View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.







10:00 a.m.
Thursday, December 3, 1987
Room 538, Dirksen Senate Office Building

Good morning, Mr. Chairman and members of the Committee.

We are pleased

to testify today on the subject of financial services reform and on two of the
bills recently introduced by members of this Committee.

We would like to

express our appreciation to you, Mr. Chairman and Senator Garn, as well as
Senators Wirth, Graham, D'Amato and Cranston for advancing the reform process
through the introduction of financial restructuring measures.

The Federal Deposit Insurance Corporation's views on overall financial
services reform and the structure of the financial services industry are set
forth in our study Mandate for Change: Restructuring the Banking Industry, a
copy of which is being submitted today for the record.

The major conclusions

of that study will be described briefly at the beginning of my testimony,
followed by the FDIC's views on the two bills on which we have been requested
to testify.

Because the bill sponsored by Senators D'Amato and Cranston was

just introduced, it will not be addressed in this statement.

We hope,

however, that it will be considered seriously along with the other two

Competitive forces and financial markets, both domestic and international,
have changed dramatically since 1933 when the Glass-Steagal1 Act first imposed
a partial separation between banking and securities activities and since 1956
when the Bank Holding Act further limited the activities of bank affiliates.
These changes are addressed at length in our study.

Existing restrictions on banking activities have handicapped the banking
industry in today's rapidly changing financial environment.

The effect of




these restrictions on banks is amply demonstrated by the appended chart that
compares the annual growth rate of banks between 1980 and 1986 to that of
other financial services firms.

Of particular importance is a comparison of

banks' growth rate of approximately eight percent during that period with that
of mutual funds and securities brokers and dealers which grew at rates of
approximately 33 percent and 28 percent, respectively.

Clearly, banks are not

being permitted to keep pace with their competitors in meeting the challenges
of the changing marketplace.

The inability of banks to compete effectively with other financial firms
concerns the FDIC since the situation could lead to a less safe and sound
banking system.

Without a doubt, banks are special.

Because of deposit

insurance, banks essentially borrow on the credit of the United States

Moreover, the banking system provides a safe harbor for the

savings of consumers, reserve liquidity and the funds transfer mechanism in
this country —

all of which are essential to the United States economy.

Thus, any threat to the banking system is a threat to the intermediation
process, private sector liquidity, the payments system and our economy.

A strong and more efficient banking system benefits consumers as well.
Increased competition and economies of scale and scope result in economic
efficiency which, in turn, results in lower costs to banks and bank

The public also benefits from increased levels of safety and

soundness in our nation's banks.

But, the system must prosper in order to be

safe and sound and prosperity can be achieved only if banks are free to
attract capital and compete effectively, at home and abroad.


believes that structural reform of our financial system is necessary to permit
banks to compete and prosper.

- 3 A number of key objectives should guide any structural reform effort.
Those objectives are:

a viable and competitive financial system and a safe

and sound banking system, increased benefits for consumers through enhanced
competition, and sufficient flexibility to respond to technological change.
One final goal is to find the financial restructuring alternative that is the
simplest and least costly to the economic system, consistent with these other

Those objectives guided the development of our study.

We believe

that the same objectives should guide the Committee in considering financial
reform and the two bills being addressed today.


From our perspective as the deposit insurer, the most important issue in
restructuring the banking industry* is the appropriate role of banking safety
supervision in the evolving financial services sector.
to that issue is:
abuse it?


Can a bank be insulated from those who might misuse or

Is it possible to create a supervisory wall around banks that

insulates them and makes them safe and sound, even from their owners,
affiliates and subsidiaries?

If the answer is "yes," there is no reason to

legislate the separation of commercial banking from securities activities and,
for that matter, in the longer term from other financial and nonfinancial

The conclusion of the FDIC study is that such a supervisory wall can be
created and that supervising conflicts of interest is the key to an effective

That conclusion is based on 54 years of supervisory experience.

FDIC supervisory role has included effective supervision of the inherent


- 4 conflicts that arise when bank directors also are borrowers of the bank.


also has provided effective supervision of the relationship between the parent
holding company, affiliated banks and the parent's nonbank subsidiaries.
Satisfactory supervision of these conflicts reinforces the conclusion that any
new conflicts can be regulated appropriately to ensure the safety and
soundness of the banking system.

The tools needed for insulating banks and establishing the "supervisory
wall" are only a logical extension of safeguards contained in existing law to
protect banks from insider abuse and conflicts of interest.
discussed in detail in our study.

Those tools are

They include (1) the transaction

limitations contained in Sections 23A and 23B of the Federal Reserve Act, (2)
the exclusion of investments in nonbanking subsidiaries in determining bank
regulatory-required capital, (3) the authority to audit both sides of any
transaction between a bank and its affiliates or subsidiaries, (4) flexibility
for bank supervisors to collect financial data from affiliated nonbanking
entities, to prohibit any transactions deemed to jeopardize the safety and
soundness of banks and to require that activities which pose undue risk be
housed outside the bank, and (5) additional penalties for those who violate
the rules.

Even with these or more stringent insulation mechanisms, abuse cannot be
prevented in âll cases.
will occur.

No matter what kind of structure is in place, abuses

While most people play by the rules —

are reasonable —

some will seek to avoid them.

particularly if the rules

Thus, the supervisory

challenge is to identify and restrain the minority who do not follow the

We.believe that regulators can meet that challenge and, thus, ensure

that the system is safe and sound.

Hhile supervisors will seek to keep every

bank safe, it must be emphasized that the primary objective is to keep the
system safe and sound.

Given adequate supervisory insulation of the bank, direct banking
regulatory and supervisory authority over bank owners and nonbanking
affiliates and subsidiaries is neither necessary nor desirable.
regulation and safety supervision could be focused on the bank —
bank alone.

and on the


focusing regulation where the Government has an interest —

and any required

regulation of the entities affiliated with that bank would be performed along
functional lines.

A supervisory wall would permit the dismantling of banking

laws that regulate the activities of nonbanking entities —
Glass-Steagall and much of the Bank Holding Company Act —

and would leave the

regulation and supervision of these nonbanking entities to the appropriate
functional regulator.

An appropriately insulated banking system also permits structural

In other words, it permits nonbanking activities to be

undertaken either in subsidiaries or holding company affiliates of the
insulated bank.

S. 1886

I would like to begin my comments on S. 1886 by expressing our
appreciation to you, Chairman Proxmire and Senator Garn, for all of your
efforts towards the introduction of this measure and thank you for considering


the views of the FDIC in that process.



We view S. 1886 as a first step in

enhancing the competitiveness of the financial services industry.

We believe

that ultimately all the activity restrictions contained in the Bank Holding
Company Act, as well as Glass-Steagall, should be eliminated.
believe it is prudent not to do it all at once.

However, we

A phaseout approach is

Thus, we agree that the repeal of Sections 20 and 32 of

Glass-Steagall is a sound first step towards total financial reform.

We must recognize, however, that by eliminating only the Glass-Steagall
restrictions, a fair competitive "two-way street" between securities firms and
banks is not assured since many securities firms are affiliated with companies
engaged in activities not permitted to bank affiliates.

Total competitive

equality between banks and securities firms can be established only if the
activity restrictions and other portions of the Bank Holding Company Act also
are removed from qualified securities firms.

The Committee should consider

adding exceptions to the Bank Holding Company Act activity restrictions for
securities firms whose primary business is securities.

Our specific comments on S. 1886 will focus on (1) bank iftsulation, (2)
functional regulation, (3) corporate structure, (4) activities permitted
within the bank and (5) concentration limitations.

In each case, the

provisions contained in the bill have been evaluated by measuring them against
the recommendations of our longer range goals for restructuring.

Bank Insulation. S. 1886 provides extensive insulation of banks from the
activities of their securities affiliates.

Investments in securities

affiliates must be out of excess funds, over and above the amount of capital

- 7 required for bank holding companies by the Federal Reserve Board.

The bill

prohibits virtually all bank extensions of credit to, and purchases of assets
from, securities affiliates.

It also expressly prohibits extensions of credit

to third parties in a number of instances in which the credit extension would
facilitate transactions of a securities affiliate.

Subject to a small bank

organization exception and specific exceptions granted by the Federal Reserve
Board, all officer and director interlocks between banks and their securities
affiliates are prohibited.

Finally, disclosure requirements reinforce the

separation between banks and their securities affiliates and ensure that
customers are aware that securities transactions are not covered by federal
deposit insurance.

The FDIC believes that the insulation mechanisms provided in S. 1886
strike a good balance between adequately insulating banks on the one hand, and
allowing banks and their securities affiliates to benefit from natural
synergies on the other.

Generally, the separation mechanisms seem to be

appropriate and not too burdensome.

We support the concept of requiring that

the capitalization of securities affiliates be out of capital in excess of
regulatory-required capital, although we believe at some point the Committee
should consider whether, in fact, it believes holding company capital —
opposed to bank capital —


should be regulated at all by bank regulators.


believe the disclosure requirements mandated by the bill are significant to
adequate bank insulation and vitally important to customer protection.


we believe that a total prohibition against interlocking officers and
directors may not be necessary, we are glad to see that there are exceptions
to that prohibition.




While we doubt the need for a total prohibition against virtually all
transactions between banks and their securities affiliates and between banks
and third parties that involve the securities affiliate, it may be the
conservative place to start.

Sections 23A and 23B already impose stringent

transaction, collateral and arm's-length requirements on transactions between
banks and their affiliates.

Moreover, both of those sections already apply to

transactions by a bank with any third party if the proceeds of the transaction
"are used for the benefit of, or transferred to, [an] affiliate."

Thus, such

third party transactions are subject to the quantitative limitations and
collateral requirements of Section 23A and the arm's length requirements of
Section 23B.

Furthermore, the arm's-length requirements of Section 23B also

specifically apply to any transaction with a third party "if an affiliate has
a financial interest in the third party or if an affiliate is a participant in
such transaction."

In view of the protections now in place, including the enhanced
protections of the new Section 23B, we question the need for imposing an
across the board, blanket prohibition against all transactions.

Still at the

outset it may be prudent to over-insulate and over-protect thè bank to insure
insulation from conflicts of interest.

Functional Regulation. The FDIC believes that functional regulation is
critical to any repeal of Glass-Steagall and all further financial
restructuring measures.
reflected in S. 1886.

We applaud the significant movement in that direction
Functional regulation avoids the layers of regulation

and duplication that result from subjecting companies to the jurisdiction of
multiple agencies.

In addition, functional regulation is fundamental to

- 9 providing competitive equality among all securities firms, irrespective of
whether they are affiliated with a bank.

For the most part, S. 1886 houses the regulation and supervision of bank
securities affiliates in the appropriate functional regulator —
Securities and Exchange Commission.


For example, implementation and

interpretation of the disclosure requirements imposed on securities affiliates
would be solely the responsibility of the SEC.

The SEC would be responsible

for determining the adequacy of the financial and managerial resources of
securities affiliates.

In addition, securities affiliates would be subject

only to capital requirements established by the SEC.

In this regard, we

believe there should be an explicit prohibition against the Federal Reserve
Board requiring extra capital in a holding company based on its affiliation
with a securities firm.

Another extremely important provision that furthers the goal of functional
regulation is the exception from FRB examination, reporting and capital
requirements provided to bank holding companies that are 80 percent engaged in
securities activities, on a consolidated basis.

We support that as a wise

We believe that a similar standard should be added to exempt

companies that are primarily engaged in securities from the Bank Holding
Company Act and, thus, provide a two-way competitive street between banks and
securities firms.

Corporate Structure. S. 1886 requires that new securities activities be
undertaken through holding company affiliates and prohibits them from being
conducted by direct subsidiaries of banks.

As described earlier and as




outlined in detail in the FDIC study, if banks are adequately insulated —


we believe the insulations contained in S. 1886 are more than adequate —


from a safety and soundness viewpoint it is irrelevant whether nonbanking
activities are conducted through affiliates or subsidiaries of banks.

If the risks and exposure are the same —

which we believe they are —

banks should be permitted to opt for the corporate structure that best suits
their business plans.

They should be able to elect to undertake new

securities activities in direct subsidiaries, as well as in holding company

Small banks would benefit, since there are about 4500 banks that

are not in holding companies.

These companies should not be forced to incur

the additional corporate and-regulatory costs of establishing a holding
company in order to affiliate with a securities firms.

Moreover, by depriving

banks of this corporate option, the bill infringes on the rights of the states
to determine permissible activities for state-chartered banks.

Further, Mr. Chairman, we respectfully disagree with your view expressed
to us in writing, that this issue should decide whether a bill repealing
Glass-Steagall provisions is supportable.

He support the bill despite the

fact that we believe its provisions in this respect are unwise in principle
and discriminatory with respect to small banks in practice.

Activities Permitted Hithin The Bank. S. 1886 would authorize national
banks to (1) underwrite municipal revenue bonds, (2) sponsor and underwrite
unit investment trusts that consist solely of securities that national banks
are permitted to underwrite and (3) sell —

mutual funds.

but not sponsor, manage or control

The latter two activities, however, are permitted to




national banks only if the national bank is not affiliated with a securities

We strongly support the addition of these new activities to those

permitted for national banks, but see no reason to prohibit them within the
bank merely because the bank has a securities affiliate.

If the risks and

competitive dynamics associated with those activities are such that the
activities are appropriate within the bank, that determination should not be
affected by the bank’s affiliation with any other company.

In keeping with

that position, we were very pleased to see that other securities activities
already permitted to national banks are no longer required to be removed to a
securities affiliate within one year of the establishment of such a company.

The FDIC believes that it would be appropriate for the Committee to assess
whether other activities should be considered "banking" and thus be authorized
specifically for national banks.

In oùr opinion, certain activities such as

the underwriting and sponsorship of mutual funds and the underwriting of
commercial paper and securitized assets also could be included.

Concentratinn Limitations. S. 1886 would prohibit affiliations between
banking firms with assets greater than $30 billion and securities firms with
assets greater than $15 billion.

We agree that the antitrust laws may not be

sufficient to deal with such interindustry affiliations.

In fact, we are in

the process of analyzing and developing our own recommendations for addressing
any such concentrations.

At this time, we would have no conceptual objection

to the approach taken in S. 1886.

We would suggest, however, that there is a

need to consider the international aspects of concentration as well.




S. 1891

We also want to thank Senators Wirth and Graham for furthering the
prospects for financial reform through the introduction of a measure which
reflects a different approach to financial restructuring.

S. 1891 would

permit banks to affiliate with all types of financial firms and we support
that as an ultimate goal.

In fact, we believe that with the proper

insulation, banks should be permitted to affiliate with commercial enterprises
as well, which S. 1891 specifically forbids.

While we concur with the goal of permitting banks to affiliate with firms
engaged in all forms of financial activities, we believe that S. 1891 moves in
the wrong direction in attempting to achieve that goal.

S. 1891 would

establish a Super Agency to regulate all companies that are engaged in any
type of financial activity, thereby, embracing all financial corporations.
Instead of developing the simplest and least costly structure, consistent with
maintaining a safe and sound banking system, S. 1891 would establish a new
megabureaucracy that would have authority not only over the banking industry,
but most of financial America.

We believe that the essence of financial restructuring should be to
construct a supervisory wall around banks that adequately insulates them from
the activities of their nonbanking subsidiaries and affiliates.

Given such a

wall, regulation and supervision of those nonbanking entities along other than
functional lines is unnecessary.

This view of financial restructuring, as

expressed in our study, generally is supported by the Barnard Committee

- 13 Report, the American Enterprise Institute study, the American Bankers
Association's Chase study and the approach in the bill introduced by Senators
Proxmire and Garn.

Finally, S. 1891 would establish a new transfer system corporation to be
owned by large users and the Federal Reserve.

We believe there is no need for

another federal agency to oversee the nation's payment system.


regulation of the banking system can do the job.


Prior to concluding my testimony, a couple of additional matters should be

First, irrespective of whether the Congress has made progress on

financial restructuring legislation, the FDIC opposes any extension of any
part of the moratorium which is scheduled to expire on March 1, 1988.

In view

of the rapidly changing marketplace, we believe it would be inappropriate to
continue to hinder banks' ability to respond to those changes within the
limits of the law as it existed prior to the moratorium.

Second, the financial institution regulatory agencies recently forwarded
to the Committee a proposal to amend the enforcement statutes to improve the
agencies' ability to address instances of insider abuse, misconduct and fraud
at our nation's depository institutions.

In brief, the proposed amendments

clarify some of the enforcement powers of the agencies, codify current
administrative interpretations of our powers and address certain anomalies
created by a recent U.S. Circuit Court of Appeals decision.

For example, the

amendments would (1) clarify that the agencies may require affirmative action

- 14 in cease-and-desist orders to correct the conditions which resulted from
unsafe or unsound banking practices, (2) specifically allow the agencies to
place limitations on the activities of an individual at a bank without having
to completely remove the individual from banking and (3) make certain that
termination of employment by a bank-related person does not affect the
agencies' authority to bring appropriate actions against that person for
improper conduct.

We would hope that this package of amendments that was

produced by all five of the federal agencies would be incorporated into any
bill reported out of this Committee.


The banking industry is experiencing and will continue to experience rapid
and critical changes.

The existing system is inequitable and inefficient.

Long-range financial services industry restructuring should be undertaken.
S. 1886 provides a first step toward that end.

On balance, and with the

reservations stated, we can support S. 1886 as enhancing the safety and
soundness of the banking system.

We believe, however, that S. 1891 moves the

regulatory system in the wrong direction and, thus, we cannot-support it.

We will be pleased to work with the Committee in its important
deliberations on these bills.


Annual Growth Rates of Rnanica! Institutions

1980 -1 9 8 6