At times, concerns have been raised that banks may use deposits, and especially insured deposits, to fund risky activities by affiliates within bank holding companies, posing risk to the banks, depositors, and the FDIC’s Deposit Insurance Fund (“DIF”). In recent years, these concerns have been voiced by some who may not have a full appreciation or understanding of existing legal firewalls, including Sections 23A and 23B of the Federal Reserve Act, specifically designed to prevent the misuse of U.S. bank resources, including deposits.

Sections 23A and 23B impose significant restrictions and conditions on all FDIC-insured banks entering into transactions with their affiliates. Pursuant to these laws, the Federal Reserve promulgated Regulation W in 2002 to define further the restrictions. Federal Reserve staff has issued numerous opinions and supervisory guidance to prevent banks from being misused as a funding source for activities of their affiliates. U.S. federal bank examiners monitor banks’ compliance with restrictions imposed by Sections 23A and 23B through on-site examinations and mandatory reporting requirements.

Section 23A protects deposits, depository institutions, and the DIF in the following ways:

• Quantitative limits: A bank’s “covered transactions” with any single affiliate (a term very broadly defined under applicable law) cannot exceed 10% of its capital, and transactions with all bank affiliates cannot exceed 20% of the bank's capital. (“Covered transactions” include loans and other extensions of credit to an affiliate, investments in the securities of an affiliate, purchases of assets from an affiliate, issuances of guarantees on behalf of an affiliate, and many other transactions exposing a bank to an affiliate’s credit risk).
• Collateral Requirements: An extension of credit by the bank to an affiliate and any guarantee on behalf of an affiliate must be appropriately secured by a statutorily defined amount of collateral (i.e., with a specified market value depending on the type of collateral used).
• Other Prudential Limitations: All covered transactions between a bank and its affiliate must be on terms and conditions that are consistent with safe and sound banking practice; moreover, a bank is generally prohibited from purchasing “low-quality assets” from its affiliates.

Section 23B complements 23A in several respects, including by requiring that transactions between banks and their affiliates be conducted on market terms, i.e., terms and circumstances substantially similar to those of comparable transactions with unaffiliated companies, commonly referred to as “arm’s length.” For example, Section 23B applies to:

• Transactions covered by Section 23A;
• Sale of assets by a bank to an affiliate;
• The provision of services by a bank to an affiliate; and
• A transaction by a bank with a third party in which an affiliate has a financial interest.

Sections 608 and 609 of the Dodd-Frank Act (“DFA”) strengthened and expanded the scope of 23A and 23B. Important changes – which came into effect in July 2012 – made by the DFA include:

• The Federal Reserve’s ability to grant exemptions from Sections 23A or 23B was restricted, and the FDIC’s role in future exemptions expanded.
• The definition of “affiliate” was amended to include any “investment fund” for which a bank or an affiliate serves as investment adviser.
• Derivatives transactions and securities lending and borrowing that result in credit exposures to the affiliate are covered by Sections 23A and 23B.
• Section 23A collateral requirements for credit transactions with affiliates were strengthened.
• A partial exemption under Section 23A for covered transactions between banks and their financial subsidiaries was removed.
• The definition of covered transaction under Section 23A was amended to cover the acceptance of debt obligations (as well as securities) of an affiliate as collateral for a loan or extension of credit.
• The definition of “loan or extension of credit” was expanded to include many derivatives, reverse repos, and securities lending and borrowing, all of which are now subject to 23A.

Sections 23A and 23B are specifically designed to restrict use of U.S. bank resources to fund affiliate activities that are disallowed inside the bank itself. Policymakers should take these long-standing protections into account when considering the future of bank regulation.

The Clearing House, established in 1853 to bring order to clearing and settlement between banks, is the nation’s oldest banking association and payments company.