United States

Author: | Published: 9 Jul 2001
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Since the enactment in November 1999 of the landmark Gramm-Leach-Bliley Act of 1999 (the GLBA), attention among practitioners has been focused on regulations issued by the leading banking agencies that implement several of the GLBA's most important provisions. Many of these went into effect during the past year. The GLBA made important changes in many of the substantive areas of interest to the US banking industry. Therefore, a review of its regulatory fallout offers a useful survey of topics of importance to the banking bar in the US.

Background

Although not as revolutionary as many commentators made it out to be, the GLBA was unquestionably the most significant amendment to US banking laws in the past few decades, not so much for the actual changes that were effected but for the principles that were adopted in bringing about those changes. This article discusses three of those principles by describing how the federal banking regulators have implemented them in issuing regulations since the GLBA's enactment: the expansion of powers available to bank holding companies (BHCs), so-called "functional" regulation, and the imposition for the first time at the federal level of measures to protect the confidentiality of information about customers.

Expansion of powers while maintaining the separation of banking and commerce

The GLBA culminated over a decade of attempts to expand the powers of banking institutions to bring them more into line with the powers of banks in virtually every other industrialized nation. The most contentious debate that underlay the final provisions of the GLBA in this area was on the question of whether a banking institution – specifically a BHC – should be permitted to expand into any activity, including commercial activities, or should still be confined to financial activities, albeit broader financial activities than those permitted under prior law. In the end, the traditional principle of the separation of banking and commerce – advocated most strongly by the Federal Reserve – was largely retained. BHCs, and only those that were sufficiently qualified, would be permitted to engage for the first time in a full range of securities, insurance, and merchant banking activities; they would not, however, be allowed to enter or acquire non-financial lines of business.

Notably, the GLBA made no significant changes to the laws – including the Depression-era Glass Steagall Act – that govern the direct activities of banks. Contrary to the impression given by much of the coverage of the legislative process, the direct restrictions of the Glass Steagall Act on depository institutions remain very much in force: as under prior law, a bank may not underwrite and deal in most securities, sell or underwrite insurance or make investments for its own account in equity securities. Rather, only a qualified BHC through a non-banking subsidiary may conduct these activities.

In the first three months of 2000, the Federal Reserve issued regulations implementing various provisions of the Act, including procedures for qualifying to exercise the new powers; a definition of the new powers and special rules that would apply to merchant banking activities.

Procedures for qualifying to exercise new powers

As noted above, not all BHCs are permitted under the GLBA to exercise the new powers that the Act makes available. Only those that qualify as a "financial holding company" (FHC) may do so.

An FHC is a BHC that demonstrates to the Federal Reserve that its subsidiary US bank is "well managed", "well capitalized" and has a satisfactory rating under the Community Reinvestment Act (CRA). Comparable requirements apply to a non-US bank that wishes to qualify as an FHC but, in that case, it (and its US bank subsidiary, if it has one) must meet the requirements.

The Federal Reserve's regulations implemented the procedures for qualifying as an FHC generally as expected. Although the procedures were seen by many non-US banks as more onerous and less self-executing than those that applied to domestic BHCs, they did, for the most part, honour the clear intention of the statute to make qualification easy and largely automatic for those institutions that met the standards. As of June 2001, over 475 BHCs, of which only 15 were non-US banking institutions, have qualified as FHCs.

The regulations provide that any FHC that later falls out of compliance with the "well managed" and "well capitalized" standards, must promptly notify the Federal Reserve and enter into an agreement with it to return to that condition or forfeit the ability to expand its activities in reliance on its FHC status and, ultimately, its status as an FHC. One of the reasons that comparatively few foreign banks have elected to qualify as FHCs is that they are reluctant to subject their worldwide operations to the requirement that they continue to maintain the GLBA's capital levels on pain of regulatory intervention by the Federal Reserve.

Definition of the new powers

The GLBA allows a BHC that qualifies as an FHC for the first time to engage in any activity that the GLBA itself defines, or the Federal Reserve determines, is financial in nature, incidental to an activity that is financial in nature or (with the participation of the Department of the Treasury) complementary to an activity that is financial in nature. The Federal Reserve's implementing regulations, as expected, specifically list those activities that as of that time had been determined to be financial in nature. They are drawn from four sources:

  • activities that the Board had determined by regulation under prior law were "so closely related to banking as to be a proper incident thereto";
  • activities that the Board had determined by order met this same "closely related" standard. (Board orders approve an application by an individual applicant to engage in one or more particular activities; a regulation makes the activity available to all BHCs);
  • activities that the Board had determined by regulation were "usual in the conduct of a banking business abroad." Three activities meet this standard that do not meet the "closely related" standard: operating a travel agency, distributing the shares of an open-end mutual fund and providing management consulting services; and
  • activities listed in the GLBA itself as having been determined by Congress to be financial in nature. They include, most notably, full-scope securities activities, including underwriting and dealing in all types of securities; merchant banking; and acting as agent or principal in the underwriting and sale of all types of insurance.

All of the activities in the first two categories continue to be permissible to a BHC that is not an FHC subject to the procedural requirements that applied under prior law. All of the activities in all four categories are permissible to a BHC that qualifies as an FHC. A BHC that is not an FHC may not apply to engage in a new activity, even one that it believes meets the "closely related" standard. By contrast, an FHC may apply for a determination that additional activities meet the "financial in nature," "incidental" or "complementary" standard of the GLBA. To date, only one additional activity has been determined by the Federal Reserve to meet the "financial in nature" standard: the activity of acting as a "finder" defined as "bringing together buyers and sellers of products and services for transactions that the buyers and sellers themselves negotiate and consummate." It has also proposed to add the activity of acting as a real estate broker to the list.

Procedures for expanding activities

A BHC that has not qualified as an FHC must, as a general rule, obtain the prior approval of the Federal Reserve to engage in a new activity or to acquire a "going concern" engaged in any activity. The Federal Reserve's approval in the latter case exempts the acquiring BHC from the requirements that would otherwise apply under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, which requires that acquisitions of a certain size may not proceed until 30 days after the parties file a notice with the Federal Trade Commission (FTC) and the Department of Justice (DOJ).

A BHC that has qualified as an FHC may begin a new activity that has been determined to be financial in nature or may acquire a "going concern" engaged in any such activity provided only that it gives the Federal Reserve notice to that effect within 30 days after the commencement of the activity or the acquisition. Because the exemption from the Hart-Scott-Rodino filing requirement is available only to an acquisition that has been approved in advance by the Federal Reserve, an FHC that relies on the 30-day after-the-fact notice procedure must file the required Hart-Scott-Rodino advance notice with the FTC and the DOJ.

Merchant banking and the proposed capital charge

In the short term, the most significant new power available to FHCs has proven to be the merchant banking power. Full-scope securities powers for the largest US and non-US BHCs have allowed those institutions freedom from an artificial 25%-of-revenues limitation previously imposed by the Glass Steagall Act, but the generic activities of dealing in and underwriting securities have been engaged in by these institutions since 1987 under prior law through their so-called Section 20 subsidiaries. Insurance activities represent a significant long-term opportunity for BHCs but they have been slow to take advantage of them by expanding de-novo and few BHCs have expanded into insurance through acquisitions.

By contrast, many leading BHCs have taken advantage of their new FHC status to free themselves from severe constraints that were imposed under prior law on the making of equity investments for their own accounts. They have used this authority not only to try to earn greater returns on larger and more aggressive investments for their own account but also to generate important new fee income by using this power to expand their sponsorship and management of private equity funds available to fellow investors. Much attention has been given to the Federal Reserve's interpretation of these new powers. It took the form of an interim regulation issued in March 2001 that prescribed the basic rules that would govern these activities and a companion proposed regulation that would impose a capital charge on all such investments. The former amplified statutory requirements that limited the length of time that a portfolio investment could be held by an FHC and restricted the degree to which its representatives could be involved in the management of a portfolio company. The interim regulation also prescribed periodic reporting requirements for FHCs engaged in the activity.

Far more controversial was the Federal Reserve's initial proposal to require an FHC in calculating its Tier 1 capital to deduct from that capital an amount equal to 50% of every dollar invested, "as a precaution that is necessary to prevent the buildup within banking organizations of excessive risk from merchant banking and other investment activities". In response to a barrage of criticism from the industry prompting hearings held in Congress, in February of this year the Federal Reserve issued for further comment a scaled back proposal that would impose a tiered capital charge ranging from eight to 25% of the amount invested. Significantly, both proposals would impose the capital charge not only on FHCs that make equity investments under the new merchant banking authority, but also on FHCs and BHCs that make equity investments under the more limited authority available under prior law.

Functional regulation and the "push-out" provisions

The second of the three major principles adopted by the GLBA was the principle of "functional regulation". Before the enactment of the GLBA, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) as the primary regulators of BHCs and state-chartered member banks and of national banks, respectively, were responsible for the oversight and supervision not only of the particular BHC or bank but also of its non-bank affiliates. This responsibility arose even in cases in which the non-bank affiliate was also overseen and supervised by a separate federal agency, most notably in the case of a broker-dealer, which is regulated by the Securities and Exchange Commission (SEC) and, typically, by the National Association of Securities Dealers (NASD) or the New York Stock Exchange.

Consistent with the expansion of powers made available under the Act, the GLBA adopted the concept of functional regulation. Under this approach, for example, the SEC and the NASD would take responsibility for overseeing the operations of a registered broker-dealer affiliate of a bank or BHC; the relevant state insurance regulator would likewise take responsibility for overseeing an insurance agency or underwriter affiliate. The objectives were, first, to do away with what was seen as unnecessary and burdensome duplication of regulatory oversight and, second, to promote cross-industry acquisitions by removing a disincentive that might discourage a securities or insurance company from acquiring a BHC or a bank. Absent functional regulation, an investment bank or insurance underwriter interested in expanding into the banking business might be reluctant to subject itself to Federal Reserve oversight.

The GLBA applied functional regulation prospectively by specifically limiting the extent to which the Federal Reserve as the supervisor of an FHC can examine or require the production of information from a non-bank affiliate that is regulated by another regulator. The Act went further, however, by effectively requiring that certain securities activities at present conducted by banks be transferred to an entity regulated by the functional regulator of those activities.

The "push-out" provisions of the GLBA

Before the enactment of the GLBA, a bank (and a US branch or agency of a non-US bank) enjoyed the authority to engage in a wide variety of securities activities without being required to register with and being subjected to regulation by the SEC and NASD, as were their non-bank competitors. These activities included agency brokerage, some securities dealing activities, and the providing of investment advice. In the GLBA, Congress largely adopted the long-standing position of the SEC that these activities should only be conducted by an entity registered with the SEC. It did so through the "push-out" provisions of the Act, so named because they have the effect of requiring a bank to "push-out" the activities it previously conducted within the bank to an affiliated registered broker-dealer or investment adviser.

The Act eliminates the so-called "bank exception" from the definition of "broker" in the Securities Exchange Act of 1934 (the 1934 Act). That exception defines a broker as any person that "engages in the business of effecting transactions in securities for the account of others" but provides that the term "does not include a bank." The Act replaces the existing exception with an exception for a bank (and therefore a branch or agency) that engages in any of 12 far more limited listed activities. The provision became effective 18 months after the enactment of the legislation, ie on May 13 2001 but has been extended by the SEC until October 1 2001. Because virtually no bank or US branch or agency of a foreign bank would want to bear the burden of being regulated as a broker-dealer, it will by that date be required to transfer its securities activities to a newly established or existing broker-dealer affiliate unless it can confine them to one or more of the 14 listed exempt activities.

Exemptions from the push-out provisions

The 12 exemptions to the push-out provisions – eight from the definition of broker, one from the definition of dealer, and three common to both broker and dealer – were designed to preserve the ability of a bank to continue to engage in certain securities activities that were part of the traditional business of banking. In the lead-up to the effective date of the push-out provisions, several of these exemptions have received the most attention from practitioners. The SEC, as the agency responsible for interpreting the 1934 Act, on May 11 2001 released interim final regulations on how some of them should be interpreted. The principal exemptions are:

Traditional banking products. Two of the 12 statutory exemptions serve to reassure the banking industry that the activities of buying and selling (to the extent otherwise permissible) of "identified banking products" and engaging in "permissible securities transactions" may remain in a bank and do not have to be "pushed out" to a registered broker dealer. Among the products covered by this exemption are deposits, commercial paper, bankers acceptances, loans and letters of credit. (Significantly, in the case of loans, the GLBA specifically provides that their inclusion in the exemption should not be taken as suggesting that they should or should not be deemed to be securities.)

Securities brokerage activities conducted as a fiduciary. Of particular importance to the private banking activities of US banks and branches of non-US banks is the GLBA's exemption from broker-dealer regulation for securities activities conducted by a bank in its trustee or fiduciary capacity, provided the bank complies with several requirements designed to limit its receipt of brokerage commission and its solicitation of brokerage business. The most important of these requirements are: (i) that a bank must be acting "in a trustee or fiduciary capacity"; (ii) that a bank's securities activities must be conducted in a trust department or other department "regularly examined by bank examiners for compliance with fiduciary principles and standards"; and (iii) that a bank must be "chiefly compensated ... on the basis of an administration or annual fee, ... a percentage of assets under management, or a flat or capped per order processing fee equal to not more than the cost incurred by the bank ...".

Securities brokerage activities conducted as a custodian. The GLBA excepts from the 1934 Act definition of "broker" the activity of providing safekeeping and custody services with respect to customer securities. The SEC has interpreted this exemption to prohibit the acceptance of orders for the purchase or sale of securities by a bank acting as a custodian unless the bank does so on an uncompensated basis.

Swap activities. The Act contains a broad definition of "swap transactions" which are exempt from the push-out provisions. Swap transactions are defined as "any swap agreement," ie "any individually negotiated contract, agreement, warrant, note, or option that is based, in whole or in part, on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies, interest or other rates, indices, or other assets, but does not include any other identified bank product," except that an equity swap must be sold to a "qualified investor" to be treated as an identified bank product.

Securities lending activities. Yet to be resolved by the SEC are the questions whether and under what circumstances a bank may continue to engage in securities lending and repurchase activities. Banks' custody departments can reasonably expect to be permitted under the GLBA's exemptions to lend and enter into repurchase agreements with respect to customers' securities held by them in that capacity. Less clear is whether banks may act as agent in arranging such transactions with respect to securities held by others.

Overshadowing the process of how these exemptions will be implemented is the question of which regulator – the SEC or the relevant banking agency – will, as a practical matter, take the lead in monitoring their implementation. Bank examiners will have the responsibility of determining whether the bank is complying with the relevant law; that law - the 1934 Act - however, will be interpreted by the SEC.

Privacy provisions

The third major principle adopted by the GLBA was that a customer of a bank should be protected from the unauthorized use by the bank of information provided to the bank in the course of the banking relationship. Title V of the GLBA for the first time at the federal level imposed restrictions on the use by "financial institutions" of "nonpublic personal information" of its customers. The provisions were hotly debated by Congress, which acted in response to growing public awareness of the unrestricted ability of these institutions to convey or sell information gathered from individuals in the course of their banking, securities and insurance activities. A compromise was struck that had the following principal features:

  • the restrictions would apply only to "nonpublic personal information" defined as personally identifiable financial information provided by a consumer to a financial institution resulting from any transaction with the consumer or any service performed for the consumer, or otherwise obtained by the financial institution. As a result, they largely affect only retail and private banking operations;
  • the restrictions would apply to "financial institutions" defined as those institutions engaged in financial activities that an FHC may engage in under the GLBA. This provision has the unusual effect of expanding those entities subject to the privacy requirements as the list of activities determined to be "financial in nature" expands when new ones are added by the Federal Reserve;
  • each institution subject to the requirements must, upon establishing a relationship with a customer, adopt and provide to its customer a written copy of its privacy policy;
  • customers must be given the opportunity to limit the institution's ability to transfer the customer information to a third party. This "opt out" alternative was chosen over a more restrictive "opt in" alternative under which an institution would not be permitted to transfer the information without first obtaining the customer's consent; and
  • by applying the restrictions only to transfers of information to a third party, an institution would be free to transfer it to an affiliate regardless of the customer's election.

On February 5 2001 the banking agencies issued final rules to implement the privacy provisions. The rules become effective July 1 2001, although existing contracts between a financial institution and a third-party service provider are grandfathered for a two-year transition period.

Conclusion

The enactment of the GLBA brought to an end over a decade of debate on the modernization of the US banking system. The action has shifted from the Congress, which is unlikely to take up any major further structural reform in the near term, to the regulators, which are charged with implementing its provisions. So far, the Federal Reserve has adopted its accustomed conservative approach to the implementation of statutory provisions. In the end, several pillars of the pre-GLBA framework remain in full force: the separation of banking and commerce, a Glass Steagall Act fully applicable to the direct operations of banks, and the pre-existing collection of competing regulatory agencies overseeing the operations of complex financial institutions. Still, functional regulation brings some rationality to that system and several important new powers have been made available to the industry.


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