Sen. Brown Leads 10 Senators in Letter Raising Concern Over Bank of America's Move of Risky Derivatives to Taxpayer-Backed Banking Unit

Brown Chairs Senate Banking Subcommittee on Financial Institutions and Consumer Protection, Brown and Rep. Brad Miller Write to Treasury Sec. Geithner, Federal Bank Regulators Urging Administration to Prevent Risky Behavior by Banks

Washington, D.C. – U.S. Sen. Sherrod Brown (D-OH) and U.S. Rep. Brad Miller (D-NC) sent letters today to Treasury Secretary Timothy Geithner and to federal banking regulators expressing concern that Bank of America has moved trillions of dollars in derivatives from its subsidiary Merrill Lynch into a subsidiary insured by the Federal Deposit Insurance Corp (FDIC). Brown, who chairs the Banking Subcommittee on Financial Institutions and Consumer Protection, was joined by U.S. Sens. Carl Levin (D-MI), Jeff Merkley (D-OR), Mark Begich (D-AK), Richard Blumenthal (D-CT), Tom Harkin (D-IA), Robert P. Casey, Jr. (D-PA), Bill Nelson (D-FL), Sheldon Whitehouse (D-RI), and Maria Cantwell (D-WA) in the letter to banking regulators.

“If banks are going to gamble, they should do it with their own money,” Brown said. “Ending ‘too big to fail’ means that depositors and taxpayers are not asked to cover Wall Street’s losses.  It’s time to put an end once and for all to taxpayer-funded bailouts of reckless banks.”

“Regulators must stop treating transactions like this as a private matter,” Miller said. “This kind of transaction raises many issues of obvious public concern. If the bank subsidiary failed, innocent taxpayers could end up paying off “exotic” derivatives.”

Three years after taxpayers rescued some of the biggest U.S. banks, lawmakers continue to question how to protect taxpayers from risks generated by investment-banking operations. The outlined concern over a reported increase in so-called 23A exemptions, referring to the section of the Federal Reserve Act that separates insured banking from investment activities.

In the letter to regulators, the lawmakers questioned the transfer of an undisclosed amount of derivatives from Merrill Lynch, a securities trading subsidiary, to Bank of America, a retail bank subsidiary. Bank of America’s retail bank has $1.04 trillion in deposits, $548 billion of which are insured by the FDIC. The transfer reportedly happened following threats of further credit downgrades that would have forced Merrill Lynch to post an additional $3.3 billion in collateral.

Three years ago, Bank of America received $45 billion in TARP funding to prevent its crash during the financial crisis.

A copy of Brown’s letter can be found below.

 

October 27, 2011

 

The Honorable Ben S. Bernanke

Chairman

Board of Governors of the Federal Reserve

20th and Constitution Avenue, N.W.

Washington, D.C.  20001

 

The Honorable Martin J. Gruenberg

Acting Chairman

Federal Deposit Insurance Corporation

550 17th Street, N.W.

Washington, D.C.  20429

 

Mr. John G. Walsh

Acting Comptroller of the Currency

Administrator of National Banks

Washington, D.C.  20219

 

Dear Chairman Bernanke, Acting Chairman Gruenberg, and Acting Comptroller Walsh:

 

Section 23A of the Federal Reserve Act restricts transactions between banks and their nonbank affiliates, placing limits on the amount of each transaction relative to a bank’s capital and prohibiting purchases of certain “low-quality” assets.[1]  The primary purposes of section 23A are protecting federally insured banks from riskier activities conducted by nonbank affiliates and preventing nonbank affiliates from benefitting from the subsidies provided by the federal safety net through the FDIC’s coverage of insured deposits.[2]  Congress sought to reinforce these principles in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), by restricting banks and their affiliates from engaging in proprietary trading or investing in private equity and hedge funds, while also requiring banks to move certain derivatives activities to their non-bank affiliates.[3]  The Dodd-Frank Act provides the Federal Deposit Insurance Corporation (FDIC) with authority as of July 21, 2012, to unilaterally reject any 23A exemption request from an insured depository institution.[4]

In the depths of the financial crisis, Goldman Sachs and Morgan Stanley converted to bank holding companies, in large part so as to participate in Federal Reserve programs designed to support them, including the Federal Reserve’s discount window.  When the Federal Reserve granted a 23A exemption to Goldman Sachs Bank in 2009, Goldman moved its multi-purpose derivatives dealer into its insured bank affiliate.  Likewise, Morgan Stanley converted to a bank holding company, and received a 23A exemption for its derivatives business.  And JPMorgan Chase Bank, N.A., currently holds 99 percent of the notional derivatives of JPMorgan Chase & Co.[5]  These actions signal a troubling policy shift that has weakened limitations on insured banks engaging in risky activities and significantly expanded the federal safety net.[6]

We write today regarding recent reports that Bank of America Corporation, the nation’s largest bank holding company by assets, has elected to transfer a substantial portion of its derivatives business from its broker-dealer affiliate Merrill Lynch & Company, Inc., to Bank of America, N.A. – the nation’s second largest bank by deposits.  As of June 30, 2011, the insured bank held $53 trillion in derivatives, an increase of $14.85 trillion – or 39 percent – from its holding prior to the purchase of Merrill Lynch.[7]  We are concerned because the reported transactions appear to violate the principles established in Section 23A of the Federal Reserve Act, and reinforced by Sections 619 and 716 of the Dodd-Frank Act, particularly “prevent[ing] the undue diversion of funds into speculative operations.”[8] 

At a time when systemically important banks are increasing their capital relative to their credit risk, these transfers are having the effect of increasing Bank of America, N.A.’s credit risk relative to capital.  Section 11 of the Federal Deposit Insurance Act provides derivatives counterparties with the ability to terminate, liquidate, or accelerate their derivatives claims.  However, derivatives contracts generally are not subject to enforcement by the receiver.[9]  As a result of this provision, the FDIC Deposit Insurance Fund – and ultimately, the U.S. taxpayer – could be required to backstop the insured bank’s derivatives losses in the event that the bank’s capital cushion proves inadequate.  These potentially risky, largely over-the-counter, transactions are now being directly backstopped by the FDIC’s Deposit Insurance Fund – and ultimately the United States Treasury.  This provides an additional safety net subsidy for one of the biggest derivatives dealers that is contrary to not only the principles, and potentially the strictures, of the Dodd-Frank Act, but also the original intent of the Federal Reserve Act and the Federal Deposit Insurance Act.

With respect to the recent actions by certain Federal banking regulators to waive restrictions or otherwise permit the largest institutions to put depositors and taxpayers at risk for the banks’ derivatives trading losses, we would like the regulators to answer the following questions:

  • What supervisory policies of the Federal banking agencies are implicated by the establishment of a large derivatives trading operation within an insured depository institution?
  • What was the policy basis for the decision by the Federal Reserve and the institution’s primary Federal banking regulator to allow large firms to put their derivatives trading operations in their insured depository institutions?
  • What is your understanding of why insured depository institutions have asked their primary Federal banking regulator to allow their insured depository institutions to house their derivatives trading operations?
  • What was the justification for allowing the transfer of derivatives trading operations, and what factors did you evaluate in making those decisions?
  • What risks arise to the insured depository institution as a result of having the derivatives business principally operated out of it?
  • Given the extremely large size of the derivatives trading operations of some banks relative to their other business operations, could losses in a derivatives trading operation threaten the solvency of those insured depository institutions? 
  • What efforts are being undertaken by the FDIC to ensure that, depositors, the Deposit Insurance Fund, and taxpayers are not put at any additional risk?
  • Has the FDIC considered adjusting its risk-adjusted premiums to reflect any additional risk, and if not, why not?

Because taxpayers may be exposed to losses to the Deposit Insurance Fund arising from certain regulatory exemptions for the transfer of Merrill Lynch’s derivatives transactions to Bank of America, N.A., it is also important to know:

  • What are the amount, composition, quality, counterparty identity, and credit exposure of the derivative contracts transferred from Merrill Lynch to Bank of America, N.A.?
  • Is it your understanding that the reported transfers were requested by Merrill Lynch’s counterparties?
  • Do the reported transfers require Bank of America to obtain an exemption from Section 23A?
  • Has Bank of America sought an exemption from Section 23A?
  • If Bank of America has sought an exemption, what was the proffered rationale?  Do you agree with this rationale?
  • Have you granted, or do you expect to grant, Bank of America an exemption from Section 23A?  If so, why?
  • Have regulators accepted the living will submitted by Bank of America, pursuant to Section 165 of the Dodd-Frank Act?

If a 23A exemption has been granted by the Federal Reserve, please provide any relevant written records, including interagency communications, concerning the granting of the exemption.

Bank holding companies are intended to serve as a source of strength to their subsidiaries.[10]  Unfortunately, as former FDIC Chairman Sheila Bair has noted, “[d]uring the crisis, FDIC-insured subsidiary banks became the source of strength both to the holding companies and holding company affiliates.”[11]  Congress, regulators, and other interested parties should take all necessary steps to ensure that these events do not repeat themselves.

We look forward to hearing your agencies’ respective views on this issue.  Given the sensitive nature of these developments, we would request your responses by November 11th, 2011.  Thank you for your prompt attention to this important matter.

 

Cc: The Honorable Timothy Geithner, Secretary, United States Department of the Treasury

 

****************************************************************************** 


October 27, 2011

 

Dear Secretary Geithner and Members of the FSOC,

We are writing concerning press reports last week that Bank of America Corp. (BAC) transferred an undisclosed amount of derivatives from Merrill Lynch, a securities trading subsidiary, to Bank of America NA, a retail bank subsidiary with $1.04 trillion in deposits, $548 billion of which are insured by the Federal Deposit Insurance Corporation (the FDIC).

Again according to the press reports, the transfer followed a credit downgrade of BAC and Merrill Lynch that might result in requirements by counterparties that Merrill Lynch post an additional $3.3 billion in collateral. The retail bank subsidiary has a higher credit rating and more in assets, and would thus be required to post less collateral. The counterparties reportedly requested the transfer to the retail bank subsidiary.

Bloomberg reported that the Federal Reserve favors the transfer to relieve BAC of the requirement of additional collateral, the FDIC opposes the transfer as increasing the risk to insured deposits, and BAC contends that regulatory approval is unnecessary.

The Bloomberg report was attributed to “people with direct knowledge of the situation.” Regulators are apparently treating the transaction as a private matter, but the transaction raises issues of obvious public concern.

First, was the transfer reviewed under section 23A of the Federal Reserve Act, and if not, why not? The section limits transactions between non-bank and bank affiliates to protect the safety and soundness of banks and to avoid effectively subsidizing high-risk transactions with deposit insurance. Because of the favored treatment of derivative contracts in receivership, it appears highly likely that losses on derivatives would result in losses to insured deposits ultimately borne by taxpayers.

The transaction would avoid the reporting and review threshold of section 23A only if the transfer was of high-quality assets constituting less than ten percent of the retail bank’s capital stock and retained earnings. The total capital stock and retained earnings of BAC and the retail bank subsidiary is $176 billion. The notional value of all derivatives held at BAC is $75 trillion, and as of second quarter of this year, $53 trillion of those were held in Bank of America NA. It is undoubtedly extremely difficult to translate the “notional value” of derivatives into actual risk, and we do not know how much of Merrill’s derivatives portfolio was transferred to Bank of America NA. The reported demand by counterparties that Merrill Lynch transfer the derivatives to the retail bank to avoid a possible requirement to post additional collateral suggests that the derivatives pose substantial risk, however. Was the transfer treated as an asset purchase of the derivates by the retail bank from Merrill Lynch? If so, was the purchase price in what was obviously not an arm’s-length transaction used to determine the applicability of section 23A?

Second, if regulators did review the transfer, either for purposes of approval under section 23A or to determine if such a review was required, how did regulators determine the risk posed by the derivatives? Did BAC or Merrill Lynch make their proprietary models available to regulators to assess that risk? Are any of the derivatives credit default swaps on European sovereign debt? If so, what effect would default on European sovereign debt have on potential liability under the swaps?

The derivatives are apparently complex, opaque, and not remotely standardized—at least one report called some of the derivatives “exotic.” And according to another published report, even by the incautious standards of derivatives traders, Merrill Lynch was considered “the cowboy.” And those calculations of risk assume that the counterparties will be able to pay any amount due on the derivative contracts, which AIG’s counterparties learned three years ago to be a bad assumption.

Third, if BAC completed the transaction without reporting under section 23A, what measures are available to regulators if regulators disagree with BAC’s contention that reporting and review under section 23A was not required? Can regulators require rescission of the transfer? If the transfer of the derivatives to the retail bank would put insured deposits at risk, would the transfer of the derivatives back to Merrill Lynch create a systemic risk to the financial system?

Finally, if the transfer was not reported and reviewed under section 23A based on BAC’s own assessment of the transfer, will regulators allow reporting and review under section 23A to be an honor system in the future?

We appreciate your prompt attention to this matter. If you have any questions, please contact Corey Frayer in Representative Brad Miller’s office at (202) 225-3032 or corey.frayer@mail.house.gov.


Sincerely,

 

___________________________                              ___________________________

Rep. Brad Miller                                                         Rep. Maxine Waters

___________________________                              ___________________________

Rep. Elijah E. Cummings                                            Rep. Michael E. Capuano

___________________________                              ___________________________

Rep. Stephen Lynch                                                     Rep. Keith Ellison

___________________________                              ___________________________

Rep. Jan Schakowsky                                                  Rep. Jackie Speier

 

 

###


[1] See 12 U.S.C. § 371c.

[2] See the Federal Reserve’s Regulation W, which is codified in 12 C.F.R. Part 223 and issued at 67 Fed. Reg. 76560 (Dec. 12, 2002).  Many have argued that banks enjoy protection from a “safety net” – a variety of implicit guarantees that their profits will be enjoyed by investors and the costs will be paid by society, including “deposit insurance and a central bank able and willing to serve as a ‘lender of last resort.’” Remarks by Paul A. Volcker before the Statutory Congress of the European People’s Parties, Bonn, Germany, Dec. 9, 2009.

[3] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 619 (2010); see also id., at § 716.

[4] See id., at § 608.

[5] See Office of the Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities Second Quarter 2011, at Table 1, Table 2.

[6] See Saule T. Omarova, From Gramm-Leach-Bliley To Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act, 89 N.C. L. Rev. 1683, 1762 (2011).

[7] See Office of the Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities Second Quarter 2011, at Table 1, Table 2; see also Office of the Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2008, at Table 1, Table 2.

[8] H.R. Rep. No. 73-150, at 1(1933).

[9] See 12 U.S.C. § 1821(e)(8)(A).

[10] See 12 C.F.R. § 225.4(a)(1).

[11] Letter from the Honorable Sheila Bair, Chairman, Federal Deposit Insurance Corporation, to Senator Susan Collins, May 7, 2010.

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