    Banks' Securities Activities: Oversight Differs Depending on Activity and
    Regulator (Chapter Report, 09/21/95, GAO/GGD-95-214).

    Pursuant to a congressional request, GAO reviewed federal bank
    regulators' oversight of banks' securities activities, focusing on the:
    (1) extent to which banks provide and regulate securities brokerage
    services; (2) results of Federal Reserve inspections of bank holding
    company subsidiaries authorized to underwrite and deal in securities;
    and (3) Federal Deposit Insurance Corporation's (FDIC) regulation of
    bank subsidiaries that can underwrite and deal in securities.

    GAO found that: (1) about 22 percent of U.S. banks offered securities
    brokerage services to their customers in 1994; (2) the Securities and
    Exchange Commission (SEC) and the National Association of Securities
    Dealers (NASD) regulated the securities activities of 88 percent of
    these 2,400 banks by providing these services through broker dealers,
    while 287 banks provided bank-direct brokerage services; (3) federal
    bank regulators did not always review bank-direct brokerage operations
    routinely, but the regulators jointly issued new guidance and
    examination procedures in 1994 that emphasized these reviews; (4)
    securities activities can be overseen by different regulators depending
    on how the banks organize their securities activities, creating the
    potential for inconsistent oversight; (5) although Federal Reserve
    examiners usually met their inspection schedules, addressed inspection
    procedures, and tested securities subsidiaries for compliance with
    applicable firewalls, there were a few cases of insufficient
    documentation; and (6) FDIC had no centralized program to oversee the
    activities of the bona fide securities subsidiaries and had not fully
    prepared its examiners to examine securities activities, posing risks to
    affiliated banks.

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  GGD-95-214
         TITLE:  Banks' Securities Activities: Oversight Differs Depending
                 on Activity and Regulator
          DATE:  09/21/95
       SUBJECT:  Securities regulation
                 Financial institutions
                 Compliance
                 Internal audits
                 Brokerage industry
                 Documentation
                 Bank holding companies
                 Banking law
                 Internal controls
                 Bank examination
    IDENTIFIER:  BIF
                 Bank Insurance Fund

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    Cover
    ================================================================ COVER

    Report to Congressional Requesters

    September 1995

    BANKS' SECURITIES ACTIVITIES -
    OVERSIGHT DIFFERS DEPENDING ON
    ACTIVITY AND REGULATOR

    GAO/GGD-95-214

    Banks' Securities Activities

    (233408)

    Abbreviations
    =============================================================== ABBREV

      BIF - Bank Insurance Fund
      CRD - Central Registration Depository
      FDIC - Federal Deposit Insurance Corporation
      FDICIA - Federal Deposit Insurance Corporation Improvement Act
      FRS - Federal Reserve System
      NASD - National Association of Securities Dealers
      OCC - Office of the Comptroller of the Currency
      SEC - Securities and Exchange Commission
      SIPC - Securities Investor Protection Corporation
      SRO - self-regulatory organization

    Letter
    =============================================================== LETTER

    B-259498

    September 21, 1995

    The Honorable John D.  Dingell
    Ranking Minority Member
    Committee on Commerce
    House of Representatives

    The Honorable Edward J.  Markey
    Ranking Minority Member
    Subcommittee on Telecommunications
     and Finance
    Committee on Commerce
    House of Representatives

    This report presents the results of our review of federal banking
    regulators' oversight of banks' securities activities.  You requested
    that we report on the extent to which banks have expanded into
    securities activities.  You also asked us to evaluate the status of
    federal banking regulators' programs for examining and enforcing
    compliance with regulatory safeguards intended to separate insured
    banking activities from securities activities and protect securities
    investors from unfair practices.  This report recommends actions to
    improve bank regulators' oversight of bank securities activities.

    As agreed with you, unless you publicly release its contents earlier,
    we plan no further distribution of this report until 5 days from its
    issue date.  At that time, we will provide copies to interested
    Members of Congress, appropriate committees, the Board of Governors
    of the Federal Reserve System, the Office of the Comptroller of the
    Currency, the Federal Deposit Insurance Corporation, the Securities
    and Exchange Commission, the National Association of Securities
    Dealers, other interested parties, and the public.

    Major contributors to this report are listed in appendix X.  If you
    have any questions, please call me at (202) 512-8678.

    James L.  Bothwell
    Director, Financial Institutions
     and Markets Issues

    EXECUTIVE SUMMARY
    ============================================================ Chapter 0

       PURPOSE
    ---------------------------------------------------------- Chapter 0:1

    Numerous U.S.  banks and bank holding companies are expanding into
    securities activities, including retail securities brokerage services
    (acting as an agent for buyers and sellers of securities), securities
    underwriting (publicly distributing new issues of securities), and
    securities dealing (trading securities as a principal in the
    secondary market).  These securities activities can provide greater
    diversification and additional income for banks, a more competitive
    securities industry, and added convenience for bank customers.  They
    may also pose additional risks to banks and new challenges to
    regulators.

    The adequacy of regulatory oversight of banks' securities activities
    concerned the Ranking Minority Member of the House Committee on
    Commerce and the Ranking Minority Member of the Subcommittee on
    Telecommunications and Finance, House Committee on Commerce.  They
    asked GAO to

      determine the extent to which banks provide securities brokerage
         services and how these services are regulated;

      evaluate the completeness and results of Federal Reserve
         inspections of bank holding company subsidiaries that the agency
         authorizes to underwrite and deal in securities; and

      evaluate the Federal Deposit Insurance Corporation's (FDIC)
         regulation of bank subsidiaries that can underwrite and deal in
         securities.

       BACKGROUND
    ---------------------------------------------------------- Chapter 0:2

    Congress passed the Glass-Steagall Act in 1933 in reaction to the
    banking crisis of the Great Depression.  The act generally prohibits
    banks from underwriting and dealing in securities, except for
    "bank-eligible" securities.  These are limited to securities offered
    and backed by the federal government and federally sponsored
    agencies, and certain state and local government securities.  As
    banks have sought to expand their product lines, federal regulators
    have provided banks, through affiliated firms, limited authority to
    underwrite and deal in "bank-ineligible" securities.  Banks subject
    to Glass-Steagall provisions may be chartered and regulated by one or
    more federal and state regulators.  National banks are chartered and
    regulated by the Office of the Comptroller of the Currency (OCC).
    State-chartered and regulated banks are also regulated federally by
    the Federal Reserve if they choose to join the Federal Reserve System
    (FRS).  If they do not join FRS, they are regulated by FDIC because
    they are federally insured.  The Federal Reserve also regulates all
    bank holding companies.

    In addition to restricting activities within banks, Section 20 of the
    Glass-Steagall Act prohibits FRS-member banks, including all national
    banks, from affiliating with firms "principally engaged" in
    underwriting ineligible securities.  The Federal Reserve interprets
    Section 20 of the act to allow bank holding companies to establish
    subsidiaries engaged in securities underwriting and dealing, as long
    as the subsidiary generates no more than 10 percent of its gross
    revenue from ineligible securities.  The subsidiary's activities must
    also be considered closely related to banking.  Bank holding
    companies must obtain Federal Reserve approval to establish
    underwriting and dealing subsidiaries, which are known as "Section 20
    subsidiaries."

    In November 1994, OCC proposed to revise its rules so that
    subsidiaries of approved national banks could engage in activities
    impermissible for the parent bank, possibly including underwriting
    and dealing in ineligible securities.  OCC is considering comments on
    the proposal.

    The Glass-Steagall Act does not prohibit subsidiaries of
    state-chartered non-FRS-member banks from engaging in securities
    activities.  In 1984, FDIC issued regulations setting out conditions
    under which "bona fide subsidiaries" of these banks may underwrite
    ineligible securities.

    The Glass-Steagall Act also does not restrict bank securities
    brokerage activities, which may take place either within a bank or an
    affiliate.  Generally, a firm that provides securities brokerage
    services (known as a broker-dealer) must register with and be
    regulated by the Securities and Exchange Commission (SEC).  Banks,
    however, are exempted from SEC registration.  Consequently, brokerage
    services provided directly by a bank are not subject to scrutiny by
    federal securities regulators.  The bank exemption does not apply to
    separately incorporated bank affiliates.

    Generally, bank regulators supervise banking organizations to ensure
    their safety and soundness and compliance with banking laws.  As part
    of their supervision, the regulators are to ensure that the banking
    organizations, including banks' securities affiliates, are adequately
    capitalized and comply with certain operating conditions and
    restrictions called "firewalls." Among other things, firewalls help
    insulate banks from credit relationships and intercompany
    transactions that pose risks to bank safety and soundness or
    potential conflicts of interest.

    Securities regulators examine and monitor the activities of
    broker-dealers for compliance with securities laws and regulations,
    including net capital rules.  Much of this regulation is done through
    self-regulatory organizations (SROs) such as the National Association
    of Securities Dealers (NASD), which enforce rules of fair practice
    among their members.  SEC evaluates the quality of SRO oversight in
    enforcing compliance with federal securities laws, including
    provisions related to preventing fraudulent and manipulative
    practices and protecting investors from such practices.

       RESULTS IN BRIEF
    ---------------------------------------------------------- Chapter 0:3

    About 22 percent of U.S.  banks offered securities brokerage services
    to their customers in 1994.  SEC and NASD regulated the securities
    activities of 88 percent of these 2,400 banks because they provided
    these services through registered broker-dealers or through
    third-party arrangements with registered broker-dealers.  However,
    287 banks provided these services on bank premises exclusively
    through bank employees.  These bank-direct brokerage operations were
    subject to regulation by federal bank regulators and were exempted
    from regulation by SEC and NASD.  GAO found that federal bank
    regulators did not always review bank-direct brokerage operations as
    part of routine bank examinations.  However, in 1994 bank regulators
    jointly issued new guidance and examination procedures that placed
    increased emphasis on such reviews.

    Because some bank securities activities are overseen by securities
    regulators while others are overseen by bank regulators, the
    potential exists for inconsistent oversight of these activities.
    This potential for inconsistent oversight has not been much of a
    problem so far, because most banks provide securities services in
    affiliates that are regulated primarily by securities regulators.
    While the regulators have coordinated their exams, among other
    things, providing consistent securities oversight, no matter where in
    an organization these activities are done, would be enhanced by
    increased cooperation, coordination, and sharing of regulatory
    expertise among bank and securities regulators.

    As of November 1994, the Federal Reserve had 35 Section 20 securities
    subsidiaries to examine for compliance with firewall requirements.
    GAO found that FRS examiners usually met their inspection schedules,
    addressed the inspection objectives and procedures outlined in FRS
    guidance, and, in general, comprehensively reviewed or tested for
    compliance with applicable firewalls.  However, GAO found a few cases
    where full compliance with all firewalls could not be assured or was
    not documented.  Specifically, for 2 of the 14 subsidiary
    examinations that GAO reviewed, neither Federal Reserve examiners nor
    the bank internal auditors, whose work the examiners can rely upon,
    had reviewed or tested all applicable firewall procedures.  Also, in
    two of the four FRS districts GAO visited, examiners had not always
    provided sufficient documentation to determine whether they had
    reviewed or tested applicable firewall procedures, especially when
    examiners relied on internal auditors.

    Unlike the Federal Reserve, FDIC had no centralized program to
    oversee the activities of the bona fide securities subsidiaries of
    state-chartered banks, and did not know how many such subsidiaries
    were actually operating.  FDIC also had not fully prepared its
    examiners to examine securities activities because it had not
    provided training and had no examination guidelines.  In some cases,
    FDIC examiners were confused about when subsidiaries needed to obtain
    the bona fide designation.  As a result, FDIC had little assurance
    about the risks these subsidiaries' activities pose to affiliated
    banks.

       GAO'S ANALYSIS
    ---------------------------------------------------------- Chapter 0:4

          BANK SECURITIES BROKERAGE
          ACTIVITIES RAISE REGULATORY
          ISSUES
    -------------------------------------------------------- Chapter 0:4.1

    About 2,400 banks--22 percent of nearly 11,100 banks
    nationwide--offered retail securities brokerage services, according
    to the results of GAO's survey of banks.  Of those 2,400 banks, most
    (88 percent) provided the services through registered brokerage
    subsidiaries or through arrangements with nonaffiliated registered
    securities broker-dealers.  The remaining 287 banks, about 12
    percent, provided direct brokerage services.  According to survey
    responses, these banks had limited their services to discount
    brokerage, in which the employees of these banks took customers'
    orders but did not make buy and sell recommendations.

    Because the securities laws exempt banks from SEC registration and
    regulation, the securities activities of the 287 banks that GAO
    estimated provide direct brokerage services are regulated by bank
    regulators.  GAO's review of regulatory examinations of 40 of these
    banks, completed during 1992 through mid-1994, showed that bank
    regulators had not reviewed the brokerage operations of 29, or 72
    percent, of the sampled banks.

    Bank regulators have since taken steps intended to improve the
    oversight of banks' direct brokerage operations.  In 1994, bank
    regulators issued a joint policy statement to banks on the sale of
    nondeposit investment products, such as mutual funds, stocks, and
    bonds.  Each regulator also issued examination guidance for reviews
    of bank-direct brokerage operations.

    Bank and securities regulators have also acted to coordinate
    examinations of most bank brokerage activities, but other regulatory
    issues need to be addressed to ensure consistent regulation of all
    bank brokerage activities.  In January 1995, all three banking
    regulators and NASD reached a formal agreement to coordinate
    examinations of bank-affiliated broker-dealers and share examination
    findings and workpapers.  However, this agreement did not address
    bank-direct brokerage operations because they are not subject to SEC
    and NASD regulation.  Also, bank and securities regulators' guidance
    and proposed rules under which bank brokerages are expected to
    operate are not consistent, and not all regulatory procedures used by
    securities regulators are available to bank regulators.  The lack of
    consistent regulatory standards for bank-related and nonbank-related
    brokerages could result in confused investors, ambiguous sales
    practice standards, and inconsistent oversight of sales
    representatives.

    Bank regulators have provided new guidance and examination procedures
    and are working to improve their oversight of bank-direct brokerage
    operations.  Nevertheless, providing consistent securities oversight,
    no matter where in an organization these activities are done, would
    be enhanced by ongoing cooperation, coordination, and sharing of
    regulatory expertise among bank and securities regulators.

          FEDERAL RESERVE INSPECTIONS
          USUALLY ASSESS COMPLIANCE
          WITH ALL APPLICABLE
          FIREWALLS
    -------------------------------------------------------- Chapter 0:4.2

    The Federal Reserve's policy is to inspect the firewall procedures of
    underwriting subsidiaries either before approving their underwriting
    and dealing activities or during initial inspections after approval,
    depending upon the type of underwriting powers sought.  Approved
    subsidiaries underwrote $59 billion of securities in 1993.  As of
    November 1994, 35 subsidiaries were operating with Federal Reserve
    approval to underwrite and deal in certain bank-ineligible
    securities.

    Federal Reserve examiners may rely upon annual reviews by the bank
    holding company internal auditors to assess subsidiaries' compliance
    with firewall requirements.  The examiners may also do their own
    annual evaluations of firewall compliance by subsidiaries during bank
    holding company inspections.  The Federal Reserve is also to
    routinely monitor the activities and financial status of the
    subsidiaries.

    Although the Federal Reserve's inspections GAO reviewed usually
    addressed all applicable firewalls, in two instances Federal Reserve
    examiners and bank holding company internal auditors did not review
    all applicable firewalls.  For example, in a 1993 inspection of a
    large underwriting subsidiary, neither Federal Reserve examiners nor
    internal auditors reviewed firewalls that restricted credit
    extensions to the underwriting subsidiary and its clients and
    customers or that prohibited intercompany transactions and transfers
    of assets between the subsidiary and affiliated insured banks.  The
    Federal Reserve inspections also did not always document the extent
    to which examiners or internal auditors had tested firewalls.  For
    example, in GAO's review of the annual inspections of six
    subsidiaries, examiners said they relied on the internal auditors'
    review and tests and did some selective review and tests themselves,
    but the review and testing was not always documented in workpapers.
    In these instances, inspection supervisors' reviews would have been
    needed to ensure that all firewalls were examined and work was
    properly documented in work papers.

    The Federal Reserve has imposed few sanctions for firewall
    noncompliance.  However, it has acted to correct identified
    compliance-related deficiencies through inspection close-out meetings
    with bank officials and required correspondence from the banks on
    actions taken to correct deficiencies.

          FDIC HAD NO PROGRAM TO
          ASSESS RISKS POSED BY
          SECURITIES ACTIVITIES
    -------------------------------------------------------- Chapter 0:4.3

    FDIC requires state-chartered non-FRS-member banks that establish or
    acquire bona fide subsidiaries to underwrite and deal in securities
    to file notices with FDIC regional directors.  FDIC then is to
    examine the parent banking organizations and the subsidiaries for
    compliance with FDIC regulations.

    Unlike the Federal Reserve, FDIC has no centralized system to oversee
    the securities activities of bank subsidiaries.  Such a system could
    help FDIC to identify banks that own operating subsidiaries and
    assess the subsidiaries' financial condition, compliance with
    firewall restrictions, and the overall risks the subsidiaries might
    pose to insured banks and the Bank Insurance Fund.  FDIC could not
    provide accurate data on the number of banks that were using
    authority granted under FDIC regulations.

    FDIC officials said that underwriting and dealing in securities were
    more common among larger banking organizations than among the
    state-chartered nonmember banks it supervises.  FDIC officials said
    that examiners could identify any bona fide subsidiaries that should
    be subject to its regulatory provisions through the examination
    process.  However, in 3 of 13 examinations GAO reviewed, FDIC
    examiners were confused about the applicability of these provisions
    and had to seek a legal determination from the FDIC regional
    headquarters about a subsidiary's status.  As of September 1994, FDIC
    had no formal examiner training program that focused on oversight of
    securities activities of state nonmember banks and their
    subsidiaries.

    Without a program to identify and routinely review the securities
    activities and the financial condition and performance of bank
    securities subsidiaries that are under FDIC's jurisdiction, FDIC
    cannot fully assess the risks the underwriting and dealing activities
    of bank subsidiaries pose to insured banks and the Bank Insurance
    Fund.

       RECOMMENDATIONS
    ---------------------------------------------------------- Chapter 0:5

    GAO is making the following recommendations:

      The Federal Reserve, FDIC, OCC, SEC, and NASD should work together
         to develop and implement an approach for regulating bank-direct
         securities activities that provides consistent and effective
         standards for investor protection, while ensuring bank safety
         and soundness.

      The Chairman of the Board of Governors of the Federal Reserve
         System should ensure that either Federal Reserve examiners or
         internal auditors review and test all applicable firewalls at
         least once annually and appropriately document the work
         performed.

      The Chairman of FDIC should establish a program to identify and
         routinely review the securities activities and the financial
         condition and performance of bona fide subsidiaries under FDIC's
         jurisdiction to assess the overall risks posed by the activities
         on federally insured banks and ensure compliance with firewalls.
         The program should provide FDIC examiners guidance and training
         on how to examine bank and bank subsidiary securities
         activities.

       AGENCY COMMENTS
    ---------------------------------------------------------- Chapter 0:6

    The Federal Reserve, FDIC, OCC, SEC, and NASD provided written
    comments on a draft of this report.  These comments are presented and
    evaluated in chapters 2, 3, and 4.  The bank regulators commented
    that they have already begun efforts to coordinate regulation of bank
    brokerage activities with securities regulators.  The securities
    regulators agreed to participate in cooperative efforts but believe
    that a system of functional regulation, in which each entity is
    regulated according to the particular activities that it undertakes,
    would provide a more effective and efficient regulatory structure.

    The Federal Reserve commented that it would promptly address GAO's
    findings on firewall compliance.  It intends to reiterate to
    examiners the need to fully inspect and document Section 20
    companies' compliance with firewalls.

    FDIC disagreed with GAO over the benefits of centralized monitoring
    of the securities activities and financial performance of bona fide
    subsidiaries of insured banks.  FDIC commented that a centralized
    program would create a burdensome reporting process while supervision
    of those institutions would still fall on regional personnel.  FDIC
    said that it is considering the scope and type of examiner training
    necessary for bank securities activities.

    FDIC also disagreed with GAO over the need for a program to assess
    the risks securities activities of bona fide subsidiaries may pose to
    insured banks and ensure compliance with regulatory firewalls.  It
    said that such a program would create a burdensome reporting process.

    GAO disagrees with FDIC's views.  GAO believes that as a regulator of
    federally insured banks, FDIC is responsible for knowing of and
    supervising activities that may pose risks to those banks.  A program
    to identify and monitor the securities activities of those banks'
    securities subsidiaries could improve FDIC's oversight immediately at
    little extra cost.  Also, because FDIC already requires banks to
    notify it of subsidiaries' securities activities and has regional
    supervision programs in place and because securities subsidiaries'
    financial data are available from reports required by securities
    SROs, a centralized program should not impose added regulatory or
    reporting burden on banks.

    INTRODUCTION
    ============================================================ Chapter 1

    Since the mid-1980s, banks have been expanding into securities
    activities by providing retail brokerage services--buying and selling
    securities for customers, which may involve making buy and sell
    recommendations--and underwriting and dealing in securities.\1 These
    securities activities can provide additional income for banks and
    convenience for bank customers, and they can foster a more
    competitive securities industry.  However, without proper management,
    including internal controls, and appropriate regulatory oversight,
    banking organizations that conduct such securities activities may be
    subject to a heightened risk of financial losses that, if large
    enough, could undermine public trust in the banking system.  Also,
    without proper oversight of the securities activities, investors may
    not be adequately protected from fraudulent and unfair sales
    practices.  As a result of concerns of and issues raised by the
    Ranking Minority Member of the House Committee on Commerce and the
    Ranking Minority Member of the Subcommittee on Telecommunications and
    Finance, House Committee on Commerce, about the expansion of banks
    into securities activities, we reviewed federal bank regulators'
    procedures and processes for examination and supervision of bank
    securities activities.

    --------------------
    \1 Underwriting is the public distribution of new issues of
    securities; dealing refers to the business of holding oneself out to
    the public as being willing to make a secondary market in a security
    by offering to buy and sell securities as principal.

       BACKGROUND
    ---------------------------------------------------------- Chapter 1:1

    Banks' expansion into securities activities presents legal and
    financial risks to federally insured banks.  How these risks are
    managed and overseen depends on how the banks are chartered and
    regulated and on how they are organized to do business.  It also
    depends on the securities activities the banks undertake, which may
    be limited by federal law and regulation.

          SECURITIES ACTIVITIES CAN
          POSE LEGAL AND FINANCIAL
          RISKS TO INSURED BANKS
    -------------------------------------------------------- Chapter 1:1.1

    Generally, the types and degree of risk that securities activities
    present to banking organizations vary by type of activity.  Discount
    brokerage activities, in which the broker only takes orders and
    executes trades for customers who make their own investment
    decisions, pose little risk.  Full-service brokerage activities, in
    which the broker also provides investment recommendations, can pose
    legal and financial risk, because the broker--including, for example,
    a federally insured bank whose employees provide investment
    advice--can be held liable for a customer's financial losses if those
    losses result from fraudulent or unsuitable investment
    recommendations.  Underwriting and dealing activities generally pose
    greater financial risk because the underwriter or dealer may incur
    losses in the principal amount (face value) of securities being
    underwritten or held.

          BANKS ARE CHARTERED AND
          REGULATED BY FEDERAL AND
          STATE AUTHORITIES
    -------------------------------------------------------- Chapter 1:1.2

    A bank's power to engage in securities activities comes from the
    government authority that charters the bank.  In the case of a
    national bank, the chartering authority is the Office of the
    Comptroller of the Currency (OCC).  OCC, as the primary regulator,
    establishes the regulations under which national banks operate.
    State authorities charter state banks.  A state bank's authority to
    engage in securities activities is established by the state banking
    agency and governed by state law.

    Two other federal agencies also have bank regulatory
    responsibilities.\2 The Board of Governors of the Federal Reserve
    System is the primary federal regulator of bank holding companies\3
    and those state-chartered banks that choose to become members of the
    Federal Reserve System (FRS).  The Federal Deposit Insurance
    Corporation (FDIC) is the primary federal regulator of
    state-chartered banks that have federally insured deposits and are
    not members of the Federal Reserve System.  FDIC also administers the
    Bank Insurance Fund (BIF), which provides deposit insurance for
    banks.  Because of this role, FDIC has back-up regulatory authority
    over all insured banks.

    The primary goal of federal bank regulators is to work toward
    improving and maintaining the safety and soundness of banks to help
    safeguard the financial system and protect depositors and other
    customers.  Regulators adopt policies and regulations and examine the
    banks under their jurisdiction for soundness and compliance with
    these policies and regulations.  The Federal Reserve also inspects
    bank holding companies to ascertain their financial strength and to
    determine the consequences of transactions between the parent bank
    holding company, its nonbanking subsidiaries, and the subsidiary
    banks.

    --------------------
    \2 The Office of Thrift Supervision and the National Credit Union
    Administration also regulate depository institutions, respectively,
    thrifts and credit unions.  Their activities were not within the
    scope of our work because it was limited to securities activities of
    commercial banks.

    \3 A bank holding company is a company that controls one or more
    banks.  A company controls a bank if it owns, controls, or has power
    to vote 25 percent or more of the voting stock of a bank, controls
    the election of a majority of the bank's directors, or exercises a
    controlling influence over the bank's management or policies.  A bank
    holding company structure allows nonbank subsidiaries to engage in a
    variety of nonbanking activities that are considered closely related
    to banking functions.

    The largest bank in a bank holding company is typically referred to
    as the lead bank and often holds most of the company's assets.
    Although the Federal Reserve is responsible for inspecting all bank
    holding companies, OCC or FDIC, respectively, would be responsible
    for regulating the lead bank if it is a nationally chartered bank or
    a state-chartered bank that is not a member of the Federal Reserve
    System.

          BANK AND SECURITIES
          REGULATORS OVERSEE VARIOUS
          BANK SECURITIES ACTIVITIES
    -------------------------------------------------------- Chapter 1:1.3

    Bank regulators and securities regulators both play a role in
    regulating the securities activities of banks; the specific roles
    they play depend on both the activities and the way banks organize
    those activities.  Brokerage services, for example, may be regulated
    by bank or securities regulators depending upon the method the bank
    uses to provide these services.  Also, both bank regulators and
    securities regulators are responsible for overseeing various aspects
    of the underwriting and dealing activities of banking organization
    subsidiaries.

    The Securities Act of 1933 and the Securities Exchange Act of 1934
    are the basis for securities regulation in the United States.  Under
    the 1934 act, firms engaged in brokering or dealing securities,
    including bank securities affiliates, must register as
    broker-dealers.\4 The Securities and Exchange Commission (SEC) is the
    federal agency responsible for securities regulation.  SEC achieves
    its mission, in part, through self-regulatory organizations (SROs)
    like the National Association of Securities Dealers (NASD) and the
    New York Stock Exchange.\5

    Basically, SEC and SROs adopt rules and regulations that the
    broker-dealers must follow to protect securities investors and
    provide for the maintenance of fair and orderly markets.  Securities
    rules and regulations require companies providing brokerage services
    to have adequate capital to protect investors from the losses of
    broker-dealers.  Such companies are also required to implement
    procedures to protect investors from unfair sales practices.  The
    inability of registered broker-dealers to meet obligations to retail
    customers--that is, to restore the funds in retail customers'
    accounts if the broker-dealers go out of business--is insured against
    by the Securities Investor Protection Corporation (SIPC).\6

    Securities regulators examine and monitor the broker-dealers'
    activities for compliance with securities laws and regulations.  SEC
    also evaluates the quality of SRO oversight in enforcing compliance
    with federal securities laws and SRO rules, including provisions
    related to preventing fraudulent and manipulative practices and
    protecting investors from such practices.

    --------------------
    \4 Broker-dealers combine the function of brokers and dealers.
    Brokers are agents who handle public orders to buy and sell
    securities.  Dealers are principals who buy and sell securities for
    their own accounts and at their own risk.

    \5 We have reported in the past on SEC and SRO regulation of the
    securities industry and broker-dealers in general, which include
    registered securities affiliates of banking organizations.  In those
    reports we recommended various actions needed to improve regulatory
    oversight of securities markets and broker-dealers and better protect
    investors.  See, for example, Securities Industry:  Strengthening
    Sales Practice Oversight (GAO/GGD-91-52, Apr.  25, 1991); Securities
    Investor Protection:  The Regulatory Framework Has Minimized SIPC's
    Losses (GAO/GGD-92-109, Sep.  28, 1992); Penny Stocks:  Regulatory
    Actions to Reduce Potential for Fraud and Abuse (GAO/GGD-93-59, Feb.
    3, 1993); and Securities Markets:  Actions Needed to Better Protect
    Investors Against Unscrupulous Brokers (GAO/GGD-94-208, Sep.  14,
    1994).

    \6 SIPC, a private, nonprofit membership corporation established by
    Congress in 1970, provides certain financial protections to the
    customers of failed U.S.  broker-dealers.  In 1992 we reported that
    SIPC had been successful at protecting investors and noted that
    SIPC's success was derived from SEC's and SROs' diligent oversight of
    the securities industry.  See Securities Investor Protection:  The
    Regulatory Framework Has Minimized SIPC's Losses (GAO/GGD-92-109,
    Sep.  28, 1992).

             BROKERAGE ACTIVITIES MAY
             BE REGULATED BY
             SECURITIES OR BANK
             REGULATORS
    ------------------------------------------------------ Chapter 1:1.3.1

    As shown in table 1.1, securities regulators are responsible for
    regulating a bank's brokerage services when a bank provides these
    services to its customers through (1) a registered securities
    brokerage affiliate; or (2) an arrangement with an unaffiliated
    registered third-party broker-dealer, whether the services are
    provided on or off bank premises.  When these services are provided
    on the bank's premises by bank employees or through a bank affiliate,
    bank regulators may examine the brokerage activities.  Bank
    regulators have no direct authority over unaffiliated, third-party
    broker-dealers, even when they operate on bank premises.  However,
    the federal banking agencies' "Interagency Statement on Retail Sales
    of Nondeposit Investment Products," February 15, 1994, requires that
    a bank's agreement with a third-party broker-dealer authorize the
    appropriate banking agency to have access to all records of the
    third-party broker as are necessary or appropriate to evaluate
    whether the third-party broker is complying with the terms of its
    agreement.  Bank regulators generally address safety and soundness
    concerns and compliance with applicable laws, regulations, and
    supervisory guidance, while securities regulators generally address
    investor protection concerns and compliance with securities laws and
    regulations.

    Banks that exclusively use their own employees, rather than an
    affiliated company, to provide securities brokerage services to
    retail customers are exempt from registration and regulation as
    broker-dealers under the 1934 securities exchange act.  The exemption
    means that these activities are outside the normal securities
    regulatory framework.  However, the antifraud provisions of the
    federal securities laws still apply.  Further, banking regulations
    require banks providing such direct securities brokerage services to
    keep records and provide customers confirmations of securities
    transactions.  Also, the securities brokerage activities of these
    banks are not SIPC-insured, unless the bank customers are also
    identified as customers of an SEC-registered broker-dealer through
    which the bank places customers' orders for execution.

                                   Table 1.1

                        Bank Methods of Providing Retail
                        Brokerage Services and Resulting
                          Regulatory Responsibilities

    Method                              Regulatory responsibility
    ----------------------------------  ----------------------------------
    Off bank premises, either through   Securities regulators. Bank
    registered securities brokerage     regulators also can examine
    affiliate or an arrangement with    activities of bank affiliates.
    an unaffiliated registered third-
    party broker-dealer.

    On bank premises through a          Bank and securities regulators.
    registered securities brokerage
    affiliate.

    On bank premises through a third-   Securities regulators. Bank
    party arrangement with an           regulators have no direct
    unaffiliated registered broker-     authority over unaffiliated
    dealer.                             broker-dealers. A bank's agreement
                                        with an unaffiliated broker-
                                        dealer is required to provide
                                        regulators access to records of
                                        the unaffiliated broker-dealer.

    On bank premises through bank's     Bank regulators.
    own employees.
    ----------------------------------------------------------------------
    Source:  GAO Analysis

             AFFILIATES THAT
             UNDERWRITE AND DEAL IN
             SECURITIES ARE REGULATED
             BY BOTH BANK AND
             SECURITIES REGULATORS
    ------------------------------------------------------ Chapter 1:1.3.2

    Banking organizations' securities underwriting and dealing activities
    are subject to regulation by both bank and securities regulators.
    Bank regulations require that a bank holding company and its
    subsidiaries that underwrite and deal in securities meet certain
    financial conditions and have regulatory limitations called firewalls
    in place and functioning to protect insured banks and bank customers
    from any possible losses of an underwriting affiliate.  Bank
    regulators examine the underwriting subsidiaries for both their
    overall financial condition and compliance with firewalls.
    Securities regulators oversee and examine the same subsidiaries for
    compliance with securities laws and SEC and SRO regulations and
    rules.

    Firewalls are policies and procedures that separate the activities of
    banks from their affiliated companies that underwrite and deal in
    securities.  These devices are meant to insulate insured banks from
    any possible losses of the underwriting affiliate.  Firewalls also
    serve to minimize conflicts of interest.

          BANKS ARE NOT PROHIBITED
          FROM PROVIDING RETAIL
          BROKERAGE SERVICES
    -------------------------------------------------------- Chapter 1:1.4

    Banks have never been prohibited by federal law or regulation from
    providing customers with retail securities brokerage services and
    associated investment advisory services.  Nevertheless, bank retail
    brokerages did not become common until after the mid-1980s, when OCC
    issued a statement that generally granted national banks approval to
    provide retail brokerage services.  The Federal Reserve also issued a
    statement approving bank holding companies' provision of retail
    brokerage services.

    After these statements were issued, banks began to request and
    receive approval from the regulators to provide retail brokerage
    services.  At the time of our review, banks' retail securities
    brokerage services included the buying and selling of securities,
    such as stocks, bonds, and mutual funds, which bank regulators refer
    to as "nondeposit investment products."

          BANKING ORGANIZATIONS CAN
          UNDERWRITE AND DEAL IN
          SECURITIES ONLY UNDER
          CERTAIN CONDITIONS
    -------------------------------------------------------- Chapter 1:1.5

    The Banking Act of 1933, commonly known as the Glass-Steagall Act,
    restricts banks and bank-affiliated companies in many underwriting
    and dealing activities.  The act allows banks and companies
    affiliated with a bank\7 to underwrite and deal in certain types of
    securities known as bank-eligible securities.  These include U.S.
    government and federally sponsored agency securities and general
    obligation bonds of states and municipalities.  Underwriting and
    dealing in other types of securities--known as bank-ineligible
    securities--are subject to specific restrictions.

    The Glass-Steagall Act was enacted in reaction to the banking crisis
    of the Great Depression, during which many banks failed and customers
    lost confidence in the banking system.  Basically, the act separates
    commercial and investment banking in an effort to enhance the safety
    and soundness of commercial banking and protect bank customers from
    potential conflict-of-interest abuses and other inequities.\8 The
    Glass-Steagall Act prohibits banks from underwriting and dealing in
    bank-ineligible securities--that is, municipal revenue bonds, private
    mortgage-backed securities, commercial paper, asset-backed
    securities, and corporate equity and debt securities (stocks and
    bonds).  More specifically:

      Section 16 of the act prohibits a national bank from underwriting
         and dealing in bank-ineligible securities.

      Section 20 of the act prohibits a Federal Reserve member bank from
         becoming affiliated with any company that is "principally
         engaged" in the underwriting, sale, or distribution of
         bank-ineligible securities.

      Section 21 of the act prohibits any person or company engaged in
         the business of underwriting, selling, and distributing
         bank-ineligible securities from engaging in the business of
         receiving deposits.

      Section 32 of the act governs interlocking relationships by
         prohibiting directors, officers, or employees of member banks
         from serving as directors, officers, or employees of any
         institution primarily engaged in underwriting and dealing in
         securities.

    The Federal Reserve Act subjects state-chartered banks that belong to
    the Federal Reserve System to the same underwriting and dealing
    restrictions as national banks.  Although Section 21 of the
    Glass-Steagall Act in effect prohibits state-chartered banks that are
    not FRS members from directly underwriting and dealing, they are not
    subject to Glass-Steagall restrictions on affiliations and, if not
    prohibited by state law, may affiliate with securities firms.
    However, bank holding companies that own state nonmember banks must
    obtain the Federal Reserve's approval under the Bank Holding Company
    Act before acquiring any underwriting subsidiary.

    Until recently, OCC interpreted the restrictions on national bank
    securities activities to apply to both banks and any subsidiary of
    the bank.  OCC, however, changed this interpretation in November
    1994, when it submitted a proposal to revise its rules governing
    corporate applications.  The proposal would set up a process for OCC
    to consider applications from individual national banks to pursue new
    activities, including securities underwriting, through establishment
    of operating subsidiaries.  OCC formerly prohibited bank subsidiaries
    from activities impermissible for the parent banks.  According to
    OCC, applications would be considered on a case-by-case basis.  OCC
    is considering comments on the proposal.

    --------------------
    \7 A bank becomes affiliated with a securities underwriting firm when
    (1) the company that owns the bank also owns the securities firm, (2)
    the securities firm owns the bank, or (3) the securities firm is a
    subsidiary of the bank.

    \8 An example of an inequity that could result if banks were allowed
    unrestricted securities activities would be banks' favoring loan
    requests of customers and clients of their securities business over
    those of other bank customers.

             SECTION 20 SUBSIDIARIES
    ------------------------------------------------------ Chapter 1:1.5.1

    In addition to restricting activities within banks, Section 20 of the
    Glass-Steagall Act prohibits Federal Reserve member banks--all
    national banks and state banks that choose to become members--from
    affiliating with an institution principally engaged in underwriting
    securities.  The Federal Reserve interprets the prohibition to allow
    banks owned by holding companies to affiliate with institutions
    engaged in securities underwriting and dealing so long as the
    activity involving bank-ineligible securities generates 10 percent or
    less of the affiliate's gross revenue.  The 10-percent threshold
    signifies that the bank-ineligible activity is not a principal
    activity of the institution.  The companies that the Federal Reserve
    has approved to underwrite and deal in bank-ineligible securities are
    known as Section 20 subsidiaries.  Generally, the principal business
    of these subsidiaries is underwriting and dealing in bank-eligible
    securities.

    Other financial and operating conditions must also be met before a
    Section 20 subsidiary may be established by a bank holding company.
    As described in further detail in chapter 3, the company must meet
    the following criteria:

      It must be adequately capitalized.

      It must be approved for such activities by the Federal Reserve
         Board.

      It must register with SEC as a broker-dealer and be a member in
         good standing of NASD.

      It must comply with certain operating conditions and firewalls.

             BONA FIDE SUBSIDIARIES
    ------------------------------------------------------ Chapter 1:1.5.2

    Although Section 21 of the Glass-Steagall Act has the effect of
    prohibiting a state-chartered non-FRS-member bank from underwriting
    securities, the prohibition does not extend to the bank's
    subsidiaries.  In 1984, FDIC issued regulations\9 setting out
    conditions under which insured state banks that are not Federal
    Reserve members can establish subsidiaries to engage in the sale,
    distribution, and underwriting of bank-ineligible securities.  These
    subsidiaries are known as bona fide subsidiaries.

    Unlike the Federal Reserve, FDIC does not require non-FRS-member
    banks to obtain advance approval from FDIC headquarters to establish
    bona fide subsidiaries.  However, any nonmember bank that wants to
    establish such subsidiaries is required to notify the Regional FDIC
    director of its intentions.  Otherwise, bona fide subsidiaries must
    meet conditions similar to those required of Section 20 subsidiaries.
    As discussed in further detail in chapter 4, the company must meet
    the following criteria:

      It must be adequately capitalized.

      It must register with SEC as a broker-dealer and be a member in
         good standing of NASD.

      It must comply with operating conditions and restrictions that are
         similar to the firewalls that the Federal Reserve requires of
         bank holding company subsidiaries.

    --------------------
    \9 12 CFR Section 337.4.

       OBJECTIVES, SCOPE, AND
       METHODOLOGY
    ---------------------------------------------------------- Chapter 1:2

    As a result of the requesters' concerns and issues raised about the
    regulation of banking organizations' expansion into securities
    brokerage, underwriting, and dealing activities, we reviewed (1) bank
    regulators' procedures and processes for examining and supervising
    banks that provide brokerage services directly by bank employees and
    (2) banking organizations' securities underwriting and dealing
    activities.  Our objectives were to assess

      the extent to which banks provide securities brokerage services and
         how these services are regulated;

      the Federal Reserve's supervision of bank holding company
         subsidiaries that the agency authorizes to underwrite and deal
         in securities, including the completeness and results of its
         inspections; and

      FDIC's regulation of bona fide subsidiaries that underwrite and
         deal in securities.

    We also sought to provide information on training available to bank
    examiners on brokerage and other securities activities.

    The scope of our work was limited to banking organizations'
    securities activities that are subject to Federal Reserve, OCC, and
    FDIC regulation.  We have reported in the past on SEC and SROs'
    regulation of the securities industry and broker-dealers in general,
    which include registered securities subsidiaries of banking
    organizations.  This report does not address other bank securities
    activities, including banks' holding securities as proprietary
    investments, which they can trade; banks' management of trusts or
    serving as investment advisers to mutual funds; and banks' activities
    as registered government and municipal securities dealers.  Also, it
    was not within the scope of our work to determine comparative degrees
    of risk associated with different types of investment products or the
    various banking and nonbanking activities that banks might engage in.

    We obtained information on regulatory programs from officials of
    federal bank regulatory agencies, reviewed agency documents and
    examination files, and surveyed a sample of banks.  To evaluate bank
    regulators' oversight of bank-direct brokerage operations we obtained
    from OCC, the Federal Reserve, and FDIC, respectively, guidance for
    examining brokerage operations and nonbanking activities of national,
    state FRS-member and state non-FRS-member banks and bank
    subsidiaries.  We reviewed regulatory examinations of banks
    identified as having bank-direct brokerage operations to determine if
    the brokerage operations were examined as directed by the guidance.
    We identified banks that provided brokerage services directly by the
    bank from our survey of banks' securities and mutual fund activities
    (see ch.  2).

    We obtained information on the Federal Reserve's supervision of
    underwriting subsidiaries of bank holding companies from Federal
    Reserve officials.  We reviewed the two most recently completed
    inspections, usually from 1992 and 1993, of the underwriting
    subsidiaries in four Federal Reserve Districts--Chicago, New York,
    Richmond, and San Francisco--to determine if the inspections were
    conducted as directed by Federal Reserve guidance on the inspection
    of nonbank subsidiaries engaged in underwriting and dealing.  The
    four districts were selected because they provided a mix of banking
    organizations and subsidiaries, including money center banks, large
    regional organizations, and foreign-owned subsidiaries.  They also
    were located near our headquarters and regional offices.

    We obtained information on regulation of securities activities
    conducted by national banks and their securities affiliates from OCC
    officials.  We also reviewed examinations and interviewed examiners
    of national banks affiliated with underwriting subsidiaries to
    determine if their examinations included procedures to review
    prohibited interaffiliate transactions between a national bank and an
    underwriting affiliate.

    We obtained information on regulation of nonmember state-chartered
    banks' securities activities from FDIC officials.  In addition to our
    review of bank-direct brokerage operations, we also reviewed and
    selected recent examinations of banks identified by FDIC as having
    bona fide subsidiaries meeting the criteria for underwriting and
    dealing in securities.

    The three bank regulators also provided us information related to the
    training of bank examiners on banks' securities activities.

    To develop information on the extent to which banks are providing
    brokerage services to retail customers and how those services are
    being provided, we surveyed a stratified random sample of 2,233 banks
    that is projectable to a nationwide universe of about 11,100
    commercial banks.  Our survey sample, described in appendix VIII,
    included Federal Reserve member, nationally chartered, and
    state-chartered banks of varying sizes.  We conducted the survey
    because data on banks' securities activities that are compiled by
    bank regulators and industry groups did not capture the information
    we sought on banks' involvement in securities brokerage and mutual
    fund activities.

    Our work was performed at the Board of Governors of the Federal
    Reserve System, OCC, and FDIC in Washington, D.C.; in the Federal
    Reserve's Chicago, New York, Richmond, and San Francisco districts;
    and in OCC's and FDIC's Atlanta, Chicago, New York, and San Francisco
    regions.  We conducted our audit work between May 1993 and September
    1994 in accordance with generally accepted government audit
    standards.  We obtained comments on a draft of the report from the
    Federal Reserve, FDIC, OCC, SEC, and NASD.  Their comments are
    presented and evaluated in chapters 2, 3, and 4 and are reprinted in
    appendixes III, IV, V, VI, and VII.

    BANKS' SECURITIES BROKERAGE
    ACTIVITIES RAISE REGULATORY ISSUES
    ============================================================ Chapter 2

    Our survey of banks showed that the securities activities of most
    banks are regulated by SEC.  The survey also showed that an estimated
    287, about 12 percent, of the estimated 2,400 banks that provide
    securities brokerage services provide those services on bank
    premises, exclusively through bank employees.  We refer to these as
    bank-direct brokerage operations.  Because banks are exempt from
    securities regulation, as noted in chapter 1, the securities
    brokerage activities of these banks are regulated by bank regulators.
    In the past, bank regulators did not always review the bank-direct
    brokerage operations as part of bank examinations, but they issued
    new guidance and examination procedures in 1994 that have increased
    emphasis on such reviews.  Nevertheless, exempting the securities
    activities of these banks from securities regulation results in
    parallel, though different, regulatory systems for the same activity.

       MANY BANKS PROVIDE RETAIL
       SECURITIES BROKERAGE SERVICES
    ---------------------------------------------------------- Chapter 2:1

    To determine the number of banks providing bank-direct and other
    brokerage services and to gather data about the nature of services
    provided, we surveyed a sample of over 2,200 banks nationwide.
    Appendixes VIII and IX provide technical information about the survey
    and the questionnaire we used.

    On the basis of the results of our survey, we estimate that about
    2,400 banks offered retail securities brokerage services as of June
    1994.  This represents about 22 percent of the 11,084 banks that we
    estimated were in the United States at the time of our survey.\1
    Figures 2.1 through 2.3 show by size, type, and region the percent of
    all banks that offered brokerage services.  For example, figure 2.1
    shows that the larger the bank, the greater the likelihood that it
    provided securities brokerage services to retail customers.

       Figure 2.1:  Estimated Percent
       of All Banks and Banks in Each
       Size Category Offering Retail
       Securities Brokerage Services

       (See figure in printed
       edition.)

    Source:  GAO survey.

    Figures 2.2 and 2.3 show the percentages of banks by type and region
    of the United States that provide securities brokerage services.

       Figure 2.2:  Estimated Percent
       of All Banks and Banks of Each
       Type Offering Retail Securities
       Brokerage Service

       (See figure in printed
       edition.)

    Source:  GAO survey.

       Figure 2.3:  Estimated Percent
       of All Banks and Banks in Each
       Region Offering Retail
       Securities Brokerage Services

       (See figure in printed
       edition.)

    Source:  GAO survey.

    Of the estimated 2,400 banks that offered retail securities brokerage
    services, 27 percent provided full-service brokerage services, 52
    percent provided discount brokerage services, and 21 percent provided
    accommodation brokerage services.\2 Except for banks operating in the
    West, we found similar patterns in the type of securities brokerage
    services banks offered by size, type of bank, and regional location,
    as shown in figures 2.4 through 2.6.  We also found that larger banks
    and banks operating in the West were more likely to offer
    full-service retail brokerage services.

       Figure 2.4:  Type of Brokerage
       Services Offered by Banks That
       Provide Securities Services in
       Each Size Category

       (See figure in printed
       edition.)

    Note:  Percentages may not add to 100 percent bacause of rounding.

    Source:  GAO survey.

       Figure 2.5:  Type of Brokerage
       Services Offered by Banks That
       Provide Securities Services by
       Type of Bank

       (See figure in printed
       edition.)

    Source:  GAO survey.

       Figure 2.6:  Type of Brokerage
       Services Offered by Banks That
       Provide Securities Services by
       Region

       (See figure in printed
       edition.)

    Source:  GAO survey.

    --------------------
    \1 The sampling errors for the weighted estimates from our survey are
    no more than plus or minus 5 percent unless otherwise noted.  The
    number of banks shown differs from the number, 11,210, shown in app.
    VIII, table VIII.1, because we estimated 126 banks in the original
    population were ineligible for our survey because they had ceased to
    operate as financial institutions.

    \2 In our survey of banks, we defined full-service brokerage as
    offering investment advice and/or buy and sell recommendations in
    conjunction with executing customer buy and sell orders, discount
    brokerage as acting solely as an agent in executing customer buy and
    sell orders, and accommodation brokerage as placing buy and sell
    orders as a service only when requested by a customer or to
    facilitate other transactions.

       MOST BANK BROKERAGE SERVICES
       WERE PROVIDED THROUGH
       SUBSIDIARIES AND THIRD-PARTY
       ARRANGEMENTS
    ---------------------------------------------------------- Chapter 2:2

    As table 2.1 shows, 12 percent of the banks that offered securities
    brokerage services (287 banks, or about 3 percent of banks
    nationwide) provided only bank-direct brokerage services.  The
    remaining 88 percent of banks that provided securities brokerage
    services did so through an SEC-registered securities broker-dealer.
    Securities brokerage services at some of these banks were provided in
    a variety of ways.  As a result, some banks responding to our survey
    provided multiple responses to describe securities brokerage
    services.  Table 2.1 shows the various ways in which banks provide
    securities brokerage services to retail customers.

                                   Table 2.1

                      How Banks Provide Retail Securities
                     Brokerage Services to Their Customers

                          (Multiple responses allowed)

                                                                      Bank
                                                                  response
                                                                         s
                                                                  (percent
    Services provided                                                    )
    ------------------------------------------------------------  --------
    Customer orders taken directly by employees of the bank only        12
    Through a leasing or networking agreement\a with a                  35
     registered broker-dealer
    Bank employee referral of customers to registered broker-           39
     dealers and/or other arrangements involving a registered
     broker-dealer
    Through registered affiliate or subsidiary broker-dealer            42
    Using dual employees\b of the bank and a registered broker-         44
     dealer
    ----------------------------------------------------------------------
    \a A leasing or networking agreement is an arrangement between a bank
    and a registered broker-dealer to offer brokerage services to
    customers on bank premises.  These arrangements can involve either
    affiliated or unaffiliated broker-dealer firms.

    \b An arrangement in which a registered broker-dealer uses bank
    employees and premises to sell securities and in return makes a
    monthly payment to the bank.  The dual employees can be paid
    incentive bonuses in addition to a fixed salary.

    Source:  GAO survey.

    To validate questionnaire responses and determine how banks handle
    brokerage transactions, we contacted all 46 banks that responded to
    our survey by April 15, 1994, indicating that they provided
    bank-direct brokerage services.  Officials of six banks said their
    employees either referred customers directly to an unaffiliated
    registered broker-dealer or provided brokerage services through a
    registered broker-dealer subsidiary.  Officials of the remaining 40
    banks confirmed that they provided bank-direct brokerage
    services--that is, services at the bank premises and exclusively
    through bank employees.  According to officials from these 40 banks,
    designated bank employees take customer-initiated orders to buy or
    sell investment products, which the bank refers to unaffiliated
    registered broker-dealers for execution and confirmation.

    After April 15, 1994, 25 additional banks responded to our survey and
    indicated that they provided bank-direct brokerage services.  The
    size, type, and location of these additional banks appeared similar
    to the characteristics of the 40 banks we had identified earlier as
    providing bank-direct brokerage services.  We did not gather
    additional information on how these 25 additional banks handled their
    retail securities brokerage operations because we had no reason to
    expect their responses would be different from the responses we
    received from the initial 46.

    Follow-up discussions with the 40 banks that provided bank-direct
    brokerage services indicated that most were not handling large
    volumes of brokerage transactions.  Officials of 16 of those banks
    said that they processed fewer than 10 transactions per month, 14
    said 10 to 25 per month, and 10 said more than 25 per month.  An
    official from 1 of the 40 banks said the bank also offered investment
    advice to retail customers.  However, the investment advice was
    offered only to retail customers interested in the bank's mutual fund
    sales program.  The official from this particular bank said the bank
    also operated a separate brokerage unit to provide discount brokerage
    services to customers interested in buying or selling other
    securities products, such as stocks, bonds, and U.S.  Treasury
    securities.

       BANK REGULATORS ARE WORKING TO
       IMPROVE REVIEWS OF BANK-DIRECT
       BROKERAGE OPERATIONS
    ---------------------------------------------------------- Chapter 2:3

    Bank regulators' responsibilities for examining bank-direct brokerage
    operations are defined by regulations and supervisory guidance.
    Before 1994, under the old guidance, bank regulators did few
    examinations of bank-direct brokerage operations.  In 1994, federal
    bank regulators issued new joint guidance and examination procedures
    for brokerage operations on bank premises.  It is too early too tell
    how frequently examinations will be done or how effective bank
    examiners will be at examining brokerage operations under the new
    guidance and examination procedures.  Examination of brokerages
    traditionally has been the responsibility of securities regulators.
    Further, not all bank examiners are trained to examine bank
    securities activities.

          BEFORE 1994, BANK REGULATORS
          DID FEW EXAMINATIONS OF
          BANK-DIRECT BROKERAGE
          OPERATIONS
    -------------------------------------------------------- Chapter 2:3.1

    Bank regulators' responsibilities to monitor banks activities,
    including bank-direct brokerage activities, although not explicitly
    stated, are defined generally by the Federal Deposit Insurance
    Corporation Improvement Act of 1991 (FDICIA) (P.L.  102-242).  The
    act, as amended in 1994, requires federal bank regulatory agencies to
    perform a full-scope, on-site examination at least once a year for
    each insured depository institution with assets greater than $250
    million.\3 The purpose of these examinations is to ensure that
    effective internal controls are in place and operating as intended to
    protect the safety and soundness of the bank.  The examinations are
    to cover all factors relevant to the safe and sound operation of the
    bank--including nonbanking activities conducted on bank premises,
    such as bank-direct brokerage services.  However, federal securities
    regulators told us that bank regulatory oversight is not equivalent
    to oversight by securities regulators because federal banking
    statutes and regulations do not comprehensively address sales
    practice issues, nor do they impose an explicit duty to supervise
    bank securities sales personnel.  In addition, they said bank
    securities customers have no formal avenue of redress for complaints.

    Regulatory responsibilities related to bank-direct brokerage
    activities are further defined by guidance that each bank regulator
    has issued on nonbanking activities, including securities brokerage
    activities.  During 1993, each of the three bank regulators
    individually issued agency guidance that instructed examiners to
    focus on the sale of nondeposit investment products on bank premises
    as part of routine bank examinations.\4

    Despite the requirements of FDICIA and existing agency guidance, many
    bank-direct brokerages were not reviewed during on-site examinations
    completed in the period 1992 through mid-1994.  The results of our
    review of examinations completed in that period showed that 28 (72
    percent) of 39 bank-direct brokerages that should have been reviewed
    were not.  (We excluded one FDIC-regulated bank from this analysis
    because it responded that it provided minimal accommodation brokerage
    services.) Because these bank-direct brokerages are exempt from SEC
    and NASD regulation and they were not reviewed by bank regulators,
    they were operating without any federal oversight.  Table 2.2 shows
    the number of bank-direct brokerages, out of the 40 we reviewed, that
    bank regulators have examined.

                                   Table 2.2

                        Bank-Direct Brokerage Operations
                       Examined by Bank Regulators in the
                          Period 1992 Through Mid-1994

                                                                Banks with
                                                         examinations that
                                                         included a review
                                      Banks with bank-      of bank-direct
                                      direct brokerage           brokerage
    Bank regulators                         operations          operations
    ------------------------------  ------------------  ------------------
    FDIC                                            18                   3
    Federal Reserve                                  4                   1
    OCC                                             17                   8
    ======================================================================
    Total                                           39                  12
    ----------------------------------------------------------------------
    Source:  GAO analysis.

    --------------------
    \3 State regulatory examinations can be substituted in alternate
    years for state-chartered banks, and longer examination periods--18
    months--can be used for banks with less than $250 million in assets
    that previous examinations have shown to be well-capitalized and
    well-managed.

    \4 FRB notice to Officers-in-Charge of Supervision at each federal
    reserve bank on the separation of mutual fund sales activities from
    insured deposit-taking activities (June 17, 1993) (SR 93-35 (FIS));
    OCC Banking Circular 274, issued July 19, 1993 (NR 93-77); FDIC
    Statement on State Nonmember Bank Sales of Mutual Funds and
    Annuities, issued October 8, 1993 (FIL-71-93).

          BANK REGULATORS HAVE ISSUED
          NEW GUIDANCE ON BANK-DIRECT
          BROKERAGE OPERATIONS
    -------------------------------------------------------- Chapter 2:3.2

    Banking regulators recently took steps to improve their oversight of
    bank-direct brokerage operations.  On February 15, 1994, federal bank
    regulators issued a joint policy statement on the sale of nondeposit
    investment products on the premises of insured banking institutions.
    This new guidance addresses investor protection issues, such as sales
    practices and suitability,\5 use of information about customers, and
    consumer disclosure and advertising requirements for the retail sale
    of mutual funds and other securities products on bank premises.  The
    new guidance applies to retail recommendations and sales of
    nondeposit investment products made by (1) employees of a banking
    organization, (2) employees of an affiliated or unaffiliated third
    party operating on the premises of the banking organization, and (3)
    sales resulting from a referral of retail customers by the
    institution to a third party when the depository institution receives
    a benefit for the referral.  The purpose of the guidance is to
    minimize the possibility of customer confusion and to safeguard the
    institution from liability under antifraud provisions of the federal
    securities laws.

    The Federal Reserve, FDIC, and OCC have taken steps to review for
    compliance with this guidance as part of their routine
    safety-and-soundness examinations.  Although the new guidance does
    not have the same force as a federal statute or bank regulation,
    federal bank regulators have informed the various banking
    organizations under their jurisdiction that, as appropriate, a review
    for compliance with the joint agency guidance will be included in
    routine bank examinations.  For example, OCC said that it directed
    examiners to include a review of nondeposit investment product sales
    activities in all bank safety and soundness examinations.  All three
    bank regulators have developed detailed examination procedures for
    their examiners to use in reviewing securities sales activities of
    banks during routine examinations.  The examination procedures
    address investor protection concerns, such as advertising,
    suitability of investments recommended, and sales practices.

    --------------------
    \5 Suitability refers to the matching of customer financial means and
    investment objectives with a suitable product.

          INFORMATION ON TRAINING
          PROVIDED TO BANK EXAMINERS
          FOR OVERSIGHT OF BANK
          SECURITIES ACTIVITIES
    -------------------------------------------------------- Chapter 2:3.3

    FDICIA requires federal bank agencies to periodically review and
    provide training to their examiners to ensure frequent, objective,
    and thorough examinations of federally insured banking institutions.
    The Federal Reserve, FDIC, and OCC provide bank examiners with
    guidance on overseeing bank securities activities.  Bank examiners at
    the Federal Reserve and OCC also receive formal training that
    addresses oversight of bank and bank subsidiaries' securities
    activities, including the joint agency guidance.  However, as of
    September 1994, FDIC had no formal examiner training program that
    focused on oversight of securities activities of state nonmember
    banks and their subsidiaries.

             THE FEDERAL RESERVE AND
             OCC PROVIDE EXAMINER
             TRAINING ON BANK
             SECURITIES ACTIVITIES
    ------------------------------------------------------ Chapter 2:3.3.1

    Federal Reserve examiners may receive training related to bank
    securities activities through specialized seminars and training
    courses.  For example, Federal Reserve examiners can attend a
    securities market seminar.  This 2- to 3-day seminar covers relevant
    securities and banking laws governing bank securities activities as
    well as retail securities brokerage activities within the bank.
    Seminar topics include inequitable and unfair sales practices,
    insider trading, customer account recordkeeping and confirmation
    requirements, firewall requirements (discussed in chapters 3 and 4),
    SEC and SRO oversight functions, and other related topics.  In
    addition, the Federal Reserve recently developed an examiner training
    course on the joint regulatory guidance on retail sale of nondeposit
    investment products in the bank.

    OCC examiners receive specialized training through conferences,
    seminars, and courses.  In December 1992, OCC offered examiners a
    conference that included a session on risks banks take in selling
    mutual funds and annuities.  This conference included a discussion of
    suitability issues.\6 In September 1993, OCC offered examiners a
    3-day seminar on bank sales of mutual funds and nondeposit investment
    products.  In addition, OCC's 1993 course catalog also lists various
    examiner training opportunities related to bank securities
    activities.  An OCC Capital Markets Expert Seminar covered a range of
    capital markets topics, including bank dealer, trading, and retail
    brokerage activities.  Another OCC course covered fundamental
    concepts and terminology of the securities business.  It explained
    the processes and procedures used in issuing, transferring, and
    regulating securities and presented an overview of securities
    industry operations and the basic industry components.  A course
    entitled "Bank Securities Dealers" was designed to enable OCC
    examiners to identify potentially unsafe and unsound practices for
    sales of municipal securities.  Another OCC examiner course focused
    on the potential effects of transactions between banks and affiliates
    and related organizations.  According to OCC, training relevant to
    examining bank securities activities was also provided in each of its
    six district offices and those examiners, in turn, provided the
    training to examiners in other offices across the country.

    --------------------
    \6 Consistent with NASD's Rules of Fair Practice, bank regulators
    expect banks to determine whether a product being recommended is an
    appropriate investment for the customer.  Banks are instructed to
    ensure that any salesperson involved in bank-related sales obtains
    sufficient information from a customer to enable the salesperson to
    make a judgment about the suitability of any recommendations to the
    customer.

             FDIC PROVIDES NO FORMAL
             EXAMINER TRAINING ON BANK
             SECURITIES ACTIVITIES
    ------------------------------------------------------ Chapter 2:3.3.2

    FDIC provided no extended formal training to its examiners on
    oversight of bank securities brokerage and underwriting activities.
    FDIC's examiner training on these subjects was limited to briefings
    on changes in regulations, a lecture on bank relationships with
    broker-dealers, and on-the-job examiner training.  FDIC officials
    said that FDIC's primary focus is to oversee the safety and soundness
    of banks--not the sales practices of bank securities subsidiaries,
    which are subject to oversight by securities industry regulators.
    However, FDIC is responsible for regulatory oversight of bank-direct
    brokerage activities of banks under FDIC's jurisdiction.  Such
    brokerages are exempt from oversight of securities regulators.

    In April 1994, FDIC provided examiners with specific examination
    procedures for examinations of bank-direct brokerage activities;
    however, the agency provides no similar guidance for examinations
    related to securities underwriting activities.  In the absence of
    such aids and a formal training program, FDIC examiners are
    instructed to use FDIC's regulation for bona fide subsidiaries as
    guidance, along with their professional judgment, in examining
    banking organizations for compliance with the FDIC firewall
    provisions that apply to bank securities underwriting activities.
    FDIC officials said that despite the lack of formal training programs
    to address bank securities underwriting and brokerage activities,
    they were confident that their examiners could assess the impact of
    banks' securities activities on the safety and soundness of state
    nonmember banks.

       BANK AND SECURITIES REGULATORS
       CAN COOPERATE TO MAKE OVERSIGHT
       OF BANK-DIRECT BROKERAGE
       OPERATIONS MORE CONSISTENT
    ---------------------------------------------------------- Chapter 2:4

    Under the current regulatory structure, either bank or securities
    regulators may oversee the securities activities of banks, depending
    on how banks organize the activities.  Therefore, to ensure that
    customers who invest in securities are treated fairly, bank and
    securities regulators must work closely together to share
    information, coordinate rules, and provide consistent examinations.
    Otherwise, securities investors can be exposed to inconsistent sales
    practices by sales representatives having different levels of
    training and experience.  Although bank and securities regulators
    have cooperated well on some activities, other opportunities for
    cooperation exist that could provide more consistent regulation of
    bank securities activities.

    On occasion bank and securities regulators have worked together.  For
    example, during 1994 bank regulators sought the assistance of SEC and
    NASD officials and examiners in developing new guidance and in
    developing and pilot-testing examination procedures.  Also during
    1994, the Federal Reserve and NASD agreed to coordinate examinations
    of bank brokerage affiliates.  In January 1995, all three banking
    regulators and NASD reached a formal agreement to coordinate
    examination schedules of bank-affiliated broker-dealers and share
    examination findings and workpapers.  Further, securities regulators
    and bank regulators told us that they are discussing various
    proposals to extend securities industry qualifications testing and
    registration to bank employees who are engaged in bank-direct
    securities activities.  The testing and registration process is to be
    backed by examination, enforcement, and disciplinary functions
    designed to be identical to those in place for the securities
    industry.  Bank and securities regulators expect to resolve this
    issue within the next several months.  SEC has also contacted the
    bank regulators to propose development of a common approach to
    eliminating the payment of referral fees to nonregistered employees
    of financial institutions.

    Despite such cooperative efforts, differences in approaches to and
    procedures for regulating bank brokerage operations persist.  For
    example, the interagency guidance sets forth standards for registered
    broker-dealers that differ, in some respects, from federal securities
    laws and regulations.  These differences were highlighted when, in
    December 1994, NASD released for comment proposed rules governing
    securities broker-dealers operating on bank premises.  The proposed
    NASD rules prohibit the payment of referral fees by the broker-dealer
    to nonregistered bank employees.  Referral fees are permitted by the
    interagency guidance, provided that they are one-time nominal fees of
    a fixed-dollar amount and not contingent on the referral resulting in
    a transaction.  The proposed rules also place stricter controls than
    the interagency guidance on the broker's use of confidential bank
    customer financial information, such as certificate of deposit
    maturity dates and balances, for soliciting sales of securities.
    Also, the proposed NASD rules place stricter limits on the use of
    bank logos in advertising materials for securities than the
    interagency guidance.

    NASD's proposed rules have generated controversy in the banking
    industry.  According to the financial press, some bankers have
    complained that the rules hold bank brokerages to standards that are
    higher than for nonbank brokerages.  For example, they note that,
    unlike bank brokerages, nonbank brokerages are not required to
    disclose that mutual funds are not federally insured.  An NASD
    official responded that when a customer deals with a brokerage in a
    bank, that brokerage has a higher responsibility to ensure that the
    customer understands the risk involved in investing in securities as
    compared to savings accounts or certificates of deposit.  According
    to NASD, its proposed rules\7 seek consistent treatment of affiliated
    and networking (third-party) broker-dealers.  Further, NASD said the
    banking guidelines established by the Interagency Statement do not
    have the force and effect of law and cannot support disciplinary
    actions against broker-dealers.  Both the Interagency Statement and
    the proposed NASD rules, however, require written acknowledgement of
    the disclosure of risks associated with investment products sold in
    banks.  The Interagency Statement is more comprehensive in that it
    also requires oral disclosure at any sales presentation or offering
    of investment advice.

    Additional cooperative efforts among bank and securities regulators
    could help make regulation more uniform and consistent by making
    information and regulatory procedures used by securities regulators
    available to bank regulators.  For example, NASD and state securities
    regulators maintain the Central Registration Depository (CRD), a
    database containing background and disciplinary information on
    broker-dealers and individual sales representatives.\8 In our
    September 1994 report and testimony before the congressional
    oversight committee\9 we recognized that the CRD information, after
    system design limitations are corrected, could be a useful regulatory
    tool for controlling the migration of unscrupulous persons among
    sectors of the financial services industry.  We recommended that SEC,
    the Treasury Department, and other regulators work together to
    increase disclosure of the CRD information among the various
    regulators of financial services.  Those regulators have begun
    actions to increase disclosure.\10 According to the Federal Reserve,
    banking and securities regulators are developing a proposal that
    would include developing a CRD recordkeeping system for bank sales
    personnel.

    --------------------
    \7 NASD's proposed rules will be held open for further notice and
    comment when they are submitted to SEC for approval.

    \8 Originally established as a centralized broker licensing and SRO
    registration system, CRD is now also used by regulators and the
    industry to help oversee brokers' activities.

    \9 Securities Markets:  Actions Needed To Better Protect Investors
    Against Unscrupulous Brokers (GAO/GGD-94-208, Sep.  14, 1994); and
    Securities Markets:  Actions Needed To Better Protect Investors
    Against Unscrupulous Brokers (GAO/T-GGD-94-190, Sep.  14, 1994).

    \10 Bank regulators currently have access to CRD but as currently
    structured, CRD does not include bank employees engaged in
    bank-direct sales of securities.

       BANK AND SECURITIES REGULATORS
       HAVE DIFFERING VIEWS ON HOW
       BANKS' SECURITIES ACTIVITIES
       SHOULD BE REGULATED
    ---------------------------------------------------------- Chapter 2:5

    Although bank and securities regulators have cooperated to develop
    guidance and related examination procedures for banks offering
    brokerage services, the same regulators have been at odds about
    whether the current regulatory structure is adequate to protect
    investors.  Securities regulators are concerned that the current
    regulatory structure for oversight of bank securities activities has
    not kept pace with changes in the market and may not be adequate to
    protect investors.  In particular, the securities regulators have
    questioned the continued exemption of banks from SEC registration and
    regulation.  They argue that the exemptions subject banks to weaker
    regulatory standards than broker-dealers.  For example, in
    congressional hearings SEC officials stated that banking regulation
    has traditionally focused on the safety and soundness of the banking
    system and the protection of depositors as opposed to protection of
    securities investors.  The securities regulators and securities
    industry representatives have stated that Congress should reassess
    the current regulatory structure in light of banks' expansion into
    securities activities and develop a system of functional regulation
    in which the securities regulators would be responsible for
    regulating all securities activities, including those of banks.\11

    In contrast, bank regulators and banking industry representatives
    have stated that measures that they have taken to strengthen
    oversight of securities activities provide adequate protection to
    customers who choose to invest through their banks.  They also said
    that reforming the regulatory structure as advocated by SEC would
    create a duplicative and burdensome regulatory environment for banks.
    Banking industry representatives have testified that functional
    regulation should be considered only in connection with comprehensive
    reform of banking regulation, including repeal of Glass-Steagall Act
    provisions that limit banks' securities activities.

    --------------------
    \11 The concept of functional regulation calls for regulation
    according to function rather than according to the entity performing
    the function.  Hence, under functional regulation SEC would be
    responsible for regulation and oversight of all securities
    broker-dealer and related activities of banks, and banking regulators
    would be precluded from examining these activities.

       CONCLUSIONS
    ---------------------------------------------------------- Chapter 2:6

    Clearly, banking and securities activities are no longer separate as
    envisioned by 1930s legislation because banks have become more
    involved in providing their customers with securities services.  The
    regulatory system, which was also designed in the 1930s, has not been
    adjusted to reflect the changed activities.  Because banks are exempt
    from SEC registration and regulation, banking organizations can chose
    how to organize their securities brokerage activities, and depending
    on that organization, how they are regulated.  For example, banks can
    choose to sell securities directly and be subject to oversight by
    banking regulators but not by securities regulators.  If these
    activities are to be regulated, then bank regulators must include
    them in their regulatory scheme and examinations.  Under the current
    regulatory structure the same type of securities activities can be
    overseen by different regulators depending on how banks organize
    their securities activities.

    The potential for inconsistent oversight has not been much of a
    problem so far because most banks provide securities services in
    subsidiaries that are regulated primarily by securities regulators.
    Further, for the 3 percent of banks nationwide that offer brokerage
    services that are exempt from regulation by securities regulators,
    bank regulators have provided new guidance and examination procedures
    and are working to improve their oversight.  Nevertheless, providing
    consistent securities oversight, no matter where in an organization
    these activities are done, would be enhanced by increased
    cooperation, coordination, and sharing of regulatory expertise among
    bank and securities regulators.  Although bank and securities
    regulators have shown that they can cooperate on oversight of
    securities sales on bank premises, as we have indicated, issues
    requiring further coordination remain.  By working more closely
    together bank and securities regulators could help ensure that both
    safety and soundness and investor protection concerns are
    appropriately addressed in regulatory requirements and examinations
    of bank-direct brokerage activities, but without added regulatory
    burden.

       RECOMMENDATION
    ---------------------------------------------------------- Chapter 2:7

    We recommend that the heads of the Federal Reserve, FDIC, OCC, SEC,
    and NASD require their respective staffs to work together to develop
    and implement an approach for regulating bank-direct securities
    activities that provides consistent and effective standards for
    investor protection while ensuring bank safety and soundness.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ---------------------------------------------------------- Chapter 2:8

          FDIC
    -------------------------------------------------------- Chapter 2:8.1

    FDIC commented that although its procedures were not flawless in the
    period covered by our review, the results shown in table 2.2 on
    bank-direct brokerages examined by bank regulators may be misleading.
    In preparing detailed comments, FDIC reviewed our analysis and said
    it found a different picture of its regulatory oversight from that
    indicated by the numbers presented.  FDIC polled its regions and
    found that three, rather than two, of the banks' brokerage activities
    were examined.  This additional examination was completed after the
    period of our survey.  We now include it in table 2.2 as being
    examined.  FDIC stated that many of the banks are not involved in
    retail sales of nondeposit investment products except to accommodate
    customer requests.  FDIC also said that the remainder of those banks
    conduct a brokerage activity only through a third-party vendor.

    We cannot explain why the securities brokerage activities of banks as
    reported by FDIC would differ from information we obtained directly
    from the banks we surveyed, unless the banks changed how they
    provided brokerage services between the time of our survey and the
    time they were last contacted by FDIC examiners.  Nineteen
    FDIC-regulated banks responded to our survey that they provided
    brokerage services to customers directly by bank employees.  We later
    called each of those banks to validate their responses.  Eighteen of
    those banks responded that they provide discount brokerages services
    by bank employees.  One bank responded that it provided minimal
    accommodation brokerage services.  We have dropped it from the table
    2.2 analysis in our final report.

    FDIC commented that its efforts have been directed at eliminating
    customer confusion concerning investment products sold by banks.  It
    said it is working closely with other federal regulators to develop
    and implement an improved and coordinated approach to supervising
    securities activities and would continue to work with SEC and NASD to
    harmonize rules.

    FDIC commented that it has supervisory responsibility over few
    banking organizations with securities activities that would require
    extensive specialized examiner training.  However, it is considering
    the type and scope of examiner training necessary.

          FEDERAL RESERVE
    -------------------------------------------------------- Chapter 2:8.2

    The Federal Reserve agreed with our recommendation that bank and
    securities regulators work together to develop and implement an
    approach for regulating bank-direct securities activities.  The
    Federal Reserve said that it has been pursuing a number of efforts to
    coordinate supervision of bank securities activities with securities
    regulators.  It also said that its joint efforts with securities
    regulators are resulting in a supervisory program for bank-direct
    sales activities that is analogous to, and consistent with,
    broker-dealer regulation.  Among these, the Federal Reserve noted
    banking regulators' efforts to make securities regulators'
    professional qualification examinations available to bank sales
    personnel.  The Federal Reserve also noted that the banking
    regulators have proposed coordinated rulemaking by the banking
    regulators, including developing a comprehensive central registration
    depository type recordkeeping system for bank sales personnel.

          OCC
    -------------------------------------------------------- Chapter 2:8.3

    OCC commented that our recommendation is consistent with actions it
    has already undertaken to improve oversight of banks' securities
    brokerage activities through better coordination and cooperation with
    securities regulators.

    OCC disagreed with our discussion of the additional risks to banks
    that are associated with securities activities.  We did not study the
    comparative risks of various banking and nonbanking activities.
    Nevertheless, securities activities can pose risks to banking
    organizations, just as they can to securities firms.  When federally
    insured banks can be affected by such risks, measures should be taken
    to insulate those banks from losses incurred by the securities
    activities.

    OCC stated that it directed examiners to include a review of
    nondeposit investment product sales activities in all bank safety and
    soundness examinations.  The examinations are to be done with
    statutory frequency--every 12 to 18 months, depending on bank size
    and condition.  OCC expects that by the end of 1995, all national
    banks that are engaged in bank-direct brokerage operations will have
    had at least one such examination.

          SEC
    -------------------------------------------------------- Chapter 2:8.4

    SEC commented that it, the federal banking regulators, and NASD have
    worked hard together but that interagency cooperation to regulate
    banks' securities activities is not enough.  It advocated a system of
    functional regulation, in which each entity is regulated according to
    the particular activity that it undertakes.  SEC stated that
    functional regulation would be a more efficient and responsible use
    of both taxpayer dollars and bank capital.  SEC emphasized the
    importance of ensuring that the applicable regulatory scheme provides
    equal protection for all investors and reduces regulatory costs.
    This, SEC commented, in turn, would ensure that competition is based
    on market performance, rather than on arbitrary differences in
    regulation.  SEC commented that our report appears to encourage a
    system of duplicative regulation, which it strongly disagrees with.

    We believe that in the present regulatory environment, in which
    bank-affiliated securities activities are regulated primarily by
    securities regulators and bank-direct activities are regulated by
    bank regulators, cooperation and coordination by regulators is a
    practical means of sharing regulatory expertise and achieving
    consistent investor protection.  Without financial system reform and
    restructuring, which could include both functional and consolidated
    regulatory systems as a means to efficient and comprehensive
    regulation, cooperation and coordination is the only way to achieve
    consistent investor protection.  Under a system of functional
    regulation, cooperation and coordination among regulators would still
    be needed to avoid duplication and coverage gaps and share
    information and examination results.

          NASD
    -------------------------------------------------------- Chapter 2:8.5

    NASD commented that it is a strong advocate of functional regulation
    as the long-term solution to establishing an effective regulatory
    structure that spans the securities activities of banks and
    broker-dealers.  However, NASD stated that it was willing to support
    our recommendation that the regulators cooperate by sharing its
    advertising and sales practice policies and procedures and experience
    and expertise in securities examinations with the bank regulators and
    assisting in bank examiner training.

    FEDERAL RESERVE INSPECTIONS
    USUALLY ASSESS COMPLIANCE WITH ALL
    APPLICABLE FIREWALLS
    ============================================================ Chapter 3

    As of November 1994, the number of Section 20 subsidiaries in
    operation was 35.  The total gross revenues of all Section 20
    subsidiaries was about $10 billion in 1993, which was about 8 percent
    of total 1993 gross revenues for the securities industry.  The
    Federal Reserve has prescribed firewalls to protect insured
    affiliated banks from risks associated with the Section 20
    subsidiaries' securities activities.  Federal Reserve examiners are
    to inspect those Section 20 subsidiaries that seek to underwrite and
    deal in corporate securities before they begin operations to ensure
    that they are capable of complying with prescribed firewalls.  For
    all other Section 20 subsidiaries, the first annual inspection is to
    include a detailed examination of compliance with applicable
    firewalls.  All subsidiaries are then to be inspected annually to
    assess their financial condition and to determine their compliance
    with firewalls and the limits on the amount of their business in
    bank-ineligible securities.

    We found that the Federal Reserve has generally maintained its annual
    inspection cycle during the last 2 years and that the Federal Reserve
    has taken steps to correct deficiencies identified by the
    inspections.  However, we also found that some firewalls were not
    examined, and documentation available in some examination files was
    inadequate for determining whether appropriate firewall inspections
    had occurred.  Thus, although the Federal Reserve in general
    comprehensively reviewed or tested for compliance with all firewalls,
    there were a few cases in which full compliance with all firewalls
    could not be assured.

       SECTION 20 SUBSIDIARIES'
       SECURITIES ACTIVITIES HAVE
       GROWN
    ---------------------------------------------------------- Chapter 3:1

    As mentioned in chapter 1, the Federal Reserve allows bank holding
    companies to establish Section 20 subsidiaries, which engage in
    limited amounts of underwriting and dealing in bank-ineligible
    securities (no more than 10 percent of the subsidiary's gross revenue
    can be derived from such activities).  The Federal Reserve has
    approved bank-ineligible securities for Section 20 activities over
    time, starting in 1987.  The initial Federal Reserve order of April
    30, 1987, approved applications of Citicorp, J.P.  Morgan & Co., and
    Bankers Trust New York Corp.  to engage in limited underwriting and
    dealing in municipal revenue bonds, mortgage-related securities, and
    commercial paper.  Later that year, the Federal Reserve issued an
    order approving the underwriting of asset-backed securities.\1 The
    activities approved in 1987 are referred to as "1987 powers" of
    Section 20 subsidiaries.  In 1989, the Federal Reserve extended the
    powers for certain Section 20 subsidiaries to underwriting and
    dealing in corporate debt and equity securities--referred to as "1989
    powers."

    As of November 1994, 35 Section 20 subsidiaries were operating under
    Federal Reserve approval.  As shown in table 3.1, 17 of those
    subsidiaries operated under 1987 powers, 14 operated under both 1987
    and 1989 powers, and 4 had 1987 and 1989 corporate-debt- only powers.
    Twelve of the 35 Section 20 subsidiaries were foreign-owned.

    The volume of activity among Section 20 subsidiaries in
    bank-ineligible securities has grown rapidly in recent years even
    though their share of revenues in the securities industry has
    declined.  In 1990, the volume of bank-ineligible securities
    underwritten by Section 20 subsidiaries was about $27.8 billion.\2
    According to Federal Reserve records, the volume of bank-ineligible
    securities underwritten by Section 20 subsidiaries in 1993 was about
    $58.6 billion, a 110-percent increase over 1990's volume.  The total
    gross revenues of the Section 20 subsidiaries increased by 57 percent
    from about $6.4 billion for 1990 to about $10.0 billion for 1993.
    However, according to SEC data, the total gross revenues of Section
    20 subsidiaries as a percent of the total for the securities industry
    declined from 10.1 percent for 1990 to 7.8 percent for 1993.  As of
    the end of 1993, Section 20 subsidiaries held 13.6 percent of the
    total securities industry assets.

    The top 10 Section 20 subsidiaries in terms of revenue production
    during 1993 included J.P.  Morgan Securities, Greenwich Capital
    Markets, BT Securities, Citicorp Securities, Barclays Capital, Chase
    Manhattan Securities, Sanwa-BGK Securities, Chemical Securities,
    Deutsche Bank Securities, and NationsBanc Capital Markets.  The
    Section 20 subsidiaries and their parent organizations are also shown
    in table 3.1.

                                   Table 3.1

                      Section 20 Subsidiaries' Securities
                     Powers and Parent Organizations as of
                                 November 1994

    Section 20 subsidiary               Parent organization
    ----------------------------------  ----------------------------------
    1987 and 1989 Corporate debt and equity powers
    ----------------------------------------------------------------------
    BA Securities, Inc.                 BankAmerica Corp.

    BT Securities Corp.                 Bankers Trust N.Y. Corp.

    Chase Securities Inc.               Chase Manhattan Corp.

    Chemical Securities Inc.            Chemical Banking Corp.

    Deutsche Bank Securities Corp.      Deutsche Bank AG\a

    Harris Nesbitt Thomson Securities,  Bankmont Financial Corp.\a
    Inc.

    Hopper Soliday and Co., Inc.        Dauphin Deposit Corp.

    J.P. Morgan Securities Inc.         J.P. Morgan and Co., Inc.

    NationsBanc Capital Markets, Inc    NationsBanc Corp.

    RBC Dominion Securities Corp.       Royal Bank of Canada\a

    Republic N.Y. Securities Corp.      Republic New York Corp.\a

    ScotiaMcleod (USA) Inc.             The Bank of Nova Scotia\a

    Toronto Dominion Securities (USA)   Toronto-Dominion Bank\a
    Inc.

    Woody Gundy Corp.                   The Canadian Imperial Bank of
                                        Commerce\a

    1987 and 1989 Corporate debt powers
    ----------------------------------------------------------------------
    Barclays Capital Corp.              Barclays Bank PLC\a

    Citicorp Securities Inc.            Citicorp

    First of America Securities, Inc.   First of America Bank Corp.

    First Chicago Capital Markets,      First Chicago Corp.
    Inc.

    1987 Powers
    ----------------------------------------------------------------------
    ABN AMRO Securities (USA) Inc.      ABN AMRO North America, Inc.\a

    Banc One Capital Corp.              Bank One Corp.

    Bank South Securities Corp.         Bank South Corp.

    Barnett Securities, Inc.            Barnett Banks Inc.

    DKB Securities Corp.                The Dai-Ichi Kangyo Bank, Ltd.\a

    First Union Securities, Inc.        First Union Corp.

    Fleet Securities, Inc.              Fleet Financial Group, Inc.

    Greenwich Capital Markets, Inc.     The Long-Term Credit Bank of
                                        Japan\a

    Huntington Capital Corp.            Huntington Bancshares, Inc.

    Liberty Investment Services, Inc.   Liberty National Bancorp, Inc.

    National City Investments Corp.     National City Corp.

    Norwest Investment Services         Norwest Corp.

    PNC Securities Corp.                PNC Bank Corp.

    Sanwa-BGK Securities Co., L.P.      The Sanwa Bank Ltd.\a

    SouthTrust Securities Inc.          SouthTrust Corp.

    SunTrust Capital Markets            SunTrust Banks, Inc.

    Synovus Securities, Inc.            Synovus Financial Corp.
    ----------------------------------------------------------------------
    \a Foreign-owned corporation.

    Source:  Federal Reserve Board.

    --------------------
    \1 These are bonds or notes backed by loans or accounts receivable
    originated by banks, credit card companies, or other providers of
    credit.  Typically, the originator of the loan or account receivable
    paper, such as for automobile loans and credit card receivables,
    sells the paper to a special trust, which repackages it as
    securities.  The securities are then underwritten by brokerage firms,
    which reoffer them to the public.

    \2 Our report, Bank Powers:  Bank Holding Company Securities
    Subsidiaries' Market Activities Update (GAO/GGD-91-131, Sep.  20,
    1991), provided information on the market activities of Section 20
    subsidiaries.  From the amount shown for the value of securities
    underwritten we excluded the amount of commercial paper underwritten
    by the Section 20 subsidiaries in 1990 to make the total amount
    consistent with data reported to the Board for 1993.  The Board did
    not include commercial paper, because issues are frequently rolled
    over and reissued several times during a year.

       THE FEDERAL RESERVE HAS
       PRESCRIBED FIREWALLS TO PROTECT
       BANKS AND REQUIRES SECTION 20
       SUBSIDIARIES TO HAVE INTERNAL
       CONTROLS
    ---------------------------------------------------------- Chapter 3:2

    Both the Federal Reserve and banking organizations that seek to
    establish Section 20 subsidiaries are to provide safeguards to
    insulate banks from subsidiaries' securities activities.  To protect
    affiliated insured banks and the parent banking organization from
    risks associated with Section 20 subsidiaries' underwriting and
    dealing activities, the Federal Reserve has prescribed various
    firewalls.  The banking organizations that establish Section 20
    subsidiaries are also to have internal controls in place to ensure
    compliance with the firewalls and to manage attendant business risks.

          FIREWALLS PROVIDE IMPORTANT
          PROTECTION FOR INSURED BANK
          AFFILIATES
    -------------------------------------------------------- Chapter 3:2.1

    As discussed briefly in chapter 1, Section 20 subsidiaries are
    subject to various limitations on their activities and operating
    conditions, which are called firewalls.  These limitations and
    operating conditions are intended to insulate affiliated banks from
    risks associated with the ineligible securities underwriting and
    dealing activities and minimize conflicts of interest.  The firewalls

      define the method a banking organization with a Section 20
         subsidiary should use to calculate its capital so that
         investments and loans to the subsidiary are not counted toward
         the consolidated capital of the bank holding company;

      limit credit extensions that the bank affiliate may make to the
         Section 20 subsidiary and its clients and customers;

      require separate offices for the Section 20 subsidiary and limit
         employees, officers, and directors from serving in the same
         capacity for both the Section 20 subsidiary and an affiliated
         bank.

      require disclosures of the nature of the Section 20 subsidiary's
         business and its relationship with the banking affiliates,
         including disclosing to customers that the subsidiary is an
         organization separate from any affiliated bank and that
         securities recommended, offered, or sold by the subsidiary are
         not bank deposits and are not insured by FDIC;

      restrict a banking affiliate from offering investment advice
         regarding securities underwritten or dealt in by the Section 20
         subsidiary unless the customer is notified of the affiliate's
         involvement;

      restrict extensions of credit and purchases of assets that would
         shift risk to insured institutions and prevent any unfair
         competitive advantage to bank-affiliated securities firms; and

      restrict the exchange of nonpublic customer information between
         banking affiliates and the Section 20 subsidiary.

    For each Section 20 subsidiary, the specific firewalls that apply
    vary according to the powers of the subsidiary and whether the
    subsidiary is foreign-owned.  All of the firewalls are published in
    the Federal Reserve's Bank Holding Company Supervision Manual.  (See
    app.  I for a list of the Federal Reserves's detailed firewall
    conditions.) In addition to meeting the firewall conditions,
    applicants seeking expanded 1989 powers to underwrite and deal in
    corporate debt and equity securities are required to establish the
    necessary managerial and operational infrastructure before receiving
    Federal Reserve approval for these activities.

    The original Federal Reserve orders giving banks approval to
    underwrite and deal in securities document the rationale and
    importance of the establishment and operations of firewalls.  The
    firewalls that prohibit extensions of credit, for example, are
    considered important for the following reasons:

      They preclude banking affiliates from making loans to depositors to
         purchase securities underwritten by a Section 20 subsidiary and
         thus seek to ensure that affiliates grant credit in a sound and
         impartial manner.

      They restrict banking subsidiaries from making unwise loans to
         improve the financial condition of the companies or
         organizations whose securities are underwritten or dealt in by
         an affiliated underwriting subsidiary, either to assist in
         marketing the securities or to prevent the customers of the
         underwriting subsidiary from incurring losses on securities sold
         by the subsidiary.

      They prohibit loans or other transactions between banking
         subsidiaries and underwriting subsidiaries to cover any
         financial losses sustained by the underwriting subsidiaries.

      They prohibit banks from purchasing low-quality assets from the
         underwriting subsidiary or providing the underwriting subsidiary
         with credit on preferential terms.  (Such transactions are
         prohibited by Sections 23A and 23B of the Federal Reserve Act.)

    Firewalls that insulate the underwriting subsidiaries from banking
    subsidiaries by requiring separate operations--including separate
    officers, directors, and employees--are important to avoid any
    conflicts of interest and prevent loss of public trust in the banking
    subsidiary should the underwriting subsidiary sustain financial
    losses.

          SUBSIDIARIES ARE DIRECTED TO
          ESTABLISH INTERNAL CONTROLS
          FOR COMPLIANCE WITH
          FIREWALLS AND OTHER
          REQUIREMENTS
    -------------------------------------------------------- Chapter 3:2.2

    The Federal Reserve generally requires Section 20 subsidiaries to
    have internal controls in place.  For example, Federal Reserve
    inspection guidance for Section 20 subsidiaries seeking 1989 powers
    directs examiners to confirm that the subsidiaries have (1) internal
    control procedures to ensure compliance with the Federal Reserve's
    firewalls; (2) written underwriting and trading position limits; (3)
    procedures for managing syndicate (group) underwritings; and (4)
    procedures for segregation of duties, control over data entry, and
    hiring competent employees.

    The banking organizations we met with use a variety of such policies,
    procedures, and control mechanisms.  According to information we
    obtained from three banking organizations, the controls used
    generally were in the form of written policies and procedures, staff
    training and awareness activities, and internal audit functions.
    Also, procedures to ensure compliance with regulations included
    compliance manuals, routine memoranda on securities underwritten and
    associated restrictions on credit relationships, separation of
    duties, supervision of employees, surveillance systems, compliance
    reviews, and internal audits.  Those Section 20 subsidiaries also had
    policies and procedures to prevent insider trading and prevent
    affiliates from engaging in impermissible credit or investment
    activities and "tie-in" arrangements.  (Tie-in or tying arrangements
    involve an agreement to provide a customer one service on the
    condition that he or she also obtain other services.  This practice
    is considered anticompetitive and is generally prohibited by the Bank
    Holding Company Act, section 106(b).) To restrict insider trading and
    impermissible credit or investment activities, the subsidiaries
    issued "watch lists" and "restricted lists." To make employees aware
    of regulatory provisions prohibiting tie-in arrangements and the
    banks' antitying policies, the subsidiaries used compliance
    guidelines, memoranda, and training.

    Officials of the three banking organizations also said that they had
    employee training programs that included reviews of regulatory
    compliance requirements.  Officials of one banking organization said
    that the organization's compliance manual is reviewed with employees,
    and insider trading and antitying policies are highlighted.
    Officials of another bank holding company said that all new hires
    were trained on securities laws and regulations as well as provisions
    on firewalls and antitying.  Officials of another banking
    organization said it provided employees ongoing regulatory compliance
    training, and it required all employees to read compliance
    regulations annually and certify that they are familiar with and will
    comply with controls and provisions governing the bank's securities
    activities.  According to Federal Reserve officials, such internal
    controls and training programs are common among the bank holding
    companies that the Federal Reserve has approved to underwrite and
    deal in bank-ineligible securities.  However, a detailed review of
    private sector banking organizations' internal control systems was
    beyond the scope of our work, and we cannot comment on the
    effectiveness of those controls.

       BOTH FEDERAL RESERVE AND
       SECURITIES REGULATORS ARE TO
       EXAMINE SECTION 20 SUBSIDIARIES
    ---------------------------------------------------------- Chapter 3:3

    Section 20 subsidiaries are to be examined by both the Federal
    Reserve and by securities regulators, but for different purposes.
    The Federal Reserve focuses on compliance with the firewalls and with
    the 10-percent limit on the subsidiaries' business in bank-ineligible
    securities.  Securities regulators examine the subsidiaries for
    compliance with securities laws and SEC and SRO regulations and
    rules.  Both the Federal Reserve and securities regulators examine
    the Section 20 subsidiaries' financial condition; however, according
    to Federal Reserve officials, the scope and objectives of the
    examinations differ.  The officials said that securities regulators
    examine financial records to check for compliance with net capital
    requirements for broker-dealers.\3 They said Federal Reserve
    examiners verify data reported to the Federal Reserve on the
    subsidiaries' financial performance\4 and focus on any adverse
    effects of the subsidiaries' operations on the consolidated bank
    holding company and its depository institution affiliates.

    --------------------
    \3 Net capital requirements are set forth in SEC Rule 15c3-1.

    \4 Section 20 subsidiaries report quarterly on Form FR Y-20,
    Financial Statements for a Bank Holding Company Subsidiary Engaged in
    Ineligible Securities Underwriting and Dealing.  The FR Y-20 data are
    considered as confidential pursuant to section (b)(4) of the Freedom
    of Information Act, 5 U.S.C.  552(b)(4).

          FEDERAL RESERVE INSPECTIONS
          FOCUS ON COMPLIANCE WITH
          FIREWALLS AND OPERATING
          CONDITIONS
    -------------------------------------------------------- Chapter 3:3.1

    The Federal Reserve's guidance on inspections of Section 20
    subsidiaries outlines four types of inspections of the subsidiaries:
    firewall condition inspections, infrastructure reviews, annual
    inspections, and supplemental inspections.  The timing and purposes
    of these inspections are described in table 3.2.

                                   Table 3.2

                     Federal Reserve Inspections of Section
                                20 Subsidiaries

    Type of        Time of
    inspection     inspection     Scope of inspection
    -------------  -------------  ----------------------------------------
    Firewall       Initial        All of the Section 20 subsidiary's
    condition      inspection     policies and operating procedures.
    inspection     for
                   compliance
                   with
                   firewalls and
                   operating
                   conditions
                   applicable to
                   1987 powers.

    Infrastructur  Before         Reviews of management, SRO examination
    e review       approval for   results, internal controls, computer and
                   1989 powers,   accounting systems, and internal audit
                   regardless of  and other areas. Examiners are to (1)
                   whether the    review and confirm that management is
                   applicant is   qualified to direct and supervise
                   seeking        securities underwriting and dealing
                   initial        activities and knowledgeable about
                   powers or has  associated risks and marketing
                   been approved  techniques; (2) review the latest SRO
                   for 1987       examination to determine compliance with
                   powers.        securities laws and regulations; (3)
                                  review internal controls to ensure that
                                  appropriate controls are in place; (4)
                                  review computer and accounting systems
                                  to determine whether the systems can
                                  process and account for the relevant
                                  securities activities; and (5) evaluate
                                  the internal audit program and auditors'
                                  qualifications and determine the
                                  adequacy of the internal audit function,
                                  recordkeeping, and accounting and
                                  computer systems.

    Annual         Annual.        Evaluations of compliance with the
    inspection                    applicable firewalls and the 10 percent
                                  revenue limitation, and assessments of
                                  the subsidiaries' financial condition.
                                  In conducting annual inspections,
                                  Federal Reserve examiners rely on the
                                  work of the subsidiary's internal
                                  auditor and focus on

                                  (1) assessing changes in subsidiary
                                  operations that may have affected
                                  applicable firewalls and

                                  (2) verifying that deficiencies found by
                                  internal and any external audits have
                                  been corrected.

                                  The annual inspection procedures
                                  emphasize that a strong internal audit
                                  department will ordinarily review and
                                  test internal controls. This minimizes
                                  the need for Federal Reserve examiners
                                  to engage in extensive review and
                                  testing of controls.

    Supplemental   Random or      Testing of the firewalls in instances
    inspections    targeted.      where a Section 20 subsidiary has a poor
                                  compliance record or has not been
                                  subject to substantial internal audits.
    ----------------------------------------------------------------------
    Source:  GAO Analysis of the Federal Reserve's Inspection Guidance.

    Additional controls over Section 20 subsidiaries are provided by
    mandatory financial reporting, the Federal Reserve's centralized
    monitoring of inspection results and the underwriting activities of
    the subsidiaries, and regulation by securities industry regulators.
    In 1990, the Federal Reserve instituted a program requiring Section
    20 subsidiaries to file quarterly reports on balance sheet, income,
    stockholders' equity, and other data on their underwriting
    activities.  These data are to be submitted on reporting Form FR
    Y-20.  The Federal Reserve uses these data to monitor compliance with
    the Federal Reserve's 10 percent revenue test and the financial
    status and underwriting activities of the Section 20 subsidiaries.
    Before FR Y-20 reporting was started, the Federal Reserve used copies
    of FOCUS Reports (Financial and Operational Combined Uniform Single
    Report) filed with securities industry Self-Regulatory Organizations
    (SROs) and other quarterly reports to monitor compliance with the 10
    percent revenue test and the financial condition of Section 20
    subsidiaries.  Staff at Federal Reserve headquarters also monitor the
    results of the Federal Reserve districts' inspections of the Section
    20 subsidiaries.

          SECURITIES REGULATORS
          EXAMINE FOR COMPLIANCE WITH
          SECURITIES LAWS AND
          REGULATIONS
    -------------------------------------------------------- Chapter 3:3.2

    Section 20 subsidiaries are also required to register with SEC and
    join an SRO.  The currently approved Section 20 subsidiaries are
    members of NASD or the New York Stock Exchange.  The SROs regulate
    and examine the Section 20 subsidiaries' compliance with securities
    laws and regulations, SRO rules of fair practice, and their
    implementation of procedures designed to restrict opportunities for
    insider trading.\5 While banking organizations should have controls
    in place to prohibit the sharing of confidential information, the
    Section 20 subsidiaries' compliance with the insider trading
    provisions is primarily under SEC, NASD, and other SRO oversight,
    rather than the bank regulators.\6

    --------------------
    \5 These procedures, required by the Insider Trading and Securities
    Fraud Enforcement Act of 1988, P.L.  100-704, are intended to prevent
    nonpublic information acquired in one capacity from being used in
    another--for example, between a financial organization's varied
    activities, such as underwriting and trading and investment research
    and advice.  NASD and NYSE have jointly developed guidelines for the
    securities industry to restrict insider trading.

    \6 We reported on SROs' adoption of insider trading provisions in
    Securities Markets:  Clearly Defined "Chinese Wall" Standards Have
    Been Issued (GAO/GGD-91-115, Aug.  21, 1991).

       SUBSIDIARIES GENERALLY WERE
       INSPECTED ANNUALLY
    ---------------------------------------------------------- Chapter 3:4

    Information on the timing of the Federal Reserve's inspections of
    Section 20 subsidiaries showed that Federal Reserve examiners
    generally inspected the Section 20 subsidiaries annually.  The
    information provided to us by Federal Reserve officials showed that
    the Federal Reserve annually inspected 30 of the 31 Section 20
    subsidiaries that were active at the end of 1992 and 1993.  One
    subsidiary was not inspected; although Federal Reserve officials
    could not provide a reason for this, they said they had made the
    district bank aware that the Section 20 subsidiary should be
    inspected annually.

    However, in the period from 1989 through 1993, a total of nine of the
    Section 20 firms were not examined annually as required.  According
    to Federal Reserve officials, annual inspections were delayed for a
    variety of reasons.  The officials said delays in inspections of
    foreign-owned subsidiaries occurred due to a 1991 reorganization of
    the Federal Reserve's New York District inspection staff.  In that
    reorganization, the officials said, two separate units were
    formed--one to inspect domestic firms and the other to inspect
    foreign-owned firms.  According to the officials, as a result of the
    reorganization, no foreign-owned subsidiaries were inspected in 1991,
    but such scheduling delays have not been repeated.  According to the
    Federal Reserve officials, other inspections were delayed because
    some districts were slow in implementing Section 20 inspection
    programs.  One Section 20 subsidiary initially was not inspected
    because, although approved in 1990 for 1989 powers, it had not
    completed an internal audit program and was not actually allowed to
    begin underwriting and dealing activities until 1991.

    We also interviewed bank examiners with OCC, the primary regulator of
    national banks.  These examiners are responsible for examining
    national banks that are subsidiaries of the same parent bank holding
    company as a Section 20 subsidiary.  The national bank examiners said
    that their examinations consider the operations of Section 20
    subsidiaries only to the extent that they might affect the safety and
    soundness of the national banks.  The examiners said they are
    concerned with the bank's overall risk exposure and the bank's
    efforts to measure and manage risk levels, and they leave the
    detailed reviews of the Section 20 subsidiaries to the Federal
    Reserve and securities regulators.

       SOME FEDERAL RESERVE
       INSPECTIONS RELIED ON INTERNAL
       AUDITS AND DID NOT ALWAYS
       ASSESS COMPLIANCE WITH ALL
       FIREWALLS
    ---------------------------------------------------------- Chapter 3:5

    Our review of the Federal Reserve's inspections of 14 Section 20
    subsidiaries located in the Chicago, New York, Richmond, and San
    Francisco Federal Reserve districts showed that the Federal Reserve
    usually conducted detailed reviews of the subsidiaries.  The district
    examiners conducted the required infrastructure reviews of
    subsidiaries seeking powers to underwrite corporate equity and debt
    securities.  The results of our analysis of four infrastructure
    reviews completed during 1993 showed that those reviews generally
    were complete and addressed all conditions listed in the Federal
    Reserve's guidance.  As noted on page 55, the Federal Reserve also
    completed annual firewall inspections of 30 of 31 approved
    underwriting subsidiaries.

    We also analyzed annual and special firewall inspections completed in
    1992 and 1993 for all 14 Section 20 subsidiaries.  The approach taken
    on the annual inspections varied among districts.  The Richmond and
    San Francisco Federal Reserve Banks generally conducted independent
    reviews and, as applicable, tested the firewall conditions.  The
    Chicago and New York Banks--especially the New York bank, in whose
    district the largest number of Section 20 subsidiaries are
    located--relied more on the banking organizations' internal auditors'
    assessments of compliance with the firewall conditions.  For example,
    our review of the Federal Reserve's annual inspections of six Section
    20 subsidiaries in the New York district found that the examiners
    relied, in all six cases, on the internal auditors' review and
    testing of the firewalls.

    Although Federal Reserve examiners said that they did some selective
    review of policies and procedures and testing of the firewalls, we
    found that such review and testing were not always documented in the
    inspection workpapers.  In addition, the workpapers did not always
    include documents showing the scope and methodology of the internal
    auditors' review and testing of firewalls.  In a 1993 report on the
    Federal Reserve's bank holding company inspections, we noted that the
    quality of Federal Reserve workpapers was inconsistent, and the
    Federal Reserve Manual did not provide guidance on workpaper
    preparation.\7 We also recommended that the Federal Reserve improve
    workpaper documentation of its bank holding company inspections.  In
    response to those recommendations, the Federal Reserve said that
    those workpapers would be subject to standards similar to the
    agency's new standards for workpapers in commercial bank
    examinations, which the Federal Reserve was testing as of September
    1994.  The Federal Reserve's standardized commercial bank work
    documentation program is intended to provide a consistent format for
    documenting the tasks performed on each examination.  The Federal
    Reserve's commercial bank examination standards also provide a format
    for examiners to follow in reviewing the work of internal auditors,
    including determining the adequacy of internal auditors' testing
    methods.

    In our review of the Federal Reserve's inspections of the Section 20
    subsidiaries, we found two instances in which neither Federal Reserve
    examiners nor the internal auditors reviewed for compliance with
    certain firewalls.  More specifically, we found the following:

      In the 1993 inspection of one of the larger Section 20
         subsidiaries, neither the Federal Reserve examiner nor the
         internal auditors reviewed firewalls that restricted credit
         extensions to the underwriting subsidiary and its clients and
         customers, prohibited interlocking directorates, required
         disclosure of the subsidiary's relationship to the parent
         organization, and prohibited intercompany transactions and
         transfers of assets between the Section 20 subsidiary and
         affiliated insured banks.  In this case, the examiner said that
         he relied on an internal audit that was the same one he relied
         on in the prior year's inspection.  The Federal Reserve
         examiners said that they used spot-checks and walk-throughs to
         review these items, and those reviews may not have been
         documented in workpapers.

      In another inspection, neither the Federal Reserve examiner nor the
         internal auditor reviewed firewalls that restrict the sale of
         securities underwritten by the Section 20 subsidiary to other
         subsidiaries of the same bank holding company and restrict any
         asset sales to affiliated banks.

    It is important that these firewalls be checked to ensure that they
    are in place and functioning properly to restrict conflicts of
    interest, risky credit relationships, and illegal intercompany
    transactions\8 and reciprocal arrangements.  In these instances,
    inspection supervisors' reviews would have been needed to ensure that
    all firewalls were examined and work was properly documented in
    workpapers.

    Federal Reserve officials said that it allowed the districts to use
    their own discretion in deciding how much to rely on the work of
    internal auditors.  Such discretion is allowed because it is a
    practical approach to covering all Section 20 subsidiaries.
    Otherwise, the districts would not be able to cover all of the bank
    holding companies and their subsidiaries if Federal Reserve examiners
    themselves did extensive testing of every regulatory requirement.
    This would be especially true for the New York district, which has
    the highest number of Section 20 subsidiaries (13).

    --------------------
    \7 Bank Examination Quality:  FRB Examinations and Inspections Do Not
    Fully Assess Bank Safety and Soundness (GAO/AFMD-93-13, Feb.  16,
    1993).

    \8 We earlier reported that during bank holding company inspections
    Federal Reserve examiners did not adequately assess risks from
    intercompany transactions.  See GAO/AFMD-93-13, Feb.  16, 1993, pp.
    45-46.

       FEDERAL RESERVE INSPECTIONS
       SEEK TO CORRECT DEFICIENCIES
       AND AVERT PROBLEMS
    ---------------------------------------------------------- Chapter 3:6

    The Federal Reserve, as well as the other federal bank regulators,
    can impose any of several informal and formal enforcement actions on
    banks that operate in an unsafe or unsound manner or fail to comply
    with laws and regulations.  Informal enforcement actions include

      meeting with bank officers and boards of directors to obtain
         agreement on improvements needed,

      requiring banks to issue commitment letters to the regulators
         specifying corrective actions that need to be taken,

      requiring bank boards of directors to issue resolutions specifying
         corrective actions, and

      requiring a memorandum of understanding between regulators and bank
         officers on actions that will be taken.

    Formal enforcement actions include formal written agreements; orders
    to cease and desist; assessments of civil money penalties; and orders
    for removal, prohibition, or suspension of individuals from bank
    operations.\9

    According to Federal Reserve officials, the Federal Reserve has taken
    few enforcement actions against Section 20 subsidiaries for firewall
    noncompliance.  Since the 1987 order that first approved Section 20
    subsidiaries, two enforcement actions have been taken, one formal and
    one informal, both during 1994.  On December 5, 1994, the Federal
    Reserve Bank of New York executed a Written Agreement with a bank
    holding company, its affiliated bank, and its Section 20 subsidiary
    not to engage in any violation of Section 23A of the Federal Reserve
    Act or any of the Federal Reserve's firewalls.  As a result of a 1994
    inspection, at the Federal Reserve's request a Section 20 subsidiary
    adopted a board of directors resolution that restricted the
    subsidiary's underwriting and dealing in ineligible securities and
    required various corrective measures.

    According to Federal Reserve officials, the Federal Reserve has taken
    few enforcement actions because the Federal Reserve emphasizes
    corrective measures, rather than enforcement actions, to ensure that
    Section 20 firms have appropriately functioning internal control and
    internal audit procedures in place.  Under this approach, Federal
    Reserve officials said, potential problems are discovered and
    corrected as part of the inspection process before they become
    serious enough to warrant an enforcement action.  However, Federal
    Reserve officials said they will take enforcement actions if their
    examiners discover (1) an incidence of serious noncompliance with
    laws, regulations, or supervisory guidance relative to a Section 20
    subsidiary; (2) repeat offenses; or (3) an unwillingness to correct
    voluntarily noted deficiencies or violations.

    Even though the Federal Reserve's inspections have not resulted in
    many enforcement actions, our review of Federal Reserve inspection
    reports showed that the Federal Reserve's annual firewall inspection
    efforts have identified deficiencies and potential problems.  In 15
    out of 31 of the most recent inspections completed during 1992 or
    1993, Federal Reserve examiners noted deficiencies.  These
    deficiencies included, among others, a lack of internal audits for a
    newly established Section 20 subsidiary and failure to account for
    and adhere to technical rules related to calculation of the amounts
    of ineligible versus eligible revenues.  According to Federal Reserve
    officials, such deficiencies are discussed with bank officials in
    inspection close-out meetings.  Following these meetings, Federal
    Reserve officials said they require the subsidiaries' management to
    respond in writing within 60 days about the actions that the
    subsidiary will take to correct such deficiencies.  The officials
    also said that the Federal Reserve would consider taking a formal or
    informal enforcement action, as appropriate, if no response were
    received or the next inspection showed that the subsidiary had failed
    to correct the deficiency.

    --------------------
    \9 The bank regulatory enforcement process is described in detail in
    our report Bank Supervision:  Prompt and Forceful Regulatory Actions
    Needed (GAO/GGD-91-69, April 15, 1991, pp.17-19).

       CONCLUSIONS
    ---------------------------------------------------------- Chapter 3:7

    The Federal Reserve's inspections of Section 20 subsidiaries were
    usually done on schedule and assessed compliance with applicable
    firewalls.  Federal Reserve examiners or bank holding company
    internal auditors usually reviewed and tested for compliance with all
    applicable firewalls.  However, the Federal Reserve's monitoring for
    firewall compliance is not complete unless Federal Reserve examiners
    or internal auditors review all applicable firewalls and unless
    Federal Reserve examiners review the completeness of the internal
    audit and document the audit's scope, methodology, and results.
    Reliable monitoring of and compliance with firewalls help ensure that
    banking organizations--including federally insured banks--are not
    engaging in unwise or unduly risky transactions with the underwriting
    subsidiaries, their clients, or their customers.

    In cases where documentation of the work performed by examiners and
    internal auditors is not sufficient, the Federal Reserve cannot
    attest to the completeness of its firewall inspections or to the
    general level of compliance with firewalls.  Also, without sufficient
    documentation we cannot fully conclude that the Federal Reserve's
    inspections are complete and effective, that the Federal Reserve has
    a basis for reliance on bank holding company internal auditors, or
    comment on the general level of compliance with the Federal Reserve's
    firewalls.  The Federal Reserve's proposed development of a
    standardized workpaper format for bank holding company inspections
    that is similar to the format that it has developed and is testing
    for commercial bank examinations could provide adequate documentation
    of the work performed by Federal Reserve examiners and internal
    auditors if applied to the Section 20 subsidiary segments of the bank
    holding company inspections.  However, those instances where firewall
    reviews are not being performed will not be remedied by
    implementation of documentation procedures.

       RECOMMENDATIONS
    ---------------------------------------------------------- Chapter 3:8

    We recommend that the Chairman of the Board of Governors of the
    Federal Reserve System ensure that either Federal Reserve examiners
    or internal auditors review and test all applicable firewalls at
    least once annually and document in inspection workpapers the work
    performed by Federal Reserve examiners or bank holding company
    internal auditors.  Federal Reserve workpapers should document
    Federal Reserve examiners' testing of the work of internal auditors
    as a basis for reliance on internal audit.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ---------------------------------------------------------- Chapter 3:9

    The Federal Reserve said that it would promptly address our findings
    related to firewall compliance.  It intends to reiterate for
    examiners the Federal Reserve's long-standing policy to inspect and
    fully document Section 20 companies' compliance with all applicable
    firewall conditions.  In addition, it will instruct examiners that
    when they rely on the reports of internal auditors, their workpapers
    must explicitly cross-reference the auditors' documentation of
    testing for compliance with each firewall.

    The Federal Reserve also noted that in recent months additional
    enhancements have been made to its supervisory program to facilitate
    oversight of Section 20 companies' regulatory compliance.  According
    to the Federal Reserve these include (1) the addition of another
    full-time, experienced staff member to its Section 20 oversight
    group; and (2) the preparation of a quarterly profile of the
    operations of each Section 20 company, including any violations of,
    or weaknesses in, controls relative to firewall conditions and the
    status of any supervisory follow-up actions and corrective measures.

    The Federal Reserve also commented on three instances that we cited
    in the draft report of examiners or internal auditors failing to
    review for compliance with certain firewalls and instances where
    examiners' review and testing of firewalls were not always
    documented.  The Federal Reserve said that those instances were
    either minor or not completely accurate.  Federal Reserve staff
    reviewed each of the instances cited to provide additional detail.

      In the first instance, Federal Reserve staff found that the
         examiners felt justified in their reliance on the same internal
         audit for two consecutive inspections.  This was because of the
         examiners' confidence in the company's strong program of
         quarterly firewall testing, history of consistent compliance,
         and the high quality of its internal audit programs.  We could
         not review private banking organizations' compliance and
         internal audit programs and cannot comment on their quality.
         However, we believe that relying on the same internal audit for
         two consecutive inspections of firewall compliance does not
         provide continued assurance of compliance with firewalls.

      In the second instance, Federal Reserve staff found that internal
         auditors failed to review compliance with a firewall restricting
         sales of securities underwritten by the Section 20 company to
         affiliates because of a recent merger.  In that case Federal
         Reserve staff found that the examiners verified compliance with
         this firewall.  However, we did not see this work and the
         results documented in the inspection workpaper files that we
         reviewed.  The Federal Reserve staff also noted that the Section
         20 company in question, at the time of the inspection, was
         operating under the Federal Reserve Board's 1987 Order and was
         not subject to the firewall governing asset sales.  According to
         our reading of the Federal Reserve's Bank Holding Company
         Supervision Manual, Section 2185.0, page 28, the 1987 Order did
         contain a firewall governing asset sales.

      In the third instance, Federal Reserve staff found that a firewall
         prohibiting reciprocal arrangements was not tested because the
         Section 20 company in question did about 98 percent of its
         business in government securities, which are not subject to
         firewalls.  This company was involved only as a minor
         participant in underwritings of ineligible securities.  This
         information was not apparent from inspection workpapers and was
         not provided to us at the time of our review.  We have dropped
         this example from the final report.

    FDIC WAS UNABLE TO ASSESS RISKS TO
    FEDERALLY INSURED BANKS POSED BY
    SECURITIES ACTIVITIES OF BANK
    SUBSIDIARIES
    ============================================================ Chapter 4

    Under FDIC regulation and supervision federally insured
    state-chartered nonmember banks under its jurisdiction can establish
    or acquire bona fide subsidiaries to underwrite and deal in
    securities--activities not permissible for banks.  However, the
    agency has not fully prepared its examiners to examine these
    activities and does not have other procedures for monitoring the
    subsidiaries' activities.  As a result, FDIC has no systematic way of
    knowing the extent to which bank subsidiaries are engaged in
    securities activities that pose risks to nonmember banks or ensuring
    that any such risks are minimized.

       BONA FIDE AND SECTION 20
       SUBSIDIARY FIREWALLS SHARE THE
       SAME PURPOSE
    ---------------------------------------------------------- Chapter 4:1

    As discussed in chapter 1, bona fide subsidiaries are subject to
    operating conditions and firewalls required under FDIC Rules and
    Regulations, Section 337.4.  The purpose of these requirements, like
    the requirements that Section 20 subsidiaries must meet, is to ensure
    the safety and soundness of bank affiliates of the bona fide
    subsidiaries and protect consumers from conflict-of-interest abuses
    and other inequities.  Generally, Section 337.4 contains the
    following provisions:

      The bona fide subsidiary must be adequately capitalized.

      The bona fide subsidiary must be physically separate from the bank
         with separate offices, separate accounting and other records,
         and separate employees and officers.

      Bona fide subsidiaries' underwriting and dealing activities are
         limited to (1) "investment quality" debt and equity securities
         that are rated in the top four rating categories by a nationally
         recognized rating service or have equivalent characteristics, or
         (2) underwriting of investment companies whose holdings are
         primarily investment quality securities or obligations of the
         U.S.  government and its agencies or money market instruments.\1

      The nature of the bona fide subsidiary's business and its
         relationship with the banking affiliates, including that the
         subsidiary is a separate organization from the bank and that
         investments recommended, offered, or sold by the subsidiary are
         not bank deposits and are not insured by FDIC, must be disclosed
         to customers.

      Credit extensions that the bank affiliate may make to the bona fide
         subsidiary and its clients and customers are limited.

      Banks are prohibited from purchasing as fiduciary any securities
         underwritten or dealt by the bona fide subsidiary.

      Banks are prohibited from transacting business through a trust
         department with a bona fide subsidiary on terms that appear
         preferential when compared to similar transactions with
         unaffiliated securities companies.

      Banks are prohibited from conditioning any loan or extension of
         credit on the requirement that the bona fide subsidiary
         underwrite or distribute a company's securities.

    Like the Federal Reserve, FDIC seeks to ensure that subsidiaries
    engaged in underwriting and dealing in bank-ineligible securities are
    insulated from bank affiliates by mandating separate
    operations--including separate officers and employees.  Also similar
    to the Federal Reserve, the FDIC Regulation requires that an insured
    nonmember bank's direct investment in a securities subsidiary not be
    counted toward the bank's capital.  FDIC expects bona fide
    subsidiaries to establish the necessary managerial and operational
    infrastructure before beginning operations.  A more detailed account
    of the Section 337.4 provisions that apply to bona fide subsidiaries
    is presented in appendix II.

    --------------------
    \1 This restriction does not apply to subsidiaries that are members
    in good standing with NASD and have been in continuous operation for
    at least 5 years.

       FDIC REQUIRES NOTIFICATION OF
       BANKS' AFFILIATION WITH BONA
       FIDE SUBSIDIARIES
    ---------------------------------------------------------- Chapter 4:2

    The Federal Reserve examines a Section 20 subsidiary before it is
    approved to underwrite and deal in corporate equity and debt
    securities.  In contrast, FDIC requires only that a nonmember bank
    notify the agency when it establishes or acquires a bona fide
    subsidiary.  Section 337.4, rather than an FDIC action of approval,
    authorizes bona fide subsidiaries to underwrite and deal in certain
    corporate equity and debt securities.  A nonmember bank is to notify
    the FDIC regional director of its intention to establish a bona fide
    subsidiary 60 days before the subsidiary is to begin operations and
    again within 10 days after it begins operations.

    FDIC makes no effort to ensure through an on-site examination that
    bona fide subsidiaries commence securities underwriting and dealing
    activities in compliance with Section 337.4 operating conditions and
    firewalls.  FDIC requires compliance with the Section 337.4
    provisions at the time that a bona fide subsidiary begins operations.
    However, as a matter of policy, after receiving the notification FDIC
    reviews the bank's compliance at the next scheduled FDIC examination
    of the bank.  Under certain conditions, this policy could allow a
    bona fide subsidiary to operate for many months before it is examined
    for compliance with Section 337.4 requirements.  For banks subject
    only to FDIC examinations, a newly established bona fide subsidiary
    could operate for nearly a year before an examination.  For banks
    that are subject to annual examinations alternating between FDIC and
    state regulators, such subsidiaries might operate without FDIC
    oversight for a longer period.\2 According to FDIC officials, FDIC
    has not established any procedure for approving state nonmember
    banks' establishment of bona fide subsidiaries because doing so would
    be burdensome on the banks.

    --------------------
    \2 The FDIC Improvement Act allows examination requirements to be met
    by state examinations in alternating years if the federal regulator
    deems this appropriate.

       FDIC DOES NOT KNOW HOW MANY
       BANKS HAVE ESTABLISHED BONA
       FIDE SUBSIDIARIES
    ---------------------------------------------------------- Chapter 4:3

    From among the more than 6,000 banks the agency supervised, FDIC
    could neither provide an accurate count of the number of banks that
    had established or acquired bona fide subsidiaries nor identify all
    such subsidiaries.  In response to our request for a list of banks
    with bona fide subsidiaries, FDIC polled its regions and identified
    80 such banks.  In our review of examination files for 13 of these
    banks, we found that none were engaged in underwriting and dealing in
    bank-ineligible securities.\3 In fact, only 5 of the 13 banks had
    actually established or acquired bona fide subsidiaries.  Of those
    five subsidiaries, three provided full-service brokerage services;
    the remaining two provided only discount brokerage services (which
    did not require bona fide subsidiary status).  Of the remaining eight
    banks that had not established bona fide subsidiaries, one provided
    full-service brokerage services (so it should have obtained bona fide
    subsidiary status), five provided only discount brokerage services,
    and two provided no brokerage services.\4

    FDIC officials later told us that the initial listing of 80 banks was
    inaccurate, and they were unable to provide us with any other data on
    banks with bona fide subsidiaries engaged in underwriting and dealing
    in bank-ineligible securities.  The officials said that examiners
    have several ways of identifying banks and subsidiaries that should
    be examined for compliance with Section 337.4:  (1) through the
    notices filed by banks to FDIC regional directors, (2) from
    information obtained from the banks in response to a preexamination
    entry letter, (3) from survey questionnaires responded to by bank
    officers, (4) from listings of bank affiliates and subsidiaries, and
    (5) from examiners' own visual examination of the banking
    organizations' activities.  According to the officials, very few
    nonmember banks have established bona fide subsidiaries for the
    purpose of underwriting and dealing in bank-ineligible securities.
    The FDIC officials said that underwriting and dealing in securities
    are more common among larger banking organizations than the
    state-chartered nonmember banks FDIC supervises.

    --------------------
    \3 The 13 banks were located in FDIC's Atlanta, Chicago, New York,
    and San Francisco regions.

    \4 As noted in chapter 1, the Glass-Steagall Act does not prohibit
    banks from providing discount and full-service brokerage services.

       SOME EXAMINERS WERE UNCERTAIN
       ABOUT EXAMINING BONA FIDE
       SUBSIDIARIES
    ---------------------------------------------------------- Chapter 4:4

    FDIC examination guidance directs examiners to review the activities
    of bank subsidiaries and their compliance with firewalls.\5 During
    examinations of nonmember banks, FDIC examiners are also to determine
    that the activities of bank subsidiaries do not endanger the safety
    and soundness of the parent institution.  When applicable, FDIC
    examiners are to review for compliance with Section 337.4 provisions.
    Although such subsidiaries are also subject to SEC and NASD
    examination, possible impacts on the safety and soundness of
    affiliated banks and compliance with firewalls to protect those banks
    are not within the scope of the SEC and NASD examinations.

    In our review of FDIC examinations, we found instances of uncertainty
    among examiners about whether the Section 337.4 provisions applied to
    the subsidiary being examined.  On two examinations--one in FDIC's
    Atlanta region and one in the San Francisco region--examiners did not
    know if the Section 337.4 provisions applied to the organization
    being examined and had to obtain determinations from FDIC regional
    legal counsels of whether the regulation applied.  In another
    instance--in the Chicago region--a bank subsidiary that was providing
    full-service brokerage services was not examined for compliance with
    the regulation because the examiners believed that it did not apply
    to full-service brokerage activities.

    The uncertainty examiners experienced regarding the applicability of
    Section 337.4 provisions is understandable.  FDIC has no process for
    approving the securities activities of individual banks; thus, going
    into examinations FDIC examiners do not know which banks should be
    examined for compliance with Section 337.4.  Further, FDIC's
    requirement that full-service brokerage subsidiaries be bona fide
    subsidiaries and comply with Section 337.4 provisions does not appear
    in FDIC's examination guidance.  Section 337.4 requires only that
    activities prohibited by the Glass-Steagall Act, namely underwriting
    and dealing, be conducted in a bona fide subsidiary.  The uncertainty
    that follows from this condition might be minimized by additional
    examiner guidance.  As noted in chapter 2, FDIC examiners are not
    provided formal training on bank securities activities.  Also, FDIC
    has no detailed examination procedures for examiners to follow in
    examining for compliance with Section 337.4.  According to FDIC
    officials, no specific examination procedures are needed because
    Section 337.4 "speaks for itself" and serves as adequate examination
    guidance.

    FDIC relies on the examination process as a means of monitoring the
    activities of bona fide subsidiaries.  However, FDIC has no reliable
    means of knowing which banks and subsidiaries should be examined for
    compliance with Section 337.4, nor has it provided clear examination
    guidance or specialized training to enable FDIC examiners to conduct
    efficient and effective compliance examinations of bona fide
    subsidiaries.

    --------------------
    \5 Securities subsidiaries of nonmember banks, including bona fide
    subsidiaries, are also subject to NASD examinations, which focus on
    investor protection issues, such as net capital position, trading
    practices, and sales practices, rather than on any effect that the
    subsidiary might have on the safety and soundness of the parent
    banking institution.

       FDIC HAS NO RELIABLE WAY TO
       MONITOR SECURITIES ACTIVITIES
       OF NON-FEDERAL RESERVE MEMBER
       BANKS
    ---------------------------------------------------------- Chapter 4:5

    FDIC delegates all oversight of the bona fide subsidiaries to its
    regions.  FDIC does not maintain centralized data on nonmember banks
    that have established or acquired bona fide subsidiaries, the volume
    of bank subsidiaries underwriting and dealing activities, the
    financial condition of the subsidiaries, or the subsidiaries'
    compliance with FDIC firewalls.  This information would be relevant
    to monitoring possible risks to federally insured banks and any
    possible effect on the FDIC-administered Bank Insurance Fund.

    The effects of FDIC's lack of centralized oversight of the securities
    activities of nonmember banks were exemplified by the results of our
    effort to obtain information about those activities.  FDIC could not
    provide a count of banks that had established bona fide subsidiaries
    or even identify any such subsidiaries.  This inability to provide
    information is most troublesome, as it bears on FDIC's ability to
    monitor the safety and soundness of banks under its jurisdiction that
    operate bona fide subsidiaries.

       CONCLUSIONS
    ---------------------------------------------------------- Chapter 4:6

    Federal banking regulators with supervisory responsibility for bank
    subsidiaries that engage in securities underwriting and dealing
    activities have a clear responsibility to adequately monitor the
    subsidiaries' activities in order to assess and minimize risks such
    activities may pose to federally insured banks.  FDIC's policies on
    compliance monitoring and examination guidance and training, and the
    lack of systematic oversight, do not enable the agency to fulfill its
    responsibility to ensure that risks securities activities pose to
    nonmember banks are minimized.

    Perhaps FDIC officials are correct in their perception that very few
    nonmember banks have engaged in underwriting and dealing in
    securities as permitted by FDIC regulations.  If so, FDIC probably
    does not need to establish a program to monitor bona fide
    subsidiaries of the same magnitude as the program the Federal Reserve
    uses to monitor Section 20 subsidiaries.  However, to ensure the
    safety and soundness of insured parent banks, FDIC at least should be
    capable of (1) identifying which of the banks it supervises have
    established bona fide subsidiaries, (2) monitoring and maintaining
    information on the size of those subsidiaries' underwriting and
    dealing activities and their capital adequacy positions, and (3)
    ensuring that the subsidiaries have controls in place and functioning
    to ensure compliance with firewalls.

       RECOMMENDATION
    ---------------------------------------------------------- Chapter 4:7

    We recommend that the Chairman, FDIC, establish a program to identify
    and routinely review the securities activities and the financial
    condition and performance of bona fide subsidiaries under FDIC's
    jurisdiction to assess the overall risks posed by the activities on
    federally insured banks and ensure compliance with firewalls.  The
    program should provide FDIC examiners guidance and training on how to
    examine bank and bank subsidiary securities activities.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ---------------------------------------------------------- Chapter 4:8

    FDIC disagreed with our recommendation that it establish a program to
    identify and routinely review the financial condition and performance
    of bona fide subsidiaries, assess risks posed by the subsidiaries'
    securities activities, and ensure compliance with firewalls.  It
    believes that its decentralized approach has provided effective
    supervision and minimized risks to insured banks.  It commented that
    because the range of permissible bank securities activities is
    subject to change over time, centralized reporting would only
    identify which banks had a bona fide subsidiary at some point in
    time.  FDIC also said that supervision of those institutions would
    still fall to regional personnel.  FDIC noted that bank securities
    subsidiaries also fall under the supervisory umbrella of SEC and
    NASD.  FDIC said that rather than create a burdensome reporting
    process, it prefers to deal with bank subsidiaries' securities
    activities on a case-by-case basis.  However, FDIC also commented
    that as the number of banks engaged in securities activities and the
    variety of such activities increase, it is considering various ways
    to improve its oversight of institution and systemic developments and
    issues.

    We disagree with FDIC's view that changes in the range of permissible
    bank securities activities make monitoring those activities difficult
    and thereby justify its not systematically monitoring those
    activities.  We believe that as a regulator of federally insured
    banks, FDIC is responsible for knowing of and supervising activities
    that may pose risks to those banks.  We believe a centrally
    administered program to identify and monitor the securities
    activities and financial performance of institutions could improve
    FDIC's oversight of nonmember banks' securities activities
    immediately at little extra cost.  For example, the centrally
    administered Federal Reserve program requires minimal staff
    resources--until recently, it required only one full-time analyst.
    With FDIC having few banking organizations with securities activities
    to oversee, a centrally administered program would likely require
    only a part-time responsibility for one headquarters staff position.
    Also, because FDIC already requires banks to notify it of
    subsidiaries' securities activities and has regional supervision
    programs in place, a centralized program should not require added
    regulatory burden on nonmember banks.  Such a program, through
    regional examiners, would rely on the results of securities
    regulators' examinations to alert FDIC of conditions that might
    affect bank safety and soundness and not encourage duplicative
    examinations.  Additional reporting burden would also not be a
    concern because securities subsidiaries' financial data are available
    from the FOCUS reports required by securities SROs.

    FEDERAL RESERVE BOARD FIREWALLS
    =========================================================== Appendix I

                           This appendix lists (1) the firewall
                             requirements the Federal Reserve
                         established in its 1987 and 1989 orders
                              approving bank holding company
                          subsidiaries to underwrite and deal in
                            bank-ineligible securities and (2)
                            firewall requirements the Federal
                            Reserve modified for underwriting
                              subsidiaries of foreign banks.

                                                                              Foreig
                                                                1987    1989      n-
    Firewall category/firewall description                    Powers  Powers   owned
    --------------------------------------------------------  ------  ------  ------
    Types of securities to be underwritten
    --------------------------------------------------------------------------------
    1. Section 20 subsidiary may underwrite and deal only in
     the following four ineligible securities: municipal
     revenue bonds, mortgage-related securities, commercial
     paper, and consumer-receivable-related (asset-backed)
     securities.
    2. Section 20 subsidiary may underwrite and deal in
     corporate debt and equity.

    Capital investment and adequacy
    --------------------------------------------------------------------------------
    3(a). Parent is required to deduct from its consolidated
     capital any investment it makes in the Section 20
     subsidiary that is treated as capital in the Section 20
     subsidiary.

     3(b). Foreign parent bank should meet Basle Accord
     risk-based capital standards.
    4. Parent will also deduct from its regulatory capital
     any credit it or a nonbank subsidiary extends directly
     or indirectly to the Section 20 subsidiary unless the
     extension of credit is fully secured by U.S. Treasury
     Securities or other marketable securities and is
     collateralized in the same manner and to the same
     extent as would be required under Section 23A(c) of the
     Federal Reserve Act if the credit extension was made by
     a member bank.
    5(a). Parent and its nonbank subsidiaries will not,
     directly or indirectly, provide any funds to, or for
     the benefit of, the Section 20 subsidiary, whether in
     the form of capital, secured or unsecured extensions of
     credit, or transfer of assets, without prior notice to
     and approval by the Board.
    5(b). A Section 20 subsidiary may not be funded by an
     applicant's U.S. bank, thrift, branch, or agency. A
     foreign bank may invest in or lend to a Section 20
     subsidiary as though foreign bank was a bank holding
     company.
    6. Before commencing new activities, parent must submit
     to the Board acceptable plans to raise additional
     capital or demonstrate that it is strongly capitalized
     and will remain so after making the capital adjustments
     authorized or required by the Board's order.
    7. Section 20 subsidiary will maintain at all times
     capital adequate to support its activity and cover
     reasonably expected expenses and losses.

    Credit extensions to customers of underwriting subsidiary
    --------------------------------------------------------------------------------
    8(a). Parent and its subsidiaries will not extend credit
     that may be viewed as enhancing credit worthiness or
     marketability of an ineligible security issue
     underwritten by the Section 20 subsidiary.
    8(b). Section 20 subsidiary will not underwrite or
     distribute ineligible securities if it knows that an
     affiliate, foreign or domestic, is providing credit
     enhancements.
    9. Parent and its non-Section 20 subsidiaries will not
     knowingly extend to a customer credit directly or
     indirectly secured by, or for the purpose of
     purchasing, any ineligible security that the Section 20
     subsidiary underwrites during the underwriting period
     or for 30 days thereafter; or to purchase from the
     Section 20 subsidiary any ineligible security in which
     it makes a market.
    10(a). Parent and its subsidiaries may not make loans to
     issuers of ineligible securities underwritten by the
     Section 20 subsidiary for purpose of payment of
     principal, interest, or dividends on such securities.
     To ensure compliance, any credit lines extended to an
     issuer by a bank affiliate shall provide for different
     timing, terms, conditions, and maturities from
     ineligible securities being underwritten.
    11. Parent will adopt appropriate procedures to assure
     that any credit extensions by it or any of its
     subsidiaries to issuers of ineligible securities
     underwritten or dealt in by the Section 20 are on an
     arm's length basis for purposes other than payment of
     principal, interest, or dividends on such securities.
    12. In any transaction involving the Section 20
     subsidiary, thrift subsidiaries will observe the             \a
     limitations of Sections 23A and 23B of the Federal
     Reserve Act as if the thrifts were banks.
    13. Requirements relating to credit extensions to
     issuers noted in items 8-12 above will also apply to
     extensions of credit to parties that are major users of
     projects that are financed by industrial revenue bonds.
    14. Parent will cause its U.S. bank subsidiaries to
     adopt policies and procedures, including appropriate
     limits on exposure, to govern their participation in
     financing transactions underwritten or arranged by the
     Section 20 subsidiary.
    15. Parent and its U.S. subsidiaries will establish
     appropriate policies, procedures, and limitations
     regarding exposure of the holding company on a
     consolidated basis to any single customer whose
     securities are underwritten or dealt in by the Section
     20 subsidiary.

    Limitations to maintain separateness of underwriting affiliate's activity
    --------------------------------------------------------------------------------
    16(a). No officer, director, or employee interlocks are
     permitted between the Section 20 and any bank
     subsidiaries of the holding company. Section 20 will
     have separate offices from any affiliated bank.
    16(b). No interlocks except one officer of branch may
     act as a director of section 20 subsidiary. The Section
     20 will have offices separate from any affiliated bank.

    Disclosure by underwriting subsidiary
    --------------------------------------------------------------------------------
    17(a). Section 20 subsidiary will provide special
     disclosure statement describing difference between the
     Section 20 subsidiary and its U.S. bank affiliates,
     pointing out that an affiliated bank could be a lender
     to an issuer and referring the customer to the
     disclosure document for details.

     Statement will state that securities sold, offered, or
     recommended by the Section 20 subsidiary are not
     deposits, are not insured by FDIC or FSLIC, are not
     guaranteed by bank affiliate, and are not an obligation
     or responsibility of the bank. Section 20 will disclose
     any material lending relationship between issuer and
     bank affiliate, and in every case whether the proceeds
     of the issue will be used to repay outstanding
     indebtedness to affiliates.

    Marketing activities on behalf of underwriting subsidiary
    --------------------------------------------------------------------------------
    18. Section 20 subsidiary and affiliated U.S. bank will
     not engage in advertising or enter into an agreement
     stating or suggesting that an affiliated bank is
     responsible in any way for the Section 20's
     obligations.
    19(a). U.S. bank affiliates of the Section 20 will not
     act as agent for, or engage in marketing activities on
     behalf of, the Section 20. In this regard, prospectuses
     and sales literature relating to securities being
     underwritten or dealt in by the Section 20 subsidiary
     may not be distributed by bank and may not be made
     available to the public at bank affiliate office,
     unless specifically requested by a customer.

    Investment advice by bank and thrift affiliates and conflicts of interest
    --------------------------------------------------------------------------------
    20. U.S. bank affiliates may not express opinion on the
     value or the advisability of purchase or sale of
     ineligible securities underwritten or dealt in by the
     Section 20 subsidiary unless the bank affiliate
     notifies the customer that the Section 20 subsidiary is
     underwriting, making a market, distributing, or dealing
     in the security.
    21. Parent and its U.S. bank, thrift, trust, or
     investment advisory subsidiary will not purchase, as a
     trustee or in any other fiduciary capacity, for
     accounts over which they have investment discretion
     ineligible securities (a) under-written by the Section
     20 subsidiary as lead underwriter or syndicate member
     during period of underwriting or selling syndicate, and
     for 60-day period after termination; (b) from the
     Section 20 if it makes a market in that security,
     unless such purchase is specifically authorized.

    Extensions of credit and purchases and sales of assets/conflicts of interest
    --------------------------------------------------------------------------------
    22. Parent and its non-Section 20 subsidiaries will not:
     (a) purchase, as principal, ineligible securities that
     are underwritten by the Section 20 subsidiary during
     underwriting period and for 60 days after close of
     underwriting period or (b) purchase from the Section 20
     subsidiary any ineligible securities in which the
     Section 20 subsidiary makes a market.
    23. Section 20 subsidiary may not underwrite or deal in
     ineligible securities issued by its affiliates or
     representing interests in, or secured by, obligations
     originated or sponsored by its affiliate, except for:
     (a) securities of affiliates if rated by a
     nonaffiliated, nationally recognized rating
     organization or are issued or guaranteed by FNMA, FHLMC
     or GNMA\,\b or represent interests in such obligations;
     and (b) grantor trusts or special purpose corporations
     created to facilitate underwriting of securities backed
     by residential mortgages originated by a nonaffiliated
     lender.
    24(a). Parent will ensure that no U.S. bank subsidiary
     will, directly or indirectly, extend credit in any
     manner to the Section 20 subsidiary; or issue a
     guarantee, acceptance, or letter of credit, including
     an endorsement or standby letter of credit, for the
     benefit of the Section 20 subsidiary.
    24(b). This prohibition does not apply to an extension
     of credit by a bank to the Section 20 subsidiary that
     is incidental to the provision of clearing services by
     the bank to the Section 20 subsidiary with respect to
     securities of the U.S. or its agencies, if the credit
     extension is fully secured by such securities, is on
     market terms, and is repaid on the same calendar day.
    25(a). All purchases and sales of assets between U.S.
     bank affiliates and Section 20 subsidiary (or third
     parties in which the Section 20 is participant, or has
     financial interest, or acts as an agent or broker or
     receives a fee for its services) will be at arm's
     length and on terms no less stringent than those
     applicable to unrelated third parties and will not
     involve low-quality securities, as defined in Section
     23A of the Federal Reserve Act.
    25(b). U.S. bank subsidiary will not, directly or
     indirectly, for its own account, purchase or sell
     financial assets of the Section 20 subsidiary. This
     limitation does not apply to the purchase and sale of
     U.S. Treasury securities that are not subject to
     repurchase or reverse repurchase agreements between the
     Section 20 subsidiary and bank affiliate.

    Limitations on transfers of information to address possible unfair competition
    --------------------------------------------------------------------------------
    26. U.S. bank affiliates may not disclose to the Section
     20 subsidiary, and vice versa, any nonpublic customer
     information, including an evaluation of credit
     worthiness of an issuer or other customer of that bank
     or Section 20 subsidiary, without customer consent.

    Reports
    --------------------------------------------------------------------------------
    27. Parent will submit quarterly to the Federal Reserve
     FOCUS reports filed with NASD or other SROs and
     detailed information on the Section 20's underwriting
     activity broken out by eligible and ineligible
     securities.

    Transfer of activities and formation of subsidiaries of an underwriting
    subsidiary to engage in underwriting and dealing
    --------------------------------------------------------------------------------
    28. Pursuant to Regulation Y, corporate reorganization
     of the Section 20 subsidiary may not be consummated
     without prior Board approval.

    Limitations on reciprocal arrangements and discriminatory treatment
    --------------------------------------------------------------------------------
    29(a). Parent and its subsidiaries may not, directly or
     indirectly, enter into any reciprocal arrangement with
     another holding company for purposes of evading Board
     requirements.
    29(b). U.S. bank affiliates of Section 20 subsidiary          \c
     will not, directly or indirectly, (a) acting alone or
     with others, extend or deny credit or services, or vary
     terms or conditions, if the effect would be to treat an
     unaffiliated securities firm less favorably than the
     Section 20, unless the extension or denial is based on
     objective criteria and is consistent with sound
     business practices; (b) extend or deny credit or
     services or vary terms or conditions with intent of
     creating a competitive advantage for the Section 20.

    Requirement for supervisory review before commencement of activities
    --------------------------------------------------------------------------------
    30. Parent may not commence proposed debt and equity
     securities underwriting and dealing activities until
     the Board has determined that policies and procedures
     have been established to ensure compliance with this
     Order's requirements, including computer, audit, and
     accounting systems, internal risk management controls,
     and operational and managerial infrastructure.
    --------------------------------------------------------------------------------
    Legend
     = Firewall applicable

    \a Sections 23A and 23B of the Federal Reserve Act were made
    applicable to thrifts in 1989 by the Financial Institutions Reform,
    Recovery, and Enforcement Act of 1989.

    \b FNMA refers to Federal National Mortgage Association; FHLMC refers
    to Federal Home Loan Mortgage Corporation; GNMA refers to Government
    National Mortgage Association.

    \c Although 1987 firewalls did not include tying restrictions,
    Section 20 subsidiaries operating with 1987 powers are not exempt
    from tying prohibitions contained in section 106(b) of the Bank
    Holding Company Act Amendments of 1970 and Federal Reserve Regulation
    Y (12 C.F.R.  225.7).

    Source:  GAO analysis of Federal Reserve information.

    FDIC BONA FIDE SUBSIDIARY
    PROVISIONS AND FIREWALLS
    ========================================================== Appendix II

    FDIC regulation 337.4 requires that a subsidiary of an insured
    nonmember bank that conducts securities activities not authorized for
    a bank under sections 16 and 21 of the Glass-Steagall Act

    (1) is adequately capitalized;

    (2) is physically separate and distinct in its operations from the
    operation of the bank;

    (3) maintains separate accounting and other corporate records;

    (4) observes separate formalities, such as board of directors'
    meetings;

    (5) maintains separate employees who are compensated by the
    subsidiary;

    (6) shares no common officers with the bank;

    (7) has a board of directors that is composed of a majority of
    persons who are neither directors nor officers of the bank; and

    (8) conducts business pursuant to independent policies and procedures
    designed to inform customers and prospective customers of the
    subsidiary that the subsidiary is an organization separate from the
    bank and that investments recommended, offered, or sold by the
    subsidiary are not bank deposits, are not insured by FDIC, and are
    not guaranteed by the bank nor are otherwise obligations of the bank.

    Bona fide subsidiaries are required to register with the Securities
    and Exchange Commission as broker-dealers and be members in good
    standing of the National Association of Securities Dealers.

    Bona fide subsidiaries' underwriting activities are limited to
    underwriting of investment quality debt and equity securities and
    underwriting of investment companies with not more than 25 percent of
    their investments in other than investment quality securities or
    obligations of the United States Government and its agencies, bank
    certificates of deposit, bankers acceptances, and other bank money
    instruments, short-term corporate debt instruments, and other similar
    investments normally associated with a money market fund.

    An insured nonmember bank that has a subsidiary or affiliate that
    engages in the sale, distribution, or underwriting of stocks, bonds,
    debentures, notes, or other securities, or acts as an investment
    advisor to any investment company shall not:

    (1) Purchase in its discretion as fiduciary, cofiduciary, or managing
    agent any security currently distributed, currently underwritten, or
    issued by its "bona fide" subsidiary or an investment company advised
    by that subsidiary, unless where allowed by regulation.

    (2) Transact business through its trust department with its
    subsidiary unless the transactions are at least comparable to
    transactions with an unaffiliated securities company or a securities
    company that is not a subsidiary of the bank.

    (3) Extend credit or make any loan directly or indirectly to any
    company the stocks, bonds, debentures, notes, or other securities of
    which are currently underwritten or distributed by its subsidiary or
    affiliate of the bank unless the company's stocks, bonds, debentures,
    notes, or other securities that are underwritten or distributed
    qualify as investment quality debt or equity securities.

    (4) Extend credit or make any loan directly or indirectly to any
    investment company whose shares are currently underwritten or
    distributed by the "bona fide" subsidiary of the bank.

    (5) Extend credit or make any loan where the purpose of the extension
    of credit or loan is to acquire any stock, bond, debenture, note, or
    other security underwritten by the bank's subsidiary or an investment
    company advised by the subsidiary, unless as allowed by regulation.

    (6) Make any loan or extension of credit to the "bona fide"
    subsidiary unless the loan or extension of credit is within limits
    imposed by Section 23A of the Federal Reserve Act.

    (7) Make any loan or extension of credit to an investment company for
    which the bank's subsidiary acts as an investment advisor unless the
    loan or extension of credit is within limits imposed by Section 23A
    of the Federal Reserve Act.

    (8) Directly or indirectly condition any loan or extension of credit
    to any company on the requirement that the company contract with, or
    agree to contract with, the bank's subsidiary to underwrite or
    distribute the company's securities or directly or indirectly
    condition any loan or extension of credit to any person on the
    requirement that the person purchase any security currently
    underwritten or distributed by the bank's subsidiary or affiliate.

    (See figure in printed edition.)Appendix III
    COMMENTS FROM THE BOARD OF
    GOVERNORS OF THE FEDERAL RESERVE
    SYSTEM
    ========================================================== Appendix II

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    The following is GAO's comment on the Federal Reserve's May 18, 1995,
    letter.

       GAO COMMENT
    -------------------------------------------------------- Appendix II:1

    1.  The caption in the executive summary, the title of chapter 3, and
    our conclusion on the effectiveness of the Federal Reserve's program
    in the final report were modified.  These changes were made in
    response to the Federal Reserve's noting the few problems we found
    after reviewing inspections of numerous individual firewall
    conditions.

    (See figure in printed edition.)Appendix IV
    COMMENTS FROM THE FEDERAL DEPOSIT
    INSURANCE CORPORATION
    ========================================================== Appendix II

    (See figure in printed edition.)

    Now on p.  36.

    (See figure in printed edition.)

    (See figure in printed edition.)

    See comment 3.

    (See figure in printed edition.)

    See comment 5.

    See comment 7.

    (See figure in printed edition.)

    The following are GAO's comments on FDIC's May 18, 1995, letter.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:2

    1.  The draft of this report referred to securities activities that
    FDIC "allows." Because FDIC pointed out that it did not have the
    authority to convey authority to banks, the text in this report was
    modified to delete the word "allows."

    2.  The analysis of table 2.2 and related text were modified, in
    part, in response to information provided by FDIC.

    3.  Table 1.1 was modified to reflect FDIC's comment that bank direct
    brokerages are not subject to regulation by SEC and NASD.  The text
    was modified to include this information.

    4.  The text and table 1.1 were modified to indicate that bank
    regulators have no authority over third-party broker-dealers
    operating on bank premises.

    5.  As FDIC pointed, out the text was modified to indicate that bank
    and securities regulators are already cooperating on developing
    testing requirements for bank personnel.

    6.  FDIC pointed out that a statement in the draft was inconsistent
    with a provision in the Federal Deposit Act and the statement was
    deleted from the text.

    7.  FDIC pointed out that a statement in the draft about its
    regulatory requirements concerning bank capital was incorrect.  The
    statement was revised to indicate that its regulations require that
    an insured nonmember bank's direct investment in a securities
    subsidiary not be counted toward the bank's capital.

    8.  FDIC pointed out that a statement in the draft about which
    subsidiaries must meet the definition of a bona fide subsidiary was
    incorrect and the statement was deleted from the text.

    (See figure in printed edition.)Appendix V
    COMMENTS FROM THE COMPTROLLER OF
    THE CURRENCY
    ========================================================== Appendix II

    (See figure in printed edition.)

    See comment 1.

    See comment 2.

    (See figure in printed edition.)

    Now on p.  41.

    Now on pp.  34 and 35.

    Now on pp.  37 and 38.

    (See figure in printed edition.)

    The following are GAO's comments on OCC's June 8, 1995, letter.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:3

    1.  OCC said the introductory section incorrectly concludes that bank
    underwriting activities necessarily increase bank risk.  It said that
    diversification into securities activities can actually reduce risk.
    In the Objective, Scope, and Methodology section we note that it was
    not in the scope of our review to determine comparative degrees of
    risk associated with different banking and nonbanking activities that
    banks might engage in.  However, banks that engage in securities
    underwriting and dealing would be subject to risks of financial
    losses just as securities firms that underwrite and deal in
    securities are.

    2.  OCC said that the draft misrepresented its proposed rule
    governing corporate applications.  The text was modified to
    incorporate OCC's interpretation of the proposal.

    3.  OCC said the draft incorrectly implied that the banking agencies
    permitted referral fees in a manner inconsistent with a NASD proposed
    rule.  The text was modified to indicate that the Interagency
    Statement permits one-time fixed-dollar amount referral fees.  OCC
    states that the NASD proposal also permits, or does not prohibit,
    such fees.  However, fees paid by the bank to bank employees are
    beyond NASD's authority.

    4.  As OCC suggested, the text was modified to note that the
    Interagency Statement also requires oral disclosure at any sales
    presentation or offering of investment advice.

    5.  OCC said that banking agency access to CRD information should not
    be highlighted as a new initiative because they have had direct
    access to that information for years.  A footnote was added to note
    limitation of the regulators access to CRD information.

    6.  In response to OCC's comments, information about the cooperative
    effort to make securities industry qualification examinations
    available to the banking industry is now characterized as an ongoing
    effort rather than a proposal.

    7.  The text was modified to include the additional training that OCC
    said was provided to examiners.

    8.  As OCC suggested, the text was modified to indicate that the
    antifraud provisions of federal securities law apply to banks in the
    same manner as registered broker-dealers.

    9.  The statement that banking regulators try to minimize their
    disclosure of enforcement actions against banks was deleted from the
    text.

    (See figure in printed edition.)Appendix VI
    COMMENTS FROM THE SECURITIES AND
    EXCHANGE COMMISSION
    ========================================================== Appendix II

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    The following are GAO's comments on SEC's May 19, 1995, letter.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:4

    1.  As SEC suggested, the text was modified to compare the number of
    bank-direct brokerages to the total number of banks that provide
    securities services.

    2.  Brokerage services that are provided through registered
    broker-dealers, including bank affiliates and independent third-party
    broker-dealers, were not included in the scope of this report, as SEC
    suggested, because they are subject to SEC and NASD regulation.  See
    p.  22.

    (See figure in printed edition.)Appendix VII
    COMMENTS FROM THE NATIONAL
    ASSOCIATION OF SECURITIES DEALERS
    ========================================================== Appendix II

    (See figure in printed edition.)

    See comment 1.

    (See figure in printed edition.)

    See comment 3.

    See comment 4.

    See comment 5.

    (See figure in printed edition.)

    The following are GAO's comments on NASD's May 17, 1995, letter.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:5

    1.  The clarification to table 1.1 that NASD suggested was made by
    providing separate categories for bank affiliates and third-party
    broker-dealers.

    2.  NASD said the bank regulators did not discuss their Joint Policy
    Statement with NASD as the draft stated.  The phrase was deleted from
    the text.

    3.  The text was modified to special "financial" information as NASD
    recommended.

    4.  The text was modified to include NASD's views on regulation of
    banks' securities brokerage activities.

    5.  As NASD indicated, information about the cooperative effort to
    make securities industry qualification examinations available to the
    banking industry is now characterized as an ongoing effort rather
    than a proposal.

    TECHNICAL APPENDIX:  SURVEY OF
    BANKS
    ======================================================== Appendix VIII

    Ranking Minority Members of congressional committees asked us to
    determine whether bank examiners check for compliance with retail
    securities brokerage safeguards and whether sanctions are imposed on
    banks that breach those safeguards.  To accomplish this, we needed to
    select for evaluation banks whose own employees were involved in the
    brokerage services offered by the bank.  We also set out to describe
    the nature and extent of retail securities activities conducted by
    banks.

    To help meet this request, we mailed questionnaires to a random
    sample of 2,233 banks.  The results of that survey are representative
    of the entire banking industry.

    Our questionnaire gathered data on the different types of retail
    securities brokerage services offered and through what arrangements
    with employees, subsidiaries, affiliates, or third parties the
    services were being offered.  In addition, we included a number of
    questions on the related subject of bank mutual fund sales programs.
    The fieldwork for the survey was conducted from February through June
    of 1994.

          SURVEY SAMPLE PLAN
    ---------------------------------------------------- Appendix VIII:0.1

    We developed the survey frame (a listing, without duplicates or
    omissions, of each element in the population of U.S.  banks) from a
    file containing the June 1993 Call Report data.  This database listed
    13,360 banks.  After removing International Banking Associations and
    New York Investment Companies (which we felt were mostly commercial
    institutions unlikely to have retail brokerage programs), our frame
    contained 11,769 banks.  Later, we excluded 559 mutual savings banks
    from the analysis, because they fell outside the scope of our work.
    Our total survey population, or universe, consisted of 11,210 banks.

    From this frame, we randomly sampled 2,233 banks.  We divided the
    institutions in the frame into 12 strata (see table VIII.1) and
    distributed our sample across those strata so that survey estimates
    from each stratum would be likely to have sampling errors for the
    most important questions of no more than � 5 percent at the
    95-percent level of confidence.  Unless otherwise noted, the survey
    statistics in this report have sampling errors within that range.

    Because we surveyed only one of a large number of possible samples of
    the bank population to develop the statistics used in this report,
    each of the estimates made from this sample has a sampling error,
    which is a measure of the precision with which the estimate
    approximates the population value.  The sampling error is the maximum
    amount by which estimates derived from our sample could differ from
    estimates from any other sample of the same size and design and is
    stated at a certain confidence level, usually 95 percent.  This means
    that if all possible samples were selected, the interval defined by
    their sampling errors would include the true population value 95
    percent of the time.  In addition to sampling error, all sample
    surveys may also be subject to error from a number of other sources,
    as described in the section on survey error and data quality below.

          QUESTIONNAIRE DESIGN AND
          ADMINISTRATION
    ---------------------------------------------------- Appendix VIII:0.2

    We developed our questionnaires in consultation with experts in the
    finance industry and at regulatory agencies, and we conducted six
    pretests with banks that represented a range of sizes and regulators.
    We made revisions to the questionnaire on the basis of the comments
    we received.  See appendix IX for a copy of the pages from the
    questionnaire used in our analysis.

    We addressed each questionnaire to the office of the President or CEO
    at each institution, using the mailing address information listed in
    the Call Report file.

    We mailed questionnaires to all 2,233 sampled banks in early February
    of 1994.  To the institutions not responding to our survey by the end
    of March 1994, we sent a follow-up questionnaire on April 1, 1994.
    We ended the fieldwork for this survey on June 16, 1994, discarding
    any questionnaire returned after that date.

          SURVEY RESPONSE
    ---------------------------------------------------- Appendix VIII:0.3

    By the end of the survey fieldwork period, we had received 1,508
    completed questionnaires, accounting for 68 percent of the banks in
    our sample.  Table VIII.1 displays, by strata, the dispositions of
    the questionnaires we sent out.  Because banks in different strata
    were sampled at different rates, and because institutions responded
    at different rates across the strata, the survey estimates made in
    this report were weighted, or statistically adjusted, so that the
    answers given by institutions in different strata were represented in
    proportion to their actual numbers in the entire population.

    There was a slight tendency for the smaller institutions (in terms of
    asset size) to respond at higher rates than larger institutions.
    Also, those responding early in the survey period tended to be the
    banks not offering brokerage services (such questionnaires required
    little work on the part of our respondents, making it easier to fill
    out the questionnaire).  We have no reason to believe that these
    patterns of response had any impact on the accuracy of the survey
    estimates.  However, we conducted no follow-up contacts with any of
    the nonrespondents to determine if their answers were significantly
    different from the answers of those who did respond.

                                                                         Table VIII.1

                                                             Survey Dispositions of Sampled Banks

    Strata
    (institution                                                                          Returned          Returned
    type and asset        Original       Initial  Ineligible\b          Adjusted  undeliverable by          unusable   Returned usable
    size)             population\a        sample   from sample          sample\c     Post Office\d   questionnaire\e     questionnaire   Response rate\f
    ----------------  ------------  ------------  ------------  ----------------  ----------------  ----------------  ----------------  ----------------
    FRS national             2,514           350             2               348                12                 2               265             0.76%
     banks up to
     $150 million
    $150-$250                  348           174             4               170                 6                 0               122              0.72
     million
    $250 MM-$1                 388           194             5               189                10                 0                98              0.52
     billion
    $1 billion and             202           150             4               146                 4                 2                75              0.51
     up
    FRS state banks            749           270             1               269                 8                 1               207              0.77
     up to
     $150 million
    $150-$250                   76            76             2                74                 4                 0                47              0.64
     million
    $250 million-$1             84            84             0                84                 3                 0                55              0.65
     billion
    $1 billion and              63            63             1                62                 5                 0                33              0.53
     up
    FDIC state banks         5,900           375             4               371                 9                 2               284              0.77
     up to
     $150 million
    $150-$250                  428           214             2               212                 7                 0               143              0.67
     million
    $250 million-$1            350           175             4               171                13                 1               120              0.70
     billion
    $1 billion and             108           108             2               106                10                 1                59              0.56
     up
    ====================================================================================================================================================
    Totals                  11,210         2,233            31             2,202                91                 9          1,508.00              0.68
    ----------------------------------------------------------------------------------------------------------------------------------------------------
    \a All banks identified in the June 1993 Call Report, except mutual
    savings banks, international bank associations, and New York
    investment companies.

    \b Sampled elements outside the survey population due to no existing
    address, merger, receivership, or other cessation of operations as a
    depository institution.

    \c Number in original sample minus number ineligible.

    \d Sampled elements in the survey population, but questionnaire
    returned undeliverable due to insufficient address, or unknown
    address and forwarding order expiration.

    \e Blank, incomplete, or refused questionnaire returned, or returned
    after cut-off date.

    \f Response rate calculated as the number of banks completing usable
    questionnaires divided by the number of eligible banks in the
    adjusted sample.

          SURVEY ERROR AND DATA
          QUALITY
    ---------------------------------------------------- Appendix VIII:0.4

    In addition to the presence of sampling errors, as discussed above,
    the practical difficulties of conducting any survey may introduce
    other types of errors, commonly referred to as nonsampling errors.
    For example, differences in how a particular question is interpreted,
    in the sources of information that are available to respondents, or
    in the types of people who do not respond can introduce unwanted
    variability into the survey results.

    We included steps in both the data collection and data analysis
    stages for the purpose of minimizing such nonsampling errors.  We
    selected our sample from the most complete and up-to-date listing of
    banks available, and we attempted to increase the response rate by
    conducting a follow-up mailing accompanied by cover letters stressing
    the importance of the survey.  To minimize errors in measurement, we
    pretested the questionnaire thoroughly and obtained reviews from
    industry experts and agency officials.

    To ensure data processing integrity, all data were double-keyed and
    verified during data entry.  Computer analyses were performed to
    identify inconsistencies or other indication of errors, and all
    computer analyses were checked by a second independent analyst.
    Finally, we performed limited validation of a number of returned
    questionnaires through contacts with respondents or review of other
    agency records.

    (See figure in printed edition.)Appendix IX
    SURVEY OF BANKS AND THRIFTS ON
    MUTUAL FUND AND SECURITIES
    ACTIVITIES
    ======================================================== Appendix VIII

    (See figure in printed edition.)

    (See figure in printed edition.)

    MAJOR CONTRIBUTORS TO THIS REPORT
    =========================================================== Appendix X

       GENERAL GOVERNMENT DIVISION,
       WASHINGTON, D.C.
    --------------------------------------------------------- Appendix X:1

    Michael A.  Burnett, Project Director
    David P.  Tarosky, Project Manager
    Charles Michael Johnson, Deputy Project Manager
    Desiree W.  Whipple, Reports Analyst
    Carl Ramirez, Social Science Analyst

       CHICAGO REGIONAL OFFICE
    --------------------------------------------------------- Appendix X:2

    Roger E.  Kolar, Senior Evaluator
    Daniel K.  Lee, Evaluator

       NEW YORK REGIONAL OFFICE
    --------------------------------------------------------- Appendix X:3

    Susan Chan, Evaluator
    Phillip F.  Merryman, Evaluator

       SAN FRANCISCO REGIONAL OFFICE
    --------------------------------------------------------- Appendix X:4

    Susan J.  Kramer, Senior Evaluator
    Donald Y.  Yamada, Senior Evaluator