Perhaps the hottest debate in banking today is the one about letting bank holding companies (BHCs) engage in certain financial lines of business outside of commercial banking. 1 Large BHCs have vigorously argued for lowering barriers to entry into investment banking, fullservice securities brokerage, the insurance business, and real estate investment and development. These BHCs point out that nonbank financial firms such as securities firms and insurance companies have been permitted into

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... ional bank activities. They argue that lowering the entry barriers into nonbank activities would not only be equitable-by leveling the playing field-but would also bring some needed competition into nonbank activities. 2 Critics of expanded BHC powers argue that if BHCs enter currently prohibited activities, the risk to bank subsidiaries will increase. They argue that many of the sought-after nonbank financial activities are riskier than commercial banking. Therefore, if BHCs are permitted to expand into those activities, they say, the incidence of commercial bank failure-or its common analogue, the Federal Deposit Insurance Corporation (FDIC) rescue-will quite likely increase. Proponents of expanded powers for BHCs, of course, have very different opinions about the impact of expansion on BHC risk. They offer two principal views of what would happen if BHCs became involved in nonbank financial activities. One is that risk, as measured by the variability of BHC profits, would decrease because of the effect of asset diversification. The other view is that such risk might increase, but that increase would be more than compensated for by an increase in * Also Adjunct Professor of Finance, University of Minnesota. •The authority to permit BHCs to engage in nonbank activities resides in the Federal Reserve System. The Bank Holding Company Act of 1956 and its subsequent amendments authorize the Fed to determine what nonbank activities, other than those specifically prohibited by law, are permissible for a BHC (defined as a holding company controlling one or more banks). The basic criteria are that a permissible activity must be closely related to banking and that it must provide net public benefits. A BHCs entry into permissible activities requires prior approval by the Fed. The nonbank activities that BHCs are specifically denied by law include (most prominently lately) the insurance and securities businesses. The Bank Holding Company Act and the Garn-St Germain Depository Institutions Act of 1982 prohibit BHCs from engaging in most insurance activities. And the Glass-Steagall sections of the Banking Act of 1933 separate commercial banking from investment banking. These prohibitions are being reconsidered today. In early 1987, for example, the Fed approved several BHC applications to underwrite a limited volume of third-party commercial paper, mortgage-backed securities, consumer receivable-related securities, and municipal revenue bonds. In August 1987, in response to the Fed's actions and other actions which tested the federal prohibitions, the U.S. Congress passed the Competitive Equality Banking Act of 1987 which imposed a moratorium on bank and BHC expansion into securities activities. Although that moratorium has expired, the specific actions taken by the Fed have been stayed by a court and are now under appeal before the U.S. Supreme Court. At the end of March 1988, with strong backing from the administration and bank regulatory agencies, the Senate passed a bill that would permit BHCs to enter some currently prohibited securities activities. By early June 1988, though, the House had not yet acted on this issue. 2 Until recently, nonbank firms were able to exploit a loophole in the Bank Holding Company Act which let them own a firm that acted like a bank as long as it did not offer both demand deposit and commercial loan services. If a firm did not offer one of those services, it was not considered a bank under the Bank Holding Company Act. Firms that exhibited these characteristics were commonly referred to as nonbank banks. This loophole was closed by the Competitive Equality Banking Act of 1987, which redefined a bank to include any financial firm whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC). Nonbank banks established before March 1987 were exempted from this law.