Risk Management

Feds Soften Structured-Finance Stance

For corporate clients of banks, the move represents a relaxation of a regime of scrutiny that regulators had recommended in 2004.
David KatzJanuary 5, 2007

After several years of strong resistance from the banking industry, the Securities and Exchange Commission, the Federal Reserve, and three other federal regulators have issued softened final guidelines on how banks should manage the risks of complicated structured-finance deals.

First proposed in 2004 in the wake of Enron’s failure, the guidelines were devised to prevent banks from using complex structured-finance transactions (CSFTs) to help companies hide debt, generate phony revenues, or create the appearance of cash flow from what are essentially borrowed funds.

The regulators’ final guidelines, issued Friday, mark a considerable retreat from the original proposal. Banking industry groups argued hard that the guidelines first proposed were too broad, casting suspicion on many legitimate transactions and effectively requiring that banks police the intentions of their corporate customers.

In an unusual move, regulators withdrew their proposal, then issued revised guidelines for comment last May. The final guidelines, which contain only minor modifications to the May revision, take “a risk- and principles-based approach” to managing the perils that CSFTs pose to banks, according to a release issued by the rule-makers. The final version, they say, focuses on those deals presenting high levels of legal or reputational risk to financial institutions.

For corporate banking clients, the move represents a relaxation of a tightened regime of bank scrutiny that the regulators had recommended in 2004. The original proposal called for banks to review how companies planned, accounted for, and disclosed CSFTs in both their financial and tax reporting. Under certain circumstances, regulators suggested, banks should even “communicate directly with the customer’s independent auditors.”

Such suggestions drew a sharp response from industry groups, with the American Bankers Association (ABA) complaining that the “insistent subtext” of the guidelines was that banks should “insert themselves into their customers’ business dealings and corporate governance.” Bank industry groups also objected to the proposal that banks extensively document all meetings with corporate clients — even for transactions that ultimately did not happen. Such proposals, complained a joint letter from several industry groups, “appear more aptly designed to affect the deputization of financial institutions as prosecutorial archivists.”

As in the earlier proposal, the authors of the final guidelines steer clear of precise definitions of CSFTs. However, they do suggest that arrangements like those structured by Citigroup and J.P. Morgan for Enron “appeared to have been designed or used to shield their customers’ true financial health from the public” and are in the purview of the statement.

In response to concerns that the original proposal was overly broad, the regulators go on to note that most structured-finance deals, including “standard public mortgage-backed securities transactions, public securitizations of retail credit cards, asset-backed commercial paper conduit transactions, and hedging-type transactions involving ‘plain vanilla’ derivatives and collateralized loan obligations,” wouldn’t typically be considered CSFTs. However, the regulators say that banks should be alert for structured-finance deals that:

• Lack “economic substance or business purpose.”

• Are put together “for questionable accounting, regulatory, or tax objectives, particularly when the transactions are executed at year end or at the end of a reporting period for the customer.”

• Create worries that the customer will report the deal in its financial statements in a “materially misleading” or inconsistent way, or in a manner that does not comply with regulations or accounting standards.

• Consist of “circular transfers of risk (either between the financial institution and the customer or between the customer and other related parties) that lack economic substance or business purpose.”

• Involve agreements that would “have a material impact on the regulatory, tax, or accounting treatment of the related transaction, or the client’s disclosure obligations.”

• Are inconsistent with market norms.

• Provide the bank with compensation that seems “substantially disproportionate to the services provided or investment made by the financial institution or to the credit, market or operational risk assumed by the institution.”

As part of their risk-management guidance, the regulators say that financial institutions should set up “a clear framework for the review and approval of individual CSFTs.” The banks’ policies and procedures should spell out the duties of the people that put together the products and structure, vet, and trade them. Financial institutions should also define what constitutes a “new” CSFT product and develop controls over the approval of such new products.

Besides the Fed’s Board of Governors and the SEC, the other framers of the final statement, which will be published shortly in the Federal Register, were the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. Because the statement focuses on “elevated-risk” CSFTs — which tend to be done by “a limited number of large financial institutions” — it won’t affect most banks but will involve only a scant few small ones, according to the agencies.