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delivery Statement by Manuel H. Johnson, Jr. Vice Chairman Board of Governors of the Federal Reserve System before the Subcommittee on Financial Institutions, Supervision, Regulation and Insurance of the Committee on Banking, Finance, and Urban Affairs United States House of Representatives March 24, 1987 I am pleased to appear before the Committee today to discuss with you again the topic of bank-affiliated export trading companies. In its consideration of the export trading company legislation in 1982, the Congress determined that U. S. export performance was inhibited by the inability of U. S. businesses, especially small- foreign markets expertise in and for the medium-sized their products mechanics of companies, due to to their exporting. The develop lack of Congress therefore sought to promote the establishment of companies that could supply the necessary expertise in order to assist U.S. companies in increasing exports of their goods and services. In enacting the Bank Export Services Act ("BESA"), the Congress decided that one method by which export trading companies could be developed was by permitting affiliations with banks through a bank holding conpany structure. Now that we have had some experience with the operation of bank-affiliated export trading companies under the legislation, we thought it would be useful to share information on that experience with you in connection with the Committee's consideration of company concept. further refinements While a beginning to the export has been made trading in the - 2 - development of export trading companies as promoters of U.S. exports, unfavorable economic conditions have not provided an atmosphere in which export trading companies can flourish. Since the passage of the legislation in October 1982, the Federal Reserve has acted upon 43 notifications by bank holding companies to establish export trading companies. Sixteen of these have been acted upon by the Reserve Banks under authority delegated to them by the Board in 1983. number represents more than 50 percent of the This notifications processed since the delegation rules were adopted. The Board recently conducted a survey of nine bank-affiliated export trading companies, selected to provide diversity of size and geographic location of the bank holding company parent. to the survey, $21 million, revenues For those export trading companies responsive the assets size ranged from $210,000 with the average being $8.2 million, ranged from thousand to ¡$18 to and gross million, with the average also being $8.2 million. The activities of these export trading companies were also quite diverse. Several were engaged almost exclusively in transactions involving the purchase and sale of goods, the others services. received their income largely from while fee-based The services included transportation; marketing and consulting; acting as an agent for a Foreign Sales Corporation; and trade financing services. The survey suggests that - 3 - bank-affiliated export trading companies are able broad range of services under the current to offer statute a and regulations and a number appear to be operating profitably. While trading results companies experienced some are suggest some operating bank-affiliated successfully/ difficulties. Of the no longer operational. In a others have 43 bank-affiliated export trading companies of which the Board 14 are export received notice/ few instances, the cessation of export trading company activity was related to changes in the ownership of the export trading company, such as through acquisitions and mergers. However, this performance has been largely related to the difficulties that bank holding companies have experienced in operating an company. In addition to poor economic conditions first years of existence, described below, diminished have also profit encountered unfamiliarity encountered companies, potential, with are the trading to which trading in their resulted in these export trading companies start-up peculiar export difficulties business. the resulting Other activities of from problems trading regardless of how long they have been operating: for example, a customer breaking the terms of its own trade agreement, or the inability of an export trading company to deliver on a major contract, or inadequate controls over the trading activities. - 4 - To the extent that the performance of bank-affiliated export trading companies has been disappointing, it should be noted that there is no evidence that trading companies without bank affiliation have been any more successful. While there is no comprehensive means of tracking the performance of all these trading companies, the General Accounting Office, of preparing its February 1986 Report Implementation of the Export conducted a obtained survey of certificates Commerce. Many of 23 of those Trading trading review firms in the course to Congress on the Company Act of 1982, that had Department of organizations from the reported that business was disappointing, citing economic factors, particularly the high value of the dollar, as the reason. Although the experience of bank-affiliated export trading companies to date has fallen short of expectations, this is due primarily climate for exchange U.S. rate for to the highly unfavorable economic exports that resulted from, the overvalued the U.S. dollar, the lack of adequate economic growth in foreign industrial countries, and the need for adjustment in many developing countries. Therefore, the period since 1982 has clearly not been a fair test of the viability of bank-affiliated export trading companies on which far-reaching changes in the law should be based. to the macro-economic companies, conditions faced by export In addition trading there are other factors contributing to their slow development. It is still a fledgling industry; the oldest of -5- the bank-affiliated export trading companies years old. is not yet four Moreover, a review of several articles concerning bank-affiliated export trading companies in recent years indicates that the affiliation of two such different corporate cultures as banking and trading inevitably creates difficulties in forging a viable and profitable enterprise. I might add that the publications generally do not attribute the lack of success of export trading companies to the Board's regulations, but rather to the various economic and business factors that I have mentioned. In efforts to make governing the operations of refinements to bank-affiliated the legislation export trading companies, which we all see as a desirable effort, it should be remembered providing that banking two essential trading company — organizations elements for were a perceived successful as export a source of capital and financing and a network of foreign offices able to evaluate foreign markets and provide necessary foreign contacts. The legislation therefore created a very limited exception to the statutory separation of banking and commerce in order to achieve the goal of improving the export sector of the economy. The BESA was not, as we read it, intended to let bank holding companies perform every type of international activity nor to relax to any great extent the provisions protecting Bank-affiliated assist other bank safety and soundness. export trading companies were companies in the export their of intended goods to and - 6 - services and not to compete with these companies by becoming themselves producers of services for export. Moreover, the Act recognizes that there are activities from which export trading companies should be explicitly excluded, activities, agriculture, manufacturing. safeguards that dealing The Act contains in such as securities commodities, these and other and important are intended to maintain the separation of banking and commerce and supervisory goals. to avoid compromising significant These measures were adopted in recognition that one goal of national importance — export promotion — should not be achieved at the expense of another — a safe and sound banking system. The Board's designed to carry regulations out the implementing statute's intent. the BESA are Because the statute did not focus on promoting trade, but on promoting U.S. exports through export trading companies, our regulations are designed to ensure that such companies engage in trade services that promote U.S. exports. As a result, the Board's regulation requires that 50 percent of a bank-affiliated export trading company's business must derive from exporting or facilitating the export of goods and services produced in the United States by persons other than subsidiaries. Under the export this test, trading a company bank-affiliated and its export trading company may provide services to any party, foreign or domestic, that is connected to an international trade transaction, as long as the majority of the company's business is export-related. - 7 - Let me at this point clear up some confusion over one aspect of the regulations. 50 percent revenues A bank-affiliated test export in the trading Board's company may provide services not only to unaffiliated persons, it can also help of to promote the goods and services of any its affiliates; that activity is considered as facilitating a U.S. export under the regulation. For example, an export trading company could market abroad computer software developed by its bank holding company parent; revenues derived activity are considered export revenues. from that Thus, contrary to the perception of some, a bank-affiliated export trading company is authorized to assist its affiliates in exporting services. As I have mentioned, one of the fundamental premises of the legislation is that bank-affiliated export trading companies will facilitate the export of goods and services of other U.S. companies and will not engage activities themselves. Accordingly, consistent with the purposes of directly in such the Board's regulations, the BESA, prevent a bank holding company, under the guise of an export trading company, from acting only as a service company for foreigners, that is, from engaging in a service activity, which might not be even a trade service, that is provided only to foreign parties. example would sells property customers. An be an insurance company that underwrites and and casualty insurance policies to foreign - This situation, in 8 - which a bank holding company becomes the producer of the service to be exported, inconsistent facilitator formation of of facilitate abroad. with an export exports. a The trading company's regulations, would be role however, as a permit joint venture with an insurance company to the sale of the insurance company's policies Therefore, there is a broad scope in the statute and the regulation for a bank-affiliated export trading company to provide services in support of exports. Some of taken issue the with legislative the Board's proposals have implicitly regulation requiring that 50 percent of an export trading company's business derive from exports or facilitating exports produced by others. This is also the area of current regulation where the most flexibility is sought companies, by the i.e., surveyed in the bank-affiliated application of the export trading 50 percent of revenues test. These legislative proposals would alter the original intent of the statute in a fundamental way. The original bill was intended to promote exports and build an export-oriented infrastructure of trading companies. Some of the proposed legislation would not seem to further those goals. First, these proposals would permit an export trading company to count as export revenues any revenues derived from third country trade. company itself is The rationale is that the export trading providing a service and that - 9 - the third country trade activity does not hurt U.S. balances because it does not involve an import. trade Our view is that such proposals sanction the development of bank-affiliated trading companies that need not facilitate the export of any product produced in the United States at all. They would permit a trading company to set up foreign companies to provide a broad range of services benefit either to U.S. to foreign parties without any jobs or toward developing an export trading industry that can serve companies that actually produce goods and services in the United States. create a movement export trade This approach would in the opposite direction services to those U.S. from providing companies that need assistance in exporting. Moreover, it is not readily apparent claim, third country trade would not harm U.S. that, as many trade. If a foreign country is buying computers from Germany, it is not buying them therefore from can the hurt United U.S. States. exports, Third as many country third trade country transactions are substitutions for U.S. exports. In addition, by permitting bank holding companies to invest in any company, regardless of its business, as long as it offers its services exclusively to foreign customers, the proposed legislation would put bank holding companies into direct competition with other U.S. companies that are intended to be the primary beneficiaries of the original act, i.e., companies that produce goods and services in the United States - which 10 - with the help of an export trading company could be exported. Such a result seems perverse in two ways. First, it reduces any incentive on the part of bank-affiliated export trading companies companies. to market their trade services to U.S, Under the proposals, if a bank holding company were to identify potential projects or markets abroad, it could establish a trading company to take on the project or service, rather than approach U.S. companies either to form a joint venture to take advantage of the opportunity or to otherwise assist the U.S. company in exporting its service. Second, activities in the which proposals a bank would holding expand the company kinds may indirectly through an export trading company. of engage There is already a statutory and regulatory framework for the expansion of the operations outside of the bank holding United States companies and Edge corporations that provides considerable flexibility in both activities and investments. For example, in some have instances, U.S. banking organizations been permitted to establish foreign companies that underwrite and sell life insurance. This has been done, however, under statutes that allow the Federal Reserve to consider fully the effect on banks and the banking system, factors not applicable to the BESA. taking into account A radical change in the authority to conduct activities overseas, such as the proposals would provide, question of should be dealt with straightforwardly as a new products and services for banking 11 - organizations. - The Board strongly supports authorization of some new products and services for bank holding companies but believes that they should be granted in a direct fashion, and not through trade legislation, especially where there would be no benefit to U.S. exports generally. Although these proposals would shift the emphasis of the original statute from export promotion to promotion of international trade per se by permitting bank holding companies to engage in general trading activities without regard to promoting U.S. exports, this is of course a matter for Congress to decide. exports The Board's regulations requiring a predominance of are, however, fully consistent with the intent of Congress at the time of passage of the BESA. With respect to the ability of a bank to finance its affiliated export trading company, the BESA subjects a bank's extension of credit to an affiliated export trading company to the provisions of section 23A. As you know, section 23A requires collateralization for any extension of credit by a bank to an affiliate, usually in an amount that exceeds the face amount of the extension of credit. appropriate in order to protect the This is entirely bank. However, in recognition of the need for a bank-affiliated export trading company to secure funding for its trading in goods, the Board has provided a reasonable exception by waiving the excess collateral requirement for loans by a bank to its affiliated - export trading company. 12 - The regulations require instead that the bank take a security interest in goods or the proceeds from the sale of goods that are subject to a contract of sale. This measure enables an export trading company to obtain financing for the activity for which financing is most needed but the exception does not subject the bank to undue risk. This liberalization of section 23A's collateral requirements is the type of carefully crafted exception to the provisions of section 23A that we believe is most appropriate in this context. It is tailored to the needs of an export trading company but ensures that the assets of the bank will not be jeopardized. The Board also expects a bank-affiliated export trading company to be capitalized adequately to support its operations. There is no regulatory requirement, however, for a certain capital level. Each case is evaluated based on its own facts. Some relate to of section the proposed 23A and to amendments capital substantial supervisory concerns. to the BESA that requirements raise The proposals would expand the ability of a bank-affiliated export trading company to take on the equity risk of foreign subsidiaries, clearly increasing the risk to which the export trading company is subject. At the same time, the proposals would reduce the safeguards for the affiliated bank, collateral by exempting all transactions from the requirements of section 23A and by permitting an export trading company to be less than adequately capitalized. - These changes 13 would - seem to be especially inappropriate at this time when there is a consensus that bank affiliates should be subject to market discipline. An affiliate should not be able to use a bank's resources — the federal guarantee for those resources — except and to the extent permitted by the provisions of section 23A. As the Board has consistently stated, export if a bank-affiliated trading company is creditworthy, it can obtain credit in the market even from a non-affiliate. If an export trading company is not creditworthy, an affiliated bank should not be placed at risk by being able to lend without collateral. total elimination directly contrary Moreover, a of section 23A collateral requirements is to the legislative proposals, approach which would taken in actually other recent strengthen the protection available to the bank. As I have previously stated, the Board has been willing to be flexible in its approach to section 23A as it applies to loans to bank-affiliated export trading companies but only where the bank will not be adversely affected. cannot support any proposal that would permit We a nonbank affiliate to drain the resources of the bank in pursuit of its business. With respect to capitalization, some of the legislative proposals would permit an export trading company to operate with a capital to assets ratio of 4 percent. That ratio would be low for most trading companies; such ratios are - typically at least 14 25 percent affiliated with banks. - for trading companies not The proposed ratio is even lower than the capital required of a bank. We see no justification for reducing the Board's ability to require that a bank holding company subsidiary be adequately capitalized in relation to its business. Having said this, it should be noted that where the proposed activities of a bank-affiliated export trading company have risk characteristics similar to those of a bank, the Board has determined that the export trading company may maintain a capital ratio equivalent to that required of a bank. Such a proposal permitting a low capital to assets ratio would also be contrary to prudent supervisory policies as reflected in recent efforts, including those of the Congress in passing the International Lending Supervision Act of 1983, increase capital international of banking activities. bank-affiliated export organizations Moreover, trading it companies involved would from to in remove the market restrictions imposed on other companies not affiliated with banks, its thereby encouraging increased risk-taking concomitant risk to the banking organization. with It should be kept in mind that a bank can be harmed not only by direct interaction with an affiliate but also by a weakening of the bank holding company's ability to serve as a source of strength to its subsidiary banks. In addition to the supervisory questions raised by these proposals on section 23A and capital adequacy, the - 15 - proposals raise a serious issue of competitive equity. These proposals place bank-affiliated export trading companies in a favored position over all other competitors by removing them from the effects of market discipline. A bank-affiliated export trading company would have a ready source of financing, even if the company is not creditworthy, and could undertake a higher volume of activities because of its low capitalization. This situation would be entirely inconsistent with the concept of a level playing field. In light of these factors, the Board must oppose any proposals that would increase the risk to the bank from the operation of the affiliated export trading company. Such export trading companies should be permitted to operate with sufficient appropriate flexibility to allow them to succeed but within constraints affiliated banks. on their ability to harm their We believe that the current statutory and regulatory framework achieves these goals. The recent past did not provide circumstances for the best test of the current framework. Changing economic conditions should make it easier for these export trading companies to operate more successfully in the next few years. While we believe that the foregoing is a realistic assessment of both the current law and the proposals that have been introduced into the Congress, the Federal Reserve is, as always, willing to work with the Congress in developing - 16 necessary legislative reforms. - We urge you, however, to keep in mind that some of the proposals raise serious supervisory concerns. Others bank-affiliated are aimed export at trading changing companies the purposes from an of export orientation to encouraging trade outside the United States or even U.S. imports. In the final analysis, of course, the goals for any new legislation are established by the Congress, and the Board always endeavors to adopt implementing regulations that reflect those goals. Thank you very much.