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]

Revenue Limit on Bank-Ineligible Activities of Subsidiaries of

Bank Holding Companies Engaged in Underwriting and Dealing in

Securities

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Board is increasing from 10 percent to 25 percent the

amount of total revenue that a nonbank subsidiary of a bank holding

company (a so-called section 20 subsidiary) may derive from

underwriting and dealing in securities that a member bank may not

underwrite or deal in. The revenue limit is designed to ensure that a

section 20 subsidiary will not be engaged principally in underwriting

and dealing in such securities in violation of section 20 of the Glass-

Steagall Act. Based on its experience supervising these subsidiaries

and developments in the securities markets since the revenue limitation

was adopted in 1987, the Board has concluded that a company earning 25

percent or less of its revenue from underwriting and dealing would not

be engaged principally in that activity for purposes of section 20.

EFFECTIVE DATE: March 6, 1997.

FOR FURTHER INFORMATION CONTACT: Gregory A. Baer, Managing Senior

Counsel (202/452-3236), Thomas M. Corsi, Senior Attorney (202/452-

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

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

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

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

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

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

DC.

SUPPLEMENTARY INFORMATION:

I. Background

Section 20 of the Glass-Steagall Act provides that a member bank of

the Federal Reserve System may not be affiliated with a company that is

``engaged principally'' in underwriting and dealing in securities. \1\

In 1987, the Board first interpreted that phrase to allow bank

affiliates to engage in underwriting and dealing in bank-ineligible

securities--that is, those securities that a member bank would not be

permitted to underwrite or deal in--when the Board approved

applications by three bank holding companies to underwrite and deal in

commercial paper, municipal revenue bonds, mortgage-backed securities,

and consumer-receivable-related securities (hereafter, ``tier-one

securities''). \2\ In

[[Page 68751]]

1989, the Board allowed five bank holding companies to underwrite and

deal in all debt and equity securities (hereafter, ``tier-two

securities''). \3\

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\1\ 12 U.S.C. 377.

\2\ Citicorp, J.P. Morgan & Co., and Bankers Trust New York

Corp., 73 Federal Reserve Bulletin 473 (1987) (hereafter, 1987

Order), aff'd, Securities Industry Ass'n v. Board of Governors, 839

F.2d 47, 66 (2d Cir.), cert. denied, 486 U.S. 1059 (1988)

(hereafter, Citicorp); Chemical New York Corp., Chase Manhattan

Corp., Bankers Trust New York Corp., Citicorp, Manufacturers Hanover

Corp., and Security Pacific Corp., 73 Federal Reserve Bulletin 731

(1987) (approving underwriting and dealing in consumer-receivable-

related securities, after having deferred decision for 60 days in

its 1987 Order).

\3\ J.P. Morgan & Co., The Chase Manhattan Corp., Bankers Trust

New York Corp., Citicorp, and Security Pacific Corp., 75 Federal

Reserve Bulletin 192 (1989) (hereafter 1989 Order), aff'd,

Securities Industries Ass'n v. Board of Governors, 900 F.2d 360

(D.C. Cir. 1990) (hereafter, SIA II).

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Currently, forty-one subsidiaries of bank holding companies are

authorized to engage in underwriting and dealing activities that are

not authorized for a member bank. Fifteen of these so-called section 20

subsidiaries have authority to underwrite and deal in tier-one

securities pursuant to the 1987 Order. Pursuant to the 1989 Order,

twenty-three section 20 subsidiaries have authority to underwrite and

deal in all tier-two securities, and three may underwrite and deal in

all debt securities.

The Board has established a revenue test to determine whether a

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

purposes of section 20. The revenue test provides that a section 20

subsidiary may not derive more than 10 percent of its total revenue

from underwriting and dealing in bank-ineligible securities. The Board

arrived at this revenue test through a series of interpretive steps, in

a series of orders.

The Board interpreted the meaning of ``engaged principally'' in its

1987 order allowing Bankers Trust New York Corporation to engage in

private placement of commercial paper. \4\ Having satisfied itself that

the ``engaged principally'' language of section 20 must allow some

level of underwriting and dealing, \5\ the Board was required to choose

between two alternative meanings of ``principal.'' The first meanings

of ``principal,'' advocated by the applicant, included definitions such

as ``chief,'' ``main,'' or ``largest,'' and translated into allowing

underwriting and dealing to constitute up to 50 percent of the section

20 subsidiary's business or, alternatively, to constitute anything

other than its largest business (collectively, the ``largest activity

interpretation''). The second meaning included definitions such as

``primary,'' ``substantial,'' ``leading,'' ``important,'' or

``outstanding'' and translated into a stricter limitation on

underwriting and dealing--that is, allowing underwriting and dealing

subject to a limit somewhat lower than 49 percent of the applicants'

business. \6\ Based on the purposes and legislative history of Glass-

Steagall Act, the Board chose the latter interpretation. \7\

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\4\ Bankers Trust New York Corporation, 73 Federal Reserve

Bulletin 138 (1987) (hereafter, Bankers Trust).

\5\ Bankers Trust order at 141; 1987 Order at 474.

\6\ Bankers Trust order at 140-42; see also 1987 Order at 477-

78, 482-83.

\7\ Bankers Trust order at 142.

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The Board further found in the Bankers Trust order that the best

measure of the underwriting and dealing activity for purposes of

section 20 was the gross revenue derived from that activity. \8\ The

Bankers Trust order found that a company deriving less than five

percent of revenue would be in compliance with section 20, but did not

attempt to identify the maximum percentage of revenue permitted by the

statute.

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\8\ Bankers Trust order at 145; 1987 Order at 483-485. In terms

of what revenue to consider, the Board ruled that securities that a

member bank was authorized to underwrite under section 16 of the

Glass-Steagall Act (for example, U.S. government securities) were

not covered by the prohibition of section 20; accordingly, the Board

decided that revenue derived from underwriting and dealing in such

securities should not count as underwriting and dealing for purposes

of section 20. Rather, only revenue earned on ``ineligible

securities''--those that a member bank could not underwrite or deal

in--was counted toward the section 20 limit. 1987 Order at 478;

Citicorp, 839 F.2d at 62.

The Board also established a test based on the company's share

of the market in a particular security, but this market share test

was subsequently struck down by the Second Circuit. The court of

appeals held that ``by using the term `engaged principally,'

Congress indicated that its principal anxiety was over the perceived

risk to bank solvency resulting from their over-involvement in

securities activity. A market share limitation simply does not

further reduce this congressional worry.'' Citicorp, 839 F.2d at 68.

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Finally, in its 1987 Order, the Board translated its interpretation

of ``engaged principally'' into a quantitative limit on the amount of

gross revenue that could permissibly be derived from underwriting and

dealing. The Board found that underwriting and dealing in bank-

ineligible securities would not be a ``substantial'' activity for a

section 20 subsidiary if the gross revenue derived from that activity

did not exceed 5 to 10 percent of the total gross revenue of the

subsidiary. \9\ As a prudential matter, the Board initially limited

ineligible revenue to 5 percent of total revenue in order to gain

experience in supervising such subsidiaries. In 1989, the Board allowed

section 20 subsidiaries to increase their underwriting and dealing

revenue to 10 percent of total revenue. \10\

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\9\ 1987 Order at 485.

\10\ 75 FR 751 (1989).

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No changes were made to the revenue test in subsequent orders

until, in January 1993, the Board allowed section 20 subsidiaries to

use an alternative revenue test that was indexed to account for changes

in interest rates since 1989. \11\ The Board found that historically

unusual changes in the level and structure of interest rates had

distorted the revenue test as a measure of the relative importance of

ineligible securities activity in a manner that was not anticipated

when the 10 percent limit was adopted in 1989. In particular, the Board

found that because bank-eligible securities (such as U.S. government

securities) tended to be shorter term than ineligible securities, an

increase in the steepness of the yield curve had caused the revenue

earned by at least some section 20 subsidiaries from holding eligible

securities to decline in relation to ineligible revenue, even as the

relative proportion of eligible and ineligible securities activities

being conducted by these subsidiaries remained unchanged. \12\ Five

section 20 subsidiaries are currently operating under this indexed

test; use of the test has not been more widespread because the systems

necessary to administer it are expensive and complicated.

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\11\ Order Approving Modifications to the Section 20 Orders, 79

Federal Reserve Bulletin 226 (1993) (hereafter, 1993 Modification

Order).

\12\ 1993 Modification Order at 228. Under the indexed revenue

test, current interest and dividend revenue from eligible and

ineligible activities for each quarter are increased or decreased by

an adjustment factor provided by the Board. The adjustment factors,

which are calculated for securities of varying durations, represent

the ratio of interest rates on Treasury securities in the most

recent quarter to those in September 1989. Section 20 subsidiaries

may use the adjustment factors to ``index'' actual interest and

dividend revenue based upon the average duration of their eligible

and ineligible securities portfolios.

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II. Proposed Change to Revenue Limit

On July 31, 1996, the Board proposed to maintain the revenue

measure but increase the revenue limit from 10 percent of total revenue

to 25 percent. \13\ The Board based this proposed increase on the

experience it has gained through supervision of the section 20

subsidiaries over a nine-year period. The Board stated its belief that

the limitation of 10 percent of total revenue it adopted in 1987,

without benefit of this experience, had unduly restricted the

underwriting and dealing activity of section 20 subsidiaries. The Board

noted that changes in the product mix that section 20 subsidiaries are

permitted to offer and developments in the securities markets had

affected the relationship between revenue and activity since 1987.

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\13\ 61 FR 40643 (August 5, 1996).

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[[Page 68752]]

III. General Summary of Comments

The Board received 42 public comments: 26 from banks, bank holding

companies and their trade groups; three from securities firms and one

of their trade groups; and the remainder from members of Congress, a

community group, a think tank, the Conference of State Bank

Supervisors, and individuals. Thirty-four commenters favored the

proposal, and eight opposed. The banking industry comments generally

supported the proposal, and the securities industry comments generally

opposed. The remaining comments were mixed.

Several banking industry commenters asked the Board to raise the

revenue limit higher than 25 percent, generally to 49 percent. Several

banking industry commenters also asked the Board to supplement the

revenue test with an asset-based test or a sales volume test.

The securities industry commenters argued that comprehensive reform

of the financial services industry is necessary and can be accomplished

only through legislative action. The Securities Industry Association

(SIA) expressed concern that if the Board were to increase the revenue

limit to 25 percent, banks and bank affiliates would have little or no

incentive to support a financial services modernization bill, because

they would have received by rule much of the relief they would have

sought in legislation. \14\ Securities industry commenters also argued

that securities, insurance, and other financial services firms would be

placed at a competitive disadvantage with banks.

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\14\ Seven members of the SIA wrote separately to dissent from

its views. The commenters noted that the association had recently

supported other, non-comprehensive legislative reform of financial

services regulation.

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Several commenters opposed the increase in the limits on the

grounds that the Board had previously rejected in its 1987 Order any

percentage limit greater than 10 percent. Commenters also stated that a

level of ineligible securities activity giving rise to 25 percent of

revenue must be considered ``substantial'' and therefore to constitute

being principally engaged in that activity.

The SIA argued that a 25 percent limit as a measure of

``substantial'' was inconsistent with other laws that establish

presumptions on a percentage basis, including the Bank Holding Company

Act and regulations of the Board and the other banking agencies. The

SIA also argued that raising the revenue limit to 25 percent could well

render section 20 meaningless by permitting affiliations between member

banks and the largest investment banks in the country, and would thus

be contrary to the intent of Congress in enacting the Glass-Steagall

Act to divorce commercial and investment banking.

A community group argued that allowing bank holding companies to

expand further into securities underwriting without increased scrutiny

under the Community Reinvestment Act would result in further neglect by

banks and bank holding companies of the credit needs of low- and

moderate-income neighborhoods and households and small businesses. The

commenter argued that banks affiliated with section 20 subsidiaries

have closed branches and reduced services to the public, and therefore

that the operation of section 20 subsidiaries has had adverse effects

on the public. The commenter argued that one of the problems that

Congress meant to address with the Glass-Steagall Act was the diversion

of financial resources in the banking system to the securities

markets--a diversion that allowed and encouraged speculation in the

securities markets and removed such funds from use in the retail

banking business. Finally, the commenter argued that allowing expanded

securities underwriting and dealing could undermine confidence in U.S.

banks during declines in the securities markets.

The Board received five comment letters from members of Congress.

Four Representatives supported the Board's proposal, and one opposed

it.

IV. Final Order

A. Introduction

Interpreting section 20 is a difficult task. The language of the

statute is ``intrinsically ambiguous,'' \15\ and further inquiry into

the legislative history is therefore necessary to interpret it. As the

Board noted in its 1987 Order, this inquiry ``requires application of a

statute adopted over 50 years ago in very different circumstances to a

financial services marketplace that technology and other competitive

forces have altered in a manner and to an extent never envisioned by

the enacting Congress.'' \16\ Furthermore, although the general purpose

of the Glass-Steagall Act was to divorce commercial and investment

banking, the express language of section 20 clearly allows some level

of investment banking for bank affiliates. \17\

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\15\ Citicorp, 839 F.2d at 63; cf. Board of Governors v. Agnew,

329 U.S. 441, 446 (1947) (the related term ``primarily engaged'' is

susceptible to a range of ``accepted and common meanings'').

\16\ 1987 Order at 475.

\17\ The premise for this divorce was that the affiliation of

commercial banking had yielded abuses that had to be corrected. See

generally Investment Company Instit. v. Camp, 401 U.S. 617, 629-34

(1970) (discussing legislative history). However, recent research

indicates that this premise may have been inaccurate. See James S.

Ang and Terry Richardson, The Underwriting Experience of Commercial

Bank Affiliates Prior to the Glass-Steagall Act: A Reexamination of

Evidence for Passage of the Act, 18 J. Banking and Finance 351, 385

(1994) (``We have found no evidence that bonds underwritten by the

security affiliates of commercial banks as a group [from 1926-1934]

were in any way inferior to the bonds underwritten by investment

banks. . . . Bank affiliate issue default rates were lower, ex ante

yields were lower, ex post prices were higher and yield/price

relation no different than investment bank issues.''); Randall S.

Kroszner and Raghuram G. Rajan, Is the Glass-Steagall Act Justified?

A Study of the U.S. Experience with Universal Banking Before 1933,

84 Amer. Econ. Rev. 810, 829 (``Not only did bank affiliates

underwrite higher-quality issues [from 1921-29], but also we find

that the affiliate-underwritten issues performed better than

comparable issues underwritten by independent investment banks.'');

George J. Benston, The Separation of Commercial and Investment

Banking: The Glass-Steagall Act Revisited and Reconsidered 41 (1990)

(``The evidence from the pre-Glass-Steagall period is totally

inconsistent with the belief that banks' securities activities or

investments caused them to fail or caused the financial system to

collapse.'').

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Although a few commenters criticized the Board for preempting the

Congress by reviewing its section 20 orders, the Board has in fact

delayed a review of its section 20 orders in the hope that

Congressional action would make such a review unnecessary. The Board

continues to believe that reform of the laws governing this nation's

financial services is needed in order to ensure that our nation's

financial system remains innovative and competitive and provides

services to customers at the lowest possible cost. The Board does not

believe that an increase in the revenue limit detracts from the need

for comprehensive reform and does not intend for this step to

substitute for such reform. Rather, the Board is exercising its

statutory responsibility to administer section 20 in light of

significant changes to the securities markets in the years since the

Board first analyzed its terms.

Summary

After considering the comments received, the Board has decided to

adopt the proposal and amend its section 20 orders to allow up to 25

percent of total revenue to be earned from underwriting and dealing in

bank-ineligible securities. The Board has concluded that a 25 percent

revenue limit is consistent with section 4(c)(8) of the Bank Holding

Company Act and section 20 of the Glass-Steagall Act.

[[Page 68753]]

C. Glass-Steagall Act Analysis

Based on its nine years of experience supervising section 20

subsidiaries, the Board has concluded that a company whose ineligible

revenue approaches 10 percent of total revenue is neither engaged

principally, nor on the verge of being engaged principally, in

underwriting and dealing for purposes of section 20. The Board has

decided that a section 20 subsidiary will not be engaged principally in

such activities so long as ineligible revenue does not exceed 25

percent of total revenue.

In reaching this decision, the Board has not revisited its

decisions, beginning with its Bankers Trust order in 1987, that the

``engaged principally'' standard of section 20 must be interpreted as

``substantial'' or ``primary,'' rather than as ``chief'' or ``main'' or

``largest.'' The Board did not propose such a reinterpretation.

Similarly, the Board has not revisited its use of revenue as the

appropriate measure of business activity.

The Board has reviewed, however, its decision in the 1987 Order

that underwriting and dealing in bank-ineligible securities would be a

``substantial activity'' of a section 20 subsidiary if such

underwriting and dealing generated more than 10 percent of the section

20 subsidiary's total revenue. The Board has concluded that the 10

percent revenue limit unduly restricts the underwriting and dealing

activity of section 20 subsidiaries to a level that falls short of

``principal engagement'' for purposes of section 20. This conclusion is

based on the Board's experience with the section 20 subsidiaries

through the process of examination and supervision. The conclusion is

also supported by identifiable changes in the relationship between

gross revenue and underwriting and dealing activity since the Board's

1987 Order.

First, a given level of activity in underwriting and dealing in

tier-two securities pursuant to the 1989 Order generally yields

substantially higher revenue than an equivalent level of activity in

underwriting and dealing in tier-one securities pursuant to the 1987

Order. Underwriting fees for tier-two securities are significantly

larger than fees for tier-one securities, particularly with respect to

equity securities and non-investment-grade debt securities. 18

Similarly, bid/offer spreads on many corporate bonds and other tier-two

securities are significantly wider than the spreads on tier-one

securities. Put another way, the Board has concluded that (all else

being equal) a company that maintained a constant level of underwriting

and dealing activity over the past nine years but shifted its product

mix to include tier-two securities would have seen a significant

increase in ineligible revenue.

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\18\ See, e.g., Investment Dealer's Digest 12 (Feb. 19, 1996);

Investment Dealer's Digest 19 (February 15, 1988).

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Commenters confirmed this experience. One large bank holding

company noted that since receiving approval in late 1994 to engage in

corporate debt and equity activities, it had earned ``an ever

increasing level of revenue derived from ineligible securities

underwriting and dealing activities without a corresponding percentage

increase in the number or size of the transactions involving ineligible

securities. The factor primarily responsible for this revenue increase

is . . . the revenues generated by corporate--particularly high yield--

debt activities. The same level of corporate debt activity as a

percentage of total transactions yields greater ineligible revenues

than a comparable number of transactions involving commercial paper or

municipal revenue bonds.''

Second, a converse trend has developed with respect to eligible

revenue, where market changes have reduced the eligible revenue derived

from a given level of activity. Most notably, increased competition in

brokerage services has diminished revenue as a function of activity.

19 Lower commissions have required companies to increase volume in

order to maintain a given level of eligible revenue. This market change

particularly affects any company with a large retail investor base--

generally those operating under the 1987 Order--that wishes to engage

in any significant level of ineligible securities activities, as it

must generally rely on brokerage activities in order to generate

eligible revenue. In contrast, the overwhelming majority of companies

operating under the 1989 Order have an institutional investor base and

generate eligible revenue through underwriting and dealing in bank-

eligible securities.

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\19\ See, e.g., The Economist 9 (April 15, 1995) (``Commissions

on listed securities as a percentage of the value of trade in these

instruments have fallen from 70-90 basis points in the early 1980s

to below 40 basis points. Even for over-the-counter trading . . .

returns have fallen from 80-90 basis points to around 20 basis

points.'')

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Finally, relative securities returns have varied over the years,

changing the mix of eligible and ineligible revenue. As noted above,

interest rate changes have reduced eligible interest revenue relative

to ineligible interest revenue. For the great majority of companies

that have elected not to use the indexed revenue test, these interest

rate changes have continued to skew their reported ratio of ineligible

to total revenue, though to a far lesser extent since a recent

clarification to the revenue limit, which stated that interest earned

on most investment-grade debt securities is treated as eligible income.

20 In addition, short term interest rates have on balance declined

over the period, and equity prices have trended higher. Therefore,

companies with tier-two powers who are engaged in equity securities

activity may well have seen an increase in their ratio of ineligible

revenue to total revenue.

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\20\ 61 FR 48953 (1996).

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Commenters supported this conclusion. Seven bank holding company

commenters and two bank trade associations specifically noted that

these developments had affected their institutions or members. None of

the commenters opposed to an increase in the revenue limit disputed the

Board's analysis. 21

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\21\ One commenter stated that the Board was precluded from

changing its view that ineligible revenue in excess of 10 percent

would violate section 20 because once the Board had made a

reasonable interpretation of a statute, and that interpretation was

affirmed by a court, the Board may not thereafter adopt a position

inconsistent with that interpretation. This statement is incorrect

as a matter of law. See, e.g., Smiley v. Citibank (South Dakota),

N.A., 116 S.Ct. 1730, 1734 (1996) (agency may reverse an earlier

position and receive judicial deference so long as the change is not

``sudden and unexplained''). As demonstrated above, the Board's

amendment to the revenue limit is based on nine years of experience

supervising section 20 subsidiaries and identifiable market and

regulatory developments since the initial interpretation.

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The Board recognizes that one reason underwriting and dealing

spreads are higher for some activities than for others is to compensate

for risk. The risks of holding high-yield bonds in inventory, for

example, are higher than the risks of holding commercial paper, which

is short-term and generally issued by a highly rated company and backed

by a bank line of credit. However, in the Board's experience, as

confirmed by the commenters, these wider spreads have resulted in

higher revenue even after accounting for losses attributable to

pricing, credit or other risks. 22 In the Board's experience, the

ability to earn these higher profits derives from financial innovation

in structuring transactions, ability to foresee shifting public needs

gained from an experienced sales force, research on the

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issuer that is credited by the market, the ability to use marketing

expertise to avoid losses, and accuracy in pricing. 23 Each of

these skills yields greater rewards with respect to tier-two securities

than tier-one securities, as tier-two securities generally trade in

thinner markets where the frequency of trading is lower, the number of

intermediaries smaller, and therefore the ability to gain a competitive

advantage is greater.

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\22\ The same point can be made with respect to the indexed

revenue test, which took into account an increase in the steepness

of the yield curve. Such a change in the shape of the yield curve

may be caused by a rise in expected future interest rates, with no

increase in interest rate risk.

\23\ See generally Ernest Bloch, Inside Investment Banking (2d

ed. 1989); 81-104. 248-73; Kenneth Garbade, Securities Markets 473-

74, 493-97 (1982).

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Although the point was not raised by the commenters, the Board

recognizes that these market and regulatory developments may have

affected each section 20 subsidiary differently, depending on the

products it offers and the duration of its interest rate-sensitive

assets. However, the Board continues to believe that only a single

revenue limit should govern. 24 Any standard that attempted to

reflect the characteristics of each security approved for a section 20

subsidiary would be unworkable. Determination of compliance on a case-

by-case basis would appear to be the only alternative to a quantitative

test. The Board is concerned that such a practice could lead to

substantial uncertainty among section 20 subsidiaries as well as the

potential for inconsistent interpretations of the statute among section

20 subsidiaries and examiners. Therefore, the Board continues to prefer

to use a single, bright-line standard.

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\24\ In Citicorp, the petitioner argued that because the Board's

interpretation of section 20 necessitated regulation, it a fortiori

contravened the Act. The court of appeals rejected this argument,

``The Board's interpretation is one that attempts to walk the line

that Congress laid down.'' 839 F.2d at 66.

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Although not disputing the Board's analysis, one commenter stated

that any amount of activity rising to 25 percent of total activity was

by definition ``substantial'' and therefore inconsistent with the

Glass-Steagall Act. The Board disagrees. The Board has used a

``substantial activity'' test as a way of determining whether a section

20 subsidiary is ``engaged principally'' in underwriting and dealing.

This reading is consistent with the general interpretation of

``principal'' as meaning ``primary,'' ``substantial,'' ``leading,''

important,'' or ``outstanding'' 25 and with the definition of

substantial as ``an essential part, point or feature.'' 26 The

Board believes that an activity that represents less than 25 percent of

a firm's total activity--or, put another way, where 75 percent of the

firm's activity is in other areas--is not per se a ``principal,''

``primary,'' ``substantial,'' ``leading,'' ``important,''

outstanding,'' or ``essential'' part of that firm's activity.

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\25\ Bankers Trust order at 141-42.

\26\ The Shorter Oxford English Dictionary, 2172 (3d ed. 1973),

cited in Citicorp, 839 F.2d at 64.

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The Board notes that its decision is consistent with an

interpretation of a parallel statute. As several commenters noted, the

New York State Banking Department has taken the position that a company

would not be ``engaged principally'' in underwriting and dealing for

purposes of New York State's ``little Glass-Steagall Act''--which

contains the same ``engaged principally'' standard as section 20--if

underwriting and dealing was 25 percent or less of its total business

activities. 27

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\27\ See Letter from Jill Considine, Superintendent of Banks,

New York State Banking Department, to Morgan Guaranty Trust Company

and Bankers Trust Company (Dec. 23, 1986). Although one commenter

argued that a 25 percent limit is inconsistent with percentage

limits established in other banking statutes and regulations, those

statutes do not rest on an interpretation of the phrase ``engaged

principally.'' Moreover, the most prominent example cited by the

commenter, the presumption of control in the Bank Holding Company

Act, is consistent with a 25 percent revenue limit, as it

establishes a presumption of control over a bank holding company

based on ownership of 25 percent or more of the company's

securities. See 12 U.S.C. 1841(a)(2). The difference between a test

of ``25 percent or less'' (under section 20) and a test of ``less

than 25 percent'' (under the Bank Holding Company Act) is

infinitesimal.

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Several commenters urged the Board to adopt a greater increase in

the revenue limit--to 50 percent or, in one case, 33 percent--on the

grounds that such an increase would be consistent with safety and

soundness and not pose risks to banks affiliated with a section 20

subsidiary. The Board notes, however, that although safety and

soundness is clearly a relevant factor under the Bank Holding Company

Act, the Board has limited authority to interpret section 20 based on

whether underwriting and dealing activities can be conducted consistent

with safety and soundness. Congress itself has decided when a company's

risks of underwriting and dealing are too great to allow affiliation

with a bank: whenever they constitute a principal activity of that

company. Thus, even if the Board were to find that affiliation posed

minimal risks, that finding would not allow the Board to raise the

section 20 revenue limit to 100 percent. Nor would a finding that

affiliation poses extreme risks allow the Board to lower the section 20

revenue limit to zero (though the Bank Holding Company Act, discussed

below, could).

Commenters raised two objections to the proposed increase in the

revenue limit based on the volume of underwriting and dealing that it

would allow. One commenter stated that even under a 10 percent revenue

limit, several section 20 subsidiaries were among the largest

underwriters in the United States and that therefore an increase in the

limit was unjustified. The Board notes that in its 1987 Order first

authorizing the establishment of a section 20 subsidiary, it required

that underwriting and dealing in each security not exceed 5 percent of

the total domestic underwriting and dealing in that security. As noted

above, this market share test was struck down by the Second Circuit as

unsupported by the language, legislative history, and purposes of the

Glass-Steagall Act.

Other commenters argued that if the threshold for the revenue test

were increased from 10 percent to 25 percent, then banks would be

permitted to affiliate with the nation's largest investment banks,

contrary to the express purpose of section 20 of the Glass-Steagall

Act.28 This argument is basically a restatement of the market

share test. The relevant question for purposes of interpreting the

Glass-Steagall Act is whether the Board's interpretation would have

allowed banks to affiliate with the securities affiliates of the 1920s

and 1930s 29 or companies engaged in activities similar to those

affiliates, not whether it would allow banks to affiliate with the

investment banks of today. Although data are sketchy, the Board

believes that securities firms deriving more than 25 percent of their

income from underwriting and dealing in securities were common in the

pre-Glass-Steagall period, and thus that the revenue limit the Board is

adopting today is consistent with the purposes of the Act.30 The

[[Page 68755]]

Board notes that while the largest section 20 subsidiaries currently

derive substantial eligible revenue from the U.S. Treasury market, the

federal government was running a budgetary surplus in the pre-Glass-

Steagall period, and the outstanding federal debt and therefore the

market for government securities were small.31 Thus, most

securities affiliates of that period could not have derived substantial

eligible revenue from underwriting and dealing in government

securities.

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\28\ Similarly, although one commenter argued that a 25 percent

revenue limit could allow underwriting and dealing to be the first

or second largest activity in the section 20 subsidiary, the Board

believes that the relationship to total revenue, not the

relationship to other activities, is controlling.

\29\ By the time of the enactment of Glass-Steagall, the major

securities affiliates of banks had been dissolved. W. Nelson Peach,

The Security Affiliates of National Banks 158 (1941). Thus, the

Glass-Steagall Act was aimed at preventing a recurrence of earlier

abuses--most particularly, those leading up to the stock market

crash of 1929--rather than at conditions prevailing at the time of

its passage.

\30\ See, e.g., Agnew, 329 U.S. at 445 (finding that in 1943 one

of the nation's leading underwriters, Eastman, Dillon & Co., earned

between 26 percent and 40 percent of its revenue by underwriting

securities). A description of the nation's two largest securities

affiliates by an observer of the time appears to indicate that they

derived revenue substantially in excess of 25 percent of its revenue

from underwriting and dealing. ``The volume of securities originated

and distributed by [the National City Company, a securities

affiliate of National City Bank,] was so large that it was necessary

to have a separate vice-president in charge of securities issued by

industrial corporations, a vice-president in charge of municipal

securities, a vice-president in charge of railroad securities, a

vice-president in charge of foreign work, a vice-president in charge

of accounting and treasury work, and a vice president in charge of

the selling organization.'' See Peach at 94. Similarly, from 1917 to

1927, the securities affiliate of Chase National Bank of New York,

Chase Securities Corporation, ``was identified only with major

issues of bonds, offering such bonds at wholesale without public

notice.'' Id. at 96.

\31\ See Robert J. Gordon, The American Business Cycle:

Continuity and Change 382 (1986); Benjamin M. Friedman, The Changing

Roles of Debt and Equity in Financing U.S. Capital Formation 96,

Table 6.2 (1982).

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Second, although not relevant to the statutory interpretation, the

Board is not convinced that a 25 percent revenue limit would allow

unlimited affiliation between banks and investment banks for purposes

of section 20. Adverse commenters provided no data to support their

assertion that it would. The Board has reviewed the publicly available

financial information for a sample of the largest investment banks, and

it is not apparent that they would be in compliance with a 25 percent

revenue limit. 32

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\32\ Determining the ineligible revenue of independent

investment banks is difficult because they do not segregate

ineligible revenue from eligible revenue in their annual reports or

the FOCUS reports that they file with the Securities Exchange

Commission. For example, an investment bank may report a given

figure for interest and dividends earned on securities without a

separate breakdown of what percentage of that amount was earned from

government securities, and many of the largest firms are primary

dealers in government securities.

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D. Bank Holding Company Act Analysis.

In its 1987 Order and 1989 Order, the Board concluded that the

applicants' proposed underwriting and dealing activities were closely

related to banking and could be expected to result in significant

benefits to the public in the form of increased competition, greater

convenience to customers, increased efficiency and maintenance of

domestic and international competitiveness.33 The Board's

experience in supervising section 20 subsidiaries has borne out this

conclusion, and the Board has now concluded that a further increase in

the revenue limit to 25 percent would extend these benefits.34

Numerous commenters stressed that an increase in the revenue limit

would allow section 20 subsidiaries to operate more efficiently and

compete more effectively domestically and globally. Such competition

should benefit both institutional and individual customers by

increasing customer choice and lowering prices. Furthermore, commenters

indicated that a higher limit would facilitate the creation of new

section 20 subsidiaries, thereby increasing competition.

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\33\ See 1987 Order at 489-90; 1989 Order at 200-02.

\34\ The Board reached the same conclusion when it reviewed its

section 20 orders in 1994. See 59 FR 35516-35517 (1994).

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The Board has also concluded, as it had in its original orders,

that an increase in the revenue limit will not cause any adverse

effects, such as undue concentration of resources, decreased or unfair

competition, conflicts of interest, or unsound banking practices that

would outweigh the projected public benefits.35 Accordingly, these

benefits will not come at an increased risk to the safety and soundness

or reputation of the nation's banks or to the federal safety net. Bank

holding companies have demonstrated over the past nine years that they

are able to manage the risks of investment banking, and section 20

subsidiaries operate as separately capitalized subsidiaries of a bank

holding company, outside the control of any affiliated bank and

therefore outside the protections of the federal safety net.36

Section 20 subsidiaries must register as broker-dealers and remain

subject to the capital regulations of the Securities Exchange

Commission.

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\35\ Accord 1987 Order at 490-502; 1989 Order at 202-10. Two

commenters disagreed with this analysis, pointing to recent claims

made against Bankers Trust Corporation regarding derivatives

trading, an NASD action against Citicorp for failing to ensure that

brokers complied with continuing education requirements, and the

Board's 1996 enforcement action against Swiss Bank Corporation for

violating the revenue limit. The Board has concluded that these

isolated incidents are not sufficient to question the safety and

soundness of underwriting and dealing generally. Moreover, the

Citicorp and Swiss Bank actions were compliance issues that did not

result in losses to either the section 20 subsidiary or an

affiliated bank, or in any other safety and soundness problems.

While Bankers Trust did suffer from abuses in its derivatives

activities, these were bank-eligible activities that were conducted

at the bank as well as the section 20 subsidiary. The section 20

revenue limit does not constrain this activity.

\36\ The federal safety net includes deposit insurance, access

to the Federal Reserve's discount window, and access to the payments

system.

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Protection against unfair competition and undue concentration of

resources is provided by the antitrust laws and special anti-tying

restrictions applicable only to banks,37 which prohibit a bank

from using its products to require or induce customers to use the

products of its securities affiliate. A section 20 subsidiary is also

subject to the consumer protection and anti-fraud provisions of the

Securities Exchange Acts of 1933 and 1934.38 In the Board's

experience, competition in the securities markets remains vibrant.

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\37\ 12 U.S.C. 1972(1).

\38\ 15 U.S.C. 77a-77z; 15 U.S.C. 78a-78ll.

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The Community Reinvestment Act does not provide for consideration

of a bank's community lending performance in deciding whether a

nonbanking activity is permissible under section 4 of the Bank Holding

Company Act or in deciding what level of underwriting and dealing

activity is permitted by section 20 of the Glass-Steagall Act. In any

event, the Board believes that expanded securities activities by bank

holding companies will not adversely affect low- and moderate-income

neighborhoods and households or small businesses. At least one study

has shown that section 20 subsidiaries bring a larger proportion of

smaller-sized issues and lower-credit-rated new issues of non-financial

firms to market than do independent investment banks.39 Although

banks affiliated with section 20 subsidiaries have closed branches

since 1987, particularly over the past few years, these closings are

intrinsic to the consolidation that is occurring in the banking

industry. Commenters provided no evidence that a bank with a securities

affiliate is more likely to close branches than a like-sized bank

without one.40 More importantly, the number of branch offices

nationwide has increased each year between 1987 and 1995, and the

population per branch has declined each year.41 Finally,

regardless of the activities of its nonbanking affiliates, a bank's

record for lending continues to be subject to review and rating under

the Community Reinvestment Act.

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\39\ Amar Gande, Manju Puri, et al., Bank Underwriting of Debt

Securities: Modern Evidence, in Bank Structure and Competition 651

(1996) (working paper).

\40\ Cf. A Review and Evaluation of Federal Margin Regulations:

A Study by the Staff of the Board of Governors of the Federal

Reserve System (December 1984) (concluding that concerns that

securities credit diverts funds from more productive uses are

unfounded).

\41\ See Stephen A. Rhoades, Bank Mergers and Industrywide

Structure, 1980-94: Staff Study of Board of Governors of the Federal

Reserve System 25 (1996); Myron L. Kwast, United States Banking

Consolidation: Current Trends and Issues Table 3 (1996) (paper

presented to OECD).

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V. Indexed Revenue Test

In conjunction with today's order, the Board is eliminating its

alternative indexed revenue test, which as noted

[[Page 68756]]

above is indexed to account for changes in interest rates since 1989.

The Board has concluded that distortion of the revenue limit from

interest rate fluctuations has been addressed by today's increase in

the revenue limit and by the recent clarification of the revenue limit,

which stated that interest earned on most investment-grade debt

securities is treated as eligible income.

VI. Section 32 of the Glass-Steagall Act

Also in conjunction with today's order, the Board intends to

interpret section 32 of the Glass-Steagall Act generally to prohibit

interlocks between a bank and any company that derives more than 25

percent of its total revenue from underwriting and dealing in bank-

ineligible securities. Section 32 prohibits personnel interlocks

between a member bank and any company ``primarily engaged'' in

underwriting and dealing in securities.42 Since 1987, the Board

has interpreted ``engaged principally'' under section 20 and

``primarily engaged'' under section 32 consistently.43 The Board

and the courts have noted that section 20 should be interpreted at

least as strictly as section 32 because ``the dangers resulting from

affiliation are arguably greater than those resulting only from

personnel interlocks.'' 44

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\42\ 12 U.S.C. 78.

\43\ Bankers Trust order at 142. The Board relied on the Supreme

Court's interpretation of section 32 in Agnew in determining that

``engaged principally'' denotes substantial activity as opposed to

the largest activity. However, the Agnew Court did not translate its

interpretation of ``primarily engaged'' into a limitation on revenue

or any other test of business activity.

\44\ Citicorp at 67.

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The Board has not, however, measured compliance with section 32 and

section 20 in the same manner, relying on a more qualitative analysis

for purposes of section 32. This difference is largely attributable to

the fact, as noted above, that the Board does not gather detailed

revenue information from securities companies other than section 20

subsidiaries. Furthermore, while the Board must continuously monitor

compliance with section 20, and is thus in need of a bright-line test,

inquiries under section 32 are infrequent.

Thus, in 1958, the Board established a nine-part guideline for

determining compliance with section 32 that included ``the dollar

volume of business of the kinds described in section 32 engaged in by

the firm or organization'' and ``the percentage ratio of such dollar

volume to the dollar volume of the firm's total business.'' However,

the Board did not establish a revenue or dollar volume limit. A

subsequent staff letter noted that ``the Board generally has determined

that a securities firm, which [sic] receives 10 percent of its gross

income from section 32 business, is 'primarily engaged' within the

meaning of [section 32],'' and the Board in its 1987 Order noted that

the Board had developed a ``general guideline'' to that effect. The

Board has never, however, imposed a specific limitation in order to

enforce compliance with section 32, and has found firms deriving more

than 10 percent of their revenue from underwriting and dealing not to

be primarily engaged. Nor has the Board ever reviewed the

appropriateness of its 10 percent guideline since its apparent adoption

in the 1950s, despite significant developments in the securities

markets since that time.

In light of those developments and the Board's action on the

section 20 revenue limit, the Board will generally find a securities

firm to be primarily engaged in underwriting and dealing for purposes

of section 32 when more than 25 percent of its total revenue derives

from underwriting and dealing in bank-ineligible securities.

By order of the Board of Governors of the Federal Reserve

System, December 20, 1996.

William W. Wiles,

Secretary of the Board.

[FR Doc. 96-32944 Filed 12-27-96; 8:45 am]

BILLING CODE 6210-01-P