J. Alfred Broaddus, Jr. Federal Reserve Bank of Richmond Richmond, Virginia Al Broaddus is president of the Federal Reserve Bank of Richmond and serves every third year as a member of the Federal Open Market Committee of the Federal Reserve System. He is the author of numerous articles on banking and monetary policy and has lectured at several colleges and universities. He is a member of the board of directors of the Virginia Council on Economic Education and the executive advisory council of the E. Claiborne Robins School of Business of the University of Richmond.      Mr. Broaddus wishes to thank John Walter, associate research officer at the Federal Reserve Bank of Richmond, for his assistance in preparing this article.

Many large U.S. financial firms today offer an array of banking, securities, and insurance services. The Bank of America Corporation, for example, parent of the largest U.S. bank, is also a securities firm, and it operates insurance agencies. Merrill Lynch, a leading securities firm, and State Farm Insurance, the top Fortune 500 insurance company, both offer bank deposits and loans.

These combinations of banking, securities, and insurance services in one financial firm have been fostered by the Gramm-Leach-Bliley Act of 1999. This Act expanded opportunities for such combinations. In reality, however, the combined services in question follow from a trend that began in the mid-1980s. Customer benefits and cost savings have fueled the trend. By simplifying the exploitation of these benefits and savings, Gramm-Leach-Bliley will probably induce firms now offering only one type of financial service to expand their menu. In a recent survey, 32 percent of community banks — smaller banks that typically emphasize traditional banking services — indicated that they plan to add new financial services to their offerings. Equally significantly, the Act is likely to encourage the expansion of banking companies into some new nonfinancial businesses previously denied them.

History of the Separation of Banking, Securities, and Insurance
Before 1933, financial companies in the United States could provide for all of their customers' banking, securities, and insurance needs. In 1933, however, the Glass-Steagall Act prohibited banks from operating a securities business; and, in 1956, the Bank Holding Company Act separated banking and insurance.

Banks had played a dominant role in the securities industry prior to the 1933 passage of Glass-Steagall. In 1930, they accounted for 61 percent of all bond underwritings — purchasing newly issued stocks or bonds directly from the issuing corporation and reselling them to investors. Following the crash of the stock market in 1929, and the failure of thousands of banks over the next several years, Glass-Steagall established a legal wall separating commercial and investment banking. Commercial banking consists primarily of gathering depos-its and making loans, especially loans to businesses — i.e. to commercial firms. Investment banking is the business of underwriting and dealing in investment securities such as stocks and bonds.

Specifically, the Glass-Steagall Act required that commercial and investment banking could be provided only by completely separate firms. Commercial banks (referred to simply as "banks" in this article) could no longer act as investment banks. Banks were also prohibited from owning or being owned by investment banking firms, and from being a subsidiary of a holding company containing an investment banking firm. These Glass-Steagall restrictions were motivated by congressional concerns regarding potential conflicts of interest arising from ties between banking and securities activities, the use of bank funds for stock market speculation, and the adverse effects of risky securities activities on bank safety.

The first half of the 20th century saw the growth of holding companies in which a bank and one or more nonbank firms, including insurance firms, might be combined. A prominent example was Transamerica, the large holding company that offered banking, and life, property, and casualty insurance. The bank was the Bank of America. Concerned that such combinations would increase in size and number, and produce a concentration of economic power, Congress restricted them in the Bank Holding Company Act of 1956. Specifically, Congress prohibited holding companies that owned banks — bank holding companies — from engaging in activities that were not "closely related to banking." The law granted the Federal Reserve the power to define the phrase "closely related to banking," and the Fed excluded insurance from that definition except in limited cases. In response, Transamerica divested the Bank of America.

Consequently, after 1956, banks were largely isolated from other elements of the financial services industry. The Glass-Steagall Act constructed a wall between banking and securities. The Bank Holding Company Act established a wall between banking and insurance.

Benefits of Combining Banking, Securities, and Insurance
While Congress saw dangers, there are potentially significant benefits from combining banking, insurance, and securities activities in one firm. In particular, costs can be lowered compared with the cost of conducting these businesses separately. Assuming a reasonable degree of competition, customers of financial firms will capture some of these cost savings in lowered fees and better interest rates. Moreover, customers gain the ability to consolidate their financial services relationships conveniently in one firm.

Substantial economies are produced, for example, when credit evaluations can be shared between lenders and securities underwriters within a single company. Imagine a firm seeking a loan from a bank, then later wishing to issue securities in the market. When deciding whether to extend a loan, the bank loan officer must evaluate the borrower's credit-worthiness. Securities underwriters perform similar evaluations when considering whether to underwrite a firm's securities. If one firm makes the loan and another underwrites the securities, two credit evaluations are necessary. If the same firm can both make a loan and underwrite securities, it can base its underwriting decision at least in part on the earlier loan evaluation, which may provide a considerable saving.

Similarly, a bank making a mortgage loan will have gathered much of the information necessary to offer an appropriate homeowner's insurance policy. As a result, it can offer the insurance policy at a lower cost than can a stand-alone insurer, which would be required to gather the information from scratch. The consumer will also benefit by avoiding duplicative paper work.

The Walls Crumble and Fall
In a competitive and dynamic economy, restrictions tend to fall if they prevent the realization of compelling economic efficiencies. Entrepre-neurs seeking to take advantage of untapped efficiencies, and to realize the gains from doing so, act like steam in a pressure cooker. They aggressively and constantly probe until a weakness is found in the restrictive wall. Once the weakness is identified, the wall can be breached. Combinations of banking, securities, and insurance provide such efficiencies. The restrictions on combinations established by the Glass-Steagall and Bank Holding Company Acts prevented the full realization of these efficiencies, leading banks to focus growing attention on identifying weak spots in the restrictions.

Banking companies eventually found loopholes in both the Glass-Steagall and Bank Holding Company Act restrictions. By exploiting these loopholes, many large U.S. banking companies were able to begin underwriting and dealing in securities by the 1990s, and a number of banks were able to begin selling insurance. Nonetheless, the Glass-Steagall and Bank Holding Company Acts remained on the books, continuing to circumscribe activities. For example, Glass-Steagall capped the income a bank holding company could earn on securities underwriting and dealing. And despite an opening that allowed banking companies to sell insurance policies underwritten by insurance companies, none was found allowing them to underwrite insurance — in other words, to offer their own insurance policies.

As banks exploited these loopholes in the Glass-Steagall and Bank Holding Company Acts, a debate over the wisdom of maintaining the two laws emerged in Congress, among academic banking economists and in the financial press. A strong consensus developed that the original justifications for the restrictions — whatever their merits when the laws were passed — no longer applied. In November 1999, the U.S. House and Senate passed the Gramm-Leach-Bliley Act and President Clinton signed it into law.

Gramm-Leach-Bliley repealed most, though not all, restrictions on banking-securities-insurance combinations. Specifically, Gramm-Leach-Bliley left in place the Glass-Steagall provisions that restricted banks from underwriting and dealing in securities directly, while allowing banks and bank holding companies — called financial holding companies by the Act — to own subsidiary securities firms. This corporate separation was deemed valuable as a means of isolating fairly risky securities activities from government-backed bank deposits. Similarly, under the Act, financial holding companies may own insurance underwriting subsidiaries. Nevertheless, because insurance companies often face large, unexpected losses, making underwriting quite risky, the Act barred banks and even subsidiaries of banks from the business, even if they are part of a financial holding company. As was the case before passage of Gramm-Leach-Bliley, banks and subsidiaries of banks are allowed to conduct the fairly low-risk activities of insurance agencies — selling insurance underwritten by other firms.

Changes Wrought by Gramm-Leach-Bliley
While several previously prohibited mergers have occurred since passage of the Gramm-Leach-Bliley Act, many observers anticipated a far greater number. There are two likely explanations for the relative paucity of new combinations. First, as already discussed, many banks and other financial firms had found ways around the Glass-Steagall and Bank Holding Company Act restrictions before Gramm-Leach-Bliley was passed. As a result, many efficiencies had already been realized, which meant less pent-up demand for new combinations. Securities firms could and did combine with banks before 1999, albeit subject to limitations. By the time of the 1999 passage of Gramm-Leach-Bliley, most large banking companies already owned securities underwriting subsidiaries. Similarly, many of the largest banks had aggressively commenced insurance sales. Second, the law was enacted only two years ago, and regulations implementing it came several months later, so there has been little time for firms to take advantage of Gramm-Leach-Bliley's simplified structure for combinations. Despite the slow start, the Act did reduce the restrictions imposed on combinations, so it will tend to encourage new combinations in the future.

While many of the largest banking companies began offering securities and insurance products even before Gramm-Leach-Bliley passed, smaller banks typically had not. Many smaller banking companies now appear poised to expand into nonbanking areas. For instance, of the approximately 500 financial holding companies formed under Gramm-Leach-Bliley rules, about 75 percent were formed by small banking companies.

The extent to which banking, securities, and insurance combinations will proliferate is difficult to predict. Yet, one fact is clear: banking companies will expand into new activities outside banking, securities, and insurance. Gramm-Leach-Bliley not only grants expanded banking, securities, and insurance powers to financial holding companies; it also authorizes the Federal Reserve, working in conjunction with the Treasury, to grant additional powers to these companies. Specifically, the Act allows the Federal Reserve and the Treasury to approve activities that are "financial in nature, or incidental or complementary to a financial activity." In contrast, before Gramm-Leach-Bliley, banking companies were limited to activities that were closely related to banking. Under the new arrangement, banks and financial holding companies have already made a number of requests to engage in activities previously denied them. For instance, following passage of the Act, banking companies requested and were granted approval to engage in the business of acting as a finder. As a finder, a banking company performs the middleman function of matching a seller with a likely buyer.

Conclusion
The November 1999 enactment of the Gramm-Leach-Bliley Act focused a great deal of public attention on expanded opportunities for one firm to offer a complete line of financial services including banking, securities, and insurance. Nevertheless, few firms have expanded substantially. Two reasons seem important. First, well before enactment, the benefits of combining these financial services in one firm had compelled large banking companies to surmount at least some of the legislated barriers that appeared to stand in the way of combinations. Second, little time has passed since enactment. In the future, more combinations are likely, many of which will probably involve community banks. Moreover, beyond banking, securities, and insurance, a number of financial companies appear eager to commence additional activities that might be authorized under Gramm-Leach-Bliley.