What is Regulation W?
Regulation W is a U.S. Federal Reserve System regulation that limits certain transactions between depository institutions, such as banks, and their affiliates. In particular, it sets quantitative limits on covered transactions and requires collateral for certain transactions. The regulation applies to banks that are members of the Federal Reserve System, insured state non-member banks and insured savings associations. Regulation W was introduced to consolidate several decades of interpretations and rulemaking under Sections 23A and 23B of the Federal Reserve Act.
- Regulation W restricts certain kinds of transactions between banks and their affiliates.
- The rules that banks must follow to comply with Regulation W were tightened by post-2008 financial reforms.
- The Dodd-Frank Act expanded the definition of a bank affiliate and the types of transactions Regulation W covers.
Understanding Regulation W
Regulation W, the rule that implements sections 23A and 23B of the Federal Reserve Act, was published on December 12, 2002, and came into effect on April 1, 2003. Regulation W along with Sections 23A and 23B limit the risks to a bank from transactions between the bank and its affiliates. They also limit the ability of a bank to transfer to its ability the subsidy arising from the bank's access to the Federal safety net, which has benefits such as lower cost insured deposits and the discount window. These objectives are accomplished by imposing quantitative and qualitative limits on the ability of a bank to extend credit to an affiliate, or engage in certain other transactions with it.
The Federal Reserve noted in January 2003 that Regulation W included 70 years' worth of interpretive guidance concerning statutory requirements "that are fairly brief, but extremely complex in application." Regulation W is comprehensive in its scope, resolving as many as nine significant issues including derivative transactions, intraday credit and financial subsidiaries.
Complying with Regulation W
As most large U.S. banks exist within a diversified holding company structure, the possibility that bank funds may be used for somewhat risky purposes exists. Regulation W seeks to limit this risk, and while it is conceptually straightforward, implementation is not easy. Compliance with Regulation W is a particular challenge for some banks that are dealing with issues such as rapid growth in capital market activities or integration of previous acquisitions.
Complying with Regulation W was complex, even before the regulatory reforms that were instituted in the wake of the 2008 financial crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act – which has been criticized by some as being overly burdensome — further tightened Regulation W’s requirements.
Because exemptions to Regulation W rules were widely used to provide emergency liquidity to affiliates during the financial crisis, the Federal Reserve’s ability to grant exemptions on its sole authority was curbed under the new rules. For example, the Federal Deposit Insurance Corporation (FDIC) now has 60 days to determine whether an exemption is justified or whether it might pose an unacceptable risk to its deposit insurance fund and raise any objections. Modifications to Regulation W have also expanded the concept of what an “affiliate” is and what constitutes a “covered transaction” under the law. Banking regulators now expect greater transparency from banks in complying with Regulation W.
Regulation W aims to protect banks and federal deposit insurance funds from undue financial risk.
When does Regulation W apply?
Given that Regulation W applies to covered transactions between a bank and its affiliate, two basic questions need to be answered in determining whether a transaction is subject to this regulation :
- Is the transaction between a bank and an affiliate of the bank?
- Is the transaction a "covered transaction'?
Regulation W defines a bank's affiliates quite broadly and includes any company that the bank directly or indirectly controls or that is sponsored and advised by a bank, as well as subsidiaries of the bank.
Covered transactions under Regulation W cover a wide spectrum of transactions, including:
- the extension of credit to an affiliate;
- investment in securities issued by an affiliate;
- asset purchases from an affiliate;
- the acceptance of securities issued by an affiliate as collateral for credit;
- the issuance of a guarantee or letter of credit on behalf of an affiliate.
Special Considerations for Regulation W
Under Regulation W, transactions with any one affiliate must total no more than 10% of a financial institution's capital, and transactions with all affiliates combined must total no more than 20% of an institution's capital. Banks are prohibited from purchasing low-quality assets from their affiliates, such as bonds with principal and interest payments that are more than 30 days past due. Any extension of credit must be secured by collateral. Collateral must have coverage that ranges between 100% and 130% of the total transaction amount.
As an example, consider a transaction where hypothetical bank BigBanc intends to purchase a loan portfolio from its subsidiary SmallBanc. In order to comply with Regulation W, BigBanc must ensure that the transaction with SmallBanc does not exceed more than 10% of its capital, and that the loan portfolio is not considered a low-quality asset. The transaction must also be done on market terms and conditions.
The Federal Reserve monitors banks' exposures to their affiliates through the FR Y-8 report that collects information on transactions between an insured depository institution and its affiliates. The report has to be submitted by banks quarterly, on the last calendar day of each quarter.
Financial institutions that are found to be in violation of Regulation W can be hit with substantial civil penalties. The amount of the fine is determined by several factors, including whether the violation was caused with intent, if it was undertaken with reckless disregard for the institution's financial safety and soundness or if it resulted in any type of gain by the perpetrator.