Add Saule Omarova's paper, From Gramm-Leach-Bliley to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act, to you early summer reading list. Don't let the long title fool you, the paper is a lucid account of how regulators drilled holes in one of the key firewalls inside financial conglomerates. The article has significant implications given that Dodd-Frank builds new firewalls, such as the Volcker Rule. Section 23A, a Depression era provision, limited banks in extending credit or purchasing assets from non-banking affiliates. Omarova describes how, once the Glass-Steagall wall came down, this provision moved from the periphery to become a key banking law rule. Post-Glass Steagall, Section 23A became one of the principal measures limiting the exposure of banks to risky activities by non-bank affiliates. Policymakers relied on 23A to curb transfers of subsidies from banks (such as deposit insurance) to non-bank affiliates. The real power of the paper comes in Omarova's meticulous analysis of a long series of Federal Reserve exemption letters. These interpretative letters began by carving out small exemptions into Section 23A. But after Glass Steagall fell, these exemptions were enlarged to enable banks to support riskier investment activities of affiliates. For example, one exemption allowed Citibank to purchase subprime mortgage assets from a newly acquired Citigroup mortgage lending affiliate. Omarova argues that these exemptions contributed to the growth of riskier investment activities. She then looks at how the Federal Reserve granted rafts of exemptions to 23A during the crisis to allow banks within large financial conglomerates to rescue their non-banking affiliates. Exemptions and Implications The paper highlights the importance of exemptions in financial regulation, both in the lead-up to crises and as a tool of financial containment. The drafters of Dodd-Frank got the message. The statute includes a number of complex limitations on the ability of financial regulators to grant exemptions. For example, with respect to Section 23A itself, agencies can veto exemptions by other agencies. (See Dodd-Frank Section 608(a)). But we'll need to wait and see whether this type of procedural contraption works. Will it stop Section 23A from being eroded will still allowing agencies to provide needed guidance and less troubling regulatory relief? What about less formal exemptions (that is regulatory "forbearance.") Omarova is not particularly optimistic in her conclusions. She notes that Section 23A was never intended to perform such a critical and central role in regulating systemic risk. But, she asks, if we reduce dependence on Section 23A, what would replace it? A comparative advantage for legal scholars Stepping back from policy implications, this paper also performs another function. It provides an example of insights for which legal scholarship is particularly well-suited compared to other disciplines. The careful reading of a long history of interpretative letters demonstrates a particular comparative advantage of legal scholars in studying of this financial crises and financial regulation generally. It is one thing talk about what financial regulation ought to do in broad sweeping terms – address systemic risk, limit moral hazard, prevent subsidies from being transferred. It is quite a bit harder to look at how rules work or unravel in the sausage factory of agencies, as regulators examine, interpret, enforce, and exempt. Saule took this same approach of carefully reading interpretative letters in an earlier, impressive work, The Quiet Metamorphosis: How Derivatives Changed the 'Business of Banking'. In that piece, she looked at over a decade of OCC interpretations that gradually allowed banks to expand their derivatives business. I'm not alone in being a fan of this new piece. George Washington's Center for Law, Economics, and Finance gave the paper first place in its inaugural Junior Scholar's workshop competition. Finally, here's the abstract: This Article examines the recent history and implementation of one of the central provisions in U.S. banking law, section 23A of the Federal Reserve Act. Enacted in 1933 in response to one of the perceived causes of the Great Depression, section 23A imposes quantitative limitations on certain extensions of credit and other transactions between a bank and its affiliates that expose a bank to an affiliate's credit or investment risk, prohibits banks from purchasing low-quality assets from their nonbank affiliates, and imposes strict collateral requirements with respect to extensions of credit to affiliates. The key purpose of these restrictions is twofold: to protect federally insured depository institutions from excessive credit exposure to their affiliates, and to prevent transfer of federal subsidy to nondepository financial institutions. After the enactment of the Gramm-Leach-Bliley Act of 1999, which removed the Glass-Steagall era prohibition on affiliation between commercial banks and investment banks, section 23A effectively became the principal statutory safeguard preventing the depository system from subsidizing potentially risky activities of nonbanking institutions. However, despite its officially endorsed significance, section 23A remains a largely obscure statute that has not attracted much scholarly attention to date. This Article seeks to fill that important gap and to explore how effective section 23A is in achieving its purported goals in practice. It examines the body of interpretive letters issued by the Board of Governors of the Federal Reserve System (the "Board") between 1996 and 2010, in which the Board granted individual banking institutions' requests to exempt their proposed transactions with affiliates from the requirements of section 23A. This Article argues that section 23A falls short of delivering the kind of robust protection for the depository system it allegedly promises, primarily because it was not designed for fulfilling such a grand task. This mismatch between its professed function and practical efficacy became particularly clear during the global financial crisis from 2007 to 2009. The Article puts together a comprehensive record showing how the Board's use of exemptive authority effectively rendered section 23A irrelevant during the crisis, by allowing commercial banks to provide financing to their affiliated securities firms, derivatives dealers, money market funds, and even automotive companies, in order to prevent potentially disastrous effects of their failure on the financial system and the broader economy. Crisis containment and systemic risk considerations consistently prevailed over the statutory purpose of preventing the leakage of the federal subsidy outside the depository system. This Article further argues that the recent amendments to section 23A under the Dodd-Frank Act of 2010 fail to address this fundamental tension in the operation of the statute. The Article concludes with a discussion of potential implications of this argument for future financial regulatory reform.
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