[Federal Register Volume 61, Number 151 (Monday, August 5, 1996)]
[Notices]
[Pages 40643-40645]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-19866]


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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; request for comments.

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SUMMARY: The Board is proposing to increase 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 
section 20 subsidiaries 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 a revenue limitation 
was adopted in 1987, the Board believes 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.

DATES: Comments must be received by September 30, 1996.

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: 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:

Background

    Section 20 of the Glass-Steagall Act provides that a member bank 
may not be affiliated with a company that is ``engaged principally'' in 
underwriting and dealing in securities.\1\ In 1987, the Board first 
allowed 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 an application by three bank holding companies to underwrite 
and deal in commercial paper, municipal revenue bonds, mortgage-backed 
securities, and consumer-receivable-related securities.\2\ In 1989, the 
Board allowed five section 20 subsidiaries to underwrite and deal in 
all debt and equity securities, subject to more rigorous firewalls.\3\
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    \1\ 12 U.S.C. 377.
    \2\ Citicorp, J.P. Morgan & Co., and Bankers Trust New York 
Corp., 73 Federal Reserve Bulletin 473 (1987), aff'd, Securities 
Industry Ass'n v. Board of Governors, 839 F.2d 47 (2d Cir.), cert. 
denied, 486 U.S. 1059 (1988) (hereafter ``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'').

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[[Page 40644]]

    Currently, thirty-nine nonbank subsidiaries of bank holding 
companies are authorized to engage in underwriting and dealing 
activities that are not authorized for a member bank. Fourteen of these 
so-called section 20 subsidiaries have authority to underwrite and deal 
in commercial paper, municipal revenue bonds, mortgage-backed 
securities, and consumer receivable related securities. Twenty-two 
section 20 subsidiaries have authority to underwrite and deal in all 
debt and equity securities, and three may underwrite and deal in all 
debt securities. Over the past nine years, the Board has had 
substantial experience in supervising the activities and operations of 
those companies. In the Board's experience, the section 20 subsidiaries 
have operated in a safe and sound manner without adverse effects on 
their affiliated banks or the public, and have provided additional 
competition in the securities markets.
    As a condition of its 1987 order approving underwriting and dealing 
in a section 20 subsidiary, the Board established a revenue test to 
ensure compliance with the ``engaged principally'' standard of section 
20. The Board arrived at a revenue test through a series of 
interpretive steps. First, the Board determined that a bank affiliate 
would be ``engaged principally'' in underwriting and dealing only if 
underwriting and dealing were a ``substantial line of business activity 
for the affiliate.'' 4 The Board further found that the best 
measure of the underwriting and dealing activity of a section 20 
subsidiary was the gross revenue derived from that activity.5 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 in determining whether a section 20 
subsidiary's level of underwriting and dealing activity was 
``substantial'' for purposes of the statute. 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.
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    \4\ Bankers Trust New York Corp., 73 Federal Reserve Bulletin 
138, 142 (1987); 1987 Order at 481-483.
    \5\ 1987 Order at 483-485.
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    Finally, the Board found that underwriting and dealing in 
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 revenues of the 
subsidiary. (As a prudential matter, the Board initially limited 
ineligible revenue to 5 percent of total revenue in order to gain 
experience in supervising such companies. In 1989, the Board raised the 
limit to 10 percent.)
    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 revenue test that was indexed to account for changes 
in interest rates since 1989.6 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.7 Five 
section 20 subsidiaries are currently operating under this indexed 
test.
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    \6\ Order Approving Modifications to the Section 20 Orders, 79 
Federal Reserve Bulletin 226 (1993) (hereafter, 1993 Modification 
Order).
    \7\ 1993 Modification Order at 228. 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. 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 
use the adjustment factors to ``index'' actual interest and dividend 
revenues based upon the average duration of their eligible and 
ineligible securities portfolios.
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    At the same time it proposed the indexed revenue test, the Board 
sought comment on use of an asset-based measure as an alternative to 
the existing gross revenue measure, and in July 1994 sought comment on 
both the asset-based measure (for a second time) and a sales volume 
measure.8 As the courts have recognized, ``the relative 
significance of the firm's activities could be measured in various 
ways--dollar volume, number of transactions, strategic significance, 
and so on.'' 9
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    \8\ 59 FR 35,516 (1994).
    \9\ Securities Industry Ass'n v. Board of Governors of the 
Federal Reserve System 847 F.2d 890, 894 (D.C. Cir. 1988). For 
example, the New York State Banking Department has interpreted its 
``little Glass-Steagall Act,'' which contains the same ``engaged 
principally'' language as section 20, to allow a securities 
affiliate of a bank to have up to 25 percent of its business 
activity consist of underwriting and dealing. New York originally 
measured activity using an asset test but has more recently employed 
a revenue test. See Letter from Deputy Superintendent Barrantes to 
Paul L. Lee (May 4, 1988).
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    The Board has recently received petitions from trade groups and 
others urging the Board to increase the revenue limit to at least 25 
percent of total revenue. Petitioners argue that the Board could 
justify a higher revenue limit either by reinterpreting ``engaged 
principally'' more consistently with the ordinary meaning of 
``principal''--that is, to include only the largest or majority 
activity--or by finding that a higher level of revenue does not yield a 
level of activity that is substantial.

Proposed Change to Revenue Limit

    The Board is proposing to maintain the revenue test but increase 
the revenue limit from 10 percent of total revenue to 25 percent. The 
Board seeks comment on whether this amended revenue test would be an 
appropriate gauge of underwriting and dealing activity for purposes of 
section 20. The Board is concerned that a test based on assets or sales 
volume would not yield benefits--in terms of greater accuracy, ease of 
administration, or immunity from manipulation--that would justify the 
costs of converting compliance systems to a new test.
    The Board is proposing to increase the revenue limit based on its 
supervision of the section 20 subsidiaries over a nine-year period. 
Based on this experience, the Board now believes that the limitation of 
10 percent of total revenue it adopted in 1987, without benefit of this 
experience, unduly restricted the underwriting and dealing activity of 
section 20 subsidiaries to a level that fell short, and continues to 
fall short, of substantial activity and principal engagement for 
purposes of section 20.
    Furthermore, the Board believes that changes in the product mix 
that section 20 subsidiaries are permitted to offer and developments in 
the securities markets have affected the relationship between revenue 
and activity. When the Board initially adopted a 5-10 percent of total 
revenue test for underwriting and dealing in investment-grade 
commercial paper, municipal revenue bonds, mortgage-backed securities 
and

[[Page 40645]]

consumer receivable related securities, the Board concluded that a 
``substantial'' level of engagement in those activities would generally 
yield revenues of greater than 10 percent of total revenue. Since 
initially establishing a revenue limit of 10 percent, the Board has 
expanded significantly the types of underwriting and dealing activities 
in which a section 20 subsidiary may engage, most notably in the 1989 
Order allowing section 20 subsidiaries to underwrite all types of debt 
and equity securities. Nevertheless, the Board has not until now 
reexamined its assumption about what level of revenue corresponds to a 
substantial level of engagement in the types of ineligible securities 
activities permitted a section 20 subsidiary.
    In fact, the Board's experience shows that the relationship between 
gross revenue and underwriting and dealing activity is not the same for 
corporate debt securities and other securities approved in the 1989 
Order as it was for securities approved in the 1987 Order. A given 
level of activity in corporate debt and equity underwriting and dealing 
yields substantially higher revenue than an equivalent amount of 
activity in underwriting and dealing in investment-grade commercial 
paper, municipal revenue bonds, mortgage-backed securities, and 
consumer receivable related securities. For example, bid/offer spreads 
on many corporate bonds and other securities authorized for dealing in 
the 1989 Order are significantly wider than the spreads on the 
securities authorized for dealing in the 1987 Order. Similarly, 
underwriting fees for those securities authorized in the 1987 Order are 
significantly smaller than fees for those securities authorized in the 
1989 Order, particularly with respect to equity securities and non-
investment grade debt securities.10 Put another way, the Board 
believes that (all things being equal) a company that maintained a 
constant level of activity over the past nine years, but shifted its 
product mix from those authorized by the 1987 Order to those authorized 
by the 1989 Order, would have seen a significant increase in ineligible 
revenue.
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    \10\ See, e.g., Investment Dealer's Digest 12 (Feb. 19, 1996); 
Investment Dealer's Digest 19 (February 15, 1988).
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    A converse trend appears to have developed with respect to eligible 
revenue, where market changes appear to have reduced the eligible 
revenue derived from a given level of activity. As noted above, to 
varying degrees over the years, prior interest rate changes have 
reduced eligible interest revenue relative to ineligible interest 
revenue for the majority of companies that have elected not to use the 
indexed revenue test. More importantly, with respect to eligible 
revenue derived from other sources, most notably brokerage services, 
increased competition has diminished revenue as a function of 
activity.11 Lower commissions have required companies to increase 
volume in order to maintain a given level of eligible revenue.
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    \11\ 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-the-counter trading * * * 
returns have fallen from 80-90 basis points to around 20 basis 
points.'')
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    In sum, the Board believes that a section 20 subsidiary company 
that (1) Maintained a steady level of both bank-eligible and ineligible 
securities activity since 1987, and (2) updated its product mix to 
include what the Board has interpreted the Bank Holding Company Act to 
allow, would have seen its the ratio of ineligible to total revenue 
more than double.
    Finally, the Board believes that this increase in the revenue limit 
would not give rise to the potential dangers to commercial banks from 
general underwriting activities that motivated the Congress to enact 
the Glass-Steagall Act, or the more general dangers of affiliation that 
motivated the Congress to enact the Bank Holding Company Act. The Board 
has now had considerable experience supervising these companies, and 
believes that they have operated in a safe and sound manner. 
Particularly given the safeguards of the examination and reporting 
process and increased emphasis on internal risk management, the Board 
believes that allowing a section 20 subsidiary to increase to 25 
percent the amount of revenue it derives from underwriting and dealing 
in ineligible securities would not pose significant risk to an 
affiliated bank.

    By order of the Board of Governors of the Federal Reserve 
System, July 31, 1996.
William W. Wiles,
Secretary of the Board.
[FR Doc. 96-19866 Filed 8-2-96; 8:45 am]
BILLING CODE 6210-01-P