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Federal R eserve Bank
OF DALLAS
ROBERT

D. M C T E E R , J R .

PRESIDENT

July 14, 1994

A ND CH IE F E X ECU TIV E O F F IC E R

Notice 94-72
TO:

The Chief Executive Officer of each
member bank and others concerned in
the Eleventh Federal Reserve District
SUBJECT
Proposal to Provide Alternative Test for
In e lig ib le Securities A ctivitie s
of Section 20 Subsidiaries
DETAILS

The Board of Governors of the Federal Reserve System has requested
public comment on a proposal to provide an alternative to the'current test
used to measure whether a section 20 subsidiary is in compliance with section
20 of the Glass-Steagall Act. Section 20 prohibits a member bank from being
affiliated with a company that is "engaged principally" in underwriting and
dealing in ineligible securities.
The current test is based on the revenue earned from ineligible
securities activities relative to the total revenue of the section 20 subsid­
iary. Based on its experience in reviewing and monitoring the operations and
activities of section 20 subsidiaries and in order to allow these subsidiaries
additional flexibility in the conduct of their securities operations, the
Board is considering alternatives to the current test. The Board is request­
ing comment on whether asset values or sales volume data, or a combination of
both measures, should be used as a new alternative test.
The Board must receive comments by
be addressed to William W. Wiles, Secretary,
Reserve System, 20th Street and Constitution
20551. All comments should refer to Docket

August 12, 1994. Comments should
Board of Governors of the Federal
Avenue, N.W., Washington, D.C.
No. R-0841.

ATTACHMENT

A copy of the Board’s notice (Federal Reserve System Docket No.
R-0841) is attached.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal Reserve Bank of Dallas:
Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012; Houston Branch Intrastate (800) 392-4162,
Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

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M R INFORMATION
OE

For more information, please contact Marion White at (214) 922-6155.
For additional copies of this Bank’s notice, please contact the Public Affairs
Department at (214) 922-5254.
Sincerely yours,

FEDERAL RESERVE SYSTEM
[DOCKET No. R-0841]
10 Percent Revenue Limit on Bank-Ineligible Activities of Subsidiaries
of Bank Holding Companies Engaged in Underwriting and Dealing in
Securities

AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Request for comments.

SUMMARY: In 1987 and 1989 the Board authorized bank holding companies
to establish separate nonbank subsidiaries ("section 20 subsidiaries") to
underwrite and deal in securities that a bank may not underwrite and deal in
directly ("ineligible securities"). In order to ensure compliance with section 20
of the Glass-Steagall Act (12 U.S.C. 377), the Board required that the amount
of revenue a section 20 subsidiary derives from ineligible securities underwriting
and dealing activities may not exceed 10 percent of the total revenue of the
subsidiary. Section 20 prohibits a member bank of the Federal Reserve System
from being affiliated with a company that is "engaged principally" in
underwriting and dealing in securities.
In January 1993, after notice and the opportunity for public
comment, the Board authorized section 20 subsidiaries to use an alternative
indexed method to compute compliance with the 10 percent revenue limitation
to account for unusual changes in the level and structure of interest rates since
1989, when the 10 percent limit was adopted. When.the Board adopted the
indexed revenue test, the Board deferred adoption of another alternative test for
the 10 percent limit that would be based on assets, rather than revenue.
Inasmuch as the Board has had increased experience in reviewing and

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monitoring the operations and activities of the section 20 subsidiaries, and in
order to allow these subsidiaries additional flexibility in the conduct of their
securities operations, the Board now proposes to modify its orders approving the
establishment of the section 20 subsidiaries to allow such subsidiaries the option
of using an alternative measure to the revenue-based tests for assessing
compliance with the 10 percent limit. The Board requests comment on whether
asset values, sales volume data, or both measures should be used as a new
alternative to the revenue test.
DATES: Comments must be received by August 12, 1994.
ADDRESSES: Comments, which should refer to Docket No. R-0841, may be
mailed to the Board of Governors of the Federal Reserve System, 20th Street
and Constitution Avenue, NW, Washington, D.C. 20551, to the attention of Mr.
William Wiles, Secretary. Comments addressed to the attention of Mr. Wiles
may be delivered to the Board’s mail room between 8:45 a.m. and 5:15 p.m.,
and to the security control room outside of those hours. Both the mail room
and security control room are accessible from the courtyard entrance on 20th
Street between Constitution Avenue and C Street, NW. Comments may be
inspected in room MP-500 between 9 a.m. and 5 p.m. weekdays, except as
provided in section 261.8 of the Board’s Rules Regarding Availability of
Information, 12 CFR 261.8.
FOR FURTHER INFORMATION CONTACT: Richard M. Ashton,
Associate General Counsel (202/452-3750), Thomas M. Corsi, Senior Attorney
(202/452-3275), Legal Division; Michael J. Schoenfeld, Senior Securities
Regulation Analyst (202/452-2781), Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve System. For the hearing
impaired only, Telecommunication Device for the Deaf (TDD), Dorthea

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Thompson (202/452-3544), Board of Governors of the Federal Reserve System,
20th Street and Constitution Avenue, NW, Washington, D.C.
SUPPLEMENTARY INFORMATION:

I.

BACKGROUND
A.

Ten Percent Limit on Ineligible Securities Activities of
Section 20 Subsidiaries
Beginning with orders issued in 1987, the Board has authorized

bank holding companies to establish nonbank subsidiaries ("section 20
subsidiaries") to underwrite and deal in securities that a bank may not
underwrite and deal in directly ("ineligible securities").- In order to assure
compliance with section 20 of the Glass-Steagall Act, the Board limited the
amount of ineligible securities that these section 20 subsidiaries could
underwrite and deal in. Section 20 provides that a member bank may not be
affiliated with a company that is "engaged principally" in underwriting and
dealing in securities.- In particular, the Board determined that a bank affiliate
would not be "engaged principally" in ineligible securities activities for purposes
of section 20 if those activities were not substantial relative to the other
activities of the subsidiary. The Board ruled that ineligible securities activities
are not a substantial part of a subsidiary’s business if the gross revenue derived
from those activities does not exceed 10 percent of the total gross revenues of

y

E.g.. Citicorp. 73 Federal Reserve Bulletin 473 (1987), aff’d. Securities
Industry Association v. Board of Governors, 839 F.2d 47 (2d Cir.), cert, denied.
486 U.S. 1059 (1988). '

y

12 U.S.C. 377. The Board and the courts have ruled that section 20
does not prohibit a member bank from being affiliated with a company that is
engaged principally in underwriting and dealing in securities that banks may
underwrite and deal in directly ("eligible securities"). See Citicorp, supra.

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the subsidiary, when revenue is averaged over a rolling 8-quarter period.
Subject to this limitation, the Board has approved the establishment of over 30
section 20 subsidiaries, several of which are authorized to underwrite and deal
in debt and equity securities generally.
B.

Adoption of Alternative Indexed Revenue Test
In July 1992, the Board proposed to establish two alternative

methods that a section 20 subsidiary could elect to use to determine compliance
with the 10 percent limit on ineligible securities activities in place of the gross
revenue test.- In proposing these alternative tests, the Board noted that
historically unusual changes in the level and structure of interest rates have
distorted the revenue test as a measure of the relative importance of ineligible
securities activities in a manner that was not anticipated when the 10 percent
limit was adopted in 1989.- To address this problem, the Board first proposed
an alternative revenue test indexed to interest rate changes that would allow for
adjustment of the current revenue of a section 20 subsidiary to account for the
unanticipated interest rate conditions. In January 1993, the Board adopted an

^ 57 FR 33507, July 29, 1992.

y

The Board pointed out that, in contrast to conditions in 1989, there was
an unusually wide difference between short- and long-term rates. Since eligible
securities tend to be shorter term than ineligible securities, the unusually sharp
increase in the steepness of the yield curve had the effect of making it appear,
based on revenue data, that the eligible securities activities of at least some
section 20 subsidiaries had been reduced, even though the relative proportion of
eligible and ineligible securities activities being conducted by those subsidiaries
remained essentially the same.

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optional alternative indexed revenue test.C.

Proposed Asset-Based Test
At the same time that the indexed revenue test was proposed, the

Board also proposed an alternative asset-based test. Specifically, the Board
proposed that the 10 percent limit would be computed by using average daily
assets held in connection with ineligible securities activities and with other
activities. The Board recognized that in 1987, when it initially decided to use
revenue as the appropriate measure of the section 20 limit on ineligible
securities activities, the Board had expressed two concerns about a test based on
average assets. One concern was that an asset-based test might be manipulated,
for example, through "matched book" repurchase and reverse repurchase
agreements for government securities. The second concern was that an average
asset test, even if computed on a daily basis, would not include securities that
were underwritten by the section 20 subsidiary but that were held only for a few
hours, which is typical in many underwriting transactions. Accordingly, when
the Board proposed an alternative asset-based test in 1992, the Board requested
comment on possible modifications to address these concerns.
A number of banking organizations commenting on the Board’s
proposal supported adoption of an asset-based alternative measure for computing
the 10 percent limit. These comments stated that, like the indexed revenue

9

79 Federal Reserve Bulletin 226 (1993). Under the indexed revenue test,
current interest and dividend revenues from eligible and ineligible activities for
each quarter are increased or decreased by an adjustment factor provided by the
Board based on the average duration of a section 20 subsidiary’s eligible and
ineligible securities portfolio. The adjustment factors, which vary according to
specific time periods of average duration, represent the ratio of interest rates on
Treasury securities in the most recent quarter to those in September 1989.

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proposal, a limit based on assets would be less susceptible than the unadjusted
revenue test to unusual changes in interest rate conditions. Those supporting the
asset-based test also stated that this test would be easier and less costly to apply
than a measure that required adjustments to revenue data and would allow for
greater predictability in the management of the operations of the subsidiary.
Many commenters also opposed establishing any specific
restrictions to address the potential for manipulative transactions. These
commenters believed that the capital and funding requirements needed to
support such transactions, as well as earnings considerations and marketimposed credit risk constraints, would effectively curtail the excessive use of
asset transactions conducted solely to increase the level of eligible
assets. Commenters also observed that implementation of such separate limits
would be difficult in practice.
On the question of the treatment of intra-day holdings of securities
that are being underwritten, while there was some support for including the
value of such securities for purposes of applying an asset-based test, other
comments opposed counting the value of such holdings on the grounds that the
10 percent limit should measure only assets that pose a risk to the section 20
subsidiary.
After considering these comments, the Board decided to defer
adoption of an alternative asset-based test, noting that the Board was not then
able to assess the potential practical effect of the test.
II.

PROPOSED ALTERNATIVE TEST
A.
Need for an Improved Alternative to the Gross Revenue
Test
Since the decision to defer consideration of the asset-based test, the

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Board has had a greater opportunity to review and analyze the operations of
section 20 subsidiaries. At the outset, the Board notes that, during this time
period and in the entire seven year period since the Board first approved the
creation of section 20 subsidiaries, the Board has not uncovered evidence of
unsafe or unsound practices, conflicts of interest, or other conduct related to the
operations of these subsidiaries that has impaired the condition of the affiliated
depository institutions or the banking organizations as a whole. The available
evidence further suggests that these subsidiaries have exerted a beneficial
procompetitive influence on the securities markets in which they compete.
When the section 20 subsidiaries were first authorized, the Board
selected revenue, rather than asset values or sales volume, as the best overall
measure of ineligible securities activities because the Board believed that such a
test would pose the fewest operational difficulties and provide the most accurate
indication of the relative importance of specific activities. The Board also noted
that although the applicants had argued that a variety of factors could be used to
judge "engaged principally" status, a single uniform standard was desirable.However, subsequent events have shown that the susceptibility of
results from the gross revenue measure to distortion caused by changes in
interest rate conditions casts doubt on the appropriateness of that test. Although
the indexed revenue test addresses these concerns, it necessarily involves
increased operational difficulties. For some section 20 subsidiaries, the costs
and resources needed to implement the indexed revenue test, with the need for
complicated duration models and the calculation of the duration of all securities
in a section 20 subsidiary’s portfolio on a regular basis, may provide a

- Citicorp, supra. 73 Federal Reserve Bulletin at 484.

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disincentive for using that test.Accordingly, and in order to provide additional flexibility to section
20 subsidiaries in the conduct of authorized activities, the Board now believes it
is desirable to consider adoption of another optional measure in addition to
revenue for applying the 10 percent limit on ineligible securities activities. The
Board believes that either asset values or sales volume, or a combination of both
measures, should be considered as a new alternative measure.
B.

Asset-Based Test as an Alternative Measure
Any asset-based test would limit a section 20 subsidiary’s average

daily assets held in connection with underwriting and dealing in ineligible
securities to 10 percent of its total average daily assets, computed on a rolling 8quarter basis. Because, as the Board observed when an asset-based test was
previously proposed, a measure relying on asset values would be less sensitive
to unanticipated changes in interest rate conditions than a test based on
revenues, such a test would address these distortions. Also, it appears that for at
least some section 20 subsidiaries a test relying on asset values may be easier in
practice to apply than the indexed revenue test. Moreover, as explained below,
in light of its greater experience with the operations of the section 20
subsidiaries, the Board is now of the view that the concerns previously
expressed about the operation of an asset-based test can be appropriately
mitigated.
The Board believes that the use of assets acquired in connection
with particular types of securities activities may represent a permissible measure

^ At present only four section 20 subsidiaries are using the indexed revenue
test.

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of compliance with the statutory limitation in section 20 on ineligible securities
activities. Asset values do provide a rough approximation of risk to the section
20 subsidiary, and risk to banking organizations was one of the concerns behind
passage of the Glass-Steagall Act. The Board notes that the New York State
Banking Department, in applying a state law restriction on the level of ineligible
securities activities of affiliates of state-chartered banks, allows the use of either
assets or revenue as a measure of compliance with the law.1. Underwriting The Board believes that, if an asset-based test is
adopted as an alternative measure, the value of any securities underwritten by a
subsidiary would have to be accounted for in computing average daily assets,
even where the securities are disposed of prior to the end of the day. The literal
language of section 20 covers any underwriting activity. Thus, under the
proposed asset-based test, if securities underwritten by a section 20 subsidiary
are recorded as assets of the subsidiary, but are disposed of before the end of
the day on which underwriting activity takes place, then the securities would be
treated as if they were carried as assets on the books of the subsidiary as of the
end of that day. If securities are underwritten by the section 20 subsidiary on a
"best efforts" or agency basis the securities would be treated as assets of the
subsidiary for each day that underwriting activity occurs with respect to that
particular security.2. Anti-manipulation Limits Should an asset-based test be adopted

- E.g.. letter, dated December 23, 1986, from New York Superintendent of
Banks to Morgan Guaranty Trust Company and Bankers Trust Company.
- Under an asset-based alternative measure, similar treatment would be
accorded an entire issue of privately-placed securities when any portion of the
issue is taken into inventory pursuant to SEC Rule 144A.

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as an alternative measure, the Board does not propose that any specific limits be
incorporated to address the potential for manipulative transactions carried out
solely to inflate artificially a section 20 subsidiary’s base of eligible assets.
Many of the comments on the previously proposed asset-based test stated that
there are sufficient financial and market constraints on the holding of excessive
eligible securities solely to support increased ineligible securities activities.
Even in the case of matched book-type transactions, counterparties typically
impose limits on the amount of transactions they will engage in with any
particular section 20 subsidiary, in order to control credit risk. The Board’s
minimum consolidated leverage ratio and the SEC’s net capital rule, which is
applicable to a section 20 subsidiary, would impose additional constraints. In
addition, the acquisition of significant amounts of eligible securities by a section
20 subsidiary in matched book or similar transactions would also tend to have
an overall negative impact on the earnings performance of the consolidated bank
holding company organization, given the small profit margins typical in such
transactions. Finally, the Board believes that it has the authority to take
appropriate corrective action where manipulative transactions are detected.
C.

Sales Volume Test as Alternative Measure
The Board is also requesting comment on adoption of sales volume

as an alternative measure. If sales volume data is used as the measure of an
alternative test for applying the 10 percent limit, then the dollar volume of a
section 20 subsidiary’s sales of ineligible securities as a result of underwriting
and dealing in such securities could not be allowed to exceed 10 percent of its
total sales volume over a rolling 8-quarter period.
The Board believes that the value of various types of securities and
other assets sold by a section 20 subsidiary bears a relationship to the

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subsidiary’s level of activity with respect to each type of security or other asset.
Use of such data is thus consistent with the statutory requirements. Under a
sales volume test, intra-day transactions like underwriting and dealing sales
would be automatically covered, even if the assets involved were not recorded
on the subsidiary’s books at the end of the day. In addition, like an asset-based
test, a sales volume test would be less sensitive to changes in interest rate
relationships. Such a test may also be easier to comply with than the current
alternative of indexed revenues.
1.

Repurchase Transactions and Other Sales Transactions One

question raised by the use of sales volume as a test of the 10 percent limit is
whether securities repurchase agreements ("repo transactions") should be treated
as "sales" and therefore covered under such a test. Repo transactions are
hybrids, having some characteristics of collateralized lending and some
characteristics of an outright sale of securities. The Federal Reserve, for
purposes of open market operations, has taken the position that repo transactions
are sales rather than loans. The Board requests comment on how repo
transactions should be treated for purposes of a sales volume test, if such a test
were adopted as an appropriate alternative measure.
In addition, the Board invites comments concerning reporting and
other administrative issues associated with implementing a sales volume test.
The Board specifically requests comment on how sales volume should be
computed for various types of transactions involving the same kinds of
underlying securities in different market places. For example, Treasury bonds
may be sold in the cash market, on a "When Issued" basis, on a forward
contract basis, or indirectly, by purchasing a put option or selling a futures
contract. Although each type of transaction may be reported differently for

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balance sheet purposes, all of the various kinds of transactions may have an
identical impact on the section 20 subsidiary’s risk profile.
The Board is considering adopting instructions similar to those
contained in the current Federal Reserve Report Series Form FR 2004, Schedule
B "Weekly Report of Cumulative Dealer Transactions" for collection of sales
volume information. Accordingly, comments are requested concerning whether
the instructions and definitions for reporting sales volume data in the FR 2004
would provide an adequate basis for developing sales volume reporting for
section 20 subsidiaries. Comments are also requested concerning the definition
and reporting of various types of transactions that are not addressed in the
existing FR 2004 report instructions.
2.

Manipulative Transactions When the Board first approved the

establishment of the section 20 subsidiaries, it considered and rejected using a
sales volume test, on the ground that the eligible securities sales volume of a
section 20 subsidiary, like asset values, could be easily inflated by repeated
matched book transactions intended for no other purpose than to inflate the
subsidiary’s eligible sales volume base.— As noted above, many of the
comments on the previously proposed asset-based test pointed out the credit risk
and market limitations on the extent to which a section 20 subsidiary may
engage in matched book or similar transactions. While these limits may be less
effective where a section 20 subsidiary engages in unusual sales of securities
with its own affiliate, rather than with a third party, solely for the purpose of
increasing the volume of eligible securities sales, these matters can be addressed
during the examination process and, as noted above, corrective action can be

Citicorp, supra. 73 Federal Reserve Bulletin at 484.

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taken where manipulative transactions are found.
D.

Compliance with Both Measures
A possible means for addressing the disadvantages of asset values

and sales volume alone as appropriate measures is to require a section 20
subsidiary electing an alternative test to comply with both measures. The Board
seeks comment on this possible requirement.
E.

Implementation of Any Alternative Test
The Board notes that comments received on the asset-based test

previously proposed suggested that, if such a test were adopted, some section 20
subsidiaries may not have access to sufficiently detailed asset data for earlier
quarters to allow computation of such a test on a rolling 8-quarter basis and may
not be able to obtain this information easily. Therefore, the Board proposes
that, if an alternative measure is adopted using either asset values or sales
volume, or a combination of both measures, a section 20 subsidiary would be
allowed, at its election, initially to comply with such a test on a prospective
basis only for the first two-year period. The Board followed this approach when
the indexed revenue test was adopted.
As was also the case with respect to adoption of the indexed
revenue test, the Board proposes that, regardless of which test may be adopted
as an alternative measure, any section 20 subsidiary electing to use a new test
would be required to continue using that test for a period of at least two years,
in order to prevent frequent switching between tests that would impair an
accurate assessment of the relative importance of the subsidiary’s ineligible
securities activities.
F.

Proposed Elimination of Indexed Revenue Test
The Board also seeks comment as to why, if a new alternative

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measure is adopted, the indexed revenue test should not be eliminated because
there would no longer be a need for that alternative measure. However, a
section 20 subsidiary would be allowed to continue to elect to use the
unadjusted revenue test, if the subsidiary wishes to avoid the costs associated
with converting to any new test.
G.

Proposed Modification of Board Orders
The Board proposes that its orders approving the establishment of

section 20 subsidiaries be modified to provide that a section 20 subsidiary may
elect, as an alternative to the existing revenue tests, to apply an asset-based test
to assess compliance with the 10 percent limit on ineligible securities activities.
Under such a test, a section 20 subsidiary would be viewed as in compliance
with that section for any quarter if the average daily assets held in connection
with underwriting and dealing in ineligible securities for that quarter, when
added to the average daily assets held in connection with ineligible securities
activities for the previous seven quarters, does not exceed 10 percent of the
average daily total assets of the subsidiary for that quarter and for the seven
previous quarters.—
7
In the alternative, the Board proposes that section 20 subsidiaries be
authorized to elect to apply, as an alternative to the existing revenue test, a sales
volume test to assess compliance with the 10 percent limit. Under such a test, a
section 20 subsidiary would be viewed as in compliance with that section for
any quarter if the total dollar volume of sales of ineligible securities from

^

Securities underwritten by the subsidiary, including securities taken into
inventory in a private placement pursuant to SEC Rule 144A, would be treated
as assets of the subsidiary for each day underwriting activity takes place with
respect to such securities.

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underwriting and dealing activities for that quarter, when added to the total
dollar volume of such sales for the previous seven quarters, does not exceed 10
percent of the total dollar volume of sales of all securities and other assets by
the subsidiary for that quarter and for the seven previous quarters.
Finally, as a third alternative, the Board proposes that section 20
subsidiaries be authorized to apply an alternative test measured by both asset
values and sales volume. Under such a test, a section 20 subsidiary would be
viewed as in compliance with section 20 for any quarter if the
subsidiary simultaneously satisfied both the asset-based and sales volume
measures described above.
By order of the Board of Governors of the Federal Reserve System,
July 6, 1994. *

William W. Wiles
Secretary of the Board


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102