AN INTRODUCTION TO THE GLASS-STEAGALL ACT

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1 AN INTRODUCTION TO THE GLASS-STEAGALL ACT Rapid changes in the financial marketplace -- inflation, competition for the savings dollar in an environment characterized by high interest rates and interest rate ceilings for some accounts but not for others, competition for the provision of other financial services from nondepository institutions, technological advances, and actions to liberalize state banking laws -- have kindled interest in reexamining the Glass-Steagall Act. Concerns about the efficient functioning of our Nation's capital markets and the declining rate of capital formation also argue for a review of the Glass-Steagall Act. To appreciate the changes in the marketplace, the observer only has to note the rapid growth of money market mutual funds, the desire of Sears "to become the largest consumer-oriented financial service entity," or the corporate mergers that took place in the financial services industry in I. What is the Glass-Steagall Act? The Glass-Steagall Act is the popular name for those parts of the Banking Act of 1933 (12 U.S.C. Sections 24, 377, 378 and 78), in which Congress attempted to differentiate --if not completely separate -- commercial banking from investment banking. Set against the background of the stock market crash of 1929, the ensuing Great Depression and the failure of over 4,000 banks, Congressional consideration of Glass-Steagall took place when public confidence in the U.S. banking system was at an all-time low. The stage was set for Congress to enact legislation to correct the perceived abuses found in the securities activities of commercial banks and their affiliates. The following four sections of the Banking Act of 1933 are commonly referred to today as the Glass-Steagall Act:

2 - 2 - Section 16 prohibits national banks and state member banks from purchasing any equity security, imposes additional limitations on their investment authority with respect to debt obligations, and prohibits their underwriting and dealing in securities except for U.S. Treasury and other agency obligations and general obligations of states and municipalities. Section 20 prohibits member banks from affiliating with organizations dealing in securities. Section 21 makes it a crime for any person engaged in the securities business to engage at the same time in the business of banking, except that any bank or trust company may engage in the securities business to the extent permitted national banks in Section 16. Section 52 prohibits interlocking directorates between member banks and such organizations (with waiver discretion granted to the Board of Governors of the Federal Reserve System). Today, any discussion of the Glass-Steagall Act usually centers around granting commercial banks new powers to compete with such nonbank competitors as Merrill Lynch, Shearson-American Express and Sears. The new powers for banks most often mentioned include: underwriting revenue bonds; sponsoring and operating mutual funds, including the popular money market mutual funds; offering other types of bonds and securities; and investing in and operating export trading companies. Each of these four proposed authorities is outlined below. For a brief insight into the history of the Glass-Steagall Act, see Treasury Secretary Regan's speech of September 18, 1981, at George Washington University, pages 7 through 9, attached. See also the attached paper on the Glass-Steagall Act prepared by the American Law Division of the Congressional Research Service. II. Municipal Revenue Bonds The Glass-Steagall Act is based upon an assumption that banks must be restricted to the extension of credit and must not be permitted to engage in commercial activities lest they use their financial power to gain an undue

3 - 3 - advantage over commercial enterprises which do not have ready access to bank credit. A longstanding exception to this policy has been made to permit banks to underwrite and deal in general obligation bonds of municipalities. They have not been permitted, however, to underwrite and deal in municipal revenue bonds. General obligation bonds are backed by the full faith and credit of the issuing state or local government to the extent of its taxing power. The principal and interest for the bonds are paid for out of the general revenues. Municipal revenue bonds are state and local government debt securities whose interest and principal are paid from the revenues of rents, tolls, or other user charges flowing from specific projects financed by the bonds. Principal proponents of legislation to permit banks to engage in underwriting revenue bonds are banks which have departments that specialize in municipal securities and officials of state and local governments who believe that their financing costs would be reduced as. a result of the additional competition afforded by commercial banks. The banks argue that the prohibition against bank underwriting of municipal revenue bonds reflects the relative unimportance of this method of municipal financing in 1933, when the Glass- Steagall Act was enacted. At that time, municipal revenue bonds were virtually unknown, while in 1980 upwards of 72% of the municipal bond market was revenue bonds. In 1980 dollar figures, general obligation bonds accounted for about $14 billion of the new security issues of state and local governments, while revenue bonds amounted to over $34 billion. Supporters of bank underwriting of municipal revenue bonds include: American Bankers Association, National Governors Association, National Association of Counties, National League of Cities, U.S. Conference of Mayors, American Federation of State, County and Municipal Employees, National Association of Homebuilders and the Federal Reserve Board.

4 - 4 - Principal opponents of legislation to allow commercial banks to under write and deal in municipal revenue bonds are securities dealers who argue that their industry would suffer undue harm as. a result of bank participation in the municipal revenue bond market. The securities industry f s main concern is that banks would enjoy a competitive advantage because of their ability to take deposits and to deduct from taxable income the cost of holding municipal bonds The Securities Industry Association has announced, however, that it will support bank underwriting of revenue bonds if conducted through a separate affiliate of the bank or bank holding company. The Reagan Administration also supports this approach and has prepared draft legislation to this effect. Treasury's draft Bank Holding Company Deregulation Act of 1981 will be discussed in more detail in a fortlicoffiijig memorandum. Pending Legislation Legislation to grant commercial banks the authority to underwrite municipal revenue bonds has been introduced in every Congressional session for the past twenty years and has passed the Senate in both 1967 and Hearings were held in 1979 by the Subcommittee on Financial Institutions, but no further action was taken. Legislation in the 97th Congress includes: 1. H.R State and Local Government Financing Reform Act of introduced by Congressmen Lundine, Barnard, et al, on March 25, 198l"i A majority of the Members of the Banking Committee and the House have cosponsored this legislation. The bill amends Section 16 of the Glass- Steagall Act to allow national banks to deal in and underwrite all nongeneral obligation bonds (except special assessment and industrial revenue bonds), issued by or on behalf of a state or municipality. In addition, several restrictions

5 - 5 - apply which are intended as safeguards. This legislation would also require the Secretary of the Treasury to submit an annual report to Congress on the distribution of revenue bond underwriting and dealing activities between commercial banks and other banking institutions. 2. S introduced by Senators Garn, Proxmire and Lugar on June 25, 1981.~ 3. S Financial Institutions Restructuring and Services Act - introduced by Senator Garn on October 7, 1981 (Sec 7101). III. Bank Mutual Funds Several bills have been introduced to allow all depository institutions to sponsor and sell their own mutual funds as a way of competing with their nondepository financial competitors, particularly money market mutual funds. Given the perception that the securities industry has intruded into what traditionally has been regarded as the realm of depository financial institutions, the proposals to permit banks to sponsor their own mutual funds has received some attention by the Congress. The legislation would amend Section 22 of the Investment Company Act of 1940 to permit banks, bank holding companies or their subsidiaries, savings ' These limitations are as follows: Banks cannot hold the obligations of any one obligor in excess of 101 of the bank f s capital and surplus; banks cannot purchase as fiduciary from itself as underwriter or dealer unless directed by court order; banks cannot purchase as fiduciary from another member of a syndicate in which they are participating until the underwriting syndicate is closed; any sale of bonds by the bank to any of its depositors or borrowers or any correspondent bank must be accompanied by a disclosure in writing that the bank is acting as underwriter or dealer; and banks cannot buy for their own account from their own account as underwriter, dealer or trader or from an affiliate. This does not apply if the bank is sole underwriter of issue or if purchased from a syndicate or other member thereof.

6 . _I banks, savings and loan associations and, in some cases, credit unions to organize and operate investment companies and to "underwrite, distribute, sell or issue securities of any investment company..." Such investment companies would be organized and registered in compliance with the Investment Company Act of 1940, and their shares registered under the Securities Act of SEC rules would govern advertising and fees. Compliance standards would be established by the appropriate federal banking regulator. Institu- - ^ tions whose size would not warrant the establishment of the fund would be authorized to serve their customers by selling shares of another institution's fund. In the 1960! s, the Comptroller of the Currency moved by regulation to permit banks to commingle agency accounts, lie., set up their own mutual funds. Initially, the SEC intervened to oppose the Comptroller's decision, thus setting the stage for the current debate. Although legislation to author ize bank mutual funds was introduced in both the 88th and the 89th Congress, no action was taken. Finally, in 1965 Citibank forced the issue by obtaining approval from both the Comptroller and the SEC to establish its own mutual fund. The Investment Company Institute, the trade association for all mutual funds, sued the Comptroller of the Currency to overturn the Citibank mutual fund ruling. After the case bounced around in the courts for several years, the Supreme Court finally ruled in favor of the Investment Company Institute. When all of the steps to offer such funds were taken together, the court ruled that these commingled agency accounts raised all of the problems of the 1930's that the Glass-Steagall Act was passed to prohibit. Legislation to permit banks to offer these mutual funds passed the Senate during the 91st Congress, but ultimately was dropped from the conference report as well.

7 - 7 - The chief proponent of this legislation is the American Bankers Association, while the main opponent is the Investment Company Institute. The Federal Reserve also opposes bank mutual funds because of the possible impact on the conduct of monetary policy and for safety and soundness reasons. Instead, the Federal Reserve would prefer to allow banks to offer commingled agency accounts through use of their trust departments as investment advisors. The Reagan Administration endorses the concept of bank mutual funds, if conducted throught a separate affiliate of a bank or bank holding company. Pending Legislation Because legislation which authorizes depository institutions to offer mutual funds amends the Investment Company Act of 1940, such bills are referred jointly to both the Energy and Commerce Committee and the House Banking Committee, 1. H.R introduced by Congressman Stark on May 6, 1981, has 28 cosponsors. 2. H.R Financial Institution Competition Act - introduced by Congressman LaFalce on August 4, S introduced by Senators Chafee, Garn, Proxmire and Hayakawa on June 24, S Financial Institutions Restructuring and Services Act - introduced by Senator Garn on October 7, 1981 (Sec. "502). IV. Other Bonds and Securities On June 26, 1981, Congressman Barnard introduced a bill, H.R. 4040, which encompasses both bond underwriting and mutual funds for banks. Title I of H.R amends Sections 16, 20 and 21 of the Glass-Steagall Act to allow commercial banks to underwrite all types of bonds, including commercial paper, corporate bonds, subordinated debentures, municipal revenue bonds and

8 - 8 - industrial revenue bonds. As in H.R. 2828, the same safeguards apply to prevent speculation and high risk investment. Title II of H.R. 4040, which is identical to Mr. LaFalce's bill, H.R. 4397, amends the Investment Company Act of 1940 to allow all types of financial institutions to operate and advise mutual funds. Finally, Title III would set up a Presidential study commission (in conjunction with all banking regulators and interested governmental bodies), to report on the barriers now present between differing financial industry corporations and make recommendations for the maintenance, modification or removal of such barriers. This report would be presented to Congress one year after enactment of the bill. Also, as in H.R. 2828, an annual report is required from Treasury on bank market share of bond underwriting in Title I. In general, trade associations have not taken a stand specifically on this bill, although the ABA f s trust division has endorsed it. The Administration is not prepared to endorse any further modification of the Glass-Steagall Act at this time beyond that which has been mentioned above. V. Export Trading Companies The last new power relating to the Glass-Steagall Act is the proposed authority for banks to invest in or operate export trading companies. An export trading company is a company whose function is to provide export services, such as market research, transportation, warehousing, aftersales service, and trade finance to both importers and exporters. Export trading companies are not mentioned specifically in any federal banking laws, but apparently banks may neither invest in export trading companies nor engage in export trade, directly or through subsidiaries. National banks appear to be precluded from investing in export trading companies

9 - 9 - by the general restrictions of the Glass-Steagall Act. A number of bills have been introduced in the 97th Congress. Most versions of the legislation would authorize national banks, state banks, bank holding companies and other types of banking organizations such as the Edge Act Corporations, to make limited investments in export trading companies. In addition, with the prior approval of the appropriate federal banking regulator, these banking organizations would be able to own an export trading company subsidiary. On April 8, 1981, the Senate passed the Export Trading Company Act of 1981 (S. 734) by a vote of 92 to 0. A similar bill, S. 2718, passed the Senate during the 96th Congress by a vote of 77 to 0. In the House, legislation per- taining to export trading companies is referred jointly to the Committees on Judiciary, Foreign Affairs and Banking. The central issue in the Banking Committee will be the degree to which banks are limited in their ability to hold equity positions in export trading companies. Pending Legislation 1. S Export Trading Company Act of passed the Senate by a vote of 92 to 0, on April B, H.R Export Trading Company Act of introduced by Mr. LaFalce in February 4, * H.R Export Trading Company Act of introduced by Mr. Bonker oh February 6, H.R Export Trading Company Act of introduced by Mr. Gibbons on February 25, H.R Export Trading Company Act of introduced by Mr. Patterson on March 25, 195TI

SECURITIES AND EXCHANGE COMMISSION Washington, D. C

SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 (202) 272.-2650 CHANGING FINANCIAL SERVICES AND REGULATION Address by John R. Evans Commissioner North American Securities Administrators Association