After World War II, the U.S. banking industry was insulated from competitive pressures by various types of government regulations (e.g., interstate branching restrictions, restrictions against the mixing of banking and securities activities,...). This insulation was eventually destroyed by various market forces (e.g., the growing reliance by corporate borrowers on the commercial paper market and the eurodollar market) and the introduction of new financial products (e.g., the development of money market funds).
Larger and more sophisticated banks found imaginative ways to meet these competitive challenges (introduction of negotiable certificates of deposit, growing use by banks of the eurodollar market, provision of corporate credit lines,...). Nevertheless, a profound shift was clearly taking place. Borrowers who had traditionally relied on bank credit were increasingly turning to securities markets for their borrowing needs. Unlike banks, securities firms were essentially free to evolve in response to changes in markets and financial products.
Many U.S. policy makers worried that this shift from bank credit to securities markets threatened the financial soundness of the U.S. banking industry. This concern led to major restructuring efforts in the 1990s. One key piece of legislation was the 1994 Riegle-Neal Act, which abolished restrictions on interstate branching. A second key piece of legislation was the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (GLB Act). The latter act relaxed the provisions of the 1933 Glass-Steagall Act requiring separation of banking and securities activities while attempting to maintain special safety-net protections for depository institutions.
The following notes focus on the basic features and effects to date of the GLB Act.
FHC: A New Financial Entity Introduced Under the GLB Act:
New financial activities authorized under the GLB Act can only be exercised by a new type of financial organization, called a financial holding company (FHC).
A bank holding company (BHC) is any organization that includes a bank among its components. An FHC is a BHC, but not all BHCs are FHCs. An FHC is a BHC that meets certain additional statutory qualifications.
In particular, in order for a BHC to be an FHC, each of its subsidiary banks must be well managed, well capitalized, and have a rating of at least satisfactory under the Community Reinvestment Act (CRA).
Key Provisions of the GLB Act:
1. The GLB Act authorizes FHCs to engage in financial activities subject to several limitations and protections. For example, FHCs are allowed to engage in insurance underwriting and sales, securities underwriting and dealing, and "merchant banking" (the ownership of securities for ultimate resale), as well as existing permissible activities for BHCs such as lending, investment advisory, financial data processing services, and certain management consulting services.
2. The GLB Act also authorizes FHCs to engage in any nonfinancial activity that the Federal Reserve Board determines is complementary to a financial activity and poses no substantial risk to the safety and soundness of depository institutions or the financial system.
3. BHCs that are not FHCs are still prohibited from mixing banking and securities activities.
4. The GLB Act confirms the Federal Reserve as the umbrella supervisor of both BHCs and FHCs subject to limitations collectively referred to as "Fed-lite." Specifically, it requires that: (a) the Federal Reserve supervise all BHCs (including FHCs); (b) primary bank regulators regulate and supervise all banking subsidiaries; and (c) functional regulators supervise and regulate select nonbank components.
5. The GLB Act endorses the view that the primary focus of the Federal Reserve's supervisory attention should be on the balance-sheet and off-balance-sheet risk exposure of BHCs and FHCs that could adversely affect insured depository institutions.
6. The GLB Act enhances privacy protections regarding the dissemination of customer account information to third parties.
7. The GLB Act includes several provisions that affect the implementation of the Community Reinvestment Act (CRA), including the requirement that a BHC cannot become an FHC unless all of the BHC's insured depository institutions have a CRA rating of satisfactory or better.
Since the GLB Act, the frequency of inter-industry mergers between banks and securities firms has not been as high as predicted. However, some major mergers have taken place: for example, Charles Schwab with U.S. Trust; and the affiliation of Travelers, Solomon, and Citicorp.
Twenty-four of the largest twenty-five BHCs have chosen to acquire FHC status. In total, about 570 domestic and foreign bank organizations have applied for and met (at at least initially) the statutory requirements for FHC status.
The largest FHCs have used their new merchant banking powers to initiate or enhance securities activities -- for example, the management of private equity funds for venture capital investment. Smaller FHCs have most commonly used their new merchant banking powers to acquire insurance brokerage entities without the previously imposed need to abide by severe location constraints.
Under the GLB Act, FHCs can complete the acquisition of non-depository subsidiaries before giving any notice of such acquisitions to the Federal Reserve, and many FHCs have taken advantage of this.
The effects of the new "Fed-lite" supervisory process on the performance of the financial sector remain to be seen. In particular, will the Federal Reserve be able to monitor effectively the activities of FHC managers and, when needed, to direct these managers to correct risk exposures that could impair the financial soundness of an FHC and its depository subsidiaries?