The Federal Reserve on May 2 proposed the creation of a new Regulation W encompassing all restrictions on bank dealings with affiliates, and in the process proposing to curtail or change ways of business banks have been using for half a century. For some, the most critical part of the Fed's broad package was the proposal to take comments on making banks' derivative dealings with affiliates "covered transactions" under Section 23A of the Federal Reserve Act subject to its collateral and size limits.
Even though it noted that some big banks are starting to collateralize such transactions voluntarily, the staff proposal for the new Reg W the board adopted said "staff believe the Board may need to subject the credit exposure arising from bank affiliate derivative transactions to Section 23A."
Only the staff proposals are available on paper until the Board's actions of May 2 are written down and put in the Federal Register.
The staff suggested to the Board that it ask for comment on a number of questions about derivatives, including how to determine when a derivative transaction, such as a deep in-the-money option purchased by a bank from an affiliate, is the functional equivalent of a loan from the bank. Other questions concern how to treat derivative transactions that effectively guarantee to a non-affiliate the credit or performance of an affiliate, and the appropriate treatment under 23A for credit derivatives that reference third party obligations held by the affiliate. The staff also said the Board should ask for comment on requiring periodic disclosure of a bank's exposure to affiliates through derivatives, whether net exposure should be collateralized and, finally, an estimate of future exposure caused by affiliate derivative dealings.
The timing of the Fed's action last Wednesday was dictated by the Gramm-Leach-Bliley Act. That law mandated that the Fed must, by May 12, "address" through a final rule whether derivatives or daylight overdrafts to affiliates should be subject to 23A. To satisfy GLBA, the Fed put out an interim rule, effective Jan. 1, 2002, which requires the monitoring, managing and controlling of credit exposures from both derivatives and intra-day transactions. As regards intra-day, the staff said that Reg W, which will be the ultimate successor of the interim rule, probably should not put them under 23A. Said the staff, "the potential risk reduction...may not justify the costs to banking organizations."
Until now, 23A and 23B had been applied to banks via occasional interpretations which the Fed put out on how they would work in individual fact patterns. The great bulk of the vast Regulation W will deal with codifying and rewriting these. On the results of the staff-proposed rewrite, Gilbert Schwartz, partner in Schwartz & Ballin, commented, "they took the old interpretations and added to them some spin that calls into question" what banks had been doing. In putting out Regulation W, he added, the central bank has "taken the opportunity to substantially tighten up the way 23A applies."
