[Federal Register Volume 62, Number 12 (Friday, January 17, 1997)]
[Proposed Rules]
[Pages 2622-2632]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-1010]
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Proposed Rules
Federal Register
________________________________________________________________________
This section of the FEDERAL REGISTER contains notices to the public of
the proposed issuance of rules and regulations. The purpose of these
notices is to give interested persons an opportunity to participate in
the rule making prior to the adoption of the final rules.
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Federal Register / Vol. 62, No. 12 / Friday, January 17, 1997 /
Proposed Rules
[[Page 2622]]
FEDERAL RESERVE SYSTEM
12 CFR Part 225
[Regulation Y; Docket No. R-0958]
Bank Holding Companies and Change in Bank Control (Regulation Y);
Review of Restrictions in the Board's Section 20 Orders
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Proposed conditions to board orders.
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SUMMARY: The Board has conducted a comprehensive review of the
prudential limitations established in its decisions under the Bank
Holding Company Act and section 20 of the Glass-Steagall Act permitting
a nonbank subsidiary of a bank holding company to underwrite and deal
in securities. The Board is seeking comment on modifications to these
limitations that the Board believes will allow section 20 subsidiaries
to operate more efficiently and serve their customers more effectively.
These modifications would allow section 20 subsidiaries to operate more
readily in conjunction with an affiliated bank, thereby maximizing
synergies, enhancing services, and possibly reducing costs.
DATES: Comments should be received on or before March 10, 1997.
ADDRESSES: Comments, which should refer to Docket No. R-0958, may be
mailed to Mr. William W. Wiles, Secretary, Board of Governors of the
Federal Reserve System, 20th Street and Constitution Avenue, N.W.,
Washington, D.C. 20551. Comments addressed to Mr. Wiles may also be
delivered to the Board's mail room between 8:45 a.m. and 5:15 p.m., and
to the security control room outside of those hours. Both the mail room
and the security control room are accessible from the courtyard
entrance on 20th Street between Constitution Avenue and C Street, N.W.
Comments may be inspected In room MP-500 between 9:00 a.m. and 5:00
p.m., except as provided in Section 261.8 of the Board's Rules
Regarding the Availability of Information, 12 CFR 261.8.
FOR FURTHER INFORMATION CONTACT: Gregory Baer, Managing Senior Counsel
(202) 452-3236, Thomas Corsi, Senior Attorney (202) 452-3275, Legal
Division; Michael J. Schoenfeld, Senior Securities Regulation Analyst
(202) 452-2781, Division of Banking Supervision and Regulation; for the
hearing impaired only, Telecommunications Device for the Deaf (TDD),
Dorothea Thompson (202) 452-3544.
SUPPLEMENTARY INFORMATION:
Background
Section 20 of the Glass-Steagall Act provides that a member bank of
the Federal Reserve System may not be affiliated with a company that is
``engaged principally'' in underwriting and dealing in
securities.1 Beginning in 1987, the Board has issued a series of
orders authorizing bank holding companies to establish ``section 20
subsidiaries'' to engage in underwriting and dealing in securities not
eligible for underwriting and dealing by a member bank. 2 In those
orders, the Board established a series of prudential restrictions as
conditions for approval under the Bank Holding Company Act. The
restrictions are designed to prevent securities underwriting and
dealing risk from being passed from a section 20 subsidiary to an
affiliated insured depository institution, and thus to the federal
safety net, and to mitigate the potential for conflicts of interest,
unfair competition, and other adverse effects that may arise from the
conduct of bank-ineligible securities activities.
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\1\ 12 U.S.C. 377.
\2\ See, e.g., J.P. Morgan & Co., The Chase Manhattan Corp.,
Bankers Trust New York Corp., Citicorp, and Security Pacific Corp.,
75 Federal Reserve Bulletin 192 (1989) (hereafter, 1989 Order);
Citicorp, J.P. Morgan & Co., and Bankers Trust New York Corp., 73
Federal Reserve Bulletin 473 (1987) (hereafter, 1987 Order); see
also Canadian Imperial Bank of Commerce, The Royal Bank of Canada,
Barclays PLC and Barclays Bank PLC, 76 Federal Reserve Bulletin 158
(1990) (applying earlier orders to section 20 subsidiaries of
foreign banks) (hereafter, 1990 Order).
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The Board's original section 20 order in 1987 contained twenty
restrictions, and the Board's subsequent order in 1989 allowing
underwriting and dealing in all debt and equity securities contained
more stringent restrictions, numbering twenty-eight in all. The
restrictions contained in these orders are not imposed on any nonbank
subsidiary of a bank holding company other than a section 20
subsidiary.
Although the restrictions imposed in the Board's section 20 orders
are commonly known as ``firewalls,'' the term is something of a
misnomer. While some of the most important restrictions are intended to
prevent an outbreak of trouble at a section 20 subsidiary from
spreading to an affiliated depository institution, many serve other
purposes. For example, some of the ``firewalls'' are procedural, and
others are directed towards consumer protection or preventing unfair
competition.
Taken together, the section 20 firewalls are a very conservative
regime designed to isolate a section 20 subsidiary from any affiliated
depository institution or bank holding company. The firewalls have
prevented bank holding companies from reaping possible synergy gains
from the operation of an investment bank. The reasons the Board chose
such a conservative regime are rooted in the time they were adopted.
First, when the Board approved establishment of the initial section
20 subsidiaries in 1987, it had little experience supervising
investment banks in the United States. Because affiliation between
banks and securities underwriters and dealers was long considered
impractical or illegal, bank holding companies had not operated such
entities since enactment of the Glass-Steagall Act in 1933. Moreover,
pre-Glass-Steagall affiliations were considered, rightly or wrongly, to
have caused losses to the banking industry and investors. 3 Thus,
affiliation of banks and investment banks presented unknown risks that
were considered substantial.
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\3\ Recent research indicates that this belief may have been
inaccurate. See, e.g., George J. Benston, The Separation of
Commercial and Investment Banking: The Glass-Steagall Act Revisited
and Reconsidered 41 (1990) (``The evidence from the pre-Glass-
Steagall period is totally inconsistent with the belief that banks'
securities activities or investments caused them to fail or caused
the financial system to collapse.'').
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Second, although the Board recognized in 1987 that supervision and
regulation of broker-dealers by the Securities and Exchange Commission
provided significant protections, the Board had little experience with
how
[[Page 2623]]
these protections operated in general or would operate within a bank
holding company in particular.
Third, significant protections that currently exist with respect to
section 20 subsidiaries were not present in 1987. Most significantly,
section 23B of the Federal Reserve Act was under consideration but had
not been adopted at the time of the Board's 1987 Order. As noted below,
many of the firewalls duplicate or overlap the restrictions of section
23B, which requires inter-affiliate transactions to be on arm's length
terms, 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. 4 Similarly, risk-
based capital standards did not exist in 1987. Because those standards
address some of the risks present in a bank's affiliation with an
investment bank, they too overlap with some of the firewalls. Also, the
Interagency Statement on Retail Sales of Nondeposit Investment Products
was not adopted until 1994. The Interagency Statement is now the
primary means by which the federal banking agencies seek to ensure that
retail banking customers are not misled about the nature of the
products that they are purchasing.
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\4\ 12 U.S.C. 371c-1.
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Introduction
In recognition that its concerns about affiliation could abate, the
Board stated at the time it adopted the firewalls that it would
continue to review their appropriateness in the light of its experience
in supervising section 20 subsidiaries. The Board has now undertaken a
comprehensive review of the restrictions imposed in its section 20
orders, and is proposing to eliminate most of them, and incorporate the
rest in a statement of operating standards that the Board believes are
appropriate for section 20 subsidiaries.
The risks of securities underwriting and dealing have in the
Board's experience proven to be manageable in a bank holding company
framework, and bank holding companies and banks have successfully
undertaken and managed activities posing similar risks for which no
firewalls were erected. Finally, many of the firewalls are duplicated,
or at least addressed in some way, by other statutes or regulations
that are more narrowly tailored to addressing the perceived risk or
conflict. Thus, in many cases where the Board is proposing to eliminate
a firewall, another restriction will remain.
The Board believes that the proposed changes will allow section 20
subsidiaries to operate more efficiently and serve their customers more
effectively, consistent with the safety and soundness of affiliated
banks. The most important changes being proposed by the Board address
the firewalls regarding funding of a section 20 subsidiary by an
affiliated bank, credit enhancements provided by a bank to issuers of
securities underwritten by a section 20 affiliate, and loans provided
by a bank to customers purchasing products of a section 20 affiliate.
These changes would allow section 20 subsidiaries to operate more
readily in conjunction with an affiliated bank, thereby maximizing
synergies, enhancing services, and possibly reducing costs.
The Board is proposing to retain those restrictions that address
issues of bank safety and soundness, significant conflicts of interest,
or other concerns that are not addressed by other statutes or
regulations. With respect to safety and soundness, the Board believes
that it is essential that any bank holding company operating a section
20 subsidiary ensure that its subsidiary banks are well capitalized.
Accordingly, the Board is proposing to reserve the discretion 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 proposes to incorporate in a statement of operating
standards the practices that it believes a bank holding company and its
section 20 subsidiary should follow in order to ensure safety and
soundness and avoid conflicts of interest. For each of the existing
firewalls, the Board seeks comment on whether that firewall, either
alone or as part of a larger framework of restrictions, is necessary to
ensure that underwriting and dealing in bank-ineligible securities is
conducted in a safe and sound manner, and not subject to significant
conflicts of interests, and should therefore be included as an
operating standard.
The Board also seeks comment on whether adjustments to the proposed
operating standards are necessary to address issues unique to foreign
banks. In its 1990 Order, the Board adopted a modified series of
firewalls for foreign banks. The Board intends for the proposed
operating standards to apply to both domestic and foreign banking
organizations operating a section 20 subsidiary.
Discussion
Set forth below are: (1) each of the firewalls established in the
Board's 1989 Order, including any amendments subsequently made to that
firewall; 5 (2) a description of whether the firewall was included
in the 1987 Order and the 1990 Order; and (3) a request for comments on
the firewall.
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\5\ Footnotes to the orders are omitted.
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I. Capital Adequacy Conditions
Firewall 1(a) (Deduction of investment in Subsidiary From Bank Holding
Company Capital)
Text of 1989 Order. In determining compliance with the Board's
Capital Adequacy Guidelines, each Applicant shall deduct from its
consolidated primary capital any investment it makes in the
underwriting subsidiary that is treated as capital in the underwriting
subsidiary. In accordance with the risk-based component of the Board's
Capital Guidelines, Applicant shall deduct 50 percent of the amount of
any investment in the underwriting subsidiary from Tier 1 capital and
50 percent from Tier 2 capital. In calculating primary capital and
risk-based capital ratios, Applicant should also exclude the
underwriting subsidiary's assets from the holding company's
consolidated assets.
1987 and 1990 Order. The 1987 Order provided for a similar capital
deduction under an earlier set of capital standards. The 1990 Order
requires compliance with internationally accepted risk-based capital
requirements after deduction of any investment in the section 20
subsidiary that is treated as capital in that subsidiary.
Request for Comment. The Board proposes to eliminate this
restriction. The purpose of this firewall was to ensure that a bank
holding company maintained sufficient resources to support its
federally insured depository institutions and other banking operations
by deducting any exposure to its section 20 subsidiary from its
regulatory capital. The Board has viewed the deduction as reinforcement
for the important requirement that any bank holding company that seeks
to establish a section 20 subsidiary, and the insured depository
institutions controlled by that bank holding company, be strongly
capitalized.
In practice, however, the deconsolidation requirement has created
regulatory burden without strengthening the capital of the
organization. The deconsolidation requirement is inconsistent with GAAP
and has therefore created confusion and imposed costs by requiring bank
[[Page 2624]]
holding companies to prepare statements on two bases. Meanwhile, the
deduction does not strengthen the capital of any insured depository
institution affiliate of the section 20 subsidiary or the section 20
subsidiary itself, which is already subject to SEC-imposed capital
requirements. Elimination of the deduction would not create or expose
any incentive for a bank holding company to take capital necessary to
support a depository institution and reinvest it in a section 20
subsidiary. Finally, the Board has recently adopted a system for
analyzing market risk that will better measure the capital adequacy of
a banking organization.
Moreover, based on its experience supervising section 20
subsidiaries over the past nine years, the Board does not believe that
the activities of a section 20 subsidiary are so uniquely risky as to
merit a capital treatment different from other nonbank affiliates,
which are not subject to a deduction requirement.
Firewall 1(b) (Deduction of Extensions of Credit From Holding Company
Capital)
Text of 1989 Order. Applicant shall also deduct from its regulatory
capital any credit it or a nonbank subsidiary extends directly or
indirectly to the underwriting subsidiary unless the extension of
credit is fully secured by U.S. Treasury securities or other marketable
securities and is collateralized in the same manner and to the same
extent as would be required under section 23A(c) of the Federal Reserve
Act if the extension of credit were made by a member bank. In the case
of the risk-based component of the Board's Capital Guidelines, the
deductions for unsecured or not fully-secured or inadequately
collateralized loans shall be taken 50 percent from Tier 1 and 50
percent from Tier 2 as described above. Notwithstanding these
adjustments, Applicant should continue to maintain adequate capital on
a fully consolidated basis.
1987 and 1990 Order. This restriction was not included in the 1987
Order. A similar deduction was required under the 1990 Order.
Request for Comment. The Board proposes to eliminate the deduction
required by this firewall for the same reasons as Firewall 1(a),\6\ but
retain the requirement that a bank holding company maintain adequate
capital on a fully consolidated basis as a condition for operating a
section 20 subsidiary.
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\6\ The Board's Capital Guidelines may continue to require
certain deductions from regulatory capital independent of this
restriction, and those deductions would be unaffected.
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Firewall 2 (Prior Approval Requirement for Investments in Subsidiary)
Text of 1989 Order. No Applicant nor any of its nonbank
subsidiaries shall, directly or indirectly, provide any funds to, or
for the benefit of, an underwriting subsidiary, whether in the form of
capital, secured or unsecured extensions of credit, or transfer of
assets, without prior notice to and approval by the Board.
1987 and 1990 Order. This restriction was not included in the 1987
Order. The same restriction was included in the 1990 Order.
Board Action. The Board is repealing this restriction, which
requires prior notice and Board approval before a bank holding company
or its nonbank subsidiaries may advance funds to its section 20
subsidiary. As the firewall is procedural, the Board is not seeking
comment on the change, which will be effective immediately.
The prior approval requirement, which is applied only to
investments in a section 20 subsidiary, was intended to ensure that
resources needed to support a bank holding company's insured
subsidiaries were not diverted to the underwriting subsidiary. However,
in practice, bank holding companies require sufficient funding
flexibility to accommodate business growth over a multi-year period,
and the Board has thus been faced with the choice of allowing them this
flexibility by approving open-ended funding plans or micromanaging the
funding of section 20 subsidiaries. The Board has opted for the former
course, relying on supervisory tools that allow the Board to institute
corrective action should it determine that excessive bank holding
company resources are being diverted to a section 20 subsidiary. The
normal supervisory process, which includes annual inspections, off-site
monitoring, and review of annual reports, has proven sufficient to
determine whether a bank holding company is disadvantaging its insured
depository institution subsidiaries by making imprudent investments in
a nonbank subsidiary. The Board therefore believes that the prior
approval firewall can be eliminated, especially as section 23A of the
Federal Reserve Act will continue to limit any transfer of funds from
an insured depository institution affiliate.\7\
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\7\ 12 U.S.C. 371c.
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Firewall 3 (Requirement of Capital Plan)
Text of 1989 Order. Before commencing the new activities, each
Applicant must submit to the Board acceptable plans to raise additional
capital as required by this Order or demonstrate that it is strongly
capitalized and will remain so after making the capital adjustments
authorized or required by this Order. An Applicant may not commence the
proposed activities until it has received a Board determination that
the capital plan satisfies the requirements of this Order and has
raised the additional capital required under the plan.
1987 and 1990 Order. This restriction was not included in the 1987
Order or the 1990 Order.
Request for Comment. The Board analyzes the capital adequacy,
financial condition, and business plan of each applicant before
approving its application to engage in underwriting and dealing
pursuant to section 20. The Board has authority, independent of this
firewall, to require an applicant to raise additional capital whenever
appropriate. The Board proposes to eliminate this firewall as
superfluous.
Firewall 4 (Capital Adequacy Requirement)
Text of 1989 Order. The underwriting subsidiary shall maintain at
all times capital adequate to support its activity and cover reasonably
expected expenses and losses in accordance with industry norms.
1987 and 1990 Order. Same.
Request for comment. The Board seeks comment on whether to retain
this firewall, which has been understood to require section 20
subsidiaries to maintain capital levels consistent with industry norms
for independent investment banks. The purpose of this capital
requirement was to prevent a section 20 subsidiary from operating below
industry capital standards by trading on the reputation of its
affiliated bank. The requirement thus seeks to prevent section 20
subsidiaries from being able to leverage themselves more than, and gain
a competitive advantage over, their independent competitors, and to
serve as a buffer to protect the affiliated bank.
This restriction has proven confusing and controversial, as
``industry norms'' are difficult to determine. Although the SEC imposes
capital and ``haircut'' requirements on all broker-dealers, including
section 20 subsidiaries, these levels cannot be considered industry
norms.\8\ Most investment banks,
[[Page 2625]]
particularly significant underwriters, maintain capital greatly in
excess of SEC minimums, and Federal Reserve examiners have accordingly
expected section 20 subsidiaries to maintain capital before haircuts
that is at least 100 percent greater capital than SEC haircut
requirements. Some section 20 subsidiaries have complained that their
competitors maintain a lesser amount of capital. 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.
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\8\ 17 CFR 240.15c3-1. The SEC capital rule is intended to allow
prompt liquidation of a broker-dealer in order to satisfy the claims
of its creditors, and broker-dealers failing to meet SEC capital
requirements are immediately liquidated. Thus, healthy broker-
dealers do not operate near SEC minimum requirements.
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Moreover, the Board already measures bank holding company capital
on a consolidated basis, including the capital and assets of the
section 20 subsidiary. Therefore, the Board believes that it may be
unnecessary to impose a separate capital requirement on the bank
holding company's section 20 subsidiary. The Board notes that such
capital requirements have not been generally imposed on other holding
company subsidiaries.
II. Credit Extensions to Customers of the Underwriting Subsidiary
The purpose of Firewalls 5-12 is to prevent a bank or bank holding
company from exposing itself to loss in order to benefit the
underwriting or dealing activities of its affiliate. They are the
firewalls most directly linked to the hazards of commercial and
investment banking affiliation that motivated the authors of the Glass-
Steagall Act. The Board has noted that preserving the soundness and
impartiality of credit is one of its major concerns under the banking
laws.
However, as financial intermediation has evolved, corporate
customers frequently seek to obtain a variety of funding mechanisms
from one organization. By prohibiting banks from providing routine
credit enhancements in tandem with a section 20 affiliate, the existing
firewalls hamper the ability of bank holding companies to serve as
full-service financial services providers and reduce options for
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 may be
the institution best suited to perform a credit analysis--and, with
smaller customers, perhaps the only institution willing to perform a
credit analysis.
Furthermore, these restrictions do not apply to credit extensions
or credit enhancements extended in conjunction with underwriting of
bank-eligible securities by a section 20 affiliate, and there has not
been significant abuse in this area.\9\ As with bank-eligible
securities, even in the absence of these firewalls, protections for the
bank would remain; those protections are discussed below in the context
of each firewall. Finally, as noted above, the Board is proposing to
reserve its authority to impose 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.
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\9\ Furthermore, since 1981, national banks have been allowed to
credit enhance their own private placements of bank-ineligible
securities. The Board is not aware of any unmanageable losses having
arisen from this activity.
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Firewall 5 (Restriction on Credit Enhancement)
Text of 1989 Order. No Applicant or subsidiary shall directly or
indirectly extend credit, issue or enter into a stand-by letter of
credit, asset purchase agreement, indemnity, guarantee, insurance or
other facility that might be viewed as enhancing the creditworthiness
or marketability of an ineligible securities issue underwritten or
distributed by the underwriting subsidiary.
1987 and 1990 Order. The 1987 Order was substantially the same, and
the 1990 Order applied the same restrictions to U.S. affiliates and
branches and agencies of foreign banks.
Request for Comment. The Board proposes to eliminate the credit
enhancement firewall, as it believes that other protections adequately
serve its purposes, and its burden on section 20 subsidiaries and their
customers therefore cannot be justified. First, a bank would be
required to hold capital against all credit enhancements extended to
customers of its section 20 affiliate. Notably, at the time the
firewalls were adopted, the existing regulatory capital regime did not
take account of off-balance-sheet obligations. Thus, a bank exposing
itself to loss by issuing a standby letter of credit, guarantee, or
other credit enhancement would not have been required to hold capital
against that exposure. Under the current risk-based capital system, a
bank would be required to hold capital against the credit equivalent
amount of such an obligation. 10
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\10\ See, e.g., 12 CFR 208, Appendix A.III.D (risk-based capital
standards for state member banks).
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Second, the amount of credit that a bank could extend to an issuer
of securities underwritten by a section 20 affiliate would also be
limited by loan-to-one borrower rules. For example, national banks may
only lend an amount equal to 15 percent of their capital on an
uncollateralized basis and an additional 10 percent of their capital on
a collateralized basis, and credit enhancements generally would be
aggregated along with all other credit extended to an issuer in
measuring compliance with these limits. 11
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\11\ 12 U.S.C. 84; 12 CFR 32.2.
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Third, the proposed operating standards include the existing
firewalls emphasizing the importance of credit standards and
documentation. Such controls should ensure that any credit enhancement
is extended consistent with the internal procedures of the bank, that
independent credit judgment is exercised, and that documentation is
maintained that would allow examiners to assess compliance with these
policies. A credit that would generally fail to meet the bank's credit
standards should not be extended because the credit would directly or
indirectly benefit a section 20 affiliate.
Finally, section 23B of the Federal Reserve Act would require that
all credit enhancements extended to an issuer whose securities are
being underwritten by a section 20 affiliate be on an arm's-length
basis. 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. Similarly, section 106 of the Bank Holding Company Act
Amendments of 1970 would prohibit a bank from offering discounted
credit enhancements on the condition that an issuer obtain investment
banking services from a section 20 affiliate.
Firewall 6 (Restriction on Funding Purchases of Securities)
Text of 1989 Order. No Applicant or subsidiary (other than the
underwriting subsidiary) shall knowingly extend credit to a customer
directly or indirectly secured by, or for the purpose of purchasing,
any ineligible security that an affiliated underwriting subsidiary
underwrites during the period of the underwriting or for 30 days
thereafter, or to purchase from the underwriting subsidiary any
ineligible security in which the underwriting
[[Page 2626]]
subsidiary makes a market. This limitation extends to all customers of
Applicant and its subsidiaries, including broker-dealers and
unaffiliated banks, but does not include lending to a broker-dealer for
the purchase of securities where an affiliated bank is the clearing
bank for such broker-dealer.
1987 and 1990 Order. The 1987 Order did not extend the restriction
for 30 days after the underwriting period, but was otherwise
substantially the same. The 1990 Order applied the same restrictions to
U.S. affiliates and branches and agencies of foreign banks, and also
prohibited the section 20 subsidiary from arranging for an extension of
credit by the foreign bank or its subsidiaries.
Request for Comment. Firewall 6 addresses what the Board believes
to be 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 below market rates in order
to induce customers to purchase securities underwritten by its section
20 affiliate or that it holds in inventory. The primary concerns are
threefold: that such extensions of credit may not be repaid, thereby
harming the bank; that customers will be induced by easy credit into
purchasing risky securities, thereby harming the customer; and that a
section 20 affiliate could reap a competitive advantage over
competitors who do not have a federally subsidized affiliate to provide
credit to their customers.
Section 11(d) of the Securities Exchange Act of 1934 addresses some
of the same concerns as Firewall 6. Section 11(d) prohibits a broker-
dealer (including a section 20 affiliate) that is acting as an
underwriter from extending or arranging for credit to customers
purchasing the newly issued securities during the underwriting period.
Thus, a section 20 subsidiary acting as underwriter would be prohibited
from arranging for an affiliated bank to make loans to customers for
purchases during an underwriting period. Still, section 11(d) would not
apply in the absence of arranging and, unlike Firewall 6, would not
cover loans to purchase a security in which a section 20 affiliate
makes a market or purchases from parties other than the section 20
affiliate.
Section 23B of the Federal Reserve Act, and in some cases section
23A of the Federal Reserve Act, would address many of these remaining
concerns and overlap the restrictions of section 11(d). Section 23B
would apply to loans to fund purchases by customers of securities from
a section 20 affiliate during the existence of the underwriting or
selling syndicate, and to any loan to purchase a security from the
inventory of the section 20 affiliate, including securities in which
the section 20 affiliate makes a market. 12 Section 23B requires
that inter-affiliate transactions be on market terms. To the extent
that the bank extended credit knowing that the proceeds would be
transferred to an affiliate, section 23A would also apply. 13
Section 23A limits transactions with any one affiliate to 10 percent of
the bank's capital, and transactions with all affiliates to 20 percent
of capital, and also requires that collateral be pledged to a bank for
any extension of credit.
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\12\ Section 23B applies to ``any transaction or series of
transactions with a third party * * * if an affiliate is a
participant in such transaction or series of transactions.'' 12
U.S.C. 371c-1(a)(2)(E).
\13\ 12 U.S.C. 371c(a)(2).
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The Board seeks comment on whether these protections are sufficient
to address the conflicts of interests that motivated creation of
Firewall 6.
Firewall 7 (Restriction on Extensions of Credit for Repayment of
Underwritten Securities)
Text of 1989 Order. No Applicant or any of its subsidiaries may,
directly or indirectly, extend credit to issuers of the ineligible
securities underwritten by an affiliated underwriting subsidiary for
the purpose of the payment of principal, interest or dividends on such
securities. To assure compliance with the foregoing, any credit lines
extended to an issuer by any bank holding company or any subsidiary
shall provide for substantially different timing, terms, conditions and
maturities from the ineligible securities being underwritten. It would
be clear, for example, that a credit has substantially different terms
and timing if it is for a documented special purpose (other than the
payment of principal, interest or dividends) or there is substantial
participation by other lenders.
1987 and 1990 Order. The 1987 Order did not prohibit extensions of
credit for the payment of dividends but was otherwise substantially the
same. The 1990 Order applied the same restrictions to U.S. affiliates
and branches and agencies of foreign banks, and also included an
arranging restriction.
Request for Comment. The Board proposes to eliminate this
restriction. The Board stated in 1987 that it was adopting this
firewall in order to prevent a bank from making unwise loans to improve
the financial condition of companies whose securities were underwritten
or dealt in by the section 20 affiliate, either to assist in the
marketing of the securities or to prevent the customers of the section
20 affiliate from incurring losses on securities sold by the
subsidiary. However, the firewall has proven burdensome and has had
unintended effects. For example, banks face compliance problems
renewing a company's revolving line of credit if a section 20
subsidiary 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 its purpose. As a result, companies seeking the best short-term
funding options sometimes find it easier to move from the bank credit
market to the commercial paper market than the reverse.
In addition, other restrictions would apply in the absence of the
firewall. Section 23B of the Federal Reserve Act would generally apply
to extensions of credit for the purpose of payment of principal,
interest or dividends that are currently covered by Firewall 7. In
addition, the conflict of interest addressed by Firewall 7 appears more
tenuous than those addressed by the prior two credit firewalls, as most
of the funds extended do not flow to the section 20 affiliate. Thus,
the Board believes that section 23B, together with the capital
requirements discussed above, should be sufficient protection against
this conflict of interest.
Firewall 8 (Procedures for Extensions of Credit)
Text of 1989 Order. Each Applicant shall adopt appropriate
procedures, including maintenance of necessary documentary records, to
assure that any extension of credit by it or any of its subsidiaries to
issuers of ineligible securities underwritten or dealt in by an
underwriting subsidiary are on an arm's length basis for purposes other
than payment of principal, interest, or dividends on the issuer's
ineligible securities being underwritten or dealt in by the
underwriting subsidiary. An extension of credit is considered to be on
an arm's length basis if the terms and conditions are substantially the
same as those prevailing at the time for comparable transactions with
issuers whose securities are not underwritten or dealt in by the
underwriting subsidiary.
1987 and 1990 Order. The 1987 Order did not restrict extensions of
credit for the payment of dividends but was otherwise substantially the
same. The 1990 Order applied the same restrictions to U.S. affiliates
and branches and agencies of foreign banks.
[[Page 2627]]
Request for Comment. The Board proposes to eliminate this firewall.
Section 23B, enacted since this firewall was initially adopted,
requires extensions of credit by a bank in conjunction with an issuance
of securities underwritten by a section 20 affiliate to be on arm's-
length terms. The federal banking agencies examine for compliance with
section 23B, and require any bank that does not maintain those
procedures necessary to ensure compliance to adopt them immediately.
Although the firewall also includes extensions of credit by nonbank
subsidiaries, those extensions of credit do not directly implicate the
federal safety net. In amending section 23A and adopting section 23B in
1987, Congress did not apply their restrictions to the parent bank
holding company or any other nonbank lender. Moreover, the bank holding
company will remain subject to capital requirements.
Firewall 9 (Restriction on Thrifts)
Text of 1989 Order. In any transaction involving an underwriting
subsidiary, Applicants' thrift subsidiaries shall observe the
limitations of sections 23A and 23B of the Federal Reserve Act as if
the thrifts were banks.
1987 and 1990 Order. The 1987 Order did not include this
restriction. The 1990 Order was the same.
Request for Comment. This condition became superfluous when the
Home Owners' Loan Act was amended to apply sections 23A and 23B of the
Federal Reserve Act to a thrift as if were a member bank 14. The
Board proposes to eliminate it.
---------------------------------------------------------------------------
\14\ 12 U.S.C. 1468(a)(1).
---------------------------------------------------------------------------
Firewall 10 (Restriction on Industrial Revenue Bonds)
Text of 1989 Order. The requirements relating to credit extensions
to issuers noted in paragraphs 5-9 above shall also apply to extensions
of credit to parties that are major users of projects that are financed
by industrial revenue bonds.
1987 and 1990 Order. Same.
Request for Comment. As the Board is proposing to eliminate the
incorporated restrictions, the Board is proposing to eliminate this
restriction as well.
Firewall 11 (Loan Documentation and Exposure Limits)
Text of 1989 Order. Applicants shall cause their subsidiary banks
and thrifts to adopt policies and procedures, including appropriate
limits on exposure, to govern their participation in financing
transactions underwritten or arranged by an underwriting subsidiary as
set forth in this Order. The Reserve Banks shall ensure that these
policies and procedures are in place at Applicants' subsidiary banks
and thrifts and Applicants shall assure that loan documentation is
available for review by Reserve Banks to ensure that an independent and
thorough credit evaluation has been undertaken in connection with bank
or thrift participation in such financing packages and that such
lending complies with the requirements of this Order and section 23B of
the Federal Reserve Act.
1987 and 1990 Order. This restriction was not included in the 1987
Order. The 1990 Order applied the same restriction to U.S. affiliates
and branches and agencies of a foreign bank.
Request for Comment. The Board is proposing to include this
restriction in slightly amended form in its operating standards for all
section 20 subsidiaries.
Firewall 12 (Procedures for Limiting Exposure to One Customer)
Text of 1989 Order. Applicants should also establish appropriate
policies, procedures, and limitations regarding exposure of the holding
company on a consolidated basis to any single customer whose securities
are underwritten or dealt in by the underwriting subsidiary.
1987 and 1990 Order. This restriction was not included in the 1987
Order. The 1990 Order applied the same restriction to U.S. affiliates
and branches and agencies of foreign banks.
Request for Comment. The Board is seeking comment on whether to
include this restriction in its operating standards for section 20
subsidiaries. The firewall restricts the ability of a holding company
to expose itself to one issuer in support of its section 20 subsidiary.
However, the need for internal limits and the appropriate
sophistication of those limits varies greatly from company to company,
and might be better addressed through the examination process.
III. Limitations to Maintain Separateness of an Underwriting
Affiliate's Activity
Firewall 13 (Interlocks Restriction)
Text of 1989 Order (as amended). 15 Directors, officers or
employees of a bank or thrift shall not serve as a majority of the
board of directors or the chief executive officer of an affiliated
section 20 subsidiary, and directors, officers or employees of a
section 20 subsidiary shall not serve as a majority of the board of
directors or the chief executive officer of an affiliated bank or
thrift. The underwriting subsidiary will have separate offices from any
affiliated bank or thrift.
---------------------------------------------------------------------------
\15\ 61 FR 57679, 57683 (1996).
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1987 and 1990 Order. The 1987 Order is the same. The 1990 Order
applies the same restriction to the U.S. bank and thrift subsidiaries
and branches and agencies of foreign banks.
Request for Comment. The Board recently amended the interlocks
restriction, and is not proposing further changes to that restriction.
However, Firewall 13 also contains a requirement that a section 20
subsidiary have separate offices from any affiliated bank, thrift,
branch or agency. The purpose of this restriction was to ensure that
customers of a section 20 subsidiary clearly understand that they are
not dealing with a bank or thrift affiliate, and that the products they
are purchasing are not federally insured or bank guaranteed.
The Board is proposing to eliminate the separate office
requirement. First, in the Board's experience, maintaining separate
offices for functions that do not involve retail customers--for
example, back-office functions--serves no purpose and represents a
needless expense. Second, for sales to retail customers, the Board
proposes to rely on the Interagency Statement on Retail Sales of
Nondeposit Investment Products, which largely duplicates this
restriction. According to the Interagency Statement, sales or
recommendations of nondeposit investment products on the premises of a
depository institution--including sales by a section 20 affiliate--
should be conducted in a physical location distinct from the area where
retail deposits are taken.
IV. Disclosure by the Underwriting Subsidiary
Firewall 14 (Customer Disclosures)
Text of 1989 Order. An underwriting subsidiary will provide each of
its customers with a special disclosure statement describing the
difference between the underwriting subsidiary and its bank and thrift
affiliates and pointing out that an affiliated bank or thrift could be
a lender to an issuer and referring the customer to the disclosure
documents for details. In addition, the statement shall state that
securities sold, offered, or recommended by the underwriting subsidiary
are not deposits, are not insured by the Federal Deposit Insurance
Corporation, are not guaranteed by an affiliated bank or thrift, and
are not otherwise an obligation or responsibility of such a bank or
thrift (unless such is the case). The underwriting subsidiary should
also disclose any material lending
[[Page 2628]]
relationship between the issuer and a bank or lending affiliate of the
underwriting subsidiary as required under the securities laws and in
every case whether the proceeds of the issue will be used to repay
outstanding indebtedness to affiliates.
1987 and 1990 Order. The 1987 Order required a less detailed but
similar disclosure. The 1990 Order extended the same restriction to
U.S. bank and thrift affiliates and branches and agencies of foreign
banks.
Request for Comment. The Board continues to believe that customer
disclosures are important to ensuring that customers of a section 20
subsidiary clearly understand that its products are not federally
insured or otherwise guaranteed by an affiliated bank. Indeed, the
Board relied on disclosures in concluding that it was appropriate to
eliminate firewalls on cross-marketing and employee interlocks. In
order to ease the burden of compliance, though, the Board is proposing
to amend the disclosure firewall to follow the Interagency Statement on
Retail Sales of Nondeposit Investment Products that applies to sales by
bank employees or on bank premises. A section 20 subsidiary would be
required to provide each of its retail customers the same disclosures
that the Interagency Statement mandates for retail customers of banks,
even when it was operating off bank premises. This would narrow the
firewall by no longer requiring disclosures to institutional customers
(who should be aware of whether a product is federally insured or bank
guaranteed) but broaden the firewall to require an acknowledgement of
the disclosure by retail customers.
V. Marketing Activities on Behalf of an Underwriting Subsidiary
Firewall 15 (Restriction on Advertising Bank Connection)
Text of 1989 Order. No underwriting subsidiary nor any affiliated
bank or thrift institution will engage in advertising or enter into an
agreement stating or suggesting that an affiliated bank or thrift is
responsible in any way for the underwriting subsidiary's obligations as
required under section 23B of the Federal Reserve Act.
1987 and 1990 Order. The 1987 Order did not contain the reference
to section 23B of the Federal Reserve Act, but was otherwise identical.
The 1990 Order extended the same restriction to bank and thrift
affiliates and branches and agencies of a foreign bank.
Request for Comment. This restriction has been superseded by
section 23B(c) of the Federal Reserve Act, and the Board is proposing
to eliminate it.
Firewall 16 (Cross-marketing and Agency Activities by Banks)
Text of 1989 Order. Reserved. 16
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\16\ This firewall was rescinded. 61 FR 57679, 57683 (1996).
---------------------------------------------------------------------------
1987 and 1990 Order. Same.
VI. Investment Advice by Bank/Thrift Affiliates
Firewall 17
Text of 1989 Order. An affiliated bank or thrift institution may
not express an opinion on the value or the advisability of the purchase
or the sale of ineligible securities underwritten or dealt in by an
affiliated underwriting subsidiary unless the bank or thrift notifies
the customer that the underwriting subsidiary is underwriting, making a
market, distributing or dealing in the security.
1987 and 1990 Order. The 1987 Order was substantially the same. The
1990 Order applied the same restrictions to U.S. affiliates and
branches and agencies of foreign banks.
Request for Comment. The Board proposes to retain this restriction.
An SEC rule (Rule 10b-10) and NASD rule (Rule 2250) require a broker-
dealer to disclose to a customer that it is a market maker in a
security before selling or recommending that security. These
restrictions are based on the conflict of interest between the broker-
dealer's duty to advise its customers and its financial interest in
selling its security. The firewall extends this restriction to an
affiliated bank based on the concern that it would have a similar
financial incentive to give advice that would benefit its affiliate. A
disclosure to the customer appears to be a sufficient means of
addressing that conflict. Accordingly, the proposal retains this
requirement, combining it with another disclosure standard.
Nonetheless, the Board is concerned with the difficulty of
complying with, and examining for compliance with, this standard,
particularly with respect to large bank holding companies operating
around the world. The Board seeks comment on whether a bank or thrift
should only be prohibited from expressing an opinion without disclosure
if it knows of its affiliate's role in the transaction. The Board also
seeks comment on whether, with this knowledge requirement or without
it, this standard is enforceable.
Firewall 18 (Restriction on Fiduciary Purchases During Underwriting
Period or From Market Maker)
Text of 1989 Order. No Applicant nor any of its bank, thrift, or
trust or investment advisory subsidiaries shall purchase, as a trustee
or in any other fiduciary capacity, for accounts over which they have
investment discretion ineligible securities (a) underwritten by the
underwriting subsidiary as lead underwriter or syndicate member during
the period of any underwriting or selling syndicate, and for a period
of 60 days after the termination thereof, and (b) from the underwriting
subsidiary if it makes a market in that security, unless, in either
case, such purchase is specifically authorized under the instrument
creating the fiduciary relationship, by court order, or by the law of
the jurisdiction under which the trust is administered.
1987 and 1990 Order. The 1987 Order did not restrict purchases of
securities in which the section 20 subsidiary makes a market but was
otherwise the same. The 1990 Order applied the same restrictions to
U.S. affiliates and branches and agencies of foreign banks.
Request for Comment. The Board proposes to eliminate this
restriction. Section 23B(b)(1)(B) of the Federal Reserve Act largely
duplicates the restrictions of Firewall 18 when a bank or thrift is
making the purchase. 17 Section 23B prohibits a bank from
purchasing, as principal or fiduciary, 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.
---------------------------------------------------------------------------
\17\ In its 1987 order, the Board noted that section 23B was
pending as proposed legislation, and appears to have created the
firewall in anticipation of that legislation.
---------------------------------------------------------------------------
Firewall 18 is broader than section 23B in that it applies for 60
days after the underwriting period. The Board does not believe that it
should reimpose a restriction that Congress decided was unnecessary,
and is not aware of any compelling reason to do so.
Firewall 18 is also broader than section 23B in that the firewall
applies when a bank holding company or its nonbank subsidiary acting as
fiduciary purchases the securities. However, if the purchases are
fiduciary, the Board believes that other protections remain. For
example, if the purchase were on behalf of a pension plan, then the
company would be subject to ERISA.18 If the purchase were on
behalf of a mutual fund, then sections 10 and 17 of
[[Page 2629]]
the Investment Company Act of 1940 restrict the ability of the mutual
fund to purchase securities from an affiliate of the investment
advisor. 19
---------------------------------------------------------------------------
\18\ 29 U.S.C. 1002(21), 1104.
\19\ 15 U.S.C. 80a-10, 80a-17.
---------------------------------------------------------------------------
VII. Extensions of Credit and Purchases and Sales of Assets
Firewall 19 (Restrictions on Purchases as Principal During Underwriting
Period or From Market Maker)
Text of 1989 Order (as amended). No Applicant nor any of its
subsidiaries, other than the underwriting subsidiary, shall purchase,
as principal, ineligible securities that are underwritten by the
underwriting subsidiary during the period of the underwriting and for
60 days after the close of the underwriting period, or shall purchase
from the underwriting subsidiary any ineligible security in which the
underwriting subsidiary makes a market.
In the case of ineligible securities that are being issued in a
simultaneous cross-border underwriting in which the underwriting
subsidiary and a foreign affiliate or affiliates are participating,
such securities may be purchased or sold pursuant to an inter-syndicate
agreement for the period of the underwriting where the purchase or sale
results from bona fide indications of interest from customers. Such
purchases or sales shall not be made for the purpose of providing
liquidity or capital support to the underwriting subsidiary or
otherwise to evade the requirements of this Order. An underwriting
subsidiary shall maintain documentation on such transactions.20
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\20\ 1990 Order at 158, 164-65, 172 (1990).
---------------------------------------------------------------------------
1987 and 1990 Order. The 1987 Order was the same. The 1990 Order
was substantially the same.
Request for Comment. The Board proposes to eliminate this
restriction, which precludes bank and nonbank subsidiaries of a bank
holding company subsidiary from obtaining attractive issues
underwritten or dealt in by a section 20 affiliate. As with Firewall
18, section 23B prohibits a bank from purchasing, as principal or
fiduciary, 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 the bank or any
affiliate. Since 1989, the Board has authorized bank holding companies
engaged in private placement activities to place up to 50 percent of an
issue of securities with their nonbank
affiliates, 21 and no supervisory concerns have arisen from this
practice.
---------------------------------------------------------------------------
\21\ J.P. Morgan & Co., 76 Federal Reserve Bulletin 26, 28
(1990).
---------------------------------------------------------------------------
Furthermore, if the bank purchases the security as principal
directly from the section 20 affiliate, section 23A would apply. The
bank would also be required to hold capital against these exposures.
Finally, member banks are limited to purchasing only investment
securities.22
---------------------------------------------------------------------------
\22\ 12 U.S.C. 24(Seventh), 335.
---------------------------------------------------------------------------
Firewall 20 (Restriction on Underwriting and Dealing in Affiliates'
Securities)
Text of 1989 Order (as amended). 23 An underwriting subsidiary
may not underwrite or deal in any ineligible securities issued by its
affiliates or representing interest in, or secured by, obligations
originated or sponsored by its affiliates (except for grantor trusts or
special purpose corporations created to facilitate underwriting of
securities backed by residential mortgages originated by a non-
affiliated lender). An underwriting subsidiary may underwrite or deal
in ineligible securities issued by (or representing interests in, or
secured by, obligations of) affiliates provided the securities are (1)
rated by an unaffiliated, nationally recognized statistical rating
organization, or (2) issued or guaranteed by FNMA, FHLMC or GNMA (or
represent interests in securities issued or guaranteed by FNMA, FHLMC,
or GNMA).
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\23\ 75 Federal Reserve Bulletin 751 (1989).
---------------------------------------------------------------------------
1987 and 1990 Order. Same.
Request for Comment. The Board proposes to eliminate this
restriction, which prohibits a section 20 affiliate from underwriting
securities issued by an affiliated bank. The purpose of the restriction
was to address the conflicts of interest presented because a section 20
subsidiary may have an incentive to overstate the quality of the
securities being issued by its affiliate.
However, Rule 2720 of the National Association of Securities
Dealers already imposes substantially the same restriction. Rule 2720,
to which section 20 subsidiaries are subject, provides that if a member
of the NASD proposes to underwrite, participate as a member of the
underwriting syndicate or selling group, or otherwise assist in the
distribution of a public offering of its own or an affiliate's
securities, then the price or yield of the issue must be set by a
qualified independent underwriter who shall also participate in the
preparation of the registration statement and prospectus, offering
circular, or similar document, exercising due diligence.
Furthermore, the Board previously has granted waivers from Firewall
20 to allow section 20 subsidiaries to underwrite equity securities
issued by affiliates.24 In granting these waivers the Board relied
in each case on the fact that there were independent sources, such as
third-party underwriters acting as syndicate managers, judging the
creditworthiness and pricing of the securities offered.
---------------------------------------------------------------------------
\24\ See Letter, dated May 2, 1996, from Jennifer J. Johnson,
Deputy Secretary of the Board to Thomas A. Plant; Letter, dated
January 6, 1994, from Jennifer J. Johnson, Associate Secretary of
the Board to Kevin Barnard, Esq.
---------------------------------------------------------------------------
Firewall 21(a) (Prohibition on Extensions of Credit to Section 20
Subsidiary)
Text of 1989 Order. Applicants shall assure that no bank or thrift
subsidiary shall, directly or indirectly, extend credit in any manner
to an affiliated underwriting subsidiary or a subsidiary thereof; or
issue a guarantee, acceptance, or letter of credit, including an
endorsement or standby letter of credit, for the benefit of the
underwriting subsidiary or a subsidiary thereof.
1987 and 1990 Order. This restriction was not contained in the 1987
Order.
The 1990 Order applied the same restrictions to U.S. bank and
thrift subsidiaries and branches and agencies of foreign banks.
Request for Comment. The Board proposes to eliminate this
restriction except insofar as it applies to intra-day extensions of
credit for clearing purposes. The purpose of the restriction was to
prevent any bank funding of a section 20 affiliate.
Because this firewall was not applied under the 1987 Order, bank
subsidiaries of the fourteen companies operating under that order have
therefore been free to, and have in fact, funded their section 20
affiliates. In nine years of supervising companies operating under the
1987 Order, the Board has not encountered significant problems arising
from such funding.
Such transactions are subject to sections 23A or 23B of the Federal
Reserve Act, which address potential conflicts of interest. Thus, even
if the firewall were repealed, a bank would not be able to expose more
than 10 percent of its capital to the section 20 affiliate directly,
would have to deal with the section 20 affiliate on arm's-length
(market) terms, could not purchase low-quality assets from the
affiliate, and could not purchase securities underwritten by a section
20
[[Page 2630]]
affiliate during the existence of the underwriting or selling syndicate
unless the bank's board of directors approves.25
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\25\ The Board is proposing to impose a new operating standard
that applies sections 23A and 23B to U.S. branches and agencies of
foreign banks for this purpose. Currently, branches and agencies are
not covered by these requirements, most notably the collateral
requirement of section 23A. This exemption has not given section 20
affiliates of foreign banks any material competitive advantage over
their domestic counterparts; generally, all lending has been
prohibited by Firewall 21(a). However, if that firewall were removed
in reliance on sections 23A and 23B, foreign banks would have a
competitive advantage unless those provisions were applied to their
branches and agencies, as their branches and agencies could fund a
section 20 affiliate without requiring collateral. With respect to
foreign banks operating under the 1990 Order, the proposal
represents relief from a restriction. Although this proposal would
impose new requirements on foreign banks operating under the 1987
Order, the Board specifically reserved its right to impose new
restrictions should circumstances change to make such requirements
appropriate. See Sanwa Bank, Ltd., 76 Federal Reserve Bulletin 568,
570 (1990).
---------------------------------------------------------------------------
One issue arises with respect to whether intra-day extensions of
credit should continue to be restricted. The Board proposes to include
an operating standard prohibiting intra-day extensions of credit for
clearing purposes unless they are (1) On market terms consistent with
section 23B of the Federal Reserve Act, and (2) fully secured. In
effect, the Board would be requiring that (1) The bank apply the same
internal exposure limits and collateral requirements in clearing for a
section 20 affiliate that it applies to third parties, and (2) even if
its general policy does not require the bank to be fully secured in
clearing, the bank be fully secured in clearing for its section 20
affiliate. The Board seeks comment on whether the latter requirement is
feasible.
Firewall 21(b)
Text of 1989 Order. This prohibition shall not apply to an
extension of credit by a bank or thrift to an underwriting subsidiary
that is incidental to the provision of clearing services by the bank or
thrift to the underwriting subsidiary with respect to securities of the
United States or its agencies, or securities on which the principal and
interest are fully guaranteed by the United States or its agencies, if
the extension of credit is fully secured by such securities, is on
market terms, and is repaid on the same calendar day. If the intra-day
clearing of such securities cannot be completed because of a bona fide
fail or operational problem incidental to the clearing process that is
beyond the control of the bank or thrift and the underwriting
subsidiary, the bank or thrift may continue the intra-day extension of
credit overnight provided the extension of credit is fully secured as
to principal and interest as described above, is on market terms, and
is repaid as early as possible on the next business day.
1987 and 1990 Orders. No exception was necessary in the 1987 Order.
The 1990 Order contained the same exception.
Request for Comment. If Firewall 21(a) were eliminated, the Board
would propose to eliminate Firewall 21(b) as moot.
Firewall 22 (Financial Assets Restriction)
Text of 1989 Order (as amended).26 No bank or thrift (or U.S.
branch or agency of a foreign bank) shall, directly or indirectly, for
its own account, purchase financial assets of an affiliated
underwriting subsidiary or a subsidiary thereof or sell such assets to
the underwriting subsidiary or subsidiary thereof. This limitation
shall not apply to the purchase and sale of assets having a readily
identifiable and publicly available market quotation and purchased at
that market quotation for purposes of section 23A of the Federal
Reserve Act, 12 U.S.C. 371c(d)(6), provided that those assets are not
subject to a repurchase or reverse repurchase agreement between the
underwriting subsidiary and its bank or thrift affiliate.
---------------------------------------------------------------------------
\26\ 61 FR 57679, 57683 (1996).
---------------------------------------------------------------------------
1987 and 1990 Orders. The 1990 Order is the same. The 1987 Order
did not include a financial assets restriction.
Request for Comment. The Board proposes to eliminate this firewall,
which is designed to prevent a bank from using purchases and sales as a
means of funding a section 20 affiliate. Section 23B of the Federal
Reserve Act would still require that all such purchases be made on
arm's-length terms, and section 23A would impose quantitative limits.
Section 23A(a)(3) also generally prohibits a bank from purchasing a
low-quality asset from an affiliate. A ``low-quality asset'' is defined
to include: (A) An asset classified as ``substandard'', ``doubtful'',
or ``loss'' or treated as ``other loans especially mentioned'' in the
section 20 affiliate's most recent report of examination or inspection;
(B) an asset in a non-accrual status; (C) an asset on which principal
or interest payments are more than thirty days past due; or (D) an
asset whose terms have been renegotiated or compromised due to the
deteriorating financial condition of the obligor.27 Moreover, the
National Bank Act limits the type of investment securities that a
national bank may hold, generally to investment grade securities.
---------------------------------------------------------------------------
\27\ 12 U.S.C. 371c (a)(3), (b)(10).
---------------------------------------------------------------------------
Elimination of this restriction would allow repurchase and reverse
repurchase agreements as a funding vehicle between a section 20
subsidiary and its affiliated banks. Such agreements would have to be
consistent with sections 23A and 23B, however.
VIII. Limitations on Transfers of Information
Firewall 23 (Disclosure of Nonpublic Information)
Text of 1989 Order. No bank or thrift shall disclose to an
underwriting subsidiary, nor shall an underwriting subsidiary disclose
to an affiliated bank or thrift, any nonpublic customer information
(including an evaluation of the creditworthiness of an issuer or other
customer of that bank or thrift, or underwriting subsidiary) without
the consent of that customer.
1987 and 1990 Order. The 1987 Order was substantially the same. The
1990 Order applied the same restrictions to U.S. bank and thrift
subsidiaries and branches and agencies of foreign banks.
Request for Comment. The Board proposes to include this restriction
in its operating standards, as it constitutes an important customer
protection.
IX. Reports
Firewall 24 (Reports to Federal Reserve)
Text of 1989 Order. Applicants shall submit quarterly to the
appropriate Federal Reserve Bank FOCUS reports filed with the NASD or
other self-regulatory organizations, and detailed information breaking
down the underwriting subsidiaries' business with respect to eligible
and ineligible securities, in order to permit monitoring of the
underwriting subsidiaries' compliance with the provisions of this
Order.
1987 and 1990 Order. Same.
Request for Comment. The Board proposes to retain this requirement
in modified form as one of the operating standards.
X. Transfer of Activities and Formation of Subsidiaries of an
Underwriting Subsidiary To Engage in Underwriting and Dealing
Firewall 25 (Scope of Order)
Text of 1989 Order. The Board's approval of the proposed
underwriting and dealing activities extends only to the subsidiaries
described above for which approval has been sought in the instant
applications. The activities may not be conducted by Applicants in any
other subsidiary without prior Board
[[Page 2631]]
review. Pursuant to Regulation Y, no corporate reorganization of any
underwriting subsidiary, such as the establishment of subsidiaries of
the underwriting subsidiary to conduct the activities, may be
consummated without prior Board approval.
1987 and 1990 Order. Same.
Request for Comment. The Board proposes to eliminate this firewall.
Each order approving section 20 activities can make plain the scope and
organizational structure of the activities approved.
XI. Limitations on Reciprocal Arrangements and Discriminatory Treatment
Firewall 26 (Prohibition on Reciprocity Arrangements)
Text of 1989 Order. No Applicant nor any of its subsidiaries may,
directly or indirectly, enter into any reciprocal arrangement. A
reciprocal arrangement means any agreement, understanding, or other
arrangement under which one bank holding company (or subsidiary
thereof) agrees to engage in a transaction with, or on behalf of,
another bank holding company (or subsidiary thereof), in exchange for
the agreement of the second bank holding company (or any subsidiary
thereof) to engage in a transaction with, or on behalf of, the first
bank holding company (or any subsidiary thereof) for the purpose of
evading any requirement of this Order or any prohibition on
transactions between, or for the benefit of, affiliates of banks
established pursuant to federal banking law or regulation.
1987 and 1990 Order. The 1990 Order is the same, but the
restriction is not included in the 1987 Order.
Request for Comment. The Board proposes to eliminate this firewall.
Anti-competitive reciprocity arrangements are prohibited by the
antitrust laws, and reciprocity arrangements involving a bank are
subject to a special per se prohibition in section 106 of the Bank
Holding Company Act Amendments of 1970.28 The Board could also
rely on the examination process to identify any evasions of the
proposed operating standards that do not run afoul of a statutory
prohibition.
---------------------------------------------------------------------------
\28\ 12 U.S.C. 1972(1).
---------------------------------------------------------------------------
Firewall 27 (Prohibition on Discriminatory Treatment)
Text of 1989 Order. No bank or thrift affiliate of an underwriting
subsidiary shall, directly or indirectly:
(a) acting alone or with others, extend or deny credit or services
(including clearing services), or vary the terms or conditions thereof,
if the effect of such action would be to treat an unaffiliated
securities firm less favorably than its affiliated underwriting
subsidiary, unless the bank or thrift demonstrates that the extension
or denial is based on objective criteria and is consistent with sound
business practices; or
(b) extend or deny credit or services or vary the terms or
conditions thereof with the intent of creating a competitive advantage
for an underwriting subsidiary of an affiliated bank holding company.
1987 and 1990 Order. This restriction is not contained in the 1987
Order. The 1990 Order applied the same restrictions to U.S. affiliates
and branches and agencies of foreign banks.
Request for Comment. This firewall addresses a potential conflict
of interest that arises when a bank is dealing with competitors of its
section 20 affiliate. The firewall prohibits the bank from denying
services to such competitors or charging them higher prices than it
would charge its affiliate. The Board is proposing to eliminate the
firewall because other laws adequately address the potential conflict.
First, the Board notes that whereas securities firms had been
restricted by section 8(a) of the Securities Exchange Act of 1934 in
the types of lenders from which they could obtain loans secured by
securities collateral--generally, to banks and other broker-dealers--
section 8(a) was recently repealed, and such restriction thereby
eliminated.29 Thus, the possibility that a bank would be able to
enforce unfavorable credit terms on a competitor of a section 20
affiliate is remote.
---------------------------------------------------------------------------
\29\ 15 U.S.C. 78h(a) (1995); National Securities Markets
Improvement Act of 1996, Pub. L. 104-290 (1996).
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Second, section 106 of the Bank Holding Company Act Amendments of
1970 prohibits a bank from, among other things, restricting
availability of, or offering discounts on, its products on the
condition that the customer not obtain products from any competitor of
the bank or its affiliates.
XII. Requirement for Supervisory Review Before Commencement of
Activities
Firewall 28 (Infrastructure Review)
Text of 1989 Order. An Applicant may not commence the proposed debt
and equity securities underwriting and dealing activities until the
Board has determined that the Applicant has established policies and
procedures to ensure compliance with the requirements of this Order,
including computer, audit and accounting systems, internal risk
management controls and the necessary operational and managerial
infrastructure. In this regard, the Board will review in one year
whether Applicants may commence underwriting and dealing in equity
securities based on a determination by the Board that they have
established the managerial and operational infrastructure and other
policies and procedures necessary to comply with the requirements of
this Order.
1987 and 1990 Order. The 1987 Order does not contain this
restriction. The 1990 Order contains the same restriction.
Request for Comment. The purpose of this restriction is to ensure
that a bank holding company has the necessary systems, internal
controls, and infrastructure to operate a section 20 subsidiary. The
Board believes that these systems are vital to the successful operation
of a section 20 subsidiary. However, because the Board and not the
section 20 subsidiary performs the review, the Board intends to require
an infrastructure review in the context of each application rather than
including it as an ``operating standard'' for section 20 subsidiaries.
The Board generally will continue to conduct an inspection prior to
allowing commencement of underwriting and dealing in corporate debt or
equity securities pursuant to the 1989 Order. In special cases such as
an acquisition, the inspection will occur as soon as practicable after
consummation. Although the existing firewall suggests that a review of
the infrastructure for equity securities activities might not occur for
a year after approval of an application, the Board has substantially
modified and shortened the pre-approval inspection period for equity
securities activities. Such inspections now frequently begin shortly
after the filing of an application, and may be completed before the
application is considered by the Board. Thus, the pre-commencement
examination generally does not create a substantial delay beyond the
application processing period.
List of Subjects 12 CFR Part 225
Administrative practice and procedure, Banks, banking, Federal
Reserve System, Holding Companies, Reporting and recordkeeping
requirements, Securities.
For the reasons set out in the preamble, the Board proposes to
amend 12 CFR Part 225 as follows:
[[Page 2632]]
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
1. The authority citation for Part 225 continues to read as
follows:
Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3908, and
3909.
2. An undesignated center heading and Sec. 225.200 would be added
to read as follows:
Conditions to Orders
Sec. 225.200 Conditions to Board's section 20 Orders.
(a) Introduction. Section 20 of the Glass-Steagall Act and section
4(c)(8) of the Bank Holding Company Act allow subsidiaries of bank
holding companies to engage to a limited extent in underwriting and
dealing in securities in which a member bank could not engage. Pursuant
to the Securities Act of 1933 and the Securities Exchange Act of 1934,
these so-called section 20 subsidiaries are required to register with
the SEC as broker-dealers and are subject to all the financial
reporting, anti-fraud and financial responsibility rules applicable to
broker-dealers. In addition, member banks are restricted in their
transactions with section 20 affiliates by sections 23A and 23B of the
Federal Reserve Act. The Board expects a section 20 subsidiary, like
any other subsidiary of a bank holding company, to be operated
prudently. Doing so would include observing corporate formalities (such
as the maintenance of separate accounting and corporate records),
maintaining adequate capital, and instituting appropriate risk
management, including independent trading and exposure limits
consistent with parent company guidelines. However, given the unique
risks of affiliation between a section 20 subsidiary and a depository
institution, the Board particularly expects the bank holding company to
ensure that its subsidiary banks are well capitalized, and requires
adherence to the following operating standards as a condition to each
order approving establishment of a section 20 subsidiary.
(b) Conditions.--(1) Capital. (i) The bank holding company or
foreign bank shall maintain adequate capital on a fully consolidated
basis.
(ii) In the event that a bank or thrift affiliate of a section 20
subsidiary shall become less than well capitalized (as defined in
section 38 of the Federal Deposit Insurance Act), and the bank holding
company or foreign bank shall fail to restore it promptly to the well
capitalized level, the Board may reimpose the funding, credit extension
and credit enhancement firewalls contained in its 1989 order allowing
underwriting and dealing in bank-ineligible securities.1
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\1\ Firewalls 5-8, 19, 21 and 22 of J.P. Morgan & Co., The Chase
Manhattan Corp., Bankers Trust New York Corp., Citicorp, and
Security Pacific Corp., 75 Federal Reserve Bulletin 192, 214-16
(1989) and, for foreign banks, Canadian Imperial Bank of Commerce,
The Royal Bank of Canada, Barclays PLC and Barclays Bank PLC, 76
Federal Reserve Bulletin 158, (1990). The Federal Reserve Bulletin
is available for sale from Publication Services--Mail Stop 127,
Board of Governors of the Federal Reserve System, Washington, DC
20551.
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(2) Internal controls. (i) Each bank holding company or foreign
bank shall cause its subsidiary banks, thrifts, and U.S. branches and
agencies to adopt policies and procedures, including appropriate limits
on exposure, to govern their participation in transactions underwritten
or arranged by a section 20 affiliate.
(ii) Each bank holding company or foreign bank shall ensure that an
independent and thorough credit evaluation has been undertaken in
connection with bank, thrift, or U.S. branch or agency participation in
such financing transactions, and that adequate documentation of that
evaluation is maintained for review by examiners of its appropriate
Federal banking agency and the Federal Reserve.
(3) Interlocks restriction. Directors, officers or employees of a
bank holding company's or foreign bank's U.S. bank or thrift
subsidiaries, branches or agencies shall not serve as a majority of the
board of directors or the chief executive officer of an affiliated
section 20 subsidiary, and directors, officers or employees of a
section 20 subsidiary shall not serve as a majority of the board of
directors or the chief executive officer 2 of an affiliated U.S.
bank or thrift subsidiary, branch or agency, except that the manager of
a branch or agency may act as a director of the underwriting
subsidiary.
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\2\ For purposes of this standard, the manager of a U.S. branch
or agency of a foreign bank normally will be considered to be the
chief executive officer of the branch or agency.
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(4) Customer disclosure. A section 20 subsidiary shall provide each
of its retail customers the disclosures, and obtain the customer
acknowledgement, required by the Interagency Statement on Retail Sales
of Nondeposit Investment Products, even when the section 20 subsidiary
is dealing with the customer off bank premises. An affiliated bank or
thrift institution may not express an opinion on the value or the
advisability of the purchase or the sale of ineligible securities
underwritten or dealt in by an affiliated underwriting subsidiary
unless the bank or thrift notifies the customer that the underwriting
subsidiary is underwriting, making a market, distributing or dealing in
the security.
(5) Credit for clearing purposes. Any intra-day extension of credit
for purposes of clearing securities that is extended to a section 20
subsidiary by an affiliated bank, thrift, branch or agency shall be:
(i) On market terms consistent with section 23B of the Federal
Reserve Act; and
(ii) Fully secured.
(6) Confidentiality of customer information. A section 20
subsidiary and its affiliated banks, thrifts, branches or agencies
shall not share with each other any nonpublic customer information
without the consent of that customer.
(7) Reporting requirement. Each bank holding company or foreign
bank shall submit quarterly to the appropriate Federal Reserve Bank
FOCUS reports filed with the NASD or other self-regulatory
organizations, and information necessary to monitor compliance with
these operating standards and section 20 of the Glass-Steagall Act, on
forms provided by the Board.
(8) Foreign banks. A foreign bank shall ensure that any extension
of credit by its U.S. branch or agency to a section 20 affiliate, and
any purchase by such branch or agency, as principal or fiduciary, of
securities for which a section 20 affiliate is a principal underwriter,
conforms to sections 23A and 23B of the Federal Reserve Act, and that
its branches and agencies not advertise nor suggest that they are
responsible for the obligations of a section 20 affiliate, consistent
with section 23B(c) of the Federal Reserve Act.
(c) Establishment of additional limitations. Based upon the
supervisory process and experience with the activities, the Board may
establish additional limitations on the conduct of these activities to
ensure that the section 20 subsidiaries' activities are consistent with
safety and soundness, conflict of interest and other considerations
relevant under the Bank Holding Company Act.
By order of the Board of Governors of the Federal Reserve
System, January 10, 1997.
William W. Wiles,
Secretary of the Board.
[FR Doc. 97-1010 Filed 1-16-97; 8:45 am]
BILLING CODE 6210-01-P
