WikiLeaks Document Release http://wikileaks.org/wiki/CRS-RS21680 February 2, 2009 Congressional Research Service Report RS21680 Affiliates in Banking, Finance, and Commerce: Development and Regulatory Background William D. Jackson, Government and Finance Division April 27, 2005 Abstract. The proliferation of corporate affiliates in banking, finance, and commerce has figured in discussion of several policy issues, including how to protect against (1) losses incurred by affiliated companies; (2) anticompetitive "tying" of bank and nonbank financial services; and (3) misuse of financial data of consumers. The Gramm-Leach- Bliley Act in 1999 greatly increased affiliations. Sharing of consumer financial information among affiliates, one issue in reauthorization of the Fair Credit Reporting Act, requires considerable attention to affiliations. Proposed Community Reinvestment Act regulations involve affiliates of banks. Comptroller of the Currency efforts to bring subsidiaries of national banks under federal banking law, preempting than state laws, also involve affiliations. This report outlines the nature and evolution of affiliates, primarily from a regulatory perspective. It provides background for discussing financial issues involving corporate affiliates. Order Code RS21680 Updated April 27, 2005 CRS Report for Congress Received through the CRS Web Affiliates in Banking, Finance, and Commerce: Development and Regulatory Background William D. Jackson Specialist in Financial Institutions Government and Finance Division http://wikileaks.org/wiki/CRS-RS21680 Summary The proliferation of corporate affiliates in banking, finance, and commerce has figured in discussion of several policy issues, including how to protect against (1) losses incurred by affiliated companies; (2) anticompetitive "tying" of bank and nonbank financial services; and (3) misuse of financial data of consumers. The Gramm-Leach- Bliley Act in 1999 greatly increased affiliations. Sharing of consumer financial information among affiliates, one issue in reauthorization of the Fair Credit Reporting Act, requires considerable attention to affiliations. Proposed Community Reinvestment Act regulations involve affiliates of banks. Comptroller of the Currency efforts to bring subsidiaries of national banks under federal banking law, preempting than state laws, also involve affiliations. This report outlines the nature and evolution of affiliates, primarily from a regulatory perspective. It provides background for discussing financial issues involving corporate affiliates and will be updated as events warrant. Background and Analysis Conducting "nonbanking" activities directly within a bank has generally been viewed as a threat to the integrity of the bank. Periodically in American financial history, and in other nations today, bank diversification into nonbanking financial and commercial business has emerged.1 Safety problems often followed because of a tendency for entrepreneurs to combine captive sources of (bank) funds with their own (commercial) uses of funds, without regard for normal due diligence. By forcing nonbanking activities into a separately capitalized, separately run company associated with a bank, policymakers sought to lessen the risks that self-funding may pose to banks, to deposit 1 Joseph G. Haubrich and Joao A. C. Santos, "Alternative Forms of Mixing Banking with Commerce: Evidence from American History," Financial Markets, Institutions & Instruments, vol. 12, no. 2, pp. 121-164. Congressional Research Service ~ The Library of Congress CRS-2 insurance funds, and to other governmental policies. Overall, financial policy has periodically limited commercial/banking affiliations since the 1830s. The term "affiliate" refers to "any company that controls, is controlled by, or is under common control with another company."2 Companies with ownership interests of 25% or more in common are usually always affiliates. Sometimes, a common ownership interest as low as 5% is sufficient if it involves director selection, policy direction, and similar control matters. Affiliations are often valued for their potential of cross- marketing, involving sharing of consumer financial information; thus becoming one focus of the Fair Credit Reporting Act debate in Congress,3 which resulted in the Fair and Accurate Credit Transactions Act of 2003, P.L. 108-159. Application of it must address cross-marketing/information-sharing involving affiliates.4 The simplest affiliation is that of a subsidiary, where a bank owns another financial business 100%. Examples are a bank owning an insurance agency, small business investment company, or securities broker. Subsidiaries are regulated by the primary regulator(s) of the owning banks. A more complicated structure involves a company controlling banks. This state-chartered business is known as a "bank holding company." http://wikileaks.org/wiki/CRS-RS21680 It "holds" the stock of one or more banks and, often, of other financial businesses. A bank holding company typically holds all the stock of at least one bank, and a mortgage company, a securities firm, or a commercial finance business. It may also hold all or part of joint ventures, foreign alliances, investment companies, and other businesses within its structure.5 The Federal Reserve (Fed) regulates bank holding companies. A more complex form of bank holding company is the financial holding company, authorized by the Gramm-Leach-Bliley Act (GLBA, P.L. 106-102) in 1999. As specially empowered bank holding companies, these entities may additionally hold full-service securities and insurance operations, including those making nonfinancial equity "merchant banking" investments. Similar diversification arrangements allow securities- based entities to form investment bank holding companies, and savings associations to come under "thrift" holding companies. GLBA listed activities for such affiliations: underwriting and dealing in securities, sponsoring and distributing mutual funds, selling and underwriting insurance, and making insurance company and merchant banking portfolio investments. Regulators may allow other business affiliations. The Fed, as the regulator of financial holding companies, oversees them to prevent affiliations from lowering the soundness of deposit-insured banks. Sections 23A and 23B of the Federal Reserve Act built financial "firewalls," which prevent banks from supporting failing nonfinancial affiliates, or engaging in anticompetitive tying in financial 2 12 U.S.C. 1841. 3 CRS Report RS21576, Fair Credit Reporting Act: Frequently Asked Questions, by Angie Welborn and Loretta Nott, and CRS Report RS21427, Financial Privacy Laws Affecting Sharing of Customer Information Among Affiliated Institutions, by Maureen Murphy. 4 Richard Cowden, "FACT Act Affiliate-Sharing Regulations Likely to Be Separate From FCRA Rules," Daily Report for Executives, Feb.11, 2004, p. A-32. 5 The Fed restricts lines of business that may be affiliated through bank holding companies, including their financial holding company form, in 12 C.F.R. Part 225, "Regulation Y." CRS-3 services. Risk of collapse of securities, insurance, and other affiliated businesses evoking deposit insurance, lender-of-last resort, or outright appropriation to cover bank losses becomes less likely. Flows of information between banking and nonbanking affiliates, or as in the Fair Credit Reporting Act, affiliated entities even if no bank is involved, are limited to preserve competition and privacy concerns. A bank or securities affiliate may also provide advice to an investment company, even without ownership. Regulators have warned bank-based organizations against contributing banking resources to advised funds. Legislative and Regulatory Actions Beginning in the 1970s, a scramble for funds encouraged businesses ranging from banks to real estate to manufacturing to affiliate with nontraditional financial firms, taking market shares from regulated U.S. banks. Regulatory and statutory reactions may have peaked in 1982.6 Table 1 summarizes the basic developments by which Congress, states, and regulatory bodies have changed relevant affiliation relationships, increasing or limiting their extent. Continuing congressional debate involves whether GLBA allows affiliation of banking with real estate activities.7 Current congressional activity questions http://wikileaks.org/wiki/CRS-RS21680 the extent to which affiliates of national banks, such as mortgage company subsidiaries, are subject to the Comptroller of the Currency's preemption of state laws.8 Table 1. 100-Year Time Line of Affiliation Environment of Banking Years Action Affiliation Change 1906- Many state laws Separated life insurance from commercial and 1907 investment banking. 1910- State banking practice, Securities affiliates of state and national banks 1929 1927 McFadden Act became prominent. 1933 Banking Act of 1933: four Defined affiliate and holding company sections are known arrangements for Federal Reserve member banks. collectively as the Glass- Added Section 23A to Federal Reserve Act, limiting Steagall Act (GSA) member bank transactions with affiliates. Outlawed ties between commercial and investment banking. Section 20 prevented Federal Reserve member banks from affiliating with companies "engaged principally" in underwriting or dealing in securities. Section 32 prevented their affiliations with securities firms via interlocking directorates. 6 CRS Report RL31981, Industrial Loan Companies/Banks and the Separation of Banking and Commerce: Legislative and Regulatory Perspectives, by William D. Jackson, and CRS Report RS21188, Enron's Banking Relationships and Congressional Repeal of the Glass-Steagall Act Separating Bank Lending from Investment Banking, by William D. Jackson. 7 CRS Report RS21104, Should Banking Powers Expand Into Real Estate Brokerage and Management?, by William D. Jackson. 8 CRS Report RL32197, Preemption of State Law for National Banks and Their Subsidiaries by the Office of the Comptroller of the Currency, by M. Maureen Murphy. CRS-4 Years Action Affiliation Change 1956 Bank Holding Company Prohibited affiliations of nonbanking entities with Act of 1956 (BHCA) companies controlling two or more banks. Federal Reserve could allow affiliations "...closely related to the business of banking...." Douglas Amendment prevented multi-bank affiliations; containing holding company banks inside state lines. 1968 Savings and Loan Holding Restricted affiliations for holding companies Company Act of 1968 owning two savings and loan associations. Exempted control over one ("unitary") association. 1969 National Association of Model Insurance Holding Company Act for states, Insurance Commissioners like BHCA but allowing nonfinancial affiliations. 1970 Bank Holding Company Prohibited nonbanking affiliations for a holding Act Amendments of 1970 company owning one bank. Prohibited banks from tying services, reciprocity, and exclusive dealing arrangements with customers generally. 1970 New York Stock Member broker/dealer firms could sell their own http://wikileaks.org/wiki/CRS-RS21680 Exchange Rule Change stock to the public, allowing affiliates directly or via holding companies in many business lines. 1974- Losses in Bank Affiliates Real estate investment trusts associated with banks 1975 weakened by economic conditions. Banks and their holding companies took large losses. 1978 International Banking Act Subjected foreign bankers in U.S. to BHCA of 1978 affiliation restrictions. 1980s Comptroller of the Permitted affiliations of limited-service "discount Currency and Federal broker" securities firms with banks. Reserve Rulings 1982 Garn-St Germain Allowed affiliation involving savings and loan Depository Institutions associations, not only real estate but also industry Act of 1982 ownership. Prevented most insurance affiliations for banks; contained Banking Affiliates Act of 1982 restricting transactions. 1982 Comptroller of the Allowed nationally-chartered "nonbank banks" to Currency Chartering offer credit cards and other services, in affiliation with financial and industrial firms. 1982 Bank Export Services Act Allowed bank holding companies to invest in export trading company affiliates. 1982 Federal Deposit Insurance State-chartered banks not members of Federal Corporation Policy Reserve could affiliate with full-service securities Statement companies, declared as not covered by GSA. 1986- Federal Reserve Rulings Authorized bank holding company affiliates to 1988 provide joint investment advice and brokerage. 1987 Federal Reserve "Section Allowed bank holding company subsidiaries to 20 Subsidiaries" Ruling underwrite municipal revenue bonds, commercial paper, and asset-backed securities. CRS-5 Years Action Affiliation Change 1987 Competitive Equality Forestalled affiliations of nonbank banks with Banking Act of 1987 nonfinancial firms. Put moratorium against new banking affiliations in securities, insurance, and real estate. Added Section 23B to Federal Reserve Act, restraining nature of transactions with affiliates. Exempted industrial banks from BHCA, allowing commercial affiliations. 1989 Federal Reserve "Section Extended 1987 authority to corporate bonds in 20 Subsidiaries" Ruling affiliates within bank holding companies. 1989 Financial Institutions Tightened affiliation/investment qualifications Reform, Recovery, and affecting savings and loan associations. Enforcement Act of 1989 1990 Federal Reserve "Section Extended 1987 authority to equity dealings (for JP 20 Subsidiaries" Ruling Morgan.) 1991 Federal Deposit Insurance Gave Federal Deposit Insurance Corporation veto Corporation Improvement over state-allowed subsidiaries of banks. Prohibited http://wikileaks.org/wiki/CRS-RS21680 Act of 1991 state bank affiliation with insurers. 1994 Riegle-Neal Interstate Repealed 1956 Douglas Amendment to BHCA, Banking and Branching allowing holding companies' bank affiliates across Efficiency Act state line boundaries. 1996 Comptroller of the Allowed subsidiaries of national banks to expand Currency Regulation activities, including insurance and securities. 1997 Federal Reserve "Section Lessened restrictions on affiliation relationships and 20 Subsidiaries" Ruling transactions involving member banks and securities operations. Exempted holding company affiliates from certain anti-tying rules. 1998 Federal Reserve Ruling Allowed insurance firm Travelers to acquire on Citigroup Business Citicorp, to become bank holding company Activities Citigroup. Conditioned on divestiture of then- impermissible affiliations. 1999 Gramm-Leach-Bliley Act, Repealed Sections 20 and 32 of GSA: allowed Title I affiliations of banks, insurance companies such as Travelers, securities businesses, etc. via financial holding companies or investment bank holding companies. Merchant banking investments of financial holding companies allowed nonfinancial affiliations. Authorized bank subsidiaries in these businesses, except insurance underwriting, title insurance, merchant banking, and real estate. Future expansion of affiliations via rulemaking. 1999 Gramm-Leach-Bliley Act, Disallowed affiliations of savings and loan holding Title IV companies for a single institution ("unitary thrift holding companies") with nonfinancial businesses. 2002 Comptroller of the National banks could purchase bonds convertible Currency Ruling into equity (stock). CRS-6 Years Action Affiliation Change 2002- Citigroup Business Divested most insurance business lines of Travelers 2004 Activities previously acquired. 2003 Federal Reserve Gave bank holding company affiliates much ability Regulation to process, store, and transmit nonfinancial data. 2003- Federal Reserve Rulings Gave financial holding company affiliates authority 2004 to take and make delivery of physical commodities. 2004 Comptroller of the Preempted many state laws governing national Currency Regulation banks and their affiliates (subsidiaries). 2005 Comptroller of the Allowed national banks to engage in electricity Currency Ruling derivative activities, beyond oil and gas derivatives. Source: Congressional Research Service, The Library of Congress. Community Reinvestment Act Regulation of Affiliates? http://wikileaks.org/wiki/CRS-RS21680 Regulators have shown concern over affiliates of banks that may be engaging in undesirable ("predatory") lending practices, in proposed regulatory language. Through evaluations under the Community Reinvestment Act of 1977 (P.L. 95-128, Title VIII), they report bankers' socially graded performance, largely in lending. They may penalize banks whose affiliates engage in "discriminatory, illegal, or abusive credit practices," by reducing the bank's Act ratings . They may require disclosure of bank loans purchased by affiliates.9 Tying? Banks and their affiliates cannot require customers to "tie" purchases of banking and nonbanking (securities, etc.) services together, nor give special treatment to some customers through affiliate arrangements. Customers may, however, voluntarily request such bundling of financial services. The Fed grants certain exemptions from its rules that otherwise limit cross-selling of banks with affiliates. It has sanctioned at least one holding company for direct tying. A trade group found that banks frequently condition corporate credit on purchase of other services.10 In the other direction, the Comptroller of the Currency found that the appearance of "tying" was a permissible, understandable phenomenon.11 The Government Accountability Office (GAO; formerly named General Accounting Office) examined whether banks tie credit to securities underwriting services, but could not prove occurrences. GAO suggested stronger enforcement of laws.12 9 See CRS Report RS20197, Community Reinvestment Act, by William D. Jackson. 10 Association for Financial Professionals, 2004 Credit Access Survey: Linking Corporate Credit to the Awarding of Other Financial Services, June 2004, 15 p. 11 Office of the Comptroller of the Currency, Today's Credit Markets, Relationship Banking, and Tying , Washington: Sept. 2003. 12 U.S. General Accounting Office, Bank Tying: Additional Steps Needed to Ensure Effective Enforcement of Tying Prohibitions, GAO Report GAO-04-03, Oct. 20, 2003.