Coming Rules Could Wall Off Banks from Affiliates

If you know only one thing about Title VI of the Dodd-Frank Act, odds are it's the Volcker Rule's ban on proprietary trading.

But another section of that title holds just as much potential to upend the industry — Section 608. It amps up Regulation W, which governs transactions between a bank and its subsidiaries and affiliates.

Depending on how the law is implemented, this section could allow regulators to ring-fence insured depositories.

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"The less the insured depository can consort with the rest of its holding company, the more of a narrow bank you construct," says Karen Shaw Petrou, managing partner of Federal Financial Analytics. "That takes you some of the way towards the more radical reform people like Elizabeth Warren, Richard Fisher and Tom Hoenig are proposing."

To proponents like these people, strict adherence to Section 608 would be great news. Banks would finally be protected from other parts of the holding company.

But to critics, that would undermine the whole point, not to mention the profitability, of being a big bank.

Petrou didn't choose sides, but notes that "the fundamental economics of a diversified bank holding company with a huge insured depository at its heart is to use those core funds for an array of activities, not just traditional lending."

Reg W, which dates to May 2001and implements the Federal Reserve Act's Section 23A and 23B, is a backbone of prudential supervision.

On paper, Reg W is plenty tough, limiting transactions between a bank and its affiliates and requiring terms and conditions be done at an arm's length.

But in practice, particularly during the crisis, Reg W has plenty of holes. The Fed liberally granted exemptions, allowing banks to provide liquidity to affiliates. These exemptions were so numerous, even Congress noticed.

So when lawmakers wrote Dodd-Frank, they tightened things up. More types of transactions are now covered and collateral requirements are stiffer. The FDIC was given the power to veto exemptions granted by the Fed.

Section 608 took effect more than a year ago, yet no rules have been proposed to implement it.

The Fed's website does promise to have a proposal out this year: "The Board expects to request comment on a proposed rule regarding the revisions to sections 23A and 23B of the Federal Reserve Act that became effective on July 21, 2012." 

That's all it says and officials at the Fed did not want to talk with me about this. Policymakers at the FDIC and the OCC didn't either.

But the agencies don't operate in a vacuum. Bankers, and their consultants, see what's happening firsthand, and they say the regulators are already applying the new, tougher version of Reg W.

According to a new report by Deloitte, they are even conducting horizontal exams to see how compliance with Reg W varies among the largest banks.

"It's a very large deal," says Chris Spoth, a Deloitte director. "It goes to protecting the depository, and that's fundamental in Dodd-Frank."

Deloitte's report is a gold mine for compliance officers. It's all about how to deal with the changes.

But there are more strategic implications of Section 608, such as whether regulators will use it to wall banks off more securely from other parts of the company. Time will tell.