"Gramm-Leach-Bliley Act - What It and Functional Regulation Mean To Community Banks"

David Baris
Executive Director
American Association of Bank Directors
Bethesda, MD 20816

Summary Presentation Before the 2001 Banking Institute
Sponsored by the UNC School of Law Center for Banking and Finance

April 5-6, 2001

To community banks, functional regulation and the opportunities presented by the Gramm-Leach-Bliley Act represent a strategic issue – whether and how to offer a new banking or financial product. Functional regulation also means that community banks must prepare themselves for multi-agency supervision, including agencies regulating the securities and insurance industry.

Today, community banks still rely heavily on interest margins and receive only a small amount of their revenue in the form of non-interest income. Large banks (over $50 billion in assets) have non-interest income approximating 50% of their revenues; community banks have, on average, only 20% of their revenues coming from non-interest income. Large banks have interest spreads under 3%, whereas community banks have spreads of 4% or more. While a higher spread appears to be advantageous for community banks, it actually means that they are more susceptible to changing market conditions and competitive factors. They also face the loss of free business checking accounts, which under current law, cannot be paid interest. Under the Small Business Interests Checking Act of 2001 (H.R. 974), which has passed the U.S. House of Representatives, payment of interest on business checking accounts will be permitted within two years of enactment, thereby increasing banks’ interest expense.

Of the 500 bank holding companies that have become financial holding companies under Gramm-Leach-Bliley ("GLB"), 370 are community banks under $500 million. My guess is that many of them haven’t used any of the powers authorized to them under GLB, or even have a clear idea on how they intend to use these new powers.

The fact is that community banks generally haven’t even used many of the powers that existed before GLB was enacted in 1999 and that still are authorized.

The preexisting powers derive from Section 4(c)8) of the Bank Holding Company Act (known as the "closely related to banking" powers), Section 24 powers (those deriving from 12 U.S.C. 24 (7), a provision in the National Bank Act authorizing national banks to engage in activities that are incidental to the business of banking) and state laws granting bank powers to state banks. Some of these powers are broad and extensive, allowing banks to engage in a broad range of activities without having to file as a financial holding company and become subject to the limitations imposed on financial holding companies. One extraordinary power that the Comptroller of the Currency has authorized to national banks is that of acting as a "finder." That is, national banks may bring a buyer and seller together and be compensated for it. The OCC does not require the product itself to be banking or financially related. For example, the OCC has allowed a national bank to run a virtual used car mall through which used car dealers sell cars to customers.

Many of the new powers granted under GLB are not of interest to community banks. These include underwriting insurance and annuities, underwriting, dealing in or making a market in stock, merchant banking, and underwriting municipal securities.

What activities are community banks most interested in and fit their businesses the best?

• Mortgage companies
• Small loan companies
• Insurance agencies
• Title insurance agencies
• Personal property leases
• Investment advisory services
• Trust activities
• Securities brokerage activities through third-party brokers

The preexisting law allowed virtually all of these activities, although with some restrictions on insurance agency activities that were lifted by GLB.

If community banks can engage in activities without becoming a financial holding company, why become a financial holding company?

The problem is that when a financial holding company is formed, several limitations or conditions become applicable. For example, bank subsidiaries and affiliates must maintain their status as well capitalized and well managed, or risk draconian bank supervisory enforcement measures such as divestiture of the financial subsidiaries. In addition, financial subsidiaries of banks cannot have assets exceeding an aggregate of 45% of the bank’s assets. Investment in the equity of financial subsidiaries is deducted from a bank’s regulatory capital. Financial subsidiaries of banks are subject to Sec. 23A and 23B of the Federal Reserve Act, which severely restricts transactions between the bank and the subsidiaries and affiliates. Operating subsidiaries (those that engage in activities that were authorized under the old law) are not subject to these restrictions.

Functional regulation is supposed to mean that it no longer matters what entity a bank uses to offer a product because the product is regulated based on the activity, not on the entity that performs the activity. However, it still matters. For example, to take advantage of the limited exemption from broker-dealer registration with the SEC, a bank, not its non-bank subsidiaries or affiliates, can qualify. Also, GLB provides that national banks cannot sell title insurance unless they are grandfathered or unless their state allows state banks to sell title insurance. The statute does not limit bank subsidiaries or nonbank affiliates from selling title insurance.

In sum, community banks have a huge array of products and services that they can offer under both the old and new law, which many of them are not offering. The problem is not with the limitations of the law, but the willingness and interest of community banks to take advantage of these business opportunities.