Why Has the Gramm-Leach-Bliley Act Failed?

Since this conference is about why the Gramm-Leach-Bliley Act has failed thus far to produce a diversified financial services industry, I'll start off by suggesting what I think is the reason: other than bank holding companies already subject to the Federal Reserve Board's regulation, very few companies have wanted or will want to let the Fed determine what businesses they can enter. In other words, the Act's requirement that companies that control banks engage only in activities that the Fed defines as "financial in nature" is its fatal flaw.

Moreover, I will argue that while it was certainly possible to make a distinction between banking and nonbanking activities--because banking had a relatively well-defined meaning--it is not possible to make a principled distinction between financial and nonfinancial activities. So the Act will produce an arbitrary set of rulings by the Fed that will ultimately bring it down.

For those in the audience who are not entirely familiar with how Gramm-Leach-Bliley works, let me outline why it is important to distinguish between financial and nonfinancial activities. The Act is an amendment to the Bank Holding Company Act, which purported to separate banking from nonbanking activities by restricting the activities of companies that control or are affiliated with banks to those businesses which are "closely related to banking."

While this phrase does not actually separate banking and commerce--since activities that are closely related to banking could still be commercial activities--the Federal Reserve for many years chose to interpret it as intended to separate banking from nonbanking activities, and generally did not permit bank holding companies--i.e., companies that control banks--to engage in activities that would not have been permissible for banks themselves.

When it finally became clear to Congress that this restriction was keeping banking organizations from competing with insurance companies and securities firms--depriving consumers of the benefits of competition and weakening the long-term prospects of banks--Congress's answer was the Gramm-Leach-Bliley Act.

The Act drew a somewhat wider circle for the affiliations of banks. It permitted organizations that controlled banks to become financial holding companies and engage in activities that are "financial in nature"--a standard that was thought to be broader than "closely related to banking." The idea was that under this broader standard, banking organizations could go into the businesses of offering securities and insurance services and securities firms and insurance companies could acquire or establish banks.

It hasn't worked out that way. To be sure, banking organizations have happily gone about acquiring insurance and securities operations, but of the hundreds and hundreds of transactions approved by the Fed in the last two years, only a handful have involved companies from outside the banking business coming in to become financial holding companies.

The reason for this seems obvious. In order to limit the affiliations of banks to companies that are engaged only in financial activities it is necessary for someone to determine what a financial activity is. That someone, under the Act, is the Fed, although it is required in this process to consult with Treasury.

Thus, once a company acquires control of a bank all its other activities are subject to approval by the Fed, and the company will be prohibited from engaging in activities that the Fed does not determine to be financial in nature. Not surprisingly, this restriction looks very troubling to securities firms and insurance companies. In general, they function under regulatory regimes that permit them to affiliate with any other kind of business. Now they are being told that if they acquire a bank and become subject to the Fed they will not be able to enter businesses that the Fed has not determined to be financial in nature.

While it is bad enough to contemplate unknown future restrictions on what businesses you can enter, the managements of securities firms and insurance companies are likely to be further alarmed by the delays associated with decisions by the Fed and the very arbitrariness of the decision when it is ultimately made. This is true because it is virtually impossible to determine what the Fed will consider to be a financial activity.

Let's start with the current controversy about real estate brokerage. The Fed currently has before it a proposed rule to determine that real estate brokerage is a financial activity. The application has been opposed, of course, by the realtors--who don't want financial services companies competing with them--and favored by banking organizations. The rule was originally proposed in December 2000, and we are now going on a year without a decision.

Imagine if you were the management of a securities firm or an insurance holding company and you wanted to go into the real estate brokerage business in order to offer this service to your customers. To do so, you would need no approvals; the only delay would be whatever was required to make the acquisition or establish the brokerage firm de novo.

But if you were the management of a financial holding company that also controls a bank you would be subject to the Fed, and a year after you decided to go into the real estate brokerage business you'd still be waiting for the Fed to determine whether real estate brokerage is a financial activity.

But the delay is only part of the problem. It might be that after all the waiting--after paying all the lawyers to press your application and argue with the lawyers representing the people who don't want your competition--the Fed will conclude that real estate brokerage is not a financial activity.

Its long delay in deciding this question suggests that the Fed considers it a difficult question. That in itself should be a warning to those who would voluntarily subject themselves to the Fed's jurisdiction.

But in fact a question like this is a difficult question--in large part because there is no principled way to distinguish between a financial activity and a nonfinancial activity. Under these circumstances, whatever decision the Fed makes will be wholly arbitrary, and that means that any company that submits itself to Fed jurisdiction is agreeing that in the future the scope of its business activities could be determined in an essentially arbitrary process. It's no wonder many companies are refusing to submit to this process.

To illustrate this point, let's consider some questions.

In what way is real estate brokerage not a financial activity? Brokerage is simply bringing together buyers and sellers. No one denies that securities brokerage would be a financial activity. What is it about real estate brokerage that makes it so different from securities brokerage that it's not a financial activity?

One argument might be that the things that are being brokered are not themselves financial items.

Well, everyone agrees that leasing is a financial activity. If a company leases cars or airplanes, it is in a financial business. Leases, of course, are also bought and sold. If someone is in the business of bringing together buyers and sellers of leases, is that a financial activity? Most people would agree it is, even if the underlying asset is a car, which is clearly not a financial asset.

So is it the lease itself--an intangible, represented by a piece of paper--that makes lease brokerage a financial activity?

What is a real estate broker doing when he or she brings together the buyer and the seller of a lease on an apartment? How is this different from a lease on a car? When a lease on a car is sold, the new owner becomes the lessor. When an apartment lease is sold, the same thing happens. One involves a car and the other a piece of real estate, but is there any principled basis for distinguishing the two?

Let's take this one step further. We've already determined that brokerage of leases would be a financial activity. A lease is a right to control a tangible asset--like a car or an apartment--for a limited period of time. What if a broker were bringing together buyers and sellers of control over a tangible asset for an unlimited period of time? Is that materially different from brokering leases? Does the period of time make the difference?

If the answer is no--and I think it must be--doesn't this mean that a real estate broker is engaged in the same activity as a broker of leases? And if a broker of leases is engaged in a financial activity isn't the same thing true of a real estate broker who brings together buyers and sellers of homes?

I went through this exercise to show the impossibility of making a clear distinction between a financial and a nonfinancial activity--even on something as simple as brokerage.

Another example of this difficulty is insurance. Everyone seems to agree that insurance is a financial activity, but why is this so? Essentially, insurance involves a contract in which, in exchange for an advance payment, an insurer agrees for a specified time to pay money if a particular contingency occurs--a casualty loss, an injury or death.

What is it about this structure that make the transaction financial? It can't be the fact that it involves the payment of a premium or promise to pay under a contract. If that were true, every purchase and sale would be a financial transaction, and every company that was in the business of selling goods or services would be engaged in a financial activity.

But if this isn't why insurance is a financial activity, then it must be the contingency part--the fact that the payment is made only if a specified contingency occurs.

Does this make any sense? Is it obvious that an obligation to pay under a contract in the event of some contingency is financial in nature, but the act of bringing together buyers and sellers of real estate is not? Again, although the consequences are vast for companies that control banks, it's not so obvious why some things are classified as financial and other things are not.

One final example will demonstrate, I think, how arbitrary the distinction can be. Everyone will agree, I suppose, that manufacturing automobiles is not a financial activity. It is unlikely that the Fed will ever authorize Citigroup to acquire General Motors. But why not?

GM has a factory, buys raw materials and parts, assembles these items into cars, and sells the cars to dealers. Clearly a nonfinancial activity. However, if I change the hypothetical a bit, it becomes difficult to distinguish this activity from something we would unambiguously regard as financial. What if GM didn't sell its cars but leased them?

Most people would say that merely leasing cars instead of selling them would not make GM a financial company. But what if GM didn't actually manufacture cars, but had them manufactured by Toyota under a contract, and then leased them? This is exactly what a leasing company does--buys a product like a car or an airplane from some independent firm and leases it--a transaction that has always been regarded as financial, as the equivalent of a loan arrangement.

Well, at what point between the manufacturing and sale of cars and the purchase and leasing of cars did the transaction convert from a commercial one to a financial one? Would the leasing company be engaged in a nonfinancial activity if, instead of buying the finished cars from Toyota it specified to Toyota that it wanted a particular chassis, transmission, engine seats, etc., to be acquired from different manufacturers and assembled by Toyota? What if it had supervisors in Toyota's plant to assure quality? What if--dissatisfied with the quality it was getting from Toyota--it sets up its own assembly plant?

At which point along this continuum--from buying the whole vehicle for purposes of leasing it, to specifying how a third party would create the vehicle that would be leased, to assembling the vehicle itself--did the company's business turn from financial to commercial? How is the Fed supposed to answer this question?

Thus, the Gramm-Leach-Bliley Act--by attempting to make a distinction between finance and commerce and setting the Fed to police this line--has made it necessary for companies to give up their freedom to enter new activities if they want to acquire a bank. This is the reason the Act has largely been a failure for any businesses other than banking organizations.

But it is important to note that the Act has also given the Fed a conceptually impossible task. The fact is, there is no way to distinguish between a commercial and a financial activity, and the arbitrary decisions that will eventually begin to emerge from this process--coupled with its failure to create a true two-way street in financial services--will eventually require the Act to be repealed or substantially modified.

We are fortunate to have with us today a distinguished panel of discussants to provide their own perspectives. The panel, as you've noticed, is broadly representative of the major participants in drafting and negotiating the Act, and living with and without it. I look forward to a lively roundtable discussion, after which we will open the roundtable for questions from the audience.

Peter J. Wallison is a resident scholar at AEI.

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