BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 97-2 (SPE)
February 21, 1997
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Section 20 Subsidiaries - Additional Clarification of Revenue Test Treatment of Interest Income
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.
Herbert A. Biern
Deputy Associate Director
Cross Reference: SR 93-24 (FIS)
Bank Holding Company Supervision Manual, Section 2185
ATTACHMENT TRANSMITTED ELECTRONICALLY BELOW
BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
ADDRESS OFFICIAL CORRESPONDENCE
TO THE BOARD
October 30, 1996
Larry P. LaRocco
ABA Securities Association
1120 Connecticut Avenue, NW
Washington, DC 20036
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.
William W. Wiles
Secretary of the Board
SR letters | 1997