Financial Services Modernization and Corporate Finance.(Financial Services Modernization Act of 1999)

The recently adopted financial services modernization legislation (the Gramm-Leach-Bliley Act) is best known for having "repealed" the Glass-Steagall Act of 1933, which separated the commercial and investment banking industries. Technically, only two provisions of the Glass-Steagall Act were repealed: Section 20, which prohibited a bank from being affiliated with any entity "engaged principally" in underwriting or dealing in corporate securities, and Section 32, which prohibited banks and securities firms (that is, an entity "primarily engaged" in underwriting or dealing in corporate securities) from sharing common officers or directors. Since the repeal of these Glass-Steagall provisions was long a major legislative goal of large U.S. banks, it may seem surprising that the repeal has met with little apparent excitement from banks interested in expanding their securities activities. We describe below why that reaction is generally justified, while suggesting a few areas in which the new law may permit banks to provide new securities-related corporate finance products, through affiliates, to their customers.

Another highly publicized provision of the new law was its elimination of the prohibition on affiliations between banks and insurance companies. This provision of the new law is part of a general expansion of the types of entities that can be owned by a bank holding company that qualifies as a "financial holding company."(1) Along with the repeal of the Glass-Steagall provisions described above, the new law expressly permits such a financial holding company to own securities firms and insurance companies. The most obvious effect of this new authority is that the old legally mandated separation of ownership in those three industries (already significantly reduced, particularly for the securities business) will be essentially eliminated. Capital should now flow freely (or at least more freely) among the three industries based on economic considerations, not significantly limited by regulatory requirements. Since, however, banks have provided credit insurance, or credit enhancement, for many years to their corporate customers, it seems unlikely that any important new corporate finance products will be offered by bank affiliates as a result of this new permission for banks to affiliate with insurance companies. Any major effect should be in the retail insurance market. The new law, however, could permit bank affiliates to compete more effectively in the financial guarantee business flits provisions are interpreted to subject that activity to only the same capital requirements as apply to competitors not affiliated with banks.

We describe below in more detail what securities and insurance products banks and their affiliates currently can provide to their corporate customers in the United States and how the new law may add, or not add, to that product list. We conclude by reviewing how the new law may generally affect other product or service offerings by financial holding companies, how it deals with derivative products, how it may affect direct product offerings by banks or their direct subsidiaries, and how it affects foreign banks operating through branches in the United States.

SECURITIES BUSINESS

Existing Law

As indicated above, the Glass-Steagall Act did not prohibit banks from being affiliated with entities that underwrite or deal in corporate securities, so long as those entities were not "principally engaged" in those activities. Only in the 1980s, however, did banks and the Federal Reserve Board take advantage of this language in Section 20 of the Act. In a 1987 order, the Federal Reserve Board accepted that underwriting and dealing in corporate securities was "closely related to the business of banking" (the old criterion for what activities were permitted for a bank holding company subsidiary). In order to ensure, however, that a bank affiliate was not "principally engaged" in such activity, the Federal Reserve Board required that any such bank affiliate (popularly known as a "Section 20" affiliate) only derive 5% of its revenue from activities, such as underwriting and dealing in corporate securities, not permitted for a bank.

Within a couple of years, the Federal Reserve Board increased that limit to 10%. This higher limit still imposed a meaningful curb on the activities of any Section 20 affiliate to which a bank was unable to transfer very large amounts of "bank-eligible" activities, such as trading in government bonds, most municipal securities, and derivatives. Many banks …