FRBSF Economic Letter
2000-10; March 31, 2000
The Gramm-Leach-Bliley Act and Financial Integration
After more than two decades of debate, full affiliation of commercial
banking with other financial services became a reality in March 2000.
The Gramm-Leach-Bliley Act (GLBA), signed into law last November, authorized
the certification of financial holding companies, the structure that looks
to be the main vehicle for linking commercial banks with securities firms,
insurance firms, and merchant banking. Subsequent to the March 11 effective
date, the Federal Reserve released a list of the first 117 institutions
certified as financial holding companies.
This Economic Letter shows
how the GLBA provides a more sensible, straightforward path toward financial
integration. Before the act was passed, banks and other financial firms
had to take a variety of side routes to integrate financially. Their progress
toward integration--not surprisingly--was, for the most part, piecemeal.
The Letter also reviews some key provisions of the act, including
the Federal Reserve's role as the umbrella supervisor for financial holding
Side routes to financial
Perhaps the best example of a side route to financial integration is
one that banks have used to get involved in securities underwriting--the
so-called Section 20 securities subsidiary. Section 20 refers to part
of the Glass-Steagall Act of 1933 that separated commercial and investment
banking. While banks retained the ability to handle certain securities
such as Treasuries, Section 20 prohibited banks from affiliating with
firms "engaged principally" in underwriting and dealing in securities,
like corporate bonds and equity. That phrase--"engaged principally"--left
room for a bank holding company to form a subsidiary that conducted a
large portion of permissible activities and a smaller portion of otherwise
The Federal Reserve first authorized such a subsidiary in 1987. Today
banking organizations operate 51 securities subsidiaries, including some
that were acquisitions of well-known securities firms--for example, Solomon
Smith Barney and, in this Federal Reserve District, firms such as Montgomery
Securities and Robertson Stephens.
Banks also have gotten into insurance through side routes. For example,
some states passed laws allowing state-chartered banks to sell insurance,
and the Comptroller of the Currency's interpretation of federal law permitted
national banks to sell insurance nationally from offices in small towns
(populations under 5,000). Despite the attention given to banking and
insurance, apparently few banks felt compelled to take full advantage
of these side routes into selling insurance.
One obvious exception would seem to be the creation of Citigroup, which
combined Citicorp, a large bank holding company, with Travelers, a large
insurance company. But this move to integration is not really representative
of organizations taking a side route. Instead, the creation of Citigroup
is better viewed as a move in anticipation of the main road being opened
up by the passage of legislation like GLBA.
Figure 1 gives some perspective
on how much banks had integrated before GLBA. The bars show banking assets
as a share of bank holding company assets for the largest organizations.
Citigroup is an outlier, as is J.P. Morgan, which traditionally has looked
more like an investment bank. For the other large banking organizations,
bank assets make up the lion's share. While the figure masks some financial
integration such as the sales of mutual funds and annuities by banks,
clearly most of the large banking organizations have a way to go if they
choose to move toward the Citigroup model.
Financial integration also has come from the other direction--securities
firms and insurance companies have found side routes, mainly by linking
up with certain types of depository institutions whose activities are
restricted in some ways. One such type of depository is the so-called
nonbank bank. This includes industrial loan banks, several of which operate
in Utah; for example, American Express owns an industrial loan bank with
about $12 billion in assets. Another option has been credit card banks,
such as the one owned by Household Finance in Nevada. Finally, the law
allowed securities firms, insurance companies, and even nonfinancial firms
to link up with depositories through the acquisition of a single thrift,
known as a "unitary thrift."
Figure 2 shows how some
of the bigger players among independent securities firms have used these
byways and side routes to acquire depositories. The top two--Morgan Stanley
Dean Witter and Merrill Lynch--both own depositories. In this Federal
Reserve District, Schwab has announced plans to purchase U.S. Trust, located
in New York, and E*TRADE recently acquired Telebank, a thrift.
Insurance companies also have acquired depositories. Among the top twenty
life insurance underwriters, for example, twelve own depository institutions,
mainly thrifts. For the most part, the depositories owned by insurance
companies are small. For example, Prudential, with consolidated assets
of $280 billion, has depositories with about $1 billion in assets.
Key provisions of GLBA
The Gramm-Leach-Bliley Act makes the path toward financial integration
more straightforward for those interested in pursuing it. It breaks down
barriers--some of which are seven decades old--and allows full affiliation
of banking with underwriting and agency activities in securities and insurance.
The act goes further by allowing affiliation between commercial and merchant
banking; that includes allowing banks to hold equity in firms for the
purpose of eventual resale.
To keep regulation responsive, the act also gives the Fed and the Treasury
the authority to define new activities that are financial in nature, or
incidental to financial activities.
Regarding banking and commerce, the act for the most part keeps them
separate, but leaves the door ajar by letting the Fed determine when some
nonfinancial activities are complementary to financial services. The act
does close the unitary thrift door for new acquisitions.
In the debate over the GLBA, one of the main sticking points was where
these new activities would be conducted, and the act represents a compromise
on that issue. While a number of activities, including underwriting municipal
securities, can be done within the bank, most of the avenues for financial
integration are pushed out to holding company affiliates or bank subsidiaries.
Figure 3 illustrates two
possible structures--in practice, institutions may use a combination of
the two structures shown. All of the new activities can be in a holding
company affiliate and some in a financial subsidiary of a bank. At this
time, insurance underwriting and merchant banking can be conducted only
in financial holding company (FHC) affiliates. For the other activities,
banks face limitations on the size of financial subsidiaries: A subsidiary
cannot be too large, either in absolute terms or relative to the size
of its bank; specifically, taken together, the assets of financial
subsidiaries have to be the lesser of $50 billion or 45% of the consolidated
assets of the bank. (Banks also can have operating subsidiaries
engaged in activities permitted for the bank.) While some institutions
probably would find it difficult to get around these limits, there is
scope for others to move activities under a bank.
Certification and supervisory structure
The GLBA also lays out the requirements for certifying a FHC or bank
to engage in expanded powers. A bank holding company that has U.S. commercial
banks can be certified as a FHC if all of the banks are well capitalized,
well managed, and have at least a satisfactory CRA rating. A securities
firm or insurance company that acquires one or more banks must apply to
be a bank holding company along with filing for certification as a FHC.
A bank seeking to operate financial subsidiaries faces similar requirements
and must file for certification with its primary federal regulator. Moreover,
the larger national and state member-banks must satisfy a "rating requirement"
if they have a financial subsidiary acting as a principal (that is, not
just as an agent or broker): Those ranking among the largest 50 must have
at least one issue of outstanding eligible debt that is rated within the
three highest investment grades, and those among the second 50 can meet
the same requirement or have a comparable "long-term issuer rating."
Finally, a foreign banking organization with only branches or agencies
in the U.S. can become a FHC if it is certified by the Federal Reserve
to be well capitalized and well managed.
An important contribution of the GLBA is the framework for supervising
integrated financial firms. It designates the Fed as the umbrella supervisor
for financial holding companies, while the securities and insurance affiliates
are subject to functional regulation by the SEC, the Commodity Futures
Trading Commission, and state insurance commissions. The GLBA directs
the Federal Reserve to rely as much as possible on the functional regulators
for examination and other information. Likewise, the primary federal regulator
of a bank also must rely on the functional regulators when securities
and insurance activities are in financial subsidiaries of a bank.
The rationale for having an umbrella supervisor over FHCs is based on
the fact that large financial institutions tend to manage their risk on
a consolidated basis and operate along business lines that cut across
legal entities. However, it is important to realize that a critical goal
of the framework, especially for the umbrella supervisor, is to protect
the bank or banks from undue exposure to risk from the other affiliates
in the organization. The corollary of that goal is to ensure that the
market does not come to think that umbrella supervision implies enhanced
federal protection of FHCs' nonbank affiliates compared to their independent
counterparts. In other words, it is important to avoid the unintended
implicit extension of the federal safety net to nonbank affiliates of
Several provisions of the act point to the primacy of protecting the
banks in a FHC. For example, the act keeps in place limits on the financial
transactions between a bank and the other holding company affiliates.
Also, if the Fed has concerns about a bank's exposure to risk from a functionally
regulated affiliate, the Fed can interact directly with the nonbank affiliate,
including conducting examinations.
Parallel provisions apply for financial subsidiaries of banks, including
limits on financial transactions between the bank and its subsidiaries.
In addition, a bank's outstanding equity investments, including retained
earnings, in its financial subsidiaries are to be deducted from the bank's
capital. To ensure transparency for the bank, published financial statements
must present separate financial information on the bank.
Legislation removing decades-old barriers between banking and other financial
services has been a long time coming. While waiting for such legislation,
financial integration did move forward. The routes, however, have been
indirect and the results piecemeal. The current legal structure provides
a more straightforward path for institutions that choose to venture down
it. At the same time, the new road clearly has retained the traditional
caution signs to address concerns over the potential risk exposure of
banks and the need to limit distortions from the federal safety net.
Finance and Regional Studies
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