A crucial element for a bank director’s satisfaction of board duties is to be alert to regulatory issues that may impair the bank’s safety and soundness and lead to regulatory sanctions. One area where this is particularly true is affiliate transactions.

Sections 23A and 23B of the Federal Reserve Act and the Federal Reserve’s Regulation W govern how a bank may engage in “covered transactions” with or involving an “affiliate.” This issue frequently arises when a bank makes a loan that is secured by the stock of the bank’s holding company. An “affiliate” includes the bank’s holding company or any company controlled by the holding company. A “covered transaction” covers many relations between a bank and its affiliates, including a loan or extension of credit to the affiliate, a purchase of securities issued by the affiliate, a purchase of assets from the affiliate and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. One covered transaction that is sometimes overlooked is the acceptance of securities of an affiliate as collateral for a loan by the bank to any person. Thus, if the bank lends money (or extends credit) to a borrower (even if the borrower is not related to the bank), and accepts holding company stock as collateral, that loan is a “covered transaction.”

There are two issues here that a bank director or bank management should keep in mind when considering whether to approve a loan secured by holding company stock. The first is that there is a quantitative limitation on the amount of a bank’s covered transactions with any one affiliate. Covered transactions with any one affiliate may not exceed 10 percent of the bank’s capital stock and surplus. Essentially, “capital stock and surplus” means the bank’s tier 1 and tier 2 capital based on the most recent CALL Report and the balance of the allowance for loan and lease losses not included in tier 2 capital and certain limited investments in financial subsidiaries. (There is also a limit on all affiliate transactions of 20 percent of the bank’s capital stock and surplus.) The regulatory policy here is that affiliate transactions can involve enhanced risks for the bank and, therefore, the amount of affiliate transactions should be limited.

What is sometimes overlooked with loan transactions, however, is the second key issue the bank should be aware of. Because a “covered transaction” includes a loan to any person where the stock of the holding company is accepted as collateral, the 10 percent limit of covered transactions respecting any one affiliate applies to all loans where the holding company stock serves as collateral. In other words, if the bank makes loans to, for example, eight different unrelated borrowers, and the stock of the holding company is pledged by each borrower to secure each borrower’s loan, the 10 percent limit applies to all eight loans in the aggregate.

There are, of course, other requirements under the affiliate transaction rules, such as collateral requirements for credit transactions, but the 10 percent limit on covered transactions with any affiliate could be a trap for the unwary when a board, loan committee, or loan officer is considering a loan secured by stock of the bank’s holding company.