On September 8, 2016, the Board of Governors of the Federal Reserve System (the "Board"), the Office of the Comptroller of the Currency ("OCC") and the Federal Deposit Insurance Corporation ("FDIC") released a report on the activities and investments that banking entities may engage in under US state and federal law (the "Report").1 The Report includes several recommendations for limitations on those activities and investments that, if fully implemented, would have a significant adverse impact on many domestic and international banking organizations, particularly larger ones.

Arising from concerns with risky and speculative activities similar to those that motivated Section 619 of the Dodd-Frank Act (the "Volcker Rule"), Section 620 of the Dodd-Frank Act required the federal banking agencies to review the activities and investments that banking entities are currently authorized to engage in and to develop recommendations regarding any changes that should be made to ensure the safety and soundness of individual firms, as well as of the US financial system.2 The Report is divided into three sections addressing the activities and investments of the banking entities regulated by each agency. The recommendations focus on limiting non-financial activities that the regulators believe raise safety and soundness risks and are inconsistent with the separation of banking and commerce.

Principal Recommendations

While the descriptive material in each section provides useful background on the current activities and investments that are permissible for banking entities, the most significant items in the Report are the specific recommendations developed by the Board and the OCC. The FDIC did not recommend any immediate legislative or regulatory changes but announced that it will review (i) equity investments, including in other financial institutions and (ii) the prudential conditions and standards used to evaluate requests for authorizations relating to mineral rights, commodities and other non-traditional activities.

The Board's section of the Report recommends that Congress enact four changes to the Bank Holding Company Act of 1956, as amended ("BHCA"), and the Home Owners' Loan Act of 1933, as amended ("HOLA").

  1. Merchant Banking. The Board recommends repeal of the authority of bank holding companies that have elected financial holding company ("FHC") status to engage in merchant banking activities. Such activities, which involve making investments in non-financial companies as part of a bona fide merchant or investment banking activity, have been permissible for more than 15 years under the Board's regulations implementing the Gramm-Leach-Bliley Act of 1999 ("GLBA").3 The Board believes that, despite the fairly extensive existing regulatory limitations on exercising merchant banking authority, the ability to engage in those activities poses unacceptable risks to an FHC's safety and soundness. The Board is not, however, recommending that Congress repeal the authority through which insurance affiliates of FHCs engage in merchant banking-type activities. Unlike the case with its other recommendations, the Board did not include a recommendation for transitional relief for merchant banking investments.
  2. Section 4(o) Commodities Activities. The Board recommends that Congress repeal the grandfather provision in Section 4(o) of the BHCA, as amended by GLBA, that permits certain FHCs to engage in a broader range of activities related to physical commodities than FHCs that do not qualify under Section 4(o). The Board recommends an appropriate transition period for the two FHCs that currently rely on this authority.4 The Report states that the Section 4(o) exemption raises safety and soundness and competitive concerns and is inconsistent with the separation of banking and commerce.
  3. Industrial Loan Company ("ILC") Exemption. The Report recommends repeal of the exemption for ILCs that are FDIC-insured from the definition of "bank" in the BHCA.5 The Board has been urging repeal of this exemption for many years, because companies that own ILCs are exempt from the BHCA's restrictions on nonbanking activities and are not subject to consolidated supervision and regulation by the Board. The Board recommends that Congress apply the BHCA to current ILC owners following a transition period.
  4. Grandfathered Unitary SLHCs ("GUSLHCs"). The Report recommends that Congress repeal the GUSLHC exemption and apply the BHCA-like activities restrictions under HOLA to current GUSLHCs following a multi-year transition period. GUSLHCs are savings and loan holding companies ("SLHCs") that have owned a single thrift institution since before the passage of GLBA. GUSLHCs are permitted to engage in any type of activity, including commercial activities, provided they meet certain asset portfolio requirements and other conditions. The Board believes that the GUSLHC structure raises competitive concerns and is inconsistent with the separation of banking and commerce.

The OCC section of the Report identifies seven recommendations that the OCC intends to implement through regulatory rulemaking and/or by issuing interpretive guidance. Some of these recommendations will apply not only to national banks and to federal branches and agencies of foreign banks but also to statechartered banks and state-licensed branches and agencies of foreign banks that are subject to the OCC's regulations indirectly through other federal banking laws.

  1. Type III Securities. National banks are authorized to hold asset-backed securities ("ABS") as Type III securities, including ABS backed by bank-impermissible assets (i.e., assets a national bank may not own directly). The OCC believes that because credit quality is tied to the underlying assets, the permissibility of holding ABS should be determined by reference to the underlying assets. Accordingly, the OCC intends to issue a proposed rule to prohibit national banks, federal branches and agencies, and federal savings associations from holding ABS that are based on bank-impermissible assets. As noted above, this proposed rule would also apply indirectly to the investment activities of state-chartered banks and state-licensed branches and agencies of foreign banks.
  2. Mark-to-Model Accounting. National banks, federal savings associations, and federal branches and agencies of foreign banks may hold certain assets and liabilities that have no ready market price and are difficult to value. These assets and liabilities are accounted for using pricing models to mark the asset or liability to fair value on a daily basis. The OCC is concerned with institutions developing concentrations in such assets and liabilities because the inherent subjectivity that goes into pricing models makes it difficult to assess an item's true risk profile and capital adequacy. Accordingly, the OCC intends to address concentrations of mark-to-model assets and liabilities with a rulemaking or guidance.
  3. Swap Dealing. National banks are authorized to conduct swap dealing business with their customers (subject to the swap push-out prohibition in Section 716 of the Dodd-Frank Act, which prohibits an insured depository institution from dealing in certain structured finance swaps). Currently, there is no prudential framework for the swap dealing activities of smaller national banks, which typically would not be subject to regulation under the Commodity Exchange Act as "swap dealers." To ensure these activities are conducted in a safe and sound manner, the OCC intends to clarify minimum prudential standards for certain national bank swap dealing activities.
  4. Clearinghouse Membership. National banks are authorized to be members of a clearinghouse if they have a risk management framework to limit their potential liability exposure. The OCC is concerned that some clearinghouses have rules that do not provide an upper limit to members' liability. To address this concern, the OCC intends to consider providing guidance to national banks on clearinghouse memberships.
  5. Physical Hedging. National banks may purchase and sell title to physical commodities to hedge commodity price risk in connection with permissible customerdriven commodity derivative transactions. The OCC believes that existing limits on what constitutes permissible hedges require further clarification. Accordingly, the OCC intends to publish guidance that clarifies the regulatory limits on physical hedging.
  6. Copper Activities. Since 1995, the OCC has permitted national banks to hold and trade copper as a precious metal. The Senate Permanent Subcommittee on Investigations recommended in 2014 "that the OCC subject copper to the same limits and reporting requirements that apply to other base metals." While national banks may own base metals in connection with certain limited banking activities (e.g., in connection with a leasing business), national banks may not hold or trade base metals as a standalone activity. The OCC has issued a proposed rule to prohibit national banks from buying and selling copper as a standalone activity.6 Comments on the proposed rule are due by November 14, 2016.
  7. Volcker Rule. The OCC, along with other federal agencies, adopted final regulations implementing the Volcker Rule in 2014 to impose limitations on banking entities' trading and fund activities. The OCC believes that certain aspects of its permissible investment regulations are contrary to the limitations imposed by the Volcker Rule. Accordingly, the OCC intends to incorporate the Volcker Rule into its investment securities regulations to eliminate any inconsistency.

Timing and Other Observations

Clearly, as evidenced by its "Commercial and Industrial Metals" proposal, the OCC's recommendations can be implemented more quickly than the Board's because they do not require legislation. Moreover, Congress is unlikely to even consider the Board's recommendations before the new Congress is seated after the November election. Because the Board's recommendations, if adopted, could have a significant effect on large banking entities in particular by requiring them to restructure or terminate certain activities and investments, industry trade groups and affected banking entities will likely oppose any changes in these powers and, at a minimum, seek appropriate transitional or grandfathering arrangements.

In addition to its express recommendations, the Report provides additional insights on how the agencies view and are likely to treat certain activities.

  1. Commodities Activities Authority. The Board did not recommend changes to GLBA's complementary authority provisions that have been used to authorize certain FHCs to engage in physical commodities trading activities, energy management services and energy tolling activities. Rather, the Board cited its January 2014 advance notice of proposed rulemaking on commodities activities of FHCs and indicated that it "is exploring what further prudential restrictions or limitations on the ability of FHCs to engage in commoditiesrelated activities are warranted to mitigate the risks associated with these activities." Due to this ongoing review and because the Board has not approved an FHC to engage in a complementary activity since 2008, we think it is unlikely that the Board would be receptive to a complementary activity application for commodities activities for the foreseeable future. Based on their recommendations, it is also unlikely that the FDIC or the OCC will approve applications expanding commodity-related activities.
  2. Merchant Banking Holding Period Extensions. At the same time that it is recommending Congressional action, the Board also noted that it is continuing to consider revisions to its merchant banking regulation to further limit safety and soundness risks and to ensure appropriate risk management of merchant banking activities.7 The Board has also historically been reluctant to grant extensions to the 10or 15-year holding period for merchant banking investments. Its recommendation to repeal the merchant banking authority will likely reinforce this tendency.8
  3. Glass-Steagall Act Reinstatement. Despite calls from both political parties in this election season as well as other public figures, the Board did not recommend that Congress reinstate the provisions of the Glass-Steagall Act, which before 1999 limited affiliations between certain securities companies and banks.
  4. ILC Approvals. While the Dodd-Frank Act's moratorium on approvals for ILCs that would be controlled by non-financial companies expired in July 2013, the FDIC has not approved any new applications since the imposition of its own moratorium in 2006. In light of the Board's continued opposition to the ILC exemption and the FDIC's past reluctance to consider applications from non-financial companies seeking to control an ILC, it is highly unlikely that a non-financial company could obtain approval to acquire an ILC in the current environment. Furthermore, even financial companies seeking to obtain an ILC may have a difficult time obtaining FDIC approval.