FRBSF Economic Letter
97-08; March 21, 1997
Cracking the Glass-Steagall Barriers
Introduction
Since 1933, the Glass-Steagall Act has stood as a wall between commercial
banking and investment banking in the U.S. financial system. But the wall
is not perfectly solid. The act does allow commercial banks to underwrite
and deal in certain classes of securities, the so-called "bank eligible
securities." Furthermore, it states only that commercial banks cannot
be affiliated with any organization that is engaged principally
in underwriting and dealing in securities, without giving a clear indication
of the degree of integration that would be permissible. As a result, commercial
banking organizations have made inroads into investment banking via their
so-called "Section 20 subsidiaries," which are bank holding
company subsidiaries authorized by the Federal Reserve to engage in a
limited amount of bank-ineligible securities activities. In this Economic
Letter, I discuss the creation of Section 20 subsidiaries, their
economic role in the financial markets, and the latest developments and
future outlook for banking organizations' securities activities.
Creation of Section 20 subsidiaries
The provisions of the Glass-Steagall Act that separated commercial banking
from investment banking are in Sections 16, 20, 21, and 32 of the Act.
Section 16 bars national banks from investing in shares of stocks, limits
them to buying and selling securities as an agent, and prohibits them
from underwriting and dealing in securities. Section 20 prohibits Federal
Reserve member banks from being affiliated with any organization that
is "engaged principally" in underwriting or dealing in securities.
Section 21 makes it unlawful for securities firms to accept deposits.
Section 32 prohibits officer, director, or employee interlocks between
a Federal Reserve member bank and any organization "primarily engaged"
in underwriting or dealing in securities.
Certain securities are exempted from the act. They include municipal
general obligation bonds, U.S. government bonds, private placement of
commercial paper, and real estate bonds, which collectively are referred
to as bank eligible securities. All other securities are deemed "bank
ineligible." More importantly, since the terms "engaged principally"
and "primarily engaged" were not defined in the Act, both the
courts and the regulators have had to determine the meaning of these terms
in enforcing the law.
In 1986, the Federal Reserve made a new ruling on Section 20 of the
Act. It allowed securities subsidiaries of bank holding companies to underwrite
and deal in certain bank ineligible securities for the first time. To
comply with the Glass-Steagall concept of not "engaging primarily"
in ineligible securities, the initial limits on revenues from these activities
were set at no more than 5% of the subsidiary's total gross revenues on
an eight-quarter moving average basis. The securities affiliates established
under this authorization are commonly referred to as Section 20 subsidiaries.
On several occasions, the Fed has expanded the securities power of Section
20 subsidiaries, including enlarging the set of permissible bank ineligible
securities, increasing the revenue limit on ineligible securities activities,
and allowing an alternative method to calculate ineligible revenues. Today,
the classes of ineligible securities that are permissible in Section 20
affiliates include corporate debt and equity, commercial paper, municipal
revenue bonds, mortgage-backed securities, and asset-backed securities.
The ineligible revenue limit was raised to 10% in 1989 and further increased
to 25% recently. Furthermore, Section 20 subsidiaries have been given
the option to index the revenue test for interest rate changes.
In requiring all ineligible securities activities to be conducted in
a subsidiary of the holding company that is separate from the commercial
bank, the Fed also erected a number of "firewalls" between the
securities subsidiary and the bank owned by the same holding company.
For example, a bank may not make loans to securities issuers to support
or enhance the securities underwritten by its securities affiliate, or
to finance the purchase of securities underwritten by its securities affiliate;
a bank may not purchase financial assets from, or sell such assets to,
its securities affiliate; the securities and bank affiliates may not have
common officers, directors, or employees, nor may they cross-market each
other's financial services; the securities affiliate may not have full
access to customer records of the commercial bank. These firewalls are
aimed at preventing conflicts of interest between the securities subsidiary
and the commercial bank, the primary concerns that led to the passage
of the Glass-Steagall Act in the first place. By restricting transactions,
information flows, and shared management between the securities subsidiary
and the commercial bank, the firewalls also safeguard the banking system
and prevent securities affiliates from tapping the safety net that is
available exclusively to commercial banks.
Economic role of Section 20 subsidiaries
To date, 40 bank holding companies have Section 20 subsidiaries. Banking
organizations have traditionally been major competitors in the underwriting
of municipal securities. Once their securities affiliates were allowed
to deal in and underwrite bank ineligible securities, a number of Section
20 subsidiaries successfully challenged the corporate underwriting market,
despite the limit on ineligible revenues. For example, during the first
six months of 1996, two of the top ten underwriters of U.S. corporate
debt by dollar volume and two of the top ten underwriters of municipal
bonds are affiliated with banking organizations.
Banking organizations have been fairly successful in entering the market
for corporate bond-underwriting partly because of their expertise in providing
credit services. Both bond-underwriting and loan-making involve credit
analysis and pricing. The main difference is that in providing credit,
banks hold and fund the loans until they mature, whereas in underwriting,
the underwriters hold the bonds for a very short period of time and quickly
resell them in the open market. Hence, in order for banks to be successful
in underwriting, they must be able to set up their own distribution channel
and network of potential buyers. This is exactly what banks have been
practicing when they securitize their loans. As banks become more prominent
in underwriting corporate securities, the ability to provide both credit
and underwriting services within the same organization allows banking
firms to offer one-stop shopping in corporate finance. Bank customers
may even enjoy lower prices when the efficiency gains from scope economies
are passed on to them.
Although banking firms have acquired a significant share of the bond
underwriting market, they have not been able to capture much of the action
in equity underwriting, which garners much higher fees than bond underwriting.
The infrastructure for underwriting equity securities is not the same
as that for underwriting bonds, because it requires different expertise
in the areas of research, client contact, and sales support. While building
up an equity underwriting department involves substantial investment by
the holding company, the most active Section 20 subsidiaries were operating
close to the 10% then ineligible revenue limit (see Figure
1), which could have hindered their expansion into equity underwriting.
Recent developments and future outlook
Following the recent failure to repeal the Glass-Steagall Act by the
Congress, the Federal Reserve submitted proposals to ease some of the
restrictions on Section 20 subsidiaries. Based on the responses, in October
1996, the Fed relaxed three firewalls between securities affiliates and
their banks. First, officers and directors may work for both the Section
20 subsidiary and the bank, provided that the directors of one may not
comprise more than 49% of the board of the other. Also, the CEO of the
bank may not be a director, officer or employee of the securities affiliate,
and vice versa. Second, the restrictions on cross-marketing between the
bank and its Section 20 subsidiary are repealed. Third, intercompany transactions
between a bank and its Section 20 affiliate are expanded to include any
assets that have a readily identifiable and publicly available market
quotation.
In addition to liberalizing the above restrictions, in December 1996,
the Fed lifted the ineligible revenue limit on Section 20 subsidiaries
from 10% to 25%. From a capital budgeting perspective, raising the revenue
cap can lower the hurdle in recovering the initial investment in the Section
20 subsidiary, thus enticing more banking firms to enter the securities
business. By the same token, it also encourages existing securities affiliates
to make capital investments in the equity underwriting business. To the
extent that the previous 10% revenue cap represented a binding constraint
on active Section 20 affiliates and hence limited their ability to expand
into equity underwriting, the recent ruling allows banking organizations
to launch a serious challenge at equity underwriting. Furthermore, under
the 10% revenue cap, banking firms had little choice but to build up their
securities affiliates from scratch. Entering the securities business by
acquisition was either infeasible due to the cap, or unattractive because
of limited growth potential. The boost in permissible ineligible revenues
makes the acquisition of an established securities firm a more viable
alternative.
In January 1997, the Fed submitted for public comment another proposal
that further relaxes the restrictions between Section 20 subsidiaries
and their bank affiliates. Since 1987 when the original Section 20 firewalls
were prescribed, the Fed implemented Section 23B of the Federal Reserve
Act, which requires all inter-affiliate transactions to be on arm's-length
terms. Also, Section 23B prohibits representing that a bank is responsible
for a Section 20 affiliate's obligations, and prohibits a bank from purchasing
certain products from a Section 20 affiliate. Thus, Section 23B makes
many of the firewalls specifically designed for the securities affiliates
redundant. In addition, as the Fed has gained experience in regulating
banks' securities affiliates, it has become apparent that some of the
Section 20 firewalls are too conservative and impede their ability to
operate efficiently and effectively. Modifying these restrictions would
allow the bank and the securities affiliate to maximize synergies, enhance
services, and possibly reduce costs.
Nevertheless, important policy questions remain to be addressed. While
policymakers seem to be in general agreement that the Glass-Steagall Act
should be repealed, there is vigorous debate on how to integrate commercial
and investment banking. At issue are: How can the financial services industry
be modernized without compromising the safety and soundness of the banking
system? What degree of integration among financial services providers,
and between financial and non-financial firms, would be socially desirable?
How should the new financial services firms be organized and regulated?
Conclusion
Although the Glass-Steagall Act, which separates
commercial banking from investment banking, has been targeted for repeal
for many years, the reform effort has failed each time. However, in enforcing
the law, banking regulators have some leeway in providing limited relief
for banking firms to engage in ineligible securities activities through
their Section 20 subsidiaries. Despite being hamstrung by numerous restrictions,
banks' securities affiliates have been able to foster meaningful competition
in the somewhat concentrated investment banking market. As financial services
customers are benefiting from banking firms' penetration into the securities
market, the restrictions on Section 20 securities affiliates are being
gradually relaxed. Nevertheless, true financial modernization can be accomplished
only by reforming the Glass-Steagall Act, rather than by loosening banking
regulations. The success of banks' securities affiliates should be viewed
as convincing economic evidence to support such reform.
Simon Kwan
Economist
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
Federal Reserve Bank of San Francisco
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