10 Percent Revenue Limit on Bank-Ineligible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Securities

FEDERAL RESERVE SYSTEM

[Docket No. R-0841]

10 Percent Revenue Limit on Bank-Ineligible Activities of

Subsidiaries of Bank Holding Companies Engaged in Underwriting and

Dealing in Securities

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Request for comments.

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SUMMARY: In 1987 and 1989 the Board authorized bank holding companies

to establish separate nonbank subsidiaries (``section 20

subsidiaries'') to underwrite and deal in securities that a bank may

not underwrite and deal in directly (``ineligible securities''). In

order to ensure compliance with section 20 of the Glass-Steagall Act

(12 U.S.C. 377), the Board required that the amount of revenue a

section 20 subsidiary derives from ineligible securities underwriting

and dealing activities may not exceed 10 percent of the total revenue

of the subsidiary. Section 20 prohibits a member bank of the Federal

Reserve System from being affiliated with a company that is ``engaged

principally'' in underwriting and dealing in securities.

In January 1993, after notice and the opportunity for public

comment, the Board authorized section 20 subsidiaries to use an

alternative indexed method to compute compliance with the 10 percent

revenue limitation to account for unusual changes in the level and

structure of interest rates since 1989, when the 10 percent limit was

adopted. When the Board adopted the indexed revenue test, the Board

deferred adoption of another alternative test for the 10 percent limit

that would be based on assets, rather than revenue. Inasmuch as the

Board has had increased experience in reviewing and monitoring the

operations and activities of the section 20 subsidiaries, and in order

to allow these subsidiaries additional flexibility in the conduct of

their securities operations, the Board now proposes to modify its

orders approving the establishment of the section 20 subsidiaries to

allow such subsidiaries the option of using an alternative measure to

the revenue-based tests for assessing compliance with the 10 percent

limit. The Board requests comment on whether asset values, sales volume

data, or both measures should be used as a new alternative to the

revenue test.

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

ADDRESSES: Comments, which should refer to Docket No. R-0841, may be

mailed to the Board of Governors of the Federal Reserve System, 20th

Street and Constitution Avenue, NW., Washington, DC 20551, to the

attention of Mr. William Wiles, Secretary. Comments addressed to the

attention of Mr. Wiles may be delivered to the Board's mail room

between 8:45 a.m. and 5:15 p.m., and to the security control room

outside of those hours. Both the mail room and security control room

are accessible from the courtyard entrance on 20th Street between

Constitution Avenue and C Street, NW. Comments may be inspected in room

MP-500 between 9 a.m. and 5 p.m. weekdays, except as provided in

section 261.8 of the Board's Rules Regarding Availability of

Information, 12 CFR 261.8.

FOR FURTHER INFORMATION CONTACT: Richard M. Ashton, Associate General

Counsel (202/452-3750), Thomas M. Corsi, Senior Attorney (202/452-

3275), Legal Division; Michael J. Schoenfeld, Senior Securities

Regulation Analyst (202/452-2781), Division of Banking Supervision and

Regulation, Board of Governors of the Federal Reserve System. For the

hearing impaired only, Telecommunication Device for the Deaf (TDD),

Dorthea Thompson (202/452-3544), Board of Governors of the Federal

Reserve System, 20th Street and Constitution Avenue, NW., Washington,

DC.

SUPPLEMENTARY INFORMATION:

1. Background

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

Subsidiaries

Beginning with orders issued in 1987, the Board has authorized bank

holding companies to establish nonbank subsidiaries (``section 20

subsidiaries'') to underwrite and deal in securities that a bank may

not underwrite and deal in directly (``ineligible securities'').1

In order to assure compliance with section 20 of the Glass-Steagall

Act, the Board limited the amount of ineligible securities that these

section 20 subsidiaries could underwrite and deal in. Section 20

provides that a member bank may not be affiliated with a company that

is ``engaged principally'' in underwriting and dealing in

securities.2 In particular, the Board determined that a bank

affiliate would not be ``engaged principally'' in ineligible securities

activities for purposes of section 20 if those activities were not

substantial relative to the other activities of the subsidiary. The

Board ruled that ineligible securities activities are not a substantial

part of a subsidiary's business if the gross revenue derived from those

activities does not exceed 10 percent of the total gross revenues of

the subsidiary, when revenue is averaged over a rolling 8-quarter

period. Subject to this limitation, the Board has approved the

establishment of over 30 section 20 subsidiaries, several of which are

authorized to underwrite and deal in debt and equity securities

generally.

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\1\E.g., Citicorp, 73 Federal Reserve Bulletin 473 (1987),

aff'd, Securities Industry Association v. Board of Governors, 839

F.2d 47 (2d Cir.), cert. denied, 486 U.S. 1059 (1988).

\2\12 U.S.C. 377. The Board and the courts have ruled that

section 20 does not prohibit a member bank from being affiliated

with a company that is engaged principally in underwriting and

dealing in securities that banks may underwrite and deal in directly

(``eligible securities''). See Citicorp, supra.

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B. Adoption of Alternative Indexed Revenue Test

In July 1992, the Board proposed to establish two alternative

methods that a section 20 subsidiary could elect to use to determine

compliance with the 10 percent limit on ineligible securities

activities in place of the gross revenue test.3 In proposing these

alternative tests, the Board noted that historically unusual changes in

the level and structure of interest rates have distorted the revenue

test as a measure of the relative importance of ineligible securities

activities in a manner that was not anticipated when the 10 percent

limit was adopted in 1989.4 To address this problem, the Board

first proposed an alternative revenue test indexed to interest rate

changes that would allow for adjustment of the current revenue of a

section 20 subsidiary to account for the unanticipated interest rate

conditions. In January 1993, the Board adopted an optional alternative

indexed revenue test.5

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\3\57 FR 33507, July 29, 1992.

\4\The Board pointed out that, in contrast to conditions in

1989, there was an unusually wide difference between short- and

long-term rates. Since eligible securities tend to be shorter term

than ineligible securities, the unusually sharp increase in the

steepness of the yield curve had the effect of making it appear,

based on revenue data, that the eligible securities activities of at

least some section 20 subsidiaries had been reduced, even though the

relative proportion of eligible and ineligible securities activities

being conducted by those subsidiaries remained essentially the same.

\5\79 Federal Reserve Bulletin 226 (1993). Under the indexed

revenue test, current interest and dividend revenues from eligible

and ineligible activities for each quarter are increased or

decreased by an adjustment factor provided by the Board based on the

average duration of a section 20 subsidiary's eligible and

ineligible securities portfolio. The adjustment factors, which vary

according to specific time periods of average duration, represent

the ratio of interest rates on Treasury securities in the most

recent quarter to those in September 1989.

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C. Proposed Asset-Based Test

At the same time that the indexed revenue test was proposed, the

Board also proposed an alternative asset-based test. Specifically, the

Board proposed that the 10 percent limit would be computed by using

average daily assets held in connection with ineligible securities

activities and with other activities. The Board recognized that in

1987, when it initially decided to use revenue as the appropriate

measure of the section 20 limit on ineligible securities activities,

the Board had expressed two concerns about a test based on average

assets. One concern was that an asset-based test might be manipulated,

for example, through ``matched book'' repurchase and reverse repurchase

agreements for government securities. The second concern was that an

average asset test, even if computed on a daily basis, would not

include securities that were underwritten by the section 20 subsidiary

but that were held only for a few hours, which is typical in many

underwriting transactions. Accordingly, when the Board proposed an

alternative asset-based test in 1992, the Board requested comment on

possible modifications to address these concerns.

A number of banking organizations commenting on the Board's

proposal supported adoption of an asset-based alternative measure for

computing the 10 percent limit. These comments stated that, like the

indexed revenue proposal, a limit based on assets would be less

susceptible than the unadjusted revenue test to unusual changes in

interest rate conditions. Those supporting the asset-based test also

stated that this test would be easier and less costly to apply than a

measure that required adjustments to revenue data and would allow for

greater predictability in the management of the operations of the

subsidiary.

Many commenters also opposed establishing any specific restrictions

to address the potential for manipulative transactions. These

commenters believed that the capital and funding requirements needed to

support such transactions, as well as earnings considerations and

market-imposed credit risk constraints, would effectively curtail the

excessive use of asset transactions conducted solely to increase the

level of eligible assets. Commenters also observed that implementation

of such separate limits would be difficult in practice.

On the question of the treatment of intra-day holdings of

securities that are being underwritten, while there was some support

for including the value of such securities for purposes of applying an

asset-based test, other comments opposed counting the value of such

holdings on the grounds that the 10 percent limit should measure only

assets that pose a risk to the section 20 subsidiary.

After considering these comments, the Board decided to defer

adoption of an alternative asset-based test, noting that the Board was

not then able to assess the potential practical effect of the test.

II. Proposed Alternative Test

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

Since the decision to defer consideration of the asset-based test,

the Board has had a greater opportunity to review and analyze the

operations of section 20 subsidiaries. At the outset, the Board notes

that, during this time period and in the entire seven year period since

the Board first approved the creation of section 20 subsidiaries, the

Board has not uncovered evidence of unsafe or unsound practices,

conflicts of interest, or other conduct related to the operations of

these subsidiaries that has impaired the condition of the affiliated

depository institutions or the banking organizations as a whole. The

available evidence further suggests that these subsidiaries have

exerted a beneficial procompetitive influence on the securities markets

in which they compete.

When the section 20 subsidiaries were first authorized, the Board

selected revenue, rather than asset values or sales volume, as the best

overall measure of ineligible securities activities because the Board

believed that such a test would pose the fewest operational

difficulties and provide the most accurate indication of the relative

importance of specific activities. The Board also noted that although

the applicants had argued that a variety of factors could be used to

judge ``engaged principally'' status, a single uniform standard was

desirable.6

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\6\Citicorp, supra, 73 Federal Reserve Bulletin at 484.

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However, subsequent events have shown that the susceptibility of

results from the gross revenue measure to distortion caused by changes

in interest rate conditions casts doubt on the appropriateness of that

test. Although the indexed revenue test addresses these concerns, it

necessarily involves increased operational difficulties. For some

section 20 subsidiaries, the costs and resources needed to implement

the indexed revenue test, with the need for complicated duration models

and the calculation of the duration of all securities in a section 20

subsidiary's portfolio on a regular basis, may provide a disincentive

for using that test.7

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\7\At present only four section 20 subsidiaries are using the

indexed revenue test.

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Accordingly, and in order to provide additional flexibility to

section 20 subsidiaries in the conduct of authorized activities, the

Board now believes it is desirable to consider adoption of another

optional measure in addition to revenue for applying 10 percent limit

on ineligible securities activities. The Board believes that either

asset values or sales volume, or a combination of both measures, should

be considered as a new alternative measure.

B. Asset-Based Test as an Alternative Measure

Any asset-based test would limit a section 20 subsidiary's average

daily assets held in connection with underwriting and dealing in

ineligible securities to 10 percent of its total average daily assets,

computed on a rolling 8-quarter basis. Because, as the Board observed

when an asset-based test was previously proposed, a measure relying on

asset values would be less sensitive to unanticipated changes in

interest rate conditions than a test based on revenues, such a test

would address these distortions. Also, it appears that for at least

some section 20 subsidiaries a test relying on asset values may be

easier in practice to apply than the indexed revenue test. Moreover, as

explained below, in light of its greater experience with the operations

of the section 20 subsidiaries, the Board is now of the view that the

concerns previously expressed about the operation of an asset-based

test can be appropriately mitigated.

The Board believes that the use of assets acquired in connection

with particular types of securities activities may represent a

permissible measure of compliance with the statutory limitation in

section 20 on ineligible securities activities. Asset values do provide

a rough approximation of risk to the section 20 subsidiary, and risk to

banking organizations was one of the concerns behind passage of the

Glass-Steagall Act. The Board notes that the New York State Banking

Department, in applying a state law restriction on the level of

ineligible securities activities of affiliates of state-chartered

banks, allows the use of either assets or revenue as a measure of

compliance with the law.8

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\8\E.g., letter, dated December 23, 1986, from New York

Superintendent of Banks to Morgan Guaranty Trust Company and Bankers

Trust Company.

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Underwriting

The Board believes that, if an asset-based test is adopted as an

alternative measure, the value of any securities underwritten by a

subsidiary would have to be accounted for in computing average daily

assets, even where the securities are disposed of prior to the end of

the day. The literal language of section 20 covers any underwriting

activity. Thus, under the proposed asset-based test, if securities

underwritten by a section 20 subsidiary are recorded as assets of the

subsidiary, but are disposed of before the end of the day on which

underwriting activity takes place, then the securities would be treated

as if they were carried as assets on the books of the subsidiary as of

the end of that day. If securities are underwritten by the section 20

subsidiary on a ``best efforts'' or agency basis the securities would

be treated as assets of the subsidiary for each day that underwriting

activity occurs with respect to that particular security.9

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\9\Under an asset-based alternative measure, similar treatment

would be accorded an entire issue of privately-placed securities

when any portion of the issue is taken into inventory pursuant to

SEC Rule 144A.

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Anti-Manipulation Limits

Should an asset-based test be adopted as an alternative measure,

the Board does not propose that any specific limits be incorporated to

address the potential for manipulative transactions carried out solely

to inflate artificially a section 20 subsidiary's base of eligible

assets. Many of the comments on the previously proposed asset-based

test stated that there are sufficient financial and market constraints

on the holding of excessive eligible securities solely to support

increased ineligible securities activities. Even in the case of matched

book-type transactions, counterparties typically impose limits on the

amount of transactions they will engage in with any particular section

20 subsidiary, in order to control credit risk. The Board's minimum

consolidated leverage ratio and the SEC's net capital rule, which is

applicable to a section 20 subsidiary, would impose additional

constraints. In addition, the acquisition of significant amounts of

eligible securities by a section 20 subsidiary in matched book or

similar transactions would also tend to have an overall negative impact

on the earnings performance of the consolidated bank holding company

organization, given the small profit margins typical in such

transactions. Finally, the Board believes that it has the authority to

take appropriate corrective action where manipulative transactions are

detected.

C. Sales Volume Test as Alternative Measure

The Board is also requesting comment on adoption of sales volume as

an alternative measure. If sales volume data is used as the measure of

an alternative test for applying the 10 percent limit, then the dollar

volume of a section 20 subsidiary's sales of ineligible securities as a

result of underwriting and dealing in such securities could not be

allowed to exceed 10 percent of its total sales volume over a rolling

8-quarter period.

The Board believes that the value of various types of securities

and other assets sold by a section 20 subsidiary bears a relationship

to the subsidiary's level of activity with respect to each type of

security or other asset. Use of such data is thus consistent with the

statutory requirements. Under a sales volume test, intra-day

transactions like underwriting and dealing sales would be automatically

covered, even if the assets involved were not recorded on the

subsidiary's books at the end of the day. In addition, like an asset-

based test, a sales volume test would be less sensitive to changes in

interest rate relationships. Such a test may also be easier to comply

with than the current alternative of indexed revenues.

Repurchase Transactions and Other Sales Transactions

One question raised by the use of sales volume as a test of the 10

percent limit is whether securities repurchase agreements (``repo

transactions'') should be treated as ``sales'' and therefore covered

under such a test. Repo transactions are hybrids, having some

characteristics of collateralized lending and some characteristics of

an outright sale of securities. The Federal Reserve, for purposes of

open market operations, has taken the position that repo transactions

are sales rather than loans. The Board requests comment on how repo

transactions should be treated for purposes of a sales volume test, if

such a test were adopted as an appropriate alternative measure.

In addition, the Board invites comments concerning reporting and

other administrative issues associated with implementing a sales volume

test. The Board specifically requests comment on how sales volume

should be computed for various types of transactions involving the same

kinds of underlying securities in different market places. For example,

Treasury bonds may be sold in the cash market, on a ``When Issued''

basis, on a forward contract basis, or indirectly, by purchasing a put

option or selling a futures contract. Although each type of transaction

may be reported differently for balance sheet purposes, all of the

various kinds of transactions may have an identical impact on the

section 20 subsidiary's risk profile.

The Board is considering adopting instructions similar to those

contained in the current Federal Reserve Report Series Form FR 2004,

Schedule B ``Weekly Report of Cumulative Dealer Transactions'' for

collection of sales volume information. Accordingly, comments are

requested concerning whether the instructions and definitions for

reporting sales volume data in the FR 2004 would provide an adequate

basis for developing sales volume reporting for section 20

subsidiaries. Comments are also requested concerning the definition and

reporting of various types of transactions that are not addressed in

the existing FR 2004 report instructions.

Manipulative Transactions

When the Board first approved the establishment of the section 20

subsidiaries, it considered and rejected using a sales volume test, on

the ground that the eligible securities sales volume of a section 20

subsidiary, like asset values, could be easily inflated by repeated

matched book transactions intended for no other purpose than to inflate

the subsidiary's eligible sales volume base.10 As noted above,

many of the comments on the previously proposed asset-based test

pointed out the credit risk and market limitations on the extent to

which a section 20 subsidiary may engage in matched book or similar

transactions. While these limits may be less effective where a section

20 subsidiary engages in unusual sales of securities with its own

affiliate, rather than with a third party, solely for the purpose of

increasing the volume of eligible securities sales, these matters can

be addressed during the examination process and, as noted above,

corrective action can be taken where manipulative transactions are

found.

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\1\0Citicorp, supra, 73 Federal Reserve Bulletin at 484.

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D. Compliance With Both Measures

A possible means for addressing the disadvantages of asset values

and sales volume alone as appropriate measures is to require a section

20 subsidiary electing an alternative test to comply with both

measures. The Board seeks comment on this possible requirement.

E. Implementation of Any Alternative Test

The Board notes that comments received on the asset-based test

previously proposed suggested that, if such a test were adopted, some

section 20 subsidiaries may not have access to sufficiently detailed

asset data for earlier quarters to allow computation of such a test on

a rolling 8-quarter basis and may not be able to obtain this

information easily. Therefore, the Board proposes that, if an

alternative measure is adopted using either asset values or sales

volume, or a combination of both measures, a section 20 subsidiary

would be allowed, at its election, initially to comply with such a test

on a prospective basis only for the first two-year period. The Board

followed this approach when the indexed revenue test was adopted.

As was also the case with respect to adoption of the indexed

revenue test, the Board proposes that, regardless of which test may be

adopted as an alternative measure, any section 20 subsidiary electing

to use a new test would be required to continue using that test for a

period of at least two years, in order to prevent frequent switching

between tests that would impair an accurate assessment of the relative

importance of the subsidiary's ineligible securities activities.

F. Proposed Elimination of Indexed Revenue Test

The Board also seeks comment as to why, if a new alternative

measure is adopted, the indexed revenue test should not be eliminated

because there would no longer be a need for that alternative measure.

However, a section 20 subsidiary would be allowed to continue to elect

to use the unadjusted revenue test, if the subsidiary wishes to avoid

the costs associated with converting to any new test.

G. Proposed Modification of Board Orders

The Board proposes that its orders approving the establishment of

section 20 subsidiaries be modified to provide that a section 20

subsidiary may elect, as an alternative to the existing revenue tests,

to apply an asset-based test to assess compliance with the 10 percent

limit on ineligible securities activities. Under such a test, a section

20 subsidiary would be viewed as in compliance with that section for

any quarter if the average daily assets held in connection with

underwriting and dealing in ineligible securities for that quarter,

when added to the average daily assets held in connection with

ineligible securities activities for the previous seven quarters, does

not exceed 10 percent of the average daily total assets of the

subsidiary for that quarter and for the seven previous quarters.11

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\1\1Securities underwritten by the subsidiary, including

securities taken into inventory in a private placement pursuant to

SEC Rule 144A, would be treated as assets of the subsidiary for each

day underwriting activity takes place with respect to such

securities.

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In the alternative, the Board proposes that section 20 subsidiaries

be authorized to elect to apply, as an alternative to the existing

revenue test, a sales volume test to assess compliance with the 10

percent limit. Under such a test, a section 20 subsidiary would be

viewed as in compliance with that section for any quarter if the total

dollar volume of sales of ineligible securities from underwriting and

dealing activities for that quarter, when added to the total dollar

volume of such sales for the previous seven quarters, does not exceed

10 percent of the total dollar volume of sales of all securities and

other assets by the subsidiary for that quarter and for the seven

previous quarters.

Finally, as a third alternative, the Board proposes that section 20

subsidiaries be authorized to apply an alternative test measured by

both asset values and sales volume. Under such a test, a section 20

subsidiary would be viewed as in compliance with section 20 for any

quarter if the subsidiary simultaneously satisfied both the asset-based

and sales volume measures described above.

By order of the Board of Governors of the Federal Reserve

System, July 6, 1994.

William W. Wiles,

Secretary of the Board.

[FR Doc. 94-16820 Filed 7-11-94; 8:45 am]

BILLING CODE 6210-01-P