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For release on delivery 9:30 a.m. E.D.T. June 17/ 1986 Statement by Manuel H. Johnson/ Jr. Member, Board of Governors of the Federal Reserve System before the Subcommittee on International Finance and Monetary Policy of the Committee on Banking, Housing, and Urban Affairs United States Senate June 17, 1986 Thank you for the opportunity to present the views of the Federal Reserve Board on S. 1934, Export Trading Company Act of 1982. the bill to amend the We at the Board support efforts to lower this country's trade deficit, and wish to work with Congress problem. in attempting It is not to arrive the view of at solutions the Board, however, amending the Bank Export Services Act ("BESA") this time. has that is necessary at Given the unfavorable economic conditions that have existed since enactment of statute to the not been the BESA, given a fair we feel test, the and effectiveness should be evaluated in the future. existing that its As to the specific provisions of S.1934, the Board opposes three of the revisions to the BESA proposed in the bill on grounds of safety and soundness, but has fewer reservations concerning two other proposed revisions. In my testimony, I will review briefly the Board's implementation to date of the BESA (Title II of the Export Trading Company Act of 1982), discuss some of the experiences of bank-affiliated export trading companies ("ETCs") and other trading companies, and analyze and give in greater detail the Board's views on the provisions of S. 1934. 2 - The BESA and the Board's - Regulations The Export Trading Company Act of 1982 ("ETC Act") was designed to help promote exports by facilitating the formation and operation of ETCs. The BESA provides a limited exception to the nonbanking prohibitions of the Bank Holding Company Act by permitting bank holding companies and certain other types of banking organizations to make equity investments in ETCs. purposes of the establishment BESA of U. S. foreign-owned ETCs; agriculture, were: (1) to ETCs that provide could be for The the competitive with (2) to provide U. S. commerce, industry and especially small and medium-sized firms with means of exporting their goods and services; a (3) to foster the participation by regional and smaller banks in the development of ETCs; and (4) to facilitate the formation of joint venture ETCs between bank holding companies and nonbank firms. Thus, traditional the BESA represents a dramatic departure banking legislation in that it from permits participation by banking organizations in commercial ventures. In recognition of this expanded latitude, however, Congress included a number of prudential safeguards to limit potential adverse financial effects on banks affiliated with ETCs. statute provides that a bank holding company may not The invest more than 5 percent of its consolidated capital and surplus in an ETC nor lend more than 10 percent capital and surplus to an ETC. of its consolidated It also provides that a bank holding company may invest in an ETC only after allowing for - review by the Federal Reserve. 3 - The Federal Reserve is required to review the notice in order to determine whether the proposal may result in unsafe or unsound banking practices, undue concentration of resources, decreased or unfair competition, or conflicts of interest, or whether the investment would have a materially adverse effect on the safety and soundness of a subsidiary bank of the bank holding company. The Board issued final BSSA in June, 1983. regulations implementing the These regulations were later modified to simplify the notification process and provide authority to the individual certain ETC notifications. for delegated Federal Reserve Banks to review Virtually all of the notifications of intent to establish ETCs have been acted upon within the 60-day time notification disapproved. period by a set bank forth to in invest the in statute, an ETC and has no been Fifteen of the 24 ETC notifications filed after the adoption of the delegation procedures were processed by the Reserve Banks with no Board review. Response to the Act Ac you are well aware, the economic climate since the ETC Act was passed has not been favorable to exports. The Act was signed during the fourth quarter of 1982 when the U.S. economy was in the depths of a recession and the volume of exports had fallen more than 20 percent from its peak in 1980. Since that time, U.S. output and employment have expanded 4 - rapidly. By contrast, U.S. - exports have rebounded moderately and still remain below their 1980 peak. trade deficit increased from $25 billion in only The U.S. 1980 to approximately $125 billion in 1985. The weakness of U.S. exports can be attributed to a number of macroeconomic developments that took place early to mid-1980's recently. and that have continued until in the fairly These factors include the rise of the dollar against foreign currencies; the relatively sluggish growth of foreign economies; and the drop in imports by countries experiencing problems meeting their external debt obligations. Moreover, as was discussed during early hearings on the BESA, U.S. manufacturers have not traditionally made widespread use of trading companies as a medium for exporting their goods. By one estimate, in 1982, there were about 2,000 American-owned trading companies active in the United States. However, percent these of companies all U.S. were exports. involved in only Larger U.S. about ten multi-national companies with substantial sales abroad had their own in-house marketing capability subsidiaries. trading Thus, company or a few had at the time the trading Act was generally was not a prominent company passed, vehicle the for selling U.S. exports, and it was unlikely that the patterns of U.S. businesses with exporting capabilities could be changed in only a few years. - Notwithstanding this 5 - business environment, 40 bank holding companies have notified the Federal Reserve System of their intent Appendix to to this invest in ETCs. testimony show (Tables the attached status notification acted upon by the System). of as each an ETC Several of these ETCs appear to be operating profitably and expanding their overseas operations. In contrast, the performance of many bank-affiliated ETCs has been disappointing. are no longer conditions operational. in their In addition first years of In fact, eleven to poor of existence these economic resulting in diminished profit potential, these ETCs have also encountered start-up difficulties trading business. resulting from unfamiliarity with Other problems encountered are peculiar to the activities of trading companies, they have been operating. substantial the regardless of how long For example, one ETC experienced difficulties because a major customer broke the terms of its trade agreement; another lost its capital because of its inability to deliver on a major contract; and a third was closed after suffering significant losses resulting from the lack of adequate controls over its trading activities. least four operations bank holding of their ETCs companies either have discontinued temporarily or the permanently because the operating losses were found to be unacceptable. At - There is no evidence, 6 - however, that ETCs affiliated with banks have been any less successful than trading companies that have no connection with banking organizations. While there is no means of tracking all these trading companies, the General Accounting Office has conducted a survey of 23 trading organizations that have obtained certificates of review from the Department of Commerce. business has been Many of these firms reported that disappointing, citing economic factors, particularly the high value of the dollar as the reason. It is also interesting to note that the membership of the National Association of Export Companies, an organization composed primarily of nonbank export trading companies, dropped by half in the last four years, again. fact and is only beginning to increase This drop in membership is reportedly a result of the that many of the member companies have gone out of business. S. 1934 There is an understandable concern about the mediocre performance of ETCs since the passage of the Act resulting in attempts to deal with the situation by amending sections of the BESA. The amendments regulations. economic Broad would modify trends, conditions — not certain however, the such Board's impeded the results of the legislation. of the Board's as unfavorable regulations — have Moreover, three of the bill's provisions present serious issues related to the safety - 7 - and soundness of banking organizations investing in ETCs. From a supervisory standpoint, we are less concerned about the other two provisions. However, I would note dealing with the calculation of export policy questions about Congressional that the revenues intent provision does raise in establishing ETCs to foster U.S. exports. 1. Transactions with Affiliates The BESA provides that extensions of credit from a bank to its affiliated ETC are covered by section 23A of the Federal Reserve Act. Section 23A is a cornerstone of the regulatory structure for protecting banks from credit judgments made for noncommercial reasons. It generally limits the amount of credit that banks may extend to a nonbank affiliate and subjects such credit extensions to certain collateral requirements. S. 1934 would exempt from section 23A of the Federal Reserve Act a bank's transactions with its affiliated ETC. purpose of this exemption, according to the The statement introducing the bill, is to remove a competitive "disadvantage" from ETCs, permitting them to borrow from their affiliated bank without meeting the collateral requirements of section 23A. Experience over the years has demonstrated that limitations on self-dealing between a bank and its affiliates are essential to help curb abuses, to maintain bank safety and 8 - - soundness and to prevent excessive risk to the federal safety net. Congress also has recognized protections found in 23A — the importance of the every deregulatory proposal in the last four years has used section 23A as the central mechanism for preserving the safety and soundness of banking organizations with expanded powers to enter nonbanking areas. The experience to date reinforces the desirability of maintaining the protections afforded by section 23A. In one case, a bank lent to its affiliated ETC amounts in violation of section 23A without required collateral. The ETC was unable to repay the advances and thus the condition of the bank was affected. not have Had section 23A been complied with, the bank would exposed itself to these losses. Therefore, an exemption from section 23A for transactions with an ETC does not appear to be in the best interests of preserving safety and soundness as it creates the opportunity for a bank's resources to be misused activities. in support of the affiliate's trading In the area of extensions of credit, it is most important to strike the proper balance between encouraging the growth of Moreover, ETCs and preventing imprudent banking the application of section 23A does practices. not impose competitive disadvantage on ETCs affiliated with banks. like other trading companies, are free to borrow They, from unaffiliated lenders on terms determined by the market. a - 9 - The Board as a matter of policy has generally not granted exemptions however, from section 23A. With respect to ETCs, the Board has included in its regulations a waiver from the strict collateralization standards of section 23A for those transactions in which the ETC takes title to goods against a firm order and the lending bank maintains a security interest these in those goods. circumstances The Board has determined a waiver would permit ETCs that in to obtain financing for transactions in goods without creating undue risk to the affiliated bank. In addition, the Board has stated that it would consider granting PTCs additional waivers from these collateral requirements baccd on specific requests. The bill also would relieve extensions of credit by a bank to its affiliateu section 23A. more than affiliate. ETC from the quantitative limits of These limitations provide that a bank may lend no ten percent of its capital and surplus to an The BESA itself limits extensions of credit by a bank holding company or its subsidiaries to an affiliated ETC to ten percent of the holding company's capital and surplus. Thus, the bill's proposed exemption could have the effect of significantly affiliates. increasing The Board the exposure strongly of a recommends bank that to its the quantitative limits on these extensions of credit be retained. 2. Capital Adequacy In reviewing notices by banking organizations to invest in ETCs, the Board considers the assets to equity ratio - of each proposed account, among 10 - ETC on a case-by-case other factors, proposed activities. the basis, riskiness S. 1934 would prohibit taking of the into ETC's the Board from disapproving a bank's investment in an ETC solely on the basis of the proposed asset to equity ratio unless that ratio were greater than 25 to 1. The Board, by reason of its responsibilities as a bank regulator, has maintenance historically of adequate recognized capital the need in individual for state the member banks and bank holding companies and in the banking system in general. Capital provides a buffer for banking organizations in of times confidence poor performance, in particular helps banking to maintain organizations public and in the banking system, and supports the reasonable growth of banking organizations. An evaluation of capital adequacy is one of the major purposes of a bank or bank holding company examination. Congress has organizations to International Lending required the maintain bank to establishing minimum Supervision achieve For the and levels this necessity adequate regulatory institutions institutions." recognized capital. for In Act of 1983, agencies to "cause maintain of adequate capital purpose, for capital banking the Congress banking capital such by banking requirements are assessed on a consolidated basis, although the capital adequacy of subsidiary organizations is also taken into account. The - latter is necessary because 11 the - condition of affiliated organizations can have an important effect on their related banks. In the case of ETCs the Board strongly recommends against the proposed legislative standard for the leveraging of ETCs. In carrying out its duty to preserve the safe and sound operation of bank holding companies/ the Board must be able to examine carefully the capital structure and proposed leveraging ratios of bank-affiliated ETCs. Capital adequacy is a critical determinant of the financial strength of the ETC and of its ability to withstand unexpected adverse developments so as not to affect the financial resources of the parent holding company or the safety and soundness of affiliated banks. There is no justification for a statutory rule allowing a minimum capital level for bank-affiliated ETCs substantially less than that required for banks, when the ETCs' activities are likely co be outside the normal range of banking operations and therefore present greater/ not fewer, risks. Thus, we do not adhere to the presumption of S. 1934 that a leveraging ratio of 25:1 would be consistent with the sound financial operation of an ETC. Many factors must be taken into account, such as the nature of the ETC's business, the size of its inventory, and the size of the bank holding company's investment in the ETC. Only a case-by-case analysis permits all these factors to be taken adequately into account. - 12 - In this regard, the Board recently acted on a request from a bank holding company to adopt a leveraging ratio for its ETC that was higher than the 10:1 ratio it had proposed in an earlier notification to a Federal Reserve Bank. After determining that the nature and riskiness of the activities proposed for the ETC were similar to those of secured lending transactions, the Board approved a leveraging ratio of 17:1. This action is illustrative of the flexible approach followed by the Board with respect to the capitalization of ETCs. In light of the critical importance of the capital adequacy of each subsidiary company in a bank holding company organization, the Board needs to retain its discretion in this area. 3. Exporting Services The BESA, read together with the Board's regulations, defines an ETC in which a banking organization is permitted to invest as a company that is exclusively engaged in international trade, and that principally exports, or provides services to facilitate produced by others. ETC to include the export of, goods and services S. 1934 would modify the definition of an companies that principally export goods or services produced by themselves or any of their affiliates. This revision would permit a bank to invest in any company that provides its own services to foreign customers regardless of whether the services relate to trade. - The common thread 13 - throughout consideration of the original legislation was that the experience and expertise of banks in financing foreign investment was thought to be needed by export trading intermediaries for companies — producers companies and that serve as of goods and suppliers services in the foreign marketing and sale of their products by providing a range of export trade services. It was not intended that banking organizations would serve as a source of capital investment in various service industries generally and assume the risks associated with those industries. The Board's regulations do not limit the ability of bank-affiliated ETCs to offer a broad range of trade-related services both in the United States and abroad. For example, the BESA and the regulations permit ETCs to provide consulting, market design, research, legal marketing, assistance, insurance product transportation research including and freight forwarding, warehousing, foreign exchange, financing and taking title to goods, when provided in order to facilitate the trade in goods and services produced by others. notifications to the Federal Reserve, providing many of the trade services According to the a number of ETCs are included in this list. Moreover, the Board has recognized that this list of services is not exhaustive. For example, activities were related upon demonstrating that the to international trade, one ETC has acquired a company in England that engages in customs bonding - 14 - services and in certain types of inventory control services related to cross-border responded favorably to trade. In addition, several export the Board has trading company notifications that specifically contemplated the establishment of overseas offices and divisions. The practical effect of S. 1934 would be to change the Congressionally intended emphasis in the BESA from promoting U.S. exports and employment to providing a vehicle by which commercial banking organizations, through the medium of an ETC, could acquire organizations serving overseas customers without any benefit to the United States trade or balance of payments position. The proposal would thus have the effect of changing the incentive in the ETC Act to promote U.S. exports, while potentially undermining the public policy objectives embodied in the separation of banking and public policy issues commerce. should be addressed Such directly important and not indirectly through technical changes in the BESA. While the last two provisions of S. 1934, which I will now discuss, appear to raise few supervisory concerns on our part, the calculation of the export revenues provision, as I have mentioned, does raise questions of policy. 1. Calculation of Export Revenues The BESA defines an ETC as a company "organized and operated principally for purposes of exporting [or facilitating the export of] goods States . . . This improving U.S. and services definition produced reflects export performance. in the United Congress' goal In accordance with of this purpose, the Board's current regulations require that more than half of an export trading company's revenues over a two-year period be derived from U.S. exports. Under S. 1934 a company would qualify as an export trading company if its revenues from imports. or associated with calculations. revenues from exports exceed its Revenues derived from third party trade countertrade would be excluded from the This would mean that an "export trading company" could bti a company substantially engaged in third party trade or countertrade involving two foreign countries, with minimal involvement States. the in exporting goods or services from the United In fact, the proposal could hurt U.S. exports, since goods being traded outside the United States can substituted for goods exported from the United States. result would amount to a substantial alteration be Such a of Congressional intent as to the purposes of ETCs to promote the export of U.S. goods and services and would be contrary to the original premise for allowing bank holding companies to engage in this activity: that the increased risks undertaken by a bank holding company through an ETC would be counter-balanced by an increase in U.S. exports. Ultimately, however, it is up to Congress to determine whether ETCs should continue to have as their primary purpose the export of U.S. goods and services. - 2. Inventory The Board's regulations 16 - provide that a notice to invest in an ETC may be delegated to the appropriate Federal Reserve Bank, rather than reviewed by the Board, if the proposed export trading company will take title to goods only against firm orders, $2 million. that the or if its inventory is worth less than Taking title to goods Board felt involves it should have the sufficient opportunity risk on a case-by-case basis to review carefully proposals involving this activity. those The Board wanted to reserve the right to disapprove proposals that could involve unsafe and unsound practices, as, for example, where a bank-affiliated ETC has an inadequate system of management controls, or where the ETC has insufficient safeguards to protect against a violation of the statutory prohibition against speculation in commodities. Board has in fact reviewed and did not object The to several notices where projected inventory is substantially greater than $2 million. S. 1934 prohibits the Board from imposing a dollar limit on an ETC's inventory unless the Board finds that the limit is necessary to prevent material adverse effects on a bank affiliate of the ETC. This provision would merely codify the Board's current practice and would provide the Board with sufficient authority to exercise its supervisory powers in this area when necessary. - 17 - Conclusion In conclusion, I would like to emphasize again the Board's support for a strengthened and expanding export sector of the U.S. economy. In this context, we would urge Congress to allow for a fair testing of the existing law and to refrain at this time from adopting the proposed amendments. NOTIFICATIONS TO ESTABLISH EXPORT TRADING COMPANIES Bank Holding Ocmpany Export Trading Company Date of Systan Action Current Status Security Pacific Corporation, San Francisco, CA Security Pacific Export Trading Company Los Angeles, CA 5/09/83 Operating Citicorp, New York, NY Citicorp Internationa] Trading Company, New York, NY 5/31/83 Operating Walter E. Heller International Corporation, Chicago, IL Heller Trading Company Chicago, IL 6/13/83 Closed First Interstate Bancorp, Los Angeles, CA First Interstate Trading Company, Los Angeles, CA 6/15/83 Operating First Kentucky National Corporation, Louisville, KY First Kentucky National Trading Company, Louisville, KY 7/25/83 Inactive Union Bancorp, Inc., Los Angeles, CA StanChart Export Services Company, Inc., Los Angeles, CA 7/25/33 Operating Crocker National Corporation, San Francisco, CA Crocker Pacific Trade Corporation, San Francisco, CA 8/30/83 Closed 9/14/83 Operating Bancorps1 International Ramapo Financial Corp., Trading Corporation, Wayne, NJ; Scmerset, NJ Ultra Bancorporation, Bridgewater, NJ; and New Jersey National Corporation, Trenton, NJ 9/19/83 State Street Boston Corporation, State Street Trade Development Corporation, Inc., Boston, MA Boston, MA International Bancshares Corporation, Laredo, TX IBC Trading Company, Laredo, TX United Midwest Bancshares, Inc., Cincinnati, OH United Midwest International Corporation, Cincinnati, OH 10/03/83 Sold Not Activated Closed 2 Bank Holding Caqpany Export Trading Ccnpany Date of System Action Current Status U.S. Bancorp, Portland, OR U.S. World Trade Corporation, Portland, OR 11/17/83 Inactive First Chicago Corporation, Chicago, IL First Chicago Trading Company, Chicago, IL 11/21/83 Operating Rainier Baneorporation, Seattle, WA Rainier International Trading Company, Seattle, WA 12/07/83 Operating Shawmut Corp., Boston, MA. Shawmut Export Corporation, Boston, MA 12/12/83 Operating Hongkong and Shanghai Banking Corporation, Hong Kong Equator Trading Company Limited, Hartford, CT 12/27/83 Operating BankAmerica Corporation, San Francisco, CA BankAmerica World Trade Corporation, San Francisco, CA 02/02/84 Inactive Bankers Trust New York Corporation, New York, NY Bankers Trust International Trading Corporation New York, NY 02/02/84 Operating First National State Baneorporation, Newark, NJ First International Trading Co., Newark, NJ 02/13/84* Operating Chase Manhattan Corp., New York, NY Chase Trade, Inc., New York, NY 02/21/84* Operating Society Corporation, Cleveland, OH Export Partnership for International Trade, Inc., Cleveland, OH 03/04/84 Operating Fleet Financial Group, Inc. Providence, RI Fleeting Trading Company, Providence, RI 03/19/84* Inactive First National Bancshares, Inc. Houma, LA First Export Corporation, Houma, LA 04/06/84* Operating Manufacturers Hanover Corporation, New York, NY C.I.T. International Sales Corporation, New York, NY 04/24/84 Operating First Union Corporation, Charlotte, NC First Union Export Trading Carpany, Charlotte, NC 05/07/84* Operating *Acted upon by Reserve Banks pursuant to Delegated Authority. 3 Bank Holding Ocnpany Export Trading Ccnpany Date of System Action Current Status Alaska Mutual Bancorporation, Anchorage, AK Mutual International Corporation, Anchorage, AK 06/06/84* Operating Frontier Bancorp, Vista, CA Interbank Trading Company, San Diego, CA 07/30/84* Not Activated Florida Park Banks, Inc. St. Petersburg, FL Park Services International, Inc., St. Petersburg, FL 09/19/84 Closed Capital Bancorp, Miami, FL Capital Trade Services, Inc., Miami, FL 09/20/84* Operating CoreStates Financial Lancaster, PA CoreStates Export Trading Ccmpany, Philadelphia, PA 10/13/84* Operating North Valley Bancorp, Redding, CA Casia-Pacific Ccmpany, Redding, CA 10/18/84* Operating 12/18/84* Operating Marine Corporation, Milwaukee, WI Marine Financial Services, Inc , 12/31/84* Milwaukee, WI Operating Ramapo Financial Corp., Wayne, NJ; Ultra Bancorporation, Bridgewater, NJ; and New Jersey National Corporation, Trenton, NJ Florida Interbank Trading Ccmpany, Inc., Jacksonville, FL 01/07/85 Operating First Wisconsin Corp., Milwaukee, WI Interkontinental Trading Co., Inc., Rolling Meadcws, IL 02/11/85 Operating Garmierce Union Corporation, Nashville, TO Ccnmerce Trading Corporation, Nashville, TO 03/22/85 Operating Valley National Corporation, Phoenix, AZ Valley Intemation Trading Company, Phoenix, AZ 04/16/85* Operating Maryland National Corporation, MN Trade Corporation, Baltimore, MD Baltimore, MD *Acted upon by Reserve Banks pursuant to Delegated Authority. 4 Bank Holding Ooqaany Export Trading Company Date of System Action Current Status Manufacturers Hanover Corporation, New York, NY Manufacturers Hanover World Trade Corporation, New York, NY 04/21/85* Operating Marine Midland Banks, Inc., Buffalo, NY Marine Midland Trade, Inc., New York, NY 04/21/85* Operating United Bancorp of Arizona, Phoenix, AZ United Bank Export Trading Canpany, Phoenix, AZ 07/05/85 Operating InterFirst Corporation, Dallas, Texas InterFirst World Trade Corporation, Dallas, Texas 04/28/86 Operating ♦Acted upon by Reserve Banks pursuant to Delegated Authority. OTHER EXPORT TRADING COMPANY NOTIFICATIONS Date of 1 System Action Bank Holding Company Export Trading Company Security Pacific Corporation, Los Angeles, CA Security Pacific Trading Co. 01/18/84 Expand Activities' Society Corporation, Cleveland, OH Export Partnership for Intercontinental Trade Inc. 03/20/85 Additional Investment Hongkong and Shanghai Banking Corporation, Hong Kong Equator Trading Co. 04/05/85 /additional Investment Citicorp, New York, NY Citicorp International Trading Co, 04/09/85 Additional Investment State Street Boston Corp., Boston, MA State Street Trade Development Co., Inc, 07/29/85 Additional Investment Citicorp, New York, NY Citicorp International Trading Co. 11/08/85 Invest in Bonded Collateral Management Vehicle State Street Boston Corp., Boston, MA State Street Trade Development Co., Inc, 12/19/85 Additional Investment Chase Manhattan Corp., New York, NY Chase Trade, Inc. 02/26/86 Increase Leveraging' to 17:1 Ramapo Financial Corp., et al., Wayne, NJ Bancorps’ International Trading Co. 05/12/86 Additional Investment Reguest *In each instance, the Federal Reserve had no objection to the proposal. 2 In its notification to the Board to establish its ETC, Security Pacific sought to engage in only limited ETC activities. The purpose of this notification was to enable it to engage in the full scope of the activities permitted under the BESA. 3 Technically, this request was for relief from a commitment, not an ETC notification.