Firewalls Seen Spoiling Glass-Steagall Reform

Lawyers and economists are worried that in lifting restrictions that prevent bank affiliations with securities firms, Congress will give bankers their cake but won't let them eat it.

Current proposals, including one outlined by the Clinton administration, all speak of the need to shield the deposit insurance fund from losses by the affiliates through the use of legal firewalls.

But the experts say fears of bank failures in the securities business, which prompt the firewall proposals, are unwarranted. They say banks outside the U.S. have not suffered due to affiliations with securities firms. Indeed, they note, studies indicate bank failures in the 1930s were unrelated to securities activity.

What the firewalls may do, they say, is squeeze the profitability out of the newly allowed activities.

"These firewalls," warned lawyer Frank C. Puleo, "can defeat the purpose."

The firewalls likely will be similar to those that apply to the Section 20 subsidiaries of banks that currently engage in limited securities activity.

These rules set minimum capitalization levels, prevent interlocking directorships, and restrict bank loans to the affiliate, bank purchases or guarantees of securities from the affiliate, and other transactions that might result in a conflict of interest or expose the bank to losses.

The danger of some current proposals, Mr. Puleo said, is an inflexibility that might prevent the desired "development of synergies" between the bank and its affiliate.

James Barth, a professor at Auburn University, agreed, noting that financial institutions make money by taking some risk. "The best firewall of all is capital," he said, arguing that strong capital requirements by themselves would both buffer the bank and discourage undue risk-taking, because capitalization puts the owners' money at stake.

Mr. Puleo, a partner in the New York firm of Milbank, Tweed, Hadley & McCloy, said firewall provisions make the proposal by Rep. Jim Leach, R- Iowa, preferable to the one by Sen. Alphonse D'Amato, R-N.Y., despite broader powers granted in the D'Amato bill. The Leach bill allows the regulators to make exceptions to firewall restrictions, he explained.

In the D'Amato bill, he said, "the firewalls mandated are fewer and a bit more targeted, but I don't see the flexibility in the way it's structured."

Congress may also create a kind of firewall when it sets ownership rules. Rep. Leach and Sen. D'Amato would require the securities affiliate to be a separately capitalized entity in the bank holding company. The administration would allow direct ownership.

Lawrence J. White, a New York University business professor, said this raises the issue of regulatory competence. If the banking regulator understands the securities activities, then direct ownership is appropriate. If not, then the separately capitalized affiliate is the better approach.

One implication of firewalls, some experts suggest, is that deregulation may subject banks to additional layers of regulatory oversight and complexity.

"Suppose we said we can't allow banks to buy assets from the parent," said Ed Kane, of Boston College. "They're going to buy the asset though someone else. They would be able to launder assets through a third party."

The regulator would have to be prepared to follow a paper trail, he said, to ferret out subtle, deliberate violations.

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