29.3 Affiliate Definitions, Covered Transactions and Collateral

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Statutory Purpose & the Federal Safety Net

Insured depository institutions enjoy substantial federal safety net benefits, including:

• Federal deposit insurance backed by the full faith and credit of the United States Government;
• Direct access to Federal Reserve discount window emergency liquidity; and
• Direct access to the Federal Reserve wholesale payment system (Fedwire).

Without strict regulatory barriers, a financial holding company or parent corporation could be tempted to exploit the bank's low-cost, government-insured deposit base to finance risky non-bank commercial ventures, bail out troubled securities or real estate affiliates, or purchase substandard assets from sister subsidiaries. Sections 23A and 23B of the Federal Reserve Act and Regulation W function as a statutory firebreak insulating the bank from its affiliates.

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Definition of an Affiliate (12 CFR § 223.2)

Under 12 CFR § 223.2, the concept of control governs affiliate status. A company controls another company if it:

1. Directly or indirectly owns, controls, or has power to vote 25% or more of any class of voting securities;
2. Controls in any manner the election of a majority of the directors or trustees; or
3. The Federal Reserve Board determines, after notice and opportunity for hearing, that the company exercises a controlling influence over management or policies.

Included Entities

An affiliate of a bank includes:

• Parent Holding Company: Any company that controls the bank (e.g., the parent bank holding company or financial holding company);
• Sister Subsidiaries: Any company controlled by the same parent company that controls the bank (e.g., an affiliated broker-dealer, mortgage company, or insurance agency);
• Sponsored and Contractually Advised Companies: Any company sponsored and advised on a contractual basis by the bank or an affiliate (e.g., real estate investment trusts or private funds);
• Investment Funds with Bank as Adviser: Any investment fund (including hedge funds, mutual funds, and private equity funds) for which the bank or an affiliate acts as investment adviser; and
• Interlocking Directorate Entities: Any company where a majority of its board of directors or trustees constitutes a majority of the board of directors or trustees of the bank.

Excluded Entities (§ 223.2(b))

Compliance officers must distinguish covered affiliates from entities expressly excluded by statute:

• Operating Subsidiaries: A subsidiary of the bank itself is generally treated as an integral part of the bank, not as an affiliate (unless it is classified as a financial subsidiary, an insured depository institution, or a broker-dealer/futures merchant).
• Bank Premises Subsidiaries: Companies formed solely to hold title to the bank's physical premises or real estate.
• DPC Subsidiaries: Companies formed solely to liquidate assets acquired in good faith in satisfaction of debts previously contracted (DPC).

Financial subsidiaries and statutory updates

A financial subsidiary is treated as an affiliate. Dodd-Frank eliminated the former exemption from the 10% single-affiliate limit; both the single-affiliate and aggregate limits must be checked. Provisions governing valuation of the investment and related transactions require care; a financial subsidiary is not a blanket route around Section 23A. Dodd-Frank also includes credit exposure from derivatives and securities borrowing or lending transactions in covered transactions. Apply the current statute along with implementing Regulation W provisions.

Section 23A Collateral Requirements (12 CFR § 223.14)

Every extension of credit to an affiliate, guarantee issued on behalf of an affiliate, and credit exposure from derivatives must be secured by qualifying collateral with a market value meeting strict statutory percentages at inception and throughout the transaction's life.

Statutory Collateral Margins

Strictly Ineligible Collateral (§ 223.14(c))

The following assets are legally disqualified from serving as collateral for covered transactions:

• Securities Issued by an Affiliate or the Bank: A bank may never accept stock, bonds, notes, or debentures issued by the bank or any of its affiliates to collateralize an affiliate credit extension.
• Low-Quality Assets: Any classified, nonaccrual, or past-due asset cannot serve as qualifying collateral.
• Intangible Assets: Goodwill, patent rights, servicing assets, and trademark valuations cannot count toward collateral coverage.

Identify covered transactions before measuring exposure

Covered transactions include loans and other credit to affiliates, purchases of affiliate securities, asset purchases from affiliates, acceptance of affiliate securities as collateral for third-party credit, and guarantees or letters of credit on affiliates’ behalf. The statute also reaches specified credit exposure from securities-financing and derivative transactions. A service fee can be subject to Section 23B without being a Section 23A covered transaction, so classify the arrangement before calculating a cap.

Ordinarily, Section 23A limits covered transactions with one affiliate to ten percent of capital stock and surplus and with all affiliates together to twenty percent. With fifty million dollars of the applicable capital base, the limits are five million and ten million dollars. Existing credit of three and a half million dollars to Affiliate A plus a proposed two-million-dollar loan produces five and a half million dollars, exceeding A’s single-affiliate limit even if aggregate affiliate exposure remains below ten million dollars. Collateral does not cure this excess. Check an asserted exemption under its own conditions and retain the safe-and-sound requirement where applicable.