The Federal Reserve Board will have to move gingerly as it takes up the proposed merger of Citicorp and Travelers Group.

The central bank is eager to oversee the world's largest financial company, and it clearly has the authority to approve the deal. But approval would put the Fed in the position of winking at the new company's brash bet that Glass-Steagall Act prohibitions will crumble. And that could raise the wrath of Congress.

"The Fed is in a very difficult spot here," said Robert A. Ansehl, former counsel to Citibank's financial institutions group and partner at Bryan Cave law firm in New York.

The nub of the issue is this: Fed approval would require Citigroup, as the merged company is to be called, to divest within two years any activity barred to bank holding companies, such as insurance underwriting.

Citigroup, though it would agree to such terms, wouldn't expect to have to fulfill them, observers say. Instead, it would use the time to lobby Congress to adopt legislation allowing the merger of banking, insurance, and securities companies.

Whether Congress will go along with this "two-year time out from the law," as Rep. John D. Dingell, D-Mich., put it, remains unclear.

Congress conceivably could block the deal with single-shot legislation, but more likely would haul Fed officials into public hearings for tongue- lashings.

In 1994, it was Rep. Dingell who held two days of emotional hearings on Mellon Bank Corp.'s combination with mutual fund giant Dreyfus Corp. Comptroller of the Currency Eugene A. Ludwig was forced to promise he would step up regulation of fund sales by banks.

To be sure, of all the regulators, the Fed is given the most deference on Capitol Hill. But to look the other way while one huge company steps around laws that Congress has unsuccessfully tried to overhaul for years is tricky, even for the exalted central bank.

"The Fed is going to get lots of pressure from those in Congress who do not like this idea and from competitors who do not like this merger," predicted L. William Seidman, the former Federal Deposit Insurance Corp. chairman.

Fed Gov. Edward W. Kelley Jr. said he expects criticism, no matter how the Fed handles the deal. He said no decisions have yet been made on whether the deal qualifies for the two-year exemption. "We will be guided by our own best judgment of the law and the case," he said. (Citigroup could apply for up to three one-year extensions.)

Karen Shaw Petrou, president of the industry consulting firm ISD/Shaw Inc., said the Fed could finesse its approval by liberally defining what it means to divest unauthorized businesses within two years. The Fed, for example, could say any Citigroup effort to make insurance underwriting legal for a bank qualifies.

In addition, the Fed could accept moves to restructure Citigroup's businesses, she said. For example, this could include efforts to move insurance underwriting to Citicorp's state-chartered bank in Delaware, to create an operating-subsidiary of Citibank, or to house some businesses in a unitary thrift holding company, she said.

But the Office of the Comptroller of the Currency has learned just how dangerous it can be to expand bank powers without congressional approval.

Lawmakers and lobbyists have blasted OCC decisions allowing Zions First National Bank to underwrite revenue bonds and Magna Bank to retain insurance offices in large towns after it converted to a national bank.

House Banking Committee Chairman Jim Leach even accused the Comptroller's Office of abrogating "the constitutional authority of Congress" by approving the Magna deal.

Yet the Fed, so far, has escaped much criticism in the Citigroup deal. Lawmakers with something to say on the deal this week, including Rep. Dingell, said it proved Congress has to act soon if it wants to have any control over the evolution of the financial services business.

It may be that lawmakers surprised by the size of the deal have yet to focus on the company's plans to use the Fed's two-year exemption to continue its underwriting operations rather than to prepare them for sale.

"It is very amusing," one supervisory source said. "The OCC does one measly little revenue bond underwriting operating subsidiary and the whole world is ready to come to an end.

"But then you get this particular transaction that is going to use a grace period in the law for a completely different purpose than what was intended and no one complains."

James D. McLaughlin, director of regulatory and trust affairs at the American Bankers Association, said the Fed is escaping criticism because the political climate has changed significantly in the past several months.

"Everyone is acknowledging as a practical matter that the Glass-Steagall and Bank Holding Company acts are dead," he said. "Congress has really become a lot more aware and ready to act in the last six months."

Paul Equale, senior vice president for government affairs at the Independent Insurance Agents of America, echoed that view, noting that his group now supports letting banks and insurance companies merge.

"The issue is different now than it was a year ago," said Mr. Equale, whose group was one of the most vocal critics of the Magna deal. "We support integration."

Also, Mr. McLaughlin said many lawmakers find it difficult to criticize Fed Chairman Alan Greenspan, because has steered the economy to unprecedented growth.

Gilbert T. Schwartz, a partner in the Washington law firm Schwartz & Ballen, said the Fed will remain unscathed by criticism unless it rejects the deal.

"The downside to the Fed is really nothing," Mr. Schwartz said. "They are getting a company under their jurisdiction that is the major player in financial services."

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