Below is an in-depth report FedFin sent to clients on August 11, 2009.  On Monday, March 8, the American Banker ran an article in which various industry sources said how shocked they were to find that the Treasury reform language included inter-affiliate transaction limits affecting OTC derivatives.  This was, in fact, addressed in detail in FedFin’s initial assessment of the language, which also noted its critical franchise impact. 

The Obama financial-industry reform plan includes language that would dramatically restructure institutions often considered too big to fail – not to mention all other bank holding companies.  Stiff new limits on the degree to which banks could fund holding-company affiliates would sharply limit the value of insured depositories to securities, insurance and similar activities, adversely affecting bank funding for OTC-derivatives and other proprietary trading in affiliated holding-company subsidiaries.  New loan limits (applied to any credit risk, not just traditional loans) would also sharply decrease the ability of banks to support affiliates and large counterparties. 

The measure would also impose new restrictions (without a grandfather) on who could own an insured depository, which would force many longstanding bank parent firms either to become BHCs (and shed commercial activities) or divest their banking operations – either of which would likely come at considerable cost.  The bill would also create new conflict-of-interest standards on banks that bar them from transactions with insiders.  It would also create a new assessment system for all insured depositories and holding companies.  While many of the bill’s provisions are controversial, they point not only to the Administration’s reform plans, but also to less high-profile actions bank regulators contemplate to break up too-big-to-fail banks and otherwise disentangle complex financial institutions.In the white paper accompanying the President’s plan, the Administration stated that one of its goals is to limit the spread of the federal subsidy and safety-net benefits to bank affiliates.  These include use of FDIC insurance and, now, other programs (which sharply reduce funding costs), and access to FRB liquidity facilities and payment-system services. 

The Administration argues that the recent crisis has both shown the value of these benefits and dramatically expanded them, with many non-traditional firms now structured as financial holding companies (FHCs). However, the value of these facilities has long been critical to all bank holding companies (BHCs), and it is essential to many strategic franchise decisions (e.g., which activities to house in a bank, which to put in a holding company and those that cannot be successfully offered within the FHC or BHC structure).  Although much in the legislation is aimed at very large firms, it would also affect even the smallest banks and BHCs by ending the longstanding practice of using bank funds to support insider business activities and imposing new supervisory fees.  As noted, who could own an insured depository would also be revised, by reimposing barriers between banking and commerce that, while supported by Congress and regulators in theory, have significant oopholes due to longstanding exceptions and grandfathers.  Each of these aspects of this section of the Obama legislation is discussed below.  FHC Activity Restructuring The Federal Reserve is charged with administering the firewalls between banks and their affiliates, but the bill would dramatically limit the Board’s ability going forward to relax these standards, even as they are tightened as discussed in more detail below. 

The FDIC has been particularly critical of recent relaxations to facilitate the transformation of large firms, including some very troubled ones, into BHCs, noting for example a decision related to GMAC that set dramatic precedent in this area.The combination of the proposed new standards and limited FRB exemption authority would combine to disentangle many BHCs and FHCs.  The fewer activities in these firms that can be funded by unlimited amounts of bank support and/or provided on non-market terms, the lower the value of holding non-banking activities.  This could spark divestiture of proprietary trading, hedge fund, merchant banking and other lines of business – some of them extremely profitable for BHCs and FHCs. 

Opponents of the Obama proposal argue that these profits provide a critical support for the insured-depository affiliate, essentially ensuring that a holding company has sufficient resources with which to serve as a source of strength.  They also note that diversified activities are a longstanding tradition outside the United States, where many major banking centers never implemented the distinction between commercial and investment banking required in the 1930s by the Glass-Steagall Act.   Proponents of the Administration approach counter, however, that these non-traditional activities increase risk because of complexity, risk correlations and conflicts of interest, supporting more of a “narrow-bank” approach in which institutions afforded FDIC insurance and other safety-net protections function principally as deposit-takers and lenders.Contributing to the restructuring that would result from the bill’s inter-affiliate transaction restrictions are provisions that would also tighten lending limits.  These would further reduce the ability of banks to support affiliates but, perhaps even more important, banks could not provide large amounts of financial support to institutional counterparties. 

The Obama Administration and FRB believe that these uncapitalized counterparty exposures – evident for example at AIG – contribute to the interconnectedness that resulted in systemic risk.  Stiff limits on how much credit risk could be extended to one party would force institutional investors and other large firms to rely on many financial institutions and thus limit the pain should the firm falter.  Ownership of Insured DepositoriesThe legislation would, as noted, bar ownership of any bank without application of the Bank Holding Company Act (BHCA).  This builds on provisions in legislation eliminating the thrift charter, in which the Administration proposes not only to eliminate federal savings associations, but also to require that any parent of a state savings association comply with the BHCA. 

The bank provisions here would cover industrial loan companies (ILCs), credit-card banks and other banks that Congress in 1987 decided to exempt from the BHCA. The length of this exception, which combines with one in 1999 for non-traditional S&L holding companies, leads opponents to argue that, whatever the merits of separating banking and commerce, doing so retroactively to firms that have posed no supervisory concerns is unfair.  They also believe that any threat from commercial ownership of insured depositories is alleviated by the firewalls discussed above under current law, let alone as these would be revised by the Obama bill.  Of course, if revised as proposed, the value of non-traditional ownership would also diminish, perhaps leading some companies that now own ILCs or other insured depositories to divest them even if grandfathered or otherwise allowed to retain their insured depository subsidiaries. 

Further, even if grandfathered under this section of the Obama plan, the very largest non-bank ILC parents (e.g., GE) could still be forced to restructure if declared to pose systemic risk.  The bill would impose a similar requirement on foreign firms found to pose systemic risk, essentially forcing them to restructure their non-U.S. operations to those permissible for a U.S. FHC to continue to do business in the United States.  This would address the competitiveness issue noted above, but at very considerable cost to foreign firms and, perhaps, to the concept of an open global financial system.  FRB AuthorityThe bill would give the Federal Reserve far-reaching authority over subsidiaries in a BHC or FHC.  In the 1999 law referenced above, Congress generally required the FRB to defer to “functional regulators” – that is, the bank regulator, SEC, state insurance regulator or other entity with express statutory responsibility for the subsidiary. 

The Board has argued that this led to the current crisis because it could not act on disturbing trends at subsidiaries of FHCs that it was then forced to support with liquidity or other aid as the financial crisis worsened.  Functional regulators strongly dispute this.  Although Treasury has suggested this is due to a “turf fight,” they argue that functional regulators have long expertise in areas that the FRB could not effectively supervise.  They, along with many in the industry, also fear that top-down FRB regulation would lead to duplication, burden and conflict that could create legal and reputational risk for covered firms.  Again, this could lead some to restructure into simpler BHCs with fewer non-traditional subsidiaries – as noted, one of the goals of the larger Administration plan in concert with the Federal Reserve.  BHC OperationsConsistent with the goal of breaking apart larger, complex firms, the Obama plan would also add a new criterion the FRB would have to consider when approving bank acquisitions:  the degree to which risk concentrations would be increased.  This would permit the Board to turn down applications even if the BHC met new, tougher capital and management standards also included in this legislative language. 

To be sure, the Board could act on this concern under current law if it feared that an acquisition might strain a BHC’s managerial resources, but the provision here gives the Board not only clear authority to do so, but also an express mandate that could lead to far fewer approvals going forward.  This would reverse or at least slow the trend in U.S. financial services towards far greater concentrations of assets held in FHCs.This provision would affect large and small BHCs, as would several others in this section of the reform legislation.  New conflict-of-interest restrictions would bar banks from a wider array of insider transactions – for example, purchasing assets from a director, officer or major shareholder.  This would likely have its greatest impact at smaller banks, which often engage in a range of community transactions with persons with close ties to the bank – but it could also limit larger firms from transactions with partnerships or similar ventures related to firm insiders.  Again, this would limit the value of an insured depository to institutions or individuals with non-banking interests.Finally, the measure would impose a new assessment for supervision by all bank and BHC regulators.  This is aimed at the regulatory-arbitrage issue noted above, as is language in the bill to limit charter shopping by troubled institutions. 

Only federally-chartered banks and thrifts now pay for their examinations, creating what the national agencies have long argued is an inappropriate cost incentive for supervision by the FRB or FDIC.  The legislation would end this, but likely at considerable cost to newly-covered firms.  The largest ones would bear the highest cost, especially at the BHC level, creating yet another reason for some to consider restructuring into smaller component firms. 

The full text of this report is available to subscription clients.