Banks are chafing under 23 proposed tax increases contained in President Clinton’s budget for the year 2010, including a much despised provision that eliminates certain deductions for corporate-owned life insurance.

So far the top item worrying banks is the proposed repeal of the exception under the corporate-owned life insurance (COLI) pro-ration rules for contracts covering employees, officers, and directors. This would prevent businesses from funding deductible interest expenses with tax-exempt or taxdeferred inside buildup on life insurance and annuity contracts. The plan would raise $1.9 billion over five years.

A similar $2.2 billion provision was offered last year, but heavy lobbying kept the provision out of any legislation. However, experts predicted that the tax would resurface this year.

Banks are also worried about the Treasury’s plan to repeal the taxfree conversions of companies when they switch from C-Corp status to S-Corp status under Section 1374. Under the Taxpayer Relief Act of 1997, banks are eligible to switch to S-Corp status if they meet all the requirements. However the tax might make it less likely for small community banks to convert. "This would put a real damper on conversions," said Donna Fisher of the American Bankers Association. "The window ought to be open a little longer before they close it."

The tax is expected to raise $212 million over the next five years and would go into effect on Jan.1, 2010 instead of the traditional chairman’s mark. The proposal would also apply to mergers between C-corporations and S- corporations after Dec. 31, 2009.

A further tax would also require that banks that use the cash method of accounting must accrue all interest, original interest discount and acquisition discount on short-term obligations, including loans made in the course of the banks business.

Fisher says the proposal attempts to get around a 1993 decision by the Court of Appeals for the Eighth Circuit that says banks do not have to accrue stated interest and original issue discount on short-terms loans. However the Clinton administration, according to Fisher, has ignored the ruling. The Treasury, in its explanation of the new taxes, said "it is inappropriate to treat short-term obligations originated by a bank differently than short-term obligations purchased by a bank. That tax is expected to raise $72 million next year with a total of $85 million over the next five years.

Banks also saw the return of a proposal designed to close what the Treasury sees as a loophole involving closely held real estate investment trusts (REITs). The proposal would impose an additional requirement for REIT qualification that no person can own stock of a REIT if they own 50% or more of the total combined voting power of all classes of voting stock or 50% and above of the total value of all shares of all classes of stock. The change is expected to raise $75 million over five years

In a much-awaited meeting last week, the Financial Accounting Standards Board decided that purchased intangibles, which formerly had to be amortized over a useful life that could not exceed 40 years, now do not necessarily have to be amortized, and placed a 20-year cap on some intangible items.

The board said that intangible items presumed to have a life of 20 years or less can overcome that if they have clearly identifiable cash flows that will continue for more than 20 years, and must have either legal rights that extend beyond the 20 years, or an observable market.

It is possible to overcome the presumption enough to say it has an indefinite life, but it would be subject to annual review for impairment and that would be based on a fair value test, said project manager Kim Petrone. The test would prove the carrying amount of assets are not recoverable based on the fair value of the asset.

Other intangibles do not have an indefinite life, such as a copyright good for the life of an author or inventor. Those intangibles should be amortized over the life of the author. Then with legal rights that are renewable indefinitely but not marketable the company has to be able to figure out the fair value, and if not, amortize it over whatever the economic life might be. Another category of assets are the identifiable intangible assets that are not reliably measurable, such as customer relationships. Those would be recognized as part of goodwill.

Dennis Garmer, business combinations expert at PWC, said the board’s decision sounded a lot like the current international standards for intangible assets. The board has said it wants to harmonize business combinations accounting internationally.

Many U.S. companies have fought the move toward the international accounting standard because it only permits merging using the pooling method of accounting if the companies are very nearly the same size. So, if more companies have to combine using the purchase method of accounting, how much goodwill is allowed to be amortized, and over how long, becomes critical.

Although the FDI Act and the Bankruptcy Code embody similar approaches to the insolvency treatment of derivatives, there are three major differences. First, while virtually any counterparty can contractually terminate and net its positions under the banking laws, the Bankruptcy Code limits those rights to specific counterparties for some contracts.

Second, the FDI Act and the Bankruptcy Code have slightly different definitions for the contracts that can be terminated and netted. Both statutes define five types of contracts that receive special treatment: repurchase agreements, securities contracts, commodity contracts, forward contracts, and swap agreements. But under the Bankruptcy Code, for example, it is unclear whether a repurchase agreement or securities contract including mortgage loans, interests in mortgage loans, and mortgage-related securities could be terminated and netted.

Third, while the FDI Act allows a receiver for a failed bank or thrift to transfer or terminate these five types of contracts–known legally as qualified financial contracts (QFCs)–in order to improve the financial condition of the receivership estate, the Bankruptcy Code does not provide similar rights to a bankruptcy trustee. These rights give bank receivers greater flexibility and also reduce systemic risks by providing a mechanism to maintain ongoing hedge transactions or other derivatives that continue to benefit the solvent counterparties.

Mike Krimminger is a Senior Policy Analyst with the Federal Deposit Insurance Corporation. The views expressed in this article are solely those of the author and should not be construed as representing the policies or views of the FDIC or other governmental entities. Part one of two. The second portion will run next week. A clear understanding of legal and contractual rights if your counterparty defaults on a derivative contract and becomes insolvent is critical to effective risk management, creditor strategies, and market responses in today’s turbulent financial environment. The importance of clear rules is illustrated by the questions surrounding the recent near collapse of Long Term Capital Management and the roiling of Asian and Latin American markets. Currently, while American rules for financial market bankruptcies are sound, there are variations between the bankruptcy laws for banks and non-banks and ambiguities in how those laws apply to some newer transactions. Clarifying and updating those laws is an important step to maintain American leadership in the financial markets.

The President’s Working Group on Financial Markets, chaired by Treasury Secretary Robert Rubin, and with representatives of the Treasury Department, the Federal Reserve, the Office of the Comptroller of the Currency, the Commodities Future Trading Commission, the Securities and Exchange Commission, the Federal Reserve Bank of New York, and the FDIC has crafted statutory proposals that update and harmonize insolvency laws while reducing the risk of a system-wide disruption in the financial markets.

One year ago, Rubin submitted the proposals to Congress, where they won general agreement from the industry and key committees. A version of the Working Group’s proposal was included in the Financial Contract Netting Improvement Act of 1998, which was introduced by Rep. James Leach. Sen. Charles Grassley introduced similar legislation in the Senate. Although Congress adjourned before final action on the legislation could be completed, it is expected that the legislation will be reintroduced shortly. Discussion drafts of the bill are circulating on Capitol Hill now.

Financial modernization legislation likely to be unveiled late this week has an excellent chance of passage because it repeals the Glass-Steagall Act while avoiding the inter-industry conflicts that have torpedoed efforts to reform the law since the mid-1970s.

According to Senate Banking Committee staffers, both Republican and Democratic members of the committee and industry lobbyists, the legislation says specifically that banks can affiliate with insurance and securities firms. But, as on several other incendiary issues, it is expected to be silent on whether banks can conduct those activities in an operating subsidiary, letting the regulators and the industries fight that issue out.

The bill as currently drafted limits national banks from conducting such activities as merchant banking, securities and insurance underwriting in operating subsidiaries if they have more than $1 billion in assets. However, because of opposition from Treasury Secretary Robert Rubin and Republican members of the committee in private comments to committee chairman Phil Gramm, R-Texas, last week, the cap is expected to be deleted when the bill is finally introduced.

The Obama administration appears optimistic that it can win support from committee Democrats for allowing banks to conduct nonbanking activities in operating subsidiaries. This represents a change in position from last fall, when committee Democrats supported the Federal Reserve Board position on the issue.

The bill is unlikely to include a definition of insurance and a requirement for functional regulation as demanded by the insurance industry, according to the consensus. But it will include some limits to the comptroller’s deference on legal disputes dealing with insurers and agents, a reflection of the strong campaign finance support from insurance agents’ interests in Texas for Gramm, sources said.

At the same time, it will not touch the issue dear to the securities industry, removing the exemption from Securities and Exchange Commission oversight for bank securities activities, the so-called "level playing field" issue. The SEC and the Securities Industry Association are said to be lining up in opposition to the bill already.

While the Gramm version may win support in the House Banking Committee, Commerce Committee support is unlikely because under the Gramm version, the Commerce panel would lose jurisdiction over securities and insurance activities conducted by banks. Reps. Thomas J. Bliley, R-Va., and John Dingell, D-Mich., chairman and ranking minority member of the Commerce Committee respectively, are likely to be vehemently opposed, according to a former House staffer who is now a securities analyst.

Bankers were recently reminded by the FDIC that starting sometime this year they have to stop using an accounting method for tax purposes that the IRS considers improper for certain short-term consumer loans. The punchline is the IRS-preferred method gives bankers more time to hold onto their money.

Many small banks use the so-called "rule of 78s" to account for interest on self-amortizing installment loans of five years or less. The rule means the interest recognition is front-loaded and more tax is paid at the beginning of the year, compared to the constant yield method, preferred by the IRS. Although the taxpayer loses some of the value of money, the rule of 78s is an easier method of bookkeeping, and popular with smaller banks.

The IRS said in 1997 bankers should stop using the improper method of accounting, but did not specify when the change should take place. Late last year the agency said any banks which had not switched methods in 1997 would have to do it by the 1999 tax year. For banks on the calendar year, that meant redoing the bookkeeping starting last month, but there are some who may not begin until later this year.

Some accountants see the new rule as a blessing for small banks which will not have to worry about keeping two sets of books anymore–one for regulatory purposes, and one for taxes.

"It’s really kind of a relief," said John Ziegelbauer, senior manager in charge of coordinating financial institution tax at Grant Thornton.

Others are simply amused that the IRS is forcing bankers to keep their money longer.

"Taxpayers using the rule of 78s were leaving dollars on the table, but they continued doing it as a matter of simplicity. What’s interesting about this is the IRS is saying a method less favorable to taxpayers is less permissible. But the IRS is interested in purity in this case," said Marc Levy, a tax expert at Deloitte.

Banks, especially smaller ones, may be able to compete more effectively with securities firms if legislation is passed allowing banks to pay interest on business checking accounts, according to industry consultants.

The provision is included in regulatory relief legislation the Senate Banking Committee will take up Oct. 11. Under the proposal, a compromise between the large and small banks, banks’ depository institutions will be allowed to make up to 24 transfers a month into interest-bearing accounts through "sweeps" until Jan. 1, 2010. After that, banks will be allowed to offer interest-bearing accounts on all business deposits.

One community bank Second Bank & Trust in Culpeper, Va., has just teamed with Goldman Sachs & Co. to offer the Capital Manager Investment Account, a sweep account that enables customers to invest excess cash overnight in one of several money market funds sponsored by Goldman Sachs Money Market Trust.

The provision is being supported primarily by smaller institutions, which do not have the resources to program their computers to "sweep" these funds overnight into money market and similar accounts.

Larger institutions, which have opposed the provision, will also gain a sweetener under the bill, a provision that will allow the Federal Reserve Board to pay interest on reserve balances banks must hold with the Fed. Under the bill, the Fed would be allowed to pay interest on those reserve accounts at a rate "not greater than the Fed Funds rate."

Edward Furash, an adviser to banks on products and deposit issues, explained that allowing smaller institutions to pay interest on checking accounts will increase the industry’s competitiveness with securities firms. "The securities markets have been eating banks’ lunch for at least the last 15 years, draining away deposits into money market funds and savings into stocks, bonds and other investments," he said. "Intermediation volume, leadership and pricing have moved to the capital markets, and deposit pricing is set by money market mutual funds."

Steve Zeisel, of the Consumer Bankers Association in Washington, said large banks with sweep capability and securities firms have been taking this business cash and investing it in money market funds, euro deposits and cash management accounts, among other investments.

The provision has the support of Federal Reserve Board chairman Alan Greenspan. Greenspan in 1997 declined to approve a request from the American Bankers Association to re-interpret a Fed regulation so as to allow banks to make 24 transfers a month into interest-bearing accounts, saying it was contrary to law.

Similar legislation was drafted last year in both the Senate and House Banking committees, and is given a good chance of passage this year.

The onus is on bankers to do a better job assessing credit risk or face the consequences, as the Federal Reserve Board followed the lead of other regulators last week by issuing guidance asking banks to tighten their lending standards to hedge funds. Risk management experts are split on how tricky that will prove to be.

"The challenge to banks is to have enough information to accurately assess risk. It’s putting the burden on the banks to come up with ways to adequately assess risk on companies before they lend to them," said Cynthia Glassman, director of commercial bank risk management at Ernst & Young.

"Hedge funds’s strategy are proprietary and their positions are their business the bottom line is it’s a credit risk issue, and if you’re going to lend to these companies you need to understand the risk, but understanding the risk on these companies is harder."

Leslie Rahl, principal in Capital Markets Risk Advisors, found the guidance like "the flag and apple pie." She explained, "It’s good common sense, but there’s nothing really people shouldn’t already be doing."

Rahl said the only thing the letter did not seem to address is the need not only to update data for changes in exchange rates and interest rates, but updating the potential for future exposure based on more subtle variables like volatility and correlation.

The move is destined to encourage banks to self-regulate, said a former regulator. But further regulation could be proposed eventually if the Fed find that banks are not responsive to the guidance, said Donald T. Vangel, a former senior vice president in bank supervision at the Federal Reserve Bank of New York.

The Fed’s Supervision and Regulation (SR) letter comes on the heels of similar statements made last week by the Office of the Comptroller of the Currency and also by the Switzerland-based Bank for International Settlements Committee on Banking Supervision.

The Fed recommended that banks have internal audit and independent risk management functions. The letter accompanying the guidance also said banks need to enhance their measurement of counterparty credit risk exposures, including the establishment of stress testing methodologies "that better incorporate the interaction of market and credit risk."

The moves by the Fed, OCC and Basle Committee follow the near-collapse of Connecticut-based hedge fund Long-Term Capital Management in September. The fund was rescued by a group of 14 financial companies, in a move coordinated by the Federal Reserve Bank of New York.

Some bankers could see a jump in the fee they pay to their trade association if a Clinton budget proposal to ring up trade associations on investment income passes.

The proposed tax hike, estimated to raise $1.4 billion over five years, would probably cause the Independent Bankers Association of America to raise fees, according to Paul Merski, the group’s director of tax policy. He added that the tax hike would also jeopardize any reserves the group has set aside for fluctuations in membership and general economic conditions.

The outlook is not all gloom and doom, however.

"We haven’t raised our dues in the seven years we’ve been the ACB, and we don’t have any plans to do it," said Robert Schmermund, director of communications for America’s Community Bankers.

But that does not mean the proposed tax, expected to raise $1.4 billion over five years, would not be painful.

Jim O’Connor, the group’s tax counsel, said it would be very difficult to estimate the bite the tax would take from the coffers because any money not spent on public education, or preparing reports for Congress, or any of the other activities which traditionally earmark the organization for tax-exempt status goes into the group’s checking account to be used next year.

Bob Wallgren, executive director of operations and finance for the American Bankers Association, concurred, saying he would have to take a look at the group’s sources and uses of funds before deciding if a fee hike was in the offing.

O’Connor said that he did not think there would be a lot of sympathy in Congress for the revenue raiser, because it shows that Congress’s intentions "are being undercut." He added, "Obviously we don’t think Congress should push it through. That investment income should be taxed so long as we perform certain valuable public policy point-of-view functions makes no sense to us."

John Hawke’s nomination as Comptroller of the Currency was expected to be reported out of the Senate Banking Committee Feb. 11, and is expected to be confirmed by the Senate shortly afterwards, ending a period of uncertainty that began with the departure of Eugene A. Ludwig at the end of his term last April.

The most important obstacle to Hawke’s nomination was removed Feb. 1 when Sen. Paul S. Sarbanes, D-Md., ranking minority member of the committee, removed a hold on Hawke’s nomination. Sarbanes’s actions were a message to Hawke and the Treasury Department he was unhappy they had blocked financial modernization legislation that contained provisions Sarbanes sought.

But the fact that Democrats in Congress are coalescing around President Clinton and his key adviser Treasury Secretary Robert Rubin, and the passage of time, made it only a matter of time before Sarbanes lifted the hold.

But Hawke’s confirmation is not likely to result in a huge immediate expansion of bank powers as the new comptroller and his superiors at the Treasury Department await the course of banking legislation. The Senate Banking Committee is likely to deal with financial modernization legislation acceptable to the agency by mid-March; the House Banking Committee is on a more uncertain course, but chairman James Leach, R-Iowa, has said he wants to pass such legislation through his committee by the end of March.

Given the fact that Congress appears to be more respectful of the bank charter than in legislation that failed to pass last year, Hawke’s general posture will be to keep the agency out of the spotlight while the legislation goes through the process, leaving banks or trade groups to take the initiative in expanding bank powers.

That policy is already in effect through the agency’s decision to file an amicus brief, rather than intervene as a party, in an Ohio case dealing with state laws that hamstrung national bank efforts to sell insurance.