From Gramm-Leach-Bliley to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act

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\u27s 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\u27 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 of 2007-2009. The Article puts together a comprehensive record showing how the Board\u27s 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