ownership of a fund would not adversely 
impact the fund's liquidity or the reliability of pricing information.
    One commenter supported the 5 percent ownership limit condition. 
Many commenters opposed the condition, largely because of its purported 
redundance on the widely held condition. Some of these commenters asked 
the Board to replace the 5 percent condition with a ``no control'' 
condition.
    The Board has decided to include in the final rule an exemption for 
extensions of credit by a member bank that are secured by shares of an 
affiliated mutual fund. To qualify for the exemption, the transaction 
must meet several conditions. First, to ensure that the affiliate 
collateral is liquid and trades at a fair price, the affiliated mutual 
fund must be an open-end investment company that is registered with the 
SEC under the 1940 Act. Second, to ensure that the member bank can 
easily establish and monitor the value of the affiliate collateral, the 
affiliated mutual fund's shares serving as collateral for the extension 
of credit must have a publicly available market price. Third, to reduce 
the member bank's incentives to use these extensions of credit as a 
mechanism to support the affiliated mutual fund, the member bank and 
its affiliates must not own more than 5 percent of the fund's shares 
(excluding certain shares held in a fiduciary capacity). Finally, the 
proceeds of the extension of credit must not be used to purchase the 
affiliated mutual fund's shares serving as collateral or otherwise used 
to benefit an affiliate. In such circumstances, the member bank's 
extension of credit would be covered by section 23A's attribution rule.
    Instead of creating a separate exemption for these transactions in 
subpart E of the rule, the Board has decided to effect this exemption 
by adjusting the valuation rule for extensions of credit secured by 
affiliate-issued securities. Inserting the exemption into the valuation 
rule for this type of covered transaction will enable users of the 
regulation to determine more easily the non-exempt covered transaction 
amount for loans secured in part by affiliate-issued securities and in 
part by other collateral. The final rule effects the exemption by 
providing that an affiliated mutual fund's shares that meet the above-
mentioned criteria do not count as affiliate-issued securities for 
purposes of the valuation rule for extensions of credit secured by 
affiliate-issued securities.

VI. Other Requirements Under Section 23A--Subpart D

    Subpart D of the rule provides guidance to banking organizations on 
three issues under section 23A: (i) Merger and acquisition transactions 
between a member bank and an affiliate; (ii) financial subsidiaries of 
a member bank; and (iii) derivative transactions between a member bank 
and an affiliate.
A. Merger and Acquisition Transactions Between a Member Bank and an 
Affiliate (Sec.  223.31)

1. The General Rule (Sec.  223.31(a-c))

    As noted above, section 23A includes a member bank's purchase of 
assets from an affiliate and a member bank's purchase of, or investment 
in, securities issued by an affiliate within the definition of covered 
transaction. In the past, the Board has been required to apply these 
provisions to transactions where a member bank directly or indirectly 
acquires an affiliate. There are three principal methods by which a 
member bank acquires an affiliate. The first method is where a member 
bank directly purchases or otherwise acquires the affiliate's assets 
and assumes the affiliate's liabilities. In this case, the transaction 
is treated as a purchase of assets, and the covered transaction amount 
is equal to the amount of any separate consideration paid by the member 
bank for the affiliate's assets (if any) plus the amount of any 
liabilities assumed by the bank in the transaction.
    The second method is where a member bank acquires an affiliate by 
merger. Because a merger with an affiliate generally results in the 
member bank acquiring all the assets of the affiliate and assuming all 
the liabilities of the affiliate, this transaction is effectively 
equivalent to the purchase and assumption transaction described in the 
previous paragraph. Accordingly, the merger transaction also is treated 
as a purchase of assets, and the covered transaction amount is again 
equal to the amount of any separate consideration paid by the member 
bank for the affiliate's assets (if any) plus the amount of any 
liabilities assumed by the bank in the transaction.\130\
---------------------------------------------------------------------------

    \130\ As noted above, section 223.3(dd) of the final rule makes 
explicit the Board's view that these merger transactions generally 
involve the purchase of assets by a member bank from an affiliate.
---------------------------------------------------------------------------

    The third method involves the contribution or sale of a controlling 
block of an affiliate's shares to a member bank. The Board previously 
has treated these transactions as a purchase of assets covered by 
section 23A if the member bank paid consideration for the shares or the 
affiliate whose shares were

[[Page 76584]]

contributed to the member bank had liabilities to any affiliate of the 
bank.\131\
---------------------------------------------------------------------------

    \131\ See, e.g., Letter dated June 11, 1999, from Robert deV. 
Frierson, Associate Secretary of the Board, to Mr. Robert L. 
Anderson. The Board adopted this view of these internal 
reorganizations principally because the transactions often were 
motivated by funding problems at the transferred affiliate or the 
member bank's parent holding company and by a desire to use the 
bank's resources to alleviate those funding needs. Soon after 
consummating such reorganizations, bank funds typically were used to 
pay down liabilities that the transferred company had to the parent 
holding company of the member bank.
---------------------------------------------------------------------------

    The proposed rule did not alter the treatment of the first two 
types of transaction described above. The proposed rule did set forth, 
however, a new treatment for the third type of transaction. The 
proposed rule provided that the acquisition by a member bank of 
securities issued by a company that was an affiliate of the bank before 
the acquisition is treated as a purchase of assets from an affiliate if 
(i) as a result of the transaction, the company becomes an operating 
subsidiary of the bank; and (ii) the company has liabilities, or the 
bank gives cash or any other consideration in exchange for the 
securities. The proposed rule also provided that these transactions 
must be valued initially at the sum of (i) the total amount of 
consideration given by the member bank in exchange for the securities; 
and (ii) the total liabilities of the company whose securities have 
been acquired by the member bank. In effect, the proposed rule required 
member banks to treat such share donations and purchases in the same 
manner as if the member bank had purchased the assets of the 
transferred company at a purchase price equal to the liabilities of the 
transferred company (plus any separate consideration paid by the bank 
for the shares).
    A number of commenters objected to this approach. Many of them 
complained that the approach would prevent banks from efficiently 
reorganizing their operations and, therefore, would put BHCs at a 
competitive disadvantage to other less regulated companies. These 
commenters also contended that the approach ignores the reality of the 
corporate limited liability shield.
    Some of these commenters simply asserted that the rule should not 
treat a donation of shares as a covered transaction because the bank is 
obtaining an asset (shares) at no cost. Other commenters offered a 
variety of alternative formulas for valuing these transactions. The 
principal alternatives offered were to value these covered transactions 
at (i) the purchase price paid by the bank for the shares plus any 
liabilities of the transferred company minus the value of the assets of 
the transferred company (as verified by an independent third party); 
(ii) the purchase price paid by the bank for the shares; (iii) the GAAP 
net worth of the transferred company; or (iv) the purchase price paid 
by the bank for the shares plus any liabilities owed by the transferred 
company to affiliates of the bank (staff's traditional approach).
    For the following reasons, the Board is adopting a valuation rule 
for these transactions that is substantially identical to the formula 
set forth in the proposed rule.\132\ Regulation W's treatment of these 
transactions is consistent with the approach that section 23A takes on 
subsidiaries of member banks and with economic and marketplace 
realities. Section 23A treats member banks and their operating 
subsidiaries as a single unit. Transactions between a member bank and 
its operating subsidiaries are not treated as covered transactions 
between a member bank and an affiliate under section 23A; rather, they 
are treated as transactions entirely inside the member bank. Similarly, 
a transaction between a member bank's operating subsidiary and an 
affiliate of the member bank is treated as a covered transaction 
between the member bank itself and an affiliate under section 23A. 
Ignoring the separate corporate form of operating subsidiaries of 
member banks and treating the assets and liabilities of operating 
subsidiaries of member banks as assets and liabilities of the member 
bank itself is, therefore, consistent with the structure of section 
23A. Accordingly, under section 23A, these share transfers in which an 
affiliate of a member bank becomes an operating subsidiary of the bank 
are properly viewed as a purchase of an affiliate's assets and an 
assumption of an affiliate's liabilities by the bank.\133\
---------------------------------------------------------------------------

    \132\ The final rule differs from the proposed rule in one small 
respect. The final rule explicitly addresses situations in which the 
assets of the transferred company include securities issued by an 
affiliate, extensions of credit to an affiliate, or other covered 
transactions. In these situations, the final rule clarifies that a 
member bank initially must value these transactions at the greater 
of (i) the purchase price paid by the bank for the shares of the 
transferred company plus the total liabilities of the transferred 
company; or (ii) the total value of all covered transactions 
acquired by the bank as a result of the transaction. For example, 
assume the transferred company has $100 of assets ($25 of which are 
loans to an affiliate) and $40 of liabilities. Upon donation of the 
company's shares to the member bank, the bank would have a $40 
covered transaction. If $45 of the transferred company's assets are 
loans to an affiliate, however, the member bank would have a $45 
covered transaction upon donation of the company's shares to the 
bank.
    \133\ One commenter contended that the rule's approach to these 
reorganization transactions unfairly counts 100 percent of the 
liabilities of the transferred company even if only 25 percent of 
the shares of the company are transferred. As noted above, this 
outcome is consistent with the structure of section 23A, which 
treats 25-percent-owned operating subsidiaries as part of the member 
bank itself.
---------------------------------------------------------------------------

    Regulation W's treatment of affiliate share transfers is also 
consistent with the Board's supervisory experience. The Board has found 
that banks often operate their consolidated organizations--because of 
capital requirements, financial reporting requirements, and 
reputational risk concerns--as if the assets and liabilities of 
subsidiaries were assets and liabilities of the bank itself. Banks 
often attempt to shore up their subsidiaries in times of financial 
stress, despite the limited liability inhering in the corporate form. 
Accordingly, the rule treats the assets and liabilities of an operating 
subsidiary of a member bank as assets and liabilities of the bank 
itself for purposes of section 23A.\134\
---------------------------------------------------------------------------

    \134\ Because a member bank usually can merge a subsidiary into 
itself, transferring all the shares of an affiliate to a member bank 
often is functionally equivalent to a transaction in which the bank 
directly acquires the assets and assumes the liabilities of the 
affiliate. As noted above, in a direct acquisition of assets and 
assumption of liabilities, the covered transaction amount would be 
equal to the total amount of liabilities assumed by the member bank.
---------------------------------------------------------------------------

    The rule only imposes asset purchase treatment on affiliate share 
transfers where the company whose shares are being transferred to the 
member bank was an affiliate of the bank before the transfer. If the 
transferred company were not an affiliate before the transfer, it would 
not be appropriate to treat the share transfer as a purchase of assets 
from an affiliate. Similarly, the rule only requires asset purchase 
treatment for affiliate share transfers where the transferred company 
becomes a subsidiary and not an affiliate of the member bank through 
the transfer. If the transferred company were not a subsidiary of the 
member bank after the transfer (because, for example, the bank acquired 
less than 25 percent of a class of voting securities of the company) or 
if the company were an affiliate of the member bank after the transfer 
(because, for example, the bank's holding company continued to own 25 
percent or more of a class of voting securities of the company or 
because the company became a financial subsidiary of the bank after the 
transfer), the Board does not believe it would be appropriate to treat 
the liabilities of the company as the liabilities of the bank for 
purposes of section 23A. In those circumstances, section 23A would not 
treat the member bank and the transferred company as a single unit.

[[Page 76585]]

    One commenter speculated that this approach to affiliate share 
transfers would create an eternal covered transaction. Under the rule, 
affiliate share transfers are deemed to be an asset purchase by the 
member bank from an affiliate and would diminish over time in the same 
manner as any other asset purchase. That is, the amount of the covered 
transaction would decline over time as the assets of the transferred 
company were sold or amortized. The amount of the covered transaction 
would not decline over time, however, as the member bank paid off the 
liabilities of the transferred company. A valuation example in the 
final rule will help to explain how the covered transaction amount of 
these affiliate share transfers winds down over time.
    Another commenter asked the Board to clarify that a BHC could 
reduce the covered transaction amount for an affiliate share transfer 
by making a cash contribution to the transferee bank in the amount of 
the liabilities of the transferred company. The Board agrees that an 
affiliate share transfer would not be a covered transaction if, in 
addition to receiving the affiliate shares, the transferee member bank 
received a cash contribution equal to the amount of the liabilities of 
the transferred company. In this situation, the member bank should not 
be deemed to have ``purchased'' the assets of the transferred company.
    The Board notes that a member bank that proposes to purchase assets 
from an affiliate as part of an internal corporate reorganization of a 
banking organization (including in a transaction that is treated as a 
purchase of assets under section 223.31 of the rule) may qualify for a 
regulatory or case-by-case exemption from section 23A. Section 
223.41(d) of the final rule sets forth a general regulatory exemption 
for these covered transactions, and part VII.C. of this preamble 
discusses both the general regulatory exemption and the Board's 
practice of granting case-by-case exemptions for these covered 
transactions. In addition, section 223.31(d) of the final rule, which 
is discussed in the following section of the preamble, provides an 
exemption for certain step transactions that are treated as asset 
purchases under section 223.31(a) of the rule.

2. Step Transaction Exemption (Sec.  223.31(d-e))

    The proposed regulation also contained a regulatory exemption for 
certain merger and acquisition transactions that result in the transfer 
of an affiliate to a member bank. Section 223.31(d) of the proposed 
rule provided an exemption from the requirements of section 23A (other 
than the safety and soundness requirement) for transactions in which, 
for example, a BHC acquires the stock of an unaffiliated company and, 
immediately after consummation of the acquisition, transfers the shares 
of the acquired company to the holding company's subsidiary member 
bank. Although these transactions technically would be treated as an 
asset purchase by a member bank from an affiliate--and the member bank 
would be required to value the covered transaction at the total amount 
of the liabilities of the acquired company (plus any separate 
consideration paid by the bank for the company)--the Board believed 
that it would be inappropriate to require a member bank to count these 
transactions toward its section 23A quantitative limits. If the member 
bank had acquired the target company directly, there would have been no 
covered transaction, and the mere fact that the bank's holding company 
owned the target company for a moment in time does not change the 
fundamental nature of the transaction.
    Consequently, the proposed regulation exempted these ``step'' 
transactions under certain conditions. First, the member bank had to 
acquire the target company immediately after the company became an 
affiliate (by being acquired by the bank's holding company, for 
example). Second, the member bank had to acquire the entire ownership 
position in the target company that its holding company acquired. 
Finally, the entire transaction had to comply with the market terms 
requirement of section 23B.
    Many commenters objected to the immediate transfer requirement, 
mostly on the basis that a BHC may want to hold the target company at 
the holding company level for some time for tax, business line 
integration, or regulatory approval reasons. Some commenters advised 
that the immediate transfer requirement could be replaced with a 
requirement that the target company be acquired by the BHC ``in 
contemplation of'' being put under the bank. Other commenters 
recommended that the immediate transfer requirement be replaced with a 
3-month, 6-month, or 1-year requirement.
    As noted in the preamble to the proposed rule, to the extent that 
the member bank acquires the target company some time after the company 
becomes an affiliate, the transaction looks less like a single 
transaction in which the bank acquires the target company and more like 
two separate transactions, the latter of which involves the bank 
acquiring assets from an affiliate. Nevertheless, in order to provide 
banking organizations with a reasonable amount of time to address 
legal, tax, and business issues relating to an acquisition, the Board 
has decided to permit member banks to avail themselves of the step 
transaction exemption if they acquire the target company within three 
months after the target company becomes an affiliate (so long as the 
appropriate Federal banking agency for the bank has approved the longer 
time period). To protect the transferee member bank from a decline in 
the financial condition or asset quality of the target company during 
the time that the acquired company is an affiliate of the bank, the 
final rule adds two conditions to the applicability of the step 
transaction exemption. First, a member bank must notify its appropriate 
Federal banking agency and the Board, at or before the time that the 
target company becomes an affiliate of the bank, of its intent 
ultimately to acquire the target company. Second, there must be no 
material change in the business or financial condition of the target 
company during the time between when the company becomes an affiliate 
of the member bank and the bank's receipt of the company.
    Several commenters also objected to the ``bank must acquire all of 
the target company'' requirement. These commenters alleged that there 
are legitimate business, regulatory, and tax reasons to distribute a 
target company's assets and subsidiaries to various bank and nonbank 
subsidiaries of the holding company. Some of these commenters advocated 
replacing the 100 percent requirement with a 25-50 percent requirement. 
The Board has decided to keep the 100 percent requirement in order to 
prevent a holding company from keeping the good subsidiaries of the 
target company and transferring the bad subsidiaries of the target 
company to the holding company's subsidiary member bank.
    Of course, if a banking organization fails to meet the terms of the 
step transaction exemption, the organization may be able to satisfy the 
conditions of Regulation W's internal corporate reorganization 
exemption or may be able to obtain a case-by-case exemption from the 
Board.
B. Financial Subsidiaries (Sec.  223.32)
    As noted above, the GLB Act amended section 23A to treat a 
financial subsidiary of a bank as an affiliate of the bank and to 
establish several special rules that apply to transactions with 
financial subsidiaries. The regulation combines all of the special 
rules that apply to transactions with financial subsidiaries in a 
single section.

[[Page 76586]]

1. Applicability of the 10 Percent Quantitative Limit to Transactions 
With a Financial Subsidiary (Sec.  223.32(a))

    First, consistent with the GLB Act, the regulation provides that 
the 10 percent quantitative limit in section 23A does not apply with 
respect to covered transactions between a member bank and any 
individual financial subsidiary of the bank. Accordingly, a member 
bank's aggregate amount of covered transactions with any individual 
financial subsidiary of the bank may exceed 10 percent of the bank's 
capital stock and surplus.\135\ A member bank's covered transactions 
with its financial subsidiaries, however, are subject to the 20 percent 
quantitative limit in section 23A. Thus, a member bank may not engage 
in a covered transaction with any affiliate (including a financial 
subsidiary) if the bank's aggregate amount of covered transactions with 
all affiliates (including financial subsidiaries) would exceed 20 
percent of the bank's capital stock and surplus.
---------------------------------------------------------------------------

    \135\ As noted above, in response to the request of a commenter, 
section 223.11 of the final rule also indicates that covered 
transactions between a member bank and its financial subsidiary are 
exempt from the 10 percent limit.
---------------------------------------------------------------------------

    The Board notes that the exemption from the 10 percent limit for 
investments by a member bank in its own financial subsidiary does not 
apply to investments by a member bank in the financial subsidiary of an 
affiliated depository institution. Although the financial subsidiary of 
an affiliated depository institution is an affiliate of the member bank 
for purposes of sections 23A and 23B, the GLB Act states that only 
``covered transactions between a bank and any individual financial 
subsidiary of the bank'' are not subject to the 10 percent limit in 
section 23A.\136\ Accordingly, a member bank may not engage in a 
covered transaction with the financial subsidiary of an affiliated 
depository institution if the aggregate amount of the member bank's 
covered transactions with that financial subsidiary would exceed 10 
percent of the bank's capital stock and surplus.
---------------------------------------------------------------------------

    \136\ 12 U.S.C. 371c(e)(3)(A) (emphasis added).
---------------------------------------------------------------------------

2. Valuation of Investments in Securities Issued by a Financial 
Subsidiary (Sec.  223.32(b))

    Because financial subsidiaries of a member bank are considered 
affiliates of the bank for purposes of section 23A, a member bank's 
purchases of and investments in the securities of its financial 
subsidiary are covered transactions under the statute. The GLB Act 
further provides that a member bank's investment in its own financial 
subsidiary, for purposes of section 23A, shall not include the retained 
earnings of the financial subsidiary.\137\ In light of this statutory 
provision, the regulation contains a special valuation rule for 
investments by a member bank in the securities of its own financial 
subsidiary.\138\ Such investments must be valued at the greater of (i) 
the price paid by the member bank for the securities; or (ii) the 
carrying value of the securities on the financial statements of the 
member bank (determined in accordance with GAAP but without reflecting 
the bank's pro rata share of any earnings retained or losses incurred 
by the financial subsidiary after the bank's acquisition of the 
securities).\139\
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    \137\ GLB Act Sec.  121(b)(1) (codified at 12 U.S.C. 
371c(e)(3)(B)).
    \138\ Consistent with the GLB Act, the special valuation formula 
in Regulation W for investments by a member bank in its own 
financial subsidiary does not apply to investments by a member bank 
in a financial subsidiary of an affiliated depository institution. 
Such investments must be valued using the general valuation formula 
set forth in section 223.23 of the final rule for investments in 
securities issued by an affiliate and, further, may trigger the 
anti-evasion rule contained in section 223.32(c)(1) of the rule.
    \139\ The regulation also makes clear that if a financial 
subsidiary is consolidated with its parent member bank under GAAP, 
the carrying value of the bank's investment in the financial 
subsidiary shall be determined based on parent-only financial 
statements of the bank.
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    This valuation rule differs from the general valuation rule for 
investments in securities issued by an affiliate only in that the 
financial subsidiary rule requires, consistent with the GLB Act, that 
the carrying value of the investment be computed without consideration 
of the retained earnings or losses of the financial subsidiary since 
the time of the member bank's investment. As a result of this rule, the 
covered transaction amount for a member bank's investment in securities 
issued by its financial subsidiary generally would not increase after 
it was made except in the event that the member bank made an additional 
capital contribution to the subsidiary or purchased additional 
securities of the subsidiary.
    The regulation provides several examples designed to assist member 
banks in valuing investments in securities issued by a financial 
subsidiary.
    One commenter criticized this valuation rule and asserted that a 
donation of shares of a financial subsidiary to a bank should never 
have a section 23A value. For the reasons discussed above in part V.C. 
of this preamble, the Board does not believe that such an approach to 
valuation would be consistent with the purposes and structure of 
section 23A.

3. Anti-Evasion Rules (Sec.  223.32(c))

    Section 23A generally applies only to transactions between a member 
bank and an affiliate of the bank and transactions between a member 
bank and a third party where some benefit of the transaction accrues to 
an affiliate of the bank. The statute generally does not apply to 
transactions between two affiliates. The GLB Act establishes two 
special anti-evasion rules, however, that govern transactions between a 
financial subsidiary of a member bank and another affiliate of the 
bank.\140\ First, the GLB Act provides that any purchase of, or 
investment in, securities issued by a member bank's financial 
subsidiary by an affiliate of the bank will be deemed to be a purchase 
of, or investment in, such securities by the bank itself. Second, the 
GLB Act authorizes the Board to deem an extension of credit made by a 
member bank's affiliate to any financial subsidiary of the bank to be 
an extension of credit by the bank to the financial subsidiary, if the 
Board determines that such action is necessary or appropriate to 
prevent evasions of the Federal Reserve Act or the GLB Act. The 
regulation incorporates both of these provisions.
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    \140\ GLB Act Sec.  121(b)(1) (codified at 12 U.S.C. 
371c(e)(4)).
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    In the proposed regulation, the Board exercised its authority under 
the second anti-evasion rule by stating that an extension of credit to 
a financial subsidiary of a member bank by an affiliate of the bank 
would be treated as an extension of credit by the bank itself to the 
financial subsidiary if the extension of credit is treated as 
regulatory capital of the financial subsidiary. An example of the kind 
of credit extension covered by this provision would be a subordinated 
loan to a financial subsidiary that is a securities broker-dealer where 
the loan is treated as capital of the subsidiary under the SEC's net 
capital rules. Although several commenters opposed this provision of 
the proposed rule, and argued that it would impede a BHC's ability to 
serve as a source of strength for a subsidiary bank, the Board has 
decided to retain this provision in the final rule. The Board believes 
that treating such an extension of credit as a covered transaction is 
appropriate because the extension of credit by the affiliate has a 
similar effect on the subsidiary's regulatory capital as an equity 
investment by the affiliate, which is treated as a covered transaction 
by the terms of the GLB Act (as described above). The Board notes that 
the final rule generally does not prevent a BHC

[[Page 76587]]

or other affiliate of a member bank from providing financial support to 
a financial subsidiary of the bank in the form of a senior or secured 
loan.
    One commenter asked the Board to determine that loans from an 
affiliate to a financial subsidiary of a member bank that count as 
regulatory capital of the financial subsidiary are treated as 
investments in the equity securities of an affiliate rather than loans 
to an affiliate, or to otherwise exempt such transactions from the 
collateral requirements of section 23A. According to this commenter, 
such a determination would be consistent with the reason for extending 
the GLB Act's anti-evasion principle to cover these loans--that the 
loans are equivalent to equity investments. The Board disagrees with 
this comment and believes that such loans by an affiliate to a member 
bank's financial subsidiary should be treated, consistent with the GLB 
Act's anti-evasion provisions, as if they were made by the member bank 
itself. If the member bank itself had made a subordinated loan counting 
as regulatory capital to its financial subsidiary, the loan would be 
subject to the quantitative limits and collateral requirements of 
section 23A as an extension of credit. Accordingly, under the final 
rule, such a loan by an affiliate of the member bank to the financial 
subsidiary also would be subject to the quantitative limits and 
collateral requirements of section 23A as an extension of credit.
    In addition, the proposed regulation provided an exception to the 
anti-evasion rules for transactions between a member bank's financial 
subsidiary and another affiliate if the other affiliate were itself a 
depository institution subject to section 23A. The exception would have 
avoided treating certain transactions as covered transactions both for 
the parent member bank of the financial subsidiary and for the other 
affiliated depository institution. After further analysis, the Board 
has decided to remove this proposed exception to the anti-evasion rule 
because the exception also would have allowed the financial subsidiary 
of a member bank to obtain funding from the entire banking organization 
in amounts that exceeded 20 percent of the parent bank's capital and 
surplus. Congress designed the anti-evasion rules to prevent a bank 
from funding its financial subsidiaries by paying dividends to its 
parent and having its parent, directly or indirectly, reinvest the 
funds into the financial subsidiary of the bank. The potential for such 
``round-tripping'' exists whether or not the parent routes such funding 
flows to a subsidiary bank's financial subsidiary through a sister 
depository institution of the bank.
    The Board may find certain other extensions of credit by an 
affiliate to a financial subsidiary to be covered transactions under 
section 23A on a case-by-case basis.
C. Derivative Transactions (Sec.  223.33)

1. Background

    Derivative transactions between a bank and its affiliates generally 
arise either from the risk management needs of the bank or the 
affiliate. Transactions arising from the bank's needs typically arise 
when a bank 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 bank is not authorized to hold the hedging asset. In order to 
manage the market risk, the bank may have an affiliate acquire the 
hedging asset. The bank would then do a ``bridging'' derivative 
transaction between itself and the affiliate maintaining the hedge.
    Other derivative transactions between a bank and its affiliate are 
affiliate-driven. A bank's affiliate may enter into an interest-rate or 
foreign-exchange derivative with the bank in order to accomplish the 
asset-liability management goals of the affiliate. For example, a BHC 
may hold a substantial amount of floating-rate assets but issue fixed-
rate debt securities to obtain cheaper funding. The BHC may then enter 
into a fixed-to-floating interest-rate swap with its subsidiary bank to 
reduce the holding company's interest-rate risk.
    Banks 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. Banks 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.

2. Actions Already Taken by the Board

    As noted above, the GLB Act required the Board to adopt, by May 12, 
2001, a final rule to address as covered transactions under section 23A 
the credit exposure arising from derivative transactions between member 
banks and their affiliates (``bank-affiliate derivatives'').\141\ 
Determining the appropriate treatment for bank-affiliate derivatives 
under section 23A is a complex and important endeavor. In light of the 
complexities of the subject matter and in light of the statutory 
deadline in the GLB Act, the Board took the following two steps on May 
11, 2001, to address under section 23A the credit exposure arising from 
bank-affiliate derivatives.
---------------------------------------------------------------------------

    \141\ At the time of enactment of the GLB Act, the Board had not 
ruled on whether derivatives between a member bank and an affiliate 
were covered transactions under section 23A or subject to the market 
terms requirement of section 23B. Although industry practice 
generally treated bank-affiliate derivatives as subject to section 
23B, industry practice did not treat bank-affiliate derivatives as 
subject to section 23A.
---------------------------------------------------------------------------

    First, the Board published an interim final rule (concurrently with 
proposed Regulation W) that subjected bank-affiliate derivatives to the 
market terms requirement of section 23B. Accordingly, the interim rule 
required each member bank to (i) have in place credit limits on its 
derivatives exposure to affiliates that are at least as strict as the 
credit limits the bank imposes on unaffiliated companies that are 
engaged in similar businesses and are substantially equivalent in size 
and credit quality; (ii) 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; and (iii) price, and 
require collateral in, derivative transactions with affiliates in a way 
that is at least as favorable to the bank as the way the bank prices, 
or requires collateral in, derivatives with comparable unaffiliated 
companies.
    The interim rule also required, under section 23A, that a member 
bank establish and maintain policies and procedures reasonably designed 
to manage the credit exposure arising from the bank's derivative 
transactions with affiliates. The policies and procedures, at a 
minimum, had to provide for monitoring and controlling the credit 
exposure arising from the member bank's derivative transactions with 
affiliates and ensuring that the bank's derivative transactions with 
affiliates complied with section 23B. The interim final rule had a 
delayed effective date of January 1, 2002.
    The second step that the Board took to address credit exposure on 
bank-affiliate derivatives under section 23A was to ask for public 
comment in the preamble to proposed Regulation W on a set of questions 
regarding the appropriate treatment of these transactions under section 
23A, including whether to subject the transactions to the quantitative 
limits and collateral requirements of the statute. The preamble made 
clear that the Board would not take additional steps to address bank-
affiliate

[[Page 76588]]

derivatives without seeking further public comment on a concrete 
proposal.

3. Public Comments

    About 16 commenters wrote in support of the interim rule approach 
to bank-affiliate derivatives. One commenter argued, however, that the 
interim rule was ineffective and insufficiently detailed to satisfy the 
GLB Act requirement that the Board issue a final rule addressing bank-
affiliate derivatives as covered transactions. Another commenter 
objected to the interim rule on a different ground, arguing that, as 
long as a BHC manages derivatives credit risk effectively, each 
subsidiary bank of the BHC should not be required to have separate 
policies and procedures on bank-affiliate derivatives.
    Commenters uniformly argued against subjecting bank-affiliate 
derivatives to the quantitative limits and collateral requirements of 
section 23A. The principal arguments advanced by commenters were that 
(i) derivatives do not fit within any of the five categories of covered 
transaction in section 23A; (ii) section 23B and the well-developed 
risk management practices in the institutional derivatives market are 
sufficient protection to banks; (iii) derivatives generally are not 
entered into for funding purposes; and (iv) covering derivatives under 
section 23A would be burdensome and may reduce the ability of a banking 
organization to centralize its risk management in the unit(s) best able 
to bear the risk.

4. Current Actions

    The Board is not prepared at this time to subject credit exposure 
arising from bank-affiliate derivatives to all the requirements of 
section 23A. The Board continues to collect information regarding the 
derivatives practices of banks and believes that more time is needed to 
determine whether the general approach of the interim rule on bank-
affiliate derivatives will suffice to prevent banks from incurring 
problematic levels of credit exposure to affiliates in these 
transactions.
    Federal Reserve examiners recently conducted a limited survey of a 
number of large banking organizations to ascertain their compliance 
with the Board's interim rule on bank-affiliate derivatives.\142\ The 
survey suggested that reliance on bank-designed policies and 
procedures, section 23B, and active examiner supervision to regulate 
bank-affiliate derivatives is appropriate and should be continued. The 
Board expects member banks to comply strictly with section 23B in their 
derivative transactions with affiliates. In this regard, the Board 
reminds member banks that section 23B requires a member bank to treat 
an affiliate no better than a similarly situated nonaffiliate. Section 
23B generally does not allow a member bank to use with an affiliate the 
terms and conditions it uses with its most creditworthy unaffiliated 
customer (unless the bank can demonstrate that the affiliate is of 
comparable creditworthiness as the bank's most creditworthy 
unaffiliated customer). Instead, section 23B requires that an affiliate 
be treated comparably (with respect to terms, conditions, and credit 
limits) to the majority of third-party customers engaged in the same 
business, and having comparable credit quality and size, as the 
affiliate. Because a bank generally has the strongest credit rating 
within a holding company, the Board generally would not expect an 
affiliate to obtain better terms and conditions from a member bank than 
the member bank receives from its major unaffiliated counterparties. In 
addition, the Board notes that market terms for derivatives among major 
financial institutions generally include daily marks to market and two-
way collateralization above a relatively small exposure threshold.
---------------------------------------------------------------------------

    \142\ Federal Reserve examiners also surveyed these same banking 
organizations to assess their compliance with the Board's interim 
rule on intraday credit. The results of this survey are discussed 
below in part VII.L. of this preamble.
---------------------------------------------------------------------------

    The Board also is taking two additional regulatory steps at this 
time to address bank-affiliate derivatives.
    a. Covering derivatives that are the functional equivalent of a 
guarantee. First, the Board is incorporating into Regulation W the 
Board's previously expressed view that credit derivatives between a 
member bank and a nonaffiliate in which the bank protects the 
nonaffiliate from a default on, or decline in value of, an obligation 
of an affiliate of the bank are covered transactions under section 23A. 
In the preamble to proposed Regulation W, the Board stated that such 
derivative transactions are guarantees by a member bank on behalf of an 
affiliate (and, hence, covered transactions) under section 23A.
    A number of commenters discussed the appropriate treatment of these 
derivatives under section 23A. A few commenters supported treating 
these derivatives as a guarantee on behalf of an affiliate under 
section 23A. Several other commenters argued that the Board should not 
treat these derivatives as section 23A guarantees if the bank has 
hedged its exposure to the affiliate with a third party. Some 
commenters also expressed the view that the rule should not treat these 
derivatives as section 23A guarantees if the affiliate's obligations 
represent a small portion of the reference assets for the credit 
derivative.
    The final Regulation W provides that these credit derivatives are 
covered transactions under section 23A and gives several examples.\143\ 
Consistent with the Board's traditional views on hedging under section 
23A, the rule does not allow a member bank to reduce its covered 
transaction amount for these derivatives to reflect hedging positions 
established by the bank with third parties. In addition, the Board does 
not agree with commenters that an exception to the rule should be 
created for a credit derivative in which affiliate obligations 
represent a small portion of the reference assets underlying the credit 
derivative. The Board intends to interpret this provision of the rule, 
however, so as to treat such 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 member 
bank.
---------------------------------------------------------------------------

    \143\ In most instances, the covered transaction amount for such 
a credit derivative would be the notional principal amount of the 
derivative.
---------------------------------------------------------------------------

    b. Including the interim rule in Regulation W. Second, in order to 
consolidate all the Board's views on sections 23A and 23B into one 
place, the Board is incorporating the provisions of the separate 
interim final rule on bank-affiliate derivatives into Regulation W. 
Under Regulation W, therefore, each member bank that engages in bank-
affiliate derivatives must (i) have policies and procedures to monitor 
and control the bank's credit exposure to affiliates in derivative 
transactions (including by imposing appropriate credit limits, mark-to-
market requirements, and collateral requirements); and (ii) ensure that 
its derivative transactions with affiliates comply with section 23B.

5. Future Actions

    The Board expects to issue, in the near future, a proposed rule 
that would invite public comment on how to treat as covered 
transactions under section 23A certain derivatives that are the 
functional equivalent of a loan by a member bank to an affiliate or the 
functional equivalent of an asset purchase by a member bank from an 
affiliate. Although the Board has not yet adopted a rule that 
explicitly addresses these types of derivatives under section 23A, the 
Board will treat as a covered transaction, as appropriate on a case-by-
case basis, any derivative between a

[[Page 76589]]

member bank and an affiliate that is entered into for the purpose of 
evading the requirements of section 23A.

VII. Exemptions--Subpart E

    Section 23A exempts several types of transactions from the 
statute's quantitative and collateral requirements and other types of 
transactions from the statute's quantitative, collateral, and low-
quality asset requirements.\144\ The regulation sets forth the 
statutory exemptions, clarifies certain of these exemptions, and 
exempts a number of additional types of transactions. The 
clarifications and additional exemptions are discussed below.
---------------------------------------------------------------------------

    \144\ 12 U.S.C. 371c(d).
---------------------------------------------------------------------------

    The Board reserves the right to revoke or modify any additional 
exemption granted by the Board in Regulation W if the Board finds that 
the exemption is resulting in unsafe or unsound banking practices. The 
Board also reserves the right to terminate the eligibility of a 
particular member bank to use any such exemption if the bank's use of 
the exemption is resulting in unsafe or unsound banking practices.
A. Sister-Bank Exemption (Sec.  223.41(a) and (b))
    Section 23A(d)(1) exempts any transaction between a member bank and 
a ``bank'' if the member bank controls 80 percent or more of the voting 
securities of the bank, the bank controls 80 percent or more of the 
voting securities of the member bank, or a company controls 80 percent 
or more of the voting securities of both the member bank and the 
bank.\145\ Section 23A states that the term ``bank'' includes ``any 
State bank, national bank, banking association, and trust company,'' 
and other Federal law provides that an insured savings association 
should be treated as a ``bank'' for purposes of the sister-bank 
exemption.\146\ Section 23A also provides the Board with authority to 
issue definitions consistent with the section as may be necessary to 
carry out the purposes of the section and to prevent evasions 
thereof.\147\ In addition, the statute provides that covered 
transactions between sister banks must be consistent with safe and 
sound banking practices.\148\
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    \145\ The sister-bank exemption in section 23A does not allow a 
member bank to avoid any restrictions on sister-bank transactions 
that may apply to the bank under the prompt corrective action 
framework set forth in section 38 of the FDI Act (12 U.S.C. 1831o) 
and regulations adopted thereunder by the bank's appropriate Federal 
banking agency.
    \146\ 12 U.S.C. 371c(b)(5), 1468(a)(2).
    \147\ 12 U.S.C. 371c(f)(1).
    \148\ 12 U.S.C. 371c(a)(4).
---------------------------------------------------------------------------

    The proposed rule clarified that the sister-bank exemption 
generally applies only to transactions between insured depository 
institutions. Although one commenter wrote in support of this 
restriction of the sister-bank exemption, many other commenters 
objected to this action. The protestants argued that restricting the 
sister-bank exemption to insured depository institutions is 
inconsistent with the statutory language and the primary purpose behind 
the exemption, which focused not on the insured status of the sister 
depository institutions but on the regulated status of the 
institutions. In addition, several of these commenters expressed the 
view that the Board does not have rulemaking authority to restrict the 
sister-bank exemption to insured depository institutions.
    The final rule continues to restrict the availability of the 
sister-bank exemption to insured depository institutions.\149\ In the 
view of the Board, this restriction is consistent with the legislative 
intent behind the exemption, which was to permit the flow of funds from 
one insured depository institution to another insured depository 
institution. In this regard, the Board notes that, under the cross-
guarantee provisions of the FDI Act, an insured depository institution 
is generally liable for any loss incurred by the FDIC in connection 
with the default of a commonly controlled insured depository 
institution.\150\ Moreover, without such an interpretation of the 
sister-bank exemption, a member bank would be able to engage in 
unlimited covered transactions with certain uninsured depository 
affiliates. Permitting a member bank to provide an unlimited amount of 
funding to an uninsured depository affiliate would facilitate an unsafe 
and unsound banking practice and would contravene one of the principal 
purposes of the statute--protecting the deposit insurance funds from 
loss.\151\
---------------------------------------------------------------------------

    \149\ For reasons of verbal economy, the final rule uses the 
term ``depository institution'' rather than ``insured depository 
institution'' to signify the set of institutions eligible for the 
sister-bank exemption (and for certain other purposes). The final 
rule defines ``depository institution,'' however, to mean an 
``insured depository institution'' as defined in the FDI Act.
    \150\ See 12 U.S.C. 1815(e).
    \151\ As noted above, a member bank and its operating 
subsidiaries are considered a single unit for purposes of section 
23A. Accordingly, under the statute and the regulation, transactions 
between a member bank (or its operating subsidiary) and the 
operating subsidiary of a sister insured depository institution 
generally qualify for the sister-bank exemption. A few commenters 
suggested that the proposed rule was ambiguous on this point. The 
Board has amended the final rule's definition of ``depository 
institution'' to eliminate any such ambiguity.
---------------------------------------------------------------------------

    A number of commenters contended that, if the final rule restricts 
the availability of the sister-bank exemption to insured depository 
institutions, the rule also should confirm that an uninsured depository 
institution subsidiary of a member bank would be considered an 
operating subsidiary (and not an affiliate) of the bank. According to 
these commenters, there is no compelling reason under section 23A to 
treat an uninsured depository institution subsidiary of a member bank 
any differently than other uninsured subsidiaries (for example, 
mortgage lending or investment advisory subsidiaries) of the bank. The 
Board agrees with this position and has revised the rule's definition 
of affiliate generally to exclude uninsured depository institution 
subsidiaries of a member bank. Accordingly, under the final rule, 
covered transactions between a member bank and a parent uninsured 
depository institution or a commonly controlled uninsured depository 
institution generally would be subject to section 23A whereas covered 
transactions between a member bank and a subsidiary uninsured 
depository institution would not be subject to section 23A.
B. Purchases of Loans on a Nonrecourse Basis (Sec.  223.41(c))
    Under section 23A(d)(6), a member bank may purchase loans on a 
nonrecourse basis from an affiliated ``bank'' exempt from section 23A, 
even if the transaction does not qualify for the sister-bank 
exemption.\152\ The rule clarifies that the scope of this exemption 
parallels that of the sister-bank exemption by stating that this 
exemption applies only to a member bank's purchase of a loan from an 
affiliated insured depository institution.
---------------------------------------------------------------------------

    \152\ 12 U.S.C. 371c(d)(6).
---------------------------------------------------------------------------

    Section 23A(d)(6) also exempts the purchase from an affiliate of 
assets that have a readily identifiable market quotation. This 
exemption is set forth separately in the regulation for purposes of 
clarity and is discussed in detail below in part VII.F. of this 
preamble.
C. Internal Corporate Reorganizations (Sec.  223.41(d))
    The Board has granted numerous section 23A exemptions, on a case-
by-case basis, for asset purchases by a bank from an affiliate that are 
part of a one-time internal corporate reorganization of a banking 
organization.\153\ The Board typically has approved such exemptions 
only if certain conditions are met, including (i) the bank's parent 
holding

[[Page 76590]]

company provides certain assurances concerning the quality of the 
transferred assets; (ii) the disinterested directors of the bank 
approve the transaction in advance; (iii) the transfer does not include 
any low-quality assets; and (iv) the bank's appropriate Federal banking 
agency and the FDIC inform the Board that they have no objection to the 
transaction.
---------------------------------------------------------------------------

    \153\ See, e.g., Travelers Group Inc. and Citicorp, 84 Federal 
Reserve Bulletin 985, 1013-14 (1998) and Letter dated November 14, 
1996, from William W. Wiles, Secretary of the Board, to John Byam.
---------------------------------------------------------------------------

    Several commenters requested that the Board include such an 
exemption in the final rule, and the Board has done so. Under this 
exemption, a member bank would be permitted to purchase assets (other 
than low-quality assets) from an affiliate (including in connection 
with an affiliate share transfer that section 223.31 of the rule treats 
as a purchase of assets) exempt from the quantitative limits of section 
23A if the following conditions are met.
    First, the asset purchase must be part of an internal corporate 
reorganization of a holding company that involves the transfer of all 
or substantially all of the shares or assets of an affiliate or of a 
division or department of an affiliate. Stated another way, the asset 
purchase must not be part of a series of periodic, ordinary course 
asset transfers from an affiliate to a member bank. Second, the member 
bank's holding company must provide the Board with contemporaneous 
notice of the transaction and must commit to the Board to make the bank 
whole, for a period of two years, for any transferred assets that 
become low-quality assets.\154\ Third, a majority of the member bank's 
directors must review and approve the transaction before consummation. 
Fourth, the section 23A value of the covered transaction must be less 
than 10 percent of the member bank's capital stock and surplus (or up 
to 25 percent of the bank's capital stock and surplus with the prior 
approval of the bank's appropriate Federal banking agency). Fifth, the 
member bank's holding company and all its subsidiary depository 
institutions must be well capitalized and well managed and must remain 
well capitalized upon consummation of the transaction.
---------------------------------------------------------------------------

    \154\ The notice also must describe the primary business 
activities of the affiliate whose shares or assets are being 
transferred to the member bank and must indicate the anticipated 
date of the reorganization.
---------------------------------------------------------------------------

    Although these criteria are stricter than what the Board 
traditionally has applied in connection with its case-by-case 
exemptions for asset purchases, the heightened strictness is 
appropriate in exchange for the flexibility that the regulatory 
exemption grants member banks. Although the regulatory exemption would 
limit the Board's opportunity to block certain internal reorganizations 
of a banking company based on an ad hoc analysis of the condition of 
the bank or the nature or quality of the assets being transferred to 
the bank, the Board believes that the well-capitalized and well-managed 
requirements, the two-year buyback commitment, and the quantitative 
limit in the rule should prevent banking companies from abusing their 
banking units in reorganization transactions.
D. Correspondent Banking (Sec.  223.42(a))
    Section 23A exempts from its quantitative limits and collateral 
requirements any deposit by a member bank in an affiliated bank or 
affiliated foreign bank that is made in the ordinary course of 
correspondent business, subject to any restrictions that the Board may 
impose.\155\ The final rule (like the proposed rule) further provides 
that such deposits must represent ongoing, working balances maintained 
by the member bank in the ordinary course of conducting the 
correspondent business. Although one commenter argued that the Board 
should eliminate this regulatory ``ongoing, working balances'' 
requirement, in the Board's view, an occasional deposit in an 
affiliated institution would not be in the ordinary course of 
correspondent business. Failure to impose this restriction on the 
correspondent banking exemption could enable member banks to abuse the 
exemption to provide one-off funding to an affiliated bank or foreign 
bank.\156\
---------------------------------------------------------------------------

    \155\ 12 U.S.C. 371c(d)(2).
    \156\ Unlike the sister-bank exemption, the exemption for 
correspondent banking deposits would apply to deposits placed by a 
member bank in an uninsured depository institution or foreign bank. 
Because the statutory exemption by its terms covers deposits made in 
a foreign bank, Congress must not have intended to restrict this 
exemption to deposits made in an insured depository institution.
---------------------------------------------------------------------------

    Although not required by section 23A or HOLA, the final rule also 
provides that correspondent deposits in an affiliated insured savings 
association are exempt if they otherwise meet the requirements of the 
exemption.
E. Secured Credit Transactions (Sec.  223.42(c))
    Section 23A exempts any credit transaction by a member bank with an 
affiliate that is ``fully secured'' by U.S. government obligations or 
by a ``segregated, earmarked'' deposit account.\157\ The rule clarifies 
that a deposit account meets the ``segregated, earmarked'' requirement 
only if the account exists for the sole purpose of securing credit 
transactions between the member bank and its affiliates and is so 
identified. This requirement would parallel the provision in section 
223.14(b)(1)(i)(D) of the rule relating to which deposits count toward 
the collateral requirements of section 23A.
---------------------------------------------------------------------------

    \157\ 12 U.S.C. 371c(d)(4).
---------------------------------------------------------------------------

    A few commenters requested confirmation that a credit transaction 
partially secured by U.S. government obligations or deposit accounts 
would be exempt under this section to the extent of such collateral. As 
noted above, under section 23A, if U.S. government obligations or 
deposit accounts are sufficient to fully secure a credit transaction, 
then the transaction is completely exempt. Under the statute, however, 
if the U.S. government obligations or deposit accounts represent less 
than full security for the credit transaction, then the amount of U.S. 
government obligations or deposits counts toward the collateral 
requirements of section 23A, but no part of the transaction is exempt 
from the statute's quantitative limits.
    In response to the request of commenters, the Board has decided to 
grant an additional exemption consistent with the spirit of the (d)(4) 
exemption in section 23A. Under this expanded form of the (d)(4) 
exemption, a credit transaction with an affiliate will be exempt ``to 
the extent that the transaction is and remains secured'' by appropriate 
(d)(4) collateral. This exemption is consistent with the Board's 
treatment of similar transactions under Regulation O and the OCC's 
interpretations of the national bank lending limits.\158\
---------------------------------------------------------------------------

    \158\ See 58 FR 26507-26508, May 4, 1993; 12 CFR 32.3(i).
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    Accordingly, under the final rule, if a member bank makes a $100 
non-amortizing term loan to an affiliate that is secured by $50 of U.S. 
Treasury securities and $75 of real estate, the value of the covered 
transaction will be $50. If the market value of the U.S. Treasury 
securities falls to $45 during the life of the loan, the value of the 
covered transaction would increase to $55. The Board expects member 
banks that use this expanded (d)(4) exemption to review the market 
value of their U.S. government obligations collateral regularly to 
ensure compliance with the exemption.
F. Purchases of Assets With Readily Identifiable Market Quotes (Sec.  
223.42(e))
    Section 23A(d)(6) exempts the purchase of assets by a member bank 
from an affiliate if the assets have a ``readily identifiable and 
publicly available market quotation'' and are purchased at their 
current market

[[Page 76591]]

quotation.\159\ The Board generally has limited the availability of 
this exemption (the ``(d)(6) exemption'') to purchases of assets with 
market prices that are recorded in widely disseminated publications 
that are readily available to the general public, such as newspapers 
with a national circulation. Because as a general matter only exchange-
traded assets are recorded in such publications, the test has ensured 
that the qualifying assets are traded actively enough to have a true 
``market quotation'' and that examiners can verify that the assets are 
purchased at their current market quotation. Regulation W codifies this 
Board interpretation of the (d)(6) exemption and clarifies that the 
exemption applies to a member bank's purchase from an affiliate of an 
asset that has a readily identifiable and publicly available market 
quotation if the asset is purchased at or below the asset's current 
market quotation.\160\
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    \159\ 12 U.S.C. 371c(d)(6).
    \160\ The proposed rule provided that all U.S. government 
obligations were eligible (d)(6) assets. The final rule provides 
that a U.S. government obligation is an eligible (d)(6) asset only 
if the obligation's price is quoted routinely in a widely 
disseminated publication that is readily available to the general 
public. The Board has tightened the rule in this regard because, 
although all U.S. government obligations have low credit risk, not 
all U.S. government obligations trade in liquid markets at publicly 
available market quotations.
---------------------------------------------------------------------------

    A number of commenters requested that the Board clarify that 
certain assets would be eligible for purchase by a member bank under 
the statutory (d)(6) exemption. These assets included (i) assets whose 
prices are quoted on an internet web site that is generally available 
to the public (with or without a subscription fee) and that provides 
actual prices of securities traded on at least a daily basis; (ii) 
securities issued by an affiliate or at least affiliate-issued 
securities that are fully guaranteed by the U.S. government or its 
agencies; and (iii) OTC securities, loans, and derivative contracts.
    With respect to the first asset class, commenters have failed to 
demonstrate that an asset whose price is quoted on an internet web site 
but is not otherwise recorded in a widely disseminated publication is 
traded in a sufficiently liquid market to ensure that a member bank's 
purchase of that asset from its affiliate would be at a fair market 
price.
    With respect to the second asset class, the Board has decided to 
remove the provision of the proposed rule that rendered the (d)(6) 
exemption unavailable for purchases of affiliate-issued securities. As 
discussed in more detail in part X of this preamble (and subpart H of 
the final rule), however, if a member bank purchases from one affiliate 
securities issued by another affiliate, the bank has engaged in two 
types of covered transaction. Under the final rule, although the (d)(6) 
exemption may exempt the one-time asset purchase from the first 
affiliate, it would not exempt the ongoing investment in securities 
issued by the second affiliate.
    With respect to the third asset class, the Board confirms that the 
(d)(6) exemption may apply to a purchase of assets that are not traded 
on an exchange. In particular, purchases of gold and silver, and 
purchases of OTC securities, loans, and derivative contracts whose 
prices are recorded in widely disseminated publications, may qualify 
for the (d)(6) exemption.
G. Purchases of Securities With a Ready Market From a Securities 
Affiliate (Sec.  223.42(f))
    Concurrently with the issuance of proposed Regulation W, the Board 
adopted a final rule that provided an additional exemption from section 
23A for certain purchases of securities by a member bank from an 
affiliate (the ``Final (d)(6) Rule'').\161\ The Final (d)(6) Rule 
expanded the statutory (d)(6) exemption to allow a member bank to 
purchase securities from an affiliate based on price quotes obtained 
from certain electronic screens so long as, among other things, the 
selling affiliate is a broker-dealer registered with the SEC; the 
securities are traded in a ready market and eligible for purchase by 
State member banks; the securities are not purchased within 30 days of 
an underwriting (if an affiliate of the bank is an underwriter of the 
securities); and the securities are not issued by an affiliate. 
Proposed Regulation W also contained this exemption, and the Board 
sought further comment on the scope and conditions of the exemption. 
Commenters expressed general support for the new exemption but 
criticized many of the particular conditions to the exemption.
---------------------------------------------------------------------------

    \161\ 66 FR 24220, May 11, 2001.
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1. Broker-Dealer Requirement

    Some commenters believed that the new (d)(6) exemption should not 
contain a U.S. registered broker-dealer requirement. Several other 
commenters urged the Board, in light of the increasing globalization of 
fixed-income markets and the rigorous supervisory frameworks for 
securities firms in many foreign jurisdictions, to allow banks to 
purchase securities from a registered foreign broker-dealer under the 
new (d)(6) exemption.
    The Board has decided to retain the U.S. registered broker-dealer 
requirement. Broker-dealers that are registered with the SEC are 
subject to supervision and examination by the SEC and are required by 
SEC regulations to keep and maintain detailed records concerning each 
securities transaction conducted by the broker-dealer. In addition, 
SEC-registered broker-dealers have experience in determining whether a 
security has a ``ready market'' under SEC regulations. The Board 
believes that these factors will help ensure that member banks satisfy 
the requirements of the expanded exemption and will assist the Federal 
banking agencies in monitoring such compliance.
    The Board does not believe it is appropriate at this time to expand 
the exemption to include securities purchases from foreign broker-
dealers because such entities may be subject to different levels of 
supervision and regulation and because of the increased difficulties 
associated with monitoring compliance by foreign entities. The final 
rule explicitly provides, however, that a member bank may request that 
the Board exempt securities purchases from a particular foreign broker-
dealer, and the Board would consider these requests on a case-by-case 
basis in light of all the facts and circumstances. In any event, the 
Board expects to evaluate the continued need for this requirement as 
banks and the Board gain experience with this expanded exemption.

2. Securities Eligible for Purchase by a State Member Bank

    A number of commenters asked the Board to eliminate the requirement 
in the new (d)(6) exemption that the securities be eligible for 
purchase by a State member bank. These commenters noted that certain 
depository institutions (notably State nonmember banks) and certain 
overseas (for example, Edge corporation) and domestic subsidiaries of 
banks have broader investment powers, including equity investment 
powers, than State member banks. Moreover, according to these 
commenters, this requirement would impose a high recordkeeping and 
compliance burden on State nonmember banks that are not subject to the 
State member bank investment rules but are already subject to a host of 
State and Federal investment regulations.
    The Board believes that the statutory and other restrictions placed 
on a State member bank's ownership of securities also are appropriate 
limits on the securities eligible for the new (d)(6) exemption. 
Although this requirement may impose some additional burden on certain 
State nonmember banks, the

[[Page 76592]]

Board believes that it is important to provide a level section 23A 
playing field and to prevent the new (d)(6) exemption from being used 
to move volatile assets from an affiliate's balance sheet to that of 
the bank.
    In addition, one commenter requested clarification that this 
requirement would not prevent a bank from using the new (d)(6) 
exemption to purchase securities permissible for a State member bank to 
purchase and hold as a hedge (even if not otherwise permissible under a 
State member bank's general investment powers). For example, the OCC 
recently determined that a national bank, subject to certain conditions 
and OCC review and approval, may acquire equity securities solely for 
the purpose of hedging the bank's exposure arising from customer-driven 
equity derivative transactions lawfully entered into by the bank.\162\ 
The Federal Reserve also recently determined that it would not prohibit 
a State member bank from acquiring equity securities to hedge the 
bank's customer-driven equity derivative transactions, subject to the 
same conditions and restrictions applicable to national banks.\163\ In 
light of the hedging purpose of these securities purchases, and the 
remaining conditions to the availability of the new (d)(6) exemption, 
the Board agrees that a member bank may purchase equity securities from 
an affiliate under the new (d)(6) exemption if the purchase is made to 
hedge the bank's permissible customer-driven equity derivative 
transaction (and the purchase meets all the other requirements of the 
exemption).
---------------------------------------------------------------------------

    \162\ See OCC Interpretive Ltr. No. 892 (Sept. 13, 2000).
    \163\ See Board press release dated Feb. 21, 2002.
---------------------------------------------------------------------------

3. No Purchases Within 30 Days of the Underwriting

    The Final (d)(6) Rule generally prohibited a member bank from using 
the new (d)(6) exemption to purchase securities within 30 days of their 
underwriting if an affiliate of the bank is an underwriter of the 
securities. One commenter argued that the new (d)(6) exemption should 
allow banks to purchase debt securities within 30 days of the 
underwriting because the market price of debt securities is easily 
verifiable during this time period. A few commenters argued that the 
new (d)(6) exemption should allow banks to purchase securities within 
30 days of the underwriting if the purchase is pre-approved by the 
bank's board of directors and does not amount to more than 50 percent 
of the total offering.
    The Board has maintained the underwriting period restriction in the 
final Regulation W because of the uncertain and volatile market values 
of securities during and shortly after an underwriting period and 
because of the conflicts of interest that may arise during and after an 
underwriting period, especially if an affiliate has difficulty selling 
its allotment. Commenters did not provide any evidence as to the 
reliability of pricing data on debt securities during an underwriting 
period, and the Board is not convinced that capping at 50 percent of 
the total offering the amount of securities a member bank may purchase 
would materially ameliorate the conflicts of interest inherent in the 
underwriting process.
    One commenter requested clarification, in light of the fact that an 
argument can be made that mutual funds are continuously underwritten, 
as to whether the new (d)(6) exemption could apply to the purchase of 
mutual fund shares distributed by an affiliate of the purchasing member 
bank. The price uncertainty and conflicts of interest concerns that 
motivated the underwriting period restriction in the new (d)(6) 
exemption do not apply in the context of mutual fund distribution. The 
1940 Act and SEC rules thereunder require mutual funds to sell shares 
at a public net asset value computed each day,\164\ and distributors of 
mutual funds do not bear the same sorts of market risks that 
underwriters of corporate debt and equity securities typically bear. In 
view of the special nature of mutual funds, the Board does not believe 
that the underwriting period restriction in the new (d)(6) exemption 
should be read to prevent a member bank from purchasing shares of a 
mutual fund distributed by an affiliate of the bank.\165\
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    \164\ 15 U.S.C. 80a-22(c); 17 CFR 270.22c-1.
    \165\ The Board notes that neither the old nor the new (d)(6) 
exemption exempts a member bank's purchase of mutual fund securities 
that are not only underwritten by an affiliate of the bank but also 
are issued by a mutual fund affiliate of the bank. See part X of 
this preamble and Sec.  223.71 of the final rule.
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4. No Securities Issued by an Affiliate

    Commenters generally supported limiting the availability of the new 
(d)(6) exemption to purchases of securities that are not issued by an 
affiliate. Several commenters argued, however, that the new (d)(6) 
exemption should allow banks to purchase affiliate-issued asset-backed 
securities because of the liquidity of the market for asset-backed 
securities. One commenter contended, on the other hand, that the new 
(d)(6) exemption is not the right vehicle for allowing banks to buy 
affiliate-issued asset-backed securities because most of these 
securities do not have a listed market price.
    A number of commenters argued that the new (d)(6) exemption should 
allow banks to purchase affiliate-issued mutual fund shares, especially 
if the mutual fund is an affiliate simply because the bank or an 
affiliate is the advisor to the fund. These commenters noted that 
mutual funds have public prices, the SEC regulates mutual funds and 
mutual fund pricing, and expanding the ability of banks to purchase 
mutual funds would enhance the ability of banks to diversify their 
investment portfolios.
    Similar to the final rule's approach to the statutory (d)(6) 
exemption, the Board has decided to remove from the new (d)(6) 
exemption the requirement that the asset purchased not be a security 
issued by an affiliate. The Board notes, however, that if a member bank 
purchases from one affiliate securities issued by another affiliate, 
although the new (d)(6) exemption may exempt the asset purchase from 
the first affiliate, it would not exempt the investment in securities 
issued by the second affiliate.

5. Price Verification Methods

    The new (d)(6) exemption, as set forth in the Final (d)(6) Rule, 
applied only in situations where the member bank is able to obtain 
price quotes on the purchased securities from an unaffiliated 
electronic, real-time pricing service. Many commenters expressed a view 
that the new (d)(6) exemption should allow banks to purchase securities 
based on price quotes from two independent dealers. These commenters 
made the following principal arguments: (i) Independent dealers have no 
incentive to quote an artificial price; (ii) the Board has determined 
that two dealer bids are an acceptable pricing mechanism for exempt 
purchases of municipal securities; (iii) the SEC allows mutual funds to 
purchase securities from an affiliate at the lowest offer price from a 
disinterested third party after a reasonable inquiry by the mutual 
fund; (iv) NASD rules require the use of dealer quotes to price certain 
securities where multiple quotes from an interdealer quotation system 
are not available; (v) dealer quotes are routinely used by securities 
traders because some seasoned corporate and mortgage-backed securities 
are traded infrequently; and (vi) dealer quotes are used to establish 
the value of securities for close-out and netting purposes in ISDA 
derivatives master agreements.

[[Page 76593]]

    Notwithstanding these comments, the Board reaffirms its previous 
conclusion that it would not be appropriate to use independent dealer 
quotations to establish a market price for a security under the new 
(d)(6) exemption. The Board is concerned that a security that is not 
quoted routinely in a widely disseminated news source or a third-party 
electronic financial network may not trade in a sufficiently liquid 
market to justify allowing a member bank to purchase unlimited amounts 
of the security from an affiliate. In the absence of recent, actual, 
publicly reported transactions, the risks of price manipulations and 
sham or reciprocal quotation arrangements are too high.

6. Record Retention

    One commenter suggested that the final rule expressly include the 
2-year record retention requirement set forth in the preamble to the 
Final (d)(6) Rule. The Board has supplemented Regulation W to include 
this recordkeeping requirement.
H. Purchasing Municipal Securities (Sec.  223.42(g))
    Regulation W exempts a member bank's purchase of municipal 
securities from an affiliate if the purchase meets a streamlined 
version of the requirements applicable to the new (d)(6) 
exemption.\166\ First, as in the new (d)(6) exemption, the member bank 
must purchase the municipal securities from a broker-dealer affiliate 
that is registered with the SEC. Second, also as in the new (d)(6) 
exemption, the municipal securities must be eligible for purchase by a 
State member bank, and the member bank must report the transaction as a 
securities purchase in its Call Report. Third, the municipal securities 
must either be rated by a nationally recognized statistical rating 
organization or must be part of an issue of securities that does not 
exceed $25 million in size. Finally, the price for the securities 
purchased must be (i) quoted routinely on an unaffiliated electronic 
service that provides indicative data from real-time financial 
networks; (ii) verified by reference to two or more actual independent 
dealer quotes on the securities to be purchased or securities that are 
comparable to the securities to be purchased; or (iii) in the case of 
securities purchased during the underwriting period, verified by 
reference to the price indicated in the syndicate manager's written 
summary of the underwriting.\167\ Under any of the three pricing 
options, the member bank must purchase the municipal securities at or 
below the quoted or verified price.
---------------------------------------------------------------------------

    \166\ The regulation defines municipal securities by reference 
to section 3(a)(29) of the Securities Exchange Act, which defines 
municipal securities as direct obligations of, or obligations 
guaranteed as to principal or interest by, a State or agency, 
instrumentality, or political subdivision thereof, and certain tax-
exempt industrial development bonds. See 17 U.S.C. 78c(a)(29).
    \167\ Under the Municipal Securities Rulemaking Board's Rule G-
11, the syndicate manager for a municipal bond underwriting is 
required to send a written summary to all members of the syndicate. 
The summary discloses the aggregate par values and prices of bonds 
sold from the syndicate account.
---------------------------------------------------------------------------

    The Board believes that the streamlined set of requirements for 
purchases of municipal securities is appropriate because municipal 
obligations generally have comparatively low default risks. In 
addition, these relaxed requirements are consistent with the expressed 
desire of Congress to support local communities' use of municipal 
securities to help meet their financing needs.
I. Purchases of Assets by Newly Formed Banks (Sec.  223.42(i))
    The rule exempts a purchase of assets by a newly chartered member 
bank from an affiliate if the appropriate Federal banking agency for 
the bank has approved the purchase. This exemption would allow 
companies to charter a new bank and transfer assets to the bank free of 
the quantitative limits and low-quality asset prohibition of section 
23A. Currently, if a company (usually a BHC) establishes a new 
subsidiary bank, the newly chartered institution cannot acquire a 
critical mass of assets from its parent company because of the 
quantitative limits of section 23A. Commenters generally agreed that 
applying the restrictions of section 23A to a newly formed bank is 
unnecessary because the chartering authority for the new bank (and, in 
the case of a new bank formed under a BHC, the Board) reviews the 
transaction to ensure that the asset transfer does not result in any 
safety or soundness problems.
J. Transactions Approved Under the Bank Merger Act (Sec.  223.42(j))
    Before issuing proposed Regulation W, the Board had provided a 
regulatory exemption from section 23A for any transaction between 
affiliated insured depository institutions if the transaction had been 
approved by the responsible Federal banking agency under the Bank 
Merger Act.\168\ The Board had provided this regulatory exemption 
because the Bank Merger Act required the primary Federal supervisor of 
the resulting insured depository institution to review these 
transactions using safety and soundness and public interest standards 
similar to those that the Board would apply in reviewing a section 23A 
exemption request. Proposed Regulation W included this exemption.
---------------------------------------------------------------------------

    \168\ See 57 FR 41643, Sept. 11, 1992.
---------------------------------------------------------------------------

    Several commenters argued that the Board should expand the Bank 
Merger Act exemption to include mergers between a national bank and a 
nonbank subsidiary or affiliate of the bank, which are reviewed by the 
OCC under the National Bank Consolidation and Merger Act (``NBCM 
Act'').\169\ The Board notes that a member bank should not need a 
special exemption from section 23A to merge with a nonbank subsidiary 
(other than a financial subsidiary and certain other nonbank 
subsidiaries) because such transactions generally will be deemed to be 
within the bank for purposes of section 23A.
---------------------------------------------------------------------------

    \169\ Section 1206(a) of the American Homeownership and Economic 
Opportunity Act of 2000 amended the NBCM Act to provide that a 
national bank may merge with one or more of its nonbank subsidiaries 
or affiliates with the approval of the OCC. See 12 U.S.C. 215a-3.
---------------------------------------------------------------------------

    The Board has determined not to grant a regulatory exemption for 
merger transactions between a national bank and its nonbank affiliate 
for a number of reasons. First, the legislative history of section 23A 
and Board experience indicate that merger transactions between banks 
and their nonbank affiliates have a greater potential for risk of loss 
to the bank than would similar transactions between sister banks and 
thus are appropriately subject to greater regulatory scrutiny. In 
addition, such transactions between banks and their nonbank affiliates 
have a greater potential for risk of loss to the Federal deposit 
insurance funds because the cross-guarantee provisions of the FDI Act 
apply only between affiliated insured depository institutions.\170\ 
Finally, although the NBCM Act provides for OCC review of such 
transactions, the statute does not establish criteria that a national 
bank must satisfy to obtain OCC approval, and the OCC has not yet 
issued implementing regulations for the statute. The Board may consider 
including in Regulation W an exemption for NBCM Act transactions after 
reviewing any future implementing regulations adopted by the OCC. The 
Board notes that any member bank merging or consolidating with a 
nonbank affiliate may be able to take advantage of the regulatory 
exemption for internal reorganization transactions contained in section 
223.41(d) of the final rule.
---------------------------------------------------------------------------

    \170\ See 12 U.S.C. 1815(e).
---------------------------------------------------------------------------

    A few other commenters urged the Board to expand the Bank Merger 
Act exemption to include Bank Merger Act

[[Page 76594]]

transactions with any affiliate (not just an insured depository 
institution affiliate) and any other transactions with affiliates that 
are subject to approval by the bank's primary Federal supervisor. For 
the reasons discussed in the previous paragraph, the Board is not 
willing to grant a regulatory exemption to any transaction between a 
member bank and an affiliate that is subject to approval by the bank's 
primary Federal supervisor.
    In light of the comments, however, the final rule does include a 
partial expansion of the traditional Bank Merger Act exemption. As 
noted above, the traditional Bank Merger Act exemption only applied to 
transactions between a member bank and an insured depository 
institution affiliate. Although the Board does not believe that 
expanding the Bank Merger Act exemption to include transactions with 
any affiliate would be consistent with the purposes of section 23A, the 
final rule makes the Bank Merger Act exemption available for merger and 
other related transactions between a member bank and a U.S. branch or 
agency of an affiliated foreign bank. The Bank Merger Act approval 
process, combined with the ongoing regulation and supervision of U.S. 
branches and agencies of foreign banks by the Federal banking agencies, 
should help ensure that such transactions do not pose significant risks 
to the member bank.
K. Purchases of Extensions of Credit (Sec.  223.42(k))
    In 1974, the Board issued a formal interpretation of section 23A 
(codified at 12 CFR 250.250) that exempted a member bank's purchase of 
a loan from an affiliate if (i) the bank made an independent evaluation 
of the creditworthiness of the borrower before the affiliate made the 
loan and (ii) the bank committed to purchase the loan before the 
affiliate made the loan (the ``250.250 exemption'').\171\ Although the 
1974 interpretation did not impose a strict dollar limit on the amount 
of an affiliate's loans that a member bank could purchase under the 
exemption, the interpretation cautioned that the purpose of the 
exemption was to allow a member bank to take advantage of an investment 
opportunity and not to alleviate the working capital needs of an 
affiliate.
---------------------------------------------------------------------------

    \171\ See 39 FR 28975, Aug. 13, 1974.
---------------------------------------------------------------------------

    By 1995, some BHCs were using the 250.250 exemption extensively to 
fund their nonbank lending affiliates. In these cases, banks were 
providing all or nearly all of such affiliates' funding. In response, 
staff indicated in an interpretive letter that the 250.250 exemption 
was not available if the dollar amount of the bank's purchases from the 
affiliate represented more than 50 percent of the total dollar amount 
of loans made by the affiliate.\172\ Staff reasoned that, in these 
circumstances, the asset purchases looked less like the bank taking 
advantage of an investment opportunity brought to it by the affiliate 
and more like the bank providing the principal ongoing funding 
mechanism for the affiliate. Staff intended that this restriction would 
require the affiliate to have alternative funding sources and would 
reduce the pressure on the bank to purchase the affiliate's extensions 
of credit.
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    \172\ Letter dated April 24, 1995, from J. Virgil Mattingly, 
Jr., General Counsel of the Board, to William F. Kroener, III, 
Federal Deposit Insurance Corporation; see also Letter dated January 
21, 1987, from Michael Bradfield, General Counsel of the Board, to 
Jeffrey C. Gerrish.
---------------------------------------------------------------------------

    Proposed Regulation W included the 250.250 exemption. The proposed 
rule also included staff's 50 percent test as a condition to the 
availability of the exemption and solicited comment on whether to 
supplement the bright-line 50 percent test with a requirement that the 
member bank not use the exemption to provide ``substantial, ongoing 
funding'' to the affiliate.

1. The Traditional 50 Percent Test

    Several commenters explicitly supported the Board's retention of a 
50 percent limit on the amount of loans a bank may purchase from an 
affiliate under the 250.250 exemption. Other commenters requested that 
the Board remove the 50 percent test because, in the view of these 
commenters, it is unnecessary and burdensome and most of these bank-
affiliate arrangements are designed to benefit the bank. A few 
commenters asked the Board to modify the 50 percent test. One of these 
commenters stated that, if the rule retains the 50 percent limit, the 
limit should be revised to be 50 percent of the total assets of the 
affiliate (not just the credit portfolio of the affiliate). Another 
commenter asked that the 50 percent per affiliate limit be revised to 
be 50 percent of the loan portfolio of all lending affiliates in the 
aggregate (to reduce the burden of monitoring each affiliate's 
compliance with the 50 percent test).
    The Board has decided to retain the 50 percent test. The Board 
continues to believe that if a member bank purchases more than half of 
the extensions of credit originated by an affiliate, the purchases 
represent the principal ongoing funding mechanism for the affiliate. 
The member bank's status as the predominant source of financing for the 
affiliate calls into question the availability of alternative funding 
sources for the affiliate, places significant pressure on the bank to 
continue to support the affiliate through asset purchases, and reduces 
the bank's ability to make independent credit decisions with respect to 
the asset purchases. The final rule does not expand the denominator of 
the 50 percent test to include all the assets of the affiliate or all 
the credit portfolios of all the lending affiliates of the member bank. 
In the Board's view, the member bank's underwriting integrity may be 
compromised if any single affiliate becomes dependent on the bank for 
financing, even if that single affiliate is a diversified company that 
becomes dependent on the bank for financing of only one portion of its 
business.

2. The ``Substantial, Ongoing Funding'' Test

    One commenter supported the rule's inclusion of the ``substantial, 
ongoing funding'' test. A large number of commenters (including most of 
the banking industry trade associations) urged the Board to remove the 
``substantial, ongoing funding'' test. These commenters contended that 
the test is too vague and subjective, may disrupt many existing 
operations, would prevent banks and their affiliates from accomplishing 
rational business planning, and is unnecessary in light of the lack of 
evidence that the existing 50 percent test has failed to check abuse.
    A ``substantial, ongoing funding'' test would provide examiners 
with the flexibility to stop arrangements in which a bank provides a 
significant amount of funding to an affiliated lending company but does 
not provide a majority of the affiliate's working capital. On the other 
hand, such a subjective standard would create legal uncertainty for 
banks that purchase a substantial amount of assets from their lending 
affiliates. In addition, use of a ``substantial, ongoing funding'' 
standard could result in inconsistent application of the 250.250 
exemption by the different Federal banking agencies and by different 
examiners within an agency.
    The final rule does not include such a supplemental standard in the 
250.250 exemption. The final rule, however, does allow the appropriate 
Federal banking agency for a member bank to reduce the 50 percent 
threshold prospectively, on a case-by-case basis, in those situations 
where the agency believes that the bank's asset purchases from an 
affiliate under the exemption may cause harm to the bank. Although

[[Page 76595]]

this agency discretion to tighten the 50 percent threshold may result 
in some inconsistency in application of the exemption, the supervisory 
benefits of the flexibility should outweigh its potential adverse 
effects.

3. Test Based on Size of Bank

    The proposed rule also sought comment on whether to limit the 
amount of assets that a member bank may purchase from an affiliate 
pursuant to the 250.250 exemption to some percentage of the bank's 
total assets. Many commenters objected to placing a limit on the 
percentage of a bank's assets that represent assets purchased from an 
affiliate under the 250.250 exemption. These commenters argued that 
case-by-case review is a better approach to addressing situations where 
a large portion of a bank's assets are loans purchased from an 
affiliate. These commenters believed that the remaining conditions of 
the exemption should suffice to prevent abuse of the bank. One 
commenter, on the other hand, recommended that the rule include a 50 
percent limit based on the assets of the bank.
    In light of the comments and the fact that the Board did not 
suggest a specific limit based on the bank's size in proposed 
Regulation W, the Board has determined to issue a further proposed rule 
(concurrently with final Regulation W) that would seek public comment 
on whether to deny the 250.250 exemption to any member bank if assets 
purchased by the bank from an affiliate under the 250.250 exemption 
represent more than 100 percent of the bank's capital stock and 
surplus. A more detailed explanation of the Board's reasons for issuing 
the further proposed rule is set forth in the preamble to the proposed 
rule.

4. Independent Credit Review by the Bank

    To qualify for the 250.250 exemption, a member bank must 
independently review the creditworthiness of each obligor before 
committing to purchase each loan.\173\ Several commenters requested 
that the Board interpret the ``independent evaluation'' requirement so 
as not to require an actual evaluation of each credit by the bank if 
the affiliate uses the same credit underwriting system as the bank. 
According to these commenters, such an interpretation would recognize 
appropriately that banks and affiliates often use the same underwriting 
standards and would encourage banks and affiliates to share effective 
underwriting practices with each other and to work toward harmonization 
of underwriting practices within a single organization. These 
commenters indicated that, as currently interpreted, the 250.250 
exemption interferes with efficient, centralized, formula-based credit 
underwriting processes. In addition, several commenters contended that 
the Board should interpret the ``independent evaluation'' requirement 
so as not to require an actual evaluation of each credit by the bank if 
the affiliate uses the underwriting standards of Fannie Mae, Freddie 
Mac, or Ginnie Mae.
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    \173\ Consistent with the Board's 1974 interpretation, the 
member bank also must not make a legally enforceable blanket advance 
commitment to purchase a stipulated amount of loans from the 
affiliate.
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    The Board does not believe that a member bank can satisfy the 
``independent evaluation'' requirement of the 250.250 exemption by 
simply having its lending affiliates use the bank's underwriting 
standards or the underwriting standards of Fannie Mae or any other 
government agency or government-sponsored enterprise. Under established 
Federal Reserve guidance, a State member bank is required to have 
clearly defined policies and procedures to ensure that it performs its 
own due diligence in analyzing the credit and other risks inherent in a 
proposed transaction.\174\ This function is not delegable to any third 
party, including affiliates of the member bank or government-sponsored 
enterprises. Accordingly, to qualify for this exemption, the member 
bank, independently and using its own credit policies and procedures, 
must itself review and approve each extension of credit before giving a 
purchase commitment to its affiliate.
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    \174\ See, e.g., Federal Reserve SR Letter No. 97-21 (SUP) (July 
11, 1997).
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5. Miscellaneous

    One commenter asked the Board to clarify whether the 250.250 
exemption could be used in connection with a bank's purchase of loans 
from an affiliate if the affiliate retained recourse on the loans. 
Consistent with the fact pattern underlying the original 250.250 
exemption and staff's traditional interpretation of the exemption, the 
final rule specifies that the exemption does not apply in situations 
where the affiliate retains recourse on the loans purchased by the 
member bank. In such a circumstance, the member bank has ongoing credit 
exposure to the affiliate. If the Board were not to adopt this 
position, a member bank arguably could incur unlimited credit exposure 
to an affiliate through exempt loan purchases under the 250.250 
exemption.
    The final rule also specifies, consistent with the fact pattern 
underlying the original 250.250 exemption and staff's traditional 
interpretation of the exemption, that the 250.250 exemption only 
applies in situations where the member bank purchases loans from an 
affiliate that were originated by the affiliate. The exemption cannot 
be used by a member bank to purchase loans from an affiliate that the 
affiliate purchased from another lender. The exemption is designed to 
facilitate a member bank using its affiliate as an origination agent, 
not to permit a member bank to take off an affiliate's books loans that 
the affiliate purchased from a third party. Among other concerns, a 
contrary determination would increase the likelihood that a member bank 
could acquire low-quality assets from an affiliate through the 
exemption.
L. Intraday Extensions of Credit (Sec.  223.42(l))
    As noted above, the GLB Act required the Board to adopt, by May 12, 
2001, a final rule to address as covered transactions under section 23A 
the credit exposure arising from intraday extensions of credit by 
member banks to their affiliates.\175\ The Board took a two-step 
approach, similar to the Board's approach to bank-affiliate 
derivatives, to fulfill this statutory mandate. First, the Board 
published an interim final rule on May 11, 2001, that (i) required, 
under section 23A, that a member bank establish and maintain policies 
and procedures reasonably designed to manage the credit exposure 
arising from the bank's intraday extensions of credit to affiliates; 
and (ii) clarified that intraday extensions of credit by a member bank 
to an affiliate are subject to the market terms requirement of section 
23B. The policies and procedures, at a minimum, had to provide for 
monitoring and controlling the member bank's intraday credit exposure 
to affiliates and ensuring that the bank's intraday credit extensions 
to affiliates comply with section 23B. The interim final rule had a 
delayed effective date of January 1, 2002.
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    \175\ The text of section 23A does not indicate that an 
extension of credit must extend overnight to qualify as a covered 
transaction. Nevertheless, at the time of enactment of the GLB Act, 
the Board had not ruled on whether intraday credit extensions by a 
member bank to an affiliate were covered transactions under section 
23A or subject to the market terms requirement of section 23B. 
Industry practice did not treat intraday credit extensions as 
subject to section 23A or 23B.
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    Second, the Board requested comment on a more detailed and more 
restrictive proposed rule on intraday credit extensions by member banks 
to affiliates

[[Page 76596]]

in Regulation W. Proposed Regulation W treated all such intraday credit 
extensions as covered transactions but exempted those intraday credits 
that arose in connection with the performance by a member bank, in the 
ordinary course of business, of securities clearing and settlement 
transactions or payment transactions on behalf of an affiliate. The 
more limited Regulation W exemption for intraday credit was available 
only if the member bank (i) had no reason to believe that the affiliate 
would have difficulty repaying the extension of credit; (ii) 
established limits on the net amount of intraday credit that the bank 
may extend to affiliates; and (iii) maintained policies and procedures 
for monitoring each affiliate's compliance with the limits. Under the 
Regulation W proposal, intraday extensions of credit by a member bank 
to an affiliate that did not meet these conditions were subject to the 
quantitative, collateral, and other requirements of section 23A. 
Importantly, under the proposed rule, an intentional intraday loan by a 
member bank to an affiliate outside of the clearing context (for 
example, a loan to allow an affiliate to meet a debt obligation coming 
due during the day) became fully subject to section 23A at the time 
during the day that the bank made the loan.
    Most commenters on the intraday credit issue expressed support for 
either the interim rule or proposed Regulation W approach to intraday 
credit, although the interim rule approach garnered more support. A few 
commenters rejected both approaches, however, and urged the Board to 
treat intraday credit as not subject to section 23A.
    Commenters generally advocated an exemption for intraday credit by 
banks to affiliates because, in the view of commenters, (i) banks do 
not use intraday credit to fund affiliates; (ii) intraday credit 
becomes covered by section 23A at the end of the day and, therefore, 
banks have incentives to monitor intraday overdrafts by affiliates; 
(iii) banks do not have the systems to monitor intraday credit 
transactions with all accounts of all affiliates in real time; and (iv) 
banks have not suffered losses on intraday credit extensions to 
affiliates. According to these commenters, the minimal benefits of the 
Regulation W approach would not outweigh the substantial costs.
    Many commenters urged the Board to grant an exemption for intraday 
credit arising from special purpose credit card transactions if the 
Board were to decide to treat intraday credit extensions as covered 
transactions under section 23A. These commenters explained that special 
purpose credit card banks make thousands of credit extensions each day 
that are deemed to be credit extensions to affiliates under section 
23A's attribution rule. These banks currently comply with section 23A 
by either selling their credit card receivables at the end of each day 
or fully securing them at the end of each day with segregated, 
earmarked deposit accounts. According to commenters, the Regulation W 
approach to intraday credit would significantly disrupt the existing 
practices of special purpose credit card banks and would create 
substantial inefficiencies for these banks (requiring thousands of 
sales of receivables each day instead of one sale at the end of each 
day). These commenters emphasized that third-party customers, not the 
affiliated merchants, are liable for repayment to the bank on these 
transactions, and that the intraday risk to the bank on these 
transactions is similar to the risk on payment or settlement 
transactions.
    In the Board's view, existing business practices indicate that the 
potential risk reduction benefits afforded by full application of the 
requirements of section 23A to intraday credit exposures to affiliates 
would not justify the costs to banking organizations of implementing 
these requirements at this time. Intraday overdrafts and other forms of 
intraday credit generally are 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 is 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 would 
require banks not only to measure exposures across multiple accounts, 
offices, and systems on a global basis but also 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. Furthermore, there is no evidence that banks, 
including special purpose credit card banks, have suffered losses from 
intraday extensions of credit to affiliates.
    Federal Reserve examiners have reviewed the policies and procedures 
that a number of large banks adopted to comply with the Board's interim 
final rule on intraday credit to affiliates. This review confirmed that 
requiring banks to adopt policies and procedures for managing the 
credit exposure arising from intraday credit extensions to affiliates 
and subjecting such transactions to section 23B is the most workable 
solution for addressing intraday credit exposure of banks to 
affiliates. For the most part, the surveyed banks treated intraday 
credit to affiliates in the same manner as they treated intraday credit 
to third parties.
    In light of these considerations, the Board is adopting an approach 
to intraday credit that is a combination of the approaches contained in 
the interim rule and proposed Regulation W. Final Regulation W provides 
that intraday credit extensions by a member bank to an affiliate are 
section 23A covered transactions but exempts all such intraday credit 
extensions from the quantitative and collateral requirements of section 
23A if the member bank (i) maintains policies and procedures for the 
management of intraday credit exposure and (ii) has no reason to 
believe that any affiliate receiving intraday credit would have 
difficulty repaying the credit in accordance with its terms.
    The approach of the final rule should impose substantially less 
burden on banking organizations than the proposed Regulation W 
approach. Most significantly, whereas the proposed rule exempted only 
intraday credit extensions relating to clearing and settlement, the 
final rule exempts all types of intraday credit. In light of the 
limited scope for, and limited history of, abuse of intraday credit to 
affiliates and the significant burden of verifying and documenting the 
use of each intraday credit extension to an affiliate, the Board does 
not believe that the regulatory benefits of this aspect of the proposed 
rule would have outweighed its regulatory burden. Unlike the proposed 
rule, the global exemptive approach of the final rule also should avoid 
interrupting the existing, unproblematic intraday business practices of 
banks that issue special purpose credit cards. In addition, the 
approach of the final rule imposes more discipline on banks than the 
interim rule approach in that the final rule requires a member bank to 
make intraday assessments of the credit quality of each affiliated 
borrower and restricts a member bank's intraday credit extensions to an 
affiliate if the bank has any doubt as to the affiliate's ability to 
repay the credit in accordance with its terms.

[[Page 76597]]

    The proposed rule did not include a definition of an intraday 
extension of credit. The final rule, however, defines an intraday 
extension of credit as an extension of credit by a member bank to an 
affiliate that the member bank expects to be repaid, sold, or 
terminated, or to qualify for a complete exemption under the rule, by 
the end of its business day in the United States. An intraday extension 
of credit would include, for example, a loan by a member bank to an 
affiliate that (i) by its terms must be repaid before the end of the 
bank's U.S. business day; (ii) the bank expects to sell at the end of 
the bank's U.S. business day; or (iii) the bank intends to fully secure 
with a segregated, earmarked deposit account at the end of the bank's 
U.S. business day. On the other hand, if a member bank makes a 30-day 
loan to an affiliate at 2 p.m. on a particular day and does not expect 
to sell the loan or to qualify the loan for an exemption under the rule 
by the end of its U.S. business day, the intraday credit exemption 
would not exempt the loan from 2 p.m. until the end of the bank's U.S. 
business day. Rather, the member bank must ensure that the loan 
complies with the requirements of Regulation W as of 2 p.m. on that day 
(unless the loan qualifies for another exemption in the rule at such 
time).
M. Riskless Principal Transactions (Sec.  223.42(m))
    The final rule contains an additional exemption that was not part 
of the proposed rule. Section 223.42(m) of the final rule exempts the 
purchase by a member bank of a security from a securities affiliate of 
the bank if (i) the bank or the securities affiliate is acting 
exclusively as a riskless principal in the transaction; and (ii) the 
security purchased is not issued or underwritten, or sold as principal 
(other than as riskless principal), by any affiliate of the bank.\176\ 
These riskless principal securities transactions between a member bank 
and an affiliate are covered transactions under section 23A because the 
member bank, acting as a principal, has purchased an asset from an 
affiliate, acting as a principal. The Board does not believe that there 
is any regulatory benefit to subjecting these transactions to section 
23A, however, because riskless principal securities transactions 
closely resemble securities brokerage transactions.
---------------------------------------------------------------------------

    \176\ This exemption parallels the exemption from the 
attribution rule provided in section 223.16(c)(1) of the final rule.
---------------------------------------------------------------------------

    The riskless principal in a riskless principal securities 
transaction buys and sells the same security contemporaneously. 
Accordingly, if a member bank acts as a riskless principal in 
purchasing a security from a securities affiliate, the asset risk 
passes promptly from the affiliate through the bank on to the bank's 
customer. If the securities affiliate acts as a riskless principal in 
selling a security to the member bank, the asset risk passes promptly 
from a third party through the affiliate to the bank. In neither case 
would the securities affiliate be able to transfer pre-existing asset 
risk from its books to the books of the member bank. Although the final 
rule exempts these riskless principal transactions from section 23A, 
such transactions would remain subject to section 23B.
N. Additional Exemption Requests
    Approximately 16 commenters asked the Board to establish formal 
filing and processing guidelines for section 23A exemption requests. 
These commenters offered a wide variety of suggested time frames for 
Board action on such requests, but most of them asked that the Board 
commit to acting within 30 to 60 days of receiving a request. In light 
of the policy importance and factual intricacy of most section 23A 
exemption requests, the Board has decided not to adopt regulatory 
deadlines for processing section 23A exemption requests. The Board has 
indicated in the final rule, however, that exemption requests should 
describe in detail the transaction or relationship for which the member 
bank seeks exemption, explain why the Board should exempt the 
transaction or relationship, and explain how the exemption would be in 
the public interest and consistent with the purposes of section 23A.
    As noted above, although sections 23A and 23B apply by their terms 
only to member banks, other Federal law subjects insured nonmember 
banks and insured thrifts to the sections as if they were member banks. 
Accordingly, insured nonmember banks and insured thrifts must apply to 
the Board (rather than their appropriate Federal banking agency) for 
any additional exemptions from section 23A or 23B.

VIII. General Provisions of Section 23B--Subpart F

    Subpart F of the regulation sets forth the principal restrictions 
of section 23B. These include (i) a requirement that most transactions 
between a member bank and its affiliates be on terms and circumstances 
that are substantially the same as those prevailing at the time for 
comparable transactions with nonaffiliates; (ii) a restriction on a 
member bank's purchase as fiduciary of assets from an affiliate; (iii) 
a restriction on a member bank's purchase, during the existence of an 
underwriting syndicate, of any security if a principal underwriter of 
the security is an affiliate; and (iv) a prohibition on publishing an 
advertisement or entering into an agreement stating that a member bank 
will be responsible for the obligations of its affiliates. For the most 
part, subpart F restates the operative provisions of section 23B, and 
these provisions are not discussed below. The remainder of this section 
of the preamble highlights four areas in which Regulation W provides 
additional guidance on section 23B.
A. Transactions Exempt From Section 23B (Sec.  223.52(a)(1))
    The market terms requirement of section 23B applies to, among other 
transactions, any ``covered transaction'' between a member bank and an 
affiliate.\177\ Section 23B(d)(3) makes clear that the term ``covered 
transaction'' in section 23B has the same meaning as the term ``covered 
transaction'' in section 23A, but does not include any transaction that 
is exempt under section 23A(d)--for example, transactions between 
sister banks, transactions fully secured by a deposit account or U.S. 
government obligations, and purchases of assets from an affiliate at a 
readily identifiable and publicly available market quotation.\178\ 
Consistent with the statute, the regulation exempts from section 23B 
any transaction that is exempt under section 23A(d).
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    \177\ 12 U.S.C. 371c-1(a)(2)(A).
    \178\ 12 U.S.C. 371c-1(d)(3).
---------------------------------------------------------------------------

    Regulation W also excludes from section 23B any covered transaction 
that is exempt from section 23A under section 223.42(i) or (j) of the 
regulation (that is, asset purchases by a newly formed member bank and 
transactions approved under the Bank Merger Act). The Board is 
excluding from section 23B this additional set of transactions because, 
in each case, the appropriate Federal banking agency for the member 
bank involved in the transaction should ensure that the terms of the 
transaction are not unfavorable to the bank.
B. Purchases of Securities for Which an Affiliate Is the Principal 
Underwriter (Sec.  223.53(b))
    The GLB Act amended section 23B in one respect. Since its passage 
in 1987, section 23B(b)(1)(B) has prohibited a member bank, whether 
acting as principal or fiduciary, from purchasing securities during the 
existence of an underwriting or selling syndicate if a

[[Page 76598]]

principal underwriter of the securities is an affiliate of the 
bank.\179\ Before the GLB Act, a member bank could escape this 
prohibition only if a majority of the outside directors of the bank 
approved the bank's securities purchase before the securities were 
initially offered to the public.\180\ The GLB Act amended section 23B, 
however, to permit a member bank to purchase securities during an 
underwriting conducted by an affiliate if the following two conditions 
are met. First, a majority of the directors of the member bank (with no 
distinction drawn between inside and outside directors) must approve 
the securities purchase before the securities are initially offered to 
the public. Second, such approval must be based on a determination that 
the purchase would be a sound investment for the member bank regardless 
of the fact that an affiliate of the bank is a principal underwriter of 
the securities.\181\ The regulation incorporates this new standard and 
clarifies that if a member bank proposes to make such a securities 
purchase in a fiduciary capacity, then the directors of the bank must 
base their approval on a determination that the purchase is a sound 
investment for the person on whose behalf the bank is acting as 
fiduciary.
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    \179\ 12 U.S.C. 371c-1(b)(1)(B).
    \180\ Many smaller banking organizations had difficulty meeting 
this standard because most or all of their banks' directors were 
officers or employees of the banks or affiliates of the banks.
    \181\ GLB Act Sec.  738 (codified at 12 U.S.C. 371c-1(b)(2)).
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    Obviously, a member bank may satisfy this director approval 
requirement by obtaining specific prior director approval of each 
securities acquisition otherwise prohibited by section 23B(b)(1)(B). 
The regulation clarifies, however, that a member bank also satisfies 
this director approval requirement if a majority of the directors of 
the bank approves appropriate standards for the bank's acquisition of 
securities otherwise prohibited by section 23B(b)(1)(B) and each such 
acquisition meets the standards adopted by the directors. In addition, 
a majority of the member bank's directors must periodically review such 
acquisitions to ensure that they meet the standards and must 
periodically review the standards to ensure they meet the ``sound 
investment'' criterion of section 23B(b)(2). The appropriate period of 
time between reviews would vary depending on the scope and nature of 
the member bank's program, but such reviews should be conducted by the 
directors at least annually. Before the passage of the GLB Act, Board 
staff informally allowed member banks, based on the legislative history 
of section 23B, to meet the director approval requirement in this 
fashion, and there is no indication that Congress in the GLB Act 
intended to alter the procedures that a member bank could use to obtain 
the requisite director approval.\182\
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    \182\ The Conference Report accompanying the Competitive 
Equality Banking Act of 1987 stated that the prior approval 
requirement of section 23B(b) could be met ``by the establishment in 
advance of specific standards by the outside directors for such 
acquisitions. If the outside directors establish such standards, 
they must regularly review acquisitions to assure that the standards 
have been followed, and they must periodically review the standards 
to assure that they continue to be appropriate in light of market 
and other conditions.'' See H.R. Conf. Rep. No. 100-261, at 133 
(1987).
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    For these reasons, the regulation codifies staff's preexisting 
approach to the director approval requirement.\183\
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    \183\ The rule also provides, consistent with existing Board 
interpretations, that a U.S. branch, agency, or commercial lending 
company of a foreign bank may comply with this requirement by 
obtaining the required approvals and reviews from either a majority 
of the directors or a majority of the senior executive officers of 
the foreign bank.
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C. The Definition of Affiliate Under Section 23B (Sec.  223.2(c))
    Section 23B states that the term ``affiliate'' under section 23B 
has the meaning given to such term in section 23A except that the term 
``affiliate'' under section 23B does not include a ``bank,'' as defined 
in section 23A.\184\ Other Federal law provides that an insured savings 
association should be treated as a ``bank'' for purposes of section 
23B.\185\ As in the case of the sister-bank exemption, proposed 
Regulation W clarified that the only companies that qualify for the 
``bank'' exception to section 23B's definition of affiliate are insured 
depository institutions.
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    \184\ 12 U.S.C. 371c-1(d)(1).
    \185\ 12 U.S.C. 1468(a)(2)(B).
---------------------------------------------------------------------------

    One commenter objected to this aspect of the proposed rule. Without 
such an interpretation, however, a member bank would be able to engage 
in transactions with certain uninsured depository affiliates on terms 
and conditions that were highly unfavorable to the bank. Entering into 
these kinds of transactions would not be consistent with bank safety 
and soundness and would contravene one of the goals of section 23B--
protecting the Federal deposit insurance funds. Accordingly, the final 
rule continues to restrict the ``bank'' exception from section 23B's 
definition of affiliate to insured depository institutions.
D. The Advertising restriction (Sec.  223.54)
    Section 23B(c), the ``advertising restriction,'' prohibits a member 
bank from publishing any advertisement or entering into any agreement 
stating or suggesting that the bank shall in any way be responsible for 
the obligations of its affiliates.\186\ Read literally, this provision 
appears to prohibit a member bank from issuing a guarantee, acceptance, 
or letter of credit on behalf of an affiliate. Because section 23A 
includes as a permissible (though limited) covered transaction the 
issuance by a member bank of a guarantee, acceptance, or letter of 
credit on behalf of its affiliates, Board staff traditionally has read 
the advertising restriction of section 23B in light of section 23A. 
That is, Board staff has not read section 23B(c) to prohibit a member 
bank from issuing a guarantee, acceptance, or letter of credit on 
behalf of an affiliate to the extent permitted under section 23A. The 
regulation contains this clarification.\187\ In response to comments 
from several banking organizations, the final rule also clarifies that 
section 23B(c) does not prohibit a member bank from making reference to 
such a guarantee, acceptance, or letter of credit in a prospectus or 
other disclosure document, for example, if otherwise required by law.
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    \186\ 12 U.S.C. 371c-1(c).
    \187\ The Board also believes that if a member bank and its 
affiliate enter into a joint undertaking with a third party, the 
contract among the parties should make clear that the bank is only 
responsible for its own obligations under the contract.
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IX. Application of Sections 23A and 23B to U.S. Branches and Agencies 
of Foreign Banks--Subpart G

    Subpart G discusses the application of sections 23A and 23B to U.S. 
branches and agencies of foreign banks. As noted above, sections 23A 
and 23B apply by their terms only to member banks of the Federal 
Reserve System, and other Federal banking laws have made insured 
nonmember banks and insured savings associations subject to the 
sections. Federal banking law generally does not subject the U.S. 
branches and agencies of foreign banks to sections 23A and 23B.
    Section 114(b)(4) of the GLB Act explicitly authorizes the Board, 
however, to impose restrictions or requirements on relationships or 
transactions between a branch, agency, or commercial lending company of 
a foreign bank in the United States and any affiliate in the United 
States of such foreign bank. The Board may impose such prudential 
limits if it finds that the

[[Page 76599]]

limits are appropriate to prevent an evasion of certain Federal banking 
laws, avoid a significant risk to the safety and soundness of 
depository institutions or any Federal deposit insurance fund, or avoid 
other adverse effects, such as undue concentration of resources, 
decreased or unfair competition, conflicts of interest, or unsound 
banking practices.
    In order to ensure competitive equity, the Board has for years 
imposed certain of the requirements of sections 23A and 23B on 
transactions between a U.S. branch or agency of a foreign bank and its 
U.S. affiliates engaged in underwriting and dealing in bank-ineligible 
securities (``section 20 affiliates'').\188\ The Board also recently 
applied sections 23A and 23B to transactions between a U.S. branch or 
agency of a foreign bank and affiliates conducting merchant banking 
activities under the GLB Act and portfolio companies held under that 
authority.\189\
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    \188\ The Board's Operating Standards for section 20 affiliates 
require (i) any intraday extensions of credit by a U.S. branch or 
agency of a foreign bank to its section 20 affiliates to comply with 
the market terms requirement of section 23B; (ii) any extensions of 
credit by a U.S. branch or agency of a foreign bank to its section 
20 affiliates and any purchase by such branch or agency of 
securities for which a section 20 affiliate is the principal 
underwriter to comply with sections 23A and 23B; and (iii) a U.S. 
branch or agency of a foreign bank to refrain from advertising or 
suggesting that it is responsible for the obligations of a section 
20 affiliate, consistent with section 23B(c). See 12 CFR 225.200; 62 
FR 45295, Aug. 27, 1997. Prior to the adoption of the Operating 
Standards, all U.S. branches and agencies of a foreign bank (like 
all member banks) were prohibited from extending credit to, or 
purchasing assets from, a section 20 affiliate. Consequently, the 
Board's 1997 decision partially to apply sections 23A and 23B to 
such branches and agencies represented a liberalization of the 
regulatory framework.
    \189\ See 12 CFR 225.176(b)(6); 66 FR 8466, Jan. 21, 2001.
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    With one material exception, the regulation applies sections 23A 
and 23B to a U.S. branch or agency of a foreign bank as if the branch 
or agency were a member bank. The material exception is that the only 
companies that are deemed affiliates of such branch or agency of a 
foreign bank are affiliates of the foreign bank that are directly 
engaged in the United States in the following GLB Act financial 
activities: (i) Insurance underwriting pursuant to section 4(k)(4)(B) 
of the BHC Act; (ii) securities underwriting and dealing pursuant to 
section 4(k)(4)(E) of the BHC Act; (iii) merchant banking activities 
pursuant to section 4(k)(4)(H) of the BHC Act; \190\ or (iv) insurance 
company investment activities pursuant to section 4(k)(4)(I) of the BHC 
Act.\191\
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    \190\ Regulation W, consistent with the merchant banking rule, 
imposes sections 23A and 23B on a covered transaction between a U.S. 
branch or agency of a foreign bank and its U.S. merchant banking 
affiliate only to the extent the proceeds of the covered transaction 
are used for the purpose of funding the affiliate's merchant banking 
activities.
    \191\ See 12 U.S.C. 1843(k)(4)(B), (E), (H), and (I).
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    The regulation also treats as a section 23A affiliate of a U.S. 
branch or agency any subsidiary of an affiliate of the foreign bank 
directly engaged in the four activities set forth above (regardless of 
whether the subsidiary itself engages in any of the four 
activities).\192\ In addition, the rule treats as a section 23A 
affiliate of a U.S. branch or agency any portfolio company controlled 
by the foreign bank under the GLB Act's merchant banking or insurance 
company investment authorities (and any subsidiary of such a portfolio 
company). The regulation does not treat as a section 23A affiliate of a 
U.S. branch or agency any other type of affiliate of the foreign bank 
(for example, foreign affiliates or U.S. affiliates engaged in 
nonbanking activities under section 4(c)(8) of the BHC Act), and does 
not treat a foreign bank's non-U.S. offices as member banks subject to 
section 23A.\193\
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    \192\ The regulation covers subsidiaries of affiliates directly 
engaged in the specified activities in order to prevent evasion. If 
these subsidiaries were not covered, the U.S. branch or agency of a 
foreign bank arguably could fund the foreign bank's U.S. insurance 
underwriter outside the scope of sections 23A and 23B by, for 
example, lending money to a subsidiary of the underwriter and having 
the subsidiary dividend or on-lend the loan proceeds to the 
underwriter.
    \193\ The text and structure of the final rule on U.S. branches 
and agencies of foreign banks are somewhat different from that of 
the proposed rule. The proposed rule provided that section 23A 
applied to transactions between a U.S. branch or agency of a foreign 
bank, on the one hand, and certain U.S. affiliates of the foreign 
bank, on the other hand. The Board has revised the proposed rule to 
ensure that foreign banks treat certain indirect affiliate 
transactions as covered transactions under Regulation W. For 
example, an argument could be made that when a U.S. branch of a 
foreign bank accepts securities issued by a U.S. insurance company 
affiliate of the foreign bank as collateral for a loan to a 
nonaffiliate, there has been no transaction between the branch and 
the insurance affiliate. These transactions are, however, covered 
transactions under section 23A. The text and structure of the final 
rule make clear that such indirect affiliate transactions by a U.S. 
branch or agency of a foreign bank are subject to the rule.
---------------------------------------------------------------------------

    Applying the restrictions of sections 23A and 23B to transactions 
between the U.S. branches and agencies of foreign banks and the 
specified U.S. affiliates will help to ensure maintenance of a 
competitive playing field between U.S. banks and foreign banks 
operating in the United States. The issue of competitive equity arises 
most strongly in connection with those activities that a U.S. bank 
cannot engage in directly or through an operating subsidiary. A U.S. 
bank may affiliate itself with a company engaged in the financial 
activities specified above only if the company is a holding company 
affiliate of the bank or, in some cases, a financial subsidiary of the 
bank. In either case, covered transactions between the U.S. bank and 
the company would be subject to sections 23A and 23B. Without 
Regulation W's extension of the scope of these statutory provisions, a 
foreign bank's U.S. branch or agency could fund and engage in 
transactions with these types of affiliates more freely than could a 
U.S. bank. To the extent that a foreign bank's U.S. branches and 
agencies are able to fund these types of U.S. affiliates outside of the 
restrictions of sections 23A and 23B, the affiliates are able to 
compete for business in the United States with a potential advantage 
not available to the analogous affiliates of U.S. banks.
    The Board does not believe that it is appropriate or necessary at 
this time to impose the requirements of sections 23A and 23B on 
transactions between a foreign bank's U.S. branch or agency and its 
U.S. affiliates that are engaged only in activities that were 
permissible for BHCs before the passage of the GLB Act (other than 
section 20 affiliates). The Board recognizes the hardship this might 
impose on foreign banks conducting such activities in the United States 
under previous law. Moreover, most of these activities may be conducted 
by a U.S. bank directly (or in an operating subsidiary) and, hence, may 
be funded by a U.S. bank in a manner that is not subject to sections 
23A and 23B.\194\
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    \194\ One U.S. bank commenter contended that Regulation W should 
be expanded to apply sections 23A and 23B to transactions between a 
foreign bank's U.S. branch or agency and a U.S. affiliate of the 
foreign bank engaged in any activities permissible under section 
4(c)(8) of the BHC Act but not permissible for U.S. banks or their 
operating subsidiaries (for example, real estate leasing). The Board 
has determined not to add such activities to the rule's foreign bank 
activity list at this time because of the hardship this would impose 
on foreign banks and because the Board has substantial supervisory 
experience with such activities and has not observed any adverse 
competitive effects in the relevant markets. The Board does not 
intend to add such activities to the list in the future unless 
adverse competitive effects develop in the relevant markets that 
could be remedied by an expansion of the scope of sections 23A and 
23B to the U.S. operations of foreign banks.
---------------------------------------------------------------------------

    The potential scope, nature, and risks of transactions and 
relationships between U.S. branches and agencies of foreign banks and 
their affiliates engaged in the United States in insurance 
underwriting, full-scope securities underwriting and dealing, merchant 
banking, and insurance company investment are unclear at this time. At 
least until the Board acquires more information and supervisory 
experience regarding these transactions

[[Page 76600]]

and relationships, applying sections 23A and 23B will help ensure 
competitive equity between foreign banks and U.S. banking organizations 
in the funding of certain of their U.S. nonbank operations. The Board 
will regularly review this section of Regulation W, consistent with the 
requirements of section 114(b)(3) of the GLB Act, to determine whether 
there is a continuing need for its restrictions and will modify or 
eliminate any restrictions that are no longer required to mitigate 
potential or actual adverse effects.
    The regulation also provides that the Board may add to the list of 
affiliates of a foreign bank that are subject to the restrictions of 
sections 23A and 23B. The Board intends generally to use this reserved 
authority to ensure competitive equity between foreign banks and U.S. 
banks with respect to affiliates engaged in the United States in new 
activities that the Board may authorize for FHCs.
    The Board also has considered the issue of how to calculate the 
capital stock and surplus of a foreign bank's U.S. branch or agency for 
purposes of section 23A. In light of the fact that foreign banks do not 
separately capitalize their U.S. branches or agencies, the regulation 
defines the capital stock and surplus of such branches and agencies by 
reference to the capital of the foreign bank as calculated under its 
home country capital standards. This definition is consistent with the 
approach adopted by the Board in its merchant banking rule,\195\ and 
represents a relaxation from the Board's current position with respect 
to foreign banks that operate section 20 affiliates in the United 
States.\196\
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    \195\ See 66 FR 8466, 8482, Jan. 31, 2001.
    \196\ The Board's position on section 20 affiliates requires 
U.S. branches and agencies of foreign banks whose home country 
supervisor has not adopted capital standards consistent with the 
Basle Accord to calculate their section 23A capital stock and 
surplus by reference to the capital of the foreign bank parent as 
calculated under standards applicable to U.S. banking organizations. 
See 62 FR 45304, Aug. 27, 1997.
---------------------------------------------------------------------------

    A number of commenters strongly objected to the foreign bank 
provisions of the proposed rule, including the Canadian Department of 
Finance, the Institute of International Bankers, the Canadian Bankers 
Association, and the Swiss Bankers Association. Several of these 
commenters challenged the Board's authority under section 114 of the 
GLB Act to apply section 23A to the U.S. branches and agencies of 
foreign banks. According to these commenters, the Board's action fails 
to meet the first requirement of section 114 (consistency with Federal 
banking law) because Federal banking law does not generally subject 
U.S. branches and agencies of foreign banks to section 23A. In 
commenters' view, the Board's action also fails to meet the second 
prong of section 114 (intention to prevent adverse effects) because the 
Board has not presented specific evidence of actual abuse and is 
admittedly acting to fight possible future abuse.
    The Board believes that its partial application of sections 23A and 
23B to the U.S. branches and agencies of foreign banks is consistent 
with Federal banking law. The Board is aware of, and commenters cited, 
no Federal banking laws that contradict or otherwise conflict with the 
provisions of subpart G of Regulation W. Moreover, the Board disagrees 
with the implication of commenters' views of section 114, which would 
render section 114 useless by preventing the Board from imposing 
safeguards under the section unless such safeguards were already 
present in Federal banking law. Commenters also have failed to present 
evidence to support their claim that the Board may only use section 114 
to combat adverse effects for which the Board has made specific 
findings. Nothing in the text or legislative history of the GLB Act 
supports this position. The Board does not believe that section 114 
requires the Board to wait, observe, and document damage to U.S. 
financial institutions or markets before it may take action under the 
section to impose prudential safeguards.
    Some commenters argued that the competitive equity justification 
for the Board's partial application of sections 23A and 23B to the U.S. 
branches and agencies of foreign banks does not fit within the ``unfair 
competition'' rationale in section 114 of the GLB Act. According to 
these commenters, the Board previously acknowledged that the ``unfair 
competition'' prong of section 4(j) of the BHC Act did not authorize 
the Board to consider disparities based on the structure of the banking 
industry.\197\ Again, the Board is not aware of, and commenters have 
not presented, evidence that the phrase ``unfair competition'' in 
section 114(b)(4)(B) of the GLB Act cannot or should not be read to 
include competitive advantages based on regulatory environment. 
Importantly, the Board is not bound by its former interpretations of 
the BHC Act when interpreting provisions of the GLB Act. The Board 
notes that its former interpretation of section 4(j) of the BHC Act 
explicitly depended on the specific legislative history of section 4(j) 
and other sections of the BHC Act. The legislative history of the GLB 
Act does not similarly constrain the Board's interpretation of section 
114. Indeed, the Congressional intent behind the GLB Act strongly 
supports the Board's position on this matter. The GLB Act authorized an 
expanded set of permissible activities for banking organizations, but 
required such activities to be conducted in section 23A affiliates of a 
bank (not directly in the bank) in order to reduce risks to the bank 
and to constrain the spread of the government subsidy enjoyed by banks. 
This Congressional concern to limit the transference of the bank 
subsidy into markets for other financial services is the same 
competitive concern that has motivated the Board to apply sections 23A 
and 23B to some portion of the U.S. operations of foreign banks.\198\
---------------------------------------------------------------------------

    \197\ See BankAmerica Corporation, 69 Federal Reserve Bulletin 
105, 111 (1983).
    \198\ The Board also notes that the ``adverse effects'' clause 
in section 114 of the GLB Act is broader than the ``adverse 
effects'' clause in section 4(j) of the BHC Act. Significantly, 
section 114, unlike section 4(j), explicitly authorizes the Board to 
consider risks to the safety and soundness of U.S. depository 
institutions. In the Board's view, the safety and soundness of U.S. 
depository institutions could be put at risk if certain of their 
affiliates are forced to compete with the affiliates of foreign 
banks at a significant regulatory disadvantage.
---------------------------------------------------------------------------

    Several commenters on the foreign bank provisions of the proposed 
rule advanced the proposition that foreign banks do not enjoy a subsidy 
in the United States and do not have a competitive advantage over U.S. 
banking organizations. In fact, according to these commenters, U.S. 
banking firms have a competitive ``home field'' advantage in the United 
States.\199\ The Board's partial application of sections 23A and 23B to 
the U.S. branches and agencies of foreign banks does not depend for its 
justification on whether foreign banks operating in the United States 
generally have a competitive advantage over U.S. banking firms. Rather, 
as noted above, the Board has chosen to extend the scope of sections 
23A and 23B to address a specific potential competitive imbalance: the 
funding advantages enjoyed by the specified types of affiliates of 
foreign banks as compared to the same types of affiliates of U.S. 
banks. Foreign banks

[[Page 76601]]

are able to raise low-cost deposits abroad and to use this low-cost 
funding to finance, including through their U.S. branches and agencies, 
the activities of the specified U.S. affiliates without having to 
comply with sections 23A and 23B. U.S. banks are limited by sections 
23A and 23B in the extent to which they are able to finance the 
operations of the specified affiliates.
---------------------------------------------------------------------------

    \199\ In support of their position, many of these commenters 
referred to a study conducted by the Federal Reserve System that 
concluded that section 20 affiliates of U.S. BHCs have outperformed 
section 20 affiliates of foreign banks. In light of the fact that 
the Board has imposed many of the restrictions of sections 23A and 
23B on transactions between the U.S. branches and agencies of 
foreign banks and their section 20 affiliates, this study does not 
provide much evidence as to whether foreign bank-owned securities 
underwriters and dealers would enjoy a competitive advantage over 
U.S. BHC-owned securities underwriters and dealers in the absence of 
an extension of sections 23A and 23B to cover foreign banks.
---------------------------------------------------------------------------

    Commenters also pointed out alleged inconsistencies in the Board's 
treatment of the U.S. branches and agencies of foreign banks under 
subpart G. First, several commenters stated that it is inconsistent and 
unfair to subject the U.S. branches and agencies of foreign banks to 
section 23A but then to deny them the benefits of the sister-bank 
exemption. Regulation W does not, as a general matter, apply section 
23A to transactions between a U.S. branch or agency and a sister U.S. 
branch, agency, or depository institution. The rule only applies 
section 23A to transactions between the U.S. branch or agency and a 
U.S. affiliate of the foreign bank engaged in the United States in 
insurance underwriting, securities underwriting and dealing, merchant 
banking, or insurance company investment. Because these activities 
generally are not permissible activities for a U.S. branch, agency, or 
subsidiary depository institution of a foreign bank, subpart G of the 
rule generally does not apply section 23A to transactions between the 
U.S. branch or agency of a foreign bank and any sister banks of the 
branch or agency.
    Second, commenters claimed that it is inconsistent to permit a U.S. 
bank to fund its non-U.S. subsidiaries through a non-U.S. branch 
without complying with section 23A, but to force a non-U.S. bank to 
fund its U.S. subsidiaries through a U.S. branch in compliance with 
section 23A. As explained above, the Board is adopting subpart G of 
Regulation W in order to mitigate potential competitive inequities in 
certain nonbanking markets in the United States. Non-U.S. financial 
regulators are free to address any similar inequities that exist in 
their nonbanking markets due to disparate regulatory treatment. The 
Board notes that section 23A generally would apply to transactions 
between a U.S. bank and a foreign affiliate of the U.S. bank engaged in 
the four specified activities (other than an Edge subsidiary of the 
U.S. bank engaged in securities underwriting and dealing or certain 
limited investment activities).

X. Miscellaneous Interpretations--Subpart H

    The Board has decided to include a subpart H in final Regulation W 
to house Board interpretations of sections 23A and 23B that do not fit 
neatly elsewhere in the regulation. Although subpart H of the final 
rule contains only a single section, the Board intends to place future 
Board miscellaneous interpretations of the statute into this subpart.
    Section 223.71 of the final rule explains how sections 23A and 23B 
apply to transactions in which a member bank purchases from one 
affiliate an asset relating to another affiliate. In some situations in 
which a member bank purchases an asset from an affiliate, the asset 
purchase qualifies for an exemption under Regulation W, but the member 
bank's resulting ownership of the purchased asset also represents 
another covered transaction (which may or may not qualify for an 
exemption under the rule). In these situations, the transaction engaged 
in by the member bank would qualify as two different types of covered 
transaction. Although an asset purchase exemption may suffice to exempt 
the member bank's asset purchase from the first affiliate, the asset 
purchase exemption does not exempt the bank's resulting covered 
transaction with the second affiliate.
    For example, assume a member bank purchases from one affiliate 
securities issued by another affiliate in a purchase that qualifies for 
the (d)(6) exemption in section 23A. The member bank's asset purchase 
from the first affiliate would be exempt under Sec.  223.42(e) of the 
rule; but the bank also would have acquired an investment in securities 
issued by the second affiliate, which would be a covered transaction 
between the bank and the second affiliate that does not qualify for the 
(d)(6) exemption. The (d)(6) exemption, by its terms, only exempts 
asset purchases by a member bank from an affiliate; hence, the (d)(6) 
exemption cannot exempt a member bank's investment in securities issued 
by an affiliate (even if the securities would qualify for the (d)(6) 
exemption).
    Section 223.71 sets forth this general interpretation and includes 
several examples to flesh out the interpretation (including the example 
given in the previous paragraph).\200\
---------------------------------------------------------------------------

    \200\ In light of the inclusion of section 223.71 in the final 
rule, the Board has removed certain conditions to the (d)(6)-related 
exemptions in section 223.42(e) and (f) of the rule.
---------------------------------------------------------------------------

XI. Effective Date; Transition Rule

    Many commenters urged the Board to provide either a transition 
period for banks to come into compliance with Regulation W or a 
grandfather for existing transactions that do not comply with the rule. 
According to these commenters, banks need such relief because of the 
many ways in which the rule is inconsistent with existing bank 
practices or existing staff interpretations of section 23A. Although 
most commenters did not propose a specific time period, one commenter 
advocated a transition period of 2 to 3 years.
    The Board recognizes that Regulation W tightens a number of 
traditional Board and staff interpretations of sections 23A and 23B. 
The Board also believes that the changes effected by the final rule are 
of substantial regulatory importance, and that the burden on member 
banks of full and prompt compliance with the final rule will be minimal 
in most cases. Accordingly, the Board has decided to delay the 
effective date of the rule only for the minimum period of time required 
by law and to provide member banks with only a limited transition 
period and grandfather authority for preexisting transactions.
    The Board has decided to make Regulation W effective as of April 1, 
2003. Accordingly, transactions entered into on or after April 1, 2003, 
will be immediately subject to the rule. Transactions entered into 
after December 12, 2002, but before April 1, 2003, will become subject 
to the rule on April 1, 2003.
    The Board also has determined to adopt a limited transition rule 
for transactions that consummate on or before the date of publication 
of final Regulation W in the Federal Register. As a general matter, any 
transaction engaged in by a member bank on or before December 12, 2002 
that would become subject to section 23A or 23B solely as a result of 
this rule, or whose treatment under section 23A or 23B would change 
solely as a result of this rule, will not become subject to this rule 
until July 1, 2003. The Board may, in its discretion, extend this 
deadline in circumstances where a member bank has demonstrated to the 
Board's satisfaction that compliance with the deadline would impose 
regulatory burden on the member bank that outweighs the regulatory 
benefit of early compliance.
    For purposes of the transition rule, a transaction is subject to 
section 23A or 23B solely as a result of Regulation W if the 
transaction is subject to section 23A or 23B under the rule but was not

[[Page 76602]]

subject to section 23A or 23B under the terms of the sections or any 
written interpretations of the sections by the Board or its staff that 
predated December 12, 2002. In addition, a transaction's treatment 
under section 23A or 23B changes solely as a result of Regulation W if 
the treatment of the transaction under the rule differs from the 
treatment of the transaction under the terms of sections 23A and 23B or 
any written interpretations of the sections by the Board or its staff 
that predated December 12, 2002.
    The transition rule has several exceptions. First, any transaction 
that qualifies for the transition rule but is renewed, extended, or 
materially altered on or after April 1, 2003, will be immediately 
subject to the rule at the time of such renewal, extension, or material 
alteration. In addition, any transaction that qualifies for the 
transition rule but is a purchase of assets by a member bank from an 
affiliate that consummated on or before December 12, 2002 will not be 
subject to this rule.
    The following examples are designed to assist member banks in 
understanding the transition rule. The first example involves an 
extension of credit that predates December 12, 2002. Suppose that on 
February 18, 2002, a member bank makes a loan to an unregistered 
investment fund advised (but not sponsored) by the bank. The member 
bank does not control the fund, but the bank's holding company owns 10 
percent of the total equity of the fund. The fund is not an affiliate 
of the member bank under sections 23A and 23B and written 
interpretations of such sections by the Board and its staff at the time 
the loan is made. The fund would become an affiliate of the member bank 
under Regulation W, and the loan would become a covered transaction, as 
of July 1, 2003.\201\ If the member bank renews the loan on May 14, 
2003, however, the loan would become a covered transaction as of May 
14, 2003.
---------------------------------------------------------------------------

    \201\ The Board would expect member banks to treat such a 
transaction, as of July 1, 2003, in accordance with the timing rules 
set forth in section 223.21(b)(2) of Regulation W for a credit 
transaction with a nonaffiliate that becomes an affiliate.
---------------------------------------------------------------------------

    The second example involves an asset purchase that predates 
December 12, 2002. Suppose that on August 9, 2002, a member bank 
purchases assets from an uninsured depository institution affiliate in 
a transaction that qualifies for the sister-bank exemption in section 
23A(d)(4). Although Regulation W renders the sister-bank exemption 
unavailable for transactions with uninsured depository institution 
affiliates as of April 1, 2003, the asset purchase would permanently 
qualify for the sister-bank exemption.
    The Board also has determined to allow member banks to apply 
certain provisions of Regulation W that relieve regulatory burden 
before the rule's effective date.\202\ In particular, notwithstanding 
the effective date and transition rule provisions discussed above, a 
member bank may choose to apply any of the following provisions of the 
rule beginning on December 12, 2002: (i) section 223.16(c)(4); (ii) 
section 223.24(a), (b), or (c); (iii) section 223.31(d); (iv) section 
223.41(d); or (v) section 223.42(c), (f), (g), (i), (j), or (k).
---------------------------------------------------------------------------

    \202\ Permitting member banks to comply with provisions of the 
final rule that relieve burden prior to the rule's effective date is 
consistent with applicable Federal law. See 5 U.S.C 553 and 12 
U.S.C. 4802.
---------------------------------------------------------------------------

Regulatory Flexibility Act

    In accordance with section 3(a) of the Regulatory Flexibility Act 
(5 U.S.C. 604(a)), the Board must publish a final regulatory 
flexibility analysis with this rulemaking. Sections 23A and 23B of the 
Federal Reserve Act limit transactions between a depository institution 
and its affiliates and authorize the Board to issue regulations as 
necessary to administer and carry out the purposes of the 
sections.\203\ Sections 23A and 23B are two of the most important 
statutory protections against a depository institution suffering losses 
from its transactions with affiliates and, correspondingly, are two of 
the most effective means of limiting the ability of a depository 
institution to transfer to its affiliates the subsidy arising from its 
access to the Federal safety net. Although sections 23A and 23B each 
grant the Board authority to issue regulations, the Board has never 
issued a regulation fully implementing either section. Instead, 
depository institutions seeking guidance on how to comply with sections 
23A and 23B have relied on a series of Board interpretations and 
informal staff opinions. Banking organizations have increasingly sought 
guidance from the Board on section 23A issues in recent years as a 
result of the increasing scope of activities conducted by modern FHCs 
and the growing complexities of the U.S. financial markets.
---------------------------------------------------------------------------

    \203\ 12 U.S.C. 371c(f) and 371c-1(e).
---------------------------------------------------------------------------

    As noted above, the Board believes that adoption of a comprehensive 
regulation implementing sections 23A and 23B is appropriate for several 
reasons. First, the new regulatory framework established by the GLB Act 
emphasizes the importance of sections 23A and 23B as a means to protect 
depository institutions from losses in transactions with affiliates. 
Moreover, adoption of a comprehensive regulation will 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.
    The Board received approximately 120 public comments in response to 
the Board's proposed section 23A rulemakings. As discussed above, 
nearly all commenters supported the Board's decision to issue 
Regulation W, but raised specific concerns on certain aspects of the 
regulation. The preamble provides a detailed discussion of the public 
comments. The Board considered the alternatives proposed by the 
comments, and the preamble describes the numerous changes that the 
Board made to the proposed rule as a result of the comments.
    Regulation W provides users with a single, comprehensive reference 
tool for complying with and analyzing issues arising under sections 23A 
and 23B. Accordingly, the regulation incorporates Board and staff 
interpretations and also restates the statutory definitions, 
restrictions, and exemptions in order to make understanding and using 
the regulation easier.
    The regulation first sets forth, in subpart A, a comprehensive 
glossary of the terms used in the regulation. Subpart B then describes 
the principal restrictions and requirements imposed by section 23A. 
Next, in subpart C, the regulation discusses the appropriate valuation 
and timing principles for covered transactions. Subpart D discusses the 
appropriate treatment under section 23A for transactions with financial 
subsidiaries, derivative transactions with affiliates, and certain 
merger and acquisition transactions with affiliates. Subpart E sets 
forth available exemptions from certain of the requirements of section 
23A. Subpart F lays out the operative provisions of section 23B. 
Subpart G discusses the application of the rule to U.S. branches and 
agencies of foreign banks. Subpart H contains an additional 
interpretation of the statute. Regulation W also includes examples 
illustrating how several of the rule's provisions apply in particular 
circumstances.
    Regulation W applies, by its terms, to all member banks regardless 
of their size. The regulation affects all insured depository 
institutions, however, because other Federal law subjects insured 
nonmember banks and insured thrifts to sections 23A and 23B as if they 
were member banks. The rule also applies indirectly to the 
``affiliates'' of insured depository institutions. A

[[Page 76603]]

depository institution's affiliates include, among other companies, any 
company that controls the institution, any company under common control 
with the institution, and certain investment funds that are advised by 
the institution or an affiliate of the institution. The number of small 
entities affected by Regulation W is estimated to be a little over 
6,500, including 3,292 depository institutions. For purposes of this 
regulatory flexibility analysis, the Board defines small entity as any 
depository institution or other company with less than $150 million in 
total assets. The Board does not collect data on all affiliates of 
depository institutions at this time. Accordingly, the exact number of 
small entities affected by the rule would require additional surveys or 
reports, which would increase the burden on the public and are not 
necessary for implementation of the rule.
    The vast majority of depository institutions that are currently in 
compliance with sections 23A and 23B will also be in compliance with 
the rule. The rule does not impose any new compliance requirements and 
mainly codifies existing practice and grants new exemptions. The rule 
includes several exemptions that will be available to a depository 
institution only if it notifies its primary Federal supervisor. This 
notification, however, allows the institution to engage in a 
transaction that is otherwise prohibited by law and replaces the 
current requirement of a more time-consuming case-by-case exemption 
request to the Board. The primary Federal supervisor of an institution 
also may require additional documentation to ensure compliance with the 
regulation. Moreover, the Board has delegated authority to the primary 
Federal supervisors of depository institutions to make certain 
determinations as to the permissibility of certain transactions.
    The rule does not result in significant additional burden to the 
institutions that must comply with its terms. The provisions of 
Regulation W, in fact, may be less burdensome than existing law because 
of the increased number of exemptions. One alternative to adopting this 
rule is to maintain the current collection of formal and informal Board 
and staff interpretations. Most public commenters believed, however, 
that the adoption of Regulation W would reduce burden by placing 
sections 23A and 23B and the Board's interpretations thereof in a 
single, comprehensive, public document.

Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3506; 5 CFR 1320 Appendix A.1), the Board reviewed the rule under the 
authority delegated to the Board by the Office of Management and 
Budget. The Federal Reserve may not conduct or sponsor, and an 
organization is not required to respond to, an information collection 
unless the Federal Reserve displays a currently valid OMB control 
number. The Federal Reserve will assign an OMB control number.
    The collection of information requirements in this final rulemaking 
are found in 12 CFR 223.15(b)(4), 223.31(d)(4), 223.41(d)(2), and 
223.43(b). This information is required to evidence compliance with 
sections 23A and 23B of the Federal Reserve Act (12 U.S.C. 371c and 
371c-1). The respondents are all insured depository institutions and 
uninsured member banks.
    The notice requirement cited in 12 CFR 223.15(b)(4) is a condition 
to an exemption for renewals of loan participations involving problem 
loans. The participating depository institution must provide its 
appropriate Federal banking agency with written notice of the renewal 
or extension of additional credit not later than 20 days after 
consummation. There will be no reporting form associated with this 
information collection. The Board estimates that approximately 10 
depository institutions will file this notice annually and that it will 
take approximately 2 hours to prepare the notice.
    The notice requirement cited in 12 CFR 223.31(d)(4) is a condition 
to an exemption for a depository institution's acquisition of an 
affiliate that becomes an operating subsidiary of the institution after 
the acquisition. The institution must provide its appropriate Federal 
banking agency and the Board with written notice of its intention to 
acquire the company at or before the time that the company becomes an 
affiliate of the institution. There will be no reporting form 
associated with this information collection. The Board estimates that 
approximately 10 depository institutions will file this notice annually 
and that it will take approximately 6 hours to prepare the notice.
    The notice requirement cited in 12 CFR 223.41(d)(2) is a condition 
to an exemption for internal corporate reorganization transactions. The 
depository institution must provide its appropriate Federal banking 
agency and the Board with written notice of the transaction before 
consummation. The notice must describe the primary business activities 
of the affiliate and indicate the proposed date of the reorganization. 
There will be no reporting form associated with this information 
collection. The Board estimates that approximately 20 depository 
institutions will file this notice annually and that it will take 
approximately 6 hours to prepare a notice.
    The notice requirement cited in 12 CFR 223.43(b) provides 
procedures for requesting additional exemptions from the requirements 
of section 23A. The depository institution must submit a written 
request to the General Counsel of the Board. The request must describe 
in detail the transaction or relationship for which the institution 
seeks exemption; explain why the Board should exempt the transaction or 
relationship; and explain how the exemption would be in the public 
interest and consistent with the purposes of section 23A. There will be 
no reporting form associated with this information collection. The 
Board estimates that approximately 5 depository institutions will file 
these requests annually and that it will take approximately 10 hours to 
prepare a request.
    The total estimated annual burden for the depository institutions 
that must comply with the above-mentioned requirements is 250 hours. 
Based on a rate of $50 per hour, the total annual cost to the public 
for these collections of information is estimated to be $12,500.
    In addition, there are existing reports (such as the Bank Holding 
Company Report of Insured Depository Institutions' Section 23A 
Transactions with Affiliates (FR Y-8; OMB No. 7100-0126)) that will be 
modified to reflect the adoption of this rule. The Board expects to 
publish a separate notice describing the changes to these reports. The 
burden associated with these collections of information will be 
addressed at that time.
    Comments are invited on (i) whether the proposed notifications are 
necessary for the proper performance of the Board's functions, 
including whether the information contained in the notifications would 
have practical utility; (ii) the accuracy of the Board's estimate of 
the burden of the proposed information collections, including the cost 
of compliance; (iii) ways to enhance the quality, utility, and clarity 
of the information to be collected; and (iv) ways to minimize the 
burden of information collections on respondents, including through the 
use of automated

[[Page 76604]]

collection techniques or other forms of information technology.
    Comments regarding any aspect of these information collections, 
including suggestions for reducing the burden, must be submitted on or 
before February 10, 2003, and may be sent to: Secretary, Board of 
Governors of the Federal Reserve System, 20th and C Streets, NW., 
Washington, DC 20551; and to the Office of Management and Budget, 
Paperwork Reduction Project (7100-[to be assigned]), Washington, DC 
20503.

Solicitation of Comments Regarding Use of ``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. The Board invited comments about how to make the proposed rule 
easier to understand and, in doing so, posed the following questions:
    (1) Has the Board organized the material in an effective manner? If 
not, how could the material be better organized?
    (2) Are the terms of the rule clearly stated? If not, how could the 
terms be more clearly stated?
    (3) Does the rule contain technical language or jargon that is 
unclear? If so, which language requires clarification?
    (4) Would a different format (with respect to grouping and order of 
sections and use of headings) make the rule easier to understand? If 
so, what changes to the format would make the rule easier to 
understand?
    (5) Would increasing the number of sections (and making each 
section shorter) clarify the rule? If so, which portions of the rule 
should be changed in this respect?
    (6) What additional changes would make the rule easier to 
understand?
    The Board also provided examples in the proposed rule to illustrate 
how several of the rule's provisions would apply in particular 
circumstances, and solicited comment on what kinds of additional 
examples should be added to the rule.
    Commenters generally expressed support for the format of the 
regulation and believed that the rule conveyed the Board's 
interpretations of section 23A in plain language. Several commenters 
did recommend, however, that the Board move the definitional sections 
of the rule to the front. In response to these comments, the Board has 
placed the rule's definitions in the first subpart of the rule.
    Several commenters also recommended clarification of several 
examples contained in the proposed rule and inclusion of additional 
examples, particularly in the valuation subpart of the rule. The final 
rule modifies several of the proposed rule's examples to enhance their 
illustrative power and includes a number of new examples to increase 
the ability of users of the regulation to understand the valuation 
formulas of the rule.

List of Subjects in 12 CFR Part 223

    Banks, Banking; Federal Reserve System.

    For the reasons set out in the preamble, title 12 of the Code of 
Federal Regulations is amended by adding a new part 223 to read as 
follows:

PART 223--TRANSACTIONS BETWEEN MEMBER BANKS AND THEIR AFFILIATES 
(REGULATION W)

Subpart A--Introduction and Definitions
Sec.
223.1 Authority, purpose, and scope.
223.2 What is an ``affiliate'' for purposes of sections 23A and 23B 
and this part?
223.3 What are the meanings of the other terms used in sections 23A 
and 23B and this part?
Subpart B--General Provisions of Section 23A
223.11 What is the maximum amount of covered transactions that a 
member bank may enter into with any single affiliate?
223.12 What is the maximum amount of covered transactions that a 
member bank may enter into with all affiliates?
223.13 What safety and soundness requirement applies to covered 
transactions?
223.14 What are the collateral requirements for a credit transaction 
with an affiliate?
223.15 May a member bank purchase a low-quality asset from an 
affiliate?
223.16 What transactions by a member bank with any person are 
treated as transactions with an affiliate?
Subpart C--Valuation and Timing Principles Under Section 23A
223.21 What valuation and timing principles apply to credit 
transactions?
223.22 What valuation and timing principles apply to asset 
purchases?
223.23 What valuation and timing principles apply to purchases of 
and investments in securities issued by an affiliate?
223.24 What valuation principles apply to extensions of credit 
secured by affiliate securities?
Subpart D--Other Requirements Under Section 23A
223.31 How does section 23A apply to a member bank's acquisition of 
an affiliate that becomes an operating subsidiary of the member bank 
after the acquisition?
223.32 What rules apply to financial subsidiaries of a member bank?
223.33 What rules apply to derivative transactions?
Subpart E--Exemptions from the Provisions of Section 23A
223.41 What covered transactions are exempt from the quantitative 
limits and collateral requirements?
223.42 What covered transactions are exempt from the quantitative 
limits, collateral requirements, and low-quality asset prohibition?
223.43 What are the standards under which the Board may grant 
additional exemptions from the requirements of section 23A?
Subpart F--General Provisions of Section 23B
223.51 What is the market terms requirement of section 23B?
223.52 What transactions with affiliates or others must comply with 
section 23B's market terms requirement?
223.53 What asset purchases are prohibited by section 23B?
223.54 What advertisements and statements are prohibited by section 
23B?
223.55 What are the standards under which the Board may grant 
exemptions from the requirements of section 23B?
Subpart G--Application of Sections 23A and 23B to U.S. Branches and 
Agencies of Foreign Banks
223.61 How do sections 23A and 23B apply to U.S. branches and 
agencies of foreign banks?
Subpart H--Miscellaneous Interpretations
223.71 How do sections 23A and 23B apply to transactions in which a 
member bank purchases from one affiliate an asset relating to 
another affiliate?

    Authority: 12 U.S.C. 371c(b)(1)(E), (b)(2)(A), and (f), 371c-
1(e), 1828(j), and 1468(a).

Subpart A--Introduction and Definitions


Sec.  223.1  Authority, purpose, and scope.

    (a) Authority. The Board of Governors of the Federal Reserve System 
(Board) has issued this part (Regulation W) under the authority of 
sections 23A(f) and 23B(e) of the Federal Reserve Act (12 U.S.C. 
371c(f), 371c-1(e)).
    (b) Purpose. Sections 23A and 23B of the Federal Reserve Act (12 
U.S.C. 371c, 371c-1) establish certain quantitative limits and other 
prudential requirements for loans, purchases of assets, and certain 
other transactions between a member bank and its affiliates. This 
regulation implements sections 23A and 23B by defining terms used in 
the statute, explaining the statute's requirements, and exempting 
certain transactions.
    (c) Scope. Sections 23A and 23B and this regulation apply by their 
terms to ``member banks''--that is, any national bank, State bank, 
trust company, or other institution that is a member of the Federal 
Reserve System. In addition, the

[[Page 76605]]

Federal Deposit Insurance Act (12 U.S.C. 1828(j)) applies sections 23A 
and 23B to insured State nonmember banks in the same manner and to the 
same extent as if they were member banks. The Home Owners' Loan Act (12 
U.S.C. 1468(a)) also applies sections 23A and 23B to insured savings 
associations in the same manner and to the same extent as if they were 
member banks (and imposes two additional restrictions).


Sec.  223.2  What is an ``affiliate'' for purposes of sections 23A and 
23B and this part?

    (a) For purposes of this part and except as provided in paragraphs 
(b) and (c) of this section, ``affiliate'' with respect to a member 
bank means:
    (1) Parent companies. Any company that controls the member bank;
    (2) Companies under common control by a parent company. Any 
company, including any subsidiary of the member bank, that is 
controlled by a company that controls the member bank;
    (3) Companies under other common control. Any company, including 
any subsidiary of the member bank, that is controlled, directly or 
indirectly, by trust or otherwise, by or for the benefit of 
shareholders who beneficially or otherwise control, directly or 
indirectly, by trust or otherwise, the member bank or any company that 
controls the member bank;
    (4) Companies with interlocking directorates. Any company in which 
a majority of its directors, trustees, or general partners (or 
individuals exercising similar functions) constitute a majority of the 
persons holding any such office with the member bank or any company 
that controls the member bank;
    (5) Sponsored and advised companies. Any company, including a real 
estate investment trust, that is sponsored and advised on a contractual 
basis by the member bank or an affiliate of the member bank;
    (6) Investment companies. (i) Any investment company for which the 
member bank or any affiliate of the member bank serves as an investment 
adviser, as defined in section 2(a)(20) of the Investment Company Act 
of 1940 (15 U.S.C. 80a-2(a)(20)); and
    (ii) Any other investment fund for which the member bank or any 
affiliate of the member bank serves as an investment advisor, if the 
member bank and its affiliates own or control in the aggregate more 
than 5 percent of any class of voting securities or of the equity 
capital of the fund;
    (7) Depository institution subsidiaries. A depository institution 
that is a subsidiary of the member bank;
    (8) Financial subsidiaries. A financial subsidiary of the member 
bank;
    (9) Companies held under merchant banking or insurance company 
investment authority--(i) In general. Any company in which a holding 
company of the member bank owns or controls, directly or indirectly, or 
acting through one or more other persons, 15 percent or more of the 
equity capital pursuant to section 4(k)(4)(H) or (I) of the Bank 
Holding Company Act (12 U.S.C. 1843(k)(4)(H) or (I)).
    (ii) General exemption. A company will not be an affiliate under 
paragraph (a)(9)(i) of this section if the holding company presents 
information to the Board that demonstrates, to the Board's 
satisfaction, that the holding company does not control the company.
    (iii) Specific exemptions. A company also will not be an affiliate 
under paragraph (a)(9)(i) of this section if:
    (A) No director, officer, or employee of the holding company serves 
as a director, trustee, or general partner (or individual exercising 
similar functions) of the company;
    (B) A person that is not affiliated or associated with the holding 
company owns or controls a greater percentage of the equity capital of 
the company than is owned or controlled by the holding company, and no 
more than one officer or employee of the holding company serves as a 
director or trustee (or individual exercising similar functions) of the 
company; or
    (C) A person that is not affiliated or associated with the holding 
company owns or controls more than 50 percent of the voting shares of 
the company, and officers and employees of the holding company do not 
constitute a majority of the directors or trustees (or individuals 
exercising similar functions) of the company.
    (iv) Application of rule to private equity funds. A holding company 
will not be deemed to own or control the equity capital of a company 
for purposes of paragraph (a)(9)(i) of this section solely by virtue of 
an investment made by the holding company in a private equity fund (as 
defined in the merchant banking subpart of the Board's Regulation Y (12 
CFR 225.173(a))) that owns or controls the equity capital of the 
company unless the holding company controls the private equity fund 
under 12 CFR 225.173(d)(4).
    (v) Definition. For purposes of this paragraph (a)(9), ``holding 
company'' with respect to a member bank means a company that controls 
the member bank, or a company that is controlled by shareholders that 
control the member bank, and all subsidiaries of the company (including 
any depository institution that is a subsidiary of the company).
    (10) Partnerships associated with the member bank or an affiliate. 
Any partnership for which the member bank or any affiliate of the 
member bank serves as a general partner or for which the member bank or 
any affiliate of the member bank causes any director, officer, or 
employee of the member bank or affiliate to serve as a general partner;
    (11) Subsidiaries of affiliates. Any subsidiary of a company 
described in paragraphs (a)(1) through (10) of this section; and
    (12) Other companies. Any company that the Board determines by 
regulation or order, or that the appropriate Federal banking agency for 
the member bank determines by order, to have a relationship with the 
member bank, or any affiliate of the member bank, such that covered 
transactions by the member bank with that company may be affected by 
the relationship to the detriment of the member bank.
    (b) ``Affiliate'' with respect to a member bank does not include:
    (1) Subsidiaries. Any company that is a subsidiary of the member 
bank, unless the company is:
    (i) A depository institution;
    (ii) A financial subsidiary;
    (iii) Directly controlled by:
    (A) One or more affiliates (other than depository institution 
affiliates) of the member bank; or
    (B) A shareholder that controls the member bank or a group of 
shareholders that together control the member bank;
    (iv) An employee stock option plan, trust, or similar organization 
that exists for the benefit of the shareholders, partners, members, or 
employees of the member bank or any of its affiliates; or
    (v) Any other company determined to be an affiliate under paragraph 
(a)(12) of this section;
    (2) Bank premises. Any company engaged solely in holding the 
premises of the member bank;
    (3) Safe deposit. Any company engaged solely in conducting a safe 
deposit business;
    (4) Government securities. Any company engaged solely in holding 
obligations of the United States or its agencies or obligations fully 
guaranteed by the United States or its agencies as to principal and 
interest; and
    (5) Companies held DPC. Any company where control results from the 
exercise of rights arising out of a bona fide debt previously 
contracted. This exclusion from the definition of ``affiliate'' applies 
only for the period of time specifically authorized under applicable 
State or Federal law or regulation or, in the absence of such law

[[Page 76606]]

or regulation, for a period of two years from the date of the exercise 
of such rights. The Board may authorize, upon application and for good 
cause shown, extensions of time for not more than one year at a time, 
but such extensions in the aggregate will not exceed three years.
    (c) For purposes of subpart F (implementing section 23B), 
``affiliate'' with respect to a member bank also does not include any 
depository institution.


Sec.  223.3  What are the meanings of the other terms used in sections 
23A and 23B and this part?

    For purposes of this part:
    (a) Aggregate amount of covered transactions means the amount of 
the covered transaction about to be engaged in added to the current 
amount of all outstanding covered transactions.
    (b) Appropriate Federal banking agency with respect to a member 
bank or other depository institution has the same meaning as in section 
3 of the Federal Deposit Insurance Act (12 U.S.C. 1813).
    (c) ``Bank holding company'' has the same meaning as in 12 CFR 
225.2.
    (d) ``Capital stock and surplus'' means the sum of:
    (1) A member bank's tier 1 and tier 2 capital under the risk-based 
capital guidelines of the appropriate Federal banking agency, based on 
the member bank's most recent consolidated Report of Condition and 
Income filed under 12 U.S.C. 1817(a)(3);
    (2) The balance of a member bank's allowance for loan and lease 
losses not included in its tier 2 capital under the risk-based capital 
guidelines of the appropriate Federal banking agency, based on the 
member bank's most recent consolidated Report of Condition and Income 
filed under 12 U.S.C. 1817(a)(3); and
    (3) The amount of any investment by a member bank in a financial 
subsidiary that counts as a covered transaction and is required to be 
deducted from the member bank's capital for regulatory capital 
purposes.
    (e) Carrying value with respect to a security means (unless 
otherwise provided) the value of the security on the financial 
statements of the member bank, determined in accordance with GAAP.
    (f) Company means a corporation, partnership, limited liability 
company, business trust, association, or similar organization and, 
unless specifically excluded, includes a member bank and a depository 
institution.
    (g) Control. (1) In general. ``Control'' by a company or 
shareholder over another company means that:
    (i) The company or shareholder, directly or indirectly, or acting 
through one or more other persons, owns, controls, or has power to vote 
25 percent or more of any class of voting securities of the other 
company;
    (ii) The company or shareholder controls in any manner the election 
of a majority of the directors, trustees, or general partners (or 
individuals exercising similar functions) of the other company; or
    (iii) The Board determines, after notice and opportunity for 
hearing, that the company or shareholder, directly or indirectly, 
exercises a controlling influence over the management or policies of 
the other company.
    (2) Ownership or control of shares as fiduciary. Notwithstanding 
any other provision of this regulation, no company will be deemed to 
control another company by virtue of its ownership or control of shares 
in a fiduciary capacity, except as provided in paragraph (a)(3) of 
Sec.  223.2 or if the company owning or controlling the shares is a 
business trust.
    (3) Ownership or control of securities by subsidiary. A company 
controls securities, assets, or other ownership interests owned or 
controlled, directly or indirectly, by any subsidiary (including a 
subsidiary depository institution) of the company.
    (4) Ownership or control of convertible instruments. A company or 
shareholder that owns or controls instruments (including options or 
warrants) that are convertible or exercisable, at the option of the 
holder or owner, into securities, controls the securities, unless the 
company or shareholder presents information to the Board that 
demonstrates, to the Board's satisfaction, that the company or 
shareholder should not be deemed to control the securities.
    (5) Ownership or control of nonvoting securities. A company or 
shareholder that owns or controls 25 percent or more of the equity 
capital of another company controls the other company, unless the 
company or shareholder presents information to the Board that 
demonstrates, to the Board's satisfaction, that the company or 
shareholder does not control the other company.
    (h) Covered transaction with respect to an affiliate means:
    (1) An extension of credit to the affiliate;
    (2) A purchase of, or an investment in, a security issued by the 
affiliate;
    (3) A purchase of an asset from the affiliate, including an asset 
subject to recourse or an agreement to repurchase, except such 
purchases of real and personal property as may be specifically exempted 
by the Board by order or regulation;
    (4) The acceptance of a security issued by the affiliate as 
collateral for an extension of credit to any person or company; and
    (5) The issuance of a guarantee, acceptance, or letter of credit, 
including an endorsement or standby letter of credit, on behalf of the 
affiliate, a confirmation of a letter of credit issued by the 
affiliate, and a cross-affiliate netting arrangement.
    (i) Credit transaction with an affiliate means:
    (1) An extension of credit to the affiliate;
    (2) An issuance of a guarantee, acceptance, or letter of credit, 
including an endorsement or standby letter of credit, on behalf of the 
affiliate and a confirmation of a letter of credit issued by the 
affiliate; and
    (3) A cross-affiliate netting arrangement.
    (j) Cross-affiliate netting arrangement means an arrangement among 
a member bank, one or more affiliates of the member bank, and one or 
more nonaffiliates of the member bank in which:
    (1) A nonaffiliate is permitted to deduct any obligations of an 
affiliate of the member bank to the nonaffiliate when settling the 
nonaffiliate's obligations to the member bank; or
    (2) The member bank is permitted or required to add any obligations 
of its affiliate to a nonaffiliate when determining the member bank's 
obligations to the nonaffiliate.
    (k) ``Depository institution'' means, unless otherwise noted, an 
insured depository institution (as defined in section 3 of the Federal 
Deposit Insurance Act (12 U.S.C. 1813)), but does not include any 
branch of a foreign bank. For purposes of this definition, an operating 
subsidiary of a depository institution is treated as part of the 
depository institution.
    (l) ``Derivative transaction'' means any derivative contract listed 
in sections III.E.1.a. through d. of Appendix A to 12 CFR part 225 and 
any similar derivative contract, including a credit derivative 
contract.
    (m) ``Eligible affiliated mutual fund securities'' has the meaning 
specified in paragraph (c)(2) of Sec.  223.24.
    (n) ``Equity capital'' means:
    (1) With respect to a corporation, preferred stock, common stock, 
capital surplus, retained earnings, and accumulated other comprehensive 
income, less treasury stock, plus any other account that constitutes 
equity of the corporation; and

[[Page 76607]]

    (2) With respect to a partnership, limited liability company, or 
other company, equity accounts similar to those described in paragraph 
(n)(1) of this section.
    (o) ``Extension of credit'' to an affiliate means the making or 
renewal of a loan, the granting of a line of credit, or the extending 
of credit in any manner whatsoever, including on an intraday basis, to 
an affiliate. An extension of credit to an affiliate includes, without 
limitation:
    (1) An advance to an affiliate by means of an overdraft, cash item, 
or otherwise;
    (2) A sale of Federal funds to an affiliate;
    (3) A lease that is the functional equivalent of an extension of 
credit to an affiliate;
    (4) An acquisition by purchase, discount, exchange, or otherwise of 
a note or other obligation, including commercial paper or other debt 
securities, of an affiliate;
    (5) Any increase in the amount of, extension of the maturity of, or 
adjustment to the interest rate term or other material term of, an 
extension of credit to an affiliate; and
    (6) Any other similar transaction as a result of which an affiliate 
becomes obligated to pay money (or its equivalent).
    (p) ``Financial subsidiary''
    (1) In general. Except as provided in paragraph (p)(2) of this 
section, the term ``financial subsidiary'' means any subsidiary of a 
member bank that:
    (i) Engages, directly or indirectly, in any activity that national 
banks are not permitted to engage in directly or that is conducted 
under terms and conditions that differ from those that govern the 
conduct of such activity by national banks; and
    (ii) Is not a subsidiary that a national bank is specifically 
authorized to own or control by the express terms of a Federal statute 
(other than 12 U.S.C. 24a), and not by implication or interpretation.
    (2) Exceptions. ``Financial subsidiary'' does not include:
    (i) A subsidiary of a member bank that is considered a financial 
subsidiary under paragraph (p)(1) of this section solely because the 
subsidiary engages in the sale of insurance as agent or broker in a 
manner that is not permitted for national banks; and
    (ii) A subsidiary of a State bank (other than a subsidiary 
described in section 46(a) of the Federal Deposit Insurance Act (12 
U.S.C. 1831w(a))) that is considered a financial subsidiary under 
paragraph (p)(1) of this section solely because the subsidiary engages 
in one or more of the following activities:
    (A) An activity that the State bank may engage in directly under 
applicable Federal and State law and that is conducted under the same 
terms and conditions that govern the conduct of the activity by the 
State bank; and
    (B) An activity that the subsidiary was authorized by applicable 
Federal and State law to engage in prior to December 12, 2002, and that 
was lawfully engaged in by the subsidiary on that date.
    (3) Subsidiaries of financial subsidiaries. If a company is a 
financial subsidiary under paragraphs (p)(1) and (p)(2) of this 
section, any subsidiary of such a company is also a financial 
subsidiary.
    (q) ``Foreign bank'' and an ``agency,'' ``branch,'' or ``commercial 
lending company'' of a foreign bank have the same meanings as in 
section 1(b) of the International Banking Act of 1978 (12 U.S.C. 3101).
    (r) ``GAAP'' means U.S. generally accepted accounting principles.
    (s) ``General purpose credit card'' has the meaning specified in 
paragraph (c)(4)(ii) of Sec.  223.16.
    (t) In contemplation. A transaction between a member bank and a 
nonaffiliate is presumed to be ``in contemplation'' of the nonaffiliate 
becoming an affiliate of the member bank if the member bank enters into 
the transaction with the nonaffiliate after the execution of, or 
commencement of negotiations designed to result in, an agreement under 
the terms of which the nonaffiliate would become an affiliate.
    (u) ``Intraday extension of credit'' has the meaning specified in 
paragraph (l)(2) of Sec.  223.42.
    (v) ``Low-quality asset'' means:
    (1) An asset (including a security) classified as ``substandard,'' 
``doubtful,'' or ``loss,'' or treated as ``special mention'' or ``other 
transfer risk problems,'' either in the most recent report of 
examination or inspection of an affiliate prepared by either a Federal 
or State supervisory agency or in any internal classification system 
used by the member bank or the affiliate (including an asset that 
receives a rating that is substantially equivalent to ``classified'' or 
``special mention'' in the internal system of the member bank or 
affiliate);
    (2) An asset in a nonaccrual status;
    (3) An asset on which principal or interest payments are more than 
thirty days past due;
    (4) An asset whose terms have been renegotiated or compromised due 
to the deteriorating financial condition of the obligor; and
    (5) An asset acquired through foreclosure, repossession, or 
otherwise in satisfaction of a debt previously contracted, if the asset 
has not yet been reviewed in an examination or inspection.
    (w) ``Member bank'' means any national bank, State bank, banking 
association, or trust company that is a member of the Federal Reserve 
System. For purposes of this definition, an operating subsidiary of a 
member bank is treated as part of the member bank.
    (x) ``Municipal securities'' has the same meaning as in section 
3(a)(29) of the Securities Exchange Act of 1934 (17 U.S.C. 78c(a)(29)).
    (y) ``Nonaffiliate'' with respect to a member bank means any person 
that is not an affiliate of the member bank.
    (z) ``Obligations of, or fully guaranteed as to principal and 
interest by, the United States or its agencies'' includes those 
obligations listed in 12 CFR 201.108(b) and any additional obligations 
as determined by the Board. The term does not include Federal Housing 
Administration or Veterans Administration loans.
    (aa) ``Operating subsidiary'' with respect to a member bank or 
other depository institution means any subsidiary of the member bank or 
depository institution other than a subsidiary described in paragraphs 
(b)(1)(i) through (v) of Sec.  223.2.
    (bb) ``Person'' means an individual, company, trust, joint venture, 
pool, syndicate, sole proprietorship, unincorporated organization, or 
any other form of entity.
    (cc) ``Principal underwriter'' has the meaning specified in 
paragraph (c)(1) of Sec.  223.53.
    (dd) ``Purchase of an asset'' by a member bank from an affiliate 
means the acquisition by a member bank of an asset from an affiliate in 
exchange for cash or any other consideration, including an assumption 
of liabilities. The merger of an affiliate into a member bank is a 
purchase of assets by the member bank from an affiliate if the member 
bank assumes any liabilities of the affiliate or pays any other form of 
consideration in the transaction.
    (ee) Riskless principal. A company is ``acting exclusively as a 
riskless principal'' if, after receiving an order to buy (or sell) a 
security from a customer, the company purchases (or sells) the security 
in the secondary market for its own account to offset a contemporaneous 
sale to (or purchase from) the customer.
    (ff) ``Securities'' means stocks, bonds, debentures, notes, or 
similar obligations (including commercial paper).

[[Page 76608]]

    (gg) ``Securities affiliate'' with respect to a member bank means:
    (1) An affiliate of the member bank that is registered with the 
Securities and Exchange Commission as a broker or dealer; or
    (2) Any other securities broker or dealer affiliate of a member 
bank that is approved by the Board.
    (hh) ``State bank'' has the same meaning as in section 3 of the 
Federal Deposit Insurance Act (12 U.S.C. 1813).
    (ii) ``Subsidiary'' with respect to a specified company means a 
company that is controlled by the specified company.
    (jj) ``Voting securities'' has the same meaning as in 12 CFR 225.2.
    (kk) ``Well capitalized'' has the same meaning as in 12 CFR 225.2 
and, in the case of any holding company that is not a bank holding 
company, ``well capitalized'' means that the holding company has and 
maintains at least the capital levels required for a bank holding 
company to be well capitalized under 12 CFR 225.2.
    (ll) ``Well managed'' has the same meaning as in 12 CFR 225.2.

Subpart B--General Provisions of Section 23A


Sec.  223.11  What is the maximum amount of covered transactions that a 
member bank may enter into with any single affiliate?

    A member bank may not engage in a covered transaction with an 
affiliate (other than a financial subsidiary of the member bank) if the 
aggregate amount of the member bank's covered transactions with such 
affiliate would exceed 10 percent of the capital stock and surplus of 
the member bank.


Sec.  223.12  What is the maximum amount of covered transactions that a 
member bank may enter into with all affiliates?

    A member bank may not engage in a covered transaction with any 
affiliate if the aggregate amount of the member bank's covered 
transactions with all affiliates would exceed 20 percent of the capital 
stock and surplus of the member bank.


Sec.  223.13  What safety and soundness requirement applies to covered 
transactions?

    A member bank may not engage in any covered transaction, including 
any transaction exempt under this regulation, unless the transaction is 
on terms and conditions that are consistent with safe and sound banking 
practices.


Sec.  223.14  What are the collateral requirements for a credit 
transaction with an affiliate?

    (a) Collateral required for extensions of credit and certain other 
covered transactions. A member bank must ensure that each of its credit 
transactions with an affiliate is secured by the amount of collateral 
required by paragraph (b) of this section at the time of the 
transaction.
    (b) Amount of collateral required. (1) The rule. A credit 
transaction described in paragraph (a) of this section must be secured 
by collateral having a market value equal to at least:
    (i) 100 percent of the amount of the transaction, if the collateral 
is:
    (A) Obligations of the United States or its agencies;
    (B) Obligations fully guaranteed by the United States or its 
agencies as to principal and interest;
    (C) Notes, drafts, bills of exchange, or bankers' acceptances that 
are eligible for rediscount or purchase by a Federal Reserve Bank; or
    (D) A segregated, earmarked deposit account with the member bank 
that is for the sole purpose of securing credit transactions between 
the member bank and its affiliates and is identified as such;
    (ii) 110 percent of the amount of the transaction, if the 
collateral is obligations of any State or political subdivision of any 
State;
    (iii) 120 percent of the amount of the transaction, if the 
collateral is other debt instruments, including loans and other 
receivables; or
    (iv) 130 percent of the amount of the transaction, if the 
collateral is stock, leases, or other real or personal property.
    (2) Example. A member bank makes a $1,000 loan to an affiliate. The 
affiliate posts as collateral for the loan $500 in U.S. Treasury 
securities, $480 in corporate debt securities, and $130 in real estate. 
The loan satisfies the collateral requirements of this section because 
$500 of the loan is 100 percent secured by obligations of the United 
States, $400 of the loan is 120 percent secured by debt instruments, 
and $100 of the loan is 130 percent secured by real estate.
    (c) Ineligible collateral. The following items are not eligible 
collateral for purposes of this section:
    (1) Low-quality assets;
    (2) Securities issued by any affiliate;
    (3) Equity securities issued by the member bank, and debt 
securities issued by the member bank that represent regulatory capital 
of the member bank;
    (4) Intangible assets (including servicing assets), unless 
specifically approved by the Board; and
    (5) Guarantees, letters of credit, and other similar instruments.
    (d) Perfection and priority requirements for collateral. (1) 
Perfection. A member bank must maintain a security interest in 
collateral required by this section that is perfected and enforceable 
under applicable law, including in the event of default resulting from 
bankruptcy, insolvency, liquidation, or similar circumstances.
    (2) Priority. A member bank either must obtain a first priority 
security interest in collateral required by this section or must deduct 
from the value of collateral obtained by the member bank the lesser of:
    (i) The amount of any security interest in the collateral that is 
senior to that of the member bank; or
    (ii) The amount of any credit secured by the collateral that is 
senior to that of the member bank.
    (3) Example. A member bank makes a $2,000 loan to an affiliate. The 
affiliate grants the member bank a second priority security interest in 
a piece of real estate valued at $3,000. Another institution that 
previously lent $1,000 to the affiliate has a first priority security 
interest in the entire parcel of real estate. This transaction is not 
in compliance with the collateral requirements of this section. Due to 
the existence of the prior third-party lien on the real estate, the 
effective value of the real estate collateral for the member bank for 
purposes of this section is only $2,000--$600 less than the amount of 
real estate collateral required by this section for the transaction 
($2,000 x 130 percent = $2,600).
    (e) Replacement requirement for retired or amortized collateral. A 
member bank must ensure that any required collateral that subsequently 
is retired or amortized is replaced with additional eligible collateral 
as needed to keep the percentage of the collateral value relative to 
the amount of the outstanding credit transaction equal to the minimum 
percentage required at the inception of the transaction.
    (f) Inapplicability of the collateral requirements to certain 
transactions. The collateral requirements of this section do not apply 
to the following transactions.
    (1) Acceptances. An acceptance that already is fully secured either 
by attached documents or by other property that is involved in the 
transaction and has an ascertainable market value.
    (2) The unused portion of certain extensions of credit. The unused 
portion of an extension of credit to an affiliate as long as the member 
bank does not have any legal obligation to advance additional funds 
under the extension of credit until the affiliate provides the amount 
of collateral required by paragraph (b) of this section with

[[Page 76609]]

respect to the entire used portion (including the amount of the 
requested advance) of the extension of credit.
    (3) Purchases of affiliate debt securities in the secondary market. 
The purchase of a debt security issued by an affiliate as long as the 
member bank purchases the debt security from a nonaffiliate in a bona 
fide secondary market transaction.


Sec.  223.15  May a member bank purchase a low-quality asset from an 
affiliate?

    (a) In general. A member bank may not purchase a low-quality asset 
from an affiliate unless, pursuant to an independent credit evaluation, 
the member bank had committed itself to purchase the asset before the 
time the asset was acquired by the affiliate.
    (b) Exemption for renewals of loan participations involving problem 
loans. The prohibition contained in paragraph (a) of this section does 
not apply to the renewal of, or extension of additional credit with 
respect to, a member bank's participation in a loan to a nonaffiliate 
that was originated by an affiliate if:
    (1) The loan was not a low-quality asset at the time the member 
bank purchased its participation;
    (2) The renewal or extension of additional credit is approved, as 
necessary to protect the participating member bank's investment by 
enhancing the ultimate collection of the original indebtedness, by the 
board of directors of the participating member bank or, if the 
originating affiliate is a depository institution, by:
    (i) An executive committee of the board of directors of the 
participating member bank; or
    (ii) One or more senior management officials of the participating 
member bank, if:
    (A) The board of directors of the member bank approves standards 
for the member bank's renewals or extensions of additional credit 
described in this paragraph (b), based on the determination set forth 
in paragraph (b)(2) of this section;
    (B) Each renewal or extension of additional credit described in 
this paragraph (b) meets the standards; and
    (C) The board of directors of the member bank periodically reviews 
renewals and extensions of additional credit described in this 
paragraph (b) to ensure that they meet the standards and periodically 
reviews the standards to ensure that they continue to meet the 
criterion set forth in paragraph (b)(2) of this section;
    (3) The participating member bank's share of the renewal or 
extension of additional credit does not exceed its proportional share 
of the original transaction by more than 5 percent, unless the member 
bank obtains the prior written approval of its appropriate Federal 
banking agency; and
    (4) The participating member bank provides its appropriate Federal 
banking agency with written notice of the renewal or extension of 
additional credit not later than 20 days after consummation.


Sec.  223.16  What transactions by a member bank with any person are 
treated as transactions with an affiliate?

    (a) In general. A member bank must treat any of its transactions 
with any person as a transaction with an affiliate to the extent that 
the proceeds of the transaction are used for the benefit of, or 
transferred to, an affiliate.
    (b) Certain agency transactions. (1) Except to the extent described 
in paragraph (b)(2) of this section, an extension of credit by a member 
bank to a nonaffiliate is not treated as an extension of credit to an 
affiliate under paragraph (a) of this section if:
    (i) The proceeds of the extension of credit are used to purchase an 
asset through an affiliate of the member bank, and the affiliate is 
acting exclusively as an agent or broker in the transaction; and
    (ii) The asset purchased by the nonaffiliate is not issued, 
underwritten, or sold as principal by any affiliate of the member bank.
    (2) The interpretation set forth in paragraph (b)(1) of this 
section does not apply to the extent of any agency fee, brokerage 
commission, or other compensation received by an affiliate from the 
proceeds of the extension of credit. The receipt of such compensation 
may qualify, however, for the exemption contained in paragraph (c)(2) 
of this section.
    (c) Exemptions. Notwithstanding paragraph (a) of this section, the 
following transactions are not subject to the quantitative limits of 
Sec. Sec.  223.11 and 223.12 or the collateral requirements of Sec.  
223.14. The transactions are, however, subject to the safety and 
soundness requirement of Sec.  223.13 and the market terms requirement 
and other provisions of subpart F (implementing section 23B).
    (1) Certain riskless principal transactions. An extension of credit 
by a member bank to a nonaffiliate, if:
    (i) The proceeds of the extension of credit are used to purchase a 
security through a securities affiliate of the member bank, and the 
securities affiliate is acting exclusively as a riskless principal in 
the transaction;
    (ii) The security purchased by the nonaffiliate is not issued, 
underwritten, or sold as principal (other than as riskless principal) 
by any affiliate of the member bank; and
    (iii) Any riskless principal mark-up or other compensation received 
by the securities affiliate from the proceeds of the extension of 
credit meets the market terms standard set forth in paragraph (c)(2) of 
this section.
    (2) Brokerage commissions, agency fees, and riskless principal 
mark-ups. An affiliate's retention of a portion of the proceeds of an 
extension of credit described in paragraph (b) or (c)(1) of this 
section as a brokerage commission, agency fee, or riskless principal 
mark-up, if that commission, fee, or mark-up is substantially the same 
as, or lower than, those prevailing at the same time for comparable 
transactions with or involving other nonaffiliates, in accordance with 
the market terms requirement of Sec.  223.51.
    (3) Preexisting lines of credit. An extension of credit by a member 
bank to a nonaffiliate, if:
    (i) The proceeds of the extension of credit are used to purchase a 
security from or through a securities affiliate of the member bank; and
    (ii) The extension of credit is made pursuant to, and consistent 
with any conditions imposed in, a preexisting line of credit that was 
not established in contemplation of the purchase of securities from or 
through an affiliate of the member bank.
    (4) General purpose credit card transactions.
    (i) In general. An extension of credit by a member bank to a 
nonaffiliate, if:
    (A) The proceeds of the extension of credit are used by the 
nonaffiliate to purchase a product or service from an affiliate of the 
member bank; and
    (B) The extension of credit is made pursuant to, and consistent 
with any conditions imposed in, a general purpose credit card issued by 
the member bank to the nonaffiliate.
    (ii) Definition. ``General purpose credit card'' means a credit 
card issued by a member bank that is widely accepted by merchants that 
are not affiliates of the member bank for the purchase of products or 
services, if:
    (A) Less than 25 percent of the total value of products and 
services purchased with the card by all cardholders are purchases of 
products and services from one or more affiliates of the member bank;
    (B) All affiliates of the member bank would be permissible for a 
financial holding company (as defined in 12 U.S.C. 1841) under section 
4 of the Bank Holding Company Act (12 U.S.C. 1843), and the member bank 
has no reason to believe that 25 percent or more of the

[[Page 76610]]

total value of products and services purchased with the card by all 
cardholders are or would be purchases of products and services from one 
or more affiliates of the member bank; or
    (C) The member bank presents information to the Board that 
demonstrates, to the Board's satisfaction, that less than 25 percent of 
the total value of products and services purchased with the card by all 
cardholders are and would be purchases of products and services from 
one or more affiliates of the member bank.
    (iii) Calculating compliance. To determine whether a credit card 
qualifies as a general purpose credit card under the standard set forth 
in paragraph (c)(4)(ii)(A) of this section, a member bank must compute 
compliance on a monthly basis, based on cardholder purchases that were 
financed by the credit card during the preceding 12 calendar months. If 
a credit card has qualified as a general purpose credit card for 3 
consecutive months but then ceases to qualify in the following month, 
the member bank may continue to treat the credit card as a general 
purpose credit card for such month and three additional months (or such 
longer period as may be permitted by the Board).
    (iv) Example of calculating compliance with the 25 percent test. A 
member bank seeks to qualify a credit card as a general purpose credit 
card under paragraph (c)(4)(ii)(A) of this section. The member bank 
assesses its compliance under paragraph (c)(4)(iii) of this section on 
the 15th day of every month (for the preceding 12 calendar months). The 
credit card qualifies as a general purpose credit card for at least 
three consecutive months. On June 15, 2005, however, the member bank 
determines that, for the 12-calendar-month period from June 1, 2004, 
through May 31, 2005, 27 percent of the total value of products and 
services purchased with the card by all cardholders were purchases of 
products and services from an affiliate of the member bank. Unless the 
credit card returns to compliance with the 25 percent limit by the 12-
calendar-month period ending August 31, 2005, the card will cease to 
qualify as a general purpose credit card as of September 1, 2005. Any 
outstanding extensions of credit under the credit card that were used 
to purchase products or services from an affiliate of the member bank 
would become covered transactions at such time.

Subpart C--Valuation and Timing Principles Under Section 23A


Sec.  223.21  What valuation and timing principles apply to credit 
transactions?

    (a) Valuation. (1) Initial valuation. Except as provided in 
paragraph (a)(2) or (3) of this section, a credit transaction with an 
affiliate initially must be valued at the greater of:
    (i) The principal amount of the transaction;
    (ii) The amount owed by the affiliate to the member bank under the 
transaction; or
    (iii) The sum of:
    (A) The amount provided to, or on behalf of, the affiliate in the 
transaction; and
    (B) Any additional amount that the member bank could be required to 
provide to, or on behalf of, the affiliate under the terms of the 
transaction.
    (2) Initial valuation of certain acquisitions of a credit 
transaction. If a member bank acquires from a nonaffiliate a credit 
transaction with an affiliate, the covered transaction initially must 
be valued at the sum of:
    (i) The total amount of consideration given (including liabilities 
assumed) by the member bank in exchange for the credit transaction; and
    (ii) Any additional amount that the member bank could be required 
to provide to, or on behalf of, the affiliate under the terms of the 
transaction.
    (3) Debt securities. The valuation principles of paragraphs (a)(1) 
and (2) of this section do not apply to a member bank's purchase of or 
investment in a debt security issued by an affiliate, which is governed 
by Sec.  223.23.
    (4) Examples. The following are examples of how to value a member 
bank's credit transactions with an affiliate.
    (i) Term loan. A member bank makes a loan to an affiliate that has 
a principal amount of $100. The affiliate pays $2 in up-front fees to 
the member bank, and the affiliate receives net loan proceeds of $98. 
The member bank must initially value the covered transaction at $100.
    (ii) Revolving credit. A member bank establishes a $300 revolving 
credit facility for an affiliate. The affiliate has drawn down $100 
under the facility. The member bank must value the covered transaction 
at $300 throughout the life of the facility.
    (iii) Guarantee. A member bank has issued a guarantee to a 
nonaffiliate on behalf of an affiliate under which the member bank 
would be obligated to pay the nonaffiliate $500 if the affiliate 
defaults on an issuance of debt securities. The member bank must value 
the guarantee at $500 throughout the life of the guarantee.
    (iv) Acquisition of a loan to an affiliate. A member bank purchases 
from a nonaffiliate a fixed-rate loan to an affiliate. The loan has an 
outstanding principal amount of $100 but, due to movements in the 
general level of interest rates since the time of the loan's 
origination, the member bank is able to purchase the loan for $90. The 
member bank initially must value the credit transaction at $90 (and 
must ensure that the credit transaction complies with the collateral 
requirements of Sec.  223.14 at the time of its acquisition of the 
loan).
    (b) Timing. (1) In general. A member bank engages in a credit 
transaction with an affiliate at the time during the day that:
    (i) The member bank becomes legally obligated to make an extension 
of credit to, issue a guarantee, acceptance, or letter of credit on 
behalf of, or confirm a letter of credit issued by, an affiliate;
    (ii) The member bank enters into a cross-affiliate netting 
arrangement; or
    (iii) The member bank acquires an extension of credit to, or 
guarantee, acceptance, or letter of credit issued on behalf of, an 
affiliate.
    (2) Credit transactions by a member bank with a nonaffiliate that 
becomes an affiliate of the member bank.
    (i) In general. A credit transaction with a nonaffiliate becomes a 
covered transaction at the time that the nonaffiliate becomes an 
affiliate of the member bank. The member bank must treat the amount of 
any such credit transaction as part of the aggregate amount of the 
member bank's covered transactions for purposes of determining 
compliance with the quantitative limits of Sec. Sec.  223.11 and 223.12 
in connection with any future covered transactions. Except as described 
in paragraph (b)(2)(ii) of this section, the member bank is not 
required to reduce the amount of its covered transactions with any 
affiliate because the nonaffiliate has become an affiliate. If the 
nonaffiliate becomes an affiliate less than one year after the member 
bank enters into the credit transaction with the nonaffiliate, the 
member bank also must ensure that the credit transaction complies with 
the collateral requirements of Sec.  223.14 promptly after the 
nonaffiliate becomes an affiliate.
    (ii) Credit transactions by a member bank with a nonaffiliate in 
contemplation of the nonaffiliate becoming an affiliate of the member 
bank. Notwithstanding the provisions of paragraph (b)(2)(i) of this 
section, if a member bank engages in a credit transaction with a 
nonaffiliate in contemplation of the nonaffiliate becoming an affiliate 
of the member

[[Page 76611]]

bank, the member bank must ensure that:
    (A) The aggregate amount of the member bank's covered transactions 
(including any such credit transaction with the nonaffiliate) would not 
exceed the quantitative limits of Sec.  223.11 or 223.12 at the time 
the nonaffiliate becomes an affiliate; and
    (B) The credit transaction complies with the collateral 
requirements of Sec.  223.14 at the time the nonaffiliate becomes an 
affiliate.
    (iii) Example. A member bank with capital stock and surplus of 
$1,000 and no outstanding covered transactions makes a $120 unsecured 
loan to a nonaffiliate. The member bank does not make the loan in 
contemplation of the nonaffiliate becoming an affiliate. Nine months 
later, the member bank's holding company purchases all the stock of the 
nonaffiliate, thereby making the nonaffiliate an affiliate of the 
member bank. The member bank is not in violation of the quantitative 
limits of Sec.  223.11 or 223.12 at the time of the stock acquisition. 
The member bank is, however, prohibited from engaging in any additional 
covered transactions with the new affiliate at least until such time as 
the value of the loan transaction falls below 10 percent of the member 
bank's capital stock and surplus. In addition, the member bank must 
bring the loan into compliance with the collateral requirements of 
Sec.  223.14 promptly after the stock acquisition.


Sec.  223.22  What valuation and timing principles apply to asset 
purchases?

    (a) Valuation. (1) In general. Except as provided in paragraph 
(a)(2) of this section, a purchase of an asset by a member bank from an 
affiliate must be valued initially at the total amount of consideration 
given (including liabilities assumed) by the member bank in exchange 
for the asset. The value of the covered transaction after the purchase 
may be reduced to reflect amortization or depreciation of the asset, to 
the extent that such reductions are consistent with GAAP.
    (2) Exceptions. (i) Purchase of an extension of credit to an 
affiliate. A purchase from an affiliate of an extension of credit to an 
affiliate must be valued in accordance with Sec.  223.21, unless the 
note or obligation evidencing the extension of credit is a security 
issued by an affiliate (in which case the transaction must be valued in 
accordance with Sec.  223.23).
    (ii) Purchase of a security issued by an affiliate. A purchase from 
an affiliate of a security issued by an affiliate must be valued in 
accordance with Sec.  223.23.
    (iii) Transfer of a subsidiary. A transfer to a member bank of 
securities issued by an affiliate that is treated as a purchase of 
assets from an affiliate under Sec.  223.31 must be valued in 
accordance with paragraph (b) of Sec.  223.31.
    (iv) Purchase of a line of credit. A purchase from an affiliate of 
a line of credit, revolving credit facility, or other similar credit 
arrangement for a nonaffiliate must be valued initially at the total 
amount of consideration given by the member bank in exchange for the 
asset plus any additional amount that the member bank could be required 
to provide to the borrower under the terms of the credit arrangement.
    (b) Timing. (1) In general. A purchase of an asset from an 
affiliate remains a covered transaction for a member bank for as long 
as the member bank holds the asset.
    (2) Asset purchases by a member bank from a nonaffiliate in 
contemplation of the nonaffiliate becoming an affiliate of the member 
bank. If a member bank purchases an asset from a nonaffiliate in 
contemplation of the nonaffiliate becoming an affiliate of the member 
bank, the asset purchase becomes a covered transaction at the time that 
the nonaffiliate becomes an affiliate of the member bank. In addition, 
the member bank must ensure that the aggregate amount of the member 
bank's covered transactions (including any such transaction with the 
nonaffiliate) would not exceed the quantitative limits of Sec.  223.11 
or 223.12 at the time the nonaffiliate becomes an affiliate.
    (c) Examples. The following are examples of how to value a member 
bank's purchase of an asset from an affiliate.
    (1) Cash purchase of assets. A member bank purchases a pool of 
loans from an affiliate for $10 million. The member bank initially must 
value the covered transaction at $10 million. Going forward, if the 
borrowers repay $6 million of the principal amount of the loans, the 
member bank may value the covered transaction at $4 million.
    (2) Purchase of assets through an assumption of liabilities. An 
affiliate of a member bank contributes real property with a fair market 
value of $200,000 to the member bank. The member bank pays the 
affiliate no cash for the property, but assumes a $50,000 mortgage on 
the property. The member bank has engaged in a covered transaction with 
the affiliate and initially must value the transaction at $50,000. 
Going forward, if the member bank retains the real property but pays 
off the mortgage, the member bank must continue to value the covered 
transaction at $50,000. If the member bank, however, sells the real 
property, the transaction ceases to be a covered transaction at the 
time of the sale (regardless of the status of the mortgage).


Sec.  223.23  What valuation and timing principles apply to purchases 
of and investments in securities issued by an affiliate?

    (a) Valuation. (1) In general. Except as provided in paragraph (b) 
of Sec.  223.32 with respect to financial subsidiaries, a member bank's 
purchase of or investment in a security issued by an affiliate must be 
valued at the greater of:
    (i) The total amount of consideration given (including liabilities 
assumed) by the member bank in exchange for the security, reduced to 
reflect amortization of the security to the extent consistent with 
GAAP; or
    (ii) The carrying value of the security.
    (2) Examples. The following are examples of how to value a member 
bank's purchase of or investment in securities issued by an affiliate 
(other than a financial subsidiary of the member bank).
    (i) Purchase of the debt securities of an affiliate. The parent 
holding company of a member bank owns 100 percent of the shares of a 
mortgage company. The member bank purchases debt securities issued by 
the mortgage company for $600. The initial carrying value of the 
securities is $600. The member bank initially must value the investment 
at $600.
    (ii) Purchase of the shares of an affiliate. The parent holding 
company of a member bank owns 51 percent of the shares of a mortgage 
company. The member bank purchases an additional 30 percent of the 
shares of the mortgage company from a third party for $100. The initial 
carrying value of the shares is $100. The member bank initially must 
value the investment at $100. Going forward, if the member bank's 
carrying value of the shares declines to $40, the member bank must 
continue to value the investment at $100.
    (iii) Contribution of the shares of an affiliate. The parent 
holding company of a member bank owns 100 percent of the shares of a 
mortgage company and contributes 30 percent of the shares to the member 
bank. The member bank gives no consideration in exchange for the 
shares. If the initial carrying value of the shares is $300, then the 
member bank initially must value the investment at $300. Going forward, 
if the member bank's carrying value of the shares increases to $500, 
the member bank must value the investment at $500.

[[Page 76612]]

    (b) Timing. (1) In general. A purchase of or investment in a 
security issued by an affiliate remains a covered transaction for a 
member bank for as long as the member bank holds the security.
    (2) A member bank's purchase of or investment in a security issued 
by a nonaffiliate that becomes an affiliate of the member bank. A 
member bank's purchase of or investment in a security issued by a 
nonaffiliate that becomes an affiliate of the member bank must be 
treated according to the same transition rules that apply to credit 
transactions described in paragraph (b)(2) of Sec.  223.21.


Sec.  223.24  What valuation principles apply to extensions of credit 
secured by affiliate securities?

    (a) Valuation of extensions of credit secured exclusively by 
affiliate securities. An extension of credit by a member bank to a 
nonaffiliate secured exclusively by securities issued by an affiliate 
of the member bank must be valued at the lesser of:
    (1) The total value of the extension of credit; or
    (2) The fair market value of the securities issued by an affiliate 
that are pledged as collateral, if the member bank verifies that such 
securities meet the market quotation standard contained in paragraph 
(e) of Sec.  223.42 or the standards set forth in paragraphs (f)(1) and 
(5) of Sec.  223.42.
    (b) Valuation of extensions of credit secured by affiliate 
securities and other collateral. An extension of credit by a member 
bank to a nonaffiliate secured in part by securities issued by an 
affiliate of the member bank and in part by nonaffiliate collateral 
must be valued at the lesser of:
    (1) The total value of the extension of credit less the fair market 
value of the nonaffiliate collateral; or
    (2) The fair market value of the securities issued by an affiliate 
that are pledged as collateral, if the member bank verifies that such 
securities meet the market quotation standard contained in paragraph 
(e) of Sec.  223.42 or the standards set forth in paragraphs (f)(1) and 
(5) of Sec.  223.42.
    (c) Exclusion of eligible affiliated mutual fund securities. (1) 
The exclusion. Eligible affiliated mutual fund securities are not 
considered to be securities issued by an affiliate, and are instead 
considered to be nonaffiliate collateral, for purposes of paragraphs 
(a) and (b) of this section, unless the member bank knows or has reason 
to know that the proceeds of the extension of credit will be used to 
purchase the eligible affiliated mutual fund securities collateral or 
will otherwise be used for the benefit of or transferred to an 
affiliate of the member bank.
    (2) Definition. ``Eligible affiliated mutual fund securities'' with 
respect to a member bank are securities issued by an affiliate of the 
member bank that is an open-end investment company registered with the 
Securities and Exchange Commission under the Investment Company Act of 
1940 (15 U.S.C. 80a-1 et seq.), if:
    (i) The securities issued by the investment company:
    (A) Meet the market quotation standard contained in paragraph (e) 
of Sec.  223.42;
    (B) Meet the standards set forth in paragraphs (f)(1) and (5) of 
Sec.  223.42; or
    (C) Have closing prices that are made public through a mutual fund 
``supermarket'' website maintained by an unaffiliated securities 
broker-dealer or mutual fund distributor; and
    (ii) The member bank and its affiliates do not own or control in 
the aggregate more than 5 percent of any class of voting securities or 
of the equity capital of the investment company (excluding securities 
held by the member bank or an affiliate in good faith in a fiduciary 
capacity, unless the member bank or affiliate holds the securities for 
the benefit of the member bank or affiliate, or the shareholders, 
employees, or subsidiaries of the member bank or affiliate).
    (3) Example. A member bank proposes to lend $100 to a nonaffiliate 
secured exclusively by eligible affiliated mutual fund securities. The 
member bank knows that the nonaffiliate intends to use all the loan 
proceeds to purchase the eligible affiliated mutual fund securities 
that would serve as collateral for the loan. Under the attribution rule 
in Sec.  223.16, the member bank must treat the loan to the 
nonaffiliate as a loan to an affiliate, and, because securities issued 
by an affiliate are ineligible collateral under Sec.  223.14, the loan 
would not be in compliance with Sec.  223.14.

Subpart D--Other Requirements Under Section 23A


Sec.  223.31  How does section 23A apply to a member bank's acquisition 
of an affiliate that becomes an operating subsidiary of the member bank 
after the acquisition?

    (a) Certain acquisitions by a member bank of securities issued by 
an affiliate are treated as a purchase of assets from an affiliate. A 
member bank's acquisition of a security issued by a company that was an 
affiliate of the member bank before the acquisition is treated as a 
purchase of assets from an affiliate, if:
    (1) As a result of the transaction, the company becomes an 
operating subsidiary of the member bank; and
    (2) The company has liabilities, or the member bank gives cash or 
any other consideration in exchange for the security.
    (b) Valuation. (1) Initial valuation. A transaction described in 
paragraph (a) of this section must be valued initially at the greater 
of:
    (i) The sum of:
    (A) The total amount of consideration given by the member bank in 
exchange for the security; and
    (B) The total liabilities of the company whose security has been 
acquired by the member bank, as of the time of the acquisition; or
    (ii) The total value of all covered transactions (as computed under 
this part) acquired by the member bank as a result of the security 
acquisition.
    (2) Ongoing valuation. The value of a transaction described in 
paragraph (a) of this section may be reduced after the initial transfer 
to reflect:
    (i) Amortization or depreciation of the assets of the transferred 
company, to the extent that such reductions are consistent with GAAP; 
and
    (ii) Sales of the assets of the transferred company.
    (c) Valuation example. The parent holding company of a member bank 
contributes between 25 and 100 percent of the voting shares of a 
mortgage company to the member bank. The parent holding company retains 
no shares of the mortgage company. The member bank gives no 
consideration in exchange for the transferred shares. The mortgage 
company has total assets of $300,000 and total liabilities of $100,000. 
The mortgage company's assets do not include any loans to an affiliate 
of the member bank or any other asset that would represent a separate 
covered transaction for the member bank upon consummation of the share 
transfer. As a result of the transaction, the mortgage company becomes 
an operating subsidiary of the member bank. The transaction is treated 
as a purchase of the assets of the mortgage company by the member bank 
from an affiliate under paragraph (a) of this section. The member bank 
initially must value the transaction at $100,000, the total amount of 
the liabilities of the mortgage company. Going forward, if the member 
bank pays off the liabilities, the member bank must continue to value 
the covered transaction at $100,000. If the member bank, however, sells 
$15,000 of the transferred assets of the mortgage company or if $15,000 
of the transferred assets amortize, the

[[Page 76613]]

member bank may value the covered transaction at $85,000.
    (d) Exemption for step transactions. A transaction described in 
paragraph (a) of this section is exempt from the requirements of this 
regulation (other than the safety and soundness requirement of Sec.  
223.13 and the market terms requirement of Sec.  223.51) if:
    (1) The member bank acquires the securities issued by the 
transferred company within one business day (or such longer period, up 
to three months, as may be permitted by the member bank's appropriate 
Federal banking agency) after the company becomes an affiliate of the 
member bank;
    (2) The member bank acquires all the securities of the transferred 
company that were transferred in connection with the transaction that 
made the company an affiliate of the member bank;
    (3) The business and financial condition (including the asset 
quality and liabilities) of the transferred company does not materially 
change from the time the company becomes an affiliate of the member 
bank and the time the member bank acquires the securities issued by the 
company; and
    (4) At or before the time that the transferred company becomes an 
affiliate of the member bank, the member bank notifies its appropriate 
Federal banking agency and the Board of the member bank's intent to 
acquire the company.
    (e) Example of step transaction. A bank holding company acquires 
100 percent of the shares of an unaffiliated leasing company. At that 
time, the subsidiary member bank of the holding company notifies its 
appropriate Federal banking agency and the Board of its intent to 
acquire the leasing company from its holding company. On the day after 
consummation of the acquisition, the holding company transfers all of 
the shares of the leasing company to the member bank. No material 
change in the business or financial condition of the leasing company 
occurs between the time of the holding company's acquisition and the 
member bank's acquisition. The leasing company has liabilities. The 
leasing company becomes an operating subsidiary of the member bank at 
the time of the transfer. This transfer by the holding company to the 
member bank, although deemed an asset purchase by the member bank from 
an affiliate under paragraph (a) of this section, would qualify for the 
exemption in paragraph (d) of this section.


Sec.  223.32  What rules apply to financial subsidiaries of a member 
bank?

    (a) Exemption from the 10 percent limit for covered transactions 
between a member bank and a single financial subsidiary. The 10 percent 
quantitative limit contained in Sec.  223.11 does not apply with 
respect to covered transactions between a member bank and a financial 
subsidiary of the member bank. The 20 percent quantitative limit 
contained in Sec.  223.12 does apply to such transactions.
    (b) Valuation of purchases of or investments in the securities of a 
financial subsidiary. (1) General rule. A member bank's purchase of or 
investment in a security issued by a financial subsidiary of the member 
bank must be valued at the greater of:
    (i) The total amount of consideration given (including liabilities 
assumed) by the member bank in exchange for the security, reduced to 
reflect amortization of the security to the extent consistent with 
GAAP; and
    (ii) The carrying value of the security (adjusted so as not to 
reflect the member bank's pro rata portion of any earnings retained or 
losses incurred by the financial subsidiary after the member bank's 
acquisition of the security).
    (2) Carrying value of an investment in a consolidated financial 
subsidiary. If a financial subsidiary is consolidated with its parent 
member bank under GAAP, the carrying value of the member bank's 
investment in securities issued by the financial subsidiary shall be 
equal to the carrying value of the securities on parent-only financial 
statements of the member bank, determined in accordance with GAAP 
(adjusted so as not to reflect the member bank's pro rata portion of 
any earnings retained or losses incurred by the financial subsidiary 
after the member bank's acquisition of the securities).
    (3) Examples of the valuation of purchases of and investments in 
the securities of a financial subsidiary. The following are examples of 
how a member bank must value its purchase of or investment in 
securities issued by a financial subsidiary of the member bank. Each 
example involves a securities underwriter that becomes a financial 
subsidiary of the member bank after the transactions described below.
    (i) Initial valuation. (A) Direct acquisition by a member bank. A 
member bank pays $500 to acquire 100 percent of the shares of a 
securities underwriter. The initial carrying value of the shares on the 
member bank's parent-only GAAP financial statements is $500. The member 
bank initially must value the investment at $500.
    (B) Contribution of a financial subsidiary to a member bank. The 
parent holding company of a member bank acquires 100 percent of the 
shares of a securities underwriter in a transaction valued at $500, and 
immediately contributes the shares to the member bank. The member bank 
gives no consideration in exchange for the shares. The member bank 
initially must value the investment at the carrying value of the shares 
on the member bank's parent-only GAAP financial statements. Under GAAP, 
the member bank's initial carrying value of the shares would be $500.
    (ii) Carrying value not adjusted for earnings and losses of the 
financial subsidiary. A member bank and its parent holding company 
engage in the transaction described in paragraph (b)(3)(i)(B) of this 
section, and the member bank initially values the investment at $500. 
In the following year, the securities underwriter earns $25 in profit, 
which is added to its retained earnings. The member bank's carrying 
value of the shares of the underwriter is not adjusted for purposes of 
this part, and the member bank must continue to value the investment at 
$500. If, however, the member bank contributes $100 of additional 
capital to the securities underwriter, the member bank must value the 
aggregate investment at $600.
    (c) Treatment of an affiliate's investments in, and extensions of 
credit to, a financial subsidiary of a member bank. (1) Investments. 
Any purchase of, or investment in, the securities of a financial 
subsidiary of a member bank by an affiliate of the member bank is 
treated as a purchase of or investment in such securities by the member 
bank.
    (2) Extensions of credit that are treated as regulatory capital of 
the financial subsidiary. Any extension of credit to a financial 
subsidiary of a member bank by an affiliate of the member bank is 
treated as an extension of credit by the member bank to the financial 
subsidiary if the extension of credit is treated as capital of the 
financial subsidiary under any Federal or State law, regulation, or 
interpretation applicable to the subsidiary.
    (3) Other extensions of credit. Any other extension of credit to a 
financial subsidiary of a member bank by an affiliate of the member 
bank will be treated as an extension of credit by the member bank to 
the financial subsidiary, if the Board determines, by regulation or 
order, that such treatment is necessary or appropriate to prevent 
evasions of the Federal Reserve Act or the Gramm-Leach-Bliley Act.

[[Page 76614]]

Sec.  223.33  What rules apply to derivative transactions?

    (a) Market terms requirement. Derivative transactions between a 
member bank and its affiliates (other than depository institutions) are 
subject to the market terms requirement of Sec.  223.51.
    (b) Policies and procedures. A member bank 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 at any 
one time from the member bank's derivative transactions with each 
affiliate and all affiliates in the aggregate (through, among other 
things, imposing appropriate credit limits, mark-to-market 
requirements, and collateral requirements); and
    (2) Ensuring that the member bank's derivative transactions with 
affiliates comply with the market terms requirement of Sec.  223.51.
    (c) Credit derivatives. A credit derivative between a member bank 
and a nonaffiliate in which the member bank provides credit protection 
to the nonaffiliate with respect to an obligation of an affiliate of 
the member bank is a guarantee by a member bank on behalf of an 
affiliate for purposes of this regulation. Such derivatives would 
include:
    (1) An agreement under which the member bank, in exchange for a 
fee, agrees to compensate the nonaffiliate for any default of the 
underlying obligation of the affiliate; and
    (2) An agreement under which the member bank, in exchange for 
payments based on the total return of the underlying obligation of the 
affiliate, agrees to pay the nonaffiliate a spread over funding costs 
plus any depreciation in the value of the underlying obligation of the 
affiliate.

Subpart E--Exemptions from the Provisions of Section 23A


Sec.  223.41  What covered transactions are exempt from the 
quantitative limits and collateral requirements?

    The following transactions are not subject to the quantitative 
limits of Sec. Sec.  223.11 and 223.12 or the collateral requirements 
of Sec.  223.14. The transactions are, however, subject to the safety 
and soundness requirement of Sec.  223.13 and the prohibition on the 
purchase of a low-quality asset of Sec.  223.15.
    (a) Parent institution/subsidiary institution transactions. 
Transactions with a depository institution if the member bank controls 
80 percent or more of the voting securities of the depository 
institution or the depository institution controls 80 percent or more 
of the voting securities of the member bank.
    (b) Transactions between a member bank and a depository institution 
owned by the same holding company. Transactions with a depository 
institution if the same company controls 80 percent or more of the 
voting securities of the member bank and the depository institution.
    (c) Certain loan purchases from an affiliated depository 
institution. Purchasing a loan on a nonrecourse basis from an 
affiliated depository institution.
    (d) Internal corporate reorganization transactions. Purchasing 
assets from an affiliate (including in connection with a transfer of 
securities issued by an affiliate to a member bank described in 
paragraph (a) of Sec.  223.31), if:
    (1) The asset purchase is part of an internal corporate 
reorganization of a holding company and involves the transfer of all or 
substantially all of the shares or assets of an affiliate or of a 
division or department of an affiliate;
    (2) The member bank provides its appropriate Federal banking agency 
and the Board with written notice of the transaction before 
consummation, including a description of the primary business 
activities of the affiliate and an indication of the proposed date of 
the asset purchase;
    (3) The member bank's top-tier holding company commits to its 
appropriate Federal banking agency and the Board before consummation 
either:
    (i) To make quarterly cash contributions to the member bank, for a 
two-year period following the member bank's purchase, equal to the book 
value plus any write-downs taken by the member bank, of any transferred 
assets that have become low-quality assets during the quarter; or
    (ii) To repurchase, on a quarterly basis for a two-year period 
following the member bank's purchase, at a price equal to the book 
value plus any write-downs taken by the member bank, any transferred 
assets that have become low-quality assets during the quarter;
    (4) The member bank's top-tier holding company complies with the 
commitment made under paragraph (d)(3) of this section;
    (5) A majority of the member bank's directors reviews and approves 
the transaction before consummation;
    (6) The value of the covered transaction (as computed under this 
part), when aggregated with the value of any other covered transactions 
(as computed under this part) engaged in by the member bank under this 
exemption during the preceding 12 calendar months, represents less than 
10 percent of the member bank's capital stock and surplus (or such 
higher amount, up to 25 percent of the member bank's capital stock and 
surplus, as may be permitted by the member bank's appropriate Federal 
banking agency after conducting a review of the member bank's financial 
condition and the quality of the assets transferred to the member 
bank); and
    (7) The holding company and all its subsidiary member banks and 
other subsidiary depository institutions are well capitalized and well 
managed and would remain well capitalized upon consummation of the 
transaction.


Sec.  223.42  What covered transactions are exempt from the 
quantitative limits, collateral requirements, and low-quality asset 
prohibition?

    The following transactions are not subject to the quantitative 
limits of Sec. Sec.  223.11 and 223.12, the collateral requirements of 
Sec.  223.14, or the prohibition on the purchase of a low-quality asset 
of Sec.  223.15. The transactions are, however, subject to the safety 
and soundness requirement of Sec.  223.13.
    (a) Making correspondent banking deposits. Making a deposit in an 
affiliated depository institution (as defined in section 3 of the 
Federal Deposit Insurance Act (12 U.S.C. 1813)) or affiliated foreign 
bank that represents an ongoing, working balance maintained in the 
ordinary course of correspondent business.
    (b) Giving credit for uncollected items. Giving immediate credit to 
an affiliate for uncollected items received in the ordinary course of 
business.
    (c) Transactions secured by cash or U.S. government securities.
    (1) In general. Engaging in a credit transaction with an affiliate 
to the extent that the transaction is and remains secured by:
    (i) Obligations of the United States or its agencies;
    (ii) Obligations fully guaranteed by the United States or its 
agencies as to principal and interest; or
    (iii) A segregated, earmarked deposit account with the member bank 
that is for the sole purpose of securing credit transactions between 
the member bank and its affiliates and is identified as such.
    (2) Example. A member bank makes a $100 non-amortizing term loan to 
an

[[Page 76615]]

affiliate secured by U.S. Treasury securities with a market value of 
$50 and real estate with a market value of $75. The value of the 
covered transaction is $50. If the market value of the U.S. Treasury 
securities falls to $45 during the life of the loan, the value of the 
covered transaction would increase to $55.
    (d) Purchasing securities of a servicing affiliate. Purchasing a 
security issued by any company engaged solely in providing services 
described in section 4(c)(1) of the Bank Holding Company Act (12 U.S.C. 
1843(c)(1)).
    (e) Purchasing certain liquid assets. Purchasing an asset having a 
readily identifiable and publicly available market quotation and 
purchased at or below the asset's current market quotation. An asset 
has a readily identifiable and publicly available market quotation if 
the asset's price is quoted routinely in a widely disseminated 
publication that is readily available to the general public.
    (f) Purchasing certain marketable securities. Purchasing a security 
from a securities affiliate, if:
    (1) The security has a ``ready market,'' as defined in 17 CFR 
240.15c3-1(c)(11)(i);
    (2) The security is eligible for a State member bank to purchase 
directly, subject to the same terms and conditions that govern the 
investment activities of a State member bank, and the member bank 
records the transaction as a purchase of a security for purposes of its 
Call Report, consistent with the requirements for a State member bank;
    (3) The security is not a low-quality asset;
    (4) The member bank does not purchase the security during an 
underwriting, or within 30 days of an underwriting, if an affiliate is 
an underwriter of the security, unless the security is purchased as 
part of an issue of obligations of, or obligations fully guaranteed as 
to principal and interest by, the United States or its agencies;
    (5) The security's price is quoted routinely on an unaffiliated 
electronic service that provides indicative data from real-time 
financial networks, provided that:
    (i) The price paid by the member bank is at or below the current 
market quotation for the security; and
    (ii) The size of the transaction executed by the member bank does 
not cast material doubt on the appropriateness of relying on the 
current market quotation for the security; and
    (6) The member bank maintains, for a period of two years, records 
and supporting information that are sufficient to enable the 
appropriate Federal banking agency to ensure the member bank's 
compliance with the terms of this exemption.
    (g) Purchasing municipal securities. Purchasing a municipal 
security from a securities affiliate if:
    (1) The security is rated by a nationally recognized statistical 
rating organization or is part of an issue of securities that does not 
exceed $25 million;
    (2) The security is eligible for purchase by a State member bank, 
subject to the same terms and conditions that govern the investment 
activities of a State member bank, and the member bank records the 
transaction as a purchase of a security for purposes of its Call 
Report, consistent with the requirements for a State member bank; and
    (3)(i) The security's price is quoted routinely on an unaffiliated 
electronic service that provides indicative data from real-time 
financial networks, provided that:
    (A) The price paid by the member bank is at or below the current 
market quotation for the security; and
    (B) The size of the transaction executed by the member bank does 
not cast material doubt on the appropriateness of relying on the 
current market quotation for the security; or
    (ii) The price paid for the security can be verified by reference 
to two or more actual, current price quotes from unaffiliated broker-
dealers on the exact security to be purchased or a security comparable 
to the security to be purchased, where:
    (A) The price quotes obtained from the unaffiliated broker-dealers 
are based on a transaction similar in size to the transaction that is 
actually executed; and
    (B) The price paid is no higher than the average of the price 
quotes; or
    (iii) The price paid for the security can be verified by reference 
to the written summary provided by the syndicate manager to syndicate 
members that discloses the aggregate par values and prices of all bonds 
sold from the syndicate account, if the member bank:
    (A) Purchases the municipal security during the underwriting period 
at a price that is at or below that indicated in the summary; and
    (B) Obtains a copy of the summary from its securities affiliate and 
retains the summary for three years.
    (h) Purchasing an extension of credit subject to a repurchase 
agreement. Purchasing from an affiliate an extension of credit that was 
originated by the member bank and sold to the affiliate subject to a 
repurchase agreement or with recourse.
    (i) Asset purchases by a newly formed member bank. The purchase of 
an asset from an affiliate by a newly formed member bank, if the 
appropriate Federal banking agency for the member bank has approved the 
asset purchase in writing in connection with its review of the 
formation of the member bank.
    (j) Transactions approved under the Bank Merger Act. Any merger or 
consolidation between a member bank and an affiliated depository 
institution or U.S. branch or agency of a foreign bank, or any 
acquisition of assets or assumption of deposit liabilities by a member 
bank from an affiliated depository institution or U.S. branch or agency 
of a foreign bank, if the transaction has been approved by the 
responsible Federal banking agency pursuant to the Bank Merger Act (12 
U.S.C. 1828(c)).
    (k) Purchasing an extension of credit from an affiliate. Purchasing 
from an affiliate, on a nonrecourse basis, an extension of credit, if:
    (1) The extension of credit was originated by the affiliate;
    (2) The member bank makes an independent evaluation of the 
creditworthiness of the borrower before the affiliate makes or commits 
to make the extension of credit;
    (3) The member bank commits to purchase the extension of credit 
before the affiliate makes or commits to make the extension of credit;
    (4) The member bank does not make a blanket advance commitment to 
purchase extensions of credit from the affiliate; and
    (5) The dollar amount of the extension of credit, when aggregated 
with the dollar amount of all other extensions of credit purchased from 
the affiliate during the preceding 12 calendar months by the member 
bank and its depository institution affiliates, does not represent more 
than 50 percent (or such lower percent as is imposed by the member 
bank's appropriate Federal banking agency) of the dollar amount of 
extensions of credit originated by the affiliate during the preceding 
12 calendar months.
    (l) Intraday extensions of credit.
    (1) In general. An intraday extension of credit to an affiliate, if 
the member bank:
    (i) Has established and maintains policies and procedures 
reasonably designed to manage the credit exposure arising from the 
member bank's intraday extensions of credit to affiliates in a safe

[[Page 76616]]

and sound manner, including policies and procedures for:
    (A) Monitoring and controlling the credit exposure arising at any 
one time from the member bank's intraday extensions of credit to each 
affiliate and all affiliates in the aggregate; and
    (B) Ensuring that any intraday extension of credit by the member 
bank to an affiliate complies with the market terms requirement of 
Sec.  223.51;
    (ii) Has no reason to believe that the affiliate will have 
difficulty repaying the extension of credit in accordance with its 
terms; and
    (iii) Ceases to treat any such extension of credit (regardless of 
jurisdiction) as an intraday extension of credit at the end of the 
member bank's business day in the United States.
    (2) Definition. Intraday extension of credit by a member bank to an 
affiliate means an extension of credit by a member bank to an affiliate 
that the member bank expects to be repaid, sold, or terminated, or to 
qualify for a complete exemption under this regulation, by the end of 
its business day in the United States.
    (m) Riskless principal transactions. Purchasing a security from a 
securities affiliate of the member bank if:
    (1) The member bank or the securities affiliate is acting 
exclusively as a riskless principal in the transaction; and
    (2) The security purchased is not issued, underwritten, or sold as 
principal (other than as riskless principal) by any affiliate of the 
member bank.


Sec.  223.43  What are the standards under which the Board may grant 
additional exemptions from the requirements of section 23A?

    (a) The standards. The Board may, at its discretion, by regulation 
or order, exempt transactions or relationships from the requirements of 
section 23A and subparts B, C, and D of this part if it finds such 
exemptions to be in the public interest and consistent with the 
purposes of section 23A.
    (b) Procedure. A member bank may request an exemption from the 
requirements of section 23A and subparts B, C, and D of this part by 
submitting a written request to the General Counsel of the Board. Such 
a request must:
    (1) Describe in detail the transaction or relationship for which 
the member bank seeks exemption;
    (2) Explain why the Board should exempt the transaction or 
relationship; and
    (3) Explain how the exemption would be in the public interest and 
consistent with the purposes of section 23A.

Subpart F--General Provisions of Section 23B


Sec.  223.51  What is the market terms requirement of section 23B?

    A member bank may not engage in a transaction described in Sec.  
223.52 unless the transaction is:
    (a) On terms and under circumstances, including credit standards, 
that are substantially the same, or at least as favorable to the member 
bank, as those prevailing at the time for comparable transactions with 
or involving nonaffiliates; or
    (b) In the absence of comparable transactions, on terms and under 
circumstances, including credit standards, that in good faith would be 
offered to, or would apply to, nonaffiliates.


Sec.  223.52  What transactions with affiliates or others must comply 
with section 23B's market terms requirement?

    (a) The market terms requirement of Sec.  223.51 applies to the 
following transactions:
    (1) Any covered transaction with an affiliate, unless the 
transaction is exempt under paragraphs (a) through (c) of Sec.  223.41 
or paragraphs (a) through (e) or (h) through (j) of Sec.  223.42;
    (2) The sale of a security or other asset to an affiliate, 
including an asset subject to an agreement to repurchase;
    (3) The payment of money or the furnishing of a service to an 
affiliate under contract, lease, or otherwise;
    (4) Any transaction in which an affiliate acts as an agent or 
broker or receives a fee for its services to the member bank or to any 
other person; and
    (5) Any transaction or series of transactions with a nonaffiliate, 
if an affiliate:
    (i) Has a financial interest in the nonaffiliate; or
    (ii) Is a participant in the transaction or series of transactions.
    (b) For the purpose of this section, any transaction by a member 
bank with any person will be deemed to be a transaction with an 
affiliate of the member bank if any of the proceeds of the transaction 
are used for the benefit of, or transferred to, the affiliate.


Sec.  223.53  What asset purchases are prohibited by section 23B?

    (a) Fiduciary purchases of assets from an affiliate. A member bank 
may not purchase as fiduciary any security or other asset from any 
affiliate unless the purchase is permitted:
    (1) Under the instrument creating the fiduciary relationship;
    (2) By court order; or
    (3) By law of the jurisdiction governing the fiduciary 
relationship.
    (b) Purchase of a security underwritten by an affiliate. (1) A 
member bank, whether acting as principal or fiduciary, may not 
knowingly purchase or otherwise acquire, during the existence of any 
underwriting or selling syndicate, any security if a principal 
underwriter of that security is an affiliate of the member bank.
    (2) Paragraph (b)(1) of this section does not apply if the purchase 
or acquisition of the security has been approved, before the security 
is initially offered for sale to the public, by a majority of the 
directors of the member bank based on a determination that the purchase 
is a sound investment for the member bank, or for the person on whose 
behalf the member bank is acting as fiduciary, as the case may be, 
irrespective of the fact that an affiliate of the member bank is a 
principal underwriter of the security.
    (3) The approval requirement of paragraph (b)(2) of this section 
may be met if:
    (i) A majority of the directors of the member bank approves 
standards for the member bank's acquisitions of securities described in 
paragraph (b)(1) of this section, based on the determination set forth 
in paragraph (b)(2) of this section;
    (ii) Each acquisition described in paragraph (b)(1) of this section 
meets the standards; and
    (iii) A majority of the directors of the member bank periodically 
reviews acquisitions described in paragraph (b)(1) of this section to 
ensure that they meet the standards and periodically reviews the 
standards to ensure that they continue to meet the criterion set forth 
in paragraph (b)(2) of this section.
    (4) A U.S. branch, agency, or commercial lending company of a 
foreign bank may comply with paragraphs (b)(2) and (b)(3) of this 
section by obtaining the approvals and reviews required by paragraphs 
(b)(2) and (b)(3) from either:
    (i) A majority of the directors of the foreign bank; or
    (ii) A majority of the senior executive officers of the foreign 
bank.
    (c) Special definitions. For purposes of this section:
    (1) ``Principal underwriter'' means any underwriter who, in 
connection with a primary distribution of securities:
    (i) Is in privity of contract with the issuer or an affiliated 
person of the issuer;
    (ii) Acting alone or in concert with one or more other persons, 
initiates or directs the formation of an underwriting syndicate; or

[[Page 76617]]

    (iii) Is allowed a rate of gross commission, spread, or other 
profit greater than the rate allowed another underwriter participating 
in the distribution.
    (2) ``Security'' has the same meaning as in section 3(a)(10) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(10)).


Sec.  223.54  What advertisements and statements are prohibited by 
section 23B?

    (a) In general. A member bank and its affiliates may not publish 
any advertisement or enter into any agreement stating or suggesting 
that the member bank will in any way be responsible for the obligations 
of its affiliates.
    (b) Guarantees, acceptances, letters of credit, and cross-affiliate 
netting arrangements subject to section 23A. Paragraph (a) of this 
section does not prohibit a member bank from:
    (1) Issuing a guarantee, acceptance, or letter of credit on behalf 
of an affiliate, confirming a letter of credit issued by an affiliate, 
or entering into a cross-affiliate netting arrangement, to the extent 
such transaction satisfies the quantitative limits of Sec. Sec.  223.11 
and 223.12 and the collateral requirements of Sec.  223.14, and is 
otherwise permitted under this regulation; or
    (2) Making reference to such a guarantee, acceptance, letter of 
credit, or cross-affiliate netting arrangement if otherwise required by 
law.


Sec.  223.55  What are the standards under which the Board may grant 
exemptions from the requirements of section 23B?

    The Board may prescribe regulations to exempt transactions or 
relationships from the requirements of section 23B and subpart F of 
this part if it finds such exemptions to be in the public interest and 
consistent with the purposes of section 23B.

Subpart G--Application of Sections 23A and 23B to U.S. Branches and 
Agencies of Foreign Banks


Sec.  223.61  How do sections 23A and 23B apply to U.S. branches and 
agencies of foreign banks?

    (a) Applicability of sections 23A and 23B to foreign banks engaged 
in underwriting insurance, underwriting or dealing in securities, 
merchant banking, or insurance company investment in the United States. 
Except as provided in this subpart, sections 23A and 23B of the Federal 
Reserve Act and the provisions of this regulation apply to each U.S. 
branch, agency, or commercial lending company of a foreign bank in the 
same manner and to the same extent as if the branch, agency, or 
commercial lending company were a member bank.
    (b) Affiliate defined. For purposes of this subpart, any company 
that would be an affiliate of a U.S. branch, agency, or commercial 
lending company of a foreign bank if such branch, agency, or commercial 
lending company were a member bank is an affiliate of the branch, 
agency, or commercial lending company if the company also is:
    (1) Directly engaged in the United States in any of the following 
activities:
    (i) Insurance underwriting pursuant to section 4(k)(4)(B) of the 
Bank Holding Company Act (12 U.S.C. 1843(k)(4)(B));
    (ii) Securities underwriting, dealing, or market making pursuant to 
section 4(k)(4)(E) of the Bank Holding Company Act (12 U.S.C. 
1843(k)(4)(E));
    (iii) Merchant banking activities pursuant to section 4(k)(4)(H) of 
the Bank Holding Company Act (12 U.S.C. 1843(k)(4)(H)) (but only to the 
extent that the proceeds of the transaction are used for the purpose of 
funding the affiliate's merchant banking activities);
    (iv) Insurance company investment activities pursuant to section 
4(k)(4)(I) of the Bank Holding Company Act (12 U.S.C. 1843(k)(4)(I)); 
or
    (v) Any other activity designated by the Board;
    (2) A portfolio company (as defined in the merchant banking subpart 
of Regulation Y (12 CFR 225.177(c))) controlled by the foreign bank or 
an affiliate of the foreign bank or a company that would be an 
affiliate of the branch, agency, or commercial lending company of the 
foreign bank under paragraph (a)(9) of Sec.  223.2 if such branch, 
agency, or commercial lending company were a member bank; or
    (3) A subsidiary of an affiliate described in paragraph (b)(1) or 
(2) of this section.
    (c) Capital stock and surplus. For purposes of this subpart, the 
``capital stock and surplus'' of a U.S. branch, agency, or commercial 
lending company of a foreign bank will be determined by reference to 
the capital of the foreign bank as calculated under its home country 
capital standards.

Subpart H--Miscellaneous Interpretations


Sec.  223.71  How do sections 23A and 23B apply to transactions in 
which a member bank purchases from one affiliate an asset relating to 
another affiliate?

    (a) In general. In some situations in which a member bank purchases 
an asset from an affiliate, the asset purchase qualifies for an 
exemption under this regulation, but the member bank's resulting 
ownership of the purchased asset also represents a covered transaction 
(which may or may not qualify for an exemption under this part). In 
these situations, the transaction engaged in by the member bank would 
qualify as two different types of covered transaction. Although an 
asset purchase exemption may suffice to exempt the member bank's asset 
purchase from the first affiliate, the asset purchase exemption does 
not exempt the member bank's resulting covered transaction with the 
second affiliate. The exemptions subject to this interpretation include 
Sec. Sec.  223.31(e), 223.41(a) through (d), and 223.42(e), (f), (i), 
(j), (k), and (m).
    (b) Examples. (1) The (d)(6) exemption. A member bank purchases 
from Affiliate A securities issued by Affiliate B in a purchase that 
qualifies for the (d)(6) exemption in section 23A. The member bank's 
asset purchase from Affiliate A would be an exempt covered transaction 
under Sec.  223.42(e); but the member bank also would have acquired an 
investment in securities issued by Affiliate B, which would be a 
covered transaction between the member bank and Affiliate B under Sec.  
223.3(h)(2) that does not qualify for the (d)(6) exemption. The (d)(6) 
exemption, by its terms, only exempts asset purchases by a member bank 
from an affiliate; hence, the (d)(6) exemption cannot exempt a member 
bank's investment in securities issued by an affiliate (even if the 
securities would qualify for the (d)(6) exemption).
    (2) The sister-bank exemption. A member bank purchases from Sister-
Bank Affiliate A a loan to Affiliate B in a purchase that qualifies for 
the sister-bank exemption in section 23A. The member bank's asset 
purchase from Sister-Bank Affiliate A would be an exempt covered 
transaction under Sec.  223.41(b); but the member bank also would have 
acquired an extension of credit to Affiliate B, which would be a 
covered transaction between the member bank and Affiliate B under Sec.  
223.3(h)(1) that does not qualify for the sister-bank exemption. The 
sister-bank exemption, by its terms, only exempts transactions by a 
member bank with a sister-bank affiliate; hence, the sister-bank 
exemption cannot exempt a member bank's extension of credit to an 
affiliate that is not a sister bank (even if the extension of credit 
was purchased from a sister bank).

    By order of the Board of Governors of the Federal Reserve 
System, November 27, 2002.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 02-30634 Filed 12-11-02; 8:45 am]
BILLING CODE 6210-01-P