[Federal Register Volume 61, Number 251 (Monday, December 30, 1996)]
[Notices]
[Pages 68750-68756]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32944]


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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.

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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.

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:

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, municipal revenue bonds, mortgage-backed securities, 
and consumer-receivable-related securities (hereafter, ``tier-one 
securities''). \2\ In

[[Page 68751]]

1989, the Board allowed five bank holding companies to underwrite and 
deal in all debt and equity securities (hereafter, ``tier-two 
securities''). \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) (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).
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    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.
    The 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 bank-ineligible 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 
``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\
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    \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.
    \6\ Bankers Trust order at 140-42; see also 1987 Order at 477-
78, 482-83.
    \7\ Bankers Trust order at 142.
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    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 company 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.
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    \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.
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    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\
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    \9\ 1987 Order at 485.
    \10\ 75 FR 751 (1989).
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    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. \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.
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    \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.
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II. 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.
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    \13\ 61 FR 40643 (August 5, 1996).

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[[Page 68752]]

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 comments 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.
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    \14\ Seven members of the SIA wrote separately to dissent from 
its views. The commenters noted that the association had recently 
supported other, non-comprehensive legislative reform of financial 
services regulation.
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    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 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 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\
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    \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'').
    \16\ 1987 Order at 475.
    \17\ 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 affiliate-underwritten 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.'').
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    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.

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.

[[Page 68753]]

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 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 to include tier-two securities would have seen a significant 
increase in ineligible revenue.
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    \18\ See, e.g., Investment Dealer's Digest 12 (Feb. 19, 1996); 
Investment Dealer's Digest 19 (February 15, 1988).
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    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 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.
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    \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-the-counter trading . . . 
returns have fallen from 80-90 basis points to around 20 basis 
points.'')
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    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 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.
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    \20\ 61 FR 48953 (1996).
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    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
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    \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.
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    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 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

[[Page 68754]]

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.
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    \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); 81-104. 248-73; Kenneth Garbade, Securities Markets 473-
74, 493-97 (1982).
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    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 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.
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    \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.
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    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 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.
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    \25\ Bankers Trust order at 141-42.
    \26\ The Shorter Oxford English Dictionary, 2172 (3d ed. 1973), 
cited in Citicorp, 839 F.2d at 64.
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    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
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    \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'' (under section 20) and a test of ``less 
than 25 percent'' (under the Bank Holding Company Act) is 
infinitesimal.
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    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 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 
Glass-Steagall Act is whether the Board's interpretation would have 
allowed banks to affiliate with the securities affiliates of the 1920s 
and 1930s 29 or companies engaged 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

[[Page 68755]]

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-Glass-
Steagall period, and the outstanding federal debt and therefore the 
market for 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.
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    \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 
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.
    \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).
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     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
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    \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.
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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 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.
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    \33\ See 1987 Order at 489-90; 1989 Order at 200-02.
    \34\ The Board reached the same conclusion when it reviewed its 
section 20 orders in 1994. See 59 FR 35516-35517 (1994).
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    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 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.
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    \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.
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    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.
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    \37\ 12 U.S.C. 1972(1).
    \38\ 15 U.S.C. 77a-77z; 15 U.S.C. 78a-78ll.
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    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 moderate-income 
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 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.
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    \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, 1980-94: 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).
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V. Indexed Revenue Test

    In conjunction with today's order, the Board is eliminating its 
alternative indexed revenue test, which as noted

[[Page 68756]]

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 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
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    \42\ 12 U.S.C. 78.
    \43\ 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 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.
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    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 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 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.
[FR Doc. 96-32944 Filed 12-27-96; 8:45 am]
BILLING CODE 6210-01-P