Ms. Phillips discusses the restrictions imposed on bank holding companies by
the US Ferderal Reserve Board Testimony of Governor Susan M. Phillips, a member of the
Board of Governors of the US Federal Reserve System, before the Subcommittee on Financial
Institutions and Regulatory Relief of the Committee on Banking, Housing and Urban Affairs of
the United States on 20/3/97.
I am pleased to be here today to discuss the Board's section 20 firewalls -- that is,
the restrictions the Board has imposed on bank holding companies engaged in underwriting and
dealing in securities. As the name suggests, the purpose of firewalls is to insulate a bank and its
customers from the potential hazards of combining commercial and investment banking.
Since last year the Board has been engaged in a comprehensive review of the 28
firewalls it erected in the late 1980s, and the Board has recently proposed to eliminate a majority
of those restrictions. This oversight hearing provides a constructive opportunity for comment
and analysis of the Board's proposal. Furthermore, if financial modernization is to move
forward, the issue of firewalls will have to be confronted again. I hope that the Board's review
and the public comment process can inform the legislative process as well.
Today, I would like to explain why the Board proposed changes to the firewalls. I
will also discuss the final changes the Board made last year to the revenue test that the Board
uses to determine compliance with section 20 of the Glass-Steagall Act, and to firewalls
regarding cross-marketing between a bank and a securities affiliate, and officer, director and
employee interlocks between two such companies.
The Firewalls in Context: Independent Protections for Banks and Consumers
Before I begin this discussion, I think it is important to place the firewalls in their
historical and regulatory context. Although the firewalls have served an important role, they are
not the only protection against the hazards of affiliation of commercial and investment banks.
One important protection is the placement of securities activities in a separate
subsidiary of the bank holding company, rather than in the bank itself or a subsidiary of the
bank. Because non-bank subsidiaries of a bank holding company operating under section 20 of
the Glass-Steagall Act are affiliates of a bank, they are not under the bank's control, do not have
their profits or losses consolidated with the bank's, and are less liable to have their creditors
recover against the bank. A bank therefore has less incentive to risk its own reputation or expose
itself or its customers to loss in order to assist a troubled section 20 affiliate or a failed
underwriting by that affiliate.
Also, because securities activities are conducted in an affiliate, banks are limited
in their ability to fund those activities by sections 23A and 23B of the Federal Reserve Act.
These restrictions are vitally important. Section 23A limits the total value of transactions with
any one affiliate to 10 percent of the bank's capital and limits transactions with all affiliates to
20 percent of capital. It also requires that substantial collateral be pledged to the bank for any
extension of credit. Section 23B requires that inter-affiliate transactions be at arm's length and
on market terms, and imposes other restrictions designed to limit conflicts of interest.
Thus, affiliate status prevents the bank from passing along the federal subsidy
inherent in the federal safety net to its section 20 affiliate by extending credit. Regulators could
conceivably limit a bank's ability to use credit to subsidize a direct securities subsidiary of the
bank as well, by applying sections 23A and 23B. But the equity investment in the subsidiary
would still be funded from subsidized resources backed by the federal safety net. Even if the
investment were deducted from the capital of the bank, the subsidy inherent in the transfer
would remain.
A second protection is examination of the bank holding company, including the
effect of securities activities on insured depository institution subsidiaries. The Federal Reserve
as holding company regulator monitors compliance with sections 23A and 23B and other aspects
of the relationship between a bank and its section 20 affiliate. In its supervision of bank holding
companies, the Board increasingly pays attention to risk management systems and policies that
are centralized at the holding company level and govern both the bank and its section 20
affiliate.
A final series of protections is the regulatory regime that applies to all
broker-dealers, including section 20 subsidiaries. The Securities Act of 1933 and the Securities
Exchange Act of 1934 impose registration, capital and disclosure requirements, anti-fraud
protections, and other investor-protection measures. These laws, and their enforcement by the
Securities and Exchange Commission, address many of the safety and soundness and
conflict-of-interest concerns about affiliation of commercial and investment banks.
I note that most of these important protections were not in place when the
Glass-Steagall Act passed in 1933. Thus, although proponents of high firewalls frequently cite
the subtle hazards of affiliation discussed in the legislative history of that Act, the regulatory
environment was far different then. I believe that the drafters of the Glass-Steagall Act would
have had a very different discussion -- and passed a very different Act -- had today's statutory
and regulatory protections been present in 1933.
Not only were these protections largely absent in 1933, some were not even
present in 1987 when the Board first erected its firewalls. Section 23B of the Federal Reserve
Act had not been adopted at the time of the Board's first section 20 order in 1987. As a result,
many of the firewalls overlap the restrictions of section 23B, which as I noted requires
interaffiliate transactions to be at arm's length and on market terms, but also prohibits a section 20
affiliate from representing that an affiliated bank is responsible for its obligations, and prohibits
a bank from purchasing certain products from a section 20 affiliate. Similarly, risk-based capital
standards did not exist in 1987, and those standards now require a bank to hold capital against
many of the on- and off-balance-sheet exposures it maintains in conjunction with a section 20
affiliate. Finally, the Interagency Statement on Retail Sales of Nondeposit Investment Products
was not adopted until 1994. The Interagency Statement includes disclosure and other
requirements that are now the primary means by which the federal banking agencies seek to
ensure that retail customers are not misled about the nature of non-deposit products they are
purchasing on bank premises.
The Board's Review
Thus, when the Board last year decided to reexamine the firewalls, we felt it
important to do so with a fresh eye, benefitting from our ten years of experience supervising the
section 20 affiliates, acknowledging regulatory and legal developments since 1987, and focusing
on the relevance of the firewalls in today's financial markets. As we began to look at the
concerns the firewalls were designed to address, we asked two questions. Does the affiliation of
a commercial and an investment bank cause safety and soundness or other concerns not present
with any other commercial bank affiliation -- concerns not addressed by general bank holding
company regulation? Does operation of a broker-dealer within a bank holding company cause
concerns that independent operation does not -- concerns not addressed by broker-dealer
regulation? In some areas -- most notably, consumer protection -- we believed that the answer
was "yes." In most other areas, however, the Board believed, at least pending public comment,
that the answer was "no."
The answers to these questions are important because the firewalls are far from
costless. They impose operational inefficiencies on bank holding companies that increase their
costs and reduce their competitiveness, and they limit a bank holding company's ability to
market its products in a way that is both most profitable and desired by its customers. As such,
the firewalls have served as a significant barrier to entry for small and mid-size bank holding
companies because those companies cannot realize sufficient synergies or achieve adequate
operating revenues to justify establishing a section 20 subsidiary. The loss is not just to these
companies but also to their customers and market competition.
Let me now discuss the most important of the firewalls to which the Board has
proposed changes. The comment period closed on this proposal last week, and the comments
were overwhelmingly favorable. I will not discuss all 28 firewalls but have attached a summary
list and their proposed disposition.
Restrictions on Funding
The Board proposed to eliminate a series of firewalls that constitute a blanket
prohibition on a bank's funding its section 20 affiliate, and to rely instead on the protections of
sections 23A and 23B of the Federal Reserve Act. The firewalls in question prohibit a bank from
extending credit to a section 20 affiliate, purchasing corporate and other non-governmental
securities being underwritten by the section 20 affiliate, or purchasing from the section 20
affiliate such securities in which the affiliate makes a market. These firewalls were intended to
prevent a bank from assisting a troubled affiliate by lending to it on preferential terms or by
bailing out a failed underwriting by purchasing securities that cannot otherwise be sold.
Except for the prohibition on purchasing securities during the underwriting
period, none of these funding firewalls was applied under the Board's original 1987 order, but
were added in 1989 when the range of permissible securities activities was expanded. Bank
subsidiaries of the fourteen companies operating under the 1987 order have therefore been free
to, and have in fact, funded their section 20 affiliates subject to sections 23A and 23B. The
Board has not encountered problems arising from such funding.
If the Board were to eliminate the funding restrictions for the remaining section
20 subsidiaries, sections 23A and 23B would continue to impose quantitative and qualitative
restrictions on inter-affiliate transactions. In addition to requiring that the transaction be on
market terms, section 23B specifically prohibits a bank from purchasing any security for which a
section 20 affiliate is a principal underwriter during the existence of the underwriting or selling
syndicate, unless such a purchase has been approved by a majority of the bank's board of
directors who are not officers of any bank or any affiliate. If the purchase is as fiduciary, the
purchase must be permitted by the instrument creating the fiduciary relationship, court order, or
state law. We believe these are substantial protections, and have proposed to rely on them in
place of a firewall.
Prohibitions on a Bank Extending or Enhancing Credit in Support of Underwriting or Dealing
by a Section 20 Affiliate
Three of the Board's firewalls restrict the ability of a bank to assist a section 20
affiliate indirectly, by enhancing the marketability of its products or lending to its customers.
These firewalls prohibit a bank from extending credit or offering credit enhancements in support
of corporate and other non-governmental securities being underwritten by its section 20 affiliate
or in which the section 20 affiliate makes a market; extending credit to issuers of securities to
repay principal or interest on securities previously underwritten by a section 20 affiliate; or
extending credit to customers to purchase securities currently being underwritten by a section 20
affiliate. The firewalls share a common purpose: to prevent a bank from imprudently exposing
itself to loss in order to benefit the underwriting or dealing activities of its affiliate.
However, as financial intermediation has evolved, corporate customers frequently
seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from
providing routine credit or credit enhancements in tandem with a section 20 affiliate, these
firewalls hamper the ability of bank holding companies to serve as full-service financial services
providers. The firewall thereby reduces options for their customers. For example, existing
corporate customers of a bank may wish to issue commercial paper or issue debt in some other
form. Although the bank may refer the customer to its section 20 affiliate, the bank is prohibited
from providing credit enhancements even though it is the institution best suited to perform a
credit analysis -- and, with smaller customers, perhaps the only institution willing to do so. As
another example, the restriction on lending for repayment of securities causes a bank compliance
problems when renewing a company's revolving line of credit if a section 20 affiliate has
underwritten an offering by that company since the credit was first extended. The bank must
either recruit other lenders to participate in the renewal or amend the line of credit in order to
specify that its purpose does not include repayment of interest or principal on the newly
underwritten securities.
Notably, even if these firewalls were lifted, a bank would still be required to hold
capital against all credit enhancements and credit extended to customers of its section 20
affiliate. Section 23B of the Federal Reserve Act would require that such credit and credit
enhancements be on an arm's-length basis. Similarly, the federal anti-tying statute would
prohibit a bank from offering discounted credit enhancements on the condition that an issuer
obtain investment banking services from a section 20 affiliate. Thus, for example, a bank could
not offer such credit enhancements below market prices, or to customers who were poor credit
risks, in order to generate underwriting business for a section 20 affiliate.
The firewall prohibiting lending to retail customers for securities purchases
during the underwriting period addresses one of the most important potential conflicts of
interests arising from the affiliation of commercial and investment banking: the possibility that a
bank would extend credit at below-market rates in order to induce consumers to purchase
securities underwritten by its section 20 affiliate. The concern here is not only safety and
soundness but customer protection.
The Securities Exchange Act of 1934 already prohibits a broker-dealer (including
a section 20 affiliate) from extending or arranging for credit to its customers during the
underwriting period. Still, we recognize the Act would not apply in the absence of arranging
and, unlike the firewall, would not cover loans to purchase a security in which a section 20
affiliate makes a market. Section 23B of the Federal Reserve Act, and to some extent section
23A, would address some of these remaining concerns, but perhaps not all. The Board will be
reviewing the comments on this firewall carefully.
Capital Requirements
The next group of firewalls I will discuss imposes capital requirements on a bank
holding company and its section 20 subsidiary. These firewalls require a bank holding company
to deduct from its capital any investment in a section 20 subsidiary and most unsecured
extensions of credit to a section 20 subsidiary engaged in debt and equity underwriting; they also
require the section 20 subsidiary to maintain its own capital in keeping with industry norms.
These requirements apply only to section 20 subsidiaries and not to any other nonbank
subsidiary of a bank holding company.
The Board proposed to eliminate the capital deductions for investments in, or
credit extended to, a section 20 subsidiary. The original purpose of the deduction was to ensure
that the holding company maintained sufficient resources to support its federally insured
depository institutions. In practice, however, the deductions have created regulatory burden
without strengthening the capital levels of the insured institutions.
The deduction is inconsistent with Generally Accepted Accounting Practices,
which require consolidation of subsidiaries for accounting purposes. The deduction therefore has
created confusion and imposed costs by requiring bank holding companies to prepare statements
on two bases. The deduction does not strengthen the capital of either the bank or its section 20
affiliate, and elimination of the deduction would not create or expose any incentive for a bank
holding company to divert necessary capital from a depository institution to a section 20
subsidiary. One of the purposes of the system of prompt corrective action adopted in 1992 is to
ensure that a bank holding company maintains the capital of its subsidiary banks.
The Board also sought comment on whether it should continue to impose a
special capital requirement on section 20 subsidiaries in addition to the SEC's net capital rules.
The purpose of this requirement was to prevent a section 20 subsidiary from being able to
leverage itself more than, and gain a competitive advantage over, its independent competitors by
trading on the reputation of its affiliated bank. Although the SEC imposes capital requirements
on all broker-dealers, these are minimum levels that are far below the industry norm.
This capital firewall has proven confusing and controversial, as "industry norms"
are difficult to determine. Federal Reserve examiners have expected section 20 subsidiaries to
maintain capital to cover risk exposure in an amount approximately twice what the SEC
requires, but some section 20 subsidiaries have complained that this is more than their
competitors maintain. They also argue that whereas SEC capital requirements allow all capital to
be concentrated in the broker-dealer and dedicated to meeting capital requirements, a bank
holding company must meet capital requirements at the bank and holding company levels as
well.
Indeed, bank holding company capital is measured on a consolidated basis, and
thus includes the capital and assets of the section 20 subsidiary. Therefore, the Board believes it
may be unnecessary to impose a separate capital requirement on the bank holding company's
section 20 subsidiary.
Remaining Restrictions
Before leaving the Board's proposal, I should also note which restrictions the
Board proposed to retain. The Board proposed to reserve its authority to reimpose the funding,
credit extension, and credit enhancement firewalls in the event that an affiliated bank or thrift
becomes less than well capitalized and the bank holding company does not promptly restore it to
the well-capitalized level. The Board considered proposing to reimpose the firewalls on less than
well capitalized banks automatically -- as some recent bills introduced in the Congress would
-but decided against it because a decline in a bank's capital ratios may be wholly unrelated to the
bank's dealings with its section 20 affiliate. Thus, for example, forcing a bank suffering serious
losses on real estate lending to desist from credit enhancements may be unproductive or -- if the
business is profitable -- counterproductive.
The Board also proposed to retain existing firewalls requiring adequate internal
controls and documentation, including a requirement that a bank exercise independent and
thorough credit judgment in any transaction involving an affiliate. Although we expect banking
organizations to have such internal controls and look for them during examinations, we believe
that they are sufficiently important to warrant reinforcement through the operating standards.
They are especially important in the section 20 context because of the likelihood that a bank and
its section 20 affiliate may be selling similar products to the same customer.
Because of the potential for customer confusion as to which products are federally
insured, the Board proposed to require a section 20 affiliate to make disclosures to customers
similar to those that the Interagency Statement requires of a bank selling nondeposit products on
bank premises. The proposal would also continue to prohibit an affiliated bank from knowingly
advising a customer to purchase securities underwritten or dealt in by a section 20 affiliate
unless it notifies the customer of its affiliate's role. The proposal also continues to prohibit a
bank and its section 20 affiliate from sharing any nonpublic customer information without the
customer's consent.
Earlier Board Action on Other Firewalls and the Revenue Limit
In addition to describing the Board's recent proposal, you also asked me to
discuss other changes the Board finalized last year: increasing the section 20 revenue limit from
10 percent to 25 percent; allowing cross-marketing between a bank and a section 20 affiliate;
permitting employee interlocks between a bank and a section 20 affiliate; and scaling back a
restriction on officer and director interlocks.
The review that led to changes to the cross-marketing and interlocks firewalls was
akin to what the Board recently went through for all the firewalls. The Board acted on these
firewalls before the rest because it had previously sought comment on them some years ago and
because they were identified by commenters as among the most unduly burdensome of all the
firewalls. After reviewing its experience administering these firewalls, the Board decided that
they caused inefficiencies that could not be justified by any benefit to safety and soundness, and
commenters agreed overwhelmingly. Repeal of the interlocks and cross-marketing restrictions
allows increased synergies in the operation of a section 20 subsidiary and its bank affiliates.
Persons may be employed by both companies, and the trend toward coordinated management of
like business functions can accelerate, with reporting lines running between companies.
Companies need not fund dual back offices or trading floors, for example. To the extent that
senior bank managers may now oversee related operations at a section 20 affiliate, risk
management and safety and soundness may be improved.
Moreover, existing disclosure requirements adequately address concerns about
customer confusion arising from increased cross-marketing and employee interlocks. Most
notably, the Interagency Statement on Retail Sales of Nondeposit Products states that, prior to
the initial sale of a non-deposit product by a bank employee or on bank premises, the customer
must receive and acknowledge a written statement that the product being sold is not federally
insured, is not a deposit or other obligation of the bank, is not guaranteed by the bank, and is
subject to investment risks including loss of principal.
Finally, with regard to the revenue limit, section 20 of the Glass-Steagall Act
prohibits a bank from being affiliated with any company "engaged principally" in underwriting
and dealing, and the Board was obliged to make a narrow, legal determination of the level of
revenue at which a company becomes "engaged principally." The Board interpreted the statute to
allow 25 percent of total revenue to be derived from underwriting and dealing in bank-ineligible
securities. In reviewing the revenue limit, the Board was not deciding what level of underwriting
and dealing was consistent with safety and soundness or public policy. If it were, the Board may
well have raised the limit to 100 percent, which would have been consistent with the Board's
support of repeal of section 20.
I am pleased to report that early indications of the effects of these changes have
been favorable. The Board currently has pending three applications to establish a section 20
subsidiary. As we had anticipated, two of these are small to mid-size bank holding companies
which may previously have either found it too expensive to fund the dual staffing required by
the interlocks restrictions or too difficult to generate sufficient eligible revenue to maintain
compliance with a ten percent revenue limit. Furthermore, existing section 20 subsidiaries have
indicated that they have been able to rationalize their organization and expand their activities
given the added flexibility with respect to both staffing and revenue.