United States General Accounting Office 

GAO	 Report to the Chairman and Ranking 

Minority Member, Committee on 

Financial Services, House of 

Representatives 

October 2003 BANK TYING 

Additional Steps 

Needed to Ensure 

Effective Enforcement 

of Tying Prohibitions 

GAO-04-4


a
Highlights of GAO-04-4, a report to the 

Chairman and Ranking Minority Member 

of the Committee on Financial Services, 

House of Representatives 

Investment affiliates of large 

commercial banks have made 

competitive inroads in the annual 

$1.3 trillion debt-underwriting 

market. Some corporate borrowers 

and officials from unaffiliated 

investment banks have alleged that 

commercial banks helped their 

investment affiliates gain market 

share by illegally tying and 

underpricing corporate credit. This 

report discusses these allegations, 

the available evidence related to 

the allegations, and federal bank 

regulatory agencies’ efforts to 

enforce the antitying provisions. 

Because documentary evidence of 

an unlawful tying arrangement 

generally is not available in bank 

files, GAO recommends that the 

Federal Reserve and OCC consider 

additional steps to enforce section 

106. Additional steps could include 

publication of specific contact 

points within the agencies to 

answer questions from banks and 

bank customers about the guidance 

in general and its application to 

specific transactions, as well as to 

accept complaints from bank 

customers who believe that they 

have been subjected to unlawful 

tying. 

Because low-priced credit could 

indicate violations of law, the 

Federal Reserve should also assess 

available evidence of loan pricing 

behavior to provide better 

supervisory information, and 

publish the results of this 

assessment. 

www.gao.gov/cgi-bin/getrpt?GAO-04-4. 

To view the full product, including the scope 

and methodology, click on the link above. For 

more information, contact Richard Hillman at 

(202) 512-8678 or hillmanr@gao.gov. 

October 2003 

BANK TYING 

Additional Steps Needed to Ensure 

Effective Enforcement of Tying 

Prohibitions 

Section 106 of the Bank Holding Company Act Amendments of 1970 

prohibits commercial banks from “tying,” a practice which includes 

conditioning the availability or terms of loans or other credit products on the 

purchase of certain other products and services. The law does permit banks 

to tie credit and traditional banking products, such as cash management, and 

does not prohibit banks from considering the profitability of their full 

relationship with customers in managing those relationships. 

Some corporate customers and officials from an investment bank not 

affiliated with a commercial bank have alleged that commercial banks 

illegally tie the availability or terms, including price, of credit to customers’ 

purchase of other services. However, with few exceptions, formal 

complaints have not been brought to the attention of the regulatory agencies 

and little documentary evidence surrounding these allegations exists, in part, 

because credit negotiations are conducted orally. Further, our review found 

that some corporate customers’ claims involved lawful ties between 

traditional banking products rather than unlawful ties. These findings 

illustrate a key challenge for banking regulators in enforcing this law: while 

regulators need to carefully consider the circumstances of specific 

transactions to determine whether the customers’ acceptance of an 

unlawfully tied product (that is, one that is not a traditional banking 

product) was made a condition of obtaining credit, documentary evidence 

on those circumstances might not be available. Therefore, regulators may 

have to look for indirect evidence to assess whether banks unlawfully tie 

products and services. Although customer information could have an 

important role in helping regulators enforce section 106, regulators generally 

have not solicited information from corporate bank customers. 

The Board of Governors of the Federal Reserve System and the Office of the 

Comptroller of the Currency (OCC) recently reviewed antitying policies and 

procedures of several large commercial banks. The Federal Reserve and 

OCC, however, did not analyze a broadly-based selection of transactions or 

generally solicit additional information from corporate borrowers about 

their knowledge of transactions. The agencies generally found no unlawful 

tying arrangements and concluded that these banks generally had adequate 

policies and procedures intended to prevent and detect tying practices. The 

agencies found variation among the banks in interpretation of the tying law 

and its exceptions. As a result, in August 2003, the Board of Governors of the 

Federal Reserve, working with OCC, released for public comment new draft 

guidance, with a goal of better informing banks and their customers about 

the requirements of the antitying provision. 
Contents


Letter


Results in Brief 


Background 


Some Corporate Borrowers Alleged That Unlawful Tying Occurs, 


but Available Evidence Did Not Substantiate These 

Allegations 

Federal Reserve and OCC Targeted Review Identified Interpretive 

Issues 

Evidence That We Reviewed on the Pricing of Corporate Credit Did 

Not Demonstrate That Commercial Banks Unlawfully Discount 

Credit 

Differences between Commercial Banks and Investment Banks Did 

Not Necessarily Affect Competition 

Conclusions 

Recommendations for Executive Action 

Agency Comments 

1 

4 

8 

15 

17 

25 

31 

39 

40 

40 

Appendixes 

Appendix I: 

Appendix II: 

Appendix III: 

Appendix IV: 

Differences in Accounting between Commercial and 

Investment Banks for Loan Commitments 

Background 


Hypothetical Scenario for Unexercised Loan Commitments 


Hypothetical Scenario for Exercised Loan Commitments 


Comments from the Federal Reserve System 

Comments from the Office of the Comptroller of the 

Currency 

GAO Contacts and Staff Acknowledgments 

GAO Contacts 

Acknowledgments 

42 

43 

45 

48 

52 

54 

56 

56 

56 

Tables	 Table 1: Accounting Differences for a Loan Commitment 48 

Table 2: Accounting Differences for a Loan Sale 51 

Page i GAO-04-4 Bank Tying 
Contents 

Abbreviations 

AICPA American Institute of Certified Public Accountants


FASB Financial Accounting Standards Board


FAS Financial Accounting Standards


FDIC Federal Deposit Insurance Corporation


OCC Office of the Comptroller of the Currency


SEC Securities and Exchange Commission


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Page ii GAO-04-4 Bank Tying 
Page 1 GAO-04-4 Bank Tying 

A

United States General Accounting Office 

Washington, D.C. 20548 

October 10, 2003


The Honorable Michael G. Oxley


Chairman, Committee on Financial Services


House of Representatives


The Honorable Barney Frank


Ranking Minority Member, 


Committee on Financial Services


House of Representatives


In the 70 years since the passage of the Glass-Steagall Act of 1933, which 


prohibited commercial banks from engaging in investment banking 


activities such as securities underwriting, changes in legislation and 


regulatory interpretations have relaxed some of the restrictions imposed 


on bank holding companies and their subsidiaries that served to distance 


commercial banks from investment banking. For example, one effect of the 


1970 amendments to the Bank Holding Company Act of 1956 was to permit 


bank holding companies to own subsidiaries engaged in limited 


underwriting activities, but only if the subsidiary was not “principally 


engaged” in such activities. More recently, the Gramm-Leach-Bliley Act of 


1999, among other things, substantially removed that limitation. As a result


of these and other developments, commercial banks and their investment


bank affiliates (investment affiliates) can provide complementary financial 


products and services. Despite these developments, commercial banks 


have remained subject to certain restrictions on their activities. Among 


them is the prohibition against tying arrangements. In general, section 106 


of the Bank Holding Company Act Amendments of 1970 (section 106) 


prohibits banks from tying the availability or price of a product or service 


to a customer’s purchase of another product or service or the customer’s


providing some additional credit, property or service.1


In recent years, investment bank affiliates of large commercial banks have


gained an increasing share of the annual $1.3 trillion debt underwriting 


market. A controversy has arisen over whether or not unlawful tying has 


contributed to this increased market share. Some unaffiliated investment 


banks (investment banks) and some corporate borrowers contend that 


1

As explained later, not all instances of bank tying are unlawful because certain types of 

products and services are not subject to the tying prohibition in the Bank Holding Company 

Act. 

Page 1 GAO-04-4 Bank Tying 
commercial banks have facilitated investment affiliates’ increased market 

share of debt underwriting by unlawfully tying the availability of bank 

credit to debt underwriting by the bank’s affiliate, a violation of section 106. 

In addition, some investment bankers assert that large commercial banks 

engage in unlawful tying by offering reduced rates for corporate credit only 

if the borrower also purchases debt underwriting services from the bank’s 

investment affiliate. If such a reduced rate were conditioned only on the 

borrower’s purchase of debt underwriting services from the commercial 

bank’s investment affiliate, the arrangement would constitute unlawful 

tying. Should the reduced rate constitute an underpricing of credit (that is, 

the extension of credit below market rates), the underpricing could also 

violate section 23B of the Federal Reserve Act of 1913 (section 23B). 

Section 23B generally requires that certain transactions between a bank 

and its affiliates occur on market terms; that is, on terms and under 

circumstances that are substantially the same, or at least as favorable to 

the bank, as those prevailing at the time for comparable transactions with 

unaffiliated companies. Section 23B applies to any transaction by a bank 

with a third party if an affiliate has a financial interest in the third party or if 

an affiliate is a participant in the transaction. The banking regulators 

suggest that the increase in debt underwriting market share by the 

investment affiliates of large commercial banks can be explained by a 

number of market and competitive factors not associated with tying, such 

as industry consolidation and acquisition of investment banking firms by 

bank holding companies. In addition, representatives from large 

commercial banks with investment affiliates contend that they sell a range 

of products and services to corporate customers, including credit, but do 

not unlawfully tie bank credit or credit pricing to underwriting services. 

Furthermore, officials from large commercial banks, federal banking and 

securities regulators, and investment bankers observe that ties between 

credit and other banking products are often customer-initiated, and thus 

exempt from the laws governing tying. 

To more fully examine the issues raised by the allegations about unlawful 

tying and underpricing of corporate credit, you asked us to determine (1) 

what evidence, if any, suggests that commercial banks with investment 

affiliates engage in unlawful tying; (2) what steps the federal banking 

regulators have taken to examine for unlawful tying and the results of these 

efforts; (3) what evidence, if any, suggests that commercial banks with 

investment affiliates unlawfully discount the price of corporate credit to 

obtain underwriting business for their investment affiliates; and (4) what, if 

any, competitive advantages accounting rules, capital standards, and 

Page 2 GAO-04-4 Bank Tying 
access to the federal safety net create for commercial banks over 

investment banks. 

In our review of possible unlawful tying practices by large commercial 

banks, we focused on wholesale corporate lending and did not address 

retail banking. We conducted a legal review of section 106 of the Bank 

Holding Company Act Amendments of 1970, section 23B of the Federal 

Reserve Act, and relevant federal regulations, and interviewed legal experts 

and academics. To describe the recent concerns about possible unlawful 

tying practices, we reviewed the results of a 2003 survey on corporate 

borrowers’ views about credit access conducted by the Association for 

Financial Professionals and reviewed recent media coverage of tying. We 

also interviewed several large corporate borrowers, and officials at several 

investment banks and commercial banks with investment affiliates. We 

also met with officials from NASD to discuss that organization’s Special 

Notice to its members and its ongoing investigation related to tying. NASD 

is a self-regulatory organization that sets and enforces market conduct 

rules governing its members, which are securities firms, including those 

affiliated with commercial banks. 

To determine what steps the federal banking regulators have taken to 

examine for unlawful tying, we reviewed the results of the Board of 

Governors of the Federal Reserve System (Federal Reserve) and the Office 

of Comptroller of the Currency (OCC) joint review on tying and 

interviewed commercial bankers to describe the measures that large 

commercial banks take to comply with the tying law. We also reviewed 

federal guidance on sections 106 and 23B and Federal Reserve and OCC 

examination procedures related to tying. In addition, we interviewed 

officials from the Federal Reserve, OCC, and the Federal Deposit Insurance 

Corporation (FDIC). 

To identify possible credit pricing abuses and factors that affect overall 

prices in wholesale credit markets, we interviewed commercial bankers, 

credit market experts, academics experts, industry observers, and officials 

at the Federal Reserve and OCC. We also reviewed economic literature on 

wholesale credit markets. 

To determine the accounting practices and requirements for commercial 

banks and investment banks, we performed a comparative analysis of 

applicable accounting standards and verified our understanding through 

interviews with officials from the Financial Accounting Standards Board 

(FASB), the American Institute of Certified Public Accountants (AICPA), 

Page 3 GAO-04-4 Bank Tying 
and the Securities and Exchange Commission (SEC). We also solicited 

feedback from FASB and AICPA officials on appendix I of our draft report 

and incorporated their technical comments in this report as appropriate. To 

determine the respective capital standards for commercial banks, we 

reviewed relevant documentation and interviewed Federal Reserve, OCC, 

and SEC officials and officials from commercial banks. We also spoke with 

Federal Reserve and OCC officials about the access of commercial banks 

and investment banks to the federal safety net. 

We recognized certain limitations on the information collected during this 

review. In particular, we recognized that much of the information provided 

to us on selected transactions and market behavior could not be 

independently verified. In addition, we did not independently verify the 

results of the 2003 survey conducted by the Association for Financial 

Professionals, which we believe are subject to methodological limitations 

that prevent us from reporting them in detail. Nor did we verify the results 

of the Federal Reserve and OCC’s special review targeted on tying. 

We conducted our work in Charlotte, N.C.; Chicago, Ill.; New York, N.Y.; 

Orlando, Fla.; and Washington, D.C., between October 2002 and October 

2003, in accordance with generally accepted government auditing 

standards. 

Results in Brief	 Although some corporate borrowers have alleged that commercial banks 

tie the availability or price of credit to the purchase of debt underwriting 

services—a violation of section 106—the available evidence did not 

substantiate these claims. Corporate borrowers could not provide 

documentary evidence to substantiate their claims. The lack of 

documentary evidence might be due to the fact that negotiations over 

credit terms and conditions (during which a tying arrangement could be 

imposed) were generally conducted orally. Borrowers also were reluctant 

to file formal complaints with banking regulators. Reasons given for their 

reluctance included a lack of documentary evidence of unlawful tying, 

uncertainty about whether certain tying arrangements were illegal, and fear 

of adverse consequences for their companies’ access to credit and for their 

individual careers. Determining whether a tying arrangement is unlawful 

requires close examination of the specific facts and circumstances of the 

transactions involved, and lawful practices can easily be mistaken for 

unlawful tying. For example, although borrowers we interviewed described 

arrangements that could represent unlawful tying by banks, other 

arrangements that they described involved lawful practices. Because 

Page 4 GAO-04-4 Bank Tying 
documentary evidence of unlawful tying is generally not available, banking 

regulators may have to look for other forms of indirect evidence to 

effectively enforce section 106.2 

Regular bank examinations in recent years have not identified any 

instances of unlawful tying that led to enforcement actions.3

 In response to 

recent allegations of unlawful tying at large commercial banks, the Federal 

Reserve and OCC conducted a joint review focused on antitying policies 

and practices at several large commercial banks and their holding 

companies. The review teams found that the banks generally had adequate 

procedures in place to comply with section 106, and that over the past year, 

some banks had made additional efforts to ensure compliance. Although 

customer information could have an important role in helping the 

regulators enforce section 106, regulators did not analyze a broadly based 

selection of transactions or contact a broad selection of customers as part 

of their review. The regulators said that they met with officials and 

members from a trade group representing corporate financial executives. 

The review teams questioned some transactions but generally did not find 

unlawful tying arrangements. The targeted review found some variation 

among banks’ interpretations of section 106, generally in areas where the 

regulators have not provided authoritative guidance. As a result, the 

Federal Reserve recently issued, for public comment, proposed guidance 

that is intended to help banks and their customers better understand what 

activities are lawful and unlawful under section 106.4

 Federal Reserve 

officials said that they hope this guidance also encourages customers to 

come forward if they believe that they have grounds to make a complaint. 

2

For purposes of this report, the term “indirect evidence” refers to information that is not 

contained in transaction documents maintained by the bank. Section 106 is codified at 12 

U.S.C. § 1972 (2000). 

3

After the Federal Reserve and OCC completed the targeted review, the Federal Reserve 

announced on August 27, 2003, that it had entered into a consent agreement and civil money 

penalty against WestLB AG, a German bank, and its New York branch, based on allegations 

that in 2001 it conditioned the availability of credit on the borrower’s obtaining underwriting 

business from a WestLB affiliate. 

4

68 Fed. Reg. 52024 (Aug. 29, 2003). OCC released a white paper, “Today’s Credit Markets, 

Relationship Banking, and Tying,” on September 25, 2003, which discussed banks’ market 

power and economic performance for evidence of tying, the market competitiveness of 

diversified banking organizations, and relationship banking. The paper concluded that the 

relationship banking practices, as described in the white paper, are consistent with the 

relevant legal framework. 

Page 5 GAO-04-4 Bank Tying 
Although officials from one investment bank alleged that the pricing of 

some corporate credit by large commercial banks was a factor in violations 

of section 106 and possibly section 23B, we found that the available 

evidence on pricing was subject to multiple interpretations and did not 

necessarily demonstrate violations of either section 106 or section 23B. 

Some investment banks contended that large commercial banks 

deliberately underpriced corporate credit to attract underwriting business 

to their investment affiliates. Section 106 prohibits a bank from setting or 

varying the terms of credit on the condition that the customer purchase 

certain other products and services from the bank or an affiliate, unless 

those products and services (such as traditional banking services) are 

exempted from the prohibition. If the price of the credit is less than the 

market price and the bank’s investment affiliate is a participant in the 

transaction, then the transaction would reduce the bank’s income for the 

benefit of its affiliate, and thus be in violation of section 23B.5

 However, our 

review of specific transactions cited by an investment bank found the 

available evidence of underpricing to be ambiguous and subject to different 

interpretations. During the course of our review, Federal Reserve staff said 

that they were considering whether to conduct a research study of pricing 

issues in the corporate loan market. Such a study could improve the 

regulators’ ability to determine if transactions are conducted at prices that 

were not determined by market forces. 

Although officials at one investment bank also contended that differences 

in accounting conventions, regulatory capital requirements, and access to 

the federal safety net provide a competitive advantage that enables 

commercial banks with investment affiliates to underprice loan 

commitments, we found that these differences did not appear to provide a 

clear and consistent competitive advantage for commercial banks. 

•	 Because commercial banks are not permitted by the accounting 

standards to recognize changes in the value of loans and loan 

commitments compared with current market prices while investment 

banks recognize these changes in their net income, officials at some 

investment banks have contended that accounting standards give 

commercial banks a competitive advantage. However, FASB, which sets 

private-sector financial accounting and reporting standards, noted that 

commercial banks and investment banks follow different accounting 

models for these transactions. Based on our analysis, banks’ adherence 

5

See 12 U.S.C.§ 371c-1 (2000). 

Page 6 GAO-04-4 Bank Tying 
to different accounting rules caused a temporary difference in the 

recognition of the service fees from short-term loan commitments—a 

difference that appeared to be relatively small compared with revenue 

from other bank activity and would be resolved by the end of the loan 

commitment period. Moreover, both commercial banks and investment 

banks must report the fair value of loan commitments in the footnotes 

of their financial statements. Further, we found that if the loan 

commitment were exercised and both firms either had the intent and 

ability to hold the loan for the foreseeable future or until maturity, or 

made the loan available for sale, the accounting would be similar and 

would not provide an advantage to either firm. 

•	 Additionally, while commercial and investment banks were subject to 

different regulatory capital requirements, practices of both commercial 

and investment banks led to avoidance of regulatory charges on loan 

commitments with a maturity of 1 year or less. Officials from one 

investment bank also contended that bank regulatory capital 

requirements gave commercial banks a competitive advantage in 

lending because they are not required to hold regulatory capital against 

short-term unfunded loan commitments. In comparison, investment 

banks could face a 100-percent regulatory capital charge if they carried 

loan commitments in their broker-dealer affiliates. However, in practice, 

investment bankers told us that they generally carry loan commitments 

outside of their broker-dealer affiliates and thus also avoid regulatory 

capital charges. 

•	 Some officials from investment banks also contended that commercial 

banks’ access to the federal safety net, including access to federal 

deposit insurance and Federal Reserve discount window lending, gives 

the banks a further cost advantage. However, industry observers and 

OCC officials said that this subsidy is likely offset by regulatory costs. 

This report includes a recommendation that the Federal Reserve and the 

OCC consider taking additional steps to ensure effective enforcement of 

section 106 and section 23B, including enhancing the information that they 

receive from corporate borrowers. For example, the agencies could 

develop a communication strategy that is directed at a broad audience of 

corporate bank customers to enhance their understanding of section 106. 

Because low priced credit could indicate a potential violation of section 

23B, we also recommend that the Federal Reserve assess available 

evidence regarding loan pricing behavior, and if appropriate, conduct 

additional research to better enable examiners to determine whether 

Page 7 GAO-04-4 Bank Tying 
transactions are conducted on market terms, and that the Federal Reserve 

publish the results of this assessment. 

Background	 Large banking organizations typically establish ongoing relationships with 

their corporate customers and evaluate the overall profitability of these 

relationships. They use company-specific information gained from 

providing certain products and services—such as credit or cash 

management—to identify additional products and services that customers 

might purchase. This practice, known as “relationship banking,” has been 

common in the financial services industry for well over a century. 

In recent years, as the legal and regulatory obstacles that limited banking 

organizations’ abilities to compete in securities and insurance activities 

have been eased, some large banking organizations have sought to expand 

the range of products and services they offer customers. In particular, some 

commercial banks have sought to decrease their reliance on the income 

earned from credit products, such as corporate loans, and to increase their 

reliance on fee-based income by providing a range of priced services to 

their customers. 

Federal Banking Regulators	 The Federal Reserve and OCC are the federal banking regulators charged 

with supervising and regulating large commercial banks. The Federal 

Reserve has primary supervisory and regulatory responsibilities for bank 

holding companies and their nonbank and foreign subsidiaries and for 

state-chartered banks that are members of the Federal Reserve System and 

their foreign branches and subsidiaries. The Federal Reserve also has 

regulatory responsibilities for transactions between member banks and 

their affiliates. OCC has primary supervisory and regulatory 

responsibilities for the domestic and foreign activities of national banks 

and their subsidiaries. OCC also has responsibility for administering and 

enforcing standards governing transactions between national banks and 

their affiliates. Among other activities, the Federal Reserve and OCC 

conduct off-site reviews and on-site examinations of large banks to provide 

periodic analysis of financial and other information, provide ongoing 

supervision of their operations, and determine compliance with banking 

laws and regulations. Federal Reserve and OCC examinations are intended 

to assess the safety and soundness of large banks and identify conditions 

that might require corrective action. 

Page 8 GAO-04-4 Bank Tying 
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.6 Section 106 makes it unlawful, with certain exceptions, 

for a bank to extend credit or furnish any product or service, or vary the 

price of any product or service (the “tying product”) on the “condition or 

requirement” that the customer obtains some additional product or service 

from the bank or its affiliate (the “tied product”).7 Under section 106, it 

would be unlawful for a bank to provide credit (or to vary the terms for 

credit) on the condition or requirement that the customer obtain some 

other product from the bank or an affiliate, unless that other product was a 

traditional bank product.8 Thus, it would be unlawful for a bank to 

condition the availability or pricing of new or renewal credit on the 

condition that the borrower purchase a nontraditional bank product from 

the bank or an affiliate. 

In contrast, section 106 does not require a bank to extend credit or provide 

any other product to a customer, as long as the bank’s decision was not 

based on the customer’s failure to satisfy a condition or requirement 

prohibited by section 106. For example, it would be lawful for a bank to 

deny credit to a customer on the basis of the customer’s financial 

condition, financial resources, or credit history, but it would be unlawful 

for a bank to deny credit because the customer failed to purchase 

underwriting services from the bank’s affiliate. 

6

See, e.g., H.R. Conf. Rep. No. 91-1747, reprinted in 1970 U.S.C.A.N. 5561, 5569. 

7

Section 106 also prohibits reciprocity and exclusive dealing arrangements. Reciprocity 

arrangements are arrangements that require a customer to provide some credit, property, or 

service to the bank or one of its affiliates as a condition of the bank providing another 

product to the customer. Exclusive dealing arrangements are arrangements that require a 

customer not to obtain some other credit, property, or service from a competitor of the bank 

or its affiliate as a condition of the bank providing another product to the customer. The 

allegations we encountered during our work did not involve such arrangements. 

8

A key exception to section 106 is that banks may condition the price or availability of a 

service or product on the basis of a customer obtaining a “traditional bank product,” which 

the section defines as “a loan, discount, deposit, or trust service.” Section 106 provides this 

exception only with respect to traditional bank products offered by the bank, but the Board 

has extended the exception to include traditional bank products offered by an affiliate of the 

bank. 12 C.F.C. § 225.7(b)(1) (2003)). 

Page 9 GAO-04-4 Bank Tying 
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.9

 At the same time, the 

Federal Reserve expanded the traditional bank products exception to 

include traditional bank products offered by nonbank affiliates. 

In the mid-1990s, the Board also added two regulatory safe harbors. First, 

the Board granted a regulatory safe harbor for combined-balance discount 

packages, which allowed a bank to vary the consideration for a product or 

package of products—based on a customer’s maintaining a combined 

minimum balance in certain products—as long as the bank offers deposits, 

the deposits are counted toward the combined-balance, and the deposits 

count at least as much as nondeposit products toward the minimum 

balance.10 Furthermore, according to the Board, under the combinedbalance 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 

9

See 83 Fed. Res. Bulletin 275 (April 1997). 

10Id. 

Page 10 GAO-04-4 Bank Tying 
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. 11 

Violations of Section 106 	 On August 29, 2003, the Board published for public comment its proposed 

interpretation and supervisory guidance concerning section 106.12 In this 

proposed interpretation, the Federal Reserve noted that determining 

whether a violation of section 106 occurred requires a detailed 

understanding of the facts underlying the transaction in question. In this 

proposed interpretation, the Federal Reserve also noted what it considers 

to be the two key elements of a violation of section 106: 

(1) The arrangement must involve two or more separate products: the 

customer‘s desired product(s) and one or more separate tied products; 

and 

(2) The bank must force the customer to obtain (or provide) the tied 

product(s) from (or to) the bank or an affiliate in order to obtain the 

customer‘s desired product(s) from the bank.

13 

A transaction does not violate section 106 unless it involves two separate 

products or services. For example, a bank does not violate section 106 by 

requiring a prospective borrower to provide the bank specified collateral to 

obtain a loan or by requiring an existing borrower to post additional 

collateral as a condition for renewing a loan. Assuming two products or 

services are involved, the legality of the arrangement depends on, among 

11Id. 

1268 Fed. Reg. 52024 (August 29, 2003). 

1368 Fed. Reg. at 52027. A tie exists under section 106 if the bank furnishes the tying product 

“on the condition or requirement” that the customer obtain the tied product or provide some 

additional credit, property or service. In its guidance, the Board stated that even if a 

condition or requirement exists, further inquiry might be necessary because the condition or 

requirement violates section 106 only if it resulted from coercion by the bank. Id. at 52028. 

As the Board recognized, however, some courts have held that a tying arrangement may 

violate section 106 without a showing that the arrangement resulted from any type of 

coercion by the bank. Id. at 52029, n. 36. 

Page 11 GAO-04-4 Bank Tying 
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 mixedproduct 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 

Page 12 GAO-04-4 Bank Tying 
desired product to another product; and (2) this condition or requirement 

was imposed or forced on the customer by the bank.”14 Thus, according to 

the Board’s proposal, if a condition or requirement exists, further inquiry 

may be necessary to determine whether the condition or requirement was 

imposed or forced on the customer by the bank: “If the condition or 

requirement resulted from coercion by the bank, then the condition or 

requirement violates section 106, unless an exemption is available for the 

transaction.”

15 This interpretation is not universally accepted, however. As 

the Board’s proposal has noted, some courts have held that a tying 

arrangement violates section 106 without a showing that the arrangement 

resulted from any type of coercion by the bank.

16 Uncertainties about the 

proper interpretation of the “condition or require” provision of section 106 

have lead to disagreement over the circumstances that violate section 106. 

It has been suggested that changes in financial markets that have occurred 

since the enactment of section 106, particularly a decreased corporate 

reliance on commercial bank loans, also are relevant in considering 

whether banks currently can base credit decisions on a “condition or 

requirement” that corporate customers buy other services. At the end of 

1970, according to the Federal Reserve’s Flow of Funds data, bank loans 

accounted for about 24 percent of the total liabilities of U.S. nonfarm, 

nonfinancial corporations. At the end of 2002, bank loans accounted for 

about 14 percent of these liabilities. 

Because section 106 applies only to commercial and savings banks, 

investment banks and insurance companies, which compete in credit 

markets with banks, are not subject to these tying restrictions.17 Thus, 

under section 106, a bank’s nonbank affiliate legally could condition the 

availability of credit from that nonbank affiliate on a customer’s purchase 

of debt underwriting services. Where a transaction involves a bank as well 

as one or more affiliates, uncertainties could exist over whether the 

1468 Fed. Reg. at 52028. 

15Id. at 52029. 

16Id., n. 36. 

17Thrifts are subject to a similar antitying prohibition. Section 5(q) of the Home Owners 

Loan Act, 12 U.S.C. § 1464(q) (2000) places restrictions on savings associations that are 

almost identical to those placed on banks by section 106, although the Office of Thrift 

Supervision may only grant exceptions to section 5(q) that conform to exceptions to section 

106 granted by the Board. 

Page 13 GAO-04-4 Bank Tying 
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.18 In 

addition, under section 106 it is lawful for bank customers to initiate ties. 

For example, a customer could use its business leverage to obtain 

favorable credit terms or require a bank to extend a corporate loan as a 

condition for purchasing debt underwriting services. 

Section 23B of the Federal 

Reserve Act of 1913 

Prohibits Transactions That 

Benefit Bank Affiliates at 

the Expense of the Bank 

Section 23B requires that transactions involving a bank and its affiliates, 

including those providing investment-banking services, be on market 

terms.19 Although section 106 generally prohibits changing the price for 

credit on the condition that the customer obtain some other services from 

the bank or its affiliates, section 23B prohibits setting the price for credit at 

a below-market rate that would reduce the bank’s income for the benefit of 

its affiliate. Banking regulators have noted that pricing credit at belowmarket rates could also be an unsafe and unsound banking practice 

independent of whether the practice violates section 23B specifically. 

18As the Board observed in its proposed interpretation and guidance, as a general matter a 

tying arrangement violates the Sherman Act (15 U.S.C. §§ 1-7 (2000)) and the Clayton Act 

(15 U.S.C. §§ 12-27 (2000)) if (1) the arrangement involves two or more products, (2) the 

seller forces a customer to purchase the tied product, (3) the seller has economic power in 

the market for the tying product sufficient to enable the seller to restrain trade in the market 

for the tied product, (4) the arrangement has anticompetitive effects in the market for the 

tied product, and (5) the arrangement affects a “not insubstantial” amount of interstate 

commerce. See 68 Fed. Reg. at 52027, n. 20. 

19In October 2002, the Federal Reserve Board approved Regulation W, which 

comprehensively implements and unifies the Board’s interpretations of sections 23A and 

23B of the Federal Reserve Act. Regulation W became effective in April 2003, and restricts 

loans by a depository institution to its affiliates, asset purchases by a depository institution 

from its affiliates, and other transactions between a depository institution and its affiliates. 

Page 14 GAO-04-4 Bank Tying 
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.20 The Association for Financial 

Professionals reported that some respondents to their survey of financial 

executives at large companies (those with revenues greater than $1 billion) 

claimed to have experienced the denial of credit or a change in terms after 

they did not award a commercial bank their bond underwriting business. In 

our interviews with corporate borrowers, one borrower said that a 

commercial bank reduced the borrower’s amount of credit by $70 million 

when the borrower declined to purchase debt underwriting services from 

the bank’s investment affiliate. In addition, several newspapers and other 

publications have also reported instances where corporate borrowers have 

felt pressured by commercial banks to purchase products prohibited under 

section 106 for the customers to maintain their access to credit. In these 

20We did not report the specific results of the Association for Financial Professionals’ 

“Credit Access Survey: Linking Corporate Credit to the Awarding of Other Financial 

Services,” March 2003, because of several methodological limitations. In particular, we 

could not determine the degree to which these survey results represent the broad 

population of large companies, due to potential biases resulting from sample design and the 

low level of participation of sampled companies. Nevertheless, although this survey may not 

precisely estimate the extent of tying complaints among this population, the results suggest 

that at least some companies claimed to have experienced forms of tying. 

Page 15 GAO-04-4 Bank Tying 
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 renew, 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.21 

21The proposed guidance noted that such an arrangement would not force a customer to 

purchase a nontraditional product in violation of section 106. 

Page 16 GAO-04-4 Bank Tying 
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 also 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 

Page 17 GAO-04-4 Bank Tying 
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 106.22 

During the course of these examinations, examiners review banks’ policies, 

procedures, controls, and internal audits. Exam teams assigned to the 

largest commercial banks continually review banks throughout the year, 

and in several cases, the teams are physically located at the bank 

throughout the year. The Federal Reserve and OCC expect examiners to be 

alert to possible violations of section 106 of the Bank Holding Company Act 

Amendments of 1970 and section 23B of the Federal Reserve Act and to 

report any evidence of possible unlawful tying for further review. Regular 

bank examinations in recent years have not identified any instances of 

unlawful tying that led to enforcement actions. Federal Reserve officials 

told us, however, that if an examiner had tying-related concerns about a 

transaction that the bank’s internal or external legal counsel had reviewed, 

examiners deferred to the bank’s legal analysis and verified that the bank 

took any appropriate corrective actions. Federal Reserve officials also said 

that legal staffs at the Board and the District Reserve Banks regularly 

receive and answer questions from examiners regarding the permissibility 

of transactions. 

In a 1995 bulletin, OCC reminded national banks of their obligations under 

section 106 and advised them to implement appropriate systems and 

controls that would promote compliance with section 106.23 Along with 

examples of lawful tying arrangements, the guidance also incorporated 

suggested measures for banks’ systems and controls, and audit and 

compliance programs. Among the suggested measures were training bank 

employees about the tying provisions, providing relevant examples of 

prohibited practices, and reviewing customer files to determine whether 

22For example, Federal Reserve Board Supervision Manuals governing bank holding 

company and state member bank examinations and OCC Bulletin 95-20 all address section 

106. 

23OCC Bulletin 95-20 (April 14, 1995). 

Page 18 GAO-04-4 Bank Tying 
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.

24 For 

24After the Federal Reserve and OCC completed the targeted review, the Federal Reserve 

announced on August 27, 2003, that it had entered into a consent agreement and civil money 

penalty against WestLB AG, a German bank, and its New York branch, based on allegations 

that it had conditioned credit on the award of underwriting business in 2001. 

Page 19 GAO-04-4 Bank Tying 
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 Federal Reserve or OCC 

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 

Page 20 GAO-04-4 Bank Tying 
Federal Reserve and OCC, at other banks, lawyers reviewed all 

transactions for tying-related issues before they were completed. The 

training materials we reviewed from two banks included examples that 

distinguished lawful from unlawful tying arrangements. Banking regulators 

noted that some banking organizations had newly enhanced policies, 

procedures, and training programs as a result of recent media and 

regulatory attention. 

However, examiners also found that the oversight by internal audit 

functions at several banks needed improvement. In one case, they found 

that bank internal auditors were trained to look for the obvious indications 

of tying, but that banks’ audit procedures would not necessarily provide a 

basis to detect all cases of tying. For example, recent antitying training 

programs at two banks helped employees identify possible tying violations. 

Officials at one large banking organization also said that banks’ compliance 

efforts generally are constrained by the inability to anticipate every 

situation that could raise tying concerns. They also noted that banks could 

not monitor every conversation that bank employees had with customers, 

and thus guarantee that mistakes would never occur. 

In addition, examiners were concerned that certain arrangements might 

cause customer confusion when dealing with employees who work for 

both the bank and its investment affiliate. In those cases, it could be 

difficult to determine whether the “dual” employee was representing the 

bank or its affiliate for specific parts of a transaction. However, the 

examiners noted that in the legal analysis of one banking organization, the 

use of such dual employees was not necessarily problematic, given that the 

tie was created by the investment affiliate, rather than the bank, and that 

section 106 addresses the legal entity involved in a transaction and not the 

employment status of the individuals involved. Proposed Federal Reserve 

guidance did not add clarification to this matter beyond emphasizing the 

importance of training programs for bank employees as an important 

internal control. 

The targeted review concluded that the policies and procedures of the 

selected banks generally provided an adequate basis to enforce compliance 

with section 106, and identified only a limited number of instances where 

the bank’s interpretation of the law permitted actions that were questioned 

during the review. However, this targeted review was limited to an 

assessment of the banks’ controls environment; and as noted above, the 

review did not test a broad range of transactions for analysis or review and 

did not include any questions addressed to a broad selection of bank 

Page 21 GAO-04-4 Bank Tying 
customers. As the Federal Reserve’s proposed interpretation of section 106 

notes, however, 

“the determination of whether a violation of section 106 has occurred often requires a 

careful review of the specific facts and circumstances associated with the relevant 

transaction (or proposed transaction) between the bank and the customer.”25 

Customers could provide information on the facts and circumstances 

associated with specific transactions and provide a basis for testing 

whether the bank actions were in compliance with its policies and 

procedures. If the banks’ actions are not consistent with their policies and 

procedures, there could be violations of section 106. A review of the 

transactions would provide direct evidence of compliance or 

noncompliance with section 106. Further, information from analysis of 

transactions and information obtained from customers could provide the 

bank regulatory agencies with more information on the circumstances 

where there could be a greater risk of tying, contributing to their risk-based 

examination strategies. 

Federal Reserve and OCC 

Identified Several 

Interpretive Issues 

The examiners and attorneys participating in the targeted review found 

variations in banks’ interpretation of section 106 in areas where 

authoritative guidance was absent or incomplete at the time of the review. 

One interpretative issue was the extent to which a bank could consider the 

profitability of the overall customer relationship in making credit 

decisions, particularly whether a bank could consider a customer’s use of 

nontraditional banking services in deciding to terminate the customer 

relationship without violating section 106. This issue also encompassed the 

appropriateness of the language that a bank might use when entering into 

or discontinuing credit relationships—including whether a bank could 

appropriately use language implying the acceptance of a tied product in a 

letter formalizing a commitment for a loan and communication protocols 

that a bank might use to disengage clients who did not meet internal 

profitability targets. 

Examiners found that all banks in the joint targeted review had undergone 

a “balance sheet reduction,” disengaging from lending relationships with 

their least desirable customers. An official at one commercial bank 

2538 Fed. Reg. at 52026. 

Page 22 GAO-04-4 Bank Tying 
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.26 For example, a bank conducting a credit 

analysis for both commercial and investment banking services and 

reducing the overall fees to only include one credit analysis might raise 

tying considerations. Banks and their outside counsels believed that this 

price reduction would be appropriate. However, the Federal Reserve staff 

said that whether or not a price reduction would be appropriate would 

depend on the facts and condition of the transaction, including whether or 

not the bank offered the customer the opportunity to obtain the discount 

from the bank separately from the tied product. 

Examiners were also concerned that some bank transactions might appear 

to circumvent section 106. For example, the examiners found one instance 

in which a nonbank affiliate had tied bridge loans to the purchase of 

securities underwriting and syndicated some or all of the loans to its 

commercial bank. The examiners noted that although this issue had not 

been addressed in the guidance available at the time, this arrangement 

created the appearance of an attempt to circumvent the application of 

section 106. The bank thereupon discontinued the practice. As mentioned 

previously, because section 106 applies only to banks,it is not a violation of 

the section for most nonbank affiliates of commercial banks to tie together 

any two products or services. The banks thereupon discontinued the 

practice. 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 

26A bridge loan is an interim financing arrangement provided by a bank, investment bank, or 

special purpose investment fund to allow a corporation to make an acquisition before 

arranging permanent financing to carry the acquisition. 

Page 23 GAO-04-4 Bank Tying 
have their principal place of business outside the United States.27 This safe 

harbor also applies to individuals who are citizens of a foreign country and 

are not resident in the United States. However, 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 also 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. 

27See also, 83 Fed. Res. Bulletin 275 (April 1997). Federal Reserve Board Bank Holding 

Company Supervision Manual, Section 3500.0.2.3, Safe Harbor for Foreign Transactions. 

Page 24 GAO-04-4 Bank Tying 
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 In recent years, the market share of the fees earned from debt and equity 

Commercial Banks Have underwriting has declined at investment banks and grown at investment 

Gained Market Share in 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 Underwriting market share that these investment banks held in 1995. In comparison, the 

market share of the three largest investment affiliates of commercial banks 

Page 25 GAO-04-4 Bank Tying 
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.

28 A syndicated loan is financing provided by a group 

of commercial banks and investment banks whereby each bank agrees to 

advance a portion of the funding. Commercial bankers contended that 

these prices of the loans and loan commitments reflected a competitive 

market, where individual lenders have no control over prices. 

Officials from one investment bank who contended that banking 

organizations have underpriced credits to win investment banking business 

drew comparisons between the original pricing terms of specific 

syndicated loans and the pricing of the same loans in the secondary 

market. Specifically, they pointed to several transactions, including one in 

which they questioned the pricing but participated because the borrower 

insisted that underwriters provide loan commitments. The investment bank 

officials said that when they subsequently attempted to sell part of their 

28Commercial paper is an unsecured obligation issued by a corporation or bank to finance 

its short-term credit needs, such as accounts receivable and inventory. Commercial paper is 

usually issued by companies with high credit ratings. Commercial paper is available in a 

wide range of denominations and can be either discounted or interest bearing. Maturities for 

commercial paper typically range from 2 to 270 days. Commonly, companies issuing 

commercial paper will also obtain a backup loan commitment that would provide funds if 

the company is unable to payoff or roll over the commercial paper as it matures. 

Page 26 GAO-04-4 Bank Tying 
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.29 Bankers also noted that if loans were underpriced, the syndicators 

would not be able to syndicate the loan to investors who are not engaged in 

debt underwriting and insist on earning a competitive return. An official 

from one commercial bank provided data on its syndicated loans, showing 

that a number of the participants in the loans and loan commitments did 

not participate in the associated securities underwriting for the borrower 

and—in spite of having no investment banking business to win—found the 

terms of the loans and loan commitments attractive. However, we do not 

know the extent, if any, to which these other participants might have had 

other revenue-generating business with the borrowers. 

Officials from a commercial bank and loan market experts also said that 

the secondary market for loans was illiquid, compared with that for most 

securities. The bank officials said that therefore prices could swing in 

response to a single large sale as a result of this illiquidity. Officials from 

one commercial bank said that the price of the loan to which investment 

bank officials referred, which had sold for about 93 cents on the dollar 

shortly after origination, had risen to about 98 cents on the dollar in 

secondary trades a few months later. These officials said that, in their 

opinion, this return in pricing toward the loan’s origination value is proof 

that the syndicated loan was never underpriced and that the movement in 

price was the result of a large portion of the facility being sold soon after 

the origination. Independent loan market experts also observed that 

trading in loan commitments is illiquid, and thus subsequent price 

fluctuations might not reflect fair value. 

29A basis point is a measure of a bond’s yield, equal to 1/100th of 1 percent of yield. 

Page 27 GAO-04-4 Bank Tying 
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.30 Banks and other financial institutions can use credit 

default swaps, among other instruments, to reduce or diversify credit risk 

exposures. With a credit default swap, the lender keeps the loan or loan 

commitment on its books and essentially purchases insurance against 

borrower default. 

Officials at one investment bank compared the prices of syndicated loans 

with the prices of credit default swaps used to hedge the credit risk of the 

loan. In their view, the differences in the two prices demonstrated that 

commercial banks underpriced corporate credit. They provided us with 

several examples of syndicated loans, wherein the difference between the 

interest rate on the loan or loan commitment and the corresponding credit 

default swap was so great that the investment bankers believed that the 

bank would have earned more from insuring the credit than extending it. 

On the other hand, Federal Reserve officials, commercial bankers, and loan 

market experts disputed the extent to which the pricing of corporate credit 

could be compared with their corresponding credit default swaps, because 

of important differences between the two products and between the 

institutions that dealt in them. Officials from the Federal Reserve noted 

that the triggering mechanisms for the two products differed. Although the 

trigger for the exercise of a credit default swap is a clearly defined 

indication of the borrower’s credit impairment, the exercise of a 

commercial paper back-up line is triggered by the issuer’s inability to 

access the commercial paper market—an event that could occur without 

there necessarily being any credit impairment of the issuer. For example, in 

1998, Russia’s declaration of a debt moratorium and the near-failure of a 

large hedge fund created financial market turmoil; since this severely 

disrupted corporations’ issuance of bonds and commercial paper, they 

drew on their loan commitments from banks. In addition, loan market 

30Credit default swaps are financial contracts that allow the transfer of credit risk from one 

market participant to another, potentially facilitating greater efficiency in the pricing and 

distribution of credit risk among financial market participants. In a “plain vanilla” credit 

default swap, the protection buyer agrees to make periodic payments (the swap “spread” or 

premium) over a predetermined number of years (the maturity of the credit default swap) to 

the protection seller in exchange for a payment in the event of default by a third party. 

Typically, credit default swaps premiums are paid quarterly, and the most common 

maturities are 3, 5, and 10 years. 

Page 28 GAO-04-4 Bank Tying 
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 backup 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 

Page 29 GAO-04-4 Bank Tying 
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.31 

It also could provide useful supervisory information. If the study finds 

indications that pricing of credit to customers who also use underwriting 

services is lower than other comparable credit, this could lend support to 

the investment banker’s allegations of violations of section 23B. However, if 

the charges are not valid and credit pricing does reflect market conditions, 

31Preliminary results from an academic study of loan pricing and securities underwriting 

suggest that the rates charged on loans to corporate borrowers who subsequently purchase 

underwriting services from an investment affiliate of the lender were not lower than rates 

charged on loans not followed by the purchase of underwriting services. See Charles W. 

Calomiris and Thanavult Pornrojnangkool, “Tying, Relationship Banking, and the Repeal of 

Glass Stegall,” Unpublished paper presented at the American Enterprise Institute, Sept. 24, 

2003. 

Page 30 GAO-04-4 Bank Tying 
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 financial 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. 

Page 31 GAO-04-4 Bank Tying 
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.32 In the historic carrying value model, commercial banks 

are not allowed to reflect changes in the fair value of loan commitments in 

their earnings. However, commercial banks are required to disclose the fair 

value of all loan commitments in the footnotes to their financial 

statements, along with the method used to determine fair value.33 

Some investment banks follow the AICPA Audit and Accounting Guide, 

Brokers and Dealers in Securities, which directs them to record the fair 

value of loan commitments.34 The AICPA guidance is directed at brokerdealers 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. 35 When using the fairvalue model, investment banks must recognize in income gains or losses 

resulting from changes in the fair value of a financial instrument, such as a 

32The historic carrying value of a loan commitment is the value of the loan commitment 

service fees at the time a firm extends the commitment. The fees received are recognized 

either over the life of the loan commitment when the likelihood of the borrower exercising 

the commitment is remote or over the life of the loan if the commitment is exercised. 

33This is required by FAS No. 107, Disclosures about Fair Value of Financial Instruments. 

34The fair value of a loan commitment is generally based on quoted market prices of similar 

transactions or modeling with market data. 

35It is important to note that, in practice, investment banks often do not hold loan 

commitments in their broker-dealer subsidiaries because of the high capital requirements of 

broker-dealers. (We discuss the regulatory capital requirements of broker-dealers in greater 

detail in the next section.) 

Page 32 GAO-04-4 Bank Tying 
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.36 The investment bank officials 

contended that the current accounting standards facilitate this alleged 

underpricing of credit because commercial banks record loan 

commitments at their historic value rather than their current value, which 

might be higher or lower, and do not have to report the losses incurred in 

extending an allegedly underpriced loan commitment. 

Officials from some investment banks also claimed that the historic 

carrying value model allowed commercial banks to hide the risk of these 

allegedly underpriced loan commitments from stockholders and market 

analysts, because the model did not require them to report changes in the 

value of loan commitments. Officials said that differences in accounting for 

36The historic carrying value model does not permit commercial banks to record these 

changes in value. 

Page 33 GAO-04-4 Bank Tying 
identical transactions might put investment banks at a disadvantage; 

compared with commercial banks when analysts reviewed their quarterly 

filings. Yet, 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 

Page 34 GAO-04-4 Bank Tying 
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 intial 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.

37 In this 

situation, both commercial banks and investment banks would be required 

to establish an allowance for probable or possible losses, based on the 

37Although investment banks generally classify financial instruments as inventory and 

account for them at fair value, AICPA Task Force members and some investment bankers 

noted that, in some instances, the firms might decide to hold a loan for the foreseeable 

future or until maturity. In this case, the loan would not be classified as held-for-sale and 

would not be accounted for at fair value. 

Page 35 GAO-04-4 Bank Tying 
estimated degree of impairment of the loan commitment or historic 

experience with similar borrowers.

38 

If both an investment bank and a commercial bank decided to sell a loan 

that it previously had the intent and ability to hold for the foreseeable 

future or until maturity, the firms would follow different guidance that 

would produce similar results. A commercial bank would follow the 

AICPA’s Statement of Position 01-6, Accounting by Certain Entities 

(Including Entities With Trade Receivables) That Lend to or Finance the 

Activities of Others that was issued in December, 2001. According to this 

guidance, once bank management decides to sell a loan that had not been 

previously classified as held-for-sale, the loan’s value should be adjusted to 

the lower of historical cost or fair value, and any amount by which 

historical cost exceeds fair value should be accounted for as a valuation 

allowance. Further, as long as the loan’s fair value remained less than 

historical cost, any subsequent changes in the loan’s fair value would be 

recognized in income. The investment bank would follow the guidance in 

the AICPA’s Audit and Accounting Guide, Brokers and Dealers in 

Securities, and account for inventory, the loan in this instance, at fair value 

and recognize changes in the fair value in earnings. 

Capital Requirements Do 

Not Give Commercial Banks 

a Competitive Advantage 

Regulatory capital is the minimum long-term funding level that financial 

institutions are required to maintain to cushion themselves against 

unexpected losses, and differing requirements for commercial banks and 

broker-dealers reflect distinct regulatory purposes.39 The primary purposes 

of commercial bank regulatory capital requirements are to maintain the 

safety and soundness of the banking and payment systems and to protect 

the deposit insurance funds. Under the bank risk-based capital guidelines, 

off-balance sheet transactions, such as loan commitments, are converted 

38According to FAS 114: Accounting by Creditors for Impairment of a Loan, a loan is 

considered impaired when, based on current information and events, it is probable that a 

creditor will be unable to collect all amounts due according to the contractual terms of the 

loan agreement. To comply with FAS 114, creditors must create a valuation allowance that 

reduces the value of the loan with a corresponding charge to a bad-debt expense. When a 

loan is not impaired, creditors must follow FAS 5: Accounting for Contingencies and 

establish an allowance for loss when there is at least a reasonable possibility that a loss or 

an additional loss might be incurred. 

39U.S. General Accounting Office, Risk Based Capital: Regulatory and Industry 

Approaches to Capital and Risk, GAO/GGD-98-153 (Washington, D.C.: July 1998). 

Page 36 GAO-04-4 Bank Tying 
into one of four categories of asset equivalents.40 Unfunded loan 

commitments of one year or less are assigned to the zero percent 

conversion category, which means that banks are not required to hold 

regulatory capital for these commitments. In contrast, the primary 

purposes of broker-dealers’ capital requirements are to protect customers 

and other market participants from losses caused by broker-dealer failures 

and to protect the integrity of the financial markets. The SEC net capital 

rule requires broker-dealer affiliates of investment banks to hold 100-

percent capital against loan commitments of any length. 41 However, 

nonbroker-dealer affiliates of investment banks are not subject to any 

regulatory capital requirements, and are therefore not required to hold 

regulatory capital against loan commitments of any length. 

It is costly for banks or other institutions to hold capital; thus, to the extent 

that the level of regulatory capital requirements determines the amount of 

capital actually held, lower capital requirements can translate into lower 

costs. Officials from an investment bank contended that bank capital 

requirements gave commercial banks with investment affiliates a cost 

advantage they could use when lending to customers who also purchased 

underwriting business. They said that because banks’ regulatory capital 

requirements for unfunded credits of 1 year or less were zero, commercial 

banks had the opportunity to adjust the length of credit commitments to 

avoid capital charges. Furthermore, officials said that the ability to avoid 

capital charges allowed commercial banks to underprice these loan 

commitments, because they could extend the commitments without the 

cost of assigning additional regulatory capital. They pointed to the high 

percentage of credit commercial banks structured in 364-day facilities as 

evidence that banks structure underpriced credit in short-term 

arrangements to avoid capital charges. 

We found no evidence that bank regulatory capital requirements provided 

commercial banks with a competitive advantage. Although investment 

banks could face a 100-percent regulatory capital charge if they carried 

loan commitments in their broker-dealer affiliates, investment bank 

officials and officials from the SEC said that, in practice, investment banks 

carried loan commitments outside of their broker-dealer affiliates, and thus 

40Effective 1990, U.S. banking regulators added regulatory capital requirements for loan 

commitments with maturities greater than 1 year. Previously, there had been no regulatory 

capital requirements for unfunded loan commitments of any length. 

41SEC Rule 15c3-1(c)(2)(viii). 

Page 37 GAO-04-4 Bank Tying 
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.42 The Federal Reserve discount 

window allows banks and other organizations to borrow funds from the 

Federal Reserve.43 Commercial banks’ ability to hold deposits backed by 

federal deposit insurance provides them with a low-cost source of funds 

available for lending. 

Industry observers and banking regulators agreed that commercial banks 

receive a subsidy from the federal safety net; however, they differed on the 

extent to which the subsidy was offset by regulatory costs. Although 

officials at the Federal Reserve and at an investment bank contended that 

access to the federal safety net gave commercial banks a net subsidy, 

officials from OCC and an industry observer said that the costs associated 

with access to the safety net might offset these advantages. We could not 

measure the extent to which regulatory costs offset the subsidy provided 

by the access to the federal safety net because reliable measures of the 

regulatory costs borne by banks were not available. 

42The federal safety net also includes access to the Federal Reserve payments system. 

Because the investment bankers with whom we spoke did not mention the payments system 

as a competitive advantage, we omitted this aspect from our discussion of the federal safety 

net. 

43In unusual and exigent circumstances, and after consulting with the Board of Governors of 

the Federal Reserve System, a Federal Reserve Bank can extend credit to an individual, 

partnership, or corporation that is not a depository institution if, in the judgment of the 

Federal Reserve Bank, credit is not available from other sources and failure to obtain such 

credit would adversely affect the economy. 

Page 38 GAO-04-4 Bank Tying 
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 

Page 39 GAO-04-4 Bank Tying 
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 

recommendation. 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 

Page 40 GAO-04-4 Bank Tying 
issuance date. At that time, we will send copies to 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. 


Richard Hillman, Director


Financial Markets and Community Investment


Page 41 GAO-04-4 Bank Tying 
Appendix I 

Differences in Accounting between 

Commercial and Investment Banks for Loan 

Commitments 

Because commercial and investment banks follow different accounting 

models, there are differences in the financial statement presentation of 

some similar transactions. This appendix summarizes the differences, 

under generally accepted accounting principles in how commercial banks 

and investment banks account for loan commitments—specifically 

commercial paper back-up credit facilities—using hypothetical scenarios 

to illustrate how these differences could affect the financial statements of a 

commercial and investment bank. 1 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. 2 

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 

1

Commercial paper is generally a short-term, unsecured, money-market obligation issued by 

prime rated commercial firms and financial companies. A commercial paper back-up facility 

is generally a short-term bank line of credit that serves as an alternate source of liquidity for 

an issuer of commercial paper lasting less than 1 year. 

2

FASB has defined fair value in FAS 107, Disclosures about Fair Value of Financial 

Instruments, as the amount at which a financial instrument could be exchanged in a current 

transaction between willing parties, other than a forced liquidation sale. 

Page 42 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


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. 3

 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.4

 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 industryspecific 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 

3

The net book value of a loan is generally its unpaid principal balance less any allowance for 

credit losses. 

4

FASB has defined a financial instrument as cash, evidence of an ownership interest in an 

entity, or a contract that both imposes on one entity a contractual obligation to (1) deliver 

cash or another financial instrument to a second entity or (2) to exchange other financial 

instruments on potentially unfavorable terms with the second entity and conveys to that 

second entity a contractual right to (1) receive cash or another financial instrument from the 

first entity or (2) to exchange other financial instruments on potentially favorable terms 

with the first entity. 

Page 43 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


Accounting for Nonrefundable Fees and Costs Associated with 

Originating or Acquiring Loans and Initial Direct Costs of Leases.

5 

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.6

 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 

5

FAS 91 Accounting for Nonrefundable Fees and Costs Associated with Originating or 

Acquiring Loans and Initial Direct Costs of Leases applies to loan commitments held by 

lending institutions. If a commercial bank held a loan commitment in a broker-dealer 

affiliate registered with the Securities and Exchange Commission, the affiliate would follow 

the AICPA guidance for broker-dealers. 

6

For simplicity, in this appendix the term investment bank will be used to mean an 

investment bank in which the broker-dealer comprises a majority of the financial activity. In 

practice, investment banks do not often hold loan commitments in their broker-dealer 

affiliates because of the high capital requirements of broker-dealers; rather, the investment 

bank would generally hold these financial instruments in a nonbroker-dealer affiliate. 

However, according to AICPA staff, at the consolidated level, the entity would retain the 

specialized accounting model used for the broker-dealer subsidiary. The commercial bank 

would continue to use FAS 91 to account for its loan commitments. A nonbroker-dealer that 

is a subsidiary of a broker-dealer holding company (not a bank holding company) may also 

follow the accounting used by its broker-dealer subsidiary, if the broker-dealer comprises 

the majority of the financial activity of the consolidated entity; that is, the fair-value model 

would also be used for the consolidated broker-dealer holding company financial 

statements. 

Page 44 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


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.”7 

Commercial Bank A would follow the accounting requirements of FAS No. 

7

The concept of materiality is discussed at length in FASB’s Concept Statement 2, 

Qualitative Characteristics of Accounting Information, paragraphs 123 – 132. 

Page 45 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


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.8

 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.9 

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 

8

If the likelihood of exercising this commitment had not been remote, Commercial Bank A 

would have followed the requirements of FAS 91, and not amortized the deferred revenue 

until the commitment was exercised. Once exercised, the bank would recognize the fee 

income over the life of the loan. If the commitment remained unexercised, income would be 

recognized upon expiration of the commitment. 

9

This is required by FAS No. 107, Disclosures about Fair Value of Financial Instruments. 

Page 46 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


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 

Page 47 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


volatility of the financial markets more transparently in Investment B’s 

financial statements. The magnitude of the difference is determined by the 

market conditions at the time and could be significant or minor. However, 

these differences would be resolved by the end of the commitment period, 

when both entities would have recognized the same amount of total 

revenue for the loan commitment. 

Table 1: Accounting Differences for a Loan Commitment 

Commercial Bank A Investment Bank B 

Accounting period 

Service-fee 

revenue 

recognized 

Balance of 

deferred 

revenue 

Service-fee 

revenue 

recognized 

Balance of 

deferred 

revenue 

Initial recording of 

the credit facility $0 $10,000 $0 $10,000 

1 3,333 6,667 2,000 8,000 

2 3,333 3,334 500 7,500 

3 3,334 0 7,500 

Total service-fee 

revenue 

recognized $10,000 $10,000 

Source: GAO. 

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 At the time the loan was made, Commercial Bank A would record the $100 

to Maturity	 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 

Page 48 GAO-04-4 Bank Tying 

0 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


($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 baddebt 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.10 Thus, both banks 

would establish an allowance for loss in line with historical performance 

for borrowers of this type.11 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 

10On June 19, 2003, AICPA issued an exposure draft of a proposed statement of position for 

allowance for credit losses. This exposure draft proposes various revisions to how banks 

would estimate credit losses and report them on their financial statements and is proposed 

to be implemented after December 15, 2003. 

11FAS 5 states that receivables by their nature usually involve some degree of uncertainty 

about their collectibility, in which case a loss contingency exists. If a loss were not probable 

and estimable, both banks would disclose in their financial statement footnotes, the loss 

contingency when there was at least a reasonable possibility that a loss or additional 

loss might be incurred. 

Page 49 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


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.12 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 01-6.13 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 

12In order to keep this exception scenario example simple, it is also assumed that there are 

not conditions that would constrain Commercial Bank A and Investment Bank B from 

selling the loan, that both banks will not retain any interest in the loans sold, and the loans 

are sold without recourse. 

13Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend 

to or Finance the Activities of Others, December, 2001. 

Page 50 GAO-04-4 Bank Tying 
Appendix I


Differences in Accounting between


Commercial and Investment Banks for Loan 


Commitments


recognized in other comprehensive income.14 Investment Bank B would 

follow the guidance in the AICPA’s Audit and Accounting Guide, Brokers 

and Dealers in Securities, as it did with loan commitments, and account 

for inventory at fair value and report changes in the fair value of the loan in 

net income. 

For example, if bank management decided to sell the loan soon after it was 

drawn when some payments had been made to reduce the principal 

balance and the net book value of this loan was $88,200,000 (unpaid 

principal balance of $90,000,000 less the related allowance of $1,800,000) 

and the fair value was 97 percent of the unpaid principal balance or 

$87,300,000, both banks would recognize the decline in value of $900,000 in 

earnings. While the loan remained available-for-sale, any changes in its fair 

value would be recorded in net income. For example, if the loan’s fair value 

declined further to $85,500,000, both banks would recognize the additional 

decline in value of $1,800,000 in earnings. 

Table 2 below summarizes the accounting similarities between Commercial 

Bank A and Investment Bank B for the loan sale. Although the two banks 

followed different guidance, the effect of the loan sale is the same for both 

banks. 

Table 2: Accounting Differences for a Loan Sale 

Commercial Bank A loss Investment Bank B loss 

Transaction amount amount 

Transfer the loan to the 

trading portfolio <$900,000> <$900,000> 

Change in fair value <$1,800,000> <$1,800,000> 

Total loss on loan sale <$2,700,000> <$2,700,000> 

Source: GAO. 

14Comprehensive income is defined in FAS 130, Reporting Comprehensive Income, as the 

change in equity [net assets] of a business during a period from transactions and other 

events and circumstances from nonowner sources. It includes all changes in equity during a 

period except those resulting from investments by owners and distributions to owners. 

Page 51 GAO-04-4 Bank Tying 
Appendix II 

Comments from the Federal Reserve System


Page 52 GAO-04-4 Bank Tying 
Appendix II


Comments from the Federal Reserve System


Page 53 GAO-04-4 Bank Tying 
Appendix III 

Comments from the Office of the Comptroller 

of the Currency 

Page 54 GAO-04-4 Bank Tying 
Appendix III


Comments from the Office of the Comptroller 


of the Currency


Page 55 GAO-04-4 Bank Tying 
Appendix IV 

GAO Contacts and Staff Acknowledgments


GAO Contacts	 Richard Hillman, (202) 512-8678 

James McDermott, (202) 512-5373 

Acknowledgments	 In addition to those individuals named above, Daniel Blair, 

Tonita W. Gillich, Gretchen Pattison, Robert Pollard, Paul Thompson, and 

John Treanor made key contributions to this report. 

(250145) Page 56 GAO-04-4 Bank Tying 
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