Nonbank activities ; Banks and banking - West ; Bank holding companies ; Banking law ; Securities

Gary C. Zimmerman

Michael C. Keeley

English

Research Papers in Economics

FRBSF WEEKLY LETTER
September 9, 1988
States Take the Lead
Currently, Congress is debating a number of
proposals that would expand the permissible
securities activities ofthe nonbank affiliates of
bank holding companies (BHCs). However, while
Congress debates, many states, including several
in the West, already have acted to expand state-
chartered banks' powers.
Permissible banking powers for state-chartered
banks that are not members of the Federal Re-
serve System are set by state statutes. Some states
now allow state banks and/or their subsidiaries to
engage not only in full securities activities, but
also in unrestricted insurance brokerage and
underwriting, direct real estate investment and
brokerage and general equity investment-ac-
tivities not even under consideration by the
Congress. More than half of all banks are state-
chartered and not members ofthe Federal Re-
serve System.
Such changes in state law indirectly may open
the door for expansion of BHC powers, even if
Congress takes no action. BHCs may own state
banks as well as national banks. Thus, depending
on state law, a BHC may be able to engage in
activities through a state bank subsidiary that
would not be permissible for its national bank
or nonbank subsidiaries.
In this Letter, we examine the additional powers
permitted state-chartered banks in the West and
the extent to which these powers are being used.
We also discuss the likely effect of expanded
state banking powers on BHCs.
Overview of state actions
Among the nine states in the Twelfth Federal
Reserve District, the powers granted to state-
chartered banks vary widely. Alaska and Hawaii
do not permit any nontraditional activities, such
as direct real estate investment, equity invest-
ment, and insurance brokerage. Although Utah
and Nevada permit direct real estate investment,
there are few, if any, banks in these states that are
actively engaged in real estate investment. Sim-
ilarly, Idaho law does not expressly authorize any
of these nontraditional activities but neither does
it prohibit them. Instead, applications to engage
in new activities are considered on a case-by-
case basis. Insurance brokerage appears to be
the only nonbank activity in which any banks
in Idaho currently are engaged. In contrast, Ari-
zona, California, Oregon, and Washington have
been the mostactive in expanding bank powers.
The activities of the state-chartered banks in
these four states are discussed below.
Arizona
Arizona permits state-chartered banks to engage
in a wide range of activities, including invest-
ment in corporate equities, real estate develop-
ment, and general insurance brokerage. A 1987
statute gives state-chartered banks investment
banking powers. Through subsidiaries, banks
are permitted to underwrite and broker mutual
funds, municipal revenue bonds, commercial pa-
per, and asset-backed securities. However, direct
real estate investment and insurance appear to
be the only areas in which state-chartered banks
are engaged.
Arizona law also allows banks to enter new lines
of business, including commercial enterprises,
through equity investments. Banks must receive
approval from the State Banking Department be-
fore engaging in such nonfinancial activities and
are limited to investing no more than 10 percent
of their assets in such equity investments. To
date, banks in Arizona have not taken advantage
ofthis authority to any significant extent.
California
California law permits both real estate investment
and general equity investment. Through equity
investment, banks can enter almost any line of
business, except insurance sales or insurance un-
derwriting, which are expressly prohibited. In
fact, both real estate investment and equity in-
vestment have been fairly popular. .
For example, according to the State Banking
Department, over 100 of the 240 nonmem,ber
banks in California have approval to engage inFRBSF
real estate activities, although only about 70
currently are active. Over time, state-chartered
banks' real estate investment has increased from
a total statewide investment of $50 million in
mid-1985 to about $170 million at year-end 1987.
Still, this total dollar level represents less than .
one percent of the active banks' assets-far be-
low the state regulatory limit of 10 percent of
assets.
Equity investment powers also have been widely
used. Such investments cover a wide range, from
car washes to securities affiliates. Moreover,
many banks have purchased corporate equities
for their own portfolios, often through the pur-
chase of mutualfund shares. Banks' equity
investments statewide (excluding real estate) now
total about $200 million.
In principle, even though equity investment
could be used to enter virtually any line of bus-
iness (except insurance), banks have made only
limited use ofthis power. In fact, banks' actual
investments fall well below the statutory limita-
tions, which stipulate that a bank's aggregate
investment may not exceed 25 percent of its
capital, and no more than 10 percent of its cap-
ital may be invested in the stock of anyone
company.
Oregon
Oregon does not permit equity investment or
securities underwriting, but a law passed in1987
does allow insurance brokerage and real estate
investment. At present, there are few banks ac-
tive in real estate investment activities.
In contrast, insurance brokerage does appear to
be a relatively common activity for banks in Ore-
gon. The passage of the 1987 law permitting
banks to enter the insurance brokeragebusiness
was the result of a hard-fought battle in the state
legislature between banking and insurance inter-
ests. Thus, it is not surprising that only one year
after its passage, nearly two-thirds of the state
nonmember banks are engaged in insurance
brokerage. Most banks limit their involvement
to life insurance and annuities, although six or
seven banks offer full service insurance. Par-
ticipation in insurance brokerage still is grow-
ing in Oregon and likely will continue.to grow.
Washington
Washington law expressly forbids insurance
underwriting and brokerage, although banks
have been lobbying to change the statute pro-
hibiting such activities. However, Washington
has permitted real estate investment since 1985.
According to the State Banking Superintendent,
about 20 percent of nonmember banks are active
in this business and typically hold about one per-
cent of their assets in real estate. Participation in
real estate activities may be limited due to the
newness of the law and the fact that many banks
feel this activity is too risky to manage and con-
trol properly.
In 1987 Washington repealed its own "Glass-
Steagall" law and now permits securities under-
writing. However, banks generally have not taken
advantage of this new power yet, perhaps be-
cause of the national moratorium on the secu-
rities activities of banks (which expired in March
of this year) and uncertainty over pending federal
legislation. However, it seems likely that some
banks in Washington soon will engage in under-
writing municipal revenue bonds.
Cautious response
Although a large number of banks in the West
are engaging in new, nontraditional activities,
many are not. Moreover, these new activities do
not represent a large portion of income or assets
even for most of the active banks. A number of
factors help to explain the cautious response. .
First, many of these new activities just recently
have been approved and banks simply have not
had the time to start up new businesses yet.
Another factor is the basic conservatism both of
state nonmember banks and state banking super-
visors. The majority of these banks are small, pri-
vately-held banks with strong capital positions
and limited managerial resources. As such, they
may be reluctant to put that capital at risk in new
activities that involve higher risk, strong competi-
tion from established providers, or require new
management skills. State regulators also appear
reluctant to approve applications for entry into
new activities for which the bank cannot demon-
strate sufficient expertise and financial resources.A shortcut?
Most states in the West, as well as in many other
parts of the country, already allow state-chartered
banks to engage in at least one activity that is not
permissible for nonbank subsidiaries of SHCs. If
the states continue to loosen restrictions on the
activities of state banks, the Congress may be
forced to address the appropriate scope of pow-
ers of national banks and SHCs.
To the extent the Federal Reserve Soard views
new powers as being consistent with
safety and soundness, SHCs may purchase state
banks to enter lines of business that are not oth-
erwise allowed. This may help to explain the
growing interest of some BHCs in acquiring state
nonmember banks. Coupled with the geogra-
phic flexibility allowed by new regional inter-
state banking compacts, state laws allowing
state-chartered nonmember banks to enter into
real estate, securities activities, equity invest-
ment, and insurance services likely will accel-
erate SHCs' movement into these once-forbidden
activities. Such a patchwork approach ultimately
may force Congress to address the appropriate
scope of banking powers and ways to prevent the
risks of these new activities from endangering the
federal deposit insurance fund.
At the same time, however, the Soard is required
to evaluate the "financial and managerial re-
sources and future prospects" of a SHC seek-
ing to acquire a bank. In this context, some of
the banks' activities might be considered so risky
as to endanger the financial resources and future
prospects of the organization. For example, the
Soard is considering a proposal which, on bank
safety and soundness grounds, would prevent
any acquisition by a SHC in which the banks in-
volved conducted real estate activities, either
directly or indirectly. However, this proposal
would allow such activities to be conducted in
a nonbank subsidiary, subject to various pruden-
tial limitations. Similarly, most proposals before
Congress emphasize placing new activities in
nonbank subsidiaries of BHCs and building "fire-
walls" between the bank and nonbank subsidi-
aries to prevent the risks from spilling over into
the bank and the deposit insurance system.
Finally, state banks' cautious response to new
powers also may reflect some uncertainty regard-
ing the status of such activities when carried out
in banks that are owned by SHCs. Specifically,
there is considerable uncertainty regarding
whether the Board of Governors of the Federal
Reserve System would approve applications by
BHCs to acquire banks that were engaged in
these new activities, either directly or through
bank subsidiaries.
BHC regulations and laws
At present, Section 4·of the Sank Holding
Company Act (1956) permits BHCs to own
nonbank subsidiaries only if those subsidiaries
are engaged in activities determined by the
Federal Reserve Soard to be "closely related to
banking and a proper incident thereto:' Cur-
rently, real estate investment and development
are not on the Fed's list (Regulation Y) of permis-
sible activities. Moreover, only limited insurance
brokerage and underwriting have been permit-
ted. Likewise, only limited securities activities,
which do not violate the "principally engaged"
clause of the Glass-Steagall Act, recently were
added to the list. Thus, the nonbank subsidiaries
of SHCs are prohibited from engaging in many
activities that are permissible for state nonmem-
ber banks in many states. Similarly, federal law
limits the permissible activities of nationally-
chartered banks and their affiliates.
However, a September 10, 1987, ruling by the
Federal Reserve Soard (the "Merchants National
decision") concluded that Section 4 prohibitions
are not applicable to the direct activities of bank
subsidiaries of BHCs. The decision also suggests
that the Soard will not oppose BHCs wishing to
acquire state banks that are engaged in insur-
ance activities.
Moreover, the Board's Regulation Y for many
years has permitted a state bank, which is owned
by a SHC, to itself acquire a wholly-owned sub-
sidiary that engages in activities in which the
parent bank may engage. (However, a partly-
owned subsidiary or joint venture would come
under the Section 4 restrictions.) For example, in
California about one-third of state nonmember
banks engaging in real estate investment are
owned by SHCs. Gary C. Zimmerman
Economist
Michael C. Keeley
Research Officer
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
Sa? Fr.ancisco, or of the Board of Governors of the Federal Reserve System.
Edlt~r1al. comments may.be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
pubhcatlO.ns can be obtamed from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702
San FranCIsco 94120. Phone (415) 974-2246. 'Research Department
Federal Reserve
Bank of
San Francisco
Alaska Arizona California Hawaii Idaho
nevada Oregon Utah Washington
(

States take the lead

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States take the lead

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