FRBSF Economic Letter
98-32; October 23, 1998
Risk and Return of Banks' Section 20 Securities Affiliates
Western Banking Quarterly is a review of banking developments
in the Twelfth Federal Reserve District, and includes FRBSF's Regional Banking Tables. It
is published in the Economic Letter on the fourth Friday of January,
April, July, and October.
In recent years, the push to allow greater affiliation among banks and
other financial firms has intensified. Through regulatory measures, banking
organizations have made inroads into both securities and insurance activities.
The legislative proposals under consideration in this session of the Congress
would take things even further by tearing down virtually all remaining
barriers to financial integration. While the legislative outcome for this
year remains uncertain, the momentum is such that further financial integration
is inevitable.
With full financial integration on the horizon, it is important to understand
what these affiliations might mean for the profitability and risk of banking
organizations, and thus the stability of the banking sector. This Economic
Letter considers the implications of affiliations between commercial
banking and securities activities. The evidence is drawn from a recent
study (Kwan 1998) that examines the relationship between the performance
of commercial banks and their so-called Section 20 securities affiliates.
Section 20 subsidiaries: some background
Sections 16, 20, 21, and 32 of the Glass-Steagall Act provide the legal
basis separating commercial banking from investment banking since 1933.
In particular, Section 20 prohibits Federal Reserve member banks from
being affiliated with any organization that is engaged principally in
securities underwriting or dealing, except municipal general obligation
bonds, U.S. government bonds, private placement of commercial papers,
and real estate bonds, which collectively are called "bank eligible securities."
However, since the term "engaged principally" was not defined in the act,
the courts and the regulators have had to determine the meaning of these
terms in enforcing the law. Beginning in 1987, the Federal Reserve authorized
bank holding companies to establish securities subsidiaries to engage
in limited underwriting and dealing in bank-ineligible securities. Today,
these securities subsidiaries can underwrite and deal in a variety of
securities, including corporate bonds and equities, as long as the revenues
from conducting bank-ineligible securities activities do not exceed 25%
of total revenues. Since the ineligible securities activities were authorized
by the Fed under Section 20 of the Glass-Steagall Act, these securities
affiliates are commonly referred to as Section 20 subsidiaries.
A sample of 23 domestic banking organizations with Section 20 subsidiaries
indicates that such firms tend to be large: their average banking assets
over the period 1990 to 1997 was $59 billion. Section 20 subsidiaries
that are primary dealers of government securities are affiliated with
even larger banks, which had average total banking assets of $94 billion.
The volume of securities activities conducted by Section 20 subsidiaries
that are primary dealers is much higher than nonprimary dealers, with
total trading assets averaging $20 billion for primary dealers and $428
million for nonprimary dealers.
Return relationship between banking and
securities activities
Kwan (1998) addresses two questions: (1) What are the profitability and
risk of securities activities relative to banking activities? and (2)
What are the potential diversification benefits of securities activities
to a banking organization? To answer the first question, the study examines
the mean and variance of the return on securities activities and compares
them to those of banking activities, with the mean return measuring profitability
and the variance of the return measuring risk. To provide insights into
the second question, the study examines the return correlation between
banking and securities activities, taking into consideration the stand-alone
risk of each type of activity.
The average quarterly return on equity (ROE) was found to be slightly
higher for bank subsidiaries than securities subsidiaries, although the
difference was not statistically significant. However, the average standard
deviation of ROE was much smaller for bank subsidiaries than securities
subsidiaries, and the difference is highly significant. It is also worth
noting that the ROE volatility was much higher among nonprimary dealers
than primary dealers. The findings suggest that while Section 20 securities
subsidiaries were no more profitable than bank subsidiaries, securities
subsidiaries were much riskier than their bank affiliates.
However, the results also point to potential diversification benefits,
since the return correlations between the bank subsidiaries and their
Section 20 affiliates are close to zero. This suggests that the combination
of a Section 20 subsidiary and a bank subsidiary can improve the risk
and return tradeoff of the banking organization. In other words, if the
bank and securities subsidiary operate independently, the firms can increase
their returns only by proportionally increasing their risk exposure; with
a bank and a securities subsidiary combined, however, the banking organization
can achieve a higher return with the same level of risk or the same return
with lower risk. Although the results indicate that banking organizations
can reduce their risk exposure by engaging in the right amount of securities
activities, too much securities activity can raise their overall risk
due to the high stand-alone risk of Section 20 subsidiaries.
Since certain kinds of securities activities are bank permissible and
are performed by banks rather than their securities affiliates, this may
confound the analysis of banking vis-a-vis securities activities by examining
activities at the subsidiary level. For robustness, the analysis also
was performed at the activity level. In essence, the securities activities
conducted by banks were subtracted from the bank subsidiaries and combined
with the securities activities conducted by their Section 20 affiliates.
This method is more precise in classifying banking versus securities activities
and allows desegregating securities activities into trading and underwriting.
Securities trading refers to buying and selling of securities, whereas
securities underwriting refers to the distribution of securities from
issuers to investors. However, the amount of capital and indirect expenses
in the bank subsidiaries that is allocated to securities activities is
unknown, so only the gross return on assets (ROA) can be computed.
Looking at ROA, the findings indicate that securities trading has a significantly
higher return and higher risk than banking activities, especially for
securities subsidiaries that are not primary dealers. Securities underwriting
is found to have similar risk and return profiles to banking activities
for primary dealers of government securities. For nonprimary dealers,
securities underwriting appears to be less profitable than commercial
banking. Regarding the portfolio diversification implications of securities
activities, the trading activities by primary dealers are found to have
potential diversification benefits for banking organizations; this is
not the case for nonprimary dealers. On the other hand, securities underwriting
is found to provide diversification benefits regardless of whether the
securities subsidiaries are primary dealers or not.
Conclusion
Using micro data from banks' Section 20 securities affiliates that were
authorized by the Federal Reserve to engage in bank-ineligible securities
activities, Kwan (1998) studied the effects of securities activities on
banking organizations' risk and profitability. Section 20 subsidiaries
were found to be riskier, but not necessary more profitable, than their
bank affiliates. The low return correlations between bank subsidiaries
and Section 20 affiliates suggest that securities affiliates can provide
diversification benefits to banking organizations.
Within the class of securities activities, securities trading is found
to be more profitable and riskier than banking activities. Securities
underwriting is found to have similar return profiles to banking activities
for primary dealers, but it is less profitable than banking activities
for nonprimary dealers. Trading activities by primary dealers seem to
provide diversification benefits to banking organizations, while trading
activities by nonprimary dealers do not. Securities underwriting by both
primary and nonprimary dealers is found to be able to diversify banking
risk.
Simon Kwan
Senior Economist
Reference
Kwan, S.H. 1998. "Securities Activities
by Commercial Banking Firms' Section 20 Subsidiaries: Risk, Return, and
Diversification Benefits." Federal Reserve Bank of San Francisco Working
Paper 98-10.
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
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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