On Sunday, September 21, 2008, the Federal Reserve Board (the “Board”) approved applications of both the Goldman Sachs Group, Inc. (“Goldman”) and Morgan Stanley to become bank holding companies under section 3 of the Bank Holding Company Act (“BHC Act”). Unlike other recent regulatory actions that test the limits of current government authority, the Board’s approval does not involve invocation of an exception or of an unusual or exigent circumstance. The approvals are noteworthy, however, because Goldman and Morgan Stanley appear to have been attracted by improved liquidity options and by the Federal Reserve’s regulatory imprimatur. The approvals also have generated some discussion about the Glass-Steagall Act (which, when fully in effect, would have barred the applications) and the repeal of some (but not all) of the Glass-Steagall provisions by the Gramm-Leach-Bliley Act in 1999 (“GLB Act”).
Federal Reserve Approvals
Goldman and Morgan Stanley each currently own an industrial loan company organized under the laws of Utah.1 Both ILCs are currently FDIC-insured, take deposits, make loans and perform other bank-like functions, but they are not technically “banks” under the BHC Act. As a result, neither Goldman nor Morgan Stanley was a bank holding company, was regulated by the Board or had the advantages, such as they are, of regulation and consolidated supervision by the Board. Until now, both companies had been regulated on a consolidated basis by the Securities and Exchange Commission (SEC).
In order to become bank holding companies, Goldman and Morgan Stanley must control banks. Goldman will convert its ILC to a Utah-chartered commercial bank, and Morgan Stanley has received approval from the Office of the Comptroller of the Currency to convert its ILC to a national bank.
Each of the investment banks engages in certain activities that the Board has determined to be financial in nature, or incidental or complementary to a financial activity under section 4(k) of the BHC Act. These activities include, among other things,
- underwriting, dealing and making a market in securities;
- providing financial, investment or economic advisory services;
- acting as a placement agent in the private placement of securities;
- engaging in merchant banking activities;
- acting as principal in foreign exchange and in derivative contracts based on financial and non-financial assets; and
- making, acquiring or brokering loans or other extensions of credit.
Such activities are permissible for financial holding companies under the GLB Act which repealed the restrictions on affiliation with securities firms that were contained in sections 20 and 32 of the Glass-Steagall Act. As compared to bank holding companies, financial holding companies can engage in an expanded list of permissible activities, predominantly in the areas of securities, insurance and merchant banking.
Morgan Stanley already has filed its election under sections 4(k) and (l) of the BHC Act to become a financial holding company, and Goldman is expected to file the same election promptly if it has not already done so. Notwithstanding the expanded list of permissible activities afforded to financial holding companies, the Board has indicated in the approval orders for both investment banks that certain activities are beyond the scope of those permitted by law.
Section 4 of the BHC Act by its terms also provides any company that becomes a bank holding company two years to conform its existing nonbanking investments and activities to the requirements of section 4 of the BHC Act, with the possibility of three one-year extensions. [Morgan Stanley and Goldman Sachs] must conform to the BHC Act any impermissible nonfinancial activities [either] may conduct within the time requirements of the Act.2
The Board’s approval orders do not specify which activities or investments of either Goldman or Morgan Stanley may be impermissible. For investments that are impermissible, Goldman and Morgan Stanley generally have two options besides complete divestiture: They could convert such investments to “merchant banking” investments, where there are limits on the time period of the investment and the ability to exert operational control, or they could reduce any investment to less than five percent of the outstanding voting shares.
In addition to limitations on investments and activities applicable to bank and financial holding companies, both Goldman and Morgan Stanley will become subject to the Board’s capital requirements and the regulatory commitment to serve as a source of strength for the subsidiary banks. The Board’s approval orders state that both Goldman and Morgan Stanley are adequately capitalized and that their subsidiaries meet all relevant capital requirements. Goldman also has stated publicly that it exceeds the well capitalized threshold of six percent for Tier 1 capital and has been above that threshold since the ratios were first calculated in 2004. Nonetheless, the Board’s capital and related financial requirements for bank holding companies seem likely to compel reduction of the historic leverage ratios of the investment banks.
Although doubtless many considerations motivated the decisions by Goldman and Morgan Stanley to become bank holding companies, two factors have appeared in press accounts and warrant some comment.
First, Goldman and Morgan Stanley both have cited access to relatively stable and inexpensive sources of funding available only to banking organizations, including insured deposits and the discount window. Neither source, however, will be completely new to either entity, and neither is a complete panacea for funding concerns. The Goldman and Morgan Stanley ILCs already have developed significant amounts of deposits. Still, the growth of these institutions in a commercial bank charter may well drive a correlated growth in deposits. The limitations on a bank’s transactions with affiliates and on its dividends, however, mean that the economic benefits of deposit funding are not easily passed along to affiliates. With respect to the discount window, Goldman and Morgan Stanley have noted that, as bank holding companies, they will have access to this financing source.3 Although the ILCs already have had access to the discount window, and although bank holding companies historically have not been able to borrow from the window,4 there are various ways in which status as a bank holding company is likely to increase funding availability from the Board. For example, over the weekend, the Board authorized the Federal Reserve Bank of New York to extend credit as needed to the U.S. and London-based broker-dealer subsidiaries of Goldman and Morgan Stanley (as well as of Merrill Lynch, which has agreed to be acquired by Bank of America).
Second, both investment banks suggest that market and counterparty confidence in their financial condition and overall safety and soundness will be enhanced by prudential supervision by the Board. Until becoming bank holding companies, Goldman and Morgan Stanley had been supervised on a consolidated basis by the SEC. If the companies are correct that market participants place a higher value on Board supervision than on SEC regulation, the Board’s informal but growing role as “systemic risk” regulator will be further enhanced.
Whatever the driving forces may be, there is clearly a “price of admission” for the investment banks to submit to Board regulation, a price which they have historically avoided. Current market conditions, however, trump the longstanding effort to remain free from Board oversight.
Glass-Steagall and Gramm-Leach-Bliley
Occasional students of U.S. history may recall that the combination of commercial and investment banking within the same Wall Street financial institutions was popularly believed to be one cause of the stock market crash in 1929, and the later Great Depression. The political response was the enactment of the Glass-Steagall Act, which was part of the Banking Act of 1933 and, in very broad terms, forced commercial and investment banking activities into separate, unaffiliated entities. Indeed, Morgan Stanley itself is a creature of that statute, having been severed from the J.P. Morgan organization.
The substance of the Glass-Steagall Act was contained in four provisions of the Banking Act of 1933. Section 16 prohibits a bank from directly underwriting securities, with the exception of certain government-related securities.5 Section 20 (repealed by the GLB Act) barred a bank from associating with any institution “engaged principally in the issue, flotation, underwriting, public sale, or distribution” of securities. Section 21 precludes a securities firm from accepting deposits.6 Section 32 (also repealed by the GLB Act) prohibited management interlocks between a bank and a firm covered by section 20. Over time, the Board eased some of the section 20 restrictions, but in 1999, the provisions still remained in effect. The GLB Act’s repeal of sections 20 and 32 of the Glass-Steagall Act (together with the addition of section 4(k) to the BHC Act) allows affiliations between banks and securities firms. Sections 16 and 21 still remain in place, however, and prevent underwriting and deposit-taking from occurring within the same corporate entity. Many bank holding companies took advantage of the elimination of the affiliation constraints in sections 20 and 32 to expand their operations into higher-margin securities businesses. Until now, however, the independent investment banks chose to enter the banking industry only in limited ways.
The role of the GLB Act and its repeal of sections 20 and 32 of the Glass-Steagall Act in the current financial crisis may continue to be a matter of debate. Certainly many mortgage originators and underwriters of mortgage-related securities were never affiliated (thus effectively continuing to observe sections 20 and 32). Moreover, although it certainly was not written with the current crisis in mind, the GLB Act appears to offer a way forward for affected investment banks, without institution-specific government assistance.