nuts and bolts of financial modernization, The

The Gramm-Leach-Bliley Act (GLB, signed into law Nov.12,1999, modernizes the U.S. financial services sector by tearing down the legal barriers between commercial banking, investment banking and insurance. Before GLB, commercial banks could only engage in the business of banking-for example, taking deposits, making loans and offering checking accounts. Companies that own banks, known as bank holding companies, were similarly limited to banking and businesses that are closely related to banking, such as leasing, providing financial advice and providing trust services. On March 11, 2000, however, these barriers came tumbling down. New financial conglomerates can be formed. Bank holding companies are now able to acquire or merge with securities firms or insurance companies, and securities firms and insurance companies can acquire banks.

Furthermore, bank holding comparties can now engage in any business that is "financial in nature." Most notably, they are permitted to sell and underwrite securities (known as investment banking), sell and underwrite insurance and engage in merchant banking. The Fed and the Treasury Department have published a list of permissible businesses that are financial in nature, and in the future may include additional activities, such as real estate development or investment. Some of these businesses involve risks that are very different from traditional commercial banking services. In securities underwriting, for example, the underwriter buys the securities from an issuing company and resells them, taking on the risk of owning any of the securities that it cannot sell. Insurance underwriting involves taking on the risk of paying the claims under insurance policies. Merchant banking involves making stock investments in businesses-usually, venture capital investments in new businesses. Regulators believe these risks are manageable and that the diversification will prove healthy.

To help insulate bank depositors-and taxpayers, who ultimately pay for any losses to the federal deposit insurance fund-from the risks of new financial businesses, banks will not be allowed to engage in these businesses directly. Instead, a bank can either set up a holding company that could own the bank and non-bank financial companies, or it can purchase or set up financial subsidiaries of its own. One big difference between these two options is that a bank holding company can conduct any financial activity through its non-bank subsidiaries, whereas a bank's subsidiaries cannot take part in insurance underwriting, merchant banking or real estate activities. Whichever structure a bank chooses, it is eligible to enter the new financial businesses only if it is well capitalized and well managed, and has a satisfactory record of lending in low- to moderateincome areas.

Functional Regulation

Before Gramm-Leach-Bliley, banks were already subject to overlapping regulation. The Fed regulates bank holding companies. The Office of the Comptroller of the Currency, which is part of the Treasury Department, regulates national banks and their subsidiaries. State banks and their subsidiaries are regulated by both the state in which they are headquartered and by the Fed (if they elect to be members of the Federal Reserve System) or the FDIC (if they are not members of the Federal Reserve System).

As banks and bank holding companies begin to engage in insurance and securities activities, they will also become subject to regulation by state insurance regulators and the Securities and Exchange Commission. To minimize overlapping regulatory burdens and potentially inconsistent requirements, GLB imposes a functional approach to regulating these diverse organizations. GLB calls for each regulator to largely defer to the regulator with expertise over a particular functionbanking, insurance or securities.

For example, banking regulators will not normally be allowed to examine or require reports from an insurance subsidiary.

That said, GLB also preserves the Fed's central role as the umbrella regulator of all companies that own banks. As these companies diversify, it is critical for a single regulator to be responsible for the entire company to help ensure the safety and soundness of the organization as a whole and to prevent losses in a securities or insurance business from jeopardizing the health of an insured bank.

Tearing down the barriers between commercial banking, investment banking and insurance was the main purpose of GLB, but it also has many other important and wide-ranging provisions. It is a historic law that promises to fundamentally alter the U.S. financial services industry.

A summary of GLB can be found on the Senate Banking Committee's web site, www.senate.gov/-banking/ conf/index.htm.

W. Scott McBride is a lawyer and an officer at the Federal Reserve Bank of St, Louis.

Copyright Federal Reserve Bank of St. Louis Apr 2000
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