GLB Credit Exposure Rule Examined

hile receiving general support for its proposals to regulate bank-affiliate derivatives transactions, the Federal Reserve Board has been urged not to take an overly restrictive approach. Proposed new Regulation W would comprehensively implement Sections 23A and 23B of the Federal Reserve Act. The Gramm-Leach-Bliley Act significantly amended Section 23 and requires the Fed to address by rule the credit exposure arising from derivative transactions.

SIA URGES FLEXIBILITY

In the SIA’s view, many of the Fed’s concerns about credit derivatives can be allayed by the application of Section 23B to such transactions. For example, the presence of non-market and atypical terms of the sort that create opportunities for banks to fund affiliates in the way the Fed fears would, in the SIA’s opinion, violate the arms-length requirements of Section 23B.

In the area of best practices, the SIA cautioned the Fed against mandating a “one-size-fits-all’’ approach that fails to accommodate the diversity of both the firms themselves and their derivatives contracts, as well as the varied risks that banks are hedging with derivatives transactions. The SIA believes that banks should follow best practices in all of their derivatives transactions, but that they should be given the flexibility to adopt policies best suited to their individual derivatives portfolios and risk exposures. The risks attendant in different types of derivative contracts may vary widely, depending on such factors as interest rates and currency volatility. Thus, there is not one set of generic best practices suitable for banks and their affiliate securities firms.

The SIA strongly opposes the imposition of any Section 23A quantitative limits or collateral restrictions on bank-affiliate derivatives transactions. Mandating quantitative limits could hamper banks from entering into affiliate derivatives transactions which, in turn, would make it more costly to protect against interest rate, foreign exchange and other risks. In addition, quantitative limits would raise an array of “exceedingly” difficult questions about how to value derivatives contracts. Banks would have to engage in the continual evaluation of affiliate derivatives transactions to ensure they remained below the quantitative limits.

As for Section 23A’s collateral restrictions, reasoned the SIA, their efficacy is obviated by the application of Section 23B to bank-affiliate derivatives transactions. Section 23B requires banks to use risk management techniques in affiliate derivatives transactions to the same extent as they are used in comparable transactions with non-affiliates. To the extent that banks are engaged in arms-length transactions with their affiliates, the SIA submits that there is no need, from a safety and soundness perspective, to impose Section 23A’s collateral restrictions on bank-affiliate transactions.

ISDA SAYS MARKET DISCIPLINE IS KEY

ISDA requests that the Fed not impose the burdens of Section 23A regulation on bank-affiliate derivatives transactions without demonstrating that the goal of bank safety and soundness cannot be accomplished by less intrusive means. The derivatives market for bank-affiliate transactions, which is mainly institutional, is well-developed and subject to robust market discipline.

ISDA further urges that the proper approach is to build on the robust risk management techniques in the institutional derivatives market through the application of Section 23B. The supervisory review of private market regulation of the institutional derivatives market reinforced by Section 23B is, in ISDA’s view, preferable to the “one size fits all’’ regulatory regime of Section 23A.

Imposition of Section 23A’s requirements, contended ISDA, would be a “significant impediment’’ to a bank’s ability to facilitate efficient consolidated risk management. From a risk management viewpoint, ISDA reasoned, it is counterproductive to create regulatory barriers to affiliate transactions that move risk from an entity booking a transaction to an affiliate that is best suited to manage the related risk.

ISDA concluded that there is neither a policy nor a legal basis for subjecting bank-affiliate derivatives transactions to Section 23A. Through supervisory review, the Fed can effectively address potential abusive transactions should a bank structure an extension of credit to an affiliate as a swap in an effort to circumvent Section 23A.

ABA URGES WIDER RANGE AND MORE FLEXIBILITY

According to the ABASA, Sections 23A and 23B were enacted to prevent transactions with affiliates that were primarily for the benefit of bank officers and directors. At the time of enactment, bank officers and directors were not directly liable or punishable for fraudulent or blatantly self-benefiting actions. However, 1991 amendments to banking law added enormously to the arsenal of punitive measures available to bank supervisors and made directors liable for their improper acts. Thus, the ABASA believes that the restrictions of Sections 23A and 23B on transactions with affiliates are now too rigid and narrow. It follows that enlargement of the exemptions to increase banks’ flexibility in structuring transactions with affiliates would be consistent with the broad regulatory authority Congress has granted to the Fed.

Specifically, the ABASA asks the Fed to reassess its position on a blanket prohibition on intangible assets as eligible collateral. At a minimum, the Fed is urged to allow as collateral those intangibles recognized under generally accepted accounting principles and under the Fed’s own capital standards to the extent that they are included in risk-based capital. Similarly, the Fed is importuned to expand the exemptions for riskless principal transactions and brokerage fees to exempt purchases of assets other than securities.

The ABASA also believes that proposed exemptions to the Fed’s attribution rule are too narrow and should be expanded to limit the rule to those cases where a third party is knowingly being used as a conduit to transfer funding from a bank to an affiliate. A transaction should not be subject to the attribution rule if the proceeds of a credit transaction somehow find their way to an affiliate and the bank had no way of knowing that this would happen and could not in any practical manner have prevented it from happening. There should be a general exception for bona fide transactions by a third party with the affiliate.