BANKING PROBLEMS CREATED BY 1986 ACT REQUIRE CONGRESSIONAL ACTION, CRS SAYS.

88-118 E

CRS REPORT FOR CONGRESS

Recent congressional actions on taxation and financial restructuring could affect the safety and soundness of commercial banks. The Tax Reform Act of 1986 may have little immediate impact on soundness, but if Glass-Steagal is repealed, soundness may be enhanced if there will be little or no insulation between banking and nonbanking activities.

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Recent congressional actions on taxation and financial restructuring legislation may have lasting ramifications on the safety and soundness of the U.S. financial industry. In this paper the terms safety and soundness mean the ability of financial institutions to effectively and profitably carry out their fiduciary responsibilities and maintain the payments system, given the existing regulatory framework and an environment with random exogenous shocks. The Congress has passed the Tax Reform Act of 1986 (TRA), which many banking experts believe will substantially raise bank taxes and lower banking institutions' profitability. Some of these analysts believe that the regulatory framework is the key to bank safety and soundness. Others strongly believe profitability is the first line of defense against insolvency and they are concerned about the impact of Tax Reform Act. ¹ Their concern is further heightened by the possible repeal or modification of the Glass-Steagall Act, which prohibits depository institutions from extensively engaging in securities and other nonbanking activities.

There are at least twelve bills in the 100th Congress any of which, if enacted, will effectively repeal the 54-year-old Glass- Steagall Act. ² Should this happen, some members of the financial community believe it will remove one of the most significant buttresses against episodes of bank holidays such as during the Great Depression. ³ In contrast to this view, other members of the financial community, some members of the Administration, and some members of the Congress strongly believe that the Tax Reform Act and the repeal of Glass-Steagall will not significantly affect the resiliency and soundness of the financial system. ⁴

This report examines the combined effects of the Tax Reform Act and the possible repeal of the Glass-Steagall Act on the financial wellbeing of the American commercial banks. While these two pieces of legislation are distinctly separate in purpose and intent, their combined impact on depository institutions may bring about the need for further regulatory and/or congressional action. The report first examines the effects TRA is expected to have on depository institutions' profits and risks. Then, it examines whether or not repealing Glass-Steagall would enhance soundness by looking at whether or not depository institutions' activities are expected to be more profitable and less risky. It concludes with some policy implications.

DO LOW EFFECTIVE TAXES ENSURE SOUNDNESS?

The banking industry argues that banks pay significant amounts of implicit taxes, in response to congressional and other studies that indicate that depository institutions pay low taxes relative to other industries. ⁵ The bankers' argument strongly leads some to the conclusion that any increase in bank taxes threatens the financial stability of depository institutions. However, the fact still remains that the average income tax rate paid by large banks was only 4.6 percent compared to 21.4 percent for all large corporations between 1980 and 1986. Bankers argue that these calculations left out the large implicit taxes that depository institutions pay because of legal reserve requirements and holding of tax-exempt assets. Moreover, despite this omission, the effective rates of large banks and all large corporations look more similar when worldwide taxes and worldwide incomes are used, 21 percent for banks and 29 percent for all corporations. ⁶ One implication made by the banks is that bank taxes were unfairly increased in the Tax Reform Act of 1986, if the banks' implicit taxes were taken into account.

Implicit taxes are paid mainly through bank holdings of municipal bonds that bear relatively low yields and bank holdings of required reserves that bear no yield. For example, if a municipal bond yields 6.6 percent and a taxable corporate bond yields 10 percent, the implicit tax on the tax-exempt bond would be 34 percent. This is because a depository institution within the top corporate tax rate of 34 percent would earn the same return net of taxes on the two investments, making the institution indifferent between these two investments. Depository institutions pay an implicit tax as long as the yields on municipal bonds are below the pre-tax yields on the taxable bonds. As a result, bankers argue that the implicit revenues provide a benefit to the State or municipality issuing the bonds because they lower these governments' cost of financing. According to Salomon Brothers, the implicit tax banks paid in 1985 by holding tax- exempt bonds totaled $5.6 billion. ⁷

Members of the banking community have also argued that depository institutions' earnings are lower because of the interest forgone on Federal Reserve legal reserve requirements. The reserve requirement is a tax because it reduces the banking industry's income on one hand, and on the other, the Federal Reserve uses the funds to buy Government securities that pay interest -- thus, directly benefiting the Government as the Federal Reserve remits its interest income, less its administrative costs, to the U.S. Treasury. According to one estimate, the reserve requirements imposed an implicit tax on the banking community of $3.5 billion in 1985. ⁸

The problem with this argument is that the bankers can not have it both ways. If depository institutions are paying implicit taxes, and if the Tax Reform Act only make them explicit, then the banks are not necessarily worse off, and their safety and soundness is not threatened. On the other hand, if depository institutions continue to pay a significant amount of implicit taxes while paying more explicit taxes, the soundness of the system may be threatened. However, after examining the provisions of the Tax Reform Act as reported below, it was concluded that one effect of TRA is to make these taxes explicit. This, in turn, may force institutions to change the assets in their portfolios -- for which there may be a cost of adjustment. It is this cost of adjustment that may have a significant impact on soundness in the long run.

TAX REFORM ACT EFFECTS ON BANKS

The Tax Reform Act (TRA) of 1986 thoroughly restructured the U.S. Tax Code with lower tax rates and the elimination of many deductions and credits. The following provisions have a potential impact on depository institutions' safety and soundness in particular:

o The elimination of loan loss reserve deductions for large banks (banks with assets greater than $500 million);

o The elimination of the deduction for interest expenses attributable to carrying tax-exempt obligations.

Other provisions that affect banks along with other business are:

o A restriction on businesses' ability to offset U.S. tax liabilities with tax credits derived from foreign withholding taxes on income;

o A reduction in tax rates on taxable income;

o An increase in minimum corporate income taxes;

o The elimination of the investment tax credit.

Loan Loss Reserves

All banks used to be able to deduct from taxable income their actual loan losses (net of recoveries) and also were permitted a deduction for net additions to loan loss reserves. Under TRA, large banks are permitted to deduct only actual loan losses. Large banks are also required to recapture as taxable income the remaining balance in their reserves over a period of 4 years. According to one estimate, the ending of this deduction is expected to increase bank taxes by about $1 billion in the near term. ⁹ But, a banking industry source estimates that it will cost the industry between $2.4 billion and $4 bi11ion from 1987 to 1990. ¹⁰ Without going into the accounting detail of the different treatment of the loan loss reserves, it is clear that growing reserve balances were encouraged under the old law because the tax break would increase with growing provision for loan losses. Despite the existence of this incentive over the years, however, U.S. banks have had inadequate loan loss reserves in relation to their stock of bad loans. ¹¹ Without this tax incentive, some experts fear that the banking system's ability to withstand defaults will be severely curtailed.

Accordingly, smaller institutions, which account for most of the record number of failures being experienced in the banking industry, will still have this deduction under TRA. In addition, most of the larger institutions with large exposure to financially troubled countries may continue to use the actual loss on bad loans deductions for the next few years as they did before TRA. In line with this, it is also important to recognize that loan loss reserves do not protect depository institutions from bad assets by, for example, setting aside a cash reserve to cover default-related expenses. Loan loss reserve is basically an accounting device for management to recognize the potential for losses. What really protects depository institutions is primary capital, and there is no evidence that the tax deduction for loan loss reserves encouraged depository institutions to increase primary capital. ¹² Even before TRA, U.S. banks still had to be prodded by regulators to raise their primary capital to an adequate level. ¹³

Interest Expenses on Tax-Exempt Assets

Before the Tax Reform Act of 1986, depository institutions could deduct from taxable income 80 percent of the interest expenses attributable to carrying tax-exempt obligations, subject to some restrictions. Under TRA, tax-exempt assets purchased after August 7, 1987, are fully taxable. ¹⁴ The impact of this provision on depository institutions' taxes is expected to be relatively small because the deduction is not being eliminated on the institutions' current holding of tax-exempt assets and the institutions are expected to reduce their future purchases of tax-exempt assets. Because the banking institutions could earn higher before-tax returns on taxable assets, as mentioned earlier, they argue that they paid an implicit tax by holding municipal bonds and other tax-exempt assets bearing relatively lower yields. Assuming the assets are of equal risks, it is estimated that the elimination of this provision will increase commercial banks' taxes some $3.9 million using 1985 as the baseline. ¹⁵

As depository institutions switch from low-yielding tax-exempt assets to higher yielding taxed assets, experts believe that the banks' income may not be significantly affected one way or the other. However, if the taxable assets are more risky, the level of risk in banking institutions' portfolios will most likely increase. With respect to Glass-Steagall, if it is repealed, depository institutions may be entering into the securities and other businesses at the same time they are already taking on riskier assets by moving out of tax- exempt bonds, which some believe to be relatively safe. ¹⁶ This move by banks has already had an adverse impact on the tax-exempt market according to press reports. However, because of the gradual process involved in shifting over and the limitations expected to be placed on banks should they enter the securities industry and other businesses that are believed to be more risky than banking, a significant increase in the riskiness of depository institutions' portfolios may take years.

Foreign Tax Credit

Because some major U.S. banks have earned up to 70 percent of their income from their foreign operations, the Tax Reform Act's restrictions on foreign tax credit may reduce the after tax earnings of these banks. Before TRA, banks were able to use the taxes paid to a foreign government as a credit against U.S. taxes. Now, TRA has reduced the value of the foreign taxes paid in two ways. First, the credit is worth less because TRA lowers the statutory corporate tax rate from 46 to 34 percent. The total credit claimed cannot exceed the tax that would have been paid on those foreign earnings if earned in the United States. For instance, an average foreign tax rate of 42 percent would have been fully creditable against U.S. taxes under the old rate of 46 percent corporate rate. The institution would now lose 8 percentage points (42 - 34) of foreign tax credit. ¹⁷ The other reduction comes from the new rule prohibiting the averaging of foreign withholding taxes on earnings abroad. Banking institutions must calculate their foreign tax credit separately. The "separate basket rule" on income subject to foreign withholding tax of at least 5 percent has limited the spillover tax benefits that banks enjoyed when incomes were averaged.

The reduction of the foreign tax credit is not expected to have an immediate or significant impact on depository institutions primarily because it is subject to a three-year delay and a five-year phase-in for some 33 International Monetary Fund member countries. Consequently, in the short-run it will have little bearing on the combined effect of the TRA and the possible repeal of Glass-Steagall. In the long run, however, this provision may be a significant determinant of the distribution of U.S. banking and securities operations between domestic and foreign markets. Moreover, as a result of this provision, U.S. institutions may want to shift their foreign operations to countries with lower withholding or expand domestic operations in order to stay competitive at home and abroad.

Other Provisions

Even though the following TRA provisions may not have any special direct or even significant impact on depository institutions, these provisions may cause depository institutions to make some adjustments in the way they do business which, in turn, may affect safety and soundness.

Corporate Tax Rate

Lowering the corporate tax rate from 46 to 34 percent is expected to have little special impact on the banking industry because the lower tax rate schedule is offset by the higher taxable income. This is due to TRA's elimination of tax deductions and exemptions the banking industry has enjoyed up until now.

Corporate Minimum Tax

Prior to the TRA, the corporate minimum tax was an "add-on" tax that was paid in addition to regulate taxes. Now it is an "alternative" minimum tax; a firm pays either its regular tax or minimum tax, whichever is higher. The new treatment of the corporate minimum tax under TRA is expected to have little or no impact on profitability of depository institutions. For these institutions both the rate and the income base have been increased under the new law. The rate was increased from 15 to 20 percent and tax-exempt income is now added back into the calculation. Even though the foreign tax credit is available to offset up to 90 percent of the minimum tax, FDIC calculations suggest that the new minimum taxes are not likely to significantly increase taxes for the banking industry as a whole. ¹⁸ Based on 1985 income and taxes, it is estimated that the minimum tax will cost the commercial banking industry about $700 million. ¹⁹

Investment Tax Credit

When the 10 percent investment tax credit was repealed by the TRA, depository institutions lost one of the most used tax breaks they enjoyed for years, primarily through their leasing operations. It is estimated that the elimination of this credit will reduce the commercial banking industry's after tax income by about $600 million. ²⁰

Overall Effects on Profitability

If the concern is solely to determine the immediate amount of money that will be transferred from depository institutions to the Government, the consensus of estimates is that it is not a significant amount. Few, if any depository institutions will be made insolvent by the Tax Reform Act of 1986. For example, the net effect of the tax reform measures on commercial banks is to raise bank taxes by $2.3 billion over 1985 base line estimates, which may be ameliorated somewhat in light of the fact that net income before taxes increased by $1.3 billion. ²¹ This is because in anticipation of the increase in taxes, depository institutions are expected to increase their before-tax income by shifting their portfolio away from low-income producing previously tax-exempted assets to higher income producing taxable assets. The impact of these tax provisions on banking institutions' profitability will depend on the rate of portfolio adjustment and the phasing in of various provisions plus the existing asset composition of each institution, among other things. However, this means that for an individual bank, the Tax Reform Act may have a dramatic effect on its aftertax income in contrast to a small effect for the industry as a whole.

A concern, on the other hand, is that as a result of the Tax Reform Act the financial systems' ability to withstand exogenous shocks has been significantly reduced in the long run. There is less agreement on this issue, however, because the cost of adjustments of depository institutions to TRA are unknown. The banking system will have to adjust to the provisions on tax-exempt bonds, loan loss reserves, and foreign tax credits. These provisions may cause some institutions to undertake more risk in their portfolios as they acquire more assets with higher before-tax returns, or switch their foreign operations to lower-tax countries. The problem is that profitability of such adjustments will not be evident for several years, as was the case when the savings and loan industry was deregulated.

SOUNDNESS AND THE REPEAL OF GLASS-STEAGALL

The second issue is the soundness effect of repealing the Glass- Steagall Act. At the beginning it is important to note that despite congressional arguments to the contrary, the actions of the 100th Congress so far further separate banking and commerce. The Competitive Equality Banking Act of 1987 (CEBA), P.L. 100-86, placed a moratorium on expanded banking powers until March 1, 1988, and extended the coverage of the Glass-Steagall Act to almost all depository institutions. ²² Furthermore, even though there are at least twelve bills in the Congress to repeal Glass-Steagall, the only legislation (CEBA) that has passed in Congress in the last five years is consistent with restrictive legislation, such as the National Banking Act of 1864, the Glass-Steagall Act of 1933 and the Bank Holding Company Act as amended in 1970. These laws are generally intended to (1) maintain the integrity of the banking system; (2) prevent self-dealing and financial abuses, and (3) limit stock market speculation. Moreover, most of the bank-related laws passed by Congress are designed to enhance the soundness of the American financial system above all else.

On the other hand, the bills being considered in the Congress to repeal the Glass-Steagall Act are the result of an explicit argument that contrary to its intended purpose, the Act is now undermining the soundness of the financial system:

The Glass-Steagall barriers between banks and securities firms and the Bank Holding Company Act barrier prohibiting affiliations between banks and other types of financial and nonfinancial business, acting in combination with each other, severely impair the mobility of corporate capital invested in the commercial banking industry. These legal barriers to the redevelopment of corporate capital by banking firms which have no counterpart in other industries, have serious adverse consequences for the financial soundness of banks and the efficiency and competitiveness of the entire U.S. financial sector. ²⁴

In addition, it is argued that depository institutions are legally restricted to activities that have been experiencing declining profits and increasing risk. The next three sections address:

o The erosion of the Glass-Steagall type barriers before The Competitive Equality Banking Act of 1987 was enacted;

o Profitability of nonbanking activities versus banking activities;

o The riskiness of banking activities versus nonbanking activities.

Erosion of the Separation of Banking and Commerce

Until the enactment of CEBA, depository institutions had been going into nonbanking activities at a dramatic rate. This was particularly true for bank holding companies (BHCs). The avenues used to expand banking activities were mainly provided by Federal and State regulators approving depository institutions' requests to enter some other form of business. As table 1 taken from William Jackson's paper, "The Separation of Banking and Commerce" indicates, the list of activities is quite extensive. While these activities have some form of restriction placed on the extent to which the institution may engage in them, the image of banking organizations only engaging in banking activities has been a myth. The mixing of commerce and banking has been permitted by State regulators, the Federal Reserve Board, the Comptroller of the Currency, and foreign governments where depository institutions have been expanding operations. By 1976 more than 285 bank holding companies had positive investments in nonbank subsidiaries; by 1984 the number almost doubled to more that 45O and has continued to grow. ²⁵

                               TABLE 1.

Primary Source: 12 C.F.R. 225.25(b).

For reason of confidentiality, the dollar amount that bank holding companies have invested in nonbank subsidiaries has not been made readily available by the Federal Reserve. Table 2 is taken from Larry Wall's paper on nonbank subsidiaries. It shows in percentage terms the amount investment in nonbank subsidiaries, using the total BHC's investment in subsidiaries as the denominator. In light of pressure on Congress for expanded powers for depository institutions, this table shows that the smaller bank holding companies have reduced their holdings in nonbank subsidiaries. ²⁶ For banks with consolidated assets below $1 billion and between $1 billion and $10 billion, the percentage have declined to almost half. Most of the growth has come from the larger bank holding companies. ²⁷

                               TABLE 2.

One of the most frequently used arguments for the repeal of Glass-Steagall and expanding powers is that depository institutions are restricted to banking activities that are relatively unprofitable as compared to nonbanking activities. Table 3 shows that financial firms including finance companies, mortgage companies, investment banks, and large diversified firms are relatively more profitable than commercial banking. These businesses' profitability as measured by their average aftertax return on equity, and average price to earnings ratios do not reflect their major set-backs from the recent bad bond and stock markets, but they indicate the attractiveness of the financial services that the depository institutions are aiming to enter. These numbers exclude depository institutions presently engaging in similar activities, such as investment banking, and other securities firms. ²⁸

                               TABLE 3.

Bank Holding Companies Are More Profitable at Banking

Tables 4-6 show the median parent bank holding company investment in nonbanking subsidiaries as a portion of total parent investment in all subsidiaries over the 1976-1984 period. These tables show that bank holding companies are most profitable at banking activities. Taking into account the limitations of these numbers, ³⁰ they indicate that the median return on parent investment in nonbank subsidiaries is consistently below that of the return on banking subsidiaries for all three sizes of bank holding companies with exception of 1977 and 1982 for the large companies and 1982 for the medium. The tables also show that nonbank activities of the larger holding companies are most successful despite the fact that they are generally lower than these companies' banking activities.

One of the most important revelations of these profit tables is that in every category of bank holding companies there are years where the consolidated returns are higher than the individual figures for the bank subsidiaries and nonbanking subsidiaries. For instance, in 1980 the median return on equity for BHCs with assets over $10 billion with positive investment in nonbanking subsidiaries was 13.6 percent for their banking subsidiaries, and only 7.9 percent for their nonbanking subsidiaries. Yet, the consolidated return was 14.2 percent. The same holds true for all the years of the larger companies, unless the Federal Reserve's calculations are somehow incorrect. This implies that through diversification the consolidated bank holding company may be better off, even though returns on the two types of activities they engage in are lower.

Moreover, theoretically it is possible to prove that the expected return on an activity that, in isolation, appears to yield relatively low return may substantially increase a bank holding company's overall return when the expected return on the entire organization is taken into consideration. ³¹ However, one must also bear in mind that the Federal Reserve data upon which these tables are based is sufficiently aggregated that there might not be proof that this is indeed the case. Larry Hall expressed concerns about interaffiliate manipulation of transfers, double leverage practices and the method of accounting used by the bank holding companies and their subsidiaries that could explain these results. He points out in his paper that it is necessary to assume that the reported income is an accurate reflection of economic values and that the parent company is not manipulating interaffiliate transfer pricing to shift reported income from one subsidiary to another. Double leverage practices may reduce net income in both the BHC and its subsidiaries and reduce equity for the consolidated bank holding company by having greater equity capital in the subsidiaries than the parent BHC and fund the excess with debt issues. This would make the return to equity in the bank holding company higher than the subsidiaries. Finally, the method and accounting used to finance the acquisition of the subsidiaries may distort the income equity figures to help bring about the observed return to equity. ³²

                              TABLES 4-6.

The Riskiness of Banking Versus Nonbanking Activities

In the first part of this paper it has been pointed out that some of the provisions of the Tax Reform Act of 1986 may induce depository institutions to acquire riskier assets independently of any repeal of Glass-Steagall. There is a concern that, repeal of Glass-Steagall would permit financial institutions to engage in riskier activities. The following examination of the literature seems to suggest that indeed the nonbanking activities of these bank holding companies are riskier. However, by allowing BHCs to engage in both, the overall portfolios of depository institutions may be less risky. This section briefly looks at the riskiness of nonbanking activities in terms of two sets of enterprises -- some nonbanking firms engaged in the activities banking firms are expected to enter, and nonbanking activities in which bank holding companies are presently engaged.

In the Federal Reserve Bank of New York study, The Recent Performance of The Commercial Banking Industry, it was not only pointed out that commercial banks remain relatively less profitable compared to other financial firms (table 5), but that bank profits are less variable:

With the exception of non-auto finance companies, the profitability of all segments of the non-bank financial industry has tended to move through wider -- often much wider -- ranges during the past decade than bank profitability, and the profit performance of many of these groups show substantially greater short-term variability than does that of the banks as a group. ³³

This implies that the chances of suffering losses in the banking business are less than the chances of enjoying stable profits from finance companies, mortgage companies, investment banks, securities brokers, various components of the insurance industry and large diversified financial firms. ³⁴ It is important to note that such profits may be variable, possibly turning negative but generally positive. Even so, the variability may create instability in the financial system as depository institutions expand and contract assets accordingly.

Most studies of bank holding companies' nonbanking activities suggest that their nonbanking activities are more risky that their banking activities. However, the majority of these studies argue that through diversification, the bank holding companies seem to be less risky than its component parts. This implies significant offsetting risks in the portfolio of the entire bank holding companies.

He [Robert E. Litan] found that bank holding companies have higher mean returns and lower coefficient of variation of returns -- implying lower risk -- than their banking subsidiaries. However, Litan notes that the bank holding companies are less risky that their bank subsidiaries for only 16 of the 31 banking organizations in his sample. ³⁵

As pointed out earlier, these conclusions are based on data that assume that reported income is not distorted by interaffiliate transactions and other accounting problems. Looking at the reported numbers, it is clear that a significant part, which should not be overlooked, of the nonbanking activities is riskier than banking.

Supporting this notion with a complex empirical test, John H. Boyd and Stanley Graham showed that the likelihood of failure for a bank holding company is significantly positively related to its nonbank activities over the period 1971 to 1977. However over the full sample period, 1971-1983, they found no such relationship between bank holding companies and nonbanking activities that is significant. While Boyd and Graham try to explain the inconsistency of their findings in terms of supervisory, regulatory and monetary policies, very little discussion of the quality of the data was offered. ³⁶

Larry Wall using a simpler correlation coefficient measure reached the following conclusion:

This research concludes that while there is indeed a correlation between the portion of nonbanking activity and BHC risk, this correlation does not necessarily mean that nonbanks are the cause of increased risk. This correlation could hold true even if nonbanks in fact decrease risk or have no impact upon BHC risk what so ever. . . . Nonbank activities appear to increase the risk for some BHCs and decrease it fur others, indicating that the riskiness of nonbanking activities should be taken into consideration in risk-based capital standard. Keep in mind, however, that nonbank subsidiaries should be analyzed in a portfolio context rather than on a stand-alone basis. . . . ³⁷

There is a great deal of merit to the argument that the portfolio approach is best. It may also require better data and more sophisticated analysis to make an accurate assessment of the impact of nonbanking activities on the riskiness of bank holding companies. Putting the data problem aside, the available numbers and analysis can be interpreted as saying that if Congress repeals Glass-Steagall and compartmentalizes depository institutions' nonbanking activities, these institutions' profitability may fall, their risk may increase. On the other hand, if Congress does not compartmentalize nonbanking activities, it may expose the insured deposits of financial institutions to more risk.

SOME IMPLICATIONS FOR PUBLIC POLICY

Equity has been a key objective of the Congress in enacting the Tax Reform Act of 1986 and in considering legislation to repeal the Glass-Steagall Act. This objective is also constrained by the responsibility of Congress to ensure the safety and soundness of the American financial system. Consequently, achieving equity that also undermines the safety and soundness of the payments system is an outcome that Congress has tried to avoid in its legislative activities.

Bearing this in mind, this report suggests several implications for the conduct of public policy.

o In its attempt to raise the amount of taxes depository institutions pay to make their taxes comparable to other corporations, depository institutions are expected to reduce their purchases of tax-exempt bonds. This may have a negative impact on the municipal bond market, and may call for some congressional attention.

o As a result of TRA's explicit tax increase on depository institutions, banking institutions are generally expected to seek out investments paying higher before-tax income. If these investments come with higher risk, the portfolios of depository institutions are expected to be riskier. Given this situation, the Congress or regulators may have to require some depository institutions to raise their capital ever further.

o With respect to the repeal of Glass-Steagall, the available evidence suggests that the nonbanking activities that the depository institutions are presently engaged in are more risky than, and some are not as profitable as, banking. Furthermore, depository institutions are most likely to lower their risk and increase their profits when engaging in these activities, only in a joint portfolio management context. This implies that the bills in Congress that will effectively insulate nonbanking activities from depository activities would lower profits and increase the riskiness of existing institutions.

o If Congress repeals Glass-Steagall within a regulatory famework that guarantees safety and soundness, but turns out to be limiting opportunities for profits, the financial system will incur significant costs in attempting to engage in nonbanking activities. As a result, these institutions may be calling upon the Congress in a few years for regulatory assistance.

SELECTED REFERENCES

Boyd, John H. and Stanley L. Graham. Risk, regulation, and bank holding company expansion into nonbanking. Federal Reserve Bank of Minneapolis. Quarterly review, Spring 1986.

Davis, Richard G. The recent performance of the commercial banking industry. Federal Reserve Bank of New York, Quarterly review, Summer 1986.

French, George E. Tax reform and its effect on the banking industry. Issue in bank regulation, Bank Administration Institute. Summer 1987.

O'Brien, James M. and Matthew D. Gelfan. Effects of the tax reform act of 1986 on commercial banks. Tax notes, February 9, 1987.

U.S. Library of Congress. Congressional Research Service. Financial institutions restructuring proposal: implications for government regulation. Report no. 88-7 E, by F. Jean Wells. Washington. 1988.

o Taxation of commercial banks in the tax reform act of 1986 (conference agreement). Report no. 86-933 E, by James E. Bickley, Washington, 1986.

o Financial services diversification: a comparative summary of major financial reform measures facing the congress. Report no. 88-67 E, by William Jackson et al. Washington, 1988.

o Financial institutions: problems and restructuring: a CRS compilation. Report no. 87-586 E, Coordinated by Walter Eubanks. Washington, 1987. p. 127-140.

² U.S. Library of Congress. Congressional Research Service. Financial Institutions Restructuring Proposal: Implications for Government Regulation. Report no. 88-7 E, by F. Jean Wells; and Financial Services Diversification: A Comparative Summary of Major Financial Reform Measures Facing the Congress. Report no. 88-67 E, by William Jackson et al. Washington, 1988.

³ U.S. Congress. Senate. Committee on Banking, Housing, and Urban Affairs. Strengthening the Safety and Soundness of the Financial Services Industry. Washington, U.S. Govt. Print. Off., 1987. p. 414-478.

⁴ U.S. Congress. House. Hearings. Committee on Government Operations. Structure and Regulation of Financial Firms and Holding Companies (Part 1-3). Washington, U.S. Govt. Print. Off., 1986.

⁵ Implicit taxes are reductions in an industry's earnings that accrue to the benefit of the public sector.

⁶ Henderson, Yolanda K. The Taxation of Banks: Particular Privileges or Objectionable Burdens? Federal Reserve Bank of Boston, New England Economic Review, May/June 1987. p. 3.

⁷ Salomon Brothers, Inc., Analytical Record of Yields and Yield Spread. New York, 1986.

⁸ Henderson. The Taxation of Banks. p. 6.

⁹ O'Brien, James M. and Matthew D. Gelfan. Effects of the Tax Reform Act of 1986 on Commercial Banks. Tax Notes, February 9, 1987. p. 597; and Corrigendum: The Impact of the Tax Reform Act of 1986 on Commercial Banks. Tax Notes, March 30, 1987.

¹⁰ French, George E. Tax Reform and Its Effect on the Banking Industry. Issues in Bank Regulation, Bank Administration Institute. Summer 1987. p. 4.

¹¹ U.S. Library of Congress. Congressional Research Service. International Banking: The Developing Country Debt Crisis Continues. Report no. 88-39 E, by William Jackson. Washington, 1988. p. 6.

¹² See part V of O'Brien and Gelfan, Effects of the Tax Reform Act of 1986 on Commercial Banks, p. 603.

¹³ See U.S. Library of Congress. Congressional Research Service. LDC Dept Developments and Regulatory Implication For U.S. Banks, by Walter W. Eubanks in Financial Institutions: Problems and Restructuring: A CRS Compilation. Report No. 87-586 E, Coordinated by Walter Eubanks. Washington, 1987. p. 127-140.

¹⁴ U.S. Library of Congress. Congressional Research Service. Taxation on Commercial Banks in the Tax Reform Act of 1986 (Conference Agreement) Report No. 86-933 E, by James M. Bickley. Washington, 1986.

¹⁵ O'Brien and Gelfan, Corrigendum, p. 1324.

¹⁶ If markets work perfectly, they will capitalize the differences in the riskiness of tax-exempt assets and taxable assets. But, market failure and imperfections often prevent this from happening.

¹⁷ Despite the additional "excess credits" there should, at the minimum, be no change in aftertax earnings. At the maximum, earnings should increase. If these unusable credits were made usable, of course, the institutions would have even higher earnings.

¹⁸ French, Tax Reform, p. 5.

¹⁹ O'Brien and Gelfan, Corrigendum, p. 1324.

²⁰ Henderson The Taxation of Banks, p. 15.

²¹ O'Brien, et al, Tax Notes, p. 1324.

²² U.S. Library of Congress. Congressional Research Service. The Competitive Equality Banking Act of 1987. Report No. IB87187 by Walter W. Eubanks et al. Washington, 1987.

²³ U.S. Library of Congress. Congressional Research Service. Financial Institutions: Problems and Restructuring. A CRS Compilation.

²⁴ U.S. Congress. House. Committee on Government Operations. Modernization of the Financial Services Industry: A Plan for Capital Mobility Within A Framework of Safe and Sound Banking. House Report 100-324. Washington, U.S. Govt. Print. Off., 1987. p. 20.

²⁵ Larry D. Wall. Nonbank Activities and Risk. Federal Reserve of Atlanta, Economic Review, October 1986. p. 21.

²⁶ Wall's paper also shows that nonbanking subsidiaries of bank holding companies have grown across the board. This suggests that even though the nonbank subsidiaries are not profitable, bank holding companies still find them desirable.

²⁷ See Wall Nonbank Activities and Risk, p. 24.

²⁸ Davis Richard C. The Recent Performance of the Commercial Banking Industry. Federal Reserve Bank of Hew York, Quarterly Review, Summer 1986, p. 4.

²⁹ See Wall, Nonbank Activities and Risk, p. 26.

³⁰ See footnote 31.

³¹ For further explanation of this outcome see Markowitz, Harry, Portfolio Selection, Journal of Finance, March 1952, p. 77-91 and Wall, Nonbank Activities and Risk, p. 21-24.

³² Wall, Nonbank Activities and Risk, p. 27.

³³ Davis, Recent Performance, p. 4.

³⁴ U.S. Library of Congress. Congressional Research Service. Merchant Banking: Opportunities or Problems for U.S. banks. Report no. 87-351 E, by Walter Eubanks and William Jackson. p. 5.

³⁵ Wall, Nonbank Activities and Risk. p. 28; and Summary of Litan, Robert E. Evaluating and Controlling the Risks of Financial Product Deregulations. Brookings Technical Series, Reprint. Washington, 1986. p. 51-52.

³⁶ Boyd, John H. and Stanley L. Graham. Risk, Regulation, and Bank Holding Company Expansion into Nonbanking. Federal Reserve Bank of Minneapolis. Quarterly Review, Spring 1986. p. 15.

³⁷ Wall, Activities and Risk, p. 32.