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Banking reform initiatives in Congress.

Congress has spent much in 1991 considering comprehensive banking and financial reform legislation, and finance officers soon will be confronted with an array of issues that will affect, in varying degrees, the way they do business. The issues identified here are already in the legislative or regulatory arena, and GFOA members should consult the GFOA Newsletter for the most up-to date information about each of them. There are four areas of particular importance as banking reform becomes a reality.

State Taxation of Interstate Banks

The banking bills originally approved by both the Senate and House banking committees authorize banks, under certain constraints, to operate interstate branches. A last-minute amendment sponsored by Senator William Roth (R-DE) that affects state taxation of banks was included in the Senate banking bill. This amendment would have changed the method by which income earned from a bank branch within a state could be taxed. The language of the Roth amendment would have required a branch of bank to be taxed as a separate entity, therapy prohibiting states from using the principles of formula apportionment and combined reporting in determining the tax to be imposed on an interstate bank.

Formula apportionment is a system used to calculate the income of a multistate entity so that the portion attributable to a particular state may be properly ascertained for taxing purposes. This allows states to tax a multistate business fairly without having to laboriously track separate transactions to determine which ones have been carried out in each state. Formula apportionment had been approved by the U.S. Supreme Court. The Roth amendment would have effectively eliminated this method of state taxation and required the specific tracking of transactions in order to calculate tax liability.

The amendment also might have prevented states from using combined reporting in state taxation of interstate banks. Combined reporting is related to formula apportionment and refers to an affiliated group of companies operating a single multistate "unitary business." Thus, currently a state is allowed to combine the income of all the members of the business in order to then determine the tax liability of those members within its borders that it is permitted to tax. Again, this method of calculation arose because of the difficulty of tracking separate transactions in a multistate business. In the case of banks, their ability to shift funds quickly and efficiently among branches makes it particularly difficult otherwise to determine which transactions have occurred within a particular state.

GFOA and other public finance interest groups contacted all senators expressing their concern about the Roth amendment. While the Roth amendment has been withdrawn from the latest version of the Senate bill, it is certain to reappear in some form if interstate branch banking is eventually enacted. Because the amendment could require state and local governments to treat bank branches as separate entities, headquarters banks would locate in states with low bank taxes. Banks would then be able to shift "reported income" to that headquarters from branches located in states with higher bank taxes. The resulting loss of revenue to these states and their local jurisdictions would be significant.

In addition, because of the incentive for headquarters banks to relocate to low-tax states, financial institutions will be more likely to move their operations to such states. The majority of the states and localities will thus be deprived of these employees and possibly of a significant tax base as well.

Losses and Liability in Check Clearance

Another amendment adopted by the Senate Banking Committee has received little attention but may alter the way in which state and local governments handle the collection and payments of checks and warrants. This amendments, offered by Senator Donald Riegle (D-MI) on behalf of the Federal Reserve Board (Fed), would make state and local government liable for any losses resulting from the mishandling of any function of the payments system. This includes the receipt, payment, collection or clearing of checks or related instruments.

For state and local governments, liability would be limited to the amount of the check or warrant, related finance charges and attorneys' fees. State and their subdivisions would not be subject to punitive damages or special class action awards. Other damages could only be recovered by a showing of bad faith.

The stated purpose of the amendment is to eliminate the ambiguity in the Expedited Funds Availability Act which currently allows allocation of loss only among depository institutions by authorizing the Fed to impose liability on all participants in the payments system. In fact, the amendment seems to be consistent with attempts by the Fed to increase the negotiability of drafts and warrants and eliminate the float from the system. Essentially, enactment of this amendment would treat these instruments as checks even though they are not drawn on a bank.

Because most state governments already treat warrants and drafts like checks, this amendment may have limited impact on state and local government procedures. However, it is important to recognize that adoption of this amendment would eliminate state and local government immunity from liability for late return or other mishandling of instruments. Checks, warrants and drafts issued by state and local governments currently are given expedited treatment under the Federal Reserve Board's Regulation CC (Availability of Funds and Collection of Checks), and it provisions also apply to the return of items that are not paid.

Electronic Funds Transfer User Fee

A legislative proposal which may have great appeal to federal revenue-seekers would impose a tax in the form of a user fee to all transactions made through large-dollar electronic payment systems in the U.S. This fee would be in addition to that already imposed by the Federal Reserve Board to recover the costs of its services. The purpose of the user fee is to provide pay-as-you-go financing to cover the losses of the BIF, Savings Association Insurance Fund and the Resolution Trust Corporation.

Senator John Kerry (D-MA), chief sponsor of the tax, has proposed the establishment of a revolving fund to be administered by the Secretary of the Treasury and funded by the user fee. The Secretary would be authorized to set the rate of the fee, the dollar amount of the transactions affected and the procedures for implementation. Senator Kerry has suggested a rate of $0.0002 per dollar transfer. At this rate, it is estimated that about $85 billion would be raised annually. This financing mechanism is designed to eliminate further increases in bank and thrift bailouts.

The electronic funds transfer fee would affect all state and local governments that use electronic payments systems. The transfer for payrolls, pension benefits, investment funds and the myriad other purposes for which public entities use Fedwire, CHIPS (clearinghouse interbank payments system) and the ACH (automated clearinghouse) would now be taxed, adding to the operating costs of already financially strapped state and local governments.

Many jurisdiction already have calculated what the direct costs as a result of imposition of this fee would mean to them and have communicated these annual estimates to their senators. Among the examples: * Los Angeles Country,
 California $25,323,179
* Monroe County, New York $ 877,552
* State of Delaware $ 686,000

* New York State Teachers

Retirement System $ 100,000 * City of Greensboro, North

Carolina $ 58,936 * Missouri Public School

Retirement System $ 24,000

State and local governments also will incur increased costs as a result of their status as customers of corporations and banks that pass on to the consumer their own increased costs resulting from this fee.

Another result of the imposition of this fee would be a return to more extensive use of paper checks and a reversal of the trend toward use of the more efficient electronic payments system. This would clearly affect investment opportunities is well as the prompt receipt and payment of various funds.

Daylight Overdraft Measurement

In January 1991, the Federal Reserve Board issued proposals regarding changes in the measurement of daylight overdrafts. Daylight overdrafts occur when funds are transferred out of an account before incoming funds are received, creating an intraday overdraft. If overdrafts are not settle by the end of the day, a bank's capital position may be exceeded. The proposals constitute another part of the Fed's ongoing efforts to control payments system risk and exposure, formally known as the Payment System Risk Reduction Program.

As presented by the Fed, the most recent daylight overdraft proposals are an attempt to reduce both direct credit risk and systemic risk. Direct risk occurs when a depository institution is unable to settle intraday overdrafts at the Federal Reserve Bank. Systemic risk occurs when a participant in a private large-dollar payments network is unable or unwilling to settle a debit position on the network. Consequently, the creditors of a failing institution may be unable to settle their own commitments. The Fed is concerned that a large number of institutions facing this problem simultaneously may cause severe repercussions to other network participants as well as to the economy in general. Depository institutions put themselves at risk as well if they allow their customer to transfer uncollected balances over wire systems in anticipation of their coverage by the end of the day.

The Fed proposal has three main components. First, it would require that the procedures used to measure daylight overdrafts be based on a modified, realtime approach to accounting for nonwire transfers. Second, the determination of a depository institution's peak and average daylight overdraft would be based on end-of-minute snapshots of each institution's account balance. Finally, the proposal would balance. Finally, the proposal would measure each institution's average daylight overdraft by using end-of-minute balances and the number of minutes in the Fedwire operating day.

GFOA commenced on the Fed proposals in May, pointing out the effects that the changes required for depository institutions would have on state and local government investment. The technology capable of determining intraday availability and balances has yet been fully developed. Those institutions that are able to undertake these complex changes will incur substantial expense and difficulty in reaching this point. The costs will undoubtedly be passed on to customers, resulting in additional expense to state and local government customers of depository institutions.

Many smaller banks will be unable to put such a system in place at all. Instead to providing state and local governments with intraday account balance information, these banks will be able to provide only delayed information and thereby delayed access to funds. The posting of ACH debit transactions and commercial check transactions would have to be delayed, possibly up to full day. Thus, a governmental unit will be unable to transfer money out of its account for the purchase of investments, and timely investment opportunities will be lost to governmental investors.

The loss of investment opportunity may have serious consequences for state and local governments. An inability to make the most opportunities investments will result in a direct loss of revenue to jurisdictions. In addition, the inability to purchase certain securities early in the day means increased risk to the governmental investor. A late transfer of funds means that a state or local government may either 1) be unable to purchase any security or 2) only receive "leftover" instruments. These less desirable instruments may not qualify under a jurisdiction's investment policy.

Finally, this change in procedure will require both depository institutions and jurisdictions to hire additional personnel to comply with these conditions and to verify their accuracy. Additional staffing will ultimately result in increased costs to state and local governments.

Because the activities which the regulations seek to prevent represent less than 10 percent of all daylight overdrafts incurred by banks, GFOA has urged the Fed to develop a simpler, more targeted approach to the overdraft problem. Final procedures are expected to be released at the end of 1991.

There are other important topics under consideration in the ongoing banking reforms efforts, such as Section 457 plan pass-through deposit insurance, commercial bank underwriting, public funds coverage and bank sales of financial guarantee insurance. New issues will undoubtedly emerge. As the U.S. banking and financial system undergoes a massive restructuring, finance officers need to be alert to those changes that will have an impact on state and local government operations.
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Author:Dotson, Betty
Publication:Government Finance Review
Date:Dec 1, 1991
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