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______ April 4, 199C
Testimony by
Manuel H. Johnson
Vice Chairman
Board of Governors of the Federal Reserve System
before the
Subcommittee on Financial Institutions
Supervision, Regulation and Insurance
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
April 4, 1990
I appreciate the opportunity to be here today to
present the views of the Federal Reserve Board on the
implications of the decision of the U.S. Court of Appeals
upholding the Board's Order in the Merchants National case.
The
decision is important for two reasons: the legal conclusion
reached regarding the applicability of the Bank Holding Company
Act to the direct activities of banks owned by bank holding
companies, as well as the potential significance of the case for
the regulation and supervision of the activities of federally
insured banks and for the resources of the federal safety net.
The Merchants National case involved a proposal by
Merchants National Corporation, an Indiana bank holding company,
to acquire and retain two Indiana state banks that engaged
directly in certain general insurance agency activities permitted
state banks under Indiana law.
One of these banks had conducted
the insurance agency activities since its founding in 1916.
As required by the Bank Holding Company Act, Merchants
National filed applications with the Board for prior approval to
acquire the banks.
Various insurance industry trade groups
protested the applications, urging the Board to prohibit the
banks from selling insurance after their acquisition by Merchants
National.
The protest turned on whether the nonbanking
provisions of the Bank Holding Company Act apply to the direct
activities of banks owned by a bank holding company in the same
manner that these provisions apply to the bank holding company
itself and to its nonbank subsidiaries.
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Section 4 of the Bank Holding Company Act generally
provides, with certain exceptions, that a bank holding company
may not directly or indirectly acquire or retain the voting
shares of any company that is not a bank or engage in any
activity other than those authorized under the Act.
The most
significant exception to this prohibition is for companies whose
activities the Board has determined to be closely related to
banking.
In 1982, Congress specifically legislated, however,
that insurance activities, with certain specified exceptions, are
not closely related to banking.
As a result, Congress has
removed the Board's discretion to permit these activities for
bank holding companies and their nonbank subsidiaries as an
exception to the general nonbanking prohibition in the Bank
Holding Company Act.
Congress has not, however, separately
prohibited insurance activities for institutions not subject to
the nonbanking restrictions of the Act.
The nonbanking restrictions of the Bank Holding
Company Act do not, by their terms, apply to the acquisition of
shares of banks or to the activities conducted directly by banks
owned by bank holding companies.
The Board has so interpreted
the provisions of section 4 of the Bank Holding Company Act since
the Act's passage in 1956, and it reaffirmed that interpretation
in the Merchants National decision.
Thus, insofar as the
nonbanking restrictions of the Bank Holding Company Act are
concerned, state banks may conduct directly those activities that
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are authorized by state law, including the insurance agency
activities at issue in Merchants National.
There is one caveat to this Board interpretation.
Where the record indicates that a bank holding company is
attempting to evade the restrictions of the Act by conducting
activities directly in the bank, the Board has applied the
restrictions of section 4 of the Act to the proposed activities.
The Board took such action on a 1985 application by Citicorp to
acquire a bank in South Dakota, where the bank's principal
purpose was to market insurance services throughout the United
States— except in South Dakota.
The Board found, based on the structure of the South
Dakota law and the fact that the South Dakota bank would serve
almost exclusively as an insurance subsidiary of Citicorp and
conduct only insignificant banking activities, that the
acquisition of the bank was primarily, if not solely, for the
purpose of enabling Citicorp to engage through the bank in
various insurance activities.
Accordingly, the Board determined
that it was precluded from approving Citicorp's application
because the acquisition was simply a device to allow Citicorp to
engage in insurance activities prohibited for bank holding
companies under section 4 of the Bank Holding Company Act.
In
contrast, in the Merchants National case, the acquired banks were
conducting a full banking business and the banks' insurance
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agency activities were a small part of the bank's business and
were to be conducted entirely within Indiana.
I would also emphasize that the Board's Merchants
National interpretation pertains only where the nonbanking
activities are conducted directly by a holding company bank.
The.
Merchants National decision does not address the situation where
the activities are conducted by a nonbank company whose shares
are controlled by a holding company bank.
The Board has
cohsistently taken the position, in accordance with the explicit
terms of the Act, that shares of a nonbank company owned by a
holding company bank are indirectly controlled by the parent
holding company and, thus, a nonbank company controlled by a
holding company bank would be an indirect subsidiary of the
parent holding company.
As such, the ownership of the shares of
the company by the bank holding company as well as the activities
of the company must qualify under the closely related to banking
exception, or one of the other exceptions to the nonbanking
provisions in the Act.
In a 1971 regulation, however, the Board recognized a
limited exception to this requirement for the acquisition of socalled "operation subsidiaries" by holding company banks.
The
regulation authorizes a state bank owned by a bank holding
company to acquire and retain, without Bodrd approval under the
Act, all of the voting shares of a company so long as the company
engages solely in activities the parent bank could conduct
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directly and only at a location at which the bank could conduct
the activities.
The purpose of this regulation was to permit
holding company state banks to compete on an equal footing with
state banks that are not in a holding company system.
The Board
recognized that the regulation could potentially become the focus
for evasion of the nonbanking restrictions of the Act over time,
and therefore stated that it would review the merits of its
decision from time to time in light of its experience in
administering the Act.
In December 1988, in light of the increase in the
conduct of nontraditional activities, such as real estate
development, by state bank operating subsidiaries, the Board
asked for comment on whether the 1971 regulation should be
modified.
The Board held a hearing on its proposal in April
1989, and has not taken further action on the proposal.
In addition to its significance for interpreting the
scope of the Bank Holding Company Act, the Merchants National
decision also has important implications for the regulation and
supervision of the direct activities of holding company banks.
Had the court decided the Merchants National case the other way,
and determined that the direct activities of holding company
banks are subject to the nonbanking restrictions of the Bank
Holding Company Act, the activities of these banks would be
limited to those the Board has determined by regulation or order
to be closely related to banking.
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The fact that the Court held that the direct activities
of holding company banks are not subject to the nonbanking
restrictions of the Act does not mean, however, that their
activities are unregulated.
The activities of national banks are
determined by the Comptroller of the Currency under the
provisions of the National Bank Act, and the activities of statechartered banks are determined by the state banking laws under
the supervision of the state banking commissioner.
The
activities of state banks are further regulated at the federal
level— by the FDIC, in the case of insured state non-member
banks, and by the Board, in the case of state banks that are
members of the Federal Reserve System.
In exercising its supervisory authority over state
member banks, the Board has recognized the interest of the states
in regulating banking within their borders.
The dual banking
system has contributed, on balance, to the flexibility and
resiliency of the banking system, and has helped make it more
responsive to the needs of both business and consumers.
Nevertheless, a serious question must be raised about any state
action that might have the potential of posing undue risk to the
resources of the federal safety net.
The framework in place for
regulating and supervising state banks ensures that the federal
interest is taken into account.
While the states, as the
chartering authority, establish in the first instance those
activities that are permissible for state banks, limitations may
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be placed on these activities by the Board, in the case of state
member banks, and the FDIC, with respect to non-member federally
insured banks.
The Board has ample statutory authority, under the
Federal Reserve Act and related statutes, to ensure that the
activities of a state member bank are consistent with safe and
sound banking practices and do not pose an undue risk of loss to
the federal safety net.
Furthermore, as reinforced by the
International Lending Supervision Act, these statutes enable the
Board to require state member banks to maintain capital that is
adequate in relation to the character and condition of its assets
and liabilities.
The Board also has authority, under the
Financial Institutions Supervisory Act, as further amended and
strengthened by the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 ("FIRREA"), to prevent, by order or rule,
state member banks from engaging in activities that are unsafe or
unsound.
In granting applications by state banks to become
members of the Federal Reserve System, the Board takes into
consideration whether the conduct of certain activities directly
by banks could have a seriously adverse impact on the safety and
soundness of the institution and the nation's banking system.
The Board has required that banks applying for membership in the
Federal Reserve System not engage in activities that the Board
views as posing an undue risk for an institution with access to
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the federal safety net.
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In addition, a state member bank may
not, without obtaining the approval of the Board, cause or permit
any change to be made in the general character of its business or
in the scope of its corporate power exercised at the time of its
admission to membership.
For example, the Board has, as a general condition of
membership, not permitted state member banks to engage in real
estate development activities, even though approximately 25
states permit banks to engage in such activities.
Similarly,
state member banks may not make direct investments in securities
of less than investment grade, even where they are permitted to
do so under their state charters.
On the other hand, the Board
has not found state authorization of insurance agency activities,
which could be comparable to those conducted by Merchant
National's subsidiary banks, or of similar agency activities to
be inconsistent with Federal Reserve membership.
Agency
activities do not raise the risk-related and competitive concerns
that would justify placing restrictions on the state-authorized
powers.
Under the Federal Deposit Insurance Act and related
statutes, the FDIC possesses authority that parallels that of the
Board.
Just as the Board considers corporate powers of a state
bank when it acts on a bank membership application, the FDIC may
take into consideration whether the corporate powers of a non
member state bank are consistent with the purposes of the Federal
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Deposit Insurance Act when it acts on an application for deposit
insurance.
In enacting some of the key reform provisions of the
FIRREA, Congress recognized the risk to the federal safety net
that can be caused where federally insured state-chartered thrift
institutions are allowed to engage in a broad range of activities
without adequate regard for the federal interest.
In that
statute, Congress prohibited a state thrift from engaging as
principal in any type of activity that is not permissible for a
federal thrift unless both parts of a two-part test are
satisfied:
(1) the FDIC has determined that the activity in
question would pose no significant risk of loss to the deposit
insurance fund, and (2) the thrift has sufficient capital to meet
the fully phased-in capital standards prescribed in that statute.
It should be noted that the legislative history of the FIRREA
made it clear that the test of a "significant risk" of loss to
the deposit insurance fund is not the relative or absolute size
of the potential loss, but whether there is significant risk that
the insurance fund will suffer a loss if a state thrift engages
in the activity.
The FIRREA also prohibits a state thrift from acquiring
or retaining any equity investment of a type or in an amount that
is not permissible for a federal thrift to acquire and retain
directly.
This prohibition would apply to investments in real
estate and equity securities.
There is an exception for service
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corporations, where the FDIC determines that the investment would
not pose any significant risk of loss to the deposit insurance
fund and where the thrift meets applicable capital standards on a
fully phased-in basis.
The Board does not believe that legislative provisions
similar to those discussed above are necessary to limit the
activities of state-chartered banks, since a system similar to
that adopted by Congress is already in place.
As I have
discussed, the activities of state banks are currently subject to
the oversight of the FDIC or the Federal Reserve, as the case may
be.
In the case of state member banks, the Board has exercised
its authority to prevent activities or investments considered to
be too risky for a depository institution with access to the
federal safety net.
In conclusion, the Board believes that it has correctly
interpreted the Bank Holding Company Act in the Merchants
National case in determining that the nonbanking restrictions of
that Act do not apply to the direct activities of holding company
subsidiary banks.
While the conduct of nonbanking activities by
depository institutions that have access to the federal safety
net requires close attention, the Board also believes that the
current regulatory scheme, which includes federal supervision and
regulation of state-chartered federally insured institutions, is
adequate to ensure the appropriate degree of supervisory
oversight.
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