MIBA’s COMPLIANCE CORNER
Bank Affiliate Transactions under Regulation W:
Overview and Best Practices
By: Paul J. Cambridge and Kevin M. Hogan, Polsinelli PC
Regulation W implements Sections 23A and 23B of
the Federal Reserve Act, which govern most transactions
between banks and their affiliates. The term “banks”
includes all national banks, as well as insured state
member and nonmember banks. Regulation W is
designed to limit a bank’s risks from transactions with
affiliates and mitigate the resulting potential impact on
the federal banking system. Bank examiners closely
scrutinize affiliate transactions, and with changes to the
affiliate transaction rules under the Dodd-Frank Act, there
appears to be a renewed focus in this area. This article
provides information regarding when and how Regulation
W applies, as well as best practices for community bank
compliance.
Overview of when Regulation W Applies
Two initial questions must be answered to determine
whether a transaction is subject to Regulation W’s
restrictions:
(1) is the transaction between a bank and an
“affiliate”?
(2) is the transaction a “covered transaction”?
The restrictions imposed by Regulation W do not
apply unless the transaction involves an affiliate and the
transaction is considered a covered transaction. Correctly
identifying situations in which Regulation W applies
hinges on an understanding of the definitions of the terms
“affiliate” and “covered transaction” contained in the
regulation.
Definition of Affiliate. Regulation W defines the term
“affiliate” broadly. Among the entities that generally fall
within the definition are the following:
 A holding company of a bank or any company
controlled by the company that controls the bank;
 Other bank and nonbank subsidiaries of the holding
company;
 Subsidiary depository institutions of the bank;
 Financial subsidiaries of the bank;
 Companies controlled by shareholders who also
control the bank;
 Companies with interlocking directors;
 Partnerships in which the bank or an affiliate serves
as general partner;
 ESOPs, trusts, or similar entities organized for the
benefit of employees, shareholders or members of the
bank or its affiliates;
 Any investment fund with respect to which a bank
or its affiliate is an investment adviser; and
 Other companies determined by the Federal
Reserve (by regulation or order).
Definition of Covered Transaction. Under Regulation
W, a “covered transaction” with an affiliate includes the
following:
 A loan or extension of credit to an affiliate;
 A purchase of, or investment in, a security issued
by an affiliate;
 A purchase of an asset from an affiliate, unless
such purchase is exempted;
 The acceptance of a security issued by an affiliate
as collateral for an extension of credit to any person
or company;
 The issuance by a bank of a guarantee, acceptance,
or letter of credit, including an endorsement or
standby letter of credit, on behalf of the affiliate, a
confirmation of a letter of credit issued by the
affiliate, and a cross-affiliate netting arrangement;
and
 Derivative and securities financing transactions to
the extent a credit exposure to an affiliate is created.
Quantitative Limitations and Collateral Requirements
under Regulation W
If a transaction both involves an “affiliate” and falls
within the definition of “covered transaction,” Regulation
W imposes quantitative limits and collateral requirements
that a bank must follow for the transaction to be in
compliance. Note that in addition to the quantitative
limits and collateral requirements, all covered
transactions must be consistent with safe and sound
banking practices, which gives the regulators broad
discretion to criticize affiliate transactions.
Information for the MIBA’s Compliance Corner is from Associate Members of the Missouri Independent Bankers Association.. These services are provided with the understanding that the Missouri Independent Bankers Association is not engaged in rendering legal, accounting or other professional services. If legal advice is required, the services of a competent professional should be sought.
Quantitative Limitations. A bank’s covered
transactions with any single affiliate may not exceed 10
percent of the bank’s capital stock and surplus, and a
bank’s aggregate covered transactions with all affiliates
cannot exceed 20 percent of the bank’s capital stock and
surplus.
furnishing of services to an affiliate under contract, lease
or otherwise, (iv) any transaction in which an affiliate
acts as an agent or broker or receives a fee for its services
to the bank, or (v) any transaction with a third party in
which an affiliate has a financial interest in the third party
and the affiliate is a participant in each transaction.
Collateral Requirements. All loans or extensions of
credit to affiliates must be collateralized between 100 –
130 percent of the principal amount, depending on the
level of risk associated with the collateral. The most
common types of collateral, such as stock, leases, or real
or personal property must have a market value equal to at
least 130 percent of the amount of the credit transaction.
A bank must maintain a perfected security interest in the
collateral, and, if the bank’s security interest does not
have first priority, the bank must deduct from the
collateral value the lesser of (i) the amount of any more
senior security interest, or (ii) the amount of any credit
secured by that senior security interest. Note that,
pursuant to Regulation W, banks may not accept stock of
an affiliate as collateral for an extension of credit to any
borrower, and affiliate stock does not count towards the
130 percent collateral requirement.
When a bank enters into any of the transactions listed
in the preceding paragraph, the transaction must be on
terms and under circumstances that are substantially the
same, or at least as favorable to the bank or its affiliate, as
those prevailing at the time for comparable transactions
with non-affiliates. If there are no comparable
transactions with non-affiliates, the bank must apply the
same standard that would, in good faith, be offered or
applied to a non-affiliate. There is no set procedure for
compliance with the “market terms” requirement. The
key is that the bank needs to act in good faith and
document how it determined that the transaction is in
compliance.
Grandfathering. Regulation W contains provisions
that provide limited grandfathering from compliance with
respect to transactions that were not subject to Regulation
W at the time of the transaction. Any covered transactions
that occurred more than one year prior to the bank and
another entity becoming affiliates need not comply with
the collateral requirements of Regulation W. Any
renewals or modifications of these existing extensions of
credit will need to comply with Regulation W, however,
since these actions are considered new covered
transactions that occur after the entity becomes an
affiliate. If the bank and another entity become affiliates
less than one year following any covered transaction, the
transaction must be brought into compliance with the
collateral requirements “promptly” after the two
institutions become affiliates.
“Market Terms” Requirement of Section 23B
Section 23B of the Federal Reserve Act requires that
certain transactions must be made on “market terms.” A
bank must satisfy the “market terms” requirement with
respect to the following transactions: (i) any covered
transaction with an affiliate, (ii) the sale of securities or
other assets to an affiliate, (iii) the payment of money or
Impact of Dodd-Frank and the Volcker Rule
on Sections 23A and 23B
Regulators have placed a renewed emphasis on
Regulation W because Dodd-Frank significantly
expanded the scope of sections 23A and 23B, and sought
to tighten the regulatory oversight. These amendments are
aimed at business practices of large financial institutions
that were seen as a driving cause of the financial crisis,
however, and many of the changes imposed by DoddFrank have a minimal impact on community banks’
compliance with Regulation W.
Definitional Changes. Dodd-Frank broadened the
definition of “affiliate” to include all investment funds for
which a bank or its affiliate serves as investment adviser.
Similarly, Dodd-Frank expanded the categories of
transactions that qualify as “covered transactions” to
include: (i) the acceptance of debt obligations of an
affiliate as collateral for a loan or extension of credit to a
third party, (ii) “derivative transactions” with an affiliate
to the extent such transaction creates a “credit exposure”
to an affiliate, and (iii) transactions with affiliates that
involve borrowing or lending securities to the extent it
creates a “credit exposure” to an affiliate. The Federal
Reserve may issue regulations or interpretations
regarding the definition of the term “credit exposure,”
which is not defined by Dodd-Frank, and regarding how
netting arrangements may be considered in determining
the amount of a covered transaction and collateral
requirements. At this time, it is unknown how the
regulators will interpret these open items.
Collateral Requirement Changes. Dodd-Frank
imposes additional collateral requirements with respect to
repurchase agreements (now considered an “extension of
credit” rather than an “asset purchase”) and derivatives
and securities financing transactions with affiliates.
Pursuant to Dodd-Frank, debt obligations of an affiliate
are prohibited as collateral for a covered transaction, and
credit transactions must now remain secured in
accordance with the collateral requirements “at all times,”
not just at the initial time of the transaction.
Volcker Rule. Under the Volcker Rule’s so-called
“Super 23A” restrictions, no banking entity or its affiliate
that (i) advises or sponsors a covered fund, (ii) organizes
and offers a covered fund under the asset management or
asset based securities issuer exemption, or (iii) retains an
ownership interest under the asset based securities issuer
exemption, may enter into certain transactions with the
covered fund. The transactions prohibited by the Volcker
Rule are: (a) a loan or extension of credit to the fund, (b)
the purchase of securities issued by the fund, (c) the
purchase of assets from the fund, (d) the issuance of
guarantees, acceptances or letters of credit on behalf of
the fund, or (e) securities borrowing or lending or
derivative transactions that result in the banking entity
having a credit exposure to the fund. Except for a limited
exemption for certain prime brokerage transactions, the
Volcker Ruler completely prohibits these transactions,
even where otherwise be permitted under Regulation W.
Regulation W Compliance Program
If the regulators find that a bank violated Regulation
W, they have the authority to impose substantial fines—
up to $1 million per day—for noncompliance. These
penalties can be levied regardless of the bank’s awareness
or understanding of Regulation W’s requirements, but the
regulators will investigate to determine if the violation
was intentional or an oversight, and the penalties imposed
will depend on the outcome of the investigation. If the
violation is determined to have any individual gain or
have affected the financial health of the institution, there
may be more severe consequences.
The first step to successful Regulation W compliance
is for a Bank to identify all affiliates so that it can make
appropriate decisions with respect to covered transactions
as they arise. It is also important to identify any potential
affiliates so strategic decisions can be made before
entering into what would be a covered transaction if the
regulators were ever to find that an affiliate relationship
exists. For example, a loan secured by the stock of an
entity in which a controlling shareholder of the bank
owns a minority interest may not be a covered transaction
now, but if the bank’s controlling shareholder were to
become a controlling shareholder of the entity in the
future, the entity would become an affiliate due to the
overlapping control. In that situation, any renewal or
modification of the loan would then be a covered
transaction in which the affiliate stock would no longer be
appropriate collateral. Banks need to have a thorough
understanding of these potential situations to be able to
make fully-informed decisions that could have
implications under Regulation W in the future.
To avoid Regulation W compliance issues, a bank’s
Board of Directors and officers should prioritize
compliance by making sure the bank has an enterprisewide compliance and oversight program. An effective
compliance program should begin with awareness,
monitoring, and management oversight across the entire
organization—which includes the bank and its affiliates.
For example, since many of the most common covered
transactions are loans, the lending personnel need to be
aware of the identity of the bank’s affiliates and the
amount of covered transactions because they are often in
the best position to flag a potential Regulation W issue,
such as insufficient collateral or a transaction in excess of
the quantitative limits. Depending on the size and
complexity of a bank’s organization and the number of
affiliate transactions, it may be helpful to establish a
Regulation W steering committee that makes strategic
and policy decisions to develop and implement the bank’s
compliance program, as well as designating a compliance
officer who is accountable for the enterprise-wide
Regulation W compliance framework, recordkeeping, and
oversight.
_________________________________
Paul J. Cambridge and Kevin M. Hogan are banking
attorneys in the St. Louis office of Polsinelli PC with
significant experience assisting community banks with
regulatory compliance issues. They can be contacted at
(314) 889-8000 and at [email protected] or
[email protected].