Bank Tying
Additional Steps Needed to Ensure Effective Enforcement of Tying Prohibitions
Gao ID: GAO-04-4 October 10, 2003
Investment affiliates of large commercial banks have made competitive inroads in the annual $1.3 trillion debt-underwriting market. Some corporate borrowers and officials from unaffiliated investment banks have alleged that commercial banks helped their investment affiliates gain market share by illegally tying and underpricing corporate credit. This report discusses these allegations, the available evidence related to the allegations, and federal bank regulatory agencies' efforts to enforce the antitying provisions.
Section 106 of the Bank Holding Company Act Amendments of 1970 prohibits commercial banks from "tying," a practice which includes conditioning the availability or terms of loans or other credit products on the purchase of certain other products and services. The law does permit banks to tie credit and traditional banking products, such as cash management, and does not prohibit banks from considering the profitability of their full relationship with customers in managing those relationships. Some corporate customers and officials from an investment bank not affiliated with a commercial bank have alleged that commercial banks illegally tie the availability or terms, including price, of credit to customers' purchase of other services. However, with few exceptions, formal complaints have not been brought to the attention of the regulatory agencies and little documentary evidence surrounding these allegations exists, in part, because credit negotiations are conducted orally. Further, our review found that some corporate customers' claims involved lawful ties between traditional banking products rather than unlawful ties. These findings illustrate a key challenge for banking regulators in enforcing this law: while regulators need to carefully consider the circumstances of specific transactions to determine whether the customers' acceptance of an unlawfully tied product (that is, one that is not a traditional banking product) was made a condition of obtaining credit, documentary evidence on those circumstances might not be available. Therefore, regulators may have to look for indirect evidence to assess whether banks unlawfully tie products and services. Although customer information could have an important role in helping regulators enforce section 106, regulators generally have not solicited information from corporate bank customers. The Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency (OCC) recently reviewed antitying policies and procedures of several large commercial banks. The Federal Reserve and OCC, however, did not analyze a broadly-based selection of transactions or generally solicit additional information from corporate borrowers about their knowledge of transactions. The agencies generally found no unlawful tying arrangements and concluded that these banks generally had adequate policies and procedures intended to prevent and detect tying practices. The agencies found variation among the banks in interpretation of the tying law and its exceptions. As a result, in August 2003, the Board of Governors of the Federal Reserve, working with OCC, released for public comment new draft guidance, with a goal of better informing banks and their customers about the requirements of the antitying provision.
GAO-04-4, Bank Tying: Additional Steps Needed to Ensure Effective Enforcement of Tying Prohibitions
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Report to the Chairman and Ranking Minority Member of the Committee on
Financial Services, House of Representatives:
October 2003:
BANK TYING:
Additional Steps Needed to Ensure Effective Enforcement of Tying
Prohibitions:
GAO-04-4:
GAO Highlights:
Highlights of GAO-04-4, a report to the Chairman and Ranking Minority
Member of the Committee on Financial Services, House of
Representatives
Why GAO Did This Study:
Investment affiliates of large commercial banks have made competitive
inroads in the annual $1.3 trillion debt-underwriting market. Some
corporate borrowers and officials from an unaffiliated investment bank
have alleged that commercial banks helped their investment affiliates
gain market share by illegally tying and underpricing corporate
credit. This report discusses these allegations, the available
evidence related to the allegations, and federal bank regulatory
agencies‘ efforts to enforce the antitying provisions.
What GAO Found:
Section 106 of the Bank Holding Company Act Amendments of 1970
prohibits commercial banks from ’tying,“ a practice which includes
conditioning the availability or terms of loans or other credit
products on the purchase of certain other products and services. The
law permits banks to tie credit and traditional banking products, such
as cash management, and does not prohibit banks from considering the
profitability of their full relationship with customers in managing
those relationships.
Some corporate customers and officials from an investment bank not
affiliated with a commercial bank have alleged that commercial banks
illegally tie the availability or terms, including price, of credit to
customers‘ purchase of other services. However, with few exceptions,
formal complaints have not been brought to the attention of the
regulatory agencies and little documentary evidence surrounding these
allegations exists, in part, because credit negotiations are conducted
orally. Further, our review found that some corporate customers‘
claims involved lawful ties between traditional banking products
rather than unlawful ties. These findings illustrate a key challenge
for banking regulators in enforcing this law: while regulators need to
carefully consider the circumstances of specific transactions to
determine whether the customers‘ acceptance of an unlawfully tied
product (that is, one that is not a traditional banking product) was
made a condition of obtaining credit, documentary evidence on those
circumstances might not be available. Therefore, regulators may have
to look for indirect evidence to assess whether banks unlawfully tie
products and services. Although customer information could have an
important role in helping regulators enforce section 106, regulators
generally have not solicited information from corporate bank
customers.
The Board of Governors of the Federal Reserve System and the Office of
the Comptroller of the Currency (OCC) recently reviewed antitying
policies and procedures of several large commercial banks. The Federal
Reserve and OCC, however, did not analyze a broadly-based selection of
transactions or generally solicit additional information from
corporate borrowers about their knowledge of transactions. The
agencies generally found no unlawful tying arrangements and concluded
that these banks generally had adequate policies and procedures
intended to prevent and detect tying practices. The agencies found
variation among the banks in interpretation of the tying law and its
exceptions. As a result, in August 2003, the Board of Governors of the
Federal Reserve, working with OCC, released for public comment new
draft guidance, with a goal of better informing banks and their
customers about the requirements of the antitying provision.
What GAO Recommends:
Because documentary evidence of an unlawful tying arrangement
generally is not available in bank files, GAO recommends that the
Federal Reserve and OCC consider additional steps to enforce section
106. Additional steps could include publication of specific contact
points within the agencies to answer questions from banks and bank
customers about the guidance in general and its application to
specific transactions, as well as to accept complaints from bank
customers who believe that they have been subjected to unlawful
tying.
Because low-priced credit could indicate violations of law, the
Federal Reserve should also assess available evidence of loan pricing
behavior to provide better supervisory information, and publish the
results of this assessment.
www.gao.gov/cgi-bin/getrpt?GAO-04-4.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Richard Hillman at
(202) 512-8678 or hillmanr@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Some Corporate Borrowers Alleged That Unlawful Tying Occurs, but
Available Evidence Did Not Substantiate These Allegations:
Federal Reserve and OCC Targeted Review Identified Interpretive
Issues:
Evidence That We Reviewed on the Pricing of Corporate Credit Did Not
Demonstrate That Commercial Banks Unlawfully Discount Credit:
Differences between Commercial Banks and Investment Banks Did Not
Necessarily Affect Competition:
Conclusions:
Recommendations for Executive Action:
Agency Comments:
Appendixes:
Appendix I: Differences in Accounting between Commercial and Investment
Banks for Loan Commitments:
Background:
Hypothetical Scenario for Unexercised Loan Commitments:
Hypothetical Scenario for Exercised Loan Commitments:
Appendixes:
Appendix II: Comments from the Federal Reserve System:
Appendix III: Comments from the Office of the Comptroller of the
Currency:
Appendix IV: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Acknowledgments:
Tables :
Table 1: Accounting Differences for a Loan Commitment:
Table 2: Accounting Differences for a Loan Sale:
Abbreviations:
AICPA: American Institute of Certified Public Accountants:
FASB: Financial Accounting Standards Board:
FAS: Financial Accounting Standards:
FDIC: Federal Deposit Insurance Corporation:
OCC: Office of the Comptroller of the Currency:
SEC: Securities and Exchange Commission:
Letter October 10, 2003:
The Honorable Michael G. Oxley
Chairman, Committee on Financial Services
House of Representatives
The Honorable Barney Frank
Ranking Member, Committee on Financial Services
House of Representatives
Dear Mr. Dingell:
In the 70 years since the passage of the Glass-Steagall Act of 1933,
which prohibited commercial banks from engaging in investment banking
activities such as securities underwriting, changes in legislation and
regulatory interpretations have relaxed some of the restrictions
imposed on bank holding companies and their subsidiaries that served to
distance commercial banks from investment banking. For example, one
effect of the 1970 amendments to the Bank Holding Company Act of 1956
was to permit bank holding companies to own subsidiaries engaged in
limited underwriting activities, but only if the subsidiary was not
"principally engaged" in such activities. More recently, the Gramm-
Leach-Bliley Act of 1999, among other things, substantially removed
that limitation. As a result of these and other developments,
commercial banks and their investment bank affiliates (investment
affiliates) can provide complementary financial products and services.
Despite these developments, commercial banks have remained subject to
certain restrictions on their activities. Among them is the prohibition
against tying arrangements. In general, section 106 of the Bank Holding
Company Act Amendments of 1970 (section 106) prohibits banks from tying
the availability or price of a product or service to a customer's
purchase of another product or service or the customer's providing some
additional credit, property or service.[Footnote 1]
In recent years, investment bank affiliates of large commercial banks
have gained an increasing share of the annual $1.3 trillion debt
underwriting market. A controversy has arisen over whether or not
unlawful tying has contributed to this increased market share. Some
unaffiliated investment banks (investment banks) and some corporate
borrowers contend that commercial banks have facilitated investment
affiliates' increased market share of debt underwriting by unlawfully
tying the availability of bank credit to debt underwriting by the
bank's affiliate, a violation of section 106. In addition, some
investment bankers assert that large commercial banks engage in
unlawful tying by offering reduced rates for corporate credit only if
the borrower also purchases debt underwriting services from the bank's
investment affiliate. If such a reduced rate were conditioned only on
the borrower's purchase of debt underwriting services from the
commercial bank's investment affiliate, the arrangement would
constitute unlawful tying. Should the reduced rate constitute an
underpricing of credit (that is, the extension of credit below market
rates), the underpricing could also violate section 23B of the Federal
Reserve Act of 1913 (section 23B).
Section 23B generally requires that certain transactions between a bank
and its affiliates occur on market terms; that is, on terms and under
circumstances that are substantially the same, or at least as favorable
to the bank, as those prevailing at the time for comparable
transactions with unaffiliated companies. Section 23B applies to any
transaction by a bank with a third party if an affiliate has a
financial interest in the third party or if an affiliate is a
participant in the transaction. The banking regulators suggest that the
increase in debt underwriting market share by the investment affiliates
of large commercial banks can be explained by a number of market and
competitive factors not associated with tying, such as industry
consolidation and acquisition of investment banking firms by bank
holding companies. In addition, representatives from large commercial
banks with investment affiliates contend that they sell a range of
products and services to corporate customers, including credit, but do
not unlawfully tie bank credit or credit pricing to underwriting
services. Furthermore, officials from large commercial banks, federal
banking and securities regulators, and investment bankers observe that
ties between credit and other banking products are often customer-
initiated, and thus exempt from the laws governing tying.
To more fully examine the issues raised by the allegations about
unlawful tying and underpricing of corporate credit, you asked us to
determine (1) what evidence, if any, suggests that commercial banks
with investment affiliates engage in unlawful tying; (2) what steps the
federal banking regulators have taken to examine for unlawful tying and
the results of these efforts; (3) what evidence, if any, suggests that
commercial banks with investment affiliates unlawfully discount the
price of corporate credit to obtain underwriting business for their
investment affiliates; and (4) what, if any, competitive advantages
accounting rules, capital standards, and access to the federal safety
net create for commercial banks over investment banks.
In our review of possible unlawful tying practices by large commercial
banks, we focused on wholesale corporate lending and did not address
retail banking. We conducted a legal review of section 106 of the Bank
Holding Company Act Amendments of 1970, section 23B of the Federal
Reserve Act, and relevant federal regulations, and interviewed legal
experts and academics. To describe the recent concerns about possible
unlawful tying practices, we reviewed the results of a 2003 survey on
corporate borrowers' views about credit access conducted by the
Association for Financial Professionals and reviewed recent media
coverage of tying. We also interviewed several large corporate
borrowers, and officials at several investment banks and commercial
banks with investment affiliates. We also met with officials from NASD
to discuss that organization's Special Notice to its members and its
ongoing investigation related to tying. NASD is a self-regulatory
organization that sets and enforces market conduct rules governing its
members, which are securities firms, including those affiliated with
commercial banks.
To determine what steps the federal banking regulators have taken to
examine for unlawful tying, we reviewed the results of the Board of
Governors of the Federal Reserve System (Federal Reserve) and the
Office of Comptroller of the Currency (OCC) joint review on tying and
interviewed commercial bankers to describe the measures that large
commercial banks take to comply with the tying law. We also reviewed
federal guidance on sections 106 and 23B and Federal Reserve and OCC
examination procedures related to tying. In addition, we interviewed
officials from the Federal Reserve, OCC, and the Federal Deposit
Insurance Corporation (FDIC).
To identify possible credit pricing abuses and factors that affect
overall prices in wholesale credit markets, we interviewed commercial
bankers, credit market experts, academics experts, industry observers,
and officials at the Federal Reserve and OCC. We also reviewed economic
literature on wholesale credit markets.
To determine the accounting practices and requirements for commercial
banks and investment banks, we performed a comparative analysis of
applicable accounting standards and verified our understanding through
interviews with officials from the Financial Accounting Standards Board
(FASB), the American Institute of Certified Public Accountants (AICPA),
and the Securities and Exchange Commission (SEC). We also solicited
feedback from FASB and AICPA officials on appendix I of our draft
report and incorporated their technical comments in this report as
appropriate. To determine the respective capital standards for
commercial banks, we reviewed relevant documentation and interviewed
Federal Reserve, OCC, and SEC officials and officials from commercial
banks. We also spoke with Federal Reserve and OCC officials about the
access of commercial banks and investment banks to the federal safety
net.
We recognized certain limitations on the information collected during
this review. In particular, we recognized that much of the information
provided to us on selected transactions and market behavior could not
be independently verified. In addition, we did not independently verify
the results of the 2003 survey conducted by the Association for
Financial Professionals, which we believe are subject to methodological
limitations that prevent us from reporting them in detail. Nor did we
verify the results of the Federal Reserve and OCC's special review
targeted on tying.
We conducted our work in Charlotte, N.C.; Chicago, Ill.; New York,
N.Y.; Orlando, Fla.; and Washington, D.C., between October 2002 and
October 2003, in accordance with generally accepted government auditing
standards.
Results in Brief:
Although some corporate borrowers have alleged that commercial banks
tie the availability or price of credit to the purchase of debt
underwriting services--a violation of section 106--the available
evidence did not substantiate these claims. Corporate borrowers could
not provide documentary evidence to substantiate their claims. The lack
of documentary evidence might be due to the fact that negotiations over
credit terms and conditions (during which a tying arrangement could be
imposed) were generally conducted orally. Borrowers also were reluctant
to file formal complaints with banking regulators. Reasons given for
their reluctance included a lack of documentary evidence of unlawful
tying, uncertainty about whether certain tying arrangements were
illegal, and fear of adverse consequences for their companies' access
to credit and for their individual careers. Determining whether a tying
arrangement is unlawful requires close examination of the specific
facts and circumstances of the transactions involved, and lawful
practices can easily be mistaken for unlawful tying. For example,
although borrowers we interviewed described arrangements that could
represent unlawful tying by banks, other arrangements that they
described involved lawful practices. Because documentary evidence of
unlawful tying is generally not available, banking:
regulators may have to look for other forms of indirect evidence to
effectively enforce section 106.[Footnote 2]
Regular bank examinations in recent years have not identified any
instances of unlawful tying that led to enforcement actions.[Footnote
3] In response to recent allegations of unlawful tying at large
commercial banks, the Federal Reserve and OCC conducted a joint review
focused on antitying policies and practices at several large commercial
banks and their holding companies. The review teams found that the
banks generally had adequate procedures in place to comply with section
106, and that over the past year, some banks had made additional
efforts to ensure compliance. Although customer information could have
an important role in helping the regulators enforce section 106,
regulators did not analyze a broadly based selection of transactions or
contact a broad selection of customers as part of their review. The
regulators said that they met with officials and members from a trade
group representing corporate financial executives. The review teams
questioned some transactions but generally did not find unlawful tying
arrangements. The targeted review found some variation among banks'
interpretations of section 106, generally in areas where the regulators
have not provided authoritative guidance. As a result, the Federal
Reserve recently issued, for public comment, proposed guidance that is
intended to help banks and their customers better understand what
activities are lawful and unlawful under section 106.[Footnote 4]
Federal Reserve officials said that they hope this guidance also
encourages customers to come forward if they believe that they have
grounds to make a complaint.
Although officials from one investment bank alleged that the pricing of
some corporate credit by large commercial banks was a factor in
violations of section 106 and possibly section 23B, we found that the
available evidence on pricing was subject to multiple interpretations
and did not necessarily demonstrate violations of either section 106 or
section 23B. Some investment banks contended that large commercial
banks deliberately underpriced corporate credit to attract underwriting
business to their investment affiliates. Section 106 prohibits a bank
from setting or varying the terms of credit on the condition that the
customer purchase certain other products and services from the bank or
an affiliate, unless those products and services (such as traditional
banking services) are exempted from the prohibition. If the price of
the credit is less than the market price and the bank's investment
affiliate is a participant in the transaction, then the transaction
would reduce the bank's income for the benefit of its affiliate, and
thus be in violation of section 23B.[Footnote 5] However, our review of
specific transactions cited by an investment bank found the available
evidence of underpricing to be ambiguous and subject to different
interpretations. During the course of our review, Federal Reserve staff
said that they were considering whether to conduct a research study of
pricing issues in the corporate loan market. Such a study could improve
the regulators' ability to determine if transactions are conducted at
prices that were not determined by market forces.
Although officials at one investment bank also contended that
differences in accounting conventions, regulatory capital
requirements, and access to the federal safety net provide a
competitive advantage that enables commercial banks with investment
affiliates to underprice loan commitments, we found that these
differences did not appear to provide a clear and consistent
competitive advantage for commercial banks.
* Because commercial banks are not permitted by the accounting
standards to recognize changes in the value of loans and loan
commitments compared with current market prices while investment banks
recognize these changes in their net income, officials at some
investment banks have contended that accounting standards give
commercial banks a competitive advantage. However, FASB, which sets
private-sector financial accounting and reporting standards, noted that
commercial banks and investment banks follow different accounting
models for these transactions. Based on our analysis, banks' adherence
to different accounting rules caused a temporary difference in the
recognition of the service fees from short-term loan commitments--a
difference that appeared to be relatively small compared with revenue
from other bank activity and would be resolved by the end of the loan
commitment period. Moreover, both commercial banks and investment banks
must report the fair value of loan commitments in the footnotes of
their financial statements. Further, we found that if the loan
commitment were exercised and both firms either had the intent and
ability to hold the loan for the foreseeable future or until maturity,
or made the loan available for sale, the accounting would be similar
and would not provide an advantage to either firm.
* Additionally, while commercial and investment banks were subject to
different regulatory capital requirements, practices of both commercial
and investment banks led to avoidance of regulatory charges on loan
commitments with a maturity of 1 year or less. Officials from one
investment bank also contended that bank regulatory capital
requirements gave commercial banks a competitive advantage in lending
because they are not required to hold regulatory capital against short-
term unfunded loan commitments. In comparison, investment banks could
face a 100-percent regulatory capital charge if they carried loan
commitments in their broker-dealer affiliates. However, in practice,
investment bankers told us that they generally carry loan commitments
outside of their broker-dealer affiliates and thus also avoid
regulatory capital charges.
* Some officials from investment banks also contended that commercial
banks' access to the federal safety net, including access to federal
deposit insurance and Federal Reserve discount window lending, gives
the banks a further cost advantage. However, industry observers and OCC
officials said that this subsidy is likely offset by regulatory costs.
This report includes a recommendation that the Federal Reserve and the
OCC consider taking additional steps to ensure effective enforcement of
section 106 and section 23B, including enhancing the information that
they receive from corporate borrowers. For example, the agencies could
develop a communication strategy that is directed at a broad audience
of corporate bank customers to enhance their understanding of section
106. Because low priced credit could indicate a potential violation of
section 23B, we also recommend that the Federal Reserve assess
available evidence regarding loan pricing behavior, and if appropriate,
conduct additional research to better enable examiners to determine
whether transactions are conducted on market terms, and that the
Federal Reserve publish the results of this assessment.
Background:
Large banking organizations typically establish ongoing relationships
with their corporate customers and evaluate the overall profitability
of these relationships.They use company-specific information gained
from providing certain products and services--such as credit or cash
management--to identify additional products and services that customers
might purchase. This practice, known as "relationship banking," has
been common in the financial services industry for well over a century.
In recent years, as the legal and regulatory obstacles that limited
banking organizations' abilities to compete in securities and insurance
activities have been eased, some large banking organizations have
sought to expand the range of products and services they offer
customers. In particular, some commercial banks have sought to decrease
their reliance on the income earned from credit products, such as
corporate loans, and to increase their reliance on fee-based income by
providing a range of priced services to their customers.
Federal Banking Regulators:
The Federal Reserve and OCC are the federal banking regulators charged
with supervising and regulating large commercial banks. The Federal
Reserve has primary supervisory and regulatory responsibilities for
bank holding companies and their nonbank and foreign subsidiaries and
for state-chartered banks that are members of the Federal Reserve
System and their foreign branches and subsidiaries. The Federal Reserve
also has regulatory responsibilities for transactions between member
banks and their affiliates. OCC has primary supervisory and regulatory
responsibilities for the domestic and foreign activities of national
banks and their subsidiaries. OCC also has responsibility for
administering and enforcing standards governing transactions between
national banks and their affiliates. Among other activities, the
Federal Reserve and OCC conduct off-site reviews and on-site
examinations of large banks to provide periodic analysis of financial
and other information, provide ongoing supervision of their operations,
and determine compliance with banking laws and regulations. Federal
Reserve and OCC examinations are intended to assess the safety and
soundness of large banks and identify conditions that might require
corrective action.
Section 106 of the Bank Holding Company Act Amendments of 1970:
Congress added section 106 to the Bank Holding Company Act in 1970 to
address concerns that an expansion in the range of activities
permissible for bank holding companies might give them an unfair
competitive advantage because of the unique role their bank
subsidiaries served as credit providers.[Footnote 6] Section 106 makes
it unlawful, with certain exceptions, for a bank to extend credit or
furnish any product or service, or vary the price of any product or
service (the "tying product") on the "condition or requirement" that
the customer obtains some additional product or service from the bank
or its affiliate (the "tied product").[Footnote 7] Under section 106,
it would be unlawful for a bank to provide credit (or to vary the terms
for credit) on the condition or requirement that the customer obtain
some other product from the bank or an affiliate, unless that other
product was a traditional bank product.[Footnote 8] Thus, it would be
unlawful for a bank to condition the availability or pricing of new or
renewal credit on the condition that the borrower purchase a
nontraditional bank product from the bank or an affiliate.
In contrast, section 106 does not require a bank to extend credit or
provide any other product to a customer, as long as the bank's decision
was not based on the customer's failure to satisfy a condition or
requirement prohibited by section 106. For example, it would be lawful
for a bank to deny credit to a customer on the basis of the customer's
financial condition, financial resources, or credit history, but it
would be unlawful for a bank to deny credit because the customer failed
to purchase underwriting services from the bank's affiliate.
Section 106 does not prohibit a bank from cross-marketing products that
are not covered by the "traditional banking product" exemption or from
granting credit or providing any other product or service to a customer
based solely on the hope that the customer obtain additional products
from the bank or its affiliates in the future, provided that the bank
does not require the customer to purchase an additional product. Also,
section 106 generally does not prohibit a bank from conditioning its
relationship with a customer on the total profitability of its
relationship with the customer.
Section 106 authorizes the Federal Reserve to make exceptions that are
not contrary to the purposes of the tying prohibitions. The Federal
Reserve has used this authority to allow banks to offer broader
categories of packaging arrangements, where it has determined that
these arrangements benefit customers and do not impair competition. In
1971, the Federal Reserve adopted a regulation that extended antitying
rules to bank holding companies and their nonbank affiliates and
approved a number of nonbanking activities that these entities could
engage in under the Bank Holding Company Act. Citing the competitive
vitality of the markets in which nonbanking companies generally
operate, in February 1997, the Federal Reserve rescinded this
regulatory extension.[Footnote 9] At the same time, the Federal Reserve
expanded the traditional bank products exception to include traditional
bank products offered by nonbank affiliates.
In the mid-1990s, the Board also added two regulatory safe harbors.
First, the Board granted a regulatory safe harbor for combined-balance
discount packages, which allowed a bank to vary the consideration for a
product or package of products--based on a customer's maintaining a
combined minimum balance in certain products--as long as the bank
offers deposits, the deposits are counted toward the combined-balance,
and the deposits count at least as much as nondeposit products toward
the minimum balance.[Footnote 10] Furthermore, according to the Board,
under the combined-balance safe harbor, the products included in the
combined balance program may be offered by either the bank or an
affiliate, provided that the bank specifies the products and the
package is structured in a way that does not, as a practical matter,
obligate a customer to purchase nontraditional bank products to obtain
the discount. Second, the Board granted a regulatory safe harbor for
foreign transactions. This safe harbor provides that the antitying
prohibitions of section 106 do not apply to transactions between a bank
and a customer if the customer is a company that is incorporated,
chartered, or otherwise organized outside of the United States, and has
its principal place of business outside of the United States, or if the
customer is an individual who is a citizen of a country other than the
United States and is not resident in the United States.[Footnote 11]
Violations of Section 106:
On August 29, 2003, the Board published for public comment its proposed
interpretation and supervisory guidance concerning section
106.[Footnote 12] In this proposed interpretation, the Federal Reserve
noted that determining whether a violation of section 106 occurred
requires a detailed understanding of the facts underlying the
transaction in question. In this proposed interpretation, the Federal
Reserve also noted what it considers to be the two key elements of a
violation of section 106:
(1) The arrangement must involve two or more separate products: the
customer's desired product(s) and one or more separate tied products;
and:
(2) The bank must force the customer to obtain (or provide) the tied
product(s) from (or to) the bank or an affiliate in order to obtain the
customer's desired product(s) from the bank.[Footnote 13]
A transaction does not violate section 106 unless it involves two
separate products or services. For example, a bank does not violate
section 106 by requiring a prospective borrower to provide the bank
specified collateral to obtain a loan or by requiring an existing
borrower to post additional collateral as a condition for renewing a
loan. Assuming two products or services are involved, the legality of
the arrangement depends on, among other things, which products and
services are involved and in what combinations. It would be unlawful
for a bank to condition the availability of corporate credit on a
borrower's purchase of debt underwriting services from its affiliate,
because a bank cannot condition the availability of a bank product on a
customer's purchase of a nontraditional product or service. According
to the Board's proposed interpretation, a bank can legally condition
the availability of a bank product, such as credit, on the customer's
selection from a mix of traditional and nontraditional products or
services--a mixed-product arrangement--only if the bank offered the
customer a "meaningful choice" of products that includes one or more
traditional bank products and did not require the customer to purchase
any specific product or service. For example, according to the Federal
Reserve, a bank could legally condition the availability of credit on a
customer's purchase of products from a list of products and services
that includes debt underwriting and cash management services, provided
that this mixed-product arrangement contained a meaningful option to
satisfy the bank's condition solely through the purchase of the
traditional bank products included in the arrangement. However, it
would be a violation of section 106 for a bank to condition the
availability of credit on a mixed-product arrangement that did not
contain a meaningful option for the customer to satisfy the bank's
condition solely through the purchase of a traditional bank product.
When a bank offers a customer a low price on credit, it might or might
not be a violation of law. If a bank reduced the cost of credit on the
condition that the customer purchase nontraditional bank products or
services offered by its investment affiliate, this arrangement would
violate section 106. However, if a bank offered a low price on credit
to attract additional business but did not condition the availability
of the price on the purchase of a prohibited product, it would not
violate section 106. Additionally, if a reduced interest rate were to
constitute underpricing of a loan, such a transaction, depending on the
circumstances, could violate section 23B of the Federal Reserve Act of
1913, which we discuss later in this section.
Whether the arrangement constitutes an unlawful tie under section 106
also depends upon whether a condition or requirement actually exists
and which party imposes the condition or requirement. Determining the
existence of either element can be difficult. The question of whether a
condition or requirement exists is particularly difficult because of
uncertainties about how to interpret that aspect of the prohibition.
According to the Board's proposal, section 106 applies if two
requirements are met: "(1) a condition or requirement exists that ties
the customer's desired product to another product; and (2) this
condition or requirement was imposed or forced on the customer by the
bank."[Footnote 14] Thus, according to the Board's proposal, if a
condition or requirement exists, further inquiry may be necessary to
determine whether the condition or requirement was imposed or forced on
the customer by the bank: "If the condition or requirement resulted
from coercion by the bank, then the condition or requirement violates
section 106, unless an exemption is available for the
transaction."[Footnote 15] This interpretation is not universally
accepted, however. As the Board's proposal has noted, some courts have
held that a tying arrangement violates section 106 without a showing
that the arrangement resulted from any type of coercion by the
bank.[Footnote 16] Uncertainties about the proper interpretation of the
"condition or require" provision of section 106 have lead to
disagreement over the circumstances that violate section 106.
It has been suggested that changes in financial markets that have
occurred since the enactment of section 106, particularly a decreased
corporate reliance on commercial bank loans, also are relevant in
considering whether banks currently can base credit decisions on a
"condition or requirement" that corporate customers buy other services.
At the end of 1970, according to the Federal Reserve's Flow of Funds
data, bank loans accounted for about 24 percent of the total
liabilities of U.S. nonfarm, nonfinancial corporations. At the end of
2002, bank loans accounted for about 14 percent of these liabilities.
Because section 106 applies only to commercial and savings banks,
investment banks and insurance companies, which compete in credit
markets with banks, are not subject to these tying
restrictions.[Footnote 17] Thus, under section 106, a bank's nonbank
affiliate legally could condition the availability of credit from that
nonbank affiliate on a customer's purchase of debt underwriting
services. Where a transaction involves a bank as well as one or more
affiliates, uncertainties could exist over whether the affiliate or the
bank imposed a condition or requirement. It should be noted, however,
that all of these financial institutions are subject to the more
broadly applicable antitrust laws, such as the Sherman Act, that
prohibit anticompetitive practices, including tying
arrangements.[Footnote 18] In addition, under section 106 it is lawful
for bank customers to initiate ties. For example, a customer could use
its business leverage to obtain favorable credit terms or require a
bank to extend a corporate loan as a condition for purchasing debt
underwriting services.
Section 23B of the Federal Reserve Act of 1913 Prohibits Transactions
That Benefit Bank Affiliates at the Expense of the Bank:
Section 23B requires that transactions involving a bank and its
affiliates, including those providing investment-banking services, be
on market terms.[Footnote 19] Although section 106 generally prohibits
changing the price for credit on the condition that the customer obtain
some other services from the bank or its affiliates, section 23B
prohibits setting the price for credit at a below-market rate that
would reduce the bank's income for the benefit of its affiliate.
Banking regulators have noted that pricing credit at below-market rates
could also be an unsafe and unsound banking practice independent of
whether the practice violates section 23B specifically.
Some Corporate Borrowers Alleged That Unlawful Tying Occurs, but
Available Evidence Did Not Substantiate These Allegations:
Some corporate borrowers alleged that commercial banks unlawfully tie
the availability of credit to the borrower's purchase of other
financial services, including debt underwriting services from their
banks' investment affiliates. Because banks, in certain circumstances,
may legally condition the availability of credit on the borrower's
purchase of other products, some of these allegations of unlawful tying
could be invalid. Substantiating charges of unlawful tying, if it
occurs, can be difficult because, in most cases, credit negotiations
are conducted orally and thus generate no documentary evidence to
support borrowers' allegations. Thus, banking regulators may have to
obtain other forms of indirect evidence to assess whether banks
unlawfully tie products and services. Although customer information
could have an important role in helping regulators enforce section 106,
regulators do not have a specific mechanism to solicit information from
corporate bank customers on an ongoing basis.
Some Corporate Borrowers Contended That Banks Unlawfully Forced Them to
Purchase Additional Services to Preserve Access to Credit:
The results of a 2003 survey of financial executives, interviews that
we conducted with corporate borrowers, and several newspaper articles,
suggest that commercial banks frequently tie access to credit to the
purchase of other financial services, including bond underwriting,
equity underwriting, and cash management.[Footnote 20] The Association
for Financial Professionals reported that some respondents to their
survey of financial executives at large companies (those with revenues
greater than $1 billion) claimed to have experienced the denial of
credit or a change in terms after they did not award a commercial bank
their bond underwriting business. In our interviews with corporate
borrowers, one borrower said that a commercial bank reduced the
borrower's amount of credit by $70 million when the borrower declined
to purchase debt underwriting services from the bank's investment
affiliate. In addition, several newspapers and other publications have
also reported instances where corporate borrowers have felt pressured
by commercial banks to purchase products prohibited under section 106
for the customers to maintain their access to credit. In these reports,
corporate borrowers have described negotiations where, in their views,
bankers strongly implied that future lending might be jeopardized
unless they agreed to purchase additional services, such as
underwriting, from the banks' investment affiliates. However, none of
these situations resulted in the corporate borrower complaining to one
of the banking regulators.
In its Special Notice to its members, NASD also noted the Association
for Financial Professional survey. The notice cautioned that NASD
regulations require members to conduct business in accordance with just
and equitable principles of trade and that it could be a violation of
these rules for any member to aid and abet a violation of section 106
by an affiliated commercial bank. NASD is conducting its own
investigation into these matters. At the time of our review, NASD had
not publicly announced any results of its ongoing investigation.
Lawful Practices Can Easily Be Mistaken for Unlawful Tying Practices:
Corporate borrowers might be unaware of the subtle distinctions that
make some tying arrangements lawful and others unlawful. Borrowers,
officials at commercial banks, and banking regulators said that some
financial executives might not be familiar with the details of section
106. For example, some borrowers we interviewed thought that banks
violated the tying law when they tied the provision of loan commitments
to borrowers' purchases of cash management services. However, such
arrangements are not unlawful, because, as noted earlier, section 106
permits banks to tie credit to these and other traditional bank
services. The legality of tying arrangements might also hinge on the
combinations of products that the borrowers are offered. For example,
recently proposed Federal Reserve guidance suggested that a bank could
legally condition the availability of credit on the purchase of other
products services, including debt underwriting, if the customer has the
meaningful choice of satisfying the condition solely through the
purchase of one or more additional traditional bank products.[Footnote
21]
Corporate Borrowers Could Not Provide Documentary Evidence to
Substantiate Allegations of Unlawful Tying:
Corporate borrowers said that because the credit arrangements are made
orally, they lack the documentary evidence to demonstrate unlawful
tying arrangements in those situations where they believe it has
occurred. Without such documentation, borrowers might find it difficult
to substantiate such claims to banking regulators or seek legal
remedies. Moreover, with few exceptions, complaints have not been
brought to the attention of the banking regulators. Some borrowers
noted that they are reluctant to report their banks' alleged unlawful
tying practices because they lack documentary evidence of such
arrangements and uncertainty about which arrangements are lawful or
unlawful under section 106. Borrowers also noted that a fear of adverse
consequences on their companies' future access to credit or on their
individual careers contributed to some borrowers' reluctance to file
formal complaints. Because documentary evidence demonstrating unlawful
tying might not be available in bank records, regulators might have to
look for other forms of indirect evidence, such as testimonial
evidence, to assess whether banks unlawfully tie products and services.
Federal Reserve and OCC Targeted Review Identified Interpretive Issues:
The guidance that the federal banking regulators have established for
their regular examinations of banks calls for examiners to be alert to
possible violations of law, including section 106. These examinations
generally focus on specific topics based on the agencies' assessments
of the banks' risk profiles, and tying is one of many possible topics.
In response to recent allegations of unlawful tying at large commercial
banks, the Federal Reserve and OCC conducted a special targeted review
of antitying policies and procedures at several large commercial banks
and their holding companies. The banking regulators focused on
antitying policies and procedures; interviewed bank managers
responsible for compliance, training, credit pricing, and internal
audits; and reviewed credit pricing policies, relationship banking
policies, and the treatment of customer complaints regarding tying. The
review did not include broadly based testing of transactions that
included interviews with corporate borrowers. The regulators said that
they met with officials and members of a trade group representing
corporate financial executives. The banking regulators found that banks
covered in the review generally had adequate controls in place. With
limited exceptions, they did not detect any unlawful combinations or
questionable transactions. The examiners did, however, identify
variation among the banks in interpreting section 106, some of which
was not addressed in the regulatory guidance then available. As a
result of the findings of the special targeted review, on August 29,
2003, the Federal Reserve released for public comment proposed guidance
to clarify the interpretation of section 106 for examiners, bankers,
and corporate borrowers. Federal Reserve officials said that they hope
that the guidance encourages customers to come forward if they have
complaints.
Tying Is a Component of Guidelines for Regular Bank Examinations:
As part of their routine examination procedures, the Federal Reserve
and OCC provide instructions for determining compliance with section
106.[Footnote 22] During the course of these examinations, examiners
review banks' policies, procedures, controls, and internal audits. Exam
teams assigned to the largest commercial banks continually review banks
throughout the year, and in several cases, the teams are physically
located at the bank throughout the year. The Federal Reserve and OCC
expect examiners to be alert to possible violations of section 106 of
the Bank Holding Company Act Amendments of 1970 and section 23B of the
Federal Reserve Act and to report any evidence of possible unlawful
tying for further review. Regular bank examinations in recent years
have not identified any instances of unlawful tying that led to
enforcement actions. Federal Reserve officials told us, however, that
if an examiner had tying-related concerns about a transaction that the
bank's internal or external legal counsel had reviewed, examiners
deferred to the bank's legal analysis and verified that the bank took
any appropriate corrective actions. Federal Reserve officials also said
that legal staffs at the Board and the District Reserve Banks regularly
receive and answer questions from examiners regarding the
permissibility of transactions.
In a 1995 bulletin, OCC reminded national banks of their obligations
under section 106 and advised them to implement appropriate systems and
controls that would promote compliance with section 106.[Footnote 23]
Along with examples of lawful tying arrangements, the guidance also
incorporated suggested measures for banks' systems and controls, and
audit and compliance programs. Among the suggested measures were
training bank employees about the tying provisions, providing relevant
examples of prohibited practices, and reviewing customer files to
determine whether any extension of credit was conditioned unlawfully on
obtaining another nontraditional product or service from the bank or
its affiliates.
In addition to reviewing banks' policies, procedures, and internal
controls, examiners also review aggregate data on a bank's pricing of
credit products. OCC officials noted that instances of unlawfully
priced loans or credit extended to borrowers who were not creditworthy
could alert examiners to potential unlawful tying arrangements.
However, Federal Reserve officials pointed out that examiners typically
do not focus on a banks' pricing of individual transactions because
factors that are unique to the bank and its relationship with the
customer affect individual pricing decisions. They said that examiners
only conduct additional analyses if there was an indication of a
potential problem within the aggregated data.
Examiners Generally Found Adequate Bank Controls and No Unlawful Tying
during a Special Review:
In recent years, banking regulators' examination strategies have moved
toward a risk-based assessment of a bank's policies, procedures, and
internal controls, and away from the former process of transaction
testing. The activities judged by the regulatory agencies to pose the
greatest risk to a bank are to receive the most scrutiny by examiners
under the risk-based approach, and transaction testing is generally
intended to validate the use and effectiveness of risk-management
systems. The effectiveness of this examination approach, however,
depends on the regulators' awareness of risk. In the case of tying, the
regulators are confronted with the disparity between frequent
allegations about tying practices and few, if any, formal complaints.
Further, the examiners generally would not contact customers as part of
the examinations and thus would have only limited access to information
about transactions or the practices that banks employ in managing their
relationships with customers.
In response to the controversy about allegations of unlawful tying, in
2002 the Federal Reserve and OCC conducted joint reviews targeted to
assessing antitying policies and procedures at large commercial banks
that, collectively, are the dominant syndicators of large corporate
credits. The Federal Reserve and OCC exam teams found limited evidence
of potentially unlawful tying in the course of the special targeted
review.[Footnote 24] For example, one bank's legal department uncovered
one instance where an account officer proposed an unlawful conditional
discount. The officer brought this to the attention of the legal
department after the officer attended antitying training. The customer
did not accept the offer, and no transaction occurred.
In addition, the teams noted that the commercial bank's interpretation
of section 106 permitted some activities that the teams questioned; one
of the banks reversed a transaction in response to examiner questions.
Attorneys on the exam teams reviewed documents regarding lawsuits
alleging unlawful tying, but they found that none of the suits
contained allegations that warranted any follow-up. For example, they
found that some of the suits involved customers who were asserting
violations of section 106 as a defense to the bank's efforts to collect
on loans and that some of the ties alleged in the suits involved ties
to traditional bank products, which are exempted from section 106.
Federal Reserve and OCC officials noted that it would be unusual to
find a provision in a loan contract or other loan documentation
containing an unlawful tie. Some corporate borrowers said that there is
no documentary evidence because banks only communicate such conditions
on loans orally. According to members of the review team, they did not
sample transactions during the review because past reviews suggested
that this would probably not produce any instances of unlawful tying
practices. The targeted review did include contacting some bank
customers to obtain information on specific transactions. The Federal
Reserve noted that without examiners being present during credit
negotiations, there is no way for examiners to know what the customer
was told. Given the complex nature of these transactions, the facts and
circumstances could vary considerably among individual transactions.
Federal Reserve officials, however, noted that customer information
could play an important role in enforcing the law, because so much
depends on whether the customer voluntarily agreed with the transaction
or was compelled to agree with the conditions imposed by the bank. As
the officials noted, this determination cannot be made based solely on
the loan documentation.
During the targeted review, Federal Reserve and OCC officials found
that all of the banks they reviewed generally had adequate procedures
in place to comply with section 106. All banks had specific antitying
policies, procedures, and training programs in place. The policies we
reviewed from two banks encouraged employees to consult legal staff for
assistance with arrangements that could raise a tying-related issue.
According to the Federal Reserve and OCC, at other banks, lawyers
reviewed all transactions for tying-related issues before they were
completed. The training materials we reviewed from two banks included
examples that distinguished lawful from unlawful tying arrangements.
Banking regulators noted that some banking organizations had newly
enhanced policies, procedures, and training programs as a result of
recent media and regulatory attention.
However, examiners also found that the oversight by internal audit
functions at several banks needed improvement. In one case, they found
that bank internal auditors were trained to look for the obvious
indications of tying, but that banks' audit procedures would not
necessarily provide a basis to detect all cases of tying. For example,
recent antitying training programs at two banks helped employees
identify possible tying violations. Officials at one large banking
organization also said that banks' compliance efforts generally are
constrained by the inability to anticipate every situation that could
raise tying concerns. They also noted that banks could not monitor
every conversation that bank employees had with customers, and thus
guarantee that mistakes would never occur.
In addition, examiners were concerned that certain arrangements might
cause customer confusion when dealing with employees who work for both
the bank and its investment affiliate. In those cases, it could be
difficult to determine whether the "dual" employee was representing the
bank or its affiliate for specific parts of a transaction. However, the
examiners noted that in the legal analysis of one banking organization,
the use of such dual employees was not necessarily problematic, given
that the tie was created by the investment affiliate, rather than the
bank, and that section 106 addresses the legal entity involved in a
transaction and not the employment status of the individuals involved.
Proposed Federal Reserve guidance did not add clarification to this
matter beyond emphasizing the importance of training programs for bank
employees as an important internal control.
The targeted review concluded that the policies and procedures of the
selected banks generally provided an adequate basis to enforce
compliance with section 106, and identified only a limited number of
instances where the bank's interpretation of the law permitted actions
that were questioned during the review. However, this targeted review
was limited to an assessment of the banks' controls environment; and as
noted above, the review did not test a broad range of transactions for
analysis or review and did not include any questions addressed to a
broad selection of bank customers. As the Federal Reserve's proposed
interpretation of section 106 notes, however,
"the determination of whether a violation of section 106 has occurred
often requires a careful review of the specific facts and circumstances
associated with the relevant transaction (or proposed transaction)
between the bank and the customer."[Footnote 25]
Customers could provide information on the facts and circumstances
associated with specific transactions and provide a basis for testing
whether the bank actions were in compliance with its policies and
procedures. If the banks' actions are not consistent with their
policies and procedures, there could be violations of section 106. A
review of the transactions would provide direct evidence of compliance
or noncompliance with section 106. Further, information from analysis
of transactions and information obtained from customers could provide
the bank regulatory agencies with more information on the circumstances
where there could be a greater risk of tying, contributing to their
risk-based examination strategies.
Federal Reserve and OCC Identified Several Interpretive Issues:
The examiners and attorneys participating in the targeted review found
variations in banks' interpretation of section 106 in areas where
authoritative guidance was absent or incomplete at the time of the
review.
One interpretative issue was the extent to which a bank could consider
the profitability of the overall customer relationship in making credit
decisions, particularly whether a bank could consider a customer's use
of nontraditional banking services in deciding to terminate the
customer relationship without violating section 106. This issue also
encompassed the appropriateness of the language that a bank might use
when entering into or discontinuing credit relationships--including
whether a bank could appropriately use language implying the acceptance
of a tied product in a letter formalizing a commitment for a loan and
communication protocols that a bank might use to disengage clients who
did not meet internal profitability targets.
Examiners found that all banks in the joint targeted review had
undergone a "balance sheet reduction," disengaging from lending
relationships with their least desirable customers. An official at one
commercial bank acknowledged that, when banks discontinue
relationships, their decision might appear to be unlawful tying from
the perspective of the customer. However, it would not be unlawful for
a bank to decline to provide credit to a customer as long as the bank's
decision was not based on the customer's failure to satisfy a condition
or requirement prohibited by section 106.
Examiners questioned whether it would be appropriate for a banking
organization to provide both a bridge loan and securities underwriting
to vary the amount of fees it charged for services that would normally
be done independently for each service.[Footnote 26] For example, a
bank conducting a credit analysis for both commercial and investment
banking services and reducing the overall fees to only include one
credit analysis might raise tying considerations. Banks and their
outside counsels believed that this price reduction would be
appropriate. However, the Federal Reserve staff said that whether or
not a price reduction would be appropriate would depend on the facts
and condition of the transaction, including whether or not the bank
offered the customer the opportunity to obtain the discount from the
bank separately from the tied product.
Examiners were also concerned that some bank transactions might appear
to circumvent section 106. For example, the examiners found one
instance in which a nonbank affiliate had tied bridge loans to the
purchase of securities underwriting and syndicated some or all of the
loans to its commercial bank. The examiners noted that although this
issue had not been addressed in the guidance available at the time,
this arrangement created the appearance of an attempt to circumvent the
application of section 106. The bank thereupon discontinued the
practice. As mentioned previously, because section 106 applies only to
banks, it is not a violation of the section for most nonbank affiliates
of commercial banks to tie together any two products or services. The
proposed interpretation of section 106 recently issued by the Federal
Reserve addresses this issue.
Finally, the examiners found that one bank might be overstating the
relief gained from the foreign transactions safe harbor. The Federal
Reserve adopted a safe harbor from the antitying rules for transactions
with corporate customers that are incorporated or otherwise organized
and that:
have their principal place of business outside the United
States.[Footnote 27] This safe harbor also applies to individuals who
are citizens of a foreign country and are not resident in the United
States. The new guidance developed by the banking regulators does not
address the examiners' specific concerns. Federal Reserve officials
said that a general rule on these issues would not be feasible and that
any determinations would depend on the facts and circumstances of the
specific transactions.
The Federal Reserve's Proposed Interpretation and Guidance Released for
Public Comment:
Based on the interpretive issues examiners found during the special
targeted review and its analysis, and after significant consultation
with OCC, the Federal Reserve recently released for public comment a
proposed interpretation of section 106. The proposed interpretation
noted that the application of section 106 is complicated and heavily
dependent on the particular circumstances and facts of specific
transactions. The proposed guidance outlines, among other things, some
of the information that would be considered in determining whether a
transaction or proposed transaction would be lawful or unlawful under
section 106. Federal Reserve officials also have noted that another
desired effect of additional guidance could be providing bank customers
a better understanding of section 106 and what bank actions are lawful.
The officials said that they hoped that the new guidance would
encourage customers to come forward with any complaints. The deadline
for public comments on the proposed guidance was September 30, 2003. At
the time of our review, the Federal Reserve was reviewing comments that
had been received.
Evidence That We Reviewed on the Pricing of Corporate Credit Did Not
Demonstrate That Commercial Banks Unlawfully Discount Credit:
Although officials at one investment bank contended that large
commercial banks deliberately "underpriced"--or priced credit at below
market rates--corporate credit to attract underwriting business to
their investment affiliates, the evidence of "underpricing" is
ambiguous and subject to different interpretations. They claimed that
these commercial banks underprice credit in an effort to promote
business at the banks' investment affiliates, which would increase the
bank holding companies' fee-based income. Such behavior, they
contended, could indicate violations of section 106, with credit terms
depending on the customer buying the tied product. The banking
regulators also noted that pricing credit below market interest rates,
if it did occur, could violate section 23B, with the bank's income
being reduced for the benefit of its investment affiliate. Commercial
bankers counter that the syndication of these loans and loan
commitments--the sharing of them among several lenders--makes it
impossible to underprice credit, since the other members of the
syndicate would not participate at below market prices. Federal Reserve
staff is considering further research into the issue of loan pricing,
which could clarify the issue.
Investment bankers and commercial bankers also disagreed whether
differences between the prices for loans and loan commitments and those
for other credit products indicated that nonmarket forces were involved
in setting credit prices. Both investment bankers and commercial
bankers cited specific transactions to support their contentions; in
some cases, they pointed to the prices for the same loan products at
different times. Commercial bankers also noted that their business
strategies called for them to ensure the profitability of their
relationship with customers; if market-driven credit prices alone did
not provide adequate profitability, the strategies commonly called for
marketing an array of other products to make the entire relationship a
profitable one. The banking regulators noted that such strategies would
be within the bounds of the law as long as the bank customers had a
"meaningful choice" that includes traditional bank products.
Investment Affiliates of Commercial Banks Have Gained Market Share in
Underwriting:
In recent years, the market share of the fees earned from debt and
equity underwriting has declined at investment banks and grown at
investment affiliates of commercial banks. In 2002, the three largest
investment banks had a combined market share of 31.9 percent, a decline
from a 38.1 percent market share that these investment banks held in
1995. In comparison, the market share of the three largest investment
affiliates of commercial banks was 30.4 percent in 2002, compared with
their 17.8 percent market share that these investment banks held in
1995. Some of this growth might be the result of the ability of
commercial banks and their investment affiliates to offer a wide array
of financial services. However, banking regulators noted that industry
consolidation and the acquisition of investment banking firms by bank
holding companies also has been a significant factor contributing to
this growth. For example, regulators noted that Citigroup Inc. is the
result of the 1998 merger of Citicorp and Travelers Group Inc., which
combined Citicorp's investment business with that of Salomon Smith
Barney, Inc., a Travelers subsidiary that was already a prominent
investment bank. J.P. Morgan & Co. Incorporated and The Chase Manhattan
Corporation also combined in 2000 to form J.P. Morgan Chase & Co.
Pricing Evidence from the Secondary Market Is Inconclusive:
Some investment bankers contended that commercial banks offer loans and
loan commitments to corporate borrowers at below-market rates if
borrowers agree to engage the services of their investment affiliates.
Large loans and loan commitments to corporations--including the lines
of credit that borrowers use in conjunction with issuing commercial
paper--are frequently syndicated.[Footnote 28] A syndicated loan is
financing provided by a group of commercial banks and investment banks
whereby each bank agrees to advance a portion of the funding.
Commercial bankers contended that these prices of the loans and loan
commitments reflected a competitive market, where individual lenders
have no control over prices.
Officials from one investment bank who contended that banking
organizations have underpriced credits to win investment banking
business drew comparisons between the original pricing terms of
specific syndicated loans and the pricing of the same loans in the
secondary market. Specifically, they pointed to several transactions,
including one in which they questioned the pricing but participated
because the borrower insisted that underwriters provide loan
commitments. The investment bank officials said that when they
subsequently attempted to sell part of their share of the credits, the
pricing was unattractive to the market and that they could not get full
value. In one case, they noted that the credit facility was sold in the
secondary market at about 93 cents on the dollar shortly after
origination. They said that, in their opinion, this immediate decline
in value was evidence that the credit facility had been underpriced at
origination.
Commercial bankers said that competition in the corporate loan market
determines loan pricing. One banker said that if a loan officer
overpriced a loan by even a basis point or two the customer would turn
to another bank.[Footnote 29] Bankers also noted that if loans were
underpriced, the syndicators would not be able to syndicate the loan to
investors who are not engaged in debt underwriting and insist on
earning a competitive return. An official from one commercial bank
provided data on its syndicated loans, showing that a number of the
participants in the loans and loan commitments did not participate in
the associated securities underwriting for the borrower and--in spite
of having no investment banking business to win--found the terms of the
loans and loan commitments attractive. However, we do not know the
extent, if any, to which these other participants might have had other
revenue-generating business with the borrowers.
Officials from a commercial bank and loan market experts also said that
the secondary market for loans was illiquid, compared with that for
most securities. The bank officials said that therefore prices could
swing in response to a single large sale as a result of this
illiquidity. Officials from one commercial bank said that the price of
the loan to which investment bank officials referred, which had sold
for about 93 cents on the dollar shortly after origination, had risen
to about 98 cents on the dollar in secondary trades a few months later.
These officials said that, in their opinion, this return in pricing
toward the loan's origination value is proof that the syndicated loan
was never underpriced and that the movement in price was the result of
a large portion of the facility being sold soon after the origination.
Independent loan market experts also observed that trading in loan
commitments is illiquid, and thus subsequent price fluctuations might
not reflect fair value.
Pricing Evidence from Credit Default Swap Markets Is Subject to
Multiple Interpretations:
Commercial bankers and investment bankers disagreed on whether a
comparison of the prices of loans and other credit products
demonstrated underpricing. In particular, one key disagreement involved
the use of credit default swaps.[Footnote 30] Banks and other financial
institutions can use credit default swaps, among other instruments, to
reduce or diversify credit risk exposures. With a credit default swap,
the lender keeps the loan or loan commitment on its books and
essentially purchases insurance against borrower default.
Officials at one investment bank compared the prices of syndicated
loans with the prices of credit default swaps used to hedge the credit
risk of the loan. In their view, the differences in the two prices
demonstrated that commercial banks underpriced corporate credit. They
provided us with several examples of syndicated loans, wherein the
difference between the interest rate on the loan or loan commitment and
the corresponding credit default swap was so great that the investment
bankers believed that the bank would have earned more from insuring the
credit than extending it.
On the other hand, Federal Reserve officials, commercial bankers, and
loan market experts disputed the extent to which the pricing of
corporate credit could be compared with their corresponding credit
default swaps, because of important differences between the two
products and between the institutions that dealt in them. Officials
from the Federal Reserve noted that the triggering mechanisms for the
two products differed. Although the trigger for the exercise of a
credit default swap is a clearly defined indication of the borrower's
credit impairment, the exercise of a commercial paper back-up line is
triggered by the issuer's inability to access the commercial paper
market--an event that could occur without there necessarily being any
credit impairment of the issuer. For example, in 1998, Russia's
declaration of a debt moratorium and the near-failure of a large hedge
fund created financial market turmoil; since this severely disrupted
corporations' issuance of bonds and commercial paper, they drew on
their loan commitments from banks. In addition, loan market experts and
officials from a commercial bank also said that the loan market and the
credit default swap market involve different participants with
different motivations. Loan market experts noted that lead originators
of loans and loan commitments have an advantage gained from knowledge
of the borrower through direct business relationships. On the other
hand, those who provide credit protection by selling credit swap might
be entities with no direct knowledge of the customer's
creditworthiness, but use these instruments for diversifying risks.
Evidence from the Pricing of Undrawn Fees Did Not Resolve Whether
Commercial Banks Unlawfully Price Credit Risk:
To present their differing positions on whether or not credit is
underpriced, investment bankers, loan market experts, and commercial
bankers discussed the pricing of selected syndicated loan commitments.
In syndicated loan commitments, participants receive commitment fees on
the undrawn amount and a specified interest rate if the loan is drawn.
In addition, participants in syndicated loan commitments are protected
from certain risks by various conditions. Also, the lead participant
might receive an up-front fee from the borrower. Each of these factors
can influence the price of the loan commitment.
Officials at one investment bank noted that the pricing for undrawn
loan commitments provided as back-up lines for commercial paper issuers
have been low for several years and had been relatively stable, even
when other credit market prices fluctuated. Available data showed that
this was the case for the fees for undrawn commitments provided for
investment-grade borrowers, with undrawn fees averaging under 0.10
percent per year of the undrawn amount. The investment bankers further
noted that the loan commitment would be drawn in the event of adverse
conditions for the borrower in the commercial paper market. Thus,
commercial paper back-up lines exposed the provider to the risk that
they might have to book loans to borrowers when they were no longer
creditworthy. In the opinion of these investment bankers, the low
undrawn loan fees do not reflect this risk.
In contrast, officials from commercial banks and loan market experts
said that the level of undrawn fees for loan commitments did not
represent all the ways that commercial banks might adjust credit terms
to address rising credit risk. These officials said that in response to
perceived weakening in credit quality, lenders had shortened the
maturity of credit lines. Lenders also tightened contract covenants to
protect themselves against a borrowers' potential future weakening. In
addition, commercial bank officials told us that other factors were
involved in the pricing of loan commitments. For example, they said
that a comprehensive analysis should include the upfront fees to
measure the total return on undrawn loan commitments. However, loan
market experts said that published loan pricing data do not include the
up-front fees that many banks collect when they extend credit. Thus,
publicly available information was insufficient to indicate the total
return commercial banks received on such lending.
Investment Banks and Commercial Banks Have Different Views on the
Profitability of Corporate Lending:
Officials at one investment bank claimed that because the fees that
commercial banks receive for corporate credits barely exceed their cost
of funds, commercial banks are not covering all of their costs and are
in essence subsidizing corporate credits. Conversely, several bankers
said that the rates they can charge on corporate credits do exceed
their cost of funds but are not always high enough to allow them to
meet their institution's profitability targets. Officials at one
commercial bank noted that their internal controls included separation
of powers, where any extensions of credit over $10 million would have
to be approved by a credit committee rather than those responsible for
managing the bank's customer relationships. However, these same
officials said that they often base lending decisions on the
profitability of customer relationships, not individual products. Thus,
a loan that might not reach profitability targets on a stand-alone
basis could still be attractive as part of an overall customer
relationship.
Federal Reserve Staff Is Considering a Study about Loan Pricing:
During our review, members of the Federal Reserve's staff said that
they were considering conducting research into pricing issues in the
corporate loan market. Such research could shed some additional light
on the charges of the investment bankers and the responses of the
commercial bankers.[Footnote 31] It also could provide useful
supervisory information. If the study finds indications that pricing of
credit to customers who also use underwriting services is lower than
other comparable credit, this could lend support to the investment
banker's allegations of violations of section 23B. However, if the
charges are not valid and credit pricing does reflect market
conditions, this information would serve as useful confirmation of the
findings of the Federal Reserve-OCC targeted review, which found that
the policies and procedures of the largest commercial banks served as
effective deterrents against unlawful tying.
Differences between Commercial Banks and Investment Banks Did Not
Necessarily Affect Competition:
Based on our analysis, the different accounting methods, capital
requirements, and levels of access to the federal safety net did not
appear to give commercial banks a consistent competitive advantage over
investment banks. Officials at some investment banks asserted that
these differences gave commercial banks an unfair advantage that they
could use in lending to customers who also purchase debt-underwriting
services from their investment affiliates. Under current accounting
rules, commercial banks and investment banks are required to use
different accounting methods to record the value of loan commitments
and loans. Although these different methods could cause temporary
differences in the financial statements for commercial banks and
investment banks. While these different methods could cause temporary
differences in financial statements, these differences would be
reconciled at the end of the credit contract periods. Further, if the
loan commitment were exercised and both firms either held the loan
until maturity or made the loan available for sale, the accounting
would be similar and would not provide an advantage to either firm.
Additionally, while commercial and investment banks were subject to
different regulatory capital requirements, practices of both commercial
and investment banks led to avoidance of regulatory charges on loan
commitments with a maturity of 1 year or less. Moreover, while the
banks had different levels of access to the federal safety net, some
industry observers argued that greater access could be offset by
corresponding greater regulatory costs.
Commercial Banks and Investment Banks Follow Different Accounting
Models for Loan Commitments:
According to FASB, which sets the private sector accounting and
reporting standards, commercial banks and investment banks follow
different accounting models for similar transactions involving loans
and loan commitments. Most commercial banks follow a mixed model, where
some financial assets and liabilities are measured at historical cost,
some at the lower of cost or market value and some at fair value. In
contrast, some investment banks follow a fair-value accounting model,
in which they report changes in the fair value of inventory, which may
include loans or loan commitments, in the periods in which the changes
occur.
Where FASB guidance is nonexistent, as is currently the case for fair-
value accounting for loan commitments, firms are required to follow
guidance from the AICPA, which provides industry specific accounting
and auditing guidance that is cleared by FASB prior to publication.
FASB officials said that it is currently appropriate for commercial
banks and investment banks to follow different accounting models
because of their different business models.
When commercial banks make loan commitments, they must follow FASB's
Statement of Financial Accounting Standards (FAS) No. 91, Accounting
for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases, which directs them
to book the historic carrying value of the fees received for loan
commitments as deferred revenue.[Footnote 32] In the historic carrying
value model, commercial banks are not allowed to reflect changes in the
fair value of loan commitments in their earnings. However, commercial
banks are required to disclose the fair value of all loan commitments
in the footnotes to their financial statements, along with the method
used to determine fair value.[Footnote 33]
Some investment banks follow the AICPA Audit and Accounting Guide,
Brokers and Dealers in Securities, which directs them to record the
fair value of loan commitments.[Footnote 34] The AICPA guidance is
directed at broker-dealers within a commercial bank or investment bank
holding company structure. However, some investment banks whose broker-
dealer subsidiaries comprised a majority of the firms' financial
activity would also be required to follow the fair-value accounting
model outlined in the AICPA guidance for instruments held in all
subsidiaries.[Footnote 35] When using the fair-value model, investment
banks must recognize in income gains or losses resulting from changes
in the fair value of a financial instrument, such as a loan commitment.
Investment banks said that they determine the current fair value of
loan commitments based on the quoted market price for an identical or
similar transaction or by modeling with market data if market prices
are not available.
According to FASB, although measurement of financial instruments at
fair value has conceptual advantages, not all issues have been
resolved, and FASB has not yet decided when, if ever, it will require
essentially all financial instruments held in its inventory to be
reported at fair value. A loan market expert said that, although the
discipline of using market-based measures works well for some
companies, fair-value accounting might not be the appropriate model for
the entire wholesale loan industry. FASB said that one reason is that
in the absence of a liquid market for loan commitments, there is
potential for management manipulation of fair value because of the
management discretion involved in choosing the data used to estimate
fair value.
Some Investment Banks Contended That Different Accounting Methods Give
Commercial Banks a Competitive Advantage:
Officials from some investment banks contended that adherence to
different accounting models gave commercial banks a competitive
advantage relative to investment banks in lending to customers who also
purchased investment banking services. They alleged that commercial
banks extended underpriced 364-day loan commitments to attract
customers' other, more profitable business--such as underwriting--but
they were not required to report on their financial statements the
difference in value, if any, between the original price of the loan
commitment and the current market price.[Footnote 36] The investment
bank officials contended that the current accounting standards
facilitate this alleged underpricing of credit because commercial banks
record loan commitments at their historic value rather than their
current value, which might be higher or lower, and do not have to
report the losses incurred in extending an allegedly underpriced loan
commitment.
Officials from some investment banks also claimed that the historic
carrying value model allowed commercial banks to hide the risk of these
allegedly underpriced loan commitments from stockholders and market
analysts, because the model did not require them to report changes in
the value of loan commitments. Officials said that differences in
accounting for identical transactions might put investment banks at a
disadvantage, compared with commercial banks when analysts reviewed
their quarterly filings. As discussed in an earlier section, it is not
clear that commercial banks underprice loan commitments.
Commercial Banks Do Not Enjoy a Consistent Competitive Advantage over
Investment Banks in Accounting for Loan Commitments:
Although commercial and investment banks might have different values on
their financial statements for similar loan commitments, both are
subject to the same fair-value footnote disclosure requirements in
which they report the fair value of all loan commitments in their
financial statement footnotes, along with the method used to determine
fair value. As a result, financial analysts and investors are presented
with the same information about the commercial and investment banks'
loan commitments in the financial statement footnotes. According to FAS
107: Disclosures about Fair Value of Financial Instruments, in the
absence of a quoted market price, firms estimate fair value based on
(1) the market prices of similar traded financial instruments with
similar credit ratings, interest rates, and maturity dates; (2) current
prices (interest rates) offered for similar financial instruments in
the entity's own lending activities; or (3) valuations obtained from
loan pricing services offered by various specialist firms or from other
sources. FASB said that they have found no conclusive evidence that an
active market for loan commitments exists; thus, the fair value
recorded might frequently be estimated through modeling with market
data. When a quoted market price for an identical transaction is not
available, management judgment and the assumptions used in the model
valuations could significantly affect the estimated fair value of a
particular financial instrument.
SEC and the banking regulators said the footnote disclosures included
with financial statements, which are the same for both commercial banks
and investment banks, were an integral part of communicating risk. They
considered the statement of position and statement of operations alone
to be incomplete instruments through which to convey the risk of loan
commitments. They emphasized that to fully ascertain a firm's financial
standing, financial footnotes must be read along with the financial
statements.
Although different accounting models would likely introduce differences
in the amount of revenue or loss recognized in any period, all
differences in accounting for loan commitments that were not exercised
would be resolved by the end of the commitment period. Any interim
accounting differences between a commercial bank and investment bank
would be relatively short-lived because most of these loan commitment
periods are less than 1 year. Further, if a loan commitment were
underpriced, an investment bank using the fair-value accounting model
would recognize the difference between the fair value and the
contractual price as a loss, while a commercial bank using the
historical cost model would not be permitted to do so. This difference
in the recognition of gains or losses would be evident in commercial
and investment banks' quarterly filings over the length of the
commitment period. However, there is no clear advantage to one method
over the other in accounting for loan commitments when the commitments
are priced consistently between the two firms at origination.
According to investment bankers we spoke with and staff from the AICPA,
loan commitments generally decline in value after they are made. Under
fair-value accounting, these declines in fair value are actually
recognized by the investment bank as revenue because the reduction is
recognized in a liability account known as deferred revenue. Therefore,
if an investment bank participated with commercial banks in a loan
commitment that was deemed underpriced, any initial loss recognized by
the investment bank would be offset by each subsequent decline in the
loan commitment's fair value. Further, as discussed in an earlier
section, it is not clear that commercial banks underprice loan
commitments. Whether a commercial bank using the historic carrying
value model or an investment bank using the fair-value model would
recognize more revenue or loss on a given loan commitment earlier or
later would depend on changes in the borrower's credit pricing, which
reflects overall market trends and customer-specific events, as well as
on the accounting model that the firm follows.
In addition, when similar loan commitments held by a commercial bank
and an investment bank are exercised and become loans, both firms would
be subject to the same accounting standards if they had the intent and
ability to hold the loan for the foreseeable future or to
maturity.[Footnote 37] In this situation, both commercial banks and
investment banks would be required to establish an allowance for
probable or possible losses, based on the
estimated degree of impairment of the loan commitment or historic
experience with similar borrowers.[Footnote 38]
If both an investment bank and a commercial bank decided to sell a loan
that it previously had the intent and ability to hold for the
foreseeable future or until maturity, the firms would follow different
guidance that would produce similar results. A commercial bank would
follow the AICPA's Statement of Position 01-6, Accounting by Certain
Entities (Including Entities With Trade Receivables) That Lend to or
Finance the Activities of Others that was issued in December, 2001.
According to this guidance, once bank management decides to sell a loan
that had not been previously classified as held-for-sale, the loan's
value should be adjusted to the lower of historical cost or fair value,
and any amount by which historical cost exceeds fair value should be
accounted for as a valuation allowance. Further, as long as the loan's
fair value remained less than historical cost, any subsequent changes
in the loan's fair value would be recognized in income. The investment
bank would follow the guidance in the AICPA's Audit and Accounting
Guide, Brokers and Dealers in Securities, and account for inventory,
the loan in this instance, at fair value and recognize changes in the
fair value in earnings.
Capital Requirements Do Not Give Commercial Banks a Competitive
Advantage:
Regulatory capital is the minimum long-term funding level that
financial institutions are required to maintain to cushion themselves
against unexpected losses, and differing requirements for commercial
banks and broker-dealers reflect distinct regulatory
purposes.[Footnote 39] The primary purposes of commercial bank
regulatory capital requirements are to maintain the safety and
soundness of the banking and payment systems and to protect the deposit
insurance funds. Under the bank risk-based capital guidelines, off-
balance sheet transactions, such as loan commitments, are converted:
into one of four categories of asset equivalents.[Footnote 40] Unfunded
loan commitments of one year or less are assigned to the zero percent
conversion category, which means that banks are not required to hold
regulatory capital for these commitments. In contrast, the primary
purposes of broker-dealers' capital requirements are to protect
customers and other market participants from losses caused by broker-
dealer failures and to protect the integrity of the financial markets.
The SEC net capital rule requires broker-dealer affiliates of
investment banks to hold 100-percent capital against loan commitments
of any length.[Footnote 41] However, nonbroker-dealer affiliates of
investment banks are not subject to any regulatory capital
requirements, and are therefore not required to hold regulatory capital
against loan commitments of any length.
It is costly for banks or other institutions to hold capital; thus, to
the extent that the level of regulatory capital requirements determines
the amount of capital actually held, lower capital requirements can
translate into lower costs. Officials from an investment bank contended
that bank capital requirements gave commercial banks with investment
affiliates a cost advantage they could use when lending to customers
who also purchased underwriting business. They said that because banks'
regulatory capital requirements for unfunded credits of 1 year or less
were zero, commercial banks had the opportunity to adjust the length of
credit commitments to avoid capital charges. Furthermore, officials
said that the ability to avoid capital charges allowed commercial banks
to underprice these loan commitments, because they could extend the
commitments without the cost of assigning additional regulatory
capital. They pointed to the high percentage of credit commercial banks
structured in 364-day facilities as evidence that banks structure
underpriced credit in short-term arrangements to avoid capital charges.
We found no evidence that bank regulatory capital requirements provided
commercial banks with a competitive advantage. Although investment
banks could face a 100-percent regulatory capital charge if they
carried loan commitments in their broker-dealer affiliates, investment
bank officials and officials from the SEC said that, in practice,
investment banks carried loan commitments outside of their broker-
dealer affiliates, and thus avoided all regulatory capital charges.
Furthermore, banking regulators did not think that the current
regulatory capital requirements adversely affected the overall amount
of capital banks held, because commercial banks generally carried
internal risk-based capital on instruments--including loan
commitments--that were in excess of the amount of regulatory capital
required. In addition, the banking regulators said that bank regulatory
capital requirements had not affected banks' use of loan commitments of
1 year or less. Although loan market data indicated that the percentage
of investment-grade loans structured on 364-day terms has increased,
commercial bank officials and banking regulators said that this shift
was, in part, the banks' response to the increased amount of risk in
lending.
Industry Observers and Some Banking Regulators Doubt That the Federal
Safety Net Provides Commercial Banks with a Competitive Advantage:
Commercial banks have access to a range of services sometimes described
as the federal safety net, which includes access to the Federal Reserve
discount window and deposit insurance.[Footnote 42] The Federal Reserve
discount window allows banks and other organizations to borrow funds
from the Federal Reserve.[Footnote 43] Commercial banks' ability to
hold deposits backed by federal deposit insurance provides them with a
low-cost source of funds available for lending.
Industry observers and banking regulators agreed that commercial banks
receive a subsidy from the federal safety net; however, they differed
on the extent to which the subsidy was offset by regulatory costs.
Although officials at the Federal Reserve and at an investment bank
contended that access to the federal safety net gave commercial banks a
net subsidy, officials from OCC and an industry observer said that the
costs associated with access to the safety net might offset these
advantages. We could not measure the extent to which regulatory costs
offset the subsidy provided by the access to the federal safety net
because reliable measures of the regulatory costs borne by banks were
not available.
Conclusions:
Although the Gramm-Leach-Bliley Act of 1999, among other things,
expanded the ability of financial services providers, including
commercial banks and their affiliates, to offer their customers a wide
range of products and services, it did not repeal the tying
prohibitions of section 106, which remains a complex provision to
enforce. Regulatory guidance has noted that some tying arrangements
involving corporate credit are clearly lawful, particularly those
involving ties between credit and traditional bank products. The
targeted review conducted by the Federal Reserve and OCC, however,
identified other arrangements that raise interpretive issues that were
not addressed in prevailing guidance. The Federal Reserve recently
issued for public comment a proposed interpretation of section 106 that
is intended to provide banks and their customers a guide to the
section. As the proposed interpretation notes, however, the complexity
of section 106 requires a careful review of the facts and circumstances
of each specific transaction. The challenge for the Federal Reserve and
OCC remains that of enforcing a law where determining whether a
violation exists or not depends on considering the precise
circumstances of specific transactions; however, information on such
circumstances is inherently limited. Customers have a key role in
providing information that is needed to enforce section 106. However,
the Federal Reserve and OCC have little information on customers'
understanding of lawful and unlawful tying under section 106 or on
customers' knowledge of the circumstances of specific transactions.
The available evidence did not clearly support contentions that banks
violated section 106 and unlawfully tied credit availability or
underpriced credit to gain investment banking revenues. Corporate
borrowers generally have not filed complaints with the banking
regulators and attribute the lack of complaints, in part, to a lack of
documentary evidence and uncertainty about which tying arrangements
section 106 prohibits. The Federal Reserve and OCC report that they
found only limited evidence of even potentially unlawful tying
practices involving corporate credit during a targeted review that
began in 2002, and they found that the banks surveyed generally had
adequate policies and procedures in place to deter violations of
section 106. However, while the teams conducting this review analyzed
some specific transactions, they did not test a broad range of
transactions, or outreach widely to bank customers. Information from
customers could be an important step in assessing both implementation
of and compliance with a bank's policies and procedures. While
regulators could take further steps to encourage customers to provide
information, in addition to the recent Federal Reserve proposal, bank
customers themselves are crucial to enforcement of section 106.
Recommendations for Executive Action:
Distinguishing lawful and unlawful tying depends on the specific facts
and circumstances of individual transactions. Because the facts, if
any, that would suggest a tying violation generally would not be found
in the loan documentation that banks maintain and because bank
customers have been unwilling to file formal complaints, effective
enforcement of section 106 requires an assessment of other indirect
forms of evidence. We therefore recommend that the Federal Reserve and
the OCC consider taking additional steps to ensure effective
enforcement of section 106 and section 23B, by enhancing the
information that they receive from corporate borrowers. For example,
the agencies could develop a communication strategy targeted at a broad
audience of corporate bank customers to help ensure that they
understand which activities are permitted under section 106 as well as
those that are prohibited. This strategy could include publication of
specific contact points within the agencies to answer questions from
banks and bank customers about the guidance in general and its
application to specific transactions, as well as to accept complaints
from bank customers who believe that they have been subjected to
unlawful tying. Because low priced credit could indicate a potential
violation of section 23B, we also recommend that the Federal Reserve
assess available evidence regarding loan pricing behavior, and if
appropriate, conduct additional research to better enable examiners to
determine whether transactions are conducted on market terms and that
the Federal Reserve publish the results of this assessment.
Agency Comments:
We requested comments on a draft of this report from the Federal
Reserve and OCC. We received written comments from the Federal Reserve
and OCC that are summarized below and reprinted in appendixes II and
III respectively. The Comptroller of the Currency and the General
Counsel of the Board of Governors of the Federal Reserve System replied
that they generally agreed with the findings of the report and
concurred in our recommendations. Federal Reserve and OCC staff also
provided technical suggestions and corrections that we have
incorporated where appropriate.
:
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from its issuance date. At that time, we will send copies the Chairman
and Ranking Minority Member, Senate Committee on Banking, Housing, and
Urban Affairs; the Chairman, House Committee on Energy and Commerce;
the Chairman of the Board of Governors of the Federal Reserve System;
and the Comptroller of the Currency. We will make copies available to
others upon request. In addition, the report will be available at no
charge on the GAO Web site at [Hyperlink, http://www.gao.gov] http://
www.gao.gov.
If you or your staff have any questions about this report, please
contact James McDermott or me at (202) 512-8678. Key contacts and major
contributors to this report are listed in appendix IV.
Sincerely yours,
Richard Hillman,
Director
Financial Markets and Community Investment:
Signed by Richard Hillman:
[End of section]
Appendixes:
[End of section]
Appendix I: Differences in Accounting between Commercial and Investment
Banks for Loan Commitments:
Because commercial and investment banks follow different accounting
models, there are differences in the financial statement presentation
of some similar transactions. This appendix summarizes the differences,
under generally accepted accounting principles in how commercial banks
and investment banks account for loan commitments--specifically
commercial paper back-up credit facilities--using hypothetical
scenarios to illustrate how these differences could affect the
financial statements of a commercial and investment bank.[Footnote 44]
We use three hypothetical scenarios to illustrate the accounting
differences that would occur between the commercial and investment
banks for similar transactions if (1) a loan commitment were made, (2)
the loan commitment was exercised by the borrower and the loan was
actually made, and (3) the loan was subsequently sold. This appendix
does not assess the differences in accounting that would occur if a
loan was made by both a commercial bank and an investment bank when one
entity decided to hold the loan to maturity and the other opted to hold
the loan as available for sale, because the basis for these actions and
the resulting accounting treatment are not similar.
The examples in this appendix demonstrate that, as of a given financial
statement reporting date, differences would likely exist between
commercial and investment banks in the reported value of a loan
commitment and a loan resulting from an exercised commitment, as well
as the recognition of the related deferred revenue. In addition, the
volatility of the fair value of loan commitments and the related loan,
if the commitment were exercised, would be reflected more transparently
in an investment bank's financial statements, because an investment
bank must recognize these changes in value in earnings as they occur in
net income.[Footnote 45] In contrast, commercial banks are not allowed
to recognize changes in the fair value of the loan commitment, its
related deferred revenue, or the related loan (if drawn). The
differences in accounting between commercial banks and investment banks
are temporary; and, as the examples in the following sections show,
whether a commercial bank or an investment bank recognizes more fee
revenue first would depend on various market conditions, including
interest rates and spreads. Similarly, any differences between the fair
value of a loan or loan commitment on an investment bank's book and the
net book value of a similar loan or loan commitment on a commercial
bank's books would be eliminated by the end of the loan term or
commitment period.[Footnote 46] Given that loan commitment terms are
usually for less than 1 year, any accounting differences between the
commercial and investment banks would be for a relatively short period
of time. Further, both commercial and investment banks are required to
make similar footnote disclosures about the fair value of their
financial instruments.[Footnote 47] Thus, neither accounting model
provides a clear advantage over the life of the loan commitment or the
loan if the commitment were exercised.
Background:
Since 1973, the Financial Accounting Standards Board (FASB) has been
establishing private-sector financial accounting and reporting
standards. In addition, the American Institute of Certified Public
Accountants (AICPA) Accounting Standards Executive Committee also
provides industry-specific authoritative guidance that is cleared with
FASB prior to publication. Where FASB guidance is nonexistent, as is
currently the case in fair-value accounting for loan commitments, firms
are required to follow AICPA guidance.
Most commercial banks generally follow a mixed-attribute accounting
model, where some financial assets and liabilities are measured at
historical cost, some at the lower of cost or market value and some at
fair value. In accounting for loan commitments, banks follow the
guidance in Statement of Financial Accounting Standards (FAS) Number
91:
Accounting for Nonrefundable Fees and Costs Associated with Originating
or Acquiring Loans and Initial Direct Costs of Leases.[Footnote 48]
Broker-dealer affiliates and investment banks whose primary business is
to act as a broker-dealer follow the AICPA's Audit and Accounting
Guide, Brokers and Dealers in Securities, where the inventory (that may
include loan commitments) are recorded at the current fair value and
the change in value from the prior period is recognized in net
income.[Footnote 49] Further, FASB currently has a project on revenue
recognition that includes the accounting for loan commitment fees by
investment banks and others. The purpose of that project includes
addressing the inconsistent recognition of commitment fee income and
may eliminate some of the accounting differences that exist between
commercial banks and investment banks described in this appendix.
FASB has stated that it is committed to work diligently toward
resolving, in a timely manner, the conceptual and practical issues
related to determining the fair values of financial instruments and
portfolios of financial instruments. Further, FASB has stated that
while measurement at fair value has conceptual advantages, all
implementation issues have not yet been resolved; and the Board has not
yet decided when, if ever, it will be feasible to require essentially
all financial instruments to be reported at fair value in the basic
financial statements. Although FASB has not yet issued comprehensive
guidance on fair-value accounting, recent literature has stated that
the fair-value accounting model provides more relevant information
about financial assets and liabilities and can keep up with today's
complex financial instruments better than the historical cost
accounting model. The effect of the fair-value accounting model is to
recognize in net income during the current accounting period amounts
that, under the historical cost model, would have been referred to as
unrealized gains or losses because the bank did not sell or otherwise
dispose of the financial instrument. Further, proponents of the fair-
value accounting model contend that unrealized gains and losses on
financial instruments are actually lost opportunities as of a specific
date to realize a gain or loss by selling or settling a financial
instrument at a current price. However, a disadvantage of fair-value
accounting exists when there is not an active market for the financial
instrument being valued. In this case, the fair value is more
subjective and is often determined by various modeling techniques or
based on the discounted value of expected future cash flows.
Hypothetical Scenario for Unexercised Loan Commitments:
On the first day of an accounting period, Commercial Bank A and
Investment Bank B each made a $100 million loan commitment to a highly
rated company to back up a commercial paper issuance. This loan
commitment was irrevocable and would expire at the end of three
quarterly accounting periods. Because the loan commitment was issued to
a highly rated company, both banks determined that the chance of the
company drawing on the facility was remote. Both banks received $10,000
in fees for these loan commitments. Commercial Bank A followed the
guidance in FAS No. 91 and recorded this transaction on a historical
cost basis while Investment Bank B, subject to specialized accounting
principles that require fair-value accounting, reported changes in fair
value included the effect of these changes in earnings.
Revenue Recognition for the Commercial Bank:
Upon receipt of the loan commitment fee, Commercial Bank A would record
the $10,000 as a liability, called deferred revenue, because the bank
would be obligated to perform services in the future in order to "earn"
this revenue. In practice, because of the relatively small or
immaterial amounts of deferred revenue compared with other liabilities
on a bank's statement of position (balance sheet), this amount would
not be reported separately and would likely be included in a line item
called "other liabilities."[Footnote 50] Commercial Bank A would follow
the accounting requirements of FAS No. 91 and recognize the revenue as
service-fee income in equal portions over the commitment period,
regardless of market conditions--a practice often referred to as
revenue recognition on a straight-line basis. Thus, at the end of the
first accounting period, Commercial Bank A would reduce the $10,000
deferred revenue on its statement of position (balance sheet) by one-
third or $3,333 and record the same amount of service-fee revenue on
the statement of operations (income statement). The same accounting
would occur at the end of the second and third accounting periods, so
that an equal portion of service revenue would have been recognized
during each period that the bank was obligated to loan the highly rated
company $100 million.[Footnote 51] Regarding disclosure of the $100
million commitment, Commercial Bank A would not report the value of the
loan commitment on its balance sheet. However, the bank would disclose
in the footnotes to its financial statements the fair value of this
commercial paper back-up facility as well as the method used to
estimate the fair value.[Footnote 52]
Revenue Recognition for the Investment Bank:
Although AICPA's Audit and Accounting Guide, Brokers and Dealers in
Securities does not provide explicit guidance for how Investment Bank B
would account for this specific transaction, the guide provides
relevant guidance on accounting for loan commitments in general. This
guide states that Investment Bank B would account for inventory,
including financial instruments such as a commercial paper back-up
facility, at fair value and report changes in the fair value of the
loan commitment in earnings. When changes occurred in the fair value of
the loan commitment, Investment Bank B would need to recognize these
differences by adjusting the balance of the deferred revenue account to
equal the new fair value of the loan commitment. Generally, quoted
market prices of identical or similar instruments, if available, are
the best evidence of the fair value of financial instruments. If quoted
market prices are not available, as is often the case with loan
commitments, management's best estimate of fair value may be based on
the quoted market price of an instrument with similar characteristics;
or it may be developed by using certain valuation techniques such as
estimated future cash flows using a discount rate commensurate with the
risk involved, option pricing models, or matrix pricing models. A
corresponding entry of identical value would be made to revenue during
the period in which the change in fair value occurred. Once the
commitment period ended, as described in the previous paragraph, the
deferred revenue account would be eliminated and the remaining balance
recorded as income.
If market conditions changed shortly after Investment Bank B issued
this credit facility and its fair value declined by 20 percent to
$8,000, Investment Bank B would reduce the deferred revenue account on
its statement of position (balance sheet) to $8,000, the new fair
value. Investment Bank B would recognize $2,000 of service-fee income,
the amount of the change in value from the last reporting period, in
its statement of operations (income statement). Investment Bank B would
also disclose in its footnotes the fair value of this credit facility,
as well as the method used to estimate the fair value.
If during the second accounting period there was another change in
market conditions and the value of this credit facility declined
another 5 percent of the original amount to $7,500, Investment Bank B
would decrease the balance in the deferred revenue account to $7,500
and recognize $500 in service-fee revenue. Further, Investment Bank B
would disclose in its footnotes the fair value of this credit facility.
During the accounting period in which the commitment to lend $100
million was due to expire, accounting period 3 in this example, the
balance of the deferred revenue account would be recognized because the
commitment period had expired and the fair value would be zero. Thus,
$7,500 would be recognized in revenue and the balance of deferred
revenue account eliminated. In this accounting period, there would be
no disclosure about the fair value of the credit facility.
Differences in Revenue Recognition Are Temporary:
The following table summarizes the amount of revenue Commercial Bank A
and Investment Bank B would recognize and the balance of the deferred
revenue account for each of the three accounting periods when there
were changes in the value of the loan commitments. Commercial Bank A
would recognize more service-fee income in accounting periods 1 and 2
than Investment Bank B. However, this situation would be reversed in
period 3, when Investment Bank B would recognize more revenue. Thus,
differences in the value of the loan commitment and the amount of
revenue recognized would likely exist between specific accounting
periods, reflecting the volatility of the financial markets more
transparently in Investment B's financial statements. The magnitude of
the difference is determined by the market conditions at the time and
could be significant or minor. However, these differences would be
resolved by the end of the commitment period, when both entities would
have recognized the same amount of total revenue for the loan
commitment.
Table 1: Accounting Differences for a Loan Commitment:
Accounting period: Initial recording of the credit facility;
Commercial Bank A: Service-fee revenue recognized: $0; Commercial Bank
A: Balance of deferred revenue: $10,000; Investment Bank B:
Service-fee revenue recognized: $0; Investment Bank B: Balance of
deferred revenue: $10,000.
Accounting period: 1; Commercial Bank A: Service-fee revenue
recognized: 3,333; Commercial Bank A: Balance of deferred revenue:
6,667; Investment Bank B: Service-fee revenue recognized:
2,000; Investment Bank B: Balance of deferred revenue: 8,000.
Accounting period: 2; Commercial Bank A: Service-fee revenue
recognized: 3,333; Commercial Bank A: Balance of deferred revenue:
3,334; Investment Bank B: Service-fee revenue recognized: 500;
Investment Bank B: Balance of deferred revenue: 7,500.
Accounting period: 3; Commercial Bank A: Service-fee revenue
recognized: 3,334; Commercial Bank A: Balance of deferred revenue: 0;
Investment Bank B: Service-fee revenue recognized: 7,500;
Investment Bank B: Balance of deferred revenue: 0.
Total service-fee revenue recognized;
Commercial Bank A: Service-fee revenue recognized: $10,000;
Investment Bank B: Service-fee revenue recognized: $10,000;
Source: GAO.
[End of table]
Hypothetical Scenario for Exercised Loan Commitments:
Commercial Bank A and Investment Bank B issued the same loan commitment
described previously. However, at the end of the second accounting
period, the highly rated company exercised its right to borrow the $100
million from each provider because its financial condition had
deteriorated and it could no longer access the commercial paper market.
The accounting treatment for this loan would depend upon whether bank
management had the intent and ability to hold the loan for the
foreseeable future or until maturity. AICPA Task Force members and some
investment bankers told us that in practice, this loan could be either
held or sold, and as a result, the accounting for both is summarized in
the following sections.
Loans Intended to Be Held to Maturity:
At the time the loan was made, Commercial Bank A would record the $100
million dollar loan as an asset on its statement of position (balance
sheet). Investment Bank B would initially record this loan at its
historical cost basis, less the loan commitment's fair value at the
time the loan was drawn ($100 million - $7,500). Further, based on an
analysis by the banks' loan review teams, a determination of
"impairment" would be made. According to FAS 114, Accounting by
Creditors for Impairment of a Loan, "a loan is impaired when, based on
current information and events, it is probable that a creditor will be
unable to collect all amounts due according to the contractual terms of
the loan agreement." If the loan were determined to be impaired, FAS
114 states that, the bank would measure the amount of impairment as
either the (1) present value of expected future cash flows discounted
at the loan's effective interest rate, (2) loan's observable market
price, or (3) fair value of the collateral if the loan were collateral
dependent.
FAS 114 directs both banks to establish an allowance for losses when
the measure of the impaired loan is less than the recorded investment
in the loan (including accrued interest, net of deferred loan fees or
costs and unamortized premium or discount) by creating a valuation
allowance that reduces the recorded value of the loan with a
corresponding charge to bad-debt expense. When there are significant
changes in the amount or timing of the expected future cash flows from
this loan, the banks would need to adjust, up or down, the loan-loss
allowance as appropriate so that the net balance of the loan reflects
management's best estimate of the loan's cash flows. However, the net
value of the loan cannot exceed the recorded investment in the loan.
If the loan were not impaired, both banks would still record an
allowance for credit losses in accordance with FAS 5, Accounting for
Contingencies, when it was probable that a future event would likely
occur that would cause a loss and the amount of the loss was
estimable.[Footnote 53] Thus, both banks would establish an allowance
for loss in line with historical performance for borrowers of this
type.[Footnote 54] Because the loan was performing, both banks would
receive identical monthly payments of principal and interest.
Generally, these cash receipts would be applied in accordance with the
loan terms, and a portion would be recorded as interest income; and the
balance applied would reduce the banks' investment in the loan. At the
end of the loan term, the balance and the related allowance for this
loan would be eliminated.
FAS 91 also directs both banks to recognize the remaining unamortized
commitment fee over the life of the loan as an adjustment to interest
income. Because the borrower's financial condition had deteriorated,
both banks would likely have charged a higher interest rate than the
rate stated in the loan commitment. As a result, at the time it becomes
evident that the loan is to be drawn, Investment Bank B would record a
liability on its balance sheet to recognize the difference between the
actual interest rate of the loan and the interest rate at which a loan
to a borrower with this level of risk would have been made--in essence
the fair value interest rate. This liability would also be amortized by
Investment Bank B over the life of the loan as an adjustment to
interest income.
Loans Made Available for Sale:
If Commercial Bank A and Investment Bank B's policies both permitted
the firms to only hold loans for the foreseeable future or until
maturity when the borrowers were highly rated, it is unlikely that the
banks would keep the loan in the previous hypothetical scenario and
would sell the loan soon after it was made.[Footnote 55] Although the
banks would follow different guidance there would be similar results.
Commercial Bank A would follow the guidance in the AICPA Statement of
Position 01-6.[Footnote 56] According to this guidance, once bank
management decides to sell a loan that had not been previously
classified as held-for-sale, the loan's value should be adjusted to the
lower of historical cost or fair value, and any amount by which
historical cost exceeds fair value should be accounted for as a
valuation allowance. Further, as long a the loan's fair value remained
less than historical cost, any subsequent changes in the loan's fair
value would be
recognized in other comprehensive income.[Footnote 57] Investment Bank
B would follow the guidance in the AICPA's Audit and Accounting Guide,
Brokers and Dealers in Securities, as it did with loan commitments, and
account for inventory at fair value and report changes in the fair
value of the loan in net income.
For example, if bank management decided to sell the loan soon after it
was drawn when some payments had been made to reduce the principal
balance and the net book value of this loan was $88,200,000 (unpaid
principal balance of $90,000,000 less the related allowance of
$1,800,000) and the fair value was 97 percent of the unpaid principal
balance or $87,300,000, both banks would recognize the decline in value
of $900,000 in earnings. While the loan remained available-for-sale,
any changes in its fair value would be recorded in net income. For
example, if the loan's fair value declined further to $85,500,000, both
banks would recognize the additional decline in value of $1,800,000 in
earnings.
Table 2 below summarizes the accounting similarities between Commercial
Bank A and Investment Bank B for the loan sale. Although the two banks
followed different guidance, the effect of the loan sale is the same
for both banks.
Table 2: Accounting Differences for a Loan Sale:
Transaction: Transfer the loan to the trading portfolio; Commercial
Bank A loss amount: ; Investment Bank B loss amount:
.
Transaction: Change in fair value; Commercial Bank A loss amount:
; Investment Bank B loss amount: .
Transaction: Total loss on loan sale; Commercial Bank A loss amount:
; Investment Bank B loss amount: .
Source: GAO.
[End of table]
[End of section]
Appendixes:
[End of section]
Appendix II: Comments from the Federal Reserve System:
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM:
WASHINGTON, D.C. 20551:
J. VIRGIL MATTINGLY, JR. GENERAL COUNSEL:
October 2, 2003:
Mr. Richard Hillman
Director:
Financial Markets and Community Investment
United States General Accounting Office Washington, D.C. 20548:
Dear Mr. Hillman:
We appreciate the opportunity to review and comment on the draft report
concerning the special anti-tying prohibitions that apply to banks
under section 106 of the Bank Holding Company Act Amendments of 1970
(GAO-04-3).
The report describes some of the steps that the Federal Reserve has
taken to ensure that banks comply with section 106, other banking
statutes and safe and sound banking practices. For example, Federal
Reserve examiners review the anti-tying programs of bank holding
companies and state member banks as part of the regular compliance
reviews of these organizations. In addition, examiners from the Federal
Reserve and the Office of the Comptroller of the Currency recently
conducted targeted anti-tying examinations at several large banking
organizations. The targeted exams indicated that the banking
organizations reviewed generally have adequate policies and procedures
to ensure compliance with the anti-tying restrictions of section 106,
and the agencies generally did not uncover unlawful tying arrangements
in these examinations. We note that the GAO also found that the
available evidence does not substantiate claims that banks are tying
the availability or price of credit to the purchase of debt
underwriting services from a securities affiliate of the bank.
The special anti-tying rules that apply to banks under section 106,
however, are quite complex. We concur with your finding that this
complexity has led to some uncertainty and confusion, both among banks
and their customers, as to what actions by a bank are prohibited and
permissible under the statute. It was, in part, to address this
uncertainty and confusion that the Federal Reserve recently requested
public comment on a formal interpretation of section 106.[NOTE 1] The
interpretation is intended to provide banks and their
customers a comprehensive guide to section 106 and includes examples of
both the types of bank actions that are prohibited and those that are
permissible under the statute.
We agree with your finding that the facts and circumstances surrounding
a particular transaction, including information from the bank's
customer, often are crucial in determining whether a violation of
section 106 has occurred. Accordingly, the Federal Reserve has
informally solicited information from corporate customers concerning
bank compliance with section 106. Moreover, the Federal Reserve's
proposed interpretation of section 106 expressly encourages customers
that believe they have been the object of an illegal tying arrangement
to contact the appropriate Federal banking agency for the bank
involved.[NOTE 2] When information provided by a customer or other
source indicates that a banking organization within the Federal
Reserve's supervisory jurisdiction has violated section 106, the
Federal Reserve will investigate the matter and, if the allegations
are established, take appropriate supervisory or enforcement action
against the organization.[NOTE 3]
Your report recommends that the Federal Reserve consider taking
additional steps to ensure the effective enforcement of section 106 by,
for example, developing a communication strategy designed to help
corporate customers of banks better understand section 106 and
publishing specific contact points at the Federal Reserve for
responding to questions and accepting customer complaints concerning
section 106. We concur with this recommendation and will consider
taking additional educational, outreach and administrative steps in
order to further improve the understanding among banks and their
customers of the prohibitions of section 106 and the ability of bank
customers to submit complaints concerning potential violations of
section 106.
The report also recommends that the Board consider whether it would be
appropriate to conduct a study of loan pricing behavior. Board staff
currently is engaged in an effort to study recent developments in the
market for syndicated loans using publicly available data. We hope that
this study will enhance the understanding of the nature of competition
among participants in this market and shed light on the factors that
influence loan pricing.
Sincerely,
Signed by:
J. V. Mattingly:
NOTES:
[1] See 68 Federal Register 52024 (Aug. 29, 2003).
[2] _Id. at 52027.
[3] See, e.g. Order to Cease and Desist and Order of Assessment of a
Civil Monetary Penalty entered into with WestLB AG, Dusseldorf,
Germany, and its New York branch, dated Aug. 27, 2003.
[End of section]
Appendix III Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency
Administrator of National Banks:
Washington, DC 20219:
October 1, 2003:
Mr. Richard J. Hillman:
Director, Financial Markets and Community Investment
United States General Accounting Office:
Washington, DC 20548:
Dear Mr. Hillman:
The Office of the Comptroller of the Currency received and reviewed a
draft report titled Bank Tying: Additional Steps Needed to Ensure
Effective Enforcement of Tying Prohibitions. The report was prepared at
Congressional request to examine allegations that commercial banks
helped their investment affiliates gain market share by illegally tying
and underpricing corporate credit. Your objectives were to determine:
(1) what evidence, if any, suggests that commercial banks with
investment affiliates engage in unlawful tying; (2) what steps the
federal banking regulators have taken to examine for unlawful tying and
the results of these efforts; (3) what evidence, if any, suggests that
commercial banks with investment affiliates unlawfully discount the
price of corporate credit to obtain underwriting business for their
investment affiliates; and (4) what, if any, competitive advantages
accounting rules, capital standards, and access to the federal safety
net create for commercial banks over investment banks.
You concluded and are reporting that available evidence did not
substantiate allegations the unlawful tying occurs; that the Board of
Governors of the Federal Reserve System's (Federal Reserve) and the
Office of the Comptroller of the Currency's (OCC) targeted reviews
identified interpretive issues; that evidence you reviewed did not
demonstrate that commercial banks unlawfully discount credit; and that
differences between commercial banks and investment banks did not
necessarily affect competition.
You recommend that the Federal Reserve and the OCC consider taking
additional steps to ensure effective enforcement of the antitying
provisions by increasing the amount of information available on which
to make an assessment.
We concur with your conclusions and agree to implement your
recommendation. We provided technical comments on the draft report to
the analysts separately.
Thank you for the opportunity to comment on the draft report.
Sincerely,
John D. Hawke, Jr.
Comptroller of the Currency:
Signed by John D. Hawke, Jr.
[End of section]
Appendix IV: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Richard Hillman, (202) 512-8678 James McDermott, (202) 512-5373:
Acknowledgments:
In addition to those individuals named above, Daniel Blair, Tonita W.
Gillich, Gretchen Pattison, Robert Pollard, Paul Thompson, and John
Treanor made key contributions to this report.
(250099):
FOOTNOTES
[1] As explained later, not all instances of bank tying are unlawful
because certain types of products and services are not subject to the
tying prohibition in the Bank Holding Company Act.
[2] For purposes of this report, the term "indirect evidence" refers to
information that is not contained in transaction documents maintained
by the bank. Section 106 is codified at 12 U.S.C.§ 1972 (2000).
[3] After the Federal Reserve and OCC completed the targeted review,
the Federal Reserve announced on August 27, 2003, that it had entered
into a consent agreement and civil money penalty against WestLB AG, a
German bank, and its New York branch, based on allegations that in 2001
it conditioned the availability of credit on the borrower's obtaining
underwriting business from a WestLB affiliate.
[4] 68 Fed. Reg. 52024 (Aug. 29, 2003). OCC released a white paper,
"Today's Credit Markets, Relationship Banking, and Tying," on September
25, 2003, which discussed banks' market power and economic performance
for evidence of tying, the market competitiveness of diversified
banking organizations, and relationship banking. The paper concluded
that the relationship banking practices, as described in the white
paper, are consistent with the relevant legal framework.
[5] See 12 U.S.C.§ 371c-1 (2000).
[6] See, e.g., H.R. Conf. Rep. No. 91-1747, reprinted in 1970
U.S.C.A.N. 5561, 5569.
[7] Section 106 also prohibits reciprocity and exclusive dealing
arrangements. Reciprocity arrangements are arrangements that require a
customer to provide some credit, property, or service to the bank or
one of its affiliates as a condition of the bank providing another
product to the customer. Exclusive dealing arrangements are
arrangements that require a customer not to obtain some other credit,
property, or service from a competitor of the bank or its affiliate as
a condition of the bank providing another product to the customer. The
allegations we encountered during our work did not involve such
arrangements.
[8] A key exception to section 106 is that banks may condition the
price or availability of a service or product on the basis of a
customer obtaining a "traditional bank product," which the section
defines as "a loan, discount, deposit, or trust service." Section 106
provides this exception only with respect to traditional bank products
offered by the bank, but the Board has extended the exception to
include traditional bank products offered by an affiliate of the bank.
12 C.F.C. § 225.7(b)(1) (2003)).
[9] See 83 Fed. Res. Bulletin 275 (April 1997).
[10] Id.
[11] Id.
[12] 68 Fed. Reg. 52024 (August 29, 2003).
[13] 68 Fed. Reg. at 52027. A tie exists under section 106 if the bank
furnishes the tying product "on the condition or requirement" that the
customer obtain the tied product or provide some additional credit,
property or service. In its guidance, the Board stated that even if a
condition or requirement exists, further inquiry might be necessary
because the condition or requirement violates section 106 only if it
resulted from coercion by the bank. Id. at 52028. As the Board
recognized, however, some courts have held that a tying arrangement may
violate section 106 without a showing that the arrangement resulted
from any type of coercion by the bank. Id. at 52029, n. 36.
[14] 68 Fed. Reg. at 52028.
[15] Id. at 52029.
[16] Id., n. 36.
[17] Thrifts are subject to a similar antitying prohibition. Section
5(q) of the Home Owners Loan Act, 12 U.S.C. § 1464(q) (2000) places
restrictions on savings associations that are almost identical to those
placed on banks by section 106, although the Office of Thrift
Supervision may only grant exceptions to section 5(q) that conform to
exceptions to section 106 granted by the Board.
[18] As the Board observed in its proposed interpretation and guidance,
as a general matter, a tying arrangement violates the Sherman Act (15
U.S.C. §§ 1-7 (2000)) and the Clayton Act (15 U.S.C. §§ 12-27 (2000))
if (1) the arrangement involves two or more products, (2) the seller
forces a customer to purchase the tied product, (3) the seller has
economic power in the market for the tying product sufficient to enable
the seller to restrain trade in the market for the tied product, (4)
the arrangement has anticompetitive effects in the market for the tied
product, and (5) the arrangement affects a "not insubstantial" amount
of interstate commerce. See 68 Fed. Reg. at 52027, n. 20.
[19] In October 2002, the Federal Reserve Board approved Regulation W,
which comprehensively implements and unifies the Board's
interpretations of sections 23A and 23B of the Federal Reserve Act.
Regulation W became effective in April 2003, and restricts loans by a
depository institution to its affiliates, asset purchases by a
depository institution from its affiliates, and other transactions
between a depository institution and its affiliates.
[20] We did not report the specific results of the Association for
Financial Professionals' "Credit Access Survey: Linking Corporate
Credit to the Awarding of Other Financial Services," March 2003,
because of several methodological limitations. In particular, we could
not determine the degree to which these survey results represent the
broad population of large companies, due to potential biases resulting
from sample design and the low level of participation of sampled
companies. Nevertheless, although this survey may not precisely
estimate the extent of tying complaints among this population, the
results suggest that at least some companies claimed to have
experienced forms of tying.
[21] The proposed guidance noted that such an arrangement would not
force a customer to purchase a nontraditional product in violation of
section 106.
[22] For example, Federal Reserve Board Supervision Manuals governing
bank holding company and state member bank examinations and OCC
Bulletin 95-20 all address section 106.
[23] OCC Bulletin 95-20 (April 14, 1995).
[24] After the Federal Reserve and OCC completed the targeted review,
the Federal Reserve announced on August 27, 2003, that it had entered
into a consent agreement and civil money penalty against WestLB AG, a
German bank, and its New York branch, based on allegations that it had
conditioned credit on the award of underwriting business in 2001.
[25] 38 Fed. Reg. at 52026.
[26] A bridge loan is an interim financing arrangement provided by a
bank, investment bank, or special purpose investment fund to allow a
corporation to make an acquisition before arranging permanent financing
to carry the acquisition.
[27] See also, 83 Fed. Res. Bulletin 275 (April 1997). Federal Reserve
Board Bank Holding Company Supervision Manual, Section 3500.0.2.3, Safe
Harbor for Foreign Transactions.
[28] Commercial paper is an unsecured obligation issued by a
corporation or bank to finance its short-term credit needs, such as
accounts receivable and inventory. Commercial paper is usually issued
by companies with high credit ratings. Commercial paper is available in
a wide range of denominations and can be either discounted or interest
bearing. Maturities for commercial paper typically range from 2 to 270
days. Commonly, companies issuing commercial paper will also obtain a
backup loan commitment that would provide funds if the company is
unable to payoff or roll over the commercial paper as it matures.
[29] A basis point is a measure of a bond's yield, equal to 1/100th of
1 percent of yield.
[30] Credit default swaps are financial contracts that allow the
transfer of credit risk from one market participant to another,
potentially facilitating greater efficiency in the pricing and
distribution of credit risk among financial market participants. In a
"plain vanilla" credit default swap, the protection buyer agrees to
make periodic payments (the swap "spread" or premium) over a
predetermined number of years (the maturity of the credit default swap)
to the protection seller in exchange for a payment in the event of
default by a third party. Typically, credit default swaps premiums are
paid quarterly, and the most common maturities are 3, 5, and 10 years.
[31] Preliminary results from an academic study of loan pricing and
securities underwriting suggest that the rates charged on loans to
corporate borrowers who subsequently purchase underwriting services
from an investment affiliate of the lender were not lower than rates
charged on loans not followed by the purchase of underwriting services.
See Charles W. Calomiris and Thanavult Pornrojnangkool, "Tying,
Relationship Banking, and the Repeal of Glass Stegall," Unpublished
paper presented at the American Enterprise Institute, Sept. 24, 2003.
[32] The historic carrying value of a loan commitment is the value of
the loan commitment service fees at the time a firm extends the
commitment. The fees received are recognized either over the life of
the loan commitment when the likelihood of the borrower exercising the
commitment is remote or over the life of the loan if the commitment is
exercised.
[33] This is required by FAS No. 107, Disclosures about Fair Value of
Financial Instruments.
[34] The fair value of a loan commitment is generally based on quoted
market prices of similar transactions or modeling with market data.
[35] It is important to note that, in practice, investment banks often
do not hold loan commitments in their broker-dealer subsidiaries
because of the high capital requirements of broker-dealers. (We discuss
the regulatory capital requirements of broker-dealers in greater detail
in the next section.)
[36] The historic carrying value model does not permit commercial banks
to record these changes in value.
[37] Although investment banks generally classify financial instruments
as inventory and account for them at fair value, AICPA Task Force
members and some investment bankers noted that, in some instances, the
firms might decide to hold a loan for the foreseeable future or until
maturity. In this case, the loan would not be classified as held-for-
sale and would not be accounted for at fair value.
[38] According to FAS 114: Accounting by Creditors for Impairment of a
Loan, a loan is considered impaired when, based on current information
and events, it is probable that a creditor will be unable to collect
all amounts due according to the contractual terms of the loan
agreement. To comply with FAS 114, creditors must create a valuation
allowance that reduces the value of the loan with a corresponding
charge to a bad-debt expense. When a loan is not impaired, creditors
must follow FAS 5: Accounting for Contingencies and establish an
allowance for loss when there is at least a reasonable possibility that
a loss or an additional loss might be incurred.
[39] U.S. General Accounting Office, Risk Based Capital: Regulatory and
Industry Approaches to Capital and Risk, GAO/GGD-98-153 (Washington,
D.C.: July 1998).
[40] Effective 1990, U.S. banking regulators added regulatory capital
requirements for loan commitments with maturities greater than 1 year.
Previously, there had been no regulatory capital requirements for
unfunded loan commitments of any length.
[41] SEC Rule 15c3-1(c)(2)(viii).
[42] The federal safety net also includes access to the Federal Reserve
payments system. Because the investment bankers with whom we spoke did
not mention the payments system as a competitive advantage, we omitted
this aspect from our discussion of the federal safety net.
[43] In unusual and exigent circumstances, and after consulting with
the Board of Governors of the Federal Reserve System, a Federal Reserve
Bank can extend credit to an individual, partnership, or corporation
that is not a depository institution if, in the judgment of the Federal
Reserve Bank, credit is not available from other sources and failure to
obtain such credit would adversely affect the economy.
[44] Commercial paper is generally a short-term, unsecured, money-
market obligation issued by prime rated commercial firms and financial
companies. A commercial paper back-up facility is generally a short-
term bank line of credit that serves as an alternate source of
liquidity for an issuer of commercial paper lasting less than 1 year.
[45] FASB has defined fair value in FAS 107, Disclosures about Fair
Value of Financial Instruments, as the amount at which a financial
instrument could be exchanged in a current transaction between willing
parties, other than a forced liquidation sale.
[46] The net book value of a loan is generally its unpaid principal
balance less any allowance for credit losses.
[47] FASB has defined a financial instrument as cash, evidence of an
ownership interest in an entity, or a contract that both imposes on one
entity a contractual obligation to (1) deliver cash or another
financial instrument to a second entity or (2) to exchange other
financial instruments on potentially unfavorable terms with the second
entity and conveys to that second entity a contractual right to (1)
receive cash or another financial instrument from the first entity or
(2) to exchange other financial instruments on potentially favorable
terms with the first entity.
[48] FAS 91 Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases
applies to loan commitments held by lending institutions. If a
commercial bank held a loan commitment in a broker-dealer affiliate
registered with the Securities and Exchange Commission, the affiliate
would follow the AICPA guidance for broker-dealers.
[49] For simplicity, in this appendix the term investment bank will be
used to mean an investment bank in which the broker-dealer comprises a
majority of the financial activity. In practice, investment banks do
not often hold loan commitments in their broker-dealer affiliates
because of the high capital requirements of broker-dealers; rather, the
investment bank would generally hold these financial instruments in a
nonbroker-dealer affiliate. However, according to AICPA staff, at the
consolidated level, the entity would retain the specialized accounting
model used for the broker-dealer subsidiary. The commercial bank would
continue to use FAS 91 to account for its loan commitments. A
nonbroker-dealer that is a subsidiary of a broker-dealer holding
company (not a bank holding company) may also follow the accounting
used by its broker-dealer subsidiary, if the broker-dealer comprises
the majority of the financial activity of the consolidated entity; that
is, the fair-value model would also be used for the consolidated
broker-dealer holding company financial statements.
[50] The concept of materiality is discussed at length in FASB's
Concept Statement 2, Qualitative Characteristics of Accounting
Information, paragraphs 123 - 132.
[51] If the likelihood of exercising this commitment had not been
remote, Commercial Bank A would have followed the requirements of FAS
91, and not amortized the deferred revenue until the commitment was
exercised. Once exercised, the bank would recognize the fee income over
the life of the loan. If the commitment remained unexercised, income
would be recognized upon expiration of the commitment.
[52] This is required by FAS No. 107, Disclosures about Fair Value of
Financial Instruments.
[53] On June 19, 2003, AICPA issued an exposure draft of a proposed
statement of position for allowance for credit losses. This exposure
draft proposes various revisions to how banks would estimate credit
losses and report them on their financial statements and is proposed to
be implemented after December 15, 2003.
[54] FAS 5 states that receivables by their nature usually involve some
degree of uncertainty about their collectibility, in which case a loss
contingency exists. If a loss were not probable and estimable, both
banks would disclose in their financial statement footnotes, the loss
contingency when there was at least a reasonable possibility that a
loss or additional loss might be incurred.
[55] In order to keep this exception scenario example simple, it is
also assumed that there are not conditions that would constrain
Commercial Bank A and Investment Bank B from selling the loan, that
both banks will not retain any interest in the loans sold, and the
loans are sold without recourse.
[56] Accounting by Certain Entities (Including Entities with Trade
Receivables) That Lend to or Finance the Activities of Others,
December, 2001.
[57] Comprehensive income is defined in FAS 130, Reporting
Comprehensive Income, as the change in equity [net assets] of a
business during a period from transactions and other events and
circumstances from nonowner sources. It includes all changes in equity
during a period except those resulting from investments by owners and
distributions to owners.
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