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For release on delivery
9 30am E D T
June 17, 1998
Statement by
Alan Greenspan
Chairman
Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
U S Senate
June 17, 1998
It is a pleasure to appear before this Committee to present the views of
the Federal Reserve on the need to enact legislation to modernize the U S
financial system and to express the Board's strong support for H R 10, which
achieves this objective
I. The Need for Financial Reform
U S financial institutions are today among the most innovative and
efficient providers of financial services in the world
They compete, however,
in a marketplace that is undergoing major and fundamental changes driven by a
revolution in technology, by dramatic innovations in the capital markets, and by
the globalization of the financial markets and the financial services industry
The Federal Reserve believes that it is essential that the nation act
promptly to modernize the rules that govern our financial institutions in order to
ensure their continued competitiveness and to foster their ability to innovate, to
operate efficiently and to provide the best and broadest possible services to
consumers as well as to maintain this nation's role as the preeminent world
financial center
We believe that it is important for Congress to set the rules for
this industry, which is so important to our nation's health and prosperity
Only
Congress has the ability to fashion rules that are comprehensive and equitable to
all participants and that guard the public interest
-2 That is why the Federal Reserve strongly supports H R 10 and urges the
Senate to consider and pass this legislation as soon as feasible
The market will continue to force change whether or not Congress acts
The strength and viability of our financial institutions, the effectiveness of our
regulatory structure, and the role and status of our financial services industry in
the international system are in play as a result of the aforementioned market
forces as well as regulatory actions
Without Congressional action, changes will
occur through exploitation of loopholes and marginal interpretations of the law
that courts feel obliged to sanction
This type of response to market forces
leads to inefficiencies, expansion of the federal safety net, potentially increased
risk exposure to the federal deposit insurance funds, and a system that will
undermine the competitiveness and innovative edge of major segments of the
financial services industry
Delay in acting on financial modernization
legislation would only limit Congress's options as these developments proliferate
and complicate, increase the difficulty of enacting protections included in
H R 10 to protect safety and soundness and the public interest, and deny to
consumers the benefits that immediate changes in our outdated banking laws will
surely bring
- 3Of course, financial modernization involves complicated and sometimes
divisive issues because it requires easing rules and opening options for some
while increasing competition for others, redrawing lines that create new limits,
and applying some pre-existing regulatory structures to new institutions
However, these issues are not new to the Senate
The Senate Banking Committee has on three previous occasions led the
way in developing financial modernization legislation, and the full Senate has
twice followed this Committee's recommendation in adopting such legislation
(A summary of these financial modernization proposals is provided at
Attachment 1 ) In 1991, the Committee passed S 543, which repealed the
Glass-Steagall Act and allowed banks to affiliate with securities firms using the
holding company structure to ensure safety and soundness, a level competitive
playing field, and protection of the taxpayer
H R 10 uses that same holding
company framework from S 543, but expands the range of permissible financial
affiliations to include insurance underwriting and merchant banking
Senate
action at this time to enact H R 10 would be an historic achievement that would
establish a sound and much-needed framework for launching our financial
services industry into the 21st century
-4There has been much—perhaps too much—arguing over details contained in
HR
10
HR
10 is a comprehensive approach to the issues of financial
modernization, and it is fundamentally a sound bill
No legislation that
endeavors to address financial modernization will be considered ideal by all, but
time will allow its rough spots to be worked out
What is most important is that for the first time there is an extraordinary
amount of agreement on nearly all of the key principles in the bill
There is no
disagreement-and there has been no disagreement for many years—that the
Glass-Steagall Act must be repealed
There is now finally no disagreement that
insurance companies and banks should be permitted to affiliate, and virtual
unanimity that banks should be permitted to sell insurance
There is no
disagreement that financial holding companies should be permitted to engage in
a broad range of other activities that are financial in nature, including merchant
banking
And, there is no disagreement that new affiliations must be permitted
on a level playing field and in a manner that permits a realistic two-way street
between banking organizations that seek to affiliate with insurance and securities
firms, and between insurance and securities firms that seek to acquire banks
Moreover, there is no disagreement that financial modernization must not place
insurance and securities firms that choose to remain independent at a
- 5disadvantage in competing against those firms that choose to affiliate with
banks
In addition, there is strong agreement that new affiliations must be
permitted within a framework that maintains the safety and soundness of our
financial system in general and the banking system in particular without
imposing unnecessary regulatory burden or intrusion
That means strong
functional regulation and reasonable, but not bank-like, umbrella oversight of
financial holding companies
A consensus has also developed that banking and commerce should not be
mixed at this time beyond the limited level needed to allow a realistic two-way
street for financial firms that are predominantly securities and insurance
companies to acquire banks
There is also agreement that the new law must
provide regulators with adequate means to protect the consumer and assure that
consumers are carefully informed about the differences between products that
are backed by federal deposit insurance and those that are not
These are the fundamental principles embodied in H R 10, save one
There are some details surrounding these aforementioned principles that are still
under discussion
These surrounding details are important, but not so important
that they should be allowed to defeat the consensus that has developed around
-6these principles themselves
It would be a disservice to the public and the
nation if, in the fruitless search for a bill that pleases everyone, the benefits of
this vital legislation are lost or delayed
There is, however, as I indicated, one fundamental principle embodied in
H R 10 upon which there is disagreement between the Federal Reserve and the
current Treasury Department, although there is agreement among the Federal
Reserve and many in the affected industries as well as earlier Treasury
Departments
That is the considered decision of the House to use the holding
company structure, and not the universal bank, as the appropriate structure to
allow the new securities and insurance affiliations
That decision, which is
fundamental to the way in which the financial services industry will develop, is
critical because it provides better protection for our banking and financial
system without damaging the national or state bank charters or limiting in any
way the benefits of financial modernization
Importantly, that decision also
prevents the spread of the safety net and the accompanying moral hazard to the
securities and insurance industries and assures a level playing field within the
financial services industry and thus full, open and fair competition as we enter
the next century
The other route towards universal banking for national banks
will, in our view, lead to greater risk for the deposit insurance funds and the
- 7taxpayer
It will also inevitably lead to a weakening of the competitive strength
of our financial services industry as independent securities, insurance and other
financial services providers operate at a disadvantage to those owned by banks
It is for these reasons that the Federal Reserve, SEC, many state functional
regulators and many in the affected industries support the holding company
framework and have opposed the universal bank approach
In virtually every other industry, Congress would not be asked to address
issues such as these, which are associated with technological and market
developments, the market would force the necessary institutional adjustments
Why is it so different for the financial system? I believe the difference reflects
the painful experience that has taught us that developments in our financial
system—especially, but not solely in our banking system—can have profound
effects on the stability of our whole economy, rather than the limited impact we
perceive from difficulties in individual nonfinancial industries
Moreover, as a society we have made the choice to create a safety net for
depository institutions, not only to protect the public's deposits, but also to
minimize the impact of adverse developments in financial markets on our
economy
Although we have clearly been successful in doing so, the safety net
has predictably created a moral hazard the banks determine the level of risk-
- 8taking and receive the gains therefrom, but do not bear the full cost of that risk,
the remainder is borne by the government
Since the sovereign credit of the
United States ultimately guarantees the stability of the banking system and the
claims of insured depositors, bank creditors do not apply the same self-interest
monitoring of banks to protect their own position as they would without
discount window access and deposit insurance
Instead, this moral hazard
requires that the guarantor, the U S government, supervise and regulate entities
with access to the safety net to protect its own, that is the taxpayers', interestthe cost of making good on the guarantee
Put another way, the safety net requires that the government replace with
law, regulation, and supervision much of the disciplinary role that the market
plays for other businesses
Our experience in the 1980's with insured thrift
institutions illustrates the necessity of avoiding expanding risks to the deposit
insurance funds and lax supervisory policies and rules
But this necessity has an
obvious downside these same rules limit innovative responses and the ability to
take the risks so necessary for economic growth
The last thing we should
want, therefore, is to widen or spread this unintended, but nevertheless
corrosive dimension of the safety net to other financial and business entities and
markets
It is clear that to do so would not only spread a subsidy to new forms
-9 of risk-taking, but ultimately require the expansion of bank-like supervision as
well
In our judgment, the holding company approach upon which H R 10 is
premised avoids this pitfall, the universal bank approach does not
While financial modernization represents a much needed reform, we
should not forget that this modernization will, by itself, introduce dramatic
changes in our financial services industry
We feel confident that the risks of
this type of reform are manageable within the holding company framework set
out in H R 10
We believe that the magnitude of the reform to our financial
system represented by allowing new and broad affiliations counsels that this is
not the time to experiment with these broad new affiliations through operating
subsidiaries, an approach that has failed the taxpayer in other contexts and has
other serious consequences
Instead, we believe the Congress is best advised to
retain the existing holding company structure, which achieves the full benefits
sought by financial modernization and has a proven track record of protecting
safety and soundness, insulating the federal safety net, and providing
competitive equality among companies that choose to affiliate with banks and
those that choose to remain independent
- 10There are two final points I want to make since they appear to drive
Treasury's opposition to H R 10
First, as I will discuss in more detail later,
H R 10 would not diminish-but would in fact enhance-the national bank
charter
Second, H R 10 would not diminish the ability of the Executive Branch
to continue to play its meaningful role in the development of banking or
economic policy
Currently, the Executive Branch influences such policy
primarily through its supervision of national banks and federal savings
associations
H R 10 would not alter the Executive Branch's supervisory
authority for national banks or federal savings associations, nor would it result
in any reduction in the predominant and growing share of this nation's banking
assets controlled by national banks and federal savings associations
Furthermore, Congress for sound public policy reasons has purposefully
apportioned responsibility for this nation's financial institutions among the
elected Executive Branch and independent regulatory agencies
H R 10 retains
this balance and the Federal Reserve does not believe it would be appropriate to
alter this balance in favor of increased Executive control of financial institution
policy
Such action would be contrary to the deliberate steps that Congress has
-11 -
taken to ensure independence in the regulation of this nation's financial
institutions, both banking and nonbanking
II. The Financial Services Act of 1998 (H.R. 10)
Although H R 10 is almost 300 pages in length, its objective is simple
and can be stated concisely—H R 10 removes outdated restrictions that currently
limit the ability of U S financial service providers, including banks, insurance
companies and securities firms, to affiliate with each other and enter each
other's markets ' This objective-permitting the affiliation of financial service
providers and thereby allowing open and free competition in the financial
services industry-is supported by the banking, insurance, and securities
industries as well as the three federal banking agencies, the Treasury
Department, and the Securities and Exchange Commission
For the most part, the remaining provisions of H R 10 are designed to
implement and complement this change and to ensure that these new affiliations
occur in a manner that is consistent with the safety and soundness of the
banking and financial system and the protection of investors and other
consumers of financial services
H R 10 requires that these new affiliations
occur within a holding company structure, which the Federal Reserve believes is
1
For the Committee's assistance. Attachment 2 to this testimony provides
an executive summary of H R 10
- 12 sound policy because it best protects the federal deposit insurance funds by
limiting the additional risks permitted to insured depository institutions
Arguably of even greater importance, the holding company structure limits the
spread of the federal safety net and its related subsidy and moral hazard to
entities or activities beyond the insured depository institutions it was intended
originally to support
H R 10 builds on the protection afforded by the holding
company structure by relying on strong functional regulation of the securities,
insurance, and banking components of the holding company
It also provides
flexibility to authorize restrictions on transactions between depository institutions
and their newly authorized affiliates when necessary to protect the safety and
soundness of affiliated depository institutions and the Federal deposit insurance
funds
H R 10 grants access to these new affiliations only to those
organizations that have and maintain well-capitalized and well-managed
subsidiary depository institutions
H R 10 also includes provisions designed to ensure that these new
affiliations occur in a manner that is consistent with the protection of
consumers
For example, the bill requires that the federal banking agencies
issue consumer protection regulations governing the retail sale of securities and
insurance products by depository institutions
And, H R 10 emphasizes the
- 13 obligation of depository institutions to help meet the credit needs of their entire
community by limiting the new affiliations to only depository institutions that
have at least a satisfactory performance record under the Community
Reinvestment Act
1 Umbrella Supervision and Functionally Regulated Entities
H R 10 for the first time would permit broad affiliations among financial
service providers that are currently supervised by different agencies
As a
result, H R 10 builds on the principle of functional regulation and includes
important provisions that encourage and facilitate cooperation among the
functional regulators
It also reduces overlap between the various regulators and
clearly allocates responsibility and accountability for supervising the different
parts of new financial holding companies
At the same time, H R 10 retains a
meaningful, albeit streamlined, level of umbrella oversight of the entire
organization to assure that some agency has a complete view of, and
accountability for, new financial holding companies and can serve a facilitating
role in relationships among functional regulators
The Federal Reserve believes that H R 10 has constructed a good balance
that provides the various regulators, including the umbrella supervisor, with the
tools needed to supervise financial holding companies adequately
In addition,
- 14 H R 10 is helpful in enhancing the ability of the relevant state and federal
supervisory agencies to share information on a confidential basis
The focus of H R 10 on functional regulation is perhaps best illustrated
through an example
Under H R 10, responsibility would be allocated for
supervising a new financial holding company comprised of an insurance
company, a securities firm, several financial companies such as a mortgage
lender and a financial data processing company, and an insured bank
H R 10
contemplates that responsibility for supervising and regulating the insurance
company, securities firm and insured bank would, as under current law, rest,
respectively, with the relevant state insurance authorities, with the Securities and
Exchange Commission and the securities self-regulating organizations, and with
the appropriate state and federal bank supervisory agencies
Each of these
agencies would retain the full authority that it currently has to examine firms
under its jurisdiction and to interpret and enforce the law applicable to the type
of company that the agency is charged with supervising
The Federal Reserve, as umbrella supervisor, would be required to the
fullest extent possible to rely on regulatory reports required and examinations
conducted by, using our example, the state insurance commissioner, the SEC
(and appropriate securities self regulatory agencies) and the appropriate state or
- 15 federal banking agency
In a problem bank situation, the Federal Reserve also
would be prohibited from requiring that the insurance company or securities
firm provide financial resources to the bank if the functional regulator
determines that such action would have a materially adverse effect on the
financial condition of the insurance company or securities firm Instead, the
Federal Reserve could order divestiture of the bank or affiliate in order to
recapitalize the bank
At the same time, H R 10 preserves the important authority of the
umbrella supervisor to apply consolidated capital standards to the financial
holding company, to examine the holding company and-under specified
circumstances—any subsidiary that poses a material risk to the insured bank, and
to enforce compliance by the organization with the Federal banking laws
This
assures that, while the functional regulators are supervising various parts of the
organization, someone is overseeing the organization as a whole as well as
subsidiaries that are not subject to other functional regulation
2 Enhanced Functional Regulation of Financial Products
Consistent with the bill's emphasis on functional regulation, H R 10 also
would repeal the blanket exemptions provided banks from the definitions of
"broker" and "dealer" in the Securities Exchange Act of 1934, requiring banks
- 16 to register with the SEC if their securities activities fall outside specified
categories of transactions
These categories are broad and would permit banks
to continue engaging in securities activities in connection with their traditional
trust, custody, safekeeping and derivatives operations and in a limited amount of
retail securities transactions without registering as a broker or dealer
The bill also establishes procedures for determining which functional
regulator would have primary responsibility for supervising the provision of new
or hybrid financial products that may be developed in the future
In the
securities area, for example, H R 10 would authorize banks, to the extent
consistent with applicable banking law, to offer and sell new or hybrid products
that are developed in the future unless the SEC determines, after a formal
rulemaking process and after consultation with the Federal banking agencies,
that the new or hybrid product is a security for purposes of the securities laws
If the SEC makes such a determination, the bill would require that the product
be sold by an SEC-registered entity, such as a subsidiary of the bank, subject to
functional regulation as a security product
The bill establishes a similar, although more complex, procedure for
determining whether future products that are classified as insurance by a state
may be underwritten by a bank within the framework of bank regulation or only
- 17 by a functionally regulated insurance underwriting affiliate
This process seeks
to ensure that banks will continue to have the ability to provide any product
banks are providing today
In addition, it assures that banks may, as principal,
provide any new form of a traditional banking product that may in the future be
characterized as insurance by state law unless the product is treated as insurance
for purposes of the federal Internal Revenue Code
There is also a procedure to
resolve disputes between insurance and banking regulators over future products
with final decisions by the courts "without unequal deference" to either the
relevant Federal or State regulators and after reviewing the history of the
regulation of the product
Although any attempt to devise rules for the classification and regulation
of future products is bound to encounter difficulties, and improvements could be
made in some marginal provisions, the substantive provisions of H R 10
governing the division of regulatory responsibility for future products are
carefully balanced in our judgment
3 Competitive Flexibility
Importantly, H R 10 provides banking organizations-both large and
small-substantial flexibility in determining how to respond to the market forces
so rapidly changing the industry
Many large banking organizations that meet
- 18 applicable criteria may elect to affiliate with full-service insurance and securities
underwriting firms and thereby become comprehensive providers or
"manufacturers" of financial products
Similarly, small banking organizations
would remain free to engage in currently authorized activities or to expand into
newly authorized principal activities at the pace most consistent with the
organization's competitive strategy
Small banking organizations also would be
free to focus their efforts in an area where they have a demonstrable competitive
advantage-the sale of any type of financial product as agent
One of the areas of great interest to banks—and one likely to increase
consumer options and benefits greatly—is insurance sales
Importantly, H R 10
would expand the insurance sales opportunities for banks by authorizing
subsidiaries of national banks to sell virtually any type of insurance product,
whether underwritten by an affiliate or a third party, from any location on a
nationwide basis
National banks also would retain their current ability to sell
insurance as agent in any place with a population of 5,000 or less
One detail
in this area that we do not support is the provision in H R 10 that requires a
national bank, for the next 5 years, to expand its insurance activities in
additional states only by buying an existing insurance agency
- 19H R 10 would also provide depository institutions important protections
against state laws that might conflict with the ability of these institutions to sell
financial products as authorized by Federal law
Some confusion and
controversy, however, have arisen in this area, particularly as to whether
H R 10 would scale back the Supreme Court's decision in the Barnett case
concerning the ability of states to regulate the sale by national banks of
insurance as agent
It is my understanding that H R 10, in fact, seeks to codify
the Barnett decision by incorporating the phraseology used by the Supreme
Court and a specific citation to the Supreme Court's opinion in Barnett into a
new Federal statute that would preempt any state law that "prevents or
significantly interferes" with the ability of any national bank or other depository
institution to engage in insurance sales activities authorized by Federal law
H R 10 does provide that a state law will not be preempted under the
Barnett standard if the law is no more restrictive than an existing Illinois statute
that governs insurance sales by banks
This statute, among other things,
requires the licensing of agents and the disclosure that insurance products sold
by the bank are not guaranteed or insured by the FDIC
This provision also
prohibits the tying of insurance products to credit products, the payment of
commissions to unlicensed persons, and the unauthorized disclosure of customer
-20information
The statute's requirements are not onerous and the Comptroller of
the Currency has recognized that the statute's requirements do not on their face
conflict with the Barnett decision
In short, the controversy in this area appears to stem largely from
confusion concerning the bill's intent, which can be addressed through clarifying
amendments designed to make plain that the bill does not scale back, and is
fully consistent with, the Barnett decision
III. Enhancements to the National Bank Charter
There has been some concern that H R 10 may damage the national bank
charter
The Federal Reserve believes that it is important that the national bank
charter not be impaired or diminished in view of its significance to the nation's
financial system
On the other hand, we do not believe the national bank
charter should be fundamentally transformed and enlarged into a universal bank
charter by allowing national banks directly or indirectly to engage in
underwriting life and property and casualty insurance, underwriting and dealing
in securities, merchant banking and direct equity investing, or real estate
investment and development
For the reasons laid out in this testimony, we
believe such an expansion of the national bank charter would be a mistake for
-21 bank safety and soundness, the deposit insurance funds and safety net, the
financial services industry (consumers and businesses alike) and the taxpayer
In the Federal Reserve's view, the concern about H R 10's effect on the
national bank charter appears based on a misunderstanding of the bill
Our
review of H R 10 indicates that it preserves the existing benefits of the national
bank charter and includes significant provisions that actually enhance the powers
of national banks
First, H R 10 does not reduce the current powers of
national banks to conduct banking activities or indeed limit the present activities
conducted by national banks
In fact, H R 10 contains several provisions that
specifically preserve these powers
Moreover, there is nothing in H R 10 that
limits the authority of the OCC to authorize new powers for national banks as
within the business of banking or incidental to a banking business under the
National Bank Act other than those activities prohibited for national banks and
future, as yet unauthorized, insurance underwriting activities
As I mentioned earlier, H R 10 contains, as has every prior version of
financial modernization legislation for the past 15 years including the recent
Treasury proposal, provisions that encourage all banks to conduct securities
activities through an affiliate or, where authorized, a subsidiary of the bank,
rather than in the bank
These provisions, however, include significant
- 22 exceptions that allow banks to continue to conduct in the bank securities
activities that are part of or incidental to traditional banking services or that are
conducted in limited numbers
And, as in the Treasury's recent modernization
proposal, the provisions of H R 10 apply equally to all national and state
banks
Second, H R 10 improves the national bank charter
H R 10 empowers
national banks to conduct any financial activity as agent through an operating
subsidiary
Under this provision, national banks may, through a subsidiary, sell
any type of insurance at any location (including in cities with a population over
5,000)
This provision also allows a subsidiary of a national bank to sell any
financial product as agent, and to engage in any financial agency activity that is
permitted for a financial holding company
Such activity, as best we can judge,
because it is rarely asset intensive and hence requires minimal equity, transfers
little subsidy to the bank subsidiary
H R 10 also authorizes national banks for the first time to underwrite any
type of municipal security, including municipal revenue bonds, directly or
through a subsidiary
At the same time, H R 10 removes the current advantage
that state banks have over national banks in the securities area
H R 10
prohibits state banks from engaging in underwriting or dealing in securities,
- 23 either directly or through an operating subsidiary, to the same extent that a
national bank is prohibited from underwriting and dealing in securities
H R 10 would clarify that national banks should not in the future
underwrite life or property and casualty insurance beyond that currently
permissible for national banks
State banks are already prohibited by the
Federal Deposit Insurance Corporation Improvement Act of 1991 from
commencing insurance underwriting activities or making equity investments
Thus, under H R 10, the only financial activity of which we are aware that
state banks in some states could conduct, either directly or in an operating
subsidiary, that national banks cannot is real estate investment and development
Treasury's recent bill, however, would wisely, in our view, also have prohibited
that activity to national banks and their subsidiaries
As I explained earlier, H R 10 also includes provisions that guarantee
national banks the right to affiliate—through holding companies—with securities
firms, insurance companies and other financial services providers, and to sell
and market the products of those affiliates notwithstanding any state law
In
addition, H R 10 preserves the rule of law established in Barnett
Together, these provisions allow national banks to remain strong and
vibrant competitors
H R 10 also does nothing to encourage national banks to
- 24 convert to state charters
Nor does H R 10 tarnish in any way the appeal that
many see in the national bank charter, particularly as a vehicle for conducting
interstate branching
Indeed, nearly 90 percent of all interstate branches are
operated by national banks, which operate under one set of rules and with one
regulator at all their locations--the OCC
The heart of the concern about H R 10's applicability to national banks
does not appear to be that it fails to enhance the national bank charter, but that
it fails to enhance the national bank charter enough for some
However, the
record does not demonstrate that the national bank charter is in decline
the opposite is true
In fact,
In the postwar years, national banks have controlled more
than 50 percent of total bank assets
In fact, the share of assets controlled by
national banks rose sharply last year and early in 1998, reflecting the increased
attractiveness of the national charter as interstate branching has been authorized,
and assets held by national banks are at the highest level this decade and near
the postwar high relative to state banks
Attachment 3 provides additional data
on the relative strength of the national bank charter
In any event, the issue that is facing Congress is not whether we need to
provide an edge to a particular type of bank charter
The record is replete with
evidence that what is really needed is reform of the laws that prevent the
-25 affiliation of banks of all types with securities firms, insurance companies and
other financial services providers, and thereby allow the financial services
industry to adjust to a rapidly changing market
That is the deficiency that
H R 10 is designed to address and does address very well
If the future finds,
contrary to the past and present, that further adjustments are needed to the
national bank charter to allow it to remain competitive and viable, those
concerns can and should be addressed more clearly once an actual deficiency is
shown
IV. Operating Subsidiaries vs. Holding Companies
One area where some have argued that H R 10 does not go far enough is
in authorizing national banks to own so-called operating subsidiaries, which are
subsidiaries of the bank that engage in activities that national banks are
forbidden by Federal law to conduct directly
This is not a detail or a technical
issue, but one that we believe is critical to determining the shape, soundness and
competitive fairness of our financial system as it develops into the 21st century,
and will have profound ramifications for our Federal safety net
There are two reasons why the Board believes that it is not wise or
necessary to expand the ability of banks to engage in new principal activities
through operating subsidiaries that are prohibited to the bank
These are
-26(1) extension of the safety net subsidy to activities beyond what Congress
originally intended and resultant harm to the vibrancy of competition in our
financial services industry, and (2) the safety and soundness implications for
banks and risk exposure of the deposit insurance funds
Extension of the Safety Net
In my introductory remarks, I noted that a
major reason the Congress is called upon to involve itself in a legislative
response to technical innovation in financial markets is the safety net
Institutions covered by it receive a subsidy because insured depositors correctly
perceive their risk exposure as virtually zero
These depositors—and other
creditors who benefit from the stability brought to the banking system by the
safety net—are willing therefore to provide funds to banks at much lower rates
than are available to competing institutions
Moreover, the insured
creditors—and many of the uninsured ones as well—do not feel the necessity to
monitor their credit exposure because of the government guarantee and the other
implications of the safety net
As a result, the government is required to
monitor the risk-taking-to put itself in the shoes of the creditors-in order to
protect the taxpayers and maintain financial market stability
The existence of this subsidy is clear in debt ratings-which are virtually
always higher at banks than at their parent holding company
It is clear in the
-27 higher capital ratios required of nonbanking financial firms, even those that
receive the same debt rating as banks
It is clear in the tendency for banking
organizations, when geographic restrictions were eased, to shift back to the bank
and its subsidiaries those activities that, while authorized for banks, had been
conducted in holding companies
Bank holding companies, the owners of most
banks, have no doubt also gained by the higher debt ratings and lower cost of
capital that comes from having as their major asset an entity--the bank-with
access to the safety net
But holding companies also own nonsubsidized entities
that have no direct access to the safety net
Accordingly, both bank holding
companies and their non-bank subsidiaries have a higher cost of capital than
banks that cannot be credibly explained by the holding companies'
responsibilities to their insured depository institutions
Moreover, any benefit
that holding companies might currently be experiencing from ownership of an
insured bank can be expected to decline as the holding company's ability to
expand its affiliations causes the insured bank to become a smaller part of the
total organization
Virtually all nonbank subsidiaries of bank holding companies, with the
exception of Section 20 securities affiliates, were historically put in the holding
company, not because the holding company could conduct broader activities
-28 than the bank, but for other reasons, such as geographic restrictions on the
bank
As these restrictions have been eased over the last decade, the share of
consolidated assets of bank holding companies associated with nonbank
activities-other than Section 20s, whose purpose is to conduct a business that is
not permissible for the bank itself—has declined by about 50 percent
Bank
holding companies tell us that the primary reason for shifting back to banks
those operations that can be shifted is to obtain cheaper funding and avoid
limitations on funding transactions contained in sections 23A and B of the
Federal Reserve Act
Activities that have stayed in holding company
subsidiaries, we are told, remain there for tax reasons, inertia, and established
names separate from the bank
In time, inertia will fade
It is critical that the subsidy implicit in the federal safety net be limited to
those activities that a bank can conduct directly
The Federal Reserve is
concerned that operating subsidiaries would be a funnel for transferring the
sovereign credit subsidy directly from the bank to finance any new principal
activities authorized by either the Congress or by OCC regulatory actionimparting a competitive advantage to such entities
We approve of new
principal activities, but we believe they should be financed competitively in the
marketplace
Moreover, we do not believe that it is possible to bring to bear
-29the separation of an operating subsidiary from its parent bank that one can
introduce between a bank and its sister affiliates
Rules can be devised to limit the aggregate equity investment made by
banks in their subsidiaries
But one cannot eliminate the fact that the equity
invested in subsidiaries is funded by the sum of insured deposits and other bank
borrowings that directly benefit from the subsidy of the safety net
Thus,
inevitably, a bank subsidiary must have lower costs of capital than an
independent entity and even a subsidiary of the bank's parent
Indeed, one
would expect that a rational banking organization would, as much as possible,
shift its nonbank activity from the bank holding company structure to the bank
subsidiary structure
Such a shift from affiliates to bank subsidiaries would
increase the subsidy and the competitive advantage of the entire banking
organization relative to its nonbank competitors
I am aware that these are often viewed as only highly technical issues,
and hence ones that are in the end, of lesser significance
I do not think so
The issue of the use of the sovereign credit is central to how our financial
system will allocate credit, and hence real resources, the kinds of risk it takes,
and the degree of supervision it requires
If the use of the sovereign credit is to
be extended, that decision ought to be made by Congress in full recognition of
- 30 the consequences of the subsidy on the financial system
But, it should not, in
the name of some technical change, or in search of some minor efficiency,
inadvertently expand significantly the use of the sovereign credit
This issue would not be so important were we not in the process of
addressing what must surely be a watershed in the revamping of our financial
structure
But we are at such a watershed, and the Federal Reserve believes
that we must avoid inadvertently extending the safety net and its associated
subsidy without a thorough understanding of the implications of such an
extension on the competitive balance and systemic risks of our financial system
The safety net subsidy is difficult to measure and several observers have
doubted its existence net of regulatory costs
Subsidy values—net or gross—vary
from bank to bank, riskier banks clearly get a larger subsidy from the safety net
than safer banks
In addition, the value of the subsidy varies over time
In
good times, such as now, markets demand a low risk premium and it is difficult
to discern the safety net subsidy
But, when markets turn weak, financial asset
holders demand to be compensated by higher yields for holding claims on
riskier entities
It is at this time that subsidy values are the most noticeable, as
spreads open up between bank and nonbank claims
What was it worth in the
late 1980s and early 1990s for a bank with a troubled loan portfolio to have
- 31 deposit liabilities guaranteed by the FDIC, to be assured that it could turn
illiquid to liquid assets at once through the Federal Reserve discount window,
and to tell its customers that payment transfers would be settled on a riskless
Federal Reserve Bank? For many, it was worth not basis points but percentage
points
For some, it meant the difference between survival and failure
The Federal Reserve has no doubt that the costs of regulation are large,
too large in our judgment and we wish to reduce the degree of regulatory
burden
But no bank has turned in its charter in order to operate without the
cost of banking regulation, which would require that it operate also without
deposit insurance or access to the discount window or payments system
To do
so would require both higher deposit and other funding costs and higher capital
It is also instructive that there are no private deposit insurers competing with the
FDIC
For the same product offered by the FDIC, private insurers would have
to charge premiums far higher than those of government insurance, and still not
be able to match the certainty of unlimited payments in the event of default, the
hallmark of a government insurer backed by the sovereign credit of the United
States
The Federal Reserve has a similar status with respect to the availability of
the discount window and nskless final settlement during a period of national
-32 economic stress
institutions
Providing such services is out of the reach of all private
The markets place substantial values on these safety net subsidies,
clearly in excess of the cost of regulation
To repeat, were it otherwise, some
banks would be dropping their charters
Safety and Soundness
Even if there were no subsidy issue, engaging in
principal activities in an operating subsidiary exposes the bank—and hence the
safety net—to greater risks
I am not arguing that the new financial activities
that financial modernization would permit to banking organizations are unusually
risky
But they do present additional risk as principal and any losses associated
with these activities would have to be absorbed
If such losses were suffered by
a bank holding company subsidiary, the loss would be consolidated into the
holding company parent-an entity without direct access to the safety net
In
contrast, if the loss occurred at a subsidiary of a bank, the loss would fall
directly on the bank parent, increasing the risk exposure of the deposit insurance
funds and the safety net
This difference is neither small nor technical
It lies
at the heart of the matter
The Treasury, as you know, has proposed and supported new principal
activities in the operating subsidiary
It argues that potential losses in the
operating subsidiary could be capped in such a way as to eliminate the exposure
- 33 of the safety net
Under the Treasury plan, investment by a bank in its
operating sub must be deducted from the regulatory capital of the bank, after
which the bank's regulatory capital position must still be deemed "wellcapitalized " Moreover, the bank would be prohibited from making good any
of the debts of the failed subsidiary
I should note that it is necessary that all of these prohibitions be statutory,
since generally accepted accounting principles-GAAP-require that the
subsidiaries' operations be consolidated with its parent and that courts determine
if a parent is responsible for the claims on its failed subsidiaries
I should
further note that what may be viewed as a regulatory matter as excess
capital—the maximum amount that is to be invested in the subsidiary under this
proposal-may or may not be excess in an economic or real sense
Regulatory
accounting principles-RAP-are not often designed to reflect economic realities,
as we saw last in the S&L crisis of the 1980s
Moreover, as I understand it, the
RAP capital deduction for purposes of computing the level of a bank's
investment in its operating subsidiaries would not be mirrored by a capital
deduction for other regulatory purposes-like loans-to-one-borrower or dividend
limit purposes
- 34 And, I can assure you it will not be deducted for the GAAP bank
statements that uninsured creditors and large loan customers will insist on
reviewing before they conduct business with the bank
Thus, a capital
deduction may matter for the regulators for some purposes, but it is not the way
the market will view the organization
In addition to being inconsistent with sound accounting standards
(GAAP), the proposed deduction treatment also runs counter to the way that
banks manage their subsidiaries, the way regulators have supervised subsidiaries
and the way financial markets are likely to perceive the bank as a whole
Historically, both bank management and supervisors have considered
subsidiaries of the bank to be an integral part of the bank (in fact they have been
treated as departments of the bank) whose operations, if material, could have a
significant impact on the bank's risk profile
Bank managers have invariably
sought to support their subsidiaries in the past, and supervisors have carefully
examined the operations of material subsidiaries in view of the difficulty in
insulating the parent bank from problems in its subsidiaries
Even if statutory barriers are erected that attempt to limit the impact of
subsidiary losses on the parent bank, substantial losses in a subsidiary will likely
erode the market's confidence in the management and health of the bank
This
- 35 would be a critical development in the case of a bank whose stabihty-and
whose level of risk to the federal deposit insurance funds—depends in large
measure on its reputation and standing in the financial markets
A law may
endeavor to mandate accounting and regulatory treatment, but it is not so easy
to alter perceptions of counter-parties or the reality of financial markets
It is worth noting that a dividend payment by a bank to its holding
company results in a real decline in bank capital
This is a genuine constraint
on the subsidy transfer from banks to their holding company affiliates and helps
explain the reality that bank dividends historically have not chronically exceeded
the dividends paid out by holding company parents plus debt service
The use
of bank dividends to fund holding company expansion would, of course,
incorporate a modest safety net subsidy since bank earnings are higher than they
otherwise would be because of the safety net
But the capital constraint-plus
the supervisor's natural tendency to guard against significant capital reductionshas limited such transfers
It is unlikely that a capital adjustment for regulatory
purposes that is in conflict with GAAP would be as effective a constraint on the
investments that a bank may make in its subsidiary
Moreover, losses in, for example, securities dealing or fire and casualty
insurance underwriting conducted in an operating subsidiary could occur so
- 36 rapidly that they could overwhelm the bank parent before actions could be taken
by the regulator
Put differently, losses in an operating subsidiary can easily far
exceed a bank's original equity investment long before the supervisor has any
such knowledge
The resulting bank safety and soundness concerns are only
deepened by the extent to which past retained earnings of the operating
subsidiary would have strengthened the capital of the parent bank—an ostensible
reason for operating subsidiaries
Such a buildup in capital could be used to
support other bank activities, and then eliminated by subsequent losses in the
operating subsidiary, leaving the bank in an undercapitalized position
The argument that operating subsidiaries are desirable because of the
organizational flexibility they provide to bank management seems less than
compelling
here
Having two options is better than one
But there is no real choice
From the purview of banking organization profitability, the operating
subsidiary is far superior to a holding company affiliate because of the funding
advantage gained from access to the safety net
Hence, if profitability is the
gauge, there is no increase in managerial flexibility
Rational management will
always select the operating subsidiary
Some observers have argued that operating subsidiaries should be allowed
to conduct broad activities as principal in the U S because Edge Corporations,
- 37which are Congressionally authorized corporations chartered to conduct a
banking business outside the U S and are largely owned by banks, have
conducted a broader range of activities as principal outside the U S without
damage to banks
As an initial matter, it is important to realize that there are
only a handful of banks that engage to any significant extent through Edge
Corporations in activities not permissible to their parent bank, and these engage
primarily in various securities activities
Importantly, Congress authorized the
Edge Corporation as a means to allow our banks to be competitive abroad
In
order to do so, Edge Corporations had to be able to conduct outside the U S
activities that are somewhat broader than those permitted domestically, provided
the activities are usual in connection with the conduct of banking in the country
in which the Edge Corporation operated
The Edge Corporation, therefore,
conducts broader activities not because Congress believed that it was, as a
general matter, prudent to permit subsidiaries of banks to conduct broad powers
Instead, Edge Corporations may conduct broader activities because they must be
allowed to be as competitive as possible in the arena in which they compete—
which is in foreign markets where the rules governing the activities of banks
and other financial service providers differ from the rules in the U S
- 38 This same principle-allowing competitive equity-argues against
authorizing operating subsidiaries to conduct broad activities within the U S
As
discussed above, the universal bank approach would allow banks and their
subsidiaries a competitive advantage over U S securities and insurance firms
that remain independent of banks—thereby inevitably impairing their competitive
strength
Thus, given the structure of the financial services industry inside the
U S , the principle of competitive equity that gave rise to the Edge Corporation
as a vehicle for conducting a banking business outside the U S argues against a
similar vehicle within the U S
Others have concluded that the Federal Reserve's objection to operating
subsidiaries is solely junsdictional—solely turf
If by such comments, these
critics believe that our concern is simply to maintain our status or prerogatives,
they are mistaken
This has certainly not been our approach to bank powers
The Board was an early and strong supporter of interstate banking, knowing that
it would induce shifts from state to national bank charters, reducing the Federal
Reserve's supervisory role
we supported it
them
Interstate banking was right for the economy, and
Operating subsidiaries are not, and that is why we oppose
- 39V. H.R. 10 and the Community Reinvestment Act
It has also been argued that H R 10 damages the Community
Reinvestment Act
The Board believes that this argument is incorrect
In fact,
enactment of H R 10 would strengthen the CRA in very material ways
The Board believes that the CRA has played an important role in
encouraging banks to identify lending markets that may be underserved and to
develop credit products and services in response to identified needs of their
communities
H R 10 provides a compelling incentive for financial holding
companies to continue these efforts by requiring as a prerequisite to the
expanded powers and affiliations authorized by the bill that all of the subsidiary
depository institutions have at least a "satisfactory" CRA rating
Moreover, H R 10 adds teeth to the CRA
enforced through the application process
Currently, the CRA is
But there is no current requirement
that a depository institution divest a bank once a merger is approved if the bank
fails to maintain adequate CRA performance levels after the merger
H R 10,
however, requires that satisfactory CRA ratings be maintained as a condition for
continued affiliation with companies authorized under the bill
Thus, a financial
holding company has a strong incentive to assure that its depository institution
subsidiaries continue to meet their CRA obligations
H R 10 also would
-40 expand the CRA to wholesale financial institutions, a new form of depository
institution authorized by the bill
There exists some confusion, however, as to whether the CRA would be
further benefitted if banks were permitted to engage, either directly or through a
subsidiary, in securities and insurance activities as principal
The CRA by its
terms requires that the Federal banking agencies assess the record of depository
institutions in meeting the credit needs of their entire community, including lowand moderate-income communities
While the CRA relates to the lending
activities of depository institutions, it does not apply to securities or insurance
underwriting activities—whether conducted by a bank, a subsidiary of a bank, or
an affiliate of a bank
Accordingly, authorizing a bank to directly or indirectly
conduct the securities and insurance underwriting activities authorized by H R
10 for financial holding companies would not increase a bank's obligations
under the CRA, although it would expose the bank and its CRA-related lending
activities to the earnings fluctuations and possible losses associated with such
principal activities
Under H R 10, banks would remain free to develop and offer the type of
innovative or targeted lending products, either directly or through a subsidiary,
that are designed to meet the identified credit needs of their communities and
-41 that are relevant to the bank's CRA assessment
Moreover, if a banking
organization elected to engage in CRA-related activities through a holding
company subsidiary, the organization would remain free under the CRA
regulations issued by all of the Federal banking agencies to have the activities of
the holding company subsidiary count towards the CRA performance of an
affiliated bank
VI. Commerce and Banking
Last year, the Board, in testimony before the House Banking and
Commerce Committees, recommended caution about authorizing banking and
commerce affiliations
We noted that technology was already in the process of
eroding any bright line between commerce and banking
Nonetheless, we
concluded that the free and open legal association of banking and commerce
would be a profound and surely irreversible structural change that should best
wait while we absorbed the significant changes called for by financial
modernization
Recent events have, if anything, strengthened our view on the desirability
for caution in this area
The Asia crisis has highlighted some of the risks that
can arise if relationships between banks and commercial firms are too close
is not so much that U S entities would face structures like those in Indonesia,
It
- 42 Thailand, or Korea
Rather it is the experience that interactions of complex
structures can make it extremely difficult to monitor, analyze, and manage
financial exposures
In short, the Board would prefer more experience with
financial change as a prelude to considering further and more profound
structural changes
We thus support the H R 10 provisions on commerce and
banking
H R 10, as passed by the House, prohibits the affiliation of banking and
commerce, with three exceptions
Companies, such as securities and insurance
firms, that engage predominantly in financial activities and that acquire an
insured depository institution may continue to own commercial firms but must
divest them within ten years (with the possibility of a further five year
extension ) Financial holding companies that own only uninsured wholesale
financial institutions also are permitted to retain limited grandfathered
investments made as of the date of enactment of the bill, but are not required to
divest them at the end of a specified period
Unitary thrift holding companies-holding companies with only one thrift
subsidiary-now may be affiliated with commercial entities
Only a few are, but
H R 10 would grandfather the ability of all unitary thrift holding companies to
establish commercial affiliations
For securities firms and insurance companies
-43 that acquire banks, however, H R 10 would not permit new commercial
affiliations
In light of the dangers of mixing banking and commerce, the Board
supports elimination of the unitary thrift loophole, which currently allows any
type of commercial firm to control a federally insured depository institution
Failure to close this loophole now would allow the conflicts inherent in banking
and commerce combinations to further develop in our economy and complicate
efforts to create a fair and level playing field for all financial service providers
Accordingly, the Federal Reserve strongly supports the provisions of
H R 10 that would prohibit new unitary thrift holding companies from having
nonfinancial affiliations on a prospective basis
However, H R 10 would also
permit existing unitary thrift holding companies to retain their current
commercial affiliations, to expand those commercial affiliations, and to sell
those rights to do so
Equity and fairness do not justify providing these
grandfathered organizations such unique economic benefits
The Board,
therefore, strongly supports an amendment to H R 10 that would at least
prohibit or significantly restrict the ability of grandfathered unitary thrift holding
companies to transfer their legislatively created grandfather rights to another
commercial organization through mergers or acquisitions
-44 VII. Conclusion
The markets are demanding that we change outdated statutory limitations
that stand in the way of more efficiently and effectively delivering financial
services to the public
Many of these changes will occur even if Congress does
not act, but only Congress can establish the ground rules designed to assure the
maximum net public benefits and a fair and level playing field for all
participants and to assure the continued primacy of U S financial markets
The Senate has an historic opportunity to modernize our financial system
by passing a bill that creates an unusually desirable framework
The Federal
Reserve urges the Committee to establish a wider scope for the delivery of
financial services through the holding company vehicle
This is the best way to
minimize the spread of the safety net subsidy and its resulting competitive
inequities, to minimize risks for depository entities and their insurance funds,
and to facilitate a safe and sound banking and financial system that is able to
serve the American public and maintain the leadership role of the American
financial system in the global economy
A-l
ATTACHMENTS
ATTACHMENT 1
Summaries of Prior Financial Modernization
Legislation Considered and Passed by the Senate
Banking Committee Since 1984
ATTACHMENT 2
Executive Summary of H R 10
ATTACHMENT 3
National Bank Market Shares
A-2
ATTACHMENT 1
Summaries of Prior Financial Modernization Legislation Considered
and Passed by the Senate Banking Committee Since 1984
I
S 2851, 98th Congress, 2d Session (1984)
After lengthy hearings in the 97th and 98th Congresses, on
June 27, 1984, the Senate Banking Committee marked-up and reported
legislation designed to revise significantly the statutory framework under which
financial institutions compete The bill, numbered S 2851 and entitled the
"Financial Services Competitive Equity Act," passed the full Senate three
months later, on September 13, 1984, by an 89 to 5 margin No action was
taken on the bill by the House of Representatives, however
Among other things, the Financial Services Competitive Equity Act
revised the Class-Steagall and Bank Holding Company Acts to authorize banking
holding companies to underwrite and deal in certain securities Specifically,
S 2851 permitted a bank holding company, or a depository institution securities
affiliate ("DISA") of a holding company, to engage in certain securities
underwriting and dealing activities in which a national bank is prohibited from
engaging, including underwriting and dealing in revenue bonds, commercial
paper, and mortgage-backed securities S 2851 did not, however, authorize
new insurance activities The bill also did not authorize any mixture of banking
and commerce
The Senate bill specified that the newly authorized securities activities
could only be conducted within the holding company framework The DISA
had to be a subsidiary of a bank holding company and not a subsidiary of a
bank To this end, the Banking Committee's Report emphasized that "the bill
would amend the Glass-Steagall Act to permit the DISA to be affiliated with
(but not to be owned by) a depository institution " S Rep No 560,
98th Cong , 2d Sess 19 (1984) (emphasis added) The Committee Report noted
that the requirement of separate incorporation and holding company affiliation
would help to prevent the DISA from drawing on the depository institution's
A-3
favorable funding and possible tax advantages and would avoid potential
conflicts of interests See id_
Under S 2851, the Board remained umbrella supervisor for bank
holding companies, and a bank holding company could engage in the newly
permitted securities activities only after giving prior notice to the Board Any
DISA also was required to register as a broker-dealer with the Securities and
Exchange Commission ("SEC") and was made subject to regulation and
supervision by the SEC
II
S 1886, 100th Congress, 2d Session (1988)
After 14 days of hearings on financial modernization, on
March 2, 1988, the Senate Banking Committee for the 100th Congress marked
up another bill to modernize regulation of financial services S 1886, entitled
the "Proxmire Financial Modernization Act of 1988," authorized more extensive
securities activities for banking organizations than had been permitted by
S 2851 in the 98th Congress S 1886 was reported to the Senate and within
the same month, on March 30, 1998, the bill passed the full Senate by a
resounding 94-2 margin The House Banking Committee also approved revision
of Glass-Steagall restrictions, but the full House took no action
S 1886 repealed sections 20 and 32 of the Glass-Steagall Act and
authorized affiliations between banks and securities companies, which were
permitted to underwrite, distribute, and deal in most types of securities,
including shares of mutual funds and corporate debt securities Permission for
securities affiliates of banks to underwrite, distribute and deal in corporate
equity securities was made contingent on a separate Congressional action, to be
taken no later than April 1991 S 1886 did not authorize the mixing of banking
and commerce
S 1886, like S 2851 in the 98th Congress, built on the framework of
the Bank Holding Company Act securities underwriting and dealing activities
were required to be conducted through a separately incorporated nonbank
subsidiary of a bank holding company that was "carefully insulated" from the
bank S Rep No 305, 100th Cong , 2d Sess 15-16 (1988) The Senate
specifically prohibited any affiliations between FDIC-insured banks and
securities companies other than through the holding company structure because,
A-4
as noted in the Banking Committee Report, conducting such activities through
holding company affiliates "is a much sounder alternative" than engaging in the
activities through subsidiaries of a bank In addition, the Report noted that the
Secretary of Treasury, as well as several academic observers, emphatically
supported the use of the holding company framework as "the only acceptable
means of expanding nonbanking activities " Id_ at 15-16, 21 (emphasis added)
The bill retained the Board's role as umbrella supervisor of bank holding
companies, and it mandated that bank holding companies obtain Board approval
under section 4 of the Bank Holding Company Act prior to acquiring or forming
a securities affiliate S 1886 also made the securities affiliate subject to
functional regulation by the SEC
The Proxmire Financial Modernization Act generally retained the
prohibition on bank holding companies engaging in insurance activities, and it
limited national banks to acting as principal, agent, or broker for credit life
insurance Finally, S 1886 allowed state bank subsidiaries of bank holding
companies, and subsidiaries of such state banks, that are located in the same
"home" state as the parent holding company to underwrite and broker insurance
products if (1) such activity is authorized by state law, and (2) the insurance
products are provided only to natural persons within the "home" state
III
S 543, 102d Congress, 1st Session (1991)
Like the Proxmire Financial Modernization Act, S 543 in the 102d
Congress repealed sections 20 and 32 of the Glass-Steagall Act and allowed
banking organizations to affiliate with securities firms S 543 was reported out
of the Senate Banking Committee on August 2, 1991, after a series of
22 hearings on financial modernization issues This bill, entitled the
"Comprehensive Deposit Insurance Reform and Taxpayer Protection Act of
1991," was eventually enacted as the Federal Deposit Insurance Corporation
Improvement Act of 1991 (commonly known as "FDICIA"), a law that
considerably strengthened the supervisory and enforcement authority of the
federal banking agencies but did not restructure the financial services industry as
the Senate Banking Committee had originally envisioned
As reported out of the Senate Banking Committee, S 543 permitted
banks and securities firms to affiliate through holding companies in a manner
A-5
that was substantially similar to that which was permitted in S 1886 in the
100th Congress and S 2851 in the 98th Congress Citing the same concerns as
had been noted in the 98th and 100th Congress, the Committee required
securities underwriting and dealing activities to be conducted in a subsidiary of a
bank holding company and not in an insured depository institution or a
subsidiary of an insured depository institution The Committee noted, for
example, the substantial dangers of allowing a bank to engage in a full range of
securities activities "The temptation for the bank to support an ailing
subsidiary would be very strong given that the bank's consolidated balance sheet
would directly reflect the securities activity " S Rep No 167, 102d Cong ,
1st Sess 157 (1991)
The Banking Committee's version of S 543 authorized a bank holding
company's securities affiliate to engage in any securities activity that is
permissible for SEC-registered broker-dealers, including underwriting and
dealing in securities of any type The Board remained the holding company
supervisor, and the SEC supervised the securities affiliate
S 543 did not permit the mixing of banking and commerce The Senate
Banking Committee examined the issue carefully and, as noted in the Committee
Report, found no convincing arguments to support the combination of banking
and nonfinancial activities Rather, the Committee Report noted at length the
potential undesirable concentration of resources, conflicts of interest, unfair
competition, and unsafe and unsound practices that could arise from the
affiliation of banks and industrial companies See id_ at 151-57
S 543 made several amendments to provisions of current law governing
insurance activities of banking organizations Expressing concerns about the
risk to the deposit insurance funds arising out of insurance underwriting, the
Senate Banking Committee generally prohibited state banks, and subsidiaries of
state banks, from engaging in insurance underwriting activities (to the same
extent as national banks are generally prohibited from engaging in insurance
underwriting activities) S 543 also gave parallel treatment to state and national
banks with respect to insurance agency activities the bill granted national banks
the same powers to sell insurance as agent as are provided under state law to
A-6
state banks operating in the same state The bill also narrowed the authority of
banks to sell insurance from towns of 5,000 or fewer Finally, the bill
generally prohibited any bank holding company from allowing a subsidiary
bank, or subsidiary of such bank, to sell insurance beyond the borders of the
state in which the bank is chartered
A-7
ATTACHMENT 2
Executive Summary H.R. 10
On May 13, 1998, the House of Representatives passed H R 10,
the Financial Services Act of 1998 This attachment presents an executive
summary of H R 10
I. Expanded Powers for Qualifying Bank Holding Companies
•
Repeal of Current Restrictions on Affiliations (Sections 101 and 102)
H R 10 would repeal those provisions of the Glass-Steagall Act and the
Bank Holding Company ("BHC") Act that restrict the ability of bank
holding companies to affiliate with securities firms and insurance
companies
•
Financial Holding Companies (Section 103) Bank holding companies
that qualify as a "financial holding company" could engage in a broad
array of financially-related activities mcluding* Securities underwriting and dealing,
* Insurance agency and insurance underwriting activities,
* Merchant banking activities,
* Any activity in the United States that the Board has found to be
usual in connection with banking overseas, and
* Any other activity that the Board determines to be financial in
nature or incidental to financial activities
* Criteria to be an FHC To qualify as a financial holding company,
each depository institution subsidiary of the bank holding company must
(i) be well capitalized and well managed, (ii) maintain at least a
satisfactory CRA rating, and (iii) have a demonstrable record of
providing low-cost basic banking services
* Failure to Continue to Meet Criteria An FHC that fails to continue
to meet any of the qualifying criteria must divest or terminate its newly
authorized financial activities (e g merchant banking or insurance or
securities underwriting activities) unless the FHC returns to qualified
status within certain time periods, typically 180 days
A-8
•
Banking and Commerce (Section 103) H R 10 would not permit an
FHC to mix banking and commerce (1 e there would be no commercial
"basket") The bill would permit a company that becomes an FHC
through the acquisition of a bank to retain those commercial activities it
held as of September 30, 1997, for 10 years after enactment provided
that the company at all times derives at least 85 percent of its revenue
from financial activities The Board may extend this 10-year divestiture
period for up to an additional 5 years on a case-by-case basis
•
Elimination of Application Requirements FHCs may engage de novo,
or acquire a company engaged, in any permissible financial activity
without the Board's prior approval The company must provide the
Board notice within 30 days after commencing a permissible nonbanking
activity or acquiring a permissible nonbanking company
•
Engaging in Innovative Activities Without Prior Board Review FHCs
may engage in, and acquire companies engaged in, activities that the
company reasonably believes are financial in nature (even if the Board
has not yet reviewed the activity) so long as the Board has not
determined that the activities are not financial FHCs could not derive
more than 5 percent of their revenue from activities conducted under this
authority, or have more than 5 percent of their assets or capital devoted
to such activities This authority is designed to allow FHCs to respond
quickly to changes in the financial services marketplace and to engage in
developing activities without a prior approval process
•
Prudential Safeguards (Section 114) H R 10 authorizes the Board to
adopt rules governing relationships between depository institutions and
their holding company affiliates if the Board finds that such rules are
consistent with the public interest and Federal law The Board must
regularly review any safeguards adopted and modify or eliminate
outdated or unnecessary safeguards
II.
Permissible Bank and Operating Subsidiary Activities
•
Holding Company Model H R 10 requires that newly authorized
principal activities (e g insurance and securities underwriting and
A-9
merchant banking) be conducted through a nonbank subsidiary of a
holding company and not through a subsidiary of an insured bank
•
Municipal Securities Activities (Section 181) H R 10 would allow
national banks directly to underwrite and deal in all types of municipal
securities
•
Financial Agency Activities (Section 121) H R 10 would authorize
subsidiaries of national banks to engage in any financial agency activity,
including those listed in H R 10 as well as any financial agency activity
permitted for FHCs, if the national bank and its depository institution
affiliates are well capitalized, well managed and have at least a
satisfactory CRA rating Under this authority, a subsidiary of a national
bank could engage in general insurance agency activities nationwide
•
Other Subsidiaries Prohibited (Section 121) H R 10 prohibits
subsidiaries of national banks from engaging as principal in any activity
that a national bank cannot conduct directly (e g insurance
underwriting, securities underwriting and dealing, merchant banking,
and real estate investment and development) This prohibition would not
apply to subsidiaries that a national bank is expressly authorized to
control by Federal law, such as Edge Act corporations, small business
investment corporations and community development corporations
• Parity of Treatment for State Banks (Section 121) H R 10 would
prohibit subsidiaries of state banks from underwriting bank-ineligible
securities (Subsidiaries of state banks already are prohibited from
engaging in insurance underwriting and merchant banking activities )
III.
Umbrella Supervision
•
Board Authority (Section 111) H R 10 provides that the Board would
be the umbrella supervisor of bank holding companies, including FHCs
and WFI holding companies Under the so-called "Fed-lite" provisions
of the bill, the Board would have the authority to require reports from
and examine bank holding companies or their subsidiaries, subject to
certain limitations
A-10
* H R 10 limits the Board's ability to obtain reports from,
examine, or take enforcement action against a functionally regulated
subsidiary of a bank holding company, such as a securities brokerdealer or insurance company subsidiary
* The Board also is required to defer to the SEC with respect to the
interpretation and enforcement of the Federal securities laws, and to
state insurance authorities with respect to the interpretation and
enforcement of state insurance laws
* The Board may not require that an insurance company or brokerdealer subsidiary of a bank holding company provide funds or
assets to an affiliated depository institution if the appropriate state
insurance authority or the SEC, respectively, determines that the
transfer would have a material adverse effect on the financial
condition of the insurance company or broker-dealer (Section 113)
•
Holding Company Capital The Board would retain the authority to
establish consolidated capital adequacy guidelines for all bank holding
companies, including FHCs The Board may not impose capital
adequacy requirements on a broker-dealer or insurance company
subsidiary of a bank holding company that is in compliance with the
capital requirements of its appropriate functional regulator
IV.
Wholesale Financial Institutions
•
New Type of Financial Institution (Section 136) H R 10 would
authorize the establishment of wholesale financial institutions WFIs
would be prohibited from accepting retail or FDIC-insured deposits, but
would have access to the discount window and the payments system
* The Board would have supervisory authority for WFIs as would
the OCC for nationally chartered WFIs and the state banking
authorities for state-chartered WFIs All WFIs would be subject to
the CRA
•
WFI Holding Companies (Section 131) The Board would serve as the
umbrella supervisor of WFI holding companies, and would have similar
A-ll
supervisory authority (reporting and examination) over WFI holding
companies as for FHCs WFI holding companies could not own an
insured bank or savings association, other than certain limited-purpose
institutions (eg a credit card bank)
* A company that becomes a WFI holding company could retain
indefinitely any commercial holdings that the company held as of
the date of enactment Otherwise, WFI holding companies would
generally be subject to the same activity and affiliation restrictions
applicable to FHCs (1 e they could engage in, or acquire companies
engaged in, only financial activities)
* The Board may adopt only risk-based capital requirements for
WFI holding companies (1 e no leverage ratio), and must focus any
capital requirements on the use by WFI holding companies of debt
and other liabilities to fund capital investments in subsidiaries
("double leverage")
V.
Insurance Activities of National Banks
•
Agency Activities (Section 121) National banks could continue to
engage directly in insurance agency activities in any location with a
population of 5,000 or less National banks also could engage in
general insurance agency activities through a subsidiary in any location
* For a period of 5 years after the date of enactment, a national
bank could commence insurance agency activities in a new state
(either directly or through a subsidiary) only by purchasing an
existing insurance agency in the state that has been licensed for at
least 2 years (Section 305)
•
Existing Principal Activities (Section 304) National banks also could
continue to provide as principal any insurance product that they were
authorized to provide as principal as of January 1, 1997 (National
banks would be prohibited from providing annuities as principal )
•
Title Insurance (Section 306) H R 10 permits any national bank that is
currently engaged in the sale or underwriting of title insurance to
A-12
continue that activity H R 10 also authorizes any national bank to sell
title insurance as agent if state banks located in the same state were
authorized to sell title insurance as agent as of January 1, 1997
* If a national bank has an affiliate or subsidiary that engages in
insurance underwriting, however, the national bank may not engage
directly in underwriting or selling title insurance (the activity must
be conducted in the affiliate), except the bank may sell title
insurance as agent to the extent permitted as of January 1, 1997, for
state banks located in the same state
Future Products (Section 304) H R 10 establishes a complex
procedure for determining whether financial products developed in the
future are banking products that may be underwritten by a national
bank, or are insurance products that may not be provided by a national
bank as principal In general, national banks would be prohibited from
underwriting a product that is classified as insurance by state law unless
the product qualifies as a "traditional banking product" and the product
does not qualify for special tax treatment as insurance under the IRS
Code
* Federal courts would be directed to resolve disputes concerning
future products without giving "unequal deference" to the positions
of the OCC or state insurance authorities
Interplay of Federal and State Law (Section 104) H R 10 would
preempt any state law that "prevents or significantly interferes" with the
ability of an insured depository institution to (1) affiliate with another
institution, where the affiliation is permitted by Federal law, or (2)
engage in any activity, either directly or in conjunction with an affiliate,
that is permissible under Federal law
* Bank Insurance Sales and Solicitation Activities H R 10
specifically adopts the Barnett decision, by name, governing the
applicability of state law to the insurance sales or solicitation
activities of insured depository institutions The bill also provides
that a state law governing insurance sales and solicitations will not
be deemed to "prevent or significantly interfere" with the insurance
A-13
sales and solicitation activities of an insured depository institution if
the law is no more restrictive than a specified, existing Illinois
statute (See Appendix A to the attached memorandum for a
summary of this Illinois statute )
•
Consumer Protection Regulations (Section 308) H R 10 directs the
Federal banking agencies to jointly publish, to the extent appropriate,
consumer protection regulations governing the retail sale of insurance
products by, or on the premises of, insured depository institutions and
WFIs
VI.
Bank Securities Activities
•
Broker-Dealer Registration (Sections 201 and 202) H R 10 would
repeal the blanket exemption provided banks from the definitions of
"broker" and "dealer" in the securities laws Banks could avoid
registering as a broker or dealer only if they limited their securities
activities to those permitted under the bill
• Exempted Transactions As a general matter, the bill would
allow banks to continue to engage, without registering as a broker
or dealer, in securities transactions in connection with their
traditional banking activities, including transactions effected in
connection with their trust, custody and safekeeping operations
H R 10 would also allow banks to engage in up to 500 retail
brokerage transactions per year without registering as a broker or
dealer
• Future Products (Section 206) Banks also could offer and sell,
without registering as a broker or dealer, new financial products
that are developed in the future unless the SEC determines after a
formal rulemaking process that the product is a security
•
Consumer Protections and Complaint Mechanism (Section 204) H R
10 requires that the Federal banking agencies jointly promulgate, after
consultation with the SEC, regulations governing the retail sale of
securities by insured depository institutions and their affiliates (other
than an SEC-registered broker-dealer) The regulations must impose
A-14
sales practice requirements that are substantially similar to the Rules of
Fair Practice of the NASD The Federal banking agencies also must
jointly establish, after consultation with the SEC, procedures for
receiving and investigating consumer complaints arising from securities
transactions with banks, including a procedure for referring fraud-related
complaints to the SEC
VII. Other Significant Aspects of the Legislation
•
Unitary Thrift Holding Companies (Section 401) H R 10 would close
the unitary thrift holding company loophole as of March 31, 1998
Companies that apply to acquire a thrift after that date could engage
only in financial activities Existing unitary thrift holding companies
would be grandfathered and could continue to engage in any type of
financial or commercial activity
•
Federal Home Loan Bank System H R 10 would significantly expand
the ability of the FHLB System to make advances to commercial banks
by (l) eliminating restrictions that require FHL Banks to focus their
lending on institutions that meet the Qualified Thrift Lender Test, and
(n) relaxing the membership requirements for insured depository
institutions H R 10 would also revise the governing structure of the
FHLB System
•
Redomestication of Mutual Insurers H R 10 would allow mutual
insurance companies to change their state of incorporation for the
purpose of reorganizing into a stock insurer with a mutual holding
company H R 10 would also preempt any state law that impedes the
redomestication of a mutual insurer or that discriminates against a
mutual insurer that has changed its state of incorporation
•
National Association of Registered Agents and Brokers H R 10 would
create a new National Association of Registered Agents and Brokers
("NARAB") to establish uniform criteria for the qualification, training,
and continuing education of insurance agents and brokers Insurance
agents and brokers that meet the requirements established by NARAB
could sell insurance in any state
A-15
CRA Study H R 10 requires the Secretary of the Treasury to conduct
a study concerning the impact of the bill on the CRA and to report the
study's findings and recommendations to the Congress within 2 years of
enactment The Treasury must consult with the Federal banking
agencies and the SEC in conducting the study and preparing the report
to Congress.
GAP Studies and Reports H R 10 requires that the General
Accounting Office (1) submit an annual report to Congress on market
concentration in the financial services industry and the impact of such
concentration on consumers, (2) submit a report to Congress within 6
months of enactment on the projected impact of the bill on banks and
other financial institutions that have less than $100 million in total
assets, and (3) study the benefits of establishing a uniform limit on the
fees that may be imposed in connection with the acquisition of financial
products
A-16
ATTACHMENT 3
National Bank Market Shares
Chart A3-1 shows the significant increase in market share for national
banks in 1997 and early 1998, when the logic of interstate branching induced
conversions mainly from state nonmember to national bank charters, as well as
absorption by national banks of state banks through merger Table A3-1
provides more detail on such shifts
The memo panel of Table A3-2 also clearly indicates that interstate
branching is dominated by national banks The upper two panels of the table
show the dominance of the national bank charter among the larger banks
Chart
Percent of Commercial Bank Assets held by National Banks
A-17
A-18
Table
A3-1
Net Change in Commercial Bank Assets from De Novos, Mergers, and Charter Conversions
Assets (S Billions)
1995-1998
National Banks
First 5
Mos 1998
12'3 1/946/9/98
76
1 13 9
60 3
181 8
08
174
26
20 8
18 9
239 7
136 8
395 4
01
136 5
60
142 6
00
76
09
85
00
28
28
56
0 1
163 1
59 4
222 6
31
173 3
152
172 8
1995
1996
1997
First 5
Mos 1998
12'31 946/9-98
80
162
24
76
182
28 2
66
163 1
81 1
258 2
00
113 9
45 7
1596
00
174
22
196
0 7
239 7
1 19 2
359 6
131 4
13 0
1995
1996
1997
Additions From
De Novo Banks
Mergers with Other Charter Types
Charter Conversions
Total Additions
40
22 0
21 1
47 1
65
86 4
52 8
145 7
Deletions From
Failures
Mergers with Other Charter Types
Charter Conversions
Total Deletions
00
162
49 7
65 9
-18 8
Net Increase In National Bank Assets from
De Novos, Mergers, and Charter Conversions
State Banks
Additions From
De Novo Banks
Mergers with National Banks
Charter Conversions
Total Additions
51 0
75 2
26
136 5
91
148 2
Deletions From
Failures
Mergers with National Banks
Charter Conversions
Total Deletions
07
22 0
18 9
41 6
00
86 4
52 4
138 8
Net Increase In Stale Bank Assets from
De Novos Mergers and Charter Conversions
33 6
94
1 0
28
28
140
-101 4
Note Asst^ for June 9 1998 are as of March 3 1 1998 the latest quarter for which financial data is available and are
adjusted for mergers
A-19
Table A3-2
Percent Distribution
Various Indicators of Relative Size
By Charter Class of Commercial Bank
As of March 31, 1998
Indicator
National
(OCC)
70 6
82 2
92 2
Consolidated Assets
Domestic Deposits
Offices in U S
Charter Class
State Member
(FR)
Top 25 By Size
29 4
178
78
State Nonmember
(FDIC)
00
00
00
Top 50 By Size
Consolidated
Domestic Deposits
Offices in U S
Assets
Consolidated Assets
Domestic Deposits
Offices in U S
2 states
3 states
4 states
5 states
More than 5 states
68 0
75 9
30 5
15
21 8
83 3
13 5
23
32
58 1
58 4
58 1
All
24 4
186
158
175
23 0
26 1
Number of Banks Operating Full-service Facilities in*
8
37
23
2
6
13
2
3
0
0
2
1
0
10
0
@FedFRASER