    Bank Tying: Additional Steps Needed to Ensure Effective
    Enforcement of Tying Prohibitions (10-OCT-03, GAO-04-3).

    Investment affiliates of large commercial banks have made
    competitive inroads in the annual $1.3 trillion debt-underwriting
    market. Some corporate borrowers and officials from an
    unaffiliated investment bank have alleged that commercial banks
    helped their investment affiliates gain market share by illegally
    tying and underpricing corporate credit. This report discusses
    these allegations, the available evidence related to the
    allegations, and federal bank regulatory agencies' efforts to
    enforce the antitying provisions.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-04-3
        ACCNO:   A08702
      TITLE:     Bank Tying: Additional Steps Needed to Ensure Effective
    Enforcement of Tying Prohibitions
         DATE:   10/10/2003
      SUBJECT:   Bank examination
    	     Bank loans
    	     Bank management
    	     Banking law
    	     Banking regulation
    	     Insured commercial banks
    	     Law enforcement
    	     Noncompliance

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    GAO-04-3

    United States General Accounting Office

    GAO

    Report to the Ranking Minority Member,

               Committee on Energy and Commerce, House of Representatives

    October 2003

    BANK TYING

     Additional Steps Needed to Ensure Effective Enforcement of Tying Prohibitions

                                           a

    GAO-04-3

    Highlights of GAO-04-3, a report to the Ranking Minority Member, the
    Committee on Energy and Commerce, House of Representatives

    Investment affiliates of large commercial banks have made competitive
    inroads in the annual $1.3 trillion debt-underwriting market. Some
    corporate borrowers and officials from an unaffiliated investment bank
    have alleged that commercial banks helped their investment affiliates gain
    market share by illegally tying and underpricing corporate credit. This
    report discusses these allegations, the available evidence related to the
    allegations, and federal bank regulatory agencies' efforts to enforce the
    antitying provisions.

    Because documentary evidence of an unlawful tying arrangement generally is
    not available in bank files, GAO recommends that the Federal Reserve and
    OCC consider additional steps to enforce section 106. Additional steps
    could include publication of specific contact points within the agencies
    to answer questions from banks and bank customers about the guidance in
    general and its application to specific transactions, as well as to accept
    complaints from bank customers who believe that they have been subjected
    to unlawful tying.

    Because low-priced credit could indicate violations of law, the Federal
    Reserve should also assess available evidence of loan pricing behavior to
    provide better supervisory information, and publish the results of this
    assessment.

    www.gao.gov/cgi-bin/getrpt?GAO-04-3.

    To view the full product, including the scope and methodology, click on
    the link above. For more information, contact Richard Hillman at (202)
    512-8678 or hillmanr@gao.gov.

    October 2003

    BANK TYING

    Additional Steps Needed to Ensure Effective Enforcement of Tying Prohibitions

    Section 106 of the Bank Holding Company Act Amendments of 1970 prohibits
    commercial banks from "tying," a practice which includes conditioning the
    availability or terms of loans or other credit products on the purchase of
    certain other products and services. The law permits banks to tie credit
    and traditional banking products, such as cash management, and does not
    prohibit banks from considering the profitability of their full
    relationship with customers in managing those relationships.

    Some corporate customers and officials from an investment bank not
    affiliated with a commercial bank have alleged that commercial banks
    illegally tie the availability or terms, including price, of credit to
    customers' purchase of other services. However, with few exceptions,
    formal complaints have not been brought to the attention of the regulatory
    agencies and little documentary evidence surrounding these allegations
    exists, in part, because credit negotiations are conducted orally.
    Further, our review found that some corporate customers' claims involved
    lawful ties between traditional banking products rather than unlawful
    ties. These findings illustrate a key challenge for banking regulators in
    enforcing this law: while regulators need to carefully consider the
    circumstances of specific transactions to determine whether the customers'
    acceptance of an unlawfully tied product (that is, one that is not a
    traditional banking product) was made a condition of obtaining credit,
    documentary evidence on those circumstances might not be available.
    Therefore, regulators may have to look for indirect evidence to assess
    whether banks unlawfully tie products and services. Although customer
    information could have an important role in helping regulators enforce
    section 106, regulators generally have not solicited information from
    corporate bank customers.

    The Board of Governors of the Federal Reserve System and the Office of the
    Comptroller of the Currency (OCC) recently reviewed antitying policies and
    procedures of several large commercial banks. The Federal Reserve and OCC,
    however, did not analyze a broadly-based selection of transactions or
    generally solicit additional information from corporate borrowers about
    their knowledge of transactions. The agencies generally found no unlawful
    tying arrangements and concluded that these banks generally had adequate
    policies and procedures intended to prevent and detect tying practices.
    The agencies found variation among the banks in interpretation of the
    tying law and its exceptions. As a result, in August 2003, the Board of
    Governors of the Federal Reserve, working with OCC, released for public
    comment new draft guidance, with a goal of better informing banks and
    their customers about the requirements of the antitying provision.

    Contents

      Letter

    Results in Brief
    Background
    Some Corporate Borrowers Alleged That Unlawful Tying Occurs,

    but Available Evidence Did Not Substantiate These Allegations Federal
    Reserve and OCC Targeted Review Identified Interpretive Issues

    Evidence That We Reviewed on the Pricing of Corporate Credit Did Not
    Demonstrate That Commercial Banks Unlawfully Discount Credit

    Differences between Commercial Banks and Investment Banks Did

    Not Necessarily Affect Competition Conclusions Recommendations for
    Executive Action Agency Comments

    1 4 8

    15

    17

    25

    31 39 40 40

    Appendixes

    Appendix I:

    Appendix II: Appendix III:

    Appendix IV: Differences in Accounting between Commercial and Investment
    Banks for Loan Commitments

    Background
    Hypothetical Scenario for Unexercised Loan Commitments
    Hypothetical Scenario for Exercised Loan Commitments

    Comments from the Federal Reserve System

    Comments from the Office of the Comptroller of the Currency

    GAO Contacts and Staff Acknowledgments

    GAO Contacts Acknowledgments 42 43 45 48

    52

    54

    56 56 56

    Tables	Table 1: Accounting Differences for a Loan Commitment 48 Table 2:
    Accounting Differences for a Loan Sale 51

    Contents

    Abbreviations

    AICPA American Institute of Certified Public Accountants
    FASB Financial Accounting Standards Board
    FAS Financial Accounting Standards
    FDIC Federal Deposit Insurance Corporation
    OCC Office of the Comptroller of the Currency
    SEC Securities and Exchange Commission

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

    A

    United States General Accounting Office Washington, D.C. 20548

    October 10, 2003

    The Honorable John D. Dingell Ranking Minority Member Committee on Energy
    and Commerce House of Representatives

    Dear Mr. Dingell:

    In the 70 years since the passage of the Glass-Steagall Act of 1933, which
    prohibited commercial banks from engaging in investment banking activities
    such as securities underwriting, changes in legislation and regulatory
    interpretations have relaxed some of the restrictions imposed on bank
    holding companies and their subsidiaries that served to distance
    commercial banks from investment banking. For example, one effect of the
    1970 amendments to the Bank Holding Company Act of 1956 was to permit bank
    holding companies to own subsidiaries engaged in limited underwriting
    activities, but only if the subsidiary was not "principally engaged" in
    such activities. More recently, the Gramm-Leach-Bliley Act of 1999, among
    other things, substantially removed that limitation. As a result of these
    and other developments, commercial banks and their investment bank
    affiliates (investment affiliates) can provide complementary financial
    products and services. Despite these developments, commercial banks have
    remained subject to certain restrictions on their activities. Among them
    is the prohibition against tying arrangements. In general, section 106 of
    the Bank Holding Company Act Amendments of 1970 (section 106) prohibits
    banks from tying the availability or price of a product or service to a
    customer's purchase of another product or service or the customer's
    providing some additional credit, property or service.1

    In recent years, investment bank affiliates of large commercial banks have
    gained an increasing share of the annual $1.3 trillion debt underwriting
    market. A controversy has arisen over whether or not unlawful tying has
    contributed to this increased market share. Some unaffiliated investment
    banks (investment banks) and some corporate borrowers contend that
    commercial banks have facilitated investment affiliates' increased market
    share of debt underwriting by unlawfully tying the availability of bank

    1As explained later, not all instances of bank tying are unlawful because
    certain types of products and services are not subject to the tying
    prohibition in the Bank Holding Company Act.

    credit to debt underwriting by the bank's affiliate, a violation of
    section 106. In addition, some investment bankers assert that large
    commercial banks engage in unlawful tying by offering reduced rates for
    corporate credit only if the borrower also purchases debt underwriting
    services from the bank's investment affiliate. If such a reduced rate were
    conditioned only on the borrower's purchase of debt underwriting services
    from the commercial bank's investment affiliate, the arrangement would
    constitute unlawful tying. Should the reduced rate constitute an
    underpricing of credit (that is, the extension of credit below market
    rates), the underpricing could also violate section 23B of the Federal
    Reserve Act of 1913 (section 23B).

    Section 23B generally requires that certain transactions between a bank
    and its affiliates occur on market terms; that is, on terms and under
    circumstances that are substantially the same, or at least as favorable to
    the bank, as those prevailing at the time for comparable transactions with
    unaffiliated companies. Section 23B applies to any transaction by a bank
    with a third party if an affiliate has a financial interest in the third
    party or if an affiliate is a participant in the transaction. The banking
    regulators suggest that the increase in debt underwriting market share by
    the investment affiliates of large commercial banks can be explained by a
    number of market and competitive factors not associated with tying, such
    as industry consolidation and acquisition of investment banking firms by
    bank holding companies. In addition, representatives from large commercial
    banks with investment affiliates contend that they sell a range of
    products and services to corporate customers, including credit, but do not
    unlawfully tie bank credit or credit pricing to underwriting services.
    Furthermore, officials from large commercial banks, federal banking and
    securities regulators, and investment bankers observe that ties between
    credit and other banking products are often customer-initiated, and thus
    exempt from the laws governing tying.

    To more fully examine the issues raised by the allegations about unlawful
    tying and underpricing of corporate credit, you asked us to determine (1)
    what evidence, if any, suggests that commercial banks with investment
    affiliates engage in unlawful tying; (2) what steps the federal banking
    regulators have taken to examine for unlawful tying and the results of
    these efforts; (3) what evidence, if any, suggests that commercial banks
    with investment affiliates unlawfully discount the price of corporate
    credit to obtain underwriting business for their investment affiliates;
    and (4) what, if any, competitive advantages accounting rules, capital
    standards, and access to the federal safety net create for commercial
    banks over investment banks.

    In our review of possible unlawful tying practices by large commercial
    banks, we focused on wholesale corporate lending and did not address
    retail banking. We conducted a legal review of section 106 of the Bank
    Holding Company Act Amendments of 1970, section 23B of the Federal Reserve
    Act, and relevant federal regulations, and interviewed legal experts and
    academics. To describe the recent concerns about possible unlawful tying
    practices, we reviewed the results of a 2003 survey on corporate
    borrowers' views about credit access conducted by the Association for
    Financial Professionals and reviewed recent media coverage of tying. We
    also interviewed several large corporate borrowers, and officials at
    several investment banks and commercial banks with investment affiliates.
    We also met with officials from NASD to discuss that organization's
    Special Notice to its members and its ongoing investigation related to
    tying. NASD is a self-regulatory organization that sets and enforces
    market conduct rules governing its members, which are securities firms,
    including those affiliated with commercial banks.

    To determine what steps the federal banking regulators have taken to
    examine for unlawful tying, we reviewed the results of the Board of
    Governors of the Federal Reserve System (Federal Reserve) and the Office
    of Comptroller of the Currency (OCC) joint review on tying and interviewed
    commercial bankers to describe the measures that large commercial banks
    take to comply with the tying law. We also reviewed federal guidance on
    sections 106 and 23B and Federal Reserve and OCC examination procedures
    related to tying. In addition, we interviewed officials from the Federal
    Reserve, OCC, and the Federal Deposit Insurance Corporation (FDIC).

    To identify possible credit pricing abuses and factors that affect overall
    prices in wholesale credit markets, we interviewed commercial bankers,
    credit market experts, academics experts, industry observers, and
    officials at the Federal Reserve and OCC. We also reviewed economic
    literature on wholesale credit markets.

    To determine the accounting practices and requirements for commercial
    banks and investment banks, we performed a comparative analysis of
    applicable accounting standards and verified our understanding through
    interviews with officials from the Financial Accounting Standards Board
    (FASB), the American Institute of Certified Public Accountants (AICPA),
    and the Securities and Exchange Commission (SEC). We also solicited
    feedback from FASB and AICPA officials on appendix I of our draft report
    and incorporated their technical comments in this report as appropriate.
    To

    determine the respective capital standards for commercial banks, we
    reviewed relevant documentation and interviewed Federal Reserve, OCC, and
    SEC officials and officials from commercial banks. We also spoke with
    Federal Reserve and OCC officials about the access of commercial banks and
    investment banks to the federal safety net.

    We recognized certain limitations on the information collected during this
    review. In particular, we recognized that much of the information provided
    to us on selected transactions and market behavior could not be
    independently verified. In addition, we did not independently verify the
    results of the 2003 survey conducted by the Association for Financial
    Professionals, which we believe are subject to methodological limitations
    that prevent us from reporting them in detail. Nor did we verify the
    results of the Federal Reserve and OCC's special review targeted on tying.

    We conducted our work in Charlotte, N.C.; Chicago, Ill.; New York, N.Y.;
    Orlando, Fla.; and Washington, D.C., between October 2002 and October
    2003, in accordance with generally accepted government auditing standards.

    Results in Brief	Although some corporate borrowers have alleged that
    commercial banks tie the availability or price of credit to the purchase
    of debt underwriting services-a violation of section 106-the available
    evidence did not substantiate these claims. Corporate borrowers could not
    provide documentary evidence to substantiate their claims. The lack of
    documentary evidence might be due to the fact that negotiations over
    credit terms and conditions (during which a tying arrangement could be
    imposed) were generally conducted orally. Borrowers also were reluctant to
    file formal complaints with banking regulators. Reasons given for their
    reluctance included a lack of documentary evidence of unlawful tying,
    uncertainty about whether certain tying arrangements were illegal, and
    fear of adverse consequences for their companies' access to credit and for
    their individual careers. Determining whether a tying arrangement is
    unlawful requires close examination of the specific facts and
    circumstances of the transactions involved, and lawful practices can
    easily be mistaken for unlawful tying. For example, although borrowers we
    interviewed described arrangements that could represent unlawful tying by
    banks, other arrangements that they described involved lawful practices.
    Because documentary evidence of unlawful tying is generally not available,
    banking

    regulators may have to look for other forms of indirect evidence to
    effectively enforce section 106.2

    Regular bank examinations in recent years have not identified any
    instances of unlawful tying that led to enforcement actions.3 In response
    to recent allegations of unlawful tying at large commercial banks, the
    Federal Reserve and OCC conducted a joint review focused on antitying
    policies and practices at several large commercial banks and their holding
    companies. The review teams found that the banks generally had adequate
    procedures in place to comply with section 106, and that over the past
    year, some banks had made additional efforts to ensure compliance.
    Although customer information could have an important role in helping the
    regulators enforce section 106, regulators did not analyze a broadly based
    selection of transactions or contact a broad selection of customers as
    part of their review. The regulators said that they met with officials and
    members from a trade group representing corporate financial executives.
    The review teams questioned some transactions but generally did not find
    unlawful tying arrangements. The targeted review found some variation
    among banks' interpretations of section 106, generally in areas where the
    regulators have not provided authoritative guidance. As a result, the
    Federal Reserve recently issued, for public comment, proposed guidance
    that is intended to help banks and their customers better understand what
    activities are lawful and unlawful under section 106.4 Federal Reserve
    officials said that they hope this guidance also encourages customers to
    come forward if they believe that they have grounds to make a complaint.

    2For purposes of this report, the term "indirect evidence" refers to
    information that is not contained in transaction documents maintained by
    the bank. Section 106 is codified at 12 U.S.C.S: 1972 (2000).

    3After the Federal Reserve and OCC completed the targeted review, the
    Federal Reserve announced on August 27, 2003, that it had entered into a
    consent agreement and civil money penalty against WestLB AG, a German
    bank, and its New York branch, based on allegations that in 2001 it
    conditioned the availability of credit on the borrower's obtaining
    underwriting business from a WestLB affiliate.

    468 Fed. Reg. 52024 (Aug. 29, 2003). OCC released a white paper, "Today's
    Credit Markets, Relationship Banking, and Tying," on September 25, 2003,
    which discussed banks' market power and economic performance for evidence
    of tying, the market competitiveness of diversified banking organizations,
    and relationship banking. The paper concluded that the relationship
    banking practices, as described in the white paper, are consistent with
    the relevant legal framework.

    Although officials from one investment bank alleged that the pricing of
    some corporate credit by large commercial banks was a factor in violations
    of section 106 and possibly section 23B, we found that the available
    evidence on pricing was subject to multiple interpretations and did not
    necessarily demonstrate violations of either section 106 or section 23B.
    Some investment banks contended that large commercial banks deliberately
    underpriced corporate credit to attract underwriting business to their
    investment affiliates. Section 106 prohibits a bank from setting or
    varying the terms of credit on the condition that the customer purchase
    certain other products and services from the bank or an affiliate, unless
    those products and services (such as traditional banking services) are
    exempted from the prohibition. If the price of the credit is less than the
    market price and the bank's investment affiliate is a participant in the
    transaction, then the transaction would reduce the bank's income for the
    benefit of its affiliate, and thus be in violation of section 23B.5
    However, our review of specific transactions cited by an investment bank
    found the available evidence of underpricing to be ambiguous and subject
    to different interpretations. During the course of our review, Federal
    Reserve staff said that they were considering whether to conduct a
    research study of pricing issues in the corporate loan market. Such a
    study could improve the regulators' ability to determine if transactions
    are conducted at prices that were not determined by market forces.

    Although officials at one investment bank also contended that differences
    in accounting conventions, regulatory capital requirements, and access to
    the federal safety net provide a competitive advantage that enables
    commercial banks with investment affiliates to underprice loan
    commitments, we found that these differences did not appear to provide a
    clear and consistent competitive advantage for commercial banks.

    o 	Because commercial banks are not permitted by the accounting standards
    to recognize changes in the value of loans and loan commitments compared
    with current market prices while investment banks recognize these changes
    in their net income, officials at some investment banks have contended
    that accounting standards give commercial banks a competitive advantage.
    However, FASB, which sets private-sector financial accounting and
    reporting standards, noted that commercial banks and investment banks
    follow different accounting models for these transactions. Based on our
    analysis, banks' adherence

    5See 12 U.S.C.S: 371c-1 (2000).

    to different accounting rules caused a temporary difference in the
    recognition of the service fees from short-term loan commitments-a
    difference that appeared to be relatively small compared with revenue from
    other bank activity and would be resolved by the end of the loan
    commitment period. Moreover, both commercial banks and investment banks
    must report the fair value of loan commitments in the footnotes of their
    financial statements. Further, we found that if the loan commitment were
    exercised and both firms either had the intent and ability to hold the
    loan for the foreseeable future or until maturity, or made the loan
    available for sale, the accounting would be similar and would not provide
    an advantage to either firm.

    o 	Additionally, while commercial and investment banks were subject to
    different regulatory capital requirements, practices of both commercial
    and investment banks led to avoidance of regulatory charges on loan
    commitments with a maturity of 1 year or less. Officials from one
    investment bank also contended that bank regulatory capital requirements
    gave commercial banks a competitive advantage in lending because they are
    not required to hold regulatory capital against short-term unfunded loan
    commitments. In comparison, investment banks could face a 100-percent
    regulatory capital charge if they carried loan commitments in their
    broker-dealer affiliates. However, in practice, investment bankers told us
    that they generally carry loan commitments outside of their broker-dealer
    affiliates and thus also avoid regulatory capital charges.

    o 	Some officials from investment banks also contended that commercial
    banks' access to the federal safety net, including access to federal
    deposit insurance and Federal Reserve discount window lending, gives the
    banks a further cost advantage. However, industry observers and OCC
    officials said that this subsidy is likely offset by regulatory costs.

    This report includes a recommendation that the Federal Reserve and the OCC
    consider taking additional steps to ensure effective enforcement of
    section 106 and section 23B, including enhancing the information that they
    receive from corporate borrowers. For example, the agencies could develop
    a communication strategy that is directed at a broad audience of corporate
    bank customers to enhance their understanding of section 106. Because low
    priced credit could indicate a potential violation of section 23B, we also
    recommend that the Federal Reserve assess available evidence regarding
    loan pricing behavior, and if appropriate, conduct additional research to
    better enable examiners to determine whether

    transactions are conducted on market terms, and that the Federal Reserve
    publish the results of this assessment.

    Background	Large banking organizations typically establish ongoing
    relationships with their corporate customers and evaluate the overall
    profitability of these relationships. They use company-specific
    information gained from providing certain products and services-such as
    credit or cash management-to identify additional products and services
    that customers might purchase. This practice, known as "relationship
    banking," has been common in the financial services industry for well over
    a century.

    In recent years, as the legal and regulatory obstacles that limited
    banking organizations' abilities to compete in securities and insurance
    activities have been eased, some large banking organizations have sought
    to expand the range of products and services they offer customers. In
    particular, some commercial banks have sought to decrease their reliance
    on the income earned from credit products, such as corporate loans, and to
    increase their reliance on fee-based income by providing a range of priced
    services to their customers.

    Federal Banking Regulators	The Federal Reserve and OCC are the federal
    banking regulators charged with supervising and regulating large
    commercial banks. The Federal Reserve has primary supervisory and
    regulatory responsibilities for bank holding companies and their nonbank
    and foreign subsidiaries and for state-chartered banks that are members of
    the Federal Reserve System and their foreign branches and subsidiaries.
    The Federal Reserve also has regulatory responsibilities for transactions
    between member banks and their affiliates. OCC has primary supervisory and
    regulatory responsibilities for the domestic and foreign activities of
    national banks and their subsidiaries. OCC also has responsibility for
    administering and enforcing standards governing transactions between
    national banks and their affiliates. Among other activities, the Federal
    Reserve and OCC conduct off-site reviews and on-site examinations of large
    banks to provide periodic analysis of financial and other information,
    provide ongoing supervision of their operations, and determine compliance
    with banking laws and regulations. Federal Reserve and OCC examinations
    are intended to assess the safety and soundness of large banks and
    identify conditions that might require corrective action.

    Section 106 of the Bank Holding Company Act Amendments of 1970

    Congress added section 106 to the Bank Holding Company Act in 1970 to
    address concerns that an expansion in the range of activities permissible
    for bank holding companies might give them an unfair competitive advantage
    because of the unique role their bank subsidiaries served as credit
    providers.6 Section 106 makes it unlawful, with certain exceptions, for a
    bank to extend credit or furnish any product or service, or vary the price
    of any product or service (the "tying product") on the "condition or
    requirement" that the customer obtains some additional product or service
    from the bank or its affiliate (the "tied product").7 Under section 106,
    it would be unlawful for a bank to provide credit (or to vary the terms
    for credit) on the condition or requirement that the customer obtain some
    other product from the bank or an affiliate, unless that other product was
    a traditional bank product.8 Thus, it would be unlawful for a bank to
    condition the availability or pricing of new or renewal credit on the
    condition that the borrower purchase a nontraditional bank product from
    the bank or an affiliate.

    In contrast, section 106 does not require a bank to extend credit or
    provide any other product to a customer, as long as the bank's decision
    was not based on the customer's failure to satisfy a condition or
    requirement prohibited by section 106. For example, it would be lawful for
    a bank to deny credit to a customer on the basis of the customer's
    financial condition, financial resources, or credit history, but it would
    be unlawful for a bank to deny credit because the customer failed to
    purchase underwriting services from the bank's affiliate.

    6See, e.g., H.R. Conf. Rep. No. 91-1747, reprinted in 1970 U.S.C.A.N.
    5561, 5569.

    7Section 106 also prohibits reciprocity and exclusive dealing
    arrangements. Reciprocity arrangements are arrangements that require a
    customer to provide some credit, property, or service to the bank or one
    of its affiliates as a condition of the bank providing another product to
    the customer. Exclusive dealing arrangements are arrangements that require
    a customer not to obtain some other credit, property, or service from a
    competitor of the bank or its affiliate as a condition of the bank
    providing another product to the customer. The allegations we encountered
    during our work did not involve such arrangements.

    8A key exception to section 106 is that banks may condition the price or
    availability of a service or product on the basis of a customer obtaining
    a "traditional bank product," which the section defines as "a loan,
    discount, deposit, or trust service." Section 106 provides this exception
    only with respect to traditional bank products offered by the bank, but
    the Board has extended the exception to include traditional bank products
    offered by an affiliate of the bank. 12 C.F.C. S: 225.7(b)(1) (2003)).

    Section 106 does not prohibit a bank from cross-marketing products that
    are not covered by the "traditional banking product" exemption or from
    granting credit or providing any other product or service to a customer
    based solely on the hope that the customer obtain additional products from
    the bank or its affiliates in the future, provided that the bank does not
    require the customer to purchase an additional product. Also, section 106
    generally does not prohibit a bank from conditioning its relationship with
    a customer on the total profitability of its relationship with the
    customer.

    Section 106 authorizes the Federal Reserve to make exceptions that are not
    contrary to the purposes of the tying prohibitions. The Federal Reserve
    has used this authority to allow banks to offer broader categories of
    packaging arrangements, where it has determined that these arrangements
    benefit customers and do not impair competition. In 1971, the Federal
    Reserve adopted a regulation that extended antitying rules to bank holding
    companies and their nonbank affiliates and approved a number of nonbanking
    activities that these entities could engage in under the Bank Holding
    Company Act. Citing the competitive vitality of the markets in which
    nonbanking companies generally operate, in February 1997, the Federal
    Reserve rescinded this regulatory extension.9 At the same time, the
    Federal Reserve expanded the traditional bank products exception to
    include traditional bank products offered by nonbank affiliates.

    In the mid-1990s, the Board also added two regulatory safe harbors. First,
    the Board granted a regulatory safe harbor for combined-balance discount
    packages, which allowed a bank to vary the consideration for a product or
    package of products-based on a customer's maintaining a combined minimum
    balance in certain products-as long as the bank offers deposits, the
    deposits are counted toward the combined-balance, and the deposits count
    at least as much as nondeposit products toward the minimum balance.10
    Furthermore, according to the Board, under the combined-balance safe
    harbor, the products included in the combined balance program may be
    offered by either the bank or an affiliate, provided that the bank
    specifies the products and the package is structured in a way that does
    not, as a practical matter, obligate a customer to purchase nontraditional
    bank products to obtain the discount. Second, the Board granted a
    regulatory safe harbor for foreign transactions. This safe harbor

    9See 83 Fed. Res. Bulletin 275 (April 1997). 10Id.

    provides that the antitying prohibitions of section 106 do not apply to
    transactions between a bank and a customer if the customer is a company
    that is incorporated, chartered, or otherwise organized outside of the
    United States, and has its principal place of business outside of the
    United States, or if the customer is an individual who is a citizen of a
    country other than the United States and is not resident in the United
    States.11

    Violations of Section 106 	On August 29, 2003, the Board published for
    public comment its proposed interpretation and supervisory guidance
    concerning section 106.12 In this proposed interpretation, the Federal
    Reserve noted that determining whether a violation of section 106 occurred
    requires a detailed understanding of the facts underlying the transaction
    in question. In this proposed interpretation, the Federal Reserve also
    noted what it considers to be the two key elements of a violation of
    section 106:

    (1) The arrangement must involve two or more separate products: the
    customer's desired product(s) and one or more separate tied products; and

    (2) The bank must force the customer to obtain (or provide) the tied
    product(s) from (or to) the bank or an affiliate in order to obtain the
    customer`s desired product(s) from the bank.13

    A transaction does not violate section 106 unless it involves two separate
    products or services. For example, a bank does not violate section 106 by
    requiring a prospective borrower to provide the bank specified collateral
    to obtain a loan or by requiring an existing borrower to post additional
    collateral as a condition for renewing a loan. Assuming two products or
    services are involved, the legality of the arrangement depends on, among

    11Id.

    1268 Fed. Reg. 52024 (August 29, 2003).

    1368 Fed. Reg. at 52027. A tie exists under section 106 if the bank
    furnishes the tying product "on the condition or requirement" that the
    customer obtain the tied product or provide some additional credit,
    property or service. In its guidance, the Board stated that even if a
    condition or requirement exists, further inquiry might be necessary
    because the condition or requirement violates section 106 only if it
    resulted from coercion by the bank. Id. at 52028. As the Board recognized,
    however, some courts have held that a tying arrangement may violate
    section 106 without a showing that the arrangement resulted from any type
    of coercion by the bank. Id. at 52029, n. 36.

    other things, which products and services are involved and in what
    combinations. It would be unlawful for a bank to condition the
    availability of corporate credit on a borrower's purchase of debt
    underwriting services from its affiliate, because a bank cannot condition
    the availability of a bank product on a customer's purchase of a
    nontraditional product or service. According to the Board's proposed
    interpretation, a bank can legally condition the availability of a bank
    product, such as credit, on the customer's selection from a mix of
    traditional and nontraditional products or services-a mixed-product
    arrangement-only if the bank offered the customer a "meaningful choice" of
    products that includes one or more traditional bank products and did not
    require the customer to purchase any specific product or service. For
    example, according to the Federal Reserve, a bank could legally condition
    the availability of credit on a customer's purchase of products from a
    list of products and services that includes debt underwriting and cash
    management services, provided that this mixed-product arrangement
    contained a meaningful option to satisfy the bank's condition solely
    through the purchase of the traditional bank products included in the
    arrangement. However, it would be a violation of section 106 for a bank to
    condition the availability of credit on a mixed-product arrangement that
    did not contain a meaningful option for the customer to satisfy the bank's
    condition solely through the purchase of a traditional bank product.

    When a bank offers a customer a low price on credit, it might or might not
    be a violation of law. If a bank reduced the cost of credit on the
    condition that the customer purchase nontraditional bank products or
    services offered by its investment affiliate, this arrangement would
    violate section 106. However, if a bank offered a low price on credit to
    attract additional business but did not condition the availability of the
    price on the purchase of a prohibited product, it would not violate
    section 106. Additionally, if a reduced interest rate were to constitute
    underpricing of a loan, such a transaction, depending on the
    circumstances, could violate section 23B of the Federal Reserve Act of
    1913, which we discuss later in this section.

    Whether the arrangement constitutes an unlawful tie under section 106 also
    depends upon whether a condition or requirement actually exists and which
    party imposes the condition or requirement. Determining the existence of
    either element can be difficult. The question of whether a condition or
    requirement exists is particularly difficult because of uncertainties
    about how to interpret that aspect of the prohibition. According to the
    Board's proposal, section 106 applies if two requirements are met: "(1) a
    condition or requirement exists that ties the customer's

    desired product to another product; and (2) this condition or requirement
    was imposed or forced on the customer by the bank."14 Thus, according to
    the Board's proposal, if a condition or requirement exists, further
    inquiry may be necessary to determine whether the condition or requirement
    was imposed or forced on the customer by the bank: "If the condition or
    requirement resulted from coercion by the bank, then the condition or
    requirement violates section 106, unless an exemption is available for the
    transaction."15 This interpretation is not universally accepted, however.
    As the Board's proposal has noted, some courts have held that a tying
    arrangement violates section 106 without a showing that the arrangement
    resulted from any type of coercion by the bank.16 Uncertainties about the
    proper interpretation of the "condition or require" provision of section
    106 have lead to disagreement over the circumstances that violate section
    106.

    It has been suggested that changes in financial markets that have occurred
    since the enactment of section 106, particularly a decreased corporate
    reliance on commercial bank loans, also are relevant in considering
    whether banks currently can base credit decisions on a "condition or
    requirement" that corporate customers buy other services. At the end of
    1970, according to the Federal Reserve's Flow of Funds data, bank loans
    accounted for about 24 percent of the total liabilities of U.S. nonfarm,
    nonfinancial corporations. At the end of 2002, bank loans accounted for
    about 14 percent of these liabilities.

    Because section 106 applies only to commercial and savings banks,
    investment banks and insurance companies, which compete in credit markets
    with banks, are not subject to these tying restrictions.17 Thus, under
    section 106, a bank's nonbank affiliate legally could condition the
    availability of credit from that nonbank affiliate on a customer's
    purchase of debt underwriting services. Where a transaction involves a
    bank as well as one or more affiliates, uncertainties could exist over
    whether the

    1468 Fed. Reg. at 52028.

    15Id. at 52029.

    16Id., n. 36.

    17Thrifts are subject to a similar antitying prohibition. Section 5(q) of
    the Home Owners Loan Act, 12 U.S.C. S: 1464(q) (2000) places restrictions
    on savings associations that are almost identical to those placed on banks
    by section 106, although the Office of Thrift Supervision may only grant
    exceptions to section 5(q) that conform to exceptions to section 106
    granted by the Board.

    affiliate or the bank imposed a condition or requirement. It should be
    noted, however, that all of these financial institutions are subject to
    the more broadly applicable antitrust laws, such as the Sherman Act, that
    prohibit anticompetitive practices, including tying arrangements.18 In
    addition, under section 106 it is lawful for bank customers to initiate
    ties. For example, a customer could use its business leverage to obtain
    favorable credit terms or require a bank to extend a corporate loan as a
    condition for purchasing debt underwriting services.

    Section 23B of the Federal Reserve Act of 1913 Prohibits Transactions That
    Benefit Bank Affiliates at the Expense of the Bank

    Section 23B requires that transactions involving a bank and its
    affiliates, including those providing investment-banking services, be on
    market terms.19 Although section 106 generally prohibits changing the
    price for credit on the condition that the customer obtain some other
    services from the bank or its affiliates, section 23B prohibits setting
    the price for credit at a below-market rate that would reduce the bank's
    income for the benefit of its affiliate. Banking regulators have noted
    that pricing credit at below-market rates could also be an unsafe and
    unsound banking practice independent of whether the practice violates
    section 23B specifically.

    18As the Board observed in its proposed interpretation and guidance, as a
    general matter, a tying arrangement violates the Sherman Act (15 U.S.C.
    S:S: 1-7 (2000)) and the Clayton Act (15 U.S.C. S:S: 12-27 (2000)) if (1)
    the arrangement involves two or more products, (2) the seller forces a
    customer to purchase the tied product, (3) the seller has economic power
    in the market for the tying product sufficient to enable the seller to
    restrain trade in the market for the tied product, (4) the arrangement has
    anticompetitive effects in the market for the tied product, and (5) the
    arrangement affects a "not insubstantial" amount of interstate commerce.
    See 68 Fed. Reg. at 52027, n. 20.

    19In October 2002, the Federal Reserve Board approved Regulation W, which
    comprehensively implements and unifies the Board's interpretations of
    sections 23A and 23B of the Federal Reserve Act. Regulation W became
    effective in April 2003, and restricts loans by a depository institution
    to its affiliates, asset purchases by a depository institution from its
    affiliates, and other transactions between a depository institution and
    its affiliates.

    Some Corporate Borrowers Alleged That Unlawful Tying Occurs, but Available
    Evidence Did Not Substantiate These Allegations

    Some corporate borrowers alleged that commercial banks unlawfully tie the
    availability of credit to the borrower's purchase of other financial
    services, including debt underwriting services from their banks'
    investment affiliates. Because banks, in certain circumstances, may
    legally condition the availability of credit on the borrower's purchase of
    other products, some of these allegations of unlawful tying could be
    invalid. Substantiating charges of unlawful tying, if it occurs, can be
    difficult because, in most cases, credit negotiations are conducted orally
    and thus generate no documentary evidence to support borrowers'
    allegations. Thus, banking regulators may have to obtain other forms of
    indirect evidence to assess whether banks unlawfully tie products and
    services. Although customer information could have an important role in
    helping regulators enforce section 106, regulators do not have a specific
    mechanism to solicit information from corporate bank customers on an
    ongoing basis.

    Some Corporate Borrowers Contended That Banks Unlawfully Forced Them to
    Purchase Additional Services to Preserve Access to Credit

    The results of a 2003 survey of financial executives, interviews that we
    conducted with corporate borrowers, and several newspaper articles,
    suggest that commercial banks frequently tie access to credit to the
    purchase of other financial services, including bond underwriting, equity
    underwriting, and cash management.20 The Association for Financial
    Professionals reported that some respondents to their survey of financial
    executives at large companies (those with revenues greater than $1
    billion) claimed to have experienced the denial of credit or a change in
    terms after they did not award a commercial bank their bond underwriting
    business. In our interviews with corporate borrowers, one borrower said
    that a commercial bank reduced the borrower's amount of credit by $70
    million when the borrower declined to purchase debt underwriting services
    from the bank's investment affiliate. In addition, several newspapers and
    other publications have also reported instances where corporate borrowers
    have felt pressured by commercial banks to purchase products prohibited
    under section 106 for the customers to maintain their access to credit. In
    these

    20We did not report the specific results of the Association for Financial
    Professionals' "Credit Access Survey: Linking Corporate Credit to the
    Awarding of Other Financial Services," March 2003, because of several
    methodological limitations. In particular, we could not determine the
    degree to which these survey results represent the broad population of
    large companies, due to potential biases resulting from sample design and
    the low level of participation of sampled companies. Nevertheless,
    although this survey may not precisely estimate the extent of tying
    complaints among this population, the results suggest that at least some
    companies claimed to have experienced forms of tying.

    reports, corporate borrowers have described negotiations where, in their
    views, bankers strongly implied that future lending might be jeopardized
    unless they agreed to purchase additional services, such as underwriting,
    from the banks' investment affiliates. However, none of these situations
    resulted in the corporate borrower complaining to one of the banking
    regulators.

    In its Special Notice to its members, NASD also noted the Association for
    Financial Professional survey. The notice cautioned that NASD regulations
    require members to conduct business in accordance with just and equitable
    principles of trade and that it could be a violation of these rules for
    any member to aid and abet a violation of section 106 by an affiliated
    commercial bank. NASD is conducting its own investigation into these
    matters. At the time of our review, NASD had not publicly announced any
    results of its ongoing investigation.

    Lawful Practices Can Easily Be Mistaken for Unlawful Tying Practices

    Corporate borrowers might be unaware of the subtle distinctions that make
    some tying arrangements lawful and others unlawful. Borrowers, officials
    at commercial banks, and banking regulators said that some financial
    executives might not be familiar with the details of section 106. For
    example, some borrowers we interviewed thought that banks violated the
    tying law when they tied the provision of loan commitments to borrowers'
    purchases of cash management services. However, such arrangements are not
    unlawful, because, as noted earlier, section 106 permits banks to tie
    credit to these and other traditional bank services. The legality of tying
    arrangements might also hinge on the combinations of products that the
    borrowers are offered. For example, recently proposed Federal Reserve
    guidance suggested that a bank could legally condition the availability of
    credit on the purchase of other products services, including debt
    underwriting, if the customer has the meaningful choice of satisfying the
    condition solely through the purchase of one or more additional
    traditional bank products.21

    21The proposed guidance noted that such an arrangement would not force a
    customer to purchase a nontraditional product in violation of section 106.

    Corporate Borrowers Could Not Provide Documentary Evidence to Substantiate
    Allegations of Unlawful Tying

    Corporate borrowers said that because the credit arrangements are made
    orally, they lack the documentary evidence to demonstrate unlawful tying
    arrangements in those situations where they believe it has occurred.
    Without such documentation, borrowers might find it difficult to
    substantiate such claims to banking regulators or seek legal remedies.
    Moreover, with few exceptions, complaints have not been brought to the
    attention of the banking regulators. Some borrowers noted that they are
    reluctant to report their banks' alleged unlawful tying practices because
    they lack documentary evidence of such arrangements and uncertainty about
    which arrangements are lawful or unlawful under section 106. Borrowers
    also noted that a fear of adverse consequences on their companies' future
    access to credit or on their individual careers contributed to some
    borrowers' reluctance to file formal complaints. Because documentary
    evidence demonstrating unlawful tying might not be available in bank
    records, regulators might have to look for other forms of indirect
    evidence, such as testimonial evidence, to assess whether banks unlawfully
    tie products and services.

    Federal Reserve and OCC Targeted Review Identified Interpretive Issues

    The guidance that the federal banking regulators have established for
    their regular examinations of banks calls for examiners to be alert to
    possible violations of law, including section 106. These examinations
    generally focus on specific topics based on the agencies' assessments of
    the banks' risk profiles, and tying is one of many possible topics. In
    response to recent allegations of unlawful tying at large commercial
    banks, the Federal Reserve and OCC conducted a special targeted review of
    antitying policies and procedures at several large commercial banks and
    their holding companies. The banking regulators focused on antitying
    policies and procedures; interviewed bank managers responsible for
    compliance, training, credit pricing, and internal audits; and reviewed
    credit pricing policies, relationship banking policies, and the treatment
    of customer complaints regarding tying. The review did not include broadly
    based testing of transactions that included interviews with corporate
    borrowers. The regulators said that they met with officials and members of
    a trade group representing corporate financial executives. The banking
    regulators found that banks covered in the review generally had adequate
    controls in place. With limited exceptions, they did not detect any
    unlawful combinations or questionable transactions. The examiners did,
    however, identify variation among the banks in interpreting section 106,
    some of which was not addressed in the regulatory guidance then available.
    As a result of the findings of the special targeted review, on August 29,
    2003, the

    Federal Reserve released for public comment proposed guidance to clarify
    the interpretation of section 106 for examiners, bankers, and corporate
    borrowers. Federal Reserve officials said that they hope that the guidance
    encourages customers to come forward if they have complaints.

    Tying Is a Component of Guidelines for Regular Bank Examinations

    As part of their routine examination procedures, the Federal Reserve and
    OCC provide instructions for determining compliance with section 106.22
    During the course of these examinations, examiners review banks' policies,
    procedures, controls, and internal audits. Exam teams assigned to the
    largest commercial banks continually review banks throughout the year, and
    in several cases, the teams are physically located at the bank throughout
    the year. The Federal Reserve and OCC expect examiners to be alert to
    possible violations of section 106 of the Bank Holding Company Act
    Amendments of 1970 and section 23B of the Federal Reserve Act and to
    report any evidence of possible unlawful tying for further review. Regular
    bank examinations in recent years have not identified any instances of
    unlawful tying that led to enforcement actions. Federal Reserve officials
    told us, however, that if an examiner had tying-related concerns about a
    transaction that the bank's internal or external legal counsel had
    reviewed, examiners deferred to the bank's legal analysis and verified
    that the bank took any appropriate corrective actions. Federal Reserve
    officials also said that legal staffs at the Board and the District
    Reserve Banks regularly receive and answer questions from examiners
    regarding the permissibility of transactions.

    In a 1995 bulletin, OCC reminded national banks of their obligations under
    section 106 and advised them to implement appropriate systems and controls
    that would promote compliance with section 106.23 Along with examples of
    lawful tying arrangements, the guidance also incorporated suggested
    measures for banks' systems and controls, and audit and compliance
    programs. Among the suggested measures were training bank employees about
    the tying provisions, providing relevant examples of prohibited practices,
    and reviewing customer files to determine whether

    22For example, Federal Reserve Board Supervision Manuals governing bank
    holding company and state member bank examinations and OCC Bulletin 95-20
    all address section 106.

    23OCC Bulletin 95-20 (April 14, 1995).

    any extension of credit was conditioned unlawfully on obtaining another
    nontraditional product or service from the bank or its affiliates.

    In addition to reviewing banks' policies, procedures, and internal
    controls, examiners also review aggregate data on a bank's pricing of
    credit products. OCC officials noted that instances of unlawfully priced
    loans or credit extended to borrowers who were not creditworthy could
    alert examiners to potential unlawful tying arrangements. However, Federal
    Reserve officials pointed out that examiners typically do not focus on a
    banks' pricing of individual transactions because factors that are unique
    to the bank and its relationship with the customer affect individual
    pricing decisions. They said that examiners only conduct additional
    analyses if there was an indication of a potential problem within the
    aggregated data.

    Examiners Generally Found Adequate Bank Controls and No Unlawful Tying
    during a Special Review

    In recent years, banking regulators' examination strategies have moved
    toward a risk-based assessment of a bank's policies, procedures, and
    internal controls, and away from the former process of transaction
    testing. The activities judged by the regulatory agencies to pose the
    greatest risk to a bank are to receive the most scrutiny by examiners
    under the risk-based approach, and transaction testing is generally
    intended to validate the use and effectiveness of risk-management systems.
    The effectiveness of this examination approach, however, depends on the
    regulators' awareness of risk. In the case of tying, the regulators are
    confronted with the disparity between frequent allegations about tying
    practices and few, if any, formal complaints. Further, the examiners
    generally would not contact customers as part of the examinations and thus
    would have only limited access to information about transactions or the
    practices that banks employ in managing their relationships with
    customers.

    In response to the controversy about allegations of unlawful tying, in
    2002 the Federal Reserve and OCC conducted joint reviews targeted to
    assessing antitying policies and procedures at large commercial banks
    that, collectively, are the dominant syndicators of large corporate
    credits. The Federal Reserve and OCC exam teams found limited evidence of
    potentially unlawful tying in the course of the special targeted review.24
    For

    24After the Federal Reserve and OCC completed the targeted review, the
    Federal Reserve announced on August 27, 2003, that it had entered into a
    consent agreement and civil money penalty against WestLB AG, a German
    bank, and its New York branch, based on allegations that it had
    conditioned credit on the award of underwriting business in 2001.

    example, one bank's legal department uncovered one instance where an
    account officer proposed an unlawful conditional discount. The officer
    brought this to the attention of the legal department after the officer
    attended antitying training. The customer did not accept the offer, and no
    transaction occurred.

    In addition, the teams noted that the commercial bank's interpretation of
    section 106 permitted some activities that the teams questioned; one of
    the banks reversed a transaction in response to examiner questions.
    Attorneys on the exam teams reviewed documents regarding lawsuits alleging
    unlawful tying, but they found that none of the suits contained
    allegations that warranted any follow-up. For example, they found that
    some of the suits involved customers who were asserting violations of
    section 106 as a defense to the bank's efforts to collect on loans and
    that some of the ties alleged in the suits involved ties to traditional
    bank products, which are exempted from section 106.

    Federal Reserve and OCC officials noted that it would be unusual to find a
    provision in a loan contract or other loan documentation containing an
    unlawful tie. Some corporate borrowers said that there is no documentary
    evidence because banks only communicate such conditions on loans orally.
    According to members of the review team, they did not sample transactions
    during the review because past reviews suggested that this would probably
    not produce any instances of unlawful tying practices. The targeted review
    did include contacting some bank customers to obtain information on
    specific transactions. The Federal Reserve noted that without examiners
    being present during credit negotiations, there is no way for examiners to
    know what the customer was told. Given the complex nature of these
    transactions, the facts and circumstances could vary considerably among
    individual transactions. Federal Reserve officials, however, noted that
    customer information could play an important role in enforcing the law,
    because so much depends on whether the customer voluntarily agreed with
    the transaction or was compelled to agree with the conditions imposed by
    the bank. As the officials noted, this determination cannot be made based
    solely on the loan documentation.

    During the targeted review, Federal Reserve and OCC officials found that
    all of the banks they reviewed generally had adequate procedures in place
    to comply with section 106. All banks had specific antitying policies,
    procedures, and training programs in place. The policies we reviewed from
    two banks encouraged employees to consult legal staff for assistance with
    arrangements that could raise a tying-related issue. According to the

    Federal Reserve and OCC, at other banks, lawyers reviewed all transactions
    for tying-related issues before they were completed. The training
    materials we reviewed from two banks included examples that distinguished
    lawful from unlawful tying arrangements. Banking regulators noted that
    some banking organizations had newly enhanced policies, procedures, and
    training programs as a result of recent media and regulatory attention.

    However, examiners also found that the oversight by internal audit
    functions at several banks needed improvement. In one case, they found
    that bank internal auditors were trained to look for the obvious
    indications of tying, but that banks' audit procedures would not
    necessarily provide a basis to detect all cases of tying. For example,
    recent antitying training programs at two banks helped employees identify
    possible tying violations. Officials at one large banking organization
    also said that banks' compliance efforts generally are constrained by the
    inability to anticipate every situation that could raise tying concerns.
    They also noted that banks could not monitor every conversation that bank
    employees had with customers, and thus guarantee that mistakes would never
    occur.

    In addition, examiners were concerned that certain arrangements might
    cause customer confusion when dealing with employees who work for both the
    bank and its investment affiliate. In those cases, it could be difficult
    to determine whether the "dual" employee was representing the bank or its
    affiliate for specific parts of a transaction. However, the examiners
    noted that in the legal analysis of one banking organization, the use of
    such dual employees was not necessarily problematic, given that the tie
    was created by the investment affiliate, rather than the bank, and that
    section 106 addresses the legal entity involved in a transaction and not
    the employment status of the individuals involved. Proposed Federal
    Reserve guidance did not add clarification to this matter beyond
    emphasizing the importance of training programs for bank employees as an
    important internal control.

    The targeted review concluded that the policies and procedures of the
    selected banks generally provided an adequate basis to enforce compliance
    with section 106, and identified only a limited number of instances where
    the bank's interpretation of the law permitted actions that were
    questioned during the review. However, this targeted review was limited to
    an assessment of the banks' controls environment; and as noted above, the
    review did not test a broad range of transactions for analysis or review
    and did not include any questions addressed to a broad selection of bank

    customers. As the Federal Reserve's proposed interpretation of section 106
    notes, however,

    "the determination of whether a violation of section 106 has occurred
    often requires a careful review of the specific facts and circumstances
    associated with the relevant transaction (or proposed transaction) between
    the bank and the customer."25

    Customers could provide information on the facts and circumstances
    associated with specific transactions and provide a basis for testing
    whether the bank actions were in compliance with its policies and
    procedures. If the banks' actions are not consistent with their policies
    and procedures, there could be violations of section 106. A review of the
    transactions would provide direct evidence of compliance or noncompliance
    with section 106. Further, information from analysis of transactions and
    information obtained from customers could provide the bank regulatory
    agencies with more information on the circumstances where there could be a
    greater risk of tying, contributing to their risk-based examination
    strategies.

    Federal Reserve and OCC Identified Several Interpretive Issues

    The examiners and attorneys participating in the targeted review found
    variations in banks' interpretation of section 106 in areas where
    authoritative guidance was absent or incomplete at the time of the review.

    One interpretative issue was the extent to which a bank could consider the
    profitability of the overall customer relationship in making credit
    decisions, particularly whether a bank could consider a customer's use of
    nontraditional banking services in deciding to terminate the customer
    relationship without violating section 106. This issue also encompassed
    the appropriateness of the language that a bank might use when entering
    into or discontinuing credit relationships-including whether a bank could
    appropriately use language implying the acceptance of a tied product in a
    letter formalizing a commitment for a loan and communication protocols
    that a bank might use to disengage clients who did not meet internal
    profitability targets.

    Examiners found that all banks in the joint targeted review had undergone
    a "balance sheet reduction," disengaging from lending relationships with
    their least desirable customers. An official at one commercial bank

    2538 Fed. Reg. at 52026.

    acknowledged that, when banks discontinue relationships, their decision
    might appear to be unlawful tying from the perspective of the customer.
    However, it would not be unlawful for a bank to decline to provide credit
    to a customer as long as the bank's decision was not based on the
    customer's failure to satisfy a condition or requirement prohibited by
    section 106.

    Examiners questioned whether it would be appropriate for a banking
    organization to provide both a bridge loan and securities underwriting to
    vary the amount of fees it charged for services that would normally be
    done independently for each service.26 For example, a bank conducting a
    credit analysis for both commercial and investment banking services and
    reducing the overall fees to only include one credit analysis might raise
    tying considerations. Banks and their outside counsels believed that this
    price reduction would be appropriate. However, the Federal Reserve staff
    said that whether or not a price reduction would be appropriate would
    depend on the facts and condition of the transaction, including whether or
    not the bank offered the customer the opportunity to obtain the discount
    from the bank separately from the tied product.

    Examiners were also concerned that some bank transactions might appear to
    circumvent section 106. For example, the examiners found one instance in
    which a nonbank affiliate had tied bridge loans to the purchase of
    securities underwriting and syndicated some or all of the loans to its
    commercial bank. The examiners noted that although this issue had not been
    addressed in the guidance available at the time, this arrangement created
    the appearance of an attempt to circumvent the application of section 106.
    The bank thereupon discontinued the practice. As mentioned previously,
    because section 106 applies only to banks, it is not a violation of the
    section for most nonbank affiliates of commercial banks to tie together
    any two products or services. The proposed interpretation of section 106
    recently issued by the Federal Reserve addresses this issue.

    Finally, the examiners found that one bank might be overstating the relief
    gained from the foreign transactions safe harbor. The Federal Reserve
    adopted a safe harbor from the antitying rules for transactions with
    corporate customers that are incorporated or otherwise organized and that

    26A bridge loan is an interim financing arrangement provided by a bank,
    investment bank, or special purpose investment fund to allow a corporation
    to make an acquisition before arranging permanent financing to carry the
    acquisition.

    have their principal place of business outside the United States.27 This
    safe harbor also applies to individuals who are citizens of a foreign
    country and are not resident in the United States. The new guidance
    developed by the banking regulators does not address the examiners'
    specific concerns. Federal Reserve officials said that a general rule on
    these issues would not be feasible and that any determinations would
    depend on the facts and circumstances of the specific transactions.

    The Federal Reserve's Proposed Interpretation and Guidance Released for
    Public Comment

    Based on the interpretive issues examiners found during the special
    targeted review and its analysis, and after significant consultation with
    OCC, the Federal Reserve recently released for public comment a proposed
    interpretation of section 106. The proposed interpretation noted that the
    application of section 106 is complicated and heavily dependent on the
    particular circumstances and facts of specific transactions. The proposed
    guidance outlines, among other things, some of the information that would
    be considered in determining whether a transaction or proposed transaction
    would be lawful or unlawful under section 106. Federal Reserve officials
    also have noted that another desired effect of additional guidance could
    be providing bank customers a better understanding of section 106 and what
    bank actions are lawful. The officials said that they hoped that the new
    guidance would encourage customers to come forward with any complaints.
    The deadline for public comments on the proposed guidance was September
    30, 2003. At the time of our review, the Federal Reserve was reviewing
    comments that had been received.

    27See also, 83 Fed. Res. Bulletin 275 (April 1997). Federal Reserve Board
    Bank Holding Company Supervision Manual, Section 3500.0.2.3, Safe Harbor
    for Foreign Transactions.

    Evidence That We Reviewed on the Pricing of Corporate Credit Did Not
    Demonstrate That Commercial Banks Unlawfully Discount Credit

    Although officials at one investment bank contended that large commercial
    banks deliberately "underpriced"-or priced credit at below market rates-
    corporate credit to attract underwriting business to their investment
    affiliates, the evidence of "underpricing" is ambiguous and subject to
    different interpretations. They claimed that these commercial banks
    underprice credit in an effort to promote business at the banks'
    investment affiliates, which would increase the bank holding companies'
    fee-based income. Such behavior, they contended, could indicate violations
    of section 106, with credit terms depending on the customer buying the
    tied product. The banking regulators also noted that pricing credit below
    market interest rates, if it did occur, could violate section 23B, with
    the bank's income being reduced for the benefit of its investment
    affiliate. Commercial bankers counter that the syndication of these loans
    and loan commitments-the sharing of them among several lenders-makes it
    impossible to underprice credit, since the other members of the syndicate
    would not participate at below market prices. Federal Reserve staff is
    considering further research into the issue of loan pricing, which could
    clarify the issue.

    Investment bankers and commercial bankers also disagreed whether
    differences between the prices for loans and loan commitments and those
    for other credit products indicated that nonmarket forces were involved in
    setting credit prices. Both investment bankers and commercial bankers
    cited specific transactions to support their contentions; in some cases,
    they pointed to the prices for the same loan products at different times.
    Commercial bankers also noted that their business strategies called for
    them to ensure the profitability of their relationship with customers; if
    market-driven credit prices alone did not provide adequate profitability,
    the strategies commonly called for marketing an array of other products to
    make the entire relationship a profitable one. The banking regulators
    noted that such strategies would be within the bounds of the law as long
    as the bank customers had a "meaningful choice" that includes traditional
    bank products.

    Investment Affiliates of In recent years, the market share of the fees
    earned from debt and equity Commercial Banks Have underwriting has
    declined at investment banks and grown at investment Gained Market Share
    in affiliates of commercial banks. In 2002, the three largest investment
    banks

               had a combined market share of 31.9 percent, a decline from a 38.1
    percentUnderwriting market share that these investment banks held in 1995.
    In comparison, the market share of the three largest investment affiliates
                                                              of commercial banks

    was 30.4 percent in 2002, compared with their 17.8 percent market share
    that these investment banks held in 1995. Some of this growth might be the
    result of the ability of commercial banks and their investment affiliates
    to offer a wide array of financial services. However, banking regulators
    noted that industry consolidation and the acquisition of investment
    banking firms by bank holding companies also has been a significant factor
    contributing to this growth. For example, regulators noted that Citigroup
    Inc. is the result of the 1998 merger of Citicorp and Travelers Group
    Inc., which combined Citicorp's investment business with that of Salomon
    Smith Barney, Inc., a Travelers subsidiary that was already a prominent
    investment bank. J.P. Morgan & Co. Incorporated and The Chase Manhattan
    Corporation also combined in 2000 to form J.P. Morgan Chase & Co.

    Pricing Evidence from the Secondary Market Is Inconclusive

    Some investment bankers contended that commercial banks offer loans and
    loan commitments to corporate borrowers at below-market rates if borrowers
    agree to engage the services of their investment affiliates. Large loans
    and loan commitments to corporations-including the lines of credit that
    borrowers use in conjunction with issuing commercial paper-are frequently
    syndicated.28 A syndicated loan is financing provided by a group of
    commercial banks and investment banks whereby each bank agrees to advance
    a portion of the funding. Commercial bankers contended that these prices
    of the loans and loan commitments reflected a competitive market, where
    individual lenders have no control over prices.

    Officials from one investment bank who contended that banking
    organizations have underpriced credits to win investment banking business
    drew comparisons between the original pricing terms of specific syndicated
    loans and the pricing of the same loans in the secondary market.
    Specifically, they pointed to several transactions, including one in which
    they questioned the pricing but participated because the borrower insisted
    that underwriters provide loan commitments. The investment bank officials
    said that when they subsequently attempted to sell part of their

    28Commercial paper is an unsecured obligation issued by a corporation or
    bank to finance its short-term credit needs, such as accounts receivable
    and inventory. Commercial paper is usually issued by companies with high
    credit ratings. Commercial paper is available in a wide range of
    denominations and can be either discounted or interest bearing. Maturities
    for commercial paper typically range from 2 to 270 days. Commonly,
    companies issuing commercial paper will also obtain a backup loan
    commitment that would provide funds if the company is unable to payoff or
    roll over the commercial paper as it matures.

    share of the credits, the pricing was unattractive to the market and that
    they could not get full value. In one case, they noted that the credit
    facility was sold in the secondary market at about 93 cents on the dollar
    shortly after origination. They said that, in their opinion, this
    immediate decline in value was evidence that the credit facility had been
    underpriced at origination.

    Commercial bankers said that competition in the corporate loan market
    determines loan pricing. One banker said that if a loan officer overpriced
    a loan by even a basis point or two the customer would turn to another
    bank.29 Bankers also noted that if loans were underpriced, the syndicators
    would not be able to syndicate the loan to investors who are not engaged
    in debt underwriting and insist on earning a competitive return. An
    official from one commercial bank provided data on its syndicated loans,
    showing that a number of the participants in the loans and loan
    commitments did not participate in the associated securities underwriting
    for the borrower and-in spite of having no investment banking business to
    win-found the terms of the loans and loan commitments attractive. However,
    we do not know the extent, if any, to which these other participants might
    have had other revenue-generating business with the borrowers.

    Officials from a commercial bank and loan market experts also said that
    the secondary market for loans was illiquid, compared with that for most
    securities. The bank officials said that therefore prices could swing in
    response to a single large sale as a result of this illiquidity. Officials
    from one commercial bank said that the price of the loan to which
    investment bank officials referred, which had sold for about 93 cents on
    the dollar shortly after origination, had risen to about 98 cents on the
    dollar in secondary trades a few months later. These officials said that,
    in their opinion, this return in pricing toward the loan's origination
    value is proof that the syndicated loan was never underpriced and that the
    movement in price was the result of a large portion of the facility being
    sold soon after the origination. Independent loan market experts also
    observed that trading in loan commitments is illiquid, and thus subsequent
    price fluctuations might not reflect fair value.

    29A basis point is a measure of a bond's yield, equal to 1/100th of 1
    percent of yield.

    Pricing Evidence from Credit Default Swap Markets Is Subject to Multiple
    Interpretations

    Commercial bankers and investment bankers disagreed on whether a
    comparison of the prices of loans and other credit products demonstrated
    underpricing. In particular, one key disagreement involved the use of
    credit default swaps.30 Banks and other financial institutions can use
    credit default swaps, among other instruments, to reduce or diversify
    credit risk exposures. With a credit default swap, the lender keeps the
    loan or loan commitment on its books and essentially purchases insurance
    against borrower default.

    Officials at one investment bank compared the prices of syndicated loans
    with the prices of credit default swaps used to hedge the credit risk of
    the loan. In their view, the differences in the two prices demonstrated
    that commercial banks underpriced corporate credit. They provided us with
    several examples of syndicated loans, wherein the difference between the
    interest rate on the loan or loan commitment and the corresponding credit
    default swap was so great that the investment bankers believed that the
    bank would have earned more from insuring the credit than extending it.

    On the other hand, Federal Reserve officials, commercial bankers, and loan
    market experts disputed the extent to which the pricing of corporate
    credit could be compared with their corresponding credit default swaps,
    because of important differences between the two products and between the
    institutions that dealt in them. Officials from the Federal Reserve noted
    that the triggering mechanisms for the two products differed. Although the
    trigger for the exercise of a credit default swap is a clearly defined
    indication of the borrower's credit impairment, the exercise of a
    commercial paper back-up line is triggered by the issuer's inability to
    access the commercial paper market-an event that could occur without there
    necessarily being any credit impairment of the issuer. For example, in
    1998, Russia's declaration of a debt moratorium and the near-failure of a
    large hedge fund created financial market turmoil; since this severely
    disrupted corporations' issuance of bonds and commercial paper, they drew
    on their loan commitments from banks. In addition, loan market

    30Credit default swaps are financial contracts that allow the transfer of
    credit risk from one market participant to another, potentially
    facilitating greater efficiency in the pricing and distribution of credit
    risk among financial market participants. In a "plain vanilla" credit
    default swap, the protection buyer agrees to make periodic payments (the
    swap "spread" or premium) over a predetermined number of years (the
    maturity of the credit default swap) to the protection seller in exchange
    for a payment in the event of default by a third party. Typically, credit
    default swaps premiums are paid quarterly, and the most common maturities
    are 3, 5, and 10 years.

    experts and officials from a commercial bank also said that the loan
    market and the credit default swap market involve different participants
    with different motivations. Loan market experts noted that lead
    originators of loans and loan commitments have an advantage gained from
    knowledge of the borrower through direct business relationships. On the
    other hand, those who provide credit protection by selling credit swap
    might be entities with no direct knowledge of the customer's
    creditworthiness, but use these instruments for diversifying risks.

    Evidence from the Pricing of Undrawn Fees Did Not Resolve Whether
    Commercial Banks Unlawfully Price Credit Risk

    To present their differing positions on whether or not credit is
    underpriced, investment bankers, loan market experts, and commercial
    bankers discussed the pricing of selected syndicated loan commitments. In
    syndicated loan commitments, participants receive commitment fees on the
    undrawn amount and a specified interest rate if the loan is drawn. In
    addition, participants in syndicated loan commitments are protected from
    certain risks by various conditions. Also, the lead participant might
    receive an up-front fee from the borrower. Each of these factors can
    influence the price of the loan commitment.

    Officials at one investment bank noted that the pricing for undrawn loan
    commitments provided as back-up lines for commercial paper issuers have
    been low for several years and had been relatively stable, even when other
    credit market prices fluctuated. Available data showed that this was the
    case for the fees for undrawn commitments provided for investment-grade
    borrowers, with undrawn fees averaging under 0.10 percent per year of the
    undrawn amount. The investment bankers further noted that the loan
    commitment would be drawn in the event of adverse conditions for the
    borrower in the commercial paper market. Thus, commercial paper back-up
    lines exposed the provider to the risk that they might have to book loans
    to borrowers when they were no longer creditworthy. In the opinion of
    these investment bankers, the low undrawn loan fees do not reflect this
    risk.

    In contrast, officials from commercial banks and loan market experts said
    that the level of undrawn fees for loan commitments did not represent all
    the ways that commercial banks might adjust credit terms to address rising
    credit risk. These officials said that in response to perceived weakening
    in credit quality, lenders had shortened the maturity of credit lines.
    Lenders also tightened contract covenants to protect themselves against a
    borrowers' potential future weakening. In addition, commercial bank
    officials told us that other factors were involved in the pricing of loan

    commitments. For example, they said that a comprehensive analysis should
    include the upfront fees to measure the total return on undrawn loan
    commitments. However, loan market experts said that published loan pricing
    data do not include the up-front fees that many banks collect when they
    extend credit. Thus, publicly available information was insufficient to
    indicate the total return commercial banks received on such lending.

    Investment Banks and Commercial Banks Have Different Views on the
    Profitability of Corporate Lending

    Officials at one investment bank claimed that because the fees that
    commercial banks receive for corporate credits barely exceed their cost of
    funds, commercial banks are not covering all of their costs and are in
    essence subsidizing corporate credits. Conversely, several bankers said
    that the rates they can charge on corporate credits do exceed their cost
    of funds but are not always high enough to allow them to meet their
    institution's profitability targets. Officials at one commercial bank
    noted that their internal controls included separation of powers, where
    any extensions of credit over $10 million would have to be approved by a
    credit committee rather than those responsible for managing the bank's
    customer relationships. However, these same officials said that they often
    base lending decisions on the profitability of customer relationships, not
    individual products. Thus, a loan that might not reach profitability
    targets on a stand-alone basis could still be attractive as part of an
    overall customer relationship.

    Federal Reserve Staff Is Considering a Study about Loan Pricing

    During our review, members of the Federal Reserve's staff said that they
    were considering conducting research into pricing issues in the corporate
    loan market. Such research could shed some additional light on the charges
    of the investment bankers and the responses of the commercial bankers.31
    It also could provide useful supervisory information. If the study finds
    indications that pricing of credit to customers who also use underwriting
    services is lower than other comparable credit, this could lend support to
    the investment banker's allegations of violations of section 23B. However,
    if the charges are not valid and credit pricing does reflect market
    conditions,

    31Preliminary results from an academic study of loan pricing and
    securities underwriting suggest that the rates charged on loans to
    corporate borrowers who subsequently purchase underwriting services from
    an investment affiliate of the lender were not lower than rates charged on
    loans not followed by the purchase of underwriting services. See Charles
    W. Calomiris and Thanavult Pornrojnangkool, "Tying, Relationship Banking,
    and the Repeal of Glass Stegall," Unpublished paper presented at the
    American Enterprise Institute, Sept. 24, 2003.

    this information would serve as useful confirmation of the findings of the
    Federal Reserve-OCC targeted review, which found that the policies and
    procedures of the largest commercial banks served as effective deterrents
    against unlawful tying.

    Differences between Commercial Banks and Investment Banks Did Not
    Necessarily Affect Competition

    Based on our analysis, the different accounting methods, capital
    requirements, and levels of access to the federal safety net did not
    appear to give commercial banks a consistent competitive advantage over
    investment banks. Officials at some investment banks asserted that these
    differences gave commercial banks an unfair advantage that they could use
    in lending to customers who also purchase debt-underwriting services from
    their investment affiliates. Under current accounting rules, commercial
    banks and investment banks are required to use different accounting
    methods to record the value of loan commitments and loans. Although these
    different methods could cause temporary differences in the financial
    statements for commercial banks and investment banks. While these
    different methods could cause temporary differences in financial
    statements, these differences would be reconciled at the end of the credit
    contract periods. Further, if the loan commitment were exercised and both
    firms either held the loan until maturity or made the loan available for
    sale, the accounting would be similar and would not provide an advantage
    to either firm. Additionally, while commercial and investment banks were
    subject to different regulatory capital requirements, practices of both
    commercial and investment banks led to avoidance of regulatory charges on
    loan commitments with a maturity of 1 year or less. Moreover, while the
    banks had different levels of access to the federal safety net, some
    industry observers argued that greater access could be offset by
    corresponding greater regulatory costs.

    Commercial Banks and Investment Banks Follow Different Accounting Models
    for Loan Commitments

    According to FASB, which sets the private sector accounting and reporting
    standards, commercial banks and investment banks follow different
    accounting models for similar transactions involving loans and loan
    commitments. Most commercial banks follow a mixed model, where some
    financial assets and liabilities are measured at historical cost, some at
    the lower of cost or market value and some at fair value. In contrast,
    some investment banks follow a fair-value accounting model, in which they
    report changes in the fair value of inventory, which may include loans or
    loan commitments, in the periods in which the changes occur.

    Where FASB guidance is nonexistent, as is currently the case for
    fair-value accounting for loan commitments, firms are required to follow
    guidance from the AICPA, which provides industry specific accounting and
    auditing guidance that is cleared by FASB prior to publication. FASB
    officials said that it is currently appropriate for commercial banks and
    investment banks to follow different accounting models because of their
    different business models.

    When commercial banks make loan commitments, they must follow FASB's
    Statement of Financial Accounting Standards (FAS) No. 91, Accounting for
    Nonrefundable Fees and Costs Associated with Originating or Acquiring
    Loans and Initial Direct Costs of Leases, which directs them to book the
    historic carrying value of the fees received for loan commitments as
    deferred revenue.32 In the historic carrying value model, commercial banks
    are not allowed to reflect changes in the fair value of loan commitments
    in their earnings. However, commercial banks are required to disclose the
    fair value of all loan commitments in the footnotes to their financial
    statements, along with the method used to determine fair value.33

    Some investment banks follow the AICPA Audit and Accounting Guide, Brokers
    and Dealers in Securities, which directs them to record the fair value of
    loan commitments.34 The AICPA guidance is directed at broker-dealers
    within a commercial bank or investment bank holding company structure.
    However, some investment banks whose broker-dealer subsidiaries comprised
    a majority of the firms' financial activity would also be required to
    follow the fair-value accounting model outlined in the AICPA guidance for
    instruments held in all subsidiaries.35 When using the fair-value model,
    investment banks must recognize in income gains or losses resulting from
    changes in the fair value of a financial instrument, such as a

    32The historic carrying value of a loan commitment is the value of the
    loan commitment service fees at the time a firm extends the commitment.
    The fees received are recognized either over the life of the loan
    commitment when the likelihood of the borrower exercising the commitment
    is remote or over the life of the loan if the commitment is exercised.

    33This is required by FAS No. 107, Disclosures about Fair Value of
    Financial Instruments.

    34 The fair value of a loan commitment is generally based on quoted market
    prices of similar transactions or modeling with market data.

    35It is important to note that, in practice, investment banks often do not
    hold loan commitments in their broker-dealer subsidiaries because of the
    high capital requirements of broker-dealers. (We discuss the regulatory
    capital requirements of broker-dealers in greater detail in the next
    section.)

    loan commitment. Investment banks said that they determine the current
    fair value of loan commitments based on the quoted market price for an
    identical or similar transaction or by modeling with market data if market
    prices are not available.

    According to FASB, although measurement of financial instruments at fair
    value has conceptual advantages, not all issues have been resolved, and
    FASB has not yet decided when, if ever, it will require essentially all
    financial instruments held in its inventory to be reported at fair value.
    A loan market expert said that, although the discipline of using
    market-based measures works well for some companies, fair-value accounting
    might not be the appropriate model for the entire wholesale loan industry.
    FASB said that one reason is that in the absence of a liquid market for
    loan commitments, there is potential for management manipulation of fair
    value because of the management discretion involved in choosing the data
    used to estimate fair value.

    Some Investment Banks Contended That Different Accounting Methods Give
    Commercial Banks a Competitive Advantage

    Officials from some investment banks contended that adherence to different
    accounting models gave commercial banks a competitive advantage relative
    to investment banks in lending to customers who also purchased investment
    banking services. They alleged that commercial banks extended underpriced
    364-day loan commitments to attract customers' other, more profitable
    business-such as underwriting-but they were not required to report on
    their financial statements the difference in value, if any, between the
    original price of the loan commitment and the current market price.36 The
    investment bank officials contended that the current accounting standards
    facilitate this alleged underpricing of credit because commercial banks
    record loan commitments at their historic value rather than their current
    value, which might be higher or lower, and do not have to report the
    losses incurred in extending an allegedly underpriced loan commitment.

    Officials from some investment banks also claimed that the historic
    carrying value model allowed commercial banks to hide the risk of these
    allegedly underpriced loan commitments from stockholders and market
    analysts, because the model did not require them to report changes in the
    value of loan commitments. Officials said that differences in accounting
    for

    36The historic carrying value model does not permit commercial banks to
    record these changes in value.

    identical transactions might put investment banks at a disadvantage,
    compared with commercial banks when analysts reviewed their quarterly
    filings. As discussed in an earlier section, it is not clear that
    commercial banks underprice loan commitments.

    Commercial Banks Do Not Enjoy a Consistent Competitive Advantage over
    Investment Banks in Accounting for Loan Commitments

    Although commercial and investment banks might have different values on
    their financial statements for similar loan commitments, both are subject
    to the same fair-value footnote disclosure requirements in which they
    report the fair value of all loan commitments in their financial statement
    footnotes, along with the method used to determine fair value. As a
    result, financial analysts and investors are presented with the same
    information about the commercial and investment banks' loan commitments in
    the financial statement footnotes. According to FAS 107: Disclosures about
    Fair Value of Financial Instruments, in the absence of a quoted market
    price, firms estimate fair value based on (1) the market prices of similar
    traded financial instruments with similar credit ratings, interest rates,
    and maturity dates; (2) current prices (interest rates) offered for
    similar financial instruments in the entity's own lending activities; or
    (3) valuations obtained from loan pricing services offered by various
    specialist firms or from other sources. FASB said that they have found no
    conclusive evidence that an active market for loan commitments exists;
    thus, the fair value recorded might frequently be estimated through
    modeling with market data. When a quoted market price for an identical
    transaction is not available, management judgment and the assumptions used
    in the model valuations could significantly affect the estimated fair
    value of a particular financial instrument.

    SEC and the banking regulators said the footnote disclosures included with
    financial statements, which are the same for both commercial banks and
    investment banks, were an integral part of communicating risk. They
    considered the statement of position and statement of operations alone to
    be incomplete instruments through which to convey the risk of loan
    commitments. They emphasized that to fully ascertain a firm's financial
    standing, financial footnotes must be read along with the financial
    statements.

    Although different accounting models would likely introduce differences in
    the amount of revenue or loss recognized in any period, all differences in
    accounting for loan commitments that were not exercised would be resolved
    by the end of the commitment period. Any interim accounting differences
    between a commercial bank and investment bank would be

    relatively short-lived because most of these loan commitment periods are
    less than 1 year. Further, if a loan commitment were underpriced, an
    investment bank using the fair-value accounting model would recognize the
    difference between the fair value and the contractual price as a loss,
    while a commercial bank using the historical cost model would not be
    permitted to do so. This difference in the recognition of gains or losses
    would be evident in commercial and investment banks' quarterly filings
    over the length of the commitment period. However, there is no clear
    advantage to one method over the other in accounting for loan commitments
    when the commitments are priced consistently between the two firms at
    origination.

    According to investment bankers we spoke with and staff from the AICPA,
    loan commitments generally decline in value after they are made. Under
    fair-value accounting, these declines in fair value are actually
    recognized by the investment bank as revenue because the reduction is
    recognized in a liability account known as deferred revenue. Therefore, if
    an investment bank participated with commercial banks in a loan commitment
    that was deemed underpriced, any initial loss recognized by the investment
    bank would be offset by each subsequent decline in the loan commitment's
    fair value. Further, as discussed in an earlier section, it is not clear
    that commercial banks underprice loan commitments. Whether a commercial
    bank using the historic carrying value model or an investment bank using
    the fair-value model would recognize more revenue or loss on a given loan
    commitment earlier or later would depend on changes in the borrower's
    credit pricing, which reflects overall market trends and customer-specific
    events, as well as on the accounting model that the firm follows.

    In addition, when similar loan commitments held by a commercial bank and
    an investment bank are exercised and become loans, both firms would be
    subject to the same accounting standards if they had the intent and
    ability to hold the loan for the foreseeable future or to maturity.37 In
    this situation, both commercial banks and investment banks would be
    required to establish an allowance for probable or possible losses, based
    on the

    37Although investment banks generally classify financial instruments as
    inventory and account for them at fair value, AICPA Task Force members and
    some investment bankers noted that, in some instances, the firms might
    decide to hold a loan for the foreseeable future or until maturity. In
    this case, the loan would not be classified as held-for-sale and would not
    be accounted for at fair value.

    estimated degree of impairment of the loan commitment or historic
    experience with similar borrowers.38

    If both an investment bank and a commercial bank decided to sell a loan
    that it previously had the intent and ability to hold for the foreseeable
    future or until maturity, the firms would follow different guidance that
    would produce similar results. A commercial bank would follow the AICPA's
    Statement of Position 01-6, Accounting by Certain Entities (Including
    Entities With Trade Receivables) That Lend to or Finance the Activities of
    Others that was issued in December, 2001. According to this guidance, once
    bank management decides to sell a loan that had not been previously
    classified as held-for-sale, the loan's value should be adjusted to the
    lower of historical cost or fair value, and any amount by which historical
    cost exceeds fair value should be accounted for as a valuation allowance.
    Further, as long as the loan's fair value remained less than historical
    cost, any subsequent changes in the loan's fair value would be recognized
    in income. The investment bank would follow the guidance in the AICPA's
    Audit and Accounting Guide, Brokers and Dealers in Securities, and account
    for inventory, the loan in this instance, at fair value and recognize
    changes in the fair value in earnings.

    Capital Requirements Do Not Give Commercial Banks a Competitive Advantage

    Regulatory capital is the minimum long-term funding level that financial
    institutions are required to maintain to cushion themselves against
    unexpected losses, and differing requirements for commercial banks and
    broker-dealers reflect distinct regulatory purposes.39 The primary
    purposes of commercial bank regulatory capital requirements are to
    maintain the safety and soundness of the banking and payment systems and
    to protect the deposit insurance funds. Under the bank risk-based capital
    guidelines, off-balance sheet transactions, such as loan commitments, are
    converted

    38According to FAS 114: Accounting by Creditors for Impairment of a Loan,
    a loan is considered impaired when, based on current information and
    events, it is probable that a creditor will be unable to collect all
    amounts due according to the contractual terms of the loan agreement. To
    comply with FAS 114, creditors must create a valuation allowance that
    reduces the value of the loan with a corresponding charge to a bad-debt
    expense. When a loan is not impaired, creditors must follow FAS 5:
    Accounting for Contingencies and establish an allowance for loss when
    there is at least a reasonable possibility that a loss or an additional
    loss might be incurred.

    39U.S. General Accounting Office, Risk Based Capital: Regulatory and
    Industry Approaches to Capital and Risk, GAO/GGD-98-153 (Washington, D.C.:
    July 1998).

    into one of four categories of asset equivalents.40 Unfunded loan
    commitments of one year or less are assigned to the zero percent
    conversion category, which means that banks are not required to hold
    regulatory capital for these commitments. In contrast, the primary
    purposes of broker-dealers' capital requirements are to protect customers
    and other market participants from losses caused by broker-dealer failures
    and to protect the integrity of the financial markets. The SEC net capital
    rule requires broker-dealer affiliates of investment banks to hold
    100-percent capital against loan commitments of any length.41 However,
    nonbroker-dealer affiliates of investment banks are not subject to any
    regulatory capital requirements, and are therefore not required to hold
    regulatory capital against loan commitments of any length.

    It is costly for banks or other institutions to hold capital; thus, to the
    extent that the level of regulatory capital requirements determines the
    amount of capital actually held, lower capital requirements can translate
    into lower costs. Officials from an investment bank contended that bank
    capital requirements gave commercial banks with investment affiliates a
    cost advantage they could use when lending to customers who also purchased
    underwriting business. They said that because banks' regulatory capital
    requirements for unfunded credits of 1 year or less were zero, commercial
    banks had the opportunity to adjust the length of credit commitments to
    avoid capital charges. Furthermore, officials said that the ability to
    avoid capital charges allowed commercial banks to underprice these loan
    commitments, because they could extend the commitments without the cost of
    assigning additional regulatory capital. They pointed to the high
    percentage of credit commercial banks structured in 364-day facilities as
    evidence that banks structure underpriced credit in short-term
    arrangements to avoid capital charges.

    We found no evidence that bank regulatory capital requirements provided
    commercial banks with a competitive advantage. Although investment banks
    could face a 100-percent regulatory capital charge if they carried loan
    commitments in their broker-dealer affiliates, investment bank officials
    and officials from the SEC said that, in practice, investment banks
    carried loan commitments outside of their broker-dealer affiliates, and
    thus

    40Effective 1990, U.S. banking regulators added regulatory capital
    requirements for loan commitments with maturities greater than 1 year.
    Previously, there had been no regulatory capital requirements for unfunded
    loan commitments of any length.

    41SEC Rule 15c3-1(c)(2)(viii).

    avoided all regulatory capital charges. Furthermore, banking regulators
    did not think that the current regulatory capital requirements adversely
    affected the overall amount of capital banks held, because commercial
    banks generally carried internal risk-based capital on instruments-
    including loan commitments-that were in excess of the amount of regulatory
    capital required. In addition, the banking regulators said that bank
    regulatory capital requirements had not affected banks' use of loan
    commitments of 1 year or less. Although loan market data indicated that
    the percentage of investment-grade loans structured on 364-day terms has
    increased, commercial bank officials and banking regulators said that this
    shift was, in part, the banks' response to the increased amount of risk in
    lending.

    Industry Observers and Some Banking Regulators Doubt That the Federal
    Safety Net Provides Commercial Banks with a Competitive Advantage

    Commercial banks have access to a range of services sometimes described as
    the federal safety net, which includes access to the Federal Reserve
    discount window and deposit insurance.42 The Federal Reserve discount
    window allows banks and other organizations to borrow funds from the
    Federal Reserve.43 Commercial banks' ability to hold deposits backed by
    federal deposit insurance provides them with a low-cost source of funds
    available for lending.

    Industry observers and banking regulators agreed that commercial banks
    receive a subsidy from the federal safety net; however, they differed on
    the extent to which the subsidy was offset by regulatory costs. Although
    officials at the Federal Reserve and at an investment bank contended that
    access to the federal safety net gave commercial banks a net subsidy,
    officials from OCC and an industry observer said that the costs associated
    with access to the safety net might offset these advantages. We could not
    measure the extent to which regulatory costs offset the subsidy provided
    by the access to the federal safety net because reliable measures of the
    regulatory costs borne by banks were not available.

    42The federal safety net also includes access to the Federal Reserve
    payments system. Because the investment bankers with whom we spoke did not
    mention the payments system as a competitive advantage, we omitted this
    aspect from our discussion of the federal safety net.

    43In unusual and exigent circumstances, and after consulting with the
    Board of Governors of the Federal Reserve System, a Federal Reserve Bank
    can extend credit to an individual, partnership, or corporation that is
    not a depository institution if, in the judgment of the Federal Reserve
    Bank, credit is not available from other sources and failure to obtain
    such credit would adversely affect the economy.

    Conclusions	Although the Gramm-Leach-Bliley Act of 1999, among other
    things, expanded the ability of financial services providers, including
    commercial banks and their affiliates, to offer their customers a wide
    range of products and services, it did not repeal the tying prohibitions
    of section 106, which remains a complex provision to enforce. Regulatory
    guidance has noted that some tying arrangements involving corporate credit
    are clearly lawful, particularly those involving ties between credit and
    traditional bank products. The targeted review conducted by the Federal
    Reserve and OCC, however, identified other arrangements that raise
    interpretive issues that were not addressed in prevailing guidance. The
    Federal Reserve recently issued for public comment a proposed
    interpretation of section 106 that is intended to provide banks and their
    customers a guide to the section. As the proposed interpretation notes,
    however, the complexity of section 106 requires a careful review of the
    facts and circumstances of each specific transaction. The challenge for
    the Federal Reserve and OCC remains that of enforcing a law where
    determining whether a violation exists or not depends on considering the
    precise circumstances of specific transactions; however, information on
    such circumstances is inherently limited. Customers have a key role in
    providing information that is needed to enforce section 106. However, the
    Federal Reserve and OCC have little information on customers'
    understanding of lawful and unlawful tying under section 106 or on
    customers' knowledge of the circumstances of specific transactions.

    The available evidence did not clearly support contentions that banks
    violated section 106 and unlawfully tied credit availability or
    underpriced credit to gain investment banking revenues. Corporate
    borrowers generally have not filed complaints with the banking regulators
    and attribute the lack of complaints, in part, to a lack of documentary
    evidence and uncertainty about which tying arrangements section 106
    prohibits. The Federal Reserve and OCC report that they found only limited
    evidence of even potentially unlawful tying practices involving corporate
    credit during a targeted review that began in 2002, and they found that
    the banks surveyed generally had adequate policies and procedures in place
    to deter violations of section 106. However, while the teams conducting
    this review analyzed some specific transactions, they did not test a broad
    range of transactions, or outreach widely to bank customers. Information
    from customers could be an important step in assessing both implementation
    of and compliance with a bank's policies and procedures. While regulators
    could take further steps to encourage customers to provide information, in
    addition to the

    recent Federal Reserve proposal, bank customers themselves are crucial to
    enforcement of section 106.

    Recommendations for Executive Action

    Distinguishing lawful and unlawful tying depends on the specific facts and
    circumstances of individual transactions. Because the facts, if any, that
    would suggest a tying violation generally would not be found in the loan
    documentation that banks maintain and because bank customers have been
    unwilling to file formal complaints, effective enforcement of section 106
    requires an assessment of other indirect forms of evidence. We therefore
    recommend that the Federal Reserve and the OCC consider taking additional
    steps to ensure effective enforcement of section 106 and section 23B, by
    enhancing the information that they receive from corporate borrowers. For
    example, the agencies could develop a communication strategy targeted at a
    broad audience of corporate bank customers to help ensure that they
    understand which activities are permitted under section 106 as well as
    those that are prohibited. This strategy could include publication of
    specific contact points within the agencies to answer questions from banks
    and bank customers about the guidance in general and its application to
    specific transactions, as well as to accept complaints from bank customers
    who believe that they have been subjected to unlawful tying. Because low
    priced credit could indicate a potential violation of section 23B, we also
    recommend that the Federal Reserve assess available evidence regarding
    loan pricing behavior, and if appropriate, conduct additional research to
    better enable examiners to determine whether transactions are conducted on
    market terms and that the Federal Reserve publish the results of this
    assessment.

    Agency Comments 	We requested comments on a draft of this report from the
    Federal Reserve and OCC. We received written comments from the Federal
    Reserve and OCC that are summarized below and reprinted in appendixes II
    and III respectively. The Comptroller of the Currency and the General
    Counsel of the Board of Governors of the Federal Reserve System replied
    that they generally agreed with the findings of the report and concurred
    in our recommendations. Federal Reserve and OCC staff also provided
    technical suggestions and corrections that we have incorporated where
    appropriate.

    As agreed with your office, unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days from
    its

    issuance date. At that time, we will send copies the Chairman and Ranking
    Minority Member, Senate Committee on Banking, Housing, and Urban
    Affairs; the Chairman, House Committee on Energy and Commerce; the
    Chairman of the Board of Governors of the Federal Reserve System; and
    the Comptroller of the Currency. We will make copies available to others
    upon request. In addition, the report will be available at no charge on
    the
    GAO Web site at http://www.gao.gov.

    If you or your staff have any questions about this report, please contact
    James McDermott or me at (202) 512-8678. Key contacts and major
    contributors to this report are listed in appendix IV.

    Sincerely yours,

    Richard Hillman, Director
    Financial Markets and Community Investment

    Appendix I

    Differences in Accounting between Commercial and Investment Banks for Loan
    Commitments

    Because commercial and investment banks follow different accounting
    models, there are differences in the financial statement presentation of
    some similar transactions. This appendix summarizes the differences, under
    generally accepted accounting principles in how commercial banks and
    investment banks account for loan commitments-specifically commercial
    paper back-up credit facilities-using hypothetical scenarios to illustrate
    how these differences could affect the financial statements of a
    commercial and investment bank. 1 We use three hypothetical scenarios to
    illustrate the accounting differences that would occur between the
    commercial and investment banks for similar transactions if (1) a loan
    commitment were made, (2) the loan commitment was exercised by the
    borrower and the loan was actually made, and (3) the loan was subsequently
    sold. This appendix does not assess the differences in accounting that
    would occur if a loan was made by both a commercial bank and an investment
    bank when one entity decided to hold the loan to maturity and the other
    opted to hold the loan as available for sale, because the basis for these
    actions and the resulting accounting treatment are not similar.

    The examples in this appendix demonstrate that, as of a given financial
    statement reporting date, differences would likely exist between
    commercial and investment banks in the reported value of a loan commitment
    and a loan resulting from an exercised commitment, as well as the
    recognition of the related deferred revenue. In addition, the volatility
    of the fair value of loan commitments and the related loan, if the
    commitment were exercised, would be reflected more transparently in an
    investment bank's financial statements, because an investment bank must
    recognize these changes in value in earnings as they occur in net income.2
    In contrast, commercial banks are not allowed to recognize changes in the
    fair value of the loan commitment, its related deferred revenue, or the
    related loan (if drawn). The differences in accounting between commercial
    banks and investment banks are temporary; and, as the examples in the
    following sections show, whether a commercial bank or an investment

    1Commercial paper is generally a short-term, unsecured, money-market
    obligation issued by prime rated commercial firms and financial companies.
    A commercial paper back-up facility is generally a short-term bank line of
    credit that serves as an alternate source of liquidity for an issuer of
    commercial paper lasting less than 1 year.

    2FASB has defined fair value in FAS 107, Disclosures about Fair Value of
    Financial Instruments, as the amount at which a financial instrument could
    be exchanged in a current transaction between willing parties, other than
    a forced liquidation sale.

                                       Appendix I
                           Differences in Accounting between
                        Commercial and Investment Banks for Loan
                                      Commitments

    bank recognizes more fee revenue first would depend on various market
    conditions, including interest rates and spreads. Similarly, any
    differences between the fair value of a loan or loan commitment on an
    investment bank's book and the net book value of a similar loan or loan
    commitment on a commercial bank's books would be eliminated by the end of
    the loan term or commitment period.3 Given that loan commitment terms are
    usually for less than 1 year, any accounting differences between the
    commercial and investment banks would be for a relatively short period of
    time. Further, both commercial and investment banks are required to make
    similar footnote disclosures about the fair value of their financial
    instruments.4 Thus, neither accounting model provides a clear advantage
    over the life of the loan commitment or the loan if the commitment were
    exercised.

    Background	Since 1973, the Financial Accounting Standards Board (FASB) has
    been establishing private-sector financial accounting and reporting
    standards. In addition, the American Institute of Certified Public
    Accountants (AICPA) Accounting Standards Executive Committee also provides
    industry-specific authoritative guidance that is cleared with FASB prior
    to publication. Where FASB guidance is nonexistent, as is currently the
    case in fair-value accounting for loan commitments, firms are required to
    follow AICPA guidance.

    Most commercial banks generally follow a mixed-attribute accounting model,
    where some financial assets and liabilities are measured at historical
    cost, some at the lower of cost or market value and some at fair value. In
    accounting for loan commitments, banks follow the guidance in Statement of
    Financial Accounting Standards (FAS) Number 91

    3The net book value of a loan is generally its unpaid principal balance
    less any allowance for credit losses.

    4FASB has defined a financial instrument as cash, evidence of an ownership
    interest in an entity, or a contract that both imposes on one entity a
    contractual obligation to (1) deliver cash or another financial instrument
    to a second entity or (2) to exchange other financial instruments on
    potentially unfavorable terms with the second entity and conveys to that
    second entity a contractual right to (1) receive cash or another financial
    instrument from the first entity or (2) to exchange other financial
    instruments on potentially favorable terms with the first entity.

    Appendix I
    Differences in Accounting between
    Commercial and Investment Banks for Loan
    Commitments

    Accounting for Nonrefundable Fees and Costs Associated with Originating or
    Acquiring Loans and Initial Direct Costs of Leases.5 Broker-dealer
    affiliates and investment banks whose primary business is to act as a
    broker-dealer follow the AICPA's Audit and Accounting Guide, Brokers and
    Dealers in Securities, where the inventory (that may include loan
    commitments) are recorded at the current fair value and the change in
    value from the prior period is recognized in net income.6 Further, FASB
    currently has a project on revenue recognition that includes the
    accounting for loan commitment fees by investment banks and others. The
    purpose of that project includes addressing the inconsistent recognition
    of commitment fee income and may eliminate some of the accounting
    differences that exist between commercial banks and investment banks
    described in this appendix.

    FASB has stated that it is committed to work diligently toward resolving,
    in a timely manner, the conceptual and practical issues related to
    determining the fair values of financial instruments and portfolios of
    financial instruments. Further, FASB has stated that while measurement at
    fair value has conceptual advantages, all implementation issues have not
    yet been resolved; and the Board has not yet decided when, if ever, it
    will be feasible to require essentially all financial instruments to be
    reported at fair value in the basic financial statements. Although FASB
    has not yet issued comprehensive guidance on fair-value accounting, recent
    literature has stated that the fair-value accounting model provides more
    relevant information about financial assets and liabilities and can keep
    up with

    5FAS 91 Accounting for Nonrefundable Fees and Costs Associated with
    Originating or Acquiring Loans and Initial Direct Costs of Leases applies
    to loan commitments held by lending institutions. If a commercial bank
    held a loan commitment in a broker-dealer affiliate registered with the
    Securities and Exchange Commission, the affiliate would follow the AICPA
    guidance for broker-dealers.

    6For simplicity, in this appendix the term investment bank will be used to
    mean an investment bank in which the broker-dealer comprises a majority of
    the financial activity. In practice, investment banks do not often hold
    loan commitments in their broker-dealer affiliates because of the high
    capital requirements of broker-dealers; rather, the investment bank would
    generally hold these financial instruments in a nonbroker-dealer
    affiliate. However, according to AICPA staff, at the consolidated level,
    the entity would retain the specialized accounting model used for the
    broker-dealer subsidiary. The commercial bank would continue to use FAS 91
    to account for its loan commitments. A nonbroker-dealer that is a
    subsidiary of a broker-dealer holding company (not a bank holding company)
    may also follow the accounting used by its broker-dealer subsidiary, if
    the broker-dealer comprises the majority of the financial activity of the
    consolidated entity; that is, the fair-value model would also be used for
    the consolidated broker-dealer holding company financial statements.

                                       Appendix I
                           Differences in Accounting between
                        Commercial and Investment Banks for Loan
                                      Commitments

    today's complex financial instruments better than the historical cost
    accounting model. The effect of the fair-value accounting model is to
    recognize in net income during the current accounting period amounts that,
    under the historical cost model, would have been referred to as unrealized
    gains or losses because the bank did not sell or otherwise dispose of the
    financial instrument. Further, proponents of the fair-value accounting
    model contend that unrealized gains and losses on financial instruments
    are actually lost opportunities as of a specific date to realize a gain or
    loss by selling or settling a financial instrument at a current price.
    However, a disadvantage of fair-value accounting exists when there is not
    an active market for the financial instrument being valued. In this case,
    the fair value is more subjective and is often determined by various
    modeling techniques or based on the discounted value of expected future
    cash flows.

    Hypothetical Scenario for Unexercised Loan Commitments

    On the first day of an accounting period, Commercial Bank A and Investment
    Bank B each made a $100 million loan commitment to a highly rated company
    to back up a commercial paper issuance. This loan commitment was
    irrevocable and would expire at the end of three quarterly accounting
    periods. Because the loan commitment was issued to a highly rated company,
    both banks determined that the chance of the company drawing on the
    facility was remote. Both banks received $10,000 in fees for these loan
    commitments. Commercial Bank A followed the guidance in FAS No. 91 and
    recorded this transaction on a historical cost basis while Investment Bank
    B, subject to specialized accounting principles that require fair-value
    accounting, reported changes in fair value included the effect of these
    changes in earnings.

    Revenue Recognition for the Upon receipt of the loan commitment fee,
    Commercial Bank A would

    Commercial Bank	record the $10,000 as a liability, called deferred
    revenue, because the bank would be obligated to perform services in the
    future in order to "earn" this revenue. In practice, because of the
    relatively small or immaterial amounts of deferred revenue compared with
    other liabilities on a bank's statement of position (balance sheet), this
    amount would not be reported separately and would likely be included in a
    line item called "other liabilities."7 Commercial Bank A would follow the
    accounting requirements of FAS No.

    7The concept of materiality is discussed at length in FASB's Concept
    Statement 2, Qualitative Characteristics of Accounting Information,
    paragraphs 123 - 132.

                                       Appendix I
                           Differences in Accounting between
                        Commercial and Investment Banks for Loan
                                      Commitments

    91 and recognize the revenue as service-fee income in equal portions over
    the commitment period, regardless of market conditions-a practice often
    referred to as revenue recognition on a straight-line basis. Thus, at the
    end of the first accounting period, Commercial Bank A would reduce the
    $10,000 deferred revenue on its statement of position (balance sheet) by
    one-third or $3,333 and record the same amount of service-fee revenue on
    the statement of operations (income statement). The same accounting would
    occur at the end of the second and third accounting periods, so that an
    equal portion of service revenue would have been recognized during each
    period that the bank was obligated to loan the highly rated company $100
    million.8 Regarding disclosure of the $100 million commitment, Commercial
    Bank A would not report the value of the loan commitment on its balance
    sheet. However, the bank would disclose in the footnotes to its financial
    statements the fair value of this commercial paper back-up facility as
    well as the method used to estimate the fair value.9

    Revenue Recognition for the Investment Bank

    Although AICPA's Audit and Accounting Guide, Brokers and Dealers in
    Securities does not provide explicit guidance for how Investment Bank B
    would account for this specific transaction, the guide provides relevant
    guidance on accounting for loan commitments in general. This guide states
    that Investment Bank B would account for inventory, including financial
    instruments such as a commercial paper back-up facility, at fair value and
    report changes in the fair value of the loan commitment in earnings. When
    changes occurred in the fair value of the loan commitment, Investment Bank
    B would need to recognize these differences by adjusting the balance of
    the deferred revenue account to equal the new fair value of the loan
    commitment. Generally, quoted market prices of identical or similar
    instruments, if available, are the best evidence of the fair value of
    financial instruments. If quoted market prices are not available, as is
    often the case with loan commitments, management's best estimate of fair
    value may be based on the quoted market price of an instrument with
    similar characteristics; or it may be developed by using certain valuation
    techniques such as estimated future cash flows using a discount rate

    8If the likelihood of exercising this commitment had not been remote,
    Commercial Bank A would have followed the requirements of FAS 91, and not
    amortized the deferred revenue until the commitment was exercised. Once
    exercised, the bank would recognize the fee income over the life of the
    loan. If the commitment remained unexercised, income would be recognized
    upon expiration of the commitment.

    9This is required by FAS No. 107, Disclosures about Fair Value of
    Financial Instruments.

                                       Appendix I
                           Differences in Accounting between
                        Commercial and Investment Banks for Loan
                                      Commitments

    commensurate with the risk involved, option pricing models, or matrix
    pricing models. A corresponding entry of identical value would be made to
    revenue during the period in which the change in fair value occurred. Once
    the commitment period ended, as described in the previous paragraph, the
    deferred revenue account would be eliminated and the remaining balance
    recorded as income.

    If market conditions changed shortly after Investment Bank B issued this
    credit facility and its fair value declined by 20 percent to $8,000,
    Investment Bank B would reduce the deferred revenue account on its
    statement of position (balance sheet) to $8,000, the new fair value.
    Investment Bank B would recognize $2,000 of service-fee income, the amount
    of the change in value from the last reporting period, in its statement of
    operations (income statement). Investment Bank B would also disclose in
    its footnotes the fair value of this credit facility, as well as the
    method used to estimate the fair value.

    If during the second accounting period there was another change in market
    conditions and the value of this credit facility declined another 5
    percent of the original amount to $7,500, Investment Bank B would decrease
    the balance in the deferred revenue account to $7,500 and recognize $500
    in service-fee revenue. Further, Investment Bank B would disclose in its
    footnotes the fair value of this credit facility.

    During the accounting period in which the commitment to lend $100 million
    was due to expire, accounting period 3 in this example, the balance of the
    deferred revenue account would be recognized because the commitment period
    had expired and the fair value would be zero. Thus, $7,500 would be
    recognized in revenue and the balance of deferred revenue account
    eliminated. In this accounting period, there would be no disclosure about
    the fair value of the credit facility.

    Differences in Revenue Recognition Are Temporary

    The following table summarizes the amount of revenue Commercial Bank A and
    Investment Bank B would recognize and the balance of the deferred revenue
    account for each of the three accounting periods when there were changes
    in the value of the loan commitments. Commercial Bank A would recognize
    more service-fee income in accounting periods 1 and 2 than Investment Bank
    B. However, this situation would be reversed in period 3, when Investment
    Bank B would recognize more revenue. Thus, differences in the value of the
    loan commitment and the amount of revenue recognized would likely exist
    between specific accounting periods, reflecting the

                                       Appendix I
                           Differences in Accounting between
                        Commercial and Investment Banks for Loan
                                      Commitments

    volatility of the financial markets more transparently in Investment B's
    financial statements. The magnitude of the difference is determined by the
    market conditions at the time and could be significant or minor. However,
    these differences would be resolved by the end of the commitment period,
    when both entities would have recognized the same amount of total revenue
    for the loan commitment.

    Table 1: Accounting Differences for a Loan Commitment

                          Commercial Bank A Investment Bank B

    Accounting period

                                                   Service-fee revenue recognized

    Balance of deferred revenue

                                                   Service-fee revenue recognized

    Balance of deferred revenue

                Initial recording of
                 the credit facility          $0  $10,000           $0    $10,000
                                   1       3,333   6,667      2,000         8,000
                                   2       3,333   3,334           500      7,500
                                   3       3,334     0        7,500
                   Total service-fee
                             revenue
                          recognized   $10,000               $10,000

                                      Source: GAO.

    Hypothetical Scenario for Exercised Loan Commitments

    Commercial Bank A and Investment Bank B issued the same loan commitment
    described previously. However, at the end of the second accounting period,
    the highly rated company exercised its right to borrow the $100 million
    from each provider because its financial condition had deteriorated and it
    could no longer access the commercial paper market. The accounting
    treatment for this loan would depend upon whether bank management had the
    intent and ability to hold the loan for the foreseeable future or until
    maturity. AICPA Task Force members and some investment bankers told us
    that in practice, this loan could be either held or sold, and as a result,
    the accounting for both is summarized in the following sections.

    Loans Intended to Be Held At the time the loan was made, Commercial Bank A
    would record the $100

    to Maturity	million dollar loan as an asset on its statement of position
    (balance sheet). Investment Bank B would initially record this loan at its
    historical cost basis, less the loan commitment's fair value at the time
    the loan was drawn

    Appendix I
    Differences in Accounting between
    Commercial and Investment Banks for Loan
    Commitments

    ($100 million -$7,500). Further, based on an analysis by the banks' loan
    review teams, a determination of "impairment" would be made. According to
    FAS 114, Accounting by Creditors for Impairment of a Loan, "a loan is
    impaired when, based on current information and events, it is probable
    that a creditor will be unable to collect all amounts due according to the
    contractual terms of the loan agreement." If the loan were determined to
    be impaired, FAS 114 states that, the bank would measure the amount of
    impairment as either the (1) present value of expected future cash flows
    discounted at the loan's effective interest rate, (2) loan's observable
    market price, or (3) fair value of the collateral if the loan were
    collateral dependent.

    FAS 114 directs both banks to establish an allowance for losses when the
    measure of the impaired loan is less than the recorded investment in the
    loan (including accrued interest, net of deferred loan fees or costs and
    unamortized premium or discount) by creating a valuation allowance that
    reduces the recorded value of the loan with a corresponding charge to
    bad-debt expense. When there are significant changes in the amount or
    timing of the expected future cash flows from this loan, the banks would
    need to adjust, up or down, the loan-loss allowance as appropriate so that
    the net balance of the loan reflects management's best estimate of the
    loan's cash flows. However, the net value of the loan cannot exceed the
    recorded investment in the loan.

    If the loan were not impaired, both banks would still record an allowance
    for credit losses in accordance with FAS 5, Accounting for Contingencies,
    when it was probable that a future event would likely occur that would
    cause a loss and the amount of the loss was estimable.10 Thus, both banks
    would establish an allowance for loss in line with historical performance
    for borrowers of this type.11 Because the loan was performing, both banks
    would receive identical monthly payments of principal and interest.
    Generally, these cash receipts would be applied in accordance with the

    10On June 19, 2003, AICPA issued an exposure draft of a proposed statement
    of position for allowance for credit losses. This exposure draft proposes
    various revisions to how banks would estimate credit losses and report
    them on their financial statements and is proposed to be implemented after
    December 15, 2003.

    11FAS 5 states that receivables by their nature usually involve some
    degree of uncertainty about their collectibility, in which case a loss
    contingency exists. If a loss were not probable and estimable, both banks
    would disclose in their financial statement footnotes, the loss
    contingency when there was at least a reasonable possibility that a loss
    or additional loss might be incurred.

                                       Appendix I
                           Differences in Accounting between
                        Commercial and Investment Banks for Loan
                                      Commitments

    loan terms, and a portion would be recorded as interest income; and the
    balance applied would reduce the banks' investment in the loan. At the end
    of the loan term, the balance and the related allowance for this loan
    would be eliminated.

    FAS 91 also directs both banks to recognize the remaining unamortized
    commitment fee over the life of the loan as an adjustment to interest
    income. Because the borrower's financial condition had deteriorated, both
    banks would likely have charged a higher interest rate than the rate
    stated in the loan commitment. As a result, at the time it becomes evident
    that the loan is to be drawn, Investment Bank B would record a liability
    on its balance sheet to recognize the difference between the actual
    interest rate of the loan and the interest rate at which a loan to a
    borrower with this level of risk would have been made-in essence the fair
    value interest rate. This liability would also be amortized by Investment
    Bank B over the life of the loan as an adjustment to interest income.

    Loans Made Available for Sale

    If Commercial Bank A and Investment Bank B's policies both permitted the
    firms to only hold loans for the foreseeable future or until maturity when
    the borrowers were highly rated, it is unlikely that the banks would keep
    the loan in the previous hypothetical scenario and would sell the loan
    soon after it was made.12 Although the banks would follow different
    guidance there would be similar results. Commercial Bank A would follow
    the guidance in the AICPA Statement of Position 01-6.13 According to this
    guidance, once bank management decides to sell a loan that had not been
    previously classified as held-for-sale, the loan's value should be
    adjusted to the lower of historical cost or fair value, and any amount by
    which historical cost exceeds fair value should be accounted for as a
    valuation allowance. Further, as long a the loan's fair value remained
    less than historical cost, any subsequent changes in the loan's fair value
    would be

    12In order to keep this exception scenario example simple, it is also
    assumed that there are not conditions that would constrain Commercial Bank
    A and Investment Bank B from selling the loan, that both banks will not
    retain any interest in the loans sold, and the loans are sold without
    recourse.

    13Accounting by Certain Entities (Including Entities with Trade
    Receivables) That Lend to or Finance the Activities of Others, December,
    2001.

    Appendix I
    Differences in Accounting between
    Commercial and Investment Banks for Loan
    Commitments

    recognized in other comprehensive income.14 Investment Bank B would follow
    the guidance in the AICPA's Audit and Accounting Guide, Brokers and
    Dealers in Securities, as it did with loan commitments, and account for
    inventory at fair value and report changes in the fair value of the loan
    in net income.

    For example, if bank management decided to sell the loan soon after it was
    drawn when some payments had been made to reduce the principal balance and
    the net book value of this loan was $88,200,000 (unpaid principal balance
    of $90,000,000 less the related allowance of $1,800,000) and the fair
    value was 97 percent of the unpaid principal balance or $87,300,000, both
    banks would recognize the decline in value of $900,000 in earnings. While
    the loan remained available-for-sale, any changes in its fair value would
    be recorded in net income. For example, if the loan's fair value declined
    further to $85,500,000, both banks would recognize the additional decline
    in value of $1,800,000 in earnings.

    Table 2 below summarizes the accounting similarities between Commercial
    Bank A and Investment Bank B for the loan sale. Although the two banks
    followed different guidance, the effect of the loan sale is the same for
    both banks.

                    Table 2: Accounting Differences for a Loan Sale

                                    Commercial Bank A loss Investment Bank B loss
                        Transaction                 amount                 amount
               Transfer the loan to
                                the
                  trading portfolio             <$900,000>             <$900,000>
               Change in fair value           <$1,800,000>           <$1,800,000>
            Total loss on loan sale           <$2,700,000>           <$2,700,000>

    Source: GAO.

    14Comprehensive income is defined in FAS 130, Reporting Comprehensive
    Income, as the change in equity [net assets] of a business during a period
    from transactions and other events and circumstances from nonowner
    sources. It includes all changes in equity during a period except those
    resulting from investments by owners and distributions to owners.

                                      Appendix II

                        Comments from the Federal Reserve System

    Appendix II
    Comments from the Federal Reserve System

    Appendix III

    Comments from the Office of the Comptroller of the Currency

    Appendix III
    Comments from the Office of the Comptroller
    of the Currency

    Appendix IV

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