Coming Dodd-Frank Bank-Affiliate Transaction Rules May Have Profound Impact on the Business of Banking

October 8, 2013

Practical Law company logoMuch focus in the banking industry has been paid on the Basel III rules, recently finalized in the US, and the Volcker Rule, which is expected to be implemented by regulators by the end of this year. However, another potentially equally important change is also expected to occur in 2013, one that will further result in the strengthened ring-fencing of US banks from their non-bank operations, and potentially have a profound effect on the business of banking. These are the changes to the affiliate transactions restrictions applicable to banks, introduced under Dodd-Frank but not yet implemented by federal agency rulemaking.

Depending on how the rules are implemented, the changes may further limit banks to traditional lending activities, and restrict their ability to engage in the type of full-service financial activities they have traditionally conducted with their non-bank affiliates. They will also require banks to have enhanced compliance programs in place, as well as increase transparency in how they manage their legal entities and intercompany transactions.

The changes, introduced under Section 608 and 609 of the Dodd-Frank Act, strengthen the affiliate-transaction restrictions under Sections 23A and 23B of the Federal Reserve Act and the Federal Reserve Board’s (FRB) Regulation W. They include:

  • Broadening the range of bank affiliates covered by the restrictions to include investment funds to which a bank or an affiliate is an investment advisor. Banking organizations will need to review their advisory relationships with funds to determine if any new funds are covered under the expanded definition of affiliate. Banks must make sure that their relationships with these funds comply with the affiliate transaction restrictions.
  • Requiring banks to treat repurchase agreement transactions as extensions of credit for Section 23A purposes. As a result of this change repurchase agreement transactions with affiliates will become subject to the collateral requirements for credit transactions.
  • Expanding the statutory definition of covered affiliate transactions to include: securities borrowing and lending transactions with an affiliate to the extent the transaction creates credit exposure of the bank or a subsidiary of the bank to the affiliate; and credit exposures to an affiliate arising out of derivative transactions.
  • Imposing new collateral requirements on affiliate transactions.
  • Changing how financial subsidiaries of banks are treated for affiliate transaction restriction purposes.
  • Limiting the FRB’s authority, and giving the FDIC veto power, to issue exemptions to banks from the affiliate transaction requirements. During the financial crisis, the FRB granted numerous affiliate-transaction restriction exemptions to banks in order to allow them to continue to provide liquidity and funding to non-bank affiliates.

Although the rules are expected to be implemented later this year, industry reports indicate that agency supervisory staff are already beginning to apply many aspects of the heightened standards.   Counsel to banks would be well advised to keep abreast of these developments and prepare for their banks for the coming changes.