Financial Evolution, Not Revolution

Historic events are funny things—what might seem earth—moving to one person might barely rate above a good TV dinner experience to another.

Take the financial modernization legislation, officially known as the Gramm-Leach-Bliley (GLB) Act, which allows banks, investment houses and insurance firms to dally in each other's business like never before. Signed into law back in November after literally two-plus decades of trenchwork, it was widely touted in the media and by industry officials as a law of—pick your adjective—landmark, historic and/or groundbreaking proportion. Some have likened it to the fall of the Berlin Wall (honest).

But these reactions are not widely shared. "If you would ask the average consumer about Gramm-Leach-Bliley, they would say, 'Who?' They don't know about it," said Norman Bobins, president and CEO of LaSalle Bank in Chicago (over $30 billion in assets).

Most people in the financial services industry agree that while new opportunities and challenges face banks and securities and insurance firms, the average consumer is not likely to see dramatic changes overnight as a result of this law.

But over the course of time, maybe just a few years, people will be buying new and different financial products and services, whether they realize it or not. The average consumer might not notice the transition, but that doesn't mean dramatic change is not taking place, according to Bobins.

"Historians will be able to tell the difference," Bobins said.

Exactly how-and where-that "difference" will come about is on the minds of many in the financial services industry. Interviews with a handful of executives from banks and bank holding companies both big and small give a different spin on the immediate impact of the law than the one coming from the mainstream media.

Big banks have been doing smaller-scale versions of what the law now legalizes for upwards of a dozen years. Smaller banks have gotten into the act as well through creative retailing arrangements, and those not already offering nontraditional financial products don't appear ready or interested in making quick leaps into unknown waters. And of the many sub-issues addressed by the law, only the new privacy regulations seemed to consistently spark much opinion.

Tepid first steps

Since the law's passage, industry folks have not been shy about praising the virtues of the new law, and claiming its spoils.

"Banking, in my view, was the clear winner" in the new law because it was "broadly beneficial to all banks regardless of size," said Don Mengedoth, president and CEO of Community First Bankshares of Fargo, N.D. ($6 billion in assets), and president-elect of the American Bankers Association.

Despite being framed as a banking law, however, both the securities and insurance industries were very interested in and satisfied with the new law. Robert Vagley, president of the American Insurance Association (AIA) called the new law "a resounding victory" for the insurance industry. "In terms of our objectives we were very satisfied," he said.

Generally, the wish list for insurance and securities interests was much shorter than that of banks. Over the years, various loopholes had allowed banks into the insurance and securities business, while shutting the door on any reverse activities.

The new law "stop(ped) the regulatory encroachment that we were experiencing over the years," Vagley said. Both industries also pushed for and received "functional" or activity-based regulation. For example, rather than having the Securities and Exchange Commission (SEC) regulate all activities of securities firms—including in insurance or banking areas—the SEC will instead regulate all securities activities, whether they take place in an investment firm or a bank.

With traditional barriers between banking, securities and insurance now gone the way of the Edsel, the expectation is that each industry will cross over into other areas. But despite all of the hullabaloo over the new law, most banks appear content to watch from the sidelines to see how things shake out.

"One thing about Gramm-Leach-Bliley is the classic (saying) of, 'Be careful what you wish for, you just might get it,'" said Bobins. "We're all scrambling around to see what it all means."

Bobins said LaSalle Bank is looking "very carefully" at new opportunities for "bringing a complete umbrella of financial service products" to its customers.

Comerica Incorporated, a $37 billion bank holding company in Detroit, was being "very deliberate" in any future actions related to the new law, according to John Doetsch, Comerica assistant vice president of communications, adding the new law "presents the opportunity to streamline" certain insurance and securities activities already operating under Comerica.

For banks "in the middle"—those regional or subnational banks with between $1 billion and $20 billion in assets—the future is uncertain under the new law, according to Young Boozer, executive vice president of Colonial Bank of Montgomery, Ala. ($11 billion in assets).

"We're probably one of those in the middle that can't do it on their own," Boozer said of branching into new financial products and services. Colonial was still finishing up on Y2K matters, and is in the midst of absorbing the acquisition of 25 banks in the last three years, and has not had a chance to put together a strategy regarding new opportunities under the new law, Boozer said.

Opinion was mixed on the lot drawn by small banks (typically defined as those with less than $1 billion in assets). Several officials from larger banks said smaller banks had the ripest opportunity to expand their offerings. Most executives of small banks, however, don't expect much change in the near future.

"I don't think it's going to have much of an impact," said Larry Dreyer, president and CEO of American Federal Savings Bank of Helena, Mont. ($150 million in assets). The bank might move into new lines of business in three or four years, he added, "when we have a chance to fully digest the law."

The typical Montana town has "one local bank, and it has one local insurance agent who graduated from the high school," Dreyer said. "I doubt that those small banks are going to go running to sell these new products."

"Our opportunities are limited in the rural areas to start with," said Jerry Melby, president and CEO of First National Bank ($34 million in assets) in Bowbells, N.D., with a population of 498. With an aging customer base in the northwest corner of the state, Melby said he doesn't see much of a market for new products because his asset base is deteriorating. Coupled with the poor state of agriculture, asset flight has ensued as older customers pass away and leave their estate to heirs who often live in metropolitan areas, he said.

Western Bank ($50 million in assets) is the only bank in the small town of Lordsburg, N.M., population 2,951—in "the (southwestern) corner of the state in the middle of nowhere," said bank president Robert Martin. With its focus on ranching, farming and tourism, "I don't see that [the new law] is going to have much of an effect" on the bank or on the economic health of the city, Martin said.

Proponents of the new law championed changes to the Federal Home Loan Bank (FHLB)—which eased eligibility requirements and access to loan funds—as a saving grace for small banks in rural communities. A survey of banks in the largely rural Ninth Federal Reserve District showed that eight in 10 bankers said the provision was either moderately or very important to their bank (see article on banker survey--link!!). A separate analysis by the Minneapolis Fed found that almost 900 banks nationwide—about 60 percent of which were ag banks—were newly eligible for FHLB membership and its more-generous lending allowances. (Ron Feldman and Jason Schmidt, "Agricultural Banks, Deposits and FHLB Funding: A Pre- and Post-Financial Modernization Analysis," Journal of Agricultural Lending, Winter 2000, pp. 45-52.)

Changes to the FHLB were "definitely positive" for community banks, according to Julian Hester, CEO of the Community Bankers Association (CBA) of Georgia, whose members average just $125 million in assets. Aggressive banks will take full advantage of new borrowing opportunities, Hester said.

But what looks good on paper might not fly so well in practice. Martin, for one, said these changes would not be of any help to Western. With a 55 percent loan-to-asset ratio (well above even previous debt ratio thresholds), the bank didn't need easier credit-it needed more people walking through the doors for consumer and business loans.

One president of a small agricultural bank in rural Kansas admitted he had not even heard about the new law or its FHLB provisions. In the midst of a severe drought throughout the state, he said he was paying more attention to the weather than to anything coming out of Washington. If the area didn't get rain in the next 60 days or so, he said, "we're going to be in a world of hurt."

Back-drafting: Allowing what's already occurring

One of the big reasons for a seemingly slow bank reaction to the new law is simple: Many banks and bank holding companies—both big and small—with an interest in providing insurance or securities products are already doing so.

For example, starting in 1987, the Board of Governors of the Federal Reserve System began approving proposals to allow affiliates of banks to underwrite and deal certain low-risk securities (like municipal revenue bonds). These proposals had to be consistent with Section 20 of the Glass-Steagall Act and the Bank Holding Company Act requiring that banks not be "engaged principally" in securities, which was originally defined as contributing not more than 5 percent of an affiliate's total revenue.

Two years later, the Fed Board started approving applications for any type of debt or equity security except open-ended mutual funds, and gradually lifted the revenue bar to 25 percent of an affiliate's revenue. Not surprisingly, numerous banking companies—especially big ones—started using this route as an end run around Glass-Steagall.

Of the top 20 largest U.S. bank holding companies-whose assets range from about $700 billion (Citigroup) to $55 billion (State Street Corp.)-85 percent had Section 20 subsidiaries engaging in the underwriting and dealing of securities. All told, 45 different U.S. and international holding companies have 52 Section 20 subsidiaries.

"What's it [the new law] mean? Not that much because we're already in securities," said one source with a Fortune 500 bank who wished to remain anonymous.

A 1986 ruling by the Office of the Comptroller of the Currency allowed national banks to sell insurance from branches in towns under 5,000 in population, and a new loophole was born. Most often, such products were offered indirectly through dealer-broker arrangements, where the bank acts as a retail distributor of sorts, has no product ownership, and receives commission from any sales.

The National Institute Companies of America (NICA) has been helping community banks do just that for the past 14 years. As a broker between financial service providers and community banks, it arranges seminars in community banks for licensed agents hawking a wide variety of insurance and other financial planning services and products.

According to NICA president Kevin Maloney, banks get a 25 percent commission on all subsequent sales, and save on costs related to "ramping up" a new line of business because everything is provided by NICA. It runs seminars in about 300 community banks nationwide every year, he said.

American Federal prefers just such a partner approach, Dreyer said. Rather than create and underwrite new securities and insurance products—not to mention having to maneuver through the regulatory hoops for each—"we just went ahead and identified someone to provide those services on our premise," Dreyer said. "I don't see (new products) as something we're ready to jump on."

Many banks appear to need a push even for the partnering route. The CBA of Georgia established a joint marketing program to help community banks offer full-service insurance, giving banks virtually all the expertise needed to sell the services and products of up to 50 insurance companies within a matter of weeks, according to Hester. "We can drop an insurance agency in a bank in 30 days," Hester said.

But despite the ease of doing so, only five banks contracted with the association in the last half of 1999 for this insurance start-up program. The association recently surveyed its membership of 330 banks, and just 40 of 100 respondents planned to get into full service insurance in the next 12 months, according to Hester.

"Banks are not willing to diversify as much as they need to," Hester said.

Even among big banks, partnering in a broker-dealer arrangement for insurance products is a more likely scenario than banks creating and underwriting their own insurance products. Margins on insurance products are poor compared with banking, said Vagley of the AIA, "and banks are not all that enamored of the vagaries of underwriting."

Privacy no longer a secret

Aside from general barrier elimination, new regulations on privacy were the only subissue in the GLB Act that regularly struck much of any chord with those interviewed.

Vagley of the AIA called the privacy measures in the law "the most sweeping privacy regulations ever passed." The law requires clear and annual disclosure of privacy policies in the sharing of sensitive personal information with affiliates and third parties, and the opportunity for consumers to "opt-out" of any information-sharing agreements with third parties.

Privacy was the top concern for consumers, according to a number of bankers. "People want to be sure their information is protected and not used inappropriately," said Boozer of Colonial Bank.

Mengedoth of Community First Bankshares said there were "some far-reaching" provisions in the privacy law "that people don't know about and won't for the next six months."

Due to a purposefully broad definition of financial services, the new law requires some companies with no previous reporting responsibilities to institute and report on their privacy practices, Mengedoth said. For example, there are some half-dozen leasing companies in Fargo "that under the definition is a financial services company and will have to report (their) privacy processes," he said. "There's going to be some gnashing of teeth."

Mengedoth pointed out that the new law establishes the first federal legislation on privacy, but would be just the first part "of an ongoing stream" of privacy measures that consumers will see from Washington in the coming years.

"Clearly we don't believe the final chapter on [privacy] has been written," Mengedoth said. "Most rhetoric on this (issue) said it didn't go far enough."

New federal "opt-out" regulations require consumers to ask to be removed from information-sharing agreements with third parties, but did not preempt states from drafting their own privacy laws. A number are already considering "opt-in" proposals whereby customers would have to volunteer to share personal information with interested third parties, according to Fritz Elmendorf, vice president of communications for the Consumer Bankers Association, a retail banking association representing (among others) 85 of the top 100 banks.

"There's a lot of action in the states. That's evidence that a lot more is going on" with regard to privacy, Elmendorf said, adding that such a scenario is "very frightening to many in the banking industry."

The privacy issue appears to be less of an issue for smaller banks, several people said. [Community banks] "are not big enough to be in the business of selling information," Hester said. "I don't see [the new privacy regulations] as a problem at all."

American Financial has had a privacy policy in place for a full year, and only a few minor changes will be needed for their published material to be in compliance. Dreyer said the bank has never shared customer information with third parties, and has no plans to in the future. "So we don't care if they have tough (privacy) restrictions or not," Dreyer said.

"We've had a hard and fast rule that we don't share proprietary information," said Ben Haines, president of First Security Bank of Southern New Mexico, a $500 million affiliate of the First Security Corp. Calling information protection "the cornerstone of (banking) industry ethics," Haines added, "It's amazing to me this is even an issue."

"Our industry should have never had allowed the proprietary information issue to become an issue," Haines said, adding that "now that the camel's nose is under the tent," the privacy issue will only become more pervasive.

A financial services evolution, not revolution

To the last, those interviewed agreed that change in the financial services industry would be deliberate. Part of the reason is that until May of this year, banks are in a holding pattern until the Fed and other regulators issue specific rules on many parts of the new law.

But awareness and apathy also appear to be significant problems among bankers. To combat the awareness problem, Mengedoth said the American Bankers Association has created a task force to promote important changes of the new law to its members.

Hester acknowledged there was low awareness of the law among community banks. "I don't think enough people have enough interest in this," Hester said. "I'm ashamed of that."

The reason is because "everybody's doing real well" in banking today, Hester said. Coming off a smooth transition from Y2K, "bankers can look around them and say, 'God, the world is great.'" Compounding the problem is the fact that "bankers are not interested in politics and regulation," Hester said.

Bankers have long known such changes in the industry were coming, and publicly professed to be ready and willing to move with the times, Hester said. But bankers "didn't think the future was ever going to get here," he said. "If they don't (change), somebody's going to take their place. ... Some are going to end up being country stores."

But caution and sure-footedness are also common traits among bankers, several sources pointed out. Bankers, said Maloney of NICA, "are suspenders and belts" types who are typically "slow to take that potential leap into a new sector."

"They are very cautious people, which is good for us," Maloney said. Bankers will pursue new opportunities only when they see the efficacy of such a move. "I think [implementation] will be a slow process," Maloney said.

This conservative mind-set means the financial modernization law will likely usher in an evolution, not a revolution, in banking. So gradual will the changes be that consumers are not likely to notice the incremental steps taken as the financial services company of the future is formed.

Ultimately, banking customers "will begin to see more expertise in their bankers" as a result of financial reform, Mengedoth said. The movement will be toward financial consulting and a "relationship where needs change" from starting a checking account to buying a car, a first house, kids' education and finally retirement. This will require bankers, insurance brokers and securities specialists alike to be cross-trained to sell and manage a new financial services portfolio, he said.

But to Bobins, the unknown and yet-to-be-defined element is the biggest asset of the financial reform legislation. The repeal of Glass-Steagall, he said, "allows people to start thinking more creatively than they have before." Prior to the new law, valuable resources were spent trying to determine whether certain activities were allowed, and how to maximize your options under the law.

The new law "frees up people's thinking going forward," Bobins said, "It takes you out of the box."