TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
In late 1996, the Board adopted a change in the manner in which interest
earned on certain securities held by a section 20 subsidiary is treated in determining
whether the company is "engaged principally" in underwriting and dealing in securities
for purposes of section 20 of the Glass-Steagall Act. After the Board's action, some
section 20 subsidiaries and their representatives raised questions about, or sought
clarifications of, the Board's revenue test calculation changes. The principal purpose
of this SR Letter is to inform you about our responses and clarifications, and to
request that your staff notify District section 20 subsidiaries about these matters. It
also requested that examiners review the adequacy of data available at section 20
firms that chose to rely on the clarifications discussed below in order to calculate their
amended revenue test ratios, and that they seek to ensure that amended FR Y-20
reports have been filed reflecting such changes.
Treatment of interest under the two-year rolling average test
The Board has amended its section 20 Orders to specify that interest
earned on the types of debt securities that a member bank may hold for its own
account (but not underwrite) will not be treated as "ineligible" revenue derived from
underwriting or dealing in bank-ineligible securities. Instead, such interest income is
treated as bank-eligible or "eligible" revenue and is included in the total revenue
generated by the company. This change became effective on November 12, 1996,
which means that the new reporting instructions should be used to compute
compliance with the revenue limitation in FR Y-20 reports filed with the Board since
the third quarter of 1996.
Following the announcement of this change, the ABA Securities
Association sought clarification. Given that compliance with the revenue test is
measured on a rolling, eight-quarter basis, guidance was sought as to whether
companies calculating compliance with the revenue test for the third quarter of 1996
could use the amended treatment of interest income for all eight quarters. The Board
has decided to permit, but not require, any section 20 subsidiary that possesses the
requisite data to use the amended treatment for the past eight quarters.
Attached for your information is the Board's letter, dated October 30,
1996, to the ABA Securities Association. Please furnish a copy of this letter to
examiners responsible for conducting section 20 inspections and request that they
review the records of any firms reclassifying prior period revenues and verify that
those firms possess the requisite data required by the Board's letter. Examiners
should also verify that amended FR Y-20 reports have been filed for any prior
quarter(s) in which revenues have been reclassified. Examiners should continue to
review FR Y-20 reports for accuracy during on-site inspections, and require
amendments if material errors are found. Other questions pertaining to interest income
Bank holding companies and their accountants have asked whether
interest earned on cash pledged against borrowed securities should be treated as
eligible or ineligible revenue. Questions have also been raised concerning the
classification of income derived from reverse repurchase agreements involving
ineligible securities. Ambiguities have arisen, in part, because existing FR Y-20 report
instructions do not specifically address either issue.
The Board's section 20 Orders state that any revenue derived from an
activity conducted as a necessary incident to ineligible underwriting and dealing
activities must be treated as ineligible revenue, unless the Board rules otherwise.
Because of this requirement, staff had assumed that any interest derived from
activities involving ineligible securities, other than agency functions, was to be
classified as ineligible revenue generated as an incident to conducting underwriting
and dealing activities. However, in its recent decision concerning the treatment of
interest associated with underwriting and dealing in ineligible debt securities, the
Board acknowledged that interest income is not inexorably linked to underwriting and
dealing in those securities. Instead, the Board concluded that revenue classification is
based upon the fact that a member bank could earn such interest from securities held
for its own account. As a result, staff has specifically addressed the current questions
in light of the Board's recent guidance.
Turning first to the question of pledging cash to secure the borrowing of
securities, it is noted that section 20 subsidiaries are broker-dealers registered with the
Securities and Exchange Commission. As such, they are subject to the Board's
Regulation T , which governs securities credit and permits the borrowing of securities
to cover short sales or "fails" to receive securities required to be delivered. Regulation
T requires that the securities borrower secure the transaction with a letter of credit or
pledge cash or other specified collateral. In instances where cash is pledged, the
borrower typically receives interest against cash collateral.
It is Board staff's view that section 20 subsidiaries may treat as eligible
revenue, interest income earned on cash pledged as collateral to secure their
borrowings of ineligible securities. This type of revenue is derived from an activity that
is distinct from underwriting and dealing functions.
Questions have also been raised concerning whether section 20
subsidiaries may also treat as eligible the interest derived from engaging in reverse
repurchase agreements secured by securities other than those that a member bank
may underwrite or deal in. In this regard, it is noted that for Call Report purposes a
reverse repurchase agreement is characterized as the purchase of assets subject to
an agreement by the purchaser to resell the assets at a specified date or in specified
circumstances; qualifying transactions are generally reported as loans. As noted
above, interest derived from those types of securities that a member bank may hold
(but not underwrite or deal in) is treated as bank-eligible revenue. Accordingly, staff
has determined that it is permissible to treat as eligible, interest revenue derived from
any reverse repurchase agreement with collateral that could be taken by a member
bank, i.e., that a member bank could hold for its own account.
Please inform each section 20 subsidiary in your District, as well as the
afinancial reports area in your Reserve Bank, of the above clarifications. Board staff
will endeavor to incorporate clarifying language in the next revision of the FR Y-20
instructions. Reserve Banks may choose to either forward a copy this SR Letter or
prepare a separate letter notifying District section 20 subsidiaries of these matters.
If you have any questions concerning any matter discussed in this
SR Letter, please contact Mike Schoenfeld at (202) 452-2781.
Deputy Associate Director
ATTACHMENT TRANSMITTED ELECTRONICALLY BELOW
OF THE FEDERAL RESERVE SYSTEM WASHINGTON, D. C. 20551 ADDRESS OFFICIAL CORRESPONDENCE TO THE BOARD
Dear Mr. LaRocco:
This letter responds to your letter of September 30, 1996, in which
you sought clarification of a recent amendment to the Board's section 20
revenue test. That test is used to determine whether a bank holding company
subsidiary is engaged principally in underwriting and dealing for purposes of
section 20 of the Glass-Steagall Act. In its order dated September 11, 1996, the
Board stated that it would no longer consider interest income earned on
securities that a member bank could hold for its own account as revenue derived
from underwriting or dealing in securities for purposes of the revenue test. The
Board also stated that section 20 subsidiaries could begin using this method to
compute compliance with the revenue limitation in reports filed for the third
quarter of 1996.
Given that compliance with the revenue test is measured on a
rolling, eight-quarter basis, you asked whether companies calculating
compliance with the revenue test for the third quarter of 1996 could use the
amended treatment of interest income for all eight quarters. The Board has
considered your request and decided to allow any section 20 subsidiary that
possesses the requisite data to use the amended treatment for the past eight
quarters. As you note, this decision is consistent with the Board's previous
practice. See Supplement to Order Approving Modifications to Section 20
Orders, 79 Federal Reserve Bulletin 360 (April 1993) (allowing use of indexed
revenue test for past quarters).
Those companies that do not have the requisite data should
continue to compute compliance on a rolling, eight-quarter basis, using reports
filed under the former method for any quarters prior to the third quarter of
1996. As you note, when the Board adopted its indexed revenue test,
companies that wished to use the test, but did not have the requisite data, were
allowed to implement the indexed revenue test on a prospective basis, building
from a one-quarter "average" to an eight-quarter average over two years. Order
Approving Modifications to Section 20 Orders, 79 Federal Reserve Bulletin 226,
230 (1993). The Board does not believe, however, that implementation on a
prospective basis would be appropriate here. The Board's recent order
interpreted an existing test, whereas its 1993 order adopted an alternative test
that required new systems in order to generate the required data. Thus, there is
less justification for disregarding revenue from the past seven quarters in
monitoring compliance with the Glass-Steagall Act.
Thank your for your interest in this matter.
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