Affiliates in Banking, Finance, and Commerce: Development and Regulatory Background

Affiliates in Banking, Finance, and Commerce: Development and Regulatory Background

Order Code RS21680
Updated April 27, 2005
CRS Report for Congress
Received through the CRS Web
Affiliates in Banking, Finance, and
Commerce: Development and
Regulatory Background
William D. Jackson
Specialist in Financial Institutions
Government and Finance Division
Summary
The proliferation of corporate affiliates in banking, finance, and commerce has
figured in discussion of several policy issues, including how to protect against (1) losses
incurred by affiliated companies; (2) anticompetitive “tying” of bank and nonbank
financial services; and (3) misuse of financial data of consumers. The Gramm-Leach-
Bliley Act in 1999 greatly increased affiliations. Sharing of consumer financial
information among affiliates, one issue in reauthorization of the Fair Credit Reporting
Act, requires considerable attention to affiliations. Proposed Community Reinvestment
Act regulations involve affiliates of banks. Comptroller of the Currency efforts to bring
subsidiaries of national banks under federal banking law, preempting than state laws,
also involve affiliations. This report outlines the nature and evolution of affiliates,
primarily from a regulatory perspective. It provides background for discussing financial
issues involving corporate affiliates and will be updated as events warrant.
Background and Analysis
Conducting “nonbanking” activities directly within a bank has generally been viewed
as a threat to the integrity of the bank. Periodically in American financial history, and in
other nations today, bank diversification into nonbanking financial and commercial
business has emerged.1 Safety problems often followed because of a tendency for
entrepreneurs to combine captive sources of (bank) funds with their own (commercial)
uses of funds, without regard for normal due diligence. By forcing nonbanking activities
into a separately capitalized, separately run company associated with a bank,
policymakers sought to lessen the risks that self-funding may pose to banks, to deposit
1 Joseph G. Haubrich and Joao A. C. Santos, “Alternative Forms of Mixing Banking with
Commerce: Evidence from American History,” Financial Markets, Institutions & Instruments,
vol. 12, no. 2, pp. 121-164.
Congressional Research Service ˜ The Library of Congress

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insurance funds, and to other governmental policies. Overall, financial policy has
periodically limited commercial/banking affiliations since the 1830s.
The term “affiliate” refers to “any company that controls, is controlled by, or is
under common control with another company.”2 Companies with ownership interests of
25% or more in common are usually always affiliates. Sometimes, a common ownership
interest as low as 5% is sufficient if it involves director selection, policy direction, and
similar control matters. Affiliations are often valued for their potential of cross-
marketing, involving sharing of consumer financial information; thus becoming one focus
of the Fair Credit Reporting Act debate in Congress,3 which resulted in the Fair and
Accurate Credit Transactions Act of 2003, P.L. 108-159. Application of it must address
cross-marketing/information-sharing involving affiliates.4
The simplest affiliation is that of a subsidiary, where a bank owns another financial
business 100%. Examples are a bank owning an insurance agency, small business
investment company, or securities broker. Subsidiaries are regulated by the primary
regulator(s) of the owning banks. A more complicated structure involves a company
controlling banks. This state-chartered business is known as a “bank holding company.”
It “holds” the stock of one or more banks and, often, of other financial businesses. A
bank holding company typically holds all the stock of at least one bank, and a mortgage
company, a securities firm, or a commercial finance business. It may also hold all or part
of joint ventures, foreign alliances, investment companies, and other businesses within
its structure.5 The Federal Reserve (Fed) regulates bank holding companies.
A more complex form of bank holding company is the financial holding company,
authorized by the Gramm-Leach-Bliley Act (GLBA, P.L. 106-102) in 1999. As specially
empowered bank holding companies, these entities may additionally hold full-service
securities and insurance operations, including those making nonfinancial equity
“merchant banking” investments. Similar diversification arrangements allow securities-
based entities to form investment bank holding companies, and savings associations to
come under “thrift” holding companies. GLBA listed activities for such affiliations:
underwriting and dealing in securities, sponsoring and distributing mutual funds, selling
and underwriting insurance, and making insurance company and merchant banking
portfolio investments. Regulators may allow other business affiliations.
The Fed, as the regulator of financial holding companies, oversees them to prevent
affiliations from lowering the soundness of deposit-insured banks. Sections 23A and 23B
of the Federal Reserve Act built financial “firewalls,” which prevent banks from
supporting failing nonfinancial affiliates, or engaging in anticompetitive tying in financial
2 12 U.S.C. 1841.
3 CRS Report RS21576, Fair Credit Reporting Act: Frequently Asked Questions, by Angie
Welborn and Loretta Nott, and CRS Report RS21427, Financial Privacy Laws Affecting Sharing
of Customer Information Among Affiliated Institutions, by Maureen Murphy.
4 Richard Cowden, “FACT Act Affiliate-Sharing Regulations Likely to Be Separate From FCRA
Rules,” Daily Report for Executives, Feb.11, 2004, p. A-32.
5 The Fed restricts lines of business that may be affiliated through bank holding companies,
including their financial holding company form, in 12 C.F.R. Part 225, “Regulation Y.”

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services. Risk of collapse of securities, insurance, and other affiliated businesses evoking
deposit insurance, lender-of-last resort, or outright appropriation to cover bank losses
becomes less likely. Flows of information between banking and nonbanking affiliates,
or as in the Fair Credit Reporting Act, affiliated entities even if no bank is involved, are
limited to preserve competition and privacy concerns. A bank or securities affiliate may
also provide advice to an investment company, even without ownership. Regulators have
warned bank-based organizations against contributing banking resources to advised funds.
Legislative and Regulatory Actions
Beginning in the 1970s, a scramble for funds encouraged businesses ranging from
banks to real estate to manufacturing to affiliate with nontraditional financial firms, taking
market shares from regulated U.S. banks. Regulatory and statutory reactions may have
peaked in 1982.6 Table 1 summarizes the basic developments by which Congress, states,
and regulatory bodies have changed relevant affiliation relationships, increasing or
limiting their extent. Continuing congressional debate involves whether GLBA allows
affiliation of banking with real estate activities.7 Current congressional activity questions
the extent to which affiliates of national banks, such as mortgage company subsidiaries,
are subject to the Comptroller of the Currency’s preemption of state laws.8
Table 1. 100-Year Time Line of Affiliation Environment of Banking
Years
Action
Affiliation Change
1906-
Many state laws
Separated life insurance from commercial and
1907
investment banking.
1910-
State banking practice,
Securities affiliates of state and national banks
1929
1927 McFadden Act
became prominent.
1933
Banking Act of 1933: four
Defined affiliate and holding company
sections are known
arrangements for Federal Reserve member banks.
collectively as the Glass-
Added Section 23A to Federal Reserve Act, limiting
Steagall Act (GSA)
member bank transactions with affiliates. Outlawed
ties between commercial and investment banking.
Section 20 prevented Federal Reserve member
banks from affiliating with companies “engaged
principally” in underwriting or dealing in securities.
Section 32 prevented their affiliations with
securities firms via interlocking directorates.
6 CRS Report RL31981, Industrial Loan Companies/Banks and the Separation of Banking and
Commerce: Legislative and Regulatory Perspectives, by William D. Jackson, and CRS Report
RS21188, Enron’s Banking Relationships and Congressional Repeal of the Glass-Steagall Act
Separating Bank Lending from Investment Banking, by William D. Jackson.
7 CRS Report RS21104, Should Banking Powers Expand Into Real Estate Brokerage and
Management?, by William D. Jackson.
8 CRS Report RL32197, Preemption of State Law for National Banks and Their Subsidiaries by
the Office of the Comptroller of the Currency, by M. Maureen Murphy.

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Years
Action
Affiliation Change
1956
Bank Holding Company
Prohibited affiliations of nonbanking entities with
Act of 1956 (BHCA)
companies controlling two or more banks. Federal
Reserve could allow affiliations “...closely related
to the business of banking....” Douglas Amendment
prevented multi-bank affiliations; containing
holding company banks inside state lines.
1968
Savings and Loan Holding
Restricted affiliations for holding companies
Company Act of 1968
owning two savings and loan associations.
Exempted control over one (“unitary”) association.
1969
National Association of
Model Insurance Holding Company Act for states,
Insurance Commissioners
like BHCA but allowing nonfinancial affiliations.
1970
Bank Holding Company
Prohibited nonbanking affiliations for a holding
Act Amendments of 1970
company owning one bank. Prohibited banks from
tying services, reciprocity, and exclusive dealing
arrangements with customers generally.
1970
New York Stock
Member broker/dealer firms could sell their own
Exchange Rule Change
stock to the public, allowing affiliates directly or via
holding companies in many business lines.
1974-
Losses in Bank Affiliates
Real estate investment trusts associated with banks
1975
weakened by economic conditions. Banks and their
holding companies took large losses.
1978
International Banking Act
Subjected foreign bankers in U.S. to BHCA
of 1978
affiliation restrictions.
1980s
Comptroller of the
Permitted affiliations of limited-service “discount
Currency and Federal
broker” securities firms with banks.
Reserve Rulings
1982
Garn-St Germain
Allowed affiliation involving savings and loan
Depository Institutions
associations, not only real estate but also industry
Act of 1982
ownership. Prevented most insurance affiliations
for banks; contained Banking Affiliates Act of
1982 restricting transactions.
1982
Comptroller of the
Allowed nationally-chartered “nonbank banks” to
Currency Chartering
offer credit cards and other services, in affiliation
with financial and industrial firms.
1982
Bank Export Services Act
Allowed bank holding companies to invest in export
trading company affiliates.
1982
Federal Deposit Insurance
State-chartered banks not members of Federal
Corporation Policy
Reserve could affiliate with full-service securities
Statement
companies, declared as not covered by GSA.
1986-
Federal Reserve Rulings
Authorized bank holding company affiliates to
1988
provide joint investment advice and brokerage.
1987
Federal Reserve “Section
Allowed bank holding company subsidiaries to
20 Subsidiaries” Ruling
underwrite municipal revenue bonds, commercial
paper, and asset-backed securities.

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Years
Action
Affiliation Change
1987
Competitive Equality
Forestalled affiliations of nonbank banks with
Banking Act of 1987
nonfinancial firms. Put moratorium against new
banking affiliations in securities, insurance, and real
estate. Added Section 23B to Federal Reserve Act,
restraining nature of transactions with affiliates.
Exempted industrial banks from BHCA, allowing
commercial affiliations.
1989
Federal Reserve “Section
Extended 1987 authority to corporate bonds in
20 Subsidiaries” Ruling
affiliates within bank holding companies.
1989
Financial Institutions
Tightened affiliation/investment qualifications
Reform, Recovery, and
affecting savings and loan associations.
Enforcement Act of 1989
1990
Federal Reserve “Section
Extended 1987 authority to equity dealings (for JP
20 Subsidiaries” Ruling
Morgan.)
1991
Federal Deposit Insurance
Gave Federal Deposit Insurance Corporation veto
Corporation Improvement
over state-allowed subsidiaries of banks. Prohibited
Act of 1991
state bank affiliation with insurers.
1994
Riegle-Neal Interstate
Repealed 1956 Douglas Amendment to BHCA,
Banking and Branching
allowing holding companies’ bank affiliates across
Efficiency Act
state line boundaries.
1996
Comptroller of the
Allowed subsidiaries of national banks to expand
Currency Regulation
activities, including insurance and securities.
1997
Federal Reserve “Section
Lessened restrictions on affiliation relationships and
20 Subsidiaries” Ruling
transactions involving member banks and securities
operations. Exempted holding company affiliates
from certain anti-tying rules.
1998
Federal Reserve Ruling
Allowed insurance firm Travelers to acquire
on Citigroup Business
Citicorp, to become bank holding company
Activities
Citigroup. Conditioned on divestiture of then-
impermissible affiliations.
1999
Gramm-Leach-Bliley Act,
Repealed Sections 20 and 32 of GSA: allowed
Title I
affiliations of banks, insurance companies such as
Travelers, securities businesses, etc. via financial
holding companies or investment bank holding
companies. Merchant banking investments of
financial holding companies allowed nonfinancial
affiliations. Authorized bank subsidiaries in these
businesses, except insurance underwriting, title
insurance, merchant banking, and real estate.
Future expansion of affiliations via rulemaking.
1999
Gramm-Leach-Bliley Act,
Disallowed affiliations of savings and loan holding
Title IV
companies for a single institution (“unitary thrift
holding companies”) with nonfinancial businesses.
2002
Comptroller of the
National banks could purchase bonds convertible
Currency Ruling
into equity (stock).

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Years
Action
Affiliation Change
2002-
Citigroup Business
Divested most insurance business lines of Travelers
2004
Activities
previously acquired.
2003
Federal Reserve
Gave bank holding company affiliates much ability
Regulation
to process, store, and transmit nonfinancial data.
2003-
Federal Reserve Rulings
Gave financial holding company affiliates authority
2004
to take and make delivery of physical commodities.
2004
Comptroller of the
Preempted many state laws governing national
Currency Regulation
banks and their affiliates (subsidiaries).
2005
Comptroller of the
Allowed national banks to engage in electricity
Currency Ruling
derivative activities, beyond oil and gas derivatives.
Source: Congressional Research Service, The Library of Congress.
Community Reinvestment Act Regulation of Affiliates?
Regulators have shown concern over affiliates of banks that may be engaging in
undesirable (“predatory”) lending practices, in proposed regulatory language. Through
evaluations under the Community Reinvestment Act of 1977 (P.L. 95-128, Title VIII),
they report bankers’ socially graded performance, largely in lending. They may penalize
banks whose affiliates engage in “discriminatory, illegal, or abusive credit practices,” by
reducing the bank’s Act ratings . They may require disclosure of bank loans purchased
by affiliates.9
Tying?
Banks and their affiliates cannot require customers to “tie” purchases of banking and
nonbanking (securities, etc.) services together, nor give special treatment to some
customers through affiliate arrangements. Customers may, however, voluntarily request
such bundling of financial services. The Fed grants certain exemptions from its rules that
otherwise limit cross-selling of banks with affiliates. It has sanctioned at least one
holding company for direct tying. A trade group found that banks frequently condition
corporate credit on purchase of other services.10 In the other direction, the Comptroller
of the Currency found that the appearance of “tying” was a permissible, understandable
phenomenon.11 The Government Accountability Office (GAO; formerly named General
Accounting Office) examined whether banks tie credit to securities underwriting services,
but could not prove occurrences. GAO suggested stronger enforcement of laws.12
9 See CRS Report RS20197, Community Reinvestment Act, by William D. Jackson.
10 Association for Financial Professionals, 2004 Credit Access Survey: Linking Corporate Credit
to the Awarding of Other Financial Services, June 2004, 15 p.
11 Office of the Comptroller of the Currency, Today’s Credit Markets, Relationship Banking, and
Tying , Washington: Sept. 2003.
12 U.S. General Accounting Office, Bank Tying: Additional Steps Needed to Ensure Effective
Enforcement of Tying Prohibitions, GAO Report GAO-04-03, Oct. 20, 2003.