[Federal Register Volume 62, Number 166 (Wednesday, August 27, 1997)]
[Rules and Regulations]
[Pages 45295-45307]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-22840]
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FEDERAL RESERVE SYSTEM
12 CFR Part 225
[Regulation Y; Docket No. R-0958]
Bank Holding Companies and Change in Bank Control (Regulation Y);
Amendments to Restrictions in the Board's Section 20 Orders
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Final Conditions to Board Orders.
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SUMMARY: The Board is modifying 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
eliminating those restrictions that have proven to be unduly burdensome
or unnecessary in light of other laws or regulations, and
[[Page 45296]]
consolidating the remaining restrictions in a series of eight operating
standards. The Board has concluded that the narrower set of
restrictions will be fully consistent with safety and soundness and
should improve operating efficiencies at section 20 subsidiaries and
increase options for their customers.
EFFECTIVE DATE: October 27, 1997.
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 Supervisory Financial Analyst
(202) 452-2781, Division of Banking Supervision and Regulation; for the
hearing impaired only, Telecommunications Device for the Deaf (TDD),
Diane Jenkins (202) 452-3544.
SUPPLEMENTARY INFORMATION:
I. Background
Section 20 of the Glass-Steagall Act prohibits a member bank of the
Federal Reserve System from being affiliated with a company that is
``engaged principally'' in underwriting and dealing in securities not
eligible for underwriting and dealing by a member bank.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 within the limits of the
Act.2
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\1\ 12 U.S.C. 377.
\2\ See, e.g., J.P. Morgan & Co. Inc., 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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In those orders, the Board has established a series of prudential
restrictions as conditions for approval under the Bank Holding Company
Act. Most of the firewalls were adopted in the Board's initial 1987
Order authorizing bank holding companies to underwrite and deal in
commercial paper, municipal revenue bonds, mortgage-backed securities,
and consumer-receivable-related securities. Others were added in 1989
when the Board authorized underwriting and dealing in all types of debt
and equity securities. The restrictions are designed to prevent
securities underwriting and dealing risks 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 affiliation of commercial and investment banks.
On January 8, 1997, the Board proposed to rescind many of the
firewalls and consolidate the remainder in a series of operating
standards to be published in the Code of Federal Regulations. The
proposal was developed through the Board's comprehensive review of its
regulations and written policies that was required by section 303 of
the Riegle Community Development and Regulatory Improvement Act of
1994.3 That statute directs the Board and other banking
agencies to streamline their regulations to improve efficiency, reduce
unnecessary costs, and eliminate unwarranted constraints on credit
availability. In the proposal, the Board stated that in its experience
the risks of securities underwriting and dealing had proven to be
manageable in a bank holding company framework, and that bank holding
companies and banks had successfully undertaken and managed activities
posing similar risks for which no firewalls were erected. The Board
noted that the purposes of the firewalls are often duplicated by other
statutes or regulations that are more narrowly tailored to addressing
the perceived risk or conflict.
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\3\ 12 U.S.C. 4803.
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II. Summary of Comments
The Board received twenty-nine public comments on its proposal, and
comments were overwhelmingly favorable. Only two commenters opposed the
Board's proposed elimination of firewalls. The remaining commenters
supported the Board's proposal, though almost all of those commenters
urged the Board to go further to rescind all or at least more of the
firewalls.
The comments generally expressed support for the proposal in a
summary fashion, reserving specific comment for the four firewalls on
which the Board sought comment and two others that proved
controversial. Those comments are discussed below in the context of
each relevant firewall.
One trade association representing community banks expressed
concerns about the proposal.4 The commenter stated that the
Board may be acting too quickly in eliminating some of the firewalls
and urged a careful approach. The commenter urged the Board to retain
the requirement that a bank holding company deduct from its regulatory
capital any investment in a section 20 subsidiary, arguing that
elimination would allow a bank holding company to lodge all of its
capital (other than bank capital) at its section 20 subsidiary, which
would mean that no capital would be available at the holding company
level if the holding company were called upon to serve as a source of
strength to its insured depository institution subsidiaries. The
commenter also urged the Board to maintain capital requirements for a
section 20 subsidiary that mirror the net capital rule of the
Securities and Exchange Commission (SEC), as the SEC could revise or
eliminate its regulation.
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\4\ The other adverse commenter did not address the proposal but
generally opposed the affiliation of commercial and investment
banking.
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The same commenter urged the Board to retain restrictions on a bank
extending credit to customers of a section 20 affiliate or offering
credit enhancements for securities underwritten by the section 20
affiliate. The commenter urged the Board to delay final action on the
proposal because one bill pending in Congress would continue to impose
such restrictions. The commenter also expressed concern that conflicts
of interest would be present when a bank lent to customers of a section
20 affiliate, and that customers needed the firewall for
protection.5
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\5\ The commenter noted that five other restrictions were being
rescinded because they were largely duplicated by sections 23A and
23B of the Federal Reserve Act (12 U.S.C. 371c and 371c-1) or other
statutes. The commenter stressed that it supported elimination so
long as eliminating the firewalls did not change the substance of
how transactions could occur.
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III. Final Notice
The Board is adopting the proposed operating standards, and the
corresponding rescission of the existing firewalls, substantially as
proposed. Based on its experience supervising section 20 subsidiaries
and the comments received on the proposal, the Board has concluded that
the great majority of risks of affiliation of commercial and investment
banks are addressed by general bank and bank holding company
regulations, and by the securities laws and regulations of the SEC,
National Association of Securities Dealers (NASD) and securities
exchanges that apply to a section 20 subsidiary just like any other
broker-dealer. However, in certain areas--for example, the potential
for a customer to confuse the financial products of a commercial and
investment bank--the Board has determined that there are unique risks
of affiliation not addressed by other
[[Page 45297]]
laws. The operating standards being adopted by the Board address those
risks.
Compliance with the operating standards will be a condition of the
continued operation of any existing section 20 subsidiary and, unless
modified in the authorizing order, a condition of the operation of any
section 20 subsidiary approved in the future. For purposes of existing
section 20 subsidiaries, the operating standards replace the Board's
existing section 20 firewalls.6
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\6\ The only exception is Firewall #1 of the Board's 1987 Order,
which set forth the types of securities to which companies operating
under that order must limit their underwriting and dealing. 1987
Order at 502-03. That restriction will continue to apply.
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Set forth below are: (1) A summary of each of the firewalls
established in the Board's orders; 7 (2) the Board's
proposal with respect to the firewall; and (3) the Board's final action
and the reasons for that action, including a discussion of any comments
received. Each of the proposed operating standards is discussed in the
context of the firewall from the 1989 Order on which it is based:
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\7\ Footnotes to the orders are omitted. Description of the
firewalls conforms to the 1989 Order. The Board's request for
comment describes the differences among the firewalls in the 1989
Order (allowing debt and equity underwriting), the 1987 Order
(allowing underwriting and dealing in only four types of debt
securities), and the 1990 Order (applicable to foreign banks).
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Operating standard Firewall
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1. Capital requirement for bank holding 1, 3 and 4.
company and section 20 subsidiary.
2. Internal controls..................... 11.
3. Interlocks restriction................ 13.
4. Customer disclosure................... 14.
5. Credit for clearing purposes.......... 21(a) & (b).
6. Funding of securities purchases from a 6.
section 20 affiliate.
7. Reporting requirement................. 24.
8. Application of sections 23A and 23B to 21(a).
foreign banks.
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Those wishing a more detailed description of the firewalls should
refer to the request for comment on the Board's proposal, where each of
the firewalls was set forth verbatim.8
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\8\ 62 FR 2622 (Jan. 17, 1997). As with the earlier notice,
references to banks include thrifts. In addition, to the extent that
the operating standards apply to banks and thrifts, they also apply
to the U.S. branches and agencies of foreign banks.
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IV. Analysis of Each Firewall
A. Capital Adequacy Conditions
Firewall 1(a) (Deduction of Investment in Subsidiary From Bank Holding
Company Capital)
Firewall 1(b) (Deduction of Extensions of Credit From Bank Holding
Company Capital)
Existing firewalls. Requires a bank holding company to maintain
adequate capital after deducting (1) any investment in a section 20
subsidiary that is treated as capital in the subsidiary (Firewall
1(a)), and (2) any credit that it or a nonbank subsidiary extends to a
section 20 subsidiary, unless the 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 (Firewall
1(b)).
Proposal. The Board proposed to rescind the capital deduction
required by this firewall, 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.
Final action. The Board is retaining the requirement that any bank
holding company operating a section 20 subsidiary be adequately
capitalized. Although bank holding companies are also subject to the
Board's risk-based capital guidelines, Operating Standard #1 will
condition the operation of a section 20 subsidiary on a bank holding
company's maintaining adequate capital.
The Board is eliminating the required capital deductions. The
capital deductions (and resulting deconsolidation for regulatory
capital purposes) are inconsistent with generally accepted accounting
principles (GAAP) and have therefore created confusion and imposed
costs by requiring bank holding companies to prepare financial
statements on two bases.
However, as one commenter noted, elimination of the capital
deductions would allow a bank holding company to lodge its capital
(other than bank capital) at the section 20 subsidiary, leaving less
capital available at the holding company level if the holding company
were called upon to serve as a source of strength to its insured
depository institution subsidiaries.9 Reflecting this
concern, the Board in its section 20 orders has consistently required
bank holding companies to maintain their ability to serve as a source
of strength to their subsidiary banks, and has satisfied itself that
the subsidiary banks of applicants, and any foreign bank applicants,
were strongly capitalized before granting approval. Moreover, with the
elimination of many of the firewalls, particularly the funding and
credit enhancement firewalls, a bank's potential exposure to its
section 20 affiliate will increase, thereby increasing the importance
of maintaining strong bank capital levels.
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\9\ 12 CFR 225.4(a)(1).
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As a protection for the bank, the Board proposed to retain the
discretion to restrict funding and credit enhancements by a bank in the
event the bank failed to qualify as well capitalized, as defined in
section 38 of the Federal Deposit Insurance Act.10 Thus, if
a bank's capital ratios fell to the adequately capitalized level (where
prompt corrective action did not yet engage), and the drop in capital
ratios were attributable to poor credit decisions relating to its
section 20 affiliate, the Board could act immediately to limit the
damage.11 The Board is adopting this proposal but also
conditioning its approval of relief from the existing firewalls on a
requirement that a bank holding company maintain the capital of its
subsidiary banks at the well-capitalized level. Thus, in the event that
a subsidiary bank fell below the well-capitalized level and the bank
holding company failed to recapitalize it, the Board could order the
bank holding company to divest its section 20 subsidiary. The Board
would expect to do so only if the subsidiary were causing harm to the
bank (and other steps such as restricting bank funding of the section
20 affiliate were ineffective), or if the divestiture of the section 20
affiliate was the only available source of funds within the
organization to recapitalize the bank. The Board notes that Glass-
Steagall reform legislation pending in the Congress also requires a
bank holding company to maintain its subsidiary banks at the well-
capitalized level as a condition of conducting securities activities.
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\10\ 12 U.S.C. 1831o.
\11\ Two commenters opposed this change because it could lead to
a substantial disruption of the business of a section 20 subsidiary
when affiliated banks experience capital difficulty. However, the
Board would expect to reimpose these restrictions only if they
addressed problems in the organization or diminished resulting risks
to its insured depository institutions.
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In applying this condition to foreign banks, the Board has decided
that a foreign bank should maintain capital at a level that is
comparable to that of a
[[Page 45298]]
U.S. banking organization, for which different capital requirements
apply to the bank and the bank holding company. As noted in the 1990
Order, foreign banks operate in the United States as both banks and
bank holding companies, and the capital requirement for a foreign bank
should take account of this fact. As noted above, in acting on
applications by foreign banks to establish section 20 subsidiaries, the
Board relied on the fact that each foreign bank was capitalized at
levels well above the applicable minimums. Consequently, and in the
interests of national treatment, the Board has decided that foreign
banks should maintain a strong capital position, above the minimum
levels of the Basle Capital Accord. The Board believes that this
standard will provide substantial equivalence in the maintenance of
capital by both domestic and foreign banking organizations that operate
section 20 subsidiaries.
Firewall 2 (Prior Approval Requirement for Investments in Subsidiary)
This firewall was repealed by the Board at the time it published
its request for comment. The firewall had required Board approval for
any bank holding company investments in a section 20 subsidiary
subsequent to its formation.
Firewall 3 (Requirement of Capital Plan)
Existing firewall. Requires that, before establishing a section 20
subsidiary, a bank holding company submit to the Board a plan to raise
additional capital or demonstrate that it is strongly capitalized and
will remain so after making authorized capital adjustments.
Proposal. The Board proposed to rescind this firewall, which was
applied in the 1989 Order granting authority to engage in underwriting
and dealing in all types of debt and equity securities, but not in the
1987 Order.
Final action. The Board is retaining this firewall in modified
form. 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
expects that any bank holding company filing a notice with the Board to
acquire and/or operate a section 20 subsidiary should have a strong
capital position. Therefore, the Board has concluded that an operating
standard setting forth the contents of a capital plan is unnecessary.
The firewall also provides, however, that applicants seeking authority
to engage in underwriting and dealing in all types of debt and equity
securities shall also remain strongly capitalized, and the Board has
not permitted applicants to commence underwriting and dealing in all
types of debt and equity securities until they have demonstrated that
they can meet this standard. Accordingly, the Board is retaining this
requirement in Operating Standard # 1. Consistent with the discussion
above, the Board will require that the bank holding company be strongly
capitalized on a fully consolidated basis, and thus will not deduct
from its capital the bank holding company's investment in, or
extensions of credit to, its section 20 subsidiary.
Firewall 4 (Capital Adequacy Requirement)
Existing firewall. Requires a section 20 subsidiary to maintain
capital adequate to support its activities and cover reasonably
expected expenses and losses in accordance with industry norms.
Proposal. The Board sought comment on whether to retain this
firewall.
Final action. The Board is rescinding this firewall, but modifying
the operating standards to require the section 20 subsidiary to notify
the Board as well as the SEC of any failure to maintain capital above
``early warning'' levels contained in SEC capital rules.
The purpose of this capital requirement was to prevent a section 20
subsidiary from operating below industry capital standards by trading
on the reputation and resources of its affiliated bank, thereby gaining
a competitive advantage over other broker-dealers. The Board has
concluded, however, that the firewall is not an effective tool for
addressing this concern, primarily because there is no defined
``industry norm.''
Although the SEC imposes ``haircut'' and capital requirements on
all broker-dealers (including section 20 subsidiaries), these minimum
capital levels cannot be considered ``industry norms.'' Because broker-
dealers that fail to meet SEC minimum capital requirements are
liquidated, and broker-dealers that fall below somewhat higher ``early
warning'' levels are required to notify the SEC, broker-dealers
ordinarily do not operate near these minimums. One commenter also
explained that significant underwriters must maintain capital greatly
in excess of SEC minimums so that they can draw down on their excess
capital when a significant underwriting arises.
Commenters also stated that any attempt to determine the
``average'' capital actually held by the industry (as opposed to the
minimum capital required by the SEC) and specify it as the industry
norm would be unwise. Capital varies significantly depending on the
activities and risk profile of the individual firm. Furthermore,
commenters noted 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.
Finally, the Board already measures bank holding company capital on
a consolidated basis, including the capital and assets of the section
20 subsidiary. Therefore, even in the absence of a special capital
requirement for section 20 subsidiaries, their ability to leverage
themselves will be constrained.
The Board has decided to require a section 20 subsidiary to notify
the Board as well as the SEC of any failure to maintain capital above
``early warning'' levels contained in SEC capital rules.\12\ If a
section 20 subsidiary is required to file a warning notice advising the
SEC that the section 20 subsidiary is experiencing financial distress,
a copy of the notice will be required to be filed concurrently with the
relevant Federal Reserve Bank. The Board would then have the authority
to take appropriate action to maintain safety and soundness.
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\12\ See 17 CFR 240.17a-11.
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B. Credit Extensions to Customers of the Underwriting Subsidiary
Firewall 5 (Restriction on Credit Enhancement)
Existing firewall. Prohibits a section 20 affiliate from extending
credit or issuing or entering 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 a bank-ineligible securities issue underwritten or distributed by
the underwriting subsidiary.\13\
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\13\ A bank-ineligible security is one that a member bank is
prohibited from underwriting or dealing in by section 16 of the
Glass-Steagall Act. 12 U.S.C. 24(Seventh); 12 U.S.C. 335.
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Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall because other
protections adequately serve its purposes, and its burden on section 20
subsidiaries and their customers therefore is not warranted. Commenters
stressed that by prohibiting banks from providing routine credit
enhancements in tandem with a section 20 affiliate, the firewall
hampers the ability of bank holding companies to serve as full-service
[[Page 45299]]
financial services providers and 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 perform a credit
analysis. The bank is precluded from providing a credit enhancement
even if it reached an independent credit decision prior to referring
the customer to its section 20 affiliate.
Moreover, significant safety and soundness protections will remain
in the absence of the firewall. First, a bank will be required to hold
capital against all credit enhancements extended to customers of its
section 20 affiliate--something that was not the case at the time the
firewall was adopted. Second, the amount of credit that a bank may
extend to an issuer of securities underwritten by an affiliated section
20 will be limited by loan-to-one borrower rules.\14\ Third, section
23B of the Federal Reserve Act will require that all credit
enhancements of securities being underwritten by a section 20 affiliate
be on market terms--that is, the same terms that would be offered to a
third party of equal creditworthiness.\15\ Thus, for example, a bank
could not offer such credit enhancements at less than market terms, 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.\16\
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\14\ 12 U.S.C. 84; 12 CFR 32.2.
\15\ 12 U.S.C. 371c-1(a)(2)(E)(ii).
\16\ 12 U.S.C. 1972(1).
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Finally, Operating Standard #2, discussed below, will require that
the bank conduct an independent and thorough credit evaluation before
offering any credit enhancement in tandem with a section 20 affiliate,
and maintain documentation of that evaluation sufficient to allow
examiners to assess compliance with its credit policies.
Firewall 6 (Restriction on Funding Purchases of Securities)
Existing firewall. This firewall prohibits a bank holding company
or its subsidiary from knowingly extending credit to a customer to fund
the purchase of a bank-ineligible security that is being underwritten
by a section 20 subsidiary during the period of the underwriting or for
30 days thereafter, or to purchase from the underwriting subsidiary any
bank-ineligible security in which the underwriting subsidiary makes a
market. The limitation 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.
Proposal. The Board sought comment on whether existing protections
were sufficient to address the primary concern of Firewall 6: 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 to facilitate its market making activities. The primary
risks of such action 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 that do not have a federally subsidized
affiliate to provide credit to their customers.
Final action. The Board is retaining this firewall as Operating
Standard #6 with respect to any extension of credit during the
underwriting period or for 30 days thereafter, subject to an exception
for preexisting lines of credit.\17\ The Board is removing the
restriction on lending for purchases of securities in which a section
20 affiliate makes a market.
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\17\ This operating standard does not apply when a section 20
subsidiary is acting only as a selling group member. Although a
selling group member may be engaged in the public sale or
distribution of securities for purposes of the Glass-Steagall Act, a
selling group member is not considered an underwriter.
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Commenters supported elimination of the firewall. Commenters
stressed that it would make little sense for a bank to expose itself to
the losses associated with unsound loans so that its section 20
affiliate could earn a fraction of those potential losses on the sale
of securities. One commenter explained that a bank may have a pre-
existing line of credit for a customer for the purchase of securities
on margin. Such a line would have been entered into based on the
customer's creditworthiness and the value of the security, not the
identity of the underwriter of any potential securities purchases, and
could also be subject to the margin requirements imposed by the Board's
Regulation U. Commenters also stressed that a section 20 subsidiary, as
a registered broker-dealer, is responsible under NASD, NYSE, and SEC
``know your customer'' and suitability rules for ensuring that the
securities purchased by a customer are suitable investments for that
particular customer.18
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\18\ Rule 2110 of the NASD's Conduct Rules (Standards of
Commercial Honor and Principles of Trade); Rule 2310 of the NASD's
Conduct Rules (Recommendations to Customers (suitability)); NYSE
Rule 405 (``know your customer''); SEC Rule 15g-9 (sales practice
rules for certain low-price securities).
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Commenters noted that 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 subsidiary)
that is acting as an underwriter from extending or arranging for credit
to customers purchasing the newly issued securities during the
underwriting period and for 30 days after 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.
Commenters also noted that section 23B of the Federal Reserve Act
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.19 Section 23B would
require the loan to be on market terms.
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\19\ 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).
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The Board has concluded, however, that these protections do not
address all the concerns behind the firewall. Section 11(d) does not
apply to a bank loan unless the loan is arranged by an affiliated
broker-dealer, and although section 23B requires the loan to be on
market terms, the Board has some concern that during an underwriting
period, when the market value of the securities is uncertain, section
23B may not be an adequate protection. In sum, the Board has concluded
that existing law is not a complete protection against the conflicts of
interest that arise when a bank lends during the underwriting period or
for 30 days thereafter.
However, the Board will revise the restriction to allow an
extension of credit to be made pursuant to a preexisting line of
credit, provided that (1) the line of credit was not entered into in
contemplation of the purchase of
[[Page 45300]]
affiliate-underwritten securities,20 and (2) either the line
of credit is unrestricted or the extension of credit is clearly
consistent with any restrictions imposed. (For example, if a customer
had a preexisting line of credit limited to purchases of rated
securities, then the bank would continue to be prohibited from lending
to purchase unrated securities underwritten by an affiliate.)
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\20\ In determining whether the line of credit is truly
preexisting, examiners will consider the timing of the line of
credit and the underwriting, the conditions imposed on the line of
credit, and whether the line of credit has been used for purposes
other than the purchase of affiliate-underwritten securities.
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The Board has concluded that these transactions do not present the
same risks as other loans made during an underwriting. Such lines of
credit are routinely used by institutional and other sophisticated
customers, and are based on the customer's overall creditworthiness as
well as margin required for any purchase; although any security
purchased using the line of credit is taken as collateral, there are
other assurances of repayment. In such cases, the customer is not being
induced by an offer of bank credit to purchase an affiliate-
underwritten security, as the customer is free to use the line of
credit to purchase other securities of the same type. Finally, for
purposes of section 23B, the pricing of the line of credit can be
compared to other, similar lines that are not used to purchase
affiliate-underwritten securities.
The Board has also concluded that the potential conflicts of
interest associated with extending securities credit are lessened, and
the protections more effective, when the section 20 affiliate is making
a secondary market in the securities. First, the section 20 affiliate's
potential exposure as market maker should be substantially less and
more manageable than its exposure as underwriter. Second, especially
because there is generally more than one firm making a market in a
given security, compliance with the market terms requirement of section
23B should be easier to determine than in the underwriting context,
where there may be no secondary market. Third, because section 11(d)
does not apply to loans for the purpose of purchasing securities in
which a broker-dealer makes a market, broker-dealers (including section
20 subsidiaries) are already permitted to lend in this context, and
lending by banks does not appear to present any greater conflict of
interest that would justify excluding them from this credit market.
Fourth, as described more fully below, existing ``Chinese Wall''
procedures should help to ensure that a bank lending officer is unaware
of the section 20 affiliate's market making role.
The Board recognizes that section 23A of the Federal Reserve Act
would apply to both types of transactions being exempted from the
firewall to the extent that the proceeds of the transaction would be
``used for the benefit of, or transferred to'' the
affiliate.21 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. As several
commenters noted, application of section 23A could not only restrict
the amount of such credit but raise interpretive and compliance
questions concerning how a bank should monitor compliance with the
statute. However, for the same reasons that the Board has decided to
exempt these transactions from the firewall, the Board is considering
whether an exemption from section 23A may also be appropriate. The
Board expects to seek comment on this and other issues arising under
sections 23A and 23B in the near future.
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\21\ 12 U.S.C. 371c(a)(2).
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Firewall 7 (Restriction on Extensions of Credit for Repayment of
Underwritten Securities)
Existing firewall. Prohibits a bank holding company or any of its
subsidiaries from extending credit to an issuer of bank-ineligible
securities previously underwritten by a section 20 affiliate for the
purpose of the payment of principal, interest or dividends on such
securities.
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall. 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 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, this conflict of
interest is more attenuated than those present when credit is extended
during the underwriting period, as the financial and reputational risks
to the section 20 affiliate are lessened once the underwriting is
successfully completed.
The firewall also 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.
Finally, in the absence of this firewall, section 23B of the
Federal Reserve Act will require that extensions of credit for the
purpose of payment of principal, interest or dividends be made on
market terms if the section 20 affiliate is a participant in the
transaction.22
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\22\ 12 U.S.C. 371c-1(a)(3).
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Firewall 8 (Procedures for Extensions of Credit)
Existing firewall. Requires a bank holding company to adopt
procedures, including maintenance of necessary documentary records, to
ensure that any extension of credit by it or any of its subsidiaries to
issuers of bank-ineligible securities underwritten or dealt in by a
section 20 subsidiary are on an arm's-length basis for purposes other
than payment of principal, interest, or dividends on the issuer's bank-
ineligible securities being underwritten or dealt in by the
underwriting subsidiary.
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall as superfluous.
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 market
terms. 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 in 1982 and
adopting section 23B in 1987, Congress chose not to apply them to the
parent bank holding company or any other nonbank lender, and the Board
sees no reason to reverse that judgment in this context.
Firewall 9 (Restriction on Thrifts)
Existing firewall. Requires thrifts to observe the limitations of
sections 23A and 23B of the Federal Reserve Act in any dealings with a
section 20 affiliate.
Proposal. The Board proposed to rescind this provision.
Final action. The Board is rescinding this firewall as superfluous,
given that the Home Owners' Loan Act has since been amended to apply
sections 23A and 23B of the Federal Reserve Act to a thrift as if it
were a member bank.23
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\23\ 12 U.S.C. 1468(a)(1).
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[[Page 45301]]
Firewall 10 (Restriction on Industrial Revenue Bonds)
Existing firewall. Applies the requirements relating to credit
extensions to issuers noted in paragraphs 5-9 above to extensions of
credit to parties that are major users of projects that are financed by
industrial revenue bonds.
Proposal. As the Board proposed to rescind the incorporated
restrictions, the Board proposed to rescind this restriction as well.
Final action. As the Board is rescinding all of the incorporated
restrictions relating to credit extensions to issuers, the Board is
rescinding this restriction as well.
Firewall 11 (Loan Documentation and Exposure Limits)
Existing firewall. Requires bank holding companies to cause their
subsidiary banks to adopt policies and procedures, including
appropriate limits on exposure, to govern their participation in
financing transactions underwritten or arranged by a section 20
affiliate. They shall also ensure that loan documentation is available
for review by the 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 firewalls and section 23B of the Federal
Reserve Act.
Proposal. The Board proposed to include this firewall in slightly
amended form in its operating standards for all section 20
subsidiaries.
Final action. The Board is retaining this restriction as part of
Operating Standard 2. The Board will thereby be imposing this
restriction for the first time on section 20 subsidiaries operating
under the 1987 Order.
Several commenters objected to retention of this requirement as
redundant in view of the current federal banking agency examination
standards for risk management. These commenters noted that this
restriction was initially adopted in the context of highly leveraged
transactions, and that additional internal control restrictions are not
placed on bank activities with respect to other nonbank subsidiaries.
However, the Board has concluded that this operating standard remains
important in light of the risks of affiliation between a section 20
subsidiary and a depository institution, particularly in view of the
Board's removal of other restrictions on such affiliation.
Firewall 12 (Procedures for Limiting Exposure to One Customer)
Existing firewall. Mandates that bank holding companies 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 section 20
subsidiary.
Proposal. The Board sought comment on whether to include this
restriction in its operating standards for section 20 subsidiaries.
Final action. The Board is rescinding this firewall. The firewall
mandates consolidated exposure limits for a bank holding company with
respect to any one issuer whose securities are underwritten or dealt in
by a section 20 subsidiary. The Board has the authority to review bank
holding company policies on exposure through the examination process
and believes that an examination is adequate to ensure that a bank
holding company is not exposed unduly to any single issuer. Bank
holding companies have successfully operated section 20 subsidiaries
under the Board's 1987 Order without being subject to this requirement.
Finally, unlike the banks for whom exposure limits are required by
Operating Standard #2, bank holding companies are not federally
insured.
C. Limitations to Maintain Separateness of an Underwriting Affiliate's
Activity
Firewall 13 (Interlocks Restriction)
Existing firewall. Prohibits directors, officers or employees of a
bank from serving 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 from
serving as a majority of the board of directors or the chief executive
officer of an affiliated bank. 24 Requires the underwriting
subsidiary to have offices separate from any affiliated bank.
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\24\ As the Board noted in a recent order, this limitation does
not apply to interlocks between a section 20 subsidiary and a
subsidiary of an affiliated bank. See Bankers Trust New York, 83
Federal Reserve Bulletin ____ (July 21, 1997).
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Proposal. The Board proposed no changes to the interlocks
restrictions, which it recently amended. The Board proposed to rescind
the separate office requirement.
Final action. The Board is rescinding 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
intends to rely on the Interagency Statement on Retail Sales of
Nondeposit Investment Products, which largely duplicates this
restriction.25 According to the Interagency Statement, sales
or recommendations of non-deposit 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.
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\25\ Federal Reserve Regulatory Service 3-1579.51.
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Several commenters suggested elimination of or modifications to the
interlocks restriction, on which the Board did not seek comment. The
Board continues to view the interlocks restriction as helping to ensure
the corporate separateness of a bank and a section 20 affiliate, and
thereby as helping to prevent a piercing of the bank's corporate veil
by creditors of the section 20 affiliate.
D. Disclosure by the Underwriting Subsidiary
Firewall 14 (Customer Disclosures)
Existing firewall. Requires a section 20 affiliate to provide each
of its customers with a special disclosure statement describing the
difference between itself and its bank affiliates, pointing out that an
affiliated bank could be a lender to an issuer, and referring the
customer to the disclosure documents for details. The statement must
also 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
section 20 affiliate should also disclose any material lending
relationship between the issuer and a bank or lending affiliate of the
section 20 affiliate as required under the securities laws and in every
case where the proceeds of the issue will be used to repay outstanding
indebtedness to affiliates.
Proposal. The Board proposed to amend this firewall to follow the
Interagency Statement on Retail Sales of Nondeposit Investment Products
that applies to sales by bank employees or on bank premises.
Final action. The Board has decided to adopt this operating
standard as proposed. A section 20 subsidiary will be required to
provide each of its retail
[[Page 45302]]
customers the same disclosures that the Interagency Statement mandates
for retail customers of banks, even when it is operating off bank
premises. 26 The disclosures of the Interagency Statement
are only slightly different from those required by the existing
firewall, however, and the amendment will allow the same form to be
used for both. The operating standard is narrower than the firewall it
replaces because it no longer requires disclosures to institutional
customers (who should be aware of whether a product is federally
insured or bank guaranteed) but broader than the existing firewall
because it requires an acknowledgment of the disclosure by retail
customers.
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\26\ For purposes of this operating standard, a retail customer
is any customer that is not an ``accredited investor'' as defined in
17 CFR 230.501(a).
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While commenters favored limiting customer disclosure requirements
to retail customers, they objected to extending the reach of the
Interagency Statement to activities conducted off bank premises, and
thereby to requiring retail customers to sign and return an
acknowledgment in those circumstances. Commenters contended that
requiring the disclosures to be made off bank premises does not further
the purpose of the requirement, which is to prevent customer confusion
regarding whether products offered by a section 20 subsidiary are
federally insured or guaranteed by an affiliated bank. One commenter
noted that the NASD has sought SEC approval of a new rule that is
designed to require disclosures consistent with those required by the
Interagency Statement.\27\
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\27\ NASD Notice to Members 96-3, NASD Files with the SEC
Proposed Rule Governing Members Operating on Bank Premises, (January
1996) and NASD Notice to Members 97-26, NASD Regulation Files
Amendment to Bank Broker-Dealer Rule (May 1997).
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The Board continues to believe that it is appropriate for a section
20 subsidiary to provide the disclosures required by the Interagency
Statement to all of its retail customers. As set forth in the
Interagency Statement, customer acknowledgment of these disclosures
will be required only at the time that a customer opens an account with
the section 20 subsidiary, and therefore should not be unduly
burdensome to obtain. Thus, this disclosure provides some benefit at
minimal cost. The Board notes that when it rejected a suggestion that a
section 20 subsidiary be required to have a different name or logo from
a banking affiliate, it relied in part on the disclosures that would be
given to customers.\28\
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\28\ 1989 Order at 209-210.
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E. Marketing Activities on Behalf of an Underwriting Subsidiary
Firewall 15 (Restriction on Advertising Bank Connection)
Existing firewall. Prohibits a section 20 affiliate and any
affiliated bank from engaging in advertising or entering into an
agreement stating or suggesting that the bank is responsible for the
section 20 affiliate's obligations.
Proposal. The Board proposed to rescind this firewall as
superfluous.
Final action. This firewall is now duplicated by section 23B(c) of
the Federal Reserve Act,\29\ and therefore the Board is rescinding it.
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\29\ 12 U.S.C. 371c-1(c).
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Firewall 16 (Cross-Marketing and Agency Activities by Banks)
This firewall was rescinded in 1996.\30\
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\30\ 61 FR 57679, 57683 (1996).
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F. Investment Advice by Bank/Thrift Affiliates
Firewall 17 (Expressing an Opinion on Securities)
Existing firewall. Prohibits a bank from expressing an opinion on
the value or the advisability of the purchase or the sale of bank-
ineligible securities underwritten or dealt in by a section 20
affiliate unless the bank notifies the customer that the section 20
affiliate is underwriting, making a market, distributing or dealing in
the security.
Proposal. The Board proposed to retain this restriction but sought
comment on whether it should only prohibit expressing an opinion when
the employee has knowledge of the affiliate's role.
Final action. The Board is retaining this restriction, with a
knowledge requirement added, as Operating Standard # 4. SEC Rule 10b-10
and NASD Rule 2250 already require a broker-dealer to provide written
disclosure to a customer that it is a market maker in a security at or
before completion of a transaction in the 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 operating standard extends these restrictions to an
affiliated bank because it would have a similar financial incentive to
give advice that would benefit its affiliate.
Commenters argued for either elimination of the firewall or
addition of a knowledge standard. Several commenters stressed that the
existing firewall essentially requires routine, widespread disclosure
of securities-related information throughout a bank holding company
system in order to ensure that employees provide the required
disclosure whenever a section 20 affiliate has a role in the
transaction. This approach is fundamentally inconsistent with the
``Chinese Wall'' procedures prevalent throughout the investment banking
industry, which address the same conflict-of-interest problem by
narrowly restricting the flow of information to those whose possession
of such information could not create a conflict of interest. One
commenter also noted that the existing firewall is difficult to enforce
for large, diversified bank holding companies because it requires that
information on all securities ``dealt in'' by the company be
disseminated to every area in the holding company system where ``an
opinion on the value or the advisability'' of a securities transaction
might be expressed.
The Board has concluded that these concerns can be abated, and the
potential conflict of interest raised by such advice still addressed,
by retaining the requirement with a knowledge standard added. Thus,
when the bank employee providing the investment advice knows of a
section 20 affiliate's role in an underwriting--as might be the case
with a dual employee--the employee must give the required disclosure.
Regardless of the employee's knowledge, the Board notes that any
potential for a conflict of interest is diminished because any dual
employee is generally prohibited from receiving compensation for
recommending an affiliate's securities.\31\
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\31\ Any dual employee engaged in the investment banking or
securities business of an NASD member must be registered as a
representative with the NASD and comply with its rules. NASD Rule
1031(a), 0115(a). The NASD consistently has taken the position in
published interpretations that it is improper for a member or a
person associated with a member to make payments of ``finders'' or
referral fees to third parties who introduce or refer prospective
brokerage customers to the firm, unless the recipient is registered
as a representative of an NASD member firm. Although the NASD has a
limited exception for ``one-time fees,'' the exception does not
include fees tied to the completion of a transaction or the opening
of an account.
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One commenter asked the Board to clarify that an opinion on the
value of a security provided by the custodial department of the bank is
not covered. Rather, the operating standard should be limited to
expressing an opinion on the advisability of purchasing or selling a
security. The Board agrees.
Firewall 18 (Restriction on Fiduciary Purchases During Underwriting
Period or From Market Maker)
Existing firewall. Prohibits a bank holding company and any of its
bank, thrift, trust or investment advisory
[[Page 45303]]
subsidiaries from purchasing, as a trustee or in any other fiduciary
capacity, for accounts over which they have investment discretion,
bank-ineligible securities (a) underwritten by a section 20 affiliate
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 section 20 affiliate if it
makes a market in that security, unless 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.
Proposal. The Board proposed to rescind this firewall.
Final notice. The Board is rescinding this firewall as superfluous.
Section 23B(b)(1)(B) of the Federal Reserve Act duplicates the
restrictions of Firewall 18 when a bank or thrift is making the
purchase.\32\ Indeed, in its 1987 order first imposing this firewall,
the Board noted that section 23B was pending as proposed legislation.
Section 23B explicitly prohibits a bank from purchasing, as principal
or fiduciary, any security for which a section 20 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.
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\32\ 12 U.S.C. 371c-1(b)(1)(B).
---------------------------------------------------------------------------
Firewall 18 is broader than section 23B in that it applies for 60
days after the underwriting period. However, the Board is not aware of
any evidence to justify imposing a restriction that Congress apparently
decided was unnecessary in the same context, and commenters did not
urge it to do so.
Firewall 18 is also broader than section 23B in that the firewall
also applies when a bank holding company or its nonbank subsidiary (and
not just a bank) purchases the securities as fiduciary. However,
nonbank affiliates of broker-dealers outside of a bank holding company
are not subject to such a firewall.
Rather, potential conflicts of interest are addressed by other
statutes or regulations. If the purchase is on behalf of a pension
plan, then the fiduciary is subject to the standard of care imposed by
ERISA.33 If the purchase is on behalf of a mutual fund, then
sections 10 and 17 of the Investment Company Act of 1940 restrict the
ability of the mutual fund to purchase securities from an affiliate of
the investment advisor.34 The Board has concluded that these
protections, in addition to state laws, are sufficient in the bank
holding company context as well.
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\33\ 29 U.S.C. 1002(21), 1104.
\34\ 15 U.S.C. 80a-10, 80a-17.
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G. Extensions of Credit and Purchases and Sales of Assets
Firewall 19 (Restrictions on Purchases as Principal During Underwriting
Period or From Market Maker)
Existing firewall. Generally prohibits a bank holding company and
any of its subsidiaries from purchasing, as principal, bank-ineligible
securities that are underwritten by a section 20 subsidiary during the
period of the underwriting and for 60 days after the close of the
underwriting period, or purchasing from the section 20 subsidiary any
bank-ineligible security in which the section 20 subsidiary makes a
market.
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall, which was
intended to prevent a section 20 affiliate from selling unattractive
issues to its affiliates. In practice, the firewall has prevented bank
and nonbank subsidiaries of a bank holding company subsidiary from
obtaining attractive issues underwritten or dealt in by a section 20
affiliate. Other restrictions provide sufficient protection to the
bank. As noted above with respect to Firewall 18, section 23B 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 the
bank or any affiliate. Section 23B also requires purchases to be on
market terms, and section 23A will apply if the bank purchases the
security as principal directly from the section 20 affiliate. The bank
would also be required to hold capital against these exposures.
Moreover, member banks are limited to purchasing only investment
securities, generally investment grade debt where compliance with
section 23B will be readily determinable.35
---------------------------------------------------------------------------
\35\ 12 U.S.C. 24 (Seventh), 335.
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Finally, 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 and no
supervisory concerns have arisen from this practice.36 The
SEC has recently permitted investment companies to purchase limited
amounts of securities for which an affiliate is acting as a principal
underwriter.37
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\36\ J.P. Morgan & Co., 76 Federal Reserve Bulletin 26, 28
(1990).
\37\ Exemption for the Acquisition of Securities During the
Existence of an Underwriting or Selling Syndicate, SEC Investment
Company Act Release No. 22775 (July 31, 1997). In addition to
limiting the amount of such purchases, the SEC requires that the
securities be purchased ``prior to the end of the first day on which
any sales are made, at a price that is not more than the price paid
by each other purchaser of securities in that offering or in any
concurrent offering of the securities.'' This standard is akin to
the market-terms requirement of section 23B of the Federal Reserve
Act.
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Firewall 20 (Restriction on underwriting and dealing in affiliates'
securities)
Existing firewall (as amended). Generally prohibits a section 20
affiliate from underwriting or dealing in any bank-ineligible
securities issued by its affiliates or representing an interest in, or
secured by, obligations originated or sponsored by its affiliates,
unless they 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).
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall. NASD Rule 2720
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 either (1) the securities must be rated by a
qualified, independent rating agency, (2) 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, or (3) in the case of equity securities only, there must be
an independent market in the security. The Board has concluded that
this protection is sufficient in the bank holding company context.
Firewall 21(a) (Prohibition on Extensions of Credit to Section 20
Subsidiary)
Existing firewall. Requires a bank holding company to ensure that
no bank subsidiary extends credit in any manner
[[Page 45304]]
to an affiliated underwriting subsidiary or a subsidiary thereof, or
issues a guarantee, acceptance, or letter of credit for the benefit of
a section 20 affiliate or a subsidiary thereof.
Proposal. The Board proposed to rescind this restriction except
insofar as it applies to intra-day extensions of credit for clearing
purposes, requiring that such intra-day extensions of credit be: (1) on
market terms consistent with section 23B of the Federal Reserve Act,
and (2) fully secured, even if the bank's general policy (and section
23B) does not require the bank to be fully secured in clearing.
Final action. The Board is rescinding the blanket prohibition on
funding, imposed by this firewall but retaining as Operating Standard
#5 the restriction on intra-day funding in modified form. Because the
operating standards apply to all section 20 subsidiaries, the Board
will thereby be imposing this restriction for the first time on section
20 subsidiaries operating under the 1987 Order.
Commenters strongly supported elimination of the funding
restriction. As for the remaining restriction on intra-day credit,
several commenters opposed requiring that intra-day credit be fully
secured even when market practice is less stringent. One commenter
stressed that such loans are intended to be intra-day transactions to
finance the purchase of securities, and historically have been
extremely low-risk. The commenter argued that the proposed operating
standard would continue to put section 20 companies at a competitive
disadvantage to dealers outside of bank holding companies. Finally, the
commenter noted that although the Board has previously encouraged
clearing banks to obtain collateral to secure daylight overdrafts, it
has not required them to obtain collateral.
Another commenter asked the Board to clarify that any limit on
intra-day credit for clearing purposes would apply only to intra-day
overdrafts related to the bank's clearing of securities trades for the
affiliated section 20 company, and not to daylight overdrafts in demand
deposit accounts that an affiliated bank may maintain as a settlement
bank for a section 20 company that is a clearing member on an exchange
(whether the product being cleared is a security or a commodity.) The
commenter also asked the Board to clarify that the proposed standard
would not apply to intra-day overdrafts in deposit accounts maintained
at an affiliated bank as a settlement bank for a section 20 company
that is engaged in clearing futures, options on futures, options traded
on a nationally recognized securities exchange as a futures commission
merchant or as a broker-dealer. Lastly, the commenter asked the Board
to clarify whether removal of the funding firewall would allow a bank
lending securities to a section 20 affiliate to issue a guarantee or
indemnity to protect its customers against losses in the event of the
section 20 company's nonperformance.
The Board is rescinding the general prohibition on
funding.38 A bank's funding of an affiliate will continue to
be limited by sections 23A and 23B of the Federal Reserve Act. Thus, a
bank will be subject to the quantitative limitations of section 23A,
will have to deal with the section 20 affiliate on market terms, will
be prohibited from purchasing low-quality assets from the affiliate,
and will be prohibited from purchasing securities underwritten by a
section 20 affiliate during the existence of the underwriting or
selling syndicate unless a majority of the bank's outside board of
directors approves. These restrictions have been sufficient with
respect to the fourteen companies operating under the 1987 Order that
have not been subject to this firewall.
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\38\ Although the funding firewall will permit a bank lending
securities to issue a guarantee or indemnification in case of a
section 20 affiliate's non-performance, any such transaction will be
subject to sections 23A and 23B of the Federal Reserve Act.
---------------------------------------------------------------------------
The Board will continue to prohibit intra-day extensions of credit
for clearing or other purposes unless they are on market terms
consistent with section 23B of the Federal Reserve Act. In effect, the
Board is requiring that the bank apply to a section 20 affiliate the
same internal exposure limits and collateral requirements for intra-day
credit that it applies to third parties. The Board believes that the
application of section 23B to all intra-day extensions of credit to a
section 20 affiliate is appropriate to ensure that such credit is not
subsidizing the activities of the section 20 affiliate to the detriment
of the bank and the section 20 affiliate's competitors. However, the
Board will not require that intra-day extensions of credit be fully
secured when market practice does not.
Finally, the operating standard being adopted by the Board applies
sections 23A and 23B of the Federal Reserve Act to U.S. branches and
agencies of foreign banks for purposes of extensions of credit to a
section 20 affiliate. Under the current firewall, lending to a section
20 affiliate by a U.S. branch and agency of a foreign bank is
prohibited, as is lending by a U.S. bank.39 Elimination of
the firewall and adoption of this operating standard will liberalize
the funding restriction for U.S. branches and agencies of foreign banks
to the same extent that the restriction is liberalized for U.S. banking
organizations.
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\39\ 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).
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Commenters sought clarification on how certain provisions of
sections 23A and 23B would apply to U.S. branches and agencies of
foreign banks. In applying the quantitative limitations of sections 23A
and 23B, a U.S. branch or agency of a foreign bank shall refer to the
capital of its foreign bank parent as calculated under its home country
capital standards if the home country supervisor of the foreign bank
has adopted capital standards consistent in all respects with the
Capital Accord of the Basle Committee on Banking Supervision (Basle
Accord). If the home country supervisor has not adopted capital
standards consistent in all respects with the Basle Accord, the branch
or agency shall refer to the capital of its foreign bank parent as
calculated under standards applicable to U.S. banking organizations.
Furthermore, in applying the provisions of section 23B that require
outside director approval for certain transactions, a foreign bank may,
at its option, seek approval for a transaction from a majority of the
senior executive officers of the foreign bank who are both located
outside the U.S. and are not officers or employees of any U.S. branch
or agency of the foreign bank.
Firewall 21(b)
Existing firewall. Established an exception to Firewall 21(a) for
clearing purposes.
Proposal. If Firewall 21(a) were rescinded, the Board proposed to
rescind Firewall 21(b) as moot.
Final action. The Board is rescinding this firewall.
Firewall 22 (Financial Assets Restriction).
Existing firewall (as amended).40 Prohibits a bank (or
U.S. branch or agency of a foreign bank) from purchasing for its own
account any financial assets of a section 20 affiliate or a subsidiary
thereof, or selling from its own account such assets to the section 20
affiliate or a subsidiary thereof. The limitation does not apply to
[[Page 45305]]
the purchase and sale of assets having a readily identifiable and
publicly available market quotation and purchased at that market
quotation (and therefore exempt from section 23A of the Federal Reserve
Act), provided that those assets are not subject to a repurchase or
reverse repurchase agreement.
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\40\ 61 FR 57679, 57683.
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Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall, which was
designed to prevent a bank from using purchases and sales as a means of
evading Firewall 21 and indirectly funding a section 20 affiliate. The
same protections on which the Board has relied in permitting direct
funding will still require that all such purchases be made on market
terms, and section 23A of the Federal Reserve Act will impose
quantitative limits. Section 23A also generally prohibits a bank from
purchasing a low-quality asset from an affiliate.41
Moreover, the National Bank Act limits the type of investment
securities that a national bank may hold, generally to investment grade
debt securities.
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\41\ 12 U.S.C. 371c(a)(3), (b)(10).
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Elimination of this restriction will 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, and market terms
generally require over-collateralization with government securities.
The Board notes that as a safety and soundness matter, it generally
emphasizes that section 20 subsidiaries should develop diverse funding
sources. Thus, a section 20 company should not rely on repurchase
agreements with an affiliated bank as its sole funding source.
H. Limitations on Transfers of Information
Firewall 23 (Disclosure of Nonpublic Information)
Existing firewall. Prohibits a bank from disclosing to a section 20
affiliate or a section 20 affiliate from disclosing to an affiliated
bank, any nonpublic customer information (including an evaluation of
the creditworthiness of an issuer or other customer of that bank, or
underwriting subsidiary) without the consent of that customer.
Proposal. The Board proposed to include this firewall as an
operating standard.
Final action. The Board is rescinding this firewall and not
adopting the proposed operating standard. Many commenters objected to
retention of this restriction. These commenters argued that although
the restriction was initially implemented to prevent a section 20
subsidiary from gaining an unfair competitive advantage through access
to its affiliated bank's credit files, it now places section 20
subsidiaries at a competitive disadvantage. Investment banks not
affiliated with bank holding companies increasingly have access to
financial information of issuers through participation in syndicated
and other commercial lending transactions, yet they may share that
information with their affiliates.
These commenters also noted that the restriction is at odds with,
and impracticable in light of, the Board's recent removal of the cross-
marketing and dual employee restrictions, which will entail sharing of
nonpublic information. Commenters also contended that existing
statutory and regulatory provisions such as the Fair Credit Reporting
Act and state consumer privacy statutes are adequate to protect retail
customers, and that retention of the restriction would impede customer
convenience. Commenters noted that the Board has recently removed
restrictions on the sharing of customer information between a bank and
an affiliate engaged in providing investment advice or full-service
brokerage.42 Finally, one commenter noted that many
customers, particularly large institutional customers, simply assume
the sharing of information will occur consistent with applicable law.
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\42\ 62 FR 9336 (1997) (amending 12 CFR 225.28(b)(7)(i)).
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After considering these comments, the Board has decided not to
adopt this operating standard, as the chances for a bank holding
company to gain a competitive advantage or harm a customer through the
sharing of information appear to be remote. The Board will continue to
monitor this area to determine if abuses do occur.
I. Reports
Firewall 24 (Reports to Federal Reserve)
Existing firewall. Requires bank holding companies to submit
quarterly to the appropriate Federal Reserve Bank copies of FOCUS
reports filed with the NASD or other self-regulatory organizations, and
detailed information breaking down the section 20 subsidiary's business
with respect to eligible and bank-ineligible securities.
Proposal. The Board proposed to retain this requirement in modified
form as one of the operating standards.
Final action. The Board is retaining this requirement as Operating
Standard #7, as it wishes the filing of these reports to be a condition
of section 20 approval and enforceable as such.
J. Transfer of Activities and Formation of Subsidiaries of an
Underwriting Subsidiary to Engage in Underwriting and Dealing
Firewall 25 (Scope of Order)
Existing firewall. Clarifies that approval of a section 20
application extends only to the subsidiaries for which approval has
been sought in the instant application. Also prohibits any corporate
reorganization without prior Board approval.
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this information, as each
order approving section 20 activities makes plain the scope and
organizational structure of the activities approved.
K. Limitations on Reciprocal Arrangements and Discriminatory Treatment
Firewall 26 (Prohibition on Reciprocity Arrangements)
Existing firewall. Prohibits a bank holding company or any
subsidiary from entering into any reciprocity arrangement. A
reciprocity 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 the firewalls or any prohibition on transactions between, or
for the benefit of, affiliates of banks established pursuant to federal
banking law or regulation.
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding 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 1970.43 The Board will rely on the
examination process to identify any evasions of the proposed operating
standards.
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\43\ 12 U.S.C. 1972(1).
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[[Page 45306]]
Firewall 27 (Prohibition on Discriminatory Treatment)
Existing firewall. Prohibits a bank from:
(a) Extending or denying credit or services (including clearing
services), or varying the terms or conditions thereof, if the effect of
such action would be to treat an unaffiliated securities firm less
favorably than its section 20 affiliate; or
(b) Extending or denying credit or services or varying the terms or
conditions thereof with the intent of creating a competitive advantage
for a section 20 affiliate.
Proposal. The Board proposed to rescind this firewall.
Final action. The Board is rescinding this firewall. This firewall
addresses a potential conflict of interest that arises when a bank is
dealing with competitors of its section 20 affiliate. However, other
laws adequately address or diminish the potential for conflict of
interest. 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.44 Thus, the possibility that a bank would be
able to enforce unfavorable credit terms on a competitor of a section
20 affiliate is remote. Second, section 106 of the Bank Holding Company
Act Amendments of 1970 prohibits a bank from, among other things,
restricting the 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.
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\44\ National Securities Markets Improvement Act of 1996, Pub.
L. 104-290 (1996) (amending 15 U.S.C. 78h(a)(1995)) .
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L. Requirement for Supervisory Review Before Commencement of Activities
Firewall 28 (Infrastructure Review)
Existing firewall. Requires a review of a bank holding company's
policies and procedures--including computer, audit and accounting
systems, internal risk management controls and the necessary
operational and managerial infrastructure--before approval to commence
corporate debt and equity underwriting and dealing activities.
Proposal. The Board proposed to require an infrastructure review in
the context of each application rather than including it as an
operating standard for section 20 subsidiaries.
Final action. The Board is rescinding the firewall. 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. 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. In special cases, such as an
acquisition of a going concern, the inspection will occur as soon as
possible after consummation.
For the foregoing reasons, the Board is (1) rescinding conditions
2-20 in its 1987 Order (and any other order incorporating those
conditions), conditions 1-28 in its 1989 Order (and any other order
incorporating those conditions), and conditions 1-28 in its 1990 Order
(and any other order incorporating those conditions).
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 amends 12 CFR
Part 225 as follows:
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, 3907,
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. Under section 20 of the Glass-Steagall Act (12
U.S.C. 377) and section 4(c)(8) of the Bank Holding Company Act (12
U.S.C. 1843(c)(8)), a nonbank subsidiary of a bank holding company may
to a limited extent underwrite and deal in securities for which
underwriting and dealing by a member bank is prohibited. 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, transactions between insured depository
institutions and their section 20 affiliates are restricted by sections
23A and 23B of the Federal Reserve Act (12 U.S.C. 371c and 371c-1). 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), and instituting appropriate risk
management, including independent trading and exposure limits
consistent with parent company guidelines.
(b) Conditions. As a condition of each order approving
establishment of a section 20 subsidiary, a bank holding company shall
comply with the following conditions.
(1) Capital. (i) A bank holding company shall maintain adequate
capital on a fully consolidated basis. If operating a section 20
authorized to underwrite and deal in all types of debt and equity
securities, a bank holding company shall maintain strong 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, 12 U.S.C. 1831o), and
the bank holding company shall fail to restore it promptly to the well
capitalized level, the Board may, in its discretion, reimpose the
funding, credit extension and credit enhancement firewalls contained in
its 1989 order allowing underwriting and dealing in bank-ineligible
securities,1 or order the bank holding company to divest the
section 20 subsidiary.
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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).
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(iii) A foreign bank that operates a branch or agency in the United
States shall maintain strong capital on a fully consolidated basis at
levels above the minimum levels required by the Basle Capital Accord.
In the event that the Board determines that the foreign bank's capital
has fallen below these levels and the foreign bank fails to restore its
capital position promptly, the Board may, in its discretion, reimpose
the funding, credit extension and credit enhancement firewalls
contained in its 1990 order allowing foreign banks to underwrite and
deal in bank-ineligible securities,2 or order the foreign
bank to divest the section 20 subsidiary.
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\2\ Firewalls 5-8, 19, 21 and 22 of Canadian Imperial Bank of
Commerce, The Royal Bank of Canada, Barclays PLC and Barclays Bank
PLC, 76 Federal Reserve Bulletin 158, (1990).
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[[Page 45307]]
(2) Internal controls. (i) Each bank holding company or foreign
bank shall cause its subsidiary banks, thrifts, branches or agencies
3 to adopt policies and procedures, including appropriate
limits on exposure, to govern their participation in transactions
underwritten or arranged by a section 20 affiliate.
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\3\ The terms ``branch'' and ``agency'' refer to a U.S. branch
and agency of a foreign bank.
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(ii) Each bank holding company or foreign bank shall ensure that an
independent and thorough credit evaluation has been undertaken in
connection with participation by a bank, thrift, or branch or agency in
such transactions, and that adequate documentation of that evaluation
is maintained for review by examiners of the appropriate federal
banking agency and the Federal Reserve.
(3) Interlocks restriction. (i) Directors, officers or employees of
a bank or thrift subsidiary of a bank holding company, or a bank or
thrift subsidiary or branch or agency of a foreign bank, shall not
serve as a majority of the board of directors or the chief executive
officer of an affiliated section 20 subsidiary.
(ii) 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 subsidiary or branch
or agency, except that the manager of a branch or agency may act as a
director of the underwriting subsidiary.
(iii) For purposes of this standard, the manager of a branch or
agency of a foreign bank generally will be considered to be the chief
executive officer of the branch or agency.
(4) Customer disclosure--(i) Disclosure to section 20 customers. A
section 20 subsidiary shall provide each of its retail customers
4 the same written and oral disclosures, and obtain the same
customer acknowledgment, required by the Interagency Statement on
Retail Sales of Nondeposit Investment Products as if it were a
depository institution.
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\4\ For purposes of this operating standard, a retail customer
is any customer that is not an ``accredited investor'' as defined in
17 CFR 230.501(a).
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(ii) Disclosures accompanying investment advice. A director,
officer, or employee of a bank, thrift, branch or agency may not
express an opinion on the value or the advisability of the purchase or
the sale of a bank-ineligible security that he or she knows is being
underwritten or dealt in by a section 20 affiliate unless he or she
notifies the customer of the affiliate's role.
(5) Intra-day credit. Any intra-day extension of credit to a
section 20 subsidiary by an affiliated bank, thrift, branch or agency
shall be on market terms consistent with section 23B of the Federal
Reserve Act.
(6) Restriction on funding purchases of securities during
underwriting period. No bank, thrift, branch or agency shall knowingly
extend credit to a customer secured by, or for the purpose of
purchasing, any bank-ineligible security that a section 20 affiliate is
underwriting or has underwritten within the past 30 days, unless:
(i) The extension of credit is made pursuant to, and consistent
with any conditions imposed in a preexisting line of credit that was
not established in contemplation of the underwriting; or
(ii) The extension of credit is made in connection with clearing
transactions for the section 20 affiliate.
(7) Reporting requirement. (i) Each bank holding company or foreign
bank shall submit quarterly to the appropriate Federal Reserve Bank any
FOCUS report filed with the NASD or other self-regulatory
organizations, and any information required by the Board to monitor
compliance with these operating standards and section 20 of the Glass-
Steagall Act, on forms provided by the Board.
(ii) In the event that a section 20 subsidiary is required to
furnish notice concerning its capitalization to the Securities and
Exchange Commission pursuant to 17 CFR 240.17a-11, a copy of the notice
shall be filed concurrently with the appropriate Federal Reserve Bank.
(8) Foreign banks. A foreign bank shall ensure that any extension
of credit by its 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 or suggest that they are
responsible for the obligations of a section 20 affiliate, consistent
with section 23B(c) of the Federal Reserve Act.
By order of the Board of Governors of the Federal Reserve
System, August 22, 1997.
William W. Wiles,
Secretary of the Board.
[FR Doc. 97-22840 Filed 8-26-97; 8:45 am]
BILLING CODE 6210-01-P
