In a new kind of municipal-revenue bond underwriting deal, Commerce Capital Markets is working on helping large cities fund mass transit improvements without having to wait until the federal grant money has trickled in.

The Cherry Hill, N.J.-based investment bank subsidiary of Commerce Bancorp would underwrite a bond that would be paid off entirely through future federal government grants. The idea is similar to grant anticipation revenue vehicle (Garvee) bonds which have been used in the last year to pay for highways, but not mass transit. Commerce Capital’s methodology on the new bonds would be different, according to Vince Stafford, CEO of the firm. Commerce Capital is proposing that the deals would not need the general obligation bonds that many Garvees require. That would be the case with deals that Commerce Capital is proposing to two major cities–which the firm declined to name until the deals are clinched.

This innovation was made possible last summer in Congress through legislation appropriating $217 billion for highway and mass transit spending over six years, called the Transportation Equity Act for the 21st Century, or Tea-21. This legislation made it a virtual guarantee that the funds will be there for municipalities to use, a change from before. Although three states used Garvee bonds which did not require additional backing from general obligation bonds–known as "naked Garvees"–last year to fund highways, the proceedure had not yet been used for mass transit.

Stafford explained the cities can get their projects started sooner by getting funding this way than getting a grant of a certain number of years and having to wait until nearly the end of that time to start. He said he is expecting a decision from one of the cities sometime this week.

Banks of all sizes would be able to conduct any securities and insurance agency activities in an operating subsidiary under compromise financial modernization legislation that is scheduled to be marked up Thursday in the House Banking Committee.

At the same time, the Senate Banking Committee appears to have fallen into partisan bickering. Legislation is being drafted by the Republicans on the committee that would reverse earlier agreements and give the insurance industry virtually everything it wants. The revised bill would allow banks with assets of $500 million or less to conduct insurance underwriting and other nonbanking activities in an operating subsidiary, and makes few concessions to the insurance agents industry. However, rollbacks of CRA provisions proposed in the bill are likely to divide the committee along party lines. A markup is projected for Wednesday, but Democrats say they will have an alternate bill and need a delay to study the new Republican version.

Under a copy of the details of the House pact obtained by Financial Modernization Report, there would be no commercial basket allowed for financial institutions covered under the law. However, language is being drafted that would allow activities that are "complementary" to financial activities and other lines of business, provided these activities remain "small," according to a synopsis of the compromise prepared by committee staffers.

The legislation would still bar bank underwriting of insurance and real estate development in operating subsidiaries, and the definition of insurance and a mandate for "functional regulation" would remain. While the agreement could still blow up, Reps. James Leach, R-Iowa, and John LaFalce, D- N.Y., chairman and ranking minority member of the House Banking Committee, appear resolved to reach an agreement on bipartisan legislation that can be passed by the committee. Under the plan, the markup will begin March 4 but is unlikely to be completed until the middle of the next week, committee staffers said.

The compromise House bill will provide the agents with safe harbors contained in last year’s final financial modernization package. However, LaFalce and Treasury Department Secretary Robert Rubin are said to be "adamant" about maintaining deference to the Comptroller of the Currency in disputes over whether a product is banking or insurance. LaFalce is also pushing for language that will allow banks to conduct insurance activities in all branches, eliminating the "place of 5,000" provision that has effectively been obliterated anyway through Comptroller interpretations. The American Council of Life Insurance is said to be insisting on no deference to the Comptroller.

A key provision in the Leach/LaFalce compromise is language that the Federal Reserve Board gets to determine for holding company affiliates what is "financial in nature," and therefore able to be conducted in an affiliate, subject to a veto by the Treasury. It is the other way around for opsubs, with the Comptroller able to determine what is "financial in nature" and therefore capable of being conducted in an opsub, subject to a Fed veto

Community Bank System is at the forefront of a number of community banks thinking about ditching their third-party broker dealers, with the idea of taking the emerging line of bank business in-house.

The $1.7-billion-asset bank received approval from the Office of the Comptroller of the Currency to establish a de novo operating subsidiary to provide brokerage advice Feb. 3, and the bank will start the new venture in mid-March, said Sanford Belden, Community’s CEO and president. Belden said the mostly rural-market bank had hired a broker to replace the service they were getting from PrimeVest. Belden declined to discuss further details pending the official announcement of the new business in the spring.

Community’s idea is gaining popularity among community banks, said John Owens, director of strategic services of the National Financial Institutions Consulting Group of McGladrey & Pullen. Owens’s primary practice is community banks and he told Financial Modernization Report that the topic is hot among community bankers, but he has not seen anyone take the plunge yet. "At this point there’s discussion in doing it–whether there’s anything to be gained from doing this in a less costly manner It’s an issue that billion-dollar banks are looking at, not implemented yet." Many of the banks considering starting their own shop are not of a size where buying a brokerage firm is feasible.

Part of the reason community banks are considering the step is the feeling they are referring more business than they are getting out of the association with a third-party broker dealer, said Patrick Kennedy. Kennedy, a partner at Kennedy Barris & Lundy, a community bank specialty law firm, noted the trend among a few of his own clients, in the asset range of $250 million to $1 billion.

"They’re creating a substantial amount of value and are thinking about better ways to control customer relationships and doing the business directly rather than referring it out," he said.

Because of the wide variance in bank size and the extent to which a bank could go in offering its own brokerage services, industry analysts have a hard time judging if the trend would bode well for banks generally.

"I think it very much depends on what you’re going to do. Just the regulatory fees would be a cost, but I’m not sure you need to spend hundreds of thousands of dollars. If you’re truly going to go out and build a business around this, then the sky’s the limit as to how much you want to spend," said Kevin Timmons, analyst with First Albany Corp. Timmons, who covers Community and other banks of that size, said Community’s was the first announcement he had seen of this kind of move. He added that it was not the only company he covers that is "not 100% happy with their relationships" with third-party broker dealers.

Bill Reid, president of the Independent Bankers Association of America’s subsidiary, IBAA Financial Services, which serves as a third-party broker dealer for the trade group’s members, said the variance on cost for a bank is wide, depending on which kind of program a bank elects. With a managed program, the third-party marketer furnishes a registered securities representative to the bank. The second way to go, the dual-capacity program, has become much more popular in recent years, Reid said. With that, the bank hires its own registered securities rep, or takes someone from within the bank and gets them trained. In that scenario, the employee is licensed to sell securities and is an independent contractor with the third-party marketer. IBAA Financial Services, which is technically for-profit, but whose main objective is to serve members, works strictly on the dual-capacity program. That is because with a dual capacity program a bank has ultimate control over the employee, and thus the way the program is marketed.

The initial fees with other third-party marketers can range from a few thousand dollars to $50,000. That cost includes training, software and other basic components. IBAA Financial Services charges between $2,900 and a maximum of $4,000 as initial fee. IBAA Financial Services’ annual maintenance fee, which ranges from $1,500 to $2,500, covers software and annual charges for licensing the broker.

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

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.

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.

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.