United States General Accounting OfBce 

Testimony 

For Release 

on Delivery 

Expected at 

9:30 a.m. 

Wednesday 

April 13, 1988 

Using "Firewalls" in a Post GlassSteagall Banking Environment 

Statement of 

Richard L. Fogel 

Assistant Comptroller General 

General Government Programs 

Before the 

Subcommittee on Telecommunications and Finance, 

Committee on Energy and Commerce 

United States House of Representatives 

GAO/T-GGD-88-25 GAOFmi16o0lt/En) 
USE OF FIREWALLS IN A POST-GLASS-STEAGALL 

BANKING ENVIRONMENT 

SUMMARY OF STATEMENT BY 

RICHARD L. FOGEL 

ASSISTANT COMPTROLLER GENERAL 

U.S. GENERAL ACCOUNTING OFFICE 

In response to a request from the Honorable Edward J. Markey, 

Chairman of the Subcommittee on Telecommunications and Finance, 

GAO is commenting today on the use of so-called "firewalls" to 

protect bank safety and soundness and prevent conflict of 

interest abuses if the Glass-Steagall Act is repealed or relaxed. 

In summary: 

GAO'S ultimate interest is to determine what ground rules will 

best allow banks and consumers to reap the presumed benefits of 

Glass-Steagall repeal and, at the same time assure the safe and 

sound operation of the banking system and consumer protection. 

GAO views firewalls as a set of legal and regulatory measures 

that separate nonbanking activities from banking activities 

carried out within the same organization and has reported that 

three types of separation are required to insulate banks: 

-- legal separation, so that the bank is not legally 

liable for the debts of its affiliates; 

-- economic separation, so that the bank is prohibited from 

excessively aiding an affiliate; and 

-- psychological or market-perception separation, so that the 

public does not perceive the bank and affiliate as one. 

GAO believes, however, that no insulation strategy should by 

itself be viewed as fail-safe, and cautions that attempts to 

create such firewalls must be weighed against the likelihood of 

reducing the presumed benefits of Glass-Steagall repeal. 

GAO views firewalls as useful in combination with other methods 

of protecting bank safety and soundness and consumers and has 

recommended that if Glass-Steagall is repealed or relaxed: 

-- the bank holding company structure be required, 

because it provides the most insulation. 

-- the holding company be required to maintain adequate 

capital and act as a source of strength to its banks. 

-- regulatory resources and expertise must be increased to assure 

compliance with laws and regulation. 
Mr. Chairman and Members of the Subcommittee: 

We are pleased to be here today to provide our views on the use 

of so-called "firewalls" to protect bank safety and soundness, 

prevent conflict of interest problems, and protect consumer 

interests. In April 1987, we issued our report entitled Bank 

Powers: Insulating Banks from the Potential Risks of Expanded 

Activities, which dealt with the strengths and weaknesses of 

various corporate structures in protecting bank safety and 

soundness. In January of this year, we issued to your 

subcommittee another report entitled Bank Powers: Issues Related 

to Repeal of the Glass-Steagall Act. This report contained 

recommendations on how to protect bank safety and soundness if a 

decision is made to repeal the Glass-Steagall laws. These two 

reports are the principal basis for our testimony today. 

Increases in the number, height and thickness of firewalls have 

been proposed by some as a means of protecting banking 

organizations from risks incurred by affiliated securities firms 

in an expanded powers environment. The recently passed Senate 

legislation (S. 1886) contains a number of firewall provisions. 

These include restrictions on corporate structure, interaffiliate 

transactions, director interlocks for larger banks, and sharing 

of confidential information, as well as other measures designed 

to prevent conflict of interest problems. S. 1886 also contains 

other "non-firewall" mechanisms to promote bank safety and 

soundness. 
Our ultimate interest is to determine what ground rules will best 

allow banks and consumers to reap the benefits that are presumed 

to flow from repeal of Glass-Steagall laws and, at the same time 

assure the safe and sound operation of the banking system and 

consumer protection. Firewalls are one of a number of means 

offering the potential to achieve this. However, we believe 

total reliance on firewalls would be inappropriate because, (1) 

no set of firewalls should be viewed as completely fail-safe, (2) 

the benefits of repeal might be lost, (3) there may be dangers in 

constructing barriers that inhibit the flow of liquidity during 

periods of financial turmoil and, (4) there may be other 

mechanisms that may prove superior in accompl ishing the des ired 

result. 

In my testimony today, I would like to first describe what we 

mean by firewalls and then offer some general views on their 

usefulness as a means of protecting bank safety and soundness. 

CORPORATE STRUCTURES 

AND FIREWALLS 

Firewalls are a set of legal and regulatory measures governing 

structural and operational relationships that organizationally 

separate nonbanking activities from banking activities carried 

out within the same organization. These laws and regulations are 

intended to legally, economically, and psychologically insulate 

or protect banks from risks incurred by nonbanking parts of the 

organization. They are also designed to prevent problems arising 

from conflicts of interest between the banking and nonbanking 

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components of the organization. From the federal government’s 

perspective, these firewalls should be designed to protect its 

ability to fulfill its deposit insurance responsibilities, limit 

the reach of the Federal Reserve’s lender of last resort 

function, and promote the safe and sound operation of the banking 

system. 

Legal separation involves steps to assure that the bank itself 

cannot be held legally liable for the debts or losses of one of 

its affiliated or subsidiary organizations. Factors important to 

achieving such separation include, separate incorporation; 

adequate capitalization; separation of day-to-day business and 

formal management structures of each organization, including 

boards of directors, bookkeeping functions, and other operations. 

Economic separation consists of structures designed to prevent 

the unrestricted flow of bank funds to nonbank affiliates, such 

as adequate and separate funding of the nonbanking unit with 

prohibitions on commingling of nonbank assets with bank assets. 

Any services or loans obtained by the affiliate from the bank 

must be at rates comparable to those charged nonaffiliated 

parties. In addition, the bank must be prevented from unduly 

transferring assets to, or purchasing bad assets from, an ailing 

affiliate. Federal Reserve Act sections 23A and 238 limit the 

extent to which, and specify the terms under which, banks may 

engage in transactions with their affiliates. 
Psychological separation or insulation protects against 

depositor perceptions that the bank and its affiliated or 

subsidiary organizations are one entity. The greatest danger 

arising from failure to achieve psychological or market 

perception separation is that problems in an affiliate could be 

perceived by depositors as the bank’s as well, leading to a run 

on the bank. Ways to mitigate against this possibility include 

using separate names and logos for the bank and affiliate, 

locating the bank and its affiliates in separate locations, 

conducting marketing activities separately, refraining 

from selling each other’s products, developing and maintaining 

separate customer lists, and providing full and appropriate 

disclosure of the noninsured status of affiliate products. 

USEFULNESS OF 

FIREWALLS 

While firewalls are no doubt needed to protect bank safety and 

soundness in a modernized regulatory environment, I would like to 

make three main points about their usefulness: 

-- No insulation strategy designed to provide legal, economic, 

and psychological separation is completely fail-safe. 

-- Attempts to increase the number, height, or thickness of 

firewalls must be weighed against the likelihood of 

diminishing the benefits that repeal of Glass-Steagall laws is 

presumed to produce; and 

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-- Firewalls should be used in combination with other legal and 

regulatory mechanisms designed to foster incentives on the 

part of bank management to operate in a safe and sound manner. 

How Protective Are 

Firewalls? 

We indicated in our recent report on issues associated with 

Glass-Steagall repeal that no set of insulation techniques is 

likely to be fail-safe in protecting a bank from the risks of 

expanded activities. We did, however, note that among the 

various corporate structures we reviewed, the bank holding 

company structure offered the greatest degree of insulation. The 

holding company is organized in such a way that it would be much 

more difficult for creditors of a failed affiliate to 

successfully pursue a claim on a bank’s assets than it would be 

in a bank subsidiary or bank department form of organization. 

Fur thermore, the restrictions on interaffiliate transactions 

within a holding company are more rigorous than those that apply 

to other organizational forms of banking. 

But adopting the holding company structure will not completely 

eliminate the possibility of misperceptions on the part of the 

public of how the affairs of nonbank affiliates might affect the 

banking affiliate. We described this potentiai market perception 

problem in our 1987 report. We cited several examples in which 

all of the corporate formalities were followed and Federal 

Reserve examiners had found no violations of restrictions 

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designed to achieve economic insulation. But market perception 

risks existed because these banks and their affiliates had common 

or similar names and logos, and used the same facilities. In 

other cases, smaller bank holding companies did not maintain 

separate boards of directors and used bank employees to conduct 

nonbank affiliate business. Of the 12 holding company nonbanking 

subsidiaries in our sample, all but one 

coordinating sales or marketing activit 

bank. 

told us they were 

ies with the affil iated 

In addition to these market perception risks there can never be 

absolute assurance that when an affiliate is deeply troubled a 

bank will not come to the affiliate's rescue, either to protect 

the bank's good name or for other reasons. While bank rescues of 

failing or troubled affiliates or subsidiaries have not been 

common place, they have been sufficiently numerous over the past 

10 years to raise doubts about the complete effectiveness of even 

legal or regulatory prohibitions on such activities. The most 

notable recent example is the Continental Illinois Bank's rescue 

of its First Options subsidiary. 

Tradeoff Between use of 

Firewalls and Achieving 

Benefits from Associating 

With Other Activities 

Moreover, it might be disadvantageous to attempt to achieve 

absolute insulation because this could eliminate the benefits 

that are presumed to flow from combining banking and securities 

activities. Outright prohibitions on such activities as cross 

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marketing of products, use of banking facilities by affiliated 

organizations, tied-in product offerings, cross marketing and the 

sharing of common names, logos, and facilities would no doubt 

reduce the potential for adverse market perception and conflict 

of interest problems. However, one of the principal purposes of 

modernizing Glass-Steaqall laws has been to capture the benefits 

that are presumed to flow to both banks and their customers from 

the joint operation of the banking and securities business. It 

, 

is argued that cross marketing and a sharing of facilities will 

reduce the costs of producing banking services which could then 

flow to customers in the form of reduced costs or improved access 

to services. 

In our report on Glass-Steagall issues, we did not render a 

judgement on the appropriate way in which to reconcile the 

tradeoff between concerns over potential conflicts of interest 

and market perception problems and capturing the benefits that 

would flow from corporate synergies and reduced costs of 

production. One approach to the tradeoff would be to impose full 

disclosure requirements on the relationship between the bank and 

the affiliate, and their products. Adequate oversight of 

compliance with those requirements should be part of this 

approach. 

Another tradeoff occurs in the area of interaffiliate extensions 

of credit. We are concerned about total prohibitions on 

extensions of credit in any manner, such as those contained in 

s. 1886, by a bank to its securities affiliate. We recognize the 

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clear potential for conflict of interest problems that exists in 

such transactions as well as their potential adverse effect on 

bank safety and soundness if allowed to occur without limitation. 

And, there is a clear cut need for prohibitions on interaffiliate 

purchases of 

iliate and on 

and 

securities being underwritten by the securit 

bank loans to purchasers of those securities 

immediately following underwriting periods. 

dealings such as those contained in S. 1886 on bank 

ies aff 

dur inq 

Commercial banks have traditionally maintained lending 

relationships with securities firms. During the market crash of 

October 1987, commercial banks were important suppliers of 

liquidity to market participants, augmented by general support 

from the Federal Reserve. If a total prohibition is placed on 

this type of lending between a bank and its affiliated securities 

firm, we are not sure that the liquidity needs of market 

participants could be as well met in the event that the October 

events are repeated. Whether the holding company would have 

sufficient strength to meet its securities subsidiary’s funding 

needs or whether banks would be willing to extend loans to 

competing holding company securities subsidiaries is a matter of 

conjecture. We recognize that the current 23A and 23B 

limitations on interaffiliate lending might prevent the bank from 

meeting its securities affiliate’s total funding needs in a 

market crisis. But such limitations at least allow some room for 

flexibility in such a situation. 
One reason advanced for the total prohibition on interaffiliate 

extensions of credit is that the current 23A and 23B restrictions 

are subject to creative interpretation and are difficult and 

cumbersome to oversee. In our view, any concern over the 

regulators' ability to enforce the 23A and 23B restrictions 

should be addressed by additional oversight and increased 

penalties for violations of restrictions. 

Firewalls in Context 

Our report on Glass-Steagall issues contains a number of 

recommendations on how to preserve bank safety and soundness and 

protect consumer interests in a world of expanded powers. Except 

for our views that the bank holding company structure provided 

the best means of organizing banking and securities activities, 

and that the 23A and 23B restrictions on interaffiliate 

transactions were preferable to outright prohibitions on such 

transactions, we did not have any specific recommendations on 

firewalls. 

Firewalls, such as those contained in S. 1886 are very important. 

But they must be employed in combination with other methods of 

protecting safety and soundness, such as adequate capital, 

requirements on the holding company that provide its management 

with incentives to operate in a safe and sound'manner, and 

increased oversight and supervision. I would like to briefly 

discuss these other elements of OUK recommended approach. 

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Capital Adequacy: We recommended that if Glass-Steagall laws are 

repealed, undercapitalized holding companies should be prohibited 

from engaging in expanded activities. The dismal experience of 

the thrift industry has made it clear that both undercapitalized 

and insolvent institutions have incentives to make decisions that 

threaten safety and soundness. Well-capitalized institutions, on 

the other hand, have every incentive to preserve and increase the 

wealth of their stockholders. In our view, requiring the 

maintenance of adequate capital levels, and promptly dealing with 

institutions that become undercapitalized or insolvent would 

provide appropriate incentives for holding companies to operate 

in a safe and sound manner. We note in this regard that S. 1886 

prohibits a bank holding company from buying a securities firm if 

in doing so the holding company would fall below its minimum 

capital requirements. However, the bill is not explicit about 

the steps to be taken if, after acquiring a securities firm, the 

holding company falls below its minimum capital level. 

Holding Company Incentives: We also recommended that the holding 

company be required to act as a source of strength for the 

banking entity. Since one important reason for permitting banks 

to enter the securities business is to strengthen banking 

profits, the profits derived from the securities business should 

be available through the holding company to support weakened 

banking institutions. Alternatively, the holding company could 

be held liable for the losses incurred by FDIC in liquidating 

failed bank subsidiaries. These requirements would provide a 

powerful set of incentives for holding company management to 

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assure that the banking and other subsidiaries operate in a safe 

and sound manner. While it has been Federal Reserve policy to 

view the holding company as a source of strength for its bank 

subsidiaries, we indicated in our January report that such a 

policy should be made a legislative requirement. S. 1886 

explicitly gives the Federal Reserve discretion to disapprove 

additional holding company investment in a securities subsidiary, 

if the holding company’s capital falls below that necessary to 

fulfill its obligation to serve as a source of strength to its 

subsidiary banks. However, s. 1886 does not require that bank 

holding company capital be used to augment the strength of bank 

subsidiaries with capital deficiencies OK other problems. 

Oversight and Supervision: Finally, it is essential that those 

contemplating actions or activities that would constitute unsafe 

and unsound practices be aware that such activities will likely 

result in timely detection and severe penalties. we do not 

believe that the current oversight capabilities of the regulators 

create this sort of climate. In our January report, we 

questioned whether the regulators have the capability to 

adequately carry out all their oversight responsibilities in 

today’s environment. And, we have serious reservations about 

their present ability to do so in an environment of expanded 

powers. Accordingly, we recommended that expansion of bank 

powers be conditioned on acquiring adequate resources to oversee 

the new activities. 

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We are pleased to note that S. 1886 as passed by the Senate 

adopts a phased approach to repeal of Glass-Steagall laws and 

also requires that the regulators develop a plan for overseeing 

compliance with the bill's f irewall provis ions and for responding 

to consumer complaints. 

---------- 

MK. Chairman, this concludes my prepared statement. We would be 

pleased to respond to questions. 

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