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Testimony by

Manuel H. Johnson

Vice Chairman

Board of Governors of the Federal Reserve System

before the

Subcommittee on General Oversight and Investigations
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives

March 19, 1990

I appreciate the opportunity to be here today to
present the views of the Federal Reserve Board on the General
Accounting Office (GAO) report entitled "Bank Powers: Activities
of Securities Subsidiaries of Bank Holding Companies."

I should

say at the outset that this report provides an excellent
discussion of the approach the Board has taken with respect to
expanded securities activities for banking organizations, as well
as of some of the outstanding issues regarding these activities.
The report also includes some initial statistical information on
securities activities that should serve as good baseline data for
those who seek to track the development of these activities.
The GAO study concurs in the overall initial approach
taken by the Board, the principal elements being the reliance on
the holding company structure and a careful, incremental
expansion of securities activities within that structure to
insulate affiliated banks and thrifts, and the resources of the
federal safety net, from any potential risk arising from the
activity, to minimize harmful conflicts of interest, and to
address competitive equity issues.
In my remarks today I will provide a brief summary of
the Board's decisions with respect to expanded securities
activities for bank holding companies, as well as a discussion of
the rationale underlying the structure adopted by the Board.
will then address the issues raised by the GAO report and the
committee^ invitation letter.





Board's Decisions on Securities Subsidiaries
In April 1987, the Board approved applications by three
bank holding companies for separately incorporated and separately
capitalized nonbank subsidiaries of the holding companies to
underwrite and deal in municipal revenue bonds, mortgage-related
securities and commercial paper.

These are securities that,

under the Glass-Steagall Act, may not be underwritten or dealt in
by a member bank directly.

The underwriting of these securities

is, however, functionally similar to securities activities
conducted by banks.

The Board's decision, as well as its

subsequent decision authorizing the underwriting of consumerreceivable-related securities, was based on section 20 of the
Glass-Steagall Act, which allows affiliates of member banks— but
not the member banks themselves— to participate in otherwise
impermissible securities underwriting and dealing activity so
long as the affiliates are not "engaged principally" in this

It is from this provision of the Glass-Steagall Act—

section 20— that the underwriting subsidiaries authorized by the
Board have derived their name— the so-called "section 20
Because of the precedent-setting nature of the
applications, the Board reached its decision only after
considerable deliberations and debate, extending nearly two

During that time, the statutory language, the legislative

history, and the implications of these proposals for banking




organizations, the financial markets generally and the federal
safety net were carefully analyzed by the Board.

As part of this

analysis, a hearing was conducted before the Board members to
obtain the most thorough public comment possible on these issues.
The ability of bank holding companies to enter the
underwriting field depended in large measure on the meaning of
the term "engaged principally" in section 20 of the GlassSteagall Act.

The Board devoted a considerable effort to

evaluation of the factors that should be used to determine the
level of underwriting and dealing activity that would not exceed
this "engaged principally" threshold.

The Board concluded that a

member bank affiliate would not be engaged principally in
underwriting or dealing in ineligible securities if those
activities were not a substantial part of the affiliate's

In particular, the Board found that where an

affiliate's gross revenue from ineligible securities activities
did not exceed a range of between five to ten percent of the
total gross revenues of the affiliate, the ineligible securities
activities would not be substantial.

The Board initially allowed

only a five percent threshold, consistent with its view that a
conservative, step-by-step approach was most appropriate in
addressing the issues raised by these new activities.
In addition, although not required by the GlassSteagall Act, the Board exercised its authority under the Bank
Holding Company Act to establish capital adequacy requirements,




as well as a number of prudential limitations or "firewalls," for
holding companies engaging in expanded securities activities.
These firewalls limit transactions between a section 20
subsidiary and its affiliates in order to address the potential
risks, conflicts of interest and competitive issues raised by the

The Board's decisions on these section 20 applications

were upheld by U.S. courts of appeals.
In January 1989, the Board expanded the range of
securities that could be underwritten in a section 20 subsidiary
to include any debt or equity security, except shares of mutual

Because of the broadened range of activities permitted,

the Board felt it prudent to strengthen further the capital
requirements for holding companies seeking to enter this field as
well as the firewalls between the section 20 subsidiary and its

Also, the Board required that before the section 20

subsidiaries could commence the expanded securities activities,
they must have in place policies and procedures to ensure
compliance with the operating conditions of the Board's Order,
and demonstrate that they possess the necessary managerial and
operational infrastructure to conduct the activity.

The Board

delayed for one year the commencement of equity activities in
order to allow adequate time for the section 20 subsidiaries to
establish, and gain experience with, the managerial and
operational infrastructure and other policies and procedures
necessary to comply with the requirements of the 1989 Order.




The 1987 and 1989 Orders were the most important
determinations by the Board establishing the structure for
allowing bank holding companies to engage in securities
underwriting and dealing activities in the United States.


Board has more recently made a number of determinations that have
adjusted the provisions of these earlier Orders.

For instance,

in September 1989, the Board raised from five to ten percent the
revenue limit on the amount of total revenues that a section 20
subsidiary could derive from ineligible securities underwriting
and dealing activities.

Under this higher limit, the ineligible

securities activities are still relatively small compared to the
bank eligible securities activities of a section 20 company.


Board also permitted, under certain narrow conditions, the
underwriting of asset-backed securities issued by affiliates.
In January 1990, the Board approved applications by
three foreign banking organizations to establish U.S. section 20

These decisions required a careful balancing of

two somewhat competing concepts: national treatment on the one
hand, and limiting the extra-territorial effects that might be
caused by full application of the firewalls on the other.
Finally, in February of this year, the Board authorized
the Federal Reserve Bank of New York to conduct, as its
supervisory resources permit, the infrastructure reviews required
by the Board's January 1989 Order before section 20 companies




could commence the equity securities underwriting and dealing
activities approved in that Order.
Rationale Governing the Board's Decisions
The Board has long been of the view that banking
organizations should, in order to maintain their basic
competitiveness, be permitted to expand their activities in
response to the challenges and opportunities that market forces
and recent advances in computer and communications technology are
creating in the financial services marketplace, both domestically
and abroad.

Broadened securities powers, in addition to helping

to maintain the domestic and international competitiveness of
U.S. banks, may also produce the potential for other substantial
public benefits.

These include increased competition through de

novo entry of banking organizations into what can sometimes be
moderately concentrated securities markets.

Such entry may be

expected to reduce concentration levels, lower customer and
financing costs, increase the availability of investment banking
services, foster product innovation to meet customer financing
needs, and enhance liquidity in these markets.

Greater customer

convenience and gains in efficiency may also be realized through
possible economies of scale and scope from coordinated commercial
and investment banking business.
The Board recognized at the outset, however, that this
expansion of powers must be soundly grounded upon a framework
that ensures that new activities are conducted in a manner fully




consistent with traditional and essential U.S. concepts of bank
safety and soundness, the avoidance of conflicts of interest,
partiality in the credit granting process and unfair competition,
and the minimization of undue risk to the resources of the
federal safety net.

After considerable reflection on the complex

issues of expanded powers in the light of these fundamental
concepts, the Board concluded that an expansion of the securities
powers of banking organizations in a manner that is faithful to
these essential public policy objectives could be achieved within
the current constraints of the law.
account four principal factors:

This decision took into

(1) the separation of the new

activity from federally insured affiliates that could be achieved
through the bank holding company organizational structure,


the need for prudential limitations to manage risks and harmful
conflicts of interest,

(3) the necessity for strong capital, and

(4) the need for careful supervision of the entry by banking
organizations into the expanded activities.

Bank Holding Company Structure.

The applications

presented to the Board proposed that the expanded securities
activities be conducted in a subsidiary of the holding company.
The applicants did not seek to engage in the activity directly
through the insured bank or a subsidiary of that bank.


holding company structure was dictated in major part by the
constraints of the Glass-Steagall Act, which, as I have noted,
generally prohibits a bank from underwriting and dealing in




securities (other than certain government securities) and limits
the affiliation of a member bank with a company engaged
principally in such activities.
The holding company structure also lends itself to a
phased-in and prudent approach to expanded securities activities.
The holding company organizational format provides an effective
structure to address the potential for risk and harmful conflicts
of interest and competitive inequities that might flow through
close association of the expanded activities with the resources
and support, direct or indirect, of the federal safety net.


effectiveness of the bank holding company format for this purpose
derives from the fact that it offers the ability to separate from
the bank the ownership and the financial, managerial and
operational control of the expanded activity.

Thus, the

potential for transference of risk and other harmful effects to
the bank, and to the federal safety net, is thereby reduced.


important element in this analysis is that in a bank holding
company structure, losses in a subsidiary are isolated from the
bank and are not reflected in the bank's financial statements and
capital accounts.
The structure also takes advantage of the benefits of
functional regulation.

A section 20 subsidiary— as a nonbank

entity separate from its affiliated banks and thrifts— is
required under the Securities Exchange Act of 1934 to register
with the Securities and Exchange Commission as a broker-dealer.




Under this regulatory system, the section 20 subsidiary is
subject to the net capital rules and other regulations of the
Commission, and will be supervised by that agency and selfregulatory bodies operating under its purview.

Prudential Limitations.

Building on the advantages

of corporate separateness achieved through the holding company
structure, the Board developed certain prudential limitations on
transactions between the subsidiary engaging in the expanded
securities activities and its insured bank affiliates.


firewalls are designed to ensure that the potential for risk and
conflicts of interest and other adverse effects of the activity
do not spill over to the insured affiliate through lending or
other inter-corporate financial transactions, and that the
benefits derived by the bank from the federal safety net are not
inappropriately extended to the section 20 subsidiary.
As I have noted, an important element in the Board's
decision was the belief that synergies could be achieved and
banking competitiveness maintained, with the potential for
substantial public benefits, through the combination of
investment and commercial banking.

The Board recognized,

however, that certain of the prudential limitations implemented
to curtail risk could lessen somewhat the anticipated synergies,
as well as increase the cost of doing business for a bankaffiliated securities company.

Nevertheless, the Board believed

it important to proceed cautiously in these areas, and that until




sufficient experience was gained, the effect of the prudential
limitations on the attainment of the expected synergies was to be
balanced against potential risks to the federal safety net.
The Board's decision was not, however, intended to be

The Board recognized the need to reformulate the

limitations on the basis of experience.

Thus, the Board's Orders

state that when experience shows that adjustments to the
firewalls are warranted, by way of tightening, loosening or other
modification, the Board retains the flexibility to do so,
consistent with the underlying goals of the Board's Order.


this vein, the Board has already made several adjustments to the
firewalls where it determined that certain transactions between
the section 20 subsidiary and its affiliated banks or thrifts
could be permitted without increasing the risks to these
The GAO has recognized the importance of this process,
and endorsed this approach in its report.

The report states that

"[w]hen bank holding companies can demonstrate adequate capital,
effective internal controls, and ability to manage new powers in
a responsible manner, consideration can be given to reducing
regulatory burden by relaxing some of the firewalls in light of
the other regulatory controls that are in place and provided that
sufficient regulatory resources are available."

Capital Adequacy.

It has long been Board policy

that strong capital is indispensable to any banking expansion





A sound capital base is fundamental in ensuring the

safety and soundness of individual institutions, and thereby
providing real protection for its customers and the resources of
the federal safety net.

Equally important in the Board's mind,

the requirement for a strong capital base promotes sound and
responsible operation, and controls the moral hazards, such as
undue risk-taking, that tend to arise when an institution
operates in reliance on the resources of the federal safety net
rather than with its own funds at stake.
Thus, it is not surprising that the Board adopted as a
prerequisite to expanded debt and equity securities activities
the requirement that there be no impairment of the capital
strength of the banking organization.

To ensure that essential

banking capital is not diverted to support the new activity, a
holding company is required to deduct from its consolidated
primary capital any investment it makes in the underwriting

This requirement serves to ensure that even if there

should be losses resulting from the new activity, the losses do
not detract from the capital needed to support the organization's
banking operations.
In addition, in authorizing the debt and equity
underwriting powers in 1989, the Board required a bank holding
company to deduct from its capital any credit it extends to an
underwriting subsidiary, unless such lending is fully secured.
The Board also took the additional step of requiring a bank




holding company seeking to avail itself of these powers either to
demonstrate that it is strongly capitalized and will remain so
after the required capital deductions or to raise additional
capital to support the expanded activity.

In most cases the

applicants were required to raise additional capital to offset
the investment in the section 20 subsidiary.
4. Supervision.

The final element in the Board's

decision on expanded securities powers has been a phased-in
approach based on the section 20 subsidiary's experience,
including a demonstrated managerial and operational
infrastructure, and the development by the Federal Reserve of
appropriate procedures for supervising these new activities.
This gradual approach allows review of the growth and operations
of the section 20 subsidiaries and provides opportunities for
adjustments and modifications to the conditions placed on the
activities, as circumstances warrant.
The Board believes its approach to be appropriate where
the alternative— the large scale introduction of new activities—
could have a potentially deleterious effect on the institutions
and the resources of the federal safety net.

In this regard, the

Board has also required annual inspections of section 2 0
subsidiaries in order to ensure compliance with the prudential

Moreover, examiners are required to monitor the

risk profile and financial condition of a bank holding company's




section 20 subsidiary to evaluate its impact on the consolidated
banking organization.
GAP Report
While the GAO has not endorsed the Board's entire
system of prudential limitations as an essential part of expanded
securities activities for bank holding conpanies, the GAO found
the overall approach of the Board to be consistent with that
suggested by the GAO in a 1988 report on repeal of the GlassSteagall Act.

The GAO suggests, however, several areas in which

the Board might consider the need for further changes in the
operations of section 20 subsidiaries.

I will discuss the major

areas cited by the GAO.
Organizational structure.

The GAO report supports, at

least in the near term, using bank holding company subsidiaries—
as opposed to subsidiaries of banks— to expand the securities
powers of banking organizations.

While not endorsing any

particular organizational structure in the long run, the GAO
would advocate (1) retaining a separate corporate identity for
the firm engaging in the ineligible securities activities;


regulation of the banking and securities affiliates by a federal
bank regulator and the SEC, respectively; and (3) regulation by
the Federal Reserve of the financial holding company that owns
the bank and securities affiliates.

As discussed, these are all

positions with which the Board agrees.




The GAO states that there is currently some legal
question regarding the extent to which a bank holding company may
be required to use nonbanking assets to support bank
subsidiaries, and therefore funds upstreamed to the parent bank
holding company may not be available to support a bank subsidiary
if the parent decides not to so invest them.

The GAO states that

" [c]larification of the operational basis of this source of
strength policy would help in providing a clearer perspective on
how the firewalls and source of strength policy work together in
strengthening banks affiliated with a Section 20 firm."
The Federal Reserve Board agrees with the GAO that
clarification in this area is desirable, and would support
efforts to ensure that bank holding companies and their
subsidiaries continue to serve as a source of strength to
troubled subsidiary banks.
Purposes, regulatory burden and effectiveness of
firewalls and other limitations.

The GAO report states that it

is important that each of the firewalls and that the purpose
served by each of the limitations on the powers of section 20
companies be as clear as possible.

In its lengthy Orders, the

Board has tried to set forth in detail its rationale for each
such limitation.

In addition, the Board has been, and will be,

reviewing the firewalls periodically, on the basis of holding
company experience in the activity, in order to ensure that they
serve the intended purpose without unnecessarily hampering the




operations of the section 20 subsidiary.

In this regard, the

Board has modified or interpreted several of the firewalls to
allow certain transactions that would not be deemed to cause any
financial risk to affiliated banks and, in its January 1990
Order, the Board stated that it would review the firewalls
regarding management interlocks and marketing as well as the
condition requiring prior approval for additional holding company
financial support of a section 20 company.
With respect to the amount of securities activities
allowed, the GAO noted that the Office of the Comptroller of the
Currency and the Association of Bank Holding Companies, in
comments on the GAO report, suggested that either a higher limit
could be set, or alternative measures could be explored, for
defining "engaged principally."

The GAO stated, however, that

it agreed with the Board's policy of using the revenue limit to
phase-in bank-ineligible securities activities.

The GAO did not

have a position on the percentage of revenue that ultimately
should be allowed.
The Board devoted considerable effort to evaluation of
the factors that should be used to determine the level of
ineligible underwriting and dealing activity that would not
exceed the substantiality threshold incorporated in the "engaged
principally" language in section 20 of the Glass-Steagall Act.
The Board determined that the five to ten percent limit was an
appropriate quantitative level of ineligible activity under that





This measure has been reviewed by several courts of

appeals and found to be consistent with the statutory provision.
Except for the "engaged principally" language in the
Glass-Steagall Act, the Board would not have chosen to have a
revenue limit on the level of ineligible securities activity of a
section 20 subsidiary.

While this limit has a prudential

effect, it was placed on the section 20 subsidiaries for legal,
not prudential, reasons.

Although one might disagree with the

precise level of ineligible activity that may be allowed and
still be within the "engaged principally" test in section 20 of
the Glass-Steagall Act, only Congress, by amending or repealing
that provision, can remove the requirement entirely.
International Perspective.

The GAO report points out

that U.S. banking organizations engage in securities activities
overseas in a different structural framework than has been
required in the United States.

What the report does not state is

that one of the basic reasons for these differences is that the
Glass-Steagall Act does not apply overseas, and there are
virtually no statutory restrictions on the activities in which
U.S. banking organizations may engage abroad.

Moreover, the Edge

Act directs the Board to create a regulatory climate in which
Edge corporations may compete effectively with foreign banks.
Because direct competitors of U.S. banks in foreign markets offer
not only commercial banking but also capital market services, the
Board has permitted U.S. banking organizations to engage in




securities activities abroad in order to be in a position to
compete with local banks.

This authority may be exercised

through indirect subsidiaries of a member bank as well as through
bank holding company subsidiaries.
It should be noted, however, that the equity
underwriting and dealing activities of U.S. banking organizations
have been constrained overseas, with dealing positions for a U.S.
banking organization being limited to $15 million in the
securities of any one issuer, and underwriting limits not covered
by binding commitments by subunderwriters also being limited to
that amount.

Proposals regarding these limitations are to be

presented to the Board in the near future, and a question that is
logically raised by any expansion of this authority is the extent
to which a section 20 approach should be required overseas.


issue and its ramifications for U.S. bank competitiveness will be
considered when the Board requests comments on amendments to the
current rules.
The GAO report also notes that in its January 1990
Order allowing three foreign banks to establish securities
subsidiaries in the United States, the Board did not apply the
firewalls exactly the same way that it had applied them to U.S.
bank holding companies one year earlier.

Those applications

raised substantial issues of national treatment, primarily
because most foreign banks do not have a holding company parent
but rather hold their U.S. investments through the foreign bank





Because the foreign bank also acts as a bank holding

company, the Board had to decide whether the bank holding company
firewalls or the bank firewalls were more appropriate.

This is

further complicated by the fact that the rationale for some of
the firewalls, such as protecting the federal safety net, does
not apply when the holding company in question is a foreign bank.
The Board examined carefully how the firewalls should
be applied to foreign bank applicants, making sure to the
greatest extent possible that pertinent safety and soundness and
competitive equity considerations were fully taken into account,
while at the same time trying to limit the extent to which
application of the firewalls would interfere with the
responsibilities of the home country supervisor and the non-U.S.
operations of the foreign banks.

Admittedly, this task cannot be

accomplished perfectly, and one might argue that under the
Board's Order it is easier for foreign organizations, than for
U.S. bank holding companies, to fund their U.S. securities
operations, although the foreign banks would argue otherwise.
The Board, however, stated in its January 1990 Order that it
would review for both domestic and foreign banking organizations
the prior approval requirements for all funding of securities
subsidiaries and the capital deduction for unsecured lending by a
bank holding company to a securities subsidiary.
Reciprocal treatment of securities firms. The GAO notes
that an issue that needs to be studied is whether there are




comparable opportunities for domestic securities firms to expand
into domestic banking.

The GAO recommends that any structure

that is adopted needs to include appropriate controls over the
entire holding company comparable to the Federal Reserve's
current control over bank holding company operations.
As recognized by the GAO, the ability of investment
banks to affiliate with commercial banks— while possible under
the current state of the law— is best accomplished by

The repeal of the Glass-Steagall Act would open the

opportunity for Congress to determine how these relationships
should be structured.
In addition to asking for comments on the GAO report,
the committee's letter also asked for our views on whose
responsibility it should be to enforce the firewalls and how they
should be enforced.

In the bank holding company context, the

Federal Reserve Board is the appropriate agency to enforce the
firewalls separating a section 20 company from its affiliated
banks and nonbanks.

As the agency responsible for supervising

and regulating the holding company on a consolidated basis, the
Board is also the appropriate agency to review the operational
and managerial infrastructure of the section 20 company to ensure
that the firewalls are in place and being observed.

This does

not mean, however, that the Board would be examining those
companies to ensure that they are in compliance with the
securities laws and regulations.

As I discussed earlier, the




Board's Orders rely on functional regulation; as a broker-dealer,
the section 20 company is and should be subject to SEC

Indeed, the Board's supervisory procedures are

designed, to the extent feasible, to avoid duplicating the
efforts of a section 20 subsidiary's designated self-regulatory

This dual regulation by function is a concept

endorsed by the GAO report.
With respect to how these firewalls should be enforced,
the Board believes it has adequate authority under the Bank
Holding Company Act and other enforcement laws, especially in
light of the increased penalty provisions contained in the
Financial Institutions Reform, Recovery, and Enforcement Act of
1989, to ensure that bank holding companies adhere to the
requirements of Board Orders.
In the absence of legislation establishing a
comprehensive framework for the conduct of securities
underwriting activities by banking organizations, the Board is
required, as provided in existing law, to act on applications
within mandated time periods.

In acting on applications by bank

holding companies to engage in expanded securities activities,
the Board is proceeding cautiously and with due regard to the
potential for risk to federally insured institutions and the
federal safety net.

The Board believes this is appropriate when

banking organizations are expanding their powers into non-


traditional activities.



This process is a continuing one, and

the Board will be reviewing periodically the operations of the
section 20 subsidiaries and the effect that the prudential
limitations have on their operations.