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Federal R eser v e B ank
OF DALLAS
ROBERT

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

P R E S ID E N T
A N D C H IE F E X E C U T I V E O F F I C E R

August 7, 1996

DALLAS, TEXAS
75265-5906

Notice 96-77

TO:

The Chief Executive Officer of each
m em ber bank and others concerned in
the Eleventh Federal Reserve District

SUBJECT
Proposals to Modify Limitations on
Section 20 Subsidiaries’ Underwriting
and Dealing in Securities
DETAILS
The Board of Governors of the Federal Reserve System has requested public
comments on three proposals to modify the conditions under which section 20 subsidiar­
ies of bank holding companies may underwrite and deal in securities.
The first proposal would increase the amount of revenue that a section 20
subsidiary may derive from underwriting and dealing in securities from 10 percent to 25
percent of its total revenue. The second proposal would amend or eliminate three of the
prudential limitations, or firewalls, imposed on the operations of the section 20 subsidiar­
ies. The third proposal would clarify that the Board will not consider interest income
earned on securities that a mem ber could hold for its own account toward a section 20
subsidiary’ revenue limit.
s
The Board must receive comments on the first proposal by September 30,
1996. Comments on this proposal should refer to Docket No. R-0841. The Board must
receive comments on the second and third proposals by September 3, 1996. Comments
on these proposals should refer to Docket Nos. R-0701 and R-0932, respectively. Please
address comments to William W. Wiles, Secretary, Board of Governors of the Federal
Reserve System, 20th Street and Constitution Avenue, N.W., Washington, D.C. 20551.
ATTACHMENTS
Copies of the Board’ notices (Federal Reserve System Docket Nos. R-0841,
s
R-0701, and R-0932) are 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)

MORE INFORMATION
For more information, please contact Bobby Coberly at (214) 922-6209. For
additional copies of this Bank’ notice, please contact the Public Affairs D epartm ent at
s
(214) 922-5254.
Sincerely yours,

FEDERAL RESERVE SYSTEM
[Docket No. R-0841]
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: Notice; Request for comments.
SUMMARY: The Board is proposing to increase from 10 percent to 25 percent
the amount of total revenue that a nonbank subsidiary of a bank holding
company (a so-called section 20 subsidiary) may derive from underwriting and
dealing in securities that a member bank may not underwrite or deal in. The
revenue limit is designed to ensure that section 20 subsidiaries will not be
engaged principally in underwriting and dealing in such securities in violation of
section 20 of the Glass-Steagall Act. Based on its experience supervising these
subsidiaries and developments in the securities markets since a revenue
limitation was adopted in 1987, the Board believes that a company earning 25
percent or less of its revenue from underwriting and dealing would not be
engaged principally in that activity for purposes of section 20.
DATES: Comments must be received by September 30, 1996.
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, DC 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: Gregory A. Baer, Managing
Senior Counsel (202/452-3236), Thomas M. Corsi, Senior Attorney
(202/452-3275), Legal Division; Michael J. Schoenfeld, Senior Securities

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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), Dorothea
Thompson (202/452-3544), Board of Governors of the Federal Reserve System,
20th Street and Constitution Avenue, NW., Washington, DC.
SUPPLEMENTARY INFORMATION:
Background
Section 20 of the Glass-Steagall Act provides that a member bank
may not be affiliated with a company that is "engaged principally" in
underwriting and dealing in securities.- In 1987, the Board first allowed bank
affiliates to engage in underwriting and dealing in bank-ineligible securities —
that is, those securities that a member bank would not be permitted to
underwrite or deal in — when the Board approved an application by three bank
holding companies to underwrite and deal in commercial paper, municipal
revenue bonds, mortgage-backed securities, and consumer-receivable-related
securities.- In 1989, the Board allowed five section 20 subsidiaries to
underwrite and deal in all debt and equity securities, subject to more rigorous
firewalls.Currently, thirty-nine nonbank subsidiaries of bank holding
companies are authorized to engage in underwriting and dealing activities that
are not authorized for a member bank. Fourteen of these so-called section 20
subsidiaries have authority to underwrite and deal in commercial paper,
municipal revenue bonds, mortgage-backed securities, and consumer receivable

1 12 U.S.C. 377.
1
- Citicorp, J.P. Morgan & Co., and Bankers Trust New York Corp., 73
Federal Reserve Bulletin 473 (1987), a f f d , Securities Industry Ass’n v. Board
of Governors. 839 F.2d 47 (2d Cir.), cert, denied, 486 U.S. 1059 (1988)
(hereafter "1987 Order").
- J.P. Morgan & Co.. The Chase Manhattan Corp., Bankers Trust New
York Corp.. Citicorp, and Security Pacific Corp., 75 Federal Reserve Bulletin
192 (1989) (hereafter " 1989 Order”).

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3

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related securities. Twenty-two section 20 subsidiaries have authority to
underwrite and deal in all debt and equity securities, and three may underwrite
and deal in all debt securities. Over the past nine years, the Board has had
substantial experience in supervising the activities and operations of those
companies. In the Board’s experience, the section 20 subsidiaries have operated
in a safe and sound manner without adverse effects on their affiliated banks or
the public, and have provided additional competition in the securities markets.
As a condition of its 1987 order approving underwriting and dealing
in a section 20 subsidiary, the Board established a revenue test to ensure
compliance with the "engaged principally" standard of section 20. The Board
arrived at a revenue test through a series of interpretive steps. First, the Board
determined that a bank affiliate would be "engaged principally" in underwriting
and dealing only if underwriting and dealing were a "substantial line of business
activity for the affiliate."- The Board further found that the best measure of the
underwriting and dealing activity of a section 20 subsidiary was the gross
revenue derived from that activity.- In terms of what revenue to consider, the
Board ruled that securities that a member bank was authorized to underwrite
under section 16 of the Glass-Steagall Act (for example, U.S. government
securities) were not covered by the prohibition of section 20; accordingly, the
Board decided that revenue derived from underwriting and dealing in such
securities should not count in determining whether a section 20 subsidiary’s
level of underwriting and dealing activity was "substantial" for purposes of the
statute. Rather, only revenue earned on "ineligible securities" — those that a
member bank could not underwrite or deal in -- was counted toward the
section 20 limit.
Finally, the Board found that underwriting and dealing in ineligible
securities would not be a "substantial" activity for a section 20 subsidiary if the
gross revenue derived from that activity did not exceed 5 to 10 percent of the
total gross revenues of the subsidiary. (As a prudential matter, the Board
initially limited ineligible revenue to 5 percent of total revenue in order to gain

Bankers Trust New York Corp., 73 Federal Reserve Bulletin 138, 142
(1987); 1987 Order at 481-483.
^ 1987 Order at 483-485.

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experience in supervising such companies. In 1989, the Board raised the limit
to 10 percent.)
No changes were made to the revenue test in subsequent orders
until, in January 1993, the Board allowed section 20 subsidiaries to use an
alternative revenue test that was indexed to account for changes in interest rates
since 1989.7 The Board found that historically unusual changes in the level and
structure of interest rates had distorted the revenue test as a measure of the
relative importance of ineligible securities activity in a manner that was not
anticipated when the 10 percent limit was adopted in 1989. In particular, the
Board found that because bank-eligible securities (such as U.S. government
securities) tended to be shorter term than ineligible securities, an increase in the
steepness of the yield curve had caused the revenue earned by at least some
section 20 subsidiaries from holding eligible securities to decline in relation to
ineligible revenue, even as the relative proportion of eligible and ineligible
securities activities being conducted by these subsidiaries remained unchanged.Five section 20 subsidiaries are currently operating under this indexed test.
At the same time it proposed the indexed revenue test, the Board
sought comment on use of an asset-based measure as an alternative to the
existing gross revenue measure, and in July 1994 sought comment on both the
asset-based measure (for a second time) and a sales volume measure.- As the
courts have recognized, "the relative significance of the firm’s activities could

- Order Approving Modifications to the Section 20 Orders, 79 Federal
Reserve Bulletin 226 (1993) (hereafter, 1993 Modification Order).
1993 Modification Order at 228. 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. The adjustment factors, which are calculated for securities of varying
durations, represent the ratio of interest rates on Treasury securities in the most
recent quarter to those in September 1989. Section 20 subsidiaries use the
adjustment factors to "index" actual interest and dividend revenues based upon
the average duration of their eligible and ineligible securities portfolios.
^ 59 FR 35,516 (1994).

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be measured in various ways — dollar volume, number of transactions, strategic
significance, and so on."The Board has recently received petitions from trade groups and
others urging the Board to increase the revenue limit to at least 25 percent of
total revenue. Petitioners argue that the Board could justify a higher revenue
limit either by reinterpreting "engaged principally" more consistently with the
ordinary meaning of "principal" — that is, to include only the largest or majority
activity — or by finding that a higher level of revenue does not yield a level of
activity that is substantial.
Proposed Change to Revenue Limit
The Board is proposing to maintain the revenue test but increase the
revenue limit from 10 percent of total revenue to 25 percent. The Board seeks
comment on whether this amended revenue test would be an appropriate gauge
of underwriting and dealing activity for purposes of section 20. The Board is
concerned that a test based on assets or sales volume would not yield benefits -in terms of greater accuracy, ease of administration, or immunity from
manipulation - that would justify the costs of converting compliance systems to
a new test.
The Board is proposing to increase the revenue limit based on its
supervision of the section 20 subsidiaries over a nine-year period. Based on this
experience, the Board now believes that the limitation of 10 percent of total
revenue it adopted in 1987, without benefit of this experience, unduly restricted
the underwriting and dealing activity of section 20 subsidiaries to a level that
fell short, and continues to fall short, of substantial activity and principal
engagement for purposes of section 20.

Securities Industry Ass’n v. Board of Governors of the Federal Reserve
System 847 F.2d 890, 894 (D.C. Cir. 1988). For example, the New York State
Banking Department has interpreted its "little Glass-Steagall Act," which
contains the same "engaged principally" language as section 20, to allow a
securities affiliate of a bank to have up to 25 percent of its business activity
consist of underwriting and dealing. New York originally measured activity
using an asset test but has more recently employed a revenue test. See Letter
from Deputy Superintendent Barrantes to Paul L. Lee (May 4, 1988).

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Furthermore, the Board believes that changes in the product mix
that section 20 subsidiaries are permitted to offer and developments in the
securities markets have affected the relationship between revenue and activity.
When the Board initially adopted a 5-10 percent of total revenue test for
underwriting and dealing in investment-grade commercial paper, municipal
revenue bonds, mortgage-backed securities and consumer receivable related
securities, the Board concluded that a "substantial" level of engagement in those
activities would generally yield revenues of greater than 10 percent of total
revenue. Since initially establishing a revenue limit of 10 percent, the Board
has expanded significantly the types of underwriting and dealing activities in
which a section 20 subsidiary may engage, most notably in the 1989 Order
allowing section 20 subsidiaries to underwrite all types of debt and equity
securities. Nevertheless, the Board has not until now reexamined its assumption
about what level of revenue corresponds to a substantial level of engagement in
the types of ineligible securities activities permitted a section 20 subsidiary.
In fact, the Board’s experience shows that the relationship between
gross revenue and underwriting and dealing activity is not the same for
corporate debt securities and other securities approved in the 1989 Order as it
was for securities approved in the 1987 Order. A given level of activity in
corporate debt and equity underwriting and dealing yields substantially higher
revenue than an equivalent amount of activity in underwriting and dealing in
investment-grade commercial paper, municipal revenue bonds, mortgage-backed
securities, and consumer receivable related securities. For example, bid/offer
spreads on many corporate bonds and other securities authorized for dealing in
the 1989 Order are significantly wider than the spreads on the securities
authorized for dealing in the 1987 Order. Similarly, underwriting fees for those
securities authorized in the 1987 Order are significantly smaller than fees for
those securities authorized in the 1989 Order, particularly with respect to equity
securities and non-investment grade debt securities.— Put another way, the
Board believes that (all things being equal) a company that maintained a
constant level of activity over the past nine years, but shifted its product mix
from those authorized by the 1987 Order to those authorized by the 1989 Order,
would have seen a significant increase in ineligible revenue.

—
See, e.g.. Investment Dealer’s Digest 12 (Feb. 19, 1996); Investment
Dealer’s Digest 19 (February 15, 1988).

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A converse trend appears to have developed with respect to eligible
revenue, where market changes appear to have reduced the eligible revenue
derived from a given level of activity. As noted above, to varying degrees over
the years, prior interest rate changes have reduced eligible interest revenue
relative to ineligible interest revenue for the majority of companies that have
elected not to use the indexed revenue test. More importantly, with respect to
eligible revenue derived from other sources, most notably brokerage services,
increased competition has diminished revenue as a function of activity.— Lower
commissions have required companies to increase volume in order to maintain a
given level of eligible revenue.
In sum, the Board believes that a section 20 subsidiary company
that (1) maintained a steady level of both bank-eligible and ineligible securities
activity since 1987, and (2) updated its product mix to include what the Board
has interpreted the Bank Holding Company Act to allow, would have seen its
the ratio of ineligible to total revenue more than double.
Finally, the Board believes that this increase in the revenue limit
would not give rise to the potential dangers to commercial banks from general
underwriting activities that motivated the Congress to enact the Glass-Steagall
Act, or the more general dangers of affiliation that motivated the Congress to
enact the Bank Holding Company Act. The Board has now had considerable
experience supervising these companies, and believes that they have operated in
a safe and sound manner. Particularly given the safeguards of the examination

—
See, e.g.. The Economist 9 (April 15, 1995) ("Commissions on listed
securities as a percentage of the value of trade in these instruments have fallen
from 70-90 basis points in the early 1980s to below 40 basis points. Even for
over-the-counter trading . . . returns have fallen from 80-90 basis points to
around 20 basis points.")

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and reporting process and increased emphasis on internal risk management, the
Board believes that allowing a section 20 subsidiary to increase to 25 percent
the amount of revenue it derives from underwriting and dealing in ineligible
securities would not pose significant risk to an affiliated bank.
By order of the Board of Governors of the Federal Reserve System,
July 31, 1996.
(signed^ William W. Wiles

William W. Wiles
Secretary of the Board.

FEDERAL RESERVE SYSTEM
[Docket No. R-0701]
Review of Restrictions on Director and Employee Interlocks,
Cross-Marketing Activities and the Purchase and Sale of Financial Assets
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Notice; Request for comment.
SUMMARY: The Board is providing a second opportunity for public comment
on proposed revisions to three of the prudential limitations established in its
decisions under the Bank Holding Company Act and section 20 of the GlassSteagall Act permitting a nonbank subsidiary of a bank holding company to
underwrite and deal in securities. The Board is proposing to ease or eliminate
the following restrictions on these so-called section 20 subsidiaries: the
prohibition on director, officer and employee interlocks between a section 20
subsidiary and its affiliated banks or thrifts (the interlocks restriction); the
restriction on a bank or thrift acting as agent for, or engaging in marketing
activities on behalf of, an affiliated section 20 subsidiary (the cross-marketing
restriction); and the restriction on the purchase and sale of financial assets
between a section 20 subsidiary and its affiliated bank or thrift (the financial
assets restriction).
DATES: Comments should be received on or before September 3, 1996.
ADDRESSES: Comments should refer to Docket No. R-0701, and may be
mailed to William W. Wiles, Secretary, Board of Governors of the Federal
Reserve System, 20th Street and Constitution Avenue, N.W., Washington, DC
20551. Comments also may be delivered to Room B-222 of the Eccles Building
between 8:45 a.m. and 5:15 p.m. weekdays, or to the guard station in the Eccles
Building courtyard on 20th Street, N.W. (between Constitution Avenue and
C Street, N.W.) at any time. Comments received will be available for
inspection in Room MP-500 of the Martin Building between 9:00 a.m. and 5:00
p.m. weekdays, except as provided in 12 CFR 261.8 of the Board’s rules
regarding availability of information.
FOR FU RTH ER INFORM ATION CONTACT: Gregory Baer, Managing
Senior Counsel (202) 452-3236, Thomas Corsi, Senior Attorney (202) 452-3275,

2
Legal Division; Michael J. Schoenfeld, Senior Securities Regulation Analyst
(202) 452-2781, Division of Banking Supervision and Regulation; for the
hearing impaired only, Telecommunications Device for the Deaf (TDD),
Dorothea Thompson (202) 452-3544.
SUPPLEMENTARY INFORMATION:
Background
In its orders authorizing bank holding companies to operate section 20
subsidiaries, the Board has established a series of prudential restrictions
(commonly referred to as firewalls) designed to prevent securities underwriting
and dealing risk from being passed from a section 20 subsidiary to an affiliated
insured depository institution, and thus to the federal safety net. The firewalls
also mitigate the potential for conflicts of interest, unfair competition, and other
adverse effects that may arise from the conduct of bank-ineligible securities
activities. See, e.g.. J.P. Morgan & Co., The Chase Manhattan Corp., Bankers
Trust New York Corp., Citicorp, and Security Pacific Corp., 75 Federal Reserve
Bulletin 192, 202-03 (1989) (hereafter, 1989 Order); Citicorp, J.P. Morgan &
Co., and Bankers Trust New York Corp., 73 Federal Reserve Bulletin 473, 492
(1987) (hereafter, 1987 Order).1 In adopting these restrictions, the Board stated
that it would continue to review their appropriateness in the light of its
experience in supervising section 20 subsidiaries.
The Board originally sought comment on changes to the interlocks, crossmarketing and financial assets restrictions on July 10, 1990. 55 FR 28,295
(1990). The Board received forty responses to its notice, with comments
coming from banks, securities firms, trade associations and other members of
the public. However, because legislation affecting the section 20 firewalls was
introduced shortly after the Board sought comment, and has been introduced
intermittently in the years since, the Board has deferred further action.
Given the passage of time since the original notice, the Board has decided
to reopen these three firewalls for comment. All comments received on the
original notice will be considered by the Board before taking final action, but

1
The 1989 Order and the 1987 Order are referred to collectively as the
"section 20 Orders."

3
commenters may wish to update their earlier submissions.
Proposed changes
Introduction
The interlocks and cross-marketing restrictions were intended to insulate a
bank or thrift from the underwriting and dealing risks borne by an affiliated
section 20 subsidiary by ensuring that each company is operated independently
and is perceived as such by its customers. The Board is considering possible
alternatives to these restrictions that would maintain the intended insulation
while allowing each company to draw on management expertise at its affiliates,
operate more efficiently, and serve its customers more effectively.
Similarly, the financial assets restriction was a prophylactic measure
designed to insulate a bank or thrift from the risks of an affiliated section 20
subsidiary by limiting one means by which a bank or thrift could fund an
affiliated section 20 subsidiary. The Board is now considering whether that
restriction is overbroad to the extent that it covers purchases and sales where the
bank or thrift assumes no credit or liquidity risk.
Interlocks
The interlocks restriction currently prohibits all director, officer, and
employee interlocks between a section 20 subsidiary and its bank or thrift
affiliates.2 The restriction seeks to ensure that customers will not be confused
about which company they are dealing with, and that in the event of troubles at
the section 20 subsidiary, the two entities will continue to operate independently
and be ruled to have done so in the event that creditors of the section 20
subsidiary attempt to recover against the bank or thrift.
By prohibiting bank or thrift employees from serving at the section 20

2
In specific cases, the Board has authorized limited officer or director
interlocks between a section 20 subsidiary and its affiliated banks. See, e.g..
National City Corporation. 80 Federal Reserve Bulletin 346, 348-9; Svnovus
Financial Corp.. 77 Federal Reserve Bulletin 954, 955-56 (1991); Banc One
Corporation. 76 Federal Reserve Bulletin 756, 758 (1990).

4
subsidiary, the interlocks restriction imposes considerable costs on bank holding
companies operating a section 20 subsidiary and serves as a barrier to entry for
those considering doing so. This cost may be prohibitive for some smaller bank
holding companies that cannot afford to pay separate staffs to perform similar
functions. Accordingly, the Board believes that this firewall should be reviewed
in order to determine whether the burdens it imposes serve functions important
to safety and soundness.
With respect to directors, the Board is seeking comment on whether to
eliminate the current blanket prohibition entirely or instead to prohibit: (1) a
majority of the board of directors of a section 20 subsidiary from being
composed of directors, officers or employees of affiliated banks or thrifts, and
(2) a majority of the board of directors of a bank or thrift from being composed
of directors, officers or employees of an affiliated section 20 subsidiary. The
Board believes that a prohibition on majority representation would help to
ensure corporate separateness, while allowing personnel costs to be reduced and
operating efficiencies to be exploited.
In addition, the Board originally requested comment on replacing the
prohibition on officer and employee interlocks with a requirement that the
section 20 subsidiary not be managed or controlled by its affiliated banks or
thrifts and that there not be a substantial identity of personnel between the
entities. Commenters strongly opposed this proposal as vague and impractical,
and the Board agrees. The Board now seeks comment on whether the
prohibition on officer and employee interlocks should be eliminated altogether
or, alternatively, limited to only the senior executive officer or senior executive
officers of the section 20 subsidiary.
The Board believes that if the restriction on officer and employee
interlocks were eliminated or modified, existing firewalls and the Interagency
Policy Statement on the Sale of Uninsured Investment Products would be
sufficient to prevent customers from being confused about which company they
are dealing with, and consequently whether any product they are obtaining is
federally insured. For example, the Board’s section 20 Orders require a section
20 subsidiary to provide each of its customers with a special disclosure
statement describing the difference between the underwriting subsidiary and its
bank and thrift affiliates, and stating that securities sold, offered or
recommended by the section 20 subsidiary are not deposits, not federally

5
insured, not guaranteed by an affiliated bank or thrift, and not otherwise an
obligation or responsibility of such bank or thrift. E.g. 1989 Order at 215. The
Board seeks comment on whether existing disclosure requirements are sufficient
to prevent customer confusion and potential liability of a bank or thrift.
The Board also seeks comment on whether concerns about corporate
separateness, even given a restriction on director interlocks, warrant maintaining
some restriction on officer interlocks. In particular, the Board seeks comment
on whether it should generally allow such interlocks but prohibit (1) any senior
executive officer of the section 20 subsidiary from serving as an officer or
employee of an affiliated bank or thrift, and (2) any senior executive officer of a
bank or thrift from serving as an officer or employee of an affiliated section 20
subsidiary.3 Alternatively, the Board seeks comment on whether the officer or
employee interlock should be limited only to the chief executive officer.
Cross-marketing
The Board’s section 20 Orders also prohibit a bank or thrift affiliate of a
section 20 subsidiary from acting as agent for, or engaging in marketing
activities on behalf of, the section 20 subsidiary.4 The Board is requesting

3 Under 12 CFR 225.71, a senior executive officer is defined to include a
person who "without regard to title, exercises the authority of one or more of the
following positions: chief executive officer, chief operating officer, chief financial
officer, chief lending officer, or chief investment officer. Senior executive officer
also includes any other person with significant influence over major policymaking
decisions. . . . " The Board seeks comment on whether, if adopted, this definition
should be amended to clarify its coverage of interlocks between U.S. branches and
agencies of foreign banks and their affiliated section 20 subsidiaries.
4 The cross-marketing restriction does not serve as a complete bar on
marketing activities by a bank or thrift on behalf of an affiliated section 20
subsidiary. Pursuant to certain conditions, the Board has allowed a bank affiliate
of a section 20 subsidiary to: (1) send materials describing the section 20
subsidiary and the section 20 subsidiary’s services to retail and commercial
customers directly or as a stuffer to bank statements; (2) have its officers and
employees send materials and letters on bank letterhead describing the section 20
(continued...)

6
comment on whether to eliminate this restriction. As noted above, the Board
believes that the disclosure requirements contained in the section 20 Orders and
the Interagency Statement on Retail Sales of Nondeposit Investment Products
may be a more narrowly tailored and less burdensome method of protecting
against customer confusion as to whether the customer is dealing with a
section 20 subsidiary or an affiliated bank or thrift.
The Board notes that the Glass-Steagall reform legislation passed at
various times by the Senate and reported by the House Banking Committee has
not prohibited cross-marketing and agency activities. That legislation would
have relied instead on disclosures regarding the uninsured status of securities
affiliates to prevent customer confusion.
Purchase of Financial Assets
The Board is also seeking comment on amending the financial assets
restriction, which generally prohibits a bank or thrift from purchasing financial
assets from, or selling such assets to, an affiliated section 20 subsidiary. An
existing exception to this restriction allows the purchase or sale of U.S. Treasury
securities or direct obligations of the Canadian federal government at market
terms, provided that they are not subject to repurchase or reverse repurchase
agreements between the underwriting subsidiary and its bank or thrift affiliates.
See, e.g., 1989 Order at 216; Canadian Imperial Bank of Commerce, The Royal
Bank of Canada, Barclays PLC and Barclays Bank PLC, 76 Federal Reserve
Bulletin 158, 172 (1990).
In establishing the exception for U.S. Treasury securities, the Board cited
the breadth and liquidity of the market for such instruments, which make

4(...continued)
subsidiary and the section 20 subsidiary’s services to the bank’s retail and
commercial customers; (3) sponsor or co-sponsor with the section 20 subsidiary
educational seminars to inform retail and commercial customers about investment
opportunities, investment strategies, and the section 20 subsidiary’s services; and
(4) have its officers and employees send invitations on bank letterhead inviting
their customers to attend the educational seminars sponsored or co-sponsored by
the banks. Letter Interpreting Section 20 Orders, 81 Federal Reserve Bulletin 198
(1995).

7
evident the "market terms" on which the sale must be transacted and ensure that
the bank will be able to resell any asset it purchases. In its 1990 Notice, the
Board sought comment on extending this exception to include those U.S.
Government agency securities and U.S. Government-sponsored agency securities
for which there is a market with a breadth and liquidity comparable to that for
U.S. Treasury securities.
The Board now seeks comment on whether it should expand this
exception to include the purchase or sale of any assets with a sufficiently broad
and liquid market to ensure that the transaction is on market terms and that the
bank is not incurring credit or liquidity risk through the purchase of assets. The
Board notes that the 1987 Order did not contain a financial assets firewall. In
the Board’s experience, banks and thrifts whose holding companies operate free
of the financial assets restriction have not experienced adverse effects from
purchasing assets from, or selling assets to, their affiliated section 20
subsidiaries.
The Board does intend to retain for now the financial assets restriction to
the extent that it prohibits a purchase or sale of illiquid assets and any purchase
or sale of assets subject to a repurchase or reverse repurchase agreement. The
Board believes that any further changes to the financial assets restriction should
be considered in conjunction with other funding firewalls, as part of a more
comprehensive review of all the remaining firewalls between a section 20
subsidiary and its affiliated banks and thrifts.
By order of the Board of Governors of the Federal Reserve System,
July 31, 1996.
(signed) William W. Wiles

William W. Wiles
Secretary of the Board.

FEDERAL RESERVE SYSTEM
[Docket No. R-0932]
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: Notice; Request for comments.
SUMMARY: The Board is proposing for comment a change in the manner in
which interest earned on securities authorized for investment by a member bank
of the Federal Reserve System is treated in determining whether a company is
engaged principally in underwriting and dealing in securities for purposes of
section 20 of the Glass-Steagall Act. In order to ensure compliance with section
20, the Board required that the amount of revenue a company derived from
underwriting and dealing in securities that a member bank may not underwrite
or deal in (ineligible securities) not exceed 10 percent of the total revenue of the
company. The Board is proposing to clarify that interest earned on the types of
debt securities that a member bank may hold for its own account is not treated
as revenue from underwriting or dealing for purposes of section 20.
DATES: Comments must be received by September 3, 1996.
ADDRESSES: Comments, which should refer to Docket No. R-0932, 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 may also be delivered to Room B-2222 of
the Eccles Building between 8:45 a.m. and 5:15 p.m. weekdays, or to the guard
station in the Eccles Building courtyard on 20th Street, N.W. (between
Constitution Avenue and C Street) at any time. Comments may be inspected in
Room MP-500 of the Martin Building between 9:00 a.m. and 5:00 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

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Regulation, Board of Governors of the Federal Reserve System. For the hearing
impaired only. Telecommunication Device for the Deaf (TDD), Dorothea
Thompson (202/452-3544), Board of Governors of the Federal Reserve System,
20th Street and Constitution Avenue, NW, Washington, D.C.
SUPPLEMENTARY INFORMATION:
Background
Beginning with orders issued in 1987, the Board has authorized
nonbank subsidiaries of bank holding companies, so-called section 20
subsidiaries, to underwrite and deal in ineligible securities.- In order to assure
compliance with section 20 of the Glass-Steagall Act,- the Board provided as a
condition of its orders that the gross revenue derived by the subsidiary from
ineligible securities underwriting and dealing activities not exceed 10 percent of
the total gross revenue of the subsidiary, when revenue is averaged over a
rolling 8-quarter period.
For purposes of computing the 10 percent revenue limit section 20
subsidiaries currently report all interest earned on third-party ineligible debt
securities held by the subsidiaries in an underwriting or dealing capacity as
revenue derived from underwriting and dealing in securities.- Questions have

- E.g., Citicorp, 73 Federal Reserve Bulletin 473 (1987), a ffd , Securities
Industry Ass’n v. Board of Governors, 839 F.2d 47 (2d Cir.), cert, denied, 486
U.S. 1059 (1988).
- Section 20 provides that a member bank may not be affiliated with a
company that is "engaged principally" in underwriting and dealing in securities.
12 U.S.C. 377. Section 20 does not prohibit a bank affiliate from underwriting
and dealing in securities that banks may underwrite and deal in directly (eligible
securities).
- Instructions for Preparation of the Financial Statements for a Bank
Holding Company Subsidiary Engaged in Bank-Ineligible Securities
Underwriting and Dealing, Form FR Y-20. Schedule SUD-I, Line Item 5
(December 1994)(FR Y-20 Instructions). See also "Structuring Bank-Eligible
and Bank-Ineligible Transactions" in FR Y-20 Instructions.

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been raised as to whether this treatment is appropriate for interest earned on
debt securities that a member bank is authorized to hold. Under the GlassSteagall Act, a member bank is expressly authorized to purchase and sell for its
own account "investment securities," which generally include investment grade
corporate debt and certain municipal revenue securities.^ The Board is aware
that pursuant to this authority many banks hold for their own account a
significant amount of investment grade debt securities. In addition, many banks
buy and sell these securities on a relatively frequent basis as part of managing
their investment portfolio. In recognition of this activity, changes to accounting
rules were made at the end of 1993 to establish separate accounting treatment
for bank portfolio securities that are "available for sale" and not intended to be
held to maturity.In view of the above, the Board is proposing to clarify that interest
earned on the types of debt securities that a member bank may hold for its own
account is not treated as revenue from underwriting or dealing in ineligible
securities for purposes of section 20. The Board believes a distinction can be
made between the interest earned by a section 20 subsidiary from holding these
kinds of securities and the profit made from underwriting or reselling them.
The profit or loss a section 20 subsidiary earns on the resale of investment grade
ineligible debt securities the subsidiary holds in inventory more closely
approximates the revenue that should be attributed to performing the functions
of dealing in or underwriting securities, the critical element of which is the
actual offering and sale of the instruments involved.-7

- 12 U.S.C. 24 Seventh, 335; 12 CFR 1.3. Member banks may not
purchase any non-investment grade debt securities or equity securities for their
own account.
- Statement of Financial Accounting Standards No. 115.
- For purposes of the section 20 revenue limitation, the Board has viewed
"public sale" to include the activity of dealing in securities -- the process of
buying and reselling to the public specific securities as part of an ongoing,
regular business. E.g.. Citicorp, supra, 73 Federal Reserve Bulletin at 506-08.
The term "underwriting" generally refers to the process by which new issues of
securities are offered and sold to the public. E.g., Securities Industry Ass’n v .
Board of Governors. 807 F.2d 1052, 1062-66 (D.C. Cir. 1986), cert, denied. 483

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On the other hand, the interest the subsidiary earns on investment
grade ineligible debt securities while it holds them in inventory more closely
represents the revenue that can be attributed to holding the securities as a
member bank may do.- Thus, the Board believes that it is reasonable to
conclude that interest revenue derived from holding the kinds of debt securities
a member bank may hold should not be treated as revenue from underwriting or
dealing in securities. The proposed clarification would apply only to interest
derived from those types of debt securities that a member bank may hold for its
own account, but not underwrite or deal in.
By order of the Board of Governors of the Federal Reserve System,
July 31, 1996.
(signed) William W.

Wiles

William W. Wiles
Secretary of the Board.

U.S. 1005 (1987).
This distinction is further reflected in the current reporting requirements
for section 20 subsidiaries and in Generally Accepted Accounting Principles for
bank holding companies, which prescribe that interest revenue be reported
separately from gains or losses on securities owned. FR Y-20 Instructions,
Statement of Income, Schedule SUD-I, Line Items 2, 5); Securities and
Exchange Commission FOCUS Report (Form X-17A-5 Part II) and instructions
thereto. Generally Accepted Accounting Principles incorporate the format of the
FOCUS Report.

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