Investment Banking Profits Seen Near Glass-Steagall Cap

With banking reform still stalled in Congress, analysts are fretting that Depression-era laws are now threatening to reduce profits at banks' investment banking units.

For nearly a decade, banks have been trying to expand their corporate businesses by setting up investment banking subsidiaries provided for under Section 20 of the Glass-Steagall law.

But under the law - which was passed in 1933 to separate commercial banks from investment banks - revenues from corporate bonds, commercial paper, and equity underwriting may not exceed 10% of a Section 20 subsidiary's total revenue.

The concern is that this will force banks to increase government securities on their balance sheets in order to avoid exceeding the 10% limit.

"This issue has the potential to depress returns," said Diane B. Glossman, an equity analyst at Salomon Brothers Inc., who recently wrote a report entitled "Section 20 Heartburn."

Even though commercial banks have had investment banking subsidiaries since 1987, it is only relatively recently that some of the largest money-center banks - including J.P. Morgan & Co., Bankers Trust New York Corp., and Chase Manhattan Corp. - have won enough corporate-bond underwriting business to raise speculation that they are brushing up against the 10% limit.

Carole Berger, another Salomon Brothers analyst, said that Michael E. O'Neill, the chief financial officer at BankAmerica Corp., had indicated in a conversation in June that the bank recently had to boost its eligible revenues to match the growth in its ineligible businesses.

Bankers who are required to disclose the percentage of ineligible revenues only to regulators would not comment for this story except to say that they are not near that limit.

American banks "say they don't feel pressured by the limit, because their ineligible revenues have also grown," said Ms. Glossman.

But in March of this year, Swiss Bank Corp.'s U.S. unit was fined $3.5 million by the Federal Reserve Board for exceeding the limit.

Analysts said that part of the reason for Swiss Bank's failure to comply with the regulation was its relatively smaller-scale eligible revenue stream.

"I don't think banks have had to chase bad or unprofitable businesses in order to meet that 90% requirement, but they have had to combine those activities in Section 20s in a way that's sometimes inefficient," said John P.C. Duncan, a lawyer in the Chicago office of Jones, Day, Reavis & Pogue.

Ms. Glossman said that investors need to be aware of the potential deleterious impact on returns of a successful investment banking business.

"The existence of this regulatory vehicle involves some additional managing of bank holding company level," Ms. Glossman said.

To be sure, even if increasing ineligible revenues in a section 20 operation may require inflating eligible revenues, the net effect on returns may be positive for many banks.

"If a company is wildly accelerating their ineligible revenues, that may be good for shareholders, because revenues may also grow faster," Ms. Glossman said.

One Section 20 banker at a non-money-center bank said that most regional banks with investment banking subsidiaries aren't anywhere near the 10% limit.

"I'm looking forward to the day when I could push up against that 10% limit," as a sign of how that business has arrived, said the banker.

"Ultimately, the problem is the unlevel playing field that you have to do things in in a way that's less efficient than your competitors," Mr. Duncan said.

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