oversight

Bank Powers: Activities of Securities Subsidiaries of Bank Holding Companies

Published by the Government Accountability Office on 1990-03-14.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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                                                               BANK POWERS
                                                               Activities of Securities
                                                               Subsidiaries of Bank
                                                               Holding Companies
      United States
      General Accounting Office
      Washington, D.C. 20648

      General Government Division

      B-237706

      March 14,199O

      The Honorable Carroll Hubbard
      Chairman, Subcommittee on General
        Oversight and Investigations
      Committee on Banking, Finance
        and Urban Affairs
      House of Representatives

I     Dear Mr. Chairman:

      This report responds to your July 18, 1989, letter requesting informa-
      tion about certain securities subsidiaries of bank holding companies.
      These subsidiaries, authorized by the Federal Reserve Board, are com-
      monly called Section 20 subsidiaries, This is a reference to the provi-
      sions in Section 20 of the Glass-Steagall Act (12 USC. sec. 377), which
      permits banks that are members of the Federal Reserve System to be
      affiliated with firms that are not principally engaged in securities activi-
      ties generally forbidden to banks themselves.’ Section 20 subsidiaries
      can function as investment banks by underwriting (publicly distributing
      new issues of securities) and as broker-dealers by buying and selling
      securities for their own accounts or for others.

      As you suggested, we met with Committee staff during August and Sep-
      tember 1989 to discuss further the scope of our work. We agreed to
      develop information on activities of Section 20 subsidiaries primarily
    , from agency records, information in the public domain, and meetings
      with regulatory and industry officials. As a result of our discussions, we
      identified several issues that Congress and regulators need to address
      when considering potential modifications to the regulation of Section 20
      subsidiaries.

      Information on Section 20 companies is contained in eight appendixes to
      this letter. The first three discuss specific topics raised in your request:
      (1) market share, pricing, and benefits to the public; (2) risk to the hold-
      ing company; and (3) the practical impact of the Board’s regulatory
      requirements, called firewalls, on bank holding companies.




       ‘This act prohibits member banks from underwriting and dealing in securities other than U.S. Gov-
      ernment and general obligation bonds of states and municipalities and certain securities issued or
      insured by certain specified government agencies or instrumentalities (bank-eligible securities).



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              The remaining five appendixes present statistics on Section 20 compa-
              nies, discuss Section 20 company capital and capital adequacy regula-
              tions, and review the legal basis for domestic and international
              securities activities of Section 20 subsidiaries and other bank holding
              company units.

  1

              Except for certain specified securities, mainly government securities,
Ba,ckground   member banks of the Federal Reserve System are prohibited under the
              1933 Glass-Steagall Act from engaging directly in securities underwrit-
              ing. However, under Section 20, member bank affiliates are permitted to
              participate in otherwise impermissible securities activities so long as the
  I           affiliate is not principally engaged in this activity.

              In 1987, the Board began approving applications submitted by bank
              holding companies to allow wholly-owned nonbank subsidiaries to
              underwrite and deal in certain bank-ineligible securities. A majority of
              the subsidiaries were already engaged in permissible, or bank-eligible,
              securities activities such as underwriting and dealing in government
              bonds. As noted above, the Board determined that the types and levels
              of activities proposed by the bank holding companies complied with the
              provisions of the Glass-Steagall Act. The Board also determined that
              these bank-ineligible securities activities met the requirements in the
              Bank Holding Company Act of 1956, as amended. This statutory stand-
              ard requires that two separate tests be met for an activity to be permis-
              sible for a bank holding company. First, the Board must determine that
              the activity is, as a general matter, closely related to banking. Second,
              the Board must determine that the activity may reasonably be expected
              to produce public benefits that outweigh possible adverse effects.

              In April 1987, in its first action, the Board approved applications sub-
              mitted by three bank holding companies requesting authority to under-
              write and deal in municipal revenue bonds, mortgage-related securities,
              and commercial paper. Later that year it approved more applications
              and also added consumer-receivable-related securities, which are securi-
              ties backed by such assets as credit card receivables or consumer auto
              loans, The Board placed a limit of 5 percent of a subsidiary’s gross reve-
              nues on the revenues that could be generated from the bank-ineligible
              activities. The Board also required these companies to observe a number
              of prudential limitations, called firewalls, designed to insulate insured
              bank affiliates from the risks associated with Section 20 subsidiaries’
              activities by assuring the capital adequacy of the holding company and



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            /      limiting both transactions and the flow of information between a securi-
            /      ties subsidiary and other affiliates of the parent banking organization.
                   (The firewalls are identified in app. VII.)

                   In January 1989, the Board approved applications by certain bank hold-
                   ing companies to underwrite and deal in corporate debt and equity
                   securities. In doing so, the Board imposed a tighter set of firewall
                   restrictions. (See app. VIII.) The Board also stipulated that holding com-
                   panies cannot initiate corporate debt and equity underwriting and deal-
                   ing until the Board has determined that the companies have the
                   necessary managerial and operational infrastructures to ensure compli-
                   ance with the firewall restrictions. Companies must also submit a satis-
                   factory capital plan that complies with the Board requirements for these
                   activities. Further, the Board placed a l-year moratorium on equity
                   securities activities. In September 1989, the Board raised the revenue
                   limit for bank-ineligible activities to 10 percent for all Section 20 compa-
                   nies In January 1990, the Board authorized several foreign banks to
                   operate Section 20 subsidiaries.

                   Under the Securities Exchange Act of 1934, Section 20 companies must
                   register as broker-dealers. As registered broker-dealers, they are subject
                   to Securities and Exchange Commission (SEC) regulation under the secur-
                   ities laws, must comply with SEC'S net capital rules, and must join an SEC-
                   approved industry self-regulatory organization. The Board, as the pri-
                   mary regulator of bank holding companies, enforces the firewall
                   requirements.


                   In the third quarter of 1989, the 13 Section 20 firms operating at that
Results in Brief   time underwrote a total of about $69 billion in bank-ineligible securities,
                   with commercial paper representing about 98 percent of the amount
                   underwritten. The firms accounted for about 2 percent or less of the
                   total market for underwriting municipal revenue bonds, mortgage-
                   backed securities, and asset-backed securities. Comparable market share
                   data are not available for commercial paper.

                   When activities of Section 20 companies in both bank-eligible and bank-
                   ineligible securities are considered, Section 20 companies accounted for
                   about 7 percent of all revenue realized by SEC-registered securities firms
                   in the second quarter of 1989 (the latest quarter for which the compari-
                   son can be made). Section 20 firms also accounted for about 4 percent of
                   total securities industry capital as of June 30, 1989. Ranked by capital,
                   6 of the top 50 securities firms in the Nation are Section 20 firms.


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                         Section 20 firms have the potential, when their activities are well estab-
                         lished and if they operate at the maximum levels authorized by the
                         Board, to make a significant impact on the structure of the securities
                         industry. Also, to date, regulatory officials have found no evidence that
                         any Section 20 firm has damaged the financial condition of a bank or
                         bank holding company. However, the scope of the bank-ineligible activi-
                         ties of Section 20 firms has been limited thus far, as the subsidiaries
                         continue to organize their operations, develop the products and services
                         they plan to offer, and identify the markets they will enter. Accordingly,
                         it is too early to draw conclusions about Section 20 firms’ impact on the
                         market, their profitability, their riskiness, or the adequacy of the regula-
                         tory system within which they operate.

                         In general, bank holding company officials that we interviewed thought
                         that the revenue limitation on the activities of Section 20 subsidiaries, as
                         well as many of the firewall provisions, are costly and place unneces-
                         sary constraints on their competitiveness in the market. Conversely,
                         securities industry officials said the firewalls are needed to assure fair
                         competition and to prevent Section 20 firms from benefiting from feder-
                         ally insured deposits maintained by their affiliated banks. Board offi-
                         cials said the requirements are meeting the Board’s regulatory
                         objectives. These officials also indicated that the Board will consider
                         modifying some of the firewalls after the Section 20 firms have obtained
                         additional operational experience.

                         In authorizing Section 20 companies to underwrite and deal in bank-inel-
                         igible securities, the Board required controls, such as separate corporate
                         identity and regulation by the SEC, that we have previously recom-
                         mended should be part of any long-term solution to the problem of how
                         banking and securities activities should be linked.” However, there are
                         other aspects of Section 20 company regulation, such as the exact pur-
                         pose of some of the firewalls and their consistency with the regulation
                         of the international activities of U.S. banks, that we believe require
                         additional scrutiny.


Objectives, Scope, and   identify how the activities of Section 20 firms have affected risk levels
Methodology              in their respective bank holding companies; how these activities have
                         affected the securities industry in terms of market share changes, the
           *             pricing of securities, and benefits to the consumer; and how the Board’s

                         “Hank Powers: Issues Related to Repeal of the Glass-Stcagall Act (GAO/GGD-88-37, dan. 22, 1988).



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firewalls have affected bank holding companies. As requested, we also
prepared information on bank holding company finances and the legal
basis for securities activities of banking organizations that provides a
broader context for discussing the activities of Section 20 companies. In
addition, we identified several issues that Congress and regulators need
to address when considering potential modifications to the regulation of
Section 20 subsidiaries.

Our 1988 report on Glass-Steagall issues said that coming to grips with
the question of Glass-Steagall repeal represents an opportunity to sys-
tematically address changes in legal and regulatory structures that are
needed to better reflect the realities of the financial market place.” This
report does not represent a comprehensive study of all of the issues
associated with amending or repealing the Glass-Steagall Act, nor does it
attempt to present conclusions on the way the relationships between
banking and securities activities should be structured. In keeping with
the nature of the request, we have limited our work to an analysis of the
Federal Reserve’s actions, taken under existing legislative authority, to
allow banking organizations to conduct certain securities activities in
separately capitalized bank holding company subsidiaries.

We interviewed officials and reviewed records at the Federal Reserve
System, Office of the Comptroller of the Currency (OCC), Federal Deposit
Insurance Corporation (FDIC), SEC, and the National Association of Secur-
ities Dealers, Inc. (NASD) to obtain information on the operations and reg-
ulation of Section 20 companies. Our review included financial
information from the reports that bank holding companies file with the
Federal Reserve (Y-9 report) and information on securities activities and
financial data from reports that securities firms file with the SEC
(FVCUS reports).

To gain better understanding of both the operation of Section 20 firms
and the firewalls, we interviewed officials at six bank holding compa-
nies that have established Section 20 subsidiaries and officials from
three investment banking firms that compete with Section 20 firms. We
also discussed aspects of Section 20 firms with representatives from
several regional banking organizations that are considering setting up a
Section 20 subsidiary. We interviewed officials from industry trade
groups, including the American Bankers Association, Association of
Bank Holding Companies, the Bank Capital Markets Association, and the
Securities Industry Association.

'1GAO/GGD-88-37,.January 22, 1988.



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We reviewed industry publications to determine how the activities of
Section 20 subsidiaries compare to the total markets in which these
firms have been active. Because the information available on these firms
was very limited, we asked Section 20 firms authorized as of September
30, 1989, to provide us with information on their underwriting activi-
ties. All 21 firms responded.

Because of the limited availability of market data, we also talked with
several persons whom we judgmentally determined would have knowl-
edge about the markets in which Section 20 firms operate. This included
officials from the Government Finance Officers Association and the Fed-
eral National Mortgage Association.

In keeping with the disclosure provisions of the Federal Banking Agency
Audit Act, the report contains only information about individual bank
holding companies that has previously been disclosed to the public by
the firms or by federal agencies.

As requested by the Subcommittee, we obtained comments on our draft
report from industry groups as well as federal agencies. The draft was
given to them for comment at the end of December 1989.

The Board of Governors provided some technical suggestions and indi-
cated that the Board’s staff found the draft to be satisfactory. (See app.
IX.) In addition to some technical points, the comments of OCCand SEC
raised several issues that are discussed in our letter. The comments of
occ and SEC, along with our views, are also contained in appendixes X
and XI, respectively.

We also received written comments from the American Bankers Associa-
tion, Association of Bank Holding Companies, Bank Capital Markets
Association, Coalition for Regional Banks, and the Securities Industry
Association, The principal points raised in these comments are discussed
in the letter. The comments, along with our views, are also contained in
appendixes XII to XVI. The National Association of Securities Dealers,
Inc., and the New York Stock Exchange provided informal comments
that required no changes to the report.

We did our work from August 1989 through January 1990 using gener-
ally accepted government auditing standards.




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                       Section 20 subsidiaries had initiated operations involving the newly
         i             authorized bank-ineligible securities activities. Six of the 13 Section 20
                       subsidiaries have been doing bank-ineligible activities less than 1 year.
                       It is therefore too early to assess the significance of Section 20 firms’
                       bank-ineligible securities activities. However, information we have
                       obtained about the activities of the firms, the risks these activities pre-
                       sent, and the firewalls adopted to safeguard against those risks does
                       provide insight into the potential market impact of these firms and the
                       issues that require further consideration.

     I

Mar$et Activities of   Between the second and third quarters of 1989 the volume of bank-
Sectjon 20 Firms       ineligible securities underwritten by Section 20 firms increased from
                       $36.2 billion to $68.7 billion, or about 90 percent. This increase was due
     !                 mainly to commercial paper underwriting activities, which represented
                       about 98 percent of the total bank-ineligible securities underwritten by
                       Section 20 firms during both quarters.

                       During the third quarter of 1989, Section 20 firms accounted for about
                       1.9 percent of the total underwriting volume of the combined markets
                       for municipal revenue bonds, mortgage-related securities, and asset-
                       backed securities. Total market volume data for commercial paper are
                       not available, and therefore commercial paper is not included in this cal-
                       culation of market share. In the individual markets for municipal reve-
                       nue bonds, mortgage-backed securities and asset-backed securities,
                       Section 20 firms’ activities represented 1.8, l-9, and 1.8 percent, respec-
                       tively, of the total volume underwritten in these markets (see fig. IV.1).
                       Industry analysts said Section 20 firms have not offered substantial
                       price discounts to gain market share.

                       Other measures also indicate the market presence of Section 20 firms.
                       As of June 30, 1989, operating Section 20 firms had about $1.8 billion in
                       capital, an increase of 28 percent over the amount invested as of March
                       30, 1989. The $1.8 billion in capital invested in Section 20 companies
                       represented about 4 percent of the capital of all securities firms regis-
                       tered with the SEC at that time. In terms of capital, 6 of the Section 20
                       firms appear to rank among the top 50 securities firms in the country. In
                       the second quarter of 1989, the $1.5 billion total revenue of Section 20
                       firms (almost all of which is from bank-eligible activities) represented
                       about 7 percent of the revenue of all securities firms registered with SEC.




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Ri$ks Associated Wit h     Although there are risks associated with Section 20 company underwrit-
Seqtion 20 and Bank        ing and dealing in bank-ineligible securities, these activities also provide
                           bank holding companies with opportunities to diversify their activities
Holding Company            and thus limit their risks from any single activity. It is too early to tell
AcY;ivities                whether Section 20 firms’ activities and placing these activities in a non-
                           bank subsidiary have actually affected the risk levels within their hold-
  I                        ing companies.

                           One factor tending to control risks associated with the activities of Sec-
                           tion 20 companies is the way that the Board has authorized this expan-
                           sion of power. The Board has limited the scope and pace of development
                           of new activities, set capital requirements, and placed limitations and
                           restrictions (firewalls) on ties between a Section 20 subsidiary and its
                           affiliates, particularly bank affiliates. Also, the Board endeavored to
                           prevent an expansion of powers beyond what the Federal Reserve and
                           other regulatory officials could effectively oversee. It should be pointed
                           out, however, that bank holding company officials and some regulatory
                           officials have said that the regulatory structure may hamper the ability
                           of the holding company as a whole to manage its exposure to a single
                           customer or market segment and, thus, the risks that may result from
                           such exposure.


Views on Impact of the     Banking officials said that the initial 5-percent limitation on the level of
Rebenue Limitations anId   revenue that could be generated from Section 20 firms’ bank-ineligible
                           securities activities hampered normal business decision processes. When
Fi4ewalls Differ           the Board raised the revenue limit to 10 percent, the officials said that
                           they believed Section 20 firms gained more flexibility to decide what
                           activities to pursue primarily on the basis of business factors rather
                           than the revenue limit. However, these officials anticipate that the
                           higher revenue limit will cause problems in developing business strate-
                           gies in the near future once the Section 20 firms become fully active in
                           their underwriting and dealing activities and have started reaching the
                           higher revenue limit set by the Board. As of June 30, 1989, the ineligible
                           revenues generated by Section 20 firms were about 3 percent of gross
                           revenues.

                           Officials of regional bank holding companies said it has been difficult
                           for many regional firms to generate a base of eligible revenues sufficient
                           to establish Section 20 firms, They say it is necessary to transfer into a
                           Section 20 subsidiary some activities that may not fit well together from
                           a business perspective in order to provide a large enough subsidiary rev-
                           enue base to make doing ineligible business worthwhile.


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--
     Officials from both multinational and regional bank holding companies
     said other firewall requirements, intended to insulate bank subsidiaries
     and their customers from the activities of Section 20 firms, increased the
     operating costs for bank holding companies. They said the prohibition
     on interlocking directors, officers, and employees increases costs by
     duplicating staff functions and associated support systems and hampers
     the ability to effectively manage risks on a holding company-wide basis.
     Officials from regional bank holding companies were also concerned that
     restrictions on cross-marketing reduced the benefits that Section 20
     companies could bring to the holding company and the individual and
     corporate customers of its bank subsidiaries.

     Banking officials said some of the firewall limits on financial ties
     between a Section 20 subsidiary and its banking affiliates prevent bank
     holding companies from undertaking certain practices that would
     enhance revenue and benefit their corporate and individual customers.
     These firewalls prohibit a bank affiliate of a Section 20 subsidiary from
     doing such things as clearing bank-ineligible securities-that    is, process-
     ing and settling securities transactions, for the Section 20 firms-guar-
     anteeing commercial paper and revenue bonds underwritten by the
     Section 20 firms, or actively marketing securities underwritten by Sec-
     tion 20 firms to customers of the bank. They said eliminating these
     firewalls would not expose the banks to increased risk and would elimi-
     nate the need for banks to give business to competing firms.

     Securities industry officials were concerned that the Board’s revenue
     limitations may permit bank holding companies to expand rapidly by
     acquiring existing securities firms. They said that a high percentage of
     the revenue of many securities firms is derived from activities that are
     permissible for bank holding companies.

     Securities industry officials also expressed concerns that the firewall
     requirements are not stringent enough to insulate bank subsidiaries
     fully from the activities of Section 20 firms or to prevent Section 20
     firms from having access to funds at a lower cost than would be availa-
     ble to securities firms. They said that a bank holding company, because
     of its association with the federal safety net, which includes deposit
     insurance and lender of last resort assistance from the Federal Reserve,
     can generally obtain funds at a lower cost compared to nonbank organi-
     zations They said that there is a perception in the market that during
     stressful times regulators may extend the federal safety net to nonbank
     subsidiaries within a holding company in order to ensure the viability of
     bank subsidiaries.


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                   Federal Reserve officials said the Board has followed a conservative
                   approach in authorizing the establishment of Section 20 companies and
                   that to date the firewalls have adequately protected federally insured
                   activities done in bank holding companies that have established Section
                   20 companies. They said that separate capitalization and other firewall
                   requirements applicable to a Section 20 firm and its affiliates have
                   effectively insulated bank subsidiaries from the activities of a Section
                   20 firm.

                   The Board granted bank holding companies powers to do a broader
                   range of securities activities as a step to enhance these companies’ com-
                   petitiveness in the financial services market. Board officials recognized
                   that some firewalls-designed       to protect federally insured activities
                   from risks associated with Section 20 company activities-could          result
                   in higher costs to the holding company than would occur without the
                   restrictions. The officials said that the Board plans to review the appro-
                   priateness of the firewall requirements and noted that to date the Board
                   has made some modifications. For example, in September 1989 the
                   Board modified the firewall that had prohibited a Section 20 company
                   from underwriting or dealing in certain bank-ineligible mortgage-backed
                   securities issued by its affiliates by allowing such transactions.

                   In November 1989, the Board made further changes to the firewalls. In a
                   decision currently relevant to one bank holding company, the Federal
                   Reserve permitted the Section 20 firm’s bank affiliates or parent to
                   extend credit to customers whose debt was privately placed4 through
                   the Section 20 firm, even if the customer used the loan to repay princi-
                   pal on that debt.5 Such extensions of credit previously were not autho-
                   rized by the Federal Reserve. The Federal Reserve also allowed the
                   parent company to buy up to half of any debt issue privately placed by
                   its Section 20 subsidiary.


                   Our previously cited 1988 report on issues related to repeal of the Glass-
G&O Observations   Steagall Act concluded that if the securities powers of banks were to be
                   expanded (whether by an act of Congress or by regulation), a phased



                   “In private placements, Section 20 firms would act in an agency capacity to arrange sales of securities
                   between an issuer and a relatively small number of institutional investors.

                   “At lcast 3 years must elapse from the time a customer’s securities are placed through the Section 20
                   subsidiary before such credit may be granted.



                   Page 10                                                                GAO/GGD-90-48     Bank Powers
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approach should be used.” A phased approach is one in which authoriza-
tion of new securities activities by banking organizations is done incre-
mentally as needed changes to regulation and oversight are put in place.
The actions taken by the Federal Reserve in allowing limited expansion
of securities activities in Section 20 companies have been generally con-
sistent with the approach we suggested. This contrasts sharply with the
experience in the thrift industry, where many firms expanded rapidly
into new activities and federal and state regulators did not exercise ade-
quate supervision.

We cannot yet tell how the market will judge Section 20 firms. We do not
know if they will prove to be profitable, if bank holding companies will
choose to use them as vehicles for substantial expansion of their securi-
ties activities (perhaps by acquiring existing securities firms), or if they
will prove to be a reasonably satisfactory long-run solution to bank
powers issues involving securities markets.

Some features of the Section 20 arrangement (such as use of a separate
SEC-regulatedsubsidiary and regulation of the entire holding company
by the Federal Reserve) are, in our view, essential, at least in the near
term, in permitting the affiliation of the banking and securities busi-
nesses. However, there are also matters that suggest the need for fur-
ther review of how best to structure securities activities within a
banking organization. For example, in order to comply with revenue lim-
itations, banking organizations that want to underwrite and deal in cer-
tain securities may have to engage in bank-eligible activities, such as
dealing extensively in government bonds, not otherwise closely related
to the business strategy of the firm .

Our work suggests that banking and securities regulators and Congress
should concentrate on seven areas in considering the need for further
changes in the arrangements for Section 20 subsidiaries.

1. International perspective. Section 20 arrangements raise several ques-
tions about the interrelationship of domestic and international aspects
of bank holding company regulation. U.S. banking organizations operate
in countries, such as the Federal Republic of Germany, Switzerland, and
the United Kingdom, that do not observe the same separation of banking
and securities activities as is mandated in the United States. In these



“GAO/GGD-88-37, .January 2’2. 1988, pages 2 and 3.



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countries, subsidiaries of U.S. banks, as well as U.S. bank holding com-
pany subsidiaries, can engage in securities operations (such as under-
writing and dealing in corporate debt) as well as traditional banking
activities within the limits set by the Federal Reserve and host country
regulators. There is no organizational separation enforced for these
activities. Allowing U.S. banks operating overseas to combine banking
and securities activities in this manner allows them to be competitive in
those markets. However, it also raises the question of exactly what it is
that makes similar arrangements inappropriate in the U.S. market. The
question is particularly relevant because applying Section 20 firewalls
only to domestic operations would seem to provide an incentive for U.S.
banking organizations to focus more on foreign markets. Therefore, it
would be useful to know more about how the activities of Section 20
subsidiaries fit into the worldwide operations of a large banking
organization,

It is also possible that firewalls intended to protect domestic banks could
eventually make it easier for foreign banking organizations than domes-
tic ones to undertake a full range of securities activities in the US. mar-
ket and perhaps in overseas markets as well. For example, several
foreign banks applying to set up Section 20 companies asked the Federal
Reserve to waive certain firewalls for them on the grounds that foreign
banks were not connected to the U.S. deposit insurance system and
hence the firewalls were not needed. In its January 1990 Order authoriz-
ing three foreign banks to establish Section 20 subsidiaries, the Board
tried, to the extent possible, to apply the firewalls to the foreign-owned
Section 20 subsidiaries. However, the firewalls do not all apply to these
firms in exactly the same way because foreign banks generally are not
organized under the same type of holding company structure that is
common in the United States, and there are limits to the restrictions that
the Board can impose on foreign banks and their subsidiaries, To an
unknown extent, therefore, foreign banking organizations may have
greater flexibility than do domestic ones in coordinating the activities of
their Section 20 firms with activities outside of the United States.

2. Organizational structure. One reason advanced for allowing Section
20 companies to engage in securities activities is the intention to
strengthen banking organizations. However, it is not clear exactly
whether or how the Section 20 firm will strengthen insured depository
institutions that are part of the holding company. To the extent that
profitable activities are moved out of the bank to provide a base of eligi-
ble revenue for the Section 20 subsidiary, it follows logically that the
bank itself becomes smaller, less diversified, and perhaps less profitable.


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                            Also, if Section 20 companies prove to be profitable, funds sent to the
                            holding company parent may not be available to a bank subsidiary if the
                            parent decides not to so invest, them .

                            The relationship of a Section 20 company to insured bank affiliates is
                            particularly important if the bank gets in trouble and is in danger of
                            failing. The Federal Reserve has a source of strength policy, incorpo-
                            rated in its Regulation Y, that a bank holding company shall serve as a
                            source of financial and managerial strength to its subsidiary banks.
                            However, the exact conditions under which a bank holding company can
                            be required to use nonbanking assets to support bank subsidiaries have
                            not been set out in detail.7 Clarification of the operational basis of this
                            source of strength policy would help in providing a clearer perspective
                            on how the firewalls and source of strength policy work together in
                            strengthening banks affiliated with a Section 20 firm .

                            In commenting on the draft of our report, occ said that we appeared to
                            endorse the Federal Reserve’s view that ineligible securities activities
                            should take place only within a securities subsidiary of a bank holding
                            company. A similar comment was made by the Association of Bank
                            Holding Companies. occ said it believes that alternative arrangements,
                            such as securities underwriting in direct subsidiaries of federally
                            insured banks, should be considered. In addition, the Coalition for
                            Regional Banks said in its comments that U.S. banks should be perm itted
                            to establish and fund Section 20 subsidiaries just as the Federal Reserve
                            has perm itted foreign banks to do. The Coalition also said that FDIC’S
                            regulations perm it insured state nonmember banks to establish subsidi-
                            aries to engage in underwriting and dealing activities, and such activi-
                            ties should not become impermissible simply because the bank is owned
                            by a bank holding company.

                            As stated earlier, we believe there are benefits associated with using
                            bank holding company subsidiaries as the way to expand the securities
                            powers of banks, at least in the near term . Although we have not
                            endorsed any particular view of how securities activities and banking
                            must be organized within a banking organization in the long run, we
                            believe certain features that are provided for in the present arrange-
                            ment should be preserved. These features are (1) separate corporate
                            identity for the firm engaging in the ineligible activities; (2) regulation

                            ‘The Financial Institutions Reform, Kecovery, and Enforcement Act of 1989, Public Law No. 101-73,
                             103 Stat. 183 (1989), holds affiliated insured depository institutions liable for each others’ losses but
                            does not extend this liability to holding companies unless they themselves are depository institutions.
                            (Sec. 206(a)(7)).



                            Page 13                                                                  GAO/GGD-90-48      Bank Powers
B-237706




of the banking and securities affiliates by a federal bank regulator and
the SEC,respectively; and (3) regulation by the Federal Reserve of the
financial holding company that owns the bank and securities affiliates.

If Section 20 firms were subsidiaries of a bank rather than a bank hold-
ing company, the problem mentioned earlier of how to have insured
banks benefit financially from the activities of Section 20 firms would
be solved. (As a bank subsidiary, alI of the Section 20 firm ’s profits would
then pass directly to the bank and the value of the securities firm would
be consolidated with the assets of the bank were the bank to fail.) But
there are also other considerations to weigh. It is by no means certain
that all Section 20 firms will make money. (In 1989, some major securi-
ties firms lost money.) If the Section 20 firm is a bank subsidiary, losses
in that subsidiary would also pass immediately to the bank and reduce
its capital. Furthermore, as a bank subsidiary, a Section 20 company
would be more directly linked to the federal safety net provided by
deposit insurance and Federal Reserve discount loans. Extension of the
federal safety net in this way may convey unwarranted competitive
advantages to firms associated with banks, and it may make market
participants less concerned about the riskiness of financial ventures
funded through Section 20 firms.

3. Purpose of firewalls and other limitations. In evaluating whether Sec-
tion 20 company arrangements represent an appropriate way to struc-
ture links between the banking and securities industries, it is important
that the purpose served by each of the limitations on the powers of Sec-
tion 20 companies and each of the firewalls be as clear as possible.

The problems involved in pinpointing the reasons for special provisions
can be illustrated by the firewall that prohibits a bank from issuing a
letter of credit to support commercial paper underwritten by its Section
20 affiliate. Looking at this firewall from a risk point of view, if the
guarantee is priced correctly, the bank would be no more exposed to risk
by the guarantee than if the bank simply made a loan to the company
for the full amount of the securities underwritten. The question of risk
in this case, therefore, is one of whether, in the absence of the firewall,
bank officials can be trusted to make reasonable pricing decisions. Fed-
eral Reserve officials say that the desire to obtain fee income may lead
the bank affiliate to be less than objective in assessing the risks involved
when pricing the letter of credit. However, the bank already can issue
letters of credit to support municipal general obligation bonds the bank
itself underwrites, and the officials of the bank have many opportuni-
ties to take risks in making other pricing decisions.


Page 14                                              GAO/GGD-9048   Bank Powers
L -_ .-.^...,lll;   “... .”-”.--... -   ---.   -
                                                   E&Y7706




                                                   In commenting on our draft report, occ said that the report generally
                                                   approved of the Federal Reserve’s 10 percent revenue lim itation, Along
                                                   with the Association of Bank Holding Companies and the Coalition for
                                                   Regional Banks, occ also pointed out that the “engaged principally” lan-
                                                   guage of the Glass-Steagall Act is subject to different interpretations.
                                                   occ said that a revenue lim it of greater than 10 percent would be legally
                                                   permissible and that it is inappropriate to set a definitive level of gross
                                                   revenues as the “engaged principally” standard for all cases. In addi-
                                                   tion, the Coalition for Regional Banks said that a revenue lim it of 25 to
                                                   49 percent of gross revenues would be more realistic. occ suggested that
                                                   alternative measures other than lim iting gross revenues should be
                                                   explored for defining “engaged principally.” The Association of Bank
                                                   Holding Companies and the Coalition for Regional Banks suggested that
                                                   the gross revenue lim it could be applied on the basis of the consolidated
                                                   revenues of the bank holding company.

                                                   Our report agrees with the Board’s policy of using the revenue lim it to
                                                   phase in bank-ineligible securities activities, but we do not have a posi-
                                                   tion on the percentage of revenue that ultimately should be allowed
                                                   under the act. W e recognize that in the long run there may be other
                                                   options for interpreting the “engaged principally” clause under the
                                                   Glass-Steagall Act and that if that act were changed, other ways of
                                                   appropriately phasing in or lim iting the securities activities of bank
                                                   holding companies could be devised.

                                                   4. Regulatory burden and the effectiveness of firewalls. A number of
                                                   banking officials we talked to commented that many of the firewalls
                                                   represent what can be termed regulatory “overkill.” They said that the
                                                   firewalls weren’t needed because enforcement of basic banking and
                                                   securities laws, such as those dealing with transactions within a holding
                                                   company and conflict of interest situations, provide sufficient protection
                                                   against risks or abuses.

                                                   In seeking to determine the best way to structure links between the
                                                   banking and securities industries, we think it would be useful for bank-
                                                   ing and securities regulators to examine individual firewalls from the
                                                   perspective of their cost and what they add to the general regulatory
                                                   structure already in place. However, the examination must include real-
                                                   istic assessmentsof the new demands associated with expanding the
                                                   securities powers of banking organizations, the capabilities of federal
                                                   and state regulators to detect and deter abuses, and the adequacy of
                                                   penalties for violations.



                                                   Page 15                                             GAO/GGD-9048   Bank Powers
B-237706




An illustration of what such an examination must include can be seen in
efforts to prevent conflict of interest abuses by institution9 and insider
abuses by employees of banking organizations. In an earlier report we
said that while instances of abuse may occur, institutional abuses of
conflicts of interest were not significant, widespread problems in the
banking industry.” However, we also pointed out that expanding the
securities powers of banking organizations could increase the potential
for conflict of interest situations. We therefore concluded that given the
harm that could result to consumers and ultimately to the banking sys-
tem from abuses, the potential for abuse warrants close attention if
banking institutions were granted expanded securities powers. There
have been instances in which banking organizations that got into trouble
have not followed general regulatory restrictions intended to prevent
conflict of interest abuses.“’ In a similar vein, studies have also shown
the incidence of insider abuses have existed in over 50 percent of the
bank failuresI’ Opportunities for insider abuse could also be expected to
increase as the securities powers of banking organizations are
expanded.12


“A conflict of interest occurs when a person or business serving more than one interest can poten-
tially benefit by favoring one interest at the expense of the others. Conflict of interest situations,
which can occur in the normal course of business operations, are neither inherently wrong nor neces-
sarily illegal. However, a conflict of interest situation represents an opportunity for abuse.

For example, the parent within a bank holding company may favor, especially during times of stress,
an affiliate in which it has more invested relative to investments in other affiliates. In such a conflict
situation, managers could, for example, make imprudent or unsound loans to an affiliate, transfer bad
assets from the affiliate to the bank, or require the bank to purchase service from the affiliate at
inflated prices.

Conflict of interest situations also exist within a securities firm. Abuses can occur, for example, when
a firm buys or sells securities or provides investment advice to customers for the purpose of assisting
its own trading, marketmaking, or underwriting activities rather than serving the customers’ best
interests.
!‘Banking: Conflict of Interest Abuses in Commercial Banking Institutions, (GAO/GGD-89-35, Jan
1989).
“‘For   example, in the mid 1970s severe problems developed in the mortgage banking affiliate of the
Hamilton National Bank, which specialized in real estate development loans. The affiliate’s operations
were funded through bank lines of credit and the sale of holding company commercial paper. When
the parent holding company was unable to roll over its commercial paper, it forced Hamilton National
Dank to buy a large amount of low-quality mortgages from the severely distressed mortgage banking
affiliate of the holding company. These purchases far exceeded the amount permitted by law (Section
23A of the Federal &serve Act) and resulted in the subsequent failure of the bank.

’’Banking: Conflict of Interest Abuses in Commercial Banking Institutions (GAO/GGD-89-35, Jan
1989), pp.23-26.1

“‘It should be noted, however, that the fact that opportunities for insider abuse may increase does
not mean that mote instances of abuse will actually occur. Factors such as good internal controls can
limit the occurrcncc of actual abuses.



Page 16                                                                 GAO/GGD-90-48      Bank Powers
B-237706




In commenting on our draft report, occ said that the draft seemed to
endorse the Federal Reserve’s system of firewalls and that we did not
consider the safeguards, such as customer protection rules administered
by SEC, or other regulatory and market safeguards that might show that
firewalls are unnecessary and/or ineffective. In addition, banking
groups felt we did not give sufficient emphasis to the burdens that
firewalls and other restrictions imposed on well-run institutions. They
also said we did not give sufficient emphasis to the reduced benefits for
corporate and individual customers that result from the firewalls.

We have not endorsed the Federal Reserve’s entire system of firewalls
as an essential part of expanded securities of bank holding companies.
However, we think a cautious approach to expanding powers is war-
ranted. Protecting against problem situations, which experience has
shown are sure to occur, is precisely a major purpose of financial mar-
ket regulation. The firewalls and other restrictions provide regulators
another set of tools for dealing with the types of problems that can arise
when banking organizations expand their securities operations. These
special provisions limit the scale of new activities and establish meas-
ures that regulators can enforce relatively easily. Of course, it remains
to be seen how effective the provisions will be. When bank holding com-
panies can demonstrate adequate capital, effective internal controls, and
ability to manage new powers in a responsible manner, consideration
can be given to reducing regulatory burden by relaxing some of the
firewalls in light of the other regulatory controls that are in place and
provided that sufficient regulatory resources are available.

In commenting on a draft of this report, the Bank Capital Markets Asso-
ciation said greater emphasis should be given to the point that some
firewalls could increase risk rather than reduce risk. One example the
Association cited was the absolute prohibition on a bank making loans to
its Section 20 affiliate if the affiliate is authorized to deal in corporate
debt and equity. The Association said that this prohibition could weaken
the overall structure of the banking organization during a liquidity crisis
such as we experienced in October 1987.

We agree with the Association’s concern in the example cited. In our
1988 report on issues related to repeal of the Glass-Steagall Act, we said
that to preserve the traditional liquidity role of banks, banks should be
permitted to lend to their securities affiliates, but only on an arm’s-
length basis.“l

“‘GAOIGGD-88-37,   January 1988, pages 7 and 8.




Page 17                                             GAO/GGD-9048   Bank Powers
5. Consumer protection. Clarification is needed as to the level of firewall
protection that is adequate to protect retail bank customers with money
to save or invest. Firewalls prevent banks from marketing securities
underwritten by Section 20 affiliates. One purpose of this restriction is
to keep customers from being confused about which products are
insured and which are not. However, the possibility for such confusion
already exists because a bank can sell securities products to its custom-
ers from a bank-owned discount brokerage subsidiary under conditions
far less stringent than those applied to Section 20 companies.

In commenting on a draft of this report, the Coalition for Regional Banks
said that customer confusion may be avoided by appropriate disclo-
sures. We agree that disclosures are important, but they may not in all
instances be sufficient to protect customers of insured depository
institutions.

6. Costs and competition. The cost of operating a Section 20 company
compared to a securities firm not affiliated with a bank is another area
that deserves further study. Banking officials said Section 20 companies
operate at a cost disadvantage due to capital requirements and various
firewalls. Securities firms officials, on the other hand, said that associa-
tion with banks gives Section 20 firms a cost advantage. Further investi-
gation of this issue was beyond the scope of this report.

7. Reciprocal treatment of securities firms. Another issue that should be
studied regarding the Section 20 arrangement is that no comparable
opportunity exists for domestic securities firms to expand into domestic
banking. However, determining the significance of Section 20 companies
from a fairness perspective is complicated by several considerations.

Under Section 23B of the Federal Reserve Act, all transactions between
holding company affiliates must be conducted on an arm’s-length basis,
so that a bank would not be permitted to give favorable treatment to an
affiliate in issuing or pricing a letter of credit. If effective, this provision
would reduce a bank’s potential competitive advantage, although banks
might still enjoy a competitive advantage from economies associated
with being able to combine banking and securities activities in a single
holding company. This advantage could result in some combination of
higher profits for banking organizations and lower prices for consumers.

Another complicating factor is that securities firms possess other advan-
tages over Section 20 subsidiaries and their bank holding companies. For



Page 18                                                GAO/GGD-90-48   Bank Powers
L--
      B-237795




                                                      .


      example, securities firms can be affiliated with activities such as insur-
      ance, which cannot generally be undertaken within bank holding compa-
      nies. Also, some securities firms are affiliated with so-called nonbank
      banks that were authorized prior to the Competitive Equality Banking
      Act of 1987 (CEBA).14 In addition, a securities firm can be affiliated
      with an overseas bank, which may provide it a degree of flexibility in
      relating securities and banking activities in both domestic and foreign
      markets that is not available to banking organizations. Furthermore, the
      parent holding companies of securities firms are not subject to the same
      type of regulation that the Federal Reserve imposes on bank holding
      companies.

      In commenting on the draft report, SEC said it agreed with our concern
      that the Section 20 arrangement provides no comparable opportunity
      for securities firms to expand into banking activities. SEC said that con-
      sideration should be given to amending the Bank Holding Company Act
      to permit securities firms to own banks without subjecting the securities
      firms and their holding companies to the full regulatory system applica-
      ble to banks and their holding companies. Various arrangements for
      associating banking and securities activities within a financial holding
      company need to be studied. However, we also believe that any struc-
      ture that is adopted needs to include appropriate controls over the
      entire holding company comparable to the Federal Reserve’s controls
      over bank holding company operations.

      In commenting on the draft report, the Coalition for Regional Banks and
      the Bank Capital Markets Association both said, in essence, that if
      safety considerations are satisfied, maintaining competitive equality
      between the banking and securities industries was not an important
      public policy objective. We believe that competitive equality is hard to
      define and that attempting to maintain a concept of competitive equality
      should not obliterate the importance of keeping US. financial markets
      healthy. However, as a practical matter, fairness issues are hard to
      ignore when changes are considered that affect industries as highly reg-
      ulated as the banking and securities industries.


      ‘“Nonbank banks were entities with bank or bank-like charters but did not meet the Bank Ilolding
      Company Act’s definition of a bank (an institution that both took demand deposits and made com-
      mercial loans). Nonbank banks could be owned by firms that were not bank holding companies and
      were not subject to the provisions of the Bank Balding Company Act. CEBA expanded the definition
      of a bank to include most institutions with FDIC insurance and thus put an end to the ability of
      companies to avoid the provisions of the Bank Holding Company Act by establishing nonbank banks.
      CXBA also grandfathered the existing nonbank banks but placed certain restrictions on their growth
      and activities.



      Page 19                                                            GAO/GGD-90-48     Bank Powers
B-237706




As arranged with the Subcommittee, we are providing copies of this
report to other interested Members of Congress, appropriate commit-
tees, executive branch agencies, and the public.

The major contributors to this report are listed in appendix XVII. If you
have any questions on this report, please call me on 275-8678.

Sincerely yours,




Craig A. Simmons
Director, Financial Institutions
  and Markets Issues




Page 20                                            GAOKGD-90-48   Bank Powers
Contents


Letter                                                                                             1

A’ pendix I                                                                                      28
  P
M,arket  Share, Pricing,   F;Jz; Share                                                           28
                                                                                                 31
a d Benefits to the        Benefits                                                              31
P“, blic
Appendix II                                                                                      34 .
Rsk to the Holding         The Nature of Risks in Section 20 Firms                               34
                           Risk to Affiliated Banks                                              37
Company
Appendix III                                                                                     40
Impact of Revenue          General Comments                                                      41
                           Revenue Limitation                                                    42
Limitation and             Capital Adequacy Conditions                                           44
Firewalls                  Restrictions and Prohibitions on Financial Ties Between               47
                               Banks and Section 20 Affiliates
                           Corporate Separateness: Prohibition Against Banks                     53
                               Sharing Employees and Information and Engaging in
                               Marketing Activities

Appendix IV                                                                                      58
Section 20
Subsidiaries’Activities
Appendix V                                                                                       68
Capital Structure and      The Capital Structure of a Bank Holding Company                       68
                           Capital Adequacy Rules for Section 20 Subsidiaries and                78
C&pita1Adequacy                Their Holding Companies
Requirements for
Bank Holding
Companies and
Section 20 Firms
            w




                           Page 22                                         GAO/GGDSO48   Bank Powens
                          Contents




                      4

Appendix VI                                                                                          80
The IRegulatory           Primary Legislative Provisions Affecting the Securities
                              Activities of Banking Organizations
                                                                                                     80

Framework Affecting       Recent Board Actions Affecting the Securities Activities                   90
the Securities                of U.S. Banking Organizations
                          SEC Regulation of Section 20 Companies                                     91
Activities of Banks
Appendix VII
Fireballs Applicable
to Section 20 Firms
Thart Underwrite and
Deal Only in Municipal
Revenue Bonds,
Mortgage-Related and
Asset-Backed
Securities, and/or
Commercial Paper
Appendix VIII
Firewalls Imposed by
the Federal Reserve
Board on Section 20
Companies Authorized
to Underwrite and
Deal1in Corporate Debt
and Equity Securities
Appendix IX
Comrnents From the
Board of Governors of
the Federal Reserve
System

                          Page 23                                            GAO/GGD-9048   Bank Powers
                         Contents




A’ pendix X                                                    108
C mments From the        GAO Comments                          110
0 fice of the
C mptroller of the
C! rrency
A pendix XI                                                    112
Cqmments From the        GAO Comments                          114
Sdcurities and
Exchange Commission
Aependix XII                                                   115
CQmmentsFrom the         GAO Comments                          118
American Bankers
Association
Appendix XIII                                                  119
C&-u-nentsFrom the       GAO Comments                          123
B&k Capital Markets
Association
Appendix XIV                                                   125
Cdmments From the        GAO Comments                          127
Association of Bank
Holding Companies
Appendix XV                                                    128
Comments From the        GAO Comments                          141
Coalition for Regional
Banks
            Y


                         Page 24        GAO/GGD-90-48   Bank Powers
                      Contents




Appkndix XVI
Comknts From the
Securities Industry
Assc/ciation
Appbndix XVII
                      General Government Division, Washington, D.C.



                                                                                              145

                      Table I. 1: Market Share of Section 20 Subsidiaries for                  28
                          Selected Bank-Ineligible Securities (Third Quarter
                           1989)
                      Table 1.2: Volume of Bank-Ineligible Securities                          29
                          Underwritten by Section 20 Firms During the Second
                          and Third Quarters of 1989
                      Table 1.3: Share of Revenue of Section 20 Firms                          30
                      Table 1.4: Comparison of Section 20 Firms’ Capital to the                30
                          Total Capital of the Securities Industry
                      Table IV. 1: Bank Holding Companies Authorized to                        60
                          Establish Section 20 Subsidiaries as of September 30,
                           1989
                      Table IV.2: Section 20 Subsidiaries That Had Commenced                   61
                          Bank-Ineligible Activities as of September 30, 1989
                      Table IV.3: Section 20 Subsidiaries Underwriting in                      61
                          Selected Bank-Ineligible Securities by Volume From
                          July 1, 1988, to September 30, 1989
                      Table IV.4: Revenues of Section 20 Subsidiaries, From                    65
                          July 1, 1988, to September 30, 1989 (Unaudited)
                      Table IV.5: Section 20 Firms’ Assets as a Percent of                     66
                          Parents’ Assets as of June 30, 1989 (Unaudited)
                      Table IV.6: Section 20 Firms’ Capital as a Percent of                    67
                          Parents’ Capital as of June 30, 1989 (Unaudited)
                      Table V. 1: Capital Structure of the Parent Companies of                 69
                          the 25 Largest Bank Holding Companies as of June
                          30,1989




                      Page 26                                          GAO/GGD-9048   Bank Powers
          Contents




          Table V.2: Capital Structure of the Parent Companies of                   70
              the 25 Largest Bank Holding Companies as of June
              30,1989
          Table V.3: Proportion of Parent Company Assets Invested                   71
              in Banking Subsidiaries for U.S. Bank Holding
              Companies Authorized to Set Up Section 20
              Subsidiaries as of December 3 1,1988
          Table V.4: Frequency of Double Leveraging in the U.S.                     74
              Bank Holding Companies Authorized to Set Up
              Section 20 Subsidiaries as of December 31, 1988
          Table V.5: Hypothetical Example of the Capital Structure                  75
              of a Consolidated Bank Holding Company
          Table V.6: Equity Capital as a Percentage of Bank Holding                 75
              Company Assets for US. Bank Holding Companies
              Authorized to Set Up Section 20 Subsidiaries as of
              December 31,1988
          Table V.7: Market Price as a Percentage of Book Value                     76
              Per Share for U.S. Bank Holding Companies
              Authorized to Set Up Section 20 Subsidiaries as of
              December 31, 1988
          Table V.8: Primary Capital as a Percentage of                             77
              Consolidated Bank Holding Company Assets for U.S.
              Bank Holding Companies Authorized to Set Up
              Section 20 Subsidiaries as of December 3 1, 1988
          Table VI. 1: Activities Closely Related to Banking and                    91
              Approved for Bank Holding Companies Contained in
              Regulation Y

Figures   Figure III. 1: Permissible Extensions of Credit to a Section              48
               20 Affiliate Under the 1987 Order
          Figure 111.2:Permissible Extensions of Credit to a Section                49
               20 Affiliate Under the 1989 Order
          Figure 111.3:Permissible Officer, Director, or Employee                    55
               Interlocks Between Section 20 Subsidiaries and
               Affiliates Under the 1987 and 1989 Orders
          Figure IV. 1: Section 20 Firms’ Market Share of                            62
               Underwriting for Selected Bank-Ineligible Securities,
               From July 1,1988, to September 30,1989
          Figure IV.2: Bank-Ineligible Municipal Revenue Bonds                       63
               Underwritten by Section 20 Firms, From July 1,
               1988, to September 30,1989




          Page 26                                             GAO/GGD-904   Bank Powers
           Contents




-..--.-i
           Figure IV.3: Bank-Ineligible Mortgage-Related Securities                    63
                Underwritten by Section 20 Firms, From July 1,
                1988, to September 30, 1989
           Figure IV.4: Bank-Ineligible Asset-Backed Securities                        64
                Underwritten by Section 20 Firms, From July 1,
                1988, to September 30,1989
           Figure IV.5: Bank-Ineligible Commercial Paper                               64
                Underwritten by Section 20 Firms, From July 1,
                1988, to September 30, 1989
           Figure IV.6: Revenues of Section 20 Firms, From July 1,                     66
                1988, to September 30, 1989
           Figure V. 1: Simplified Structure of a Bank Holding                         68
               Company
           Figure V.2: Hypothetical Example of the Capital                             73
               Structure of Bank Holding Company Subsidiaries
               (Dollars in millions)
           Figure VI. 1: Possible Organization Structure for the                       84
               Conduct of U.S. Bank Holding Company’s
               International Operations
           Figure VI.2: Limitations on Transactions Between                            86
               Affiliates in U.S. Banking Organization’s
               International Operations
           Figure VI.3: Constituent Elements of U.S. Bank Holding                      88
               Companies Eligible to Underwrite Corporate Debt



           Abbreviations

           FDIC       Federal Deposit Insurance Corporation
           GAO        General Accounting Office
           MSRB       Municipal Securities Rulemaking Board
           NASD       National Association of Securities Dealers, Inc.
           NYSE       New York Stock Exchange
           occ        Office of the Comptroller of the Currency
           SEC        Securities and Exchange Commission
           SIA        Securities Industry Association
           SRO        Self-regulatory organization
           Subs.      Subsidiaries
           IJS.       IJnited States
           lQ89       First quarter, 1989
           2Q89       Second quarter, 1989
           3Q89       Third quarter, 1989


           Page 27                                             GAO/GGD-9048   Bank Powers



                                                                                       ,,
Apjpendix I

l!@wketShare, Pricing, and Benefits to                                                                                                                ’
the Public

--.m
                                             This appendix discusses effects on market share, prices, and benefits to
                                             the public of Section 20 firms’ activity in the markets for commercial
                                             paper, municipal revenue bonds, asset-backed securities, and mortgage-
                                             backed securities. Since subsidiaries only began operations after June
                                             1988, trend analyses and comprehensive discussions of impact are diffi-
                                             cult to make.

       1


                                             To the extent possible, we estimated the market share of Section 20 sub-
Market Share                                 sidiaries in underwriting bank-ineligible securities on the basis of data
                                             we compiled from the subsidiaries themselves and estimates of total
                                             market activity compiled by industry sources. We also examined other
                                             indicators of the market impact of Section 20 companies-relative
                                             shares of total revenue and capital.


Urlderwriting          Data                  We obtained market activity data from each Section 20 subsidiary that
                                             as of September 30, 1989, had received approval from the Federal
                                             Reserve to do business in any of the four categories of the securities we
                                             were requested to examine. Table I. 1 shows the relevant total under-
                                             writing activity of the securities industry and, where possible, Section
                                             20 subsidiaries’ share of that volume in these securities for the third
                                             quarter of 1989. As noted, a comparable computation for market share
                                             cannot be made for commercial paper based on information available.

      1.1: Market Share of Section 20
      diaries for Selected Bank-lneliglble   Dollars in millions
Sedurities (Third Ouarter 1989)                                                              Total market            Section 20           Section 20
                                                       -____.--                                    volume               volume          market share
                                             Mortgage-backed       securitiesa                    $30,917.4                $600.0                    1.94%
                                             Municipal revenue bonds                               21,789.g                 385.6                    1.77
                                             Commercial paper                                            NAb             67,659.g                     NA
                                             Consumer-related receivables                          -2,447.8                  45.0                    1 .a4
                                             %ection 20 firms deal only in obligations that are secured by or represent an interest in one to four
                                             family residential real estate and are rated as investment quality by a nationally recognized rating
                                             agency, such as Moody’s.
                                             bNA: Not available. Quarterly market volume data for commercial paper are not compiled by industry
                                             sources. Data are available for the total amount outstanding for a given pornt in time.
                                             Sources: Investment Dealer’s Digest, GAO analysis,


                                             In the third quarter of 1989, Section 20 subsidiaries underwrote a total
                                             of $68,690.5 million in bank-ineligible securities, 98.5 percent of which
                                             was commercial paper. Of the 13 Section 20 firms doing business in
                                             bank-ineligible securities during the third quarter of 1989, the greatest


                                             Page 28                                                                  GAO/SD-90-48       Bank Powers
                                        Appendix I
                                        Market Share, Pricing, and Benefits    to
                                        the Public




                                        number had commenced activities in the municipal revenue bond market
                                        (10) and the commercial paper market (7). The top three firms
                                        accounted for about 65 percent of the total amount of ineligible securi-
                                        ties underwritten by Section 20 firms.

                                        The total volume of underwriting activity in bank-ineligible securities of
                                        Section 20 firms grew between the second and third quarter of 1989.
                                        Table I.2 shows that between the second and third quarters of 1989, the
                                        volume of bank-ineligible securities underwritten increased by $32,535.9
                                        million, or almost 90 percent. As mentioned above, the share of commer-
                                        cial paper was approximately 98.5 percent of all bank-ineligible securi-
                                        ties underwritten by active Section 20 firms (see app. IV). The high rate
                                        of increase reflects the fact that firms were still in a start-up period dur-
                                        ing the second quarter.

                                        In the third quarter of 1989, revenues from bank-ineligible securities
                                        activities accounted for about 1.8 percent of the total revenue of the
                                        Section 20 firms. Under the 10 percent revenue limitation, the revenue
                                        from underwriting and dealing in bank-ineligible securities could triple
                                        if total revenue for the firms stayed constant.

Table I.$ Volume of Bank-Ineligible
Securities Underwritten by Section 20   Dollars
                                        _-- .- in.._millions
Firms During the Second and Third         Number of active firms                                                           Increase
Quarteri of 1999                        2089                 3Q89                     2089                3Q89           Amount     Percent
                                                                                                                      ._-____
                                        13                          13           $36,154.7            $68,690.6        $32,535.9           90.0




Totals Revenue of Section               To provide additional insight into the market presence of Section 20
20 Subsidiaries                         firms, we examined the total revenues of Section 20 firms from all
                                        sources compared to total revenues of all securities firms. Total reve-
                                        nues include revenues generated from both bank-eligible’ and bank-
                                        ineligible activities, i.e., the four kinds of securities we examined plus
                                        the debt securities that were approved in January 1989 (see app. IV for
                                        a more detailed discussion of debt securities). Table I.3 compares the
                                        amount of revenues generated during the first and second quarters of
                                        1989 by Section 20 subsidiaries to the total revenue during the same



                                         ‘The bank-eligible revenues include bank-eligible activities that were being done by the subsidiaries
                                        prior to commencing bank-ineligible activities, as well as bank-eligible activities that may have been
                                        transfcrrcd from bank affiliates.



                                        Page 29                                                                GAO/GGD90-48        Bank Powers
                                             Appendix I
                                             Market Share, Pricing, and Benefits   to
                                             the Public




.._. .   - --.-   -
                                             periods for all securities firms registered with SEC. The revenue of Sec-
                                             tion 20 firms grew from 5.2 percent of the industry total in the first
                                             quarter of 1989 to 7.2 percent in the second quarter of 1989.

Table 1.3: Share of Revenue of Section 20
Fir&                                         Dollars in millions    ~....-__~                                      -___-    ..- ~~~~..
                                                    -~~-. --- -~~                        lQ89 ________2Q89                 Increase
                                             Section 20 subsidiaries                      $890     -~ $1,461
                                                                                                      20,,85-.--                 64.2%
                                                                                                                       -..-~~~~. ~ii,7
                                             Total securities industrv                   17.147
                                             Section 20 subsidiaries’ share of total        5.2           7.2
                                             Source: SEC, GAO analysis.

                                                                                                                                   -
Total Capital of Section 20                   Another measure of the relative size of Section 20 companies we
Subsidiaries                                  examined is the capital invested in the firms. Table I.4 shows the total
                                             “amount of capital (ownership equity plus subordinated debt, i.e., debt
                                              with claims on assets ranked below other, more senior debt) for all of
                                              Section 20 subsidiaries as of March 31, 1989, and June 30, 1989. The
                                              table also shows total capital for all securities firms registered with SEC.
                                              As of June 30, 1989, there was a total of $1,818 million of capital in
                                              Section 20 firms. This represented 3.7 percent of total capital in the
                                              securities industry. The share of industry capital in Section 20 firms
    ,                                         increased in the second quarter because the capital of Section 20 firms
                                              increased almost 27.5 percent while the total for the industry increased
                                              about 3 percent.

Table 1.4: Comparison of Section 20
Firms’ Capital to the Total Capital of the   Dollars in millions          _....__~~
Securities industry
                                             Section 20 subsidiaries
                                             Total securities industry
                                             Section 20 subsidiaries’ share of total
                                             Source: SEC, GAO analysis

                                             The capitalization of some individual Section 20 firms placed them
                                             among some of the larger securities firms registered with SEC. When
                                             ranked according to capital, 6 of the Section 20 firms were among the
                                             top 50 broker-dealers as of the end of the second quarter of 1989. Three
                                             of these 6 were among the largest 25 broker-dealers.




                                             Page 30                                              GAO/GGD-SO-48 Bank Powers
           Appendix I
           Market Share, Pricing, and Benefits   to
           the PubUc




           Although Section 20 firms seem to have the potential to increase their
           market presence, there is no way to know at this point how fast this will
           occur or whether it will occur at all. We observed that factors influenc-
           ing the growth of these subsidiaries include the profitability (success) of
           the firms, regulatory arrangements, and domestic and international mar-
           ket conditions.

           The Federal Reserve has some impact on the level of capital-and hence
           market penetration- available to Section 20 companies. Under the Fed-
           eral Reserve’s firewalls, bank holding companies must receive approval
           before increasing the capital the parent invests in their Section 20 sub-
           sidiaries. The Federal Reserve must also approve the acquisition of
           firms that might be merged into the Section 20 subsidiary. Thus, these
           subsidiaries cannot grow by direct investment by the parent or by acqui-
           sition without Federal Reserve approval. The firms can, however, accu-
           mulate retained earnings if they are successful. The Board also
           encourages Section 20 firms to seek capital infusions on their own by
           issuing debt directly to outside investors.


           Data were difficult to obtain concerning the impact Section 20 subsidi-
Pricing    aries’ entry into the securities market has had on pricing. Officials from
           both the banking and the securities industries said that profit margins
           were thin in most areas of activity. They also pointed out that prices
           were not necessarily good indications of profitability. They said that
           while Section 20 firms’ pricing for their underwriting activities have
           generally followed industry trends, the profitability of each underwrit-
           ing will be affected by the terms and conditions of each transaction.
           Securities analysts could not provide us with evidence of price-cutting.

           One official from a Section 20 subsidiary said that the firm did not want
           to undercut prices and that it had little economic incentive to do so.
           Because of the 10 percent revenue limit, the official said they have no
           incentive to build market share by reducing prices below costs.


           This section discusses the benefits to the public of Section 20 subsidi-
Benefits   aries In theory, Section 20 subsidiaries may benefit customers by add-
           ing competition, convenience, and liquidity to the various securities
           markets. These benefits are particularly important for two reasons.
           First, the securities market is expanding due to such factors as techno-
           logical changes that make it easier for many firms to raise money by



           Page 31                                             GAO/GGD-9048   Bank Powers
     Appendix I
     Market Share, Pricing, and Benefits   to
     the Public




--
     issuing securities. Section 20 subsidiaries provide these firms with addi-
     tional sources for raising money from capital markets. Second, certain
     segments of the securities markets are concentrated relative to the bank-
     eligible segments of these markets. For example, the top five securities
     firms underwrote approximately 93 percent of all asset-backed securi-
     ties in the first 9 months of 1989. Concentration may also be present in
     the market for mortgage-backed securities where the top 5 firms under-
     wrote 60 percent of these securities during the first 9 months of 1989.
     The top 5 firms underwrote almost 53 percent of the municipal revenue
     bonds issued during the first 9 months of 1989, while the top 5 firms
     underwrote about 37 percent of the municipal general obligation bonds
     issued during the same period. Additional competition may lead to lower
     prices and may also lead to greater innovation and better service. How-
     ever, several analysts said there are significant economies of scale in
     securities underwriting, and therefore it was difficult to say whether
     Section 20 companies will make much of a difference in reducing market
     concentration.

     Regional banks in particular said they can offer better service to cus-
     tomers, especially middle-sized corporations, that would not usually
     enter the securities market. They said this would increase the sources of
     lower cost funds to these firms and would also enhance the liquidity of
     the market due to increased activity. We heard conflicting views from
     analysts about how significant this untapped market is.

     Section 20 subsidiaries have not existed long enough for us to measure
     actual benefits. To get some appreciation of the actual benefits Section
     20 firms have brought to the marketplace thus far, we talked to indus-
     try specialists in some of the markets served by Section 20 firms. They
     all agreed that the market impact of bank-ineligible securities has been
     minimal.

     Industry specialists, however, differed on their views of the long-term
     effects of Section 20 subsidiaries, depending on the particular product.
     One underwriting analyst predicted that Section 20 subsidiaries will add
     to the overcapacity already found in the industry, especially in fixed-
     income securities such as municipal revenue bonds. He foresaw a drop in
     prices, which will not benefit the subsidiaries since margins are already
     thin. In the short run, issuers of securities would benefit. He also sug-
     gested that in order for securities firms to defend themselves against the
     competition, they will need a bigger capital base. According to the offi-
     cial, in the long run this growth in capital would result in a more concen-
     trated market, with only the largest firms surviving because of their


     Page 32                                            GAO/GGD-90-48   Bank Powers
Appendix I
Market Share, Pricing, and Benefits   to
the Public




ability to raise new capital. An official of an association that represents
participants in the municipal revenue bond market said issuers are
becoming more sophisticated and demanding more competitive arrange-
ments. They are, for example, soliciting bids for traditionally unsolicited
negotiated deals. Additional competition from the Section 20 subsidi-
aries will add to this trend, which he believed will eventually lead to
consolidation among revenue bond underwriting.

To date, Section 20 firms have been created as new firms, resulting from
reorganizations within the holding company. Since Section 20 firms were
newly created entities, they have added to the number of firms in the
market able to reach more potential issuers and investors in the market
for bank-ineligible securities. The number of market participants will
not expand if bank holding companies build up their Section 20 compa-
nies by acquiring existing securities firms. As noted in appendix III,
some securities industry representatives believed that banks could eas-
ily acquire and operate existing securities firms under the 10 percent
revenue limit imposed by the Federal Reserve.

Officials from the Section 20 subsidiaries suggested that these subsidi-
aries offered greater convenience and innovations to clients. For exam-
ple, they said bank holding companies can more closely and more
quickly meet the needs of the customer, especially businesses, through
“one-stop-shopping,” that is, being able to offer a variety of services to
meet the financing needs of their customers through one entity. On the
other hand, banking representatives said that firewalls, such as the
inability of the bank to market the products of an affiliated securities
firm, prevented some of the potential benefits of one-stop-shopping
from being realized. A spokesperson for the securities industry doubted
the validity of the one-stop-shopping concept. The representative said
that historically, institutional customers obtain their financial services
from more than one institution, They want to diversify their portfolios
and sources of financing not only by type of investment, but also by
suppliers of financial services.




Page 33                                             GAO/GGD-90-48   Bank Powers
  I
Appendix II

Risk to the Holding Company


                         This appendix discusses how the operations of Section 20 subsidiaries
                         have affected the risk levels of bank holding companies. It also discusses
                         differences between risk to the holding company and risk to an affili-
                         ated bank. We define risk as the probability of experiencing significant
                         financial difficulty, perhaps sufficient enough to cause the firm to fail.


                         Underwriting and dealing in securities involves market, credit, and busi-
The Nature of Risks in   ness risks. Market risk is the situation where securities purchased by
Section 20 Firms         the Section 20 firm in an underwriting or dealing capacity fall in price
                         due to changes in general economic conditions. Possible increases in
                         interest rates are a major source of market risk. Credit risk represents
                         the situation where an issuer is unable to pay interest and principal
                         according to the terms of the debt offering. Credit risk generally applies
                         only to the time that a Section 20 firm owns the security, in order to
                         protect its reputation, a firm may feel obligated to absorb some losses in
                         situations involving securities initially underwritten by the firm, if those
                         losses occur within a short period of time after the underwriting. Busi-
                         ness risk represents the inability to earn a profit from entering a new
                         line of business. For example, some U.S. banking organizations have
                         scaled back their securities activities in overseas markets in response to
                         losses they experienced due to high costs and low spread margins.

                         Although there are risks involved in underwriting and dealing in securi-
                         ties, these risks need to be assessed in association with the risks of other
                         activities of bank holding companies. Bank holding companies are
                         already authorized to assume many risks through such activities as
                         making and holding commercial loans, trading in government bonds, and
                         entering into forward contracts in the foreign currency markets.

                         In approving broader bank holding company securities powers in Sec-
                         tion 20 holding company subsidiaries, the Federal Reserve Board deter-
                         mined that this would allow them to diversify further their activities
                         and generate new sources of revenue at a manageable level of risk, thus
                         strengthening the overall banking organization, This action of the Board
                         was consistent with the observation financial analysts have made that,
                         considered in isolation, underwriting securities involves less risk than
                         extending and holding loans. For example, Robert E. Litan wrote in a
                         1987 Brookings Institution Study:

                         “In a typical securities offering, the underwriter bears the risk of loss for only a few
                         days, whereas a commercial bank bears the risk of a loan default until the loan is
                         due. In addition, by definition, the underwriter deals in assets that are liquid and



                         Page 34                                                     GAO/GGD-90-48   Rank Powers
--
             Appendix II
         ,   Risk to the Holding   Company




             readily traded; despite the progressive securitization of commercial bank balance
             sheets, most bank loans remain illiquid because they are specific to the borrower.“’

     ,       The Section 20 companies are also fully SEC-regUl&d                          as is any securities
             firm.

             The financial statements of the nation’s top 25 bank holding companies
             illustrate the scale of bank holding company activities that can generate
             risks. The combined balance sheet assets of these companies as of June
             30, 1989, was $1.4 trillion. Of this amount, $216 billion, or about 15 per-
             cent of the total, was in commercial and industrial loans held by banking
             or nonbanking subsidiaries. Another $38 billion (about 3 percent of
             assets) was held in trading accounts. Off-balance sheet commitments as
             of that date that could also generate risks included $2.2 trillion in com-
             mitments to purchase foreign currencies and U.S. dollars; $1.1 trillion in
             interest rate swaps; over $600 billion in futures, forwards, and standby
             contracts;” and about $600 billion in various loan commitments and let-
             ters of credit.

             The fact that Section 20 firms allow bank holding companies the oppor-
             tunity to reduce risk by additional diversification does not mean that
             the companies will actually use the new powers to reduce risk. At the
             present time, experience does not allow a determination on whether the
             new activities, either individually or collectively, have actually
             increased or decreased risk to the holding company. For example, it is
             not possible to draw conclusions at this time about how profitable the
             new subsidiaries will be.

             To date, a number of the Section 20 firms have been examined by NASD
             and the Federal Reserve. We have been advised by officials of these
             organizations that no significant uncorrected problems in the operations
             of these firms have been detected. Similarly, officials at the Federal
             Reserve System cannot point to any known instance since the Section 20
             subsidiaries have commenced bank-ineligible activities in which the
             activities of a Section 20 subsidiary have adversely affected a bank
             holding company.

             ‘Hobert E. Litan, What Should Hanks Do?, Washington, DC: The Bookings Institution, 1987, pp. 88-
             89.
             21nterest rate swaps are transactions used to hedge against or displace interest rate risks. Futures
             contracts are exchange traded contracts for delayed delivery of securities or money market instru-
             ments in which the buyer agrees to purchase and the seller agrees to deliver, at a specified future
                  of a specified instrument at a specified price or yield. Standby contracts are optional delivery
             ddtc?,
             contracts.



             Page 35                                                                 GAO/MS904         Bank Powers
         Appendix II
         Risk to the Holding   Company




        The recent thrift industry debacle demonstrated clearly the dangers
        associated with allowing financial institutions to engage in new activi-
        ties that, if not well managed or regulated, can destroy the financial
        health of the firms. Undercapitalized thrifts were able to expand rapidly
        into new activities after 1982, and thrift regulators were unprepared to
        supervise and control the activities of many problem institutions.:’

        Federal Reserve authorization of new activities for Section 20 subsidi-
        aries has followed a different set of policies from those that character-
        ized the thrift industry. The Board has approved Section 20 subsidiaries
        on a case-by-case basis. This has allowed the Federal Reserve Board to
        assess the adequacy of each holding company’s capital and management
        systems before new activities could be undertaken. Furthermore, a
        number of specific restrictions (firewalls) were placed on the firms to
        limit the risk to the holding company that could result from the new
        activities. These included the following:

    l   The subsidiary must be separately capitalized such that the capital
        meets SECstandards and industry norms and does not detract from the
        adequacy of the capital associated with holding company activities
        outside of the Section 20 subsidiary. The financial press, such as the
        American Banker, had reported several instances in which holding com-
        panies had to increase their equity capital in order to obtain Federal
        Reserve approval to expand the powers of a securities subsidiary.
    l   The scale of new activities is controlled by requiring approval of all
        funds invested in the subsidiary and by limiting revenues from new
        activities to 10 percent of the revenues of the subsidiary. The revenue
        limitation means that 90 percent of the revenues of the subsidiary must
        come from activities authorized to be conducted directly by a national
        bank or a state member bank. The result of these limitations is that only
        a small portion of the revenue of the Section 20 subsidiary can be
        derived from heretofore ineligible activities, and only a small portion of
        the holding company’s capital is at risk in these new activities.
l       Restrictions are placed on the internal operations of the holding com-
        pany to limit the extent to which the bank can incur risks in support of
        affiliate Section 20 companies.

        These restrictions and their practical effect on holding company opera-
        tions are discussed at greater length in appendix III.


        “It should be emphasized, however, that by no means can all of the problems in the thrift industry bc
        attributed to new activities.



        Page 36                                                              GAO/GGD-90-48      Bank   Powers
--&.-
        ”
                     Appendix II
                     Risk to the Holding Company




                     The firewall restrictions imposed by the Federal Reserve are not, how-
                     ever, all designed simply to protect the safety and soundness of the
                     bank. Some of them serve other purposes as well. These other purposes
                     include protecting customers against conflict-of-interest abuses and iso-
                     lating selected securities activities from the federal safety net for banks,
                     especially deposit insurance. Competitive considerations associated with
                     having banking and nonbanking organizations participating in securities
                     markets also played a part in the design of the firewalls.

                     The firewalls most directly related to protecting the safety and sound-
                     ness of the bank are those concerned with bank extensions of credit and
                     purchases of assets in situations that involve the activities of Section 20
                     companies. It should be noted that many of these firewalls do not apply
                     to the overseas activities of bank holding companies.

                     It is, of course, too early to say whether the various provisions will
                     work as intended to protect the holding company from excessive risks.
                     However, the controlled expansion of Section 20 companies has given
                     the Federal Reserve System, as regulator of the holding company, tim e
                     to develop expertise in regulating the new activities.


                     In a 1987 report on insulating banks from potential downside risks of
Risk to Affiliated   expanded activities, we concluded that risks to the bank and its insured
Batiks               deposits cannot be completely eliminateds4 W e pointed out, however,
                     that risks to the bank would be m inimized by separating the nonbank
                     activities legally, economically, and in the perception of the market. The
                     specific means for accomplishing these objectives involved such things
                     as separation of boards of directors and places of business; restrictions
                     on flow of funds from the bank to the affiliate; and controls over pricing
                     of services to affiliates, marketing arrangements, and corporate powers.

                     The restrictions placed on Section 20 companies seem generally to con-
                     form to the conditions that we found would be necessary for insulation.

                     To date, there is no evidence that the activities of Section 20 companies
                     have adversely affected bank affiliates, It should also be noted, how-
                     ever, that such damage, were it to occur, would be most likely to occur
                     at a tim e when either the bank or the Section 20 firm was under great


                     “Bank Powers: Insulating Banks From the Potential Risks of Expanded Activities, (GAO/GGD-8735,
                     Apr. 14, 1987).



                     Page 37                                                         GAO/GGD-90-48    Bank Powers
         Appendix II
         Risk to the Holding   Company




--
         financial stress. To date, none of the Section 20 firms have operated
         under these conditions.

         As discussed in greater length in appendix III, holding companies believe
         that the Board’s limitations on the revenues a Section 20 firm can gener-
         ate from bank-ineligible securities activities can force them to make bus-
         iness decisions based strictly on regulatory considerations. For example,
         the revenue limitation requires a sufficient level of revenues from bank-
         eligible securities activities to assure that a Section 20 firm does not
         exceed the revenue limitation. Since the start-up costs for securities
         activities are significant, holding companies may opt to transfer bank-
         eligible securities activities from both bank and nonbank subsidiaries
         into the Section 20 subsidiary. Transfer of such profitable activities
         from a bank could negatively affect the overall performance and finan-
         cial condition of the bank. It would also, by definition, make the bank
         smaller and less diversified. Some capital may also be moved out of the
         bank along with the transfer of functions.

         Federal Reserve officials acknowledge that the indirect effect of the rev-
         enue limitation may be counter-productive in that a less risky activity
         may be transferred from a bank to a Section 20 subsidiary. However,
         these officials note that the 10 percent revenue limitation is based on
         legal, rather than financial, considerations. The Federal Reserve offi-
         cials also point out that the firewalls are based on the concept that risks
         from securities activities must be kept separate from and insulated from
         the bank. They said that losses, if any, from securities activities:

     l should not enjoy protection of deposit insurance or other aspects of the
       federal safety net for depository institutions; and
     . should not be transmitted to a bank’s income statement because volatil-
       ity of reported earnings may cause loss of confidence in a bank.

         There exists a trade-off between potential benefits and losses relative to
         the bank. The outcome of this trade-off depends on whether the activi-
         ties turn out to be profitable or only some securities activities are
         required to be done outside the bank.

         If Section 20 companies are profitable, the holding company is strength-
         ened. It is not clear, however, how this necessarily contributes to
         strengthening an affiliated bank. Funds sent to the parent by the Section




         Page 38                                            GAO/GGD9048   Bank Powers
Appendix II
Risk to the Holding   Company




20 subsidiary are directly available to an affiliated bank only if the par-
ent decides to reinvest them in the bank.”

The Federal Reserve has a policy incorporated in its Regulation Y that a
holding company shall serve as a source of financial and managerial
strength for its banks. However, the exact conditions under which the
holding company can be required to use nonbanking assets of the hold-
ing company to support an affiliated bank and protect the deposit insur-
ance fund have not been set out in detail.

Questions can also be raised about the net effects of some of the
firewalls. If it is true that there are benefits from combining banking
and securities activities within one banking organization, many of these
benefits would likely show up as additional profitable bank activities.
By restricting the ability of the bank to participate with securities affili-
ates, the firewalls may make it harder for the bank to benefit from the
expanded powers.

In addition, some banking officials have suggested that the management
structure required to comply with firewall restrictions may make it
harder to control risk exposure on a holding company-wide basis. This is
discussed in appendix III.




“Payments to the parent by the Section 20 subsidiary may, however, make it easier for the parent to
leave more bank profits in the bank. In addition, the parent would be in a better position to inject
additional capital into the bank to comply with capital requirements if asked to do so by the Federal
Reserve.




Page 39                                                               GAO/GGD-99-48     Bank Powers
Adpendix III

Impact of Revenue Limitation and F’irewalls


                   This appendix summarizes the comments of industry officials and regu-
                   lators about the practical impact of special regulatory restrictions the
                   Federal Reserve Board imposed on the operations of Section 20 subsidi-
                   aries. These restrictions, often called firewalls, can be grouped into the
                   four following categories:

               l revenue limitation;
               . capital adequacy conditions;
               . restrictions and prohibitions on financial ties between banks and Section
                 20 affiliates;! and
               l prohibition against banks sharing employees or confidential informa-
                 tion, or engaging in marketing activities on behalf of a Section 20
                 affiliate.

                   Except for the revenue limitation, the firewalls supplement provisions in
                   federal statutes that govern the relationships between banks and their
                   affiliates and regulate securities activities.

                   The Board has actually issued two sets of firewalls. The first set, con-
                   tained in the 1987 Order, applies to Section 20 companies that have been
                   authorized to underwrite and deal only in municipal revenue bonds,
                   mortgage-related securities, consumer-receivable-related securities, and
                   commercial paper. (This act is contained in app. VII.) The latter set of
                   firewalls, contained in the 1989 Order, applies to Section 20 companies
                   that are also authorized to underwrite debt and equity securities. (See
                   app. VIII.)

                   Our judgments about the practical impact of the firewalls were limited
                   by the short time Section 20 subsidiaries have been operating, the lack
                   of nonproprietary information, and limited time available to complete
                   this assignment, We addressed the practical effects of firewalls by inter-
                   viewing officials in the regulatory agencies and the commercial banking
                   and investment banking industries. In the banking industry, we obtained
                   the views of officials who operate Section 20 subsidiaries and those who
                   are considering doing so. We included representatives of both multina-
                   tional and regional bank holding companies in our discussions.

                   We have summarized the general comments of the industry officials and
                   regulators as well as some of the specific comments made about each
                   category of firewall restrictions.

                   ‘licstrictions that apply to insured bank affiliates generally apply in the same manner, and to the
                   same extent, lo fcdcrdlly insured thrift affiliates and to subsidiaries of bank or thrift affiliates.



                   Page 40                                                                 GAO/GGD90-48       Bank Powers
                  Appendix 111
                  Impact of Revenue Limitation   and Firewalls




                  In general, banking officials with whom we spoke said that the process
Gen@al Comments   the Board used in approving Section 20 subsidiary activities was appro-
                  priate. They said that the Board’s case-by-case approval process and
                  limits on the scale of new underwriting and dealing activities allowed
                  the Board to ensure that individual companies would carry out the new
                  activities gradually and cautiously, while also maintaining regulatory
                  requirements, While the banking officials with whom we spoke also saw
                  the necessity of imposing some restrictions in order to protect the bank,
                  its depositors, and the federal safety net, some officials expressed con-
                  cern that the Board has gone too far in attempting to provide that pro-
                  tection. They said the firewalls unnecessarily raised costs, created
                  management problems, and made it harder to service customers com-
                  petitively. A number of banking representatives believed that regula-
                  tory tools available to bank regulators, SEC, and the Federal Reserve
                  could sufficiently protect against abuses without the additional costs
                  incurred with the firewall provisions.

                  Securities industry officials with whom we spoke said that requiring
                  bank holding companies to establish a separate underwriting subsidiary
                  that is operationally and financially independent of insured bank affili-
                  ates is the most appropriate way to permit bank expansion into securi-
                  ties underwriting. However, these officials questioned the need for
                  allowing bank holding companies to underwrite securities. In support of
                  this view, they pointed to the low profitability in the underwriting
                  activities that have been authorized and the generally higher profit mar-
                  gins of regional and smaller banks that were not engaged in domestic or
                  overseas securities activities.

                  Some securities industry officials also questioned the effectiveness of
                  some of the firewalls and said that Section 20 companies would benefit
                  from special federal programs for banks such as deposit insurance. The
                  officials also said that existing arrangements would allow bank holding
                  companies eventually to acquire most independent broker-dealers.


Comments From     In its 1987 Order, the Board said that the existing regulatory framework
Regulators        for banks, bank holding companies, and securities firms has not yet been
                  proven effective in protecting against potential conflicts of interest,
                  unsound banking practices, and other adverse effects associated with
                  commercial bank and investment bank affiliation. Accordingly, in
                  approving expanded activities for bank holding companies, the Board
                  determined that the existing framework should be supplemented by the
                  additional limitations contained in the firewalls. The Board indicated,


                  Page 4 1                                          GAO/GGD90-48   Bank Powers
                      Appendix III
                      Impact of Revenue Limitation   and Firewalls




                      however, that it would consider modifying some of the firewalls and
                      other restrictions.

                     To date, the Board has modified several firewalls. Federal Reserve offi-
                     cials recognized that the firewalls created some inefficiencies and
                     increased the operating costs for bank holding companies. However,
                     they believed that the potential conflicts of interest and unfair competi-
                     tion would be difficult to monitor and control without the firewalls.
                     Moreover, they believe that need to minimize the transfer of risk to fed-
                     erally insured depository institutions and the federal safety net out-
                     weigh the benefits to the holding company of efficient operations or
                     lower operating costs.


                     The Board’s 1987 Order concluded that engaging in bank-ineligible
Rkvenue Limitation   activities would not violate Section 20 of the Glass-Steagall Act if the
                     subsidiary derived only 5 percent to 10 percent of its gross revenues
                     from underwriting and dealing in bank-ineligible activities. As previ-
                     ously noted, the revenue limitation, originally set at 5 percent, was
                     raised to 10 percent in 1989.


Cdmments From Bank   The revenue limit was a concern among all the bank holding company
Ccimpany Officials   officials with whom we spoke. Officials in multinational bank holding
                     companies said the lo-percent limit has allowed them more flexibility
                     than did the 5-percent limit. They reported that they currently do not
                     have significant difficulties operating within the lo-percent limit
                     because they have proceeded slowly. However, they projected that the
                     lo-percent limit could become a constraint over the next few years
                     because, as their operations continue to mature, the Section 20 firms
                     will probably generate ineligible revenues that will approach the current
                     revenue limit. Regional bank holding company officials said that
                     although the new 10 percent revenue limit has eased entry for some
                     regional bank holding companies, the revenue limit continues to con-
                     strain their operations because of the difficulty in transferring bank-
                     eligible activities into the Section 20 firm sufficient to support antici-
                     pated levels of bank-ineligible activities.

                     Both multinational and regional bank holding company officials shared
                     the concern that the revenue limit forces managers to make decisions
                     about how to structure their products lines and services primarily on
                     the basis of the amount of revenue the activity would generate. This
                     particularly concerned companies that were not primary dealers or that


                     Page 42                                            GAO/GGD-90-48   Bank Powers
                            Appendix III
                            Impact of Revenue Limitation      and Fhwalls




                            otherwise did not trade a large volume of government securities.z Offi-
                            cials commented that in order for many companies not involved in
                            extensive government securities trading to establish a Section 20 subsid-
                            iary, it would be necessary to combine some operations that may not fit
                            well together from a business perspective.

                            Some officials were reluctant to consolidate nonbanking operations in
                            the Section 20 subsidiary. While these activities would generate eligible
                            revenue, the officials said that the SEXnet capital rule and the firewall
                            requiring a bank holding company to deduct investments in the Section
                            20 subsidiary from regulatory capital make funding these operations
                            more expensive than if the activities were done outside the subsidiary.
                            This appears to have had the greatest impact on regional holding
                            companies.

        /
Cornbents From Securities   One securities industry official commented that the 10 percent revenue
Indubtry Officials          limit effectively permits bank holding companies to rank among the top
                            investment bank companies. This official noted that the entire invest-
                            ment industry’s underwriting revenues were only about 8 percent of
                            gross revenues in the first half of 1989 and said that most of the other
                            revenues earned by the investment industry were derived from bank-
                            eligible activities. Therefore, the official suggested that a bank holding
                            company could buy an existing large investment bank and still be within
    !                       the 10 percent revenue limit.

                            While not disputing the point that banks may find acquisition of an
                            existing securities firm an attractive expansion route, another securities
                            industry official noted that underwriting securities is not the only activ-
                            ity that generates bank-ineligible revenues for securities firms. For
                            example, the official said underwriting mutual funds and insurance-
                            related products and secondary market trading associated with bank-
                            ineligible securities are important sources of bank-ineligible revenues to
                            some securities firms.




                            “Hank holding company officials have said that Section 20 subsidiaries that are not primary dealers
                            find it difficult to generate sizeable levels of eligible revenues to measure against ineligible revenues.
                            A number of bank holding company officials have commented to the Federal Reserve that it is diffi-
                            cult to enter the over-thecounter 1J.S.government securities market because margins have declined,
                            and start-up costs and ovcrh(?l,l :tw significant.



                            Page 43                                                                  GAO/GGD-90-48      Bank Powers
  -I--                Appendix III
   I                  Impact of Revenue Limitation   and Firewalls




  $nments From       Federal Reserve officials said that in principle the firewalls do not pro-
  ? wlators          hibit a bank holding company from acquiring an investment banking
   f                 firm. However, they said it is not obvious from investment banks’
   I                 reports of income what portion of their revenues is derived from bank-
   ~                 eligible or bank-ineligible activities. Accordingly, they have no way of
                     knowing whether a bank holding company could, in fact, purchase a
                     diversified broker-dealer and operate within the firewall requirements,

                     The officials said that they are not concerned about whether the 10 per-
                     cent revenue limit allows Section 20 subsidiaries to rank among the larg-
                     est investment banking firms. They said that the market should
                     determine the size of the firm. In addition, the officials said that the
                     Glass-Steagall Act does not specify what size bank-affiliated underwrit-
                     ing subsidiaries should be, as long as they are not “engaged principally”
                     in underwriting and dealing in bank-ineligible securities. At the present
                     time, they said, the revenue limit, rather than size, is the appropriate
                     measure of the extent to which a firm can underwrite bank-ineligible
                     securities without being “engaged principally” in that activity.


                     The firewalls related to capital require Section 20 subsidiaries and their
Capital Adequacy     parent bank holding companies to maintain adequate capital at all times.
Conditions           The firewalls also require that investments in a Section 20 subsidiary be
                     deducted from the parent company’s regulatory capital for determining
                     compliance with capital adequacy guidelines. (See app. V.) In addition,
                     the 1989 Order requires that unsecured extensions of credit to the Sec-
                     tion 20 subsidiary by the parent bank holding company or any of its
                     nonbank subsidiaries also be deducted from the parent company’s regu-
                     latory capital. Together, these restrictions are intended to ensure that a
                     bank holding company maintains a strong capital position to support its
                     subsidiary banks and that the resources needed for that support would
                     not be put at risk to fund the securities activities of the Section 20
                     subsidiary.


Comments From Bank   Overall, the officials with whom we spoke did not identify significant
Corbpany Officials   problems with the requirement that the Section 20 subsidiary be ade-
                     quately capitalized in accordance with industry norms. However, there
                     was no consensus about what the industry norm really is for a Section
                     20 subsidiary. Broker-dealers tend to have capital that is several times
            u        greater than SEC’s net capital requirements. The officials believed that
                     the market determines the appropriate level of capital for a broker-
                     dealer.


                     Page 44                                            GAO/GGD-90-48   Bank Powers
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          Appendix III
          Impact of Revenue Limitation     and Firewalls




          Regional bank holding company officials raised concerns about deduct-
          ing capital investments in the Section 20 subsidiary from the regulatory
          capital of the parent bank holding company. They believed that the mar-
          ket for new capital is such that it is prohibitively expensive for regional
          companies to raise new capital. In that regard, the officials said the capi-
          tal requirement would be met primarily by moving part of the capital
          base from the bank subsidiary to the Section 20 subsidiary. They
          believed these transfers could potentially weaken the bank by reducing
          its capital base and by leaving its balance sheet less diversified.

          Officials of some multinational bank holding companies said the require-
          ment that unsecured extensions of credit between the parent or any of
          its nonbank subsidiaries and the Section 20 company be deducted from
          the parent company’s capital is unnecessary and costly.:J The officials
          said that this requirement essentially cuts the Section 20 subsidiary off
          from a relatively low cost of funding-the      parent company’s access to
          the capital markets- and increased the subsidiary’s cost of raising
          funds relative to its competitors’ costs. For example, in order for a par-
          ent company loan to a Section 20 subsidiary to be exempt from the
          deduction from the parent’s regulatory capital, the subsidiary must col-
          lateralize the loan in the same manner and to the same extent that
          would be required under Section 23A of the Federal Reserve Act.”
          Because competitors of Section 20 subsidiaries do not have to contend
          with such a restriction, and can therefore raise funds through their par-
          ent relatively easily, officials believed that the Section 20 subsidiary’s
          funding costs are higher than those of their competitors.

          Some officials we spoke with said that the firewalls encourage the Sec-
          tion 20 subsidiary to raise funds by borrowing from nonaffiliated com-
          panies. Under this alternative, the subsidiary simply borrows funds
          from unaffiliated banks at market rates. The officials said that they



          “This rcquircment primarily affects the bank holding companies that received expanded powers
          under the Doard’s 1989 Order. In the Board’s earlier Order, no limit was placed on the amount of
          funds that a holding company and its nonbank affiliates could lend to the Section 20 subsidiary.

          ‘Although Section 23A of the Federal Reserve Act governs extensions of credit between member
          banks and affiliates, the Board specifically required that its collateral requirements apply to cxton-
          sions of credit between a Section 20 subsidiary and affiliates. Under this requirement, extensions of
          credit must be collateralized with securities valued between 100 and 130 percent of the value of the
          loan. For example, if 100 percent of the amount of an advance from the holding company is secured
          by U.S. government securities, no deduction from the holding company’s capital is required. If mar-
          k&able equity securities are used to secure the advance, the market value of these securities must be
          equal to 130 percent of the amount of the loan in order to avoid deduction from the holding com-
          pany’s capital.



          Page 45                                                                 GAO/GGD9048       Bank Powers
                             Appendix III
                             Impact of Revenue Limitation   and Firewalls




                             would prefer to pay market rates to their affiliates for funds rather
                             than pay these rates to competitors.


    mments From Securities   Securities industry officials said that the market already awards bank
    ustry Officials          holding companies a lower cost of funds than some of its competitors
                             that have higher credit ratings because of the implicit extension of the
                             federal safety net from the bank subsidiary to the entire holding com-
                             pany. They believed that Section 20 subsidiaries should not be allowed
                             to obtain funding through their parent bank holding companies, because
                             such funding would jeopardize the financial resources that should be
                             available for the bank subsidiaries and would give Section 20 subsidi-
                             aries an unfair competitive advantage because of their ability to obtain
                             low cost-funding.

--a--.
Coimments From               In the Board’s 1989 Order, it noted that in view of the amount of the
Regulators                   investment that may be required to support the activities of Section 20
                             firms, it was important to ensure that the holding company does not
                             impair its financial resources through its funding of a Section 20 subsidi-
                             ary. Under the Board’s source of strength policy, a holding company
                             should maintain the financial flexibility and capital-raising capacity to
                             obtain additional resources for assisting its subsidiary banks.

                             The Board also noted that these requirements were essential because
                             they tend to ensure that the Section 20 subsidiary maintains adequate
                             levels of capital to support its operations on a stand-alone basis. The
                             Board believed it essential to limit the Section 20 subsidiary’s ability to
                             draw on the resources of the parent holding company to help ensure
                             that the market would evaluate the financial standing of the Section 20
                             subsidiary on the basis of its own resources.

                             In both the 1987 and 1989 Orders, the Board noted that with respect to
                             investment bank officials’ claims, no evidence showed that a Section 20
                             subsidiary would by reason of its affiliation with federally insured
                             banks necessarily have access to lower cost funds than its competitors
                             that were not affiliated with banks. The Board indicated that rates paid
                             by bank holding companies on their commercial paper have generally
                             been the same as those paid by corporations of similar size and credit
                             ratings. Furthermore, according to the Orders, a corporation’s funding
                             costs are a function of a variety of economic factors, including size, capi-
                             tal, and earnings. The Orders also noted that while the regulatory
                             framework under which a corporation operates is a factor that might


                             Page 46                                             GAO/GGD90-48   Bank Powers
                        Appendix III
                        Impact of Revenue Limitation    and Firewalls




                        affect the cost of funds, the same bank regulatory structure that pro-
                        vides deposit insurance also imposes restraints and costs on the opera-
                        tion of banks and their affiliates that were not imposed on other
                        corporations.

       1


                        In both the 1987 and 1989 Orders, the Board specified a number of
Res&rictions and        firewalls designed to limit the transfer of risk in the activities of the
Pro@bitions on          Section 20 subsidiary to the federal safety net and to federally insured
Fin* ncial Ties         banks.” In the 1987 Order, banks could lend to Section 20 affiliates, sub-
                        ject to the limitations on loans and other transactions between banks
Bet k een Banks and      and affiliates contained in Sections 23A and 23B of the Federal Reserve
Set ion 20 Affiliates   Act. (See fig. III. 1.) However, under the 1989 Order, the Board required
   f                    a prohibition (see fig. 111.2)rather than a limitation on extensions of
                        credit from banks to Section 20 affiliates (with the exception of credit
                        incidental to clearing services with respect to U.S. government or agency
                        securities). The 1989 Order also prohibited the purchase and sale of
                        financial assets between banks and Section 20 affiliates, while the 1987
                        Order permitted these transactions. Both Orders prohibited banks from
                        providing credit enhancements for securities issued by a Section 20 affil-
                        iate. The Orders also prohibited banks from extending credit to custom-
                        ers of the Section 20 affiliate for the purpose of paying principal,
                        interest, or dividends on securities underwritten or dealt in by the Sec-
                        tion 20 affiliate.




                        “Note that use of the term “bank” refers to federally insured domestic bank and thrift affiliates and
                        their direct and indirect subsidiaries. Accordingly, the term bank does not include foreign bank sub-
                        sidiaries of the parent holding company.



                        Page 47                                                               GAO/GGD-90-48      Bank Powers
-1                                                                                                                                                        -
                                                  Appendix III
     I                                            Impact of Revenue Limitation         and Firewalls




Figure 111.1:Permissible Extensions of Credit to a Section 20 Affiliate Under the 1987 Order




                                                  paR*                     &
                                          s#*                          @
                                                                   &
                                    **                       s?
                                                           Y@
                                                       &
                                                  e
                                              d
                                            CT
                                         zie
                                     H
                                d                                  Domestic location        w M *      w w Q&    Extensions of credit permitted subject
                                                   I                                                             to the collateral requirements
                                                                                                                 of sections 23A and 238 of the
                                                     -I                                                          Federal Reserve Act
                                                   I           ’
                                                                   Foreign location
                                                   La      J                                -SW+WS.W+            Extensions of credit on an arms
                                                                                                                 length basis unrestricted

                                                  Note: The provisions of the April 30, 1987, Order apply to certain bank holding companies authorized to
                                                  underwrite and deal in only municipal revenue bonds, mortgage-related securities, consumer-receivable-
                                                  related securities, and commercial paper.




                                                  Page 48                                                                 GAO/GGD90-48         Bank Powers
          .

“-1
                                             Appendix III
                                             Impact of Revenue Limitation      and Firewalls




Figure 111.2:Permissible Extensions of Credit to a Section 20 Affiliate Under the 1989 Order

                                                                   U.S. Bank Holding
                                                                   Company Parent




                                                                                          :-,J-;l rj&-J
                                                                                          ,Foreign Nonbank




                                                                                     w w OII RU w S&        Extensions of credit permitted sub]ect
                                                           Domestic location                                to the collateral requirements of sectlons
                                                                                                            23A and 238 of the Federal Reserve Act.
                                                II                                                          Unsecured extensions of credit are also
                                              I          ’ Foreign location                                 permltted, but the amount of the loan must
                                              LI     J                                                      ba deducted from the capital of the holding
                                                                                                            company.

                                             Note: The 1989 Order applres to certain bank holding companies authorized to underwrite and deal in
                                             corporate debt securities (and conditionally authorized to underwrite and deal in corporate equrty secur-
                                             ities) rn addition to the securities authorized in the 1987 Order. For those bank holding companies, the
                                             restrictions in the 1989 Order apply rn the same manner and to the same extent wrth respect to securi-
                                             ties activities authorized in the 1987 Order.




                                             Page 49                                                                  GAO/GGD-9048        Bank Powers
                     Appendix III
                     Impact of Revenue Limitation    and Firewalls




Comments From Bank   Some bank holding company officials with whom we spoke said that
Company Officials    establishing a limit on extensions of credit from banks to Section 20
                     affiliates is a reasonable measure to protect the bank. However, officials
                     from multinational bank holding companies that received expanded
                     authority under the Board’s 1989 Order commented that the prohibition
                     against extensions of credit is unnecessary since such transactions were
                     already limited by Sections 23A and 23B of the Federal Reserve Act.
                     Some regional and multinational bank holding company officials said
                     that firewalls prohibiting affiliated banks from entering into agreements
                     that enhance the creditworthiness of securities underwritten or distrib-
                     uted by the Section 20 subsidiary were unnecessary. Some officials
                     argued that under existing law and regulations, a bank can provide let-
                     ters of credit to issuers of certain bank-eligible securities (for example,
                     municipal general obligation bonds) that the bank underwrites. They
                     said the risk exposure that results from such credit enhancement, if
                     priced correctly, is no greater than the risk associated with making a
                     direct loan to the issuer of the security. They also commented that this
                     restriction precludes affiliated banks from a potentially profitable
                     source of business.

                     Some officials commented that the inability of banks to provide credit
                     enhancements for securities underwritten by affiliates gives some for-
                     eign banking organizations a competitive advantage over U.S. bank
                     holding companies. The officials said that some foreign banks operating
                     in the IJnited States are permitted to, and do, provide such enhance-
                     ments for securities underwritten by their affiliates.” Thus, they
                     believed some foreign banks are able to offer a more complete line of
                     services to customers compared to U.S. bank holding companies.

                     The ABA, in commenting on our draft report, stated that this prohibi-
                     tion on credit enhancements is uneconomical and creates inefficiencies
                     and negative public perceptions. It believes customers will have to pay
                     more for credit-enhancement services because they would have to
                     obtain these services from another bank not involved in underwriting


                     “The officials are referring to the 17 foreign banks that were grandfathered under Section 8 of the
                     International Banking Act of 1978 (ISA). Under Section 8 of the IBA, any foreign bank that controls a
                     bank that operates in the U.S. shall be subject to the Bank Holding Company Act of 1966 and subse-
                     quent amendments in the same manner and to the same extent as if it were a bank holding company.
                     The purpose of this provision was to bring the permissible nonbanking activities of foreign banks
                     more in line with those of domestic bank holding companies. However, a foreign bank could continue
                     to engage in nonbanking activities in the United States in which it was lawfully engaged prior to
                     enactment of the IBA but the bank is generally not permitted to expand its grandfathered nonbank
                     activities by developing new product lines or through acquisition of or merger with another company.



                     Page 60                                                              GAO/GGD-9048      Bank Powers
Appendix III
Impact of Revenue Limitation   and Firewalls




the securities. Additionally, the ABA believes the public may .draw nega-
tive inferences from instances where a bank does not issue a credit
enhancement for securities underwritten by its affiliate.

Additionally, the ABA said that the firewall prohibition on the
purchases by a bank of debt issues privately placed by its Section 20
subsidiary affiliate is unnecessary and could prove detrimental to the
bank’s reputation in the community. As an example, ABA said that an
underwriting subsidiary affiliate could underwrite a revenue bond
offering for constructing a local airport. Normally, as a member of the
community a bank would be expected to purchase a part of the offering
for its own portfolio. The ABA stated that the firewall would prohibit
the bank from purchasing the securities underwritten by its Section 20
affiliate and that this could reflect poorly on the bank’s reputation in
the community.

Some multinational bank holding company officials with whom we
spoke questioned the practicality of the firewall that prohibits banks
from extending credit to customers of a Section 20 affiliate for the pur-
pose of paying principal and interest on ineligible securities underwrit-
ten by that affiliate. The officials said this firewall imposes undue
burden on banks and impedes the ability of the Section 20 affiliate to
offer a full range of services to its customers. For example, customers of
the Section 20 subsidiary that issued debt securities or other securities
underwritten by the Section 20 subsidiary may find it to their advan-
tage to swap out of the securities into a bank loan, or vice versa. IJnder
this scenario, the customer would either use the proceeds of a bank loan
to pay off outstanding debt or use the proceeds of a debt issue to pay off
a bank loan, The officials said that while the Section 20 subsidiary may
underwrite debt securities for the customer, the proceeds of which could
be used to pay off loans held by bank affiliates, under the firewall pro-
visions, the Section 20 subsidiary must send the customer to unaffiliated
banks to secure the loan to pay off the debt issue. Thus, they said, the
Section 20 subsidiary is forced to encourage some customers to develop
relationships with competitors. Moreover, the officials pointed out that
some foreign banks operating in the United States are able to provide
this service to their customers.

Some multinational company officials said that such transactions as a
bank purchasing financial assets from a Section 20 affiliate are part of
banks’ normal operations. They noted that these transactions were per-
mitted in the 1987 Order and believed that such transactions were effec-
tively regulated by Sections 23A and 23B of the Federal Reserve Act.


Page 51                                            GAO/GGD-9048   Rank   Powers
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                           Appendix III
                           Impact of Revenue Limitation     and Firewalls




                           The officials believed that in that light, a prohibition is unnecessary.
                           Some officials were concerned that it is not clear whether and/or how
                           this prohibition applies to overseas affiliates and believed that this lack
                           of clarity impedes the efficiency of their U.S. operations.

                           Officials with whom we spoke expressed concerns about the prohibition
                           against affiliated banks providing clearing services for the Section 20
                           subsidiary with respect to securities other than government securities.7
                           They argued that it is inefficient and costly to clear through nonaf-
                           filiates because of the additional costs of establishing a relationship
                           with an unaffiliated company. The officials pointed out that providing
                           intra-day credit with respect to clearing services is a normal part of
                           doing business with a securities company, and they did not see a need to
                           exclude banks from earning money by providing this service to Section
                           20 affiliates. The officials were displeased that the holding company is
                           forced to put money in the pockets of its competitors in the form of fees
                           for clearing services.


Cwhments From Securities   Securities industry officials said that to allow banks to provide any
Indiustry Officials        funding at all for Section 20 affiliates would not only create a competi-
                           tive advantage for the Section 20 subsidiary by its accessto low cost
                           bank funds (in the form of insured deposits), but would also expose the
                           federal safety net to the risk of the Section 20 affiliate’s activities. They
                           said that without a prohibition against banks providing funding to Sec-
                           tion 20 affiliates, a bank could be pressured to lend substantial amounts
                           of federally insured funds to a Section 20 affiliate to avert that affili-
                           ate’s demise. The officials said such exposure to the activities of the Sec-
                           tion 20 affiliate would threaten the integrity of the entire banking
                           system.


Comments From              In its 1987 Order, the Board permitted banks to lend to and engage in
Regulators                 transactions involving the purchase and sale of financial assets with
                           Section 20 affiliates, subject to the lim itations of Sections 23A and 23B
                           of the Federal Reserve Act, because of the “lim ited range of activities
                           authorized” in that Order. However, in its 1989 Order, the Board
                           believed it essential to prohibit those transactions in order to lim it the
                           risk of the expanded activities from being transferred to affiliated

                           ‘IJnder the Board’s 1989 Order, prohibitions on extensions of credit do not apply to credit extended
                           by a bank to a Section 20 subsidiary that is incidental to the provision of clearing services for ITS.
                           government securities.



                           Page 62                                                                GAO/GGD-90-48      Bank Powers
                        Appendix III
                        Impact of Revenue Limitation   and Firewalls




                        banks. The Board believed such prohibitions would also promote corpo-
                        rate separateness by ensuring that the operations of Section 20 subsidi-
                        aries would be carried out on a stand-alone basis and would not be
                        financed by affiliated banks.

                        The Board noted that Sections 23A and 23B of the Federal Reserve Act
                        permit banks to lend substantial amounts of their resources-up to 10
                        percent of their capital-to or in support of a Section 20 affiliate. How-
                        ever, the Board noted that its experience has shown that the restrictions
                        of Sections 23A and 23B are not completely effective to insulate the
                        risks of Section 20 subsidiaries from affiliated banks, and, given the
                        complexity of their provisions, Sections 23A and 23B are subject to
                        avoidance by creative interpretation, particularly in times of stress,

                        For the same reasons relating to funding of the Section 20 affiliate, the
                        Board believed that federally insured banks should not for their own
                        account purchase financial assets from, or sell such assets to, a Section
                        20 affiliate. In addition, Federal Reserve officials said the firewalls are
                        directed toward eliminating any competitive advantage that a Section 20
                        subsidiary may have by reason of its bank affiliation over that of a
                        securities firm not affiliated with a bank.


                        The prohibitions against common officers, directors, and employees in
Corporate               the Section 20 subsidiary and affiliated banks (interlocks); marketing by
Separateness:           bank affiliates on behalf of Section 20 subsidiaries; and transfers of non-
Prohibition Against     public information about a customer were designed to ensure that
                        insured depository institutions are insulated both structurally and oper-
Banks Sharing           ationally from the activities of the Section 20 subsidiary.
Employees and
Information and
Engaging in Marketing
Activities

Comments by Bank        Bank holding company officials in general said that both bank holding
Company Officials       companies and investment banking firms have successfully managed the
                        potential conflicts these firewalls were designed to prevent. Moreover,
             .Y         officials said existing regulation by SEC of broker-dealers, rules of NASD
                        and the Municipal Securities Rulemaking Board (MSRB) applicable to
                        broker-dealers, and fiduciary requirements under common law and



                        Page 53                                            GAO/GGD-90-48   Bank Powers
Appendix III
Impact of Revenue Limitation   and Firewalls




banking regulation adequately address potential conflicts. The officials
with whom we spoke said that in that light, these firewalls are unneces-
sary and impede their ability to compete.

Both regional and multinational bank holding company officials said the
prohibition against officer, director, or employee interlocks (see fig.
111.3)make it difficult to comply with the provisions of other firewalls
because it impedes the flow of necessary information between affiliates.
For example, officials said that it is difficult to monitor extensions of
credit by bank subsidiaries to clients of the Section 20 subsidiaries when
managers in the subsidiaries must report to different individuals. (This
problem is compounded by the prohibition against bank subsidiaries dis-
closing information about their customers to Section 20 affiliates.) A
problem could occur when the Section 20 subsidiary serves a client that
has bad loans with an affiliated bank. According to some bank holding
company officials, because the affiliated bank may not disclose informa-
tion about the creditworthiness of its customers without prior customer
consent, the holding company’s ability to adequately monitor its credit
risk exposure adequately is hampered.




Page 64                                            GAO/GGD9048   Bank Powers
                          Appendix III
                          Impact of Revenue Limitation           and Flrewalls




                                                     U.S. Bank Holding
                                                     Company Parent


                                               r                      %




      I1-111
        Foreign
                      I
      I     Branch    ’
1     I,,-,           J




--t     Corporation




                           r-l
                           c             I
                                             Domestic location
                                                                      m~-\ww<<<~\w<<<<<<@. Interlocks permitted

                               111
                           I             ’ Foreign location
                           L-        J




                          Page 65                                                                     GAO/GGD-9048   Bank Powers
Appendix III
Impact of Revenue Limitation     and Firewalls




Both multinational and regional bank holding company officials said
this restriction has forced them to make awkward changes in the organi-
zation of a holding company. For example, some officials said they have
securities operations in various subsidiaries of the holding company.
Thus, the bank’s treasury department manages the bank’s liquidity; the
trust department executes trades on behalf of customers; the parent
company raises funds in capital markets; and the Section 20 subsidiary
and overseas securities subsidiaries execute trades for customers and
deal, or make a market, in various securities. The officials said the abil-
ity to have one individual coordinate and manage the securities activi-
ties in various parts of the holding company is essential to the efficiency
and adequate risk management of the holding company.

Officials said this firewall has caused personnel duplication throughout
the holding company. Although both multinational and regional officials
complained that this duplication has significantly raised the personnel
expenses for the holding company, the problem appears to be greater for
regional firms. According to regional bank holding company officials,
regional firms are too small to bear the expense of such duplications of
personnel.

Bank holding company officials reported that the firewall prohibiting
bank affiliates from engaging in marketing activities on behalf of the
Section 20 subsidiary has impeded the ability of both regional and mul-
tinational bank holding companies to provide a full range of financial
services to their customers.8 Officials with whom we spoke said they
would be able to meet the financing needs of their customers more eco-
nomically, efficiently, and effectively if one person could explain the
nature of the various products and services that the company has to
offer. Officials said this is of particular concern when a customer needs
financing that involves, for example, a combination of bank loans and
debt securities, The officials pointed out that this firewall makes it diffi-
cult to give proper advice on the financing vehicles that best suit their
client’s needs, and then to structure and close the deal, because it
requires that the client talk to several employees.

The prohibition against affiliated banks disclosing nonpublic informa-
tion (including an evaluation of the creditworthiness of an issuer or
other customer of that bank affiliate) to the Section 20 subsidiary
causes problems for both regional and multinational companies. The

‘lJnder the prohibition, bank officers may inform a customer that the services of the Section 20 sub-
sidiary exist but may not distribute prospectuses and sales literature to the public.



Page 66                                                               GAO/GGD9048       Bank Powers
      .

                             Appendix III
                             Impact of Revenue Limitation   and Firewalls




                             officials said that having the customer sign a consent form usually takes
                             care of the problem. However, they said that when a customer does not
                             give consent, this firewall diminishes the cost savings that a Section 20
                             subsidiary would otherwise accrue if it were able to draw on the results
                             of activities, such as credit investigations, that are done as a normal
                             part of business in bank affiliates.


     ents From Secu rities   Securities industry officials said that firewalls prohibiting Section 20
        Officials            subsidiaries and bank affiliates from sharing employees and nonpublic
                             customer information and engaging in cross-marketing activities are
                             necessary to prevent abuses and conflicts of interest. They also said that
                             Section 20 subsidiaries would have an unfair competitive advantage
                             over securities firms that are not affiliated with banks if they had ready
                             access to confidential information about bank affiliates’ customers.


Comrhents From               Federal Reserve officials reiterated that while recognizing that the
Regu/ators                   firewalls cause some duplications and inefficiencies, the restrictions are
                             necessary because the potential conflicts of interest and unsound bank-
                             ing practices would be difficult to monitor and control without the
                             firewalls.




                             Page 57                                            GAO/GGD-90-48   Bank Powers
Apicndix   IV

Sktion 20 Subsidiaries’Activities


_-
                To date, the Board has authorized 21 bank holding companies to estab-
                lish Section 20 subsidiaries. This appendix provides general information
                about these companies.

                In 1987, the Board first authorized bank holding companies to under-
                write and deal, to a limited extent, in municipal revenue bonds, mort-
                gage-related securities, consumer-receivable-related (asset-backed)
                securities, and commercial paper.’ As of September 30, 1989, a total of
                21 bank holding companies--9 multinational, 10 regional, and 2 foreign
                banks-have applied for and receive, “,Board approval to engage in the
                above bank-ineligible activities.“, x (See table IV.1 .)




                ‘The Board’s April 30, 1987, Order authorized certain bank holding companies to underwrite and deal
                in bank-ineligible municipal revenue bonds, 1 to 4 family mortgage-backed securities, and commercial
                paper. The Board’s #July 14, 1987, Order authorized certain bank holding companies to underwrite
                and deal in consumer-receivable-related-securities. The 2d Circuit upheld the Board’s 1987 Orders in
                Securities Industry A&n. v. Federal Reserve System, 839 F.2d, 62 (2d Cir.), cert.
                                                                                              -- denied, 108 S Ct.
                2830 (1988). In a .January 18, 1989, Order, the Board authorized certain bank holding companies to
                add underwriting and dealing in corporate debt securities and, conditionally, corporate equity securi-
                ties to their list of approved bank-ineligible activities.

                “The Hank of Montreal has received authority to underwrite and deal in only commercial paper.

                “As of February 16, 1990, the Board had authorized five additional Section 20 subsidiaries-two
                owned by domestic bank holding companies and three owned by foreign banks-and had received
                applications for two others from foreign banks.
                The E%deralReserve Board authorized Norwest Corporation and Sovran Financial Corporation to
                underwrite and deal in municipal revenue bonds, mortgage-related securities, asset-backed securities
                and commercial paper on December 20, 1989, and February 12, 1990, respectively. On .January 4,
                1990, the Federal Reserve Board authorized three foreign banks: Canadian Imperial Dank of Com-
                merce, Toronlo, Ontario, Canada; The Royal Bank of Canada, Montreal, Quebec, Canada; and Bar-
                clays Hank PIX, London, England to underwrite and deal to a limited extent in all types of debt
                securities in the linitod States through Section 20 subsidiaries. In addition, after appropriate manage-
                ment reviews were completed, Canadian Imperial Bank of Commerce and The Royal Bank of Canada
                were also authorized to underwrite and deal in equity securities.
                The Section 20 subsidiaries of Canadian Imperial Bank of Commerce and The Royal Bank of Canada
                were 17,s.securities firms purchased by the banks in 1988. Under the terms of the acquisitions autho-
                rized by the Hoard, the banks agreed to terminate all bank-ineligible activities that were being done at
                that time by the securities firms. The Section 20 subsidiary of Barclays Hank PLC was a subsidiary
                established by Jsarclays that had been engaged in bank-eligible securities activities prior to the
                Hoard’s .January 1990 action.



                Page 58                                                                GAO/GGD-9048       Bank Powers
,

    Appendix IV
    Section 20 Subsidiaries’ Activities




    Although the Board first authorized Section 20 subsidiaries in April
    1987, none of the subsidiaries actually commenced bank-ineligible activ-
    ities until after June 198S4 Thus, as of September 30,1989, most of the
    subsidiaries had been doing bank-ineligible activities barely more than a
    year, and eight of the Section 20 subsidiaries had not begun bank-
    ineligible activities at all. (See table IV.2.)

    Bank holding companies have proceeded slowly with the authorized
    bank-ineligible activities. Many have not pursued the full range of these
    activities but have concentrated instead on those bank-ineligible securi-
    ties that most complement their current activities. Accordingly, table
    IV.3 and figure IV. 1 show that Section 20 subsidiaries have underwrit-
    ten a relatively small volume of bank-ineligible securities. In addition,
    figures IV.2 through IV.5 show the volume of bank-ineligible securities
    underwritten by Section 20 firms,




    ‘The actual effective date for starting the activities was delayed by two events. First, the Congres-
    sional moratorium contdincd in the Competitive Equality Banking Act of 1987, Pub. L. No. 10086,
    101 Stat. 552, delayed any expansion of bank powers until after March 1, 1988. Second, bank holding
    companies were issued a stay on commencing the new powers until the United States Court of
    Appeals affirmed the validity of the Hoard’s interpretation of “engaged principally,” which was
    based on limiting the revenues that could be generated from bank&eligible activities to 5 to 10 per-
    cent of gross revenues. See Securities Industry Ass’n. v. Federal Reserve System, 839 F. 2d, 62 (2d
    Cir.), --
           cert. denied 108 S. Ct. 2830 (1988).



    Page 69                                                               GAO/GGD-90-48     Bank Powers
                                       Appendix IV
                                       Section 20 Subsidiaries’      Activities




Table N-1: Bank Holding Companies
Authorized to Establish Section 20     Bank holding company                       Headquarters             Section 20 subsidiary
Su sidiaries as of September 30,188g   Multinational _----~
  P                                                                           ___
                                       Bankers Trust New York Corp.               NY                       BT Securities Corp.
                                       Bank of Boston Corp.                       MA                       BancBoston Securities, Inc.
                                       Chase     Manhattan Corp.                  NY                       Chase Securities, Inc. -I
                                       ._-..-___.-__._.___
                                       Chemical Banking Corp.                     NY                       Chemical Securities, Inc.
                                       Citicorp                                   NY                       Citicorp Securities Markets, --
                                                                                                           Inc.                   --
                                       __..____      --__---        ----
                                       First Chicago Corp.                        IL                       First Chicago Capital
                                                                                                           Markets, Inc.
                                        _..._----.-          .-.- --..-
                                       J.P.  Morgan --_-~-.
                                                       & Co., Inc.                NY                       J.P. Morgan Securities,
                                                                                                                                 -__-.Inc.
                                       _.-__-_                   .----.
                                       Manufacturers Hanover Corp.                NY                       Manufacturers Hanover
                                                                                                           Securities Corp. ---___
                                       ..--___._---.-.
                                       Security Pacific Corp.                     CA                       pccurity Pacific Securities,
                                                           ____-                                                       _______--
                                       Regional
                                       ____._           _--..    -
                                       Bank of New England Corp.                  MA                       BNE Capital Markets, Inc.
                                       Barnett Banks, Inc.                        FL                       Barnett Brokerage Service,
                                                                _.___~____                                 Inc. ._____
                                       CoreStates Financial                                                CoreStates Securities Corp.
                                                                .~- Corp.         PA
                                       First      Union Corp.                     NC                       First Union Securities,___.---.
                                                                                                                                           Inc.
                                       -.---A--.-
                                       Fleet/Norstar Financial Group              RI                       Adams McEntee, Fleet/
                                                                                                           Norstar Securities,
                                                                                                                    .-~_-----      Inc.
                                                           -..-    --
                                       Huntington Bancshares,                                              The Huntington Company
                                                                 .-__ Inc.
                                                                        __-       OH                                                -__-
                                       Marine Midland Banks, Inc.                 NY                       Marine Midland Capital
                                                                                                           Markets Corp.        .-.--
                                       NCNB Corp.                                 NC                       NCNB Capital Markets, Inc.
                                                        ~_.~. -___.                                            ~________-
                                       PNC Financial Corp.                        PA                       PNC Securities Corp.
                                       SouthTrust Corp.                           AL                       SouthTrust
                                                                                                                 _.___~ Securities,
                                                                                                                              .~___ Inc.--
                                                                                                         -__
                                       Foreign                                    ____-                     -.__                        _---
                                       The Bank of Montreal                       Canada                   Nesbitt Thomson Securities,
                                                                                                 ___~.     Inc.             ___~     ~-.
                                                                                       --__
                                       Westpac Banking Corp.                      Australia                Westpac Pollock Government
                                                                                                           Securities. Inc.

                                       Source: Federal Reserve.




                 J




                                       Page 60                                                               GAO/GGD-90-48        Bank Powers
                                           Appendix IV
                                           Section 20 Subsidiaries’   Activities




Table IN.2: Section 20 Subsidiaries That
Had Commenced Bank-Ineligible                                                                                           Date       Ineligible activity
Activities as of September 30,1989         Section 20 subsidiary                                                 authorized              commenced
                                           BT Securities
                                                   .~_. . Corp.
                                                           ~~~~~~~-..
                                                                 .- .-~~                                               Apr.   87            2nd   qtr.   88
                                           Citicorp Securities Markets, Inc.                                     --    Apr.   87            2nd   qtr.   88
        I
                                           J.P. Morgan Securities, Inc.                                                Apr.   87            2nd   qtr.   88
                                           Chemical Securities, Inc.                                                   May    87            2nd   qtr.   88

                                           Manufacturers Hanover Securities Corp.                                      May    87             3rd qtr. 88
                                           Chase Securities, Inc.                                                      May    87             3rd qtr. 88
                                           Marine __-.
                                                   Midland                                                             Jul.   87             3rd qtr. 88
                                                        -._ Capital
                                                             .~~~ Markets Corp.~--__                                          _____.._~~
                                           BNE Capital Markets, Inc.                                                    Jul. 87                 qtr.~~~89
                                                                  ~~ .- ..~~                                            Jul, 87 ____~~... 1 st ~~~~
                                           PNC Securities Corp.                                                                           1st qtr. 89
                                           First Chicago Capital Markets, Inc.                                         Aug. 88            1 st qtr. 89
                                             ._ ___._.._~-~~~~~~~~ .~---.-                  ___--

                                           Adams McEntee, Fleet/Norstar             Securities, Inc.                   Oct. 88                 4th qtr. 88
                                           The Huntington Company                                                      Nov. 88
                                                                                                                            -___               4th qtr. 88
                                                                                                                                      -..-.. ~~~--~.. ~~~~~
                                           Westpac Pollock Government Securities, Inc.                                 Mar. 89              2nd qtr. 89
                                           Note: Eight Section 20 subsidiaries had not commenced bank-ineligible activities as of September 30,
                                           1989.
                                           Source: Federal Reserve.
.____..._
     --.L ___.__._.___
                 ---
Table IV.3: Section 20 Subsidiaries
Unde&iting in Selected Bank-Ineligible     Dollars in millions
Securities by Volume From July 1, 1988,                                                             Mortgage-
to September 30,1989                                                   Municipal                       related   Asset-backed              Commercial
                                           Period                 revenue bonds                     securities       securities                paw
                                           3rd qtr 88                              $150.0               $148.0                $9.4 .-~        $11,983.6
                                                                                                                                              .-.-.. ~-~~~
                                           4thqtr 88                                385.7                311.1               350.5              29,050.o
                                           1 st qtr 89                              291.7                873.6               342.0              41,366.6
                                                                                               ~-
                                           2nd qtr 89                               453.6                400.0           ---~ 53.0              35248.1
                                           3rd atr 89                               385.6                600.0        --      45.0              67,659.g




                         Y




                                           Page 61                                                                     GAO/GGD9048         Bank Powers
                                           Appendix IV
                                           Section 20 Subsidiaries’   Activities




Fig@ IV.l: Section 20 Firms’ Market
Shdre of Underwriting for Selected Bank-
    gible Securities, From July 1, 1988,   IS   Porcont of Tolal Market
              30,1989                      14
                                           13
                                           12
                                           11
                                           10
                                            9
                                            8
                                            7
                                            6
                                            5
                                            4
                                            3
                                            2
                                            1
                                            0

                                                3rd Qtr 66            4th Qtr 55       lstQtr62   2nd atr 59       3rdOlrSQ

                                                         Municipal revenue bonds
                                                         Mortgage-related securities
                                                         Asset-backed sea~ities




                                           Page 62                                                  GAO/GGD-9048   Bank Powers
                                          Appendlx IV
                                          Section 20 Subsidiaries’     Activities




Figure IV.2: Bank-Ineligible Municipal
Revenue: Bonds Underwritten by Section
20 Firms; From July 1, 1988, to           500     Dollan In Mllllona




                                                                                    r
Septembier 30,1989                        450

                                          400

                                          3110

                                          300

                                          250

                                          200

                                          150

                                          100

                                           w

                                            0

                                                  SrdtXr      4thOtr   l#tQtr       2nd Otr    SrdOtr
                                                  88          w        89           89         89
                                                  Volume of Municipal Rovonrw Bonds Undrtwrltton




Figure W.3: Bank-Ineligible Mortgage-
Related $ecurities Underwritten by
Section 20 Firms, From July 1, 1988, to   (Dollars In Mllllonr)
September 30,1989                         SW

                                          800




                                          wo
                                          400

                                          300

                                          200              r
                                                  3rdOtr      4thatr   tat Otr      2ndOtr    3rdQtr
                                                  88          58       89           89        89
                                                  Volume of Mortgaga-Ralatad Sacurltlr        Undwwrltton




                                          Page 03                                                           GAO/GGD-9048   Bank Powers
   I                                                                                                                           i
   I




                                          Appendix IV
                                          Section 20 Subsidiaries’ Activities




Figqre IV.4: Bank-Ineligible Asset-
Baqked Securities Underwritten by
Seqtion 20 Firms, From July 1,1988, to    400       (Dollars In MIllIons)
Se()tember 30,1989
                                          WQ

                                          800

                                          250

                                          200

                                          lS0

                                          rw

                                           50

                                               0

                                                    3rdQtr     4thQtr  1stOtr  PndQtr 2rdQtr
                                                    88         88      69      89        89
                                                    Voluma of Aasst-Baobd Sscurltles Undsmrittsn




Fiqure IV.5 Bank-Ineligible Commercial
Paper Underwritten by Section 20 Firms,
From July 1,1988, to September 30,1989    71       (Dollan In Billions)
                                          70
                                          65
                                          60
                                          55
                                          SO
                                          45
                                          40
                                          35
                                          30
                                          25
                                          20
                                          16
                                          10
                                           5
                                           0

                                                   SrdCttr    4thUr         1stOtr   2ndtXr
                                                                                        2rdOtr
                                                   88         88            89       89 89
                                                   Vdumo of Commerical Papsr Undsrwrltten




                                          Page 64                                                  GAO/&D-9048   Bank Powers
              7
         IL.-..-
-*
                                          Appendix IV
                                          Section 20 Subsidiaries’       Activities




                                          To generate a base of eligible revenues against which revenues from
                                          bank-ineligible activities can be measured, bank holding companies gen-
                                          erally transfer bank-eligible activities, such as underwriting and dealing
                                          in obligations of the United States, general obligations of states and their
                                          political subdivisions, investment advisory and securities brokerage ser-
                                          vices, and placement of commercial paper and other types of securities
                                          as agent from their bank and nonbank subsidiaries into the Section 20
                                          subsidiary. Relative to other bank-eligible activities, government securi-
                                          ties activities generate substantial revenues. Seven Section 20 subsidi-
                                          aries that are primary dealers in government securities include

                                      l BT Securities Corp;
                                      l Chase Securities, Inc.;
                                      . Chemical Securities, Inc.;
                                      l Citicorp Securities Markets, Inc.;
                                      . J.P. Morgan Securities, Inc.;
                                      l Manufacturers Hanover Securities Corp; and
                                      . Westpac Pollock Government Securities, Inc.

                                          During the second quarter of 1989, the 13 Section 20 subsidiaries that
                                          were operating during that time generated about $50 million in revenues
                                          from their bank-ineligible activities. (See table IV.4.) These revenues
                                          made up a small portion (about 3.3 percent) of the second quarter 1989
                                          gross revenues for those subsidiaries, well within the Board’s 10 percent
                                          revenue limitation, (See fig. IV.6.)

                                          Bank holding companies have continued to capitalize their Section 20
                                          subsidiaries as they organize their operations. In terms of assets and
                                          capital, most of the Section 20 subsidiaries are still small relative to the
                                          size of the parent holding company. (See table IV.5 and table IV.6.)
1-1--                                                                                                                                                     -
Table IV.4: Revenues of Section 20
Subsidiaries, From July 1, 1988, to       Dollars ~~..~--~
                                                   in millions-..- ~~. ~. .-..-
September 30, 1989 (Unaudited)            _._..~                                                                             I_~ --___--.-I-           -. -.
                                                                                                                                               Ineligible as
                                                                           Number                                                              a percent of
                                                                          of active          Eligible          Ineligible         Gross                gross
                                          Period                              firms        revenues
                                                                                             --I_.             revenues        revenues           revenues
                                          3rd qtr 88                                   7              $592             $2            $594                .34
                                                                                           --.----
                                          4th qtr 88                                   9                708            25              733              3.41
                                          1st qtr 89                                  12                859            21              880              2.39
                                          2nd qtr 89           ~.                     13              1,452-           50            1,502              3.33
                                                                                           ~.-       --
                                          3rd $r 89                                   13              1,349            25            1,374              1.82
                                          Source: Federal Reserve




                                          Page 66                                                                           GAO/GGD-SO-48      Bank Powers
._ _ ;   .._   --. - .x ..--                      -
     I                                      Appendix IV
     I                                      Section 20 Subsidiaries’     Activities




-
Figtire IV.6: Revenues of Section 20
Fir@, From July 1, 1988, to September
                                            1.6   Qroas Rwenues (Dollars In Billions)
30, :1989

                                            1.4




                                                  SrdQtr      4thOtr     1stQr        2ndQtr   ZQtr
                                                              66         69           99

                                                             Revenues from bank-ineligible activities
                                                  b
                                                             Revenues from bank-eligible activities

                                            This chart IS based on unaudited data.

                                            Source: Federal Reserve


Table IV.5: Section 20 Firms’ Assets as a
Peecent of Parents’ Assets as of June                                                                                           Number of Secti;n2X
30,:1989 (Unaudltcd)                        Percent range               ~~     ..- ~~~~~~~~...               -
                                            < 1 percent                                                                                                   ~6
                                                                                                                          --~       .-. -~--    --. .~~
                                            1 percent     < 5 percent                                            __-___                                    2
                                            5 percent     < 15 percent                                                                                     2
                                            15 percent     < -~.~
                                                              24 percent                                                                                   3
                                            TDtal  ..--              ~~~~~~~~.
                                                                            .-~~
                                                                                                                                                          13

                                            Note, Eight Sectlon 20 subsldianes are excluded from this analysis




                                            Page 66                                                                 GAO/GGD-90-48              Bank Powers
                                             Appendix IV
                                             Section 20 Subsidiaries’   Activities




Table IVd8: Section 20 Firms’ Capital as a
Percent pf Parents’ Capital as of June                                                                                   Number of Sectiy$
30, 1989~(Unaudlted)                         Percent range                                                                          __ _--..
                                             -c 1 percent                                                                                     4
                                             1 percent < 3 percent
                                             ---                                                                         -______              4
                                             3 percent -=c6 percent                                                                           2
                                             6 percent < 8 percent                                                                   _____--- 3
                                             Total                                                                                           13
                                             Note: Eight Section 20 subsidiaries are excluded from this analysis.




                                             Page 67                                                                GAO/GGD-9048   Bank Powers
   ,
Abpcndix V
  /
  apital Structure and Capital Adequacy
2 equirements for Bank Holding Companies and

Section 20 Firms
                                             This appendix discusses the capitalization of Section 20 companies and
                                             the regulatory capital requirements that apply to these bank holding
                                             company subsidiaries,

                                             The first section discusses the concept of capital, citing some statistics
                                             of bank holding companies that had received Federal Reserve approval
                                             to set up Section 20 subsidiaries as of September 30, 1989. The second
                                             section discusses capital adequacy standards relevant to Section 20 sub-
                                             sidiaries and their holding companies.


                                             A simplified illustration of a bank holding company with banking and
The Capital Structure                        nonbanking subsidiaries, all wholly owned, is shown in figure V. 1. The
of a Hank Holding                            capital structure can be considered from the point of view of the parent,
Company                                      each subsidiary, and the entire holding company on a consolidated basis.
                                             Other ways of looking at capital are the market value of the capital
                                             stock and regulatory capital.


Figure V.l: Simplified Structure of a Bank
Holding Company




                                             A bank holding company parent is typically financed by a combination
                                             of debt and equity. Some of the funds from these sources are used to
                                             finance activities of the parent company itself. However, most of the
                                             funds arc used to support subsidiaries in the form of equity investments
                                             or loans. I



                                             ‘This is I ypicxlly rc~fc~rcd1.0as downstrcaming funds.



                                             Page 08                                                   GAO/GGD-9048   Bank I’owers
                                             Appendix V
                                             Capital Structure and Capital Adequacy
                                             Requirements for Bank Holding Companies
                                             and Section 20 Firms




                                             The capital structure of the parent companies of the Nation’s largest
                                             bank holding companies is summarized in table V. 1. The table compiles
                                             financial data from the parent companies of the top 25 bank holding
                                             companies as of June 30, 1989. These companies had a total of $77 bil-
                                             lion in equity capital,” $69 billion in long-term debt and other liabilities,
                                             and $48 billion in commercial paper and other short-term debt. Of the
                                             $194 billion in parent company assets, $102 billion represents funds
                                             invested in subsidiaries involved in banking-related activities, $66 bil-
                                             lion represents investments in nonbanking subsidiaries, and $26 billion
                                             represents investments in other activities of the parent.

Table V.!: Capital Structure of the Parent
Companjes of the 25 Largest Bank             Dollars in billions
Holding pompanies as of June 30,1989         Assets
        1                                    lnv&tment&      banking subsidiaries                                                                 $102
        !                                       ioan advances and -other ~._.
                                                                          receivables
                                                                            --___                                                         (24)
                                                Equity investments                                                                        (78)~
                                             Investments s nonbanking subsidiaries                                                                  66
                                                Loan adv&ces-and other receivables                                                        (52)
                                                Equity investments                                                                        (14)
                                             Other assets      -~ ~~      ~~..~_~__.__            .-~----~                                          26
                                                                                                                                                  $194

                                             Liabilities and equity
                                             Commercial paper and other short-term debt                                                            $48
                                             Long-term debt and other liabilities .._____-          ~~-.-~~~    ~~. ~~                              69
                                             Eq& capital                ~~~..
                                                                            .--.       -._            .--.      ~~       ~~                         77
                                                                                                                                                  $194
                                             Notes: Banklng subsldianes include both banks and bank holding companles.
                                             This table IS an aggregation of flnanclal data from the 25 largest bank holding companies.
                                             Source. Federal Reserve Form Y-9.

                                             The information contained in table V. 1 is summarized on a percentage
                                             basis in table V.2. For the top 25 bank holding companies, investments
                                             in banking subsidiaries represent just over half (53 percent) of parent
                                             company assets. As a general rule, a much greater portion of the invest-
                                             mcnt in banking subsidiaries is equity than is the case with the invest-
                                             ment, in nonbanking subsidiaries.




                                             “Vor this purpow, all types of equity capital have been added togcthu.



                                             Page 69                                                                  GAO/GGD-90-48       Bank Powers
                                             Appendix V
                                             Capital Structure and Capital Adequacy
                                             Requirements for Bank Holding Companies
   ,                                         and Section 20 Firms




                                             The proportion of parent company assets invested in banking subsidi-
                                             aries varies, of course, among bank holding companies. Table V.3 sum-
                                             marizes the variation among the 19 U.S. bank holding companies that
                                             have been authorized, as of September 30, 1989, to set up Section 20
                                             subsidiaries. This table is comprised of data from the year ending
                                             December 31, 1988, the most current end-of-year data available during
                                             our study. The proportion of assets invested in banking subsidiaries is
                                             less than 40 percent for two of the companies and 80 percent or greater
                                             for six of the companies.

Tat+e V.2: Capital Structure of the Parent
Coppanies of the 25 Largest Bank             Figures in percent                  ____-
Holiding Companies as of June 30,1989        Assets
                                             --__
                                             Investments in banking subsidiaries                              -- --___-                             53%
                                                Loan advances and other.~-.-
                                                                          receivables                                                  (13)
                                                Equity investments                                                                     (40)
                                             Investments in nonbanking subsidiaries                                                                 34
                                                Loan advances
                                                         .--    and other receivables                                                  (27)
                                                Equity investments                                                                      (7)
                                             Other assets                                          .-~-                                       ~.-    13
                                                                           ._____~ --                                                               100%

                                             Liabilities and equity                                            -
                                             Commercial paper and other short-term debt
                                                                                     ~..                                                             25%
                                             Long-term debt and other liabilities                                                                    35
                                             Equity capital                             .-                                     .~                    40
                                                                                                                                                    100%
                                             Notes: BankIng subsidianes include both banks and bank holding companies
                                             This table is based on an aggregation of financial data from the 25 largest bank holding companies
                                             Source: GAO analysis based on table V.l




                                             Page 70                                                                GAO/GGD-90-48     Bank Powers
                                          Appendix V
                                          Capital Structure and Capital Adequacy
                                          Requirements for Bank Holding Companies
                                          and Section  20 Firms




Table V.3: Proportion of Parent Company
Assets I vested in Bank4ng Subsidiaries                                                                  Number of U.S. bank in banking
for U.S. ank Holding Companies                                                                           subsidiaries holding companies
Authoriz d to Set Up Section 20           Parent company investments in banking                            authorized to set up Section 20
Subsidia ies as of December 31, 1988      !!?!!?!!!!‘B!!!~___ ~~. ~~_. ~. ~~.~~~~_~                 ___ _.                    subsidiaries
                                          lessthan40%                                                                                           2
                                          40-59                                                                                                 7
                                          60-79                                                                                                 4
       i
                                          80-100                                                                                                6
                                          Total                                                                                             19
                                          Notes: Information IS not available for two foreign bank holding companies.
                                          Banking subsidiaries Include both banks and bank holding companies.

                                          Source: GAO analysis based on Federal Reserve Form Y-9



                                          Loans and equity investments received from the parent company are
                                          two important elements in the financial arrangements of bank holding
                                          company subsidiaries. Each subsidiary also has assets, liabilities, and
                                          retained earnings associated with its line of business. The principal lia-
                                          bilities of banking subsidiaries are typically deposits.

                                          Funds sent from the subsidiary to the parent company take the form of
                                          payments of interest and principal on loans and dividends on stock.:’The
                                          subsidiary may purchase services from the parent or another subsidiary
                                          or may lend money to the parent or another subsidiary.

                                          A simplified hypothetical example of the capital structure of holding
                                          company subsidiaries is shown in figure V.2, The numbers used are
                                          based on the percentages found in table V.2.”

                                          The concept of leveraging is important when the capital structure of a
                                          bank holding company subsidiary is examined. Financial leverage is the
                                          use of debt to supplement equity in a company’s capital structure. A
                                          situation called double leveraging exists when a parent company invests
                                          borrowed funds in a subsidiary as equity.

                                          An example of double leveraging is found in figure V.2. The parent’s
                                          equity investment in the bank and nonbank subsidiaries is $47 million.

                                          “This is typically referred to as upstreaming funds.

                                          ‘In this cxamplc, parent company assets, which were equal to 100 percent in table V.2, equal $100
                                          million. IJsing this as a baseline figure, we developed the relative sizes of the bank and nonbank
                                          subsidiaries based on balance sheet data as of year end 1988 for the top 26 bank holding companies.



                                          Page 7 1                                                                 GAO/GGD-9048   Bank Powers
Appendix V
Capital Structure and Capital Adequacy
Requirements for Bank Holding Companies
and Section 20 Firms




However, the equity capital of the parent company is only $40 million.
Dividing the equity invested in the subsidiaries by the equity of the par-
ent gives a ratio that measures the extent to which a company is double
leveraged. Double leveraging exists when the ratio exceeds 100 percent.
In this example, the ratio is 118 percent.




Page 72                                            GAO/GGD-90-48   Bank Powers
                                                            Appendix V
                                                            Capital &ructure. and Capital Adequacy
                                                            Requirements for Bank Holding Companies
                                                            and Section 20 F’irms




Figure V/2: Hypothetical Example of the Capital Structure of Bank Holding Company Subsidiaries (Dollars in millions)




                                     Banking Subsldalrles                                               Nonbanking Subsldairles




                                       ”

  -.._   _I   __   -..._   ._--.._



                                                            Note. Banking subsidiaries includes both bank and bank holding companies
                                                            Source: GAO analysis based on Table V.2 and Federal Reserve Form Y-9.




                                                            Page 73                                                              GAO/GGD90-48   Bank Powers
             .--
   /                                     Appendix V
   I                                     Capital Structure and Capital Adequacy
   I                                     Requirements for Bank Holding Companies
                                         and Section 20 Firms




                                         Table V-4 shows the extent to which the 19 U.S. bank holding companies
                                         authorized to set up Section 20 subsidiaries were double leveraged as of
                                         December 31, 1988. Three of the companies have ratios below 100 per-
                                         cent, and seven of the companies have ratios of 120 percent or greater.

                                         In order to evaluate double leveraging in a bank holding company, the
                                         Federal Reserve uses a “building block” approach when examining the
                                         capital of a bank holding company. This means that the Federal Reserve
                                         looks at both the amount and components of capital of the consolidated
                                         holding company and of the bank and nonbank subsidiaries.
   .I .._...-_”
             ..__.
                --
Tab e V.4: Frequency of Double
Lev,I raging in the U.S. Bank Holding                                                            Number of U.S. bank holding companies
Companies Authorized to Set Up Section   Equity invested in subsidiaries divided by              authorized to set up Section 20
20 gubsidiaries as of December 31,1988   total equity of parent                                  subsidiaries
                                         90%.99%                                                 3
                                         100-109                                                 3
                                         110-119                                                 6
                                         120-129                                                 4
       /
       /                                 greater  than 129 .-~~~
                                            ~~.~~~~--..-.-..-~                                   3
                                         Total                                                  19
                                         Notes: Information IS not available for two foreign bank holding companies.

                                         Double leveraging exists when the equity invested in the subsidiaries as a percentage of the total equrty
                                         of the parent is greater than 100 percent.

                                         Source: GAO analysis based on Federal Reserve Form Y-9



                                         A consolidated statement of assets, liabilities, and capital for the hypo-
                                         thetical bank holding company used in figure V.2 is shown in table V.5.
                                         Equity capital of $40 million supports $732 million in assets. Equity cap-
                                         ital represents the shareholders’ financial ownership and is the principal
                                         component of regulatory capital. The ratio of equity capital to assets in
                                         this hypothetical holding company is 5.5 percent.




                                         Page 74                                                                  GAO/GGD-90-48    Bank Powers
-“---a---
                                           Appendix V
                                           Capital Structure and Capital Adequacy
                                           Requirements for Bank Holding Companies
                                           and Section 20 Firms




Table V.!$ Hypothetical Example of the
Capital S ructure of a Consolidated Bank   Dollars in millions
                                           ----                        -----___                                                                -
Holding E ompany                           Assets
                                           _____.^ -..----.-._--_-.-__                 _- .I_
                                           Assets                                                                           ____._-.--.     $732
                                                                                                                                             -.-
                                           Liabilities  and Equity Capital ---
                                              _----~.----l_--                                         --                  .____    -._    -.-~-.~.
                                           Liabilities           .._._...._.-. ~~.--                          --                            $629
                                           Equity capital                                                                                     40
                                                                                                                                            $732
                                           Source: GAO analysis based on table V.4 and Federal Reserve Form Y-9.


                                           The ratio of equity capital to holding company assets varies among bank
                                           holding companies. An analysis of the equity capital ratio of the 19 U.S.
                                           bank holding companies authorized to set up Section 20 subsidiaries is
                                           shown in table V.6. As of December 31, 1988, four of the companies had
                                           ratios between 4.5 percent and 5 percent, while six of the companies had
                                           ratios greater than 6.5 percent.
-_.-.-
Table V.zquity   Capital as a
Percent ge of Bank Holding Company                                                                 Number of U.S. bank holding companies
Assets ”or U.S. Bank Holding Companies                                                                       authorized to set up Section 20
Authorixed to Set Up Section 20            Equity capital divided by total assets                                               subsidiaries
                                                                                                                                  ___-.-.
Subsidibries as of December 31,1988        4.5%-4.9%
                                            ._-.__.-  _.._- ...- ~...~--~-                                                                   4
                                           5.054                                                                                             3
                                           5.5-5.9                               -..__II            __--.-~.       ___.- __.._~~-.--...-~    3
                                                                                                                                             -
                                           6.064                                                                                             3
                                           greater   than-.._.
                                           __.. ..--..-    6.4 ~.~---~ ~~.                                                                   6
                                           Total                                                                                           19
                                           Note: Information is not available for two foreign bank holding companies.

                                           Source: GAO analysis from Federal Reserve Form Y-9.




Market Value                               Financial market analysts often look at the capital of bank holding com-
                                           panies (or any company) from the point of view of the market value of
                                           the company. This is calculated by multiplying total shares outstanding
                                           by the price per share. The market value may be greater or less than the
                                           book value or equity shown on the company’s financial statements. The
                                           ratio of market value to book value is one indication of the company’s
                                           financial strength.

                                           The range of the market to book value ratio for 16 US. bank holding
                                           companies authorized to set up Section 20 companies is shown in



                                           Page 7.5                                                                 GAO/GGD-9048   Bank Powers
                                                                                                                                                -
                                           Appendix V
                                           Capital Structure and Capital Adequacy
                                           Requirements for Bank Holding Companies
                                           and Section 20 Firms




                                           table V.7. As of December 31, 1988, the ratios ranged from between 50
                                           percent and 69 percent to more than 130 percent.
Tabie V.7: Market Price as a Percentage
of Bbok Value Per Share for U.S. Bank                                                              Number of U.S. bank holding companies
HOI ing Companies Authorized to Set Up                                                                     authorized to set up Section 20
Set ion 20 Subsidiaries as of December    Market price divided bv book value                                                  subsidiaries
31, 1 988                                 50%-69%                                                                                                     3
                                          70-89                                                                                                       2
                                          go-109                                                                                                      3
                                          1 IO-129                                                                                                    3
                                          greater than 129                                          ____--      --..                                  5
                                          Total                                                                                                     16
                                          Note: Information is not available for two foreign and three domestlc bank holding companies
                                          Source: Federal Reserve.




Ihq?JAatory Capital                       The Federal Reserve’s basic capital standard for bank holding compa-
                                          nies is defined in terms of the holding company’s consolidated financial
                                          statements and is stated as a percentage of holding company assets. At
                                          present, bank holding companies must have what is termed primary
                                          capital equal to at least 5.5 percent of assets and total capital of at least
                                          6 percent of assets5 Total capital is comprised of primary and secondary
                                          capital.” The primary and secondary capital ratios applied to the holding
                                          company are the same ratios that the Federal Reserve and other federal
                                          regulators apply to commercial banks. Regulatory officials can also raise
                                          the capital requirements of any individual holding company or bank if
                                          circumstances warrant.

                                          Table V.8 shows the primary capital as a percentage of the bank holding
                                          company assets for the 19 U.S. bank holding companies authorized to
                                          set up Section 20 subsidiaries. This table shows that as of December 3 1,
                                          1988, all of the companies were at least 1 percentage point above the
                                          minimum 5.5 percent requirement, and most were well above the
                                          minimum.

                                          “Primary capital consists of common and perpetual preferred stock, surplus (excluding surplus rolat-
                                          ing to limited-life-preferred stock), undivided profits, allowance for loan and lease losses, capital
                                          reserves, minority interest in consolidated subsidiaries, and a limited amount of perpetual debt
                                          instruments and mandatory convertible instruments.

                                          “Secondary capital includes perpetual debt, perpetual preferred stock, and mandatory c~onvc~rtibk~
                                          instruments in excess of the limits allowed as primary capital. It also includes limited-lif(:-prcfcrr(,d
                                          stock, subordinat,ed notes and debentures, and unsecured long-term debt of the parent. company and
                                          its nonbank subsidiaries.



                                          Page 76                                                                      GAO/GGD-9048   Bank Powers
                   I *
-~.-..!--.--       +---..-
                                          Appendix V
                   I                      Capital Structure and Capital Adequacy
                                          Requirements for Bank Holding Companies
                                          and Section 20 Firms




Table V.Si Primary Capital as a
Percenta’ e of Consolidated Bank                                                                  Number of U.S. bank holding companies
Holding 8 ompany Assets for U.S. Bank                                                                     authorized to set up Section 20
Holding ompanies Authorized to Set Up     Primary capital divided by total assets                                            subsidiaries
Section $ 0 Subsidiaries as of December   less than 6.5%                                                                   _.._ ~.----~    -         6
31,1988        j                          6.5-7.4                 ~-                                                                                 3
                                          7.5-8.4                                            ~._~_._. -.-- .---                                      6
                                          8.5-9.4                                                ----             __-..- . . - -.                    6
                                          -.9ilO.O
                                               _.  ..   .~. ._   ~.._~~. ~.   ~-.~- ~.                                                     _ _._   ~.4
                                          Total                                                                                                    19
                                          Note: Information is not available for two foreign bank holding companies.
                                          Source: GAO analysis from Federal Reserve Form Y-Q


                                          I3y the end of 1990, bank holding companies must also meet a new risk-
                                          based capital standard. The Federal Reserve is requiring that new risk-
                                          based capital requirements applying to banks, bank holding companies,
                                          and other federally regulated banking agencies be phased in. This stand-
                                          ard takes account of the off-balance sheet commitments, such as letters
                                          of credit and guarantees, in addition to the assets included on the bal-
                                          ance sheet. The various assets and off-balance sheet items are placed
                                          into risk categories that are then weighted by degree of risk.

                                          A bank holding company’s risk-based capital ratio is calculated by divid-
                                          ing its qualifying capital for regulatory purposes by the sum of its risk-
                                          wdighted assets. By year-end 1990, banking organizations are expected
                                          to meet a minimum interim target ratio for qualifying total capital to
                                          risk-weighted assets of 7.25 percent, and by 1992 the target ratio is 8
                                          percent. At least one-half of these capital targets must be in the form of
                                          Tier 1 capital7 and the rest can be Tier 2 capital.#

                                          The Section 20 subsidiaries              of bank holding companies are required to
                                          meet the capital standards              for broker-dealers set by SEC.These require-
                                          ments are explained in the              following section, together with other aspects
                                          of holding company capital               regulations applicable to Section 20
                                          subsidiaries.



                                          ‘Tier 1 capital consists of core capital elements, such as common stockholders’ equity, minority inter-
                                          ests in equity accounLsof consolidated subsidiaries, and perpetual preferred stock (limited amounts),
                                          less goodwill.
                                          “Tier 2 capital includes pcrpctual preferred stock (unlimited amounts) and related SU~@US,
                                          allowances for loan and ICWX losses, hybrid capital instruments, and term-subordindtcd debt and
                                          intormcdiatc term-preferred stock, including related surplus.



                                          Page 77                                                                      GAO/GGD-9048       Bank Powers
                         Appendix V
                         Capital Structure and Capital Adequacy
                         Requirements for Bank Holding Companies
                         and Section 20 Firms




C$pital Adequacy
Roles for Section 20
Subsidiaries and Their
H@ding Companies

SEjC Rules               To ensure that broker-dealers can meet financial responsibilities to their
                         customers and to other market participants, Section 20 firms and all
                         other broker-dealers must comply with SEC’Snet capital rule, which is
                         designed to address the liquidity of securities firms. The net capital rule
                         requires that broker-dealers maintain a minimum capital level at all
                         times.

                         Capital in securities firms consists of equity and various forms of
                         subordinated debt. The net capital rule requires broker-dealers to com-
                         pute their capital from financial statements prepared by valuing the
                         firm’s security positions at current market prices rather than at histori-
                         cal values as banks are permitted to do. The rule then requires that
                         deductions be made from capital for fixed assets, unsecured receivables,
                         and for risk characteristics of particular assets. The risk-related deduc-
                         tions, known as “haircuts,” reflect price fluctuations based on historical
                         experience. When a broker-dealer’s net capital falls below required
                         levels, the broker-dealer must immediately notify its regulators and
                         cease operations unless additional capital is obtained.

                         One significant difference between SEC and bank holding company capi-
                         tal regulations should be noted. The SEC net capital rule applies only to
                         the capital of broker-dealers registered with SEC. The rule does not
                         extend beyond broker-dealers to parent companies, other affiliates, or
                         holding companies on a consolidated basis unless their activities are spe-
                         cifically subject to SEC regulations. Therefore, there is no formal regula-
                         tory control over double leveraging or over other activities of the parent
                         or affiliates of an SEC firm comparable to the regulation that the Federal
                         Reserve applies to bank holding companies with Section 20 subsidiaries.
                         A full comparison between the treatment of capital investments in
                         broker-dealer subsidiaries made by bank holding companies and securi-
                         ties holding companies was beyond the scope of this report.




                         Page 78                                             GAO/GGD90-48   Bank Powers
                        Appendix V
                        Capital Structure and Capital Adequacy
                        Requirements for Bank Holding Companies
                        and Section 20 Firms




Bank! Holding Company   In addition to ensuring that Section 20 subsidiaries meet SEC capital
Rules;                  requirements, bank holding companies with Section 20 subsidiaries are
                        also required to meet the Federal Reserve’s capital requirements that
     /                  apply to the consolidated holding company. The Federal Reserve Sys-
                        tem’s capital adequacy standards for bank holding companies involve
                        several components. First, as pointed out above, bank holding compa-
    ,                   nies must have sufficient capital as a percentage of the holding com-
                        pany’s total assets on a consolidated basis. The Board also requires
                        holding companies to capitalize all nonbanking subsidiaries in accord-
                        ance with industry standards and with the risk factors involved in the
                        particular firm. Furthermore, the Federal Reserve can control the
                        amount of investment made in any subsidiary. The aim of the Federal
                        Reserve’s capital regulation is to ensure, to the extent feasible, that the
                        subsidiary can support itself on a stand-alone basis while at the same
                        time maintaining the bank holding company’s ability to serve as a source
                        of financial strength to its subsidiary banks.

                        In computing bank holding company capital ratios, the assets and liabili-
                        ties of any bank holding company subsidiary that is not consolidated for
                        supervisory or regulatory purposes are deducted from the assets, liabili-
                        ties, and capital of the holding company. A Section 20 company, which
                        must comply with SEC’S net capital rule, is such a subsidiary. Hence, the
                        parent’s investment in the Section 20 subsidiary, together with the
                        assets and liabilities of the Section 20 subsidiary, are deducted from the
                        assets, liabilities, and capital of the bank holding company. In approving
                        Section 20 subsidiaries, however, the Federal Reserve has held that the
                        parent investment in the subsidiary cannot weaken the capital of the
                        holding company.




                        Page 79                                            GAO/GGD90-48   Bank Powers
ARpendix VI

The Regulatory Framework Affecting the
&curities Activities of Banks

                            This appendix highlights the legislation affecting banking organizations’
                            domestic and foreign activities and summarizes the actions taken by the
                            Federal Reserve Board in allowing Section 20 companies to underwrite
                            and deal in bank-ineligible securities. It also describes SEC’Srole in regu-
                            lating Section 20 companies’ bank-ineligible securities activities.


-P imary Legislative
                            ing the securities activities of banking organizations. The relevant stat-
 P::ovisions Affecting      utes are addressed in the order in which the basic statutes were enacted.
t e Securities
 A1 tivities of Banking
 Otiganizations

National Banki ng Act and   The securities activities of banks are determined by a variety of federal
State Laws                  and state laws. A number of state laws permit state-chartered banks to
                            engage in some securities activities that are not permitted for national
                            banks.

                            The National Currency Act of 1863 and the National Bank Act of 1864,
                            administered by the Office of the Comptroller of the Currency (occ), cre-
                            ated a system of national banks that today includes about 4,300 banks
                            with about $1.8 trillion in assets. The National Bank Act precluded
                            national banks from underwriting corporate securities directly. How-
                            ever, the statute did not prohibit national banks from being affiliated
                            with organizations that did securities activities. This allowed national
                            banks the opportunity to establish state-chartered affiliates that could
                            do securities activities.

                            Under regulatory guidance from occ, national banks are allowed to
                            engage in a full range of government securities activities, make private
                            placement of corporate securities, and buy and sell all types of securities
                            as agent for customers. National banks can also own for their invest-
                            ment account a limited amount of corporate bonds, provided they are
                            marketable and investment quality. In a 1987 ruling upheld in Septem-
                            ber 1989 by the United States Court of Appeals for the Second Circuit,
                            occ permitted national banks to offer mortgage pass-through certifi-
                            cates, representing interests in mortgage loans originated by the bank.
                            The court found the sale of such certificates within the business of




                            Page80                                              GAO/GGD-904BankPowers
                       Appendix VI
                       The Regulatory Framework Affecting       the
                       Securities Activities of Banks




                       banking and not in violation of Glass-Steagall’s prohibition on under-
                       writing securities. I

     -c


Fedel,da1Reserve Act   In 1913, Congress enacted the Federal Reserve Act, which established
                       the Federal Reserve System and its Board of Governors. This act
                       requires national banks to be members of the Federal Reserve System. It
                       also contained provisions allowing state-chartered banks to join the Fed-
                       eral Reserve System, making them member banks and subject to Board
                       regulation, State member banks are subject to the same limitations on
                       their securities activities that apply to national banks.

                       The act also contains provisions that affect the transactions between a
                       bank and its affiliates. Section 23A of this act prohibits a member bank
                       from extending credit to, or purchasing assets from, an affiliate in
                       excess of 10 percent of the bank’s capital and places an aggregate cap of
                       20 percent of capital for transactions to all affiliates. This section also
                       requires generally that any bank loans to an affiliate be fully collateral-
                       ized as a minimum, or up to 130 percent of the loan amount, depending
                       on the composition of the collateral. Section 23B of this act requires that
                       covered transactions, such as the sale of assets or services purchased
                       under contract, between a bank and an affiliate must be on terms sub-
                       stantially the same as those prevailing at the time for comparable trans-
                       actions involving nonaffiliates. The limitations of Section 23B were
                       made applicable to all FDIc-insured banks in 1987.


McFadden Act           Under the McFadden Act of 1927, banking activities were limited by
                       provisions prohibiting the interstate branching by banks. However, the
                       law reaffirmed the authority of national banks to buy and sell invest-
                       ment securities.


Glass-Steagall Act     The Banking Act of 1933 significantly limited the securities activities of
                       banks. Popularly referred to as the Glass-Steagall Act, it contains the
                       following-four sections which deal with the separation of commercial
                       banking from investment banking.

                       ‘See Securities Industry Ass’n. v. Clarke, 88.5 F.2d 1934 (2d Cir. 1989) which is currently on appeal
                       to the Supreme Court. It should be noted that mortgage-related securities activities carried out in a
                       securities subsidiary of a bank holding company have been considered a “bank-ineligible” activity
                       when permissible levels of such activity are calculated for Section 29 purposes. If the CCC interpreta-
                       tion is upheld by the Supreme Court, the Federal Reserve would have to determine whether revenue
                       from the activity constitutes bank-eligible revenue, which would increase the revenue base, as
                       opposed to bank-ineligible revenue, which would not.



                       Page 81                                                                GAO/GGD-9048      Bank Powers
                            Appendix VI
                            The Regulatory Framework Affecting        the
                            Securities Activities of Banks




                        * Section 16 prohibits a national bank from underwriting securities other
                          than U.S. government and general obligation bonds of states and munici-
                          palities and certain securities issued or insured by certain specified gov-
                          ernment agencies or instrumentalities. It does, however, allow a national
                          bank to purchase or sell securities without recourse, solely on the order,
                          and for the account of, customers. Section 5(c) of the act extends these
                          prohibitions to state-chartered member banks.
                        l Section 21 prohibits any firm engaged in the deposit-taking business,
                          including a bank, from engaging in the business of issuing, underwriting,
                          selling, or distributing securities, except as permitted under Section 16.
                        + Section 20 prohibits a member bank from being affiliated with any firm
                          engaged principally in the issue, flotation, underwriting, public sale, or
                          distribution of securities.’
                        . Section 32 prohibits management and employee interlocks between
                          member banks and firms primarily engaged in the issue, flotation,
                          underwriting, public sale, or distribution of securities, except as permit-
                          ted by regulation of the Federal Reserve Board.

.-F-----




I%$nk Holding Company       The Bank llolding Company Act of 1956, as amended, administered by
                            the Board, allows bank holding company nonbank subsidiaries to engage
A&                          in activities that are permissible for banks as well as those that banks
                            are not permitted to engage in. A holding company must, however, com-
                            ply with the provisions contained in the Glass-Steagall Act. Board regu-
                            lations promulgated under the Bank Holding Company Act are
                            contained in its Regulation Y.

                            Under Section 4(c)(8) of the act, the Board can authorize bank holding
                            companies-and their subsidiaries-to engage in activities that it deter-
                            mines are closely related to and a proper incident to banking. This sec-
                            tion of the act also requires the Board to determine that an approved
                            new activity may be expected to produce public benefits, such as greater
                            convenience or increased competition, that outweigh possible adverse
                            effects, such as unsound banking practices and conflicts of interest.

                            In authorizing Section 20 companies, the Board used its authority under
                            the Bank Holding Company Act to impose requirements regarding reve-
                            nue limitations, capitalization, and firewalls.


                            ‘This prohibition does not extend to the securities underwriting activities permissible under ktion
                             16 of the act, See Securities Industry Ass’n. v. Federal Reserve System, 839, F.2d 47 (2d Cir.), cert.
                            9,       108 S. Ct. 2830 ( 1988).



                            Page 82                                                                  GAO/&D-9048        Bank Powers
                         Appendix VI
                         The Regulatory Framework Affecting        the
                         Securities Activities of Banks




Inter ational Securiti   To allow U.S. banking organizations to be more competitive in foreign
      lh
Activities of U.S.       markets, the federal regulatory structure permits domestic commercial
                         banks and bank holding companies to do a range of securities activities
Com&ercial Banking       overseas that is broader than those permitted in the U.S. market. One
Orga+zations             primary reason this occurs is that provisions contained in the Glass-
                         Steagall Act do not apply to U.S. banks’ foreign activities. U.S. banking
                         organizations do international securities and other activities primarily
                         through some combination of foreign branches of the domestic parent
                         bank, or through foreign bank and nonbank subsidiaries, Edge Act cor-
                         poration subsidiariesrJ and joint venture companies (noncontrolling
                         interests in foreign banks and financial companies) of the parent bank
                         or bank holding company. An example of the organizational structures
                         that are possible within the holding company is shown in figure VI. 1.




                         %ection 25(a) of the Federal Reserve Act (the Edge Act) authorizes the Board of Governors to char-
                         ter corporations for the purpose of engaging in international or foreign banking or other international
                         and foreign operations.



                         Page 83                                                                GAO/GGD90-48       Bank Powers
                                                                                                                                -
                                            Appendix VI
                                            The Regulatory Framework Affecting   the
                                            Securities Activities of Banks




Figure VI.1: Possible Organization Structure for the Conduct of U.S. Bank Holding Company’s International Operations




I’
I
I




                                               III
                                                         U.S. locations


                                              I      ~ ’ Overseas locations
                                              ID,




                                           Page 84                                                   GAO/GGD-90-48     Bank Powers
Appendix VI
The Regulatory Framework Affecting        the
Securities Activities of Banks




All of these organizational structures must comply with applicable U.S.
laws regarding powers, capitalization, and transactions within the hold-
ing company. In addition, all of the organizational arrangements must
comply with the banking laws and regulations of the host country.4

The following statutory provisions of the Federal Reserve Act and the
Bank Holding Company Act are the key guidelines for the overseas
activities of member banks and bank holding companies.

Section 25 of the Federal Reserve Act permits national banks to estab-
lish foreign branches, invest directly in foreign banks, and exercise
other powers, including limited securities activities that are usual in
connection with banking in the place where foreign branches transact
business5 Branches are limited by statute to underwriting and distribut-
ing only government securities of the country in which the branch is
located.
Section 25(a) of the Federal Reserve Act authorizes national banks to
own Edge Act corporations and gives Edge Act corporations a broad
range of foreign investment powers.
Section 4(c)( 13) of the Bank Holding Company Act allows U.S. bank
holding companies to make direct foreign investments.
Sections 23A and 23B of the Federal Reserve Act limit transactions
between the domestic bank and the bank holding company parent or its
affiliates. The relationships to which these limitations apply are summa-
rized in figure VI.2. The restrictions do not apply to transactions taking
place within the shaded box shown in figure VI.2. Everything in the
shaded box is owned by the bank and, for bank regulatory purposes, can
be viewed on a consolidated basis.




“Ranking and securities regulatory structures and rules vary among countries. For example, the
Glass-Steagall Act in the IJnited States and its equivalent, Article 65, in Japan separate the securities
and banking industries and thus result in different regulatory structures than in the United Kingdom,
where banks are allowed to engage in securities activities.
“Under the provisions of Section 9 of the Federal Reserve Act, the Federal Reserve interprets Section
26 to also apply to state-chartered member banks.



Page 85                                                                 GAO/GGD-SO-48 Bank Powers
                                             Appendix VI
                                             The Regulatory Framework Affecting               the
                                             Securities Activities of Banks




Figu/re Vl.2: Limitations on Transactions Between Affiliates in U.S. Banking Organization’s International Operations

                                                             U.S. Bank Holding
                                                                 Company

                                                       \




                                                              U.S. locations
                                                 I
                                                    II
                                                 I           ’ Overseas locations
                                                 L- J
                     ”
                                                  :::::::::::::;:;:::::;:;::::j
                                                  .i;:i:ili:;ilijl:i:iiiijiii
                                                    ....~...~.~.~.~.......
                                                             :
                                                   .:>:~:~Yj::j,
                                                           .:.:.:.Transactions unrestricted



                                             Page 86                                                     GAO/GGD-90-48   Bank Powers
--------I


            Appendix Vl
            T h e Regulatory F r a m e w o r k A ffecting           the
            Securities Activities of B a n k s




            R e g u l a tio n K i m p l e m e n ts key sections o f th e F e d e r a l R e s e r v e a n d B a n k
            H o l d i n g C o m p a n y A c tsfi It describes th e activities th a t b a n k s a n d b a n k
            h o l d i n g c o m p a n i e sm a y e n g a g ein o v e r s e a sth r o u g h fo r e i g n branches,
            fo r e i g n subsidiaries, a n d E d g e A c t corporations. T h e activities permitted
            b y R e g u l a tio n K generally e n c o m p a s sall d o m e s tic b a n k i n g p o w e r s plus
            s o m e a d d i tio n a l b a n k i n g p o w e r s (in th e c a s e o f b r a n c h e s ) a n d invest-
            m e n t b a n k i n g p o w e r s , s u c h a s underwriting a n d d e a l i n g in e q u i ty securi-
            tie s (in th e c a s e o f subsidiaries). Generally, U .S . b a n k i n g organizations
            m a y e n g a g ein activities permitted b y R e g u l a tio n K to th e extent th a t
            th e s e activities a r e permitted b y h o s t c o u n try regulators. S u b j e c t to
            prior B o a r d approval, b a n k s or b a n k h o l d i n g c o m p a n i e sm a y also e n g a g e
            in activities th a t a r e n o t prescribed in R e g u l a tio n K b u t a r e permissible
            b y th e regulations o f th e h o s t c o u n try.

            T o illustrate th e o p p o r tunities th a t exist o v e r s e a s for b a n k h o l d i n g c o m -
            p a n i e s to e n g a g ein securities activities, th e constituent e l e m e n ts o f b a n k
            h o l d i n g c o m p a n i e seligible to underwrite corporate d e b t a r e s h o w n in
            fig u r e V I.3 . E x c e p t for th e S e c tio n 2 0 firm s , all o f this underwriting
            m u s t ta k e p l a c e in e n titie s o f th e b a n k or its h o l d i n g c o m p a n y th a t can-
            n o t o p e r a te in U .S . d o m e s tic securities m a r k e ts, S e c tio n 2 0 c o m p a n i e s
            c a n underwrite corporate d e b t,a n d e q u i ty only a fter receiving prior
            a p p r o v a l from th e F e d e r a l Reserve.




            “Iicgulation K also implements the International B a n k i n g Act of 1 9 7 8 (which a d d r e s s e sthe IJ.S. activ-
            ities of foreign banks), the B a n k Export ServicesAct (which relates to export trading companies),a n d
            the International L e n d i n gS u p e r v i s i o nAct (which s t r e n g t h e n e dfederal supervisionof the foreign
            l e n d i n g of’IJ.S. bunks). A s n o t e d a b o v e ,g e n e r a lregulationsi m p l e m e n t i n gthe B a n k H o l d i n g C o m p a n y
            Act a r e c o n t a i n e din R e g u l a t i o nY .



            Page 87                                                                                          G A O /G G D - 9 0 - 4 8 B a n k P o w e r s
                                           Appendix VI
                                           The Regulatory Framework Affecting           the
                                           Securities Activities of Banks




Figbre Vl.3: Constituent Elements of U.S. Bank Holding Companies Eligible to Underwrite Corporate Debt

                                                                  U.S. Bank Holding
                                                                      Company




                                                                                   I
                                           I             1*




                                            I   II
                                                              U.S.   locations



                                           I             1
                                                              Overseas      locations
                                           LI        J


                                               ~~ :... Transactions unrestricted
                                               >..............,..........
                                         * Organlzational elements eligible to underwrite corporate debt

                                          1 Only 4 Section 20 companies authorized to underwnte corporate debt as of September 30, 1989.




                                          Page 8H                                                             GAO/GGD90-48      Bank Powers
Appendix VI
The Regulatory Framework Affecting      the
Securities Activities of Banks




Regulation K contains specific limitations on some of the activities that
are allowed. For example, the aggregate commitment of a banking
organization and its subsidiaries to underwrite shares of an issuer can-
not exceed $15 million. In addition, the total loans and extensions of
credit, including underwriting commitments, to any one person by an
Edge Corporation or foreign bank subsidiary of a member bank when
aggregated with loans and extensions of credit by the member bank to
that person cannot exceed the member bank’s limitations on loans and
extensions of credit to any one person.

Regulation K does not impose on the foreign operations of U.S. banking
organizations many of the so-called firewall provisions that apply to
nontraditional domestic activities. For example, there are no such
restrictions on interlocking boards of directors or joint marketing activi-
ties between a bank and nonbank affiliate. A reason for this is that
many of the firewalls are designed to protect the investing public and
depositors in the United States and to encourage competition in the U.S.
market. Regulation K does, however, require that all U.S. banking orga-
nizations’ operations be in accordance with high standards of banking or
financial prudence.

The Federal Reserve is reviewing Regulation K now and intends to pub-
lish a revised regulation for comment by early 1990. Federal Reserve
officials said that they expect a significant area of industry concern to
be the quantitative limitations that Regulation K imposes on securities
underwriting and dealing activities.

The international activities of US. banking organizations are subject to
supervisory examinations and inspections by the Federal Reserve, OCC,
and the Federal Deposit Insurance Corporation (FDIC).~ In addition, these
U.S. bank regulators reached an agreement with the central banks and
banking supervisors of 11 other industrialized countries on international
guidelines for uniform, risk-based capital standards8 These guidelines
are explained in appendix V. Regulators from these countries, including
the IJnited States, have also agreed to broad supervisory guidelines.



‘The Federal Reserve is responsible for regulating and supervising the foreign operations of member
banks and bank holding companies. The Federal Reserve also charters, regulates, and supervises
Edge Act corporations. OCC charters and supervises national banks. State nonmember banks, which
are regulated by FDIC, have relatively small international operations.

sThe 11 other industrial countries include Belgium, Cawdda, France, Germany, Italy,   .Javdn,   Luxem-
bourg, the Netherlands, Sweden, Switzerland, and the IJnited Kingdom.



Page 89                                                              GAO/GGD-90-48         Bank Powers
                           Appendix VI
                           The Regulatory Framework Affecting   the
                           Securities Activities of Banks




                           The Board may use two methods to allow bank holding companies to
Recent Board Actions       initiate new activities that it determines are closely related to banking.
Affecting the              The Board can amend its regulations to determine that an activity is
Securities Activities of   closely related to banking. Once added to this list of permissible activi-
                           ties, the approval process for a bank holding company to engage in this
U$3.Banking                activity is simplified. The Board can also approve applications submit-
O#ganizations              ted to it by individual holding companies seeking its approval to initiate
                           new activities specified in their applications. As of October 1989, the
                           Board’s Regulation Y listed 24 activities that it determined are closely
                           related to banking and appropriate activities for holding companies to
                           do; 6 of them are related to securities activities. (See table VI. 1.)
                           Through its application process, the Board has also approved requests
                           by holding companies to do 25 additional new activities that were not
                           specifically listed in the Board’s regulations.

                           Beginning in 1987, the Board began approving, on a case-by-case basis,
                           applications submitted by bank holding companies seeking to under-
                           write and deal in bank-ineligible securities through wholly owned non-
                           bank subsidiaries. When the Board approved these additional securities
                           powers for bank holding companies and determined that the activities of
                           the companies were consistent with Section 20 of the Glass-Steagall Act,
                           it used its authority under the Bank Holding Company Act to establish
                           firewall requirements.




                           Page 90                                             GAO/GGD-90-48   Bank Powers
             .
-..-
                                              Appendix VI
                                              The Regulatory Framework Affecting      the
                                              Securities Activities of Banks




Table \ Iljl: Activities Closely Related to
Bankin          Approved for Bank Holding     Activities                                                           Securities-related
                                                                            --.-_____.-
Compa es Contained in Regulation Y            Making and servicing loans                                             No
                                              Industrial banking                                                     No_______.._ -.--~ -.~~..-..~~-.
                                              Trust company functions             ..~~.---. -~-____                  Yes
                                                                                                                         __-
                                              Investment or financial advice ~~ -~~__                                Yes
                                              Leasing personal or real property                                      No
                                              Community development                                                  No _______ -.__~--.--..-
                                              Data processing                                                        No
                                              Insurance agency and brokerage in connection with credit               No
                                                 extensions                                     ____-
                                              Underwriting insurance   - ~~.related
                                                                                ~~-- ..~to an extension of credit    No
                                              Providing     courier                                                  No
                                                             -. _-- services
                                                 _. - _._.....            -...-. . .~~-----
                                              Management consulting to non-affiliated bank and nonbank               No
                                                 deposit institutions
                                              issuing and selling money orders, savings bonds, and                   No
                                                 travelers checks                 -~ --.-~.-                        .___    _.._ _. .~~._~.~~~...~~_~
                                                                                                                                                    -
        //                                    Real estate and personal property appraising                           No
                                              Arranging commercial real estate equity financing                      No
                                              Securit&brokerage                                                      Yes
                                                                                                                     .-..__.-~~~----~             ~~~
                                              Underwriting and dealing in government obligations and                 Yes
                                                 money._-.market instruments                                      _______~~_ .__ -- ~~~ ~..-~~
                                              Foreign exchan&advisory              and   transactional services      No
                                                                      -~~~ ..~~._    .______-
                                              Future commission merchant                                -___         Yes
                                              Investment advice on financial futures and options on futures Yes
                                                      ..-_.       ~. . ..~
                                              Consumer financial counseling                                          No
                                              Tax planning and preparation                 _~~~ -__-                 No
                                              Check-guaranty servrces                                                No_ ..~~~-_~--.-~~~ --... .~~
                                              Operating a collection agency                                          No
                                              Operating a credit bureau                                              No




                                              SECregulates Section 20 companies no differently from any other bro-
SEC’Regulation of                             ker-dealer. A securities subsidiary registers with SEC and a self-
Section 20 Companies                          regulatory organization (SRO), such as NASD or NYSE, depending on the
                                              type of activity it plans to pursue. SROSmonitor the activities of regis-
                                              tered securities firms, SEC,in turn, oversees the rules and activities of
                                              the SNOSand, on a selective basis, of individual firms as well. The regula-
                                              tory system is thus a mixture of self-regulation and direct regulation by
                                              SIX:.SECprovides direct oversight by doing investigations, by taking dis-
                                              ciplinary actions against firms or against an SRO itself for not doing an
                                              adequate self-regulatory job, and by implementing or changing its
                                              existing regulations. SRO rules are subject to SEC approval.



                                              Pagr 91                                                               GAO/GGD-9048      Bank Powers
Appendix Vl
The Regulatory Framework Affecting   the
Securities Activities of Banks




SROSevaluate members for financial health and compliance with both
SECregulations and their own. Enforcement is carried out through peri-
odic, unannounced examinations; investigations of alleged violations;
disciplinary action against members; and assessment of penalties where
appropriate. The SRO tests individuals before they can be registered as
principals or representatives (except for individuals associated with
firms solely engaged in government securities transactions). Principals
are responsible for the management and/or supervision of the securities
firm.

All but three of the Section 20 companies that were authorized as of
September 30, 1989, have designated NASD as their primary SRO. NASD-
registered members can engage in investment banking and deal in over-
the-counter securities. Three Section 20 companies have designated NBE
as their primary SRO.

Generally, SEC has no authority over the underwriting, dealing, or secur-
ities brokerage activities of banks. The Federal Reserve enforces its
firewalls applicable to Section 20 firms since these firms are affiliated
with bank holding companies. SEC specifies its own regulations regarding
capital and personnel but makes no mention of separating the banking
and securities subsidiaries of bank holding companies. The Federal
Reserve instructs its examiners not to duplicate the function of the SRO
or SEC. SEC and the Federal Reserve have no formal contact with each
other regarding firewalls.

An SEC attempt to regulate a securities activity within a bank (i.e., not
within a subsidiary corporation) was invalidated by a court ruling. Spe-
cifically, in 1985, SEC adopted Rule 3b-9, which would have required
banks engaging in securities business for profit to register as broker-
dealers with SEC under the Securities Exchange Act of 1934. The Circuit
Court of Appeals for the District of Columbia declared Rule 3b-9 unlaw-
ful under the 1934 act. The court noted, however, that despite recent
FDIC and Federal Reserve Board interpretations of the Glass-Steagall Act
permitting banks to engage in brokerage services for nonbanking cus-
tomers, the 1934 act still specifically excluded banks from rules gov-
erning broker-dealers and suggested any change in this interpretation
would require action by Congress. (See American Bankers Ass’n. v.




Page 92                                           GAO/GGDSO-QS Bank Powers
Appendix VI
The Regulatory Framework Affecting        the
Securities Activities of Bauks




S.E.C., 804 F.2d 739, 750 (D.C. Cir. 1986).) In 1987, SEC supported legis-
lation that Congress did not enact, which would have given SEC power to
regulate certain securities activities of banks.”




“Both the IIouse and the Senate introduced legislation in 1988 (1I.R. 6094 and S.1886, respectively)
that would have amended the Glass-Steagall Act and expand SEC’s power to regulate certain bank
securities activities; Congress did not enact this legislation.



Page 93                                                                GAO/GGD-9048      Bank Powers
Adpendix VII
  /
Ij’irewaUsApplicable to Section 20 F’irms That
underwrite and Deal Only in Municipal
Revenue Bonds, Mortgage-Relatedand Asset-
Backed
-       Securities, and/or Commercial Paper
                 This appendix quotes the firewall requirements the Board established in
                              April 1987. The Board still applies these firewalls to Section 20 compa-
                              nies having authority to underwrite and deal only in municipal revenue
                              bonds, mortgage-related and asset-backed securities, and/or commercial
                              paper.

                              “A. Types of Securities to be Underwritten

                              1, The underwriting subsidiaries shall limit their underwriting and deal-
                              ing in ineligible securities to the following:’
                              a. Municipal revenue bonds that are rated as investment quality (i.e., in
                              one of the top four categories) by a nationally recognized rating age&y,
                              except that industrial development bonds in these categories shall be
                              limited to “public ownership” industrial development bonds (i.e., those
                              tax exempt bonds where the issuer, or the governmental unit on behalf
                              of which the bonds are issued, is the sole owner, for federal income tax
                              purposes, of the financed facility (such as airports and mass commuting
                              facilities)).
                              b. Mortgage-related securities (obligations secured by or representing an
                              interest in l-4 family residential real estate), rated as investment quality
                              (i.e., in one of the top 4 categories) by a nationally recognized rating
                              agency.
                              c. Commercial paper that is exempt from registration and prospectus
                              requirements of the S.E.C. pursuant to the Securities Act of 1933 and
                              that is short term, of prime quality, and issued in denominations no
                              smaller than $100,000.”

                              “B. Capital     Investment

                              2. Each Applicant’s investment in an underwriting subsidiary and the
                              assets of the underwriting subsidiary shall be excluded in determining
                              the holding company’s consolidated primary capital under the Board’s
                              Capital Adequacy Guidelines.”

                              “C. Capital Adequacy

                              3. The underwriting subsidiary shall maintain at all times capital ade-
                              quate to support its activity and cover reasonably expected expenses
                              and losses in accordance with industry norms.
                              4. Applicants shall submit quarterly to the Federal Reserve Bank of New

                              ‘Authority to underwrite and deal in consumer-receivable-related securities was not included in the
                              April 1987 Order. This authority was added in a separate Order in May 1987.



                              Page 94                                                              GAO/GGD-9049        Bank Powers




                                                                                                                   I
.

    Appendix VII
    Firewalls Applicable to Section 20 Firms That
    Underwrite and Deal Only in Municipal
    Revenue Bonds, Mortgage-Related    and Asset-
    Backed Securities, and/or Commercial Paper




    York FOCUS reports filed with the NASD or other self-regulatory organi-
    zations, and detailed information breaking down the underwriting sub-
    sidiaries’ business with respect to eligible and ineligible securities, in
    order to permit monitoring of the underwriting subsidiaries’ compliance
    with the provisions of this Order.”

    “D. Credit Extensions by Lending Affiliates to Customers of the Under-
    writing Subsidiary

    5. No Applicant or subsidiary shall extend credit, issue or enter into a
    stand-by letter of credit, asset purchase agreement, indemnity, insur-
    ance or other facility that might be viewed as enhancing the
    creditworthiness or marketability of an ineligible securities issue under-
    written by an affiliated underwriting subsidiary.
    6. No lending affiliate of an underwriting subsidiary shall knowingly
    extend credit to a customer secured by, or for the purpose of purchas-
    ing, any ineligible security that an affiliated underwriting subsidiary
    underwrites during the period of the underwriting, or to purchase from
    the underwriting subsidiary any ineligible security in which the under-
    writing subsidiary makes a market. This limitation extends to all cus-
    tomers of lending affiliates, including brokers-dealers, and unaffiliated
    banks, but does not include lending to a broker-dealer for the purchase
    of securities where an affiliated bank is the clearing bank for such bro-
    ker-dealer.
    7. No Applicant or any of its subsidiaries may make loans to issuers of
    ineligible securities underwritten by an affiliated underwriting subsidi-
    ary for the purpose of the payment of principal and interest on such
    securities, To assure compliance with the foregoing, any credit lines
    extended to an issuer by any lending subsidiary of the bank holding
    company shall provide for substantially different timing, terms, condi-
    tions and maturities from the ineligible securities being underwritten. It
    would be clear, for example, that a credit has substantially different
    terms and timing if it is for a documented special purpose (other than
    the payment of principal and interest) or there is substantial participa-
    tion by other lenders.
    8. Each Applicant shall adopt appropriate procedures, including mainte-
    nance of necessary documentary records, to assure that any extensions
    of credit to issuers of ineligible securities underwritten or dealt in by an
    underwriting subsidiary are on an arm’s length basis for purposes other
    than payment of principal and interest on the issuer’s ineligible securi-
    ties being underwritten or dealt in by the subsidiary. An extension of




    Page 96                                              GAO/GGD-9048   Bank Powers
Appendix VU
Firewalls Applicable to Section 20 Firms That
Underwrite and Deal Only in Municipal
Revenue Bonds, Mortgage-Related    and Asset-
Backed Securities, and/or Commercial Paper




credit is considered to be on an arm’s length basis if the terms and condi-
tions are substantially the same as those prevailing at the time for com-
parable transactions with issuers whose securities are not underwritten
or dealt in by the underwriting subsidiaries.
9. The requirements relating to credit extensions to issuers noted in
paragraphs 5-8 above shall also apply to extensions of credit to parties
that are major users of projects that are financed by industrial revenue
bonds.”

“E. Limitations to Maintain Separateness of an Underwriting                  Affiliate’s
Activity

10. There will be no officer, director, or employee interlocks between an
underwriting subsidiary and any of the holding company’s bank or
thrift subsidiaries. The underwriting subsidiary will have separate
offices from any affiliated bank.”

“F. Disclosure by the Underwriting              Subsidiary

 11. An underwriting subsidiary will provide each of its customers with a
special disclosure statement describing the difference between the
underwriting subsidiary and its banking affiliates and pointing out an
affiliated bank could be a lender to an issuer and referring the customer
to the disclosure documents for details. The statement shall also indicate
that the obligations of the underwriting subsidiary are not those of any
affiliated bank and that the bank is not responsible for securities sold by
the underwriting subsidiary. The underwriting subsidiary should dis-
close any material lending relationship between the issuer and a bank or
lending affiliate of the underwriting subsidiary as required under the
securities laws and in every case whether the proceeds of the issue will
be used to repay outstanding indebtedness to affiliates.
12. No underwriting subsidiary nor any affiliated bank or thrift institu-
tion will engage in advertising or enter into an agreement stating or sug-
gesting that an affiliated bank is responsible in any way for the
underwriting subsidiary’s obligations.
13. No bank or thrift affiliate of the underwriting subsidiary will act as
agent for, or engage in marketing activities on behalf of, the underwrit-
ing subsidiaries. In this regard, prospectuses and sales literature of an
underwriting subsidiary may not be distributed by a bank or thrift affil-
iate; nor should any such literature be made available to the public at
any offices of any such affiliate, unless specifically requested by a
customer.”



Page 96                                                      GAO/GGD-90-48    Bank Powers
----, .
          Appendix VII
          Firewalls Applicable to Section 20 Firms That
          Underwrite  and Deal Only in Municipal
          Revenue Bonds, Mortgage-Related    and Asset-
          Backed Securities, and/or Commercial Paper




          “G. Investment Advice by Bank/Thrift                  Affiliates

          14. An affiliated bank or thrift institution may not express an opinion
          with respect to the advisability of the purchase of ineligible securities
          underwritten or dealt in by an underwriting subsidiary unless the bank
          or thrift affiliate notifies the customer that its affiliated underwriting
          subsidiary is underwriting or making a market in the security.”

          “H. Conflicts of Interest

          15. No Applicant nor any of its subsidiaries, other than the underwriting
          subsidiary, shall purchase, as principal, ineligible securities that are
          underwritten by the underwriting subsidiary during the period of the
          underwriting and for 60 days after the close of the underwriting period,
          or shall purchase from the underwriting subsidiary any ineligible secur-
          ity in which the underwriting subsidiary makes a market except that, in
          the case of ineligible securities that are being issued in a simultaneous
          cross-border underwriting in which the underwriting subsidiary and a
          foreign affiliate or affiliates are participating, such securities may be
          purchased or sold pursuant to an intersyndicate agreement for the
          period of the underwriting where the purchase or sale results from bona
          fide indications of interest from customers. Such purchases or sales shall
          not be made for purposes of providing liquidity or capital support to the
          underwriting subsidiary or otherwise to evade the requirements of this
          Order. An underwriting subsidiary shall maintain documentation on
          such transactions.2
          16. No Applicant nor any of its bank, thrift, or trust or investment advi-
          sory company subsidiaries shall purchase, as a trustee or in any other
          fiduciary capacity, for accounts over which they have investment dis-
          cretion ineligible securities
          (i) underwritten by the underwriting subsidiary as lead underwriter of
          syndicate member during the period of any underwriting or selling syn-
          dicate, and for a period of 60 days after the termination thereof, and
          (ii) from the underwriting subsidiary if it makes a market in that secur-
          ity, unless, in either case, such purchase is specifically authorized under
          the instrument creating the fiduciary relationship, by court order, or by
          the law of the jurisdiction under which the trust is administered.
          17, An underwriting subsidiary may not underwrite or deal in any ineli-
          gible securities issued by its affiliates or representing interests in, or
          secured by, obligations originated or sponsored by its affiliate (except
          for grantor trusts or special purpose corporations created to facilitate

          ‘This firewall w&q modified, as above, in a January 1990 Board Order.



          Page 97                                                             GAO/GGD-90-48   Bank Powers
Appendix VU
Firewalls Applicable to Section 20 Firms That
Underwrite and Deal Only in Municipal
Revenue Bonds, Mortgage-Related    and Asset-
Backed Securities, and/or Commercial Paper




underwriting of securities backed by residential mortgages originated by
a non-affiliated lender) unless such securities are rated by an unaffili-
ated, nationally recognized rating organization or are issued or guaran-
teed by the Federal National Mortgage Association, the Federal Home
Loan Mortgage Corporation, or the Government National Mortgage
Association or represent interests in securities issued or guaranteed by
such agenciesZ1
18. No bank or thrift shall, directly or indirectly, for its own account,
purchase financial assets of an affiliated underwriting subsidiary or a
subsidiary thereof or sell such assets to the underwriting subsidiary or
subsidiary thereof. This limitation shall not apply to the purchase and
sale of U.S. Treasury securities or direct obligations of the Canadian fed-
eral government that are not subject to repurchase or reverse repur-
chase agreements between the underwriting subsidiary and its bank or
thrift affiliates4 ”

“I. Limitations to Address Possible Unfair Competition

19. No lending affiliate of an underwriting subsidiary may disclose to
the underwriting subsidiary any nonpublic customer information con-
sisting of an evaluation of the creditworthiness of an issuer or other cus-
tomer of the underwriting subsidiary (other than as required by
securities laws and with the issuer’s consent) and no officers or employ-
ees of the underwriting subsidiary may disclose such information to its
affiliates.”

“J. Formation of Subsidiaries of an Underwriting                    Subsidiary to Engage
in Underwriting and Dealing

20. Pursuant to Regulation Y, no corporate reorganization of an under-
writing subsidiary, such as the establishment of subsidiaries of the
underwriting subsidiary to conduct the activities, may be consummated
without prior Board approval.”




“This firewall was modified, as above, in a September 1989 Board Order.

,‘This firewall was modified, as above, in January 1989 and January 1990 Board Orders.



Page 98                                                             GAO/GGD-9043     Bank Powem
Appen$x*VIII

FirkzwallsImposed by the Federal Reserve
Board on Section 20 Companies Authorized to
Un#erwrite ayld Deal in Corporate Debt and
El&ity Securities
               This appendix quotes the firewall requirements applicable to Section 20
               companies authorized by the Board to underwrite and deal in corporate
               debt and equity securities. These requirements, first promulgated in
               January 1989, apply to all ineligible securities activities carried out in
               those Section 20 firms, not just corporate debt and equity. At the pre-
               sent time, no Section 20 company has been permitted to commence
               underwriting and dealing in corporate equities.

               “A. Capital Adequacy Conditions
                l(a). In determining compliance with the Board’s Capital Adequacy
               Guidelines, each Applicant shall deduct from its consolidated primary
               capital any investment it makes in the underwriting subsidiary that is
               treated as capital in the underwriting subsidiary. In accordance with the
               risk-based component of the Board’s Capital Guidelines, Applicant shall
               deduct 50 percent of the amount of any investment in the underwriting
               subsidiary from Tier 1 capital and 50 percent from Tier 2 capital. In
               calculating primary capital and risk-based capital ratios, Applicant
               should also exclude the underwriting subsidiary’s assets from the hold-
               ing company’s consolidated assets.
               (b). Applicant shall also deduct from its regulatory capital any credit it
               or a nonbank subsidiary extends directly or indirectly to the underwrit-
               ing 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 extension of credit were
               made by a member bank.’ In the case of the risk-based component of the
               Board’s Capital Guidelines, the deductions for unsecured or not fully-
               secured or inadequately collateralized loans shall be taken 50 percent
               from Tier 1 and 50 percent from Tier 2 as described above.
               Notwithstanding these adjustments, Applicant should continue to main-
               tain adequate capital on a fully consolidated basis.
               2. No Applicant nor any of its nonbank subsidiaries shall, directly or
               indirectly, provide any funds to, or for the benefit of, an underwriting
               subsidiary, whether in the form of capital, secured or unsecured exten-
               sions of credit, or transfer of assets, without prior notice to and
               approval by the Board.
               3. Before commencing the new activities, each Applicant must submit to
               the Board acceptable plans to raise additional capital as required by this
               Order or demonstrate that it is strongly capitalized and will remain so
               after making the capital adjustments authorized or required by this

               ‘An extension of credit means any loan, guarantee, or other form of credit exposure, including those
               described in condition 6.



               Page 99                                                              GAO/GGDSO-48       Bank Powers
Appendix VIII
Firewalls Imposed by the Federal Reserve
Board on Section 20 Companies Authorized to
Underwrite  and Deal in C!erporate Debt and
Equity Securities




Order. An Applicant may not commence the proposed activities until it
has received a Board determination that the capital plan satisfies the
requirements of this Order and has raised the additional capital required
under the plan.
4. The underwriting subsidiary shall maintain at all times capital ade-
quate to support its activity and cover reasonably expected expenses
and losses in accordance with industry norms.”

“B. Credit Extensions to Customers of the Underwriting                             Subsidiary2

5. No applicant or subsidiary shall directly or indirectly extend credit,
issue or enter into a stand-by letter of credit, asset purchase agreement,
indemnity, guarantee, insurance or other facility that might be viewed
as enhancing the creditworthiness or marketability of an ineligible
securities issue underwritten or distributed by the underwriting subsidi-
ary.
6. No Applicant or subsidiary (other than the underwriting subsidiary)
shall knowingly extend credit to a customer directly or indirectly
secured by, or for the purpose of purchasing, any ineligible security that
an affiliated underwriting subsidiary underwrites during the period of
the underwriting or for 30 days thereafter, or to purchase from the
underwriting subsidiary any ineligible security in which the underwrit-
ing subsidiary makes a market. This limitation extends to all customers
of Applicant and its subsidiaries, including broker-dealers and unaffili-
ated banks, but does not include lending to a broker-dealer for the pur-
chase of securities where an affiliated bank is the clearing bank for such
broker-dealer.
7. No Applicant or any of its subsidiaries may, directly or indirectly,
extend credit to issuers of ineligible securities underwritten by an affili-
ated underwriting subsidiary for the purpose of the payment of princi-
pal, interest or dividends on such securities. To assure compliance with
the foregoing, any credit lines extended to an issuer by any bank holding
company or any subsidiary shall provide for substantially different tim-
ing, terms, conditions and maturities from the ineligible securities being
underwritten. It would be clear, for example, that a credit has substan-
tially different terms and timing if it is for a documented special pur-
pose (other than the payment of principal, interest or dividends) or
there is substantial participation by other lenders.
8. Each Applicant shall adopt appropriate procedures, including mainte-
nance of necessary documentary records, to assure that any extension

‘?Jnless otherwise stated, these conditions shall apply to a subsidiary of a bank or thrift institution to
the same extent as they apply to the bank or thrift institution.



Page 100                                                                 GAO/GGD-9048       Bank Powers
Appendix VIII
Firewalls Imposed by the Federal Reserve
Board on Section 20 Companies Authorized to
Underwrite and Deal in Corporate Debt and
Equity Securities




of credit by it or any of its subsidiaries to issuers of ineligible securities
underwritten or dealt in by an underwriting subsidiary are on an arm’s
length basis for purposes other than payment of principal, interest, or
dividends on the issuer’s ineligible securities being underwritten or dealt
in by the underwriting subsidiary. An extension of credit is considered
to be on an arm’s length basis if the terms and conditions are substan-
tially the same as those prevailing at the time for comparable transac-
tions with issuers whose securities are not underwritten or dealt in by
the underwriting subsidiary.
9. In any transaction involving an underwriting subsidiary, Applicants’
thrift subsidiaries shall observe the limitations of sections 23A and 23B
of the Federal Reserve Act as if the thrifts were banks.
10. The requirements relating to credit extensions to issuers noted in
paragraphs 5 - 9 above shall also apply to extensions of credit to parties
that are major users of projects that are financed by industrial revenue
bonds.
11. Applicants shall cause their subsidiary banks and thrifts to adopt
policies and procedures, including appropriate limits on exposure, to
govern their participation in financing transactions underwritten or
arranged by an underwriting subsidiary as set forth in this Order. The
Reserve Banks shall ensure that these policies and procedures are in
place at Applicants’ subsidiary banks and thrifts and Applicants shall
assure that loan documentation is available for review by Reserve
Banks to ensure that an independent and thorough credit evaluation has
been undertaken in connection with bank or thrift participation in such
financing packages and that such lending complies with the require-
ments of this Order and section 23B of the Federal Reserve Act.
12. Applicants should also establish appropriate policies, procedures,
and limitations regarding exposure of the holding company on a consoli-
dated basis to any single customer whose securities are underwritten or
dealt in by the underwriting subsidiary.”

“C. Limitations to Maintain Separateness of an Underwriting                             Affiliate’s
Activity

13. There will be no officer, director, or employee interlocks between an
underwriting subsidiary and any of the holding company’s bank or
thrift subsidiaries. The underwriting subsidiary will have separate
offices from any affiliated bank or thrift.” ”


“An underwriting subsidiary may have offices in the same building as a bank or thrift affiliate if the
underwriting subsidiary’s offices are clearly distinguished from those of the bank or thrift affiliate.



Page 101                                                               GAO/GGD-SO-48 Bank Powers
Appendix VIII
Firewalls Imposed by the Federal Reserve
Board on Section 20 Companies Authorized to
UnderwrIte and Deal in Corporate Debt and
Equity Securities




“D. Disclosure by the Underwriting                 Subsidiary

 14. An underwriting subsidiary will provide each of its customers with a
special disclosure statement describing the difference between the
underwriting subsidiary and its bank and thrift affiliates and pointing
out that an affiliated bank or thrift could be a lender to an issuer and
referring the customer to the disclosure documents for details. In addi-
tion, the statement shall state that securities sold, offered, or recom-
mended by the underwriting subsidiary are not deposits, are not insured
by the Federal Deposit Insurance Corporation or the Federal Savings
and Loan Insurance Corporation, are not guaranteed by an affiliated
bank or thrift, and are not otherwise an obligation or responsibility of
such a bank or thrift (unless such is the case). The underwriting subsidi-
ary should also disclose any material lending relationship between the
issuer and a bank or lending affiliate of the underwriting subsidiary as
required under the securities laws and in every case whether the pro-
ceeds of the issue will be used to repay outstanding indebtedness to
affiliates.”

“E. Marketing Activities on Behalf of an Underwriting                         Subsidiary

15. No underwriting subsidiary nor any affiliated bank or thrift institu-
tion will engage in advertising or enter into an agreement stating or sug-
gesting that an affiliated bank or thrift is responsible in any way for the
underwriting subsidiary’s obligations as required under section 23B of
the Federal Reserve Act.
16. No bank or thrift affiliate of the underwriting subsidiary will act as
agent for, or engage in marketing activities on behalf of, the underwrit-
ing subsidiaryW4In this regard, prospectuses and sales literature relating
to securities being underwritten or dealt in by an underwriting subsidi-
ary may not be distributed by a bank or thrift affiliate; nor should any
such literature be made available to the public at any offices of any such
affiliate, unless specifically requested by a customer.”

“F. Investment Advice by Bank/Thrift                   Affiliates

17. An affiliated bank or thrift institution may not express an opinion
on the value or the advisability of the purchase or the sale of ineligible
securities underwritten or dealt in by an affiliated underwriting subsidi-
ary unless the bank or thrift notifies the customer that the underwriting

“This condition does not prevent a bank or thrift from informing its customers of the available ser-
vices of the underwriting subsidiary.



Page 102                                                              GAO/GM%9048        Bank Powers
Appendix VIII
Fix~walls Imposed by the Federal Reserve
Board on Section 20 Companies Authorized to
Underwrite and Deal in Corporate Debt and
Equity Securities




subsidiary is underwriting, making a market, distributing or dealing in
the security.
18. No Applicant nor any of its bank, thrift, or trust or investment advi-
sory subsidiaries shall purchase, as a trustee or in any other fiduciary
capacity, for accounts over which they have investment discretion ineli-
gible securities (a) underwritten by the underwriting subsidiary as lead
underwriter or syndicate member during the period of any underwriting
or selling syndicate, and for a period of 60 days after the termination
thereof, and (b) from the underwriting subsidiary if it makes a market
in that security, unless, in either case, such purchase is specifically
authorized under the instrument creating the fiduciary relationship, by
court order, or by the law of the jurisdiction under which the trust is
administered.”

“G. Extensions of Credit and Purchases and Sales of Assets

19. No Applicant nor any of its subsidiaries, other than the underwriting
subsidiary, shall purchase, as principal, ineligible securities that are
underwritten by the underwriting subsidiary during the period of the
underwriting and for 60 days after the close of the underwriting period,
or shall purchase from the underwriting subsidiary any ineligible secur-
ity in which the underwriting subsidiary makes a market except that, in
the case of ineligible securities that are being issued in a simultaneous
cross-border underwriting in which the underwriting subsidiary and a
foreign affiliate or affiliates are participating, such securities may be
purchased or sold pursuant to an intersyndicate agreement for the
period of the underwriting where the purchase or sale results from bona
fide indications of interest from customers. Such purchases or sales shall
not be made for purposes of providing liquidity or capital support to the
underwriting subsidiary or otherwise to evade the requirements of this
Order. An underwriting subsidiary shall maintain documentation on
such transactions.”

20. An underwriting subsidiary may not underwrite or deal in any ineli-
gible securities issued by its affiliates or representing interests in, or
secured by, obligations originated or sponsored by its affiliates (except
for grantor trusts or special purpose corporations created to facilitate
underwriting of securities backed by residential mortgages originated by
a non-affiliated lender) unless the securities are rated by an unaffiliated,
nationally recognized rating organization or are issued or guaranteed by
the Federal National Mortgage Corporation, or the Government National

“This firewall was modified, as above, in a January 1990 Board Order.



Page 103                                                            GAO/GGD-9048   Bank Powers
Appendix VIII
Flrewalls Imposed by the Federal Reserve
Board on Section 20 Companies Authorized t,o
Underwrite and Deal in Corporate Debt and
Equity Securities




Mortgage Association or represent interests in securities issued or guar-
anteed by such agencies.”
21(a). Applicants shall assure that no bank or thrift subsidiary shall,
directly or indirectly, extend credit in any manner to an affiliated
underwriting subsidiary or a subsidiary thereof; or issue a guarantee,
acceptance, or letter of credit, including an endorsement or standby let-
ter of credit, for the benefit of the underwriting subsidiary or a subsidi-
ary thereof.
(b). This prohibition shall not apply to an extension of credit by a ba.nk
or thrift to an underwriting subsidiary that is incidental to the provision
of clearing services by the bank or thrift to the underwriting subsidiary
with respect to securities of the United States or Canada or their agen-
cies, or securities on which the principal and interest are fully guaran-
teed by the United States or Canada or their agencies, if the extension of
credit is fully secured by such securities, is on market terms, and is
repaid on the same calendar day. If the intra-day clearing of such securi-
ties cannot be completed because of a bona fide fail or operational prob-
lem incidental to the clearing process that is beyond the control of the
bank or thrift and the underwriting subsidiary, the bank or thrift may
continue the intra-day extension of credit overnight provided the exten-
sion of credit is fully secured as to principal and interest as described
above, is on market terms, and is repaid as early as possible on the next
business day.7
22. No bank or thrift shall, directly or indirectly, for its own account,
purchase financial assets of an affiliated underwriting subsidiary or a
subsidiary thereof or sell such assets to the underwriting subsidiary or
subsidiary thereof. This limitation shall not apply to the purchase and
sale of lJ.S. Treasury securities or direct obligations of the Canadian fed-
eral government that are not subject to repurchase or reverse repur-
chase agreements between the underwriting subsidiary and its bank or
thrift affiliates.“”

“II. Limitations on Transfers of Information

23. No bank or thrift shall disclose to an underwriting subsidiary, nor
shall an underwriting subsidiary disclose to an affiliated bank or thrift,
any nonpublic customer information (including an evaluation of the


“This firewall was modified, as above, in a September 1989 Board Order
‘This fircwall was modified, as above, in a January 1990 Board Order.

H?‘his firewall was modified, as above, in a January 1990 Board Order.



Page 104                                                             GAO/GGD-90-48   Bank Powers
                  1


-.-A..-..-_i---



                      A p p e n d i x V III
                      Firewalls Im p o s e d by the Federal R e s e r v e
                      B o a r d o n Section 2 0 C o m p a n i e s Authorized to
                      Underwrite a n d D e a l in Corporate Debt a n d
                      Equity Securities




                      creditworthiness o f a n issuer or o th e r customer o f th a t b a n k or thrift, or
                      underwriting subsidiary) without th e c o n s e n t o f th a t customer.”

                      “I. R e p o r ts

                      2 4 . Applicants shall s u b m i t q u a r terly to th e appropriate F e d e r a l
                      R e s e r v e B a n k E Q C U Sreports filed with th e N A S D or o th e r self-regulatory
                      organizations, a n d d e tailed information b r e a k i n g d o w n th e underwriting
                      subsidiaries’b u s i n e s swith respect to eligible a n d ineligible securities, in
                      o r d e r to permit m o n i toring o f th e underwriting subsidiaries’c o m p l i a n c e
                      with th e provisions o f this O rder.!’”

                      “J. Transfer o f A c tivities a n d F o r m a tio n o f Subsidiarieso f a n U n d e r -
                      writing Subsidiary to E n g a g ein Underwriting a n d D e a l i n g

                      2 5 . T h e B o a r d ’s a p p r o v a l o f th e p r o p o s e d underwriting a n d d e a l i n g
                      activities extends only to th e subsidiaries d e s c r i b e d a b o v e for w h i c h
                      a p p r o v a l h a s b e e n s o u g h t in th e instant applications. T h e activities m a y
                      n o t b e c o n d u c te d b y Applicants in a n y o th e r subsidiary without prior
                      B o a r d review. P u r s u a n t to R e g u l a tio n Y , n o corporate reorganization o f
                      a n underwriting subsidiary, s u c h a s th e establishment o f subsidiaries o f
                      th e underwriting subsidiary to c o n d u c t th e activities, m a y b e c o n s u m -
                      m a te d without prior B o a r d approval.”

                      “K . Limitations o n Reciprocal A r r a n g e m e n ts a n d Discriminatory
                      Treatment

                      2 6 . N o Applicant n o r a n y o f its subsidiaries m a y , directly or indirectly
                      e n ter into a n y reciprocal a r r a n g e m e n t. A reciprocal a r r a n g e m e n t m e a n s
                      a n y a g r e e m e n t,u n d e r s ta n d i n g , or o th e r a r r a n g e m e n t u n d e r w h i c h o n e
                      b a n k h o l d i n g c o m p a n y (or subsidiary th e r e o f) a g r e e sto e n g a g ein a
                      transaction with, or o n b e h a l f o f, a n o th e r b a n k h o l d i n g c o m p a n y (or
                      subsidiary th e r e o f), in e x c h a n g efor th e a g r e e m e n to f th e s e c o n d b a n k
                      h o l d i n g c o m p a n y (or a n y subsidiary th e r e o f) to e n g a g ein a transaction
                      with, or o n b e h a l f o f, th e first b a n k h o l d i n g c o m p a n y (or a n y subsidiary
                      th e r e o f) for th e p u r p o s e o f e v a d i n g a n y r e q u i r e m e n t o f this O rder or
                      a n y prohibition o n transactions b e tween, or for th e b e n e fit o f, a ffiliates
                      o f b a n k s established p u r s u a n t to fe d e r a l b a n k i n g l a w or regulation.
                      2 7 . N o b a n k or thrift a ffiliate o f a n underwriting subsidiary shall,
                      directly or indirectly:


                      “T h e 1 3 o a r dwill m a k e available in the future a form o n w h i c h this information s h o u l d b e submitted.



                      Page 10B                                                                           G A O /G G D - 9 0 4 8 B a n k P o w e r s
Appendix VIII
Firewalls Imposed by the Federal Reserve
Board on Section 20 Companies Authorized to
Underwrite and Deal in Corporate Debt and
Equity Securities




(a) acting alone or with others, extend or deny credit or services (includ-
ing clearing services), or vary the terms or conditions thereof, if the
effect of such action would be to treat an unaffiliated securities firm less
favorably than its affiliated underwriting subsidiary, unless the bank or
thrift demonstrates that the extension or denial is based on objective
criteria and is consistent with sound business practices; or
(b) extend or deny credit or services or vary the terms or conditions
thereof with the intent of creating a competitive advantage for an
underwriting subsidiary of an affiliated bank holding company.”

“I,. Requirement for Supervisory Review Before Commencement of
Activities

28. An Applicant may not commence the proposed debt and equity
securities underwriting and dealing activities until the Board has deter-
mined that the Applicant has established policies and procedures to
ensure compliance with the requirements of this Order, including com-
puter, audit and accounting systems, internal risk management controls
and the necessary operational and managerial infrastructure. In this
regard, the Board will review in one year whether Applicants may com-
mence underwriting and dealing in equity securities based on a determi-
nation by the Board that they have established the managerial and
operational infrastructure and other policies and procedures necessary
to comply with the requirements of this Order.”




Page 106                                           GAO/GGD-904   Bank Powers
Cements From the Board of Governors of the
Federal Reserve System


                                          BOARD         OF   GOVERNORS
                                                          OF THE
                                      FEDERAL          RESERVE        SYSTEM
                                                WASHINGTON,  D. C. 20551




                                                  January        23,      1990




              Mr. Richard L. Fogel
              Assistant   Comptroller     General
              United States General Accounting                           Office
              Washington,   D.C.      20548
              Dear Mr.       Fogel:
                             This is in response to your letter               of December
              22nd to Chairman Greenspan enclosing              for our review and
              comment a draft         report   "Bank Powers:     Activities       of
              Securities       Subsidiaries     of Bank Holding     Companies*.         Our
              staff    subsequently       conveyed some suggestions           for editorial
              and technical       changes to your staff       in oral discussions           and
              we understand       that these changes will        be incorporated          in the
              final    report.      Except for these suggestions            for language
              changes, the staff          found the report    to be satisfactory.
                              If  you have any further questions                         with respect          to
              this matter,        please call Robert S. Plotkin,                         Assistant
              Director,       452-2782.
                                                                 Very       truly    yours,


                                                               rederick           M. Struble
                                                               Associate           Director




                Page 107                                                                       GAO/GGD-90-48    Bank Powers
A$pendix X

@mments From the Office of the Comptroller *
df the Currency

Notie: GAO comments
sudplementing those in the
repbrt text appear at the
end of this appendix.

                             0
                             Comptroller     of the Currency
                             Adminlstrator     of National Banks

                             Washington, D.C. 20219

                             February         7, 1990


                             Mr. Richard   L. Fogel
                             Assistant   Comptroller  General
                             General Government Division
                             United States General Accounting                    Office
                             Washington,   D.C. 20548

                             Dear Mr.         Fogel:
                             We have reviewed         your draft        of a proposed report              entitled        Bank
                             Powe s.     ctivities      of Securities            Subsidiaries        of Bank Holding
                             COlW&ig.          The study reviews            the principal         legislation         affecting
                             the securities        powers of bank affiliates.                   It discusses           the
                             reasoning    behind the Federal Reserve Board's                        (Board) decision            to
                             allow banks to underwrite               "ineligible        securities"         on a limited
                             basis under Section           20 of the Glass-Steagall                 Act.      It examines the
                             conflicts     of interest        that arise when investment                  and commercial
                             banking are combined.              It discusses        the firewalls           that have been
                             established       by the Board to ensure the safety                     and soundness of the
                             banking system,        to control         conflict     of interest          abuse, and to
                             insulate    the deposit        insurance         fund from risks          associated         with
                             securities      transactions.           The study also includes                statistics         on the
                             volume of securities           activities,          as well as on the market
                             penetration       of Section       20 subsidiaries,           and identifies            seven areas
                             requiring     further     study.
                             We        interpret      the statement        on page 19 that the use of a "separate
                                 SEC-regulated          subsidiary      and regulation       of the entire        holding
                                 company by the Federal Reserve [are] essential                         in permitting       the
                                 affiliation        of the banking and securities               businesses"       to be an
                                 endorsement        of the Federal Reserve's            view that ineligible
                                 securities        activities        should take place only within             a securities
                                 affiliate       of a bank holding          company.     We recommend that the draft
                                 acknowledge        that there are reasonable             alternatives       to the affiliate
                                 structure,        e.g. securities         underwriting      in direct      subsidiaries       of
                                 federally       insured      banks.      A proper choice among alternative
                                 organizational           structures      could be made once the costs and benefits
                                 of each are weighed.                Looking at alternative          organizational
                                 structures        might be included          in your list      of topics      for further
                                 study.




                                         Page 108                                                            GAO/GGD-SO-48     Bank Powers
                             Appendix X
                             Comments From the Office of the
                             Cum&roller of the Currency




                    Similarly,       the study seems to endorse the Federal Reserve's                   system
                    of firewalls        as an effective      means of preventing          underwriting     risks
                    from being transmitted           from the securities       affiliate       to the
                    federally      insured    bank.     There is no discussion           of safeguards,      such
                    as customer protection          rules administered        by the SEC, that might
See con   lent 2    show firewalls        to be unnecessary      and/or ineffective.             We recommend
Now on    ) 1.517   that the discussion         on pages 22 and 23 of the draft              be adjusted      to
                    recognize      that the need for particular          firewalls        be examined in
                    light     of their    cost and of other regulatory           and market safeguards.
                    In addition,          the report     generally      approves the Federal           Reserve's     10
                    percent     limit       on income from bank-ineligible              securities
                    activities.          We have previously          stated that we believe            that some
                    greater     level       of bank-ineligible         activity     would be legally
                    permissible         under Section        20 and that it is inappropriate                to set a
                    definitive        level    of gross income as the "engaged principally"
                    standard      for all cases.           We have also stated          that tests       other than
                    gross income are legally               permissible        and should be explored          for
                    determining         the meaning of "engaged principally"                    under Section     20.
          ent 3     We recommend that the draft                recognize        the possibility       of
                    alternative         approaches     for defining         "engaged principally"           under
                    Section     20.
                    One of the stated      objectives    of the report       is to "identify   how the
                    activities    of Section     20 firms have affected         risk levels  in their
                    respective    bank holding      companies."    Appendix II would better          meet
                    that objective     by describing     the risks    associated     with securities
                    underwriting     and how they compare with traditional             risks and by
See cordment 4.     evaluating    the impact and effects        of diversification.
                    We  also had some comments of a technical       nature that were provided
                    separately      for your consideration in putting     the draft into final
                    report    form.
                    Thank you for       the opportunity         to comment.

                    Sincerely,


                    Judith%   Walter
                    Senior Deputy Comptroller             for   Administration




                            Page 109                                                           GAO/MD-9048      Bank Powers
                 Appendix X
                 Comments From the Office of the
                 Comptroller of the Currency




                 The following are GAO'S comments on the Office of the Comptroller of
                 the Currency’s letter dated February 7, 1990.


G ’ 0 Comments   1. We have recognized some benefits associated with the holding com-
 A               pany structure, including the ability to generally accommodate the
 I               expanded powers of banking organizations while organizationally insu-
                 lating federally insured activities from the risks associated with the
                 expanded powers. However, we have not endorsed the holding company
                 structure as the only structure appropriate in the long run to be used
                 with the expansion of securities powers that may be approved for bank-
                 ing organizations. We have modified our discussion of these points in the
                 report on pages 12 to 14.

                 2. Our report recognizes that the general intent of the firewalls-insu-
                 lating federally insured institutions from the risks associated with the
                 activities of securities affiliates -is appropriate and that they provide a
                 basis for maintaining regulatory controls as new powers are being
                 phased in. Our work did not include assessing the effectiveness of the
                 firewalls. Therefore, we have no basis for endorsing the present set of
                 firewalls as a permanent feature of how banking organizations are
                 organized. Our draft report discussed the need to further study the pur-
                 pose of the firewalls and the potential regulatory burden they could
                 impose. We expanded our discussion of this point on pages 15 to 17 of
                 the report.

                 3. We agree with the Board’s policy of the revenue limit as an approach
                 to phasing in bank-ineligible securities activities. However, we have not
                 endorsed any definitive level of gross revenues as the most proper inter-
                 pretation of the “engaged principally” clause. The report has been modi-
                 fied to recognize that alternative approaches for defining “engaged
                 principally” under Section 20 of the Glass-Steagall Act could be explored
                 once experience can be relied upon to determine the impact of such
                 approaches, and once the purpose of the firewalls and other limitations
                 are further clarified. See pages 14 and 15.

                 4. A more detailed discussion of the risk characteristics of securities
                 activities, particularly when done within bank holding companies,
                 would no doubt be useful for readers. However, we do not believe the
                 report needs to be modified to incorporate additional material in this
                 area. Appendix II discusses the nature of the risks associated with Sec-
                 tion 20 subsidiary securities activities and recognizes that these activi-
                 ties could allow bank holding companies the opportunity to reduce risk


                 Page 110                                           GAO/GGD-904   Bank Powers
    Appendlx X
    Comments From the Office of the
    Comptroller of the Currency




    through diversification of activities. Our report also notes that the lim-
    ited time that Section 20 firms have been active does not allow a deter-
    mination on whether the new activities have actually increased or
    decreased risk to the holding company. See pages 37 to 39.




Y




    Page 111                                            GAO/&D-99-48   Bank Powers
   ,
 Arjpendix XI

 Cbmments From the Securities and
 &change Commission

sudplementlng those In the
repbrt text appear at the
end of this appendix.
                                                                      UNITED     STATES
                                                   SECURITIES     AND     EXCHANGE            COMMISSION
                                                                WASHINGTON.       DC.     20549




                                                                               January        26,   1990


                             Richard   L. Fogel
                             Assistant   Comptroller    General
                             General Government Division
                             U.S. General Accounting      Office
                             Washington,   D.C.     20548
                             Dear Mr.     Fogel:
                                   Thank you for          the opportunity      to comment on the General
                             Accounting  Office's           December 22, 1989 draft         report  entitled,    Bank
                               g ers.    Activities       of Securities      Subsidiaries      of Bank Holding
                             !Zokanie~.          My Office    and the staff      of the Divisions      of Market
                             Regulation,         Enforcement,    and Investment        Management have reviewed
                             the draft       report.      Based upon that review,          a number of technical
                             suggestions         have been orally      provided.       This letter   comments on
                             several     issues addressed        in the draft      report    which are of
                             particular        concern to the Commission.
                                     I agree with your conclusion                 that requiring       banks to conduct
                             bank-ineligible          securities      activities         in subsidiaries,       subject    to
                             the regulatory         scheme for broker-dealers                which Congress designed
                             for the protection           of investors,         is an essential        condition     to
                             permitting      the affiliation          of banking and securities              firms.    The
                             Commission has supported              this requirement           and has recommended
                             that any legislation             to expand the securities             powers of banks
                             require     banks to conduct most of their                    new and existing
                             securities      activities         in separate       entities     subject    to full
                             Commission regulation.
                                     I also agree with your observation               that another concern
                             raised by the Section          20 arrangement         is that no completely
                             comparable     opportunity      exists      for securities        firms to expand into
                             banking activities.          Although      securities      firms could engage in
                             certain    banking activities          if the firms and their            parent holding
                             companies complied with the same banking regulations                         applicable
                             to banks and bank holding           companies engaging in those activities,
                             this would be impracticable.               It would be much more difficult              for
                             securities     firms,   which are not organized              within     a bank holding
                             company structure,         to comply with these regulations,                 than it is
                             for banks, which are already              organized     within      that structure.
See comment 1                Accordingly,      consideration       should be given to amending the Bank
                             Holding    Company Act to permit           securities      firms to own banks




                                   Page 112                                                                GAO/GGD-9048   Bank Powers
.,.-..-l^..l   _-._




                                   A p p e n d i xX I
                                   C o m m e n tsF ro m th e S e c u ri ti e sa n d
                                   E x c h a n g eC o m m i s s i o n




                          R i c h a rd L . F o g e l
                          Pa g e 2

                          w i th o u t s u b j e c ti n g th e s e fi rm s a n d th e i r h o l d i n g c o m p a n i e sto th e
                          fu l l re g u l a to ry s y s te m a p p l i c a b l e to b a n k s a n d b a n k h o l d i n g
                          companies.

                                    In o rd e r to a c c o m m o d a yteo u r ti m e s c h e d u l e , th e s ta ff  has
                          not     s u b m i tte d th i s c o m m e n lt e tte r to th e C o m m i s s i o nfo r i ts
                          re v i e w . A g a i n , I a p p re c i a te th i s o p p o rtu n i ty to c o m m e n ot n th e
                          d ra ft re p o rt.
                                                                                      S i n c e re l y ,


                                                                                      !i i i i h ? k ;% + ~
                                                                                      G e n e ra l C o u n s e l




                      Y




                                  Page113                                                                          G A O /G G D -9 0 4 8 B a n k P o w e rs
                Appendix Xl
                Comments From the Securities   and
                Exchange Commission




----
                The following are GAO’S comments on the Securities and Exchange Com-
                mission’s letter dated January 26, 1990.


\GAO Comments
                iates within the same financial holding company needs to provide for
                regulatory controls over the entire holding company comparable to the
       ,        Federal Reserve’s controls over bank holding companies. A discussion of
       I        this point has been included in the letter. See pages 18 to 20.




                Page 114                                         GAO/GGD-90-48   Bank Powers
Appendix XII

Cbrpments From the American
Bankers Association

Note: GA@ comments
supplemei7tlng those In the
report texi appear at the
                                                                                    AMERICAN                 I 170 Conncctlc”, Avenue. N w
end of thij appendix.                                                               BANKERS                  Washin&wm   DC
                                                                                    ASSOCIATION              20036




                                                                                    AGENCY REMlIONS,         BIIECTOI.
                                                                                    TRUST AND SECURITIES     ,.me, D McLaughll”
                                                                                                             .ZCl21663.5324




                              January     8,   1990


                              Richard    L. Fogel
                              Assistant     Comptroller General
                              General Government Division
                              United States General
                                 Accounting    Office
                              Washington,     DC 20548
                              RE:    Draft Report      -- Bank Powers:        Activities        of Securities
                                     Subsidiaries      of Bank Holding       Companies
                              Dear Mr.     Fogel:
                              The American Bankers Association                  ("ABAr) appreciates          the
                              opportunity       to review and comment on the General Accounting
                              Offices       ("GAO") draft        report   on bank-ineligible            securities
                              activities      carried      out by wholly-owned           subsidiaries       of bank
                              holding     companies.        At the outset,         the GAO is to be commended on
                              the thorough        effort    given to compiling           the report.        As the GAO
                              has recognized,          the nature and extent          to which banks conduct
                              securities      activities       through Section         20 subsidiaries          is only
                              just evolving.           In consideration         of the infancy        of those
                              activities      and in recognition          that the viewpoints            of various
                              persons will        change    as comfort      levels     increase,      the ABA believes
                              that the report          sets out fairly        the current       thoughts     of
                              interested      persons regarding         those activities.
See comment      1            The ABA does, however, wish to offer                the following      comments and
                              sug estions    regarding      the report.       First   and foremost,       the ABA
                              be1 Steves it is important         that the report      note that the securities
                              industry    has recently      announced that it no longer opposes repeal
                              of the Glass-Steagall         Act.     Accordingly,     the report      should state
                              that positions     articulated        by the securities       industry    and
                              contained    in the report       may have changed.

See comment 2
                              Another     issue involves         the competitive      concerns between the
                              banking and securities             industries.      The GAO, in its report,     has
                              expressed      the opinion       that the case for continued        maintenance   of
                              the firewalls         may be much stronger         when viewed in terms of
Now pp. 18-20.                competitive         concerns    (pp. 21 and 24).        ABA agrees that the
                              extensive      list     of burdensome firewalls         does keep many banks from
                              competing      in securities         services.     On the other hand, the report
                              cites,    as evidence        of competitive      disadvantages    to securities




                                        Page116                                                            GAO/GGD90-48BankPowem
                                    Appendix XII
                                    Comments From the American
                                    Bankers Association




                                                                                                                                         1
                                                                                   AMERICAN            CONTINUING   OUR ILTKR   Of

                                                                                   BANKERS
                                                                                   ASSOCIATION
                                                                                                       January 8, 1990




                           firms,    the fact that securities         firms competing   with Section      20
                           subsidiaries     are not affiliated       with banks and have no comparable
                           opportunity    to expand into banking.           The ABA disagrees     and would
                           direct    the GAO's attention       to the fact that several       securities
                           firms own banks.       A discussion      of these firms'    banking activities
                           would be helpful     to clear understanding         of the issues involved.
                           With regard to the report's              discussion       on the firewall
Seb comment 3.             prohibiting      banks from supplying           any form of credit         enhancement
                           for ineligible         securities     to be underwritten           by the underwriting
Now pp. 50-52.             subsidiary      (p. 70), mention should also be made that this
                           prohibition       is uneconomical        and creates       market inefficiencies        and
                           negative     public     perceptions.        Specifically,        customers    seeking
                           credit     enhancements        for their    securities      to be underwritten        by a
                           bank holding        company subsidiary        will     have to go to another bank
                           and inevitably         will    pay more for the credit           enhancement feature.
                           In addition,        the public     may draw negative          inferences    regarding
                           the worth of the underwritten               securities      if the bank does not
                           issue the credit           enhancement for securities            being underwritten      by
                           its affiliate.
                           The discussion         regarding    the prohibition       on cross-marketing
Ni$w pp. 56 and 57.         (p. 79) should include          the thought      that this prohibition           is both
Se’e comment 3.            uneconomical       and inefficient.        For example, customers             that have a
                           long history       of dealing      with specific      corporate     lending      personnel
                           will    not be able to use the same bank holding                 company personnel
                           for its underwriting           needs and will       have to negotiate         separately
                           for those needs with other bank holding                  company personnel.
                           Inefficiencies        are created      when such a situation          occurs.       As a
                           result,      customers     may choose to go elsewhere           where their
                           financial      needs can be addressed         in one package.          Competitors       can
                           offer     all these services        and more.
See comment 3              The firewall        discussion      should also include          a discussion
                           regarding      the affiliate        purchase restriction           firewall.
                           Specifically,         that firewall       prevents,      under certain       conditions,
                           bank holding        companies and their         affiliates       from purchasing,         as
                           principal,       ineligible      securities      that are underwritten           by the
                           Section      20 subsidiary.         While that prohibition             has been somewhat
                           modified,      as the report        recognizes,       in that bank holding
                           companies and their           nonbank affiliates           may purchase      less than 50%
                           of any debt issue privately               placed by the Section            20 subsidiary,
                           the prohibition          is nevertheless       unnecessary       and may, in fact,
                           prove detrimental           to the bank's reputation           in the community.           For
                           example,      an underwriting        subsidiary       may be engaged in a large
                           revenue bond offering            in connection        with construction         at the

                      .-                                                                                                             -



                                   Page116                                                          GAO/GGD-90-48BankPowers
          Appendix XII
          Comments From the American
          Bankers Association




                                                    AMERICAN           CONTINUINGOUR        LETTLROF

                                                    BANKERS
                                                    ASSOCIATION
                                                                       January         8,    1990


.’
                                                                      SHLETNO          3
.'   ,,



local      airport.       Normally,   a bank, as a member of that community,
would be expected to purchase part of that offering                    for its own
portfolio.           However, the prohibition      against  purchasing
securities          underwritten    by the underwriting    subsidiary      would
deprive       the bank from participating        in the project       and,
consequently,          may reflect    poorly  on the bank's reputation         in the
community.
In conclusion, the ABA appreciates              the opportunity  to review                  and
comment on the GAO's draft  report.               If you have any questions,
please do not hesitate  to contact             our office.
Sincerely,
7,,,.,-‘3   T-c L<.,lT‘~‘\...          /y;\q
c
James D. McLaughlin




          Page 117                                                  GAO/GGD-9048             Bank Powers
   -                                                               *
Appendix XII
Comments From the American
Bankers Association




The following are GAO'S comments on the American Bankers Associa-
tion’s letter dated January 8, 1990.




tained in appendix XVI.

2. We clarified our report to show that U.S. securities   firms generally
cannot own US. banks without themselves becoming          bank holding com-
panies. However, we pointed out that securities firms     own some non-
bank banks and do have opportunities to be affiliated      with banks
located outside the US. See pages 18 and 19.

3. Our discussion of the regulatory burden of firewalls has been
expanded. (See pp. 15 to 17.) Also, the points made by the ABA have
been incorporated into relevant portions of appendix III.




Page 118                                            GAO/GGD-9048       Bank Powers
 Appenc$x XIII

 Cb&rnents From the Bank Capital
 Ma&kets Association

 Note GAO comments
 supplemdntlng those in the
 report texit appear at the
 end of thib appendix.
                              BANK CAPITAL MARKETS ASSOCIATION
                              NATIONAL iW!SS
                                           BIJILDINO.
                                                 SUITE
                                                    200.
                                                      WASHINOTON. DC
                                                                   20045(202)
                                                                           347-5510


                                                                                            THOMAS P. RIDEOUT
                                                                                            lxF,c~    DIRscrOR


                                                               December 27,       1989

                               Mr. Richard   L. Fogel
                               Assistant   Comptroller      General
                               General Accounting      Office
                               Washington,   D.C.   20548

                               Dear Mr.     Fogel:

                                  We appreciate          the opportunity          to comment on the GAO draft
                               report  entitled         Banb Powers. . Activities            of Securitiee
                                                                Iioldina   Ce               We believe     the
                               report     provides      useful      background      information     on the so-
                               called     Section     20 securities        affiliates       authorized     by the
                               Federal     Reserve Board in 1987 and 1989. With regard to the
                               continuing       debate over the need to repeal or reform the
                               Glass-Steagall         Act, we also believe             it is noteworthy       that
                               the GAO did not uncover any evidence of abuse or threats                            to
                               the Federal        Deposit     Insurance     Fund on the part of Section              20
                               affiliates       although      to us, these results            are not surprising.
See comfbent 1                     Most of the information         developed    by the GAO is
                               summarized in the eight appendices             to the report.     We have no
                               particular      quarrel     with the information     presented    although
                               the discussion         does focus exclusively      on the commercial
                               banking     industry.      We think the report     would be more useful
                               for public      policy    purposes   if it included     comparable
                               information      on the securities      industry    where appropriate.

See cominent   2                  Towards that end, we suggest an additional               appendix    that
                              would review levels         of concentration    in securities
                              underwriting       and analyze the extent to which these
                              concentration        ratios  could be diminished      if banking
                              organizations        were permitted    to compete. Certainly        the high
                              levels    of concentration       in securities    underwriting      was a
                              major public       policy   concern on the part of the House and
                              Senate Banking Committees in 1988 when both Committees
                              approved     legislation     to modernize the Glass-Steagall           Act.
See comment 3.                    Another appendix         should be included        to describe      the
                              current    financial      structure   of securities          holding   companies
                              and in particular,         the degree of double-leveraging               between
                              the parent and its broker-dealer               subsidiaries.        The amount of
                              double-leveraging         allowed   securities      firms is clearly
                              relevant     to the debate over many of the restraints                   the
                              securities       industry     seeks to impose on bank holding
                              companies      in the name of competitive           equity.      For example,




                                 Page119                                                            GAO/GGD-904BankPowers
                      Appendix XIII
                      CommentsFromtheBankCapital
                      Markets Association




                 the requirement       that bank holding          companies must deduct
                 their   capital    investment       in their     securities       subsidiaries
                 from their      own capital     base is often justified               on the theory
                 that it keeps bank-affiliated             securities        firm6 from gaining
                 a competitive      advantage over unaffiliated                securities      firms.
                 We believe      a careful    review of the financial              structure      of
                 non-bank affiliated         securities      firms will        lead to precisely
                 the opposite      conclusion     -- the FED's current             capital    rules
                 place bank affiliated          securities      firms at a competitive
                 disadvantaqe.

!3+ commcnf 4        Although      the report    reaches no specific        conclusions,    it
                 does spell       out seven areas that the regulators             and the
                 Congress should consider           in determining     financial
                 restructuring        policy.   We would suggest an eighth           point whose
                 theme is implicit          in much of the material        in the appendices
                 but is nowhere made explicit.            The point     is this:     At some
                 level.     firewaLls      have a werverse effect.        Rather than
                         ina r&k.      thev actuallv    increase    risk.
                     As examples,           we would cite many of the operational
                 firewalls        that require       separate     staffs        and prevent          banking
                 organizations           from utilizing      their     most       experienced
                 personnel        to oversee the combined banking/securities
                 activities.         Another example is the absolute                     prohibition       on a
                 bank making loans to its securities                      affiliate.         This
                 prohibition         could weaken the overall              structure         of the
                 banking organization             during a liquidity              crisis     such aa we
                 experienced         in October of 1987. Also, the requirement                          that
                 securities         activities      be conducted        in separate          affiliate6
                  (as opposed to a subsidiary              of the bank) can actually                    weaken
                 the bank by moving profitable                 activities           from its balance
                 sheet.      The aaccts cf the nccurit.ies                affiliate         are al60
                 placed beyond the reach of the FDIC in the event the bank
                 itself      fails.
Se@ comrrwnl 4       On a more general          level,      we would argue that excessive
                 firewalls      will    discourage       many banking organizations             from
                 diversifying        their   activities,         thereby   incurring     more risk.
                 If banks are not allowed to follow                    the natural     evolution     of
                 the banking business            into the securities          markets,     they will
                 be compelled        into making riskier            loans to marginal        borrowers
                 in order to recapture             their     lost profits.     This is a formula
                 for m        risk,     not m         risk.




                      Page120
---7---
                                        Appendix XIII
                                        Comments From the Bank Capital
                                        Markets Association




                                      After    the debacle of the thrift           industry,      it is clear
                                  that the Congress and the regulators                 need to look at
                                  financial      legislation       in the light     of its risk to the tax-
                                  payers.     It does not follow,        however, that the most cautious
                                  policy    is necessarily        the safest.     Indeed, there are cases
                                  where doing nothing         can be the riskiest           of all policies.       We
                                  think Glass-Steagall           reform is clearly         one of those cases.
                                  Relaxing      most of the Federal Reserve Board's fire-walls
                                  imposed on Section 20 securities              affiliates      will    strengthen
                                  and not weaken our financial            system and provide          less risk to
                                  the nation's       tax-payers.
See corriment 5                          W e also have some observations                 on two of your seven
                                  points      listed     on pages 19 through 24. Point 2 starts                       with
Now pp ~1O-20                     the unassailable            proposition       that "It is important             to be as
Point 2 10 the draft IS now       clear as possible             about the purpose of firewalls.                   It then
point 3, knd beglns on p.         goes on to discuss the prohibition                     against        a bank issuing
14
                                  guarantees          on issues underwritten            by its securities
                                  affiliate.          The report     correctly       states that "On risk
                                  grounds,        the need for the firewall              can be questioned.             If the
                                  guarantee         is priced correctly,           the bank would be no more
                                  exposed to risk by the guarantee than if the bank simply
                                  made a loan to the company. 1( The report                       then suggests that
                                  on competitive          grounds the case for the firewall                   may be
                                  stronger        and that its removal may place securities                       firms       at
                                  a competitive          disadvantage.        It is' hard to follow           this      logic.
                                  If the guarantee            is competitively          priced       (as would be
                                  required       under Section 23B of the Federal Reserve Act),                            it
                                  does not afford           the bank's securities             affiliate      any
                                  competitive          advantage over a securities                firm not affiliated
                                  with a bank.
See COImment 6                        W e suggest this point be dropped. The conclusion                    is not
                                  supported      by the example cited.         More importantly,        the notion
                                  that competitive      equity arguments should be given major
                                  weight in imposing firewall           restrictions        on an entire
                                  industry     is suspect,    especially       when raised by a rival
                                  industry     seeking to insulate        itself     from outside
                                  competition.      If safety conditions          are satisfied,       public
                                  policy    ought to act on the presumption              that more competition
                                  is in the public      interest.     Restricting        competition      in the
                                  name of competitive        equity   is a dangerous game that is bound
                                  end in a weaker and less productive                financial     system.
Now pp 15-17                         Point number 4 on page 22 refers  to a prior    GAO report
                                  concluding  that institutional abuses or conflict8    of




                              Y




                                       Page 121                                                               GAO/GGD-9048         Bank Powers
                    Appendix XIII
                    Comments From the Bank Capital
                    Markets Association




-   .   .




                interest      were not a widespread        problem in the banking
                industry.      We certainly       agree. The report    goes on, however,
                to state that "given the harm that could result                to consumers
                and,    ultimately,        to banking safety    and soundness from
                abuses, the potential           for future    abuses warrants    close
                attention       if banking institutions        were granted   expanded
                securities        powers."
                    We believe      this sentence is unduly alarmist           and not
                justified      by GAO’s own evidence.      Certainly     the Congress and
                the regulators         should think about potential        abuses, but they
                should also think         about potential    benefits    from expanded
                competition,       especially    when the probability        of gain far
                exceeds the possibility          of any loss. Considering         only the
                possibility       of potential     abuse is a formula      for enacting
                excessive      and counter-productive      firewalls.      We urge that
See comment 7   point     four be dropped or at the very least be re-written               to
                include      a more balanced treatment       of the likely       gains
                resulting      from expanded bank securities          powers.
                   We appreciate     the   opportunity    to comment on your       draft
                report.




                                             Thomas P. Rideout
                                             Executive Director




                    Page 122                                                  GAO/GGD-90-48     Bank Powers
  ’
               Appendix XIII
               Comments From the Bank Capital
               Markets Association




               The follc ving are GAO'S comments on the Bank Capital Markets Associa-
               tion’s letter dated December 27, 1989.


               1, Given the nature of the request, most of the information in the report
GAO’Comments   is concerned with the operations of Section 20 firms and bank holding
               companies. W e agree that additional information about the securities
               industry would be useful; however, in order to meet our requester’s
               information needs in a timely manner, we were unable to develop this
               information, Nevertheless, at various points, the report does discuss the
               nature of risks in the securities industry, market share, and capital ade-
               quacy regulation in the securities industry.

               2. On the basis of data availability, we have included information on the
               levels of concentration in the securities markets in which Section 20
               firms have initiated underwriting activities. (See app. I.) Since Section
               20 firms have been operating for a relatively short time, it is still too
               early to determine the impact they could have on the securities market.
               The discussion in appendix I also points out that it is not necessarily the
               case that expanding the securities powers of banks over the long run
               will reduce market concentration in underwriting markets. See pages
               31 and 32.

               3. Our work did not include an analysis of the financial structure of
               securities holding companies. However, at several places in the report
               we do point out that the holding companies of securities firms are not
               subject to the same capital regulation as bank holding companies.
               See page 78.

               4. Our draft report recognized banking officials’ concerns about the reg-
               ulatory burden imposed by the firewalls and that it would be useful to
               examine individual firewalls from the perspective of what can and can-
               not be accomplished under the current regulatory structure.

               The report has, however, been modified to include an expanded discus-
               sion of regulatory burden and the possibility that firewalls could
               increase risk. (See pp. 15-17.) As noted, we agree that the prohibition on
               a bank making loans to its securities affiliates could weaken the overall
               structure of a banking organization during a liquidity crisis. See page 17.

               5. Our discussion is intended to help focus attention on the purpose of
               the firewalls, and we think that competitive aspects are of concern to



               Page 123                                            GAO/GGD9048   Bank Powers
Appendix XIII
Comments From the Bank Capital
Markets Association




many people. We have modified the discussion to take account of Sec-
tion 23R of the Federal Reserve Act, but the existence of this provision
does not necessarily take care of all competitive considerations, in part
because the provision may be ignored if the firm experiences financial
stress. In addition there may be economies of combining banking and
securities activities that would benefit the banking organization. See
pages 18 and 19.

6. The report was modified to include a discussion of whether it was
appropriate to consider competitive equality. See pages 18 and 19.

7. We agree that potential benefits should be considered in determining
the appropriateness of firewalls. However, we also believe that it is rea-
sonable to be cautious in phasing in powers in new areas where the
potential exists for conflicts of interest or abuses such as insider trad-
ing. The discussion of this point has been modified to clarify our view.
See pages 15 to 17.




Page 124                                            GAO/GGD90-48   Bank Powers
Gdnments From the Association of Bank
Holding Companies

__-_. .--.r~.-
Note Gk$O comments
                                                                                                                           -
supplem~ntrng those in the
                             r
                                      ASSOCIATION              of BANK        HOLDING    COMPANIES
                                   RICHAm
                                       u WHITIN
                                 OENERll
                                    COUNSEL.
                                          SECRETAW                                  IMFIFTEENTH
                                                                                           STREET.
                                                                                               Nw WYASHINOTON
                                                                                                       Dc *cm5
                                                                                             ,202,39.?
                                                                                                  t150

                                                                        January 5, 1990




                                    Mr. Richard L. Fozel
                                    Assistant Comptroller General
                                    General Government Division
                                    General Accounting Office
                                    Washington, D.C. 20548
                                    Dear Mr. Fozel:
                                         Thank you for the opportunity to review and comment upon your draft
                                    report on bank ineligible securities activities carried out by wholly-owned
                                    subsidiaries of bank holding companies.
                                         As you know, although the authority for bank holding companies to engage
                                    in such activities was granted only recently, this development provides a
                                    significant opportunity for bank holding companies to serve their customers,
                                    diversify their product base and business risks, and compete more effectively in
                                    the financial services sector. Accordingly, we commend you for addressing this
                                    important topic and for noting that such activities have not “damaged the
                                    financial condition of a bank or bank holding company.” We hope that your
                                    conclusions will quell the criticism from opponents to the conduct of ineligible
                                    securities activities by subsidiaries of bank holding companies.

See comment      1                       In general, we agree with your report and the conclusions therein. We do
                                    have, however, a few comments. First, on page 12, we would suggest that you
Now p 8.                            insert the phrase “without limitation or regulation” after the word “dealing” in
                                    the second line after the subheading “Risks Associated With Section 20 and Bank
                                    Holding Company Activities.” Without this addition, the sentence seems to
                                    imply that such risks cannot be managed and can be counter-balanced only by
                                    the opportunities or benefits from the conduct of such activities by subsidiaries
                                    of bank holding companies.
See comment 2.
                                         Second, the background discussion on pages 2-5 of the report should make
Now pp 2 and 3                      clear that the limitations on gross revenues from ineligible activities were
                                    imposed as a result of the Federal Reserve Board’s interpretation of the
                                    “engaged principally” language of section 20 of the Glass-Steagall Act. Further,
                                    it should be noted that that language is subject to different interpretations,
                                    including authorization to allow Section 20 subsidiaries of bank holding
                                    companies to contribute to over twenty-five percent of the organization’s
                                    revenues. It is possible that the Federal Reserve Board’s current interpretation
                                    could change over time.




                                        Page 126                                                       GAO/GGD-90-48Bank Powers
                         Appendix XIV
                         Comments From the Association   of Bank
                         Holding Companies




                        ASSOCIATION            of BANK         HOLDING          COMPANIES

                     Mr. Richard L. Fozel                -2-                      January 5, 1990



                          Finally, recognizing that the section 20 language could accommodate a
4     comment 3      greater volume of ineligible activities, we believe your list of additional areas
                     that should be considered by the Congress (see pp. 19-24) should include whether
Now   pp.   1 O-20
                     greater ineligible securities activities, when subject to appropriate regulation,
                     in fact would result in any increased risks to the banking system.
                          In conclusion, we appreciate the chance to comment on your study. You
                     and your staff are to be commended on a job well done.
                                                         Sincerely,

                                                         I;l*krdh.~
                                                         Richard M. Whiting




                        Page 126                                                       GAO/GGD9048       Bank Powers
      ,
  ’
               Appendtv XIV
               Comments From the Association   of Bank
               Holding Companies




               The following are GAO'S comments on the Association of Bank Holding
               Companies’letter dated January 5, 1990.


GA( Comments   cannot be managed. W e have modified the discussion in the report to
               make it clear that although there have been benefits associated with
               using the holding company structure, having independent bank holding
               company subsidiaries is not necessarily the only way to structure the
               expanded securities activities for banking organizations in the long run.
               See pages 12 to 14.

               2. W e think the report is clear on this point. Although the question of
               whether to raise the revenue lim it further is not an issue currently
               before the Board, we recognize the Board’s continuing authority to reex-
               amine lim itations established on Section 20 subsidiaries.

               3. Our discussion of regulatory burden on pages 15 to 17 has been modi-
               fied to recognize that expanded securities activities is one of the restric-
               tions that, like revenue lim its and some of the firewalls, m ight be
               modified in the future.




               Page 127                                             GAO/GGD-90-48   Bank Powers
Appendix XV

@mments From. the Coalition for
Regional Banks

Not&: GAO comments
supplementing those in the
report text appear at the
end~of this appendix
                                                              Coalition for Regional Banks
                             llw &our4     Oroup                                                       ol Counul
                             lb00   Lofayom     C*ntor                                                 ARNOLD 81 PORTER
                             sun0 Is0                                                                  1200 New Hampshire,     N.W.
                             11 IS 21 al Stml,   N.W.                                                  W48hlngton.  D.C. 20036
                             WashIngton,    D.C. 200363308                                             Phone: 202/728-3554
                             Phone: 202/7211-11409

                                                                       January   18,   1990



                                           Mr. Richard   L. Fogs1
                                           Assistant   Comptroller      General
                                           United States General Accounting             Office
                                           Waehington,   D.C.     20548

                                           Dear Mr.          Fogel:

                                                     The Coalition   for Regional    Banks appreciates     the
                                           opportunity    to comment on the draft      GAO Report entitled
                                           "Bank Powers: Activities      of Securities    Subsidiaries     of
                                           Bank Holding     Companies.Vq
                                                     The Report provides       a useful    and objective
                                           discussion      of  the regulatory    framework applicable        to
                                           section     20 subsidiaries      of bank holding    companies and
                                           the effect      of the so-called     V1firewall@' restrictions
                                           imposed by the Federal Reserve Board on such activities.
                                           We believe      that the Report would provide        a more complete
                                           view if greater        emphasis were given to the
                                           disproportionate        impact of the firewalls      on regional
                                           banking organizations         and we have enclosed       specific
                                           comments in this regard.
                                                      We appreciated    the opportunity  to meet with the
                                           GAO  staff    in the formulation     of the Report.  On behalf
                                           of the Coalition        for Regional  Banks, I am submitting   the
                                           enclosed     comments on specific     points made in the Report.
                                                                                 Sincerely       'n


                                                                                 Melanie L.-Fein
                                                                                 Arnold 61 Porter
                                                                                 Counsel to The Coalition
                                                                                    For Regional  Banks
                                          Enclosure
                                          cc:            Stephen C. Swaim
                                                         Edward Wroblewski




                                           Page128                                                    GAO/GGD-9048BankPowers
                  Appendix XV
                  Comments Fmm the Coalition                for
                  Regional Banks




          ,                          Comments on the GAO Report                                 Entitled
                                   "Bank Powers:   Activities   of                              Securities
                                   Subsidiaries  of Bank Holding                                Companies"

See comr ncnt 1                   1.        The Coalition            for      Regional           Banks believes
                  that      the        Report         should      emphasize         more clearly                 the
                  disproportionate                     effect      on regional             bank        holding
                  companies             of the         gross      revenue        limit          applicable         to
                  section          20 subsidiaries.
                              As        a    result       of the       ten portent               gross        revenue
                  limit,      a        section         20 oubsidiary             muet have a substantial
                  volume      of revenue                from      bank-eligible                 activities         in order
                  to engage             in any significant                    volume       of      ineligible
                  underwriting                and dealing            activity.             The only            major
                  source      of        eligible          revenues          is   from      underwriting                and
                  dealing          in U.S.            government           securities.               The structure           of
                  the U.S.             government          securities            market,           however,
                  generally             precludes          bank holding             companieo                from major
                  involvement                in this       market          unless        they      qualify        as
                  primary          dealers,            which      most regional                 bank holding
                  companies             do not.        1

                  1 The Federal         Reserve Bank of New York designates
                  certain    large banks and securities            firms as primary
                  dealers.      There are currently         approximately       43 primary
                  dealers,     of which seven are domestic            banks and several
                  more are nonbank subsidiaries             of bank holding       companies.
                  Each primary      dealer    is required     to maintain      at least    a
                  minimum one percent         share of the total        primary    dealer
                  tranmactions      with customers,       to submit competitive         bids
                  at every Treasury        auction,    and to maintain       capital    of at
                  least    $50 million.       The Federal Reserve         Bank of New York
                                                  [Footnote     continued    on next page]




                  Page 129                                                                                    GAO/GGD90-48BankPowers
 Appendix XV
 Comments From the Coalition                  for
 Regional Banks




                                                     -2-



              Regional             bank      holding          companies               that        are    not
affiliated            with         primary          dealers             in U.S.        government
securities            operate             under      a severe              competitive
disadvantage              relative             to    section             20 subsidiaries                    that
are      primary       dealers             because          they         lack        the     large       base of
eligible        revenues              from        underwriting                  government
eecurities.               For example,                a8 shown in the                        attached
chart,        a section              20 subsidiary                 of      a regional              bank
holding        company with                  gross         eligible             revenues           of    $15
million        per     year          could      generate                ineligible            revenues             of
no more        than       approximately                    $1.67         million,            resulting             in a
minuecule          market            share.          Interest              income          on positions
would      account           for      a eignificant                   portion          of thie           amount,
thereby        limiting              even further              the         ability           of    a
l ection       20 l ubeidiary                 to engage               in underwriting
activitie8.               Depending             on the         eize          of each issue,                  the
groee      revenue           limit        would       permit             a regional               section          20



 [Footnote     continued     from previous     page]
has limited       the number of primary        dealers    to a maximum
of approximately         50 firms.     See Federal Reserve Bank of
New York, "Criteria          and Procedures     Applied     to Firms
Intereeted      in Becoming and Remaining Primary               Dealers,"
Prese Release of November 17, 1988.                Primary dealers
control     75 percent     of the market in government
eocuritiee      with 200-300 secondary        dealers     accounting       for
the remaining        25 percent.      The combined     average     daily
trading     volume of all primary        dealers     in August,      1988,
was $100.1 billion         for immediate     delivery,        75 Fed. Rae.
Bull.    A31   (1989).     This figure     doee not include        a large
volume of activity         consieting    of securities        sold   under
repurchase      agreements.




Page 130                                                                                           GAO/GGD90-48           Bank Powers
         Appendix XV
         Comments From the Coalition            for
         Regional Banks




                                                       - 3 -



    subsidiary             to engage           in only              a very           few underwriting
    transactions.
                  In order           to hold          itself             out     as a creditable
    underwriter             and dealer           in         ineligible                securities,                     a
    section         20 subsidiary               must be able                     to respond                     to
    request6         for      bide      on underwriting                        deals          and to
    participate             regularly           in the              underwriting                    and         dealing
    markets.          Under          a ten      percent              limit,           a regional                     section
    20 eubeidiary              may quickly                  exhaust            its     quota              for
    ineligible             underwriting               revenue             and be unable                         to
    participate             in underwriting8                        of    local        municipal                     projects
    of major         regional           importance.
                 The ten        percent          gross              revenue           limit           thus           makes it
    difficult         or      impossible              for      many regional                        bank holding
    companies         to participate                   meaningfully                    or competitively
    in the       ineligible             securities                  underwriting                    markets.              A 25
    to     49 percent          gross      revenue              limit           would          be more
    reali8tic.              The U.S.           Department                 of    Justice               and the
    Comptroller             of the       Currency              have stated                    their             legal
    opinions         that      the     Glass-Steagall                      Act       permits               such a
    latitude         of underwriting                   and dealing                    activities.
                 Uore meaningful                 participation                       by regional                      bank
    holding         companies          aloo      would              be possible                if      the           Board
    applied         the     gross      revenue              limit         baaed on a bank holding
    company'8         total         consolidated                    revenues           rather              than
    revenues         of the          section          20 subsidiary                    only.               Such an
w




         Page 131                                                                                               GAO/GGD-90-48    Bank Powers
                    Appendix Xv
                    Comments From the Coalition                    for
                    Regional Banks




                                                                              -4-


                  approach           would         be consistent                       with        the      Glass-Steagall              Act
                  as well        a8 previous                 interpretations                           by the         Board.
See domment 1,                  2.      The Coalition                         for      Regional             Banks also
                 believes            that         the     Report              should          place         greater       emphasis
                 on the         disproportionate                         effect             of     the      firewalls
                 generally            on regional                 banking                organizations.                   This
                 disproportionate                       effect           is         evidenced            by the         percentage
                 of regional                banking          firms             that         have       actually          activated
                 their        section             20 subsidiaries.                            Of      the    nine
                 multinational                    banking         firms              with        section        20 approval,
                 seven,         or 77 percent                    of the              total,         have       begun their
                 bank-ineligible                    activities.                        In contrast,                 of the       ten
                 regional            banking            firms      with              section           20 approval,              only
                 five,        or 50% of the                  total,                 have begun their                    bank-
                 ineligible            activities                 (Tables                IV.1       and IV.2            of the
                 Report).
                                Because            of their           smaller                 size,         regional       companies
                 are     lees        able         to ab8orb           the            additional              organizational
                 and operational                    costs        required                   to comply           with      the
                 firewalls.                 The prohibition                         on officer               and director
                 interlocks,                for     example,             typically                 means that             regional
                 bank holding                companies            engaged                 in underwriting
                 activities            must either                hire              duplicative               management
                 personnel            or dilute             existing                  management.                 Moreover,
                 because        of     their            **relationship                   banking"             approach          to
                 customers,            the        cross-marketing                        restrictions                 may have a




                   Page 132                                                                                               GAO/GGD-90-48       Bank Powers
                  Appendlx XV
                  Comments From the Coalition                       for
                  Regional Banks




                                                                            -5-


                 more significant                        adverse           impact              on regional                    banking
                 organizations                    and their               customers.                  In O@relationship
                 banking",                the     customer            has the             convenience                     of looking              to
                 his      individual                relationship                   manager            for      all            of his
                 financing                needs,         a benefit                that         is    not possible                     under
                 the      firewall               restrictions.
See com(ment 1                      3.      On page 14, the                    Report               states         that         regional
Now p Ed         bank holding                    company ofiicials                        stated            that
                                it is necesuary     to transfer   into a
                                Section  20 subsidiary      8ome activities
                                that may not Sit well together          from                                              a
                                buainess  perspective     in order to
                                provide  a large enough subsidiary
                                revenue base to make doing ineligible
                                business  worthwhile.
                 We would                point      out       that,        in addition                  to        incompatibility,
                 it      is    unfeasible                to     locate         most non-securities                                   related
                 activities                 in a section                  20 subsidiary                     due      to        the        net

                 capital             rule        of the        Securities                 and Exchange                        Commission.
                 Mor8over,                the     Federal           Reserve              Board        requires                 a bank
                 holding             company to deduct                       from         its        regulatory                 capital
                 any capital                 supporting               the      section               20 subsidiary                        and
                 imposes             other        restrictions,                    such as cross-marketing                                      and
                 interlock8                 prohibitions,                  that          make the            conduct                 of
                 activitier                 through           the     section             20 subsidiary                        expensive
                 and impractical                     from        a business                point            of view.                  This
Now p. 44.       point         is made in Appendix                           III         (p.        59) but          should               be
                 emphasized                 in the        body of the Report.                                We would                 note
                 that         the        SEC's     net        capital          rule        provides                an adequate




                  Page133                                                                                                      GAO/GGD-90-48           Bank Powers
                  Appendix XV
                  Comments From the Coalition                  for
                  Regional Banks




                                                                      -6-


                 safeguard               to ensure          the      solvency          of a section                20
                 subsidiary               and thus          the      Board's          capital       deduction                 is
                 unnecensary                and costly.
                                 4.       The Coalition               for       Regional        Banks believes
See f$omment 2
                 that      banks          should        be permitted                to establish                and fund
                 section              20 subsidiaries                in the         same      manner       that         the
                 Board      has permitted                   foreign          banks       to do so.               g@$ Board
                 Order      dated           January        4, 1990,             approving         section           20
                 applications                by Canadian              Imperial           Bank of Commerce,                         The
                 Royal      Bank of             Canada,           and Barclays               Bank PIE.             The FDIC's
                 regulations                permit        insured           state      nonmember banks                   to
                 establish              subsidiaries               to engage           in underwriting                   and
                 dealing          activities.                  12 C.F.R.            337.4.        Such activities
                 should          not      become impermissible                        simply      because           a bank           is
                 ownad      by         a bank        holding         company.           The Board*8                authority
                 to regulate                the      activities            of subsidiaries                 of holding
                 company          banks         is    doubtful            in any event.                 Allowing          banks
                 to operato               separate         section           20 subsidiaries                    would     afford
                 domemtic              banks      competitive             parity        with      foreign           banks           and
                 would      enable           domestic             banks      to diversify               their       income
                 and     risks          on a consolidated                    basis.
See comment 3
                                 5.       on page@ 59-60,                 the       Report      cites           a security
Now p. 46
                 industry              official18          comments           that      "the     entire           investment
                 industry's               revenues         from      underwriting               were only               about
                 eight      percent            of gross            revenues           in the     first           half     of
                 1989"      and therefore                  a bank holding                    company could               acquire




                 Page 134                                                                                        GAO/GGD-90-48            Bank Powers
                      Appendix XV
                      CommentsFromtheCoalitionfor
                      RegIonalBanks




-


                                                                         -7-


                     a large       existing          securities                 firm        and still           be within             the
                     ten     percent        qross        revenue            limit.           This         statement         may be
                     mialsadinq          because              the     Board's          gross        revenue         limit        is

                     applicable          not      only         to underwriting                    activities             but
                     dealing       as well.              It     would          be useful            for      the    GAO to
                     ascertain          and report              the      percentage               of the        investment
                     indu8try'm           revenues             that      are derived                from       dealing
                     activities           in addition                 to underwriting                     activities.
                                  In    any    event,               regional         bank holding               companies
                     generally          are    not       interested                in acquiring                existing
                     securities           firms      given            the      poor      condition             of such          firms
                     qanorally.

    See comment 1.                6.      On page 13, the                      draft        Report         states        that
    Nowp   8.                     bank holding        company officials    and some
                                  regulatory      officials     have said that    the
                                  regulatory      structure     may hamper the
                                  ability     of the holding       company as a
                                  whole to manage its exposure to a
                                  single     customer or market segment and,
                                  thus, the risks          that may result   from
                                  such exposure.
                     We would          note     that,          while         the       separate           subsidiary
                     requirement,              interlocks               restrictions,                 and other
                     firawalla           may interfere                  with         management's              ability          to
                     moat      efficiently              monitor             and control             risk       exposure,              bank
                     holding           companies          are not undertaking                         undue risks               as a
                     result        of the firewalls                     but        rather      are managing                 such
                     risks        through       burdensome                  policies          and procedures                   that




                        Page136                                                                                          GAO/GGD-9048BankPowers
     AppendixXV
     CommentsFromtheCoaUionfor
     RegionalBanks




                                                         -8-


otherwise            would         be unnecessary                  in the          absence          of certain
of the         firewalls.
               7.         In a number of places,                           the     Report          refers        to
concerns            by securities                  industry            officials           that      bank
holding         company section                     20 activities                  will         enable         bank
holding         companies             to compete                unfairly           with         securities
firms      (n.g.,           p.     15).          The Report             states          that,       while        the
need for            the     firawalls              may be legitimately                          questioned,
elimination               of the          firewalls             may place           eacuritiss                 firms
at     a competitive                disadvantage:
                [o]n competitive      grounds,   however, the
               case for the firswall        may be much
               l tronqer.    Securities     firma competing
               with Section     20 firms are not
               affiliated    with a bank and therefore
               could be placed at a competitive
               disadvantage                if      the     firewalls             were
               eliminated.                 (P. 21).
The     Coalition            for      Regional             Banks believes                  that
competition               between          securities              firms         and banking
organizations                is     not         a valid         Glass-Steaqall                   concern.
The Glams-Steagall                        Act was not              intended             as a device              to
insulate            the     securities              industry            from       competition.                  Even
if     bank holding                company section                     20 subsidiaries                   did     have
a competitive                advantaqo              over        securities              firms       (which
they      do not),           public             policy         would     not       dictate          that
inefficient               and burdensome                   restraints              be imposed              on
section         20 subsidiaries.




     Page136                                                                                        GAO/GGD-90-48BankPowers



                                                                                                                          ,.-
                               Appendix~
                              CommenteFrom LheCodtion                         for
                              Regional Bar&e




                                                                                      -9-


See comment 6.                              8.         In several              instances               (pp.      15-16,             24,    and 73),
N O W pp.~9, 18,46, and 52.
                              the    Report            quotes         securities              indu8try               officials             as
                              objecting            to the          section             20 eubeidiaries'                          access      to        low
                              cost        funds        in the          form of           ineured         deposits                 from their
                              affiliated               banks.           The securities                   industry                 position             is
                              misleading               for      two reasons.                  First,           under             the    Board's
                              most recent               firewalls,              banks         may not provide                          any funds
                              to their            section          20 affiliates.                       Even if              they       could,          a
                              bank        loan     to an affiliate                       muet comply                  with        the
                              quantitative                   limitatione               and collateral                      requirements                 of

                              section            23A    of      the     Federal             Reserve           Act.           A    oection          20
                              subsidiary               mu8t seek bank borrowings                                     from unaffiliated
                              banks.             Second,          8ecuritie8                iinns       have acce8s                    to theue
                              so-called            "low         cost         funds."            They are permitted                          to
                              borrow         from banks                and are not               subject              to     section             23A
                              IiXliit8.           From        a parity           perspective,                   a non-bank-
                              affiliated               eecurities               firm        enjoy8        the         same access                 to
                              nlo~        co8t      funds"            as does a bank-affiliated                                   section          20
                              affiliate.                 The Board              itself          has rejected                     the      argument
                              that        section            20 subeidiarie8                    hav8 acCe88 to lower                              cost
                              funds        than        their          securities              indu8try               competitors,                 au

Now pp. 46 and 47.            noted        in Appendix                 III      (p.      66).
                                             Moreover,                banking          organizations                    operate            subject
                              to numerous                regulatory                 restriction8                that         impose          a
                              "regulatory                tax@' on their                  operations.                       In addition             to
                              the     section            20 firewalls                  that         impo8e Costly




                                Paye137                                                                                                   GAO/GGD-9043BankPowers
                                Appendix XV
                                Comments From the Coalition                   for
                                Regional Banks




                                                                                    - 10 -


                           inefficiencies,                     banks         are         subject         to disadvantages
                           resulting             from        the      cost       of deposit                insurance          premiums,
                           foregone            interest              on required                 reserves,          and capital
                           requirements                higher           than        would         be maintained               in the
                           absence            of regulation                  and deposit                 insurance.            $&s
                           "Regulatory                Burden          Handicaps                 Low-Risk       Banking,"           Federal
                          Reserve             Bank of Chicago,                      micaao           Fed Letter,              January,
                           1988,        No. 5.
                                         We also             would        note           that     a number of securities
                           firms        do in         fact          have bank affiliates                       and are not
                          subject         to the             full      range         of firewalls                 applicable            to
                          8ection             20 8ub8idiaries.
See,comment      7.                      9.           The Report              on page 23 refer8                      to potential
No?   p.   18.            customer             confusion              about         whether         inveetment           products             are
                          in8Ured         or not.               We would             point         out     that      customer
                          confusion             may be avoided                      by     appropriate              disclosures.
                          Banks         are     not     exempt            from       the        anti-fraud           provisions              of
                          the      8ecuritiee                law8 and the                  Securities             and Exchange
                          Commi88ion              recently             has initiated                 a program           to
                          aggressively                 monitor           bank compliance                     with     8uCh laws.

See comment 8.                           10.          On page 70, the                      Report        states       that      bank
Now p. 50.                holding         company             official8              etated         that      some foreign              bank8
                          operating             in the          United         States            are permitted               to provide
                          credit         enhancements                  for     securitiee                underwritten            by their
                          affiliates.                 We are           unaware             of any such activities                       or
                          authority             for     such activities                         by foreign          banks.         It
                      Y




                            Page 138                                                                                          GAO/GGD-9048          Bank Powers
  Appendix XV
  Comments From the Coalition           for
  RegIonal Banks




                                              - 11 -


would       be useful    for      the     Report       to   identify   under   what
authority        such   foreign         banks      are purportedly       providing
credit       enhancements.




  Page139                                                                  GAO/GGD-904BankPowers
                                                           Appendix XV
                                                           Comments From the Coalition                                  for
                                                           Regional Banks




I                                    YAXIYUY     PERYlSSlBLf           “NOERYR,,,6N            AMOUNTS    IN              BAN8     INCLIGl9LE           YUNICIPAL
                 BONDS.         OR     CORPORATE     DEBT      OR     COYYON     STOCK,        BASED   UPON               5%.    10% AND      25%       GROSS     REVENUE        LIUIT

                                                                             (Ill   MillIons       Of        Dollars)


                                                           P.mi,slbleA                             Typical6                               Mar lmu                           Tot.IC
                                                           In~li9lDlm                     -L     “oderwrl               t ,rrg     =      *nnua     I                       *s,usncus      =   YPr-*el
                                                                  cross                              Sprflad                           UnderwrItten               ’         (1966)             Stlal-0
                                                               Revenues                                                                   AlnO”nt

                                                                    so.79                               I.     1x                         s   b5.6                           s    75,000            0.09%

                                                                    $1 .67                                                                $139.2                                                 O.lSY

                                                                    $5.00                                                                 $416.7                                                 0.56X




d.nrporato                 ‘,X                                      so.79                               0.7%                              $112.9                             $236.460            0.05%
~ I&b,
                          IOU                                       11.67                                                                 1238.1                                                 0.10x

                          25u                                       15.00                                                                 5714.3                                                0.30%


    ( Oll”“O,l
    s11,1*                 5%                                       so.79                                     5x                          S   15.6                           S    29.600        0.05x

                          10%                                       $1 .67                                                                s   33.4                                              0.11%

                          25%                                       15.00                                                                 $100.0                                                0.34%




                                                           Page 140                                                                                                                 GAO/GGD-90-48        Bank Powers
               Appendix XV
               Comments From the Coalition for
               Regional Banks




               The following are GAO’S comments on the Coalition for Regional Banks’
               letter dated January 18, 1990.


               1. In appendix III of the report, we discuss the practical impact the fire-
GAO Comments   wall requirements have on banking organizations, including regional
               bank holding companies. We believe the report reflects the concerns and
               perspectives that regional banking organizations have concerning the
               firewalls.

               2. The Board’s approval of foreign banking organizations’ applications
               to establish Section 20 subsidiaries occurred after we completed our
               audit; therefore, we did not have the opportunity to study the Board’s
               approval in any detail. However, as noted in the report letter (see pages
               12 through 14), we believe that the appropriate long-run structure to
               accommodate expanded activities authorized for banking organizations
               is a topic that should be studied further.

               3. We did not obtain information on securities industry revenues gener-
               ated from dealing activities, since the Section 20 firms that have initi-
               ated the new activities have primarily conducted underwriting
               activities. However, a banking organization’s decision to acquire an
               existing securities firm would be affected not only by the amount of rev-
               enue generated from bank-ineligible activities, but by other business
               considerations, such as the firm’s profitability and how well the firm
               would fit into the banking organization’s strategic business plans.

               4. The text has been modified to better illustrate the need for determin-
               ing the purpose served by each firewall.

               5. We agree that while provisions contained in the Glass-Steagall Act
               generally tend to establish a degree of separation between the banking
               and securities industries, it does not appear that the act was intended to
               blunt competition among providers of financial services.

               6. We agree that under either the firewall requirements or provisions
               contained in the Federal Reserve Act, loans made by a bank to an affili-
               ate are required to be on essentially the same terms as those that exist
               in the markets for similar transactions. Therefore, it appears that the
               Federal Reserve’s objective is to assure that a Section 20 subsidiary does
               not unduly benefit from being affiliated with an insured institution.
               Additionally, securities firms affiliated with a bank holding company, as



               Page 141                                            GAO/GGD-SO-48 Bank Powers
Appendix XV
Comments From the Coalition   for
Regional Banks




defined in the Board’s regulations, would also be required to comply
with the Board’s firewalls.

7. We agree that adequate and appropriate disclosure, properly regu-
lated, would be an effective mechanism to assure that a customer can
clearly distinguish between federally insured and uninsured products
and services that may be available from a federally insured institution.

8. The Bank Holding Company Act, as amended, defined a bank holding
company as a company, including a foreign banking organization, that
has direct or indirect control of a bank. Under Section 4(a)(2) of the act,
certain foreign banking organizations qualify for grandfathered privi-
leges under Section 8 of the International Banking Act of 1978 (IBA).
Under Section 8 of the IBA, any foreign bank that controls a bank that
operates in the United States shall be subject to the Bank Holding Com-
pany Act of 1956 and subsequent amendments in the same manner and
to the same extent as if it were a bank holding company. The purpose of
this provision was to bring the permissible nonbanking activities of for-
eign banks more in line with those of domestic bank holding companies.
However, a foreign bank could continue to engage in nonbanking activi-
ties in the United States in which it was lawfully engaged before enact-
ment of the IBA.




Page 142                                            GAO/GGD-SO-48 Bank Powers
*pdix         XVI

Cotients From the Securities
In&&y Association

        --c




                                                    RITIES         INDUSTRY   ASSOCIATION
                                                                               12021    296-9410          Facslmfle,   (2021     296-9775
                    1850   M Street,   N. W.. Wash!ngton.    0.C    20036


                                                                                       January     8,   1990


                                MK. Richard      L. Fogel
                                Assistant     Comptroller      General
                                United    States
                                General Accounting        Office
                                Washington,      D.C. 20548

                                Dear      Mr.      Fogel:
                                              Let me begin by thanking            you for providing           us with a
                                copy of your draft           report     "Banking    Powers:     Activities        of
                                Securities       Subsidiaries        of Bank Holding        Companies".        This is a
                                very difficult        subject      to analyze     because there are no readily
                                available      data sources        on specific      securities     products,        and
                                there has been little            experience      with the Section          20
                                Subsidiaries.         You have done a superb job in consolidating                       the
                                available      information       in the appendices.
                                      The basic      information      concerning         the industry        comes from
                                the SEC Focus Report.             This basic        regulatory        document has not
                                been changed since the mid-1970's,                    and contains         a simple    one
                                page income statement.              Obviously,        the industry         has changed
                                substantially        since that time,          and continues          to change.       The
                                industry       and the regulators        would be able to get a better
                                picture      if revenues      and profitability           were reported          by product
                                line.     The Commission         does little        analysis      of the industry,          and
                                frankly,       that analysis      is left      to this       association.         Changes in
                                the Focus Report could provide                 significantly          better
                                information,        and make industry          and product        line     analysis    more
                                meaningful.
                                      Given the limited           data and experience          we certainly     agree
                                that it is too early             to draw conclusions          as to the competitive
                                impact of the Section              20 Subsidiaries,       or how real or necessary
                                the firewalls          are.    $:A has long supported           a legislative
                                solution      to intersect.on           between investment       and commerical
                                banking.        Your report        raises    the issues     that need to be
                                analyzed      before      the Congress can undertake            a redefinition      of
                                national      policy      in the banking        and securities      industries.       We
                                look forward         to working       with you and the Congress towards             that
                                redefinition.




                                                                                       ijfij?&d@
                                                                                       Director     of Government              Relations




                             Page 143                                                                             GAO/GGD-9048BankPowers
Adpendix XVII                                                                        r
  i                                                                                          L-
D+fIajor
      Contributors to This Report


                        Stephen C. Swaim, Assistant Director, 452-2834
Gkneral Government      Edward S. Wroblewski, Evaluator-in-Charge
Division, Washington,   Karen R. Wiseman, Evaluator
D1.C.                   Gayle L. DeLong, Evaluator
                        Lou V. B. Smith, Evaluator
                        Kristi A. Peterson, Evaluator




                        Page 144                                         GAO/GGD-90-48   Bank Powers
Page 145   GAO/GGD-99-48   Bank Powers
/                        c




    Page 146   GAO/GGD-904BankPowers
.




    Page147   GAO/GGD-go-48
                         BankPowers
IkelaM GAO products


Qommercial Banking   (GAo/cxm-89-36, Jan. 27, 1989).

                     Bank Powers: Issues Related to Repeal of the Glass-Steagall Act (GAO/
                     GGD-88-37, Jan. 22, 1988).

                     Issues Related to Repeal of the Glass-Steagall Act (GAojT-GGD-88-9,
                     Feb. 10, 1988).

                     Using “Firewalls” in a Post Glass-Steagall Banking Environment (GAO/T-
                     GGD-88-26, Apr. 13, 1988).

                     International Finance: U.S. Commercial Banks’ Securities Activities in
                     London (GAO/NSLAD-88-238, Sept. 8, 1988).

                     Safeguards That Need to Accompany Changes to Glass-Steagall Laws
                     (GAO/T-~~~-88-61, Sept. 13, 1988)

                     CommerciaI Banking: Lending to Troubled Sectors (GAo/GGD-~~-~~~BR,
                     Sept. 26, 1988).

                     Bank Powers: Insulating Banks From the Potential Risks of Expanded
                     Activities (GAO/GGD-87-36, Apr. 14, 1987).


                     Financial Markets: Preliminary Observation on the October 1987 Crash
The Securities       (GAO/GGD-8838, Jan. 26, 1988).
ILndustry
                     Securities and Futures: How the Markets Developed and How They Are
                     Regulated (GAO/GGD-86-26, May 15, 1986).

                     Securities Regulation: Securities and Exchange Commission Oversight of
                     Self-Regulation (GAO/GGD-86-83, Sept. 30, 1986).


Financial Services   1988).
Activity
                     Financial Services Information on Nonbank Banks (GAO/GGD-86-46FS, Mar.
                     21, 1986).
           Y




~2as263)             Page148                                             GAO/GGD9048BankPowers
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