The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FEDERAL RESERVE SYSTEM
[Docket No. R-0841]
Revenue Limit on Bank-Ineligible Activities of Subsidiaries of Bank
Holding Companies Engaged in Underwriting and Dealing in Securities
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Notice.
SUMMARY: The Board is increasing from 10 percent to 25 percent the amount of
total revenue that a nonbank subsidiary of a bank holding company (a so-called
section 20 subsidiary) may derive from underwriting and dealing in securities that a
member bank may not underwrite or deal in. The revenue limit is designed to
ensure that a section 20 subsidiary will not be engaged principally in underwriting
and dealing in such securities in violation of section 20 of the Glass-Steagall Act.
Based on its experience supervising these subsidiaries and developments in the
securities markets since the revenue limitation was adopted in 1987, the Board has
concluded that a company earning 25 percent or less of its revenue from
underwriting and dealing would not be engaged principally in that activity for
purposes of section 20.
EFFECTIVE DATE: March 6, 1997.
-2FOR FURTHER INFORMATION CONTACT: Gregory A. Baer, Managing
Senior Counsel (202/452-3236), Thomas M. Corsi, Senior Attorney
(202/452-3275), Legal Division; Michael J. Schoenfeld, Senior Securities
Regulation Analyst (202/452- 2781), Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve System. For the hearing
impaired only, Telecommunication Device for the Deaf (TDD), Dorothea Thompson
(202/452-3544), Board of Governors of the Federal Reserve System, 20th Street
and Constitution Avenue, NW., Washington, DC.
SUPPLEMENTARY INFORMATION:
I. Background
Section 20 of 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.1/ In 1987, the Board first
interpreted that phrase to allow bank affiliates to engage in underwriting and dealing
in bank-ineligible securities -- that is, those securities that a member bank would not
be permitted to underwrite or deal in -- when the Board approved applications by
three bank holding companies to underwrite and deal in commercial paper,
1/
12 U.S.C. 377.
-3municipal revenue bonds, mortgage-backed securities, and
consumer-receivable-related securities (hereafter, "tier-one securities").2/ In 1989,
the Board allowed five bank holding companies to underwrite and deal in all debt
and equity securities (hereafter, "tier-two securities").3/
Currently, forty-one subsidiaries of bank holding companies are
authorized to engage in underwriting and dealing activities that are not authorized
for a member bank. Fifteen of these so-called section 20 subsidiaries have authority
to underwrite and deal in tier-one securities pursuant to the 1987 Order. Pursuant to
the 1989 Order, twenty-three section 20 subsidiaries have authority to underwrite
and deal in all tier-two securities, and three may underwrite and deal in all debt
securities.
2/
Citicorp, J.P. Morgan & Co., and Bankers Trust New York Corp., 73 Federal
Reserve Bulletin 473 (1987) (hereafter, 1987 Order), aff'd, Securities Industry Ass'n
v. Board of Governors, 839 F.2d 47, 66 (2d Cir.), cert. denied, 486 U.S. 1059
(1988) (hereafter, Citicorp); Chemical New York Corp., Chase Manhattan Corp.,
Bankers Trust New York Corp., Citicorp, Manufacturers Hanover Corp., and
Security Pacific Corp., 73 Federal Reserve Bulletin 731 (1987) (approving
underwriting and dealing in consumer-receivable-related securities, after having
deferred decision for 60 days in its 1987 Order).
3/
J.P. Morgan & Co., The Chase Manhattan Corp., Bankers Trust New York
Corp., Citicorp, and Security Pacific Corp., 75 Federal Reserve Bulletin 192 (1989)
(hereafter 1989 Order), aff'd, Securities Industries Ass'n v. Board of Governors, 900
F.2d 360 (D.C. Cir. 1990) (hereafter, SIA II).
-4The Board has established a revenue test to determine whether a
company is "engaged principally" in underwriting and dealing for purposes of
section 20. The revenue test provides that a section 20 subsidiary may not derive
more than 10 percent of its total revenue from underwriting and dealing in bankineligible securities. The Board arrived at this revenue test through a series of
interpretive steps, in a series of orders.
The Board interpreted the meaning of "engaged principally" in its 1987
order allowing Bankers Trust New York Corporation to engage in private placement
of commercial paper.4/ Having satisfied itself that the "engaged principally"
language of section 20 must allow some level of underwriting and dealing,5/ the
Board was required to choose between two alternative meanings of "principal." The
first meanings of "principal," advocated by the applicant, included definitions such
as "chief," "main," or "largest," and translated into allowing underwriting and
dealing to constitute up to 50 percent of the section 20 subsidiary's business or,
alternatively, to constitute anything other than its largest business (collectively, the
"largest activity interpretation"). The second meaning included definitions such as
4/
Bankers Trust New York Corporation, 73 Federal Reserve Bulletin 138
(1987) (hereafter, Bankers Trust).
5/
Bankers Trust order at 141; 1987 Order at 474.
-5"primary," "substantial," "leading," "important," or "outstanding" and translated into
a stricter limitation on underwriting and dealing -- that is, allowing underwriting and
dealing subject to a limit somewhat lower than 49 percent of the applicants'
business.6/ Based on the purposes and legislative history of Glass-Steagall Act, the
Board chose the latter interpretation.7/
The Board further found in the Bankers Trust order that the best
measure of the underwriting and dealing activity for purposes of section 20 was the
gross revenue derived from that activity.8/ The Bankers Trust order found that a
6/
Bankers Trust order at 140-42; see also 1987 Order at 477-78, 482-83.
7/
Bankers Trust order at 142.
8/
Bankers Trust order at 145; 1987 Order at 483-485. In terms of what revenue
to consider, the Board ruled that securities that a member bank was authorized to
underwrite under section 16 of the Glass-Steagall Act (for example, U.S.
government securities) were not covered by the prohibition of section 20;
accordingly, the Board decided that revenue derived from underwriting and dealing
in such securities should not count as underwriting and dealing for purposes of
section 20. Rather, only revenue earned on "ineligible securities" -- those that a
member bank could not underwrite or deal in -- was counted toward the section 20
limit. 1987 Order at 478; Citicorp, 839 F.2d at 62.
The Board also established a test based on the company's share of the
market in a particular security, but this market share test was subsequently struck
down by the Second Circuit. The court of appeals held that "by using the term
'engaged principally,' Congress indicated that its principal anxiety was over the
perceived risk to bank solvency resulting from their over-involvement in securities
activity. A market share limitation simply does not further reduce this congressional
worry." Citicorp, 839 F.2d at 68.
-6company deriving less than five percent of revenue would be in compliance with
section 20, but did not attempt to identify the maximum percentage of revenue
permitted by the statute.
Finally, in its 1987 Order, the Board translated its interpretation of
"engaged principally" into a quantitative limit on the amount of gross revenue that
could permissibly be derived from underwriting and dealing. The Board found that
underwriting and dealing in bank-ineligible securities would not be a "substantial"
activity for a section 20 subsidiary if the gross revenue derived from that activity did
not exceed 5 to 10 percent of the total gross revenue of the subsidiary.9/ As a
prudential matter, the Board initially limited ineligible revenue to 5 percent of total
revenue in order to gain experience in supervising such subsidiaries. In 1989, the
Board allowed section 20 subsidiaries to increase their underwriting and dealing
revenue to 10 percent of total revenue.10/
No changes were made to the revenue test in subsequent orders until,
in January 1993, the Board allowed section 20 subsidiaries to use an alternative
9/
10/
1987 Order at 485.
75 Fed. Reg. 751 (1989).
-7revenue test that was indexed to account for changes in interest rates since 1989.11/
The Board found that historically unusual changes in the level and structure of
interest rates had distorted the revenue test as a measure of the relative importance
of ineligible securities activity in a manner that was not anticipated when the
10 percent limit was adopted in 1989. In particular, the Board found that because
bank-eligible securities (such as U.S. government securities) tended to be shorter
term than ineligible securities, an increase in the steepness of the yield curve had
caused the revenue earned by at least some section 20 subsidiaries from holding
eligible securities to decline in relation to ineligible revenue, even as the relative
proportion of eligible and ineligible securities activities being conducted by these
subsidiaries remained unchanged.12/ Five section 20 subsidiaries are currently
operating under this indexed test; use of the test has not been more widespread
because the systems necessary to administer it are expensive and complicated.
11/
Order Approving Modifications to the Section 20 Orders, 79 Federal Reserve
Bulletin 226 (1993) (hereafter, 1993 Modification Order).
12/
1993 Modification Order at 228. Under the indexed revenue test, current
interest and dividend revenue from eligible and ineligible activities for each quarter
are increased or decreased by an adjustment factor provided by the Board. The
adjustment factors, which are calculated for securities of varying durations,
represent the ratio of interest rates on Treasury securities in the most recent quarter
to those in September 1989. Section 20 subsidiaries may use the adjustment factors
to "index" actual interest and dividend revenue based upon the average duration of
their eligible and ineligible securities portfolios.
-8II. Proposed Change to Revenue Limit
On July 31, 1996, the Board proposed to maintain the revenue measure
but increase the revenue limit from 10 percent of total revenue to 25 percent.13/ The
Board based this proposed increase on the experience it has gained through
supervision of the section 20 subsidiaries over a nine-year period. The Board stated
its belief that the limitation of 10 percent of total revenue it adopted in 1987, without
benefit of this experience, had unduly restricted the underwriting and dealing
activity of section 20 subsidiaries.
The Board noted that changes in the
product mix that section 20 subsidiaries are permitted to offer and developments in
the securities markets had affected the relationship between revenue and activity
since 1987.
III. General Summary of Comments
The Board received 42 public comments: 26 from banks, bank holding
companies and their trade groups; three from securities firms and one of their trade
groups; and the remainder from members of Congress, a community group, a think
tank, the Conference of State Bank Supervisors, and individuals. Thirty-four
commenters favored the proposal, and eight opposed. The banking industry
13/
61 FR 40643 (August 5, 1996).
-9comments generally supported the proposal, and the securities industry comments
generally opposed. The remaining comments were mixed.
Several banking industry commenters asked the Board to raise the
revenue limit higher than 25 percent, generally to 49 percent. Several banking
industry commenters also asked the Board to supplement the revenue test with an
asset-based test or a sales volume test.
The securities industry commenters argued that comprehensive reform
of the financial services industry is necessary and can be accomplished only through
legislative action. The Securities Industry Association (SIA) expressed concern that
if the Board were to increase the revenue limit to 25 percent, banks and bank
affiliates would have little or no incentive to support a financial services
modernization bill, because they would have received by rule much of the relief they
would have sought in legislation.14/ Securities industry commenters also argued that
securities, insurance, and other financial services firms would be placed at a
competitive disadvantage with banks.
14/
Seven members of the SIA wrote separately to dissent from its views. The
commenters noted that the association had recently supported other, noncomprehensive legislative reform of financial services regulation.
- 10 Several commenters opposed the increase in the limits on the grounds
that the Board had previously rejected in its 1987 Order any percentage limit greater
than 10 percent. Commenters also stated that a level of ineligible securities activity
giving rise to 25 percent of revenue must be considered "substantial" and therefore
to constitute being principally engaged in that activity.
The SIA argued that a 25 percent limit as a measure of "substantial"
was inconsistent with other laws that establish presumptions on a percentage basis,
including the Bank Holding Company Act and regulations of the Board and the
other banking agencies. The SIA also argued that raising the revenue limit to 25
percent could well render section 20 meaningless by permitting affiliations between
member banks and the largest investment banks in the country, and would thus be
contrary to the intent of Congress in enacting the Glass-Steagall Act to divorce
commercial and investment banking.
A community group argued that allowing bank holding companies to
expand further into securities underwriting without increased scrutiny under the
Community Reinvestment Act would result in further neglect by banks and bank
holding companies of the credit needs of low- and moderate-income neighborhoods
and households and small businesses. The commenter argued that banks affiliated
with section 20 subsidiaries have closed branches and reduced services to the
- 11 public, and therefore that the operation of section 20 subsidiaries has had adverse
effects on the public. The commenter argued that one of the problems that Congress
meant to address with the Glass-Steagall Act was the diversion of financial
resources in the banking system to the securities markets -- a diversion that allowed
and encouraged speculation in the securities markets and removed such funds from
use in the retail banking business. Finally, the commenter argued that allowing
expanded securities underwriting and dealing could undermine confidence in U.S.
banks during declines in the securities markets.
The Board received five comment letters from members of Congress.
Four Representatives supported the Board's proposal, and one opposed it.
IV. Final Order
A. Introduction
Interpreting section 20 is a difficult task. The language of the statute is
"intrinsically ambiguous,"15/ and further inquiry into the legislative history is
therefore necessary to interpret it. As the Board noted in its 1987 Order, this
inquiry "requires application of a statute adopted over 50 years ago in very different
15/
Citicorp, 839 F.2d at 63; cf. Board of Governors v. Agnew, 329 U.S. 441,
446 (1947) (the related term "primarily engaged" is susceptible to a range of
"accepted and common meanings").
- 12 circumstances to a financial services marketplace that technology and other
competitive forces have altered in a manner and to an extent never envisioned by the
enacting Congress."16/ Furthermore, although the general purpose of the
Glass-Steagall Act was to divorce commercial and investment banking, the express
language of section 20 clearly allows some level of investment banking for bank
affiliates.17/
16/
17/
1987 Order at 475.
The premise for this divorce was that the affiliation of commercial banking
had yielded abuses that had to be corrected. See generally Investment Company
Instit. v. Camp, 401 U.S. 617, 629-34 (1970) (discussing legislative history).
However, recent research indicates that this premise may have been inaccurate. See
James S. Ang and Terry Richardson, The Underwriting Experience of Commercial
Bank Affiliates Prior to the Glass-Steagall Act: A Reexamination of Evidence for
Passage of the Act, 18 J. Banking and Finance 351, 385 (1994) ("We have found no
evidence that bonds underwritten by the security affiliates of commercial banks as a
group [from 1926-1934] were in any way inferior to the bonds underwritten by
investment banks. . . . Bank affiliate issue default rates were lower, ex ante yields
were lower, ex post prices were higher and yield/price relation no different than
investment bank issues."); Randall S. Kroszner and Raghuram G. Rajan, Is the
Glass-Steagall Act Justified? A Study of the U.S. Experience with Universal
Banking Before 1933, 84 Amer. Econ. Rev. 810, 829 ("Not only did bank affiliates
underwrite higher-quality issues [from 1921-29], but also we find that the affiliateunderwritten issues performed better than comparable issues underwritten by
independent investment banks."); George J. Benston, The Separation of Commercial
and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered 41
(1990) ("The evidence from the pre-Glass-Steagall period is totally inconsistent with
the belief that banks' securities activities or investments caused them to fail or
caused the financial system to collapse.").
- 13 Although a few commenters criticized the Board for preempting the
Congress by reviewing its section 20 orders, the Board has in fact delayed a review
of its section 20 orders in the hope that Congressional action would make such a
review unnecessary. The Board continues to believe that reform of the laws
governing this nation's financial services is needed in order to ensure that our
nation's financial system remains innovative and competitive and provides services
to customers at the lowest possible cost. The Board does not believe that an
increase in the revenue limit detracts from the need for comprehensive reform and
does not intend for this step to substitute for such reform. Rather, the Board is
exercising its statutory responsibility to administer section 20 in light of significant
changes to the securities markets in the years since the Board first analyzed its
terms.
B. Summary
After considering the comments received, the Board has decided to
adopt the proposal and amend its section 20 orders to allow up to 25 percent of total
revenue to be earned from underwriting and dealing in bank-ineligible securities.
The Board has concluded that a 25 percent revenue limit is consistent with
section 4(c)(8) of the Bank Holding Company Act and section 20 of the
Glass-Steagall Act.
- 14 C. Glass-Steagall Act Analysis.
Based on its nine years of experience supervising section 20
subsidiaries, the Board has concluded that a company whose ineligible revenue
approaches 10 percent of total revenue is neither engaged principally, nor on the
verge of being engaged principally, in underwriting and dealing for purposes of
section 20. The Board has decided that a section 20 subsidiary will not be engaged
principally in such activities so long as ineligible revenue does not exceed 25
percent of total revenue.
In reaching this decision, the Board has not revisited its decisions,
beginning with its Bankers Trust order in 1987, that the "engaged principally"
standard of section 20 must be interpreted as "substantial" or "primary," rather than
as "chief" or "main" or "largest." The Board did not propose such a reinterpretation.
Similarly, the Board has not revisited its use of revenue as the appropriate measure
of business activity.
The Board has reviewed, however, its decision in the 1987 Order that
underwriting and dealing in bank-ineligible securities would be a "substantial
activity" of a section 20 subsidiary if such underwriting and dealing generated more
than 10 percent of the section 20 subsidiary's total revenue. The Board has
concluded that the 10 percent revenue limit unduly restricts the underwriting and
- 15 dealing activity of section 20 subsidiaries to a level that falls short of "principal
engagement" for purposes of section 20. This conclusion is based on the Board's
experience with the section 20 subsidiaries through the process of examination and
supervision. The conclusion is also supported by identifiable changes in the
relationship between gross revenue and underwriting and dealing activity since the
Board's 1987 Order.
First, a given level of activity in underwriting and dealing in tier-two
securities pursuant to the 1989 Order generally yields substantially higher revenue
than an equivalent level of activity in underwriting and dealing in tier-one securities
pursuant to the 1987 Order. Underwriting fees for tier-two securities are
significantly larger than fees for tier-one securities, particularly with respect to
equity securities and non-investment-grade debt securities.18/ Similarly, bid/offer
spreads on many corporate bonds and other tier-two securities are significantly
wider than the spreads on tier-one securities. Put another way, the Board has
concluded that (all else being equal) a company that maintained a constant level of
underwriting and dealing activity over the past nine years but shifted its product mix
18/
See, e.g., Investment Dealer's Digest 12 (Feb. 19, 1996); Investment Dealer's
Digest 19 (February 15, 1988).
- 16 to include tier-two securities would have seen a significant increase in ineligible
revenue.
Commenters confirmed this experience. One large bank holding
company noted that since receiving approval in late 1994 to engage in corporate
debt and equity activities, it had earned "an ever increasing level of revenue derived
from ineligible securities underwriting and dealing activities without a corresponding
percentage increase in the number or size of the transactions involving ineligible
securities. The factor primarily responsible for this revenue increase is . . . the
revenues generated by corporate -- particularly high yield -- debt activities. The
same level of corporate debt activity as a percentage of total transactions yields
greater ineligible revenues than a comparable number of transactions involving
commercial paper or municipal revenue bonds."
Second, a converse trend has developed with respect to eligible
revenue, where market changes have reduced the eligible revenue derived from a
given level of activity. Most notably, increased competition in brokerage services
has diminished revenue as a function of activity.19/ Lower commissions have
19/
See, e.g., The Economist 9 (April 15, 1995) ("Commissions on listed
securities as a percentage of the value of trade in these instruments have fallen from
70-90 basis points in the early 1980s to below 40 basis points. Even for over-thecounter trading . . . returns have fallen from 80-90 basis points to around 20 basis
- 17 required companies to increase volume in order to maintain a given level of eligible
revenue. This market change particularly affects any company with a large retail
investor base -- generally those operating under the 1987 Order -- that wishes to
engage in any significant level of ineligible securities activities, as it must generally
rely on brokerage activities in order to generate eligible revenue. In contrast, the
overwhelming majority of companies operating under the 1989 Order have an
institutional investor base and generate eligible revenue through underwriting and
dealing in bank-eligible securities.
Finally, relative securities returns have varied over the years, changing
the mix of eligible and ineligible revenue.
As noted above, interest rate changes have reduced eligible interest
revenue relative to ineligible interest revenue. For the great majority of companies
that have elected not to use the indexed revenue test, these interest rate changes
have continued to skew their reported ratio of ineligible to total revenue, though to a
far lesser extent since a recent clarification to the revenue limit, which stated that
interest earned on most investment-grade debt securities is treated as eligible
income.20/ In addition, short term interest rates have on balance declined over the
points.")
20/
61 FR 48953 (1996).
- 18 period, and equity prices have trended higher. Therefore, companies with tier-two
powers who are engaged in equity securities activity may well have seen an increase
in their ratio of ineligible revenue to total revenue.
Commenters supported this conclusion. Seven bank holding company
commenters and two bank trade associations specifically noted that these
developments had affected their institutions or members. None of the commenters
opposed to an increase in the revenue limit disputed the Board's analysis.21/
The Board recognizes that one reason underwriting and dealing spreads
are higher for some activities than for others is to compensate for risk. The risks of
holding high-yield bonds in inventory, for example, are higher than the risks of
holding commercial paper, which is short-term and generally issued by a highly
rated company and backed by a bank line of credit. However, in the Board's
21/
One commenter stated that the Board was precluded from changing its view
that ineligible revenue in excess of 10 percent would violate section 20 because
once the Board had made a reasonable interpretation of a statute, and that
interpretation was affirmed by a court, the Board may not thereafter adopt a position
inconsistent with that interpretation. This statement is incorrect as a matter of law.
See, e.g., Smiley v. Citibank (South Dakota), N.A., 116 S.Ct. 1730, 1734 (1996)
(agency may reverse an earlier position and receive judicial deference so long as the
change is not "sudden and unexplained"). As demonstrated above, the Board's
amendment to the revenue limit is based on nine years of experience supervising
section 20 subsidiaries and identifiable market and regulatory developments since
the initial interpretation.
- 19 experience, as confirmed by the commenters, these wider spreads have resulted in
higher revenue even after accounting for losses attributable to pricing, credit or
other risks.22/ In the Board's experience, the ability to earn these higher profits
derives from financial innovation in structuring transactions, ability to foresee
shifting public needs gained from an experienced sales force, research on the issuer
that is credited by the market, the ability to use marketing expertise to avoid losses,
and accuracy in pricing.23/ Each of these skills yields greater rewards with respect
to tier-two securities than tier-one securities, as tier-two securities generally trade in
thinner markets where the frequency of trading is lower, the number of
intermediaries smaller, and therefore the ability to gain a competitive advantage is
greater.
Although the point was not raised by the commenters, the Board
recognizes that these market and regulatory developments may have affected each
section 20 subsidiary differently, depending on the products it offers and the
duration of its interest rate-sensitive assets. However, the Board continues to
22/
The same point can be made with respect to the indexed revenue test, which
took into account an increase in the steepness of the yield curve. Such a change in
the shape of the yield curve may be caused by a rise in expected future interest
rates, with no increase in interest rate risk.
23/
See generally Ernest Bloch, Inside Investment Banking (2d ed. 1989); 81104. 248-73; Kenneth Garbade, Securities Markets 473-74, 493-97 (1982).
- 20 believe that only a single revenue limit should govern.24/ Any standard that
attempted to reflect the characteristics of each security approved for a section 20
subsidiary would be unworkable. Determination of compliance on a case-by-case
basis would appear to be the only alternative to a quantitative test. The Board is
concerned that such a practice could lead to substantial uncertainty among section
20 subsidiaries as well as the potential for inconsistent interpretations of the statute
among section 20 subsidiaries and examiners. Therefore, the Board continues to
prefer to use a single, bright-line standard.
Although not disputing the Board's analysis, one commenter stated that
any amount of activity rising to 25 percent of total activity was by definition
"substantial" and therefore inconsistent with the Glass-Steagall Act. The Board
disagrees. The Board has used a "substantial activity" test as a way of determining
whether a section 20 subsidiary is "engaged principally" in underwriting and
dealing. This reading is consistent with the general interpretation of "principal" as
meaning "primary," "substantial," "leading," important," or "outstanding"25/ and with
24/
In Citicorp, the petitioner argued that because the Board's interpretation of
section 20 necessitated regulation, it a fortiori contravened the Act. The
court of appeals rejected this argument, "The Board's interpretation is one that
attempts to walk the line that Congress laid down." 839 F.2d at 66.
25/
Bankers Trust order at 141-42.
- 21 the definition of substantial as "an essential part, point or feature."26/ The Board
believes that an activity that represents less than 25 percent of a firm's total activity - or, put another way, where 75 percent of the firm's activity is in other areas -- is
not per se a "principal," "primary," "substantial," "leading," "important,"
outstanding," or "essential" part of that firm's activity.
The Board notes that its decision is consistent with an interpretation of
a parallel statute. As several commenters noted, the New York State Banking
Department has taken the position that a company would not be "engaged
principally" in underwriting and dealing for purposes of New York State's "little
Glass-Steagall Act" -- which contains the same "engaged principally" standard as
section 20 -- if underwriting and dealing was 25 percent or less of its total business
activities.27/
26/
The Shorter Oxford English Dictionary, 2172 (3d ed. 1973), cited in Citicorp,
839 F.2d at 64.
27/
See Letter from Jill Considine, Superintendent of Banks, New York State
Banking Department, to Morgan Guaranty Trust Company and Bankers Trust
Company (Dec. 23, 1986). Although one commenter argued that a 25 percent limit
is inconsistent with percentage limits established in other banking statutes and
regulations, those statutes do not rest on an interpretation of the phrase "engaged
principally." Moreover, the most prominent example cited by the commenter, the
presumption of control in the Bank Holding Company Act, is consistent with a 25
percent revenue limit, as it establishes a presumption of control over a bank holding
company based on ownership of 25 percent or more of the company's securities.
See 12 U.S.C. 1841(a)(2). The difference between a test of "25 percent or less"
- 22 Several commenters urged the Board to adopt a greater increase in the
revenue limit -- to 50 percent or, in one case, 33 percent -- on the grounds that such
an increase would be consistent with safety and soundness and not pose risks to
banks affiliated with a section 20 subsidiary. The Board notes, however, that
although safety and soundness is clearly a relevant factor under the Bank Holding
Company Act, the Board has limited authority to interpret section 20 based on
whether underwriting and dealing activities can be conducted consistent with safety
and soundness. Congress itself has decided when a company's risks of underwriting
and dealing are too great to allow affiliation with a bank: whenever they constitute
a principal activity of that company. Thus, even if the Board were to find that
affiliation posed minimal risks, that finding would not allow the Board to raise the
section 20 revenue limit to 100 percent. Nor would a finding that affiliation poses
extreme risks allow the Board to lower the section 20 revenue limit to zero (though
the Bank Holding Company Act, discussed below, could).
Commenters raised two objections to the proposed increase in the
revenue limit based on the volume of underwriting and dealing that it would allow.
One commenter stated that even under a 10 percent revenue limit, several section 20
(under section 20) and a test of "less than
25 percent" (under the Bank Holding Company Act) is infinitesimal.
- 23 subsidiaries were among the largest underwriters in the United States and that
therefore an increase in the limit was unjustified. The Board notes that in its 1987
Order first authorizing the establishment of a section 20 subsidiary, it required that
underwriting and dealing in each security not exceed 5 percent of the total domestic
underwriting and dealing in that security. As noted above, this market share test
was struck down by the Second Circuit as unsupported by the language, legislative
history, and purposes of the Glass-Steagall Act.
Other commenters argued that if the threshold for the revenue test were
increased from 10 percent to 25 percent, then banks would be permitted to affiliate
with the nation's largest investment banks, contrary to the express purpose of section
20 of the Glass-Steagall Act.28/ This argument is basically a restatement of the
market share test. The relevant question for purposes of interpreting the GlassSteagall Act is whether the Board's interpretation would have allowed banks to
affiliate with the securities affiliates of the 1920s and 1930s29/ or companies engaged
28/
Similarly, although one commenter argued that a 25 percent revenue limit
could allow underwriting and dealing to be the first or second largest activity in the
section 20 subsidiary, the Board believes that the relationship to total revenue, not
the relationship to other activities, is controlling.
29/
By the time of the enactment of Glass-Steagall, the major securities affiliates
of banks had been dissolved. W. Nelson Peach, The Security Affiliates of National
Banks 158 (1941). Thus, the Glass-Steagall Act was aimed at preventing a
recurrence of earlier abuses --most particularly, those leading up to the stock market
- 24 in activities similar to those affiliates, not whether it would allow banks to affiliate
with the investment banks of today. Although data are sketchy, the Board believes
that securities firms deriving more than 25 percent of their income from
underwriting and dealing in securities were common in the pre-Glass-Steagall
period, and thus that the revenue limit the Board is adopting today is consistent with
the purposes of the Act.30/ The Board notes that while the largest section 20
subsidiaries currently derive substantial eligible revenue from the U.S. Treasury
market, the federal government was running a budgetary surplus in the pre-GlassSteagall period, and the outstanding federal debt and therefore the market for
crash of 1929 -- rather than at conditions prevailing at the time of its passage.
30/
See, e.g., Agnew, 329 U.S. at 445 (finding that in 1943 one of the nation's
leading underwriters, Eastman, Dillon & Co., earned between 26 percent and 40
percent of its revenue by underwriting securities). A description of the nation's two
largest securities affiliates by an observer of the time appears to indicate that they
derived revenue substantially in excess of 25 percent of its revenue from
underwriting and dealing. "The volume of securities originated and distributed by
[the National City Company, a securities affiliate of National City Bank,] was so
large that it was necessary to have a separate vice-president in charge of securities
issued by industrial corporations, a vice-president in charge of municipal securities,
a vice-president in charge of railroad securities, a vice-president in charge of foreign
work, a vice-president in charge of accounting and treasury work, and a vice
president in charge of the selling organization." See Peach at 94. Similarly, from
1917 to 1927, the securities affiliate of Chase National Bank of New York, Chase
Securities Corporation, "was identified only with major issues of bonds, offering
such bonds at wholesale without public notice." Id. at 96.
- 25 government securities were small.31/ Thus, most securities affiliates of that period
could not have derived substantial eligible revenue from underwriting and dealing in
government securities.
Second, although not relevant to the statutory interpretation, the Board
is not convinced that a 25 percent revenue limit would allow unlimited affiliation
between banks and investment banks for purposes of section 20. Adverse
commenters provided no data to support their assertion that it would. The Board
has reviewed the publicly available financial information for a sample of the largest
investment banks, and it is not apparent that they would be in compliance with a 25
percent revenue limit.32/
D. Bank Holding Company Act Analysis.
In its 1987 Order and 1989 Order, the Board concluded that the
applicants' proposed underwriting and dealing activities were closely related to
31/
See Robert J. Gordon, The American Business Cycle: Continuity and Change
382 (1986); Benjamin M. Friedman, The Changing Roles of Debt and Equity in
Financing U.S. Capital Formation 96, Table 6.2 (1982).
32/
Determining the ineligible revenue of independent investment banks is
difficult because they do not segregate ineligible revenue from eligible revenue in
their annual reports or the FOCUS reports that they file with the Securities
Exchange Commission. For example, an investment bank may report a given figure
for interest and dividends earned on securities without a separate breakdown of
what percentage of that amount was earned from government securities, and many
of the largest firms are primary dealers in government securities.
- 26 banking and could be expected to result in significant benefits to the public in the
form of increased competition, greater convenience to customers, increased
efficiency and maintenance of domestic and international competitiveness.33/ The
Board's experience in supervising section 20 subsidiaries has borne out this
conclusion, and the Board has now concluded that a further increase in the revenue
limit to 25 percent would extend these benefits.34/ Numerous commenters stressed
that an increase in the revenue limit would allow section 20 subsidiaries to operate
more efficiently and compete more effectively domestically and globally. Such
competition should benefit both institutional and individual customers by increasing
customer choice and lowering prices. Furthermore, commenters indicated that a
higher limit would facilitate the creation of new section 20 subsidiaries, thereby
increasing competition.
The Board has also concluded, as it had in its original orders, that an
increase in the revenue limit will not cause any adverse effects, such as undue
concentration of resources, decreased or unfair competition, conflicts of interest, or
33/
34/
See 1987 Order at 489-90; 1989 Order at 200-02.
The Board reached the same conclusion when it reviewed its section 20
orders in 1994. See 59 FR 35516 - 35517 (1994).
- 27 unsound banking practices that would outweigh the projected public benefits.35/
Accordingly, these benefits will not come at an increased risk to the safety and
soundness or reputation of the nation's banks or to the federal safety net. Bank
holding companies have demonstrated over the past nine years that they are able to
manage the risks of investment banking, and section 20 subsidiaries operate as
separately capitalized subsidiaries of a bank holding company, outside the control of
any affiliated bank and therefore outside the protections of the federal safety net.36/
Section 20 subsidiaries must register as broker-dealers and remain subject to the
capital regulations of the Securities Exchange Commission.
35/
Accord 1987 Order at 490-502; 1989 Order at 202-10. Two commenters
disagreed with this analysis, pointing to recent claims made against Bankers Trust
Corporation regarding derivatives trading, an NASD action against Citicorp for
failing to ensure that brokers complied with continuing education requirements, and
the Board's 1996 enforcement action against Swiss Bank Corporation for violating
the revenue limit. The Board has concluded that these isolated incidents are not
sufficient to question the safety and soundness of underwriting and dealing
generally. Moreover, the Citicorp and Swiss Bank actions were compliance issues
that did not result in losses to either the section 20 subsidiary or an affiliated bank,
or in any other safety and soundness problems. While Bankers Trust did suffer from
abuses in its derivatives activities, these were bank-eligible activities that were
conducted at the bank as well as the section 20 subsidiary. The section 20 revenue
limit does not constrain this activity.
36/
The federal safety net includes deposit insurance, access to the Federal
Reserve's discount window, and access to the payments system.
- 28 Protection against unfair competition and undue concentration of
resources is provided by the antitrust laws and special anti-tying restrictions
applicable only to banks,37/ which prohibit a bank from using its products to require
or induce customers to use the products of its securities affiliate. A section 20
subsidiary is also subject to the consumer protection and anti-fraud provisions of the
Securities Exchange Acts of 1933 and 1934.38/ In the Board's experience,
competition in the securities markets remains vibrant.
The Community Reinvestment Act does not provide for consideration
of a bank's community lending performance in deciding whether a nonbanking
activity is permissible under section 4 of the Bank Holding Company Act or in
deciding what level of underwriting and dealing activity is permitted by section 20
of the Glass-Steagall Act. In any event, the Board believes that expanded securities
activities by bank holding companies will not adversely affect low- and moderateincome neighborhoods and households or small businesses. At least one study has
shown that section 20 subsidiaries bring a larger proportion of smaller-sized issues
and lower-credit-rated new issues of non-financial firms to market than do
37/
12 U.S.C. 1972(1).
38/
15 U.S.C. 77a-77z; 15 U.S.C. 78a-78ll.
- 29 independent investment banks.39/ Although banks affiliated with section 20
subsidiaries have closed branches since 1987, particularly over the past few years,
these closings are intrinsic to the consolidation that is occurring in the banking
industry. Commenters provided no evidence that a bank with a securities affiliate is
more likely to close branches than a like-sized bank without one.40/ More
importantly, the number of branch offices nationwide has increased each year
between 1987 and 1995, and the population per branch has declined each year.41/
Finally, regardless of the activities of its nonbanking affiliates, a bank's
record for lending continues to be subject to review and rating under the Community
Reinvestment Act.
V. Indexed Revenue Test
39/
Amar Gande, Manju Puri, et al., Bank Underwriting of Debt Securities:
Modern Evidence, in Bank Structure and Competition 651 (1996) (working paper).
40/
Cf. A Review and Evaluation of Federal Margin Regulations: A Study by the
Staff of the Board of Governors of the Federal Reserve System (December 1984)
(concluding that concerns that securities credit diverts funds from more productive
uses are unfounded).
41/
See Stephen A. Rhoades, Bank Mergers and Industrywide Structure, 198094: Staff Study of Board of Governors of the Federal Reserve System 25 (1996);
Myron L. Kwast, United States Banking Consolidation: Current Trends and Issues
Table 3 (1996) (paper presented to OECD).
- 30 In conjunction with today's order, the Board is eliminating its
alternative indexed revenue test, which as noted above is indexed to account for
changes in interest rates since 1989. The Board has concluded that distortion of the
revenue limit from interest rate fluctuations has been addressed by today's increase
in the revenue limit and by the recent clarification of the revenue limit, which stated
that interest earned on most investment-grade debt securities is treated as eligible
income.
VI. Section 32 of the Glass-Steagall Act
Also in conjunction with today's order, the Board intends to interpret
section 32 of the Glass-Steagall Act generally to prohibit interlocks between a bank
and any company that derives more than 25 percent of its total revenue from
underwriting and dealing in bank-ineligible securities. Section 32 prohibits
personnel interlocks between a member bank and any company "primarily engaged"
in underwriting and dealing in securities.42/ Since 1987, the Board has interpreted
"engaged principally" under section 20 and "primarily engaged" under section 32
consistently.43/ The Board and the courts have noted that section 20 should be
42/
43/
12 U.S.C. 78.
Bankers Trust order at 142. The Board relied on the Supreme Court's
interpretation of section 32 in Agnew in determining that "engaged principally"
denotes substantial activity as opposed to the largest activity. However, the Agnew
- 31 interpreted at least as strictly as section 32 because "the dangers resulting from
affiliation are arguably greater than those resulting only from personnel
interlocks."44/
The Board has not, however, measured compliance with section 32 and
section 20 in the same manner, relying on a more qualitative analysis for purposes of
section 32. This difference is largely attributable to the fact, as noted above, that
the Board does not gather detailed revenue information from securities companies
other than section 20 subsidiaries. Furthermore, while the Board must continuously
monitor compliance with section 20, and is thus in need of a bright-line test,
inquiries under section 32 are infrequent.
Thus, in 1958, the Board established a nine-part guideline for
determining compliance with section 32 that included "the dollar volume of business
of the kinds described in section 32 engaged in by the firm or organization" and "the
percentage ratio of such dollar volume to the dollar volume of the firm's total
business." However, the Board did not establish a revenue or dollar volume limit.
A subsequent staff letter noted that "the Board generally has determined that a
Court did not translate its interpretation of "primarily engaged" into a limitation on
revenue or any other test of business activity.
44/
Citicorp at 67.
- 32 securities firm, which [sic] receives 10 percent of its gross income from section 32
business, is 'primarily engaged' within the meaning of [section 32]," and the Board in
its 1987 Order noted that the Board had developed a "general guideline" to that
effect. The Board has never, however, imposed a specific limitation in order to
enforce compliance with section 32, and has found firms deriving more than 10
percent of their revenue from underwriting and dealing not to be primarily engaged.
Nor has the Board ever reviewed the appropriateness of its 10 percent guideline
since its apparent adoption in the 1950s, despite significant developments in the
securities markets since that time.
In light of those developments and the Board's action on the section 20
revenue limit, the Board will generally find a securities firm to be primarily engaged
in underwriting and dealing for purposes of section 32 when
- 33 more than 25 percent of its total revenue derives from underwriting and dealing in
bank-ineligible securities.
By order of the Board of Governors of the Federal Reserve System,
December 20, 1996.
William W. Wiles
Secretary of the Board.
BILLING CODE 6210-01-P