What Is Regulation W?
Regulation W places limitations on specific types of transactions that can occur between banks and their affiliated entities. Financial reforms after 2008 have led to tighter rules for banks to comply with Regulation W. The Dodd-Frank Act broadened the scope of what is considered a bank affiliate and the transactions subject to Regulation W.
U.S. Federal Reserve System (FRS) Regulation W restricts transactions between depository institutions and their affiliates. It enforces quantitative limits and mandates collateral for specific transactions. The regulation applies to Federal Reserve member banks, insured state non-member banks, and insured savings associations. It was introduced to streamline interpretations and rulemaking under Sections 23A and 23B of the Federal Reserve Act.
What Is Regulation W?
Regulation W, a crucial implementation of sections 23A and 23B within the Federal Reserve Act, took effect on April 1, 2003, following its publication on December 12, 2002.
The primary objective of sections 23A and 23B, as enforced by Regulation W, is to mitigate the risks faced by banks in transactions with their affiliates. Additionally, the regulation restricts depository institutions from transferring the benefits arising from their access to the federal safety net – which includes advantages like lower-cost insured deposits and access to the discount window – to their affiliates. This is achieved by imposing both quantitative and qualitative limits on the extension of credit and other specific transactions between banks and their companions.
Remarkably, Regulation W is an all-encompassing framework that resolves nine significant issues, such as derivative transactions, intraday credit, and financial subsidiaries. The regulation integrates 70 years' worth of interpretive guidance to address complex statutory requirements effectively.
Navigating Regulation W
The potential for funding somewhat risky purposes lies within the diversified holding company structure of most large U.S. banks. Regulation W steps in with a straightforward conceptual approach to curb this risk, albeit a challenging implementation. Some banks face particular difficulties complying with Regulation W, especially those dealing with rapid growth in capital market activities or integrating previous acquisitions.
Even before the post-2008 financial crisis regulatory reforms, complying with Regulation W proved complex. The Dodd-Frank Wall Street Reform and Consumer Protection Act added further rigidity to the regulation's requirements, drawing criticism for its perceived burdensome nature.
Notably, the financial crisis prompted exemptions under Regulation W to provide emergency liquidity to affiliates. However, new rules restricted the Fed's sole authority to grant exemptions. Instead, the Federal Deposit Insurance Corporation (FDIC) now has 60 days to assess the justification for an exemption and identify any potential risks to its deposit insurance fund.
Additionally, modifications to Regulation W expanded the definition of "affiliate" and "covered transaction," demanding greater transparency from banks as they adhere to the regulation. At its core, Regulation W endeavors to safeguard banks and federal deposit insurance funds from unwarranted financial risk.
Applicability of Regulation W
Regulation W's scope involves covered transactions between a bank and its affiliate, prompting two fundamental questions for determining its applicability:
- Is the transaction between a bank and its affiliate?
- Does the transaction qualify as a "covered transaction"?
Regulation W defines a bank's affiliates quite expansively, encompassing companies directly or indirectly controlled by the bank, as well as those sponsored and advised by the bank, including its subsidiaries.
Covered transactions, as per Regulation W, encompass a wide range of dealings, such as:
- Extending credit to an affiliate
- Investing in securities issued by an affiliate
- Making asset purchases from an affiliate
- Accepting securities issued by an affiliate as collateral for credit
- Issuing a guarantee or letter of credit on behalf of an affiliate.
Regulation W Compliance and Monitoring
To adhere to Regulation W, financial institutions must ensure that transactions with any affiliate do not exceed 10% of the institution's capital, and all combined affiliate transactions must stay within 20% of the institution's capital.
The regulation also prohibits banks from acquiring low-quality assets from their affiliates, such as bonds with overdue principal and interest payments, by more than 30 days. Additionally, any credit extension must be backed by collateral, ranging from 100% to 130% coverage of the total transaction amount.
Consider a hypothetical scenario where BigBanc, a bank, plans to purchase a loan portfolio from its subsidiary, SmallBanc. To comply with Regulation W, BigBanc must ensure that the transaction stays within 10% of its capital, the loan portfolio is not deemed low-quality, and the transaction follows market terms and conditions.
The Federal Reserve monitors banks' exposures to their affiliates by submitting quarterly FR Y-8 reports, which gather information on transactions between insured depository institutions and their companions. These reports must be submitted on the last calendar day of each quarter.
Non-compliance with Regulation W can result in substantial civil penalties. The fines are determined based on intent, reckless disregard for financial safety and soundness, and any gains resulting from the violation.
Regulation W, fittingly named the 23rd regulation in the Federal Reserve Bank's "alphabet regulations," governs covered transactions between a bank and its affiliates as stipulated in Section 23A of the Federal Reserve Act. Section 23A outlines the criteria for companies to be considered bank affiliates and specifies the types of transactions covered by this statute. It also establishes quantifiable restrictions on a bank's covered transactions with individual affiliates and the cumulative total with all affiliates. Additionally, the regulation outlines collateral requirements for specific bank transactions with affiliates.