Banking Interpretations

April 25, 2003 

Marcia Wallace, Esq.
The Bank of New York
One Wall Street
New York, NY 10286

Dear Ms. Wallace:

This responds to your letter of July 11, 2002, and attached memorandum from your counsel, Sullivan & Cromwell (the “S&C Legal Memorandum”), wherein you seek the the New York State Banking Department’s (the “Department’s”) concurrence that certain proposed equity derivatives transactions to be conducted by the Bank of New York (“Bank”), a New York state-chartered member bank, are within the authority of a New York state-chartered bank under the New York Banking Law (“Banking Law”).  In addition, you seek the Department’s concurrence that Bank may acquire equity securities for the purpose of hedging such equity derivative transactions.[1]

We concur with your analysis that the proposed activities as described are “incidental” to the “business of banking” under Section 96.1 of the Banking Law.  Please be aware that this letter clarifying the legal authority of the Bank to conduct such activities does not constitute approval for the Bank to conduct the activities.  In accordance with longstanding Department practice, any approval to actually engage in the proposed activities must be granted in writing by the Deputy of the Division within the Department responsible for supervising the Bank.  Such approval, if granted, must follow a review and analysis by the Division of the Bank’s business plan, expertise, infrastructure and internal controls with respect to the proposed activities, and the Division’s Deputy must be satisfied that the business plan and controls are acceptable for the safe and sound conduct of the business.  In addition, such activities will continue to be monitored through the examination process and, depending upon the findings of such examination, the Department may choose to modify or withdraw its approval of such activities in the future.

The Proposed Transactions

The Bank proposes to enter into cash-settled derivatives transactions with its institutional customers and high net worth individuals based on equities and equity indices.[2]  The Bank stated that it does not plan to enter into equity derivatives transactions with affiliates or with funds or other entities advised or sponsored by the Bank or its affiliates.[3]  All of the proposed transactions would be “matched” by offsetting transactions or hedged on a portfolio basis to minimize equity price risk to the Bank.  The specific proposed transactions would be equity swaps, equity calls, equity puts, protective equity puts with a loan, equity collars, monetizing equity collars, barrier options, and forwards/variable delivery forwards (all collectively referred to as “the equity derivatives transactions”).[4]  The Bank has also applied to the Department for authority to hedge its permissible derivatives transactions by acquiring no more than five percent of a class of equity securities of any one issuer.

Legal Analysis


The Bank is a New York state-chartered bank, and, as such, its powers are defined by New York State law.  Section 96 of the Banking Law enumerates certain powers of New York banks, including the powers:

“…to discount, purchase and negotiate promissory notes, drafts, bills of exchange, other evidences of debt… lend money on real or personal security; borrow money and secure such borrowings by pledging assets; buy and sell exchange, coin and bullion; and receive deposits of moneys, securities or other personal property upon such terms as the bank or trust company shall prescribe; and exercise all such incidental powers as shall be necessary to carry on the business of banking….” (italics added)  (Banking Law Section 96.1).

It is well settled by the New York courts that the activities in which New York banks may engage are not limited to those enumerated in the Banking Law.  In Curtiss v. Leavitt (15 N.Y. 9) (N.Y. 1857), the New York Court of Appeals rejected a narrow reading of the “incidental powers” provision of the Banking Law, now codified at Banking Law Section 96.1.  In that case, the Court reasoned that the enumerated powers in the statute “were evidently not intended to restrict the appropriate business of banking, but as a mere legislative definition of that business; a definition not indispensable; perhaps, but eminently useful” (Id. at 58).  In explaining that the term “necessary” should be afforded a flexible meaning, the Court stated: “There may be an absolute necessity, a great necessity, and a small necessity; and between these degrees there may be others depending on ever varying efficiencies of human affairs” (Id. at 64).  Similarly, in Dyer v. Broadway Central Bank (252 N.Y. 430, 434), the Court of Appeals stated that “care should be exercised not to cripple [banking organizations] and break down their usefulness by a narrow and unreasonable construction of the statutes which will result in unwisely limiting their usefulness in the transaction of business under modern conditions.”

In a more recent case, in which the Court of Appeals upheld a determination by the Department that the purchase and sale of fixed- and variable-rate annuities was “incidental” to the “business of banking” within the meaning of Banking Law Section 96.1, the Court again noted: “we have long been mindful that the business of banking is not static but rather must adjust to meet the needs of the customers to whom banking organizations provide a valuable service.”  In the Matter of New York State Association of Life Underwriters Inc., et. al., v. New York State Banking Department (83 N.Y. 2d 353, 361) (N.Y. 1994) (“Life Underwriters”).  In Life Underwriters, the Court pointed out that the “incidental powers” clause is subject to interpretation, and the Court confirmed that “the Banking Department is charged with execution of the laws relating to individuals, partnerships and corporations to which [the Banking Law] is applicable…” and “is presumed to have the requisite knowledge and understanding of the operational practices of such banking organizations and of the Banking Law.” (Id. at 360).



Over the past decade or so, the Department has determined that acting as principal in various types of derivatives transactions constitutes a permissible banking activity and is “incidental” to the “business of banking” pursuant to Banking Law Section 96.1 in a series of approvals granted on a case-by-case basis to specified banks upon their application to the Department. 

  1. Early Department Commodities Derivatives Approvals

In 1987, the Department allowed a New York state-chartered bank to engage in cash-settled oil swaps on a matched basis (i.e. a contract with a producer would be offset by a contract with a user).  The Department viewed this as a “riskless principal” credit intermediation activity.  (See September 25, 1987 letter from First Deputy David T. Halvorson to Mark C. Brickell).  In 1988, the Department issued a broader approval permitting a New York state-chartered bank to make loans, take deposits, and enter derivatives transactions linked to commodity prices or indices.  (See November 14, 1988 Letter from First Deputy David T. Halvorson to Anthony J. Horan) (“Halvorson Letter”).  Specifically, the activities approved included:  (i) making loans and taking deposits having terms measured according to the prices of commodities or according to financial or economic indices; (ii) entering into over-the-counter (“OTC”) derivative financial contracts such as swaps, forward contracts and option agreements having such terms; and (iii) entering into exchange-traded options and futures contracts relating to such commodities or indices for the purpose of hedging the lending, deposit-taking and derivatives activities.

The incoming request letter submitted by Mr. Horan, dated October 4, 1988 (the “Horan Letter”) described the evolution of the financial intermediation function that led to “cross-market” intermediation as well as new types of products to accommodate banking customers’ needs.[5]  As described in the Horan Letter, borrowers whose profitability or ability to service debt (for example, oil companies, mining companies and industrial users of certain commodities such as utilities and airlines) are becoming increasingly sensitive to the need to manage their risk by linking their financing transactions to the commodities markets.  Lenders and investors who have direct or indirect commodity-related risks (e.g. because of the nature of the borrowers/issuers whose obligations they hold or the nature of their sources or uses of funds) have similar hedging needs.  These needs translate into demands in the corporate and institutional marketplace for intermediation by financial institutions in ways that cut across financial markets, linking different currencies, fixed and floating interest rates and cash flows based on prices of commodities or on economic or financial indices. (“Horan Letter” at p. 2).[6]

The financial intermediation function provided by banks further evolved such that banks used products, such as swaps, options and forwards – to provide the same intermediation function for borrowers.  The evolution of the “derivative products” market followed the “unbundling” of traditional loan and deposit products whereby banks entered into contracts with customers that provided for the desired cash flows, but eliminated the underlying loan or deposit instruments.  For example, swaps evolved from loan arrangements known as “parallel” loans and deposits. (“Horan Letter” at p. 4).[7]

In approving the types of derivatives activities described in the Horan Letter, the Department concurred with the legal analysis stated in the letter. Banks have the power to take deposits and make loans – and products derivative thereof – involving interest rates or other features linked to prices of commodities, or to indices such as commodity price indices and security price indices.  The Department has approved similar activities (See e.g. March 8, 1995 letter from Assistant Counsel Stacey Cooper to Stuart K. Fleischmann, Esq., concerning issuance of equity-linked certificates of deposit by a foreign bank branch).  Loans made by banks may also have interest rates or other terms that are functions of commodity prices or other indices.  Banks have long engaged in lending in which the amount of interest payable by a borrower has been a function of the borrower’s profitability.  For borrowers in agricultural and natural resource dependent industries, such arrangements have implicitly resulted in linkage to price levels of the underlying commodities on which the borrowers depend.

The Horan Letter also illustrated that engaging as principal in transactions in derivative instruments is a form of financial intermediation, which itself is a banking power that is broader than the power to make loans and take deposits.  Intermediation by banks involves: (i) serving as an informational “clearinghouse” (bringing customers with offsetting needs together); (ii) acting as a “middle-man” in evaluating the credit risk of parties and accepting the credit risk of customers on both sides of offsetting transactions; and (iii) “customizing” financial obligations by permitting customers’ obligations to banks and their claims on banks to be tailored to their particular needs.

The hedging aspects of the derivatives activities proposed in the Horan Letter were also found by the Department to be authorized for banks.  Specifically, hedging on a portfolio basis, which is more efficient than having to find two (or more, for multiple-leg transactions) offsetting back-to-back contracts, was viewed as acceptable and uninfluential in a determination of whether the underlying derivatives activities themselves were permissible.  Also, hedging through the purchase and sale of financial futures contracts and options was also deemed to be a permissible “incidental” activity, irrespective of the fact that the bank could not directly invest in the underlying instrument.

Essential to the Department’s determination that the derivatives activities proposed in the Horan Letter were a permissible bank activity was the fact that the bank’s business would not be a “positioning” business.  That is, the bank would neither seek to nor take any outright market risk relating to the prices of the commodities or indices at issue.  Instead, the purpose of engaging in the activities was to engage in financial intermediation and offer products to customers to hedge their risks.  This has often been referred to in banking regulators’ jargon as the requirement that the activities be “customer-driven”.  The Department also required that each bank that was the subject of a specific approval have formal policies and procedures in place to address the various risks inherent in the activities, including commodity risk, liquidity risk, counterparty risk, hedging risk, as well as policies relating to credit approval, risk limits and internal controls and procedures.  The Department also insisted that the Board and senior management have policies and procedures in place to ensure that all risks associated with the activities in the bank are kept within prudent bounds, that speculation is avoided, and that mismatches are kept within limits appropriate in light of the capital and expertise of the specific bank.  (Halvorson Letter).

  1. Later Department Commodities Derivatives Approvals

In the ensuing years, the Department has granted numerous approvals to several New York banks as well as to New York-licensed branches and agencies of foreign banks to engage in similar derivatives activities, generally on substantially the same conditions as approved early on in the Halvorson Letter.  Certain permutations have occurred with respect to certain approvals depending on the circumstances presented.  Several of the additional approvals over the years have allowed the same types of derivatives activities based on different commodities or indices than those previously approved.  The Department has found the legal authority for permitting derivatives activities for different commodities or indices to be exactly the same as that employed by the Horan Letter – namely, that the activities, conducted on the terms described therein, constitute a form of financial intermediation which is both part of the business of banking and incidental to other enumerated banking powers.  The main new issues that have been considered by the Department are the different risks that may be presented by the not-yet-approved underlying types of commodities or other indices.  For example, if the price of the underlying commodity is very volatile, the price risks could be high.  Similarly, if there is not sufficient depth to the market for the commodity (or index, etc.), efficient hedging without market disruption might not be possible.  Counterparty risks may vary depending upon the instruments in question.  In any event, the Department must be satisfied that factors such as business plan, risk limits, hedging methodologies, and management and internal controls, are satisfactory each time a banking institution proposes to engage in derivatives activities involving new or different commodities or underlying instruments.

Other conditions of the Department’s approvals have been modified from time to time as well.  For example, in some cases, the Department has allowed banks to hedge risks from engaging in permitted commodities derivatives transactions by entering into transactions that involve physical delivery of commodities or documents evidencing title to commodities.  In connection with such approved “physical hedging” activities, the Department has also allowed banks to engage in all activities incidental to taking or making delivery, including storing, transporting, and disposing of such commodities.  Such incidental activities would, of course, not be performed by the bank itself.  The bank would enter into contracts with owners of storage and transportation facilities. The legal justification for “physical hedging” is no different than that for hedging with exchange-traded financial derivatives.  In both cases an otherwise impermissible investment can be made as the mechanism for protecting the bank from the risks it incurs in offering a financial product based on the price of a commodity.  Markets involving physical delivery may also offer a more “precise” hedge than those involving exchange-traded instruments, thus lowering a bank’s “basis risk” (i.e. the risk that price fluctuations of the hedging instrument will not exactly match the price fluctuations of the underlying instrument).


The Office of the Comptroller of the Currency (“OCC”) has, through a series of interpretative letters, permitted similar commodities derivatives and related hedging activities for national banks.  In 1987, the OCC allowed a national bank to enter into commodity index swaps on a matched basis (i.e. a contract with a user would be matched with a contract with a producer, and vice versa).  The OCC noted that because the transactions would be matched, the only risk to the bank would be its credit risk to a particular user or producer ( OCC No-Objection Letter No. 87-5, July 20, 1987).  Later, the authority for national banks to engage in commodity index swaps on an unmatched basis was permitted.  The bank would no longer have to wait until perfectly offsetting swap contracts are available before entering into a commodity price index swap agreement with a counterparty.  Instead, it could enter into swap agreements and hedge any unmatched commodity price risk exposure by purchasing and selling exchange-traded commodity futures with the intention of entering into offsetting commodity swaps if they became available.  The bank would not use unmatched commodity swaps to speculate in commodity price movements.  Also, the bank would never take delivery of a commodity.  Rather, all instruments would be cash-settled.  Like the  Department, the OCC found the derivatives activities conducted on such terms to be a form of financial intermediation – and thus a permissible banking activity, not an impermissible investment or trading activity.  (OCC No-Objection Letter 90-1, February 16, 1990).  A later OCC letter permitted national banks to conduct a commodity price index swaps business on a “portfolio hedged” basis.  That is, rather than separately hedge each unmatched swap, the bank could hedge its exposure on a portfolio basis.  The OCC also allowed national banks to use OTC instruments such as options and exchange-traded futures, to hedge the commodity price risk associated with unmatched swaps.  The banks were also permitted to hedge commodity price risk from unmatched swaps with offsetting swaps, futures and options on closely-related (i.e. not necessarily identical) commodities.  (OCC Letter from Horace G. Sneed, March 2, 1992 (unpublished) (“Swaps Warehousing Letter”).

In 1988, the OCC affirmed the power of a national bank to take deposits linked to commodities or indices.  (Decision of the Comptroller of the Currency on the Request by Chase Manhattan Bank, N.A., to offer the Chase Market Investment Deposit Account, August 8, 1988) (“MII Deposit”).  The OCC’s determination that offering such an index-linked deposit was permissible as part of the business of banking was upheld in a Federal District Court decision (Investment Company Institute v. Ludwig 884 F. Supp. 4 (D.D.C. 1995). 

The OCC has also permitted national banks to enter into contracts for the purpose of hedging bank-permissible derivatives activities which contracts provide for “physical delivery” of the bank-impermissible commodity.  In no case would the bank actually take physical delivery of the commodities.  Delivery would occur by transfer of warehouse receipts or simultaneous “pass-through” delivery to another party. (OCC Interpretive Letter No. 684, August 4, 1995).



Following the earlier commodities derivatives approvals, banks have requested permission to engage in equity-linked derivatives activities.  The issues presented to banking regulators with respect to equity derivatives activities are substantially the same as those presented by commodities derivatives activities.  Because equity derivatives activities may involve individual securities or a basket of securities as the underlying reference asset for a derivative contract, an additional issue is raised whether such contracts may be entered into by banks consistent with New York Banking Law and federal Glass-Steagall Act restrictions on banks purchasing and dealing in securities.

  1. OCC Equity Swaps Approval

As early as 1994, the OCC permitted national banks to engage in equity derivative swaps (See Interpretive Letter No. 652, September 13, 1994 (the “Equity Swaps Letter”).  The parties to an equity derivative swap contract agree to make payments to each other based on an increase or decrease in the notional principal investment in a particular equity or equity index.  One party (the “short”) agrees to make periodic payments to the counterparty (the “long”) if there is an increase in the value of the notional principal investment.  The short also agrees to pay the long amounts equal to the dividends on the equity or the equity index.  The long agrees to make periodic payments to the short based on a specified floating rate of interest applied to the same notional principal investment.  In addition, the long agrees to make payments to the short if there is any decrease in the value of the notional investment in the equity or equity index.  The notional principal investment under an equity derivative swap is adjusted each period to reflect changes in the value of the underlying equity or equity index.  There is no physical delivery of the securities underlying an equity derivative swap.  Banks will sometimes enter into separate but offsetting contracts with different counterparties; in essence resulting in payments being transferred between the shorts and the longs by the intermediary banks.  At times, however, banks may hedge swaps exposure by acquiring or selling non-swap financial instruments, such as exchange-traded futures or options.

The legal rationale as to why such activities constitute an activity that is part of the business of banking is identical to why similar activities involving commodities as the underlying reference asset constitute the business of banking.  In the Equity Swaps Letter, the OCC reasoned that these activities – like commodities derivatives activities – involve a transfer and receipt of payments that are a logical outgrowth of bank’s power to take deposits and make loans.  The activities are another form of financial intermediation which involve a bank’s ability to determine the rates or factors on which it will base its contract to pay or receive funds.  The activities are a permissible banking activity if performed on the same conditions as commodity derivatives activities as a form of financial intermediation or as a tool to manage risk.

With respect to the Glass-Steagall Act issue, the OCC opined that, as in the case of commodity price index swaps, banks may engage in activities that constitute permissible banking activities even if they are not permitted to own the underlying instrument.  The OCC also enumerated various differences between owning an equity and equity derivative swap contracts, including:  (i) parties to equity derivative swaps do not acquire voting or management rights, which are generally associated with equity ownership; (ii) equity owners receive dividends if declared by boards when funds are legally available, whereas dividend payments under equity derivative swaps are governed by the terms of the contract;  and (iii) a party to an equity derivative swap may not dispose of the securities underlying the equity derivative swap as the actual owner of securities can.  Also, the OCC found that owners of equity securities are exposed directly to the market risks of holding corporate stock, whereas parties to an equity derivative swap are exposed indirectly to the market risks of the corporate stock underlying the equity derivative swap and directly to the credit risk of the counterparty. (Id.). 

  1. Department Equity Swaps Approval

The  Department, citing the OCC’s Equity Swaps Letter, as well as the Department’s own previous commodity derivatives approvals and the rationale thereunder, confirmed the authority of New York state-chartered banks to engage in equity derivative swaps in 1995. (See e.g. May 22, 1995 letter from Robert H. McCormick to Canadian Imperial Bank of Commerce – New York Agency).

  1. OCC Approvals to Engage in Equity Derivatives Activities Other than Equity Swaps

Recent OCC letters have, directly and indirectly, addressed equity derivatives.[8]  In addition, more recent OCC letters have, directly and indirectly, addressed equity derivatives.  In 2002, the OCC confirmed the ability of a national bank to engage in derivatives activities – such as swaps, options and forwards – based on the price of electricity. (See OCC Interpretive Letter No. 937, June 27, 2002).  Letter 937 did not specifically at length address equity derivatives, but the letter at the outset notes that the national bank (in this case, Bank of America) currently engages in a variety of financial intermediation transactions involving exchanges of payments based on interest rates, and the value of equities and commodities. (Id.).

Directly related to the issue at hand, the OCC issued a letter addressed to Mr. Kieran Fallon of the Federal Reserve Board’s (“FRB’s”) Legal staff. (See Letter dated September 19, 2002 from Julie Williams, Esq. to Kieran Fallon, Esq.) (“September 19 Letter”).  The FRB requested that the OCC confirm in writing whether it would be permissible for a national bank to engage in cash-settled “equity derivatives transactions” that involve exchange of payments between a bank and its customers based on changes in the value of equity securities.  The OCC’s September 19 Letter generally addresses cash-settled equity options and forwards.[9]  It does not expressly address the various specific types of contracts proposed by the Bank in the current proposal  -- i.e. equity swaps, equity calls, equity puts, protective equity puts with a loan, equity collars, monetizing equity collars, barrier options, and forwards/variable delivery forwards.  We understand that the FRB’s request to the OCC was, in fact, prompted by the Bank’s current proposal.

The September 19 Letter concludes that equity derivatives transactions are permissible if they are part of a bank’s customer-driven, non-proprietary financial intermediation business, and if the bank has in place an appropriate risk measurement and management process for its derivatives and hedging activities.  The OCC noted that, in the absence of particular facts and supervisory knowledge of a particular institution, it would be unable to opine whether particular equity derivatives transactions are permissible.  In other words, the OCC’s determinations that derivatives activities are permissible are made, as at the Department, on an institution-by-institution basis, and the OCC’s opinions do not apply generally to all national banks.  Nevertheless, the OCC stated that cash-settled equity options and forwards may be permissible for national banks under the same rationale provided in OCC precedent addressing equity and equity index swaps.  The OCC stated that, similar to swaps, these option and forward products fundamentally involve exchanges of payments based on the value of equities, and that the OCC has viewed these transactions as permissible if they are part of a financial intermediation business and an appropriate risk measurement and management process is established.

  1. Department Approvals Regarding Equity Derivatives Activities Other than Equity Swaps

In 1992, the Department approved a New York state-chartered bank’s request to expand its commodity-related financing activities to include certain equity derivatives products.  Specifically, the Department approved a bank engaging in equity swaps, forwards and options whose price would be based on equity indices or baskets of equity securities.  Such transactions would be matched so as to limit the bank’s exposure to equity market risk arising from changes in such indices.  The Department also allowed the same bank to engage in unmatched portfolio hedged transactions for certain approved equity derivative transactions.  Such transactions would be limited to those that had received senior management’s approval through the bank’s standard approval process similar to the one already in place for the bank’s commodity derivatives products.  In such transactions, the bank would contract with a single counterparty and hedge the market risk on a portfolio basis, subject to trading limits and management review. (See February 6, 1992 letter from Deputy Superintendent Carmine M. Tenga to Jeffrey R. Larsen).

In 1995, the Department interposed no objection to the New York-licensed agency of a foreign bank entering into various derivatives contracts – including swaps, options, swaptions, caps, collars, floors and collars, based on equities and equity indices.  The Agency represented that it intended to hedge its principal exposures from such transactions on a matched basis and that all derivatives contracts would be cash-settled. (May 22, 1995 McCormick letter, supra.).

In the Department’s view, derivatives activities linked to equities or equity indices – if conducted subject to the same conditions that have been required in commodity-linked activities – constitute fundamentally the same banking activity as commodity-related derivatives activities.  If the transactions are customer-driven (i.e. the business is not a “positioning” business, but conducted as a means to serve the legitimate business purposes of customers) and if the bank does not conduct the activities for speculative purposes, but seeks to conduct its business on a matched basis by using offsetting transactions or hedging on a portfolio basis, and if the derivatives activities are cash-settled, the activities are a permissible banking activity similar to commodities derivatives.  The bank is engaging in financial intermediation activities that are part of the business of banking, and would be within the “incidental powers” permitted for New York banks under Banking Law Section 96.1.


To the extent that a bank’s engaging in equity-based derivatives might raise an additional issue of whether such activities might be viewed as a bank impermissibly purchasing or dealing in securities, we believe that such activities would not violate banking law prohibitions on purchasing or holding stock, except as expressly permitted.  (See N.Y. Banking Law Section 97; 12 U.S.C. 24 (Seventh)).

  1. New York Banking Law Considerations

As far as New York Banking Law is concerned, the Department would not view a New York bank’s entering into equity derivatives contracts as an “investment” in securities within the meaning of Section 97.  As discussed above, the activity is one of financial intermediation and is not conducted in a manner so as to hold a “position”, or investment, in the equities underlying the derivative instruments.  This rationale applies whether the underlying reference asset is a single security or a basket of securities.  Any prohibition on investing, dealing or underwriting securities is inapplicable if the securities activities are otherwise permissible banking activities.  This rationale has been upheld more than once in the New York courts.  In Block v. Pennsylvania Exchange Bank, 253 N.Y. 227 (N.Y. 1930) (“Block”), the New York Court of Appeals distinguished between impermissible purchases of securities and a bank’s purchases of securities that were permissible as part of the business of banking:[10]

“On the one side are speculative purchases for the benefit of the bank itself, or in the aid of some transaction foreign to the banking function.  On the other are transactions where the pledge of credit of the bank is tributary to an exchange of credit for the accommodation of a customer.”

Life Underwriters is another New York Court of Appeals decision that reaffirmed that the primary analytical legal question in connection with new banking activities or products is whether the activity constitutes the “business of banking”:

“While the Court has not sanctioned every activity engaged in by banks as an incidental power necessary to carry on the business of banking, commercial banks in this state now engage in such activities as selling certificates of deposit, buying or selling securities on behalf of customers, establishing individual retirement accounts, and providing financial planning and investment counseling services.  It therefore follows, as the precedent of this Court demonstrates, that the “incidental powers” clause of Banking Law 96(1) may be construed so as not to limit the term “business of banking” to activities which are necessary to achieve the powers expressly authorized in the statute.  Rather, the clause must be construed as an independent, express grant of power, intended to reflect the ever-changing demands of the banking business”.  (Id. at 363).

That case dealt with the ability of a New York state commercial bank to sell fixed- and variable-rate annuities.  While the Court found that annuity contracts were investment products, rather than insurance contracts, the case illustrates that even if annuities are deemed to be insurance for certain purposes, this does not overcome, or necessarily exclude, a determination that an activity performed by banks involving the investment in question is rightfully part of the “business of banking”.

  1. Federal Law Considerations

The Department would not purport to make a determination whether the Bank’s proposed activities are permissible under applicable federal laws, including, but not limited to, the Glass-Steagall Act.  The OCC has determined that equity derivatives activities are part of the business of banking.  As pointed out in S&C’s Legal Memorandum, both the OCC’s and the FRB’s views are relevant to this question as the Bank is a Federal Deposit Insurance Corporation (“FDIC”) – insured bank, as well as a member of the Federal Reserve System.  Section 24 of the Federal Deposit Insurance Act provides that, subject to certain exceptions that may be granted by the FDIC, an insured bank may not (i) engage as principal in any type of activity, or (ii) acquire any equity investment, that is not permissible for a national bank. (12 U.S.C. 1831a(a)(1) and (c)(1)).  Accordingly, the Bank must assure that the activities are permissible under applicable federal law.  Additionally, Section 9(20) of the Federal Reserve Act subjects Federal Reserve member banks to the same limitations on securities activities applicable to national banks under Section 16 of the Glass-Steagall Act. (12 U.S.C. 24 (Seventh)). 

  1. OCC view that activities properly part of the business of banking, even if they involve securities for purposes of other federal laws, do not violate Glass-Steagall

As noted above, the OCC’s previous commodity derivatives opinions, as well as the Equity Swaps Letter and the September 19 Letter indicate that the OCC would similarly find the specific types of equity derivatives transactions in the Bank’s proposal to be permissible banking transactions.  While some might observe that the equity derivatives contracts proposed to be entered into by the Bank may clearly be deemed to be “securities” under certain laws, for example, the federal securities laws, this fact, if true, would not preclude a finding that the activities constituted part of the “business of banking”.

The Gramm-Leach-Bliley Act of 1999 (“GLBA”), which, among other things, modernized the federal banking law, clarified and permitted a range of expanded activities that may be conducted within banking organizations.  One area addressed by the GLBA was the exemption extended to banks as either a “broker” or “dealer” under the Securities Exchange Act of 1934 (“Exchange Act”).  The GLBA clarified that banks may offer “identified banking products” without registration as a “broker” or “dealer” under the Exchange Act.  The term “identified banking products” includes certain swap agreements.  “Swap agreement”, in turn, is defined in the GLBA as:

“…any individually negotiated contract, agreement, warrant, note or option that is based, in whole or in part, on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies, interest or other rates, indices or other assets, but does not include any other identified banking product.”

As pointed out in the S&C Legal Memorandum, in the Commodities Futures Modernization Act of 2000 (“CFMA”), Congress excluded “swap agreements” from the definition of “security” in Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(ii) of the Exchange Act.  For this purpose, the definition of “swap agreement” excluded, among other things, options on securities.  As a result, certain of the proposed equity derivatives transactions may be considered “securities” under federal securities laws.  The CFMA did not, however, amend the definition of “identified banking products” in Section 206 of the GLBA.  Thus, Congress continued to recognize that banks engage in equity options and other similar transactions, notwithstanding that they may be securities under the federal securities laws.  (See S&C Legal Memorandum, fn. 8). 

The OCC has stated its view that activities that may involve national banks buying and selling securities, if constituting an otherwise permissible banking power, do not violate the prohibition on banks investing in, dealing in, or underwriting securities contained in Section 16 of Glass-Steagall.  In its recent letter permitting national banks to purchase equity securities to hedge exposures from otherwise permissible banking transactions, the OCC reviewed the legislative history of Glass-Steagall Section 16 which, provides, in pertinent part, that a national bank shall have the power:

“..To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits, by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing and circulating notes according to the provisions of this chapter. 

The business of dealing in securities and stock by the association shall be limited to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, and the association shall not underwrite any issue of securities or stock:

Provided that the association may purchase for its own account investment securities under such limitations and restrictions as the Comptroller of the Currency may by regulation prescribe. In no event shall the total amount of investment securities of any one obligor or maker, held by the association for its own account, exceed at any time 10 per centum of its capital stock actually paid in and unimpaired….

As used in this section, the term “investment securities” shall mean marketable obligations, evidencing indebtedness of any person, copartnership, association, or corporation in the form of bonds, notes and/or debentures commonly known as investment securities under such further definition of the term ”investment securities” as by regulation may be prescribed by the Comptroller of the Currency.  Except as hereinafter provided or otherwise permitted by law, nothing herein contained shall authorize the purchase by the association for its own account of any shares of stock of any corporation.  The limitations and restrictions herein contained as to dealing in, underwriting and purchasing for its own account, investment securities shall not apply to obligations of the United States….. (12 U.S.C. 24 (Seventh))  (paragraph spacing and underlining added for clarity and emphasis).

In reviewing the origin of the phrasing employed within this section, the OCC set forth its view that the prohibitory language contained in the fifth sentence of 12 U.S.C. 24 (Seventh), to wit: “nothing herein contained shall authorize the purchase by the association for its own account of any shares of stock of the corporation” was meant to be a limitation on the securities investment authority otherwise granted to national banks in that section.  In other words, the OCC believes that Congress intended to clarify that the authority for national banks to hold “investment securities” was not meant to be seen as the basis for holding stock.  However, the OCC argues that the provision in the fifth sentence could not have been a total ban on the owning of stock, since banks may own stock of subsidiaries, or stock taken in satisfaction of debts due, and in certain other circumstances.  In other words, the prohibition is on holding equities as a type of “portfolio investment”. (See OCC Interpretive Letter No. 892, September 13, 2000).  However, to the extent that bank equity activities, or the hedging thereof, may involve banks buying or selling securities, they would not be banned by Section 16 in the OCC’s view since they are not engaged in by the bank as an “investment” activity, but rather as a financial intermediation activity.  In fact, as discussed previously, a condition imposed by the OCC and the Department on derivatives activities involving underlying reference assets that the bank is not permitted to invest in directly, is that the bank may not take price risk on the asset, and must minimize its exposure through matched or hedged positions.

  1. Federal Case Law

Federal case law also establishes that an activity that is validly part of the “business of banking” is not rendered impermissible for banks because of its characterization as a different activity for purposes of a different statute.  In Securities Industry Association v. Clarke, 885 F. 2d 1034 (2d Cir. 1989), cert. denied, 493 U.S. 1070 (1990), the U.S. Court of Appeals for the Second Circuit held that securities activities conducted as part of a permissible banking activity are not precluded by the existence of an express prohibition on underwriting and dealing.  That case involved the securitization of mortgage loans and selling of mortgage-backed certificates by a national bank.  The Court of Appeals upheld the Comptroller’s determination that the activity constituted part of the “business of banking” and therefore did not violate Section 16 of the Glass-Steagall Act.  The Comptroller found that mortgage-backed securities were not securities within the meaning of the Glass-Steagall Act, although they may have been securities for securities laws purposes.  Moreover, the Comptroller determined, and the Court agreed, that even if mortgage-backed securities constituted securities, the bank’s purchase or selling thereof did not constitute impermissible underwriting or dealing in securities, since the activity was a legitimate part of the business of banking. 

Another case held that the purpose of the Glass-Steagall Act was to separate commercial and investment banking, not to limit the ability of commercial banks to conduct activities recognized as commercial banking. (See Securities Industry Association v. Board of Governors of the Federal Reserve System 839 F. 2d 47 (2d Cir. 1988) cert. denied 486 U.S. 1059 (1988)).

Likewise, the U.S. Supreme Court, in upholding the authority of national banks to sell annuities pursuant to the “incidental powers” clause in the National Bank Act, held that even if an activity is prohibited in one statute, the agency may permit an activity based on a different characterization of that activity in another statute.  See Nationsbank v. Variable Annuity Life Insurance Company, 513 U.S. 251, 262 (1995))


As noted, the Bank has also requested the Department’s concurrence with its conclusion that it would be permissible for a New York state-chartered bank to hedge permissible equity derivatives transactions by acquiring up to five percent of a class of stock of any issuer.  We believe this is within the “incidental” powers of a New York bank pursuant to Banking Law Section 96.1.  A bank is not only permitted to hedge its risk arising from its permissible banking activities; it would be criticized for not doing so.  As is the case with hedging commodities derivatives activities through the purchase of commodity instruments that themselves would not constitute permissible bank investments, the purchase of equities may provide the Bank the least-cost and most effective hedge in connection with conducting certain of the equity derivative activities. 

In Interpretive Letter No. 892, (supra.), the OCC confirmed the authority of a national bank to acquire equities for the purpose of hedging bank permissible equity derivative transactions which are originated by bank customers for valid and independent business purposes.  The OCC required that the banks must use such equities solely for hedging and not for speculative purposes.  In addition, the banks may not take anticipatory, or maintain residual positions in equities except as necessary for the orderly establishment or unwinding of a hedging position.  Also, the banks may not acquire equities for hedging purposes that constitute more than five percent of a class of stock of any issuer.

Following the OCC’s Interpretive Letter concerning the ability of a national bank to hedge equity derivative transactions by purchasing equities, the FRB issued a statement that it would not apply Section 9 of the Federal Reserve Act so as to prohibit a state member bank from purchasing equity securities to hedge risks arising from equity derivative transactions entered into by the bank with an unaffiliated third party, provided such purchases are made in accordance with the same conditions and restrictions applicable to national banks and the state member bank receives any required state approvals as well as approval of the FRB’s Director of Supervision and Regulation prior to engaging in the activity of acquiring equity securities for hedging purposes.  (See  FRB Statement Concerning the Acquisition of Stock by State Member Banks to Hedge Equity Derivative Transactions, February 21, 2002).  The Department believes that it is permissible for a New York bank to acquire equity securities to hedge equity derivatives transactions on the same conditions applicable to national banks.

Summary and Conclusion

We concur with your view that the Bank, as a New York state-chartered bank, has the authority pursuant to the “incidental powers” clause in Banking Law Section 96.1 to enter into the proposed equity derivatives transactions as long as they are: (i) cash-settled; (ii) customer-driven (i.e. entered into with independent third-party customers for legitimate customer business purposes such as reducing the customers’ exposure to various risks); (iii) conducted as a means of financial intermediation; and (iv) “matched” by offsetting transactions or hedged on a portfolio basis to minimize equity price risk.[11] 

By “financial intermediation”, the Department understands that a transaction will be customer driven by a Customer A and the Bank simultaneously or contemporaneously will hedge the transaction with a Customer B (or through portfolio hedging).  Customer B would not be the same (or a consolidated entity of) Customer A.  Further, a special purpose vehicle (SPV) or special purpose entity (SPE) would not be considered by the Department to be a “customer” for purposes of analyzing the identity of Customer A and/or Customer B.

In addition, the Department would not consider a transaction to be properly hedged if the Bank’s hedge transaction were with the Bank’s SPV or SPE or with a subsidiary of the Bank that is consolidated (using GAAP) on the Bank’s balance sheet, unless that subsidiary, in turn, simultaneously or contemporaneously hedges the transaction with an entity not consolidated on the Bank’s balance sheet.

Likewise, the Bank also has the legal authority pursuant to the “incidental powers” clause to acquire physical equities only to match or hedge the permissible equity derivatives transactions described above and not for speculative investment purposes.  The Bank may acquire no more than five percent of a class of stock of any issuer, on the same terms and conditions as such hedging is permitted for national banks by the OCC and for state member banks by the FRB, including that the Bank will not take anticipatory or maintain residual positions in equities except as necessary to the orderly establishment or unwinding of a hedging position.

The Department believes that a limitation on total exposure to a single person or entity is prudent in connection with equity derivatives activities.  Specifically, total unsecured single person or entity exposure, including extensions of credit plus net equity exposure, shall not exceed 15% of the Bank’s capital stock, surplus and undivided profits.  Additional secured extensions of credit may be extended to the same person or entity up to an additional 10% of the Bank’s capital stock, surplus and undivided profits.

With respect to the Bank’s ownership of equities resulting from equity derivatives activities, the Bank’s ownership of a class of stock of any issuer may not exceed 5% of such class of stock. The aggregate amount of all ownership of common and preferred stock may not exceed the lesser of 2% of assets or 20% of capital stock, surplus and undivided profits of the Bank.  Stock ownership position shall include net equity position (long v. short) for the Bank’s equity derivatives activities.

Finally, the Bank’s legal lending limit calculation shall include all loans and loan equivalents (such as prepaid amounts in connection with derivatives activities) associated with derivatives products, as more fully discussed in the correspondence between the Department and the Bank in connection with the Bank’s proposal.

This letter only addresses the legal permissibility of such activities. The activities may not be commenced or engaged in without the specific approval of the Division within the Department responsible for supervision of the Bank.  If the Bank’s proposal as described in its various written submissions referred to earlier should change in any respect, the Department’s view of the permissibility of the activities, and/or the conditions applicable to the Bank in conducting the activities, could change.  Accordingly, the Bank must notify the Department should its proposal as described change in any respect.

If you have any questions concerning this letter, you may contact either me or Assistant Counsel Rosanne Notaro at (212) 709–1663. 

I trust that the foregoing is helpful.


Sara A. Kelsey
Deputy Superintendent and Counsel

[1]               The July 11, 2002 letter and memorandum were supplemented by additional informational submissions including (i) a July 29, 2002 letter from Elizabeth T. Davy, Esq. of  S&C to Rosanne Notaro, Esq., of the Department; (ii) an August 16, 2002 letter from Marcia Wallace, Esq,. to Mr. Jay Bernstein of the Federal Reserve Bank of New York, with a copy to Sara Kelsey, Esq. of the Department; (iii) a November 1, 2002 submission from Thomas P. Gibbons to P. Vincent Conlon of the Department; (iv) a March 4, 2003 submission from Garland D. Sims, Esq. of the Bank to Sara Kelsey, Esq., and (v) a March 28, 2003 submission from Garland D. Sims to Rosanne Notaro, Esq.

[2]               The return on equity derivatives transactions is linked to the price of one or more equity securities or an index of such securities.

[3]               March 4, 2003 submission.  The Bank further stated that if these plans should change, the Bank would consult with the Department prior to engaging in such transactions.

[4]               Bank also included a request for approval for “other similar products.”  The Department prefers approving specific types of derivatives transactions, rather than granting a generic approval, so that the Department has the opportunity to perform the review and analysis noted above as to any proposal that Bank engage in a specific type of transaction.

[5]               “Cross market” intermediation refers to creating loans or other obligations of customers owing to banks measured by one yardstick, while creating deposits or other obligations of banks owing to customers that are measured by another yardstick.

[6]               The Horan Letter illustrated the legitimate business motivation of such transactions using several examples.  For example, an airline that decides to buy a fleet of expensive but fuel-efficient new airplanes engages in a transaction that increases a company’s debt load and decreases its fuel needs.  Such a transaction (or the alternate decision to buy less expensive and less efficient planes) involves an interplay between the airline’s fuel costs and interest costs.  A financial institution can enable the airline to manage its interrelated interest rate and commodity risks through a loan bearing interest that is linked to the price of oil and through a swap of cash flows based on LIBOR against cash flows linked to the price of oil.

In another example, an institution such as Sallie Mae, which is attractive to Japanese lenders but has no inherent yen exposure, will issue yen-denominated debt at a low interest rate and concurrently use a swap to hedge the yen-dollar risk created by such debt, thereby getting dollar funding at lowest all-in cost of funds then available in the global market.

[7]               For example, a customer with commercial income in U.S. dollars and commercial payment obligations in yen could eliminate its currency mismatch by entering into an arrangement with a bank providing for a loan by the bank of dollars and a parallel deposit with the bank in yen.  The customer’s commercial income in dollars could then be used to make payments on the dollar loan, and the customer could use the yen payments on the deposit to meet its commercial obligations for yen.  As the swaps market matured and the unbundling process progressed, the element of principal involved in the parallel loan structure was often omitted in order to reduce the credit risk and to avoid unnecessary “ballooning” of the balance sheets of both the bank and customer.  (“Horan Letter” at p. 4).

[8]               With respect to equity derivatives activities other than equity swaps, we understand, as noted in the S&C Legal Memorandum accompanying your letter, that it appears to be the case that one or more national banks have read the OCC’s Equity Swaps Letter as broad authority to engage in equity derivatives transactions other than equity swaps. The S&C Legal Memorandum cites the recent case, Caiola v. Citibank, N.A., 2002 WL 1401478 (2d Cir. 2002).  The case involved a dispute between Citibank, N.A. (“Citibank”) and its client regarding synthetic and cash-settled OTC put and call options entered into by Citibank.  Although the legal permissibility under the banking laws of banks engaging in put and call options was not at issue in the case, the case provides strong evidence that Citibank (to whom the OCC addressed the Equity Swaps Letter) has entered into derivatives transactions other than the “swaps” described in the Equity Swaps Letter.

[9]               As noted above, the OCC previously had taken a similar position with respect to equity derivative swaps.  See Equity Swaps Letter.

[10]             As noted in S&C’s Legal Memorandum, in Block, the bank purchased securities in its own name as principal on behalf of unnamed third parties.  In his decision, Justice Cardozo treated the transactions as similar to riskless principal in which the bank substitutes its own credit for the credit of its customers in the marketplace.  At the time of the Block decision, the purchase by a bank of common stock of corporations was “wholly beyond the power of a bank… distinctly contrary to public policy, and in that sense, illegal.”  (See Dyer v. Broadway Central Bank, 233 N.Y. 96, 96 (N.Y. App. Div. 1929)).

[11]             Specific prudential guidelines for minimizing equity price risk will be more fully addressed in the Department’s supervisory approval.