In Focus: From Fed, 274 Pages On Affiliate Transactions

WASHINGTON — The Federal Reserve Board issued a passel of rules and proposals last week designed to simplify regulation of banks’ transactions with their affiliates — an area of increasing concern in the post-Gramm-Leach-Bliley world of financial conglomerates.

For such a complicated move in a sensitive area, the initial take by experts is surprisingly upbeat. Absent is the invective against the Fed’s merchant banking capital proposal.

But for those whose job it is to translate and comment on the 274 pages of highly technical language — many of whom were lugging the documents home to read over the weekend — complete understanding is a long way off.

One industry source declined to comment on the rule in any depth because, as he said, “it’s so damn huge.”

Richard M. Whiting, general counsel for the Financial Services Roundtable, called the proposals “arcane to the nth degree” but appeared to agree with the Fed that the rules would be good for the industry.

At its board meeting Wednesday the Fed proposed Regulation W. It would compile numerous previous rulings on the implementation of sections 23A and 23B of the Federal Reserve Act, which governs banks’ ability to make loans and execute other transactions with affiliated companies. It also issued an interim final rule, required by the Gramm-Leach-Bliley Act, that places restrictions on derivatives transactions and intraday extensions of credit between banks and affiliates.

Finally, the Fed issued a rule granting exemptions from 23A and 23B to certain loans and purchases — exemptions the banking industry had been seeking for years.

When the interim rule on derivatives takes effect on Jan. 1, 2002, it and the final rule will be rolled into Reg W to create a single comprehensive regulation.

“This is particularly important at this time because 23A and 23B are the major firewalls the Gramm-Leach-Bliley Act uses to make sure that the financial system works properly,” Mr. Whiting said.

The original intent of 23A was to prevent banks from allowing the amount of its loans to affiliates to exceed certain limits. Its sister law, section 23B, was meant to prevent banks from doing business with affiliates on terms less favorable to the bank than a normal, arm’s-length transaction. The concern was that in an attempt to bail out a struggling subsidiary, a bank might compromise its own safety and soundness.

Reg W would consolidate numerous findings by the Fed about how 23A and 23B apply to bank transactions but would also introduce numerous exemptions for specified transactions.

The interim final rule addresses two distinct types of transactions: derivatives and intraday extensions of credit.

It expresses the Fed’s belief that derivative transactions, for example, an agreement between a bank and its affiliate to hedge interest rates or market risk, are covered by 23B. It is less certain about 23A, noting that derivative transactions “resemble” transactions covered by the law.

In the rule the Fed requires that banks have policies and procedures in place to control credit exposure to affiliates but does not specifically state that they are covered by 23A. It also asks for comment on whether or not it should require that specific “best practices” be implemented by all banks.

William J. Sweet Jr., a partner here with the law firm of Skadden, Arps, Slate, Meagher & Flom, praised the central bank for taking what he called “a pretty cautious route” on the derivatives question. “[They] are not going to immediately implement some dollar and collateral requirements. That sounds like a good way to go as they figure it out,” he said.

The element of the rule dealing with intraday extensions of credit is couched in a bevy of exemptions that would allow current practices, such as securities clearing and settlement transactions, to occur without tripping 23A and 23B restrictions.

During the presentation of the rule to the Fed Board, general counsel J. Virgil Mattingly said that section of the rule was intended to stop only one sort of transaction — “a deliberate intraday overdraft made by a bank to an affiliate that needs the funding that day to get through the day.”

H. Rodgin Cohen, chairman and senior partner of the law firm Sullivan & Cromwell, said, “The general view is that the Fed dealt with what are two very difficult issues in a very pragmatic and effective way. The question everyone has is whether there will be further changes.”

The rules, both proposed and final, are expected to be published in the Federal Register shortly. The final rules will be effective 30 days after publication. The proposed Reg W and the interim final rule governing derivative and intraday transactions will be open for comment for 90 days after publication.


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