[Federal Register Volume 61, Number 181 (Tuesday, September 17, 1996)]
[Notices]
[Pages 48953-48954]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-23728]


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FEDERAL RESERVE SYSTEM

[Docket No. R-0932]


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: Notice.

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SUMMARY: The Board is adopting a change in the manner in which interest 
earned on certain securities held by a company in an underwriting or 
dealing capacity is treated in determining whether the company is 
engaged principally in underwriting and dealing in securities for 
purposes of section 20 of the Glass-Steagall Act. In order to ensure 
compliance with section 20, the Board requires that the revenue a 
company derives from underwriting and dealing in securities that a 
member bank may not underwrite or deal in (ineligible securities) not 
exceed 10 percent of the total revenue of the company. The Board is 
amending its section 20 orders to specify that interest earned on the 
types of debt securities that a member bank may hold for its own 
account is not to be treated as revenue from underwriting or dealing in 
securities for purposes of section 20. Interest on these securities 
will continue to be included in total revenue. Section 20 subsidiaries 
may use this method to compute compliance with the revenue limitation 
in reports filed with the Board after the effective date of this 
amendment.

EFFECTIVE DATE: November 12, 1996.

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, Dorthea 
Thompson (202/452-3544), Board of Governors of the Federal Reserve 
System, 20th Street and Constitution Avenue, NW, Washington, D.C.

SUPPLEMENTARY INFORMATION:

Background

    Beginning with orders issued in 1987, the Board has authorized 
certain nonbank subsidiaries of bank holding companies, so-called 
section 20 subsidiaries, to underwrite and deal in ineligible 
securities.1 In order to ensure compliance with section 20 of the 
Glass-Steagall Act, the Board provided that the gross revenue derived 
by a section 20 subsidiary from underwriting and dealing in ineligible 
securities not exceed 10 percent of the total gross revenue of the 
subsidiary, when revenue is averaged over a rolling 8-quarter 
period.2
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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\  Section 20 provides that a member bank may not be 
affiliated with a company that is ``engaged principally'' in 
underwriting and dealing in securities. 12 U.S.C. 377. Section 20 
does not prohibit a bank affiliate from underwriting and dealing in 
securities that banks may underwrite and deal in directly (eligible 
securities).
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    For purposes of complying with the 10 percent revenue limit, 
section 20 subsidiaries have reported all interest they earn on third-
party ineligible debt securities held in an underwriting or dealing 
capacity as revenue derived from underwriting and dealing in ineligible 
securities.3 Questions have been raised as to whether this 
treatment is appropriate for interest earned on debt securities that a 
member bank is authorized to hold for its own account under the Glass-
Steagall Act. Accordingly, on July 31, 1996, the Board sought public 
comment on a proposal to amend its section 20 orders to provide that 
interest earned by a section 20 subsidiary on the types of debt 
securities that a member bank may hold would no longer be treated as 
ineligible revenue.4
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    \3\  Instructions for Preparation of the Financial Statements 
for a Bank Holding Company Subsidiary Engaged in Bank-Ineligible 
Securities Underwriting and Dealing, Form FR Y-20. Schedule SUD-I, 
Line Item 5 (December 1994)(FR Y-20 Instructions); see also 
``Structuring Bank-Eligible and Bank-Ineligible Transactions'' in FR 
Y-20 Instructions.
    \4\  61 FR 40642 (1996).
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Summary of Public Comments

    The Board received a total of 38 public comments in response to its 
proposal. All but two of the commenters expressed support for the 
Board's proposal for the reasons noted in the Board's request for 
public comments.
    One commenter noted that the Board's request for comment on the 
proposal did not address either the effect the proposal would have on 
section 20 subsidiaries, or the possibility that the proposal could 
permit section 20 subsidiaries to manipulate the revenue 
limitation.5 This commenter suggested that the Board defer action 
on the proposal until it examined these issues and included the result 
of that examination in a second notice requesting public comment on the 
proposal. More generally, the commenter stated that comprehensive 
reform and modernization of the financial services industry by Congress 
is the only means by which banks and securities firms will be able to 
compete and affiliate on a fair and rational basis. For this reason, 
the commenter urged the Board to defer action on this and other 
proposed amendments to its section 20 orders.
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    \5\  The other commenter who urged the Board not to adopt this 
proposal did not set forth any reasons for opposing it.
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    Several commenters urged the Board to clarify or expand its 
proposal. Five commenters opined that the Board should allow section 20 
subsidiaries to treat income derived from holding any security (as 
opposed to only those securities a member bank may hold) as eligible 
revenue--that is, toward total revenue but not ineligible revenue. Four 
commenters also asserted that section 20 subsidiaries should be able to 
treat the profit earned from trading in securities for investment 
purposes, as opposed to dealing in securities, as eligible revenue, 
particularly with respect to securities that member banks may invest 
in.

Discussion

    After reviewing the public comments, and for the reasons set forth 
below, the Board has decided to adopt the proposed amendment without 
change. The Board believes that it is not appropriate to treat interest 
earned on securities that a member bank is expressly authorized by the 
Glass-Steagall Act to hold as revenue from underwriting and dealing in 
ineligible securities.6 Banks hold such securities for their own 
account, and buy and sell them on a relatively frequent basis as part 
of managing their investment portfolio. In recognition of this 
activity, the Financial Accounting Standards Board changed its 
accounting rules at the end of 1993 to establish separate accounting 
treatment for bank portfolio securities that are ``available for sale''

[[Page 48954]]

and not intended to be held to maturity.7
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    \6\  12 U.S.C. 24 (Seventh), 335; 12 CFR 1.3.
    \7\  Statement of Financial Accounting Standards No. 115.
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    Furthermore, the Board believes that there is a distinction between 
the interest earned by a section 20 subsidiary from holding these kinds 
of securities and the profit made from underwriting or reselling them. 
The profit or loss a section 20 subsidiary earns on the resale of 
ineligible debt securities the subsidiary holds in inventory is the 
revenue that should be attributed to performing the functions of 
dealing in or underwriting these securities, the critical element of 
which is the actual offering and sale of the instruments 
involved.8 On the other hand, the interest a subsidiary earns on 
ineligible debt securities while it holds them in inventory is revenue 
best attributed to holding the securities as a member bank may do under 
the Glass-Steagall Act.9
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    \8\  For purposes of the section 20 revenue limitation, the 
Board has viewed ``public sale'' to include the activity of dealing 
in securities--the process of buying and reselling to the public 
specific securities as part of an ongoing, regular business. E.g., 
Citicorp, supra, at 506-08. The term ``underwriting'' generally 
refers to the process by which new issues of securities are offered 
and sold to the public. E.g., Securities Industry Association v. 
Board of Governors, 807 F.2d 1052, 1062-66 (D.C. Cir. 1986), cert. 
denied, 483 U.S. 1005 (1987).
    \9\  This distinction is further reflected in the current 
reporting requirements for section 20 subsidiaries and in Generally 
Accepted Accounting Principles for bank holding companies, which 
prescribe that interest revenue be reported separately from gains or 
losses on securities owned. FR Y-20 Instructions, Statement of 
Income, Schedule SUD-I, Line Items 2, 5); Securities and Exchange 
Commission FOCUS Report (Form X-17A-5 Part II) and instructions 
thereto. Generally Accepted Accounting Principles incorporate the 
format of the FOCUS Report.
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    Accordingly, the Board is amending its section 20 orders to specify 
that a section 20 subsidiary may treat interest earned on the types of 
debt securities that a member bank may hold for its own account, either 
for investment or as an underwriter or dealer, as eligible revenue in 
calculating compliance with the Board's revenue limitation.
    With respect to the suggestion to defer action on this proposal, 
the Board does not believe that the impact of this interpretation on 
any particular firm is relevant to whether the interpretation properly 
reflects the requirements of section 20. However, the Board has used 
proprietary data to consider the impact the proposal could be expected 
to have on each section 20 subsidiary based on its activities and 
portfolio composition during prior quarters. Review of reports and 
other data provided by the section 20 subsidiaries indicates that the 
impact of the change will vary considerably depending on the products 
offered and inventory maintained by each subsidiary, as well as the 
profitability of those products.10
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    \10\  The change will have the greatest impact on those section 
20 subsidiaries with debt and equity underwriting powers who are 
primary dealers and maintain substantial inventories of government 
and investment-grade ineligible debt securities. Data for two recent 
quarters indicates that if the change had been in effect, quarterly 
ineligible revenue for each such company would have decreased 
between 19 percent and 79 percent.
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    Similarly, the Board does not believe that there would be any 
benefit in seeking additional public comment regarding manipulation of 
the revenue test that could arise from the proposed amendment. The 
Board does not believe that the amendment would lead to manipulation of 
the test. Interest earned on a security is sufficiently distinct from 
the profit earned or loss incurred on a security as to allow the Board 
to monitor the appropriate classification of revenue. As noted, the 
Board's quarterly report for section 20 subsidiaries requires that they 
report interest income and dividends received separately from profit or 
loss.
    Furthermore, the Board has supervised revenue test compliance by 
section 20 subsidiaries for nine years, and has developed substantial 
experience in ensuring that section 20 subsidiaries properly classify a 
variety of different types of revenue in computing compliance with the 
limitation on ineligible revenue.11 Section 20 subsidiaries have 
adopted policies, procedures, accounting systems, and related controls 
to ensure proper classification of revenues. The Board expects section 
20 subsidiaries will amend accounting systems and controls as 
necessary, and that internal auditors will continue to monitor revenue 
test compliance and revise their audit programs in response to the 
Board's action.
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    \11\  As noted above, section 20 subsidiaries currently report 
interest income and dividends received separately from profit or 
loss on Form FR Y-20.
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    The Board will review suggestions for further changes offered by 
commenters at a later date.

    By order of the Board of Governors of the Federal Reserve 
System, September 11, 1996.12
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    \12\  Voting for this action: Chairman Greenspan, Vice Chair 
Rivlin, and Governors Kelley, Lindsey, Phillips, Yellen and Meyer.
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William W. Wiles,
Secretary of the Board.
[FR Doc. 96-23728 Filed 9-16-96; 8:45 am]
BILLING CODE 6210-01-P