Regulation W is a U.S. Federal Reserve regulation that limits certain transactions between depository institutions, such as banks, and their affiliates. It sets quantitative limits on covered transactions and requires collateral for specific types of engagements.
The regulation applies to banks that are members of the Federal Reserve, insured state non-member banks, and insured savings associations. Regulation W was introduced to consolidate decades of interpretations and rulemaking under Sections 23A and 23B of the Federal Reserve Act.
Key Insights
- Regulation W restricts particular types of transactions between banks and their affiliates.
- Financial reforms following the 2008 crisis have tightened these rules significantly.
- The Dodd-Frank Act expanded the scope of what constitutes a bank affiliate and the spectrum of transactions covered.
Understanding Regulation W
Regulation W implements Sections 23A and 23B of the Federal Reserve Act. Published on December 12, 2002, and effective from April 1, 2003, it sets profound limitations on the risks a bank can take on through transactions with its affiliates.
These statutes aim to prevent a depository institution from transferring benefits received from federal protections—such as insured deposits and access to the discount window—to its affiliates. This is achieved by enforcing qualitative and quantitative limits on the bank’s ability to extend credit or engage in specific other transactions with its affiliate.
Even before the 2008 reforms, Regulation W encompassed decades of interpretive guidance. In January 2003, it was noted to include over 70 years of regulatory insights into areas like derivative transactions, intraday credit, and financial subsidiaries.
Complying With Regulation W
For large U.S. banks, existing under a diversified holding company structure, the risk of bank funds being mobilized for risky activities is notably high. Regulation W aims to mitigate this risk. Despite its seemingly straightforward principles, the implementation of Regulation W is complex, posing significant compliance challenges, especially amid rapid growth or acquisitions.
The complexity of complying with Regulation W increased further with the reforms following the 2008 crisis under the Dodd-Frank Act, which is often criticized for its heavy burdens.
Regulation W ensures no excessive self-financing during emergencies by curbing the ability of the Federal Reserve to grant exemptions unilaterally. With reforms, institutions must get joint approval from the Federal Deposit Insurance Corporation (FDIC), especially if the exemption might pose a risk to the FDIC’s insurance fund.
Additionally, the definition of “affiliate” and what constitutes a “covered transaction” has expanded. Modern banking regulators expect banks to display heightened transparency in compliance activities.
When Does Regulation W Apply?
Determining the applicability of Regulation W to a transaction depends on two primary questions:
- Is the transaction between a bank and its affiliate?
- Is the transaction a “covered transaction”?
Regulation W broadly defines a bank’s affiliates to include any company directly or indirectly controlled by the bank, in addition to entities sponsored and advised by the bank and its subsidiaries.
Covered transactions encompass:
- Extending credit to an affiliate
- Investment in securities issued by an affiliate
- Asset purchases from an affiliate
- Securities issued by an affiliate accepted as collateral for credit
- Guarantees or letters of credit issued on behalf of an affiliate
Special Considerations
Transactions with any single affiliate must not exceed 10% of the bank’s capital, while transactions with all affiliates combined must not exceed 20% of the capital. Additionally, banks are restricted from purchasing low-quality assets (e.g., bonds more than 30 days past due) from affiliates.
Example: Compliance Scenario
Consider BigBanc planning to purchase a loan portfolio from its subsidiary SmallBanc. To comply with Regulation W, BigBanc must ensure the transaction doesn’t exceed 10% of its capital and the loan portfolio isn’t low-quality. Moreover, the transaction must occur under market terms and conditions.
The Federal Reserve monitors banks’ exposures to their affiliates via the FR Y-8 report, which is submitted quarterly at the end of each quarter. Violations can lead to significant civil penalties, considering factors such as intent, disregard for safety and soundness, or any resulting gains.
How Does Regulation W Work?
Regulation W leverages rulemaking authority granted by Sections 23A and 23B of the Federal Reserve Act. It regulates covered transactions such as extending credit to an affiliate, asset purchases, and accepting affiliated securities as collateral.
What Are the Limits for Transactions?
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Single Affiliate: No transaction with a single affiliate can be greater than 10% of the institution’s capital.
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All Affiliates Combined: Transactions with all affiliates must not exceed 20% of the institution’s held capital.
Exemptions Under Regulation W
Federal Reserve Banks can grant exemptions under Regulation W, but some also require approval from the FDIC.
Conclusion
As the 23rd regulation mirroring the 23rd letter of the alphabet, Regulation W governs covered transactions between banks and their affiliates. It defines affiliates, specified transactions, and sets quantitative limits and collateral requirements to mitigate undue financial risks to banks and federal deposit insurance.
Following the significant reforms post-2008, the compliance landscape under Regulation W has become more stringent, ensuring the financial safety and soundness of institutions remain robust.
Related Terms: Federal Reserve Act, Dodd-Frank Act, collateral requirements, capital market, FDIC.
References
- Code of Federal Regulations. “Part 223-Transactions Between Member Banks and Their Affiliates (Regulation W)”.
- Board of Governors of the Federal Reserve System. “Adoption of Regulation W Implementing Sections 23A and 23B of the Federal Reserve Act”.
- Board of Governors of the Federal Reserve System. “Legal Interpretations-Frequently Asked Questions About Regulation W”.
- Federal Registrar. “Transactions Between Member Banks and Their Affiliates”.
- Board of Governors of the Federal Reserve System. “Report Forms-FR Y-8”.
- Board of Governors of the Federal Reserve System. “Federal Reserve Act: Section 29. Civil Money Penalty”.
