The Gramm-Leach-Bliley Act: What's In It for Banks and Thrifts

The Gramm-Leach-Bliley Act, signed into law by President Clinton on November 12, 1999, is a sweeping piece of financial modernization legislation. In broad terms, the Act:

• provides for affiliations among banking, insurance and securities firms
• establishes certain principles of "functional regulation" applicable to such operations
• imposes broad new consumer protections relating to privacy.

This Update summarizes key provisions of the Act with a particular focus on those provisions that will be of interest to banks and thrifts and their holding companies. Other Updates on the Act include:

• The Gramm-Leach-Bliley Act: What's In It for the Insurance Industry
• The Gramm-Leach-Bliley Act: What's In It for the Investment Management Industry
• The Gramm-Leach-Bliley Act: New Privacy Provisions Become Law
• SBICs After Gramm-Leach-Bliley

Expanded Powers

A centerpiece of the Gramm-Leach-Bliley Act is the authority for expanded activities by banks and bank holding companies. Unless otherwise noted, these provisions take effect 120 days after enactment of the Act, which is March 11, 2000.

Holding Company Powers

Financial Holding Companies

A key mechanism for the expanded banking powers under the Gramm-Leach-Bliley Act is the creation of a new kind of bank holding company, referred to as a "financial holding company." An eligible bank holding company that makes an election to be a financial holding company will be authorized to engage in any activity that is "financial in nature or incidental to financial activities," and any activity that the Fed determines is "complementary to financial activities" and does not pose undue risks to the financial system. (Early indications from the Fed are that "complementary" activities will be limited in amount, as well as by the nature of the connection to financial activities.)

Bank holding companies that do not qualify or do not elect to be financial holding companies will be subject to the existing limitations on permissible activities. However, no new activities may be approved by the Fed as "closely related to banking" for these purposes after the date of enactment of the Gramm-Leach-Bliley Act.

Financial Activities

Activities that are defined by the Act as "financial in nature" specifically include:

• lending, exchanging, transferring, investing for others, or safeguarding money or securities
• all existing activities approved for bank holding companies as "closely related to banking"
• all activities approved under Regulation K for bank holding companies to engage in outside of the United States (the principal activity covered by this would be a travel agency)
• insuring, guaranteeing or indemnifying against loss, harm, damage, illness, disability or death, or providing and issuing annuities, and acting as principal, agent or broker for purposes of the foregoing, in any state
• providing financial, investment or economic advisory services, including advising an investment company
• issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly
• underwriting, dealing in or making a market in securities
• certain merchant banking activities (discussed below).

In addition, the Fed is called upon to define by regulation the extent to which activities in the following categories may be financial in nature:

• lending, exchanging, transferring, investing for others or safeguarding financial assets other than money
• providing any device or other instrumentality for transferring money or other financial assets
• arranging, effecting or facilitating financial transactions for the account of third parties.

Merchant Banking Activities

Under the so-called merchant banking powers of the Act, broad authority is given for bank holding companies that are financial holding companies to take equity positions in companies or assets, including controlling interests, subject to certain restrictions designed to distinguish permissible merchant banking type investments from impermissibly engaging in the business of the other company.

In order to come within these provisions, the investment must be made either (i) by an insurance company engaged predominately in underwriting life, accident and health, or property and casualty insurance (other than credit-related insurance) in the ordinary course of business of such insurance company in accordance with relevant State laws, or (ii) by a securities affiliate, an investment adviser to an insurance company, or affiliate thereof, as part of a bona fide underwriting or merchant or investment banking activity, with the investment held for a period of time to enable the sale or disposition thereof on a reasonable basis. In either case, during the period such investment is held, the bank holding company must not routinely manage or operate the portfolio company except as may be necessary or required to obtain a reasonable return on investment.

Loans by an affiliated depository institution to a controlled portfolio company would be restricted, and for these purposes there is a presumption that any portfolio company is controlled if 15 percent or more of the total equity capital of the portfolio company is controlled directly or indirectly by the financial holding company.

National Bank Powers

As a corollary to financial holding companies, the Act also creates a new kind of national bank subsidiary called a "financial subsidiary." Financial subsidiaries are also authorized to engage in activities that are "financial in nature or incidental to financial activities," but they have no authority to engage in activities that are "complementary to financial activities." In addition, the following activities are expressly precluded for a subsidiary of a national bank:

• real estate development or real estate investment activities, unless otherwise expressly authorized by law
• merchant banking activities, for at least five years (provision is made for regulations by the Fed and OCC to allow for merchant banking after five years)
• insurance underwriting or issuance, subject to certain grandfathered activities
• title insurance issuance or agency activities, except (i) title agency activities if, and to the extent, that State institutions are permitted under State law to engage in such title insurance agency activities, and (ii) grandfathered title insurance activities, subject to certain "push-out" requirements if there is an affiliated insurer.

The Gramm-Leach-Bliley Act does not expressly amend the provisions of the National Bank Act on which the OCC has based its existing operating subsidiary regulations, and arguably the OCC could continue to approve activities to be conducted through operating subsidiaries that are not permissible for national banks themselves (such as securities activities), without regard to the new provisions regarding financial subsidiaries. However, preliminary indications from the OCC are that any activities not permissible for national banks directly will be required to be housed in a financial subsidiary.

Conditions to Expanded Powers

In order to engage in activities not authorized under current law, a bank holding company or national bank must maintain compliance at all times with the following requirements:

• all depository institutions within the holding company group must be well capitalized under the risk-based capital system applicable to banks and bank holding companies and
• all depository institutions within the holding company group must be well managed, as determined by the applicable banking regulator.

In addition, at the time of commencement (de novo or by acquisition) of any new activity not permissible under current law, all depository institutions within the holding company group must have a "satisfactory" rating under the Community Reinvestment Act.

For financial subsidiaries of national banks, certain additional conditions and limitations apply.

• The aggregate consolidated total assets of all financial subsidiaries of a national bank cannot exceed the lesser of 45 percent of consolidated total assets or $50 billion (these limits are to be adjusted based on an indexing method to be established by regulation).
• If the national bank is one of the 100 largest insured banks and is engaged in financial activities as principal (not just as agent), it must meet certain requirements relating to maintaining outstanding investment grade subordinated debt.

In calculating regulatory capital:

• the aggregate amount of the outstanding equity investment, including retained earnings, of a national bank in all financial subsidiaries must be deducted from the assets and tangible equity of the national bank and
• the assets and liabilities of the financial subsidiaries shall not be consolidated with those of the national bank, and any published financial statement of a national bank that controls a financial subsidiary must separately present financial information for the bank in this manner.

A national bank with a financial subsidiary must maintain appropriate policies and procedures to safeguard the bank against the risks of the financial subsidiary and maintain corporate separateness.

Sections 23A and 23B apply to transactions with financial subsidiaries, but:

• only the aggregate limitation of Section 23A applies (20 percent of capital), not the limitation on transactions with any one affiliate (10 percent of capital)
• retained earnings are not counted in calculating the amount of the investment in the financial subsidiary.

The Bank Holding Company Act anti-tying provisions will apply to financial subsidiaries of national banks as though they were subsidiaries of the holding company and not subsidiaries of the bank.

Additional Municipal Underwriting Authority

In addition to the new powers that can be exercised through financial subsidiaries, as described above, national banks are given expanded authority to engage directly in the underwriting of municipal bonds, including limited obligation bonds, revenue bonds and certain government owned facilities bonds (obligations that satisfy the requirements of section 142(b)(1) of the Internal Revenue Code).

State Banks

Under a new Section 46 to the FDIA, state banks are authorized to control or hold an interest in a subsidiary that engages in activities that would only be permissible for a national bank to conduct through a financial subsidiary, if:

• the state bank and each depository institution affiliate of the state bank are well capitalized
• the state bank complies with the capital deduction and financial statement disclosure requirements applicable to national banks with financial subsidiaries, as described above
• the state bank complies with the financial and operational safeguards applicable to national banks with financial subsidiaries, as described above.

Sections 23A and 23B of the Federal Reserve Act, restricting "covered transactions" between depository institutions and their affiliates, will apply as described above to any subsidiary that, if it was a subsidiary of a national bank, would be a financial subsidiary.

Gramm-Leach-Bliley does not amend FDIA '24 and, therefore, the authority of state banks to engage in many activities (directly or through subsidiaries) not permissible for a national bank would appear to survive, based upon FDIC approval of the activity as not posing a significant threat to the deposit insurance system.

Thrifts and Thrift Holding Companies

The Gramm-Leach-Bliley Act closes the unitary thrift holding company door, pursuant to which the bank holding company activities limitations did not apply to a holding company of a single savings association. Grandfathering is provided for companies that were approved as thrift holding companies before, or pursuant to an application filed before, May 4, 1999 (a date carefully chosen to exclude an application from Wal-Mart). Among other issues with respect to these grandfathering provisions, there would appear to be some uncertainty as to the ability of an existing unitary thrift holding company to engage in new activities that are not financial in nature, especially where the holding company's existing activities do not exceed those limits.

The grandfathering of existing unitary thrift holding companies would not apply to any new company that becomes a holding company of the savings association, except pursuant to certain permitted corporate reorganizations.

For new thrift holding companies that meet the criteria of a unitary thrift holding company, the new financial holding company powers would be available. There is some uncertainty whether such powers extend to thrift holding companies that do not meet the standards for unitary thrift holding company treatment. However, we expect the OTS to do everything it can to maintain a level playing field for such holding companies.

The powers of state and federal savings associations remain unchanged by the new Act.

Functional Regulation

General

A financial holding company is still a bank holding company, and the Fed is given primary regulatory jurisdiction over any holding company system that includes a bank. However, under Gramm-Leach-Bliley, the Fed is generally instructed to defer to the supervision and examination of subsidiaries by other regulators. For example, in implementing any reporting requirements it may impose, the Fed is required to accept to the fullest extent possible reports submitted to other regulators, audited financial statements and publicly available information. Similarly, the Fed is generally required to defer to examinations made by other regulators.

Certain special protections are given to "functionally regulated subsidiaries," defined as any company that is not a bank holding company and is a registered broker-dealer, a registered investment adviser (with respect to its investment advisory activities and activities incidental thereto), a registered investment company, an insurance company (with respect to its insurance activities and activities incidental thereto) or a CFTC regulated company (with respect to its commodities activities and activities incidental thereto).

• The Fed may examine functionally regulated subsidiaries only if: (1) the Fed has reasonable cause to believe that such a subsidiary is engaged in activities that pose a material risk to an affiliate depository institution; (2) it reasonably believes after reviewing the relevant reports that examining the subsidiary is necessary to adequately inform the Fed of the systems for monitoring risks; or, (3) based on reports and other available information, the Fed has reasonable cause to believe that a subsidiary is not in compliance with the BHCA or other federal law that the Fed has specific jurisdiction to enforce and the Fed cannot make such a determination through examination of an affiliated depository institution or the holding company.
• The Fed is not authorized to prescribe capital requirements for any functionally regulated subsidiary that is in compliance with applicable capital requirements of another federal regulatory authority, a state insurance authority, or is a registered investment adviser or licensed insurance agent.
• The Fed is prohibited from requiring a broker-dealer or insurance company that is a bank holding company to infuse funds into a depository institution if the company's functional regulator determines, in writing, that such action would have a material adverse effect on the broker-dealer or insurance company. If the functional regulator makes such a determination, the Fed may require the holding company to divest its depository institution.

Streamlined FRB Regulation

A bank holding company and its nonbank subsidiaries may engage in any nonbanking activity that the Fed has determined by regulation or order to be closely related to banking as of the day before the enactment of the Act. In order to engage in the expanded activities available under Gramm-Leach-Bliley, a bank holding company must elect to be treated as a financial holding company.

A bank holding company that has qualified for financial holding company treatment may, without prior Fed approval, engage in any financial activity designated in the Act and any activity that the Fed has determined to be financial in nature or incidental thereto or complimentary to a financial activity. Such activities require only a 30-day post-commencement notice.

The Act also makes clear that a financial holding company declaration will satisfy the bank holding company registration requirements contained in section 5(a) of the Bank Holding Company Act.

Bank Investment Company and Broker-Dealer Activities

As part of the functional regulation scheme imposed under the Act, the bank exemptions from investment adviser and broker-dealer are significantly scaled back. Banks that advise registered investment companies will be required to register under the Investment Advisers Act, and bank broker-dealer activities will have to be carefully scrutinized to confirm whether they fit within new, narrower exemptions from broker-dealer regulation. For additional information on these provisions and other provisions of the Act regarding bank securities activities, please refer to our separate Update titled "The Gramm-Leach-Bliley Act - What's in It for … Investment Management Firms."

CRA Reform

CRA Sunshine Requirements

The so-called "CRA sunshine" provisions of the Act require the full disclosure of any agreement between an insured depository institution (or its affiliate) and a nongovernmental entity or person where the agreement is made pursuant to or in connection with the Community Reinvestment Act (the CRA), involving funds or other resources of an insured depository institution or affiliate. Subject to certain exceptions, the disclosure requirement applies to any written agreement that provides cash or grants in excess of $10,000 or loans with a principal amount in excess of $50,000.

Any depository institution that is a party to such an agreement must disclose the full text of the agreement to its primary federal banking regulator and the public and must provide an annual report of its activity to its primary federal banking regulator. The entity or person receiving the funds must do the same annually and must include an accounting of the use of the funds.

Small Bank Regulatory Relief

The Act provides significant regulatory relief for small banks (depository institutions with less than $250 million in assets). Pursuant to the Act, a small bank with an "outstanding" CRA rating may be examined not more than once every five years and a small bank with a "satisfactory" rating may be examined not more than once every four years. More frequent examinations may occur where mergers are sought with another bank or thrift.

FHLB Modernization

The Act significantly reforms the Federal Home Loan Bank System (the FHLBank System) by easing membership requirements, expanding borrowing access for FDIC-insured banks and thrifts with $500 million or less in assets (Community Financial Institutions), eliminating distinctions between qualified thrift lender (QTL) and non-QTL members, revising the system's capital structure and decentralizing its governance.

Membership Requirements

The Act eliminates mandatory FHLBank membership for federal savings associations. In addition, Community Financial Institutions are no longer required to have 10 percent of their total assets in residential mortgage loans and related assets to qualify for membership. Banks and thrifts with more than $500 million in assets are still required to comply with the 10 percent requirement. The Act also eliminates the requirement that non-QTL members purchase additional stock in their FHLBank.

Advances to Members

Gramm-Leach-Bliley permits Community Financial Institutions to obtain long-term FHLBank advances for lending to small businesses, small farms and small agri-business. The Act also eliminates the cap on aggregate outstanding advances made by any FHLBank to any member. With regard to collateral, eligible collateral for Community Financial Institutions receiving any FHLBank advances may now include secured loans for small business, agriculture or securities representing a whole interest in such secured loans. The Act also removes the 30 percent cap on "other real estate related collateral."

Capital Structure

The Gramm-Leach-Bliley Act establishes a new capital structure for the FHLBanks. Two classes of stock are authorized: Class A (redeemable on six-months notice) and Class B (redeemable on five-years notice). FHLBanks are required to meet a 5 percent leverage minimum tied to total capital and a risk-based requirement tied to permanent capital. The FHLBank Board must issue regulations prescribing uniform capital standards applicable to each FHLBank within one year of enactment of the Act.

Decentralization of Control

Governance of the FHLBanks has been decentralized from the FHLBank Board to the individual FHLBanks.

Withdrawal of Proposed Financial Management and Achievement Regulation

On November 15, 1999, in light of the enactment of Gramm-Leach-Bliley, the FHLBank Board withdrew its proposed Financial Management and Achievement Regulation which, among other things, would have required the FHLBanks to divest their mortgage-backed securities investments over a five-year period.

ATM Fee Reform

The Act amends the Electronic Fund Transfer Act (the EFT Act) to require automated teller machine (ATM) operators who impose a fee for use of an ATM by noncustomers to post a notice on the machine and on the screen that a fee will be charged and the amount of the fee. The notice must be posted on the machine, or a paper notice issued, before the consumer is irrevocably committed to completing the transaction. No surcharge may be imposed unless the notices are made and the consumer elects to proceed with the transaction. These requirements will not apply to any ATM that lacks the technical capability to provide the notice requirements until December 31, 2004.

The Act also amends the EFT Act to require that the initial disclosures made by financial institutions include a notice that a fee may be imposed by (i) an ATM operator if the consumer initiates a transfer from an ATM that is not operated by the card issuer, and (ii) any national, regional or local network utilized to effect the transaction.

Expanded S-Corp Access

The Gramm-Leach-Bliley Act directs the Comptroller General of the United States to conduct a study on possible revisions to the rules governing S corporations and to issue a report to Congress no later than six months after the enactment of the Act. Possible revisions to be studied include increasing the permissible number of shareholders in S corporations, permitting the shares of such corporations to be held in individual retirement accounts, clarifying that interest on investments held for safety, soundness and liquidity purposes should not be considered to be passive income, discontinuing the treatment of stock held by bank directors as a disqualifying personal class of stock for such corporations, and improving federal tax treatment of bad debt and interest deductions. The Comptroller General also must consider the impact such revisions might have on community banks.

Privacy

The Gramm-Leach-Bliley Act imposes broad and potentially onerous provisions regarding the privacy of consumer financial information, including provisions restricting the transfer of such information to third parties and requiring the adoption and disclosure of privacy policies. For additional information, please refer to our separate Update titled "New Privacy Provisions Become Law."

The Gramm-Leach-Bliley Act is a truly landmark piece of legislation and will shape the financial services landscape for years to come. Please feel free to contact us if you have any questions about the Act or its effect on your company.