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 [email protected].

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
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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

                     GAO Contacts and Staff Acknowledgments

GAO Contacts	Richard Hillman, (202) 512-8678 James McDermott, (202)
512-5373

Acknowledgments	In addition to those individuals named above, Daniel
Blair, Tonita W. Gillich, Gretchen Pattison, Robert Pollard, Paul
Thompson, and John Treanor made key contributions to this report.

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