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FEDERAL RESERVE BANK
OF NEW YORK
C ircu la r N o.
[
10723 "1
July 2 0 , 1 9 9 4
SECURITIES UNDERWRITING ACTIVITIES BY SECTION 20
SUBSIDIARIES OF BANK HOLDING COMPANIES
Proposed Alternative Methods to Measure Compliance
With the “Engaged Principally” Test of Section 20
of the Glass-Steagall Act
C om m ents R equested by A u g u st 12
To All Bank Holding Companies, Branches
and Agencies of Foreign Banks, and Others
Concerned, in the Second Federal Reserve District:
The following statement has been issued by the Board of Governors of the Federal Reserve
System:
The Federal Reserve Board 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 the “engaged
principally” criterion of 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.
Comment is requested by August 12, 1994.
The current test is based on the revenue earned from ineligible securities activities relative to the
total revenue of the section 20 subsidiary. This proposal arises now due to the Board’s increased
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 requesting comment on whether asset values or sales volume data, or a combination of both
measures, should be used as a new alternative test.
Printed on the following pages is the text of the proposal, which has been published in the
Federal R eg ister of July 12. Comments thereon should be submitted by August 12, and may be sent
to the Board of Governors, as specified in the notice, or to our Banking Applications Department.
W il l ia m J. M c D o n o u g h ,
P resident.
M 79l
35516
3
Federal Register / Vol. 59, No. 132 / Tuesday, July 12, 1994 / Notices
FEDERAL RESERVE SYSTEM
[Docket No. R-0841J
10 Percent Revenue Limit on Bankineligible 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.
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 M P-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.
In 1 9 8 7 and 1 9 8 9 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 FOR FURTHER INFORMATION CONTACT:
20 of the Glass-Steagall Act (12 U.S.C.
Richard M. Ashton, Associate General
377), the Board required that the
Counsel (202/452—3750), Thomas M.
amount of revenue a section 20
Corsi, Senior Attorney (202/452-3275),
subsidiary derives from ineligible
Legal Division; Michael J. Schoenfeld,
securities underwriting and dealing
Senior Securities Regulation Analyst
activities may not exceed 10 percent of
(202/452-2781), Division of Banking
the total revenue of the subsidiary.
Supervision and Regulation, Board of
Section 20 prohibits a member bank of
Governors of the Federal Reserve
the Federal Reserve System from being
System. For the hearing impaired only,
affiliated with a company that is
Telecommunication Device for the Deaf
“engaged principally” in underwriting
(TDD), Dorthea Thompson (202/452and dealing in securities.
3544), Board of Governors of the Federal
In January 1993, after notice and the
Reserve System, 20th Street and
opportunity for public comment, the
Constitution Avenue, NW., Washington,
Board authorized section 20 subsidiaries DC.
to use an alternative indexed method to
SUPPLEMENTARY INFORMATION:
compute compliance with the 10
percent revenue limitation to account
1. Background
for unusual changes in the level and
A. Ten Percent Limit on Ineligible
structure of interest rates since 1989,
Securities Activities o f Section 20
when the 10 percent limit was adopted.
Subsidiaries
When the Board adopted the indexed
revenue test, the Board deferred
Beginning with orders issued in 1987,
adoption of another alternative test for
the Board has authorized bank holding
the 10 percent limit that would be based companies to establish nonbank
on assets, rather than revenue.
subsidiaries (“section 20 subsidiaries’*)
Inasmuch as the Board has had
to underwrite and deal in securities that
increased experience in reviewing and
a bank may not underwrite and deal in
monitoring the operations and activities directly (“ineligible securities*’).1 In
of the section 20 subsidiaries, and in
order to assure compliance with section
order to allow these subsidiaries
20 of the Glass-Steagall A c t the Board
additional flexibility in the conduct of
limited the amount of ineligible
their securities operations, the Board
securities that these section 20
now proposes to modify its orders
subsidiaries could underwrite and deal
approving the establishment of the
in. Section 20 provides that a member
section 20 subsidiaries to allow such
bank may not be affiliated with a
subsidiaries the option of using an
company that is “engaged principally”
alternative measure to the revenuein underwriting and dealing in
based tests for assessing compliance
securities.12 In particular, the Board
with the 10 percent limit. The Board
requests comment on whether asset
1E .g ., C it ic o r p , 73 Federal Reserve Bulletin 473
(1987), o f f d. Securities I n d u s t r y A s s o c i a t i o n v.
values, sales volume data, or both
Board o f G o v e r n o r s , 839 F.2d 47 (2d Cir.), c e r t ,
measures should be used as a new
denied, 486 U.S. 1059 (1988).
alternative to the revenue test.
2 12 U.S.C. 377. The Board and tbe courts have
ruled that section 20 does not prohibit a member
DATES: Comments must be received by
bank from being affiliated with a company that is
August 12,1994.
engaged principally in underwriting and dealing in
ADDRESSES: Comments, which should
securities that banks may underwrite and deal in
directly ("eligible securities"). S e e C i t i c o r p , s u p r a .
refer to Docket No. R-0841, may be
SUMMARY:
Federal Register / Vol. 59, No. 132 f Tuesday, July 12, 1994 / Notices
detennined 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 o f a
subsidiary’s business if the gross
revenue derived from those activities
does not exceed 10 percent of the total
gross revenues of the subsidiary, when
revenue is averaged over a rolling 8quarter 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.
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
B. Adoption o f Alternative Indexed
securities. The second concern was that
Revenue Test
an average asset test, even if computed
on a daily basis, would not include
In July 1992, the Board proposed to
establish two alternative methods that a securities that were underwritten by the
section 20 subsidiary but that were held
section 20 subsidiary could elect to use
only for a few hours, which is typical
to determine compliance with the 10
in many underwriting transactions.
percent limit on ineligible securities
Accordingly, when the Board proposed
activities in place of the gross revenue
an alternative asset-based test in 1992,
test.3 In proposing these alternative
the Board requested comment on
tests, the Board noted that historically
possible modifications to address these
unusual changes in the level and
structure of interest rates have distorted concerns.
A number of banking organizations
the revenue test as a measure of the
commenting
on the Board’s proposal
relative importance of ineligible
supported adoption of an asset-based
securities activities in a manner that
was not anticipated when the 10 percent alternative measure for computing the
10 percent limit. These comments stated
limit was adopted in 1989.4 To address
that, like the indexed revenue proposal,
this problem, the Board first proposed
a limit based on assets would he less
an alternative revenue test indexed to
susceptible than the unadjusted revenue
interest rate changes that would allow
test
to unusual changes in interest rate
for adjustment of the current revenue of
conditions. Those supporting the asseta section 20 subsidiary to account for
based test also stated that this test
the unanticipated interest rate
would be easier and less costly to apply
conditions. In January 1993, the Board
adopted an optional alternative indexed than a measure that required
adjustments to revenue data and would
revenue test.3*•
allow for greater predictability in the
management of the operations of the
'57 FR 33507, July 29, 1902.
subsidiary.
•*The Board pointed out that, in contrast to
Many commenters also opposed
conditions in 1989. there was an unusually wide
difference between short- and long-term rates. Since establishing any specific restrictions to
eligible securities tend to be shorter term than
address the potential for manipulative
ineligible securities, the unusually sharp increase in transactions. These commenters
the steepness of the yield curve had the effect of
believed that the capital and funding
making it appear, based on revenue data, that the
requirements needed to support such
eligible securities activities of at least some section
20 subsidiaries had been reduced, even though the
transactions, as well as earnings
relative proportion of eligible and ineligible
considerations and market-imposed
securities activities being conducted by those
credit risk constraints, would effectively
subsidiaries remained essentially .the same.
curtail the excessive use of asset
5 79 Federal Reserve Bulletin 226 (1993). Under
the indexed revenue test, current interest and
transactions conducted solely to
dividend revenues from eligible and ineligible
increase the level of eligible assets.
activities for each quarter are increased or
Commenters also observed that
decreased by an adjustment factor provided by the
implementation of such separate limits
Board based on the average duration of a section 20
subsidiary’s eligible and ineligible securities
would be difficult in practice.
portfolio. The adjustment factors, which vary
On the question of the treatment of
according to specific time periods of average
intra-day
holdings of securities that are
duration, represent the ratio o f interest rates on
being underwritten, while there was
Treasury securities in the most recent quarter to
those in September 1 9 8 U.
some support for including the value of
35517
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
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 OTganizations 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.
Wnen 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 ail
n C it ic o r p . s u p r a .
484.
73 Federal Reserve Bulletin <tt
M
35518
Federal Register / Vol. 59, No. 132 / Tuesday, July 12, 1994 / Notices
securities in a section 20 subsidiary’s
portfolio on a regular basis, may provide
a disincentive for using that test.7
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 m easure in
addition to revenue for applying 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
Underwriting
The Board believes that, if an assetbased test is adopted as an alternative
measure, the value of any securities
underw ritten by a subsidiary would
have to be accounted for in com puting
average daily assets, even w here the
securities are disposed of prior to the
end of the day. The literal language of
section 20 covers any underw riting
activity. Thus, under the proposed
asset-based test, if securities
underw ritten by a section 20 subsidiary
are recorded as assets of the subsidiary,
but are disposed of before the end of the
day on which underw riting 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
underw ritten by the section 20
subsidiary on a" “best efforts” or agency
basis the securities w ould be treated as
assets of the subsidiary for each day that
underw riting activity occurs w ith
respect to that particular security 9
Any asset-based test would limit a
section 20 subsidiary’s average daily
assets held in connection w ith
underw riting and dealing in ineligible
securities to 10 percent of its total
average daily assets, com puted on a
rolling 8-quarter basis. Because, as the
Board observed w hen an asset-based test
was previously proposed, a measure
relying on asset values w ould be less
sensitive to unanticipated changes in
interest rate conditions than a test based
on revenues, such a test w ould 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 w ith 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 perm issible m easure of
compliance w ith the statutory limitation
in section 20 on ineligible securities
activities. Asset values do provide a
rough approxim ation of risk to the
section 20 subsidiary, and risk to
banking organizations was one of the
concerns behind passage of the GlassSteagall 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 com pliance w ith the law.8
Should an asset-based test be adopted
as an alternative measure, the Board
does not propose that any specific limits
be incorporated to address the potential
for m anipulative transactions carried
out solely to inflate artificially a section
20 subsidiary’s base of eligible assets.
Many of the com m ents 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 lim its on the am ount
of transactions they will engage in with
any particular section 20 subsidiary, in
order to control credit risk. The Board's
m inim um consolidated leverage ratio
and the SEC’s net capital rule, w hich is
applicable to a section 20 subsidiary,
would impose additional constraints. In
addition, the acquisition of significant
am ounts of eligible securities by a
section 20 subsidiary in m atched book
or sim ilar transactions w ould 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
7 At p resen t o n ly fou r s e c tio n 20 s u b sid ia r ie s are
u sin g th e in d e x e d r e v e n u e test.
KE.g., letter, d ated D ecem b er 23. 1986, from N e w
Y ork S u p er in ten d en t o f B an k s to M organ G uaranty
T ru st C om pan y an d B ankers Trust C om pan y.
9 U n d er an a sse t-b a sed a ltern a tiv e m ea su re,
sim ila r treatm ent w o u ld be a cc o rd ed an en tir e issu e
o f p r iv a te ly -p la ced s e c u r itie s w h e n a n y p o rtio n o f
the issu e is tak en in to in v en to ry p u rsu a n t to SEC
R ule 144 A.
M
Anti-M anipulation Limits
corrective action where m anipulative
transactions are detected.
C. Sales Volume Test as Alternative
Measure
The Board is also requesting comment
on adoption of sales volum e as an
alternative measure. If sales volume data
is used as the m easure of an alternative
test for applying the 10 percent limit,
then the dollar volum e of a section 20
subsidiary’s sales of ineligible securities
as a result of underw riting and dealing
in such securities could not be allowed
to exceed 10 percent of its total sales
volum e 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 subsidiary’s
level of activity w ith respect to each
type of security or other asset. Use of
such data is thus consistent with the
statutory requirem ents. Under a sales
volum e test, intra-day transactions like
underw riting and dealing sales would
be autom atically 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 w ould be less
sensitive to changes in interest rate
relationships. Such a test may also be
easier to com ply w ith than the current
alternative of indexed revenues.
Repurchase Transactions and Other
Sales Transactions
One question raised by the use of
sales volume as a test of the 10 percent
lim it is w hether 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
altfernative measure.
In addition, the Board invites
com m ents concerning reporting and
other adm inistrative issues associated
w ith im plem enting a sales volume test.
The Board specifically requests
comment on how sales volume should
be com puted 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
/u r n
Federal Register / Vol. 59, No. 132 / T u esd ay , Ju ly 12, 1994 / N o tices
purchasing a put option or selling a
futures con tract A lthough each type of
transaction may be reported differently
for balance sheet purposes, all of the
various kinds of transactions may have
an identical im pact on th e section 20
subsidiary’s risk profile.
The Board is considering adopting
instructions sim ilar to those contained
in the current Federal Reserve Report
Series Form FR 2004, Schedule B
“ Weekly Report of Cum ulative Dealer
Transactions” for collection of sales
volume inform ation. Accordingly,
com m ents are requested concerning
w hether the instructions a n d definitions
for reporting sales volum e data in the
FR 2004 w ould 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.
Manipulative Transactions
When the Board first approved the
establishm ent o f th e section 20
subsidiaries, it considered and rejected
using a sales volum e test, on the ground
that the eligible securities sales volume
of a section 20 subsidiary, like asset
values, could be easily inflated by
repeated m atched book transactions
intended for no other purpose than to
inflate the subsidiary’s eligible safes
volume base.10*As noted above, many of
the comments on the previously
proposed asset-based test pointed out
the credit risk and m arket lim itations on
the extent to w hich a section 20
subsidiary may engage in matched book
or sim ilar transactions. W hile these
lim its may be less effective where a
section 20 subsidiary engages in
unusual sales of securities with its own
affiliate, rather than w ith 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 taken
where m anipulative transactions are
found.
D. Compliance With Both Measures
A possible m eans for addressing the
disadvantages of asset values and sales
volume alone as appropriate m easures is
(o require a section 20 subsidiary
electing an alternative test to comply
w ith both measures. The Board seeks
comment on this possible requirement.
'" C it ic o r p , s u p ra , 7 3 Federal R eserve B u lle tin at
4H4.
E. Implementation o f A ny 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 com putation 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 com bination of both
measures, a section 20 subsidiary w ould
be allowed, at its election, initially to
com ply with such a test on a
prospective basis only for the first twoyear period. The Board followed this
approach when the indexed revenue test
was adopted.
As was also the case w ith 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
w ould be required to continue using
that test for a period of at least two
years, in order to prevent frequent
sw itching between tests that w ould
im pair an accurate assessm ent of the
relative importance of th e subsidiary’s
ineligible securities activities.
F. Proposed Elimination o f Indexed
Revenue Test
The Board also seeks comment as to
why, if a new alternative measure is
adopted, the indexed revenue test
should not be elim inated because there
would no longer be a need for that
alternative measure. However, a section
20 subsidiary w ould be allowed to
continue to elect to use the unadjusted
revenue test, if the subsidiary wishes to
avoid the costs associated w ith
converting to any new test.
G. Proposed Modification o f Board
Orders
The Board proposes that its orders
approving the establishm ent of section
20 subsidiaries be m odified 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 com pliance w ith the 10 percent
limit on ineligible securities activities.
Under such a test, a section 20
subsidiary would be view ed as in
com pliance w ith that section for any
quarter if the average daily assets held
in connection w ith underw riting and
dealing in ineligible securities for that
quarter, when added to the average
daily assets held in connection with
35519
ineligible securities activities for the
previous seven quarters, does not
exceed 10 percent of th e average daily
total assets o f the subsidiary for that
quarter and for the seven previous
quarters.11
In th e 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 com pliance
w ith the 10 percent limit. U nder such a
test, a section 20 subsidiary w ould be
viewed as in com pliance w ith that
section for any quarter if th e total dollar
volum e of sales of ineligible securities
from underw riting and dealing activities
for that quarter, w hen added to the total
dollar volum e 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 m easured by both asset
values and sales volume. Under such a
test, a section 20 subsidiary w ould be
viewed as in com pliance w ith section
20 for any quarter if the subsidiary
sim ultaneously satisfied both the assetbased and sales volume measures
described above.
By order o f the Board o f G overnors of the
F ederal R eserve S y stem , July 6 ,1 9 9 4 .
William W. Wiles,
Secretary of the Board.
[FR Doc. 94-16820 Fried 7-11-94; 8:45 amj
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