[Federal Register Volume 59, Number 132 (Tuesday, July 12, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16820]


[[Page Unknown]]

[Federal Register: July 12, 1994]


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FEDERAL RESERVE SYSTEM

[Docket No. R-0841]

 

10 Percent 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: Request for comments.

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SUMMARY: In 1987 and 1989 the Board authorized bank holding companies 
to establish separate nonbank subsidiaries (``section 20 
subsidiaries'') to underwrite and deal in securities that a bank may 
not underwrite and deal in directly (``ineligible securities''). In 
order to ensure compliance with section 20 of the Glass-Steagall Act 
(12 U.S.C. 377), the Board required that the amount of revenue a 
section 20 subsidiary derives from ineligible securities underwriting 
and dealing activities may not exceed 10 percent of the total revenue 
of the subsidiary. Section 20 prohibits a member bank of the Federal 
Reserve System from being affiliated with a company that is ``engaged 
principally'' in underwriting and dealing in securities.
    In January 1993, after notice and the opportunity for public 
comment, the Board authorized section 20 subsidiaries to use an 
alternative indexed method to compute compliance with the 10 percent 
revenue limitation to account for unusual changes in the level and 
structure of interest rates since 1989, when the 10 percent limit was 
adopted. When the Board adopted the indexed revenue test, the Board 
deferred adoption of another alternative test for the 10 percent limit 
that would be based on assets, rather than revenue. Inasmuch as the 
Board has had increased experience in reviewing and monitoring the 
operations and activities of the section 20 subsidiaries, and in order 
to allow these subsidiaries additional flexibility in the conduct of 
their securities operations, the Board now proposes to modify its 
orders approving the establishment of the section 20 subsidiaries to 
allow such subsidiaries the option of using an alternative measure to 
the revenue-based tests for assessing compliance with the 10 percent 
limit. The Board requests comment on whether asset values, sales volume 
data, or both measures should be used as a new alternative to the 
revenue test.

DATES: Comments must be received by August 12, 1994.

ADDRESSES: Comments, which should refer to Docket No. R-0841, may be 
mailed to the Board of Governors of the Federal Reserve System, 20th 
Street and Constitution Avenue, NW., Washington, DC 20551, to the 
attention of Mr. William Wiles, Secretary. Comments addressed to the 
attention of Mr. Wiles may be delivered to the Board's mail room 
between 8:45 a.m. and 5:15 p.m., and to the security control room 
outside of those hours. Both the mail room and security control room 
are accessible from the courtyard entrance on 20th Street between 
Constitution Avenue and C Street, NW. Comments may be inspected in room 
MP-500 between 9 a.m. and 5 p.m. weekdays, except as provided in 
section 261.8 of the Board's Rules Regarding Availability of 
Information, 12 CFR 261.8.

FOR FURTHER INFORMATION CONTACT: Richard M. Ashton, Associate General 
Counsel (202/452-3750), Thomas M. Corsi, Senior Attorney (202/452-
3275), Legal Division; Michael J. Schoenfeld, Senior Securities 
Regulation Analyst (202/452-2781), Division of Banking Supervision and 
Regulation, Board of Governors of the Federal Reserve System. For the 
hearing impaired only, Telecommunication Device for the Deaf (TDD), 
Dorthea Thompson (202/452-3544), Board of Governors of the Federal 
Reserve System, 20th Street and Constitution Avenue, NW., Washington, 
DC.

SUPPLEMENTARY INFORMATION:

1. Background

A. Ten Percent Limit on Ineligible Securities Activities of Section 20 
Subsidiaries

    Beginning with orders issued in 1987, the Board has authorized bank 
holding companies to establish nonbank subsidiaries (``section 20 
subsidiaries'') to underwrite and deal in securities that a bank may 
not underwrite and deal in directly (``ineligible securities'').1 
In order to assure compliance with section 20 of the Glass-Steagall 
Act, the Board limited the amount of ineligible securities that these 
section 20 subsidiaries could underwrite and deal in. Section 20 
provides that a member bank may not be affiliated with a company that 
is ``engaged principally'' in underwriting and dealing in 
securities.2 In particular, the Board determined that a bank 
affiliate would not be ``engaged principally'' in ineligible securities 
activities for purposes of section 20 if those activities were not 
substantial relative to the other activities of the subsidiary. The 
Board ruled that ineligible securities activities are not a substantial 
part of a subsidiary's business if the gross revenue derived from those 
activities does not exceed 10 percent of the total gross revenues of 
the subsidiary, when revenue is averaged over a rolling 8-quarter 
period. Subject to this limitation, the Board has approved the 
establishment of over 30 section 20 subsidiaries, several of which are 
authorized to underwrite and deal in debt and equity securities 
generally.
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    \1\E.g., Citicorp, 73 Federal Reserve Bulletin 473 (1987), 
aff'd, Securities Industry Association v. Board of Governors, 839 
F.2d 47 (2d Cir.), cert. denied, 486 U.S. 1059 (1988).
    \2\12 U.S.C. 377. The Board and the courts have ruled that 
section 20 does not prohibit a member bank from being affiliated 
with a company that is engaged principally in underwriting and 
dealing in securities that banks may underwrite and deal in directly 
(``eligible securities''). See Citicorp, supra.
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B. Adoption of Alternative Indexed Revenue Test

    In July 1992, the Board proposed to establish two alternative 
methods that a section 20 subsidiary could elect to use to determine 
compliance with the 10 percent limit on ineligible securities 
activities in place of the gross revenue test.3 In proposing these 
alternative tests, the Board noted that historically unusual changes in 
the level and structure of interest rates have distorted the revenue 
test as a measure of the relative importance of ineligible securities 
activities in a manner that was not anticipated when the 10 percent 
limit was adopted in 1989.4 To address this problem, the Board 
first proposed an alternative revenue test indexed to interest rate 
changes that would allow for adjustment of the current revenue of a 
section 20 subsidiary to account for the unanticipated interest rate 
conditions. In January 1993, the Board adopted an optional alternative 
indexed revenue test.5
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    \3\57 FR 33507, July 29, 1992.
    \4\The Board pointed out that, in contrast to conditions in 
1989, there was an unusually wide difference between short- and 
long-term rates. Since eligible securities tend to be shorter term 
than ineligible securities, the unusually sharp increase in the 
steepness of the yield curve had the effect of making it appear, 
based on revenue data, that the eligible securities activities of at 
least some section 20 subsidiaries had been reduced, even though the 
relative proportion of eligible and ineligible securities activities 
being conducted by those subsidiaries remained essentially the same.
    \5\79 Federal Reserve Bulletin 226 (1993). Under the indexed 
revenue test, current interest and dividend revenues from eligible 
and ineligible activities for each quarter are increased or 
decreased by an adjustment factor provided by the Board based on the 
average duration of a section 20 subsidiary's eligible and 
ineligible securities portfolio. The adjustment factors, which vary 
according to specific time periods of average duration, represent 
the ratio of interest rates on Treasury securities in the most 
recent quarter to those in September 1989.
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C. Proposed Asset-Based Test

    At the same time that the indexed revenue test was proposed, the 
Board also proposed an alternative asset-based test. Specifically, the 
Board proposed that the 10 percent limit would be computed by using 
average daily assets held in connection with ineligible securities 
activities and with other activities. The Board recognized that in 
1987, when it initially decided to use revenue as the appropriate 
measure of the section 20 limit on ineligible securities activities, 
the Board had expressed two concerns about a test based on average 
assets. One concern was that an asset-based test might be manipulated, 
for example, through ``matched book'' repurchase and reverse repurchase 
agreements for government securities. The second concern was that an 
average asset test, even if computed on a daily basis, would not 
include securities that were underwritten by the section 20 subsidiary 
but that were held only for a few hours, which is typical in many 
underwriting transactions. Accordingly, when the Board proposed an 
alternative asset-based test in 1992, the Board requested comment on 
possible modifications to address these concerns.
    A number of banking organizations commenting on the Board's 
proposal supported adoption of an asset-based alternative measure for 
computing the 10 percent limit. These comments stated that, like the 
indexed revenue proposal, a limit based on assets would be less 
susceptible than the unadjusted revenue test to unusual changes in 
interest rate conditions. Those supporting the asset-based test also 
stated that this test would be easier and less costly to apply than a 
measure that required adjustments to revenue data and would allow for 
greater predictability in the management of the operations of the 
subsidiary.
    Many commenters also opposed establishing any specific restrictions 
to address the potential for manipulative transactions. These 
commenters believed that the capital and funding requirements needed to 
support such transactions, as well as earnings considerations and 
market-imposed credit risk constraints, would effectively curtail the 
excessive use of asset transactions conducted solely to increase the 
level of eligible assets. Commenters also observed that implementation 
of such separate limits would be difficult in practice.
    On the question of the treatment of intra-day holdings of 
securities that are being underwritten, while there was some support 
for including the value of such securities for purposes of applying an 
asset-based test, other comments opposed counting the value of such 
holdings on the grounds that the 10 percent limit should measure only 
assets that pose a risk to the section 20 subsidiary.
    After considering these comments, the Board decided to defer 
adoption of an alternative asset-based test, noting that the Board was 
not then able to assess the potential practical effect of the test.

II. Proposed Alternative Test

A. Need for an Improved Alternative to the Gross Revenue Test

    Since the decision to defer consideration of the asset-based test, 
the Board has had a greater opportunity to review and analyze the 
operations of section 20 subsidiaries. At the outset, the Board notes 
that, during this time period and in the entire seven year period since 
the Board first approved the creation of section 20 subsidiaries, the 
Board has not uncovered evidence of unsafe or unsound practices, 
conflicts of interest, or other conduct related to the operations of 
these subsidiaries that has impaired the condition of the affiliated 
depository institutions or the banking organizations as a whole. The 
available evidence further suggests that these subsidiaries have 
exerted a beneficial procompetitive influence on the securities markets 
in which they compete.
    When the section 20 subsidiaries were first authorized, the Board 
selected revenue, rather than asset values or sales volume, as the best 
overall measure of ineligible securities activities because the Board 
believed that such a test would pose the fewest operational 
difficulties and provide the most accurate indication of the relative 
importance of specific activities. The Board also noted that although 
the applicants had argued that a variety of factors could be used to 
judge ``engaged principally'' status, a single uniform standard was 
desirable.6
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    \6\Citicorp, supra, 73 Federal Reserve Bulletin at 484.
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    However, subsequent events have shown that the susceptibility of 
results from the gross revenue measure to distortion caused by changes 
in interest rate conditions casts doubt on the appropriateness of that 
test. Although the indexed revenue test addresses these concerns, it 
necessarily involves increased operational difficulties. For some 
section 20 subsidiaries, the costs and resources needed to implement 
the indexed revenue test, with the need for complicated duration models 
and the calculation of the duration of all securities in a section 20 
subsidiary's portfolio on a regular basis, may provide a disincentive 
for using that test.7
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    \7\At present only four section 20 subsidiaries are using the 
indexed revenue test.
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    Accordingly, and in order to provide additional flexibility to 
section 20 subsidiaries in the conduct of authorized activities, the 
Board now believes it is desirable to consider adoption of another 
optional measure in addition to revenue for applying 10 percent limit 
on ineligible securities activities. The Board believes that either 
asset values or sales volume, or a combination of both measures, should 
be considered as a new alternative measure.

B. Asset-Based Test as an Alternative Measure

    Any asset-based test would limit a section 20 subsidiary's average 
daily assets held in connection with underwriting and dealing in 
ineligible securities to 10 percent of its total average daily assets, 
computed on a rolling 8-quarter basis. Because, as the Board observed 
when an asset-based test was previously proposed, a measure relying on 
asset values would be less sensitive to unanticipated changes in 
interest rate conditions than a test based on revenues, such a test 
would address these distortions. Also, it appears that for at least 
some section 20 subsidiaries a test relying on asset values may be 
easier in practice to apply than the indexed revenue test. Moreover, as 
explained below, in light of its greater experience with the operations 
of the section 20 subsidiaries, the Board is now of the view that the 
concerns previously expressed about the operation of an asset-based 
test can be appropriately mitigated.
    The Board believes that the use of assets acquired in connection 
with particular types of securities activities may represent a 
permissible measure of compliance with the statutory limitation in 
section 20 on ineligible securities activities. Asset values do provide 
a rough approximation of risk to the section 20 subsidiary, and risk to 
banking organizations was one of the concerns behind passage of the 
Glass-Steagall Act. The Board notes that the New York State Banking 
Department, in applying a state law restriction on the level of 
ineligible securities activities of affiliates of state-chartered 
banks, allows the use of either assets or revenue as a measure of 
compliance with the law.8
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    \8\E.g., letter, dated December 23, 1986, from New York 
Superintendent of Banks to Morgan Guaranty Trust Company and Bankers 
Trust Company.
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Underwriting
    The Board believes that, if an asset-based test is adopted as an 
alternative measure, the value of any securities underwritten by a 
subsidiary would have to be accounted for in computing average daily 
assets, even where the securities are disposed of prior to the end of 
the day. The literal language of section 20 covers any underwriting 
activity. Thus, under the proposed asset-based test, if securities 
underwritten by a section 20 subsidiary are recorded as assets of the 
subsidiary, but are disposed of before the end of the day on which 
underwriting activity takes place, then the securities would be treated 
as if they were carried as assets on the books of the subsidiary as of 
the end of that day. If securities are underwritten by the section 20 
subsidiary on a ``best efforts'' or agency basis the securities would 
be treated as assets of the subsidiary for each day that underwriting 
activity occurs with respect to that particular security.9
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    \9\Under an asset-based alternative measure, similar treatment 
would be accorded an entire issue of privately-placed securities 
when any portion of the issue is taken into inventory pursuant to 
SEC Rule 144A.
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Anti-Manipulation Limits
    Should an asset-based test be adopted as an alternative measure, 
the Board does not propose that any specific limits be incorporated to 
address the potential for manipulative transactions carried out solely 
to inflate artificially a section 20 subsidiary's base of eligible 
assets. Many of the comments on the previously proposed asset-based 
test stated that there are sufficient financial and market constraints 
on the holding of excessive eligible securities solely to support 
increased ineligible securities activities. Even in the case of matched 
book-type transactions, counterparties typically impose limits on the 
amount of transactions they will engage in with any particular section 
20 subsidiary, in order to control credit risk. The Board's minimum 
consolidated leverage ratio and the SEC's net capital rule, which is 
applicable to a section 20 subsidiary, would impose additional 
constraints. In addition, the acquisition of significant amounts of 
eligible securities by a section 20 subsidiary in matched book or 
similar transactions would also tend to have an overall negative impact 
on the earnings performance of the consolidated bank holding company 
organization, given the small profit margins typical in such 
transactions. Finally, the Board believes that it has the authority to 
take appropriate corrective action where manipulative transactions are 
detected.

C. Sales Volume Test as Alternative Measure

    The Board is also requesting comment on adoption of sales volume as 
an alternative measure. If sales volume data is used as the measure of 
an alternative test for applying the 10 percent limit, then the dollar 
volume of a section 20 subsidiary's sales of ineligible securities as a 
result of underwriting and dealing in such securities could not be 
allowed to exceed 10 percent of its total sales volume over a rolling 
8-quarter period.
    The Board believes that the value of various types of securities 
and other assets sold by a section 20 subsidiary bears a relationship 
to the subsidiary's level of activity with respect to each type of 
security or other asset. Use of such data is thus consistent with the 
statutory requirements. Under a sales volume test, intra-day 
transactions like underwriting and dealing sales would be automatically 
covered, even if the assets involved were not recorded on the 
subsidiary's books at the end of the day. In addition, like an asset-
based test, a sales volume test would be less sensitive to changes in 
interest rate relationships. Such a test may also be easier to comply 
with than the current alternative of indexed revenues.
Repurchase Transactions and Other Sales Transactions
    One question raised by the use of sales volume as a test of the 10 
percent limit is whether securities repurchase agreements (``repo 
transactions'') should be treated as ``sales'' and therefore covered 
under such a test. Repo transactions are hybrids, having some 
characteristics of collateralized lending and some characteristics of 
an outright sale of securities. The Federal Reserve, for purposes of 
open market operations, has taken the position that repo transactions 
are sales rather than loans. The Board requests comment on how repo 
transactions should be treated for purposes of a sales volume test, if 
such a test were adopted as an appropriate alternative measure.
    In addition, the Board invites comments concerning reporting and 
other administrative issues associated with implementing a sales volume 
test. The Board specifically requests comment on how sales volume 
should be computed for various types of transactions involving the same 
kinds of underlying securities in different market places. For example, 
Treasury bonds may be sold in the cash market, on a ``When Issued'' 
basis, on a forward contract basis, or indirectly, by purchasing a put 
option or selling a futures contract. Although each type of transaction 
may be reported differently for balance sheet purposes, all of the 
various kinds of transactions may have an identical impact on the 
section 20 subsidiary's risk profile.
    The Board is considering adopting instructions similar to those 
contained in the current Federal Reserve Report Series Form FR 2004, 
Schedule B ``Weekly Report of Cumulative Dealer Transactions'' for 
collection of sales volume information. Accordingly, comments are 
requested concerning whether the instructions and definitions for 
reporting sales volume data in the FR 2004 would provide an adequate 
basis for developing sales volume reporting for section 20 
subsidiaries. Comments are also requested concerning the definition and 
reporting of various types of transactions that are not addressed in 
the existing FR 2004 report instructions.
Manipulative Transactions
    When the Board first approved the establishment of the section 20 
subsidiaries, it considered and rejected using a sales volume test, on 
the ground that the eligible securities sales volume of a section 20 
subsidiary, like asset values, could be easily inflated by repeated 
matched book transactions intended for no other purpose than to inflate 
the subsidiary's eligible sales volume base.10 As noted above, 
many of the comments on the previously proposed asset-based test 
pointed out the credit risk and market limitations on the extent to 
which a section 20 subsidiary may engage in matched book or similar 
transactions. While these limits may be less effective where a section 
20 subsidiary engages in unusual sales of securities with its own 
affiliate, rather than with a third party, solely for the purpose of 
increasing the volume of eligible securities sales, these matters can 
be addressed during the examination process and, as noted above, 
corrective action can be taken where manipulative transactions are 
found.
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    \1\0Citicorp, supra, 73 Federal Reserve Bulletin at 484.
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D. Compliance With Both Measures

    A possible means for addressing the disadvantages of asset values 
and sales volume alone as appropriate measures is to require a section 
20 subsidiary electing an alternative test to comply with both 
measures. The Board seeks comment on this possible requirement.

E. Implementation of Any Alternative Test

    The Board notes that comments received on the asset-based test 
previously proposed suggested that, if such a test were adopted, some 
section 20 subsidiaries may not have access to sufficiently detailed 
asset data for earlier quarters to allow computation of such a test on 
a rolling 8-quarter basis and may not be able to obtain this 
information easily. Therefore, the Board proposes that, if an 
alternative measure is adopted using either asset values or sales 
volume, or a combination of both measures, a section 20 subsidiary 
would be allowed, at its election, initially to comply with such a test 
on a prospective basis only for the first two-year period. The Board 
followed this approach when the indexed revenue test was adopted.
    As was also the case with respect to adoption of the indexed 
revenue test, the Board proposes that, regardless of which test may be 
adopted as an alternative measure, any section 20 subsidiary electing 
to use a new test would be required to continue using that test for a 
period of at least two years, in order to prevent frequent switching 
between tests that would impair an accurate assessment of the relative 
importance of the subsidiary's ineligible securities activities.

F. Proposed Elimination of Indexed Revenue Test

    The Board also seeks comment as to why, if a new alternative 
measure is adopted, the indexed revenue test should not be eliminated 
because there would no longer be a need for that alternative measure. 
However, a section 20 subsidiary would be allowed to continue to elect 
to use the unadjusted revenue test, if the subsidiary wishes to avoid 
the costs associated with converting to any new test.

G. Proposed Modification of Board Orders

    The Board proposes that its orders approving the establishment of 
section 20 subsidiaries be modified to provide that a section 20 
subsidiary may elect, as an alternative to the existing revenue tests, 
to apply an asset-based test to assess compliance with the 10 percent 
limit on ineligible securities activities. Under such a test, a section 
20 subsidiary would be viewed as in compliance with that section for 
any quarter if the average daily assets held in connection with 
underwriting and dealing in ineligible securities for that quarter, 
when added to the average daily assets held in connection with 
ineligible securities activities for the previous seven quarters, does 
not exceed 10 percent of the average daily total assets of the 
subsidiary for that quarter and for the seven previous quarters.11
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    \1\1Securities underwritten by the subsidiary, including 
securities taken into inventory in a private placement pursuant to 
SEC Rule 144A, would be treated as assets of the subsidiary for each 
day underwriting activity takes place with respect to such 
securities.
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    In the alternative, the Board proposes that section 20 subsidiaries 
be authorized to elect to apply, as an alternative to the existing 
revenue test, a sales volume test to assess compliance with the 10 
percent limit. Under such a test, a section 20 subsidiary would be 
viewed as in compliance with that section for any quarter if the total 
dollar volume of sales of ineligible securities from underwriting and 
dealing activities for that quarter, when added to the total dollar 
volume of such sales for the previous seven quarters, does not exceed 
10 percent of the total dollar volume of sales of all securities and 
other assets by the subsidiary for that quarter and for the seven 
previous quarters.
    Finally, as a third alternative, the Board proposes that section 20 
subsidiaries be authorized to apply an alternative test measured by 
both asset values and sales volume. Under such a test, a section 20 
subsidiary would be viewed as in compliance with section 20 for any 
quarter if the subsidiary simultaneously satisfied both the asset-based 
and sales volume measures described above.

    By order of the Board of Governors of the Federal Reserve 
System, July 6, 1994.
William W. Wiles,
Secretary of the Board.
[FR Doc. 94-16820 Filed 7-11-94; 8:45 am]
BILLING CODE 6210-01-P