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S. HRG. 105-426
TffE-FE
RESERVE’S PROPOSED CHANGES
arch ^
’W SECnON 20 FIREWALLS
rat fleaorva Bank=
of St. Louis
HEARING
NOV 16 1998
BEFO RE THE
SUBCOMMITTEE ON FINANCIAL INSTITUTIONS
AND REGULATORY RELIEF
OF THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
ON
A REVIEW OF THE FEDERAL RESERVE’S PROPOSED MODIFICATIONS TO
THE FIREWALLS THAT SEPARATB COMMERCIAL BANKS AND THEIR
SECURITIES AFFILIATES TO DETERMINE IF SAFETY AND SOUNDNESS
MEASURES ARE STILL IN PLACE, AND FOR OTHER PURPOSES
MARCH 20, 1997
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
47-726 CC
WASHINGTON : 1997
For sale by the U.S. Government Printing Office
Superintendent of Documents. Congressional Sales Office, Washington, DC 20402
ISBN 0 - 1 6 - 0 5 6 5 6 9 - 3
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
ALFONSE M. D’AMATO, New York, Chairman
PHIL GRAMM, Texas
PAUL S. SARBANES, Maryland
RICHARD C. SHELBY, Alabama
CHRISTOPHER J. DODD, Connecticut
CONNIE MACK, Florida
JOHN F. KERRY, Massachusetts
LAUCH FAIRCLOTH, North Carolina
RICHARD H. BRYAN, Nevada
ROBERT F. BENNETT, Utah
BARBARA BOXER, California
CAROL MOSELEY-BRAUN, Illinois
ROD GRAMS, Minnesota
WAYNE ALLARD, Colorado
TIM JOHNSON, South Dakota
JACK REED, Rhode Island
MICHAEL B. ENZI, Wyoming
CHUCK HAGEL, Nebraska
H o w a r d A. M e n e l l , Staff Director
S t e v e n B . H a r r is , Democratic Staff Director and Chief Counsel
P h il ip E. B e c h t e l , Chief Counsel
PEGGY K u h n , Financial Analyst
MARTIN J. G r u e n b e r g , Democratic Senior Counsel
S a r a h B l o o m R a s k i n , Democratic Counsel
G e o r g e E. W h it t l e , Editor
S u b c o m m it t e e
on
F in a n c ia l I n s t it u t io n s
and
R e g u l a t o r y R e l ie f
LAUCH FAIRCLOTH, North Carolina, Chairman
WAYNE ALLARD, Colorado
RICHARD H. BRYAN, Nevada
MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota
RICHARD C. SHELBY, Alabama
BARBARA BOXER, California
CONNIE MACK, Florida
CAROL MOSELEY-BRAUN, Illinois
ROD GRAMS, Minnesota
JACK REED, Rhode Island
PHIL GRAMM, Texas
J a m e s E. H y l a n d , Staff Director
C h r is t in e H e s s e , Counsel
(II)
C O N T E N T S
THURSDAY, MARCH 20, 1997
Page
Opening statement o f Senator Faircloth ....................................................................
Opening statements, comments, or prepared statements of:
Senator S a rb an es.......................................................................................................
Senator D’A m a to ........................................................................................................
Prepared statement ..........................................................................................
Senator Bryan ............................................................................................................
Senator Enzi ..............................................................................................................
Senator Grams ...........................................................................................................
Senator Reed ..............................................................................................................
1
2
4
44
5
6
12
13
W ITN ESSES
Susan M. Phillips, Member, Board of Governors, Federal Reserve System .......
Prepared statement ..................................................................................................
The Firewalls in Context: Independent Protections for Banks and
Consumers ......................................................................................................
The Board’s Review ..........................................................................................
Restrictions on F u n d in g ...................................................................................
Prohibitions on a Bank Extending or Enhancing Credit in Support
o f Underwriting or Dealing by a Section 20 Affiliate ..........................
Capital Requirements ......................................................................................
Remaining Restrictions ....................................................................................
Earlier Board Action on Other Firewalls and the Revenue Limit ........
Summary o f the Federal Reserve Board’s Existing and Proposed Securi
ties Firewalls ..........................................................................................................
General Provision ..............................................................................................
Firewall-by-Firewall C om parison ..................................................................
Response to written questions of Senator Sarbanes .........................................
Victor A. Warnement, General Counsel, NationsBanc Capital Markets, Inc.,
Subsidiary o f NationsBank Corporation .................................................................
Prepared statement ..................................................................................................
General Overview o f the Federal Reserve Board’s Firewalls Modification
Proposal ...................................................................................................................
Proposed Amendments to Firewalls .............................................................
Specific Responses to the Chairman’s Request for Testimony on Particu
lar Areas ..................................................................................................................
Support or Lack o f Support o f the Federal Reserve’s Proposal .............
Safety and Soundness Concerns ...................................................................
Adequacy of Customer Protections ...............................................................
Risks o f Unfair Advantage for Section 20 Companies .............................
Adequacy o f Other Statutory and Regulatory P rotection s......................
Other Recent Fed Action Impacting Section 20 Activities ......................
Conclusion ...........................................................................................................
Richard B. Roberts, Executive Vice President and Treasurer, Wachovia Cor
poration, on behalf o f the ABA Securities Association and the American
Bankers Association; accompanied by Rachel Robbins, General Counsel and
Managing Director, J.P. Morgan & Co., Incorporated .........................................
Prepared statement ..................................................................................................
Background .........................................................................................................
The Board’s Proposal .......................................................................................
Safety and Soundness Issues .........................................................................
Conflicts o f Interest and Consumer Protection Issues .............................
(III)
7
44
44
45
46
46
47
48
48
49
49
49
74
24
55
57
57
58
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59
60
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28
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65
IV
Page
Richard B. Roberts, Executive Vice President and Treasurer, Wachovia Cororation, on behalf of the ABA Securities Association and the American
ankers Association; accompanied by Rachel Robbins, General Counsel and
Managing Director, J.P. Morgan & Co., Incorporated—Continued
Prepared statement—Continued
Firewall Restrictions and Regional Bank Holding Companies.............
Conclusion..............................................................................................
Charles W. Calomiris, Paul M. Montrone Professor of Finance and Economics,
Graduate School of Business, Columbia University........................................
Prepared statement......................................................................................
Response to written questions of Senator Faircloth ....................................
g
A d d it io n a l M a t e r ia l S u p p l ie d
f o r th e
32
67
72
R ecord
Governor Susan M. Phillips subsequently submitted the following information
at the request of Senator Paul S. Sarbanes....................................................
Governor Susan M. Phillips subsequently submitted the following information
at the request of Senator Lauch Faircloth ......................................................
Governor Susan M. Phillips subsequently submitted the following information
at the request of Senator Michael B. E nzi......................................................
66
67
75
77
80
THE FEDERAL RESERVE’S PROPOSED
CHANGES TO SECTION 20 FIREWALLS
THURSDAY, MARCH 20, 1997
U.S. Senate ,
C ommittee on Banking , H ousing , and U rban A ffairs,
S ubcommittee on F inancial Institutions and
Regulatory Relief ,
Washington, DC.
The Subcommittee met at 10:05 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Lauch Faircloth (Chair
man of the Subcommittee) presiding.
OPENING STATEMENT OF SENATOR LAUCH FAIRCLOTH
Senator Faircloth . The Subcommittee will come to order.
I want to welcome all of the witnesses and the people that are
here this morning because it is an important hearing and will have
a lasting effect on the banking industry. So I thank everyone for
coming.
This is the first hearing of the Financial Institutions Subcommit
tee in the 105th Congress. I want to welcome Senator Sarbanes
and thank him for being here this morning. I look forward to work
ing together. Also, Senator Bryan has now joined us.
Very simply, we called this morning’s hearing because the Fed
eral Reserve’s proposal is an important one. In fact, much of what
has transformed the banking industry over the last decade has
been in the regulatory area, not in the legislative area. The legisla
tive area should have taken a more aggressive lead position than
it has. This is why we’re having this hearing. It is the job of Con
gress to conduct prudent oversight of the banking agencies. With
respect to this issue at hand, Section 20, firewalls.
No one is more supportive of doing away with unnecessary rules
and regulations in the Federal bureaucracy than I am. But many
of these laws are drafted by people who have never been involved
in the private sector, banking or otherwise.
But having said that, we need laws to protect against financial
fraud. Some people might say, and I hear this, that times have
changed. It can’t happen again. We have more capital in the indus
try and we have tougher regulators. This is true. But there can and
there will be financial fraud, it is just a question of the scale to
which it happens. It will happen.
That is why this Subcommittee is taking a close look at what the
Federal Reserve is doing. Certainly, there’s some duplication in the
laws affecting banks and security firms that should be done away
with. And I am fully supportive of raising the threshold to 25 per-
(l)
cent for noneligible securities. But there are some important things
that should be kept. In fact, the Federal Reserve has proposed
keeping some of the key firewalls that we are going to be talking
about today.
So the real purpose of the hearing is to explore these areas. Let’s
look at them and keep the Congress informed. That’s what we plan
to do with the witnesses today.
Before we begin, let me recognize Senator Bryan for an opening
statement, and then Senator Sarbanes.
Senator B r y a n . Mr. Chairman, if you have no objection, I would
be pleased to yield to the Ranking Member of the Full Committee,
and then make a statement after that.
Senator F a i r c l o t h . Certainly.
Senator Sarbanes.
OPENING STATEMENT OF SENATOR PAUL S. SARBANES
Senator SARBANES. Thank you very much, Senator Bryan.
I am going to have to leave to go to another hearing. In fact,
Chairman Greenspan is testifying this morning and I am supposed
to be at that hearing. It’s a busy day for the Fed on the Hill.
Mr. Chairman, I want to commend you for convening this impor
tant hearing. The growth of securities underwriting subsidiaries of
bank holding companies, the so-called Section 20 subsidiaries, is
one of the most significant developments in the structure of finan
cial services over the past decade.
These securities affiliates have been approved by the Fed pursu
ant to its interpretation of Section 20 of the Glass-Steagall Act. To
date, the Federal Reserve has conditioned approval for these secu
rities affiliates on compliance with a set of numerous and rigorous
firewalls.
Now, the Fed has proposed to modify these firewalls—actually,
in fact, to eliminate most of them, or a great number of them. It
is highly appropriate, therefore, that the Subcommittee review the
firewalls and the Fed’s recent proposal.
As I understand it, the firewalls imposed by the Fed on Section
20 subsidiaries serve three purposes.
First, and most importantly, they protect FDIC-insured banks
and the taxpayers who stand behind that insurance fund. They are
intended to prevent the risks associated with underwriting and
with dealing in securities from spilling over into insured depository
institutions. Specific provisions intended to prevent this include
prohibitions on banks extending credit to or purchasing assets from
Section 20 affiliates, and prohibitions on banks extending credit to
enhance the marketability of or to repay securities underwritten by
a Section 20 affiliate.
Second, certain firewalls are designed to prevent a Section 20 af
filiate from competing unfairly with securities firms not affiliated
with banks. For example, the Fed has prohibited banks from ex
tending credit for the purpose of purchasing securities under
written by a Section 20 affiliate.
Finally, some of the firewalls are designed to protect customers
from potential conflicts of interest. As an example, the Fed has pro
hibited banks from purchasing securities underwritten by Section
20 affiliates for their trust and fiduciary accounts.
3
Now in January of this year, the Federal Reserve proposed the
most sweeping revisions to these firewalls since the Fed began ap
proving securities underwriting by Section 20 affiliates in 1987. In
the Fed’s own words, it is “proposing to eliminate most of them.”
The gist of the Federal Reserve’s position is that experience with
Section 20 affiliates has shown that specific regulatory propositions
for such affiliates are not needed. Instead, the Fed takes the view
that the statutory provisions that apply to all bank affiliates are
sufficient to govern the relations between a bank and an under
writing affiliate.
As I understand it, the Fed proposes to rely chiefly on Sections
23A and 23B of the Federal Reserve Act, which limit the volume
of transactions between a bank and its affiliates and require such
transactions to be on terms at least as favorable to the bank as
those prevailing for comparable transactions.
The firewalls have protected banks and their customers and have
not hindered the growth of Section 20 affiliates in number or in
size. The Fed has recently taken action to allow these affiliates to
grow larger.
The current proposal represents a significant change in the
structure governing securities affiliates of banks. It deserves to be
reviewed, both for its own importance, and for the light it may shed
on any financial legislation the Committee may consider this Con
gress. Therefore, I think, Chairman Faircloth, this is a very impor
tant hearing.
Now, since I cannot stay, I am going to leave a couple of ques
tions for the record for Governor Phillips.
Governor Phillips, the questions I want to ask you are about the
adequacy of the statutory firewalls on which the Federal Reserve
now proposes to rely. Currently, the regulatory firewalls adopted by
the Fed prohibit certain types of transactions. For example, a bank
is forbidden to lend money in order to make payments on or to
increase the marketability of securities underwritten by a securi
ties affiliate. A bank is also forbidden to purchase securities under
written by an affiliate.
As I understand it, the statutory provisions discussed in your
testimony limit the aggregate volume of transactions of affiliates,
but do not prohibit some types of transactions. The question is
don’t some types of transactions pose such clear conflicts of interest
that they should not be permitted at all? Aren’t these precisely the
types of transactions about which we need to be on guard, in fact,
the very types of transactions that were found to be commonplace
before the enactment of Glass-Steagall?
So, as you can see, my concern runs to the fact that some of
these types of transactions you now are precluding from rigorously
controlling through regulation. If you drop your regulations and
rely only on the statutory provisions that run to the volume of
transactions rather than the type of transaction, you are going to
be permitting practices to take place which I think would cause
any reasonable observer to be concerned about the safety and pru
dence, and competitive workings of our economic system.
Thank you very much.
Senator F a i r c l o t h . Thank you, Senator Sarbanes.
4
We have been joined by the Chairman of the Senate Banking
Committee, Senator D’Amato. We would be delighted to hear his
statement or anything he has to say.
OPENING STATEMENT OF SENATOR ALFONSE M. D’AMATO
The C h a irm a n . Senator Faircloth, I want to join with Senator
Sarbanes in commending you for calling this hearing on this very
important issue.
Let me say this. What I have a sense of is that we are having
a very unwholesome competition, very unwholesome, and that com
petition is between the regulators.
We have the Comptroller of the Currency issuing regulations,
and some of them are absolutely imprudent. And the Federal Re
serve Board responding with equally imprudent proposals—to
eliminate “firewalls.”
I also join with Senator Sarbanes in expressing very real concern
about almost a total abdication of separation between the Section
20 affiliate and the insured bank and assuring that we prevent
self-dealing, and that we keep the resources of the American tax
payer from being placed at risk in situations that it was never in
tended to be used for.
Now, I have to tell you, as far as I am concerned, if this competi
tion between the regulators continues, then I am prepared to start
to offer piecemeal, single-shot legislation dealing with what I per
ceive to be overreaching, dangerous kinds of opening up taxpayers
to the kinds of situations that we’ve experienced in years gone by.
We have seen failures where people never dreamed they would
take place, just recently as it relates to the thrifts, taxpayers being
exposed to losses of billions and tens of billions of dollars.
I know why the Fed is coming up with the proposal we examine
today. They don’t want to “lose the action.” They are the prime reg
ulator and they have done a good job. Suddenly the Comptroller’s
action makes the Section 20 affiliate and the holding company
structure unnecessary because a bank can now create a subsidiary.
I think the actions of both regulators imperil the system.
If we don’t have taxpayers’ dollars backing these business enter
prises, through the FDIC, and that’s what they are, I don’t care.
Run a casino, if you want. But, by gosh, let’s make sure that we
don’t have taxpayers’ dollars that are going to be placed at risk. It
is just wrong.
I think that we, the Congress, also bear responsibility for having
acted in a way which has encouraged and almost given license to
the Office of the Comptroller to go their merry way by not acting
on broad financial reform.
I would suggest one other thing, Mr. Chairman. I think that we
should get Mr. Ludwig in here and go over some of these rules that
he’s promulgating. This mad dash, and that’s what it is, this dash
into an area that I think can jeopardize the taxpayers of this coun
try by creating operating subsidiaries of a bank for the purpose of
engaging in “nonbanking” activities—securities, insurance, etc.—
that the bank itself is not permitted to engage in. It is probably not
legal; it is certainly unwise.
I don’t want to see a situation where we begin to get into the
kinds of conflicts that Senator Sarbanes has touched on. Let’s not
5
kid ourselves, that is what we are doing, and we should not be al
lowing that.
So while I understand and I have great respect for the Fed and
its work, and I have been a constant supporter, I will tell you, what
we have now is an unhealthy competition between regulators.
Those are my concerns. I think it’s wrong. I am going to ask that
my full statement, which expresses what I have just said in very
judicious terms be placed-----[Laughter.]
—in the record, and please strike all of my other remarks.
No.
[Laughter.]
Thank you, Senator Faircloth.
Senator Faircloth . Thank you, Senator D’Amato.
I voiced exactly what you just said previously, and I want our au
dience to know that there had been no-----The Chairman . N o collaboration.
Senator Faircloth . —previous conversation or cooperation. Just
simply, when the legislature failed to lead, then the regulators
jumped in front, and that is exactly what happened.
Now, I would like to recognize the Ranking Member on this Sub
committee, Senator Bryan.
OPENING STATEMENT OF SENATOR RICHARD H. BRYAN
Senator Bryan . Thank you very much, Mr. Chairman.
I want to join with my colleagues in commending you for holding
this very important hearing.
Currently, there are some 28 firewalls which the Federal Reserve
has in place which were designed to protect a bank and its cus
tomers from the potential hazards of combining commercial and in
vestment banking. In January of this year, the Federal Reserve
proposed sweeping revisions to those firewalls. Now, there are
some who claim that the proposal doesn’t go far enough, and others
who complain that it goes too far.
My own personal inclination is to be very cautious in this area.
And I say so, Mr. Chairman, because my baptism on this Commit
tee as a new Member in 1989 was the occasion in which the sav
ings and loan collapse burst forth upon the land. In retrospect, I
believe that crisis could have been fully anticipated as a con
sequence of the enactment of Garn-St Germain in the early 1980’s.
Then, as now, it is contended that it is a new world, that there
are different types of competition, different kinds of products that
are on the market. The S&L’s asserted that they could no longer
compete effectively in the marketplace. And so we changed dra
matically, I say, we, the Congress, changed very dramatically the
operating rules for S&L’s. In 1989, we reaped the harvest of those
changes and the American taxpayer suffered the consequence as
the result of our action in enacting FIRREA, necessary to protect
many, many depositors.
I remember all too well the fiasco of customers in the lobbies of
Lincoln Savings and Loan branches being encouraged to swap their
Federally-insured CD’s for worthless junk bonds.
Soon thereafter, we faced a crisis in the banking industry. We
provided a line of credit, which we did not have to draw down
upon, and the industry today is healthy and enjoys record profits.
We are all very pleased to see that that has come about.
But I guess the bottom line is that I am not crazy about expand
ing powers and reducing safeguards that may undermine the insur
ance fund and may lead to some regulatory abuses.
I am going to abbreviate my comments because Senator D’Amato
has raised a concern that I have, and that is the competition
among regulators to reach the lowest common denominator of regu
lation so that their particular regulatory institution will be more
attractive than other rival regulators, reducing burdens upon those
who are regulated.
I must say, I do not oppose the changes that we have made in
the past to lighten the regulatory burden. I was a cosponsor of the
legislation that was enacted in the last session of the Congress,
The Economic Growth and Regulatory Paperwork Reduction Act of
1995, and before that worked with Members on both sides of the
political aisle as we reduced the burdens on the banking industry
with respect to the currency transaction reports.
I think those were solid and well thought out, and I believe that
the burdens that existed prior to the enactment of these two pieces
of legislation were appropriate for us to take action.
But having said that, it is my view that the overarching concern
is to protect the public. And although financial institutions change
and market conditions change and new financial products are of
fered almost monthly, it is my view that the basic quality of human
nature has not changed, and that the underlying rationale—I say
that with all respect to my colleagues—is that human nature has
not changed, and human nature will not change. There are those
who are obviously motivated by greed who cannot resist the temp
tation of taking advantage of others, and so I think we have to be
realistic in terms of approaching the format that we are going to
use as a regulatory model. And that is a concern that I have.
Let me just express one other concern and I will abbreviate my
remarks, Mr. Chairman, because I do want to hear the witnesses,
as I know my other colleagues do. That is that I am troubled to
some extent by the fact that, rather than approaching this in a
comprehensive sense, we have allowed the regulators to do it piece
meal. I have some real concerns about that.
I would hope that we can address a comprehensive regulatory
update, recognizing that the old framework does not reflect the
modem realities. But I must say I am going to approach this with
a great deal of caution because I am concerned about the nature
of some of the proposals that have been advanced and this competi
tion among the regulators that our Chairman has so forcefully ad
dressed himself to.
Thank you, Mr. Chairman.
Senator F a i r c l o t h . Thank you, Senator Bryan.
We recognize Senator Enzi of Wyoming.
OPENING COMMENTS OF SENATOR MICHAEL B. ENZI
Senator E n zi. Thank you, Mr. Chairman.
This hearing is an important part of the process of the regulatory
changes that have been proposed by the Federal Reserve Board
7
and they will have an enormous impact on the financial services
industry.
The proposed regulatory changes not only have an impact on the
select few that deal directly with the banks and securities, but also
on the average American. This hearing is all about taking the nec
essary precautions against the possibility of repeating the errors
that devastated the financial markets during the 1920,s and the
1930’s. It is our duty to carefully examine all attempts to remove
the regulatory firewalls that have disciplined financial services in
this country.
Granted, many changes other than the Glass-Steagall have taken
place since the Great Depression that have provided additional
safeguards and firewalls. Some of these firewalls are archaic and
unnecessary. The financial services industry is changing and is
growing at such a rapid pace that it has outgrown many of the re
strictions.
I am not opposed to modernization. In fact, I am a champion of
it. However, we should still proceed cautiously when dealing with
such a far-reaching issue as this.
I look forward to further examining the regulatory changes.
Thank you, Mr. Chairman.
Senator F a i r c l o t h . Thank you, Senator Enzi.
I must say that I am delighted to see the interest shown by the
other Senators on the Banking Committee this morning. It dem
onstrates to all of us the interest and the weight that it carries on
this issue.
Now let me welcome our first witness. Dr. Susan Phillips, a Gov
ernor of the Federal Reserve Board, has been an outstanding mem
ber of the Board since 1991. She was former Chairperson of the
Commodity Futures Trading Commission from 1983 to 1987.
Let me also add, Dr. Phillips, that your entire statement will be
made part of the record. So we hope that you’ll be able to keep the
spoken part of your statement to 10 minutes or thereabouts.
We appreciate you being here today and we look forward to see
ing you again because we are probably going to be having some
more hearings.
OPENING STATEMENT OF SUSAN M. PHILLIPS
MEMBER, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Dr. P h i l l i p s . Thank you very much, Mr. Chairman.
I am very pleased to be here today to discuss the Board’s Section
20 firewalls. I will try to abbreviate my comments and would ap
preciate my full statement being included in the record.
Section 20 firewalls are the restrictions the Board has imposed
on bank holding companies engaged in underwriting and dealing in
securities. The purpose of the firewalls is to insulate a bank and
its customers from the potential hazards of combining commercial
and investment banking.
Since last year the Board has been engaged in a comprehensive
review of the 28 firewalls it erected in the late 1980’s, and the
Board has recently proposed to eliminate a majority of those re
strictions. This oversight hearing, I think, provides a constructive
opportunity for comment and analysis of the Board’s proposal.
8
To start, it might be useful to place the firewalls in their histori
cal and regulatory context. Although the firewalls have served an
important role, they are not the only protection against the hazards
of affiliation of commercial and investment banks. It is these other
protections on which the Board is proposing to rely in removing
many of the firewalls.
One important protection is the placement of securities activities
in a separate subsidiary of the bank holding company, rather than
in the bank itself or a subsidiary of the bank. Affiliates of a bank
are not under the bank’s control, do not have their profits or losses
consolidated with the bank’s, and are less liable to have their credi
tors recover against the bank. A bank, therefore, has less incentive
to risk its own reputation or expose itself or its customers to loss
in order to assist a troubled Section 20 affiliate or a failed under
writing by that affiliate.
Also, because securities activities are conducted in an affiliate,
banks are limited in their ability to fund those activities by Sec
tions 23A and 23B of the Federal Reserve Act. These restrictions
are vitally important. Section 23A limits the total value of trans
actions with any one affiliate to 10 percent of the bank’s capital
and limits transactions with all affiliates to 20 percent of capital.
It also requires that substantial collateral be pledged to the bank
for any extension of credit. Section 23B requires that inter-affiliate
transactions be at arm’s length and on market terms, and imposes
other restrictions designed to limit conflicts of interest.
Thus, affiliate status prevents the bank from passing along the
Federal subsidy inherent in the Federal safety net to its Section 20
affiliate by extending credit. Regulators could conceivably limit a
bank’s ability to use credit to subsidize a direct security subsidiary
of the bank by applying Sections 23A and 23B. But the equity in
vestment in the subsidiary would still be funded from subsidized
resources backed by the Federal safety net. Even if the investment
were deducted from the capital of the bank, the subsidy inherent
in the transfer would remain.
A second protection is examination of the bank holding company,
including the effect of securities activities on insured depository
institution subsidiaries. The Federal Reserve monitors compliance
with Sections 23A and 23B and other aspects of the relationship
between a bank and its Section 20 affiliate. In its supervision of
bank holding companies, the Board increasingly pays attention to
risk-management systems and policies that are centralized at the
holding company level governing both the bank and its Section 20
affiliate.
A final series of protections is the regulatory regime that applies
to all broker-dealers, including Section 20 subsidiaries. The Securi
ties Act of 1933 and the Securities Exchange Act of 1934 impose
registration, capital and disclosure requirements, anti-fraud protec
tions, and other investor-protection measures. These laws, and
their enforcement by the Securities and Exchange Commission, ad
dress many of the safety and soundness and conflict-of-interest con
cerns about affiliation of commercial and investment banks.
Many of these protections were not present in 1987 when the
Board first
ito firowallc
.9-£B._nf the Federal Reserve
Act had not beeq adopted. Risk-based capita 1 standards now re-
RESEARCH LIBRARY
Fedara! Reserve Bank
of St. Louis
9
quire a bank to hold capital against many of the on- and off-balance-sheet exposures it maintains in conjunction with a Section 20
affiliate. Finally, the Interagency Statement on Retail Sales of
Nondeposit Investment Products was not adopted until 1994. The
Interagency Statement includes disclosure and other requirements
that are now the primary means by which the Federal banking
agencies seek to ensure that retail customers are not misled about
the nature of nondeposit products they are purchasing on bank
premises.
When the Board last year decided to re-examine the firewalls, we
felt it important to do so with a fresh eye, benefiting from 10 years
of experience supervising the Section 20 affiliates, acknowledging
both regulatory and legal developments since 1987, and focusing on
the relevance of the firewalls in today’s financial markets. As we
began to look at the concerns that the firewalls were designed to
address, we asked two questions.
First, does the affiliation of a commercial bank and an invest
ment bank cause safety and soundness or other concerns not
present with any other commercial bank affiliation, concerns not
addressed by general bank holding company regulation?
Second, does operation of a broker-dealer within a bank holding
company cause concerns that independent operation does not—con
cerns not addressed by broker-dealer regulation?
In some areas, most notably, consumer protection, we believed
that the answer was “yes*” In most other areas, however, the Board
believed, at least pending public comment, that the answer was
no.
The answers to these questions are important because the fire
walls are far from costless. They impose operational inefficiencies
on bank holding companies that increase their costs and reduce
their competitiveness, and they limit a bank holding company’s
ability to market its products in a way that is both most profitable
and desired by its customers. As such, the firewalls have served as
a significant barrier to entry for small- and mid-sized bank holding
companies because those companies cannot realize sufficient syner
gies or achieve adequate operating revenues to justify establishing
a Section 20 subsidiary. The loss is not just to these companies, but
also to their customers and market competition.
Let me now briefly mention the most important of the firewalls
to which the Board has proposed changes. I will not discuss all 28
of the firewalls but have attached a summary list to my full state
ment and their proposed disposition.
The comment period on this proposal closed last week.
The Board proposed to eliminate a series of the firewalls that
constitute a blanket prohibition on a bank’s funding its Section 20
affiliate, and instead rely on the protections of Sections 23A and
23B of the Federal Reserve Act. The firewalls in question prohibit
a bank from extending credit to a Section 20 affiliate or purchasing
corporate and other nongovernmental securities being underwritten
by the Section 20 affiliate, or in which the affiliate makes a mar
ket. These firewalls were intended to prevent a bank from assisting
a troubled affiliate by lending to it on preferential terms or by bail
ing out a failed underwriting by purchasing securities that cannot
otherwise be sold.
10
If the Board were to eliminate the funding restrictions, Sections
23A and 23B of the Federal Reserve Act would continue to impose
quantitative and qualitative restrictions on inter-affiliate trans
actions. They would limit the amount of such funding, require that
it be collateralized, require that such funding be on arm’s-length
terms and at market rates, and require that any purchase by the
bank be approved by its outside directors. We believe these are
substantial protections, and have proposed to rely on them in place
of a firewall.
Indeed, 14 of the Section 20 subsidiaries which operate under the
Board’s 1987 securities order have for 10 years operated without a
funding firewall, but subject to Sections 23A and 23B. The Board
has not encountered funding abuses at those companies.
Three of the Board’s firewalls restrict the ability of a bank to as
sist a Section 20 affiliate indirectly by enhancing the marketability
of its products or lending to its customers. These firewalls prohibit
a bank from extending credit or offering credit enhancements in
support of corporate and other nongovernmental securities being
underwritten by its Section 20 affiliate, or in which the Section 20
affiliate makes a market; extending credit to issuers of securities
to repay principal or interest on securities previously underwritten
by a Section 20 affiliate; or extending credit to customers to pur
chase securities currently being underwritten by a Section 20 affili
ate. The firewalls share a common purpose—to prevent a bank
from imprudently exposing itself to loss in order to benefit the un
derwriting or dealing activities of its affiliates.
However, as financial intermediation has evolved, corporate cus
tomers frequently seek to obtain a variety of funding mechanisms
from one source. By prohibiting banks from providing routine credit
or credit enhancements in tandem with a Section 20 affiliate, these
firewalls hamper the ability of bank holding companies to serve as
full-service financial services providers, reducing options for their
customers. For example, existing corporate customers of a bank
may wish to issue commercial paper or issue debt in some other
form. Although the bank may refer the customer to its Section 20
affiliate, the bank is prohibited from providing credit enhance
ments even though it is the institution best suited to perform a
credit analysis—and, with smaller customers, it is perhaps the only
institution willing to do so.
As another example, the restriction on lending for repayment of
securities causes a bank compliance problems when renewing a
company’s revolving line of credit if a Section 20 affiliate has un
derwritten an offering by that company since the credit was first
extended. The bank must either recruit other lenders to participate
in the renewal or amend the line of credit in order to specify that
its purpose does not include repayment of interest or principal on
the newly underwritten securities.
Even if these firewalls were lifted, a bank would still be required
to hold capital against all credit enhancements and credit extended
to customers of its Section 20 affiliate. Section 23B would require
that such credit and credit enhancements be on an arm’s-length
basis. Similarly, the Federal anti-tying statute would prohibit a
bank from offering discounted credit enhancements on the condi
tion that an issuer obtain investment banking services from a Sec-
11
tion 20 affiliate. Thus, for example, a bank could not offer such
credit enhancements at below market prices, or to customers who
were poor credit risks, in order to generate underwriting business
for Section 20 affiliates.
The next pair of firewalls I will discuss requires a bank holding
company to deduct from its capital any investment in or extensions
of credit to a Section 20 subsidiary.
The original purpose of the deduction was to ensure that the
holding company maintained sufficient resources to support its
Federally-insured depository institutions. The Board proposed to
eliminate this deduction.
The capital deduction is not required for any other nonbank sub
sidiary of a bank holding company and is inconsistent with Gen
erally Accepted Accounting Practices which require consolidation of
subsidiaries for accounting purposes. The deduction, therefore, has
created confusion and imposed costs by requiring bank holding
companies to prepare statements on two bases. The deduction does
not strengthen the capital of either the bank or its Section 20 affili
ate, and elimination of the deduction would not create or expose
any incentive for a bank holding company to divert necessary cap
ital from a depository institution to a Section 20 subsidiary.
The Board has already finalized important changes to the crossmarketing and interlocks firewalls which previously prohibited a
bank and a Section 20 affiliate from sharing personnel or market
ing efforts. The Board acted on these firewalls before the others be
cause it had previously sought comment on them some years ago
and because they were identified by commentors as the most truly
burdensome.
After reviewing its experience administering these firewalls, the
Board decided that they caused inefficiencies that could not be jus
tified by any benefit to safety and soundness. In fact, to the extent
that senior bank managers may now oversee related operations at
a Section 20 affiliate, risk management and safety and soundness
may actually be improved.
Moreover, existing disclosure requirements adequately address
concerns about customer confusion arising from increased crossmarketing and employee interlocks. Specifically, the Interagency
Statement on Retail Sales of Nondeposit Products states that, prior
to the initial sale of a nondeposit product by a bank employee or
on bank premises, the customer must receive and acknowledge a
written statement that the product being sold is not Federally-in
sured, is not a deposit or other obligation of the bank, is not guar
anteed by the bank, and is subject to investment risks including
loss of principal.
I’m pleased to report that early indications of the effects of these
changes and the change in the revenue limit have been favorable.
The Board currently has pending three applications to establish a
Section 20 subsidiary. As we had anticipated, two of these are
small- to mid-size bank holding companies which may previously
have found it either too expensive to fund the dual-staffing re
quired by the interlocks restrictions or too difficult to generate suf
ficient eligible revenue to maintain compliance with a 10 percent
revenue limit. Furthermore, existing Section 20 subsidiaries have
indicated that they have been able to rationalize their organization
12
and expand their activities given the added flexibility with respect
to both staffing and revenue.
Before concluding, I should also like to note which restrictions
the Board proposed to retain.
The Board proposed to retain as operating standards existing
firewalls requiring adequate internal controls and documentation,
including a requirement that a bank exercise an independent and
thorough credit judgment in any transaction involving an affiliate.
Such standards are especially important in the Section 20 context
because of the likelihood that a bank and its Section 20 affiliate
may be selling similar products to the same customer.
Because of the potential for customer confusion as to which prod
ucts are Federally-insured, the Board proposed to require a Section
20 affiliate to make disclosures to customers similar to those that
the Interagency Statement requires of banks selling nondeposit
products on bank premises.
The proposal would also continue to prohibit an affiliated bank
from knowingly advising a customer to purchase securities under
written or dealt in by a Section 20 affiliate unless it notifies the
customer of the affiliate’s role. The proposal also continues to pro
hibit a bank and its Section 20 affiliate from sharing any nonpublic
customer information without the customer’s consent.
Thank you very much, Mr. Chairman. That concludes my formal
statement.
Senator F a i r c l o t h . Thank you, Dr. Phillips.
Before we start the questioning of Dr. Phillips, I want to recog
nize Senator Grams from Minnesota for an opening statement.
OPENING COMMENTS OF SENATOR ROD GRAMS
Senator G ram s. Thank you very much, Mr. Chairman. I’ll try to
be brief. I know we want to get to the questions.
This Subcommittee today will be reviewing the Federal Reserve’s
proposal of January 17 to significantly modify 28 regulatory fire
walls that restrict transactions between a bank and its Section 20
securities affiliate.
Firewalls have been implemented by the Federal Reserve for two
primary reasons. First, they maintain the safety and soundness of
the deposit insurance system by buffering a bank from the risks of
the activities of its nonbank affiliates. Second, for those who believe
that a bank receives a net deposit insurance subsidy, they prevent
the bank from artificially subsidizing the activities of its nonbank
affiliates.
Historically, firewalls have been an effective mechanism for con
trolling transactions between banks and their affiliates. Such regu
lations, however, can be cumbersome and can increase consumers’
costs for financial services. And it is because of these costs that I
commend the Federal Reserve for looking into ways to judiciously
amend their firewalls while still maintaining the safety and sound
ness of the deposit insurance system.
I think our review of firewalls is also important in the context
of the current debate over financial modernization.
As you know, I strongly support financial modernization. I be
lieve that the affiliation and cross-marketing restrictions of the
Glass-Steagall Act and the Bank Holding Company Act artificially
13
segregate the three types of financial services—banking, securities,
and insurance. These laws create artificial barriers to competition
that hurt consumers by making financial services more costly and
less convenient.
It is my view that the application of statutory and regulatory
firewalls between the bank and all of its nonbank affiliates and op
erating subsidiaries will permit us to terminate all affiliation and
cross-marketing restrictions in a safe and sound manner.
Mr. Chairman, again, I want to commend you for holding this
important oversight hearing and I look forward to hearing from our
distinguished witness this morning.
Senator B r y a n . Thank you very much, Senator Grams.
Senator G ram s. Thank you.
Senator B r y a n . The Chairman has asked me to recognize our
colleague, Senator Reed, for any comments that he would care to
make at this point.
OPENING COMMENTS OF SENATOR JACK REED
Senator R e e d . Mr. Chairman, like all of our colleagues, we are
interested in the testimony of the witness.
Suffice it to say that the Section 20 subsidiaries have provided
a great service to consumers and lower costs in delivery of securi
ties. I am interested in hearing the rationale for some of these
changes. But, by and large, the Federal Reserve’s policy toward
Section 20 subsidiaries have been very effective in delivery services
to consumers throughout the Nation.
Thank you, Mr. Chairman.
Senator F a i r c l o t h . Thank you, Senator Reed.
I have some questions, and I am sure all of the other Senators
do. But one fundamental question that is disturbing a lot of Sen
ators, as you can gather by the number we have at this Sub
committee hearing this morning, is the rivalry between regulators
in the banking industry.
I don’t think it reflects well upon either of the regulators. Did the
Fed decide to re-examine the firewalls because of what was going
on by the Comptroller of the Currency? Did that influence your get
ting into the re-examining? What prompted the Fed to re-examine
the firewalls? We have a lot of people here today, including a lot
of Senators, so if you would, answer as briefly and to the point as
possible.
Dr. P h i ll ip s . Yes, sir, Mr. Chairman.
First of all, I don’t think this question of rivalry with respect to
other regulators played a factor at all in this particular case. In
fact, really, the Federal Reserve is the only regulator that sets the
firewalls. So in that sense, this was something that we were doing
on our own.
Senator F a i r c l o t h . Well, may I interrupt you?
Dr. P h i ll ip s . Surely.
Senator F a i r c l o t h . Does Mr. Ludwig know that?
[Laughter.]
Dr. P h i l l i p s . I’m sure he does. Yes, I’m sure he does.
But I wanted to indicate that when these firewalls were first
erected, the Fed indicated at that time an interest in continuing to
monitor the effectiveness of the firewalls. I think at the time there
http://fraser.stlouisfed.org/
47-726 - 98 - 2
Federal Reserve Bank of St. Louis
14
was concern that maybe additional ones should be added. There
was a sense that we needed to gain some experience because this
was new for the banking industry. We actually first proposed to
amend some of the firewalls in 1990.
So this has been a longstanding effort. And then as part of the
Riegle-Neal Regulatory Reduction Review, Section 303, the effort to
review the firewalls was folded into that review.
But predominantly, there have been a number of things that
have changed which I tried to outline in my testimony. So we tried
to look at the firewalls with a fresh eye.
Senator Faircloth . Well, it might not be so, but the feeling of
many Members of this Banking Committee is that the fresh eye
came after Comptroller of the Currency Ludwig started coming out
with some rules of his own.
And while we are talking about the Comptroller of the Currency,
I noted on page 1 of your statement at the bottom, you mentioned
that one of the important protections in place is that the securities
activities are an affiliate of the bank, not in the bank itself. What
do you think of the Comptroller of the Currency’s Part 5 proposals?
Are the firewalls adequate in that proposal?
Dr. Phillips. Well, I must say that we had felt that it was much
more appropriate to have these kinds of activities in an affiliate of
a holding company. And we have believed that the holding com
pany is a better mechanism to contain the kinds of moral hazard
concerns that are attendant to the leakage of the safety net to non
banking activities.
It is for that reason that we believe that the holding company
format is better than an operating subsidiary format for the expan
sion of these nonbanking activities, so that the safety net and the
benefits of access to a depository institution aren’t spread unduly.
Senator Faircloth . Thank you.
Now have the SEC and the National Association of Securities
Dealers been consulted on the proposals you have come forth with?
Dr. Phillips. I must admit I am not sure whether or not they
have commented. But I will be glad to check on whether they have
submitted a comment. I don’t believe they did.
Senator FAIRCLOTH. I mean did you consult with them?
Dr. Phillips . When we were proposing the regulations?
Senator Faircloth . Yes.
Dr. Phillips. I don’t believe we did.
Senator Faircloth . You did not?
Dr. Phillips. But I’ll check. Let me check to make sure on that
because the staff do routinely talk with staffs of other agencies, so
they may have done so. I didn’t, however.
Senator Faircloth . In your statement you mentioned the cost of
complying with the firewalls, this is a most important issue.
Just as a general rule, the Federal Government has gotten out
of control on the cost-benefits of regulations we issue. It’s an area
in which we have just gone way overboard without any sensitivity
to the private sector and the realities of making money. We issue
rules and regulations and don’t worry about what the cost and the
effect will be. How costly is it going to be to a bank? And maybe
give us a good example of the extra cost to the banks to keep these
firewalls in place.
15
Again, if I may ask, we only have 5 minutes per Senator, so we
need to move succinctly with the questions.
Dr. P h i ll ip s . I think one of the best evidences of the costs of
these firewalls is the fact that we really haven’t had that many
firms set up Section 20 subsidiaries—only about 40.
Many of the smaller firms, mid-sized firms, have not found it eco
nomic to be able to set up a Section 20 sub. It’s the revenue limit
that we have had in the past that constrain, but in addition, the
firewalls.
So we’re very hopeful that reducing the firewalls and the change
in the limit will, in fact, allow some of the small- and mid-sized
companies to be able to set up a Section 20 sub. And that should
improve competition and provide services to smaller firms in the
capital formation process.
Senator F a i r c l o t h . Thank you.
Senator Bryan.
Senator Bryan . Thank you very much, Mr. Chairman.
Let me follow up on the last question that our Chairman asked.
I gather that the rationale in part for the changes that are being
proposed by the Fed is that they are very costly. The Chairman
just asked you about the cost as it relates to some of these changes
that are being made. And you have indicated that part of the cost,
in your view, is that a lot of financial institutions of mid-size have
not chosen to establish these subsidiaries. Therefore, you conclude
that it must be too costly for them to do so, that by making the
change, that they will be more encouraged to do so, if I understood
the thrust of your testimony?
Dr. P h i ll ip s . Yes, sir.
Senator Bryan . I s that based upon surveys? Anecdotal evidence?
What do you base that conclusion on?
Dr. P h i ll ip s . Well, certainly it has been comments from bankers
over the period of years that we have had these firewalls in place.
In some instances, it has been the comment process. And of course,
the earlier firewall changes that we put out for comment in 1990.
So we have had an extended period of formal conversation with the
banking community on these issues.
Senator Bryan . I would appreciate it if you would have your
staff make available to us those comments that you have pre
viously received so that we might have a chance to look at them
in a different context.
Dr. P h i ll ip s . Surely.
Senator B ryan . Let me ask you. One of the changes that you
make is to change the capital requirements for investing in these
subsidiaries. You indicate that, in your view, it is no longer nec
essary to have this capital deducted from the capital requirements
of the holding company. I gather that you reached the conclusion
that there is no greater risk, so you say in your testimony, than
in other types of holding company subsidiaries. Is that right?
Dr. P h i ll ip s . That is correct. Now a holding company must still
be adequately capitalized.
Senator Bryan . No, I understand that. But it seems to me that
your premise is that a securities affiliate or subsidiary is no riskier
than any other kind of subsidiary. What do you base that on?
16
Dr. Phillips. Well, I think that is part of the case. But in addi
tion, the SEC, of course, has capital requirements. And so these
Section 20 affiliates are subject to the same kinds of regulations,
including SEC capital requirements.
Senator Bryan . It just seems to me that common sense would
suggest to us that certain subsidiaries may be riskier than others.
It may be legitimate to impose greater requirements with respect
to those kinds of subsidiaries in which there would be a higher
risk. I gather your conclusion is that there’s not a higher risk in
terms of a securities subsidiary.
Dr. Phillips. I think what we are focusing most of our super
visory power on at this point is at the holding company level and
trying to assure that the holding company is adequately capital
ized. To that extent, that is going to include, of course, all of the
affiliates. And if you have a broad diversification, that may well
augur for what level of capital would be appropriate at the holding
company level.
Senator Bryan . I gather from your testimony that you have pro
vided and what you have testified here orally this morning, that
the relationship between the securities subsidiary and the holding
company must be, “an arm’s-length transaction or relationship.”
Many of the firewalls that were previously proposed in 1987 and
1989, I believe you have testified, had specific categorical prohibi
tions—you can’t do this, you can’t do that. You have now kind of
changed that whole basis, it seems to me, in the new regulations.
I guess my question is how do you make a determination as to
whether these transactions are arm’s length until a problem has
surfaced and then you go back and retrospectively review that rela
tionship and you may very well conclude that, look, it was not an
arm’s-length transaction?
Dr. Phillips . Well, I think those kinds of considerations can al
ways come up, and hopefully, would be caught in the examination
process.
So to that extent, if you name specific kinds of transactions that
are prohibited, as soon as you do that, folks are going to find ways
of creating some other slightly different kind of transaction to sort
of “game” the system.
We felt that it’s appropriate to have more general standards, to
have transactions adequately collateralized and, as we indicated, at
arm’s-length distance, and then go back in the supervision process
to try to assure that conduct is being appropriately conducted.
Senator Bryan . It seems to me these changes do enhance the
risks that are involved. Now maybe it’s as you say, that those risks
are offset by other considerations that you’ve suggested to justify
the proposed changes.
My last question, Mr. Chairman, and I know my time is about
to expire, is two-fold. One, how frequently are these institutions
today audited or subjected to an examination? Two, do you propose
as a result of reducing the firewalls, giving them much greater lati
tude, having much less in the way of restrictions—what are you
proposing, if anything, with respect to an increased regime for reg
ulatory review, either in terms of an examination, an audit, or
some type of an intermediate evaluation of the institution?
17
Dr. Phillips. We have been actually in recent years overhauling
the examination process to make it more risk-focused and to-----Senator B ryan . H ow often does that occur?
Excuse me, Dr. Phillips.
Dr. Phillips. Actually, we do them on an annual basis.
Senator B ryan . So you do it on an annual basis, then.
Dr. Phillips. Yes, sir. The other thing I wanted to mention is
that, if you look at various kinds of activities that are undertaken
by banks and securities affiliates and so on, you can make a good
argument that securities activities are no more risky than other
activities that are undertaken in the bank; for example, loan activi
ties. That is still predominantly where banks lose money.
It’s not as much the risk as it is the question of not spreading
the subsidy from banking activities to other kinds of activities.
Senator B ryan . So I take it that the answer to my question is
that you would not increase the frequency of the evaluation?
Dr. Phillips. N o, sir. At least we’re not anticipating at this time.
Senator Bryan . Would you change the focus of it? Would you
conduct a different type of an examination or inspection? And I’m
not using words of art, so help me out here, Dr. Phillips. But what
I’m saying is you are changing the rules dramatically, and what
they are allowed to do is greatly expanded as a result of these pro
posals. Would the type of examination or inspection that you do an
nually, would that change or would it continue to be the same kind
that it’s been in the past?
Dr. Phillips. I believe we will have to make some adjustments
to the examination process with more emphasis on 23A and 23B,
in particular. And also on the disclosure requirements. That’s an
other major protection.
Senator B ryan . Thank you very much.
Senator Faircloth . Thank you, Senator Bryan.
Senator Rod Grams.
Senator G rams . Thank you very much, Mr. Chairman.
Dr. Phillips, we know firewalls are invaluable and a tool for
buffering banks from any risk taken by its nonbank affiliates. But
to go back to the question of talking about cost, and you said it has
probably limited a number of these banks. But how costly are they?
Do firewalls impose costs on the consumers of banks, the cus
tomers, and their security affiliates? And if so, can you give us ex
amples?
It is costly, so we are really passing that cost on, and these fire
walls, if duplicative, add additional cost and less convenience for
the consumers. Is that right?
Dr. Phillips. Yes, we believe that to be the case. And part of it,
I think, is a change in the market practices of customers wanting
one-stop financial services.
Senator Grams . Right.
Dr. Phillips. And so, to the extent that we prohibit Section 20
affiliates from doing certain kinds of things, then the customer has
to break up their request over several institutions and that is cost
ly. In some cases, it makes them unable to obtain certain kinds of
services.
Senator G rams . So it does take away from the convenience and
it does add, in most cases, to the cost to the consumer?
18
Dr. Phillips . Yes, sir, we believe that to be the case.
Senator G rams . It is also my understanding that the regulatory
firewalls that you are proposing to modify are those that do not
apply to the foreign security subsidiaries of U.S. banks. If that’s
the case, what has been the experience of banks and their foreign
subsidiaries over the past decades? In other words, has the lack of
firewalls caused any problem?
Dr. Phillips . N o. And in fact-----Senator Grams . Drawing from experience.
Dr. Phillips . That actually is part of the experience that we’ve
drawn on in the examination of these firewalls.
When the Board erected the firewalls in 1987, I don’t think many
people were quite sure how things were going to develop. And so,
the Board was very conservative with firewalls. But over a period
of time, I think it’s been that experience, and not seeing problems,
as you cited, or in these original 1987 companies, 14 companies,
that we have not had significant problems. And that gave us assur
ance that it was appropriate to make this proposal.
Senator G rams . So this is just good oversight, going back and
finding where some of the problems or unintended consequences
have evolved, and to try to change them?
Dr. Phillips . Yes, sir.
Senator G rams . I would like to take away from the focus of the
regulatory firewalls for just a minute to take a look at the firewall
of Section 23A of the Federal Reserve Act.
Now Section 23A states that a Federally-insured depository insti
tution may not extend credit to a nonbank affiliate greater than 10
percent of capital and surplus. It is my understanding that day
light overdrafts are exempted from this limitation. If that’s the
case, have a lack of restrictions on the aggregate amount of day
light overdrafts ever impaired bank safety and soundness and is
this a risk that we need to be concerned about at all?
Dr. Phillips. That is something we constantly do have under re
view. And maybe at some point we will get to a point where we
can address that specifically. That is part of the safety net. And so,
part of what we are trying to do is make sure that we are not hav
ing the safety net leaked to some of this nonbanking activity. But
that surely is part of the safety net.
Senator G rams . D o you know if it has ever impaired a bank’s
safety and soundness?
Dr. Phillips . N o, it has not, and that is watched very carefully
during the day. It has not yet been a specific problem, but it is
something that we constantly monitor.
Senator G rams . Thank you very much, Mr. Chairman.
Senator Faircloth . Thank you, Senator Grams.
Next, we’ll hear from Senator Reed.
Senator Reed . Thank you, Mr. Chairman.
Most of the firewalls or the changes you are proposing have to
do with underwriting activities of the subsidiaries. Is that a fair as
sessment?
Dr. Phillips . Generally, that is the largest part of their activity,
yes, Senator Reed.
19
Senator Reed . Originally, the Board imposed limitations on the
amount of revenue they can derive from underwriting activities. Is
that correct?
Dr. Phillips . We still actually have a revenue limit in place.
Senator Reed . And that’s about 25 percent?
Dr. Phillips. Twenty-five percent, yes, sir.
Senator Reed . But despite that revenue limit, does this con
stitute most of their activities, the underwriting?
Dr. Phillips. Yes. That’s the predominant reason for setting up
a Section 20 subsidiary.
Senator Reed . With respect to Senator Bryan’s question about
the capital accounting, you’re proposing that now the bank holding
company can include within its capital its investment in the Sec
tion 20 subsidiary?
Dr. Phillips . Yes.
Senator Reed . Is that the book investment or is there some peri
odic evaluation of the actual value of the investment?
Dr. Phillips . I believe it is the book investment. But if you don’t
mind, let me check that one for you.
Senator Reed . OK. Some other proposed changes. The Board pro
poses to eliminate the firewall with respect to extending credit to
anyone who is viewed with the purpose of enhancing the market
ability of securities underwritten by the subsidiary. Why would you
consider eliminating that firewall? If a bank is extending credit,
the bank of the holding company is extending credit to someone
who is trying to enhance the marketability of the securities, isn’t
that something that we should be concerned about?
Dr. Phillips. Well, this I think goes back partially to some devel
opments that have occurred in financial markets. It’s now become
a lot more routine to provide credit enhancements, and I don’t
think that that was as common early on. Part of the concern,
though, is that those credit enhancements be adequately collateral
ized and the banks must hold capital against those enhancements.
And that was not the case earlier. So we believe that there are
existing newer restrictions in place to address that.
Senator Reed . So your view is that the rules pertaining to the
bank subsidiary with respect to the collateralization and the cap
ital of the bank is sufficient to preclude the necessity for this par
ticular rule.
Dr. Phillips. Yes, to protect the bank.
Senator Reed . There is another proposal you are making that
would eliminate the current prohibition of advertising that would
suggest that the bank is in any way responsible for the securities
operations. Could you justify that proposal?
Dr. Phillips. Well, there has been concern about customers be
lieving that if this is related to a bank, that it might be guaranteed
by the bank, that it might then, in fact, ultimately be guaranteed
by the Federal Government. We felt that it’s appropriate to make
those kinds of disclosures quite clear. And this has also been the
case, for example, with the sale of mutual funds, to make sure that
customers do not believe that those are insured products.
Senator Reed . I may have misunderstood it, but it appears that
in the proposal you are eliminating that requirement.
20
Dr. Phillips . We were eliminating it, but actually, it’s because
we separately have an Interagency Statement that has been devel
oped. It was actually done just in 1994. And so, this Interagency
Statement that now is broader we believe will cover this concern.
It is also in Section 23B, my staff have just informed me. But the
Interagency Statement specifically does address some of these dis
closure factors.
Senator Reed . So, in effect, this disclosure is covered in some
other provision of the law.
Dr. Phillips. Yes, which is why we’re proposing to eliminate it.
Senator Reed . Most of this whole approach to the firewalls is
simply taking away requirements in your specific regulation which
are contained in other provisions of the law or other practices.
Dr. Phillips . That is largely the case. Sections 23A and 23B, we
believe, adequately cover a lot of the factors, but in addition, this
disclosure statement.
Senator Reed . Rather than just going through each one of these
little items and quizzing you, could you indicate from your position
and the Federal Reserve’s position, what are the remaining fire
walls that provide the kind of safety and soundness that we all as
sume is provided by Federal Reserve’s regulation with respect to
the sections—what would you point to, say, when we finish this
regulatory process? Here are the three or four things that still
make this supremely sound and sure.
Dr. Phillips. Well, I would stress 23A and 23B, the funding re
quirements that are contained there. Section 23B requiring arm’slength transactions, the risk-based capital requirements, and the
requirement that the holding company be adequately capitalized.
The other thing that actually has not been mentioned so far is
prompt corrective action at the bank level. Some of those things
have been implemented since the firewalls were erected. And then
in addition, of course, the disclosure statement and the increased
emphasis on making sure that customers understand that these
are not insured products.
So I think that it is the combination of those things that have
given us reason to believe that it is appropriate to re-examine these
firewalls.
Senator Reed . Thank you.
Thank you, Mr. Chairman.
Senator Faircloth . Thank you, Senator Reed.
Next we’ll call on Senator Enzi for any questions he may have.
Senator E nzi . Thank you, Mr. Chairman.
I think that probably in this particular hearing, we are talking
more complex than I am able to listen. So I will have to try some
questions maybe that have been asked to some degree already.
I want to turn to some of the specifics of the firewalls, particu
larly the issue of capital.
Why shouldn’t bank holding companies deduct from their capital
the amount of money that’s been put in the securities subsidiary?
Aren’t we trying to insulate the bank holding company from any
losses in the securities subsidiary? And wouldn’t it make sense to
keep them separately capitalized?
Dr. Phillips. Actually, the holding company must consolidate
capital. So, in that sense, the capital at the Section 20 subsidiary
21
is already counted. And it is required to maintain adequate capital
and at the same time the bank is required to be well capitalized.
If the bank becomes less than well capitalized, we must take
prompt corrective action, which means the holding company may
have to inject capital at that point to the bank.
The focus is really on assuring the safety and soundness of the
depository institution. If you were to subtract the capital, it doesn’t
really add or detract, in a sense, to the safety and soundness of the
bank because of these additional requirements.
Senator E nzi . So you are saying that there’s a double capitaliza
tion that we don’t need any more?
Dr. Phillips. Well, because it’s consolidated in any case, I think
that’s where the protection is.
Senator Enzi . OK. The Board has said it will review the firewall
about lending to a customer to buy securities from the securities
subsidiary that it has underwritten.
My question is this—isn’t it an important firewall that we keep?
Even the Fed has noted that this is the one that gives rise to the
greatest potential conflict. Could the firewall be abused if there
were a steep decline in the stock market, and there seems to be
some indication that that could happen?
Dr. Phillips. Again, I think I would point to these other kinds
of protections. The arm’s-length requirement, for example, if it
were a trust customer of a bank, there has to be full disclosure
with regard to the marketing activities of a Section 20 affiliate.
So I think it is the disclosure and the collateralization that is re
quired and, again, the capital requirements.
Senator Enzi . H ow often are the arm’s-length reviews of the
transactions looked at and reported?
Dr. Phillips. Those would be reviewed as part of the supervision
process, as part of the examination process. We do such examina
tions annually.
Senator Enzi . And you think that will be adequate to take care
of any potential conflicts?
Dr. Phillips. Well, we believe that to be the case. And as I say,
there have been some companies that operated under the earlier
order that were not subject to the firewalls, and we have not seen,
for example, funding problems or capital problems.
But clearly, to the extent one changes rules or firewalls, we are
going to have to make appropriate changes in the examination
process to make sure that we pick up and we try to observe what
kind of behavioral changes we’re seeing by the banks.
Senator Enzi . Based on that answer, I suspect I know the an
swer to the next question, then, and that’s some concerns about the
bank trust accounts. The Fed has proposed allowing the bank to
purchase securities from the securities affiliate. It could then be
placed in bank trust accounts. This seems to me to have some great
potential for abuse. What’s the reason that the Board thinks that
this can be repealed safely?
Dr. Phillips. Again, I think it really has to do with the kinds
of disclosure requirements. A customer will have to acknowledge
and approve these kinds of inter-affiliate transactions. So there
would have to be full disclosure of those kinds of activities.
22
Senator E nzi . We are talking about just bank trust accounts, not
individual trust accounts?
Dr. Phillips . No, I think it would be both.
Senator E nzi . And so the bank who handles the trusts and has
the right to handle that trust without complete disclosure to the in
dividual in some cases is going to make notification to whom?
Dr. Phillips. First of all, you would have to have disclosure as
to the nature of the transaction. In addition, the bank would have
to have set up appropriate separation of activities so that it’s truly
at an arm’s-length transaction.
I am not quite sure where you are heading with this, but we will
be glad to take a further look at that one if this is an area that
you have a particular concern.
Senator Enzi . I’m just trying to watch out for the consumer here
and see if the notification is something really that the consumer is
going to get or, again, if we’re relying on an annual audit to pick
up these sorts of things which may or may not be found.
Dr. Phillips. We are requiring that the consumer actually sign
a consent.
Senator E nzi . A blanket consent once, or each transaction?
Dr. Phillips. I believe it would have to be with respect to each
transaction.
Senator E nzi. OK. My time is up.
Senator Faircloth . Dr. Phillips, one thing that bothers me some
is that you were not sure whether the SEC and Arthur Levitt had
been contacted—maybe some staff did, maybe some staff didn’t.
This has gone on for some time and you do not know whether it
has even been discussed with the SEC or the National Association
of Securities Dealers. You think it might have. But it would just
seem to me, and I’ll just make the statement, that if it hasn’t been
done, it needs to be done and quickly.
Dr. Phillips. We’ll be glad to do so.
Senator Faircloth . Following up on Senator Enzi’s question, I
know what you said, that the bank would be required to—the trust
department, before it moves into an account.
But we are thinking in terms of a relatively smaller bank situa
tion, a small bank. The securities subsidiary has some securities
that maybe they have underwritten, or whatever. They aren’t doing
well at all.
What is to stop them from moving in to improve the bank’s state
ment, from moving a good bit of those into senile Ms. Jones’ trust
account?
Dr. Phillips. Well, first of all, in coming back to this Interagency
Statement and the required disclosures-----Senator Faircloth . Just quick and simple, what is the required
disclosure?
Dr. Phillips. In other words, that this was a security that had
been underwritten by the Section 20 affiliate.
Senator Faircloth . They disclose that to the Federal Reserve.
Dr. Phillips. They disclose it to the customer and the customer
would have to acknowledge that as part of the statement. Also,
they are supposed to separately-----Senator Faircloth . Wait a minute. Now, they disclose that to
the customer. The customer has great confidence in the bank or
23
they wouldn’t be a customer. So what’s to stop the bank from
glossing this over to the customer, the value? We’ve underwritten
this. We know it’s wonderful. We wouldn’t have taken it unless it
was a really great opportunity. What’s to stop the bank from say
ing that when they have a problem on their hands?
Dr. P h il l ip s . Section 23B is still going to prohibit a bank from
purchasing, either as principal or as fiduciary, any security which
the Section 20 affiliate is the principal underwriter. So we believe
that that protection is-----Senator F a ir c lo th . N ow , we’re cutting out all the sections. Tell
me that again. Eliminate all the sections. Just tell me what you
just said flat out.
Dr. P h il l ip s . OK. Section 23B of the Federal Reserve Act—this
is separate. This is not a firewall. This is part of the Federal Re
serve Act. It prohibits a bank from purchasing as principal or as
fiduciary any security for which a Section 20 affiliate is a principal
underwriter during the existence of the underwriting or selling
syndicate, unless such a purchase has been approved by a majority
of the bank’s board of directors who are not officers of any bank
or any affiliate. If the purchase is as fiduciary, the purchase must
be permitted by the instrument creating the fiduciary relationship,
court order, or State law.
Senator F a ir c lo th . Well, that is certainly a lot of impressive
language.
[Laughter.]
I’m still not sure it’s as waterproofed as the language sounds.
On the issue of lending to help out the security affiliate, the
Board is proposing to repeal the firewall that prevents lending to
an issuing company for the purpose of repaying the security affili
ate. If we repeal this, would it not give the securities firm associ
ated with a Federally-insured bank an upper hand in the securities
business?
Dr. P h illips . Here I think 23A, which, again, limits the amount
of credit which can be extended to an affiliate to 10 percent of cap
ital helps. In addition, those transactions must be collateralized.
Senator F a ir c lo th . Well, Dr. Phillips, certainly a lot has been
said about 23A and 23B. The Federal Reserve Act is in place to
protect abuses. Section 23B prevents lending on more favorable
terms to an affiliate as a securities affiliate. How vigorously do
bank examiners look at the lending transactions between affiliates?
Realistically, how close do the examiners, when they go in, look at
these transactions between affiliates of the bank?
Dr. P h il l ip s . S o far as I know, they do look at them very care
fully, and there have been violations that have been discovered.
If it would be helpful to the Subcommittee, I would be glad to
have the staff write a more detailed report on our supervision expe
rience under 23A and 23B.
Senator F a ir c lo th . I would like that.
Senator Enzi, do you have any further questions?
Senator E n zi . It seems to me it would be pretty handy if we had
a little better summary of these firewalls and the consumer protec
tion that’s left when the firewall is gone on each of them.
24
Senator Faircloth . I think that is probably very good. Would
you like to ask Dr. Phillips to give you maybe a written summary
of how that would exist?
Senator Enzi. Yes. I really would appreciate that. Also, Senator
Reed asked for the list of what’s left after these firewalls are gone.
I think that’s an extremely important one, too.
Dr. Phillips. We’ll be glad to supply that.
Senator Faircloth . Thank you, Dr. Phillips, and thank you for
being with us today.
Now, I would like to welcome the second panel.
Mr. Victor Wamement from NationsBanc Capital Markets, Inc.
Mr. Wamement is the General Counsel for their Section 20 sub
sidiary in Charlotte.
Mr. Rick Roberts is here on behalf of the ABA Securities Associa
tion and the American Bankers Association. Mr. Roberts is the Ex
ecutive Vice President and Treasurer of Wachovia Corporation in
Winston-Salem, North Carolina and Atlanta, Georgia. He is accom
panied by Ms. Rachel Robbins, General Counsel and Managing Di
rector for J.P. Morgan & Co., Inc. in New York.
Finally, I would like to welcome Professor Charles Calomiris,
from the Columbia University, Graduate School of Business in New
York. He’s now affiliated with the American Enterprise Institute.
Mr. Calomiris, is that the correct pronunciation of your name?
Mr. Calomiris . Callo-miris.
Senator Faircloth . Calomiris.
Let me add that each of your statements will be entered into the
record in their entirety. And we do ask, in view of the time, if you
could limit your opening statement to 10 minutes.
Mr. Warnement, we will begin with you, if we may.
OPENING STATEMENT OF VICTOR A. WARNEMENT
GENERAL COUNSEL, NATIONSBANC CAPITAL MARKETS, INC.
SUBSIDIARY OF NATIONSBANK CORPORATION
Mr. W arnement . Thank you, Mr. Chairman.
Mr. Chairman and Members of the Subcommittee, I welcome this
opportunity to offer my views on the Federal Reserve Board’s pro
posed modifications to the firewalls applicable to Section 20 sub
sidiaries of bank holding companies. I commend the Subcommittee
for holding this oversight hearing and its interest in understanding
more about the Fed’s proposals to generally reduce the regulatory
burdens currently imposed on Section 20 companies.
As General Counsel to NationsBanc Capital-Markets, Inc., one of
the largest and most active Section 20’s in the country, and given
my prior experience in representing numerous issuers and invest
ment banks in securities transactions as an outside lawyer, I be
lieve I can provide some insights with respect to these proposed
modifications from both a regulatory and business perspective.
I would like to first provide some background perspective from
NationBank’s viewpoint and then respond to the areas of concern
raised in Senator Faircloth’s letter requesting our testimony.
As the financial services industry has grown and changed at an
accelerating pace over the past several decades, and extremely rap
idly over the past 10 years, our Nation’s bank holding companies
have become more and more constrained by what in many respects
25
has become an outdated regulatory framework. The American econ
omy, our industries, consumers, and communities will gain from
the kinds of reforms and modifications initiated by the Federal Re
serve Board over the past several months to permit bank holding
companies to deliver more competitive products and services to
their customers.
The Fed’s recent and proposed changes will allow Section 20’s to
operate and compete more efficiently and effectively. This in turn
will ultimately work to the benefit of both retail and institutional
customers of all types to increase competition, lower costs, increase
access to financial products and services, and improve service and
continuing innovation.
The Fed has acknowledged that existing firewalls, when adopted,
were a conservative set of rules. While accomplishing their original
purpose of isolating Section 20’s from most of its affiliates, the fire
walls have created significant compliance costs for bank holding
companies and have impeded dramatically the synergies and effi
ciencies that they should gain from operating permissible invest
ment banking and capital markets’ businesses.
The absence of abuse and record of performance by bank holding
companies in utilizing their underwriting powers has been fostered
by prudent risk management, by senior management of our respec
tive institutions, and by continuing developments and innovation in
risk-management systems and techniques that permit relevant
risks to be assessed and controlled in a more precise manner.
As the Subcommittee knows, the Fed is proposing to replace its
28 firewalls with eight operating conditions. We believe it is appro
priate to repeal all firewalls, except those where the Fed’s concerns
are not addressed by other statutes and regulations. In large part,
the Fed’s action may be seen as an acknowledgement that securi
ties underwriting and dealing activities are not inherently riskier
than certain other banking and nonbanking activities currently un
dertaken by bank holding companies and, therefore, should not be
subject to more burdensome limitations.
I would like to now respond to the issues raised by Senator
Faircloth in his letter requesting our testimony.
First, NationsBank does support the Fed’s proposed modifica
tions. We, along with numerous others, believe the Fed could rea
sonably go further in reducing the regulatory burdens we face. We,
and other institutions and various industry groups, have submitted
comment letters to the Fed expressing this general view because
adequate other protections do exist. We hope the Fed considers
those views carefully in its considerations.
Let us be clear—we fully support the Fed’s current initiative as
a prudent and reasonable approach in reducing both unnecessary
and burdensome regulations.
The Chairman has also asked that we address concerns involving
safety and soundness.
The Fed’s proposed changes can clearly be implemented while
preserving the safety and soundness of our Nation’s banking sys
tem and the integrity of its insured depository institutions. In fact,
reducing these regulatory burdens and permitting them to be more
actively and efficiently engaged in the securities business should
have the effect of ultimately enhancing the safety and soundness
26
of our banking system. The experience of the past 10 years has
demonstrated that bank holding companies can operate profitable
and sound investment banking business.
Even if the firewalls were totally eliminated, numerous layers of
regulation and supervision would still apply to Section 20 activi
ties. It is also very important to note that the Fed has gained tre
mendous experience in understanding and supervising Section 20
activities and the foreign bank subsidiaries of our bank holding
companies.
The bank and securities regulators are also moving in the direc
tion of a more functional and consistent regulatory approach, and
the Fed now places great emphasis on evaluating, understanding,
and making recommendations concerning the soundness of our
risk-management systems and our philosophies.
Finally, as the Fed’s annual examinations have focused more
heavily on risk management and internal controls, the Fed has
acknowledged that both bank holding companies and banks have
engaged in activities at least as risky as underwriting and dealing
securities in a Section 20 affiliate without the restrictions currently
imposed by the Section 20 firewalls—for example, venture capital
activities in the U.S. and Section 20-like activities in foreign sub
sidiaries of U.S. bank holding companies.
In addition, we have periodic contact with Fed staff concerning
issues we may have in order not to violate the Fed’s regulatory
framework.
We have also been asked to comment on the adequacy of other
customer protections.
Modifications currently proposed when combined with existing
disclosure requirements for customers of all securities firms simply
do not increase the likelihood of customer abuse. There are numer
ous securities laws and regulations that generally govern disclo
sures to customers. There are also numerous legal and regulatory
protections concerning potential misuse of nonpublic customer in
formation.
Virtually all institutional customers are capable of protecting
themselves from abusive or coercive business practices. Given the
competition within the industry, these customers generally pre
serve far too many options to be forced into using products they do
not want or could obtain from other institutions at lower prices.
Retail customers of bank holding companies, on the other hand,
receive the added benefit of special disclosures required by the
Interagency Statement. Even a number of consumer advocates
have conceded that banks have greatly improved in warning cus
tomers about the risks attendant with securities investments.
Moreover, studies have indicated that adherence to the existing
disclosure requirements actually work well with customers when
actually used. The anti-tying rules for banks add additional cus
tomer protections which should not be overlooked in considering
the risks of abuse or coercion.
Thus, we do not believe that the proposed changes increase the
risk of coercion of customers or that those customers will not be
adequately protected by the various statutes, regulations, and su
pervisory oversight to which our country’s banking companies are
subject.
27
The Chairman has also asked for comment on the potential com
petitive advantages that might result to Section 20 companies from
this relief.
The proposed modifications will not lead to an advantage for Sec
tion 20’s. The changes merely work to help level the regulatory
playing field which has been generally tilted against Section 20’s
as compared to other firms since their inception in 1987. A Section
20’s relationship with affiliate banks can sometimes represent a
reputational hurdle to be overcome rather than an advantage rel
ative to nonbank competitors.
In addition, the different areas of the financial services industry
have continued to converge, bank holding companies’ nonbank se
curities competitor firms are becoming formidable in traditional
banking areas, such as the syndicated lending business.
It should also be noted that banks have never dominated over
the securities firms in the eligible securities fields in which they
have been permitted to operate for the past 65 years. Section 20’s
will still continue to carry a higher degree of regulatory burden rel
ative to other firms.
Moreover, given the various other protections which exist under
Sections 23A and 23B and the anti-tying rules, the ability of bank
affiliates to directly or indirectly support Section 20 activities on
anything less than an arm’s-length basis is highly dubious. Ulti
mately, the Fed’s proposal helps open the door to a freer and fairer
system of competition.
It is also interesting to note that no nonbank securities firm or
their traditional industry groups submitted a comment letter to the
Fed in opposition to its proposed changes.
Mr. Chairman, you asked for comment on the existence of other
statutes or regulations to act as substitutes for the firewalls.
There are numerous statutory and regulatory protections outside
the firewalls framework that will serve to address the fundamental
risks associated with the underwriting and dealing activities of
Section 20’s. Any of the firewalls that duplicate or overlap the pro
tections afforded by Section 23B, which was not adopted at the
time of the Fed’s initial approval of Section 20’s, can reasonably be
eliminated.
Section 23B clearly requires affiliate transactions to be conducted
at arm’s length, typically requiring pricing and other economic
terms to essentially mirror those found in the marketplace in deal
ing with other customers.
In addition, the current risk-based capital standards utilized by
banks and their holding companies were not in effect in 1987. They
provide a clear and concise way to measure the safety and sound
ness of the bank holding company.
Last, the Interagency Statement was only adopted in 1994. This
statement has become the primary means by which the Federal
banking agencies attempt to ensure that retail customers are not
misled about the nature of Nondeposit Investment Products.
Finally, you have also sought our comment on other recent Fed
action impacting Section 20’s. NationsBank fully supports the Fed’s
recent actions to modify or to eliminate some of the other reg
ulatory constraints affecting Section 20’s, including raising the
ineligible revenue ratio from 10 person to 25 percent, the elimi
28
nation of the cross-marketing restrictions, and the relaxation of the
firewalls permitting dual employees between a Section 20 and its
bank affiliates.
The regulatory relief recently adopted or currently proposed by
the Fed concerning Section 20 activities is long overdue. In an in
creasingly competitive and globalized financial system, our Nation’s
economy will benefit from the increased flexibilities these changes
will bring. NationsBank broadly supports the Fed’s proposal and
applauds its efforts in continuing to modernize the financial serv
ices industry. We believe that the Fed has acted extremely pru
dently in evaluating these matters and in proposing these changes.
Mr. Chairman, I appreciate the opportunity the Subcommittee
has given me to present views on these important developments to
the banking and securities industry and for our Nation’s consum
ers, businesses, and economy.
Thank you.
Senator Faircloth . Thank you, Mr. Warnement.
Now, we will hear from Mr. Roberts from Wachovia.
OPENING STATEMENT OF RICHARD B. ROBERTS
EXECUTIVE VICE PRESIDENT AND TREASURER
WACHOVIA CORPORATION
ON BEHALF OF THE
ABA SECURITIES ASSOCIATION AND THE
AMERICAN BANKERS ASSOCIATION
ACCOMPANIED BY RACHEL ROBBINS
GENERAL COUNSEL AND MANAGING DIRECTOR
J.P. MORGAN & CO., INCORPORATED
Mr. Roberts. Thank you, Mr. Chairman.
I am Richard Roberts, Executive Vice President and Treasurer of
Wachovia Corporation headquarters in Winston-Salem, North
Carolina, and in Atlanta, Georgia. I am also Chairman of the
Board of the ABA Securities Association.
Accompanying me today is Ms. Rachel Robbins, General Counsel
and Managing Director of J.P. Morgan & Co., Incorporated. Ms.
Robbins is on the ABASA Board and is also Chair of the ABASA
Lawyers’ Committee. Under her leadership that committee has
carefully reviewed all of the Fed’s recent proposed changes in the
Section 20 activities.
The ABASA is a separately chartered affiliate of the American
Bankers Association formed in 1995, to develop policy and provide
representation for banks underwriting and dealing in securities,
proprietary mutual funds, and derivatives.
Mr. Chairman, I commend you for holding this oversight hearing
on the Federal Reserve’s proposal to modify existing Section 20
firewalls and I appreciate the opportunity to appear here today to
discuss these very important issues.
For the approximately 40 bank holding companies and foreign
banks that have established Section 20 firms, the existing firewall
provisions impose tremendous regulatory burdens and costs on
doing business today. For many other banking organizations that
have not yet established Section 20 firms, the costs and the bur
dens associated with these firewalls have effectively prevented
them from establishing Section 20 firms.
29
I should point out that Wachovia has not established a Section
20, and the reason for not having done so is that the current fire
walls represent an impediment to conducting business in an effi
cient manner.
As I will discuss more fully later in my testimony, the ABA Secu
rities Association and their 21 members, including the Wachovia
Corporation, strongly favor the recent Board’s action proposing to
modify the existing firewalls. These modifications, when adopted,
will allow all Section 20 firms to operate much more efficiently and
effectively, which can only inure to the benefit of our customers.
We believe that these modifications are also an important step to
ward bringing vigorous new competition to the financial services
industry, but, Mr. Chairman, they are only that, a first step.
The bank regulatory structure needs to be modernized to allow
all institutions the option to offer all financial services to our cus
tomers. All financial service providers should have the ability to
offer all services free from unnecessary legislative barriers and
costly regulatory hoops. Not all providers will choose to offer all
services. But the decision of what products and services to offer
should be a business judgment that each individual institution is
free to make. Given all the changes in today’s financial services
marketplace, it simply makes no sense to create a system that lim
its free and fair competition.
Consequently, ABASA’s strong endorsement of the Board’s pro
posal should not, in any way, detract from our position that truly
comprehensive financial services reform is needed. Only Congress
has the power to adopt such reform and ABASA would strongly en
courage the Subcommittee to assist in moving these reform efforts
forward.
The firewall restrictions were designed more than 20 years ago
for securities underwriting and dealing risks from being passed
from a Section 20 subsidiary to an affiliate insured deposit institu
tion. In addition, these restrictions addressed the potential for con
flicts of interest, unfair competition, and other adverse effects that
might, it was thought at the time, arise from the conduct of these
bank ineligible securities activities.
I will say that these very conservative firewalls were put in place
with the idea that they would be periodically reviewed. And there’s
a pattern of that, as you can see, from 1987 coming forward.
The Board’s proposal, after undertaking a complete review of the
firewall restrictions, with 10 years’ experience, has now determined
to propose comprehensive changes to these firewall restrictions.
Specifically, the Board has proposed to retain eight firewall provi
sions by incorporating them into a statement of operating stand
ards and to eliminate the remainder. The Federal Reserve Board
has had considerable opportunity to analyze the perceived risks
posed by these activities to affiliated insured depositories and has
concluded that any perceived risks posed by securities underwriting
and dealing activities have proven to be manageable.
They have seen first-hand how bank affiliates operate in the real
world and have come to recognize the impediments the firewalls
have imposed. And at this same time, the Board has gained greater
familiarity and experience in the operation of the Federal securities
laws and the protections afforded by those laws through the super-
47-726 - 98 - 3
30
vision and regulation of broker-dealers by the Securities and Ex
change Commission and the National Association of Securities
Dealers. That experience has allowed the Board to conclude that
many of the firewall provisions are unnecessary in light of the Fed
eral securities law requirements.
Finally, legislative and regulatory initiatives put in place after
the original firewalls were established have also demonstrated that
many of the firewall restrictions are largely redundant of these
other provisions. These initiatives include Section 23B of the Fed
eral Reserve Act, the Interagency Statement on Retail Sales of
Nondeposit Investment Products, and the Risk-Based Capital
Standards. Clearly, these new safeguards, in combination with pre
existing regulatory limitations applicable to all nonbanking subsidi
aries, squarely address the fundamental concerns that precipitated
the initial establishments of the firewalls.
Your letter of invitation, Mr. Chairman, asks whether proposed
firewall modifications can be made while still preserving the safety
and soundness of the banking system and protecting affiliated in
sured deposit institution. We are convinced that they can.
There is no evidence that security activities are more risky than
traditional commercial banking activities. The weight of evidence
suggests that these activities do not raise the risk profile of a bank
ing institution. In fact, just the opposite is true. These activities
lower risk profiles and provide even more protection for the bank.
We firmly believe safety and soundness of the insured depository
institution will be safeguarded by existing Federal security law
capital requirements enforced by both the SEC and the NASD, and
requiring bank holding companies to maintain, consistent with
GAAP, adequate capital on a fully consolidated basis. Benefits to
the banking organizations will include reduced regulatory burdens
and the ability to compete on a more equal footing, at least with
respect to capital requirements, with other nonbank affiliated in
vestment banking services providers.
The Board has also proposed to eliminate the firewalls which
generally prohibit bank holding companies and their subsidiaries
from extending credit to the Section 20 firm. These restrictions
were originally to prevent a bank or its parent from exposing itself
to loss in order to benefit the Section 20 firm’s underwriting and
dealing activities. In truth, however, these firewalls have hampered
the ability of bank holding companies to serve as full-service finan
cial services providers and have reduced funding options available
to our customers.
For example, it is not uncommon for bank corporate customers
to fund their activities by accessing the capital markets through a
commercial paper issuance. In these situations, the bank will refer
its customer to its Section 20 affiliate. Under the current firewall
restrictions, the bank would be prohibited from providing credit en
hancement to commercial paper even though the bank itself may
be the institution best suited to perform a credit analysis or, worse
yet, for smaller companies, the only institution willing to perform
the necessary credit analysis.
Many of the conflict of interest concerns are more than ade
quately addressed by other existing statutory and regulatory safe
31
guards. Duplicative and redundant firewall restrictions are simply
not needed.
For example, as the Board has recognized, the current risk-based
capital system would require the bank to hold capital against the
exposure on any credit enhancements extended to Section 20 cus
tomers. Loan-to-one borrower rules would also limit the amount of
credit that a bank could extend to an issuer of securities under
written by the Section 20 firm. Perhaps more significantly, any
transaction or series of transactions between a member bank and
a third party would be subject to the arm’s-length dealing require
ments of Section 23B of the Federal Reserve Act where an affiliate
of the member bank is a participant.
As a consequence, even without these firewalls, member banks
would still be strictly prohibited from extending or granting credit
to customers on preferential terms. In short, the stated purpose of
these firewalls can be, and is, accomplished without the added
operational burden of specific firewall restrictions.
Mr. Chairman, you have asked whether the modifications pro
posed will provide adequate protection to customers of the bank or
securities affiliate. I believe the above demonstrates most strongly
that both bank and Section 20 customers are provided with signifi
cant protections under the Federal securities laws and banking
laws to justify the Board’s proposed elimination of many of these
firewall provisions.
All the disclosure requirements of the Federal securities laws
apply to banking organizations’ securities activities. In addition,
the Federal banking regulators require certain disclosures to be
made when retail customers purchase investment products from
the bank lobby. These statutory and regulatory requirements pro
vide added protections to many bank and Section 20 firm cus
tomers.
Mr. Chairman, I think it’s important to understand the historical
context in which these original restrictions were established. At the
time the original firewalls were adopted the Board was facing liti
gation, which it subsequently won. As a result, the Board adopted
a very conservative framework of firewall restrictions that it recog
nized could, like the initial 5 percent income limitation, over time
be loosened. And we know the pattern it subsequently has followed.
Generally speaking, the restrictions were very conservative and
were often geared to the characteristics of the money-center banks
and the burdens and inefficiencies that, it was thought, those insti
tutions could afford to carry.
Regional bank holding companies, such as mine, have been un
able to carry the same burdens with the inefficiencies. As a result,
issuers and would-be issuers of securities in cities and towns all
over the country were forced to go to New York and other money
centers to raise capital. In far too many instances, they bypassed
the regionals with whom they had done business for years, who
knew their needs, knew their communities, but could not provide
the needs because of regulatory impediments.
The Board has endeavored to ease some of the most burdensome
firewall restrictions, including eliminating the cross-marketing pro
hibition and significantly modifying the personal interlock prohibi
tion. These actions, taken in concert with raising the cap on the
32
revenue earned from 10 percent to 25 percent for ineligible security
underwriting, have already encouraged several banks to seek au
thorization either to establish a Section 20 firm, or to expand the
authorization for existing Section 20’s.
In conclusion, Mr. Chairman, ABASA appreciates the opportu
nity to appear before the Subcommittee to discuss the Board’s re
cent proposal to modify its firewall provisions applicable to Section
20,s. While ABASA is hopeful that the modifications, when adopt
ed, will encourage other bank holding company firms to establish
Section 20 underwriting firms, these modifications are only a first
step toward comprehensive reform of our financial system. ABASA
encourages the Subcommittee and its Members to work with all
appropriate parties in order to enact meaningful financial reform
legislation. We stand ready to work with you and other Members
of your Subcommittee.
Once again, thank you, Mr. Chairman.
Senator Faircloth . Thank you, Mr. Roberts.
Mr. Calomiris.
OPENING STATEMENT OF CHARLES W. CALOMIRIS
PAUL M. MONTRONE PROFESSOR OF FINANCE AND
ECONOMICS, GRADUATE SCHOOL OF BUSINESS
COLUMBIA UNIVERSITY
Mr. Calomiris . Thank you, Mr. Chairman.
It is a pleasure to appear here today. Let me briefly summarize
my written testimony.
The last decade has seen dramatic and beneficial bank deregula
tion, especially the relaxation of geographical and activity limita
tions on bank holding companies.
Deregulation has sparked little controversy among scholars of
banking or banking history. There is a remarkable degree of agree
ment among these scholars, supported by an extensive body of re
search, that historical limits on bank locations and activities have
served no legitimate economic purpose. Rather, these costly limits,
especially the separation of commercial and investment banking in
1933, are artifacts of specific historical political battles in which
facts and economic logic have often taken a backseat to populist
passions or special interest politics.
Competitive pressure, especially the loss of U.S. banks’ domestic
and international market shares in the 1980’s, helped to push the
Federal Reserve Board in 1987, and subsequently to use its author
ity to relax restrictions on bank underwriting activities. Initially,
the Fed proceeded with extreme caution. It allowed very limited
underwriting of private debt, and later equity, but attached to
those activities a host of firewalls intended to prevent the transfer
of loss from a Section 20 underwriting affiliate to a chartered bank,
and to prevent dishonest business practices.
The first goal reflected a legitimate concern. The Fed correctly
worried about the abuse of deposit insurance and the discount win
dow—the possibility of Government subsidization of risk in new
activities. The second goal reflected unsubstantiated and misguided
concerns, which the Fed has subsequently learned about.
Experience has proven that accusations about dishonest behavior
resulting from combining commercial and investment banking his
33
torically were unfounded, and that limitations on combining these
activities are very costly.
The Federal Reserve Board has recently circulated a set of pro
posals to relax or eliminate many of the firewalls that limit connec
tions between banks and the nonbank affiliates of bank holding
companies.
The principal question I will address today is the desirability of
the Fed’s recent proposals to reduce firewalls for Section 20 affil
iates of bank holding companies. More broadly, however, I will
assess the desirability of expanding bank activities into securities
markets and related areas, and the importance of relaxing firewalls
to allow efficiency gains from such an expansion.
I support enlarging the range and size of permissible nonbank
activities within banks or bank holding companies, and scaling
back firewalls as the Federal Reserve Board now proposes to do.
Doing so will allow banks to compete more effectively for corporate
relationships, and will benefit bank customers and their stockhold
ers, at least as much as it will benefit banks.
Let me begin with some historical perspective on the origins of
the separation of commercial and investment banking, which is
essential to the debate over bank activity limits and firewalls.
In the United States, banks became interested in underwriting
and holding corporate debt and equity in the 1920’s. The relaxation
of branching laws during that period created new opportunities for
banks to become large. As they became large, they turned increas
ingly to industrial as opposed to only commercial finance, and they
found it profitable to mix bank lending with underwriting. Doing
so made it possible to better serve their corporate clients’ funding
needs, providing better access to investments for their trust cus
tomers, and reduce banks' cost of funds, since the new activities
were highly diversified.
The mixing of lending and underwriting activities had produced
similar synergies in German universal banking around the turn of
the 20th century, which were well understood in the United States
by the 1920’s.
- The synergies for mixing lending, equity holding, and underwrit
ing in the United States and Germany historically are present and
visible in the United States today, even under the current limited
incarnation of universal banking. Evidence from the last decade of
U.S. experience suggests that Section 20 underwriting affiliates
increase average returns and reduce risk for their bank holding
companies.
The primary sources of these gains are the repeat use of informa
tion, the enhancement of corporate control over clients, and the
diversification of bank income.
It is important to keep in mind that in a competitive banking
system these reduced costs of intermediation accrue mainly to bank
customers—that is, banks’ clients’ stockholders and bank deposi
tors. It is also important to note that these synergies are often
undermined by firewalls.
If firewalls require separation of types of activities into different
entities—that is, entities with separate corporate identities, liabil
ities, and capital—then some of the cost of funds advantages from
diversification across activities will be limited. If firewalls require
34
that lending and underwriting by the bank not be allowed for the
same client firm, then any potential information synergies across
activities will be foregone. If firewalls prevent banks from being ac
tively involved in controlling the firms they finance—via boards of
directors, or trust account and mutual fund holdings of stock—then
control synergies will be limited.
The current Fed proposals to repeal firewalls would improve the
efficiency of the financial system mainly by increasing the multiple
use of information within the bank and by enhancing bank involve
ment in corporate control.
It is worth noting that the Fed is not proposing to remove all
protections. The Fed proposes to retain the limitations on the mix
ing of bank and nonbank risks—specifically, Sections 23A and 23B
of the Federal Reserve Act, which limit the extent of lending from
banks to nonbank affiliates, and require that it be fully collateral
ized and priced as an arm’s-length loan. Chairman Greenspan ar
gues that Sections 23A and 23B provide essential protection
against the abuse of deposit insurance protection by bank holding
companies.
I share Chairman Greenspan’s concern that under the current
deposit insurance system the absence of financial firewalls like 23A
and 23B could lead to abuse of deposit insurance. But I do not
agree with his solution. A better alternative would be to remove
the possibility that banks would receive subsidized insurance,
which would thereby remove any incentive problem from mixing
the risks of lending and underwriting, and thus, allow banks and
their customers to reap the enormous diversification gains from re
laxing Sections 23A and 23B.
Chairman Greenspan also argues that the holding company
structure is a superior mechanism for administering firewalls, and
that thus it is essential to restrict Section 20 activities and other
nonbank activities to bank holding company affiliates—that is, reg
ulated by the Fed. Thus, he does not support the Comptroller’s
initiative to allow new activities to occur within subsidiaries of na
tional banks. I do not share his view. There is no reason I can dis
cern why any particular firewall cannot be administered as well
within a bank subsidiary structure as it is within a bank holding
company affiliate structure; and in fact, the AJAC subsidiaries are
a good example of just what I’m talking about.
And I want to emphasize, too, that it is my understanding that
the Comptroller would exactly replicate the Fed’s policies in fire
walls and their enforcement.
The argument for retaining a Federal Reserve monopoly on regu
lating Section 20 activities seems to rest on the view that there’s
a need to have an "umbrella” regulator, namely, the Fed, that over
seas all holding company risks. That is only necessary if potential
subsidies from deposit insurance cannot be eliminated and if fire
walls cannot insulate banks from the risks undertaken by nonbank
subsidiaries or affiliates.
Since neither of these necessary conditions need be true, I do not
support the Fed’s view that it should retain a regulatory monopoly.
Indeed, there are advantages, I think, to allowing the Comptroller
and the Fed to compete over bank activity regulation.
35
In conclusion, I strongly support the Fed's proposal to roll back
firewalls. I also encourage the Fed, the Comptroller, and Congress
to consider reforms to deposit insurance that would permit addi
tional rolling back of firewalls. Finally, I encourage Congress to re
tain the current healthy competition that exists between the Office
of the Comptroller and the Fed.
If we succeed in freeing the banks from costly and unwarranted
limitations on their powers, significant gains will follow for banks
and their customers. The banks that stand to gain will increasingly
include super-regional and regional banks, in addition to moneycenter banks. As the technology for placing securities improves,
and barriers to low-cost public issues of securities are removed,
more and more regionals and super-regionals will find it advan
tageous to establish Section 20 affiliates or subsidiaries. The social
gains of that expanded access to private and public equity finance
for all banks’ corporate clients could be large.
Thank you.
Senator F a ir c lo th . Thank you, Mr. Calomiris.
A couple of things have appeared so far in this hearing. One of
them is that, for all of the Senators who have been here and I
think for everyone else, it is an absolute necessity that we main
tain the public’s confidence in banks. That’s paramount in anything
we do and that we don’t do anything to erode that.
Another thing that has bothered me, and as I heard from other
Members, is the somewhat evidence of a rush between the Federal
Reserve and the Comptroller of the Currency to come forth with
some rules and regulations, and who gets there first and whose are
the most impressive.
I intend to have a hearing immediately after recess and ask Mr.
Ludwig, the Comptroller of the Currency, to come and explain some
of his proposals. I think it will serve us well to do that.
One thing that I have heard from each of our witnesses today,
Mr. Roberts, Mr. Warnement, Mr. Calomiris, and also Ms. Phillips,
is that the securities business and dealing in securities and under
writing is no more dangerous an activity than is ordinary lending.
In general, ordinary lending in most banks is spread among many,
many customers. The underwriting is spread among fewer cus
tomers of the bank.
Many years in the automobile business and several dealerships,
and I was taught this by some very good bankers, and this was a
time in which all paper was recourse paper, before the banks be
came so generous that they took over the risk, but the fundamental
rule was don’t worry about the retail paper. You’ll lose some, but
it will take care of itself. Watch the floor plan, that is where you
can go broke and lose it all rather rapidly. The retail paper—is
there any, and I will start with Mr. Warnement. Since this seems
to be a theme, is there any rationale to such an analogy?
Mr. W ar n e m e n t . Well, I think, historically, you can look at the
scenario you have posed.
Developments in the business have allowed the underwriting and
the distribution of corporate bonds as essentially a more efficient
means of delivering liquid credit than delivering long-term illiquid
loans to the same borrower.
36
If we look at a corporate customer and instead of making it a
very sizable loan that we hold on our balance sheet—the equivalent
of holding the floor plan with an auto dealer—and the enduring
risks inherent in holding that illiquid loan for a long time, where
market conditions can change, the business can go away, and a
whole lot of things can impair the quality of that credit over time,
compared to taking and structuring the same level of credit in the
bond market, where the financial institution goes in, makes a deci
sion based on due diligence, credit quality, and a lot of other
things, first, whether to underwrite, and then it goes on to distrib
ute that debt across investors across the country, resulting in less
financial risk to the institution.
Now, I would be remiss not to acknowledge that large corporate
bank credits can now be distributed, syndicated across other finan
cial institutions, although such loans are not as liquid as bonds.
I would also point out that our nonbank competitors have en
tered into that syndicated lending business in a very significant
way. For example, in the “Who's News” sections of The Wall Street
Journal or The American Banker or other industry publications,
you can see a movement and a recruiting process going on by our
competitors to continue to delve into the traditional banking busi
nesses.
There is a convergence of all of these activities in the financial
products that result and are engineered for customers.
Senator Faircloth. Thank you, Mr. Roberts.
Yes, Ms. Robbins.
Ms. Robbins . Could I just add something to that?
Senator Faircloth . Y ou certainly may.
Ms. Robbins . I would just like to follow up on that comment. I
would say that the syndicated lending business is actually riskier
than the underwriting business.
The process is almost identical, as Mr. Warnement said, in that
the bank makes a decision to extend a large amount of credit to
one customer and then sells this off to other banks. The same proc
ess in the underwriting of the corporate bond. The difference is
that in the underwriting of the corporate bond, you are dealing
with a rated instrument. You are dealing with an instrument that
is going to be sold in a broader, more liquid market, about which
there is lots of research being written. So you have a creditworthy
rated instrument in a more liquid market. And if anything, the cor
porate bond is nothing more than a more liquid loan that is rated.
Senator Faircloth . Thank you. That answers it.
Senator Reed.
Senator Reed . Thank you, Mr. Chairman.
Mr. Roberts. Mr. Chairman, if I might?
Senator Faircloth . Yes, go ahead.
Mr. Roberts. I thought I might add a little comment to what we
have heard here.
I take a view on diversification of portfolio reduces risk for a
bank. That action has proved true over many, many years. And to
use an example, let’s go back to the floor plan and the individual
notes that are purchased.
If you have two banks, or it could be a bank and an insurance
company or an investment company. I am just going to use the ex
37
ample of two banks. Let's say you have Bank A where all they have
is floor plan paper; you have Bank B where all they have is indi
rect notes, which has covered many, many customers. The
securitization process and so forth allows an equilibrium and diver
sification to take place between these entities, of which you can get
a diversified portfolio on the bank’s balance sheet, if that’s what
you want.
I take another view, too, that a financial intermediary being a
bank, can conduct business in two ways. One, originate and book
for your own account. Therefore, you have that asset and it is in
a less liquid form, as Ms. Robbins just mentioned. Or you can take
a purist view of the financial intermediary process of originate, un
derwrite, and sell, and thus, distributing the risk. And so I believe,
if anything, this process reduces the risk for the financial institu
tion called the bank.
Senator Faircloth . Thank you, Mr. Roberts.
And if you will allow me just one minute, we will ask Mr.
Calomiris if he has a thought on it.
Mr. Calomiris . Well, I also wanted to point out, banks’ risks are
not encompassed by lending and underwriting, and neither are
their profits. There are a couple of other activities that are at least
as risky within bank holding companies as underwriting that
haven’t even been discussed and are currently regulated very dif
ferently. Removing these firewalls would simply bring the Section
20 affiliates into the same playing field as those other ones.
A good example is venture capital affiliates under Regulation Y,
which perfectly illustrate Mr. Roberts’ point about diversification.
Venture capital profits and bank holding companies, some of the
largest ones, have been larger than Section 20 profits. They have,
in fact, saved many of the largest bank holding companies in the
United States during the 1980’s, First Chicago, Continental. They
have made an enormous contribution to the profits of CitiCorp, of
Chase, of Chemical, even of Norwest.
Senator Faircloth . Did you say, I’m sorry, Chicago?
Mr. Calomiris. First Chicago.
Senator Faircloth . First Chicago.
Mr. Calomiris. And Continental of Illinois.
Senator Faircloth . Yes.
Mr. Calomiris. For some of these banks, for all the ones I men
tioned other than Norwest, their contribution to the bottom line of
the banks over the last 20 years has been greater than 20 percent.
That’s the venture capital subsidiaries no one’s been talking about.
So my point, they are regulated under Regulation Y. Sections
23A and 23B apply to them, but not all of these other superfluous
firewalls. They seem to have done very well. Not only have they
done well, but they have contributed an enormous amount of profit
that has saved some of the banks that were threatened during the
1980’s. I could say the same thing about the foreign subsidiaries,
which are not affiliates. They’re subsidiaries of some of the largest
American banks.
So I think we could talk about derivative activities and interest
rate risk speculation. Banks are engaged in a lot of risks. Section
20 risk has been discriminated against, and I think quite unfairly.
Senator Faircloth . Thank you.
38
Senator Reed.
Senator Reed . Thank you, Mr. Chairman.
Professor Calomiris, perhaps one reason that Section 20 risks
have been discriminated against is that, in the history of the
1920,s, which you point to, note that it helped diversify activities.
Also there were some abuses in terms of affiliates making loans to
bail-out troubled companies, the equities being sold by the securi
ties affiliate, all these things. I am just wondering, in a fair sort
of capitulation of the 1920,s, aren’t there some dangers we still
have to be aware of and look to?
Mr. Calomiris. Senator, Fm glad you raised that question. I was
very frustrated, frankly, by many of the comments of the Senators
who have left the room who apparently have not read the last 10
years of research on the 1920’s.
In my written comments, I have an extensive footnote which
summarizes probably a dozen different research products. One is a
book by George Benston specifically on the Pecora hearings and the
allegations of conflicts of interest and dishonest behavior. The oth
ers have been very detailed statistical studies by several people
published in the best economics journals that basically refute this
argument. Let me give you just a very brief flavor of it.
The argument that the banks were giving their worst risks to the
customers who were buying their bonds or their stocks in order to
bail themselves out as lenders, would imply that the ex-post per
formance of the bonds that were sold by the banks would have
been worse than the performance of the bonds sold by the inde
pendent investment banks. The opposite is the case, even after con
trolling for the initial yields or ratings of those bonds. Banks, if
anything, were much more careful in their underwriting behavior
in the 1920’s. There just is no basis for this argijirient. So I hope
you will look at some of the references and read^ome of that work.
Senator Reed . Thank you for drawing our attention to footnotes,
which are often overlooked in our deliberations.
Let me ask another general question and anyone on the panel
who feels willing can jump in.
A lot has been said about risk-based capital as a development
since the first authorization of Section 20 subsidiaries as a major
check in place today that was not in place originally that will pro
vide protection for the banking system. I wonder if anyone can just
comment upon risk-based capital in terms of how it will be a check
in this regard.
Mr. Roberts, Ms. Robbins.
Mr. Roberts. I’ll be glad to respond first to that.
I think that the objective of risk-based capital goes back to, I
think, the Basil Accord that established standards which were to
be applied on a global basis. They’re very specific standards with
regard to not only the quantity of capital, but also the quality of
capital as well by defining what is Tier 1, the highest quality, basi
cally, equity capital, and allowance for reserves, and then your
more junior-type capital, being the Tier 2, which includes things
like subordinated debt and all.
These are standards which must be upheld. And you also have
used the term, well capitalized, throughout the documents that you
have had here, that if these high standards are not met, then I will
39
tell you that the pulling of the plug of the relief of the firewalls on
those particular institutions would more than likely take place by
the Federal Reserve.
Senator R e e d . Let me follow that question. First, would a bank
holding company with a Section 20 subsidiary be required to have
more capital because of the risk of the Section 20 subsidiary?
Ms. ROBBINS. The Section 20 is, as Governor Phillips mentioned,
a registered broker-dealer with the SEC. So it complies with all the
SEC capital rules.
Senator R e e d . Right.
Ms. R o bbin s . In addition, it’s subject to the overall consolidated
risk-based capital requirements that apply to the whole holding
company. It would not have higher risk-based capital requirements
than any other.
Senator R e e d . No. My question was would the bank holding com
pany be required to have higher capital?
Ms. R o bbin s . It has to be well capitalized in order to have a Sec
tion 20 in the first place.
Senator R e e d . S o, essentially, the test of the Federal Reserve is
they look first at the capital of the holding company and determin
ing if it’s well capitalized.
Ms. R o bbin s . Right.
Senator R e e d . And then authorize the Section 20 subsidiary.
Ms. R o bbin s . Exactly.
Senator R e e d . Will that be the procedure going forward with
these firewall changes?
Ms. R o b b in s . Yes.
Mr. W arn em en t . I think to the extent, Senator Reed, that you
think about increased competition and more regional banks being
able to come into this field, it’s important to understand the rigor
ous tests that the Fed puts a bank holding company through in
order to establish a Section 20 company.
There are significant costs to it. Some of us in the industry view
it as probably the most difficult power or activity to get permission
to engage in from the Federal Reserve. And you have to go through
a rigorous process of building out your infrastructure and hiring
people, developing policies and procedures, putting in computer
systems, and a number of other things before the Fed comes in and
looks at your readiness to begin to engage in the business.
Senator R e e d . Let me ask a final question. Mr. Roberts alluded
to it. If the capital of a holding company declines for any reason,
is there provisions in the law today where the authority to operate
a Section 20 subsidiary would be circumscribed?
Mr. R o berts . The Fed has the empowerment or the authority to
do such.
Senator R e e d . Let me take it from another perspective. If the
Section 20 subsidiary was engaged in underwriting that proved to
be bad and generated losses, what remedy would the Federal Re
serve then have?
Ms. R ob b in s . They could stop the activities. They could require
you to shut down the Section 20.
But I think it’s important to recognize that not only the history
in the last 10 years of the activities of all of these companies, but
also the history for two decades abroad, where, by the way, there
40
are no firewalls, not even 23A and 23B, has demonstrated that
these activities are done safely and prudently and are not riskier
than banking.
Senator Reed . Can I just ask one other question?
Senator F a i r c l o t h . Yes, you can. Go ahead.
Senator R e e d . One other comment that Ms. Phillips made with
respect to the proposed new firewalls or new walls, fireproof or oth
erwise, is the advertising prohibition today, which basically says
that the bank cannot imply, nor anyone in the holding company
system imply, that these securities are somehow sponsored by the
bank or related to the bank, to me seems to be a very critical one
because consumers who are going out and looking at a product and
all they will see is the bank name. They won’t see underneath the
bank, subsidiary of such and such. They will see the Wachovia
term, or whatever. And then her response was this is all protected
now by the Interagency Statement. Would you comment?
Ms. R o b b in s . Let me just clarify that. That firewall was lifted
from proposed 23B, which was not yet enacted at the time the Fed
imposed their first set of firewalls. Section 23B, as has since been
enacted, has that identical language. So it’s there in the law.
It’s important to remember that 23B was enacted by Congress 10
years ago when Congress was debating, and one of the many times
Congress was debating increasing bank powers. Section 23B was
designed as the safeguard necessary to enable banks to expand
through holding company affiliates into the securities business.
What ultimately happened was that the new powers were never
granted, but the safeguards that were intended to go along with
them came in place in 23B. So it was really Congress’ version of
firewalls for securities activities before the Fed’s.
Mr. W a r n e m e n t. Senator Reed.
Senator Reed . Yes, please.
Mr. W a r n e m e n t. I would also add on the advertising front that
Section 20 companies are subject to the NASD’s rules concerning
advertising. We in no way are allowed to imply that a bank is
guaranteeing or is responsible for &ny instrument being under
written or dealt in by the Section 20 company.
As part of that process, advertising gets reviewed at most institu
tions by their compliance people, and if it is a large advertising
campaign, the disclaimers or statements that are included in ad
vertising are reviewed by their legal departments and, ultimately,
are submitted to and reviewed regularly by the NASD’s regulatory
staff or supervisory staff.
We have received a number of calls by regulators about our ad
vertising saying, we would like you to adjust—we think it’s OK, but
we would like it to be a little clearer this way and that way. It’s
not an area in which, I believe, financial institutions are going to
mess around with those risks.
Senator R e e d . Professor.
Mr. C a lo m ir is . At the same time, I think it’s important to men
tion that cross-marketing is extremely important. In some studies
of some bank mergers that I have done, I found that revenue
synergies, if you like, synergies from cross-marketing building upon
relationships, can be at least as large and at least as important for
the gains from consolidations as simple cost-cuttings.
41
So, again, as in many of these firewalls, you don’t want to throw
away the baby with the bathwater. You want to limit the potential
abuses in the advertising. But you can’t go so far that you destroy
the relationship advantage.
Senator Reed . Thank you.
Thank you, Mr. Chairman.
Senator Faircloth. Thank you, Senator Reed.
I have two little wind-up questions. I assume the answers will
be pretty brief.
Mr. Warnement and Ms. Robbins, have you had to turn away
some customers because their relationship as a customer of the
bank would make it too burdensome to do business, I mean with
the Section 20? Have you had to turn away customers? Are you
aware of any problems this has created?
Ms. Robbins. I think there have been a number of situations
where the best solution to a customer’s problems would have in
volved a loan from the bank or some credit from the bank combined
with a capital markets transaction in the Section 20. And yes,
there have been times where we have had to say to a customer, we
can’t do it all for you.
Senator Faircloth. Mr. Warnement, has NationsBank had the
same problem?
Mr. W arnement. NationsBank has certainly had the same gen
eral experiences as J.P. Morgan.
I think further in this realm, that it can increase the cost to the
customer because the cost of doing due diligence at multiple insti
tutions is not insignificant. The sharing of information about one
overall transaction within one institution is more efficient and rep
resents a significant savings to those customers.
Furthermore, when you explore, as NationsBank is very big in,
small- and mid-sized corporate customers, they have probably
fewer options than some of the largest corporate customers in
America. They need access to relationships with financial institu
tions who are able to bring a full array of services efficiently to
them, as opposed to having to turn them away, saying, we would
love to do it. We are capable of doing it. We are just not allowed
to do it.
Therefore, we have to deliver the customer over to a competitor,
which, frankly, is usually lurking somewhere in the background,
ensuring that we are delivering adequate and fair pricing.
Senator Faircloth. Well, First Union said they appreciated the
customers.
[Laughter.]
Mr. W arnement. It’s one of the benefits of being headquartered
three or four blocks away.
[Laughter.]
Senator Faircloth. Thank you.
This is the last question and it is not exactly a question. But if
each of you would address it, I’ll start with Mr. Roberts.
Of course, all of you represent the Nation’s best in banks.
Wachovia is unquestioned in every way, maybe one of the better
banks in the country. All of you are. But what I’m asking you now
is a question that other Senators have requested that I ask.
42
I don’t think anyone is worried about J.P. Morgan or Nations
Bank or Wachovia. But all of you are aware of a much, much
smaller tier of banks. Is there a possibility that relaxing the fire
walls will invite and encourage people into this business who are
simply not up to the task and have the capability of handling all
of the things you have discussed here today? I think that it’s not
the top tier. What do you think of that?
Mr. R o b e r t s . Mr. Chairman, that is an excellent question be
cause it kind of hits at the very heart of some things with my own
company.
As you recall in my opening comments, I made the statement
that the firewalls heretofore have been a big impediment to us con
ducting business in an efficient manner and, therefore, we have not
done a Section 20.
Now, being quite truthful, intellectually honest—and I use the
word, encumbrances, coming down somewhat, the firewalls, or
being eliminated in many cases, of course. It has made it more pal
atable for Wachovia to enter into this. However, in making this de
cision, there is a tremendous amount of due diligence that one has
to go through. There is a tremendous cost still associated with set
ting up the infrastructure to make this work. Management cannot
lightly just decide to turn the switch on tomorrow morning and be
come a Section 20 and jump into the business.
The word infrastructure covers a tremendous amount of ground.
I am referring when I say that to the back office, the operating sys
tems, the computer systems, the resources that are needed that
must be in place, such as people with the right skill sets and tal
ents, and licensing as well. You also must have very thorough and
very clear controls and policies in place.
Now what’s the acid test in all of this? The acid test is when you
go for an infrastructure review. It is very detailed and very specific
and all of these elements must be in place before, even with the
lower firewalls being dissipated.
Senator F a i r c l o t h . Mr. Roberts, who would conduct the infra
structure review?
Mr. R o b e r t s . I will tell you, on our cells, we are, number one,
doing it, due diligence ourselves. Then hiring a third-party consult
ant to double-check us. And the final test is the regulatory Federal
Reserve System themselves.
Ms. R o b b in s . Yes. And then in addition, of course, because this
is a regulated subsidiary by the SEC and the NASD, you also have
reviews and have to meet their requirements for systems and infra
structure.
Senator F a i r c l o t h . Mr. Warnement.
Mr. W a r n e m e n t. I think that the protection of the overall Fed
eral safety net, as it regards thinking about smaller firms who are
not quite ready or who have different risk management philoso
phies, ultimately resides in the supervisory activities of both the
securities regulators who have jurisdiction over these firms, as well
as the Federal Reserve.
Frankly, if the firewalls are brought down, we expect to see even
more rigorous reviews of affiliate transactions than we faced in the
past, evidencing safety and soundness.
43
We spend a great deal of time focusing on affiliated transactions,
including some of the types that were described today, because we
know that: first, we don’t want to take undue risk that threatens
our institution; and second, we also know that our regulators are
going to look very carefully at those transactions.
Senator Faircloth. Thank you.
Mr. Calomiris.
Mr. Calomiris. I suppose the only thing that I thought of that
wasn’t said is that capital requirements are still being instituted.
Banks don’t have some sort of a carte blanche to establish these
affiliates whenever they want.
I would add to that, though, and this really isn’t just pertaining
to the Section 20 issue, that I think there are some issues, not just
having to do with Section 20 affiliates, but more broadly, about
whether FIRREA and the FDIC really finished the job of deposit
insurance reform, especially in a world of increasing complexity
and increasing opportunities for very rapid risk-taking.
Section 20 isn’t the place that I’m most worried about that. And
I’m not worried about it right now because the capital of our banks
is very large. But I see some potential problems down the road. So,
I would encourage you to think more broadly about revisiting the
safety net issue, which I know is on the front burner for the bank
ers’ roundtable. It is on the front burner for a lot of other organiza
tions, who want to have greater freedom and are worried about the
deposit insurance being used as an excuse not to give it to them.
But I think that provides us with an opportunity to improve the
safeguards for the taxpayers, too.
Senator Faircloth . Thank you.
I want to thank all of you for being here today. This is something
that is very much in the forefront of the thinking and the interest,
and especially as there’s been some concern, as you heard today,
maybe at some point of competitive position between the regu
lators, and that simply is going to have to be eliminated and ironed
out. We intend to see that it is.
As I say, as soon as we reconvene after the Easter recess, I ex
pect to have a hearing in which I intend to ask Comptroller of the
Currency Ludwig to appear and explain.
There isn’t anyone more interested than I am, and I think most
of the Members of the Subcommittee, to see needless regulations
and expensive regulations eliminated. We have done too much in
the past 40 years in the Federal Government of piling them on
without regard to the cost factor involved in regulations. And that
applies not only to banking. That is business in general.
So one place to start eliminating any possible rules and regula
tions would be in the banking industry, and I intend to move in
that direction.
I thank each of you for being here.
The Subcommittee is adjourned.
[Whereupon, at 12:38 p.m., the Subcommittee was adjourned.]
[Prepared statements, response to written questions, and addi
tional material submitted for the record follow:]
44
PREPARED STATEMENT OF SENATOR ALFONSE M. D’AMATO
Mr. Chairman, you are certainly to be commended for convening this hearing o f
the Subcommittee on Financial Institutions and Regulatory Relief; It is your first
as Chairman o f the Subcommittee and you have chosen an important subject—the
wisdom o f the proposal by the Federal Reserve to eliminate safeguards— so-called
“firewalls”— that it has developed and implemented as a condition o f allowing bank
holding companies to diversify into the securities business.
Mr. Chairman, I believe strongly in the need for “firewalls” and other safeguards
between an insured bank and its securities affiliates. Not only is the taxpayer who
ultimately stands behind FDIC insurance protected, but fair competition is also as
sured between Section 20 affiliates o f bank holding companies and other securities
and investment banking firms. To underscore the importance of firewalls as a core
element o f financial modernization, my proposal— S. 298—and virtually every other
legislative alternative introduced in the House or Senate over the past decade is
predicated upon effective firewalls and other safeguards to insulate the bank from
excessive risks.
Congress may be partially to blame for the Fed’s imprudent proposal concerning
firewalls as well as for the Comptroller of the Currency’s ill-advised proposal to
allow operating subsidiaries o f a bank to conduct “nonbanking” activities. I believe
both o f these actions are unwise. By our failure to act on a modernization proposal,
we have initiated an unwholesome rivalry between bank regulators.
Regulatory actions by the Fed and the OCC will never be a substitute for com
prehensive and balanced action by Congress to modernize our outdated laws. The
Fed’s action on firewalls— the focus o f your hearing today—demonstrates once again
why Congress must assert itself in this important area. If we do not, I am afraid
competition between the regulators will not produce a more competitive marketplace
or protect the American taxpayer from a repeat o f future financial crises similar to
the S&L’s in the late 1980’s.
Mr. Chairman, I join you in urging the Fed to reconsider its proposal to eliminate
the firewalls between commercial banks and their securities affiliates.
PREPARED STATEMENT OF SUSAN M. PHILLIPS
M em b er, B o a r d o f G o v e r n o r s o f t h e F e d e r a l R e s e r v e S y ste m
M a r c h 20, 1997
I am pleased to be here today to discuss the Board’s Section 20 firewalls— that
is, the restrictions the Board has imposed on bank holding companies engaged in
underwriting and dealing in securities. As the name suggests, the purpose o f fire
walls is to insulate a bank and its customers from the potential hazards o f combin
ing commercial and investment banking.
Since last year the Board has been engaged in a comprehensive review o f the 28
firewalls it erected in the late 1980’s, and the Board has recently proposed to elimi
nate a majority o f those restrictions. This oversight hearing provides a constructive
opportunity for comment and analysis o f the Board’s proposal. Furthermore, if
financial modernization is to move forward, the issue o f firewalls will have to be
confronted again. I hope that the Board’s review and the public comment process
can inform the legislative process as well.
Today, I would like to explain why the Board proposed changes to the firewalls.
I will also discuss the final changes the Board made last year to the revenue test
that the Board uses to determine compliance with Section 20 o f the Glass-Steagall
Act, and to firewalls regarding cross-marketing between a bank and a securities
affiliate, and officer, director and employee interlocks between two such companies.
The Firewalls in Context:
Independent Protections for Banks and Consumers
Before I begin this discussion, I think it is important to place the firewalls in their
historical and regulatory context. Although the firewalls have served an important
role, they are not the only protection against the hazards of affiliation o f commercial
and investment banks.
One important protection is the placement o f securities activities in a separate
subsidiary o f the bank holding company, rather than in the bank itself or a subsidi
ary o f the bank. Because nonbank subsidiaries o f a bank holding company operating
under Section 20 o f the Glass-Steagall Act are affiliates o f a bank, they are not
under the bank’s control, do not have their profits or losses consolidated with the
bank’s, and are less liable to have their creditors recover against the bank. A bank,
45
therefore, has less incentive to risk its own reputation or to expose itself or its
customers to loss in order to assist a troubled Section 20 affiliate or a failed under
writing by that affiliate.
Also, because securities activities are conducted in an affiliate, banks are limited
in their ability to fund those activities by Sections 23A and 23B o f the Federal Re
serve Act. These restrictions are vitally important. Section 2CA limits the total value
o f transactions with any one affiliate to 10 percent o f the bank’s capital and limits
transactions with all affiliates to 20 percent o f capital. It also requires that substan
tial collateral be pledged to the bank for any extension o f credit. Section 23B re
quires that inter-affiliate transactions be at arm’s length and on market terms, and
imposes other restrictions designed to limit conflicts o f interest.
Thus, affiliate status prevents the bank from passing along the Federal subsidy
inherent in the Federal safety net to its Section 20 affiliate by extending credit. The
regulators could conceivably limit a bank’s ability to use credit to subsidize a direct
securities subsidiary of the bank as well, by applying Sections 23A and 23B. But
the equity investment in the subsidiary would still be funded from subsidized re
sources backed by the Federal safety net. Even if the investment were deducted
from the capital o f the bank, the subsidy inherent in the transfer would remain.
A second protection is examination o f the bank holding company, including the
effect o f securities activities on insured depository institution subsidiaries. The Fed
eral Reserve as holding company regulator monitors compliance with Sections 23A
and 23B and other aspects o f the relationship between a bank and its Section 20
affiliate. In its supervision o f bank holding companies, the Board increasingly pays
attention to risk-management systems and policies that are centralized at the hold
ing company level and govern both the bank and its Section 20 affiliate.
A final series o f protections is the regulatory regime that applies to all brokerdealers, including Section 20 subsidiaries. The Securities Act o f 1933 and the Se
curities Exchange Act o f 1934 impose registration, capital and disclosure require
ments, anti-fraud protections, and other investor-protection measures. These laws,
and their enforcement by the Securities and Exchange Commission, address many
o f the safety and soundness and the conflict-of-interest concerns about affiliation o f
commercial and investment banks.
I note that most o f these important protections were not in place when the GlassSteagall Act passed in 1933. Thus, although proponents o f high firewalls frequently
cite the subtle hazards o f affiliation discussed in the legislative history o f that Act,
the regulatory environment was far different then. I believe that the drafters o f the
Glass-Steagall Act would have had a very different discussion— passed a very d if
ferent Act—had today’s statutory and regulatory protections been present in 1933.
Not only were these protections largely absent in 1933, some were not even pres
ent in 1987 when the Board first erected its firewalls. Section 23B o f the Federal
Reserve Act had not been adopted at the time o f the Board’s first Section 20 order
in 1987. As a result, many of the firewalls overlap the restrictions o f Section 23B,
which as I noted requires inter-affiliate transactions to be at arm’s length and on
market terms, but also prohibits a Section 20 affiliate from representing that an
affiliated bank is responsible for its obligations, and prohibits a bank from purchas
ing certain products from a Section 20 affiliate. Similarly, risk-based capital stand
ards did not exist in 1987, and those standards now require a bank to hold capital
against many o f the on- and off-balance-sheet exposures it maintains in conjunction
with a Section 20 affiliate. And finally, the Interagency Statement on Retail Sales
o f Nondeposit Investment Products was not adopted until 1994. The Interagency
Statement includes disclosure and other requirements that are now the primary
means by which the Federal banking agencies seek to ensure that retail customers
are not misled about the nature o f nondeposit products they are purchasing on bank
premises.
The Board’s Review
Thus, when the Board last year decided to re-examine the firewalls, we felt it im
portant to do so with a fresh eye, benefiting from our 10 years o f experience super
vising the Section 20 affiliates, acknowledging regulatory and legal developments
since 1987, and focusing on the relevance o f the firewalls in today’s financial mar
kets. As we began to look at the concerns the firewalls were designed to address,
we asked two questions. Does the affiliation o f a commercial and an investment
bank cause safety and soundness or other concerns not present with any other com
mercial bank affiliation— concerns not addressed by general bank holding company
regulation? Does operation o f a broker-dealer within a bank holding company cause
concerns that independent operation does not— concerns not addressed by brokerdealer regulation? In some areas— most notably, consumer protection— we believed
46
tha,t the answer was ‘‘yes.” In most other areas, however, the Board believed, at
least pending public comment, that the answer was “no.”
The answers to these questions are important because the firewalls are far from
costless. They impose operational inefficiencies on bank holding companies that in
crease their costs and reduce their competitiveness, and they limit a bank holding
company’s ability to market its products in a way that is both most profitable and
desired by its customers. As such, the firewalls have served as a significant barrier
to entry for small- and mid-size bank holding companies because those companies
cannot realize sufficient synergies or achieve adequate operating revenues to justify
establishing a Section 20 subsidiary. The loss is not just to these companies but also
to their customers and market competition.
Let me now discuss the most important o f the firewalls to which the Board has
proposed changes. The comment period closed on this proposal last week, and the
comments were overwhelmingly favorable. I will not discuss all 28 firewalls but
have attached a summary list and their proposed disposition.
Restrictions on Funding
The Board proposed to eliminate a series o f firewalls that constitute a blanket
prohibition on a bank’s funding its Section 20 affiliate, and to rely instead on the
protections of Sections 23A and 23B of the Federal Reserve Act. The firewalls in
question prohibit a bank from extending credit to a Section 20 affiliate, purchasing
corporate and other nongovernmental securities being underwritten by the Section
20 affiliate, or purchasing from the Section 20 affiliate such securities in which the
affiliate makes a market. These firewalls were intended to prevent a bank from as
sisting a troubled affiliate by lending to it on preferential terms or by bailing out
a failed underwriting by purchasing securities that cannot otherwise be sold.
Except for the prohibition on purchasing securities during this underwriting period, none of these funding firewalls was applied under the Board’s original 1987 order,
but were added in 1989 when the range of permissible securities activities was ex
panded. Bank subsidiaries o f the 14 companies operating under the 1987 order have
therefore been free to, and have in fact, funded their Section 20 affiliates subject
to Sections 23A and 23B. The Board has not encountered problems arising from
such funding.
If the Board were to eliminate the funding restrictions for the remaining Section
20 subsidiaries, Sections 23A and 23B would continue to impose quantitative and
qualitative restrictions on inter-affiliate transactions. In addition to requiring that
the transaction be on market terms, Section 23B specifically prohibits a bank from
purchasing any security for which a Section 20 affiliate is a principal underwriter
during the existence of the underwriting or selling syndicate, unless such a pur
chase has been approved by a majority o f the bank’s board of directors who are not
officers o f any bank or any affiliate. If the purchase is as fiduciary, the purchase
must be permitted by the instrument creating the fiduciary relationship, court
order, or State law. We believe these are substantial protections, and have proposed
to rely on them in place o f a firewall.
Prohibitions on a Bank Extending or Enhancing Credit in Support of
Underwriting or Dealing by a Section 20 Affiliate
Three o f the Board’s firewalls restrict the ability of a bank to assist a Section 20
affiliate indirectly, by enhancing the marketability o f its products or lending to its
customers. These firewalls prohibit a bank from extending credit or offering credit
enhancements in support o f corporate and other nongovernmental securities being
underwritten by its Section 20 affiliate or in which the Section 20 affiliate makes
a market; extending credit to issuers o f securities to repay principal or interest on
securities previously underwritten by a Section 20 affiliate; or extending credit to
customers to purchase securities currently being underwritten by a Section 20 affili
ate. The firewalls share a common purpose: to prevent a bank from imprudently
exposing itself to loss in order to benefit the underwriting or dealing activities o f
its affiliate.
However, as financial intermediation has evolved, corporate customers frequently
seek to obtain a variety o f funding mechanisms from one source. By prohibiting
banks from providing routine credit or credit enhancements in tandem with a Sec
tion 20 affiliate, these firewalls hamper the ability of bank holding companies to
serve as full-service financial services providers. The firewall thereby reduces op
tions for their customers. For example, existing corporate customers o f a bank may
wish to issue commercial paper or issue debt in some other form. Although the bank
may refer the customer to its Section 20 affiliate, the bank is prohibited from pro
viding credit enhancements even though it is the institution best suited to perform
a credit analysis— and, with smaller customers, perhaps the only institution willing
47
to do so. As another example, the restriction on lending for repayment o f securities
causes a bank compliance problems when renewing a company’s revolving line o f
credit if a Section 20 affiliate has underwritten an offering by that company since
the credit was first extended. The bank must either recruit other lenders to par
ticipate in the renewal or amend the line o f credit in order to specify that its pur
pose does not include repayment o f interest or principal on the newly underwritten
securities.
Notably, even if these firewalls were lifted, a bank would still be required to hold
capital against all credit enhancements and credit extended to customers o f its Sec
tion 20 affiliate. Section 23B o f the Federal Reserve Act would require that such
credit and credit enhancements be on an arm’s-length basis. Similarly, the Federal
anti-tying statute would prohibit a bank from offering discounted credit enhance
ments on the condition tnat an issuer obtain investment banking services from a
Section 20 affiliate. Thus, for example, a bank could not offer such credit enhance
ments below market prices, or to customers who were poor credit risks, in order to
generate underwriting business for a Section 20 affiliate.
The firewall prohibiting lending to retail customers for securities purchases dur
ing the underwriting period addresses one o f the most important potential conflicts
o f interests arising from the affiliation o f commercial and investment banking: the
possibility that a bank would extend credit at below-market rates in order to induce
consumers to purchase securities underwritten by its Section 20 affiliate. The con
cern here is not only safety and soundness but customer protection.
The Securities Exchange Act o f 1934 already prohibits a broker-dealer (including
a Section 20 affiliate) from extending or arranging for credit to its customers during
the underwriting period. Still, we recognize the Act would not apply in the absence
o f arranging and, unlike the firewall, would not cover loans to purchase a security
in which a Section 20 affiliate makes a market. Section 23B o f the Federal Reserve
Act, and to some extent Section 23A, would address some o f these remaining con
cerns, but perhaps not all. The Board will be reviewing the comments on this fire
wall carefully.
Capital Requirements
The next group o f firewalls that I will discuss imposes capital requirements on
a bank holding company and its Section 20 subsidiary. These firewalls require a
bank holding company to deduct from its capital any investment in a Section 20
subsidiary and most unsecured extensions o f credit to a Section 20 subsidiary en
gaged in debt and equity underwriting; they also require the Section 20 subsidiary
to maintain its own capital in keeping with industry norms. These requirements
apply only to Section 20 subsidiaries and not to any other nonbank subsidiary o f
a bank holding company.
The Board proposed to eliminate the capital deductions for investments in, or
credit extended to, a Section 20 subsidiary. The original purpose o f the deduction
was to ensure that the holding company maintained sufficient resources to support
its Federally-insured depository institutions. In practice, however, the deductions
have created regulatory burden without strengthening the capital levels o f the in
sured institutions.
The deduction is inconsistent with the Generally Accepted Accounting Practices,
which require consolidation o f subsidiaries for accounting purposes. The deduction,
therefore, has created confusion and imposed costs by requiring bank holding com
panies to prepare statements on two bases. The deduction does not strengthen the
capital o f either the bank or its Section 20 affiliate, and elimination o f the deduction
would not create or expose any incentive for a bank holding company to divert nec
essary capital from a depository institution to a Section 20 subsidiary. One o f the
purposes o f the system o f prompt corrective action adopted in 1992 is to ensure that
a bank holding company maintains the capital o f its subsidiary banks.
The Board also sought comment on whether it should continue to impose a special
capital requirement on Section 20 subsidiaries in addition to the SEC’s net capital
rules. The purpose o f this requirement was to prevent a Section 20 subsidiary from
being able to leverage itself more than, and gain a competitive advantage over, its
independent competitors by trading on the reputation o f its affiliated bank. Al
though the SEC imposes capital requirements on all broker-dealers, these are mini
mum levels that are far below the industry norm.
This capital firewall has proven confusing and controversial, as “industry norms”
are difficult to determine. Federal Reserve examiners have expected Section 20 sub
sidiaries to maintain capital to cover risk exposure in an amount approximately
twice what the SEC requires, but some Section 20 subsidiaries have complained
that this is more than their competitors maintain. They also argue that whereas
SEC capital requirements allow all capital to be concentrated in the broker-dealer
48
and dedicated to meeting capital requirements, a bank holding company must meet
capital requirements at the bank and holding company levels as well.
Indeed, bank holding company capital is measured on a consolidated basis, and
thus includes the capital and assets of the Section 20 subsidiary. Therefore, the
Board believes it may be unnecessary to impose a separate capital requirement on
the bank holding company’s Section 20 subsidiary.
Remaining Restrictions
Before leaving the Board’s proposal, I should also note which restrictions the
Board proposed to retain. The Board proposed to reserve its authority to reimpose
the funding, credit extension, and credit enhancement firewalls in the event that an
affiliated bank or thrift becomes less than well capitalized and the bank holding
company does not promptly restore it to the well-capitalized level. The Board consid
ered proposing to reimpose the firewalls on less than well capitalized banks auto
matically— as some recent bills introduced in the Congress would—but decided
against it because a decline in a bank’s capital ratios may be wholly unrelated to
the bank’s dealings with its Section 20 affiliate. Thus, for example, forcing a bank
suffering serious losses on real estate lending to desist from credit enhancements
may be unproductive or— if the business is profitable— counterproductive.
The Board also proposed to retain existing firewalls requiring adequate internal
controls and documentation, including a requirement that a bank exercise independ
ent and thorough credit judgment in any transaction involving an affiliate. Although
we expect banking organizations to have such internal controls and look for them
during examinations, we believe that they are sufficiently important to warrant re
inforcement through the operating standards. They are especially important in the
Section 20 context because o f the likelihood that a bank and its Section 20 affiliate
may be selling similar products to the same customer.
Because of the potential for customer confusion as to which products are Feder
ally-insured, the Board proposed to require a Section 20 affiliate to make disclosures
to customers similar to those that the Interagency Statement requires of a bank
selling nondeposit products on bank premises. The proposal would also continue to
prohibit an affiliated bank from knowingly advising a customer to purchase securi
ties underwritten or dealt in by a Section 20 affiliate unless it notifies the customer
o f its affiliate’s role. The proposal also continues to prohibit a bank and its Section
20 affiliate from sharing any nonpublic customer information without the customer’s
consent.
Earlier Board Action on Other Firewalls and the Revenue Limit
In addition to describing the Board’s recent proposal, you also asked me to discuss
other changes the Board finalized last year: increasing the Section 20 revenue limit
from 10 percent to 25 percent; allowing cross-marketing between a bank and a Sec
tion 20 affiliate; permitting employee interlocks between a bank and a Section 20
affiliate; and scaling back a restriction on officer and director interlocks.
The review that led to changes to the cross-marketing and interlocks firewalls was
akin to what the Board recently went through for all the firewalls. The Board acted
on these firewalls before the rest because it had previously sought comment on them
some years ago and because they were identified by commenters as among the most
unduly burdensome of all the firewalls. After reviewing its experience administering
these firewalls, the Board decided that they caused inefficiencies that could not be
justified by any benefit to safety and soundness, and commenters agreed
overwhelmingly. Repeal o f the interlocks and cross marketing restrictions allows in
creased synergies in the operation o f a Section 20 subsidiary and its bank affiliates.
Persons may be employed by both companies, and the trend toward coordinated
management o f like business functions can accelerate, with reporting lines running
between companies. Companies need not fund dual back offices or trading floors, for
example. To the extent that senior bank managers may now oversee related oper
ations at a Section 20 affiliate, risk management and safety and soundness may be
improved.
Moreover, existing disclosure requirements adequately address concerns about
customer confusion arising from increased cross-marketing and employee interlocks.
Most notably, the Interagency Statement on Retail Sales o f Nondeposit Products
states that, prior to the initial sale o f a nondeposit product by a bank employee or
on bank premises, the customer must receive and acknowledge a written statement
that the product being sold is not Federally-insured, is not a deposit or other obliga
tion o f the bank, is not guaranteed by the bank, and is subject to investment risks
including loss of principal.
Finally, with regard to the revenue limit, Section 20 of the Glass-Steagall Act
prohibits a bank from being affiliated with any company “engaged principally” in
49
underwriting and dealing, and the Board was obliged to make a narrow, legal deter
mination o f the level o f revenue at which a company becomes “engaged principally.”
The Board interpreted the statute to allow 25 percent o f total revenue to be derived
from underwriting and dealing in bank-ineligible securities. In reviewing the reve
nue limit, the Board was not deciding what level o f underwriting and dealing was
consistent with safety and soundness or public policy. If it were, the Board may well
have raised the limit to 100 percent, which would have been consistent with the
Board’s support of repeal o f Section 20.
I am pleased to report that early indications o f the effects o f these changes have
been favorable. The Board currently has pending three applications to establish a
Section 20 subsidiary. As we had anticipated, two o f these are small- to mid-size
bank holding companies which may previously have either found it too expensive
to fund the dual staffing required by the interlocks restrictions or too difficult to
generate sufficient eligible revenue to maintain compliance with a 10 percent reve
nue limit. Furthermore, existing Section 20 subsidiaries have indicated that they
have been able to rationalize their organization and expand their activities given
the added flexibility with respect to both staffing and revenue.
SUMMARY OF THE FEDERAL RESERVE BOARD’S
EXISTING AND PROPOSED SECURITIES FIREWALLS
General Provision
The Board’s proposal retains the authority o f the Board to reimpose these restric
tions on banks that are not well capitalized, but does not do so automatically. For
example, the Board could restrict an undercapitalized bank from credit enhancing
securities underwritten by a securities affiliate if such funding had caused a deple
tion o f capital at the bank, but could allow such credit enhancements to continue
if they were profitable (and the bank’s troubles were due to, for example, real estate
lending and/or a regional economic downturn).
Firewall-by-Firewall Comparison
/. Capital Adequacy Conditions
F i r e w a l l 1(a)— D e d u c t i o n o f I n v e s t m e n t in S u b s i d i a r y f r o m
B a n k H o ld in g C om pany C a p ita l
Existing Firewall. A bank holding company must deduct from its regulatory cap
ital any investment it makes in the Section 20 subsidiary that is treated as capital
in the Section 20 subsidiary.
Board's Proposal. The Board proposed to eliminate this restriction. The deconsoli
dation requirement is inconsistent with GAAP and has therefore created confusion
and imposed costs by requiring bank holding companies to prepare statements on
two bases. Meanwhile, the deduction does not strengthen the capital o f any insured
depository institution affiliate of the Section 20 subsidiary or the Section 20 subsidi
ary itself, which is already subject to SEC-imposed capital requirements. Elimi
nation o f the deduction would not create or expose any incentive for a bank holding
company to take capital necessary to support a depository institution and reinvest
it in a Section 20 subsidiary. Finally, the Board has recently adopted a system for
analyzing market risk that will better measure the capital adequacy o f a banking
organization.
F i r e w a l l 1(b)— D e d u c t i o n o f E x t e n s i o n s o f C r e d i t f r o m
H o ld in g C om pany C a p ita l
Existing Firewall. A bank holding company must deduct from its regulatory cap
ital any credit it or a nonbank subsidiary extends directly or indirectly to the Sec
tion 20 subsidiary unless the extension o f credit is fully secured by U.S. Treasury
securities or other marketable securities and is collateralized in the same manner
and to the same extent as would be required under Section 23A(c) o f the Federal
Reserve Act if the extension o f credit were made by a member bank.
Board's Proposal. The Board proposed to eliminate the deduction required by this
firewall for the same reasons as Firewall 1(a), but retain the requirement that a
bank holding company maintain adequate capital on a fully consolidated basis as
a condition for operating a Section 20 subsidiary.
F i r e w a l l 2— P r i o r A p p r o v a l R e q u i r e m e n t f o r I n v e s t m e n t s in S u b s i d i a r y
Existing Firewall. Neither a bank holding company nor its nonbank subsidiaries
may provide capital, credit, or any other funds to a Section 20 subsidiary without
prior notice to and approval by the Board.
Board Action. The Board has repealed this restriction.
50
F ir e w a ll 3 — R e q u ire m e n t
of
C a p ita l P la n
Existing Firewall. Before commencing bank-ineligible securities activities, each
bank holding company must submit to the Board acceptable plans to raise addi
tional capital or demonstrate that it is strongly capitalized and will remain so after
making the capital adjustments authorized or required by this Order.
Board’s Proposal. The Board proposes to eliminate this firewall as superfluous,
since the Board fully analyzes each application, including available capital.
F i r e w a l l 4 — C a p it a l A d e q u a c y R e q u ir e m e n t
Existing Firewall. The underwriting subsidiary shall maintain at all times capital
adequate to support its activity and cover reasonably expected expenses and losses
in accordance with industry norms.
Board’s Proposal. The Board sought comment on whether to retain this firewall,
which has been understood to require Section 20 subsidiaries to maintain capital
levels consistent with industry norms for independent investment banks. The pur
pose o f this capital requirement was to prevent a Section 20 subsidiary from operat
ing below industry capital standards by trading on the reputation o f its affiliated
bank. The requirement thus seeks to prevent Section 20 subsidiaries from being
able to leverage themselves more than, and gain a competitive advantage over, their
independent competitors and to serve as a buffer to protect the affiliated bank. How
ever, the restriction has proven confusing and controversial, as “industry norms” are
difficult to determine.
II. Credit Extensions to Customers o f the Underwriting Subsidiary
F ir e w a ll 5— R e s t r ic t io n o n C r e d it E n h a n cem en t
Existing Firewall. No bank holding company or its subsidiary shall extend credit,
issue, or enter into a stand-by letter o f credit, asset purchase agreement, indemnity,
guarantee, insurance, or other facility that might be viewed as enhancing the credit
worthiness or marketability o f an ineligible securities issue underwritten or distrib
uted by the underwriting subsidiary.
Board’s Proposal. The Board proposed to eliminate the credit enhancement fire
wall, as other protections (capital requirements that now include off-balance-sheet
obligations, loan-to-one-borrower restrictions, internal controls, the “arms-length”
requirement o f Section 23B) adequately serve its purposes, and its burden on Sec
tion 20 subsidiaries and their customers therefore cannot be justified. A require
ment for internal controls relating to such credits is retained.
F i r e w a l l 6 — R e s t r i c t i o n o n F u n d in g P u r c h a s e s o f S e c u r it ie s
Existing Firewall. No bank holding company or subsidiary (other than the under
writing subsidiary) shall knowingly extend credit to a customer in order to purchase
an ineligible security that an affiliated underwriting subsidiary underwrites during
the period o f the underwriting or for 30 days thereafter, or to purchase from the
underwriting subsidiary any ineligible security in which the underwriting subsidi
ary makes a market.
Board’s Proposal. The Board sought comment on whether to retain this firewall,
noting its importance but asking whether its concerns are adequately addressed by
Section 11(d) o f the Securities Exchange Act of 1934 and Section 23B o f the Federal
Reserve Act.
F i r e w a l l 7— R e s t r i c t i o n o n E x t e n s i o n s o f C r e d i t f o r R e p a y m e n t o f
U n d e r w r it t e n S e c u r it ie s
Existing Firewall. N o b a n k h o ld in g co m p a n y o r a n y o f its s u b s id ia r ie s m a y ex ten d
c r e d it to is s u e r s o f t h e in e lig ib le s e c u r itie s u n d e r w r itte n b y a S e c tio n 2 0 a ffilia te fo r
th e p u r p o s e o f t h e p a y m e n t o f p rin cip a l, in te re st, o r d iv id e n d s o n s u c h se cu ritie s .
E x ce p tio n i f s u b s t a n t ia l p a r tic ip a tio n b y o th e r le n d e r s o r i f te r m s o f lo a n m a k e c le a r
it h a s a n o th e r p u r p o s e .
Board’s Proposal. The Board proposed to eliminate this restriction. The firewall
has proven burdensome and has had unintended effects. For example, banks face
compliance problems renewing a company's revolving line o f credit i f a Section 20
subsidiary has underwritten an offering by that company since the credit was first
extended; the bank must either recruit other lenders to participate in the renewal
or amend the line o f credit in order to specify its purpose. In addition, Section 23B
o f the Federal Reserve Act would generally apply to extensions o f credit for the pur
pose o f payment o f principal, interest, or dividends that are currently covered by
Firewall 7. A requirement for internal controls relating to such credits is retained.
51
F i r e w a l l 8— P r o c e d u r e s f o r C o m p ly in g w it h R e s t r ic t io n o r
E x te n s io n s o f C r e d it
Existing Firewall. Each bank holding company shall adopt appropriate proce
dures, including maintenance o f necessary documentary records, to assure that any
extension of credit by it or any o f its subsidiaries to issuers o f ineligible securities
underwritten or dealt in by an underwriting subsidiary are on an arm’s length basis
for purposes other than payment o f principal, interest, or dividends on the issuer’s
ineligible securities being underwritten or dealt in by the underwriting subsidiary.
Board’s Proposal. The Board proposed to eliminate this firewall. Section 23B,
enacted since this firewall was initially adopted, requires extensions o f credit by a
bank in conjunction with an issuance o f securities underwritten by a Section 20 af
filiate to be on arm’s-length terms.
F ir e w a ll 9 — R e s tr ic tio n o n T h r ift s
Existing Firewall. In a n y tr a n s a c tio n in v o lv in g a n u n d e r w r itin g s u b s id ia r y , A p p li
c a n ts ’ th r ift su b sid ia rie s sh a ll o b s e r v e t h e lim it a t io n s o f S e c tio n s 23A an d 23B o f
t h e F e d e r a l R e se rv e A c t a s i f th e th r ift s w e r e b a n k s.
Board’s Proposal. This condition became superfluous when the Home Owners’
Loan Act was amended to apply Sections 23A and 23B o f the Federal Reserve Act
.to a thrift as if were a member bank. The Board proposed to eliminate it.
F i r e w a l l 10— R e s t r i c t i o n o n I n d u s t r i a l R e v e n u e B o n d s
Existing Firewall. The requirements relating to credit extensions to issuers noted
in paragraphs 5 -9 above shall also apply to extensions o f credit to parties that are
major users o f projects that are financed by industrial revenue bonds.
Board’s Proposal. As the Board is proposing to eliminate the incorporated restric
tions, the. Board is proposing to eliminate this restriction as well.
F i r e w a l l 11—-L o a n D o c u m e n t a t i o n a n d E x p o s u r e L im it s
Existing Firewall. Bank holding companies shall cause their subsidiary banks and
thrifts to adopt policies and procedures, including appropriate limits on exposure,
to govern their participation in financing transactions underwritten or arranged by
an underwriting subsidiary as set forth in this Order. The Reserve Banks shall en
sure that these policies and procedures are in place at Applicants’ subsidiary banks
and thrifts and Applicants shall assure that loan documentation is available for
review by Reserve Banks to ensure that an independent and thorough credit evalua
tion has been undertaken in connection with bank or thrift participation in such fi
nancing packages and that such lending complies with the requirements o f this
Order and Section 23B o f the Federal Reserve Act.
Board’s Proposal. The Reserve Board proposed to retain this restriction in slightly
amended form.
F i r e w a l l 12— P r o c e d u r e s f o r L i m i t i n g E x p o s u r e t o O n e C u s t o m e r
Existing Firewall. Bank holding companies should establish appropriate policies,
procedures, and limitations regarding exposure o f the holding company on a consoli
dated basis to any single customer whose securities are underwritten or dealt in by
the underwriting subsidiary.
Board’s Proposal. The Board is seeking comment on whether to include this re
striction in its operating standards for Section 20 subsidiaries. The firewall restricts
the ability of a holding company to expose itself to one issuer in support o f its Sec
tion 20 subsidiary. However, the need for internal limits and the appropriate sophis
tication o f those limits varies greatly from company to company, and might be better
addressed through the examination process.
III. Limitations to Maintain Separateness o f an Underwriting
Affiliate’s Activity
F i r e w a l l 13— I n t e r l o c k s R e s t r i c t i o n
Existing Firewall (as amended).1 Directors, officers, or employees o f a bank or
thrift shall not serve as a majority o f the board o f directors or the chief executive
officer o f an affiliated Section 20 subsidiary, and directors, officers, or employees o f
a Section 20 subsidiary shall not serve as a majority o f the board o f directors or
the chief executive officer o f an affiliated bank or thrift. The underwriting subsidi
ary will have separate offices from any affiliated bank or thrift.
Board’s Proposal. The Board recently amended the restriction on interlocks, and
did not propose further changes to that restriction. The Board did propose to elimi
*61 FR 57679, 57683 (1996).
52
nate the separate office requirement, relying on the Interagency Statement on Re
tail Sales of Nondeposit Investment Products.
IV. D isclo su re by th e U n d erw ritin g S u bsidiary
F ir e w a ll 14— C u s to m e r D is c lo s u r e s
Existing Firewall. A S e c tio n 20 s u b s id ia r y w ill p ro v id e each o f its c u s t o m e r s w ith
a sp e cia l d is c lo s u r e s t a t e m e n t d e s c rib in g th e d iffe re n ce b e tw e e n th e u n d e r w r it in g
su b sid ia r y a n d its b a n k a n d t h r ift a ffilia te s an d p o in tin g ou t th a t a n a ffilia te d b a n k
o r th r ift co u ld b e a le n d e r to a n is s u e r an d r e fe r rin g the c u s to m e r to th e d is c lo s u r e
d o cu m e n ts fo r d e ta ils . In a d d itio n , th e s ta te m e n t sh all state th a t s e c u r itie s so ld ,
offe re d , o r r e c o m m e n d e d b y th e u n d e r w r itin g su b sid ia ry are n o t d e p o s its , a r e n ot
in s u re d b y th e F e d e r a l D e p o s it I n s u r a n c e C o rp o ra tio n , are not g u a ra n te e d b y a n a f
filia te d b a n k o r th r ift, a n d a r e n o t o th e r w is e an o b lig a tion or r e s p o n s ib ility o f su ch
a b a n k o r th r ift (u n le s s s u ch is th e ca se). T h e u n d e rw ritin g su b s id ia r y s h o u ld a lso
d isclo s e a n y m a te r ia l le n d in g r e la tio n s h ip b e tw e e n the issu er a n d a b a n k o r le n d in g
a ffilia te o f t h e u n d e r w r it in g su b s id ia r y a s re q u ire d u n d e r th e s e c u r itie s la w s an d
in e v e r y ca se w h e th e r th e p r o c e e d s o f th e issu e w ill b e u sed to r e p a y o u ts ta n d in g
in d e b te d n e ss to a ffilia te s .
Board’s Proposal. The Board proposed to amend the disclosure firewall to follow
the Interagency Statement on Retail Sales of Nondeposit Investment Products that
applies to sales by bank employees or on bank premises. A Section 20 subsidiary
would be required to provide each o f its retail customers the same disclosures that
the Interagency Statement mandates for retail customers of banks, even when it
was operating off bank premises. This would narrow the firewall by no longer re
quiring disclosures to institutional customers (who should be aware o f whether a
product is Federally-insured or bank guaranteed) but broaden the firewall to require
an acknowledgement of the disclosure by retail customers.
V. M a rk etin g A c tiv itie s o n B e h a lf o f an U n d erw ritin g S u bsid iary
F i r e w a l l 15— R e s t r i c t i o n o n A d v e r t i s i n g B a n k C o n n e c t i o n
Existing Firewall. Prohibits a Section 20 or any other affiliate from suggesting
that an affiliated bank or thrift is responsible in any way for the underwriting sub
sidiary’s obligations.
Board’s Proposal. This restriction has been superseded by Section 23B(c) o f the
Federal Reserve Act, and the Board proposed to eliminate it.
F i r e w a l l 1 6 — C r o s s - M a r k e t i n g a n d A g e n c y A c t i v i t i e s by B a n k s
Existing Firewall. A lr e a d y d e le te d .2
VI. In v estm en t A d v ic e by B ank/T hrift A ffilia te s
F i r e w a l l 17— I n v e s t m e n t A d v i c e
Existing Firewall. An affiliated bank may not express an opinion on the value or
the advisability o f the purchase or the sale o f ineligible securities underwritten or
dealt in by a Section 20 affiliate unless the bank or thrift notifies the customer that
the underwriting subsidiary is underwriting, making a market, distributing or deal
ing in the security.
Board’s Proposal. The Board proposed to retain this restriction.
F i r e w a l l 1 8 — R e s t r i c t i o n o n F i d u c i a r y P u r c h a s e s D u r in g
U n d e r w r it in g P e r io d o r fr o m M a r k e t M a k e r
Existing Firewall. No bank holding company or its bank subsidiaries shall pur
chase, as a trustee or in any other fiduciary capacity, for accounts over which they
have investment discretion ineligible securities: (a) underwritten by the underwrit
ing subsidiary as lead underwriter or syndicate member during the period o f any
underwriting or selling syndicate, and for a period of 60 days after the termination
thereof; and, (b) from the underwriting subsidiary if it makes a market in that
security, unless, in either case, such purchase is specifically authorized under the
instrument creating the fiduciary relationship, by court order, or by the law o f the
jurisdiction under which the trust is administered.
Board’s Proposal. The Board proposed to eliminate this restriction, which is now
largely duplicated by Section 23B(b)(l)(B) o f the Federal Reserve Act.
2 61 FR 57679, 57683 (1996).
53
VII. E xten sion s o f C red it an d P u rc h a se s a n d S a les o f A ssets
F i r e w a l l 19— R e s t r i c t i o n s o n P u r c h a s e s a s P r i n c i p a l D u r i n g
U n d e r w r it in g P e r io d o r fr o m M a r k e t M a k e r
Existing Firewall (as amended). No bank holding company or its subsidiaries shall
purchase, as principal, ineligible securities that are underwritten by a Section 20
affiliate during the period of the underwriting and for 60 days after the close of the
underwriting period, or shall purchase from the underwriting subsidiary any ineli
gible security in which the underwriting subsidiary makes a market.
Board's Proposal. The Board proposed to eliminate this restriction, which pre
cludes bank and nonbank subsidiaries o f a bank holding company subsidiary from
obtaining attractive issues underwritten or dealt in by a Section 20 affiliate. As with
Firewall 18, Section 23B prohibits a bank from purchasing, as principal or fiduciary,
any security for which a Section 20 affiliate is a principal underwriter during the
existence o f the underwriting or selling syndicate, unless such a purchase has been
approved by a majority of the bank’s board o f directors who are not officers o f the
bank or any affiliate.
F i r e w a l l 20— R e s t r i c t i o n o n U n d e r w r i t i n g a n d D e a l i n g in
A f f i l i a t e s ’ S e c u r itie s
Existing Firewall (as amended).3 A Section 20 subsidiary may not underwrite or
deal in any ineligible securities issued by its affiliates or representing interest in,
or secured by, obligations originated or sponsored by its affiliates. (There are a few
exceptions for rated securities and GSE securities.)
Board’s Proposal. The Board proposed to eliminate this restriction, which pro
hibits a Section 20 affiliate from underwriting securities issued by an affiliated
bank. Rule 2720 of the National Association o f Securities Dealers already imposes
substantially the same restriction.
F i r e w a l l 21(a)— P r o h i b i t i o n o n E x t e n s i o n s o f C r e d i t t o
S e c t i o n 20 S u b s id ia r y
Existing Firewall. Bank holding companies shall ensure that no bank subsidiary
extends credit to a Section 20 affiliate, or issues a guarantee, acceptance, or letter
of credit, including an endorsement or standby letter o f credit, for the benefit o f the
Section 20 affiliate.
Board’s Proposal. The Board proposed to eliminate this restriction except insofar
as it applies to intra-day extensions o f credit for clearing purposes. Because this
firewall was not applied under the 1987 Order, bank subsidiaries o f the 14 compa
nies operating under that order have therefore been free to, and have in fact, funded
their Section 20 affiliates. In 9 years o f supervising companies operating under the
1987 Order, the Board has not encountered significant problems arising from such
funding. Such transactions are also subject to Sections 23A or 23B o f the Federal
Reserve Act, which address potential conflicts o f interest.
F i r e w a l l 21(b)
Existing Firewall. [This firewall is an exception to Firewall 21(a) for clearing.]
Board’s Proposal. The Board proposed to eliminate Firewall 21(b).
F i r e w a l l 22— F in a n c ia l A s s e t s R e s t r i c t i o n
Existing Firewall (as amended).4 A bank may not, for its own account, purchase
financial assets of an affiliated underwriting subsidiary or a subsidiary thereof or
sell such assets to the underwriting subsidiary or subsidiary thereof. This limitation
shall not apply to the purchase and sale o f assets having a readily identifiable and
publicly available market quotation and purchased at that market quotation, pro
vided that they are not part of a repurchase or reverse repurchase agreement.
Board’s Proposal. The Board proposed to eliminate this firewall. Section 23B o f
the Federal Reserve Act would still require that all such purchases be made on
arm’s-length terms, and Section 23A would impose quantitative limits. Moreover,
the National Bank Act limits the type o f investment securities that a national bank
may hold, generally to investment grade securities. Elimination o f this restriction
would allow repurchase and reverse repurchase agreements as a funding vehicle be
tween a Section 20 subsidiary and its affiliated banks.
3 75 Federal Reserve Bulletin 751 (1989).
4 61 FR 57679, 57683 (1996).
54
VIII. L im ita tion s o n T ra n sfers o f In form a tion
F ir e w a ll 23— D is c lo s u r e o f N o n p u b lic I n fo r m a tio n
Existing Firewall. N o b a n k o r th r ift sh a ll d isclo s e to an u n d e r w r it in g su b s id ia r y ,
n o r sh a ll a n u n d e r w r it in g s u b s id ia r y d isclo s e to a n a ffilia ted b a n k o r th r ift, a n y
n o n p u b lic c u s t o m e r in fo r m a tio n (in clu d in g a n e v a lu a tion o f th e c r e d it w o r t h in e s s o f
a n is s u e r o r o t h e r c u s t o m e r o f t h a t b a n k o r th rift, o r u n d e r w r itin g s u b s id ia r y ) w it h
o u t th e c o n s e n t o f th a t c u sto m e r .
Board's Proposal. The Board proposes to include this restriction in its operating
standards, as it constitutes an important customer protection.
IX . R ep orts
F ir e w a ll 24— R e p o rts t o F e d e r a l R e se rv e
Existing Firewall. B a n k h o ld in g co m p a n ie s sh all su b m it q u a r te r ly r e p o r t s to th e
F e d e r a l R e s e r v e , th e NASD, a n d o th e r s e lf-re g u la to ry o r g a n iz a tion s.
Board's Proposal. The Board proposed to retain this requirement.
X . T ra n sfer o f A c tiv itie s a n d F orm a tion o f S u bsid iaries o f a n U n d erw ritin g
S u bsid iary to E n g a g e in U n d erw ritin g an d D ea lin g
F i r e w a l l 2 5— S c o p e
of
Order
Existing Firewall. The Board’s approval extends only to the subsidiaries described
above for which approval has been sought in the instant applications.
Board's Proposal. The Board proposes to eliminate this firewall. Each order ap
proving Section 20 activities can make plain the scope and organizational structure
of the activities approved.
XI. L im ita tio n s o n R e c ip r o c a l A rra n g em en ts an d D iscrim in a to ry T rea tm en t
F ir e w a ll 2 6 — P r o h ib it io n o n R e c ip r o c ity A rra n g e m e n ts
Existing Firewall. N o A p p lic a n t n o r a n y o f its su b sid ia ries m a y , d ir e c t ly o r in d i
r ectly , e n te r in to a n y r e c ip r o c a l a rra n g e m e n t. A recip roca l a r r a n g e m e n t m e a n s a n y
a g r e e m e n t, u n d e r s ta n d in g , o r o th e r a r r a n g e m e n t u n d er w h ic h o n e b a n k h o ld in g
c o m p a n y (o r su b s id ia r y t h e r e o f) a g r e e s to e n g a g e in a tra n sa c tio n w ith , o r on b e h a lf
of, a n o th e r b a n k h o ld in g c o m p a n y (o r su b sid ia r y th e r e o f), in e x c h a n g e fo r th e a g r e e
m e n t o f th e se c o n d b a n k h o ld in g co m p a n y (o r a n y su b sid ia ry t h e r e o f) to e n g a g e in
a tra n sa c tio n w ith , o r o n b e h a l f of, th e first b a n k h o ld in g c o m p a n y (o r a n y s u b s id i
a ry t h e r e o f) fo r th e p u r p o s e o f e v a d in g a n y re q u ire m e n t o f th is O r d e r o r a n y p r o h i
b itio n on tr a n s a c tio n s b e t w e e n , o r fo r th e b e n e fit of, a ffilia tes o f b a n k s e s ta b lis h e d
p u r s u a n t to F e d e r a l b a n k in g la w o r re g u la tio n .
Board's Proposal. The Board proposed to eliminate this firewall. Anticompetitive
reciprocity arrangements are prohibited by the antitrust laws, and reciprocity ar
rangements involving a bank are subject to a special per se prohibition in Section
106 o f the Bank Holding Company Act Amendments of 1970. The Board could also
rely on the examination process to identify any evasions o f the proposed operating
standards that do not run afoul o f a statutory prohibition.
F i r e w a l l 27— P r o h i b i t i o n o n D i s c r i m i n a t o r y T r e a t m e n t
Existing Firewall. No bank or thrift affiliate o f an underwriting subsidiary shall,
directly or indirectly: (a) extend or deny credit or services if the effect o f such action
would be to treat an unaffiliated securities firm less favorably than its affiliated
underwriting subsidiary; or (b) extend or deny credit or services with the intent o f
creating a competitive advantage for a Section 20 affiliate.
Board's Proposal. The Board proposed to eliminate the firewall because other laws
adequately address the potential conflict. Whereas securities firms had been re
stricted by Section 8(a) o f the Securities Exchange Act of 1934 in the types o f lend
ers from which they could obtain loans secured by securities collateral— generally,
to banks and other broker-dealers— Section 8(a) was recently repealed, and such
restriction thereby eliminated.
XII. R e q u ire m e n t f o r S u p erv isory R eview B e fo re C om m en cem en t o f A c tiv itie s
F i r e w a l l 2 8 — I n f r a s t r u c t u r e R e v ie w
Existing Firewall. An Applicant may not commence the proposed debt and equity
securities underwriting and dealing activities until the Board has determined that
the Applicant has established policies and procedures to ensure compliance with the
requirements o f this Order.
Board's Proposal. The Board proposed to continue to require an infrastructure re
view in the context o f each application rather than including it as an “operating
standard” for Section 20 subsidiaries.
55
PREPARED STATEMENT OF VICTOR A. WARNEMENT
G e n er al C o u n se l
N a t io n s B a n c C a p ita l M a r k e t s , I n c ., S u b s id ia r y
of
N a t io n s B a n k C or p o r a tio n
M a r c h 20, 1997
Mr. Chairman and Members o f the Subcommittee, I welcome this opportunity to
offer my views on the Federal Reserve Board’s proposed modifications to the fire
walls applicable to “Section 20 subsidiaries” o f bank holding companies. I commend
the Subcommittee for holding this oversight hearing and its interest in understand
ing more about the Fed’s proposals to generally reduce the regulatory burdens cur
rently imposed on Section 20 companies.
As General Counsel to NationsBanc Capital Markets, Inc., one o f the largest and
most active Section 20 companies in the country and a subsidiary o f NationsBank
Corporation, the fourth largest bank holding company in the United States, and
given my prior outside law firm experience in representing numerous issuers and
investment banks in various securities transactions, I believe I can provide some
insights with respect to these proposed modifications from both a regulatory and
business perspective.
In my testimony here today, I will first provide some background perspective and
thoughts about the Fed’s proposed changes. I will then provide a brief overview of
the proposals. And finally, I will respond to the six points raised in Senator Faircloth’s March 11th letter requesting my testimony.
As the financial services industry has grown and changed at an accelerating pace
over the past several decades, driven over the past 10 or so years by dynamic mar
ket forces and technological change, our Nation’s bank holding companies have be
come more and more constrained by what in many respects has become an anti
quated legal and regulatory framework. The American economy, our industries, our
consumers, and our communities will gain from the kinds o f reforms and modifica
tions initiated by the Federal Reserve Board over the past several months to permit
bank holding companies to deliver efficiently more competitive products and services
to their customers. This is a primary goal o f the Federal Reserve which the industry
applauds. There is little doubt that the additional cost, expense, and inefficiency as
sociated with compliance within the existing constraints, which are not applicable
to nonbank securities firms, realistically prevents or inhibits Section 20 companies
ultimately from being able to provide better pricing for their products and services.
The Federal Reserve Board’s recent and proposed changes, and additional changes
that we at NationsBank and others throughout the industry believe are both ration
al and prudent, will allow Section 20 companies to operate and compete more effi
ciently and effectively. This in turn will ultimately work to the benefit o f both retail
and institutional customers o f all types through increased competition, lower costs,
increased access to financial products and services, and improved service and con
tinuing innovation, all o f which will aid in our country’s economic growth.
It is undeniably in the public interest to allow bank holding companies to compete
on a level playing field with their nonbank financial service industry competitors.
Those competitors have made great inroads into areas where customers would have
in the past sought out traditional bank services, either by entering directly into
competitive activities (such as the syndicated loan business for large corporate cus
tomers) or by engineering and developing substitute products and markets.
The time for these changes has clearly come, and many believe they could have
prudently been made several years ago. Clearly, advances in communications and
technology continue to increase competition in the financial services industry, both
domestically and internationally. The continuing strength, vitality, and potentially,
the long-term viability o f our Nation’s banking system depends on the avoidance or
elimination o f govemmentally-imposed burdens that impede competition and create
or foster inefficiencies that serve no strong public policy purpose. If our bank hold
ing companies are to continue to serve the public, play a vital role in our Nation’s
economy, compete here and around the world in this rapidly changing environment,
their management must have the ability to meet competition and to adapt their
unique businesses to their selected markets. These businesses should not continue
to be constrained by firewalls that have been rendered obsolete by real world experi
ence and developments, or by constraints that have become generally redundant due
to the existence of other laws or regulatory schemes.
The long-term vitality and vibrancy of our Nation’s banking system necessitates
flexibility to adapt to the marketplace. If bank holding companies, in part through
their Section 20 company activities, remain highly profitable, then they remain a
better “source of strength” for their subsidiary banks. Appropriate, but not overly
burdensome supervision and regulation and the flexibility to move the business into
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new or growing areas o f the financial services industry provides the greatest oppor
tunity to maintain a safe and sound, yet strong and vibrant banking system within
our country.
Since 1987, the Fed has permitted various bank holding companies to establish
Section 20 companies to engage in underwriting and dealing in certain securities
not eligible for underwriting and dealing by a bank which is a member o f the Fed
eral Reserve System. In 1989, as it gained experience, the Fed began to allow Sec
tion 20 companies to underwrite and deal in all types of debt and equity securities.
Since then, the Fed has imposed a series of prudential restrictions, commonly
known as firewalls, as a condition to establishing a Section 20 company. These fire
walls were intended to isolate the Section 20 companies from affiliated depository
institutions and to prevent the risks perceived to be associated with such securities
activities from adversely impacting an affiliated insured depository institution or its
bank holding company and, consequently, to the Federal safety net which supports
such institutions. Further, the firewalls were created to mitigate potential conflicts
of interest, unfair competition, and other adverse effects thought to be associated
with such activities.
The Fed has acknowledged that the existing firewalls are a conservative set of
rules. However, many of us who live and breath daily in the interplay among these
and other overlapping regulatory constraints and the realities o f running successful
businesses competing with firms not similarly constrained believe the current fire
walls are extremely conservative. While accomplishing their original purpose o f iso
lating a Section 20 company from most of its affiliates, the firewalls have impeded
dramatically the synergies and efficiencies that bank holding companies should gain
from operating permissible investment banking and capital markets businesses.
Originally, the Fed’s approach was an understandable regulatory approach given
the Fed’s unfamiliarity with these securities activities and the supervision o f invest
ment banking operations, its perception that there were or might be substantial
unknown risks associated with these activities in a bank holding company and the
Fed’s concern over how existing broker-dealer securities regulation would overlap
with broker-dealer subsidiaries of a bank holding company.
The Fed has been very active in supervising and monitoring the Section 20 activi
ties o f bank holding companies. NationsBank, along with all other bank holding
companies, undergo significant periodic examinations by the staffs o f the applicable
Federal Reserve Banks. These examinations are in addition to the frequent contact
many o f us in the industry have with our Federal Reserve examiners or the staff
of the Federal Reserve Board to ensure our compliance with these firewalls. All of
this is in addition to the regulatory supervision brought to bear by the NASD/SEC
regulatory scheme on NationsBanc Capital Markets, Inc. and other Section 20 com
panies. In fact, next month NationsBank will be hosting both Fed and NASD exam
iners during their reviews o f our Section 20 company’s activities.
As the Fed has gained experience with supervising and overseeing the activities
of Section 20 companies, the Fed has concluded that the risks attendant with securi
ties underwriting and dealing activities are manageable by Section 20 companies
and its management at the bank holding company level. In no way should the Fed’s
conclusion that many o f the current firewalls be eliminated, or greatly modified, be
viewed as being undertaken too rapidly or without careful consideration. In addition
to the Fed’s own experience, additional laws and regulations have been implemented
rendering many o f the firewalls obsolete or generally redundant, and, therefore, un
necessarily burdensome.
O f equal significance is the absence of abuses by bank holding companies in util
izing their underwriting powers over the past 10 years. The strong record o f per
formance and compliance with regulatory and statutory constraints by Section 20
subsidiaries is also reflected in the number of bills that have been introduced in the
current and prior Congressional sessions that would permit bank holding companies
to underwrite and deal in securities to an even greater degree. This record is par
ticularly noteworthy in light o f the fact that Section 20 subsidiaries are among the
most regulated companies in the financial services industry. In addition to detailed
inspections by the Fed, Section 20 subsidiaries are also inspected and/or regulated
by the Securities and Exchange Commission, the National Association o f Securities
Dealers, Inc., and State securities regulators. Because o f their historical signifi
cance, Section 20 subsidiaries have also been subject to close scrutiny by the Con
gress, acting through the General Accounting Office, and receive a large amount o f
public attention.
In my view and that o f many o f my colleagues from the industry, this absence
of abuse and record o f performance has been fostered by prudent risk taking and
risk management by senior management o f our respective institutions and by con
tinuing developments and innovation in risk-management systems and techniques
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that permit relevant risks to be assessed in a more precise manner. The use o f these
systems and techniques, which are followed and encouraged by our various regu
lators, permit risk to be assessed and managed in terms o f interest rate, market,
and counterparty risk across the entire holding company. Risk management plays
a significant and vital role within the structure o f NationsBank and I am confident,
with most o f our bank holding company competitors. In addition, most bank holding
companies operating significant Section 2 0 companies have hired numerous experi
enced personnel in management, legal, and compliance functions to properly support
and foster the prudent growth o f their businesses. Many o f us, hired over the past
10 years to focus on our firms’ respective securities activities, have had to essen
tially take a crash course in bank regulatory matters governing securities activities,
often feeling like we have learned a substantially different regulatory scheme, and
it is only where our activities fit fully within the confines o f each regulatory scheme
that we are permitted to play, so to speak, in the business.
For the reasons stated above, NationsBank supports the Federal Reserve Board’s
proposed firewalls modifications and believes them to be fully appropriate in light
o f other protections which prudently manage the risks inherent in the securities
activities permitted to be engaged in by Section 20 companies.
GENERAL OVERVIEW OF THE FEDERAL RESERVE BOARD’S
FIREWALLS MODIFICATION PROPOSAL
The Fed is proposing to replace its 28 firewalls with eight operating conditions.
Essentially, the Fed’s objective is to repeal all firewalls except those whose concerns
are not addressed by other statutes or regulations. In large part, the Fed’s action
may be interpreted as an acknowledgment that securities underwriting and dealing
activities are not inherently riskier than other banking and nonbanlang activities
and, therefore, should not be subject to more burdensome limitations.
Thus, rather than flatly prohibit a bank from lending to a Section 20 affiliate as
the current firewalls do, under the new operating standards, these loans would be
permitted, but subject to the same limitations that would apply to a loan by a bank
to a leasing or consumer finance affiliate. The eight remaining conditions address
such areas as capital adequacy, internal controls, interlocks between a Section 20
company and its bank affiliates, customer disclosures, and confidential customer in
formation.
I would like to briefly review each o f the Fed’s proposed modifications, all o f which
we support.
Proposed Amendments to Firewalls
The Fed’s proposed modifications to the Firewalls are best summarized into five
principal categories:
1. Bank Holding Company Capital Requirements
2. Section 20 Company Capital Requirements
3. Credit-Related Activities Supporting a Section 20 Company’s
underwriting or Dealing Activities
4. Restrictions on Funding o f Section 20 Company
5. Disclosure Requirements
B a n k H o l d i n g C o m p a n y C a p i t a l R e q u ir e m e n t s
The Fed has proposed to eliminate the firewalls that have previously required the
bank holding company to deduct from its capital any investment made in its Section
20 subsidiary ana any extension o f credit it may have made to its Section 20 sub
sidiary unless the credit were fully secured by marketable securities. These firewalls
were intended to ensure that holding companies maintained sufficient capital as a
source o f strength in supporting its Federally-insured depository institutions by
eliminating any exposure to its Section 20 affiliate for regulatory capital calcula
tions. As the Fed has noted, this requirement has created regulatory burdens with
out any apparent strengthening o f capital levels o f bank holding companies.
S e c t io n 2 0 C o m p a n y C a p i t a l R e q u ir e m e n t s
The Fed is seeking comment on whether to eliminate, modify, or retain a separate
restriction on a Section 20 company which would require it to “maintain at all times
capital adequate to support its activities and cover reasonably expected expenses
and losses in accordance with industry norms.” This firewall was originally created
due to a concern that in some manner a Section 20 subsidiary would be able to
leverage itself more effectively and therefore gain a competitive advantage over its
nonbank securities competitors based on some ability to capitalize on the reputation
o f its affiliated banks or thrifts. This requirement has proven confusing and con
58
troversial as “industry norms” have proven to be too nebulous a standard to accu
rately apply.
C r e d it -R e l a t e d A c t i v it ie s S u p p o r t in g a S e c t io n 20 C o m p a n y ’ s U n d e r w r it in g
o r D e a l in g A c t i v it ie s
The Fed has proposed to eliminate two of the three firewalls restricting the ability
of a bank to extend credit or offer credit enhancement in support o f securities being
underwritten by a Section 20 company. Both o f these firewalls are intended to pre
vent a bank from imprudently exposing itself to risk of losses in order to benefit
the securities activities o f its Section 20 affiliate. A bank has no greater incentive
to make loans or extend credit to customers of its Section 20 subsidiary than it does
to customers o f subsidiaries engaged in other activities, such as leasing, factoring,
derivatives-related activities or consumer finance. In addition, Section 23B o f the
Federal Reserve Act requires that any loans made to enhance the credit o f issuers
whose securities are being underwritten by a Section 20 affiliate or extending credit
to issuers o f securities previously underwritten by a Section 20 affiliate for the pur
pose o f paying principal, interest, or dividends on those securities must be made on
an arm’s length basis. As a further protection, the anti-tying rules applicable to
banks under the Bank Holding Company Act Amendments of 1970 prohibit banks
from offering discounted credit enhancements or loans on the condition that issuers
obtain capital markets services from Section 20 affiliates.
R e s t r ic t io n s o n F u n d i n g o f S e c t io n 20 C o m p a n y
The series o f firewalls prohibiting a bank from funding a Section 20 affiliate di
rectly through a loan or indirectly through a purchase of assets, firewalls 18-19 and
21-22, are proposed to be largely eliminated. Given the Fed’s supervision o f a num
ber of Section 20 companies operating under orders that permit such funding and
not encountering significant problems therefrom, and given the protections afforded
by Sections 23A and 23B o f the Federal Reserve Act’s constraints on inter-affiliate
transactions, these modifications are highly appropriate.
D is c l o s u r e R e q u ir e m e n t s
Current firewall 14 establishes specific disclosure requirements for Section 20
companies to provide help in ensuring that their customers understand the products
offered by the Section 20 company are not Federally-insured or otherwise guaran
teed by an affiliated bank. The Board’s proposal would amend firewall 14 to follow
the Interagency Statement, which generally applies to sales to retail customers by
bank employees or occurring on bank premises. As compared to the current firewall,
the Board’s proposal would appropriately eliminate the disclosure requirement for
institutional customers o f Section 20 companies, but would require an acknowledg
ment o f the special disclosures provided to retail customers o f Section 20 companies,
even when occurring off the bank’s premises.
I would like to now provide specific responses to the issues raised by Senator
Faircloth in his March 11th letter requesting testimony with respect to six particu
lar areas.
SPECIFIC RESPONSES TO THE CHAIRMAN’S REQUEST FOR
TESTIMONY ON PARTICULAR AREAS
Support or Lack o f Support of the Federal Reserve’s Proposal
For the reasons I have stated above in my testimony, NationsBank supports the
Federal Reserve’s proposed modifications, with two exceptions.
First, NationsBank believes that the Fed should not extend the interagency State
ment, as proposed, to require the acknowledgment by a retail customer o f a Section
20 o f special disclosures in connection with sales occurring off the bank’s premises.
To require special disclosure by retail accounts in conjunction with sales occurring
off bank premises is unduly burdensome in light o f the low level o f risk o f customer
confusion about the status o f nondeposit investment products where customers are
not exposed to traditional “bank” signage and traditional bank products. The low
level o f risk o f confusion under such circumstances simply does not warrant the im
position o f the added burden o f obtaining special customer acknowledgments beyond
those that are generally required by securities regulators.
Second, NationsBank opposes the retention of firewall 23 as an operating stand
ard. Firewall 23, which prohibits the sharing of nonpublic customer information be
tween a Section 20 company and its bank/thrift affiliates without customer consent,
was formulated to address concerns that Section 20 subsidiaries might have an un
fair competitive advantage over securities firms unaffiliated with banks if access to
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bank information was freely available. Such special concerns are simply unfounded.
Since that time, securities firms have expanded rapidly into all areas o f commercial
lending unhampered by firewall 23. Thus, firewall 23 only ensures that securities
firms engaged in such businesses have an unfair competitive advantage over Section
20 companies. In addition, it is inconsistent and highly impractical on the part o f
the Board to permit banks and Section 20 affiliates to have dual officers, directors,
and employees yet not expect such personnel to utilize customer information gained
from acting in one capacity to better serve the customer’s needs when acting in his
or her other permitted capacity. Moreover, there is no similar limitation on sharing
such information between banks and other affiliated nonbank entities. Finally,
existing securities laws and regulations are clearly sufficient to address other poten
tial abuses by a Section 20 company o f earlier concern to the Fed through the use
o f Chinese walls, deal teams and the like to separate personnel having nonpublic
information from those who sell and trade securities based on publicly available in
formation.
A number of industry groups and other institutions have indicated in their com
ment letters to the Fed concerning these proposals that other operating standards
based on existing firewalls proposed to be retained, in fact, be eliminated or greatly
modified as being: (i) redundant o f existing requirements to maintain appropriate
policies and procedures governing all transactions, not special ones for dealing with
an affiliated Section 20 company (firewall 11); and, (ii) duplicative o f or potentially
conflicting with certain SEC/NASD requirements, where a depository institution
may not give investment advice regarding securities underwritten or dealt in by an
affiliated Section 20 company unless (firewall 17) the relationship is disclosed (with
such groups and institutions believing that such disclosure obligation if not elimi
nated, then at a minimum being based on a “knowledge” standard rather than act
ing as an absolute prohibition).
Safety and Soundness Concerns
The Federal Reserve’s proposed changes to the firewalls may clearly be imple
mented while preserving the safety and soundness o f our Nation’s banking system
and the integrity o f its insured depository institutions. In fact, reducing the regu
latory burdens imposed on Section 20 companies and permitting them to be more
actively and efficiently engaged in the securities business should have the effect o f
enhancing safety and soundness principles.
First, the experience of the past 10 years has demonstrated that bank holding
companies can operate profitable and sound investment banking businesses. Thus,
there is the potential greater diversification in the lines o f business pursued by
bank holding companies.
Second, the removal o f certain firewalls that overlap with or are generally redun
dant o f other statutory or regulatory protections does not on balance, increase risks
in any manner that is not dramatically outweighed by the benefits to many institu
tions, and ultimately to the public, o f removing unnecessary and in many instances
outdated regulations. It is important to note that even if firewalls were totally elimi
nated, numerous layers o f regulations and supervision would still apply to Section
20 companies.
Third, the Federal Reserve Board and its staff and examiners have gained im
measurable experience in understanding and supervising our Section 20 activities.
Moreover, the regulators are moving in the direction o f a more functional regulatory
approach and we have observed greater cooperation among the various regulators
having supervisory jurisdiction over Section 20 companies. The regulators now place
great emphasis on evaluating, understanding, and making recommendations con
cerning the soundness o f our processes for assessing, managing, and controlling the
risks.
Fourth, senior management at NationsBank and at other institutions have also
placed great emphasis on risk management systems and techniques. A t Nations
Bank, the head o f all risk management is a Vice Chairman o f our Company and
a member o f its five-person policy committee. Our senior management has indicated
that if we cannot operate our Section 20 company in a manner that does not impair
or present undue risk to the entire company, then we should not engage in the
business.
Finally, as the Fed’s examinations have focused more heavily on risk management
and internal controls, the Fed has acknowledged that both bank holding companies
and banks have engaged in activities “at least as risky as underwriting and dealing
securities in a Section 20 affiliate . . . without the restrictions currently imposed
in the Section 20 firewalls.”
It is also important to note that the Fed has proposed to reserve the right to reimpose certain key restrictions—the funding, credit extension, and credit enhancement
60
firewalls— on an institution-by-institution basis should particular circumstances
warrant. We also have little doubt that the Fed would impose these or other restric
tions on all Section 20 companies should it perceive undue risks affecting the entire
industry that might systemically harm the bank holding companies. We find this
approach vastly preferable to a system that is more rigid and outmoded in today’s
marketplace.
Adequacy of Customer Protections
The modifications currently proposed to the firewalls when combined with exist
ing disclosure requirements concerning customers o f all securities firms, simply do
not increase the likelihood o f customer abuse. First, for purposes o f considering cus
tomers protections in the securities field, customers o f financial institutions should
be divided into essentially two classes—institutional and retail. Under existing secu
rities law concepts, retail (individual) customers can be further divided between
those who are deemed to be sophisticated enough to “fend for themselves” in terms
of the need for additional levels o f disclosure about the nature o f potential invest
ments and those customers who may need additional protections.
Virtually all institutional customers are capable o f protecting themselves from
abusive or coercive business practices. Given the level of competition generally with
in the financial services industry, these customers have or preserve far too many
options to be forced into using products or services they do not desire or could obtain
from other institutions at lower prices. Retail customers, on the other hand, receive
the benefit of special disclosures required by the Interagency Statement (for retail
sales o f nondeposit investment products) that require an acknowledgment o f special
disclosures about a lack o f Federal insurance supporting certain products any time
such sales are made by bank personnel or from bank premises. The Fed has further
proposed extending those disclosure requirements to retail accounts even with re
spect to sales occurring off bank premises. In addition, the securities laws and regu
lations require that all statements or information supplied to a customer, whether
institutional or retail, not contain any material misstatements or omissions with re
spect to any proposed investment. Further, the NASD has filed with the Securities
and Exchange Commission for approval certain rules governing fair practices in
which the NASD is attempting to eliminate inconsistencies and conflicts between
the NASD’s rules and the interagency Statement. Finally, given the litigious nature
of the securities business and certain degree of regulatory pressure, banking institu
tions have taken steps to offer better and clearer customer information. Even a
number of consumer advocates have conceded that banks have improved greatly in
warning customers about the risks attendant with securities investments.
Moreover, the anti-tying statute applicable to all national banks prohibits the
banks from requiring customers to obtain any additional products or services as a
condition to obtaining a particular product or service that they may desire. The ex
ceptions in the tying statute for certain traditional banking products are not appli
cable to permit the tying o f any bank product or service on obtaining a different
securities-related product or service. The tying statute also prohibits the banks from
entering into exclusive dealing arrangements with its customers.
As a result, we do not believe that the proposed firewall modifications increase
the risk of coercion o f customers or that those customers will not be adequately pro
tected by the various statutes, regulations, and supervisory oversight to which our
country’s banking companies are subject.
Risks o f Unfair Advantage for Section 20 Companies
In our view and the view o f many o f my colleagues in the industry, the proposed
modifications will not lead to an advantage for Section 20 companies. The changes
will merely work to help level the regulatory playing field which has been generally
tilted against Section 20 companies as compared to other firms. Due to the myriad
o f bank regulations with which we must comply, some of which are admitted by reg
ulators to be conservative and in some respects redundant with other regulations
and much o f which our nonbank competitors do not face, Section 20 companies have
been at a competitive disadvantage since their inception relative to other firms in
trying to build and establish their Section 20 companies as meaningful players in
the securities business.
The process of building our securities underwriting and dealing activities has been
a challenging and sometimes arduous process in significant part because our non
bank competitors for institutional business often point to the relationship with a
bank as demonstrating some lack o f competence or experience in the securities busi
ness. In other words, a Section 20 company’s relationship with affiliate banks can
sometimes represent a hurdle to be overcome, not an advantage relative to our
nonbank competitors.
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Moreover, Section 20 companies will continue to carry a higher degree o f regula
tory burdens than other firms. Further, given the various other protections which
exist, the ability o f bank affiliates to directly or indirectly support Section 20 activi
ties on anything less than an arm’s length basis is highly dubious. Ultimately, the
Section 20 companies simply believe and desire that the Fed’s proposals will help
open the door to a more open, free, and fair system o f competition. It is also inter
esting to note that no nonbank securities firm or their traditional industry groups
submitted a comment letter to the Fed in opposition to these proposed changes.
Adequacy o f Other Statutory and Regulatory Protections
You have also sought comment on the existence o f other statutes or regulations
to act as “substitutes” for the firewalls. There are numerous statutory and regu
latory protections outside o f the firewalls proposed for elimination that will serve
to address the fundamental risks associated with the underwriting and dealing ac
tivities o f Section 20 affiliates.
A number o f these “protections” did not exist at the time o f the adoption o f the
initial or current firewalls and were thus not available to address certain o f the
Fed’s concerns about the potential risks o f these activities.
First, Section 23B o f the Federal Reserve Act was not adopted at the time o f the
Fed’s initial approval of Section 20 companies in 1987. It is significant that many
of the firewalls are duplicate or overlap the constraints o f Section 23B. Section 23B
requires affiliate transactions to be conducted at arm’s length, typically requiring
pricing and other economic terms to essentially mirror those found in the market
place, thus greatly protecting the affiliated banks. Section 23B further prohibits
representing that an affiliated bank is responsible for a Section 20 company’s obli
gations and it prohibits a bank from purchasing certain products from a Section 20
affiliate.
Second, the current risk-based capital standards utilized by banks and their hold
ing companies were not in effect in 1987. Pursuant to the separate measurement
o f the capital adequacy of bank holding companies and their affiliated banks, undue
concentration of resources in Section 20 activities is effectively limited. Because
these standards address some of the risks which may be present in a bank’s affili
ation with an investment banking operation, those standards may be viewed as
overlapping with some o f the current firewalls.
Third, the Interagency Statement on Retail Sales o f Nondeposit Investment Prod
ucts was adopted in 1994. This statement has become the primary means by which
the Federal Banking Agencies attempt to ensure that retail customers are not mis
led about the nature of any Nondeposit Investment Product that those customers
may be considering for purchase. Thus, a great deal o f the disclosure risk over
which the Fed has been concerned is effectively addressed thus making the special
disclosure requirements contained within the firewalls duplicative and, therefore,
unnecessary.
A couple o f other important protections have existed for some time. The anti-tying
rules o f the Bank Holding Company Act Amendments o f 1970 prohibits banks from
offering discounts on products on the condition that an issuer obtain investment
banking services from a Section 20 affiliate or requiring the use o f a Section 20 affil
iate in order to obtain some banking product that the customer seeks. The antitying rules thus address a great deal o f the “coercion risk” that so many nonbank
competitors like to point out. In addition, the antitrust provisions o f the Sherman
Act also apply to address noncompetitive practices.
In addition, Section 23A o f the Federal Reserve Act will limit and control any
arm’s-length transactions a bank does engage in with a Section 20 affiliate. Under
Section 23A, transactions with any one affiliate are limited to 10 percent o f a bank’s
capital and transaction, with all affiliates limited to 20 percent o f that capital, and
are required to receive collateral covering any extension o f credit to its affiliates.
Other Recent Fed Action Impacting Section 20 Activities
You have also sought our comment on other recent Federal Reserve action impact
ing Section 20 activities. NationsBank generally support the Fed’s recent actions to
modify or eliminate some of the regulatory constraints affecting Section 20 activi
ties, including raising the ineligible revenue ratio from 10 percent to 25 percent, the
elimination o f the cross-marketing restrictions, and the relaxation o f the firewalls
permitting dual employees between a Section 20 company and its bank affiliates.
First, with respect to increasing the revenue limit, we believe the Federal Reserve
Board acted within the deference afforded to reasonable judgments o f Governmental
agencies with regard to the meaning o f ambiguous terms in any statute that is
charged with administering. The Fed prudently and consistently with safety and
62
soundness principles reasonably raised the ineligible revenue limit to 25 percent of
a Section 20 company’s total revenue.
We concur with the Board that based on its experience, a 10 percent revenue limi
tation had unduly restricted the underwriting and dealing activity of Section 20
companies to a level that fell short of statutory limits involved with being “prin
cipally engaged” for purposes o f § 20 of the Glass-Steagall Act. The Fed was also cor
rect in our view in observing that product mix of Section 20 companies had changed
and that developments in the securities markets more generally had also affected
the relationship between revenue and appropriate activities since the establishment
of the 10 percent limit in 1989.
Second, the cross-marketing firewall was initially adopted in an attempt to ade
quately address concerns about customer confusion. However, as mentioned above,
the risks of such confusion with respect to the sale of any nondeposit product is
mitigated by the existence o f the Interagency Statement, adopted in 1994, which
provides that for any sale or attempted sale by a bank employee or occurring on
bank premises, the customer must receive and acknowledged a written statement
that the product being sold is not Federally-insured, is not a deposit or other obliga
tion of the bank, it is not guaranteed by the bank, and is subject to investment risks
including loss o f principal. While some may suggest that banks may be able to pack
age products in a manner to gain an unfair competitive advantage, we agree with
the Fed’s perspective that these dangers are addressed by existing antitrust laws
including the Sherman Act and the anti-tying rules of the Bank Holding Company
Act Amendments of 1970. Further, as a practical matter, the cross-marketing fire
wall would not serve to create some alleged competitive equality between Section
20 companies and other securities firms since under the cross-marketing firewall
personnel could simply be moved into the Section 20 company from where they
could market the activities o f both the Section 20 company and their bank affiliates.
In addition, existing securities regulations limit the ability of bank personnel to at
tempt to sell or offer to sell securities underwritten or dealt in by a broker-dealer
in potential violation of the registration and supervisory requirements governing all
such personnel.
Finally, with respect to the modifications to the interlocks firewall which now will
permit dual employees or officers between banks and their Section 20 affiliates, ex
cept with respect to Chief Executive Officer and a majority o f the Board o f Directors
of each type of entity, NationsBank believes such a firewall was outdated in light
of the Section 20 company history and the opportunity such a modification permits
in terms o f the operational efficiency for bank holding companies overall. This modi
fication may also allow easier entry into the business by smaller banking organiza
tions that otherwise could not afford to bear the costs of staffing a separate Section
20 company separate from its bank affiliates. We also recognize the Fed’s concern
that while the interlocks firewall is unnecessary to prevent customer confusion or
to ensure appropriate corporate separateness, proper risk management may require
a revisitation o f the interlocks between a Section 20 and its bank affiliates for cer
tain sensitive custodial or fiduciary areas.
Conclusion
The regulatory relief recently made or currently proposed to be made by the Fed
concerning Section 20 activities is long overdue. In an increasingly competitive and
globalized financial system our Nation’s consumers, their communities, and our
economy will benefit from the increased flexibility these changes will bring and our
banking system should not remain subject to somewhat static and now unnecessary
regulatory burdens on its activities. NationsBank along with a number o f industry
groups and their respective members broadly support the Fed’s proposal and ap
plauds its efforts in continuing to modernize the financial services industry. We
believe that the Fed has acted extremely prudently in evaluating these matters and
in proposing these changes in light of Section 20 company history, the Federal Re
serve’s experience in supervising their activities and today’s market conditions.
Mr. Chairman, I appreciate the opportunity the Subcommittee has given me to
present views on these important developments to the banking and securities indus
tries and for our Nation’s consumers, business, and economy. I would be happy to
answer any questions that you or other Members o f the Subcommittee may have.
63
PREPARED STATEMENT OF RICHARD B. ROBERTS
E x e cu t iv e V ice P resident and T r e a su r e r o f W a c h o v ia C o r p o r a tio n
ON BEHALF OF THE
ABA S ecu rities A s sociation an d t h e A m e r ic a n B a n k e r s A s so c ia t io n
M ar c h 20, 1997
Mr. Chairman, I am Richard Roberts, Executive Vice President and Treasurer o f
Wachovia Corporation headquartered in Winston-Salem, North Carolina, and in At
lanta, Georgia. Wachovia is the parent bank holding company o f four nationallychartered banks and a Federal savings bank. While Wachovia does not have a Sec
tion 20 firm,1 I am very familiar with Section 20 firms and their operations as I
have closely watched and studied their development over the last 10 years.
I am also Chairman o f the Board of the ABA Securities Association (“ABASA”).
Accompanying me today is Ms. Rachel Robbins, General Counsel and Managing Di
rector o f J.P. Morgan & Co., Incorporated. Ms. Robbins is also associated with
ABASA as the Chair o f the ABASA Lawyers’ Committee. Under her leadership that
committee has carefully reviewed all o f the recent Fed’s proposed changes in Section
20 activities.
The ABASA is a separately chartered trade association o f the American Bankers
Association (“ABA”) formed in 1995, to develop policy and provide representation for
banks underwriting and dealing in securities, proprietary mutual funds, and deriv
atives. The ABA brings together all elements o f the banking community to best
represent the interests o f this rapidly changing industry. Its membership— which in
cludes community, regional, and money center banks and holding companies, as well
as savings associations, trust companies, and savings banks— makes ABA the larg
est banking trade association in the country. The view expressed herein represent
the views o f both the ABASA and the ABA.
Mr. Chairman, I commend you for holding this oversight hearing on the Federal
Reserve Board’s (“Board”) proposal to modify existing Section 20 firewalls and I
appreciate the opportunity to appear here today to discuss these very important
issues. For the approximately 40 bank holding companies and foreign banks that
have established Section 20 firms, the existing firewall provisions impose tremen
dous regulatory burdens and costs on doing business today. For many other banking
organizations that have not yet established Section 20 firms, the costs and burdens
associated with these firewalls have effectively prevented them from establishing
Section 20 firms.
I should add that the reason Wachovia has not established a Section 20 is that
the current firewalls represent an impediment to conducting business in an efficient
manner.
As I will discuss more fully later in my testimony, the ABA Securities Association
and its 21 members,2 including the Wachovia Corporation, strongly favor the recent
Board’s action proposing to modify the existing firewalls. These modifications, when
adopted, will allow all Section 20 firms to operate much more efficiently and effec
tively, which can only inure to the benefit o f our customers. We believe that these
modifications are also an important step forward in bringing vigorous new competi
tion to the financial services industry, but, Mr. Chairman, they are only that—a
first step.
The bank regulatory structure needs to be modernized to allow all institutions the
option to offer all financial services to our customers. All financial services providers
should have the ability to offer all services free from unnecessary legislative barriers
and costly regulatory hoops. Not all providers will choose to oner all services. But
the decisions o f what products and services to offer should be a business judgment
that each individual institution is free to make. Given all the changes in today’s
financial services marketplace, it simply makes no sense to create a system that
limits free and fair competition.
Consequently, ABASA’s strong endorsement o f the Board’s proposal should not, in
any way, detract from our position that truly comprehensive financial services re
form is needed. Only the Congress has the power to adopt such reform and ABASA
1Wachovia Corporation offers certain underwriting and dealing services to its capital market
clients through its National banks.
2 ABASA members include: BankAmerica Corporation, BankBoston, Bank o f Montreal/Nesbitt
Bum s, Banc One Corporation, Bankers Trust New York Corporation, Barclays Bank PLC, The
Chase Manhattan Corporation, Citicorp, First Chicago NBD Corporation, First Security Cor
poration, First Union Corporation, Fleet Financial Group, J.P. Morgan & Co., Incorporated,
KeyCorp, Mellon Bank Corporation, NationsBank Corporation, Norwest Corporation, PNC Bank
Corp., State Street Bank & Trust Company, SunTrust Banks, Inc. and Wachovia Corporation.
64
would strongly encourage this Subcommittee to assist in moving these reform efforts
forward.
Background
As the Subcommittee is aware, Section 20 o f the Glass-Steagall Act provides that
a member bank of the Federal Reserve System may not be affiliated with a company
that is “engaged principally” in underwriting and dealing in securities. In 1987, the
Board first authorized bank holding companies to establish “Section 20 subsidiaries”
to engage to a limited extent in underwriting and dealing in securities not eligible
for underwriting and dealing by a member bank, including municipal revenue bond,
commercial paper, certain mortgage-back and other asset-back securities (“Tier I
powers”).3 Subsequent Board orders expanded the list of ineligible securities author
ized for Section 20 firms to include corporate debt and equity securities (“Tier II
powers”).4
In connection with issuing these orders, the Board established a series of restric
tions as conditions for approving underwriting and dealing in ineligible securities.
The Board’s 1987 order contained 20 restrictions applicable to those firms seeking
authorization to underwrite and deal in Tier I products. With the 1989 Board order
approving Tier II powers, the number o f restrictions expanded to 28. These restric
tions are commonly known as “firewalls.”
The firewall restrictions were designed to prevent any perceived securities under
writing and dealing risk from being passed from a Section 20 subsidiary to an affili
ated insured depository institution. In addition, these restrictions addressed the
potential for conflicts o f interest, unfair competition, and other adverse effects that
might, it was thought at the time, arise from the conduct o f these bank ineligible
securities activities.
The Board’s Proposal
After undertaking a complete review o f the firewall restrictions, the Board has
now determined to propose comprehensive changes to these firewall restrictions.
Specifically, the Board has proposed to retain 8 firewall provisions by incorporating
them into a statement o f operating standards and to eliminate the remainder.
Mr. Chairman, these modifications are not being proposed in a vacuum. Rather,
they are being undertaken after almost 10 years of Board experience supervising
Section 20 firms and their bank ineligible securities underwriting and dealing ac
tivities. In that time, the Board has had considerable opportunity to analyze the
perceived risks posed by these activities to affiliated insured depositories and has
concluded that any perceived risks posed by securities underwriting and dealing ac
tivities have proven to be manageable.5
In this same time period, the Board has gained greater familiarity and experience
with the operation o f the Federal securities laws and the protections afforded by
those laws through the supervision and regulation o f broker-dealers by the Securi
ties and Exchange Commission (“SEC”) and the National Association o f Securities
Dealers (“NASD”). That experience has allowed the Board to conclude that many of
the firewall provisions are unnecessary in light o f the Federal securities law require
ments.
Finally, legislative and regulatory initiatives put in place after the original fire
walls were established have also demonstrated that many o f the firewall restrictions
are largely redundant of these other provisions. These initiatives include Section
23B of the Federal Reserve Act,6 Risk-Based Capital Standards,7 and the Inter
agency Statement on Retail Sales o f Nondeposit Investment Products.8 Clearly,
these new safeguards, in combination with pre-existing regulatory limitations appli
cable to all nonbanking subsidiaries, squarely address the fundamental concerns
that precipitated the initial establishment o f the firewalls.
3 Citicorp, J.P. Morgan & Co., and Bankers Trust New York Corp., 73 Federal Reserve Bul
letin 473 (1987).
4 J.P. Morgan & Co., The Chase Manhattan Corp., Bankers Trust New York Corp., Citicorp,
and Security Pacific Corp., 75 Federal Reserve Bulletin 192 (1989).
5Bank Holding Companies and Change in Bank Control (Regulation Y); Review of Restrictions
in the Board's Section Orders, Docket No. R -0958, 62 Fed. Reg. 2622, 2623 (January 17, 1997).
6 12 U.S.C. Section 3 7 1 c -l.
1 See 54 Federal Register 4186 (January 27, 1989).
8 Interagency Statement on Retail Sales o f Nondeposit Investment Products (FRB, FDIC,
OCC, OTS), February 15, 1994; OCC Bulletin 9 4 -1 3 , February 24, 1994; as clarified and inter
preted in Joint Agency Release dated September 12, 1995.
65
S a fety a n d S ou n d n ess Issu es
Your letter o f invitation, Mr. Chairman, asks whether the proposed firewall modi
fications can be made while still preserving the safety and soundness o f the banking
system and protecting affiliated insured depository institutions. We are convinced
they can.
There is no evidence that securities activities are more risky than traditional com
mercial banking activities. The weight o f evidence to date suggests that these activi
ties d o n o t raise the risk profile o f the banking institution. In fact, ju st the opposite
is true. These activities will lo w er the risk profile and provide even m o re protection
for the bank.
Banks have offered so-called “nontraditional” products for many years, through
many different operational structures. Foreign banks have engaged in securities and
insurance activities for years, and many U.S. banking companies have similar oper
ations overseas. A recent study analyzing available data concluded: “Our study o f
the evidence leads us to conclude that moderate increases in private securities ac
tivities have not increased either the riskiness or failure rate o f commercial banks
in the past nor promise to do so in the future.” 9
For example, the Board has proposed to eliminate as unnecessary or redundant
the firewalls which generally pertain to capital requirements for bank holding com
panies, insured bank subsidiaries, and Section 20 firms. In place o f these firewall
provisions, the Board has proposed to require that a bank holding company main
tain adequate capital on a fully consolidated basis.10
This modification recognizes that certain firewalls that required bank holding
companies to deduct from capital any investment in, or credit extended to, the Sec
tion 20 subsidiary did not achieve their intended goal o f strengthening the capital
o f the insured depository institution or the Section 20 subsidiary. Rather, these fire
walls effectively created regulatory burdens by forcing bank holding companies to
prepare two sets o f financials— one to satisfy GAAP accounting principles and one
to satisfy the Board’s firewall restrictions.11
Moreover, as registered broker-dealers, Section 20 firms are already subject to the
SEC’s net capital requirements, thus obviating the need for an additional layer o f
capital requirements merely because the Section 20 firm is part o f a bank holding
company. Finally, eliminating any firewalls that effectively required the Section 20
firm to maintain levels o f capital in excess o f those required by nonbank affiliated
investment firms would place Section 20 firms on a parity, at least with respect to
capital, with those firms.
In sum, the safety and soundness o f the insured depository institution will be
ensured, in this context, by existing Federal security law capital requirements en
forced by both the SEC and the NASD, and requiring bank holding companies to
maintain, consistent with GAAP, adequate capital on a fully consolidated basis.
Benefits to the banking organizations will include reduced regulatory burdens and
the ability to compete on a more equal footing, at least with respect to capital re
quirements, with other nonbank affiliated investment banking services providers.
C o n flic ts o f In terest a n d C on su m er P r o t e c t io n Issu es
The Board has also proposed to eliminate the firewalls which generally prohibit
bank holding companies and their subsidiaries from extending credit to the Section
20 firm. These restrictions were originally intended to prevent a bank or its parent
from exposing itself to loss in order to benefit the Section 20 firm’s underwriting
and dealing activities. In truth, however, these firewalls have hampered the ability
o f bank holding companies to serve as full-service financial services providers and
have reduced funding options available to our customers.
For example, it is not uncommon for bank corporate customers to fund their ac
tivities by accessing the capital markets through a commercial paper issuance. In
these situations, the bank will refer its customer to its Section 20 affiliate. Under
the current firewall restrictions, the bank would be prohibited from providing credit
enhancement to the commercial paper even though the bank itself may be the insti
tution best suited to perform a credit analysis or, worse yet, for smaller corpora
tions, the only institution willing to perform the necessary credit analysis.
9 George J. Benston (John H. Harland Professor o f Finance, Accounting and Economics,
Goizueta Business School, Emory University) and George G. Kaufman (John F. Smith Professor
o f Finance and Banking, School o f Business Administration, Loyola University): “ Commercial
Banking and Securities Activities: A Survey of the Risks and Returns ” October 1995, page 1.
10 The operating standard specifically gives the Board authority to reimpose certain funding
and other firewalls if the bank or thrift affiliate becomes less than well capitalized.
11 The inability to consolidate Section 20 capital with that o f the parent holding company is
inconsistent with GAAP accounting principles.
66
Significantly, many of the conflict of interest concerns that underlie Firewalls 5 12 are more than adequately addressed by other existing statutory and regulatory
safeguards. Consequently, no need exists to maintain duplicative and redundant
firewall restrictions that achieve the same results.
For instance, as the Board has recognized, the current risk-based capital system
would require the bank to hold capital against the exposure on any credit enhance
ments extended to Section 20 customers. Loan-to-one borrower rules would also
limit the amount o f credit that a bank could extend to an issuer o f securities under
written by a Section 20 firm.12 Perhaps more significantly, any transaction or series
o f transactions between a member bank and a third party would be subject to the
arm’s-length dealing requirements of Section 23B of the Federal Reserve Act where
an affiliate of the member bank is a participant.13
Loans extended to customers for the purpose o f purchasing, during an underwrit
ing, ineligible securities underwritten by the Section 20 affiliate are also covered by
other statutory provisions. Section 11(d) o f the Securities Exchange Act o f 1934 pro
hibits any broker-dealer, including a Section 20 firm, from extending or arranging
credit to customers during the underwriting period. Loans extended to customers
during an underwriting or selling syndicate for the purpose o f purchasing securities
from an affiliated Section 20 firm and loans for purchases o f securities from the in
ventory o f the Section 20 firm are required by Section 23B o f the Federal Reserve
Act to be conducted on market terms.
As a consequence, even without these firewalls, member banks would still be
strictly prohibited from extending or granting credit to customers on preferential
terms. In short, the stated purpose o f these firewalls can be, and is, accomplished
without the added operational burden of specific firewall restrictions.
Mr. Chairman, you have asked whether the modifications proposed will provide
adequate protection to customers of the bank or securities affiliate. I believe the
above discussion demonstrates most strongly that both bank and Section 20 cus
tomers are provided with significant protections under the Federal securities laws
and banking laws to justify the Board’s proposed elimination o f many o f these fire
wall provisions.
In addition, I would point out that many other protections are afforded to cus
tomers o f both the bank and the Section 20 firm. Specifically, the numerous disclo
sure requirements o f the Federal securities laws apply to banking organizations’
securities activities. In addition, the Federal banking regulators require certain dis
closures to be made when retail customers purchase investment products from the
bank lobby. These statutory and regulatory requirements provide added protections
to many bank and Section 20 firm customers.
Firewall Restrictions and Regional Bank Holding Companies
Mr. Chairman, I think it is important to understand the historical context in
which these original firewall restrictions were established. At the time the original
firewalls were adopted the Board was facing litigation, which it subsequently won.
As a result, the Board adopted a very conservative framework o f firewall restrictions
that it recognized could, like the initial 5 percent income limitation, over time be
loosened.
Generally speaking, the restrictions were established in connection with moneycenter bank holding company applications to establish Section 20 firms. As a result,
the specific firewall provisions were often geared to the characteristics o f the moneycenter banks and the burdens and inefficiencies that, it was thought, those institu
tions could afford to carry.
Regional bank holding companies, such as mine, have been unable to carry these
same burdens and inefficiencies. This can be attributable to a number o f factors:
• First, regional institutions generally do not have large, steady sources o f eligible
revenues to support a meaningful amount o f ineligible activities. Without reve
nues from, for example, primary Government securities dealer operations, re
gional firms must rely on less predictable sources o f revenue such as bank-eligible
public finance activities or brokerage services.
• The costs o f doing business through a Section 20 company carry a high threshold
o f fixed costs, while the primary benefit {i.e., bank-ineligible revenues) is currently
subject to strict firewall limitations. Few regional institutions find this to be an
attractive business prospect. This point is most evident by the fact that o f the ap
12 For example, national banks may only lend an amount equal to 15 percent o f their capital
on an uncollateralized basis and an additional 10 percent o f their capital on a collateralized
basis, and credit enhancements generally would be aggregated long with all other credit ex
tended to an issuer in measuring compliance with these limits. See 12 U.S.C. 84; 12 C.F.R. 32.2.
1312 U.S.C. Section 371c-l(a)(2)(E ).
/>
67
proximately 17 regional bank holding companies authorized to establish Section
20 firms, only four are authorized to exercise Tier II powers and, thus, willing to
operate under the most burdensome firewall provisions.
• Regional bank holding companies are more likely to need to proceed gradually in
establishing and expanding Section 20 operations, but this is inconsistent with
current requirements. Senior managements o f regional institutions are often re
luctant to abruptly move some o f their most valuable businesses out o f their
banks and into separate companies that must be isolated from the banks by fire
walls, especially when those firewalls leave little room for fine tuning, monitoring,
achieving economies or simply rethinking a decision.
• Although the Tier I firewalls are less restrictive than the Tier II firewalls, the
powers associated with Tier I firewalls (e.g., municipal revenue bond, commercial
paper, certain mortgage-back and other asset-back securities underwriting) are no
longer economically viable options for many regional institutions. The thinner
spreads on these products make Tier I status too costly, even as a transitional
step to Tier II corporate debt and equity powers.
• As discussed above, safety and soundness require that there be coordination
throughout a bank holding company system on such matters as credit policies,
rate risk and other risk management, regulatory compliance, and management ac
countability. This coordination tends to be more direct for regional institutions.
These requirements, while fostering independence o f operation in larger institu
tions, can actually interfere with safe and sound operating practices in regional
institutions.
Some o f the problems associated with the firewall restrictions and revenue cap
limitations have dissipated somewhat over the last couple o f months as the Board
has endeavored to ease some o f the most burdensome firewall restrictions, including
eliminating the cross-marketing prohibition and significantly modifying the person
nel interlock prohibition. These actions taken in concert with raising the cap on rev
enue earned from 10 to 25 percent for ineligible securities underwriting activities
have already encouraged several banks to seek authorization either to establish a
Section 20 underwriting firm or expand the authorization for existing Section 20
firms. Much more is needed, however, if other regional banking firms are to engage
in securities underwriting activities. We believe that the Board’s proposed modifica
tions to existing firewalls are a step in that direction.
Conclusion
In conclusion, Mr. Chairman, ABASA appreciates the opportunity to appear before
the Subcommittee to discuss the Board’s recent proposal to modify its firewall provi
sions applicable to Section 20 firms. While ABASA is hopeful that the modifications,
when adopted, will encourage other bank holding company firms to establish Section
20 underwriting firms, these modifications are only a first step toward comprehen
sive reform o f our financial system. ABASA encourages the Subcommittee and its
Members to work with all appropriate parties in order to enact meaningful financial
reform legislation. ABASA stands ready to work with you and other Members o f
your Subcommittee, Mr. Chairman.
PREPARED STATEMENT OF CHARLES W. CALOMIRIS
P au l M. M on tro n e P ro f e ss o r o f F in a n c e a n d E co n o m ic s
G raduate S c h o o l o f B u s in e s s , C o l u m b ia U n iv e r sit y
M arch
20,1997
Mr. Chairman and Members o f the Subcommittee on Financial Institutions and
Regulatory Relief, it is a pleasure to appear here today. The last decade has seen
dramatic and beneficial bank deregulation. O f particular importance have been the
relaxation o f geographical and activity limitations on bank holding companies,
achieved respectively by Congressional action and new regulatory interpretations o f
existing law.1 Recently, both the Federal Reserve Board and the Comptroller o f the
Currency have sought to further enhance the flexibility o f bank operations by reduc
ing limits on bank activities, and there is a push for Congressional action to repeal
‘ For a review of the evolution of Federal Reserve actions and court interpretations o f Section
20 law, see George Kaufman and Larry Mote, “Glass-Steagall: Repeal by Regulatory and Judi
cial Reinterpretation,” Banking Law Journal, September-October 1990, pp. 388-421.
68
outright the separation o f commercial and investment banking imposed in the Bank
ing Act o f 1933.
While deregulation has been dramatic, it is worth noting that it has sparked little
controversy, or even surprise, among scholars o f banking or banking history. There
is a remarkable degree o f agreement among these scholars— supported by an exten
sive body o f research— that historic limitations on bank locations and activities have
served no legitimate economic purpose. Rather, these costly limits— especially the
separation o f commercial and investment banking in 1933— are artifacts o f specific
historical political battles in which facts and economic logic have often taken a back
seat to populist passions or special interest politics.2
Competitive pressure— especially the loss o f U.S. banks’ domestic and interna
tional market shares in the 1980’s—helped to push the Federal Reserve Board in
1987 and subsequently to use its authority to relax restrictions on bank underwrit
ing activities. Initially, the Fed proceeded with extreme caution. It allowed very lim
ited underwriting o f private debt, and later equity, but attached to those activities
a host of “firewalls” intended to serve two different sets of purposes— (1) to prevent
the transfer o f loss from a Section 20 underwriting affiliate to a chartered bank, and
(2) to prevent “conflicts o f interest” from arising from the mixture o f commercial and
investment banking. The first concern was largely that of economists who correctly
worried about the abuse o f deposit insurance and the discount window— the possibil
ity of Government subsidization o f risk in new activities. The second concern was
that banks might use their new powers to coerce client firms or cheat purchasers
of securities (despite clear and strong economic incentives not to do so). This second
concern reflected the unsubstantiated and misguided arguments that underlay the
Pecora Hearings of 1932, and the limitations imposed on the mixing o f commercial
and investment banking in 1933.3
The Federal Reserve Board has recently circulated a set o f proposals to relax or
eliminate many o f the “firewalls” that limit connections between banks and the non
bank affiliates o f bank holding companies.4 It is worth noting that if the Fed pro
ceeds with these proposed changes, the consequences will stretch beyond the holding
company affiliates regulated by the Fed, since the Office o f the Comptroller o f Cur
rency, which has invited banks to channel their “nonbanking” activities through
2 For a critical discussion o f the hearings leading to the passage o f Glass-Steagall, see George
Benston, The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revis
ited and Reconsidered, Norwell: Kluwer Academic Press, 1989. For evidence that conflicts o f
interest between commercial and investment banking were absent in the 1920’s, see Randall S.
Kroszner and Raghuram G. Rajan, “Is the Glass-Steagall Act Justified? A Study o f the U.S. Ex
perience with Universal Banking Before 1933/’ American Economic Review, Vol. 84 (September),
1994, pp. 810-832; Randall S. Kroszner and Raghuram G. Rajan, “ Organization Structure and
Credibility: Evidence from Commercial Bank Securities Activities before the Glass-Steagall Act,”
Journal of Monetary Economics, forthcoming; Manju Puri, “The Long-Term Default Performance
o f Bank Underwritten Securities Issues,” Journal of Banking and Finance, 1994. On the politi
cal economy o f the passage o f the 1933 Act more generally, see Charles W. Calomiris and Eu
gene N. White, “The Origins o f Federal Deposit Insurance,” in The Regulated Economy: A His
torical Approach to Political Economy, edited by Claudia Goldin and Gary Libecap, Chicago:
University o f Chicago Press, 1994. For a discussion o f the historical costs to the United States
o f limiting banks’ powers, see Eugene N. White, “Before the Glass-Steagall Act: An Analysis of
the Investment Banking Activities o f National Banks,” Explorations in Economic History, Vol.
23 (January), 1986, pp. 33 -5 5 ; Charles W. Calomiris, “Regulation, Industrial Structure, and In
stability in U.S. Banking: An Historical Approach,” in Structural Change in Banking, edited by
Michael Klausner and Lawrence J. White, Homewood, Illinois: Business One-Irwin, 1993, pp.
19-115; Charles W. Calomiris, “The Costs o f Rejecting Universal Banking: American Finance
in the German Mirror, 1870-1914,” in The Coordination of Activity Within and Between Firms,
edited by Naomi Lamoreaux and Daniel Raff, Chicago: University o f Chicago Press, 1995, pp.
257-315; Charles W. Calomiris and Carlos Ramirez, “The Role o f Financial Relationships in the
History o f American Corporate Finance,” Journal of Applied Corporate Finance, Volume 9, Num
ber 2 (Summer), 1996, pp. 52 -7 3 ; J. Bradford De Long, “Did J.P. Morgan’s Men Add Value?,”
in Inside the Business Enterprise: Historical Perspectives on the Use o f Information, edited by
Peter Temin, Chicago: University o f Chicago Press, 1991, pp. 205-236; Carlos D. Ramirez, “Did
J.P. Morgan’s Men Add Liquidity? Corporate Investment, Cash Flow, and Financial Structure
at the Turn o f the Twentieth Century,” Journal of Finance, Vol. 50 (June), 1995, 661-678; Ran
dall S. Kroszner, “The Evolution o f Universal Banking and Its Regulation in Twentieth Century
America,” in Universal Banking: Financial System Design Reconsidered, edited by Anthony
Saunders and Ingo Walter, Homewood, Illinois: Business One-Irwin, 1996, pp. 70-99.
3 For a discussion o f why banks face a strong incentive to behave honestly, and how this leads
to voluntary structural constraints (or “firewalls”) within bank holding companies to ensure
greater credibility, see Randall S. Kroszner and Raghuram G. Rajan, “Organization Structure
and Credibility: Evidence from Commercial Bank Securities Activities before the Glass-Steagall
Act,” Journal of Monetary Economics, forthcoming.
4 Federal Reserve Board, “Review o f Restrictions in the Board’s Section 20 Orders,” January
9, 1997.
69
national bank subsidiaries, is almost sure to follow the Fed’s lead on firewalls, at
least in the near term.
The principal question I will address today is the desirability of the Fed’s recent
proposals to reduce firewalls. More broadly, however, I will assess the desirability
o f expanding bank activities into securities markets and related areas, and the im
portance o f relaxing firewalls to allow efficiency gains from such an expansion. Mr.
Chairman, at the end of my remarks, I will also provide responses to the specific
written questions you posed in your letter o f March 14.
To summarize, I support enlarging the range and size o f permissible “nonbank”
activities within banks or bank holding companies, and scaling back the firewalls
that the Federal Reserve Board established in 1987 and in 1989, as the Federal
Reserve Board now proposes to do. Doing so will allow banks to compete more
effectively for corporate relationships, and will benefit bank customers and their
stockholders at least as much as it will benefit banks. I will also argue that outright
repeal o f Glass-Steagall prohibitions and further relaxation o f firewalls should be
considered by Congress and bank regulators.
Let me begin with some historical perspective on the origins o f the separation o f
commercial and investment banking, which is essential to the debate over bank
activity limits and firewalls. In the United States, banks became interested in un
derwriting and holding corporate debt and equity in the 1920’s. The relaxation o f
branching laws during that period created new opportunities for banks to become
large. As they became large, they turned increasingly to industrial as opposed to
only commercial finance, and they found it profitable to mix bank lending with un
derwriting. Doing so made it possible to better serve their corporate clients’ funding
needs, provide better access to investments for their trust customers, and reduce
banks’ costs o f funds, since the new activities were highly diversifying.5
The mixing of lending and underwriting activities had produced important
synergies in German universal banking around the turn o f the 20th century, which
were well understood in the United States by the 1920’s. German banks offered very
rich portfolio opportunities to their trust customers, charged very little (even by late
20th century standards) for equity underwriting, and managed to promote hightech, large-scale industrialization in Germany at an unprecedented speed.6
Both the American and the German historical experiences support the view that
allowing banks to lend, underwrite, and manage securities accounts substantially
reduced bank costs o f intermediation. The synergies from mixing lending, equity
holding, and underwriting in the United States and Germany historically are
present and visible in the United States today, even under the current limited incar
nation o f universal banking. Evidence from the current U.S. experience suggests
that Section 20 (underwriting) affiliates increase average returns and reduce risk
for their bank holding companies.7 Venture capital finance is another area in which
there are strong corporate finance synergies, both with lending and with underwrit
ing, since venture capital finance precedes public stock offerings.
The primary synergies are the repeat use o f information, the enhancement o f
corporate control, and the diversification o f bank income.8 By lending and under
writing, banks are able to use knowledge about the performance and risk o f their
corporate borrowers to reduce the cost o f underwriting and marketing securities.
Furthermore, informed banks’ involvement as holders o f equity (mainly via trust ac
count proxies) can enhance their control over firms and helped them to protect trust
customers’ interests, which also makes it easier to market equity. Finally, because
lending and underwriting tend to be imperfectly correlated risks, combining the
5 Evidence on diversification advantages is presented in Eugene N. White, “Before the GlassSteagall Act . .
(op. cit). A review o f the literature on efficiency gains in serving corporate
clients is provided in Charles W. Calomiris and Carlos Ramirez, “The Role o f Financial Relation
ships . . .” (op. cit).
6 For a discussion of the German case, see Charles W. Calomiris, “The Costs o f Rejecting Uni
versal Banking . . ” (op. cit.).
7 See Elijah Brewer, “Relationship Between Bank Holding Company Risk and Nonbank Activ
ity,” Journal of Economics and Business, Vol. 41 (November), pp. 337-353; Myron Kwast, “The
Impact o f Underwriting and Dealing on Bank Return and Risks,” Journal of Banking and
Finance, Vol. 13, pp. 101-125; Vincent P. Apilado, John G. Gallo, and Larry J. Lockwood, “Ex
panded Securit'as Underwriting: Implications for Bank Risk and Return,” Journal of Economics
and Business, Vol. 45, pp. 143-158; Simon H. Kwan, “Securities Activities by Commercial Bank
ing Firm s’ Section 20 Subsidiaries,” Federal Reserve Bank o f San Francisco, Working Paper,
January 1997.
8 For a more detailed discussion, see Charles W. Calomiris, “Comments on Steinherr,
Kroszner, and Benston Papers,” in Universal Banking: Financial System Design Reconsidered,
edited by Anthony Saunders and Ingo Walter, Homewood, Illinois: Business One-Irwin, 1996,
109-117.
70
activities can help banks to diversify their assets, which economizes on bank capital
and reduces banks’ costs o f funds.
It is very important to keep in mind that in a competitive banking system these
reduced costs o f intermediation accrue mainly to bank customers (that is, banks’ cli
ents’ stockholders and bank depositors). It is also important to note that these
synergies are undermined by firewalls.
If firewalls require separation o f types of activities into different entities (that is,
entities with separate corporate identities, liabilities, and capital) then cost o f funds
advantages from diversification across activities will be severely limited. If firewalls
require that lending and underwriting by the bank not be allowed for the same cli
ent firm, then any potential information synergies across activities will be foregone.
If firewalls prevent banks from being actively involved in controlling the firms they
finance (via boards o f directors, or trust account and mutual fund holdings o f stock),
then control synergies will be limited.
The current Fed proposals to repeal firewalls would improve the efficiency o f the
financial system mainly by increasing the multiple use o f information within the
bank and by enhancing bank involvement in corporate control. These proposals
reflect a growing realization that concerns over conflicts o f interest are largely un
founded (as they were in 1933) because dishonest behavior is contrary to the inter
ests of the bank, especially in the highly competitive financial services industry, and
is already proscribed by other laws and regulations.
It is worth noting that the Fed is not proposing to remove all firewalls. The Fed
proposes to retain the limitations on the mixing of “bank” and “nonbank” risks (spe
cifically, Sections 23A and 23B o f the Federal Reserve Act, which limit the extent
of lending from banks to nonbank affiliates, and require that it be fully collatera
lized and priced as an arm’s-length loan). Chairman Greenspan argues in his testi
mony o f February 13, 1997, that Sections 23A and 23B provide essential protection
against the abuse o f deposit insurance protection by bank holding companies.9
I share Chairman Greenspan’s concern that under the current deposit insurance
system the absence o f financial firewalls (like 23A and 23B) could lead to abuse o f
deposit insurance.10 But I do not agree with his solution to the problem. A better
alternative would be to remove the possibility that banks would receive subsidized
insurance, which would thereby remove any incentive problem from mixing the risks
of lending and underwriting, and thus allow banks and their customers to reap the
gains from relaxing Sections 23A and 23B. Such reform is feasible and the relative
merits o f various approaches for doing so— including subordinated debt require
ments and other deposit insurance reforms— are currently being debated among
bankers, academics, and regulators.
Chairman Greenspan also argued that the holding company structure is a supe
rior mechanism for administering firewalls, and that thus it is essential to restrict
Section 20 activities (and other “nonbank”activities) to bank holding company affili
ates. Thus, he does not support the Comptroller’s “Part Five” initiative to allow new
activities to occur within subsidiaries o f national banks. I do not share his view.
There is no reason I can discern why any particular firewall cannot be administered
as well within a bank subsidiary structure as it is within a bank holding company
affiliate structure.11 Also, it is my understanding that there is little merit to the
argument that legally, the “corporate veil” o f a subsidiary is more easily pierced
than that o f an affiliate.
The argument for retaining a Federal Reserve monopoly on regulating Section 20
activities seems, then, to rest on the view that there is a need to have an “umbrella”
regulator (namely, the Fed) that oversees all holding company risks. That is only
necessary, logically, if two conditions are satisfied: First, if potential subsidies from
deposit insurance cannot be eliminated; and second, if firewalls cannot insulate
banks from the risks undertaken by nonbank subsidiaries or affiliates. Since I be
lieve neither o f these necessary conditions is true, I do not support the Fed’s view
that it should retain a regulatory monopoly over nonbank activities.
9 Alan Greenspan, “Statement Before the Subcommittee on Financial Institutions and Con
sumer Credit o f the Committee on Banking and Financial Services, U.S. House o f Representa
tives,” February 13, 1997.
101 do not agree with Chairman Greenspan’s view that there is currently a subsidy enjoyed
by 'many banks by virtue o f their access to deposit insurance, but I do think there is the poten
tial for a subsidy, particularly under the current deposit insurance laws, if Sections 23A and
23B were removed. For a discussion o f whether there is a current subsidy, see Gary Whalen,
“The Competitive Implications o f Safety Net-Related Subsidies,” Economics Department W ork
ing Paper, Office o f the Comptroller o f the Currency, February 1997.
11 See also, Gary Whalen, “Bank Organizational Form and the Risks o f Expanded Activities,”
Economics Working Paper 97 -1, Office o f the Comptroller o f the Currency, January 1997.
71
An advantage to allowing the Comptroller to “compete” with the Fed over
nonbank activity regulation is that such competition will promote a health tendency
for both regulators to properly balance the costs and benefits o f firewalls, and thus
produce neither excessive caution nor imprudent deregulation. Competing regulators
jealous o f each other’s “turf” will not be imprudent because a financial collapse of
a barks under their authority would risk a significant loss o f their powers. At the
same time, excessive caution would produce an immediate loss o f regulatory power,
since banks would gravitate toward the more liberal regulator. Thus, competing
regulators are likely to consider and balance both costs and benefits when making
regulatory decisions.
In conclusion, I strongly support the Fed’s proposal to roll back firewalls. I also
encourage the Fed, the Office of the Comptroller, and Congress to consider reforms
to deposit insurance that would permit additional rolling back o f firewalls. Finally,
I encourage Congress to retain the current healthy competition that exists between
the Office o f the Comptroller of the Currency and the Federal Reserve Board.
I f Congress and bank regulators succeed in freeing banks from costly and unwar
ranted limitations on their powers, the advantages for banks and their customers
will be large. I would emphasize that the banks that will gain from such expansion
o f powers will increasingly include super-regional and regional banks, in addition
to money-center banks. As the technology for placing securities improves, and bar
riers to low-cost public issues of securities are removed for many firms, it seems
likely that more and more regionals and super-regionals will find it advantageous
to establish Section 20 affiliates or subsidiaries to publicly place their clients’ debt
and equity in securities markets. Those innovations and the curtailment o f firewalls
will also encourage regionals and super-regionals to enter the highly profitable area
o f venture capital finance via SBIC’s (Small Business Investment Companies) or
Regulation Y venture capital affiliates. Venture capital finance is an important mid
dle ground in the financial life cycle of firms between an early “bank lending stage”
and a late “public securities financing stage.” Thus, bank involvement in venture
capital will magnify synergies between bank lending and public securities under
writing.
Not only will regional and super-regional banks benefit from those changes, but
so will their corporate clients. Many more firms will enjoy lower costs o f finance
from access to private equity (in venture capital affiliates), which leads naturally
to public debt and eauity offerings (underwritten by Section 20 affiliates). The social
gains o f that expanded access to private and public equity finance could be large.
72
RESPONSE TO WRITTEN QUESTIONS OF SENATOR FAIRCLOTH
FROM CHARLES W. CALOMIRIS
[B e l o w I p r o v i d e a n s w e r s t o t h e q u e s t i o n s p o s e d i n
C h a i r m a n F a i r c l o t h ’ s H e a r i n g I n v i t a t i o n o f M a r c h 14, 1997]
Q .l. Provide a historical perspective on the separation of invest
ment and commercial banking and the development of the firewalls
in 1987.
A .l. The separation of commercial and investment banking in 1933
reflected two factors. The first was the Depression-era view (seem
ingly confirmed by the Pecora hearings) that securities underwrit
ing by banks had been “dishonest” and had crippled banks during
the Depression. This recent research (noted above) has shown that
securities underwriting by banks prior to 1933 was at least as hon
est as securities underwriting outside of banks, and that securities
activities helped to stabilize banks because they were highly diver
sifying. The second, and most important, factor leading to the pas
sage of Glass-Steagall was Carter Glass's fervent commitment to
separating commercial and investment banking.
The Banking Act of 1933 was a compromise between Steagall
(who advocated deposit insurance as a palliative for small banks in
distress) and Glass (who pushed for the separation of commercial
and investment banking, and for Regulation Q). Glass was an origi
nal architect of the Federal Reserve Act of 1913, and an advocate
of the “real bills doctrine,” which held that banks should mainly
finance commercial, rather than industrial activity. Regulation Q
was designed largely to undermine reserve pyramiding in New
York, and thus remove banks from financing activities in the call
money market. Similarly, the separation of commercial and invest
ment banking would encourage banks to avoid securities dealings,
and industrial finance more generally. The real bills doctrine was
viewed as a means to preserve the money supply from unwarranted
supply fluctuations unrelated to real economic activity. Obviously,
this debate is not relevant to current bank regulatory policy, since
Section 20 affiliates, activities have no effect on the money supply.
Furthermore, to my knowledge, the real bills doctrine has no cur
rent advocates.
Q.2. Can changes be made to firewalls while preserving the safety
and soundness of the banking system and the integrity of the in
sured depository institution?
A.2. To reiterate, I believe that there is no threat to the safety of
banks or the banking system from relaxing the firewalls the Fed
is now proposing to relax. If the Fed were considering relaxing Sec
tions 23A and 23B without making additional changes to deposit
insurance law, that might pose a problem, but that is not what the
Fed is proposing to do.
Q.3. Can changes be made to firewalls while adequately protecting
customers of the bank or securities affiliate from coercion?
A.3. Evidence suggests that allowing closer linkages between com
mercial banks and underwriting operations would improve banks’
information about their customers and their ability to control their
financial decisions, but that does not mean it would increase “coer
cion” (which I would define as the power of banks to extract “rents”
73
from their customers). Whether beneficial discipline or non-beneficial coercion results from expanded bank powers depends on how
competitive the banking system is. In today’s highly competitive
system, discipline rather than coercion would result from greater
bank powers. Indeed, one could argue that because expanding pow
ers via relaxed firewalls would increase competition in financial
services broadly defined, it would actually reduce the potential for
coercion. It is important to note that corporate bank customers do
not see any threat to their well being from expanding bank powers.
Indeed, corporate clients of banks were among the earliest advo
cates of allowing banks to underwrite securities. The Fed’s decision
to permit banks to engage in underwriting specifically cited survey
results of corporate managers, who overwhelmingly recommended
doing so.
Q.4. Will the firewalls give securities firms affiliated with an in
sured depository institution an advantage over other firms?
A.4. The fact that there are synergies between commercial banking
and investment banking implies that banks’ competitive positions
would be improved relative to investment banks by relaxing fire
walls. But that is not to say that banks will be better off because
of their access to deposit insurance, per se. So long as Sections 23A
and 23B limit the mixing of risks between banks and nonbank
affiliates (or subsidiaries) there is little potential for abuse of de
posit insurance, even if deposit insurance were subsidized, and
thus the presence of deposit insurance cannot provide a competitive
advantage.
Q.5. If the firewalls are modified what other protections exist in
statute and regulation that will serve as a substitute?
A.5. The Fed’s “Review of Restrictions in the Board’s Section 20
Orders” (January 9, 1997) reviews a large range of remaining safe
guards, including capital requirements, Sections 23A and 23B re
strictions, SEC regulations, and other laws and regulations. I agree
with the Fed’s view that these remaining safeguards are adequate.
Q.6. Please offer general comments on other recent modifications
made by the Board to Section 20 activities, including the raising
of the cap from 10 percent to 25 percent and the easing of crossmarketing restrictions.
A.6. I am in favor of both. Obviously, synergies will be larger if the
volume of equity underwriting is larger, since this is one of the
most important sources of the gains discussed above. I would be in
favor of eliminating the revenue cap altogether. With respect to
cross-marketing, it is important to note that banking is a ‘‘relationship-based,” not a “product-based” business. Cross-marketing is es
sential to the logic of the efficiency gains from universal banking.
Recent research has argued against the view that dishonest behav
ior would result from permitting cross-marketing.
74
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM GOVERNOR SUSAN M. PHILLIPS
Q.l. Currently, the Federal Reserve requires a bank holding com
pany to deduct from its capital any investments in and extensions
of credit to a securities affiliate. As you testified, Governor Phillips,
the purpose of this provision was to ensure that capital needed by
a Federally-insured bank was not diverted instead to a securities
affiliate. As I understand it, the Federal Reserve now proposes to
eliminate this provision, so that investments by a bank holding
company in a securities subsidiary will be treated the same as in
vestments in any other type of subsidiary. Should all investments
in subsidiaries by bank holding companies be treated the same?
Q.2. Isn't an investment in a securities subsidiary riskier than,
say, an investment in a data processing subsidiary?
A.1. & A.2. Although the Federal Reserve Board has not finalized
action on its proposal, the Board has stated its preliminary belief
that a bank holding company’s investment in a Section 20 subsidi
ary should not be deducted from capital. (The firewall affects only
the bank holding company’s regulatory capital, not the capital of
any of its subsidiary banks.) The Board noted that bank holding
company investments in other subsidiaries require no such capital
deduction. Bank holding companies are subject to consolidated cap
ital requirements, and therefore capital must be held against the
assets of the Section 20 subsidiary and all other subsidiaries of the
bank holding company. This treatment is consistent with Generally
Accepted Accounting Principles (GAAP), which requires consolida
tion of all wholly-owned subsidiaries, and does not provide for cap
ital deductions for any particular type of subsidiary.
In practice, the deconsolidation requirement has created regula
tory burden without strengthening the capital of the organization.
Its inconsistency with GAAP has created confusion and imposed
costs by requiring bank holding companies to prepare statements
on two bases, while independent bank analysts have continued to
focus on the consolidated bank holding company. Meanwhile, the
deduction does not strengthen the capital of any insured depository
institution affiliate of the Section 20 subsidiary or the Section 20
subsidiary itself, which is already subject to SEC-imposed capital
requirements.
The relative risks presented by bank holding company subsidiar
ies, of course, vary depending on the amount and type of activities
undertaken, as well as the quality of the systems and management
charged with measuring and managing risk. The Federal Reserve
Board’s experience with Section 20 subsidiaries is that their risks
are manageable and that they have not caused significant losses to
any of the bank holding companies that operate them. Thus, I can
not say that operation of a Section 20 affiliate is inherently more
risky than operation of some other bank holding company subsidi
aries—including bank and nonbank subsidiaries engaged in com
mercial lending.
75
GOVERNOR SUSAN M. PHILLIPS SUBSEQUENTLY SUBMITTED
THE FOLLOWING INFORMATION FOR THE RECORD
AT THE REQUEST OF SENATOR PAUL S. SARBANES
Q. [D]on’t some types of transactions pose such clear conflicts of
interest that they should not be permitted at all? Aren’t these pre
cisely the types of transactions about which we need to be on
guard, in fact, the very types of transactions that were found to be
commonplace before the enactment of Glass-Steagall?
A. I agree that there are some types of transactions involving a
bank and a securities affiliate that pose such serious conflicts of in
terest that they should be prohibited. However, I believe that the
banking and securities laws generally prohibit or restrict these
transactions in a way that protects customers, the insured institu
tion, and the interests of fair competition. The Section 20 firewalls
were not enacted or in any way mandated by Congress, but were
rather a conservative, discretionary step taken by the Federal Re
serve Board pursuant to its authority under the Bank Holding
Company Act in order to make absolutely certain that underwriting
and dealing risk was not passed to a bank. In evaluating the com
ments and deciding whether to adopt its proposal, the Board will
be evaluating whether these special, additional protections con
tinue to be necessary.
Two types of transactions that pose special concerns involve: (1)
the possibility of a bank’s trust department making fiduciary pur
chases of securities being underwritten or dealt in by a Section 20
affiliate; and, (2) the possibility of a bank lending at below-market
rates to customers to induce them to purchase securities being un
derwritten or dealt in by an affiliate.
Fiduciary Purchases
Section 23B of the Federal Reserve Act prohibits a bank from
making fiduciary purchases from a Section 20 affiliate’s dealer
portfolio unless the purchase is permitted by the customer’s trust
agreement with the bank, a court order, or State law. (This restric
tion parallels a very similar restriction on a national bank making
fiduciary purchases of bank-eligible bonds that it is underwriting.)
Furthermore, the trust officer is under a fiduciary duty to the cus
tomer, which if violated can make the trust officer and the bank
liable. (For a retail customer, this would be a matter of State law.
If the purchase were on behalf of a pension fund, ERISA would im
pose the duty.) Thus, if the asset being purchased were not a suit
able investment for the customer and the customer lost money, he
or she could sue for damages.
Section 23B also requires that any purchase of Section 20-underwritten securities by an affiliated bank—whether acting as fidu
ciary or as principal—be approved by a majority of the bank’s
board of directors who are not officers of any bank or any affiliate.
The outside directors can satisfy this requirement either by caseby-case approvals or by the establishment in advance of specific
standards for such purchases. However, any such standards must
be regularly reviewed to ensure that they have been followed in
practice and continue to be appropriate in light of market and
other conditions.
76
Finally, like any other broker-dealer, a Section 20 affiliate is sub
ject to the disclosure and anti-fraud provisions of the securities
laws, the NASD, and the exchanges. Under the securities laws, a
bank could be held liable for aiding and abetting any violation.
Loans to Facilitate Customer Purchases of an
Affiliate’s Securities
A second type of transaction that provokes concern is the poten
tial for a bank to lend to a customer in order to allow the customer
to purchase securities being underwritten or dealt in by a Section
20 affiliate. The concern is three-fold: first, that the customer
might be induced or coerced into purchasing bad securities; second,
that the bank might risk its own safety and soundness by lending
at below-market terms in order to support an affiliate; and third,
that the Section 20 affiliate might gain a competitive advantage
over its independent investment banking competitors. Again, pro
tections aside from the existing Section 20 firewalls guard against
these dangers, and the Board will have to decide whether they are
sufficient in all cases.
Customer Protections
The customer is protected both by regulating the terms of the
transaction and by informing the customer about it. As for terms,
the bank cannot entice a customer into making the purchase with
easy credit terms. Section 23B of the Federal Reserve Act requires
that any loan to a customer to purchase from an affiliate be on
arm's-length terms, and the anti-tying laws prohibit a bank from
offering discounted credit on the condition that the proceeds be
used to purchase securities from an affiliate.
Disclosure requirements ensure that the customer is aware of the
nature of the product being purchased. The Interagency Statement
on Retail Sales of Nondeposit Investment Products requires the
bank to inform the customer that any product being purchased
from a securities affiliate is not Federally-insured or guaranteed by
the bank. Under the Board’s proposed operating standards, a bank
could not recommend the purchase of securities being underwritten
by an affiliate unless it notified the customer of its affiliate's role.
Finally, if a customer wishes to borrow from a bank to fund a
purchase of securities from a Section 20 affiliate, the idea must
originate with the customer. A Section 20 affiliate is prohibited by
Section 11(d) of the Securities Exchange Act of 1934 from arrang
ing for a bank to lend during the underwriting period. Thus, a
broker could not say, ‘Til make this purchase easy by arranging for
you to borrow from our affiliated bank.”
Bank Protections
The bank as well as the customer is protected when lending to
fund securities purchases from an affiliate. (Indeed, many of the
same restrictions also protect a bank when it lends directly to the
Section 20 affiliate or provides credit enhancements in support of
securities underwritten by an affiliate.)
Under Section 23B, any loan to a customer to fund a purchase
of securities from an affiliate must be on arm's-length terms—that
is, at market rates. (The same is true for loans to an affiliate or
77
credit enhancement on behalf of securities underwritten by an affil
iate.) Thus, the bank cannot expose itself to loss by underpricing
credit or taking insufficient collateral in an effort to benefit its se
curities affiliate. To the extent that the proceeds of the loan are
transferred to the Section 20 affiliate, Section 23A of the Federal
Reserve Act imposes quantitative limits on the amount of the loan
and specifies the collateral that must be held.
The bank must hold capital against such a loan, and against any
guaranty or other off-balance-sheet contingent liability. (This was
not true at the time the Section 20 firewalls were first adopted by
the Board.) Furthermore, under the national bank lending limit, a
bank cannot lend to any one person an amount greater than 15
percent of its capital on an uncollateralized basis and more than
10 percent of its capital on a collateralized basis.1
Under the Board's proposed operating standards, if the bank
should become less than well capitalized, the Board would retain
discretion to stop any dealings involving a securities affiliate.
Competitors
The anti-tying laws prohibit a bank from conditioning the avail
ability of a loan, or a more favorable rate on a loan, on a customer’s
using the proceeds to purchase securities from an affiliate. (The
same laws prohibit a bank from conditioning the availability of a
loan, or a more favorable rate on the loan, on an issuer using a Sec
tion 20 affiliate for the underwriting.)
GOVERNOR SUSAN M. PHILLIPS SUBSEQUENTLY SUBMITTED
THE FOLLOWING INFORMATION FOR THE RECORD
AT THE REQUEST OF SENATOR LAUCH FAIRCLOTH
SECTIONS 23A AND 23B OF THE FEDERAL RESERVE ACT
FEDERAL RESERVE’S SUPERVISORY EXPERIENCE
This memorandum provides information on how the Federal Re
serve examines for and enforces compliance with Sections 23A and
23B of the Federal Reserve Act. Included below are a description
of the examination procedures used to monitor compliance and de
tect violations, and the measures used to correct violations and to
prevent their recurrence, and a summary of representative viola
tions discovered. While the provisions of Sections 23A and 23B
apply to all FDIC-insured depository institutions, the information
provided herein pertains only to the examination procedures and
supervisory experience of the Federal Reserve in enforcing these
provisions.
Sections 23A/23B Examination Policies and Procedures
The Federal Reserve takes a two-pronged approach in verifying
compliance with Sections 23A and 23B by reviewing transactions
at the subsidiary bank level during commercial bank and trust ex
aminations, and by reviewing intercompany transactions at the
parent level (including nonbank subsidiaries) during bank holding
1This is the national bank lending limit, but State laws are similar.
78
company inspections. In instances where the Federal Reserve is not
the primary Federal bank regulator, our examiners rely on the pri
mary Federal regulator's report of examination for any violations
of law applicable to intercompany transactions.
The main inspection and examination objectives with regard to
Sections 23A and 23B can be summarized as follows: (1) to analyze
and assess the financial impact of transactions between subsidiary
banks, and their subsidiaries, and their affiliates; (2) to determine
whether inter-affiliate transactions comply with the various restric
tions of Sections 23A and 23B; (3) to determine if low-quality assets
have been purchased by a bank; (4) to determine whether a bank
has purchased, as a fiduciary, or for its own account, any securities
or other assets from an affiliate (permissible under certain circum
stances); (5) to determine whether any advertisement or agreement
implies, in any way, that a bank will be responsible for the obliga
tions of an affiliate; (6) to determine whether transactions are con
sistent with safe and sound banking practices; and (7) to initiate
corrective action when policies, procedures, practices, or internal
controls are deficient or when violations have been noted.
When conducting a bank holding company inspection, Federal
Reserve examiners are instructed to: (1) review the holding compa
ny's policies and procedures regarding intercompany transactions
of subsidiary banks; (2) focus attention on certain activities that
might create problem situations; (3) review checking accounts and
bank statements of the parent and nonbank subsidiaries for over
drafts; (4) review relevant accounts payable and review receivables
to identify possible noncompliance with Sections 23A and 23B; (5)
review other transactions that the parent or other affiliate has
engaged in with affiliated banks to determine whether they are
subject to Sections 23A and 23B restrictions; and (6) discuss the
findings with management. Also, during Section 20 subsidiary in
spections, Federal Reserve examiners: (1) verify compliance with
firewalls restricting intercompany transactions; (2) review inter
company transactions noted on financial reports; and (3) review
service agreements for compliance with Section 23B in instances
where a Section 20 subsidiary serves as agent for an affiliated
bank.
In conducting State member bank examinations, Federal Reserve
examiners are requested to: (1) review information concerning fees
paid and received and receivables from, and payable to, affiliates;
(2) ensure compliance with the quantitative transaction limits with
affiliates; (3) verify compliance with the collateral requirements of
Section 23A; (4) ensure that low-quality assets have not been pur
chased from an affiliate; and (5) determine that all transactions
with affiliates are on market terms and are consistent with safe
and sound banking practices.
With respect to trust examinations, Federal Reserve examiners
identify and evaluate policies and procedures related to purchasing
securities from affiliates and impermissible self-dealing. Moreover,
Federal Reserve trust examiners review securities transactions
with affiliates for compliance with Section 23B, as well as State
and common law prohibitions.
79
Detection of Sections 23A and 23B Violations
The vast majority of violations of Sections 23A and 23B tend to
occur at small bank holding company organizations, despite the
fact that the transactions between small banks and their affiliates
usually are not numerous or complex. Small bank holding compa
nies generally have less sophisticated internal control environ
ments and compliance functions. On the other hand, the larger
bank holding companies often have more complex structures, with
a consequently greater potential for transactions that might violate
Sections 23A and 23B. Larger organizations, however, generally
have much more disciplined internal control environments and so
phisticated compliance functions, thereby reducing the potential for
violations.
Section 23A
Violations of Section 23A conceptually can be divided into two
groups: (1) relatively simple Section 23A violations, which rep
resent roughly 90 percent of all Section 23A violations, and which
are normally detected in the examination process; or (2) more com
plex and, in some instances, convoluted transactions, the detection
of which may require a thorough knowledge of Federal Reserve rul
ings and interpretations, staff opinions and interpretive letters.
The latter transactions tend to be the ones that are more difficult
to identify—particularly if there should be malfeasance and an at
tempt to evade deliberately statutory requirements. Common vio
lations of Section 23A include: (1) overdrafts and other unsecured
or inadequately secured extensions of credit, including tax overpay
ments of a bank to its parent holding company and failure of an
affiliate to reimburse promptly the bank for advancement of ex
penses; (2) extensions of credit or purchases of assets in excess of
the quantitative limit; and (3) purchases of low-quality assets.
All of the above violations relate to the transfer of bank funds
to an affiliate in disregard for the quantitative or qualitative re
quirements of Section 23A. Section 23A is designed to protect in
sured depository institutions by ensuring that those institutions
are not disadvantaged, from a liquidity or loss standpoint, in trans
actions with affiliates, or otherwise put at risk to the benefit of
affiliates.
Section 23B
The basic premise of Section 23B is simple: A bank must engage
in transactions with its affiliates that are on terms as least as fa
vorable to the insured institution as those prevailing at the time
for comparable transactions with unaffiliated companies. In the ex
treme, it is easy to identify readily certain transactions as abusive,
such as nonpayment for services or facilities. In less extreme situa
tions, however, it may be difficult to demonstrate that a trans
action took place on market terms, because of the subjective nature
of the standard. It may, for example, be difficult to find comparable
transactions involving non-affiliated parties. Nevertheless, examin
ers have been able to detect abuses where they have occurred.
The common violations of Section 23B include: (1) extensions of
credit that contain terms that could not be obtained from a non
affiliate; (2) bank payment of an expense for the benefit of an affili
80
ate; (3) bank prepayment of a parent-assessed management fee;
and (4) no reimbursement to the bank for salaries and benefits of
bank employees who perform some type of work for an affiliate.
Corrective Action
Generally, Sections 23A and 23B violations are discovered during
the examination or inspection process. During favorable economic
banking conditions, the preponderance of the violations found by
examiners are technical in nature and do not involve abusive prac
tices. Generally, these violations are noted and brought to the insti
tution’s attention either by the examiners meeting with the institu
tion’s management and board of directors or by inclusion in the ex
amination or inspection report, or both. For the most part, such
violations are corrected voluntarily, and generally soon after being
brought to the attention of the organization. In the small number
of cases where violations are not immediately corrected or recur,
and are noted in the next examination or inspection report, the Re
serve Banks will likely institute some type of informal supervisory
action (for example, board of directors’ resolutions, and memoran
dums of understanding). In the past several years, there have been
a very small number of informal actions taken by Reserve Banks.
On the other hand, when the banking industry is experiencing
difficulties, violations tend to involve more abusive practices, for
example, a bank’s improper funding of an affiliate experiencing li
quidity problems.
With respect to abusive practices or situations involving chronic
violations, formal enforcement actions (such as written agreements,
cease and desist orders, or civil money penalties) will be pursued.
Over the past 3 years, 12 formal enforcement actions taken by the
Federal Reserve have addressed violations of Sections 23A and
23B, among other problems or deficiencies, and directed future
compliance with the law. These actions have addressed the follow
ing types of violations: (1) bank extension of unsecured credit to an
affiliate; (2) bank payment of an affiliate’s expenses; (3) an affili
ate’s overdrawn account at the bank; (4) bank overpayment of tax
liability to the parent bank holding company; (5) bank exceeding
aggregate limit on covered transactions; (6) bank transactions with
an affiliate not at arm’s length; (7) an affiliate’s use of bank person
nel without compensating the bank; and (8) unreimbursed affiliate
expenses. One of these formal actions involved a Section 23B viola
tion in connection with the fee structure associated with a Section
20 subsidiary serving as agent for its affiliated bank.
GOVERNOR SUSAN M. PHILLIPS SUBSEQUENTLY SUBMITTED
THE FOLLOWING INFORMATION FOR THE RECORD
AT THE REQUEST OF SENATOR MICHAEL B. ENZI
SUMMARY OF REMAINING PROTECTIONS IF THE BOARD’S
FIREWALL PROPOSAL WERE ADOPTED
Capital Requirements
• Risk-based capital requirements for bank holding companies (in
cluding consolidated assets of any Section 20 subsidiary).
81
• Risk-based capital requirements for insured depository institu
tions.
• Board operating standard requiring that bank holding company
or foreign bank maintain adequate capital on a fully consolidated
basis.
• SEC net capital rules imposed on Section 20 subsidiary (like any
other broker-dealer).
• The Generally Accepted Accounting Procedures (GAAP), which
require that financial statements accurately reflect the capital
strength of the holding company on a consolidated basis.
Protections For The Bank When Bank Lends Directly To
Section 20 Affiliate
• Under Sections 23A or 23B of the Federal Reserve Act, a bank
would not be able to expose more than 10 percent of its capital
to the Section 20 affiliate directly, would have to deal with the
Section 20 affiliate on arm’s-length (market) terms, could not
purchase low-quality assets from the affiliate, and could not pur
chase securities underwritten by a Section 20 affiliate during the
existence of the underwriting or selling syndicate unless the
bank’s board of directors approves. The bank is further prohib
ited from engaging in any unsafe or unsound practice with an
affiliate.
• The Board’s proposed operating standard would also restrict
intra-day extensions of credit that fall outside of Sections 23A
and 23B, generally holding them to the same standard as 23B.
• Purchases of assets by a bank from its affiliate (which could be
manipulated to serve as a funding vehicle) are also subject to
Section 23B. Section 23A(a)(3) also generally prohibits a bank
from purchasing a low-quality asset from an affiliate. A “lowquality asset” is defined to include: (A) an asset classified as
“substandard,” “doubtful,” or “loss” or treated as “other loans es
pecially mentioned” in the Section 20 affiliate’s most recent re
port of examination or inspection; (B) an asset in an non-accrual
status; (C) an asset on which principal or interest payments are
more than 30 days past due; or (D) an asset whose terms have
been renegotiated or compromised due to the deteriorating finan
cial condition of the obligor.
Protections To Ensure That Customers Are Not Confused
When Purchasing Products Of The Section 20 Affiliate
• The Interagency Statement on Retail Sales of Nondeposit Invest
ment Products imposes disclosure and other requirements on
sales of nondeposit investment products either by bank employ
ees or on bank premises. The required disclosures, which a Sec
tion 20 affiliate selling securities on bank premises would also
have to make, are designed to ensure that customers understand
that they are not dealing with a bank or thrift, and that the
products they are purchasing are not Federally-insured or bank
guaranteed. The Interagency Statement also requires that sales
or recommendations of nondeposit investment products on the
premises of a depository institution be conducted in a physical
location distinct from the area where retail deposits are taken.
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• Proposed operating standard would require Section 20 affiliate to
make the same disclosures even when not operating on bank
premises.
• Proposed operating standard would prohibit a bank from know
ingly expressing an opinion on the advisability of purchasing or
selling ineligible securities underwritten or dealt in by an affili
ated underwriting subsidiary unless the bank notifies the cus
tomer that the underwriting subsidiary is underwriting, making
a market, distributing or dealing in the security.
• Section 23B(c) of the Federal Reserve Act prohibits a bank or any
Section 20 affiliate from advertising or entering into an agree
ment stating or suggesting that the bank is responsible in any
way for the Section 20 affiliate's obligations. A parallel SEC rule
(Rule 10b-10) and NASD rule (Rule 2250) would require a Sec
tion 20 affiliate to disclose that it is a market maker in a secu
rity before selling or recommending that security.
Protections For The Bank And For Fair Competition
When Bank Enhances The Creditworthiness Of
Securities Being Underwritten By A Section 20 Affiliate
(e.g., Through A Guarantee Or Standby Letter Of Credit)
• Section 23B of the Federal Reserve Act requires that all credit
enhancements extended to an issuer whose securities are being
underwritten by a Section 20 affiliate be on market terms—that
is the same terms it would extend to an issuer whose securities
were being underwritten by an unaffiliated third-party. Con
sequently, for example, a bank could not offer such credit en
hancements at below-market prices, or to customers who were
poor credit risks, in order to generate underwriting business for
a Section 20 affiliate.
• Section 106 of the Bank Holding Company Act Amendments of
1970 would prohibit a bank from offering discounted credit en
hancements on the condition that an issuer obtain investment
banking services from a Section 20 affiliate.
• Risk-based capital requirements require that capital be held
against credit enhancements.
• Under the National Bank Act's loan-to-one borrower rules, na
tional banks may only lend an amount equal to 15 percent of
their capital on an uncollateralized basis and an additional 10
percent of their capital on a collateralized basis, and credit en
hancements generally would be aggregated along with all other
credit extended to an issuer in measuring compliance with these
limits. State laws applicable to State banks are generally the
same.
• The proposed operating standards require internal controls to en
sure that any credit enhancement is extended consistent with the
internal procedures of the bank, that independent credit judg
ment is exercised, and that documentation is maintained that
would allow examiners to assess compliance with these policies.
jBSv
Protections When Bank Lends To Customer To Purchase
Securities From An Affiliate
• Section 23B (transaction must be on arm’s-length terms), and
Section 23A (in cases where the bank knows that the proceeds
are being transferred to an affiliate).
• The anti-tying statute (Section 106 of the Bank Holding Conu
pany Act Amendments of 1970) prohibits a bank from condi
tioning a loan, or the terms thereof, on a customer’s using the
roceeds to purchase securities from an affiliate,
ection 11(d) of the Securities Exchange Act of 1934 prohibits a
broker-dealer (including a Section 20 affiliate) that is acting as
an underwriter from extending or arranging for credit to cus
tomers purchasing the newly-issued securities during the under
writing period. Thus, a Section 20 subsidiary acting as under
writer would be prohibited from arranging for an affiliated bank
to make loans to customers for purchases during an underwriting
period.1
• Proposed operating standard, discussed above, would prohibit a
bank from advising on the purchase without disclosing the affili
ate’s role.
E
Protections For The Bank When Bank Wishes To Lend To
Corporate Customer For Repayment Of Securities
Previously Underwritten By An Affiliate
• Section 23B.
• Capital requirements.
Protecting Bank From Being Held Liable For The Actions Of
A Section 20 Affiliate (Piercing Corporate Veil Of Bank)
• Section 20 affiliate is separately incorporated and capitalized and
is not controlled by the bank. Therefore, it is less likely to be
held to be a “mere instrumentality” of the bank, which could lead
to the bank’s being held liable.
• Proposed operating standard requires that the chief executive
officer and a majority of the board of directors of each company
be independent of the other.
• Separate books and records.
Protections When Bank Purchases Affiliate-Underwritten
Securities As Principal Or Fiduciary
• Section 23B(b)(l)(B) of the Federal Reserve Act prohibits a bank
from purchasing, as principal or fiduciary, any security for which
a Section 20 is a principal underwriter during the existence of
the underwriting or selling syndicate. Although there is an ex
ception if the purchase has been approved by a majority of the
bank’s board or directors who are not officers of any bank or any
affiliate, this does not happen often.
• If the purchase is as fiduciary, the purchase must be permitted
by the instrument creating the fiduciary relationship, court
order, or State law.
1 Section 11(d) would not apply in the absence of arranging and, unlike Firewall 6, would not
cover loans to purchase a security in which a Section 20 affiliate makes a market or purchases
from parties other than the Section 20 affiliate.
84
• If a fiduciary purchase were on behalf of a pension plan, then
ERISA would impose a fiduciary duty on the trustee.2 If the pur
chase were on behalf of a mutual fund, then Sections 10 and 17
of the Investment Company Act of 1940 would restrict the ability
of the mutual fund to purchase securities from an affiliate of the
investment advisor.3 If the purchase were on behalf of an indi
vidual, State law would impose a fiduciary duty on the trustee.
• If the bank were to purchase the security as principal directly
from the Section 20 affiliate, Section 23A would limit the amount
of such purchases. The bank would also be required to hold cap
ital against these exposures.
• The National Bank Act limits member banks to purchasing as
principal only readily marketable securities.4
o
2 29 U.S.C. 1002(21), 1104.
3 15 U.S.C. 80a-10, 80a-17.
4 12 U.S.C. 24 (Seventh), 335.
@FedFRASER