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.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”). 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.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. 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. 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.

		Violations of Section 106

On August 29, 2003, the Board published for public comment its proposed  interpretation and supervisory guidance concerning section 106. 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.
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.” 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.” 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. 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. 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. 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. 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. 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.

		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.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. 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. 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 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.”
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. 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. 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. 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.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. 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.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.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.
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.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.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. 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. 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.
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. 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. 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. 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. The Federal Reserve discount  window allows banks and other organizations to borrow funds from the  Federal Reserve.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 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.

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. 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.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.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. 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.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. 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  Upon receipt of the loan commitment fee, Commercial Bank A would  Commercial Bank	 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.”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. 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.

		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.

	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. Thus, both banks  would establish an allowance for loss in line with historical performance  for borrowers of this type. 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. 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. 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. 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.

Comments from the Federal Reserve System

Comments from the Office of the Comptroller of the Currency

GAO Contacts and Staff Acknowledgments

	GAO Contacts

	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.

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Summary:
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.