October 20, 2003
The Honorable Alan Greenspan The Honorable John D. Hawke, Jr. Dear Chairman Greenspan and Comptroller Hawke: I am writing with respect to the October 10, 2003, report, Bank Tying: Additional Steps Needed to Ensure Effective Enforcement of Tying Products, GAO-04-3, which was prepared by the U.S. General Accounting Office (GAO) at my request (see, my letters dated July 11, 2002, September 12, 2002, and November 4, 2002). On April 29, 2003, the Chairman and Ranking Member of the Committee on Financial Services asked that this report also be submitted to them under separate cover. The report that we are releasing today updates GAO's previous report, Bank Oversight: Few Cases of Tying Have Been Detected, GAO/GGD-97-58 ( May 8, 1997) in response to a growing chorus of complaints from customers and competitors of banks regarding alleged tying violations and numerous press reports indicating increased concerns about illegal tying and underpricing of credit. "There are laws, but no one seems to obey them and no one seems to enforce them," observed one banker in "The God That Failed," Investment Dealers' Digest, September 9, 2002, at 32. One reason the practice continues to flourish, say bankers, is that illegal tying is hard to prove. Following an extensive review, GAO has found that the application of the antitying laws "is complicated and heavily dependent on the particular circumstances and facts of specific transactions" (p. 24). This fact, along with the lack of timely, clear, and comprehensive guidance, has contributed to widespread confusion about what is prohibited and what is permitted. GAO notes that the Board of Governors of the Federal Reserve System (Federal Reserve) and the Office of the Comptroller of the Currency (OCC) recently conducted targeted reviews of the antitying policies and procedures of several large commercial banks, and the Federal Reserve, working with the OCC, recently solicited public comment on proposed interpretation and supervisory guidance. GAO concludes that more needs to be done to ensure effective enforcement, and that loan pricing behavior merits further study. My specific comments on the 55-page GAO report are as follows: 1. In March 2003, the Association for Financial Professionals (AFP) reported that 56 percent of companies with revenues greater than $1 billion responding to the AFP's survey reported that their commercial bank credit providers denied credit or changed the terms of credit after the company did not award the bank other financial business. According to GAO, none of these situations resulted in the corporate borrower complaining to one of the banking regulators (p. 16).GAO determined that substantiating charges of unlawful tying, if it occurs, can be difficult because, in most cases, credit negotiations are conducted orally and thus generate no documentary evidence to support borrowers' allegations (pp. 15, 17). More than one banker has said: "Only an idiot would put the tie in writing. And there's always documentation in the files indicating that these laws were not violated." GAO found that, with few exceptions, complaints have not been brought to the attention of bank regulators. Corporate borrowers cited (1) the lack of documentary evidence, (2) fear of adverse consequences on their companies' future access to credit or their individual careers, and (3) uncertainty about which arrangements are lawful or unlawful, as reasons for not filing claims with bank regulators or seeking legal remedies. The GAO report section heading "Corporate Borrowers Could Not Provide Documentary Evidence to Substantiate Allegations of Unlawful Tying" (p. 17) thus accurately reflects what GAO found. GAO was forced to conclude therefore that "the available evidence did not clearly support contentions that banks violated section 106 [the antitying restrictions]" (p. 39) while noting "thus, banking regulators may have to obtain other forms of indirect evidence to assess whether banks unlawfully tie products and services" (p. 15). GAO suggested that, because documentary evidence demonstrating unlawful tying might not be available in bank records, regulators might have to look for other forms of indirect evidence, such as testimonial evidence, to assess whether banks unlawfully tie products and services (p. 17). I agree. GAO found that, although customer information could have an important role in helping regulators conduct enforcement in this area, regulators do not have a specific mechanism to solicit information from bank customers on an ongoing basis (p. 15). I believe that this shortcoming should be addressed promptly by a mechanism that addresses the concerns of the complainants about retribution. 2. GAO reports that Federal Reserve and OCC regular bank examinations (pp. 17-19) have moved toward a risk-based assessment of a bank's policies, procedures, and internal controls, with tying being one of many possible topics, and away from testing particular transactions. GAO notes, correctly, that (1) the effectiveness of this approach depends on the regulators' awareness of risk, and (2) in the case of tying, regulators are confronted with a disparity between frequent allegations and few, if any, formal complaints. GAO further found that examiners generally would not contact customers as part of their examinations and thus would have only limited access to information about transactions or practices that might point to possible illegal tying. This is problematic. 3. The GAO report also discusses the special targeted reviews that the Federal Reserve and OCC began in 2002 (pp. 19-24). According to GAO, your reviews (1) focused on policies and procedures, (2) relied on interviews with bank managers responsible for compliance, training, credit pricing, and internal audit, and (3) did not include broad-based testing of transactions that included interviews with corporate borrowers. GAO reports that the targeted review did include contacting some bank customers to obtain information on specific transactions. GAO reports that you did not detect any unlawful combinations or questionable transactions other than the limited instances discussed in the GAO report, and that you are of the view that banks covered in the review generally had adequate controls in place. GAO reports that examiners found that oversight by internal audit functions at several banks needed improvement, and that examiners were concerned that certain "dual employee" arrangements might cause customer confusion about the legality of tying arrangement. GAO raises serious questions about the limitations of the targeted reviews, and I tend to agree. 4. According to GAO, the targeted reviews found variations in banks' interpretations of section 106 in areas where authoritative guidance was absent or incomplete (p. 22). Examiners were concerned that some bank transactions might circumvent section 106 (p. 23). This is unacceptable. 5. In response, GAO notes that the Federal Reserve recently released for public comment a proposed interpretation of the antitying restrictions. I commend the Federal Reserve for this action. On review, however, the interpretation is overly complex and raises as many questions as it answers. I continue to see many pitfalls for the wary and unwary alike. Absent is any strong statement that you expect the banks to obey the law. The tone of the document appears to be tilted toward a "wink and nod" approach to noncompliance: "Cross-marketing and cross-selling, whether suggestive or aggressive, are part of the nature of ordinary business dealings." The OCC issued a white paper arguing that "relationship banking" practices are consistent with the relevant legal framework (68 Fed. Reg. 52024, Aug. 29, 2003), and Comptroller Hawke is quoted in an October 27, 2003, Business Week Commentary calling this "one of the phoniest issues of all time. Are we to believe that big, sophisticated borrowers are being coerced?" This is very troubling. Section 106 of the Bank Holding Company Act generally prohibits a bank from conditioning the availability or price of one product or requirement that the customer also obtain another product from the bank or an affiliate of the bank. But that is far from the end of the inquiry. The arrangement must involve two or more separate products: the customer's desired product and one or more separate tied products. And the bank must force the customer to obtain or provide the tied product from or to the bank or affiliate in order to obtain the desired product from the bank. There are many, many exceptions that erode the rule and sew confusion, some expressly stated by the statute and others created by Federal Reserve rule or order. The prohibition applies only to tying arrangements imposed by the bank, and not to those imposed by its nonbank affiliates, inviting mischief and subterfuge, footnote 17 notwithstanding. The bank is allowed to tie the availability or price of a bank product such as a loan to the customer's purchase of a "traditional bank product" from the bank. The scope of this term, and therefore this exception, continues to expand. Pretty soon, there will be no point to the prohibition. And in the financial services equivalent of the much-disavowed "don't ask, don't tell" policy, the interpretation outlines how banks can link loans to investment banking deals by setting a "hurdle rate" for customer relationships that forces the corporate customer to buy high-fee non-traditional products. 6. Some critics have complained that large commercial banks deliberately priced credit at below market rates to attract underwriting business to their investment banking affiliates. GAO found that the evidence of "mispricing" or "underpricing" is "ambiguous and subject to different interpretations" and notes that Federal Reserve staff is considering further research into the issue (p. 25). The banking regulators said that pricing credit below market interest rates, if it did occur, could raise serious issues under section 23B of the Federal Reserve Act, with the bank's income being reduced for the benefit of its investment affiliate. I strongly support further study. 7. GAO concluded that the different accounting methods, capital requirements, and levels of access to the federal safety net did not appear to give commercial banks "a consistent competitive advantage" over investment banks (p. 31), while noting that there are differences and advantages (pp. 31-38 and Appendix 1 pp. 42-51). For example, industry observers and banking regulators agreed that commercial banks receive a subsidy from the federal safety net; however, they differed on the extent to which the subsidy was offset by regulatory costs. Of particular interest, given this Committee's jurisdiction over accounting standards, is GAO's finding that the volatility of the fair value of loan commitments and the related loan, if the commitment were exercised, "would be reflected more transparently in an investment bank's financial statements, because an investment bank must recognize these changes in value in earnings as they occur in net income" (p. 42). GAO determined, however, that this is offset by the facts that (1) because loan commitment terms are usually for less than one year, the accounting differences would be short-lived, and (2) both commercial banks and investment banks are required to make similar footnote disclosures about the fair value of their financial instruments (pp. 42-43). Recommendations: Because the facts, if any, that would suggest a tying violation generally would not be found in the loan documentation that banks maintain and because bank customers have been unwilling to file formal complaints, effective enforcement of section 106 has been stymied and requires an assessment of other means and forms of evidence. GAO recommends that the Federal Reserve and the OCC take additional steps to ensure effective enforcement of section 106 and 23B by enhancing the information that they receive from corporate borrowers. GAO suggests that you develop a broad-based communication strategy to better educate the corporate community about which activities are prohibited and permitted, and establish contact points within your organizations to answer questions about the guidance and specific transactions, as well as to accept complaints. GAO also recommends that the Federal Reserve conduct additional research on loan pricing behavior, and publish the results of this assessment. I agree with these recommendations and urge their implementation. When Congress adopted section 106 in 1970, we were concerned about maintaining fair competition. I continue to stand by that goal. The passage of the Gramm-Leach-Bliley Act in 1999 greatly complicates this task. It created many opportunities for positive innovation but also innumerable conflicts of interest and opportunities for abusive behavior. Illegal tying is extortion, pure and simple. It is unclear to me that your organizations take this matter seriously. Sincerely,
cc: The Honorable W. J. "Billy" Tauzin, Chairman The Honorable Michael G. Oxley, Chairman The Honorable Barney Frank, Ranking Member
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