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TESTIMONY OF
RICKI HELFER
CHAIRMAN
FEDERAL DEPOSIT INSURANCE CORPORATION
ON
H.R. 1062, »'THE FINANCIAL SERVICES COMPETITIVENESS
ACT OF 1995" AND RELATED ISSUES
BEFORE THE
SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE
AND THE
SUBCOMMITTEE ON COMMERCE, TRADE AND HAZARDOUS MATERIALS
COMMITTEE ON COMMERCE
U.S. HOUSE OF REPRESENTATIVES
10:00 A.M.
JUNE 6, 1995
ROOM 2123 RAYBURN HOUSE OFFICE BUILDING
INTRODUCTION
Chairman Fields, Chairman Oxley and members of the
Subcommittees, I appreciate and welcome this opportunity to
present the views of the Federal Deposit Insurance Corporation on
the Financial Services Competitiveness Act of 1995, and related
issues.
I commend you for placing a high priority on the need
for structural reform of our financial system.
The FDIC supports a repeal of the Glass-Steagall
restrictions on the securities activities of commercial banking
organizations, provided that this is accompanied by the
appropriate protection to the deposit insurance funds.
In the
financial and regulatory environment of today, the Glass-Steagall
restrictions do not serve a useful public purpose.
Repeal of the
restrictions would strengthen banking organizations by allowing
diversification of income sources and better service to
customers, and would promote an efficient and competitive
evolution of U.S. financial markets.
History demonstrates, however, that expansion of the
activities of banking organizations must be accompanied by
adequate safeguards.
The controls that exist today to protect
insured institutions from the risks of related nonbanking
have generally proven satisfactory in the normal course
2
of business.
When banking organizations have experienced severe
financial stress, however, interaffiliate transactions have
occurred that have resulted in material losses to the deposit
insurance funds, although these have not been solely responsible
for any bank failures.
The FDIC has a special interest in the
adeguacy of safeguards to protect the deposit insurance funds.
My testimony contains several specific comments in this area.
Financial markets have changed dramatically since 1933, when
the Glass-Steagall Act first imposed a separation between banking
and securities underwriting activities, and since 1956, when the
Bank Holding Company Act further limited the activities of bank
affiliates.
To a greater extent than ever before, nonbanking
firms now are offering financial products that were once the
exclusive domain of banks.
Improvements in information
technology and innovations in financial markets make it possible
for the best business customers of banks to have access to the
capital markets directly, and, in the process, to bypass
traditional financial intermediaries.
Large corporations meet their funding needs through the
issue of commercial paper, debt securities, equity and through
loans.
The Glass-Steagall restrictions prevent most banking
organizations from providing the full range of funding options to
their customers.
The shrinking role of banks in lending to
business is illustrated by the declining proportion that bank
3
loans represent of the liabilities of nonfinancial corporations.
This share declined from about 22 percent in 1974 to 13.7 percent
at year-end 1994, the lowest proportion since these data were
first collected in the early 1950s.
Similarly, it is noteworthy
that banks have grown much less rapidly than other financial
intermediaries during the past ten years.
For example, banking
assets grew at an average annual rate of 4.8 percent, compared to
growth rates of 26.7 percent and 14.1 percent for mutual funds
and securities firms, respectively.
Attachment A shows average
annual growth rates of the assets of various types of financial
institutions for the past ten years.
There is indirect evidence which suggests that as banks have
lost their best business customers, they have to some extent
turned to riskier ventures such as construction finance and
commercial real estate loans.
Although the banking industry has
experienced record profits recently, the wide swings in past
performance indicate increased risks in the industry.
In the
last ten years, the banking industry achieved both its lowest
annual return on assets (approximately 0.09 percent in 1987) and
its highest return on assets (1.20 percent in 1993) since the
implementation of deposit insurance.
As discussed in Attachment
B, the volatile swings in the health and performance of the
industry may result in part from constraints that limit
alternatives for generating profits.
Restrictions that resulted
in the loss of many of their best corporate loan customers,
4
combined with the need to maintain profit margins and keep market
share, led many banks to increase their concentrations in
alternative high-yield assets.
Some of these investments, such
as construction and real estate development loans, loans to
developing—country borrowers and loans to finance highly
leveraged commercial transactions, carried higher, sometimes
unfamiliar, credit risks.
Other investments, including longer-
term fixed-rate securities and home mortgage loans, as well as
securities derivatives, increased the interest—rate risk of
banks.
Some might ask whether we are forgetting the lessons of an
earlier time —
the 1920s and 1930s.
Congress imposed the
restrictions of Glass-Steagall in reaction to the abuses of bank
securities affiliates and the perception that the abuses
contributed substantially to the banking crisis of the 1930s.
Attachment C to my testimony describes the historical evidence on
this subject.
The evidence generally suggests that the concerns
that bank securities activities played a major causal role in the
banking crisis were overblown, and that remedies other than the
Glass-Steagall restrictions would have addressed the abuses more
effectively.
When the historical debate is finished, however, we come to
this:
we have in place today a regulatory structure of
comprehensive banking and securities regulation that did not
\
5
exist: in 1933, including restrictions on interaffiliate
transactions.
Moreover, the marketplace has moved well beyond
the Glass-Steagall restrictions.
of the labels, are converging.
Financial products, regardless
The Glass-Steagall Act stands
like a dam in the middle of a mighty river that is finding other
channels for its inevitable currents.
On balance, I believe the
risks of eliminating the Glass-Steagall prohibitions can be
contained and that the benefits of an evolving marketplace
outweigh the costs.
Finally, I would argue that an easing of the broad range of
restrictions on activities of banking organizations beyond those
that are financial in nature should proceed in a cautious,
incremental manner.
Banking organizations have expertise in
managing financial risks.
We should develop a body of experience
to evaluate the safety-and-soundness implications of any new
financial affiliations, before allowing broader affiliations with
firms exposed to a different range of risks.
Setting aside real
estate development, the limited, but generally successful,
experience of the affiliation of savings associations with
commercial firms may provide a useful starting point for such an
evaluation in the future.
However, it does not provide a clear
model for intermingling the more comprehensive risk profile of
banking with commercial activities.
6
My testimony will first summarize the special concerns of
the FDIC, as deposit insurer, with respect to expanded activities
of bank subsidiaries and affiliates.
Next, I will discuss the
safeguards that are necessary to protect the deposit insurance
funds and the financial system.
I will then review the
advantages and disadvantages of particular organizational
structures with respect to the location of new securities
activities.
The balance of my testimony will focus on specific
provisions of the Financial Services Competitiveness Act of 1995.
PERSPECTIVE OF THE DEPOSIT INSURER
As the deposit insurer, the FDIC has a vital interest in the
safety and soundness of insured institutions and the integrity of
the deposit insurance funds.
Events of the past decade have
demonstrated how costly deposit insurance can be.
The Bank
Insurance Fund (BIF) and the banking industry have spent almost
$33 billion to resolve failing banks in the period from 1985 to
1994 (see Figure 1).
The thrift crisis, in contrast borne by the
taxpayers, has been estimated to cost $150 billion.
We cannot attribute all of the insurance losses to economic
events or poor management of depository institutions.
A
significant share of the responsibility must be assigned to
poorly planned efforts to deregulate financial services and
ineffective supervision in some areas.
Thus, it is imperative
FIGURE 1
Deposit Insurance Cost - Ten Years Ending 1994
FDIC Bank Insurance Fund
$7
(In $ Millions)
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
Estimated Losses
1,099
1,722
2,007
6,721
6,273
2,856
6,739
4,695
570
139
Insurance Premiums
(assessments)
1,433
1,517
1,696
1,773
1,885
2,855
5,161
5,588
5,784
5,591
Cumulative Deposit Insurance Cost - Ten Years Ending 1994
FDIC Bank Insurance Fund
On $ Millions)
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
Estimated Losses
1,099
2,821
4,828
11,549
17,822
20,678
27,417
32,112
32,682
32,821
Insurance Premiums
(assessments)
1,433
2,950
4,646
6,419
8,304
11,159
16,320
21,908
27,692
33,283
The 1994 figure reflects rebates to some institutions that appealed their 1993 assessments.
Sources: 1993 FDIC Annual Report and FDIC Failed Bank Cost Analysis, 1986 -1993.
7
that we proceed deliberately as we contemplate a substantial
expansion of the powers available to banking organizations.
In the ten-year period ending December 1994, there were
1,368 failures of institutions insured by the BIF, accounting for
almost two-thirds of the 2,121 failures that have occurred since
the inception of federal deposit insurance in 1933.
These failed
banks had combined assets of $236 billion, and cost an estimated
$32.8 billion to resolve.
The number of failures reached an
annual record level of 221 in 1988, while the losses and combined
assets of failed banks peaked in 1991.
The 13 bank failures in
1994 were the fewest since ten banks failed in 1981, and speak to
the significantly improved financial condition of the banking
industry.
While a number of factors contributed to the rise and
decline of bank failures during this period, two elements —
the
phenomenon of "rolling regional recessions," coupled with
constraints on geographic diversification in some regions
reflected in the geographic patterns of failures.
are
The
agricultural Midwest, the Southwestern oil states, New England,
and California all experienced sharp increases in bank failures
in the past decade, stemming in large part from regional economic
downturns.
In general, the largest losses to the FDIC occurred
in those states where regional recessions have been most severe.
8
The most costly failures can be linked to excessive
concentrations in commercial real estate lending and construction
and land development loans.
Rapid accumulation of these loans
preceded the rise in failures in the Southwest and Northeast, the
regions where the FDIC losses were greatest.
An FDIC study
published in 1990 found that failing banks in Texas increased
their concentrations in these assets long after the decline in
local real estate markets had begun.
Failed savings banks in New
England also had much higher proportions of their balance sheets
invested in construction and land development loans, where they
had little previous experience.
There are two lessons to be drawn from these experiences.
First, inadequate diversification of income sources is dangerous
for banking organizations.
This is an argument in favor of the
repeal of the Glass—Steagall restrictions.
in lending by insured institutions —
activities —
Second, rapid growth
particularly in unfamiliar
can result in significant losses.
This emphasizes
the need for strong supervision and monitoring by the regulators
using adequate safeguards to protect insured financial
institutions.
9
The Demise of the FSLIC
The experience of the thrift industry in the 1980s serves as
an even stronger reminder of the importance of maintaining
safety-and-soundness standards.
The highlights of the experience
bear repeating as we consider the expansion of activities of
banking organizations.
In the early 1980s, most of the thrift
industry was economically insolvent due to interest-rate-induced
losses from lending longer term at lower interest rates and
borrowing short-term at higher interest rates.
Rather than
address the problems directly, the political and regulatory
response was to relax capital and accounting standards, forbear
from closing insolvent institutions, and expand the powers
available to thrifts.
Federal legislation in the early 1980s significantly
liberalized the permissible assets of thrifts.
By 1982, thrifts
could make commercial mortgage loans of up to 40 percent of
assets, consumer loans up to 30 percent of assets and commercial
loans and leases each up to 10 percent of assets.
By midyear
1983, the Federal Home Loan Bank Board (FHLBB) allowed federally
chartered savings and loan associations to invest up to 11
percent of their assets in high-risk bonds.
Direct equity
investments in real estate, equity securities and in subsidiary
service corporations were permitted up to 3 percent of assets.
Several states permitted state-chartered institutions
10
significantly greater scope for direct investments.
The attempt
by many troubled institutions to use the new powers to "grow
themselves out of their problems" added substantially to the cost
of the thrift crisis.
Some might argue that the experience of thrifts in the 1980s
is irrelevant today.
I would disagree.
Wherever there is a
government guarantee, there will be some who attempt to exploit
it inappropriately.
risks.
Mechanisms must be in place to contain these
In addition, the supervisory staff that has been trained
to detect losses from traditional activities will need to become
familiar with the risks and potential losses associated with the
new activities.
We also must keep in mind the extent to which a strong
deposit insurance system depends on a sound regulatory structure
as we eliminate the Glass-Steagall barriers.
Securities
activities of banking organizations should be subject to the
regulation of the Securities and Exchange Commission (SEC).
As
securities activity increases in the banking industry, so will
the role of functional regulation and the need to coordinate the
distinct regulatory approaches.
Supervision has been the
keystone of the regulation of commercial banking, while
disclosure and market discipline have been the key elements of
securities regulation.
The challenge will be to combine these
approaches in a seamless fashion that permits no gaps that might
11
threaten the insurance funds, and yet avoids burdening banks with
regulatory overlap.
Finally, as banking organizations enter new activities, care
should be taken to confine deposit insurance protection
appropriately.
Securities markets in the United States are
dynamic and innovative? they have expanded the growth potential
of the economy and have become the envy of the world.
Our
securities markets do not need the backing of the deposit
insurance guarantee, nor do they need the added requirements of
bank regulation that come with it.
To promote the continued
efficiency of securities markets, as well as to protect the
insurance funds from undue risk, it is critical to separate the
insured entity from the securities units of the banking firm.
This will be addressed more extensively in the following
discussion of necessary safeguards to the insurance funds and the
appropriate structure for the conduct of new activities by
banking organ izat ions.
PROTECTION FOR THE INSURANCE FUNDS
My testimony has emphasized that in expanding the securities
activities of banking organizations, we must not lose sight of
the need to maintain the safety and soundness of insured
institutions.
This requires protection against inappropriate
12
transactions between insured institutions and their securities
subsidiaries and affiliates.
In general terms, there are two areas of concern from an
insurance standpoint with respect to transactions between an
insured institution and a related securities firm.
The first
involves the inappropriate use of an insured institution to
benefit a related securities firm in the course of business.
A
second arises when an insured institution is in danger of
failure.
In the latter situation, there is an incentive for the
owners and creditors of the related entities to extract value
from the insured entity prior to its failure in order to maximize
the share of losses borne by the FDIC and minimize their own
losses.
The FDIC's experience suggests useful lessons regarding
necessary protections for the insurance funds in both areas.
There are numerous ways an insured institution could benefit
a related securities firm in the course of business.
include:
These
direct equity injections to a securities subsidiary;
upstreaming of dividends to a parent that are used to inject
equity to a securities affiliate; purchasing of assets from, or
extensions of credit to, the related firm; issuing a guarantee,
acceptance or letter of credit for the benefit of the related
firm; extending credit to finance the purchase of securities
underwritten by the related firm; and extending credit to the
issuers of securities underwritten by the related firm for
13
purposes of allowing the issuers to make payments of principal,
interest or dividends on the securities.
There are three main dangers in such transactions from the
standpoint of the deposit insurer.
First is the danger that the
consolidated entity will attempt to use the resources of the
insured institution to promote and support the securities firm in
a way that compromises the safety and soundness of the insured
institution.
An equally important concern is that the business
relationship between the insured entity and the securities firm
will create a misperception that the investment products of the
securities firm are federally insured.
Finally, there is the
danger that the business and operating relationship will cause
the courts to "pierce the corporate veil" —
that is, to hold the
insured entity responsible for the debts of the securities firm
in the event the securities firm fails.
Current law provides a number of safeguards against these
dangers.
Attachment D provides a summary of some of the major
provisions.
We must be concerned with how well these safeguards
will work after Glass-Steagall restrictions are lifted.
The
experience with the involvement of banks with securities
activities has to this point been limited, but generally
favorable.
Since 1987, the Federal Reserve has allowed limited
securities activities in so-called "Section 20 subsidiaries" of
bank holding companies.
The Federal Reserve indicates that there
14
have been no instances in which a Section 20 subsidiary adversely
affected an affiliated bank.
There are currently 36 bank holding
companies that have Section 20 subsidiaries; these subsidiaries
range in size from a few million dollars in assets to tens of
billions of dollars in assets.
There has been one failure of an
insured institution affiliated with a Section 20 subsidiary.
The
Section 20 subsidiary played no role in causing the failure.
U.S. banks also are permitted to engage in securities
activities overseas within various limitations.
Typically these
activities are conducted by subsidiaries of Edge Corporations,
which, in turn, are generally subsidiaries of U.S. banks.
Federal Reserve staff indicate that these activities have not
posed any significant safety-and-soundness problems for U.S.
banks.
The FDIC permits institutions it supervises to engage in
securities activities through "bona fide subsidiaries” —
that
is, subsidiaries that meet certain criteria designed to ensure
corporate separateness from the insured banks.
A detailed
description of the bona fide subsidiary structure and the FDIC's
regulatory safeguards in place to insulate the insured
institution is included in Attachment D.
More limited activities
are permissible to subsidiaries that do not meet the "bona fide"
subsidiary test.
15
The experience of banking organizations conducting
securities activities through such subsidiaries has been limited.
Currently, only one FDIC-supervised institution owns a subsidiary
actively engaged in the full range of securities activities
permitted by the FDIC.
There are, however, over 400 insured
nonmember banks that have subsidiaries engaged in more limited
securities-related activities.
These include management of the
bank's securities portfolio, investment advisory activities, and
acting as a broker/dealer.
With one exception, none of these
activities has given cause for a significant safety-and-soundness
concern.
There has been one failure of an insured institution
supervised by the FDIC that conducted securities activities
through a subsidiary.
While not the sole cause of the failure,
the business relationship with the securities subsidiary added to
the cost of the failure.
The bank made a substantial unsecured
loan that was used to benefit the securities subsidiary.
This
transaction was in compliance with the restrictions on affiliate
transactions of Section 23A of the Federal Reserve Act because
Section 23A does not specifically apply to transactions between a
bank and its subsidiary.
Given the Federal Reserve's residual
rulemaking authority with respect to Sections 23A and 23B, we
will work with the Federal Reserve to determine whether the
provisions of Sections 23A and 23B should be extended to apply to
16
these subsidiaries.
We would also support an amendment to the
legislation to assure coverage of these kinds of transactions.
The experience with bank-sponsored mutual funds has also
been free of substantial safety—and—soundness concerns.
Nevertheless, this experience demonstrates that the mixing of
banking with securities activities is not without risk.
Within
last year, 12 banking organizations have elected to provide
assistance to their proprietary money-market mutual
funds.
The assistance has ranged from $1 million to about $83
million.
The decisions to provide assistance presumably
reflected business judgments that weighed the cost of the
assistance against the loss of reputational capital that these
organizations would have sustained if investors in their mutual
funds had suffered losses.
None of these episodes posed any serious safety-andsoundness concerns to the insured entities.
In all but two
cases, the assistance was provided by the holding company rather
than the bank, and in no case did the assistance exceed
approximately one percent of the consolidated capital of the
holding company.
Nevertheless, the instances serve as a reminder
that banking organizations can have an incentive to manage their
businesses as a unit, and the result may involve the transfer of
resources among affiliates that can adversely affect the insured
entity«
17
The affiliation of banking and securities activities as it
currently exists in both bank subsidiaries and bank affiliates
has, in general, not presented significant safety-and-soundness
concerns.
This experience suggests that current safeguards are
for the most part adequate and that any reform of Glass-Steagall
should include similar safeguards against dealings between the
insured bank and a securities affiliate.
Although the experience thus far has been generally
positive, it has been limited.
As mentioned above, we have not
seen the combination of a failed or severely distressed bank that
was associated with significant securities activity.
This is
important from the perspective of the deposit insurer because the
past decade provided examples where distressed banks breached
statutory or regulatory protection of the insured bank to the
detriment of the FDIC.
While none of the interaffiliate transactions were solely
responsible for the failure of any insured institutions, there
were a number of instances where “deathbed transactions” were
proposed or consummated that served to advantage the holding
company or an affiliate at the expense of the insured bank.
transactions often involved sums in the tens of millions of
dollars.
approval.
that did.
Not all of these transactions required regulatory
The regulators often, but not always, denied those
The
18
Unpaid tax refunds arose as an issue in more than one case.
Bank holding companies generally receive tax payments from and
downstream tax refunds to their banking subsidiaries, acting as
agent between the bank and the Internal Revenue Service.
The
FDIC has observed that in some cases unpaid tax refunds
accumulated on the books of failing bank subsidiaries, leaving
the cash with the holding company.
This practice occurred
without regulatory approval.
Consolidation of nonbank activities at the parent level is
another way to transfer value away from insured bank
subsidiaries.
One notable case involved the consolidation of
trust operations at the subsidiary banks into a single parentowned company that was later sold at a profit.
When service
company affiliates carry out data processing or other activities
for banks, the issue of intercompany pricing also is raised.
In
one case the FDIC observed a large and retroactive increase in
charges by an asset management company to troubled bank
affiliates.
In other cases, service company affiliates failed to
provide promised overhead reimbursement for the use of bank
premises.
Linked deals involving the sale of purchased mortgage
servicing rights have in some cases been used either to subsidize
the sale of a holding company asset or to allow the bank
subsidiary to book an accounting gain.
The effect of a linked
19
deal may be to either transfer value to the parent or delay the
closing of a subsidiary without the benefit of needed fresh
capital.
Finally, there have been instances of "poison pills" created
by interaffiliate transactions.
In one case, key bank staff were
transferred to the holding company payroll, apparently to reduce
the attractiveness of bringing in an outside acquirer.
Interaffiliate data processing contracts also have been
structured so as to limit the availability of information to the
FDIC or an acquirer after the bank was closed, thereby making
regulatory intervention more costly.
To summarize, factors other than interaffiliate transactions
typically have caused the failure of FDIC-insured subsidiaries of
bank holding companies.
However, such transactions were used in
several cases to extract value from the insured bank just prior
to its failure at the expense of the deposit insurance fund.
This generally did not come about through excessive dividends or
the transfer of blatantly misvalued assets.
They more often
occurred through the pricing of services traded between
affiliates, early retirement of subordinated debt and linked
deals involving third parties.
These transactions probably added
tens of millions of dollars to the losses realized in resolving
these large banking organizations.
20
Some of the most spectacular examples of inappropriate
intercompany transactions come from the thrift industry in the
1980s.
Thrifts have traditionally spawned a variety of
subsidiary service corporations to perform tasks such as mortgage
servicing, brokerage, title insurance and other types of
insurance.
With the liberalization of federal and state
restrictions on direct real estate investment in the early 1980s,
^*e real estate development subsidiary became a common vehicle
these activities.
However, while federally chartered
institutions in the early— to mid-1980s were limited to investing
3 percent of assets in these activities, state—chartered
institutions in California and Texas could make virtually
unlimited direct investments.
Two factors made this liberalization of powers particularly
conducive to creating losses for the Federal Savings and Loan
Insurance Corporation (FSLIC) and later the Resolution Trust
Corporation (RTC).
First, under regulatory accounting practices,
direct investments in subsidiaries were carried on the books of
the parent thrift at historical cost, instead of their market
value, which was often considerably lower.
Second, thrift
regulators as a rule neglected to conduct detailed examinations
subsidiary operations.
Under these conditions, thrift
managers were free to invest in residential and commercial real
estate development activities with which they had little
experience, and when these projects became problematic they could
21
use a variety of transactions to hide the losses.
The thrift
could make unsound loans to help sell new properties built by the
subsidiary.
In some cases the thrift would sell the note to the
subsidiary, removing it from the balance sheet for a period.
Our review of the examples described above suggests that,
for the most part, the problem has not been that the existing
protections were inadequate.
Instead, it appears that the
regulatory community has been reluctant at times to enforce these
protections.
This reluctance is understandable to some extent,
given the considerable uncertainties that surround banks in
distress and the desire to mitigate market pressures that may
unnecessarily aggravate the plight of those banking organizations
that have a chance to survive.
What steps can be taken to encourage more vigilant
enforcement of protections?
First, the enforcement of safeguards
against transactions between an insured bank and its securities
affiliates should allow for few exceptions.
Congress should
consider whether the perspective of the FDIC as insurer would be
useful in identifying, through guidelines or other means, those
limited areas where exceptions to the safeguards may be
beneficial without creating the potential for losses to the
insurance funds.
In addition or in the alternative, it may be
useful to develop an interagency codification of the standards
for enforcing Sections 23A and 23B of the Federal Reserve Act, so
22
that insured financial institutions and all regulatory agencies
have clear notice and fuller understanding of the nuances of
these safeguards.
Second, while sound business judgment should
dictate when healthy, well-capitalized banks provide support to
related entities, such support should come through the transfer
of excess bank capital —
beyond the capital required for a well-
capitalized bank —— not through the relaxation of safeguards such
as those discussed earlier.
For bank holding companies, this
means the well—capitalized bank could provide dividends that
allow the parent to provide support to nonbank subsidiaries.
For
banks conducting activities in subsidiaries, the bank could make
additional equity investments in the subsidiary and those
investments should be deducted from bank capital before
determining whether the insured bank meets the standard of being
well-capitalized.
In addition, bank regulators may want to consider whether to
require prompt reporting of intercompany transactions under
certain conditions, as the SEC does in some contexts.
These
requirements may be tied to the capital level of the bank, the
size of the transaction, or other relevant factors.
As the deposit insurer, it is the FDIC's responsibility not
only to protect depositors when a bank fails, but also to learn
from the failure of that bank.
The FDIC is prepared to provide
information and analysis to fellow regulators where there is
23
evidence that intercompany transactions have contributed to the
failure of, or increased the cost of resolving, an insured
institution.
Such reports would contribute to an increased
understanding and awareness of these issues, and we believe
ultimately would promote improved enforcement of the safeguards.
STRUCTURAL ISSUES
An important consideration in the deliberations concerning
the possible combination of traditional commercial banking and
securities activities is the organizational structure under which
such combinations would be permitted.
deposit insurer focuses on.two issues:
The perspective of the
the ability to insulate
the insured bank from the risks of the securities underwriting
activities and the burdens and inefficiencies associated with a
particular regulatory structure.
The following analysis
addresses these issues.
There are two organizational structures with which we have
experience in the United States that can be used to combine
commercial and securities underwriting activities.
These are:
(1) the conduct of each activity in separate organizations owned
and controlled by a common "parent” organization (the "bank
holding company" model)? and (2) the conduct of each activity in
a separate organization, one of which owns and controls the other
entity (the "bona fide subsidiary" model).
A third model —
the
24
conduct of both activities within the same entity (the "universal
banking” model) —— has been used in some other developed
countries.
For reasons discussed in Appendix B, I believe that
universal banking is not a model that would best fit the dynamic
financial marketplace in the United States or provide sufficient
protection for the deposit insurance funds against the effects of
potential conflicts of interest between banking and nonbanking
functions in an insured entity.
The Bank Holding Company Model
Since the adoption of the Bank Holding Company Act of 1956,
one of the primary methods of expanding permissible activities
beyond those associated with traditional commercial banking has
been through formation of affiliated entities within the bank
holding company umbrella.
Within this framework, banking
organizations have been permitted to engage in an increasing
array of financial services.
Most recently, some bank holding
companies have been permitted by the Federal Reserve to engage in
corporate securities underwriting activities through so-called
"Section 20" subsidiaries.
Attachment E describes in detail the
prohibitions and restrictions on securities activities that are
imposed by Section 20 of the Glass-Steagall Act and by the Bank
Holding Company Act.
25
In terms of the criteria for safeguards set forth earlier,
the bank holding company model has considerable merit.
The
advantages include:
•
Provision of a good framework for monitoring
transactions between insured and non-insured affiliates
and for detecting transfers of value that could
threaten the insured institution; and
•
Maintenance of a meaningful corporate separation
between insured and non-insured organizations to assure
that nonbank affiliates have no competitive advantages
from the insured status of the bank.
The disadvantages of the bank holding company model include:
•
In distressed situations, the parent will have the
incentive to transfer or divert value away from the
insured bank, leaving greater losses for the FDIC if
the bank ultimately fails; and
•
The holding company model requires bank owners to
establish and maintain an additional corporation.
This
may add costs, inefficiencies, complexity and, in some
cases, an additional regulator.
26
Bona Fide Subsidiary Mod^l
From a practical perspective, there has been less experience
with the "bona fide" subsidiary form of organization than with
the bank holding company form.
ear^-^-er‘
However, the experience discussed
this testimony supports the view that direct ownership
of a securities firm by an insured bank need not be significantly
different from the bank holding company model in terms of
affording protections to the deposit insurance funds, and may
have some additional advantages.
Analytically, there are several factors that make this
approach different from the bank holding company model.
The
advantages of the bona fide subsidiary approach include:
The residual value of the subsidiary accrues to the
bank, not the holding company; and
The bank, rather than the parent, controls the
allocation of excess capital of the organization.
This
may mean that in making corporate investment decisions,
greater weight will be given to the needs of the
insured bank.
Financial investments will be structured
to diversify the risks of the bank's portfolio, while
investment in systems and physical capital will benefit
the operations of the bank.
27
However, on the negative side:
•
While corporate separateness theoretically can be
maintained regardless of organizational structure, in
practice, a bank holding company structure may be a
more effective vehicle for this purpose;
•
Inappropriate wealth transfers may be more easily
executed if made directly to a subsidiary, rather than
indirectly to the parent and then to an affiliate? and
•
Consolidated earnings of a bank that includes a fully
consolidated securities firm may exhibit more
volatility than the bank alone.
This may be negatively
perceived by the market, and might inhibit the ability
of banks to raise capital or attract funds at market
rates.
Based on these observations, it is clear that there are
advantages and disadvantages to both models.
Furthermore, the
safeguards that are necessary to protect the insured bank and
ultimately the insurance funds can be similar for either
structure.
If these safeguards are in place and enforced, either
approach will work.
If safeguards are inadequate or there is not
a strong commitment to enforcing them, the deposit insurance
28
funds, the financial system and the public will suffer,
regardless of which model is used.
In the final analysis, I favor allowing financial
institutions to choose the model that best suits their business
needs, as long as strong safeguards are in place to protect the
insurance funds.
Legislation based on a progressive vision of
the evolution of financial services need not mandate a particular
structure.
A combination of flexibility and sound regulation has
contributed to the successful development of the U.S. financial
system, and these key elements should be present in any proposal
for reform.
COMMENTS ON THE FINANCIAL SERVICES COMPETITIVENESS ACT OF 1995
I
want to commend the Subcommittee Chairmen again for
holding this hearing to serve as a focus for debate on how best
to achieve financial services reform.
The Financial Services
Competitiveness Act of 1995, as reported from the Committee on
Banking and Financial Services ("the bill"), is designed to
enhance competition in the financial services industry by
providing a prudential framework for the affiliation of banks and
securities firms.
It accomplishes this by eliminating current
statutory restrictions on these affiliations and establishing a
comprehensive framework for affiliations within a holding company
29
structure overseen by the Federal Reserve with functional
regulation of securities activities by the SEC.
As discussed earlier in my testimony, the protections
against inappropriate intercompany transactions provided in the
bill are sound.
I would expect that any exceptions to these
restrictions that could be made pursuant to the legislation would
be structured to protect the deposit insurance funds from
potential losses.
Moreover, provided the appropriate protections
are in place, I would support an approach that allows a
commercial bank the flexibility to conduct securities activities
in an affiliate of its holding company where the bank has a
holding company or wishes to organize one, or in a subsidiary of
the bank where that approach more effectively conforms to the
business plan of the organization.
I recognize, however, that
the bill would permit additional securities activities to be
conducted only under the holding company structure.
While I do
not believe the advantages of the bank holding company structure
are so pronounced as to justify imposing additional costs on the
banking system by mandating a particular structure, I support the
bill as a reasonable balancing of the competing considerations of
safety and soundness and additional flexibility for banking
organizations.
30
Criteria for Approval
Turning to a more detailed discussion of the bill, any
expanded authority may be exercised only through a financial
services holding company structure and only when the Federal
Reserve has concluded that certain procedural safeguards have
been met.
The criteria outlined in the bill are sensible and
appropriate.
Only financial services holding companies that are
adequately capitalized are eligible to acquire a securities
affiliate.
For purposes of determining whether a financial
services holding company is adequately capitalized, the holding
company's capital and total assets are reduced by the holding
company's equity investment in any securities affiliate, and
fu*"kher reduced by certain extensions of credit to any securities
affiliate.
The lead bank within the holding company must be wellcapitalized before the holding company is eligible to acquire a
securities affiliate.
Moreover, 80 percent of the aggregate
total risk—weighted assets of the holding company's depository
institutions must be controlled by well—capitalized institutions,
excluding certain recently acquired depository institutions.
subsidiary depository institutions controlled by the holding
company must be well—capitalized or adequately capitalized.
All
31
Well-capitalized financial services holding companies may
elect alternative capital treatment, however.
A financial
services holding company and its depository institution
subsidiaries will be deemed to have satisfied the capital
requirements prescribed by the bill if the holding company files
a notice of its election for alternative capital treatment with
the Federal Reserve; all of the holding company's depository
institutions are at least adequately capitalized; and the holding
company is well-capitalized and would continue to be wellcapitalized immediately after the acquisition of the securities
affiliate.
Any holding company that elects such alternative
capital treatment will be liable for any loss incurred by the
FDIC in connection with the default of any insured depository
institution controlled by the holding company.
We support these provisions.
I believe these provisions
help to preserve a strong capital cushion for the bank and the
financial services holding company as a possible source of
strength for its banking subsidiaries.
It is appropriate to
impose losses incurred by the FDIC on holding companies that
elect the alternative capital treatment described above.
The bill properly provides an incentive to financial
services holding companies and their depository institutions to
maintain adequate capital levels after they have been allowed to
affiliate with a securities company.
In the event the lead
32
depository institution drops below the well—capitalized category,
or if well-capitalized institutions cease to control 80 percent
of the aggregate total risk-weighted assets of the depository
institutions within the holding company, the holding company must
execute an agreement with the Federal Reserve to meet the
prescribed capital requirements within a reasonable period of
time or to divest control of the depository institution within
180 days (or such additional period of time as the Federal
Reserve may determine is reasonable).
If the holding company
fails to execute such an agreement or fails to comply with such
an agreement, the securities affiliate cannot agree to underwrite
or deal in any securities starting 180 days after the capital
deterioration, with limited exceptions.
While there are
certainly instances where, as provided for in the bill, the
securities affiliate should be barred from agreeing to underwrite
or deal in any securities, such a blanket prohibition may not be
P^u^snt in all cases.
For example, a profitable securities
may serve as a source of strength to a holding company
and its bank subsidiary.
At the same time, however, we note that the bill gives the
Federal Reserve the authority to waive the capital safeguards for
up to two years if the financial services holding company submits
a recapitalization plan for the banks.
We have an interest in
assuring that a waiver will be granted only in situations where
greater safety and soundness can be expected to result and losses
33
to the insurance fund are not likely to be increased.
For that
reason, we want to work with the Federal Reserve on an
interagency basis to develop guidelines on when waivers of these
safeguards would be appropriate.
In addition to capital conditions, the bill imposes a broad
array of managerial safeguards and internal controls.
The
holding company and all of its depository institutions must be
well-managed.
The financial services holding company must have
the "managerial resources" necessary to conduct the securities
activities safely and soundly.
The holding company must have
adequate policies and procedures in place to manage any potential
financial or operational risks.
In addition, the holding company
must have established adequate policies and procedures to provide
reasonable assurance of maintenance of corporate separateness
within the financial services holding company.
Finally, the
acquisition must not adversely affect the safety and soundness of
the financial services holding company or any depository
institution subsidiary of the holding company.
These operational
safeguards, particularly the emphasis on maintaining corporate
separateness, are well—designed to insulate federally insured
banks from the risks of securities activities.
The bill provides that a holding company's acquisition of a
securities affiliate must not result in an undue concentration of
resources in the financial services business.
The bill also
34
provides that the lead depository institution subsidiary as well
as the depository institutions controlling at least 80 percent of
the aggregate total risk-weighted assets of all depository
institutions controlled by the holding company must have achieved
a satisfactory record of meeting community credit needs during
the most recent examination.
We support these provisions.
The bill also places several interaffiliate safeguards on
the relationship between a securities firm and its affiliated
bank or parent holding company.
For example, a depository
institution affiliated with a securities affiliate is prohibited
from extending credit to the securities affiliate, issuing a
guarantee, acceptance, or letter of credit for the benefit of the
securities affiliate or, with certain exceptions, purchasing
assets of the securities affiliate for its own account.
support these safeguards.
I
In moving from a framework based on
Prohibition to one based on regulation, prudential safeguards
such as those set forth in the bill will avert the hazards GlassSteagall was intended to prevent.
In addition, the bill provides for some exceptions to the
safeguards for well-capitalized banks.
For example, a well-
capitalized institution may extend credit for the purpose of
enhancing the marketability of a securities issue underwritten by
its securities affiliate but only if the depository institution
has adopted limits on its exposure to any single customer whose
35
securities are underwritten by the affiliate and the transaction
is on an arm's-length basis.
This appears to be a reasonable
exception to the safeguards.
The FDIC would like to work with
the Federal Reserve to assure that in practice, any additional
exceptions to the safeguards will not present substantial risks
to the deposit insurance funds.
Some may argue that the safeguards provided for in this bill
would hamper the ability of a financial services holding company
to compete against non-regulated entities and would impede its
ability to realize business synergies.
The potential for risks
associated with the conduct of such activities by an entity
affiliated with insured depository institutions, however, carries
with it the need for some protections for the insured
institution.
The bill draws an appropriate balance between these
competing considerations.
I
also support the additional safeguards for director and
senior executive officer interlocks.
Finally, I support the
various public disclosures included in the bill.
In particular,
I strongly support the requirement that customers be informed
that the securities offered or sold by securities affiliates of
insured banks are not federally insured deposits.
This is an
important protection for these customers and for the deposit
insurance funds.
36
Existing Bank Securities Activities
The bill provides that, subject to discretionary
determinations by the SEC or the Federal Reserve, banks could
continue to conduct some existing securities activities within
the bank.
Some of these activities must be moved to a Separately
Identifiable Department (SID) and some activities must be moved
to an affiliate —
both of which would be functionally regulated
by the SEC.
While there is no separate capital requirement for SIDs, the
risk associated with the activities conducted through the SID is
included currently in the assessment of the bank's overall
capital adequacy.
In addition, bank regulators are in the
process of developing a proposed amendment to more formally
incorporate market risks associated with underwriting and dealing
activities into their capital adequacy requirements.
Concerns have been raised about the provisions of the bill
that provide for discretionary determinations of the SEC and the
Federal Reserve with respect to what is a security or a bank
product and where such activities can be conducted.
Such
determinations could result in limitations or unnecessary
regulatory burdens on activities that have been conducted within
the bank for many years without posing significant safety-andsoundness problems.
We believe that there may be some room for
37
further refinement of these provisions in order to avoid
unnecessary organizational or regulatory burdens.
Functional Regulation
With respect to regulation, the bill calls upon the banking
agencies and the SEC to work together to ensure compliance with
the securities laws.
As I mentioned earlier in my statement,
functional and supervisory regulation must be seamless to be
effective.
By calling for the banking agencies and the SEC to
share information, the bill promotes this goal by facilitating
coordination among the regulatory agencies.
Further refinement
may need to be made to the provisions of the bill with respect to
SEC and Federal Reserve discretion in order to avoid the
possibility of duplicative supervisory and reporting burdens.
Securities Firms
The bill creates the possibility for securities firms to
become affiliated with banks by acquiring an insured bank and
becoming a financial services holding company.
In circumstances
where more than 50 percent of a company's business involves
securities activities, the bill allows the company five years,
with the possibility of an additional five-year extension, to
divest its nonfinancial activities.
In addition, such a company
could be permitted to continue holding any subsidiaries engaged
38
in financial activities that the Federal Reserve has not
authorized if the company acquired the subsidiaries more than two
years prior to its becoming a financial services holding company
and the aggregate investment by the company in these subsidiaries
does not exceed 10 percent of the total consolidated capital and
surplus of the company.
The company would not be permitted to
engage in any new activities not otherwise authorized by the bill
once it becomes a financial services holding company.
This means
that some securities companies that become financial services
holding companies could be permitted to engage in activities not
otherwise permitted generally to financial services holding
companies.
I
support in general the approach of the bill with respect
to the affiliation of a securities firm with an insured
institution.
If it is understood that prudential restrictions
may be imposed by the Federal Reserve where necessary to protect
the safety or soundness of an insured institution with respect to
a grandfathered affiliate's activities, I see no reason to go
further and require divestiture.
Further, it should be clear
that each of the banking agencies should be able to apply the
full panoply of enforcement powers, ranging from cease-and-desist
actions to deposit insurance termination, in order to protect an
insured bank and the deposit insurance funds.
39
Wholesale Financial Institutions
The bill provides the additional option of an "investment
bank holding company” (IBHC) that would be allowed to engage in a
broader range of financial activities and could conduct banking
activities through a "wholesale financial institution" (WFI).
WFIs would be uninsured state member banks that could, with
certain exceptions, only take initial deposits over $100,000.
This provision allows for a wholesale banking operation to
conduct a broader range of financial services activities without
exposing the deposit insurance funds to the risks of these
activities.
The IBHC concept may prove attractive to some financial
firms and may even cause some FDIC-insured banks to consider
terminating their deposit insurance.
The proposed IBHC appears
to the FDIC to be sound as long as there is clear disclosure to
the public of the uninsured nature of commercial bank operations
and the exceptions for initial deposits of $100,000 or less are
appropriately limited and clearly defined for public disclosure
purposes.
40
Holding Company Supervision
The bill provides a different supervisory structure for
holding companies engaged primarily in nonbanking activities.
Certain financial services holding companies and investment bank
holding companies, that have relatively smaller percentages of
consolidated risk-weighted assets in depository institution
assets, would be under limited reporting and examination
requirements and minimal approval requirements for new
activities.
As insurer, the FDIC finds this approach reasonable,
and adequate, to provide for the identification of risks
associated with nonbanking activities.
Capital requirements and
guarantee provisions protect the insured depository institutions
and maintain a degree of supervision that while appropriate, does
not unduly disadvantage financial services holding companies or
investment bank holding companies with respect to unregulated
entities.
Voluntary Termination of Insured Status
In order to facilitate transition by existing insured
depository institutions to WFI status, the bill adds a new
section governing voluntary termination of deposit insurance and
repeals certain provisions of the FDI Act with respect to such
termination.
The bill would permit an "insured State bank" or a
national bank to voluntarily terminate its status as an insured
41
depository institution upon six months' written notice to the
FDIC, the Federal Reserve, and the institution's depositors.
Before a bank may terminate its insurance under this provision,
the deposit insurance fund must equal or exceed the fund's
designated reserve ratio (DRR) of 1.25.
In addition, the FDIC
must confirm that the insurance fund will continue to equal or
exceed the fund's DRR for the two semiannual assessment periods
following notification of the institution's intent to terminate
insurance.
If the insurance fund does not meet its DRR, the bank
must pay an exit fee and obtain the approval of the FDIC and the
Federal Reserve.
The FDIC is required to prescribe procedures
for assessing any such exit fee by regulation.
The FDIC currently has in place procedures governing the
termination of insurance.
The legislative provisions described
above appear to be intended to prevent the dilution of the fund
for which coverage would be terminated.
However, because a
termination of insurance has the effect of increasing, not
decreasing, the reserve ratio of the affected fund, Congress may
wish to reconsider this provision.
Moreover, the requirement
that the FDIC confirm that the insurance fund would not fall
below the DRR for one year following notification of the intent
to terminate insurance would be very difficult to satisfy.
Thus,
the provision could have the unintended effect of precluding the
transition of insured institutions to WFI status and of
preventing voluntary terminations of insured coverage where no
42
disadvantage to the deposit insurance fund would necessarily
result.
Savings associations as well as insured depository
institutions excepted from the Bank Holding Company Act
definition of “bank” would no longer be eligible voluntarily to
terminate insured status.
We believe these institutions, which
are presently authorized under the law to leave the federal
deposit insurance system, should continue to have that option.
The primary purpose of this provision of the bill is
presumably to protect depositors when insured institutions
convert to non-insured status.
We agree that depositor
protection must be paramount when any insured institution
voluntarily relinquishes its insured status.
Under current law, an insured depository institution must
obtain prior written consent of the FDIC before it may convert to
non—insured status.
The FDIC weighs several factors prescribed
by statute in deciding whether to grant or withhold such consent.
The bill does not amend or repeal these provisions? the FDIC's
power to disapprove any institution's conversion from insured to
non—insured status would continue without change.
The voluntary
termination procedures specified in the bill, however, differ
somewhat from these consent requirements found elsewhere in the
FDI Act.
Consequently, it would be appropriate to clarify the
43
bill to assure consistency of the various termination provisions.
The bill could in part be clarified by including a provision that
the bill does not override the provisions of Section 18(i) of the
FDI Act.
The bill provides that a depository institution that
voluntarily elects to terminate its insured status shall no
longer receive insurance of any of its deposits after the
specified transition period.
It also should be made clear that
this provision is not intended to bar a formerly insured
institution from reapplying for federal deposit insurance.
Under the bill, any institution that voluntarily terminates
its status as an insured depository institution is prohibited
from accepting deposits unless the institution becomes a WFI.
If
the institution becomes a WFI, it may not accept any initial
deposit that is $100,000 or less other than on an incidental
and occasional basis.
These prohibitions limit the flexibility
non-insured institutions now have under federal law.
It is not
clear why the law should compel institutions that have
voluntarily terminated insurance to obtain WFI status so that
they can accept deposits where state law permits other kinds of
uninsured entities.
The flexibility non—insured institutions
enjoy under current federal and state laws should not be
diminished without good cause.
The bill can be improved by
clarifying the termination provisions along the lines I have
44
outlined.
The FDIC will be pleased to work with members of
Congress in making reasonable modifications to these provisions
to avoid unintended consequences.
In conclusion, on balance the bill represents a thoughtful
approach to easing the restrictions between commercial and
investment banking.
It provides for prudential safeguards and
appropriate restrictions designed to insulate insured
institutions from the risks inherent in investment banking
activities.
It is an important foundation for considering the
most effective and efficient approach by which appropriate
financial services reform can be achieved.
CONCLUSIONS
The restrictions of the Glass-Steagall Act do not serve a
useful purpose.
Their repeal would strengthen banking
organizations by helping them to diversify their income sources,
and would promote the efficient, competitive evolution of
financial markets in the United States.
History demonstrates,
however, that a significant expansion of the powers available to
insured institutions must be accompanied by appropriate
safeguards for the insurance funds.
Chairman Leach and other
members of the House Committee on Banking and Financial Services
have recognized the need for such safeguards in the bill.
45
Existing experience with the combination of banks and
securities firms suggests that, in general, current safeguards
have been adequate to prevent significant safety—and—soundness
concerns in the normal course of business.
This experience has
been limited, however; in particular, we have not seen a severely
distressed banking organization that had significant securities
activities.
The experience of the FDIC has been that in times of
financial stress, banking organizations may attempt to engage in
transactions that transfer resources from the insured entity to
the owners and creditors of the parent company or nonbanking
affiliates.
In some cases the FDIC has suffered material loss as
a result of such transactions.
We seek to assure that reform of
Glass-Steagall is not the vehicle for more such episodes.
My general comments on the safeguards against inappropriate
intercompany transactions in the proposed bill are as follows.
First, exceptions to the safeguards should be allowed only after
taking account of potential losses to the insurance funds.
While
there should be room for supervisory discretion and the exercise
of good business judgment in determining whether a healthy bank
may support an affiliate, such support should be provided through
transfers of excess capital —
capitalized bank —
not through relaxations of restrictions on
intercompany transactions.
beyond that required for a well-
Second, it could be useful to develop
46
an interagency codification of the standards for enforcing
Sections 23A and 23B of the Federal Reserve Act.
To promote
improved enforcement of the safeguards, the FDIC is prepared to
provide information and analysis to fellow regulators on
instances where intercompany transactions contributed to the
failure of, or increased the cost of resolving, an insured
institution.
There are two United States models for conducting the new
securities activities within banking organizations —
company model and the bona fide subsidiary model.
the holding
There are
advantages and disadvantages both to housing the securities
activities in bank subsidiaries, and to housing the activities in
holding company affiliates.
On balance, I do not believe the
case for either approach is strong enough to warrant dictating to
banks which approach they must choose.
In general, I believe that banks should be able to chose the
corporate structure that is most efficient for them, provided
adequate safeguards are in place to protect insured financial
institutions and the insurance funds.
H.R. 1062 is a sound and
constructive approach to evaluating how best to reform our
financial system.
The FDIC stands ready to assist the
Subcommittees with this important effort.
Attachment A
Average Annual Growth Rates of Financial Institution Assets
Average Annual Growth Rates (Percent)
Ten Years Ending 12/31/94
26.7
__ i____________ i____________ i_____
i
Commercial
Savings
Banks
Institutions*
Credit
Unions
Life
Insurance
Companies
Mutual
Funds
Security Brokers Finance
& Dealers
Companies
* FDIC-lnsured Savings institutions, includes savings banks, savings associations and S&Ls.
Source: Row of Funds, Federal Reserve System; FDIC Research Information System;
National Credit Union Administration.
Asset growth rates are expressed as annual average for the 10-year period
12/31/84 to 12/31/94, adjusted for compounding.
ATTACHMENT B
THE CHANGING FINANCIAL MARKETPLACE
Banking was a simpler business in the early decades of the
Federal Deposit Insurance Corporation. Interest rates were
regulated and stable. Competition from nonbanking companies was
limited. Banks were the primary source of borrowed funds for
even the strongest, best-established businesses. In more recent
years, the financial services industry, technology and capital
markets have evolved, creating new risks and new opportunities.
Bankers have had to manage the risks, but the Glass-Steagall Act
and other legislation limit the ability of bankers to mitigate
risk by diversifying their sources of income.
Credit-risk exposure has increased dramatically since
enactment of the Glass-Steagall Act. In 1935, approximately onethird of the industry's balance sheet was concentrated in assets
that bear significant credit risk. Now, over 60 percent of
banking assets are exposed to credit risk.
Beginning in the mid-1960s and lasting through the mid1980s, the industry experienced rapid asset growth, typically
exceeding ten percent per year. In that 20-year span, the assets
of the industry increased nearly tenfold, from $345 billion to
almost $3 trillion. This growth was achieved by increasing
credit risk and decreasing the proportion of lower risk
investments. During this period, commercial banks built up large
portfolios of loans with concentrated credit risk including loans
with large balances at risk to a single borrower.1
In 1935, about one-quarter of the balance sheet was invested
in loans with "credit-risk concentrations." That level increased
to almost 45 percent in 1984 (prior to the wave of recent bank
failures), and has declined to 34 percent as of December 1994.
Until the early 1980s, asset growth was fueled by commercial and
industrial ("C&I") loans. C&I loan concentrations reached their
highest level in 1982, peaking at nearly 25 percent of the
industry's balance sheet. There were some notable lending
excesses during these boom years, including real estate
investment trusts, less-developed-country loans, and energy
credits.
In the early 1980s, the largest commercial borrowers learned
to bypass banks and replace loans from banks with lower-cost
commercial paper. Burgeoning loan demand from energy-related
businesses supported continued C&I loan growth for a time, but by
Credit-risk-concentrated
loans
include
commercial
and
industrial loans, commercial real estate and construction loans,
and loans secured by multifamily residential properties.
2
December 1994, C&I loans had declined to 15.4 percent of the
industry's total assets.
When C&I loans began to decline, many banks turned to
commercial real estate loans and construction loans for new -but high risk -- profit opportunities. In the mid- to
late-1980s, growing concentrations in commercial real estate
loans and construction loans offset shrinkage in C&I loans. In
1976, commercial real estate loans and construction loans
together comprised about five percent of the balance sheet. In
ten years, the concentration increased to nearly nine percent of
assets. It reached its highest level -- 11 percent - - i n 1990.
Banks were not the only providers of these loans. Savings and
loan associations and other nonbank lenders also financed the
speculative real estate development. Consequently, real estate
markets in many regions became overbuilt, credit losses soared
and commercial real estate loan demand diminished.
Loan growth since 1990 has been concentrated in loans where
credit risk is more diversified. Credit card, consumer and home
mortgage loans extend relatively small and often collateralized
balances to a relatively large number of borrowers. Failure of a
single borrower to repay does not have a significant impact on a
bank's earnings or capital. Most of the growth in "credit-riskdiversified" loans has come from home mortgages. Concentrations
in home mortgage loans have nearly doubled since 1984, increasing
from 7.7 percent of the industry's balance sheet to nearly 15
percent as of year-end 1994. Credit card loans constitute 4.9
percent of assets and other "consumer" loans constitute 7.8
percent.
Beginning in 1990, the industry's risk profile began to
change direction. Banks were able to take advantage of a
widening difference between shorter- and longer-term interest
rates to improve earnings while reducing credit risk. They
shortened the average maturity of their liabilities and increased
their concentrations of fixed-rate securities and residential_
mortgages. In effect, the industry replaced some of*its credit
risk with higher levels of interest-rate risk. The industry's
asset composition has changed since the deregulation of deposit
interest rates. In the early 1990s, the growth of investment
securities held by banks -- primarily mortgage-backed instruments
and U.S. Treasury securities -- accelerated. Market conditions
also favored the growth of home mortgages, which have more than
doubled since 1986, increasing from $223 billion at year-end 1986
to $568.9 billion as of December 31, 1994. While about 46
percent of these loans in the portfolios of banks carry
adjustable rates, there is still interest-rate exposure, due to
repricing lags, as well as caps that limit the amount by which
the interest rates on the loans can increase.
3
In recent years, increased market volatility has made it
more important for banks to manage risks other than credit risk,
such as interest-rate risk, prepayment risk, and foreign-exchange
risk. Banks have responded to this challenge by devoting
considerable resources to asset-liability management and other
risk management systems.
The tools for managing these risks have expanded
considerably over the past decade, particularly with the
increasing use of off-balance-sheet instruments such as swaps,
options, and forward contracts. While smaller banks for the most
part still use on-balance-sheet instruments to manage risk, these
off-balance-sheet instruments have become an integral part of
risk management for most large banks.
Banks are not only end users of these swaps, options, and
forwards. Several large banks are major dealers of over-thecounter instruments. This activity has provided an important
source of revenue and allowed these banks to respond to the needs
of their customers. Nevertheless, a series of recent losses has
raised concerns about the potential risks of these investments.
Record bank failures in the 1980s and early 1990s were
quickly replaced with record earnings as the economy improved in
a very favorable interest-rate environment. In the last ten
years, the industry achieved both its lowest annual return on
assets (about 0.09 percent in 1987) and its highest return on
assets (1.20 percent in 1993) since the implementation of deposit
insurance in 1933. Declining loan losses account for the wide
swing in earnings. Declining loan-loss provisions have added
roughly 25 basis points (pre-tax) to the industry's return on
assets in 1992 and 1993, and 18 basis points in 1994. Interest
margins have improved steadily since 1934, but these improvements
have had relatively little impact compared with the reduced
burden of loan-loss provisions. Ten-year growth in noninterest
income has outstripped noninterest expense growth by a narrow
margin, providing a relatively small boost to the industry's
bottom line.
Bankers were not able to obtain expanded powers when the
industry was in trouble, as in the late 1980s, owing to concerns
about adding new potential risks to an industry struggling with
existing risks. Now, opponents may argue that expanded powers
are not needed, given the record profits the industry has
reported for the last three years. Volatile swings in the health
and performance of the industry may result in part from
constraints that limit alternatives for generating profits. The
data show that credit risk, interest-rate risk and competition
have all increased since the enactment of Glass-Steagall. While
the earnings trend recently has been positive, the wide swings in
past performance indicate heightened uncertainty and increased
risks in the industry.
4
International Developments
Global competitive pressures also present a compelling need
to reconsider the Glass-Steagall prohibitions between^investment
and commercial banking. Domestic financial deregulation in major
industrialized nations, the development of new financial
instruments, and advances in communication and computer
technologies have contributed to the rapid integration of
international financial markets during the past two decades.
These changes in the financial marketplace, both^domestic and
international, have led several major industrialized nations to
change their laws governing financial institutions, with the goal
of creating a more level competitive playing field. In
particular, there has been a growing worldwide trend toward
easing traditional distinctions among the three major^segments of
the financial services industry -- commercial banks, investment
firms, and insurance companies.
It should be noted that commercial and investment banking
have long been combined in countries with universal banking
systems, such as Germany and most of western Europe. Universal
banks have the authority to offer the full range of banking and
financial services -- including securities underwriting and
brokering of both government and corporate debt and equity -- Jj
within a single legal entity, the bank. Although some financial
services are provided through subsidiaries, the bank or financial
services holding company structure is virtually unknown in other
countries.
In contrast to the universal banking structure allowed in
Continental European countries, Canada, Japan and the United
Kingdom traditionally maintained barriers and restrictions
against combining commercial and investment banking activities.
These restrictions have been largely removed by legislation in
each of these countries. For example, British banks were
permitted to join the stock exchange in 1986 and to acquire or
develop investment banking subsidiaries. These affiliations are
important to the ability of British banks to compete within the
European Union's single market.
Canada amended its laws governing financial institutions in
1987 and 1992, removing many of the statutory barriers separating
banks, trust companies, insurance companies and^securities firms,
to allow greater latitude in bank ownership of institutions in
the other financial sectors. As a result, most of the major
Canadian securities firms are now owned by banks. Additionally/
banks were permitted to offer more services "in-house," and to
set up networking arrangements through which their branches _sell
the products of institutions in other sectors of the financial
industry.
5
,
In 1 9 9 2 Japan approved the "Financial System Reform Act,"
amending Japan's Securities and Exchange Law, and effectively
removing the barriers between investment and commercial banking.
By law since 1993, banks and securities companies have been
allowed to enter each other's businesses through subsidiaries,
although the establishment of securities subsidiaries by Japan's
City Banks was delayed until July 1994. Additionally, the
Ministry of Finance has elected to restrict the range of powers
permissible for new subsidiaries of banks and securities firms.
Thus, new trust banking subsidiaries are not permitted to manage
pension funds and new securities subsidiaries of banks are only
permitted to underwrite corporate bonds. In any event, Japan has
had a moratorium on new equity offerings, with the exception of
initial public offerings, since 1990.
As a result of these legislative changes in other countries,
the United States stands alone among the 25 nations comprising
the Organization for Economic Cooperation and Development (OECD)
in continuing to impose domestic legal restrictions on
affiliations between commercial banks and securities firms.
Efforts to quantify the effect of these restrictions on the
international competitiveness of U.S. banks are hampered by
cross-border differences in accounting practices, tax laws, and
other regulations governing financial institutions. Moreover,
the data may be misleading due to currency fluctuations.
Therefore, while we hesitate to provide any statistics regarding
international competitiveness, some anecdotal evidence may be
instructive.
Among the advantages of universal banking often cited are
the cost savings derived from the ability to cross-sell a wider
range of products and to offer highly-competitive products at a
lower cost by subsidizing them with higher margins on lesscompetitive products. Universal banks may have a significant
competitive advantage in customer loyalty through their ability
to provide customers with all their financial services needs.
Finally, universal banks have greater opportunities to spread
risk and to smooth out income fluctuations in different areas of
their business.
Not surprisingly, universal banks tend to be large and
profitable institutions. The degree to which they dominate
domestic market share varies according to the number, powers, and
other structural characteristics of countries with universal
banks. In Germany, for example, the four largest universal banks
controlled less than 10 percent of total domestic bank assets in
1991; during the same year, the four largest Swiss banks
controlled nearly 50 percent of domestic bank assets. These
differences may be attributed to differences in their respective
domestic markets: German banks directly compete with
approximately 200 regional banks, over 700 government -owned
savings banks, and nearly 3,000 cooperative banks, many of which
6
are also universal banks; in Switzerland, which has only about
600 institutions, most of the regional banks are small savings
banks that specialize in mortgage lending.
There are several disadvantages inherent to universal
banking as well. The one most often cited is the obvious
potential for conflicts of interest among different areas of
business. Another disadvantage is that capital markets are not
as developed in countries with universal banking. It should be
noted here that universal banks typically are permitted to own
fairly sizeable equity positions in nonfinancial firms.
Banking and commerce links also exist in Japan, where banks
are permitted to own equity investments in up to five percent in
any one company. Studies comparing the German-style universal
banking system and Japan's "keiretsu" form of industrial
organization with the segmented U.S. banking system have
concluded that the former may provide several important economic
benefits. While these banking and commerce links no doubt have
contributed to the industrial growth in these countries in the
postwar era, they do raise serious concerns over concentration of
power.
In Japan, these concerns are addressed through limitations
on equity investments and the absence of bank personnel in the
day-to-day management of nonfinancial firms. In contrast to
Japan, where banks typically interfere only in cases of corporate
distress, Germany not only permits banks to own shares, but also
to serve on the supervisory boards of corporations and to
exercise proxy rights over large blocks of shares through bankmanaged portfolios. Other countries with universal banking have
tended to curb bank control over industrial firms in recent
years. Proposals to do so in Germany recently have been
introduced as a result of the near-failure of several of
Germany's nonfinancial firms.
These highly publicized cases were more of an embarrassment
to Germany's major banks than a threat to their safety and
soundness. These banks have been able to withstand losses due to
their sheer size and strength, and to the very conservative
accounting practices that allow equities to be carried at
historical cost and allow banks to transfer portions of income to
hidden reserves.
In fact, there are no cases in recent memory of a major bank
failing in another country due to its securities activities or
affiliations with commercial firms. The majority of banking
problems in industrialized countries have been the result of
traditional banking activities. For example, losses from
foreign-exchange trading have caused isolated cases of bank
failures, while real estate lending in "boom" years led to
system-wide banking crises in the United Kingdom, most of the
7
Scandinavian countries and Japan, in addition to the well-known
problems encountered by U.S. banks and savings and loan
institutions.
If other problems have occurred, and no doubt there have
been some, they have been dealt with quietly and effectively,
without recourse to deposit insurance funds. This is largely due
to the differences in the supervisory structure of countries that
permit such affiliations, and to differences in failureresolution methods and the role of deposit insurance. For
example, while deposit insurance coverage is roughly comparable
between the United States and Japan, the private sector plays a
larger role in the operation of deposit insurance in many other
countries. Consequently, the direct link to the government's
"full faith and credit" is less explicit than in the United
States. Major banks in other countries also are called upon more
often to help in "bailouts" of other banks, voluntarily or
otherwise, due to a traditionally close relationship with the
central bank and more highly concentrated banking systems.
Given the greater potential for conflicts of interest
between insured and uninsured functions, the governmental nature
of deposit insurance in the United States, and the more dynamic
and diverse financial marketplace in the United States, the
universal banking model does not seem to be as suited to the
current U.S. environment as other Models with which the United
States has experience.
ATTACHMENT C
HISTORICAL BACKGROUND
Information concerning the principal abuses that arose
during the 1920s and early 1930s in connection with the
investment banking activities of commercial bank affiliates is
largely limited to the extensive Senate investigation into stock
exchange practices, which included the highly publicized Pecora
hearings. A substantial portion of these hearings, which were
held in 1933 and 1934, dealt with the activities of the
securities affiliates of the country's two largest commercial
banks, National City Bank and Chase National Bank.
The Glass-Steagall Act, which to a certain extent was the
result of these hearings, was enacted primarily for three
reasons. First, Congress believed the Act would help to protect
and maintain the financial stability of the commercial banking
system, and would strengthen public confidence in commercial
banks. Second, Congress wanted to eliminate the potential for
conflicts of interest that could result from the performance of
both commercial and investment banking operations. The final^
Congressional concern was a belief that the securities operations
of banks tended to exaggerate financial and business fluctuations
and undermine the economic stability of the country by channeling
bank deposits into "speculative" securities activities.
The actual and potential abuses that were revealed during
the Senate investigation can be categorized as follows: first,
abuses that were common to the entire investment banking
industry; second, abuses that may be attributed to the use of
affiliates for the personal profit of bank officers and
directors; and third, abuses related to conflicts of interest
that resulted from the mixing of commercial and investment
banking functions. The primary types of abuses relevant to each
of these categories are discussed below. Analyses of the
appropriate remedies for these abuses are presented, together
with comments directed toward examining the degree to which the
Glass-Steagall Act was an effective or desirable solution.
Abuses Common to the Investment Banking Business
The principal types of abuses common to the investment
banking business during the 1920s and early 1930s included:
•
underwriting and distributing unsound and speculative
securities
•
conveying untruthful or misleading information in the
prospectuses accompanying new issues
•
manipulating the market for certain stocks and bonds while
they were being issued.
2
(Examples of the first two types of abuses can be found by
examining National City Company's involvement in the financial
operationsrof the Republic of Peru. Throughout the 1920s
National City Company received reports that Peru was politically
unstable, had a bad debt record, suffered from a depleted
Treasury and was, in short, an extremely poor credit risk. In
1927 and 1928, National City Company participated, nevertheless,
in the underwriting of bond issues by the government of Peru.
The jprospectuses that were distributed made no mention of Peru's
political and economic difficulties. As a result, the public
purchased $90 million of the bonds, which went into default in
1931 and sold for less than five percent of their face value in
1933.
While the National City case may be one of the more flagrant
examples of these types of abuses, it was generally acknowledged
that the extremely competitive banking environment of the 1920s
led bankers to encourage overborrowing, particularly by
governments and political subdivisions in Europe and South
America. Questionable practices were employed to induce the
public to purchase the security issues that resulted from the
promotional efforts of bank affiliates. In addition to
falsifying or withholding pertinent information, National City
Company and Chase Securities Corporation attempted, on occasion,
to prop up the price of securities while the securities were
being sold.
A large portion of the abuses uncovered during the Pecora
hearings were common to the entire investment banking industry.
Because these problems were not directly related to the
relationship between banks and their affiliates, the GlassSteagall Act was not the proper remedy for these kinds of abuses.
There are several reasons why the problems just described are of
less concern today. First, the Securities Act of 1933 and the
Securities Exchange Act of 1934 hold individuals involved in the
issuance of securities responsible for any misstatement of facts
failure to reveal pertinent information concerning the
financial condition of governments and corporations issuing
securities. Second, it is now the duty of the SEC to prevent any
manipulation of the market while a security is being issued.
Additionally, these safeguards may help deter banks from
underwriting unsound and speculative securities.
£>elf-Dealincr by Bank Officers and Directors
Bank affiliates not only attempted to manipulate the stock
and bond prices of other business and governmental entities, they
also attempted to manipulate the stock prices of their parent
banks. The procedure generally employed was for the affiliate to
organize investment pools that traded in the stock of the parent
bank. While the pools were financed primarily by the affiliates,
they were generally open to selected individuals, including bank
3
officers and directors. Bank officials claimed that the purposes
of such trading accounts were to steady the market in order to
maintain public confidence in the bank and to encourage increased
distribution of the bank's stock. However, there were other
motivations for such activity.
First, it is likely that many of the participants expected
to benefit from their inside information and gain large profits
from their trading activity. In practice, however, these
expectations were not always realized. Chase's affiliates earned
only $159,000 in profit on trades in Chase National Bank stock
totaling $900 million. National City Company sustained $10
million in losses from dealing in the stock of its parent bank.
A second reason may have been that by advancing the stock's
price it became more attractive to the stockholders of other
banks that were acquired on an exchange-of-stock basis. Chase
National and National City Bank each acquired several other banks
during the period when their affiliates were trading in their
stock.
In addition to the profits obtained by trading in their own
bank's stock, bank officers and directors often received
compensation from affiliates far in excess of that paid to them
by their banks. For example, instead of permitting the stock of
affiliates to be owned by bank stockholders, the stock was often
wholly owned by officers and directors of the bank. This
"ownership” may have been illegal and was clearly improper.
Because the profit opportunities of the affiliates were a direct
result of their association with their parent banks, any profits
they derived rightfully belonged to the bank's stockholders.
The types of abuses just described sparked public outrage
against commercial banks and their investment banking affiliates.
However, the Glass-Steagall Act was not the proper remedy for
such self-dealing and insider abuse. Trading accounts in the
stock of parent banks by affiliates and the participation in such
trading by bank officials could have been prevented by making it
illegal for affiliates to deal in or own the stock of parent
banks. The establishment of management funds is a problem mainly
of concern to stockholders. With adequate disclosure of the
salaries and bonuses distributed through such funds, stockholders
can determine whether they are excessive. Affiliates owned
entirely by bank officers and directors instead of by bank
stockholders also could have been prohibited.
Abuses Arising From the Mixture of Commercial and Investment
Banking
There were a number of abuses that occurred from the mixing
of commercial and investment banking functions. Most of these
relate to conflict-of-interest concerns, and while they have
4
implications for bank safety and soundness, there is no evidence
that a large number of bank failures were due to interactions
between banks and their affiliates. The types of abuses revealed
during Senate testimony in 1933-34 included:
•
Using the affiliate as a dumping ground for bad bank loans.
In an example highlighted during the Pecora hearings, National
City Bank transferred to National City Company $25 million worth
of loans to Cuban sugar producers after the price of sugar
collapsed and the borrowers were unable to repay the loans.
•
Using the bank or its trust department as a receptacle for
securities the affiliate could not sell. While examples where
Chase National Bank bailed out its affiliates were revealed
during the Senate investigation, it appears that trust
departments generally were not used for such a purpose.
•
Lending to finance the purchase of securities underwritten
by the affiliate. This could have been another means whereby the
affiliate's problems were transferred to the bank. That is, if
the affiliate found it difficult to sell a particular issue, the
bank may have chosen to offer loans to prospective purchasers
under conditions disadvantageous to bank stockholders.
•
Excessive lending to affiliates to finance underwritings.
This practice may have led to an inadequate level of bank asset
diversification, the significance of which would have depended
upon the quality of the underwritings.
•
There was a tendency for banks to invest too much in long
term securities. This practice caused liquidity problems that
contributed to a number of bank failures during the late 1920s.
•
Lowering the quality of bank assets by purchasing part of a
poorly performing security after it had been issued. The reason
for such action would have been that the bank was concerned with
its image if a security its affiliate had underwritten or
distributed began to lose value.
•
Lending to a corporation that would otherwise have defaulted
on an issue underwritten by the bank's securities affiliate.
Again, this would have occurred if a bank was concerned that its
image would be severely tarnished in the event a corporation
defaulted on an issue the bank's affiliate had underwritten or
distributed.
The first five problems outlined above could have been
controlled with fairly simple legislative remedies. For example,
to prevent the use of a bank or its affiliate as the dumping
ground for the other's bad assets, federal authorities could have
been given, and now have, authority to conduct simultaneous
examinations on a periodic basis. Lending to finance the
5
purchase of securities underwritten by a bank's affiliate could
have been prohibited. The concern that banks may lend excessive
amounts to their affiliates could be handled by prohibiting such
lending, by requiring that it be collateralized, or by simply
placing a limit, perhaps as a percentage of bank capital, on the
amount a bank may invest in any one and in all of its affiliates.
However, the underlying concern in this case is that banks, by
investing heavily in their affiliates, would not have a
sufficiently diversified asset base. This concern can also be
directly addressed by limiting overall investments in related
markets or product lines. Similarly, the tendency for banks to
invest too much in long-term securities could be controlled by
prohibiting or limiting the number or amount of securities a bank
could purchase from operating securities affiliates.
The potential for "tie-ins" also should be of concern.
While it appears that investment banks can, and on occasion do,
threaten to withhold certain services unless an entire "package"
is purchased, the power of such a threat takes on a somewhat
greater significance when it is a line of credit that might be
withdrawn if an issuer does not choose a particular bank or bank
affiliate as its underwriter. As with the previous two concerns
it does not appear that examples of abuse were uncovered during
the Pecora hearings.
The types of potential tie-ins that should be of concern to
public policymakers are due either to self-dealing or to
inadequate levels of competition. In neither case is a continued
separation of commercial and investment banking an appropriate
way to address effectively the problem. An example of the former
is if a bank official tried to induce potential customers into
purchasing a service (presumably, but not necessarily, at a
relatively high price), in which the official had a personal
interest, by tying-in and underpricing at the expense of the
bank's or its affiliate's stockholders a second service in which
the official's personal stake was less direct. Self-dealing of
this kind can largely be prevented by other means.
In the absence of self-dealing at the expense of the
benefactors of the proceeds of one of the tied-in services, the
only way the tie-in threat can be effective is if the customer
has no viable alternative. In competitive markets, customers
would simply purchase the services elsewhere at more reasonable
rates. This type of tie-in, to the extent it can occur,
represents only one facet of a broader antitrust concern which is
most appropriately dealt with through policies designed to foster
greater competition. Since most banking markets are reasonably
competitive, it is highly unlikely that investment bankers, as a
group, will be at an unfair competitive advantage due to such
tie-ins. Moreover, since nondepository institutions are becoming
more involved in the extension of credit, it is difficult to
argue that commercial banks should not be permitted to underwrite
6
corporate securities on the grounds that such tie-ins are
possible.
Conclusion
By the 1930s, the general view in Congress was that the
mixing of commercial and investment banking posed a threat to the
safety and soundness of the banking system, created numerous
conflict-of-interest situations and led to economic instability
due to the channeling of bank deposits into "speculative"
securities activities. To alleviate those concerns, the GlassSteagall Act was enacted.
From the evidence gathered during the Senate investigation
into stock exchange practices it appears that, to the extent the
concerns of Congress were valid, they could have been handled
through less disruptive legislative means. There is little
evidence that the investment banking activities of commercial
bank affiliates were a major factor in causing bank failures.
Where investments in securities underwritten by affiliates
contributed to an institution's failure, it was generally because
the bank was illiquid due to an overinvestment in long-term
assets. Affiliate losses were generally due to speculative
activities unrelated to investment banking.
Most of the abuses that arose during the 1920s in connection
with the operation of security affiliates by commercial banks
appear to have been conflict of interest concerns rather than
factors threatening the safety and soundness of commercial banks.
However, it appears that most of these problems could have been
remedied without having to resort to a forced separation of
commercial and investment banking. Certain abuses which arise
from mixing commercial and investment banking cannot entirely be
controlled; but, they do not appear to have been so significant
as to have warranted legislation separating commercial and
investment banking. Finally, the provision of the 1934
Securities Exchange Act that authorized the Federal Reserve Board
to regulate the extension of credit for the purchase of
securities effectively achieved the third objective of the GlassSteagall Act, which was to control the speculative uses of bank
assets in the securities markets.
In conclusion, bank affiliates were not regulated, examined,
or in any way restricted in the activities they could participate
in until the 1930s. As a result, abuses occurred. A certain
degree of supervision and regulation and some restrictions on
bank affiliate powers would have gone a long way towards
eliminating the types of abuses that occurred during this period.
ATTACHMENT D
CURRENT SAFEGUARDS
Section 23A of the Federal Reserve Act restricts
transactions between member banks and their affiliates, and the
Federal Deposit Insurance Act extends the coverage of 23A to
nonmember insured banks. Section 23A attempts to prevent the
misuse of insured institutions by placing quantitative
limitations on "covered transactions" between a bank and its
affiliate, establishing collateral requirements for certain
transactions, requiring that all transactions be on terms and
conditions that are consistent with safe and sound banking, and
prohibiting a bank from purchasing low-quality assets of an
affiliate.
"Covered transactions" include loans to an affiliate,
purchases of securities issued by an affiliate, acceptance of
securities issued by an affiliate as collateral, and the issuance
of a guarantee, acceptance or letter of credit on behalf of an
affiliate.
Section 23B of the Federal Reserve Act places additional
limitations on federally insured banks and their affiliates, by
providing that a bank may engage in certain transactions with its
affiliates only on an "arm's length" basis. In addition to the
"covered transactions'* of Section 23A, Section 23B applies to the
sale of securities or other assets to an affiliate, to service
contracts between the bank and its affiliate, and to transactions
with a third party where the affiliate has a financial interest
in the third party.
The Federal Reserve Board has established prudential
limitations on the activities of the "Section 20 companies" of
bank holding companies (BHCs) that underwrite and deal in debt
and equity securities to a limited extent. Among other things,
in determining capital compliance, BHCs must deduct from
consolidated primary capital any investment in an underwriting
subsidiary, or any extension of credit that does not meet certain
collateral requirements. BHCs and their subsidiaries are
prohibited from: entering into any financial arrangement that
might be viewed as enhancing the marketability of a bankineligible security issued by the underwriting subsidiary;
extending credit to a customer to purchase a bank-ineligible
security issued by the securities affiliate during or shortly
after the underwriting period; or purchasing ineligible
securities from a securities affiliate during or shortly after
the underwriting period. Officer, director or employee
interlocks between a BHC's underwriting subsidiary and any bank
or thrift subsidiary are prohibited. An underwriting subsidiary
must provide adequate disclosures that its products are not
federally insured. There are limitations on the ability of
affiliated banks or thrifts to provide investment advice
regarding the purchase of securities underwritten or dealt in by
the securities affiliate. Bank or thrift subsidiaries are
prohibited from extending credit to a securities affiliate except
2
in certain limited instances, or from purchasing or selling
certain financial assets to or from a securities affiliate.
On December 28, 1984, the FDIC implemented its regulation on
securities activities of subsidiaries of insured nonmember banks
and bank transactions with affiliated securities companies (12
CFR § 337.4) . At that time, the FDIC determined that it is not
unlawful under the Glass-Steagall Act for an insured nonmember
bank to establish or acquire a bona fide subsidiary that engages
in securities activities nor for an insured nonmember bank to
become affiliated with a company engaged in securities activities
if authorized under state law. At the same time, the FDIC found
that some risk may be associated with those activities. In order
to address that risk, the FDIC regulation (1) defines bona fide
subsidiary, (2) requires notice of intent to acquire or establish
a securities subsidiary, (3) limits the permissible securities
activities of insured nonmember bank subsidiaries, and (4) places
certain other restrictions on loans, extensions of credit and
other transactions between insured nonmember banks and their
subsidiaries or affiliates that engage in securities activities.
In our regulation, the term "bona fide" subsidiary means a
subsidiary of an insured nonmember bank that at a minimum: (1) is
adequately capitalized, (2) is physically separate and distinct
in its operations from the operations of the bank, (3) maintains
separate accounting and other corporate records, (4) observes
separate corporate formalities such as separate board of
directors meetings, (5) maintains separate employees who are
compensated by the subsidiary, (6) shares no common officers with
the bank, (7) a majority of the board of directors is composed of
persons who are neither directors nor officers of the bank, and
(8) conducts business pursuant to independent policies and
procedures designed to inform customers and prospective customers
of the subsidiary that the subsidiary is a separate organization
from the bank and that investments recommended, offered or sold
by the subsidiary are not bank deposits, are not insured by the
FDIC, and are not guaranteed by the bank nor are otherwise
obligations of the bank.
This definition is imposed to ensure the separateness of the
subsidiary and the bank. This separation is necessary as the
bank would be prohibited by the Glass-Steagall Act from engaging
in many activities the subsidiary might undertake. Also, the
separation safeguards the soundness of the parent bank.
The regulation provides that the insured nonmember bank must
give the FDIC written notice of intent to establish or acquire a
subsidiary that engages in any securities activity at least 60
days prior to consummating the acquisition or commencement of the
operation of the subsidiary. These notices serve as a
supervisory mechanism to apprise the FDIC of which insured
nonmember banks are conducting securities activities through
3
their subsidiaries that pose potential risks to which the bank
otherwise would not be exposed.
Activities of the subsidiary are limited in that it may not
engage in the underwriting of securities that would otherwise be
prohibited to the bank itself under the Glass-Steagall Act
unless the subsidiary meets the bona fide definition and the
activities are limited to underwriting of investment quality
securities.
A subsidiary may engage in underwriting other than that
listed above if it meets the definition of bona fide and the
following conditions are met:
(a) The subsidiary is a member in good standing of the
National Association of Securities Dealers (NASD);
(b) The subsidiary has been in continuous operation for a
five-year period preceding the notice to the FDIC;
(c) No director, officer, general partner, employee or 10
percent shareholder has been convicted within five years of
any felony or misdemeanor in connection with the purchase or
sale of any security;
(d) Neither the subsidiary nor any of its directors,
officers, general partners, employees, or 10 percent
shareholders is subject to any state or federal
administrative order or court order, judgment or decree
arising out of the conduct of the securities business;
(e) None of the subsidiary's directors, officers, general
partners, employees or 10 percent shareholders are subject
to an order entered within five years issued by the
Securities and Exchange Commission pursuant to certain
provisions of the Securities Exchange Act of 1934 or the
Investment Advisors Act of 1940; and
(f) All officers of the subsidiary who have supervisory
responsibility for underwriting activities have at least
five years experience in similar activities at NASD member
securities firms.
A bona fide subsidiary must be adequately capitalized, and
therefore, they must meet the capital standards of the INASD and
SEC. As a protection to the insurance fund, a bank's investment
in these subsidiaries engaged in securities activities that would
be prohibited to the bank under the Glass-Steagall Act is not
counted toward the bank's capital, that is, the investment in the
subsidiary is deducted before compliance with capital
requirements is measured.
4
An insured nonmember bank which has a subsidiary or
affiliate that engages in the sale, distribution, or underwriting
of stocks, bonds, debentures or notes, or other securities, or
acts as an investment advisor to any investment company may not
engage in any of the following transactions:
(1) Purchase in its discretion as fiduciary any security
currently distributed, underwritten or issued by the
subsidiary unless the purchase is authorized by a trust
instrument or is permissible under applicable law;
(2) Transact business through the trust department with the
securities firm unless the transactions are at least
comparable to transactions with an unaffiliated company;
(3) Extend credit or make any loan directly or indirectly
to any company whose obligations are underwritten or
distributed by the securities firm unless the securities are
of investment quality;
(4) Extend credit or make any loan directly or indirectly
to any investment company whose shares are underwritten or
distributed by the securities company;
(5) Extend credit or make any loan where the purpose of the
loan is to acquire securities underwritten or distributed by
the securities company;
(6) Make any loans or extensions of credit to a subsidiary
or affiliate of the bank that distributes or underwrites
securities or advises an investment company in excess of the
limits and restrictions set by section 23A of the Federal
Reserve Act;
(7) Make any loan or
company for which the
investment advisor in
set by section 23A of
extension of credit to any investment
securities company acts as an
excess of the limits and restrictions
the Federal Reserve Act; and,
(8) Directly or indirectly condition any loan or extension
of credit to any company on the requirement that the company
contract with the banks securities company to underwrite or
distribute the company's securities or condition a loan to a
person on the requirement that the person purchase any
security underwritten or distributed by the bank's
securities company.
An insured nonmember bank is prohibited by regulation from
becoming affiliated with any company that directly engages in the
sale, distribution, or underwriting of stocks, bonds, debentures,
notes or other securities unless:
(1) The securities business of
the affiliate is physically separate and distinct from the
5
operation of the bank;
(2) the bank and the affiliate share no
common officers;
(3) a majority of the board of directors of the
bank is composed of persons who are neither directors or officers
of the affiliate;
(4) any employee of the affiliate who is also
an employee of the bank does not conduct any securities
activities of the affiliate on the premises of the bank that
involve customer contact; and (5) the affiliate conducts
business pursuant to independent policies and procedures designed
to inform customers and prospective customers of the affiliate
that the affiliate is a separate organization from the bank and
that investments recommended, offered or sold by the affiliate
are not bank deposits, are not insured by the FDIC, and are not
guaranteed by the bank nor are otherwise obligations of the bank.
The FDIC has chosen not to require notices relative to affiliates
because we would normally find out about the affiliation in a
deposit insurance application or a change of bank control notice.
The FDIC has created an atmosphere in which bank affiliation
with entities engaged in securities activities is very
controlled. Although we have examination authority over bank
subsidiaries and under Section 1 0 (b) of the Federal Deposit
Insurance Act we have the authority to conduct examinations of
affiliates to determine the effect of that relationship on the
insured institution, we have in practice allowed these entities
to be functionally regulated, that is FDIC examination of the
insured bank and SEC and NASD oversight of the securities
subsidiary or affiliate.
The FDIC feels that its established separations for banks
and securities firms has created an environment in which the
FDIC's responsibility to protect the insurance fund has been met
without creating duplicative regulation for the securities firms.
However, our experience indicates that these separations may not
be perfect. Insider maneuvering may be able to evade the intent
of the firewalls, securities firms affiliated with nonbank bank
holding companies may fall outside the regulatory coverage of
Part 337.4, and if systemic problems were to develop in the
securities industry, the difficulties may overwhelm the
protection in place.
Therefore, the FDIC believes that functional regulation
should not be designed in a fashion that would preclude the FDIC
from examining securities subsidiaries and affiliates for matters
which are unsafe and unsound. This would include reviewing
insider involvement in the securities firms, monitoring financial
transactions between the insured institution and the securities
firm, reviewing securities firms records to assure that the
restrictions contained in Part 337.4 are being adhered to, and
regularly reviewing financial statements of the securities firms.
The FDIC is also maintaining an open dialogue with the NASD
and the SEC concerning matters of mutual interest. To that end,
6
we have jjentered ^into an agreement in principle with the NASD
concerning examination of securities companies affiliated with
insured institutions and have begun a dialogue with the SEC
concerning the exchange of information which may be pertinent to
the mission of the FDIC.
The number of banks which have subsidiaries engaged in
activities that could not be conducted in the bank itself is very
small. ^The activities these subsidiaries are engaged in are
underwriting of debt and equity securities and distribution and
management of mutual funds. We have received notices from 444
banks that have subsidiaries which are engaged in activities that
do not require the subsidiary to meet the definition of bona fide
such as investment advisory activities, sale of securities and
management of the bank's securities portfolio.
Sincejjimplementation of the FDIC's regulation, the
relationships between banks and securities firms have not been a
matter of supervisory concern. We believe in great part that
this can be attributed to the protections we have in place.
However, we are aware that in a time of financial turmoil that
these protections may not be adequate and a program of direct
examination may be necessary to protect the insurance fund and
continuation of our examination authority in that area is
important.
ATTACHMENT E
PROHIBITIONS AND RESTRICTIONS ON SECURITIES
ACTIVITIES IMPOSED BY SECTION 20 OF THE
GLASS -STEAGALL ACT AND BY THE BANK HOLDING COMPANY ACT
Section 20 of the Glass-Steagall Act ("Section 20") (12
U.S.C. §377) prohibits banks that are members of the Federal
Reserve System ("member banks") from affiliating with
organizations that are "engaged principally" in underwriting,
distributing or selling securities. Section 20 states, in
relevant part, that: "no member bank shall be affiliated in any
manner . . . with any corporation, association, business trust,
or other similar organization engaged principally in the issue,
flotation, underwriting, public sale . . . of stocks, bonds,
debentures, notes, or other securities . . . ." 12 U.S.C. §377.
The statute defines an "affiliate" to include any corporation,
business trust, association or other similar organization -(1) Of which a member bank, directly or
indirectly, owns or controls either a majority of
the voting shares or more than 50 percent of the
number of shares voted for the election of
directors, trustees, or other persons exercising
similar functions . . .
(2) Of which control is held, directly or
indirectly, through stock ownership . . . by the
shareholders of the member bank who own or control
either a majority of the shares of such bank or
more than 50 percent of the number of shares voted
for the election of directors of such
bank . . .
(3) Of which a majority of directors, trustees, or
other persons exercising similar functions are
directors of any one member bank; or
(4) Which owns or controls, directly or
indirectly, either a majority of the shares of
capital stock of a member bank or more that 50
percent of the number of shares voted for the
election of directors of a member bank . . . . 12
U.S.C. §221a.
In contrast to Section 16 of the Glass-Steagall Act, which
imposes an absolute ban on bank securities underwriting
activities, Section 20 prohibits affiliations between banks and
entities that are "engaged principally" in securities
underwriting activities. Therefore, affiliations are permitted
2
as long as the nonbank institution is not engaged "principally"
in the securities activities restricted by Section 20. Section
20 itself, however, does not define the term "principally
engaged." The legislative history of Section 20 also fails to
define or explain the precise meaning of the term.1 To date, the
United States Supreme Court has not ruled on the question and
very few lower federal courts have addressed it.2 Thus, the
meaning of the term ^engaged principally" is not firmly resolved.
Based on court decisions on other related provisions of the
Glass-Steagall Act, and absent further clarification by the
United States Supreme Court, the term "engaged principally" is
not confined to the majority of a firm's business. Instead, any
bank affiliate engaged in securities underwriting as a
"substantial activity" would be in violation of Section 20.3 A
determination of what level of activity is "substantial,"
however, is still required.
The Federal Reserve has approved numerous applications
allowing so-called "Section 20 subsidiaries" to underwrite and
deal in securities (that are not exempt from the Glass-Steagall
restrictions (i.e.,"ineligible securities")) on the grounds that
the^subsidiaries are not "engaged principally" in such
activities, and thus their affiliation with member banks is not
proscribed by Section 20.4 In a precedential order issued in
1987 ("1987 Order") the Board of Governors of the Federal Reserve
System imposed a "five-to-ten-percent" standard to differentiate
permissible from impermissible levels of securities underwriting
activities. The Board explained its rationale, in part, as
follows:
[T]he Board believes it is bound by the statutory
language of section 20 [of the Glass-Steagall Act]
to conclude that a member bank affiliate may
underwrite and deal in the ineligible securities
proposed in the application, provided that this
line of business does not constitute a principal
or substantial activity for the affiliate. The
1 See Banking Law, Vol. 5, § 96.02 [3] (Matthew Bender, 1994).
2 In Board of Governors v. Agnew, 329 U.S. 441 (1947), the
United States Supreme court defined the term "primarily" to mean
"substantial." This was in the context of section 32 of the GlassSteagall Act, however, and not Section 20. (Section 32 restricts
director and employee overlap between member banks and
entities "primarily engaged" in securities underwriting.)
3 £ f • Board of Governors v. Agnew, supra
4 The Federal Reserve has approved the establishment of over
thirty "Section 20 subsidiaries." 59 Fed. Reg. 35,517 (1994).
3
Board reaffirms its conclusion . . . that Congress
intended that the Engaged principally' standard
permit a level of otherwise impermissible
underwriting activity in an affiliate that would
not be quantitatively so substantial as to present
a danger to affiliated banks . . . .
With respect to the appropriate quantitative level
of ineligible activity permitted under section 20,
the Board concludes that a member bank affiliate
would not be substantially engaged in underwriting
or dealing in ineligible securities if its gross
revenue from that activity does not exceed a range
of between five to ten percent of its total gross
revenues . . . . " Citicorp. J.P. Morgan & Co. .
Inc., and Bankers Trust New York Coro.. 73 Fed.
Res. Bull. 473, 475 (1987).5
5
The Federal Reserve Board's standard was sustained by the
Second Circuit Court of Appeals in Sec. Ind. Ass'n v. Board of
Governors. 839 F.2d 47, 68 (2d Cir. 1988), cert. denied. 486 U.S.
1059 (1988) .
In July 1994, the Federal Reserve requested comments on
proposed alternatives to the current "gross revenue" and "indexed
gross revenue" tests. 59 Fed Reg. 35,516 (1994).
4
With specified exceptions, the Bank Holding Company Act6
("BHC Act) prohibits a Bank Holding Company ("BHC") from
acquiring direct or indirect ownership or control of any voting
shares of any company that is not a bank (12 U.S.C. §1843(a)).
Under Section 4(c) (8) of the BHC Act (Id. at 1843(c) (8)) that
prohibition does not apply to a BHC's acquisition of "shares of
any company the activities of which the [Federal Reserve]
Board . . . has determined (by order or regulation) to be so
closely related to banking or managing or controlling banks as to
be a proper incident thereto . . . ."^ In the 1987 Order the
Federal Reserve concluded that underwriting and dealing in
"ineligible securities" is "closely related" and a "proper
incident" to banking under the BHC Act.8
Specifically, the Board of Governors stated that
"underwriting and dealing in commercial paper, municipal revenue
bonds and 1-4 family mortgage-related securities, under the
limitations discussed in [the 1987] Order, are closely related to
banking, because banks provide services that are so operationally
and functionally similar to the proposed services that banking
organizations are particularly well equipped to provide such
services . . . [T]he proposed activities are natural extensions
6
The BHC Act requires approval by the Federal Reserve for the
formation of a BHC. 12 U.S.C. §1841 et seq. A BHC is any "company"
that has "control" over any "bank" or over any company that is or
becomes a BHC.
The BHC Act defines a "company, " in part, as a
corporation, partnership, business trust, association, or similar
organization. Id. at 1841(b) . A "bank" includes an "insured bank"
under the Federal Deposit Insurance Act that: (1) accepts demand
deposits or deposits that the depositor may withdraw by check or
similar means for payment to third parties, and (2) is engaged in
the business of making commercial loans.
Id. at 1841(c).
Under the BHC Act a company "controls" a bank if: (1) the
company directly or indirectly owns, controls, or has the power to
vote at least 25 percent of any class of the bank's voting
securities; (2) the company controls the election of a majority of
the bank's board of directors or trustees; or (3) the Federal
Reserve determines after the opportunity for hearing that the
company exercises a controlling influence over the bank's
management or policies. Id. at 1841(a).
This exception is implemented by the Federal Reserve in
Regulation Y of the Federal Reserve's regulations. 12 C.F.R. §225.
8
1987 Order, p. 477.
5
of activities currently conducted by banks . . . ."9 The Board
of Governors also concluded that the "proposed underwriting and
dealing activities" were a "proper incident to banking [because
they] may reasonably be expected to result in substantial public
benefits that outweigh possible adverse effects."10
In the orders that the Federal Reserve has issued in
connection with the permissible securities underwriting
activities of member bank affiliates, the Federal Reserve has
expressed concerns about the potential for adverse effects that
might result from the proposed activities, such as unsound
banking practices, conflicts of interest, unfair competition,
undue concentration of resources and loss of public confidence.
Because of these concerns, the Federal Reserve has included
limitations and conditions in its "Section 20" orders. There
were separate protections in the Federal Reserve's original order
of which the following are the most significant:
• In determining compliance with capital adequacy
requirements, the applicant is required to deduct from
its consolidated capital any investment in the^
underwriting subsidiary that is treated as capital in
the underwriting subsidiary.
• The underwriting subsidiary shall maintain at all
times capital adequate to support its activity and
cover reasonably expected expenses and losses in
accordance with industry norms.
• No applicant or subsidiary shall extend credit,
issue or enter into a stand-by letter of credit, asset
purchase agreement, indemnity, insurance or other
facility that might be viewed as enhancing the I
creditworthiness or marketability of an ineligible
securities issue underwritten by an affiliated
underwriting subsidiary.
• There will be no officer, director or employee
interlocks between an underwriting subsidiary and any
of the BHC's bank or thrift subsidiaries.
• An underwriting subsidiary will provide each of its
customers with a special disclosure statement
9 1987 Order, p. 487.
10 1987 Order, p.489.
6
describing the difference between the underwriting
subsidiary and its banking affiliates.
• An affiliated bank may not express an opinion with
respect to the advisability of the purchase of the
ineligible securities underwritten or dealt in by an
underwriting subsidiary unless the bank affiliate
notifies the customer that its affiliated underwriting
subsidiary is underwriting or making a market in the
security.
• No applicant or any of its subsidiaries, other than
the underwriting subsidiary, shall purchase, as
principal, ineligible securities that are underwritten
by the underwriting subsidiary during the period of the
underwriting and for 60 days after the close of the
underwriting period.
• No lending affiliates of an underwriting subsidiary
may disclose to the underwriting subsidiary any non
public customer information consisting of an evaluation
of the creditworthiness of an issuer or other customer
of the underwriting subsidiary (other than as required
by securities laws and with the issuer's consent) and
no officers or employees of the underwriting subsidiary
may disclose such information to its affiliates.11
ii
1987 Order, pp. 503-504.
@FedFRASER