Some definitions. A bank is a thing that takes in money from depositors and lends it out to good people who want to buy homes and build small businesses. Everything is very wholesome. There are toasters. But banks tend to be owned by bank holding companies. A bank holding company is a thing that takes in money from flighty speculative investors and lends it out to bad people to do risky things.
I mean, I don’t know, those definitions are totally wrong and fake, but they are useful, aren’t they? Certainly there is a widespread belief that banks, which have access to the insured deposits of hard-working Americans, shouldn’t be using those deposits to fund all the creepy activities that their bond-trader and investment-banker colleagues get up to. But the boundary between those categories turns out to be incredibly porous.
Here’s a great story from the Wall Street Journal about how Bank of America used its insured bank to finance tax avoidance trades for hedge funds. There is a lot to unpack there. There are the tax trades, for one thing, and the insured bank thing, for another, and then there is the eternal question: Why Is This Bad?
First the tax trades. These are dividend-arbitrage trades, which schematically go like this:
— A hedge fund could own some stock, perhaps financed with a margin loan from its prime broker. But then it would have to pay taxes on the dividends that it receives on that stock.1
— Or it could let its prime broker own the stock and get economic exposure to the value of the stock (and the dividends) through a total return swap. For reasons,2 the prime broker may not have to pay taxes on the dividends that it receives on the stock, and the hedge fund may not have to pay taxes on the payments it receives on the swap. So it’s replaced taxable dividend payments with non-taxable swap payments.
Those two transactions are economic equivalents,3 but are taxed differently, and ”economic equivalence” and “differential taxation” are two of the most combustible sticks that investment banks rub together to make products. So dividend arbitrage is a product. It’s a controversial product, though.4 In fact, it’s not a product anymore in the U.S., because the tax rules were changed a few years ago to put a stop to it. It lives on in Europe, though, which is where Bank of America was doing these trades.
So, that’s controversial, I don’t know, think your thoughts about whether hedge funds should be allowed to avoid withholding taxes on dividends.5 The point is: In some places, they are. So we’ll move right along to the bank stuff.
Bank of America didn’t just do these trades. Lots of people do these trades!6 Bank of America’s sin was that it did the trades out of its bank, Bank of America, N.A., rather than out of Merrill Lynch International, a non-bank subsidiary of the bank holding company:
One afternoon in February 2011, bankers, traders and others crowded into a Bank of America auditorium in London for a “town hall” meeting. Executives announced that they were changing the way they loaned money to certain clients, according to people who attended. The money for the loans now would come through BANA rather than Merrill Lynch International.
I love “town halls,” by the way. Everyone gathers in the auditorium to hear the big news. An executive walks up to the podium. An expectant hush settles on the crowd. The executive clears his throat and says, “From now on, we’ll be financing our London dividend arbitrage business out of our insured U.S. bank instead of our international broker-dealer!” The crowd erupts in a frenzy of applause. The traders carry the triumphant executive out of the room on their shoulders, acclaiming him as a conquering hero of derivatives funding.
Where was I. Obviously Merrill Lynch International sounds like it should be up to no good. ”Merrill Lynch” is an investment-bank name, and the “International” also carries an air of intrigue and mystery. But “Bank of America, N.A.,” is the opposite. It’s a bank. Of America. It shouldn’t be funding dodgy swaps in London.
One simple question is, well, why not? Surely there is a rule that says, “Bank of America, N.A., which is funded by the checking accounts of moms and pops across the land, and those deposits are federally insured by taxpayers by the way, shouldn’t be doing creepy overseas equity swaps,” no?
Ha, no, of course not. Here’s the Wall Street Journal again:
Experts said it is inappropriate for Bank of America to tap the entity holding federally insured deposits to finance risky investment-banking trades.
“I don’t think it’s an appropriate use,” said Sheila Bair, the former chairman of the Federal Deposit Insurance Corp. “Activities with a substantial reputational risk… should not be done inside a bank. You have explicit government backing inside a bank. There is taxpayer risk there.”
Notice that the quote starts with, “I don’t think it’s an appropriate use.” If it were illegal, Sheila Bair would have said something like, “Ha, what, that’s illegal under Rule XYZ.” She didn’t. She expressed her personal opinion as to its appropriateness. Bank activities are obviously not regulated based on the personal opinions of former regulators, but are they regulated based on the personal opinions of current regulators?
Kind of? Here, as I understand it (dimly!), is how the rules work. First, banks are allowed to do lots and lots and lots of things. There’s a list. It’s called “Activities Permissible for a National Bank.” Here it is. Here is one thing on the list:
Derivatives Activities. National banks may offer investment advice and engage in a variety of derivative activities (including swaps, futures, forwards, and options) as a financial intermediary or to manage or reduce risks.
That seems to cover dividend arbitrage, no/? Engaging in swaps as a financial intermediary? In fact, the Office of the Comptroller of the Currency — the federal regulator responsible for Bank of America, N.A. — has allowed banks to trade equity total return swaps since 1994.7 And the OCC and the Federal Reserve specifically gave Bank of America permission to trade equity swaps, and to hedge those swaps by buying or selling the underlying stock, in 2000 and 2005.8 When I say “specifically gave Bank of America permission,” I mean it: That OCC ruling applied to “three national banks,” including Bank of America, which are allowed to do these trades even if other banks aren’t. The Fed ruling is addressed directly to Bank of America.9
Fun fact: Remember swaps push-out/? That was a rule that was going to forbid bank holding companies from doing certain swaps in their insured bank subsidiaries. Equity swaps were on the list. When swaps push-out died late last year, this trade remained legal.
— Relevant European tax rules allow banks to help clients avoid tax withholding by using total return swaps.
— Relevant U.S. banking rules, or rulings, or letters anyway, allow banks, or Bank of America anyway, to deal in total return swaps with clients.
So, that’s it, we’re done. Bank of America is just allowed to do this. It’s fine. Really the question is why it took it until February 2011 to start doing it.10
Oh, I mean, it’s stopped doing it now:
On June 2, 2014, Fabrizio Gallo, Bank of America’s global head of equities, wrote a letter to the Richmond Fed, according to a copy of the letter reviewed by the Journal. “Our intention,” Mr Gallo wrote, “is to phase out the use of BANA in parts of the business and to transition without delay to a more operationally sound foundation.”
This seems to have been prompted in part by a whistleblower who claims “that Bank of America’s London-based Merrill Lynch International unit has extended ‘extreme levels of BANA leverage’ to fund ‘increasingly aggressive and reckless’ tax-avoidance trades.” Also by reactions of current regulators who, like Sheila Bair, seem to find these trades not that great.
Their concerns are not totally obvious. One possibility is that the “extreme levels of BANA leverage” and “increasingly aggressive and reckless” trades were actually risky trades: that Bank of America was lending a lot of money against volatile stocks, and that if the stocks went down the borrowers would walk away and leave Bank of America with the loss. One generally doesn’t think of equities prime brokerage as the thing that will bring down a bank, but you never know, maybe Bank of America was running a real risk of losing so much money that it would put insured deposits at risk. If so, is it still providing unsafe levels of leverage at Merrill Lynch? Or: Is it still providing unsafe levels of leverage on its (perfectly legal) equity swaps that aren’t aimed at dividend tax avoidance?
Or maybe the concern is mostly the one Bair identified: the “reputational risk” of helping clients avoid taxes. It is a little hard for me to see how insured deposits could be on the hook for that: If Bank of America loses business, or gets fined, for doing naughty tax-avoidance trades, the fines or lost business will presumably be incurred at the holding-company level, and won’t distinguish whether these trades were done at the broker-dealer or at the bank. In other words, moving the trades from Bank of America N.A. to Merrill Lynch International, but still doing the trades, doesn’t actually seem to solve any reputational problems.11
But I guess that’s not the point. What a bank can do isn’t really determined by a rigorous assessment of risks, and it’s certainly not determined by, like, written public rules. There’s a more or less unwritten list of what’s actually allowed, based on an accretion of what regulators think — or used to think — is appropriate. No wonder the list is full of surprises.
- Strictly, those taxes would be withheld in the country of origin, because many countries impose a withholding tax on dividends paid to foreigners (or to certain foreigners, e.g. those from countries that don’t have a tax treaty with the country of origin). So for instance U.S. companies have to withhold 30 percent tax on dividend payments to non-U.S. persons, and many countries have analogous regimes.
- So for instance if the bank is in the country of origin, there’s no withholding on the dividends paid to the banks. (And it can offset that income against its cost on the swap, so there’s no taxable net income from passing the dividend through.) And payments on swaps are not dividends, so they’re not subject to dividend-specific withholding taxes. (Though they are in the U.S., now.)
- The equivalence of a swap and a margin loan is fundamental to much prime brokerage, delta-one, etc., business, though I guess it’s not immediately obvious. The idea is that there’s a pot full of money. The client puts up X percent of the money, and the prime broker puts up 100 – X. (X is called the “margin”: It’s the client’s equity in the margin loan, or the client’s collateral in the derivative transaction.) The pot buys some stock. The client gets the upside and downside of the stock. The prime broker gets its money back at the end. If the stock loses a ton of value all at once, the margin is wiped out, and then there’s the awkward moment of the prime broker coming to the client and asking for more margin. (Awkward in either the swap or the loan context.) Everything is the same, it just has different names. And different tax, regulatory, etc. regimes. (Also different margining mechanics, usually, though those are somewhat flexible.)
An option can also be a margin loan (or a swap), if you want it to be, as Renaissance Technologies sometimes did.
- The older Wall Street Journal article that I linked in the text focuses on short-term dividend arbitrage trades around dividend dates, in which “the banks temporarily transfer ownership of a client’s shares to a lower-tax jurisdiction around the time when the client expects to collect a dividend on those shares.” I would have thought that long-term total return financing is a better way to do these trades, if you’re getting leverage from your prime broker anyway, but what do I know.
- Tax withholding just feels crude, doesn’t it? Like, hedge funds are pass-through entities, mostly, and the income ends up in the hands of taxpayers (somewhere) and institutions, and the ones who are taxpayers pay taxes on it at the rates applicable to them. Just chopping off 30 percent at the beginning of the process seems somehow unsporting. But I realize that not everyone shares my view of taxation as a sport.
- Again, from the Wall Street Journal in September:
Other banks that arrange similar transfers of corporate stock include Citigroup Inc., Deutsche Bank AG , Goldman Sachs Group Inc. and Morgan Stanley , according to clients and people involved in the business. Banks collect fees on the transactions.
- The source for that permission is OCC Interpretive Letter No. 652, which I can’t find on Google. But it is referenced inthis scholarly and very interesting interpretation letter from the New York State Department of Financial Services, approving Bank of New York’s request for permission to engage in equity derivatives trading (again, out of its regulated bank). A sample:
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.
- You might read that New York DFS letter quoted in the last footnote to suggest that banks are allowed to engage in equity swaps, but not in holding the underlying equities: They need to do back-to-back swaps, intermediating between the client and another client, or the client and the bank holding company’s non-bank broker-dealer subsidiary.
But you’d be wrong! The DFS letter goes on:
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.
Here is OCC Interpretive Letter No. 892, from September 2000:
In brief, the OCC determined, in the case of three national banks, that the banks could take positions in equity securities solely to hedge bank permissible equity derivative transactions originated by customers for their valid and independent business purposes. The banks committed that they will use equities solely for hedging and not for speculative purposes.
Letter 892 does not name the three banks, but the 2005 letter from the Federal Reserve Board (allowing Bank of America, N.A. to borrow stock from its non-bank affiliates as part of its hedging) makes it clear that Bank of America was one of them (see footnote 2).
9. It’s worth pausing here on how weird this is. Banks can’t generally be dealers in stocks; they can’t trade stocks for market-making purposes. (Bank holding companies can have broker-dealer subsidiaries, but in this post, unlike in most of my posts, I’m using “bank” to mean “bank,” not “bank holding company as a consolidated entity.”) And they certainly can’t trade stocks for proprietary-trading purposes. (For bank holding companies, that’s sort of gray area.) But they can trade stocks “synthetically,” by dealing in equity derivatives. And they can even trade actual stocks, as long as they’re doing so to hedge their equity derivatives.
10. Right? I’m guessing just, like, Merrill did a lot more European equity derivatives trades than Bank of America before the merger, and it took a while after the merger for people to figure out that this was a good use of Bank of America, N.A. funds. Or maybe it’s not that great a use, and until February 2011 there were higher and better uses.
To contact the author on this story: Matt Levine at firstname.lastname@example.org
To contact the editor on this story: Zara Kessler at email@example.com