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Is financial modernization anything new?

Limited available data suggests that rather than revolutionizing the financial system, GLB actually builds on the integration that already exists between banks and other financial service providers

April 1, 2000


Ron J. Feldman Assistant Vice President
Jason Schmidt Senior Financial Economist
Is financial modernization anything new?

The Gramm-Leach-Bliley Act of 1999 (GLB) purports to modernize the financial services industry by sweeping away the regulatory structure constructed in the post-Depression period. It is certainly true that GLB removed the patchwork series of government regulations that have barred commercial banks, insurance companies and securities firms from directly participating in one another's business activities. At the same time, the limited available data suggests that rather than revolutionizing the financial system, GLB actually builds on the integration that already exists between banks and other financial service providers.

The Gramm-Leach-Bliley Act: What does it allow?

Under the provisions of GLB, commercial banks, insurance companies and securities firms will be able to more freely affiliate or merge with one another. GLB accomplishes this through two means. The first is the creation of a new entity, the financial holding company (FHC), whose subsidiaries are able to engage in activities that are either financial in nature or incidental to such activities. Examples of permissible businesses include traditional banking, insurance underwriting and agency activity, securities underwriting and dealing, and merchant banking. The law permits only firms that own banks and that meet certain regulatory tests, of financial health for example, to become FHCs and set up these nonbanking subsidiaries. As of March 23 just under 150 bank holding companies had been authorized by the Federal Reserve Board to become FHCs.

The second method for exercising new powers is through a subsidiary of the bank itself rather than the firm or holding company that owns the bank. These bank subsidiaries can engage in activities that are financial in nature as well, although they face more restrictions than the FHC subsidiaries. For example, the bank subsidiary cannot underwrite insurance, issue annuities or engage in merchant banking for at least the next five years.

At face value, the expanded powers offered under GLB would appear to represent a significant step forward in terms of integrating financial service providers. After all, it is routinely said that laws passed before GLB did not allow for banking organizations to engage in securities or insurance operations. However, during the decades that financial modernization has been debated, considerable assimilation has already occurred between banking, insurance and securities operations.

Banks selling insurance

In today's market it is not particularly noteworthy to find a bank selling insurance. Banks were able to do this given certain legal exemptions. For example, in the 1990s regulators and courts found that banks with a national charter and subsidiaries of bank holding companies could sell insurance in areas with populations under 5,000. In fact, the regulator of national banks, the Comptroller of the Currency, found that national bank insurance agency subsidiaries in these small places could sell insurance nationwide. Some states have entered the fray as well, granting their own state-chartered banks broad general insurance agency powers to match those obtained by their national counterparts.

Exactly how extensive is the sale of insurance by banks? Due to the haphazard nature in which banks have received their insurance powers, they currently are not required to report to regulators information concerning their insurance product sales as a separate item. Instead, it is lumped together with an amalgam of other types of noninterest income (see discussion of this type of income in the October 1999 and January 2000 issues of the fedgazette), making it difficult to estimate the total insurance sales from banks from regulatory data. We do know that there are roughly 900 bank-affiliated insurance agencies in the country, representing about 500 unique banking organizations. Within the Ninth District there are currently 51 banking organizations selling insurance through 84 subsidiary agencies. According to the Association of Banks in Insurance, commercial banks sold nearly $9 billion of insurance products during 1999, an increase of 35 percent from the previous year.

It is worth noting that insurance underwriting—insurance activities that expose the bank to losses from insurance policies—is a different story. In general, banking organizations have been prohibited from engaging in this activity. GLB will allow mass entry by banks into this field for the first time.

Banks and securities

The 1933 Glass-Steagall Act barred banks from affiliating with companies that were "engaged principally in" the underwriting and dealing of stocks, corporate bonds, etc. However, banks were still allowed to sell and underwrite government securities, municipal general obligation bonds and certain types of commercial paper. Additionally, they were able to buy and sell all types of securities for the account of their customers.

Moreover, the phrase, "engaged principally in," was interpreted by the Federal Reserve Board in 1986 to mean that a bank holding company could in fact own a firm that dealt in the prohibited "bank ineligible" securities—provided the revenue they generated was less than 5 percent of the company's total revenues. The Federal Reserve Board has gradually increased the revenue cap that these "Section 20 subsidiaries" could meet, pushing it up to 10 percent in 1990 and recently lifting it again to 25 percent. The set of permissible bank-ineligible securities has also been expanded to include not only corporate debt and equity but also more exotic instruments like mortgage-backed and asset-backed securities. There are 53 Section 20 subsidiaries currently operating today, including two in the Ninth District that are affiliated with U.S. Bancorp. Combined, these 53 firms generated over $3 billion in noninterest income last year—compared with $141 billion in noninterest income for the nation's 8,500 commercial banks.

In addition to Section 20 subsidiaries, banks have also been able to perform a variety of functions with respect to mutual funds. Banking organizations were first authorized by regulators to become directly involved in mutual fund operations in 1972. Since then, their roles have gradually expanded to include activities like the recording of purchases and redemption of fund shares, executing the portfolio transactions and managing the fund's investment portfolio. One of the most significant roles played by banks is to serve as a distribution channel. Banking organizations accounted for roughly $2.4 trillion in mutual fund sales last year—approximately 90 percent of which were short-term money market mutual funds-and produced over $4 billion in noninterest income.

What is the real impact of the Gramm-Leach-Bliley Act?

Even if it is not revolutionary, GLB will accomplish at least two objectives. First, it provides a clear method for future integration of banks with other financial businesses, as opposed to the haphazard system that is currently in place. This integration should build on the connections between banking, insurance and securities operations that already exist. Second, it will allow banks to enter some new business lines, such as insurance underwriting, for the first time.

For more on Gramm-Leach-Bliley, see the special issue of The Region magazine that includes discussion and analysis of GLB, an interview with Rep. Leach and a historical look at what led to the act's passage.