Yesterday, US Senator Chris Dodd, Chairman of the US Senate Committee on Banking, Housing, and Urban Affairs, released draft financial reform legislation (the “Dodd Bill”). The purpose of this memorandum is to review its proposed changes to Section 23A (“Section 23A”) of the Federal Reserve Act (the “Act”).

Current Law

Section 23A limits certain transactions (“covered transactions”) between banks and affiliates to those in an aggregate amount less than 10% (as to any single affiliate) or 20% (as to all transactions with affiliates in the aggregate) of the capital stock and surplus of the bank. Covered transactions currently include:

  • loans or extensions of credit to affiliates;  
  • purchases of assets from affiliates;  
  • acceptance of securities or debt obligations of affiliates as collateral for a loan to any person; and  
  • issuances of a guarantee, acceptance, letter of credit, etc., on behalf of an affiliate.  

The statute also sets collateral requirements for loans, extensions of credit, and other “loan-like” transactions with affiliates ranging from 100% to 130% of the amount of the loan and forbids the use of “low-quality assets” as collateral in these transactions.

Proposed Changes

Covered Transactions. The Dodd Bill adds the following to the definition of “covered transactions”:

  • transactions with affiliates that involve the borrowing or lending of securities, to the extent they cause the member bank to have credit exposure to the affiliate; and
  • derivative transactions with affiliates, to the extent they cause the member bank to have credit exposure to the affiliate.1

Under the proposed bill, Section 23A’s currently applicable collateral requirements would also apply to these new types of covered transactions.

Exemptions. The Board of the Federal Reserve (the “Board”) may still exempt transactions from these requirements, but only by regulation, not by order, and its ability to do so is subject to veto by the Chairperson of the FDIC. The Comptroller of the Currency may exempt national banks and the FDIC may exempt state banks. Both are also subject to veto by the Chair of the FDIC.  

Amounts of Covered Transactions. The statute gives the Board the ability to issue regulations or interpretations with respect to netting agreements and how such agreements may be taken into account in determining the amount of a covered transaction or whether it is adequately secured.

Comparison with House Bill

The U.S. House of Representatives passed its own version of a financial reform bill (the “House Bill”) late last year.2 Its proposed changes to Section 23A are similar to those contained in the Dodd Bill, with a few notable exceptions.

First, the House Bill includes in the definition of “covered transactions” not only derivative transactions that cause current exposure to the credit risk of the affiliate, but also those that pose “potential future” credit risk.

Second, rather than permit the Board (or, in the case of national or state banks, the Comptroller of the Currency and the FDIC, respectively) to exempt a transaction or institution from the requirements of Section 23A (subject to the later objection of the FDIC), the House Bill would require the concurrence of the Chairperson of the FDIC prior to granting the exemption. However, the Board may exempt a transaction by order (as is the case under current law), not merely by regulation.

Third, the House Bill does not permit the Board to consider netting agreements in evaluating the amount of a transaction or collateral securing an obligation.