Politics and potential lawsuits proved potent restraints when the Federal Reserve finally proposed loosening the limits on bank securities activities last week.
Industry experts said the central bank could - and should - have allowed a holding company subsidiary to earn half its revenues from underwriting commercial securities.
But fear of congressional reprisals and lawsuits from the securities industry motivated the Fed to settle on a 25% revenue cap, banking lawyers, consultants, and analysts said.
"As a practical matter, the Fed has gone as far as it dares," said Charles Horn, a law partner at Mayer, Brown & Platt in Washington. "Others have suggested they could have gone as high as 49%, but I don't realistically think they could go above the 25% because of the political climate."
"This is about as far as the Fed could go without triggering a lawsuit by the securities industry that would have gone all the way to the Supreme Court," said Washington consultant Edward Furash.
The Fed made its first dent in the Glass-Steagall wall dividing commercial and investment banking in 1987, permitting J.P. Morgan & Co., Bankers Trust New York Corp., and Citicorp to start underwriting debt and equities from section 20 subsidiaries.
But the move was timid: Revenues from the new activities were limited to 5% of the securities unit's total income. The units made the bulk of their money buying and selling government securities.
The Fed doubled the cap to 10% in 1990, and ever since has been under industry pressure to further increase it. The Fed's July 31 proposal to raise the cap to 25% was hailed by bankers, but the move falls short of satisfying the industry's goal of parity with the likes of Merrill Lynch & Co. and Goldman, Sachs & Co.
"This clearly should not be confused with a complete fix of the problem," said David S. Berry, research director at Keefe, Bruyette & Woods Inc. "Commercial banks still have to go through hoops investment banks don't go through. In no way would I construe this as a level playing field."
Observers said that in addition to raising the revenue cap to 49%, the Fed should have enhanced competition in the investment banking business by:
*Reducing the capital backing securities underwriting,
*Counting more products toward the revenue cap, and
*Eliminating firewalls that prevent a bank and a section 20 affiliate from working together.
The Fed currently requires banking units to hold twice as much capital as the Securities and Exchange Commission mandates for investment houses. These reserve requirements are costing section 20 affiliates millions of dollars in lost profits.
The Fed also limits the number of products a bank can use to beef up its overall section 20 revenues. For example, fees from mortgage-backed securities could inflate the section 20's total revenue, giving it more room under the revenue cap to underwrite securities.
The Fed also could base the revenue test on a holding company's total revenues, rather than the income from its section 20. That would add to the mix income from mortgage banking, consumer finance, and leasing activities.
"All that revenue could be in the equation," said Melanie Fein, a law partner at Arnold & Porter in Washington. "All the Fed has to do is view the holding company and the section 20 as a single entity."
Finally, the Fed could eliminate several of the more burdensome firewalls. For example, standby letters of credit could be issued by the bank to its section 20 affiliate. The Fed's proposal does remove three firewalls. Banks and section 20 affiliates would be permitted to share employees and directors, to sell assets to each other, and to market each unit's products.