Equity Hedging: OCC Needs to Establish Policy on Publishing
Interpretive Decisions (16-AUG-01, GAO-01-945).
This report provides (1) information on the process the Office of
the Comptroller of the Currency (OCC) used to make its decision
to allow banks to acquire equities and (2) discusses whether the
decision was consistent with the way in which OCC generally makes
and communicates its decisions. The report also contains a legal
decision as to whether national banks are authorized to purchase
equity securities to hedge their equity derivative transactions
under existing law. OCC has discretion to determine how it will
convey its decisions, but the criteria it uses to determine when
and whether to publish its decisions are unclear. For the equity
hedging decision, OCC first determined that banks may hold
equities to hedge equity derivative transactions under the
National Bank Act. OCC then decided that the requesting banks
would not be allowed to engage in the activity of equity hedging
without first obtaining supervisory staff approval of their
activities and risk management systems. This enabled OCC to
ensure that each bank had the necessary risk management systems
in place to monitor risks and prevent speculation. OCC did not
publish its interpretation until after a congressional inquiry in
September 2000 questioning its decision. In making decisions
interpreting the National Bank Act, OCC has published written
interpretive letters. OCC has been criticized for using
supervisory approval as a way to avoid public scrutiny of its
decision and has left itself open to questions not only about the
process used in this case, but also about the criteria it uses to
decide when to publish its interpretive decisions. Helping
Congress and other banking regulators affected by OCC's decisions
understand the criteria OCC uses to determine when and whether to
publish interpretive decisions could help mitigate concerns that
arise when OCC interprets federal banking laws that affect other
banking regulators and are considered controversial. GAO agrees
with OCC's conclusion that the four national banks have authority
under the National Bank Act to own equities to hedge their equity
derivative transactions. To support this conclusion, OCC first
determined that certain equity derivative transactions and
managing the risks of those transactions are a permissible
banking activity authorized by the National Bank Act. OCC next
found that owning equities to conduct these hedging activities is
not prohibited by the stock-related limitations contained in the
law. GAO concurs with OCC's conclusion that those limitations do
not prohibit the four banks from maintaining the stock hedges as
an incidental activity.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-01-945
ACCNO: A01617
TITLE: Equity Hedging: OCC Needs to Establish Policy on
Publishing Interpretive Decisions
DATE: 08/16/2001
SUBJECT: Hedging
National banks
Legal opinions
Regulatory agencies
Risk management
Derivative securities
Banking law
Decision making
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GAO-01-945
Report to the Honorable James A. Leach House of Representatives
United States General Accounting Office
GAO
August 2001 EQUITY HEDGING OCC Needs to Establish Policy on Publishing
Interpretive Decisions
GAO- 01- 945
Page i GAO- 01- 945 Equity Hedging Letter 1
Results in Brief 2 Background 3 OCC?s Process in Making Its Equity Hedging
Decision Is
Controversial 5 We Concur With OCC?s Legal Decision 15 Conclusions 20
Recommendations for Executive Action Agency Comments 22 Scope and
Methodology 22
Appendix I Equity Derivative Hedging 25
Appendix II Legal Analysis of OCC Equity Hedging Decision 28
Appendix III Comments From the Comptroller of the Currency 47
Tables
Table 1: Relevant Provisions of Section 24( Seventh) 16
Abbreviations
EIC examiner- in- charge FDIC Federal Deposit Insurance Corporation GLBA
Gramm- Leach- Bliley Act OCC Office of the Comptroller of the Currency VALIC
Variable Annuity Life Insurance Company Contents
Page 1 GAO- 01- 945 Equity Hedging
August 16, 2001 The Honorable James A. Leach House of Representatives
Dear Mr. Leach: This report responds to your request that we review the
Office of the Comptroller of the Currency?s (OCC) legal decision and the
process OCC used to allow national banks 1 to acquire equities to hedge the
risks arising from customer- driven equity derivative transactions. 2 Over
the last 10 years, a small number of large national and state banks have
become equity derivative dealers. Prior to OCC?s decision to allow national
banks to hedge their equity derivative transactions within the bank,
national banks had been hedging these transactions through nonbank
affiliates of holding companies. Rather than hedge in this manner, four
national banks sought OCC?s opinion on whether it was permissible to hedge
their equity derivative transactions by holding equities in the bank.
Section 24( Seventh) of the National Bank Act, 12 U. S. C. sect. 24( Seventh),
contains equity- related limitations and restrictions that generally
prohibit a national bank from purchasing equities for its own account. These
same limitations and restrictions also apply to state banks. 3 OCC
considered the permissibility of banks owning equities under the National
Bank Act and approved four national banks? requests, concluding that the
equity limitations in section 24( Seventh) of the National Bank Act do not
prohibit the purchase of equities for the purpose of hedging customer-
driven equity derivative transactions.
Because of your view on the equity ownership prohibitions contained in
section 24( Seventh), you questioned OCC?s decision, stating that allowing
banks to own equity in commercial companies is something that is not
1 National banks are banks that are federally chartered and regulated by
OCC. 2 Equities are stocks (ownership interest possessed by shareholders of
a corporation). In a letter to you (OCC interpretive Letter No. 892 at 1
(Sept. 8, 2000)), the Comptroller of the Currency described ?customer
driven? transactions as ?originated by customers for their valid and
independent business purposes.? The Comptroller also stated that the term
?equity derivative transactions? means ?transactions in which a portion of
the return (including interest, principal or payment streams) is linked to
the price of a particular equity security or to an index of such
securities.?
3 See footnotes 19 and 20.
United States General Accounting Office Washington, DC 20548
Page 2 GAO- 01- 945 Equity Hedging
sanctioned by law. You also questioned the way in which OCC made its
decision, noting that OCC appeared to have granted its approval to the
national banks in ?virtual secrecy,? or without notice or opportunity for
public comment.
Our objectives in this review were to (1) provide you with information on
the process OCC used to make its decision to allow banks to acquire equities
and discuss whether the decision was consistent with the way in which OCC
generally makes and communicates its decisions and (2) provide a legal
opinion as to whether national banks are authorized to purchase equity
securities to hedge their equity derivative transactions under existing law.
OCC has discretion to determine how it will convey its decisions, but the
criteria it uses to determine when and whether to publish its decisions are
unclear. For the equity hedging decision, OCC first determined that banks
holding equities to hedge equity derivative transactions was a permissible
activity under the National Bank Act. OCC then decided that the requesting
banks would not be allowed to engage in the activity of equity hedging
without first obtaining supervisory staff approval of their activities and
risk management systems, enabling OCC to ensure that each bank had the
necessary risk management systems in place to monitor risks and prevent
speculation. OCC did not publish its interpretation until after it received
a congressional inquiry in September 2000 questioning its decision. In
making certain other decisions interpreting the National Bank Act, OCC has
published written interpretive letters. By approving the equity hedge
decision the way it did, OCC has been criticized for using supervisory
approval as a way to avoid public scrutiny of its decision and has left
itself open to questions not only about the process used in this case, but
also about the criteria OCC uses to decide when to publish its interpretive
decisions. Helping the Congress and other banking regulators affected by
OCC?s decisions understand the criteria OCC uses to determine when and
whether to publish interpretive decisions could help mitigate concerns that
arise when OCC interprets federal banking laws that not only affect other
banking regulators but are also considered controversial.
We agree with OCC?s conclusion that the four national banks have authority
under the National Bank Act to own equities to hedge their equity derivative
transactions. To support this conclusion, OCC first determined that certain
equity derivative transactions and managing the risks of those transactions
are a permissible banking activity authorized by Results in Brief
Page 3 GAO- 01- 945 Equity Hedging
section 24( Seventh) of the National Bank Act. OCC next found that owning
equities to conduct these hedging activities is not prohibited by the stock-
related limitations contained in the section. We concur with OCC?s
conclusion that those limitations do not prohibit the four banks from
maintaining the stock hedges as an incidental activity.
We recommend that the Comptroller of the Currency establish a policy that
articulates the criteria OCC uses in deciding when and whether to publish
its interpretive decisions. We also recommend that the Comptroller of the
Currency publish legal interpretations that pertain to section 24( Seventh)
of the National Bank Act in order to keep other federal bank regulators and
financial institutions informed of its interpretation.
We provided a draft of this report to the Comptroller of the Currency. OCC
agreed with our recommendations.
The rapid rise in equity prices over the last 10 years has been accompanied
by new strategies for hedging equity positions. In the mid- 1990s, some
national banks began engaging in customer- driven equity derivative
transactions. Since then, equity derivatives have become an increasing part
of banks? businesses, as bank customers, both institutions and private
clients, increasingly use equity derivative products to hedge their equity
positions. Equity derivative products include instruments such as equity
options, equity collars, equity and equity- indexed swaps, and other
products. 4 Although the notional amount of equity derivatives is still
small compared with the volumes of other types of derivatives that bank
customers use, it has tripled in the last 5 years. According to the Bank for
International Settlements, the volume of equity derivative notional amounts
has gone from $630 billion in 1995 to almost $1.9 trillion in 2000, while
the notional amount for all over- the- counter derivatives has increased
from $41 trillion in 1995 to over $95 trillion in 2000. According to OCC
officials, the trading revenue from equity derivatives has also increased as
a share of bank customer revenues. As the equity derivatives
4 An equity option is the right to buy (call option) or sell (put option) a
specified amount of shares of an underlying instrument (equity) for an
agreed upon amount. An equity collar is an option that limits upside and
downside risk by selling a call and buying a put. An equity index swap is an
arrangement in which two parties (called counterparties) enter into an
agreement to exchange periodic appreciation or depreciation on an equity
index such as the Standard and Poor?s 500 Index. Background
Page 4 GAO- 01- 945 Equity Hedging
business has grown, banks have increasingly had to devote more attention and
resources to managing the risks related to equity derivatives. Banks hedge
in order to offset or manage the risks arising from engaging in equity
derivative transactions.
Until recently, national banks hedged their equity derivative transactions
through holding company affiliates. The equity derivative was booked at the
bank, and the equities used to hedge the equity derivative transactions were
booked in a holding company affiliate. The holding company affiliates were
usually nonbank entities that were not broker- dealers and were set up for
the express purpose of hedging the bank?s equity derivative risks. The banks
would instruct the affiliates on the structure, nature, and timing of the
relevant hedging transactions, and the affiliates would enter into the
hedging transactions only when directed. These arrangements allowed the
banks to hedge their equity derivative exposures without ever directly
owning or selling the stock, in accordance with prevailing guidelines.
The hedging transactions that the affiliates engaged in included ?mirror?
transactions and going long or short in a particular equity or basket of
equities. For example, if a bank sold an equity derivative to its customer,
it would purchase an identical equity derivative from its affiliate in order
to hedge any risk, ?mirroring? the initial transaction. Some of the banks we
spoke with said that instead of entering into mirror transactions with their
affiliates, they would instruct their affiliates to buy or short (sell)
equities on a delta equivalent basis. 5 Banking officials told us that no
matter what type of hedge the bank booked through the affiliate, the risks
arising from engaging in customer- driven equity derivative transactions
always remained in the bank, even when the bank hedged its risks through the
affiliate. See appendix I for a more detailed example of an equity
derivative hedge.
5 Delta is a hedge ratio that banks calculate to determine the amount of
equity the bank must buy or short, so that for any given change in the price
of the equity, the equity hedge position will change by the same amount as
the change in the equity derivative position. With delta 1 hedging, a one-
to- one correlation exists between the amount of shares the bank instructs
the affiliate to purchase or short to hedge the bank?s exposure and the
amount of shares underlying the equity derivative. Delta hedging, as
distinct from delta 1 hedging, usually involves equity options. The
objective of delta hedging is to have the change in the value of the client
derivative transaction match the change in the value of the equity hedge,
but in different directions. Unlike delta 1 hedging, the amount of equity
the bank would instruct its affiliate to hold would vary over time as the
price of the underlying equity changed.
Page 5 GAO- 01- 945 Equity Hedging
Beginning in December 1999, certain national banks requested OCC?s opinion
on whether it would be permissible for them to hedge their customer- driven
equity derivative transactions within the bank, eliminating the need to
enter into hedging transactions with affiliates. After months of
consideration, on July 20, 2000, OCC began verbally approving the banks?
requests, relying on its internal written interpretation of section 24(
Seventh). As a result of OCC?s decision, the banks have begun to directly
book equity hedges within the banks. In addition, some state- chartered
banks have also asked their primary federal banking regulators about OCC?s
decision and its implication for their activities.
Beginning in December 1999, three national banks requested OCC?s opinion on
whether the banks may hold equities to hedge their customerdriven equity
derivative transactions. 6 The banks said that their inability to hedge
their equity derivative transactions directly in the bank had caused them to
incur additional expenses and potentially increased their risk. OCC approved
the banks? requests, but initially did not make its decision public. After
deciding that equity hedging in the bank was a permissible activity, the
process OCC used to approve the banks? request was one in which OCC required
each bank to obtain supervisory staff approval prior to engaging in the
activity of equity hedging within the bank. OCC has acknowledged that its
initial decision was made in a nonpublic manner. But OCC has insisted that
it was necessary to grant the approval on a bank- by- bank basis rather than
issuing a blanket approval, in order to ensure that each bank had the
necessary risk management systems in place to monitor risks and prevent
speculation. In making certain other decisions about equities or hedges, OCC
has published written legal interpretations. Because OCC has the discretion
to determine how it will convey its decisions, no one process exists for
doing so. Consequently, OCC leaves itself open to being questioned when it
does not publish a written interpretation on issues that others may consider
controversial.
Three banks initially requested OCC?s interpretation about whether it would
be permissible to hold equities in the bank in order to hedge their equity
derivative transactions. Prior to OCC?s decision, the banks hedged their
equity derivative exposures through contractual arrangements with holding
company affiliates, which were set up as separate legal entities for
6 A fourth bank received OCC?s approval after OCC had made its decision.
OCC?s Process in
Making Its Equity Hedging Decision Is Controversial
Banks Request OCC?s Approval to Equity Hedge Within the Banks
Page 6 GAO- 01- 945 Equity Hedging
the sole purpose of hedging the bank?s equity derivative transactions. The
banks hedged in this manner largely because of the perceived legal
constraints preventing banks from direct ownership of equities. In making
their requests to OCC, the banks stated that purchasing, holding, or selling
equities was a more cost- effective and accurate way to hedge exposures
arising from equity derivative transactions. The banks also maintained that
they could more practically manage the risks associated with equity
derivative transactions by purchasing and booking equity hedges within the
bank.
The primary reasons the banks gave for requesting OCC?s approval were that
booking equity hedges within the bank was likely to reduce their costs and
their exposure to operations risks. The cost savings would result from
eliminating the need for corporate funding and the expense of maintaining
and managing a separate legal entity. The corporate funding expense occurred
because a bank?s affiliate obtained its funding from the bank?s corporate
parent at a rate higher than the bank?s own funding rate. 7 In addition, the
banks maintained the affiliate as a separate legal entity, sometimes
incurring the expense of maintaining separate staff and supporting the
processing, reconciliation, accounting, and reporting requirements for
internal transactions between the bank and its affiliate. 8 The cost of both
corporate funding and maintaining a separate legal entity made it expensive
for the banks to hedge their equity derivative transactions through
affiliates.
The banks also said that they could reduce operations risks by directly
hedging their equity derivative transactions within the bank. According to
banking officials, hedging through an affiliate created numerous trading,
operational, and funding inefficiencies. For example, a bank?s affiliate
might have to maintain a long equity position in one account and a short
position in another because of the limitations on the banks holding
7 By funding the hedging activity through the bank holding company rather
than the bank, the banks were trying to avoid creating a covered
transaction. Under the Federal Reserve Act and Federal Reserve Board
regulations, certain financial transactions between banks and their
affiliates, such as loans, are defined as ?covered transactions? subject to
requirements intended to limit the bank?s exposure to an affiliate?s credit
or investment risk. 12 U. S. C. sect.sect. 371c, 371c- 1 (1994 & Supp. 2000); 12 C.
F. R. Part 250 (2001). A bank could have created a covered transaction if
the bank directly extended credit to its affiliate to fund the purchases and
sales of equities used to hedge the bank?s equity derivative transactions.
8 This expense, which included capital usage, was included in a fee the bank
paid to its corporate parent.
Page 7 GAO- 01- 945 Equity Hedging
equities. Long and short positions in different entities were not
effectively netted, or canceled out, in the risk reports a bank produced.
Risk management systems would not always recognize all positions taken by a
bank and its affiliate, increasing the chance of trading, risk management,
and operational inefficiencies. The banks said that the optimal way to hedge
would be to net the long and short position in the same entity, increasing
the bank?s operational efficiency. Banking officials also said that in order
to hedge through an affiliate, banks must make multiple trades, resulting in
more transactional inputs that can lead to errors and the need for more
reconciliation.
Banking officials said two developments spurred their requests: OCC?s
decision to allow national banks to hedge nonqualified employee deferred
compensation plans, and the passage of the Gramm- Leach- Bliley Act (GLBA)
of 1999. 9 In December 1999, OCC decided to allow national banks to hold an
interest in insurance company products and other products in order to hedge,
on a dollar- for- dollar basis, their deferred compensation obligations to
employees. 10 Banking officials said that they thought the same analysis
would support a bank?s ability to hedge its equity derivative transactions
within the bank. In addition, with the passage of GLBA, the Federal Reserve
Board was instructed to address the question of whether credit exposures
arising from derivative transactions between an insured depository
institution and its affiliates should be covered by section 23A of the
Federal Reserve Act. 11 The Federal Reserve was considering whether
transactions between the banks and their hedging affiliates constituted
loans or extensions of credit instead of funding for the purchases and sales
that banks termed the transactions. 12 Banking officials said that if the
Federal Reserve Board did determine that credit exposure arising from
derivative transactions was covered by section 23A of the Federal Reserve
9 Gramm- Leach- Bliley Act, Pub. L. No. 106- 102, 113 Stat. 1338 (1999). 10
OCC Interpretive Letter No. 878 (Dec. 22, 1999). Banks proposed to offer
their employees a variety of registered investment companies and private
investment funds as benchmarks under the employee compensation plan. The
benchmark funds were to include funds that invest exclusively in bank-
eligible assets, as well as funds that invest in assets traditionally
impermissible for investment by national banks. To hedge their obligations
under the employee compensation plan, the banks were proposing to acquire
the number of units of each benchmark fund selected by the employee.
11 Pub. L. No. 106- 102 sect. 121( b)( 3), 12 U. S. C. sect. 371c( f)( 3) (Supp.
2000). 12 Federal Reserve officials said that the banks were providing the
holding company with funds that ultimately allowed holding company
affiliates to purchase or sell the equities used to hedge the banks? equity
derivative transactions.
Page 8 GAO- 01- 945 Equity Hedging
Act, then the Federal Reserve could impose collateral requirements, markedly
increasing the cost of hedging their equity derivative transactions through
affiliates. 13 Lawyers representing two of the banks said that they could
not get a definitive reply from Federal Reserve Board officials on this
question. As a result, the banks turned to OCC.
After the decision that equity hedging in the bank was a permissible
activity, the process OCC used to allow four national banks to hedge their
equity derivative transactions was one in which OCC required each bank to
obtain supervisory approval prior to engaging in the activity of equity
hedging within the bank. OCC officials said that the legal determination
allowing banks to hold equities to hedge equity derivative transactions
could not be made without OCC supervisory staff generally determining that
there was no safety and soundness risk in allowing banks to hedge their
equity derivative transactions within the bank. Once the legal determination
was made, OCC decided that in order for equity hedging within a particular
bank to be permissible, OCC supervisory staff would have to first review and
approve the types of equity derivative transactions, processes governing
proposed hedges, and internal risk management systems of the requesting
banks. OCC considered its approval to be a supervisory matter relating to
each institution rather than one that is generally applicable to all
national banks. As a result, OCC decided not to publish its interpretation,
even though OCC has previously published interpretations on the National
Bank Act, including decisions relating to hedging and equities.
In December 1999, outside counsel for two national banks called OCC to ask
if OCC was receptive to allowing banks to hedge their equity derivative
transactions by holding equities within the bank. The Chief Counsel?s Office
agreed to explore the legal issue. In January 2000, OCC requested that the
outside counsel for one of the banks submit a written letter to the Chief
Counsel?s Office in order to facilitate OCC?s consideration of a possible
framework for banks themselves to engage in equity derivative hedges. The
outside counsel complied and sent requests on behalf of these banks to OCC
for its interpretation on whether the National Bank Act provides the
authority for banks to minimize the risks associated with customer- related
equity derivative transactions through
13 See 12 U. S. C. sect. 371c( c), (f) (1994 & Supp. 2000). OCC Determines
Equity
Hedging Is Permissible, Subject to Supervisory Approval
Supervisory Concerns Dominated OCC?s Decisionmaking Process
Page 9 GAO- 01- 945 Equity Hedging
hedging transactions, including hedging transactions involving long and
short positions in physical equity securities.
In considering whether banks should be allowed to hold equities for hedging
purposes, OCC decided that its supervisory office would need to determine if
this activity posed a safety and soundness risk. OCC officials said that in
making any decision, they always consult with the examinerin- charge (EIC)
or the deputy comptroller for large bank supervision of the institution
requesting an opinion on possible issues that need to be taken into
consideration before an interpretation is issued. However, in this case OCC
said that the supervisory judgment was to be a major factor in determining
whether this activity would be permitted. OCC?s Chief Counsel told us that
the agency was looking not so much for examiner approval as for assurances
that OCC supervisory staff would have no objections to OCC determining that
holding equities within the bank to hedge equity derivative transactions is
a permissible activity. Thus, if OCC supervisory staff had determined that
equity hedging within a national bank posed safety and soundness risks, OCC
could not have permitted the activity. OCC supervisory staff said they did
not see a reason to oppose the permissibility of equity hedging on a safety
and soundness basis. Based on the supervisory staff?s findings, OCC moved
ahead with its deliberations.
After being informed that OCC would consider the legal aspects, the banks
sent in proposals for their equity hedging programs. Our review of OCC
documents and discussions with OCC officials showed that OCC supervisory
staff sought to understand the specific nature of the banks? hedging
proposals, the benefits of allowing banks to engage in this activity, and
OCC?s examiners? ability to supervise the activity effectively. In May 2000,
OCC formed a working group separate from field staff, which immediately
decided that the requesting banks should brief OCC on the methods they would
use to control the risks arising from the transactions.
In considering the equity hedging proposals, OCC evaluated the types of
products that would be involved, as well as the risk management systems the
banks would need to have in place to effectively equity hedge within the
banks. 14 OCC supervisory staff said they focused on the models and
methodologies the banks would use to measure risk, such as the risk limits
14 The type of equity products the banks were engaging in included equity
options, equity forwards, equity swaps, and variable forwards.
Page 10 GAO- 01- 945 Equity Hedging
that would be imposed to manage the risks. 15 OCC was particularly concerned
about whether the risks at the bank level, especially market risk, would
change because of this proposal. Other supervisory concerns related to the
types of controls that would need to be in place to prevent speculation and
the taking of anticipatory or residual positions in stocks.
In order to ensure that banks effectively monitored their equity derivative
transactions and hedges, OCC decided that while it would determine that it
was legal for banks to hold equities to hedge equity derivative
transactions, it would not be permissible for banks to engage in this
activity without obtaining EIC approval of their activities and risk
management systems. Furthermore, when the four banks submitted their equity
hedging proposals to OCC, the banks made certain representations as to how
they would conduct hedging within the bank. OCC determined that the banks
would be allowed to engage in equity hedges within the bank only if the
equity hedges were done the way the banks represented to OCC in their
requests. The banks represented that they would
use equities solely for hedging and not speculative purposes and not
take anticipatory or maintain residual positions in equities except as
necessary to the orderly establishment or unwinding of a hedging position.
OCC officials said that if in practice the bank?s equity hedging programs
did not meet those representations, the banks would not be engaging in a
permissible activity, and OCC could take enforcement actions against them if
necessary.
OCC Chief Counsel?s Office prepared an ?Equity Hedge Memorandum? on July 13,
2000, that was for internal use only and not for public distribution. The
memorandum, which laid out the rationale for OCC?s legal decision allowing
banks to hold equities in order to hedge equity derivative transactions, was
sent solely to the Deputy Comptrollers for Large Bank Supervision.
15 Specific types of equity derivative transactions, such as options and
collars, pose specific risks. In order to manage price or market risk, banks
first have to quantify them. Several measures exist to quantify risk,
including delta, gamma, and vega. As previously stated, delta measures the
sensitivity of an option?s value to small changes in the price of the
underlying asset. Gamma measures the amount delta would change in response
to a change in the price of the underlying asset (in this case equity). Vega
measures the sensitivity of an option?s price to changes in the volatility
of the price of the underlying asset (equity). In managing an options
portfolio, managers try to limit the bank?s exposures to these risks. OCC
Did Not Initially Make Its
Approval Public
Page 11 GAO- 01- 945 Equity Hedging
At the time the Equity Hedge Memorandum was finalized, OCC had not decided
how to publicly communicate its decision. The Chief Counsel?s Office and the
Deputy Comptrollers for Large Bank Supervision met to determine how to let
all national banks know about the OCC decision without making it public.
After much deliberation, OCC decided that the Securities and Corporate
Practices Division attorneys would prepare a communication strategy for the
Deputy Comptrollers for Large Bank Supervision to give to EICs. The EICs
would not promote the proposal or provide copies of the Equity Hedge
Memorandum to banks. Instead, they would encourage banks interested in
equity hedging to contact OCC?s Securities and Corporate Practices Division
in order to determine whether their proposals for equity hedging were
permissible under OCC?s legal determination. The EICs would also be
responsible for determining whether the banks had the appropriate risk
management systems in place prior to engaging in the activity of equity
hedging in order to prevent equity hedging in the bank from being used for
speculation.
On July 25, 2000, a cover distribution memorandum was finalized and sent
from the Chief Counsel?s Office to the Deputy Comptrollers for Large Bank
Supervision and large bank EICs, District Deputy Comptrollers, and Assistant
Deputy Comptrollers for mid- sized banks stating that OCC supervisory staff
may discuss OCC?s position with national banks other than the requesting
banks. The memorandum stated that because the Equity Hedge Memorandum was an
internal document, it was not to be distributed outside of OCC. The
memorandum also stated that each bank was to be directed to obtain its EIC?s
approval prior to hedging equity derivative transactions with equities and
that EICs were to make sure that banks had adequate procedures in place to
ensure that the bank?s equity holdings were not for speculative purposes.
The EICs of the three requesting banks had already notified their banks of
OCC?s approval prior to the distribution of the Equity Hedge Memorandum to
all the EICs of large banks. 16 The EICs of the three requesting banks spoke
to their banks? legal departments to say that OCC had determined that
hedging equity derivative transactions is a permissible activity, subject to
supervisory approval of the banks? risk management systems. The banks were
told that the legal determination was effective immediately and were
encouraged to contact the Securities and Corporate Practices Division to
determine whether their equity derivative activity was, in fact,
16 The fourth bank also received EIC notification on July 26, 2000.
Page 12 GAO- 01- 945 Equity Hedging
permissible under OCC?s legal determination. Finally, the EICs informed
their banks that equities would be held for hedging purposes only and not
for speculation, as represented by the banks. The EICs said that an
additional meeting would need to be set up with the banks? risk management
staff to discuss expectations regarding the safety and soundness practices
and policies that would have to be implemented. The banks were to formalize
their policies and procedures and risk management systems so that the EICs
could review them either during targeted examinations, the current
supervisory cycle, or as the bank implemented policies and procedures. 17
We interviewed the EICs of the four banks that OCC had given approval to
equity hedge within the bank to get a better understanding of the process
used to approve the banks? policies and procedures. The EICs told us that
they asked the banks to put together individual risk management programs
that would monitor the risks arising from equity derivative transactions,
in- house equity hedges, and any speculation resulting from hedging within
the bank. In some cases, the EICs made recommendations that banks
implemented before undertaking equity hedges. The EICs said that they also
discussed with banking officials the types of reporting requirements that
would be put in place to mitigate speculation.
The way in which OCC approved this activity caused you and certain
regulatory officials to question OCC?s process for determining whether to
publish a decision and to ask whether OCC circumvented its ?normal? process
in communicating this decision. Because OCC has discretion in determining
how it conveys its decisions to national banks, it does not have one set
process for doing so. Thus, it is unclear what criteria OCC uses to
determine when and whether to publish its decisions. OCC officials said,
however, that there are several ways to convey decisions to national banks.
For example, OCC can publish an interpretive letter when a bank requests its
interpretation of the law. By using this method, OCC is letting all national
banks know its interpretation of the law or the permissibility of an
activity. Also, examiners for large banks reside in the
17 According to OCC examination manuals, in large banks most examination-
related work is conducted during the 12- month supervisory cycle through
various ongoing supervisory activities or targeted examinations. Targeted
examinations are often conducted as integrated risk reviews by business or
product line. Since a product may have implications for several risk
categories, the targeted reviews evaluate risk controls and processes for
each applicable risk category. OCC Decision Not to
Initially Publish Its Interpretation Is Questioned
Page 13 GAO- 01- 945 Equity Hedging
banks and frequently talk informally with bank staff. In some cases, an
examiner will attempt to obtain the views of OCC?s legal staff about a
specific activity and will ask for an oral or written opinion. Additionally,
legal staff from the banks often communicate informally with OCC?s legal
staff and may seek informal counsel on various issues. Furthermore, OCC can
issue no- objection letters when national banks ask if the agency objects to
a particular activity; however, such letters are usually not legal
decisions. Finally, OCC said that it provides oral comments to banks
whenever necessary.
OCC officials said that the form of their response is dictated by the way
the question is posed. In other words, if a bank requests a written opinion,
OCC will respond with a written opinion. With the equity hedge decision, OCC
did not initially issue either an interpretive letter or an opinion letter.
OCC and national banking officials told us that the agency chose initially
to provide a verbal opinion on the permissibility of equity hedging to the
requesting banks because the banks requested an oral response.
We asked OCC officials whether OCC?s initial decision not to publish its
interpretation was based on concern about a reaction from members of
Congress or officials from other federal banking agencies. The Chief Counsel
told us that OCC did not publish its interpretation because it was focused
and narrow in terms of notifying the banks that had requested the approval.
OCC also did not want to encourage other national banks that it believed
should not be engaged in equity derivatives to pursue this activity because
of the decision. The Chief Counsel also said that the circumstances in this
decision were limited to a small number of national banks that were likely
to present to OCC the issue of wanting to hedge their equity derivative
transactions within the bank. Thus, OCC believed that only a handful of
institutions would be affected by its legal determination.
In light of the nonpublic way in which OCC initially conveyed its equity
hedge decision, questions arose about OCC?s overall process for determining
whether to publish its decisions and the legal basis on which a decision was
made. OCC has previously published numerous decisions regarding equities and
hedging. For example, OCC has published decisions allowing banks to invest
in warrants, 18 to maintain ownership of equity in
18 A warrant is a financial instrument that usually entitles the holder to
buy a proportionate amount of common stock at a specified price, usually
higher than the market price at the time of issuance, for a period of years
or to perpetuity.
Page 14 GAO- 01- 945 Equity Hedging
insurance companies, and to own otherwise impermissible investments to hedge
employee compensation plans. Furthermore, OCC?s 1994 decision authorizing
national banks to engage in equity derivative transactions was a published
decision.
OCC?s Chief Counsel said that OCC tries to publish its decisions, such as
interpretive letters, on a regular basis and has an informal process whereby
a law department committee reviews decisions and decides which to publish.
However, the committee does not comment on and publish every decision. The
equity hedge decision was not submitted to the committee initially because
at the time OCC did not intend the decision to apply to all national banks.
OCC officials told us that from the time they made their legal
determination, they were considering how best to publicly treat their
decision. However, congressional concern about the decision prompted them to
issue Comptroller Hawke?s response to your inquiry as an interpretive letter
in September 2000.
Other federal banking regulators also have an interest in OCC publishing its
decisions, especially when OCC interprets the equity- related provisions
contained in section 24( Seventh). The Federal Reserve Act provides that
state member banks are subject to the same limitations and conditions with
respect to investment securities and stock as those contained in section 24(
Seventh). 19 The Federal Deposit Insurance Act prohibits insured state banks
from engaging in any activity that is not permissible for a national bank
unless the Federal Deposit Insurance Corporation (FDIC) determines that the
activity would pose no significant risks to the deposit insurance fund and
the bank complies with applicable federal capital standards. 20 Federal
Reserve officials told us that the Federal Reserve independently determines
whether a particular equity- related activity is permissible under section
24( Seventh). FDIC told us that in deciding on the permissibility of a
bank?s securities activity, the agency typically relies on OCC?s
determination. By failing to inform other federal banking regulators of
their analysis, OCC potentially affects how those regulators interpret the
National Bank Act on behalf of the institutions they oversee.
19 12 U. S. C.sect. 335 (1994). 20 12 U. S. C. sect. 1831a( a)( 1) (Supp. 2000).
Page 15 GAO- 01- 945 Equity Hedging
We agree with OCC?s conclusion that the purchase of equity securities by a
national bank for the purpose of hedging its customer- driven equity
derivative transactions is a permissible incidental banking activity. To
support its conclusion, OCC first determined that customer- driven equity
derivative transactions and managing the risks of those transactions are
permissible banking activities authorized by section 24( Seventh) of the
National Bank Act. OCC next found that owning equities to conduct the
hedging activity is not prohibited by the stock- related limitations
contained in the section. We believe that OCC?s analysis is based on a
reasonable construction of section 24( Seventh).
National bank powers, as well as limitations on those powers, are contained
in the National Bank Act. Specifically, the first sentence of Section 24(
Seventh) (referred to as the ?powers clause?) provides that a national bank
may engage in the business of banking, which includes but is not limited to
the five types of activity enumerated in the sentence, and any activity
incidental to the business of banking. 21 The stock- and securities- related
restrictions, which immediately follow the powers clause are in table 1.
21 NationsBank of North Carolina v. Variable Annuity Life Insurance Co., 513
U. S. 251 (1995) (VALIC). The first sentence of section 24( Seventh) lists
the following five activities as within the business of banking ?discounting
and negotiating promissory notes, drafts, bills of exchange, and other
evidences of debt . . . receiving deposits . . . buying and selling
exchange, coin, and bullion . . . loaning money on personal security and . .
. obtaining, issuing and circulating notes according to the provisions of
title 62 of the Revised Statutes.? In VALIC, the Supreme Court held that the
business of banking is not limited to the five types of activity enumerated
in the first sentence, and said that OCC has discretion ?within reasonable
bounds? to determine whether an activity constitutes the business of
banking. We Concur With
OCC?s Legal Decision The Bank Powers Provision Defines and Limits Banking
Activities
Page 16 GAO- 01- 945 Equity Hedging
Table 1: Relevant Provisions of Section 24( Seventh) Components of section
24( Seventh) Provision
Powers clause (First sentence) To exercise by its board of directors or duly
authorized officers or agents, subject to law, all such incidental powers as
shall be necessary to carry on the business of banking; by discounting and
negotiating promissory notes, drafts, bills of exchange, and other evidences
of debt; by receiving deposits; by buying and selling exchange, coin, and
bullion; by loaning money on personal security; and by obtaining, issuing,
and circulating notes according to the provisions of title 62 of the Revised
Statutes. Dealing and Underwriting Prohibition (Second sentence) The
business of dealing in securities and stock by the association shall be
limited to purchasing and selling such securities and stock without
recourse, solely upon the order, and for the account of, customers, and in
no case for its own account and the association shall not underwrite any
issue of securities or stock. Stock Ownership Limitation (Fifth sentence)
Except as hereinafter provided or otherwise permitted by law, nothing
herein contained shall authorize the purchase by the association for its own
account of any shares of stock of any corporation.
Source: 12 U. S. C.sect. 24( Seventh).
In approving the equity hedging activity, OCC maintained its long- standing
position, which dates back to the 1960s, that national banks may hold stock
in certain instances based on the incidental activities authority contained
in the powers clause. 22 In a letter to you dated September 8, 2000 (Equity
Hedge Letter), the Comptroller relied upon a provision in GLBA referring to
equity derivative transactions as transactions that are part of the banking
business. 23 OCC also referred to an earlier interpretive letter, which
concluded that one type of equity derivative transaction- equity derivative
swaps- is a permissible banking activity under the powers clause and stated
that hedging risks is an integral part of such transactions as well as other
permissible banking activities. 24 Relying again on the powers clause, OCC
next concluded that the banks? purchase of equity securities to hedge equity
derivative transactions is permissible because the activity is incidental to
the business of banking. Specifically, OCC determined that equity hedging
benefits the banks by enabling them to efficiently manage risks arising from
permissible derivative activities and thus are convenient and useful to
those activities. In this regard, we note that each approval was conditioned
upon OCC examiners determination
22 Acquisition of Controlling Stock Interest in Subsidiary Operations
Corporations, 31 Fed. Reg. 11459 (1966). 23 Equity Hedge Letter at 5- 6.
24 Equity Hedge Letter at 5- 8.
Page 17 GAO- 01- 945 Equity Hedging
that a particular bank?s risk management system is adequate. Finally, OCC
concluded that the equity hedging activity does not violate the stock
ownership limitations contained in section 24( Seventh). (See app. II.) We
believe OCC had reasonable bases for reaching these conclusions.
In determining that the limitations on securities and stock ownership
contained in section 24( Seventh) do not prohibit hedging with equities, OCC
first concluded that this activity does not constitute dealing or
underwriting under the statute. Specifically, the statute limits a national
bank?s ability to engage in the ?. . . business of dealing in securities and
stock . . . to purchasing and selling such securities and stock without
recourse, solely upon the order, and for the account of, customers, and in
no case for its own account.? Furthermore, the sentence prohibits a national
bank from underwriting any issue of securities or stock.
The National Bank Act does not define any of the key terms in the second
sentence. Accordingly, OCC has defined the term ?the business of dealing? as
the purchase and sale of securities as part of a regular business. OCC has
defined a dealer as one that maintains an inventory of securities and holds
itself out to the public as willing to purchase, sell, and continuously
quote prices for these securities. 25 In essence, OCC has interpreted this
?dealing in? limitation on banks as prohibiting only those securities
activities that constitute the business of dealing, not all purchases and
sales of securities by banks as principal if such holdings qualify as being
incidental to a permissible business function.
Although the banks, in connection with the hedging activity, will purchase
and sell equity securities on a regular basis, OCC concluded that securities
hedges do not constitute dealing in securities, which is prohibited by the
second sentence. According to OCC, the banks will not hold the securities as
inventory in order to engage in the business of regularly buying and selling
them in the secondary market. They will not act as market makers in the
securities by continuously quoting prices on both sides of the market. 26
They will purchase and sell the securities solely to hedge their own risks
and not for the speculative purpose of profiting from price movements. As
OCC further points out in the Equity Hedge Letter, unlike the business of
dealing, securities hedges are intended to manage and
25 Equity Hedge Letter at 10- 11. 26 Id.
Hedging With Equities Does Not Violate the Dealing or Underwriting
Prohibitions of the National Bank Act
Page 18 GAO- 01- 945 Equity Hedging
reduce a bank?s own risks arising from bank- permissible activities. Based
on these reasons and subject to the outlined conditions, we concur with
OCC?s conclusion that the equity hedging in question does not constitute
dealing in securities as prohibited by section 24( Seventh).
OCC also has defined underwriting in the second sentence as encompassing the
purchase of securities from an issuer for distribution and sale to investors
through a public offering. In connection with the equity hedging activity,
the banks will not engage in underwriting securities. We concur with OCC?s
conclusion that the equity hedging activity does not violate the
underwriting prohibition because the banks, in connection with the equity
hedges, will not participate in a public offering of securities to
investors. 27 Furthermore, we believe that OCC?s interpretation of the
second sentence and its determination that equity hedging does not
constitute dealing and underwriting in securities are reasonable.
OCC interprets the fifth sentence of section 24( Seventh), which limits a
bank?s ability to purchase stock for its own account, as clarifying that the
immediately preceding provision permitting banks to own certain debt
securities does not authorize national banks to purchase stock. The fifth
sentence provides ?[ e] xcept as hereinafter provided or otherwise permitted
by law, nothing herein contained shall authorize the purchase by the
association for its own account of any shares of stock of any corporation.?
This sentence, rather than affirmatively proscribing stock ownership,
provides that ?nothing herein contained? authorizes a national bank to
purchase stock for its own account, subject to two exceptions. In our view,
although the sentence has a generally prohibitive effect on a national
bank?s ability to own stock, it does not contain an absolute bar on stock
ownership. We concur with OCC?s view that the fifth sentence is not a
blanket prohibition on all equity holdings by national banks and that
national banks have the power to acquire and hold corporate stock in those
specific circumstances that qualify as incidental to the business of
banking.
A key point to OCC?s analysis of the fifth sentence is its interpretation of
the phrase ?nothing herein contained.? If the phrase pertains to section 24(
Seventh) in its entirety, it means that nothing in the section, including
27 Id.
Hedging With Equities Is Not Prohibited by the Stock Ownership Limitation
Contained in the National Bank Act
Page 19 GAO- 01- 945 Equity Hedging
the powers granted to national banks by the powers clause, authorizes a
national bank to purchase stock for its own account unless the activity is
permitted in subsequent provisions of the section or ?otherwise permitted by
law.? Because neither the subsequent provisions of the section nor any
statutory provision outside of section 24( Seventh) authorizes stock
ownership except in specific circumstances not pertinent here, under this
interpretation the sentence would bar banks from owning stock for hedging
purposes. On the other hand, if the phrase ?nothing herein contained? does
not refer to the authority contained in the powers clause, stock ownership
is ?otherwise permitted by law? to the extent authorized in the first
sentence and therefore is not prohibited by the fifth sentence.
OCC interprets the phrase ?nothing herein contained? as referring only to a
specific provision in section 24( Seventh) that does not apply to stock
ownership. The Congress added the fifth sentence in a 1933 amendment to
section 24( Seventh) that also permitted national banks to purchase certain
types of debt securities, which the section describes as ?investment
securities.? OCC has concluded that the Congress added the fifth sentence to
clarify that nothing contained in the investment securities ownership
authority permits national banks to purchase corporate stock. Consequently,
banks may purchase stock if the activity is ?otherwise permitted by law,?
which law includes the powers clause. OCC thus interprets the powers clause
to permit stock ownership as an activity incidental to the business of
banking.
We believe that the fifth sentence was intended to do more than clarify the
investment securities ownership authority. We interpret the sentence as
generally prohibiting national banks from owning stock for their own
accounts. Therefore, we do not completely agree with OCC?s analysis of the
fifth sentence. However, we find that it is reasonable for OCC to conclude
that this sentence, like the second sentence, does not preclude a national
bank from owning securities if such ownership is authorized by the powers
clause as an activity incidental to the business of banking. 28
The powers clause, which was enacted in 1864, initially was interpreted to
restrict the securities activities of national banks by, among other things,
prohibiting these banks from dealing and investing in stocks. Early
28 Failure to interpret these sentences this way would appear to result in a
bank?s inability to hold securities as collateral on a failed loan. All of
the federal banking agencies have recognized banks? ability to hold
securities for this purpose.
Page 20 GAO- 01- 945 Equity Hedging
Supreme Court decisions interpreted the clause to prohibit bank dealing and
investment in stocks and securities but held that a national bank?s
incidental power to engage in activities necessary for it to carry on the
business of banking includes stock ownership. In two cases, the Supreme
Court permitted stock ownership because it was incidental to one of the
enumerated banking powers. Thus, the Supreme Court held that a bank was not
prohibited from owning stock when the stock was acquired to compromise a
preexisting debt 29 or when it was taken as personal security incidental to
the power to loan money. 30
The second and fifth sentences were passed in 1933 as part of the
GlassSteagall Act, which was enacted to prohibit commercial banks from
engaging directly in investment banking. Neither section 16 of GlassSteagall
nor the act?s legislative history indicate that the Congress intended to
reverse or modify these decisions or the underlying principle that a
national bank?s incidental power includes owning stock when necessary to
carry on the business of banking. The exception in the fifth sentence
allowing for banks to own stock as ?otherwise permitted by law? can
reasonably be interpreted as referring to the incidental powers provision,
as construed by the Supreme Court before passage of section 16, that permits
national banks to own stock for incidental purposes. Accordingly, OCC had a
reasonable basis for concluding that hedging with equities, which it
determined to be incidental to the business of banking, is not prohibited by
the second or fifth sentences of section 24( Seventh).
Although we concluded that OCC had a reasonable basis for making its equity
hedging decision, the process it used to communicate the decision to
national banks, regulatory officials, and other interested parties raised
concerns, especially given the nature of the legal interpretation to be
communicated- banks owning equities. OCC?s stated goal was to communicate
its decision on the law as a supervisory matter rather than as a generally
applicable legal interpretation for all national banks. By verbally
conveying its approval to the requesting banks and requiring that those
banks and other interested national banks receive EIC approval prior to
booking equity hedges within the bank, OCC ensured that its decision would
not be generally applicable to all national banks.
29 First National Bank of Charlotte v. National Exchange Bank of Baltimore,
92 US 122, 128 (1875). 30 California National Bank v. Kennedy, 167 U. S.
362, 366- 67 (1897). Conclusions
Page 21 GAO- 01- 945 Equity Hedging
OCC has continually emphasized that the reason it conveyed its approval in
this way was because safety and soundness concerns led it to conclude that
banks needed to obtain supervisory approval prior to engaging in equity
hedging within the bank. However, it is hard to understand how this
interpretation differs substantially from previous decisions OCC has made in
which supervisory approval was a precondition for banks to engage in an
activity deemed permissible. In addition, by communicating its decision the
way it did, OCC eventually drew external attention that focused on the basis
for the nonpublic nature of that communication. Because the basis for
determining whether to publish its interpretations was unclear, some were
left to assume that OCC does not publish an interpretive decision when it
does not want to draw attention to a decision. Much of the concern about the
basis for OCC?s decision could have been avoided if OCC had had a well-
defined policy that clearly articulated the criteria used to decide when and
whether to publish interpretive decisions and had acted in accordance with
those criteria.
OCC determines permissible bank equity- related activities under section 24(
Seventh) of the National Bank Act, and its conclusions are relevant in
determining whether such activities are permissible for state- chartered
banks that are members of the Federal Reserve System or insured by FDIC.
Thus, in this situation when OCC interpreted section 24( Seventh) to permit
an equity- related activity for the first time, informing the other federal
bank regulators and the banks they regulate of the decision would have
contributed to regulatory transparency and efficiency in a number of ways.
For example, furnishing the information to the federally regulated state-
chartered banks would have enabled them to determine whether such an
activity was suitable for their purposes and to seek regulatory guidance
from their respective regulators. Furthermore, providing its decision and
analysis to the Federal Reserve and FDIC would have given each agency an
opportunity to decide whether OCC?s interpretation should serve as guidance
for all the institutions they supervise and, if not, to set forth clear
standards for those institutions to follow.
The issue of banks owning equities has been the subject of debate for
decades. The recent OCC interpretation focuses on the activity of holding
equities in the bank as incidental to its equity derivatives banking
business. One of the criteria expressed in the interpretation states that
banks are not to hold equities for speculative purposes. However, it can be
difficult in practice to draw too fine a line between speculation and
hedging. As such, continued OCC oversight will be required to monitor that
line. More controversial issues could be raised if OCC were to take an even
broader interpretation of the business of banking or its incidental
Page 22 GAO- 01- 945 Equity Hedging
powers so that owning equities outright would become a permissible banking
activity for national banks. Whether such controversies should be settled by
regulatory interpretation or by legislation would be a fundamental question.
Because of larger questions that the process of reaching and announcing this
equity hedge decision raises about OCC?s interpretive decisionmaking
process, we recommend that the Comptroller of the Currency establish a
policy that articulates the criteria OCC uses in deciding when to publish
its interpretive decisions. Furthermore, because interpretations relating to
section 24( Seventh) of the National Bank Act have implications for other
banking regulators, we recommend that the Comptroller publish all legal
decisions that pertain to section 24( Seventh) in order to keep other bank
regulators and financial institutions informed of OCC?s analysis.
We received written comments on a draft of this report from OCC that are
reprinted in appendix III. OCC agreed with our recommendations and said that
they are currently in the process of establishing a policy that is
responsive to our recommendations. OCC also provided technical comments on
the draft that we incorporated as appropriate.
To report on the process by which OCC approved this activity, we spoke to
OCC legal officials about the process used, the way in which their approval
was communicated to banks, and other ways in which OCC could have
communicated its decision. We reviewed OCC?s internal documentation
(including e- mails, notes, and rough drafts of memorandums) on its internal
decisionmaking process and concerns that OCC had about granting this
approval. Included in the files we reviewed was information on the role of
OCC supervisory staff in OCC?s approval, as well as information on the types
of equity hedges banks would be engaging in and the risks involved. To
further understand the supervisory role in the approval process and the
equity hedge activities, we interviewed the EICs of the four banks that had
requested OCC?s approval and other risk management and supervisory officials
at OCC. We also talked with legal and risk management officials from the
Federal Reserve Board and FDIC about how their banks were hedging their
equity derivatives exposure through affiliates and what they believed the
risks were in allowing banks to book equity hedges within the bank. Finally,
we spoke to officials from banks that were equity derivative dealers to get
a better understanding of equity hedging and to get their views on OCC?s
approval. The five banks Recommendations for
Executive Action Agency Comments Scope and Methodology
Page 23 GAO- 01- 945 Equity Hedging
we interviewed included two national banks that are engaging in equity
hedges within the bank, one national bank that has not sought OCC?s approval
to hedge within the bank, and two state member banks of the Federal Reserve
that are large equity derivatives dealers. The interviews with banking
regulators and the banks included detailed discussions on OCC?s decision as
well as on the process OCC used in granting its approval.
In order to determine whether OCC?s decision was in accordance with section
24( Seventh) of the National Bank Act, we examined OCC?s letter outlining
its legal opinion and related OCC documents, the applicable and related
statutory provisions, legislative history, prior OCC decisions under section
24( Seventh), and relevant case law and secondary sources. In addition, we
spoke with attorneys at OCC regarding its opinion in this case and prior
decisions. We also spoke with lawyers at the Federal Reserve Board and the
FDIC to get their views on OCC?s legal opinion and the related statutory
provisions applicable to the state banks they regulate. Finally, we spoke
with a number of banks, including their counsel, that are equity derivative
dealers to get their views of the OCC approval.
We performed our work between February and June 2001 in accordance with
generally accepted government auditing standards. We visited regulatory
agencies and banks in Washington, D. C.; New York, N. Y.; and Chicago, Ill.
As agreed with you, unless you publicly release its contents earlier, we
plan no further distribution of this report until 30 days from its issue
date. At that time, we will provide copies to the Chairman and Ranking
Minority Member, House Committee on Financial Services, and the Chairman and
Ranking Minority Member, Senate Committee on Banking, Housing and Urban
Affairs. We are also sending copies to the Comptroller of the Currency and
the Chairmen of the Federal Reserve Board and the FDIC. Copies will be made
available to others on request.
This report was prepared under the direction of Barbara I. Keller, Assistant
Director, Financial Markets and Community Investment, and Rosemary Healy,
Assistant General Counsel, Office of the General
Page 24 GAO- 01- 945 Equity Hedging
Counsel. If you have any questions about this report, please contact me at
(202) 512- 8678 or Susan Poling at (202) 512- 7648. Key contributors to this
report were Tamara Cross, Paul Thompson, John Treanor, and Emily Chalmers.
Thomas J. McCool Managing Director, Financial Markets
and Community Investment Susan A. Poling Associate General Counsel
Appendix I: Equity Derivative Hedging Page 25 GAO- 01- 945 Equity Hedging
The Office of the Comptroller of the Currency (OCC) and banking officials
said that banks have clients that may have concentrated equity holdings
representing significant risks to the bank?s customer. Although customers
may engage in a put option with a bank to protect against the risk that
their equity price might fall, the most common product bank customers have
purchased to protect against the downside risk of their equity position is a
zero- cost collar. The collar is created when the customer purchases a put
option from the bank at a strike price below the current market price of the
stock and sells a call option to the bank at a price above the current
market price of the stock. With a collar, the bank provides the customer
with a minimum and maximum value around the customer?s equity position until
the expiration of the option. The collar is referred to as a zero- cost
collar because the premium the customer receives from the bank for selling
the call option to the bank exactly offsets the premium or purchase price
the customer pays to the bank in purchasing the put option.
A customer owns 100,000 shares of XYZ stock with a current market price of
$50. In entering the collar, the customer buys a 3- year, European- style,
cash- settled 1 XYZ put option from the bank, with a strike price of $35 and
sells a 3- year, European- style, cash- settled XYZ call option to the bank,
with a strike price of $90. The collar minimum is $35 dollars and the
maximum is $90. The customer is thus protected if the price of XYZ falls
below $35 but is ?exposed? to the price difference between the put strike
price and current market price until the price falls below $35. The customer
participates in the appreciation of XYZ?s price up to $90 but does not
participate in any upside appreciation of XYZ?s price above $90. If the
price of XYZ stock is below $35 upon expiration of the collar, the bank pays
the customer the difference between the strike price of $35 and the current
market price below $35. If the price of XYZ is above $90 upon expiration of
the collar, the customer pays the bank the difference between the strike
price of $90 and current market price above $90. If, however, the price of
XYZ is between $35 and $90 at the time of expiration of the collar, the
options expire worthless.
1 If the customer wanted to physically settle its option at the time of
expiration, the customer would sell its shares to the bank with the put
option and the investor would pledge its shares to the bank to secure its
obligations to the bank under the call option. Appendix I: Equity Derivative
Hedging
An Example of an Equity Collar
Appendix I: Equity Derivative Hedging Page 26 GAO- 01- 945 Equity Hedging
Prior to OCC?s decision, banks hedged their equity derivative transactions
by entering into offsetting mirror transactions with their affiliates. The
bank entered into a collar with its affiliate that exactly matched the
collar entered into with a customer. For example, the XYZ collar entered
into with the customer consisted of the bank buying an XYZ call option from
the customer and selling an XYZ put option to the customer. The mirror
transaction with the affiliate consisted of the bank purchasing an XYZ put
option from its affiliate with the exact terms and conditions of the XYZ put
the bank sold to the customer and selling an XYZ call option to the
affiliate with the exact terms and conditions of the XYZ call that the bank
bought from the customer. As a result of this mirror transaction with the
affiliate, the bank has perfectly hedged its market risk. The hedging
affiliate would then hedge its collar with the bank by taking a position in
XYZ stock- that is, by shorting XYZ stock.
Once OCC made its decision that banks were allowed to hedge their equity
derivative transactions by booking equity hedges within the bank, the
requesting banks were no longer obligated to enter into mirror transactions
with an affiliate in order to hedge their collars. Banks could therefore
hedge changes in their equity derivative transactions through delta hedging.
As previously stated, delta is a hedge ratio that banks calculate to
determine the amount of equity the bank must buy or short, so that for small
changes in the price of the equity, the bank?s equity hedge position and its
contract with the client will change by equal, and offsetting, amounts.
With the XYZ collar example, as the price of XYZ goes up, the value of the
XYZ collar increases because the bank?s call option increases in value and
the put option decreases in value. Without entering into a perfect mirror
collar with its affiliate, the bank needs an equity hedge position that
changes in value as the value of the collar changes, but in a different
direction than the change in the value of the collar. Thus, the bank needs
an equity hedge position that declines in value when the price of XYZ rises
and increases in value when the price of XYZ falls. The bank would therefore
short XYZ on a delta basis because a short position in XYZ would produce
losses when the price of XYZ rises. For example, the bank would determine an
initial delta of say 0.7, so that for every $100 represented by the collar,
the bank needs to be short $70 in XYZ stock. Then for every $1.00 increase
in price of XYZ, the collar value to the bank increases by $0.70, an amount
which is offset by losses in the short position the bank has in XYZ shares.
Alternatively, for every $1.00 decrease in the price of XYZ, the collar
value to the bank decreases by $0.70, which again is offset Hedging Through
an
Affiliate Hedging Within the Bank
Appendix I: Equity Derivative Hedging Page 27 GAO- 01- 945 Equity Hedging
by a gain the short position in XYZ shares. Over the life of the collar, the
bank rebalances its hedge, buying and selling XYZ shares as the collar?s
delta changes. At maturity, the collar?s delta is either 0 percent or 100
percent- 100 percent if the price of XYZ is below the put strike price or
above the call price and 0 percent if the price of XYZ is between the strike
prices.
Banks contend that being able to book equity positions within the bank
enables the bank to net its positions more effectively on a portfolio basis.
For example, when a bank customer sells an XYZ put option to the bank, the
bank?s hedge is to go long or buy the XYZ stock on a delta basis. If the
bank has sold collars on XYZ stock to other customers, then the bank?s hedge
for those positions would be to short XYZ stock. At the end of the day, the
short and long positions of XYZ stock are to cancel each other out, and the
bank then hedges any residual position that is left over. Banks also contend
that hedging within the bank decreases the operational risk of booking back-
to- back transactions and reduces costs.
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 28 GAO- 01- 945 Equity Hedging
During 2000, the Office of the Comptroller of the Currency (OCC) approved
the requests of four national banks to purchase equities to hedge their
equity derivative transactions. In approving these requests, OCC concluded
that a provision of the National Bank Act, 12 U. S. C. sect. 24( Seventh), which
generally prohibits national banks from purchasing stock for their own
account, does not prohibit these banks from purchasing equities to hedge
their customer- driven equity derivative transactions. 1 That provision sets
forth the primary authority for national banks to engage in the business of
banking by limiting their activities to those that are either part of the
banking business or incidental to carrying on that business (an incidental
power). OCC concluded that the four banks have authority, by virtue of their
incidental powers, to own stock as a hedge against equity derivatives risks,
provided that their hedging programs satisfy supervisory requirements.
Representative James A. Leach, a member of the House Committee on Financial
Services, asked us to assess the process OCC followed in issuing its
approval and to determine whether national banks have authority under the
National Bank Act to own corporate stock to hedge their equity derivative
transactions. Our work relating to the approval process is discussed in the
accompanying report. Our analysis of whether national banks have authority
to hedge equity derivative transactions by owning equities is discussed in
this appendix.
After a review of applicable laws, judicial decisions, and related
materials, we agree with OCC?s conclusion that the four national banks have
authority under the National Bank Act to own corporate stock to hedge their
equity derivative transactions. OCC?s approvals are consistent with a
1 In a letter to Representative Leach dated September 8, 2000, the
Comptroller described the term ?equity derivative transactions? to mean
?transactions in which a portion of the return (including interest,
principal or payment streams) is linked to the price of a particular equity
security or to an index of such securities. Equity derivative transactions
include equity and equity index swaps, equity index deposits, equity- linked
loans and debt issues, and other bank permissible equity derivative
products.? The Comptroller described ?customer driven? transactions as
?originated by customers for their valid and independent business purposes.?
OCC Interpretive Letter No. 892 at 1 (Sept. 8, 2000) (Equity Hedge Letter).
Appendix II: Legal Analysis of OCC Equity
Hedging Decision
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 29 GAO- 01- 945 Equity Hedging
reasonable interpretation of section 24( Seventh). 2 OCC first determined
that the business of banking includes equity derivative transactions and
managing the risks of those transactions. OCC further determined that the
four banks have authority under their incidental powers to own stock in
order to carry on that business, subject to approval of their risk
management systems. OCC construes section 24( Seventh) so that
notwithstanding a general prohibition against stock ownership, a national
bank may own stock only as necessary to carry on the business of banking. We
believe that interpreting section 24( Seventh) to permit equity hedging as
an incidental power is reasonable.
National banks derive their general banking powers from section 24( Seventh)
of the National Bank Act. The first sentence of the section, known as the
?powers clause,? authorizes national banks to conduct ?the business of
banking? and to exercise ?all such incidental powers as shall be necessary
to carry on? that business. 3 The second sentence limits a national bank?s
business of dealing in securities and stocks to brokerage and specifically
prohibits owning securities and stocks as part of the bank?s business of
dealing in securities. The second sentence also prohibits national banks
from underwriting any issue of securities and stocks. 4 The fifth sentence
states that a national bank is not authorized to
2 Under Chevron U. S. A., Inc. v. Natural Resources Defense Council, 467 U.
S. 837, 842- 843 (1984), and, more recently, United States v. Mead Corp.,
121 S. Ct. 2164 (2001), OCC?s approvals likely would be accorded deference
by the courts. In Mead, the Supreme Court recognized that it gave
considerable weight to an OCC opinion of whether an activity constitutes the
business of banking or an incidental activity under section 24 (Seventh)
despite the lack of a notice- and- comment procedure or other administrative
formality.
Mead, 121 S. Ct. at 2173 (citing NationsBank of N. C., N. A. v. Variable
Annuity Life Ins. Co., 513 U. S. 251, 256- 57, 263 (1995)).
3 The powers clause provides that a national bank shall have the following
power: To exercise by its board of directors or duly authorized officers or
agents, subject to law, all such incidental powers as shall be necessary to
carry on the business of banking; by discounting and negotiating promissory
notes, drafts, bills of exchange, and other evidences of debt; by receiving
deposits; by buying and selling exchange, coin, and bullion; by loaning
money on personal security; and by obtaining, issuing, and circulating notes
according to the provisions of title 62 of the Revised Statutes.
4 The second sentence states, in pertinent part, as follows: Background
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 30 GAO- 01- 945 Equity Hedging
purchase corporate stock for its own account, except as specifically
provided in subsequent parts of the section or otherwise permitted by law. 5
Four national banks sought OCC?s approval to purchase equities to hedge
their customer- driven equity derivative transactions. OCC determined that
equity derivative transactions and hedging the related risks are part of the
business of banking. OCC approved the four banks? ownership of stocks to
hedge equity derivatives by interpreting the stock- related limitations and
restrictions in section 24( Seventh) to mean that national banks generally
are prohibited from owning stock but are authorized to do so if owning stock
constitutes a permissible incidental activity. An incidental activity is one
that is necessary to carry on the business of banking. 6 OCC concluded that
the purchase of equity securities as a hedging device is an incidental
activity not prohibited by the stock- related limitations contained in
section 24( Seventh).
OCC based its approvals on an interpretation of section 24( Seventh) it has
relied on since the 1960s. 7 OCC reiterated this position in 1996 in its
revised final rules governing national bank ownership of subsidiaries.
Specifically addressing the fifth sentence, OCC stated:
?This language, which was added to 12 U. S. C. 24( Seventh) by section 16 of
the 1933 Act has, for decades, been consistently interpreted by the OCC as
preventing national banks
The business of dealing in securities and stock by the association shall be
limited to purchasing and selling such securities and stock without
recourse, solely upon the order, and for the account of, customers, and in
no case for its own account, and the association shall not underwrite any
issue of securities or stock: . . . Provided, That the association may
purchase for its own account investment securities under such limitations
and restrictions as the Comptroller of the Currency may by regulation
prescribe.
The term ?investment securities? is defined elsewhere in the section to mean
certain marketable debt securities.
5 The fifth sentence states as follows: ?Except as hereinafter provided or
otherwise permitted by law, nothing herein contained shall authorize the
purchase by the association for its own account of any shares of stock of
any corporation.?
6 In an interview, OCC officials told us that an activity cannot be
incidental to conducting an authorized banking activity unless the
incidental activity is conducted in a safe and sound manner. OCC defines an
activity as ?incidental? to the business of banking when the activity is
?convenient? or ?useful? to conducting statutorily enumerated banking
activities or other activities that are permissible because they are part of
?the business of banking.? Equity Hedge Letter at 9; See infra note 34.
7 Equity Hedge Letter at 14; Acquisition of Controlling Stock Interest In
Subsidiary Operations Corporation, 31 Fed. Reg. 11459 (1966).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 31 GAO- 01- 945 Equity Hedging
from undertaking the types of speculative stock purchases that were the
object of the 1933 Act, not as a bar to the ability of national banks to
have subsidiaries or to own stock, where such ownership is otherwise
authorized. This interpretation is entirely consistent with the language of
12 U. S. C. 24( Seventh) cited above - that the new provisions added in 1933
do not authorize national banks to purchase corporate stock, but to the
extent other authority exists to do so, that authority remains intact
(citation omitted).? 8
This interpretation of national bank powers is the legal foundation of OCC?s
decision to permit equity hedging.
The following discussion sets forth our analysis of OCC?s authority to
determine which activities constitute the business of banking and our
reasons for concluding that OCC acted within its authority by considering
equity derivative transactions and associated risk management programs to be
part of the business of banking. We then analyze the laws and principles
applicable to OCC?s conclusion that section 24( Seventh) does not prohibit
equity hedging and discuss the reasons why we believe OCC?s interpretation
of the section is reasonable.
OCC?s approvals of equity hedging by the four banks touches upon several
aspects of the nature of dealing in equity derivatives as a banking business
and the legality of the banks? owning stock to hedge the risks arising from
the business. In contrast with earlier opinion letters concluding that
derivatives transactions are permissible because they are a financial
intermediary activity incidental to the business of banking, OCC now
considers such transactions to be a part of the business of banking. 9 In
addition, the approvals broke new ground by specifically authorizing the
ownership of stock as an activity incidental to that function.
8 61 Fed. Reg. 60,342, 60, 351 (1996). 9 In the Equity Hedge Letter, the
Comptroller acknowledged that OCC once considered financial intermediation,
which includes equity derivative transactions, to be an incidental activity
but has re- examined this position and now considers financial
intermediation to be a function in its own right as within the business of
banking. Equity Hedge Letter at 7 n. 19. Discussion
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 32 GAO- 01- 945 Equity Hedging
In a letter to Representative Leach dated September 8, 2000 (Equity Hedge
Letter), the Comptroller of the Currency (Comptroller) stated that equity
derivative transactions are authorized under express authorities in the
National Bank Act and as part of the business of banking. He pointed out,
moreover, that where bank- permissible activities involve risks, ?? banks
must manage [the risks] as part of the business of banking . . . and may
engage in hedging activities to do so.?
OCC has discretion, ?within reasonable bounds,? to determine whether an
activity, including derivatives transactions, is part of the business of
banking. In NationsBank of North Carolina, N. A. v. Variable Annuity Life
Insurance Co. (VALIC), the Supreme Court addressed the question of what
constitutes the business of banking under section 24( Seventh) by holding
that ?? the business of banking? is not limited to the enumerated powers in
[the first sentence of] sect.24 Seventh and that the Comptroller therefore has
discretion to authorize activities beyond those specifically enumerated.? 10
The Supreme Court further observed that ?[ t] he exercise of the
Comptroller?s discretion, however, must be kept within reasonable bounds?
and that ?[ v] entures distant from dealing in financial investment
instruments . . . may exceed those bounds.? 11 In this case, OCC exercised
its discretion in concluding that equity derivative transactions are part of
the business of banking.
In reaching this conclusion, the Comptroller relied upon a definition in the
Gramm- Leach- Bliley Act (GLBA) describing certain instruments in which
banks may conduct business. 12 GLBA specifies that banks conducting
transactions in ?identified banking products? are not within the definitions
of ?broker? and ?dealer? contained in the Securities Exchange Act of 1934
10 513 U. S. 251, 258 n. 2 (1995). Prior to VALIC, a debate existed as to
whether the business of banking authorized in the powers clause was limited
to the five activities enumerated in the clause, which are as follows:
?discounting and negotiating promissory notes, drafts, bills of exchange,
and other evidences of debt . . . receiving deposits . . . buying and
selling exchange, coin, and bullion . . . loaning money on personal security
. . . and obtaining, issuing, and circulating notes according to the
provisions of title 62 of the Revised Statutes.? In VALIC, the Supreme Court
accepted OCC?s determination that the business of banking includes the
brokerage of financial instruments as part of national banks? traditional
function as financial intermediaries. 513 U. S. at 257, 258- 259. The
Supreme Court upheld the agency?s determination that brokerage of annuities
is ?incidental? to that function. 513 U. S. at 264.
11 VALIC, 513 U. S. at 258 n. 2. 12 Gramm- Leach- Bliley Act, Pub. L. No.
106- 102, 113 Stat. 1338 (1999). Equity Derivatives
Transactions and Hedging the Associated Risks Are Part of the Business of
Banking
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 33 GAO- 01- 945 Equity Hedging
(Exchange Act). 13 GLBA defines ?identified banking products? to include
?swap agreements,? which are defined as:
?any individually negotiated contract, agreement, warrant, note or option
that is based, in whole or in part, on the value of, any interest in, or any
quantitative measure or the occurrence of any event relating to, one or more
commodities, securities, currencies, interest or other rates, indices, or
other assets, but does not include any other identified banking product.? 14
Thus, the Comptroller concluded that because equity derivative transactions
are swap agreements as defined by GLBA, they are part of the business of
banking.
The Comptroller?s reliance on GLBA?s definition of ?identified banking
products? is reasonable. GLBA defines both brokers and dealers as persons
engaged in the securities business. 15 The Congress excluded banks that
engage in swap transactions from these definitions because it recognized
that banks, by conducting such activities, might otherwise be subject to the
Exchange Act. It is reasonable to infer that the Congress, by acknowledging
bank equity derivative transactions as a business activity, considers them
to be part of the business of banking. Even if the Comptroller?s reliance on
GLBA?s provision is misplaced, OCC appears to have appropriately concluded
that equity derivative transactions are part
13 15 U. S. C. sect. 78c( a)( 4)( B)( xi) (Supp. 2000); 15 U. S. C. sect. 78c( a)(
5)( iv) (Supp. 2000). 14 15 U. S. C. sect.78c( a)( 6) (Supp. 2000). Compare
Equity Hedge Letter at 1 n. 1. 15 Section 201 of GLBA amended the term
broker as defined in the Exchange Act, to mean ?any person engaged in the
business of effecting transactions in securities for the account of others.?
15 U. S. C. sect. 78c( a)( 4)( A) (Supp. 2000). Section 202 amended the term
dealer, as defined in the Exchange Act, to mean ?any person engaged in the
business of buying and selling securities for such person?s own account
through a broker or otherwise.? See 15 U. S. C. sect. 78c( a)( 5)( A) (Supp.
2000).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 34 GAO- 01- 945 Equity Hedging
of the business of banking based on the application of tests generally used
to determine whether an activity constitutes the business of banking. 16
In addition to determining that customer- driven equity derivative
transactions are part of the business of banking, OCC concluded that hedging
the risks arising from those transactions is part of the business of banking
because risk management is ?integral? to equity derivative transactions as
well as other bank activities incurring risk. When a national bank?s
business involves derivatives, OCC always has required the bank to take
appropriate risk management measures. 17 When OCC determined that equity
swap business was authorized as an incidental power, it required adequate
risk management not as an activity ?incidental to the incidental?
derivatives business, but as a part of that business governed by supervisory
principles. 18 In conjunction with its present position that financial
intermediation (and therefore derivatives dealing) constitutes the business
of banking, OCC continues to consider risk management to be part of that
function, as it considers risk management to be part of any banking activity
involving risk. 19 Finally, it is clear from our interviews with officials
from several large banking institutions that risk management is an inherent
part of the banks? equity derivative activities. According to these
officials, even when equity derivative transactions were hedged through
arrangements with affiliates with the
16 OCC applied tests used by courts for determining whether an activity is
part of the business of banking. Equity Hedge Letter at 4- 6 (citing
Merchant Bank v. State Bank, 77 U. S. 604 (1871); M& M Leasing Corp v.
Seattle First Nat?l Bank, 563 F. 2d 1377, 1382 (9th Cir. 1977), cert.
denied, 436 U. S. 956 (1978); American Insurance Assn. V. Clarke, 865 F. 2d
278, 282 (2d Cir. 1988). The tests consider whether the activity (1) is
functionally equivalent to or a logical outgrowth of a recognized banking
function, (2) benefits bank customers and/ or strengthens the bank, and (3)
presents risks of a type similar to those already assumed by banks. Equity
Hedge Letter at 4 n. 8; Julie L. Williams and Mark P. Jacobsen,
The Business of Banking: Looking to the Future, 50 Bus. Law. 783 (1995). The
Equity Hedge Letter discusses how the function of financial intermediation
is a logical outgrowth of recognized banking functions, how the activity
benefits customers and strengthens the bank, and how equity hedging presents
risks of a type similar to those already assumed by banks. As discussed
previously, OCC acknowledges that it no longer considers the function to
constitute an incidental activity. This recharacterization of the activity
does not appear to be arbitrary or to have a prejudicial effect-
consequences that have occasionally undermined agency changes of position.
Smiley v. Citibank, 517 U. S. 735, 742 (1996).
17 OCC approved the stock hedging in question here subject to each bank?s
compliance with supervisory risk management standards. 18 OCC Interpretive
Letter No. 652 (Sept. 13, 1994).
19 See Equity Hedge Letter at 7.
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 35 GAO- 01- 945 Equity Hedging
affiliates holding the stock for hedging purposes (mirror transactions), the
risks (profit and loss) of owning the stock as a hedge were attributed to
the banks. In this regard, we note that each of the approvals in the matter
under discussion was conditioned on OCC?s determining that the particular
bank?s risk management controls are adequate. 20
Based on the previous analysis, in our view, OCC reasonably concluded that
the business of banking includes equity derivative transactions and managing
the risks of those transactions. OCC?s conclusion is based on a reasonable
interpretation of GLBA and the application of tests typically used by courts
to determine whether an activity is part of the business of banking. 21
Section 24( Seventh) contains limitations and restrictions upon a national
bank?s authority to do business in securities. The section allows banks to
own certain debt securities (defined in the section as ?investment
securities?) and to deal in, underwrite, and purchase for their own account
government obligations specified in the section, but it imposes limitations
specific to stocks and other bank- ineligible securities. 22 The second
sentence prohibits banks from dealing in and underwriting bank- ineligible
securities, and specifically stocks. The fifth sentence states as follows:
?Except as hereinafter provided or otherwise permitted by law, nothing
herein contained shall authorize the purchase by the association [i. e., a
national bank] for its own account of any shares of stock of any
corporation.?
OCC interpreted the second sentence as prohibiting stock ownership only in
the contexts of dealing and underwriting. 23 OCC concluded that owning stock
for hedging purposes does not constitute either type of activity. Thus, the
second sentence does not apply here. OCC interprets the fifth sentence as a
statutory explanation that amendments made to section 24( Seventh) in 1933
did not authorize banks to purchase stock for their
20 Equity Hedge Letter at 1- 2. 21 See note 41 supra.
22 For purposes of this opinion, the term ?bank- ineligible securities?
refers to all types of debt and equity securities that a bank may not own,
underwrite, or deal in directly under 12 U. S. C. sect. 24( Seventh).
23 Equity Hedge Letter at 10- 11. Section 24( Seventh) Does
Not Prohibit Banks From Owning Stocks for Incidental Purposes
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 36 GAO- 01- 945 Equity Hedging
own account. 24 According to OCC, the sentence does not affect a national
bank?s authority to own stock. 25
We believe that OCC?s interpretation of section 24( Seventh) is reasonable.
We base our conclusion on Supreme Court decisions since the 19th century,
which hold that the powers clause permits stock ownership as an incidental
power, and on the reasoning that the Congress did not overrule or limit this
principle when it inserted the stock ownership prohibitions in 1933. We
note, moreover, that interpreting section 24( Seventh) to permit stock
hedging as an incidental power is consistent with other indications by the
Congress that the section does not impose a complete bar against national
bank ownership of corporate stock.
Since the early days of the National Bank Act, the Supreme Court and OCC
have interpreted the powers clause as granting national banks two distinct
but related powers- the power to carry on the business of banking and the
incidental powers necessary to conduct the business. 26 Certain activities
prohibited because they did not constitute the business of banking were
nonetheless authorized because they were necessary for banks to carry on
their business. This analysis is found in Supreme Court decisions dating to
the late 19th century, in which the Court interpreted the powers clause to
prohibit national banks from owning stock for dealing, investment, and other
purposes, but recognized that banks have authority to own stock as an
incidental power.
In First National Bank of Charlotte v. National Exchange Bank of Baltimore,
the Supreme Court in 1875 determined that national bank dealings in stock
were implicitly prohibited because authority to engage in such activities
was not granted by the powers clause. 27 However, the Supreme Court held
that the plaintiff national bank was authorized to acquire stock, ?with a
view to their subsequent sale or conversion into money so as to make good or
reduce an anticipated loss,? in a ?fair and
bona fide compromise of a contested claim . . . growing out of a legitimate
24 Equity Hedge Letter at 12- 14. 25 As discussed later, OCC maintains that
section 24( Seventh) nonetheless prohibits stock ownership except as an
incidental activity. 26 Since it was adopted in 1864, the powers clause has
remained virtually unchanged.
27 First National Bank of Charlotte v. National Exchange Bank of Baltimore,
92 U. S. 122, 128 (1875). National Bank Incidental
Powers Permit Stock Ownership
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 37 GAO- 01- 945 Equity Hedging
banking transaction.? 28 In addition, the Supreme Court observed that the
bank directors had specific authority to transact the bank?s business and
that section 24( Seventh) granted all incidental powers necessary to carry
out that authority. 29
The Supreme Court applied the same reasoning with respect to the performance
of a commercial banking activity- that is, lending. On this point, in
California National Bank v. Kennedy the Court made the following
observation:
?It is settled that the United States statutes relative to national banks
constitute the measure of the authority of such corporations, and that they
cannot rightfully exercise any powers except those expressly granted, or
which are incidental to carrying on the business for which they are
established. . . . No express power to acquire the stock of another
corporation is conferred upon a national bank, but it has been held that, as
incidental to the power to loan money on personal security, a bank may, in
the usual course of doing such business, accept stock of another corporation
as collateral, and, by the enforcement of its rights as pledge, it may
become the owner of the collateral . . . . So, also, a national bank may be
conceded to possess the incidental power of accepting in good faith stock of
another corporation as security for a previous indebtedness. It is clear,
however, that a national bank does not possess the power to deal in stocks.?
30
It is clear from these and other Supreme Court decisions that before 1933,
national banks were prohibited from doing business or investing in corporate
stock but that owning stock was permissible when necessary in order for
banks to conduct their business affairs or carry on commercial banking
activities. 31
28 Id. at 126- 28. 29 Id.
30 167 U. S. 362, 366- 67 (1897) (citations omitted). In First National Bank
of Ottawa v. Converse, 200 U. S. 425, (1906), the Supreme Court made clear
that business of banking also does not include investing in stock for
speculative purposes. In that case, the Court stated that ?no authority,
express or implied, has ever been conferred by the statutes of the United
States upon a national bank to engage in or promote a purely speculative
business or adventure. . . . [I] t follows that the bank had no power to
engage in such business by taking stock or otherwise.? Id. at 438- 39.
31 The Supreme Court has applied the same analysis in holding that national
banks? incidental powers authorize other types of activity that do not
constitute the business of banking. Edward Symons, The ?Business of Banking?
in Historical Perspective, 51 Geo. Wash. L. Rev. 676, 683, 702- 13 (1983).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 38 GAO- 01- 945 Equity Hedging
The Supreme Court decisions permitting stock ownership as an incidental
power were decided before the stock- related limitations and restrictions in
section 24( Seventh) became law in 1933. 32 Whether OCC correctly approved
stock ownership for hedging purposes depends upon the scope of national
banks? incidental power to own stock before 1933 and the effect of the 1933
provisions upon that power. We believe that the authority to own stock as an
incidental power was not limited to the facts of the cases decided by the
Supreme Court and that the 1933 provisions did not limit the banks?
incidental powers to own stock.
The powers clause defines a national bank?s incidental powers as those
?necessary? for the bank to carry on the business of banking. Nothing in the
clause itself suggests that stock ownership qualifies as ?necessary? only in
relation to particular types of banking activities. Although the Supreme
Court decisions permitting stock ownership as an incidental power involved
particular sets of circumstances, nothing in those decisions suggests that
the incidental powers authority was limited to those circumstances. 33 In
approving stock hedging by the four banks, OCC applied the standard
generally accepted to show that an activity is ?necessary? and, therefore,
permissible as an incidental power. 34 OCC?s decision that the four banks
have incidental authority to own stock as a hedging device is consistent
with the express language of the powers clause as well as with Supreme Court
interpretations of the clause in place before 1933.
32 Banking Act of 1933, Pub. L. No. 73- 66, 48 Stat. 162 (1933) (codified in
scattered sections of title 12 of the Unites States Code) (1933 Banking
Act). The stock- related limitations and restrictions in section 24(
Seventh) were contained in section 16 of the Glass- Steagall Act, which
consists of sections 16, 20, 21, and 32 of the 1933 Banking Act.
33 See First National Bank of Charlotte, 92 U. S. at 127 (describing
incidental powers to be ?such as are required to meet all the legitimate
demands of the authorized business, and to enable a bank to conduct its
affairs, within the general scope of its charter, safely and prudently?).
34 Equity Hedge Letter at 9- 10. To determine whether a particular activity
is necessary to carry on the business of banking, OCC applies standards
derived from a decision of the First Circuit Court of Appeals in Arnold
Tours, Inc., v. Camp, 472 F. 2d 427, 432 (1st Cir. 1972) and VALIC and
standards generally accepted by courts. See Independent Insurance Agents of
America v. Hawke, 211 F. 3d 638, 640 (D. C. Cir. 2000). In Arnold Tours, the
court held that the term ?necessary? in 12 U. S. C. sect.24( Seventh) should be
construed broadly to include activities that are ?convenient and useful? to
one of the five types of activity enumerated in the first sentence. Arnold
Tours, 472 F. 2d at 432. Applying the holding in VALIC, OCC determines
whether an activity is convenient and useful to an activity that constitutes
the business of banking regardless of whether the activity is covered by the
statutory list. Prohibitions on Stock
Ownership Do Not Limit National Banks? Incidental Power to Own Stock
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 39 GAO- 01- 945 Equity Hedging
Nothing in section 16 of the Glass- Steagall Act or the legislative history
of the 1933 Banking Act establishes that the Congress limited the scope of
incidental powers with respect to stock ownership. The purpose of the Glass-
Steagall provisions was to separate commercial banks from engaging directly
in investment banking. 35 The Congress adopted section 16 to prohibit banks
from risking depositor funds by participating directly or indirectly in
bank- ineligible securities and stock markets as dealers, underwriters, or
investors. 36 Nothing in the section or its history indicates that the
Congress sought to prohibit or limit the ability of national banks to
conduct activities recognized as commercial banking.
The second sentence of section 24( Seventh) specifies that a national bank?s
?business of dealing in securities and stock? is limited to brokerage and
does not include purchasing and selling securities and stock for the bank?s
own account. In addition, the sentence specifically prohibits a national
bank from underwriting securities and stock. The terms ?dealing? and
?underwriting? are not defined in the 1933 Banking Act. OCC interprets the
dealing activity referred to in the second sentence to encompass the
purchase of securities as principal for resale to others. According to OCC,
dealing is buying and selling as part of a regular business. A dealer
typically maintains an inventory of securities and holds itself out to the
public as willing to purchase, sell, and continuously quote
35 See Citicorp, 73 Fed. Res. Bull. 473, 479 (1987), aff?d sub nom.
Securities Industry Ass?n v. Board of Governors of the Federal Reserve
System, 839 F. 2d 47 (2d Cir.), cert. denied,
486 U. S. 1059 (1988). In its decision in that proceeding, the Federal
Reserve said that the Glass- Steagall Act provisions ?were enacted with one
central purpose in mind, to protect bank depositors from the hazards that
Congress viewed as attributable to the combination of commercial and
investment banking.?
36 During the years before 1933, national banks were involved in investment
banking primarily through state- chartered affiliates whose investment
banking activities largely involved bonds and other debt securities. After
passage of the McFadden Act in 1927, Pub. L. No. 69- 639, which amended
section 24( Seventh) specifically to permit national banks to purchase and
sell certain debt securities (bonds and other forms of indebtedness
described as ?investment securities?), bank affiliates, often using the
banks? resources, also engaged in underwriting operations, stock speculation
and maintaining a market for the bank?s own stock. Among other things, these
activities gave rise to the concern that bank deposits were being placed at
risk in the stock market. Board of Governors of Fed. Reserve Sys. v.
Investment Co. Inst., 450 U. S. 46, 61, n. 27 & 28 (1981); see also Edwin J.
Perkins, The Divorce of Commercial and Investment Banking: A History, 6
Banking L. J. 483, 495- 505 (1971).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 40 GAO- 01- 945 Equity Hedging
prices. 37 Similarly, OCC interprets the underwriting activity prohibited by
the sentence to be ?the purchase of securities from an issuer for
distribution and sale to investors. . . . [o] ne cannot be an underwriter in
the absence of a public offering.? 38 Given these definitions, the second
sentence only prohibits national banks from owning stock as part of the
general prohibition against dealing in and underwriting certain securities
and stock. We consider OCC?s reliance on these definitions to be reasonable
and therefore agree with its conclusion that the second sentence does not
prohibit equity hedging. 39
Unlike the second sentence, the fifth sentence by its terms does not
affirmatively proscribe stock ownership. Rather, the fifth sentence utilizes
explanatory language. It states that ?nothing herein contained? authorizes a
national bank to purchase stock for its own account, subject to two
exceptions. The first exception allows for any stock ownership authority
37 Equity Hedge Letter at 10- 11; see also Citicorp, 73 Fed. Res. Bull. at
481 (according to the Federal Reserve Board, the term ?dealer? commonly
refers to an entity that holds itself out to the public as being willing to
buy and sell securities for its own account (citation omitted)).
38 Equity Hedge Letter at 11. 39 See, e. g., Securities Industry Ass?n v.
Board of Governors of the Federal Reserve System,
468 U. S. 137, 158 n. 11 (1984) (discounting commercial paper is not the
?business of dealing? in securities prohibited by the second sentence
because the discounting activity is part of the business of banking). By
?limiting? banks? ?business of dealing? to brokerage, the syntax of the
second sentence suggests that the Congress considered securities brokerage
to be an activity within banks? business of dealing. Brokerage is not within
the definition of dealing applied by OCC. OCC?s definition of dealing,
therefore, might appear to be underinclusive. In this regard, we note that
in the Securities Act of 1933, the Congress defined the term ?dealer? to
mean ?any person who engages either for all or part of his time, directly or
indirectly, as agent, broker, or principal, in the business of offering,
buying, selling, or otherwise dealing or trading in securities issues by
another person.? 15 U. S. C.sect. 77b( 12) (1994). The legislative history of
the Securities Act of 1933 indicates that the Congress used this expansive
definition of ?dealer? for the purpose of subjecting those within the
definition to the same advertising restrictions that apply to dealers in
order to prevent brokers and others from ?being used as a cloak for the sale
of securities.? H. R. Rep. No. 85, 73d Cong. 1st Sess. 14 (1933). This
action suggests that even in the context of the Securities Act of 1933 the
Congress considered dealing to be an activity distinct from brokerage. OCC?s
interpretation appears to be consistent with the general understanding of
the practice of ?dealing in? securities that existed before the second
sentence was adopted in 1933. As early as 1875, the Supreme Court observed
that ?a prohibition against trading and dealing [is] nothing more than a
prohibition against engaging in the ordinary business of buying and selling
for profit, and [does] not include purchases resulting from ordinary banking
transactions.? First National Bank of Charlotte, 92 U. S. at 128 (1875)
(citation omitted).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 41 GAO- 01- 945 Equity Hedging
provided in the portion of section 24( Seventh) that follows the sentence.
40 The second exception allows for stock ownership ?otherwise permitted by
law.?
In OCC?s view, this sentence does not prohibit stock hedging because it does
not affect a national bank?s authority to own stock to the extent authorized
by the powers clause. OCC considers the fifth sentence to be simply a
statement by the Congress clarifying that amendments made to section 24(
Seventh) by section 16 of the Glass- Steagall Act did not authorize national
banks to purchase stock for their own account. Thus, the sentence has no
effect on bank powers that existed before section 16 was passed. A key point
in OCC?s analysis of the sentence is the meaning of the phrase ?nothing
herein contained.? If the phrase pertains to section 24( Seventh) in its
entirety, it means that nothing in the section, including the powers granted
to national banks by the powers clause, authorizes a national bank to
purchase stock for its own account unless the activity is permitted in
subsequent provisions of the section or ?otherwise permitted by law.? In
this sense, the phrase ?otherwise permitted by law? refers to laws other
than section 24( Seventh). Because neither the subsequent provisions of the
section nor any law outside of section 24( Seventh) authorize stock
ownership except in specific circumstances not pertinent here, under this
interpretation the sentence would bar the ownership of stock as an
incidental power. On the other hand, if the phrase ?nothing herein
contained? does not refer to the authority contained in the powers clause,
stock ownership is ?otherwise permitted by law? to the extent authorized in
the powers clause and therefore is not prohibited by the fifth sentence.
OCC interprets the phrase ?nothing herein contained? so that it refers only
to a specific provision in section 24( Seventh) that does not apply to stock
ownership. Although section 16 of the Glass- Steagall Act limited bank
powers with respect to securities and stock, the section authorized national
banks to own certain types of securities for their own account. These
securities, referred to in the section as ?investment securities,? are
defined generally as ?marketable obligations, evidencing indebtedness.? OCC
maintains that the Congress added the fifth sentence only to clarify that
nothing contained in the investment securities ownership authority
40 Following the fifth sentence, section 24( Seventh) specifically provides
that the limitations and restrictions relating to dealing in, underwriting
and purchasing investment securities do not apply to several government or
government- related obligations and securities and stock issued in
connection with government- sanctioned programs.
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 42 GAO- 01- 945 Equity Hedging
permits national banks to purchase corporate stock. Consequently, the fifth
sentence recognizes that banks may purchase stock if the activity is
?otherwise permitted by law,? which law includes the incidental powers
authority contained in the powers clause. 41
The fifth sentence, in our view, was intended to do more than clarify that
the authority to own debt securities does not authorize national banks to
own stock. 42 We believe that the sentence generally prohibits national
banks from owning stock. 43 However, we believe that the sentence permits
stock ownership as an incidental power because that activity was within the
powers granted by the powers clause at the time the Congress enacted section
16 and, therefore, falls within the ?otherwise permitted by law?
41 As noted previously, OCC has maintained this position since at least
1966. The interpretation of section 24( Seventh) on which OCC relied in
approving the stock hedging is essentially the same one that the agency
first announced in the Federal Register in 1966 and has adhered to since
then. OCC Rules, Policies, and Procedures for Corporate Activities, 61 Fed.
Reg. 60342, 60351 (Nov. 27, 1996); 12 C. F. R. sect. 7. 10 (published at 31 Fed.
Reg. 11459 (Aug. 31, 1966)).
42 Additional evidence that the Congress intended generally to prohibit
stock ownership through the fifth sentence exists in the Banking Act of
1935. Pub. L. No. 74- 305, 74 Stat. 684 (1935). In that act, the Congress
amended the second and fifth sentences to reflect what was originally
intended by section 16 of the 1933 Act. The fifth sentence language in the
1933 Act said, in pertinent part, that ?nothing herein contained shall
authorize the purchase by the association (bank) of any shares of stock of
any corporation.? The 1935 Act added the words ?for its own account? after
the term ?association.? 74 Stat. 709. The purpose of this provision was to
clarify section 24( Seventh) to provide that national banks may not buy and
sell stocks for their own account. S. Rep. No. 74- 1007, 74th Cong., 2d
Sess. 1935 at 17.
43 OCC itself has expressed the view that section 24( Seventh) generally
prohibits national banks from owning stock. For example, in a 1979
interpretive letter OCC stated as follows: ?With limited exceptions for
investment securities and certain other named securities, 12 U. S. C. sect.24(
Seventh) prohibits a national bank from purchasing stock for its own
account.? OCC Interpretive Letter No. 96 (May 14, 1979), reprinted in Fed.
Banking L. Rep. (CCH) para. 85,171; See also OCC Interpretive Letter regarding
Point of Sale Terminals (Nov. 9, 1992) (national banks are generally
prohibited from purchasing or owning corporate stock by virtue of 12 U. S.
C. sect. 24( Seventh); whether a bank may acquire and own stock in another
entity will turn on whether such shares are being acquired to facilitate the
bank?s participation in a legitimate banking activity rather than for
investment or speculative purposes). In OCC Interpretive Letter No. 419 at
p. 7 (Feb. 16, 1988), reprinted in Fed. Banking L. Rep. (CCH) P85,643. OCC
stated as follows:
Our concern with national banks purchasing stock in a corporation arises
from the language of Section 16 of the Glass- Steagall Act which provides
that except as hereinafter provided or otherwise permitted by law, nothing
herein contained shall authorize the purchase by [a national bank] for its
own account of any shares of stock of any corporation (brackets in the
original).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 43 GAO- 01- 945 Equity Hedging
exception contained in the sentence. Moreover, such an interpretation is in
harmony with the overall purpose of the section and other provisions of the
1933 Banking Act, which contained section 16 of the Glass- Steagall Act.
Interpreting the fifth sentence as a general prohibition that nonetheless
permits stock ownership as an incidental power is consistent with both the
purpose of section 16 and provisions of the 1933 Banking Act. Incidental
powers are, by statutory definition, necessary to the performance of an
activity that constitutes the business of banking. Limiting a bank?s
incidental powers also limits the bank?s ability to conduct its business. 44
While section 16 establishes that the Congress considered stock ownership
generally not to be part of the business of banking, nothing in the section
indicates that the Congress also intended to limit a national bank?s ability
to carry on the business of banking. This principle underlies fundamental
banking activities recognized by both OCC and the Federal Reserve Board. 45
For example, both agencies recognize the authority of the banks they
regulate to collateralize for a loan with stock and to take possession of
the stock upon default. 46 Both agencies permit the banks they regulate to
own stock in subsidiaries based on the incidental powers authority in the
powers clause. 47
44 This principle underlies the early Supreme Court decisions recognizing a
national bank?s authority to own stock as an incidental power even though
the business of banking did not include stock ownership. As demonstrated in
the preceding discussion of those decisions, the Supreme Court observed that
banks could not conduct legitimate activities without such authority.
45 Under the Federal Reserve Act, state member banks are ?subject to the
same limitations and conditions with respect to the purchasing, selling,
underwriting, and holding of investment securities and stock as are
applicable in the case of national banks? under 12 U. S. C. sect. 24( Seventh).
12 U. S. C. sect. 335 (1994). In addition, the Federal Deposit Insurance Act
prohibits insured state banks from engaging as principal in any type of
activity that is not permissible for a national bank unless the FDIC
determines that the activity would pose no significant risk to the
appropriate deposit insurance fund and the insured state bank complies with
applicable capital standards. 12 U. S. C. sect. 1831a( a)( 1) (Supp. 2000).
46 12 C. F. R. sect. 1.7 (2001) (national banks may own securities held in
satisfaction of debts previously contracted); 12 C. F. R sect. 225.12 (2001)
(state member bank may acquire without Board approval voting securities of a
bank or bank holding company in the regular course of securing or collecting
a debt previously contracted in good faith).
47 See 12 C. F. R. sect. 5.34 (2001) (OCC); 61 Fed. Reg. at 60342 (OCC); 12 C.
F. R. sect. 250.141( c) (2001) (Federal Reserve); 1968 Fed. Res. Bull. 168
(incidental powers authority in 12 U. S. C. sect. 24( Seventh) authorizes state
member banks to own stock in wholly owned subsidiaries engaged in activities
the banks themselves may perform).
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 44 GAO- 01- 945 Equity Hedging
A review of other provisions of the 1933 Banking Act indicates that the
Congress contemplated stock ownership as an activity incidental to the
business of banking. 48 Nothing in the Banking Act of 1933 or elsewhere in
the National Bank Act specifically authorized national banks to own
subsidiaries or interests in affiliates. Owning stock for this purpose was
not listed in section 24( Seventh) as a banking activity. However, in the
1933 act, the Congress specifically recognized the power of national banks
to own corporate stock despite the fifth sentence. Section 2 of the act
defined the term ?affiliate? to include ?any corporation, business trust,
association, or other similar organization . . . of which a member bank,
directly or indirectly, owns or controls either a majority of the voting
shares or more than 50 per centum of the number of shares voted for the
election of its directors.? 49 Section 16 preserved a preexisting provision
of section 24( Seventh) limiting the amount of stock a national bank could
own in a corporation operating a safe deposit business, even though banks
had no specific authority to own such stock. 50
48 A fundamental principle of statutory construction is that the various
provisions of a statute should be construed as a whole and that a particular
section of a statute may not be interpreted in isolation without regard to
other sections of the statute of which it is a part.
United States v. Morton, 467 U. S. 822, 828 (1984); Philbrook v. Glodgett,
421 U. S. 707, 713 (1975).
49 Pub. L. No. 73- 66 sect. 2( b), 12 U. S. C. sect. 221a (1994). 50 See S. Rep. No.
69- 473 (69th Cong., 2d Sess. 1926) at 7 (accompanying Pub. L. No. 69- 639 sect.
2 (1927) (McFadden Act)) (safe deposit provision was added to section 24(
Seventh) by the McFadden Act in recognition that conducting safe deposit
business and investing in corporations organized to conduct the business ?is
a business which is regularly carried on by national banks?). With regard to
this provision, the Supreme Court made the following observation: ?The
language of the proviso of sect. 24, just quoted, is the language suitable to
impose restrictions on a recognized power, not the language that would be
used in creating a new power.? Colorado Nat. Bank of Denver v. Bedford, 310
U. S. 41, 49 (1940). Because the Congress recognized stock ownership for
this purpose as a permissible activity even though owning stock was not
within the activities enumerated in the first sentence and was prohibited
except as an incidental power, it is reasonable to infer that the Congress
considered owning stock in a corporation to have been authorized as an
incidental power. This conclusion is consistent with another McFadden Act
amendment to section 24( Seventh) recognizing bank activities which had been
conducted pursuant to the incidental powers authority. Section 2 of the
McFadden Act amended section 24( Seventh) specifically to permit national
banks to engage in the nonrecourse buying and selling of ?investment (debt)
securities.? The legislative history states that the Congress made this
amendment to recognize as the business of banking an activity that
previously had been authorized as incidental to banks? express authority to
discount and negotiate promissory notes. S. Rep. No. 69- 473 at 5- 7.
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 45 GAO- 01- 945 Equity Hedging
Considering the specific purposes of section 16 and national banks? express
incidental powers authority, which included stock ownership long before
section 16 was enacted, it is reasonable to interpret the fifth sentence as
recognizing stock ownership to be otherwise permitted by law pursuant to the
incidental powers provision. The legislative history of the 1935 Banking Act
contains no congressional explanation of the ?otherwise permitted by law?
exception to the general prohibition against stock ownership. We note,
however, that if the Congress had intended to prohibit stock ownership
except as provided in the part of section 24( Seventh) following the fifth
sentence and in statutory provisions other than section 24( Seventh), the
exception for stock ownership as otherwise permitted by law would be
redundant. As OCC pointed out in its 1966 interpretation of section 24(
Seventh) permitting ownership of subsidiaries, another statute permitting
stock ownership would take effect regardless of such an exception. 51
We agree with OCC?s conclusion that national banks, subject to supervisory
approval, have authority under the National Bank Act to own corporate stock
to hedge their customer- driven equity derivative transactions. OCC
determined that equity derivatives dealing and managing the risks of that
activity are part of the business of banking based on a reasonable
interpretation of GLBA and the application of the test typically used by
courts to determine whether an activity is part of the business of banking.
Applying the generally accepted judicial test for determining whether an
activity is within a national bank?s incidental powers authority, OCC also
reasonably concluded that equity hedging is incidental to the business of
banking. Although 12 U. S. C. sect. 24( Seventh) generally prohibits national
banks from owning stock, the prohibition does not limit a bank?s authority
to own stock as an incidental power. Since the early days of the National
Bank Act of 1864, the powers clause has been interpreted to authorize stock
ownership as an incidental power. We concur with OCC that nothing in the
stock ownership prohibition restricts or limits this interpretation. The
second sentence of section 24( Seventh) prohibits national banks from owning
stock in order to engage in the business of dealing in or underwriting
securities and stock. The fifth sentence of the section 24( Seventh)
generally prohibits national banks
51 1966 Fed. Reg. 11459 n. 4; see, e. g., United States v. Dalcour, 203 U.
S. 408, 421 (1906) (interpreting phrase ?unless otherwise provided by law?
contained in another federal statute as ?refer[ ring] to existing provisions
and not to be merely a futile permission to future legislatures to make a
change?). Conclusion
Appendix II: Legal Analysis of OCC Equity Hedging Decision
Page 46 GAO- 01- 945 Equity Hedging
from purchasing stock for their own account, but the sentence recognizes
that national banks may own stock if the activity is otherwise permitted by
law. When the Congress enacted the fifth sentence in 1933, incidental
ownership was permitted by the powers clause. Nothing in the 1933 amendments
indicates that the Congress intended to limit the meaning of the powers
clause. Moreover, interpreting section 24( Seventh) to permit stock
ownership as an incidental power is consistent with a reasoned
interpretation of the Banking Act of 1933 in its entirety.
Page 47 GAO- 01- 945 Equity Hedging
Appendix III: Comments From the Comptroller of the Currency
Page 48 GAO- 01- 945 Equity Hedging (250017)
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