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Have We Only Just Begun?

Challenges in implementing the Gramm-Leach-Bliley regime

March 1, 2000


Ron J. Feldman Assistant Vice President
Niel Willardson Senior Vice President and General Counsel (former)
James M. Lyon Senior Vice President
Have We Only Just Begun?

History shows that expanding the powers of banking organizations while maintaining an adequate supervisory framework to prevent excessive risk taking is a daunting task. Past expansions of bank powers have, unfortunately, often been coupled with inadequate policy regimes for addressing new risk-taking opportunities. Not infrequently, additional legislation has subsequently been required to establish a more robust response. Although it is difficult to predict, this pattern may repeat itself with the Gramm-Leach-Bliley (GLB) Act of 1999. In our view, the provisions of GLB result in four significant implementation challenges.

First, it is not clear whether regulators can effectively identify and respond to inadequate risk management in the largest banking organizations.

Second, the objectives of holding company regulation and supervision may be too vague under the GLB framework, as are the means by which GLB will be implemented.

Third, the shift to functional regulation (securities regulators examining securities firms regardless of affiliation, bank regulators examining banks, etc.) will require difficult-to-achieve coordination between regulators.

Finally, these challenges may lead creditors of nonbanking financial firms affiliated with banking organizations to believe they will receive government protection if these firms fail. Such thinking could lead to excessive risk taking by these nonbanking affiliates.

Obviously Congress can enact additional safeguards if these implementation challenges prove too serious to adequately address within the GLB framework. Potential congressional responses include (1) consolidating regulators, (2) increasing the command and control authority of regulators, and (3) expanding the role of the market's assessment of banking organization risk taking in the regulatory process. Increasing regulatory authority has been the usual response in previous legislative efforts to repair the results of expanded powers. However, increased use of markets may have a greater chance of passage this time thanks, in part, to some of the provisions in GLB.

The historical premise: Expansion of powers but incomplete regulatory responses

The passage of GLB was the culmination of a multidecade effort to eliminate many of the restrictions on the activities of banking organizations. Nothing as comprehensive as GLB has been approved in the past, but over the years Congress enacted a variety of smaller steps to increase the powers of banks. While this historical record is complex and somewhat ambiguous it suggests a general trend—Congress expands the powers of banking organizations only to find that the regulatory structure it created to address the potential for increased risk taking is deficient.

Two laws passed during the 1980s, the Depository Institutions Deregulation and Monetary Control Act and the Garn-St. Germain Depository Institutions Act, illustrate this trend. Both laws took steps, such as removing interest rate ceilings on deposit accounts and broadening permissible activities, to deregulate the banking industry. In adopting these expanding authorities for banks, legislators and regulators assumed that the existing regulatory framework adequately addressed the risk taking that the new powers made possible.

However, thrift and bank failures in the mid-1980s and early 1990s demonstrated that risk taking was not adequately under control. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was the first step to redress the deficiencies of the earlier legislation. This law increased the powers of regulators to take action against banks deemed to be high risk. FIRREA was followed by the FDIC Improvement Act of 1991, which created a supervisory system characterized by more frequent examinations, additional capital, and immediate and automatic action against banks with financial problems.

The question facing analysts of GLB, and ultimately the public, is whether this cycle will occur again. The importance of this question is underscored by the fact that sandwiched between expansion legislation of the early 1980s and the regulatory regime of the late 1980s and early 1990s were billions of dollars of losses to deposit insurance funds.

How GLB addresses expanded powers

The authors of GLB did not merely assume that the existing regulatory structure was sufficient to address the new powers available to banking organizations. Rather, the legislation takes some steps to mitigate against risk taking associated with new powers.

  • Restriction of powers. GLB provides methods for banking organizations to carry out securities, insurance, merchant banking and other powers while restricting the powers in at least three ways. First, the law forbids certain activities outright, such as commercial operations unrelated to financial activities. Second, the law requires certain activities to be carried out by subsidiaries of the financial holding company (FHC) rather than the bank itself. Finally, regulators have the authority to determine what new powers will be allowed in the future.

  • Institutions must be "fit." GLB restricts the grant of expanded powers to institutions that meet several regulatory tests of financial and regulatory health. In general, the insured banks controlled by organizations that carry out the new powers have to meet a capital test, be "well managed, and have a satisfactory or better rating under the Community Reinvestment Act." Firms have a deadline to get back into compliance if they fail to meet these standards in the future. Regulators can require banking organizations to cease new activities and even divest if noncompliance continues.

  • The Fed's role in FHCs. The Federal Reserve will supervise and regulate FHCs. The Federal Reserve will have access to data on risks across the entire organization, as well as information on the firm's management of those risks. Regulators will thus be in position to evaluate and presumably act on risks that threaten the safety and soundness of the insured banks. The Federal Reserve can also require FHCs to hold capital to absorb losses that they face.

  • Limiting safety net spillovers. GLB takes a variety of steps to limit the chance that nonbank creditors will think they are insulated from financial loss. These creditors might infer such protection because many creditors of their large bank affiliates assume government bailouts will shield them from loss. Moreover, regulators fearing systemic risk or contagion may have incentives to protect these creditors to prevent other banking organizations, which may have direct exposure or similar operations to the failing firm, from suffering losses. To limit this so-called safety net spillover, GLB takes the following steps:

    • Requires nonbanking activities to take place in legal entities separate from the bank.
    • Limits the transactions that can occur between a bank and nonbank affiliates.
    • Creates a system of functional regulation to limit direct contact between bank examiners and nonbanking affiliates.

The open question is whether the responses of GLB to limit risk taking will prove effective given the challenges the new policy regime will face.

Challenges facing the GLB framework

There are at least four major areas where the GLB framework will face challenges: (1) regulatory identification and response to high-risk activities, (2) holding company supervision and regulation, (3) functional regulation and (4) limits on safety net spillovers.

Identification and response to high-risk activities
Bank regulation relies primarily on the regulators' ability to determine how much risk is posed by the banking organization's various operations. GLB continues this general approach of depending on identification of risks by regulators. Yet, the growing complexity of the largest banking organizations has made it more difficult for regulators to master the operations of the firms they supervise. This task will likely be even more complicated as banking organizations move into GLB-approved activities where supervisors have less experience, such as merchant banking.

Even if ex ante identification of potential problems was not an issue, the response to problems envisioned by GLB might be. As noted, GLB gives bank regulators the power to prevent out-of-compliance FHCs from carrying out expanded powers and allows forcible divestiture. Although these authorities sound reasonable and effective in theory, we have some doubt about their practical effect. This is especially true for the more Draconian sanctions, like divestiture. There is virtually no precedent to support the view that this sort of cleaving of the going concern can be accomplished without fatally damaging all of the component parts in the process. In other words, the costs of divestiture may be so high as to greatly reduce its use. This same logic applies to regulators' willingness to force a FHC to stop carrying out expanded activities that generate income. Regulators may be reluctant to take such actions for fear of making a banking organization even more vulnerable to failure.

Holding company supervision and regulation
GLB counts on effective supervision of holding companies to protect against failures of insured depositories. However, the effectiveness of this holding company supervision and even its objectives are somewhat unclear in the new GLB environment. Traditionally, bank holding companies engaged in bank-focused activities and had a
bank-dominated culture. Banking or banking-like services were the core products for the consolidated entity resulting in a familiar framework in which banking supervisors could examine and judge the solvency of the holding company.

More recently holding companies have developed with more nonbanking assets and cultural influences and GLB will accelerate this trend. Indeed, one of the first firms to publicly announce its intent to become a FHC was Charles Schwab Inc., as part of its planned acquisition of U.S. Trust. For such organizations, it may be less obvious how the FHC's operations relate to the insured banks it controls. As a result, it will be unclear how to examine these FHCs and how to determine the objectives such exams should achieve.

Imposing new regulations on these FHCs will also raise significant challenges. For example, GLB gives the Federal Reserve the right to issue consolidated capital requirements for FHCs. Trying to determine the riskiness of the entire firm and thereby determine appropriate capital levels could prove nearly impossible. Regulators may therefore create relatively simple capital standards such as a leverage ratio (for example, a requirement that capital equal some percent of total assets). Yet, such simple measures, by definition, often end up setting capital at levels that are inadequate protection against failure or so high that they lead to distorted behavior on the part of banking organizations.

Functional regulation
There are at least two reasons to doubt the ultimate effectiveness of a system of functional regulation. First, the objectives and skills of the different regulators involved with supervision of FHCs and their subsidiaries vary considerably. For example, the primary mission of the securities regulators may lead to a focus on investor protection and market integrity rather than the "safety and soundness" of the securities firm. As a result, bank regulators may not find the reports and information generated by the securities regulators sufficient to ascertain the threat the securities affiliate poses to the insured banks. This perceived deficiency might encourage bank regulators to obtain direct examination access to the securities firm.

Second, functional regulation requires regulators to share information and operate in a coordinated fashion. At times regulators capture their conclusions in written reports, but much of their assessments will reside with the examiners themselves or in more informal written material. Distributing informal analysis poses a logistical test that could inhibit full sharing of data and analysis as could data security concerns. Whatever the reasons, failure to fully share information among regulators would limit accurate risk assessments.

Safety net spillovers
GLB took several steps to address the potential for spillover of the bank safety net. But, these steps may not change regulators' concerns and thus may not change creditors' perceptions. For example, GLB requires that many nonbanking activities take place outside the banking organization. This requirement places the creditors of nonbanking operations one step removed from the insured bank. But does this legal distinction change the underlying fear of contagion that motivates ex post protection in the first place? Likewise, we find it hard to accept that the presence or absence of functional regulation makes much difference for creditors. Is it credible to believe that policymakers are less concerned about the effect of a nonbank failure on an affiliated bank merely because bank examiners did not examine the nonbank firm? In total, GLB may not be particularly effective in limiting safety net spillovers. This limitation would make the regulators' job even more difficult because significant parts of the FHC will now face lower than previous levels of market discipline and therefore have an incentive to take on too much risk.

Additional reforms
The existence of challenges does not mean that the GLB framework is doomed to future amendments. Indeed, the framework created by the legislation could be the proper response to the new powers and new world in which banking organizations find themselves. If the challenges do prove too difficult to address, Congress has at least three types of additional reforms to which it could turn. These include consolidation of regulators, increased authority for bank regulators and increased use of market assessment of risks.

Consolidate regulators
If the coordination between multiple regulators poses a significant problem post-GLB, then one potential solution is some form of consolidation. Consolidation could occur between regulators (for example, combining securities and bank regulation) or within one type of regulator (for example, creating a national insurance regulator). These combinations might reduce regulatory burden and produce more coherent risk assessments. However, this type of reform has been suggested on many occasions only to raise serious objections focusing on a lack of regulatory options and the downsides of consolidating power.

Increase authority for bank regulators
Legislators who believe that banking organizations will take on too much risk post-GLB can give regulators more authority to limit the use of expanded powers. Such steps could include making it more difficult for firms to qualify for FHC status, placing additional restrictions on the types of new powers that are available to FHCs, and further constraining the types of exposures banks can have to nonbanking affiliates.

Legislators could also remove regulatory discretion in addressing the expanded powers of risky FHCs and provide risky firms with less due process. This could speed the delivery of supervisory action against these institutions when it is deemed appropriate. Congress has taken such steps in the past, including requiring specific regulatory actions based on a bank's capital levels.

The underlying concern with these reforms is the difficulty regulators face in setting the appropriate level of risk taking by banking organizations. Regulators surely identify many cases where risk taking is, in some sense, "too high" and respond appropriately. However, augmented regulatory power could lead to too little risk taking by banks. While due process surely allows additional risk taking it also protects against abuse of power.

Finding the right regulatory balance was becoming trickier before GLB became law. The underlying problem is the rising complexity and scope of operations of banking organizations as well as the blunt tools that regulators have at their disposal. In fact, these concerns have led this Reserve bank, among others, to call for Congress to consider a third option—the increased use of market signals and discipline—for reforming the legislative framework.

Increase market discipline
GLB envisions a slightly increased use of the market's assessment of risk in regulating banks. For example, the law requires certain banks carrying out expanded powers to have relatively high credit ratings. It also calls for a study of a plan that would put a group of creditors at large banking organizations at clearer risk of loss. The rationale and potential benefits of these aspects of GLB, along with a suggestion that the law did not go far enough, are discussed in detail in President Gary Stern's column. The gist of the argument is that bank creditors with money to lose can provide valuable price pressure on banking organizations and provide measures of banking organizations' riskiness through the prices they charge. This Reserve bank has long supported plans to increase such market discipline and ensure that the price signals are incorporated into the regulatory framework. Both steps should help manage risk taking, particularly by the new large banking organizations created by GLB. And while President Stern argues that the legislation does not go as far as it could in terms of market discipline or signals, he also notes that policymakers have an opportunity to better contain risk taking by fully exploiting the GLB framework in the future. We would only emphasize that market data and discipline initiatives are particularly well suited to bolster the potentially weak areas of GLB. Market-based reforms could provide additional risk assessments on large, complex organizations and would directly address safety net spillovers by putting creditors at credible risk of loss.


The recent expansion of powers for banking organizations may be the first of several legislative steps to adapt to a new banking environment. In particular, the law may not have created an adequate regime to manage the risk taking of the new banking organizations it created. If so, Congress may need to enact additional reforms and those based on market data and discipline may prove the most attractive.