WASHINGTON - The Gramm-Leach Bliley Act has been in force for a full year, and the question remains: Will it work?
Will companies adopt the financial holding company structure that the law created in order to offer banking, insurance, and securities under one corporate roof?
The new structure is not proving popular, but experts have blamed a host of unrelated factors. For example, many banks and securities firms had already merged via regulatory loopholes; relatively low stock prices during the past year discouraged deals; and continued consolidation within industry sectors pushed cross-industry mergers to the sidelines.
Of the dozens of people interviewed for this series, most still expect Gramm-Leach-Bliley to transform the financial services business.
The most common prediction: a wave of mergers between banks and insurers. "The first year is not really an indication of things to come," said Steve Blumenthal, a public policy analyst at Schwab Capital Markets. "Everyone is still warming up their engines."
Whether Gramm-Leach-Bliley - a year old come Sunday - ultimately succeeds will depend on how tightly the Federal Reserve Board supervises financial holding companies.
"In principle, this could be the framework to allow us to go ahead for the next 50 years," said Randall S. Kroszner, professor of economics at the Graduate School of Business of the University of Chicago. "It just depends on how the regulators implement it."
SO FAR, NOT SO GOOD
If the Fed's take on merchant banking is any indication, Gramm-Leach-Bliley's legacy is in trouble.
The Fed quickly tarnished what had been considered the new law's crown jewels by proposing expensive capital rules for merchant banking. In March, the Fed, which oversees financial holding companies, said it wanted every $1 invested to be backed with 50 cents of capital. Merchant banking powers - allowing investments in nonfinancial companies - were intended to make Gramm-Leach-Bliley a two-way street for securities firms. Brokers were supposed to be able to buy banks without being forced to divest such investments.
Yet the securities firm that pushed the hardest for Gramm-Leach-Bliley - Merrill Lynch & Co. - has not become a financial holding company. Merrill, which operates two limited-purpose banks, is not interested in discussing its reasons. Repeated requests for interviews finally prompted this statement: "Merrill Lynch supported legislation to modernize the financial services industry and believes the legislation that passed was in the best interest of the industry and its clients. As a matter of policy, we do not comment on our internal plans."
But there is no doubt that the Fed's merchant banking plan - and other, broader supervisory moves - has cooled nonbanks' interest in becoming financial holding companies.
Here's how a senior insurance company executive reacted to the merchant banking rules: "When we saw those, we said, 'This is the new Fed? This is the umbrella supervisor?' No thanks."
WHAT'S NOT TO LIKE?
Many brokers also turned down the chance to discuss on the record the prospect of Fed oversight, but their man in Washington - Marc Lackritz, president of the Securities Industry Association - agreed that rigid banking regulation makes his members uncomfortable.
"People in the securities business have a different regulatory culture," he said. "As a result, they will think long and hard before changing that.
"Besides, they can do a lot of the things they need to do without becoming financial holding companies."
However, Mr. Lackritz said it was important to his industry that it gained the option to buy banks. And when it makes sense for their customers, securities firms will use it, he said. "Schwab bought U.S. Trust for a specific reason; they knew what they wanted for their customers," he said. "Most securities firms don't think of banking per se as being a great business. It really is more a question of business strategy: Who are your customers, and how do you best serve them?"
That's why Friedman Billings Ramsey Group Inc., a boutique investment banker in Arlington, Va., is buying a small bank in Bethesda, Md. Webb Hayes, head of the private-client group at Friedman Billings, said that the one piece missing from a "well rounded" structure "was to have commercial banking powers and fiduciary powers."
But Bob Smith, Friedman's chief operating officer, acknowledged that Mr. Hayes' experience at a commercial bank overseen by the Fed had played a role in the firm's decision. "We would probably be a lot less likely to take the plunge if Mr. Hayes had not joined us a year and a half ago," Mr. Smith said. "There is just a fear of the unknown factor at work here for some of the nonbank players."
Gary Hughes, general counsel at the American Council of Life Insurers, agreed.
"Once you get authority," he said, "then you actually have to sit down and think from a strategic standpoint, 'Is that really what you want to do?' "
Mr. Hughes said he had expected commercial banks to buy underwriters. "The one surprise was, we really didn't see commercial banks acquire insurance companies," he said. "There was some consternation in our business that we were just teeing ourselves up to be acquired by commercial banks.
"But it's been kind of a standstill."
Mr. Hughes said the prospect of Fed oversight played a role but a secondary one. "The notion, at least in theory, of a fairly heavy regulatory role by the Fed is something to give you pause," he said. "But more important has been the stock market - financial service firms haven't had the greatest year - so some of the fervor to do deals has been tempered."
Beyond merchant banking, two other issues weigh on nonbanks: capital requirements and regulatory intrusions.
For now, financial holding companies are following the same capital rules as bank holding companies. But the Fed is expected to ease up. The law instructs the central bank to subtract the assets and capital of an insurance arm from the holding company's totals, leaving it to state regulators to set insurers' capital requirements.
For example, once MetLife's application to become a financial holding company is approved and its purchase of a New Jersey bank is closed, its holding company's capital would be determined by the size of its bank - not its insurance business.
Securities firms are also expected to get a break, but the Fed has not proposed any change yet.
On the oversight question, the Fed spelled out how it plans to supervise financial holding companies in an Aug. 15 letter to examiners. To say it was not well received would be an understatement.
"That letter scared the hell out of insurance companies," said Ronald R. Glancz, a partner in the Venable law firm here. "Nobody is used to having the Fed sitting in on their board meetings."
In its letter, the Fed said it intends to "develop strong relationships with senior management and boards of directors" of financial holding companies.
AND THAT'S NOT ALL
Rather than marvel at how few companies have adopted the financial holding company structure, Steve Roberts, a former senior Fed official who is now a partner specializing in regulatory compliance at KPMG LLP, said he is surprised that 435 companies have taken the plunge, considering the penalties if their capital, management, or Community Reinvestment Act ratings deteriorate.
"It's a lot tougher than people think," Mr. Roberts said of the law. "In today's world, it's easy to meet the standards. But what happens when the credit cycle changes?"
Under the law, financial holding companies must be well-capitalized and well-managed, and their banks must maintain at least "satisfactory" CRA grades. Missteps can draw sanctions. A lower CRA grade essentially stops a financial holding company in its tracks, barring it from making acquisitions or starting any new activity authorized by the law. However, it will not be forced to divest any asset.
If management or capital suffers, the Fed notifies the holding company, and it has 180 days to fix the problem. After that, the Fed may bar the company from offering new products and could require it to sell its bank. "There are dangers to becoming a financial holding company," said James D. McLaughlin, director of regulatory affairs at the American Bankers Association.
"In a coming downturn," he said, "will a large bank continue to assure itself that it will meet all three of those?" If it does not, the company could be forced to raise capital, upgrade management, and suspend acquisition activity. "They could be frozen," Mr. McLaughlin said.
IN THE FED'S COURT
Much work remains for the Fed. Its merchant banking plan, pending since March, is expected to be reproposed and reissued for another round of public comments. Its proposal on holding company capital is still being written. Most observers expect the Fed to loosen up with time and experience. "The Fed will loosen its grip to make this law work. They're practical," said Mr. Glancz, a former government lawyer.
But critics contend that the central bank will never change its cautious ways. "The Fed is going to move at its own pace," said Bert Ely, an industry consultant in Alexandria, Va. "The world be damned."
In an interview, Fed Governor Laurence Meyer acknowledged that a mountain of work awaits the central bank, but he made no apologies for its enforcement of the law to date.
"Because banks are subject to the federal safety net, all organizations that include a bank have a higher degree of regulation and supervisory oversight than nonbanking organizations," he said. "That's the nature of our financial system.
"Becoming a financial holding company is a major strategic decision for a nonbank," he said. "It was probably a misperception to assume that there would be very rapid activity in that regard immediately following passage of the act. I think that will build over time as nonbank firms decide exactly what direction they want to go and who their partners are going to be."
But Mr. Meyer said nonbanks will bite - eventually.
As banks move deeper into the securities and insurance businesses, he said, "it stands to reason that nonbanks that want to compete effectively with these more diversified banking organizations are going to find themselves in a position where they may feel they want to become a financial holding company, too.
"I think financial holding companies will be a mainstay of our financial system."
Thursday: The law's long-term impact and some predictions.
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