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At the Annual Washington Conference of the Institute of International Bankers
March 3, 1997

Recent Developments in Supervision and Regulation and How They Affect the
Debate on Financial Modernization
I am pleased to have the opportunity to address this group at a time when developments in
global financial markets are presenting particular challenges for market participants and
market regulators alike.
I was asked to talk with you today about both developments in Federal Reserve supervision
and regulation, as well as the approaches to financial modernization being debated in the
Congress. I won't try to cover the full waterfront on these topics, but would like to share
with you some of the Board's considerable rethinking about the way we supervise and
regulate bank holding companies. I will also describe how I believe the recent Board
initiatives coming out of this process may well alter the debate about the structure and
supervision of financial services in the United States -- a topic I believe has received
insufficient attention in the legislative debate so far.
I will focus my discussion of recent Board actions on the supervisory process and on three
regulatory changes made or proposed by the Board: changes to the application and
nonbanking provisions of Regulation Y, changes and proposed changes to the Boardimposed "firewalls" between a bank and a securities affiliate, and changes to the Board's
anti-tying rules. I stress these three not necessarily because they are the most important
undertaken by the Board, but because I believe that they most directly affect the debate
about how financial services should be supervised.
Supervisory Changes
The cornerstone of the bank supervisory process is the verification of prudent practices and
financial condition through on-site examinations, coupled with off-site surveillance.
Traditionally, on-site examinations of bank holding companies and their nonbank
subsidiaries have focused on verifying compliance and determining the financial condition of
an institution at the time of the examination by reviewing their loans and by testing other
transactions. This process is changing.
The Federal Reserve's supervisory oversight at the bank holding company level is
increasingly directed at evaluating risk management, internal controls, and decisionmaking
processes that are shared between a bank and its parent, rather than focusing on transactions
and positions at nonbank affiliates. This focus is necessary given the continuing trend toward
integrated management of financial activities on a consolidated basis. Testing the adequacy
of risk management and internal control helps us understand the financial condition of the
consolidated organization and the potential impact of consolidated risk management policies
and internal controls on the operations of the insured depository institution. To implement
this approach, the Federal Reserve last year began assigning a formal rating to risk

management in our holding company and bank examination reports.
Changes have come not just in what we examine, but also in how we examine. We are
making greater use of internal risk management reports, the results of internal risk models,
and the work of internal and external auditors. For example, the Federal Reserve is now
collecting internal loan classification reports prepared by most of our larger banks, as well as
other information generated by their internal risk management systems. This approach has a
further advantage in that it can generally be conducted off-site, at less burden to the firm.
Our examinations are also becoming more efficient through pre-visitation planning that
better identifies those areas of a company's activities that pose the greatest risk. We are also
making greater use of computer technology in the examination process and using automated
systems that permit examiners to analyze data on their personal computers. And, of course,
whenever possible we rely upon examination and inspection reports prepared by regulators
of the individual entities within the bank holding company.
Like examinations, disclosure practices of the past also focused narrowly on the financial
condition of an institution at a point in time, using conventional accounting and regulatory
measures. Today, however, disclosures are expanding to reveal not only the current risks of
the balance sheet, but also management's philosophy for managing and controlling risk.
Disclosure is an important aid to us as supervisors and, we hope, to market analysts.
Improved disclosure has already been put into practice for derivatives and market risks, and
we will continue to urge better and more broadly based disclosure of all major activities and
The Effect of Supervisory Changes on Legislation
As the issue of consolidated or "umbrella" supervision is debated in the legislative process, I
believe it is important to examine how these supervisory developments alter that debate.
There are those who argue that umbrella supervision of a diverse financial services holding
company would either be an impossible task or an intolerable burden. But the risk-analysis
and surveillance techniques that we have decided are the most effective for bank holding
companies should also be adaptable to more diverse financial organizations that include
banking operations. Clearly, we must all give additional thought to how such an adaptation
would work so that we minimize the intrusion into new activities. Perhaps there should be
some kind of carve-out for firms whose banking operations are a small part of the
organization or if the firm is otherwise regulated. Nevertheless, to be successful, a financial
services company should reap synergy gains not only by marketing a variety of products to
customers but also by pooling and jointly managing diverse financial risks. Thus, the
movement toward use of one treasury, one risk management policy, and one set of exposure
limits would continue. It is those policies and risks that an umbrella supervisor must
understand in order to gauge the risks to the insured institution.
In fact, as I am sure this group will recall in the wake of BCCI, the Congress also became
convinced of the importance of consolidated supervision of any banking organization.
Through the Foreign Bank Supervision Enhancement Act, the United States not only
recognized the importance of consolidated supervision, but strongly encouraged it as an
international principle of banking supervision by requiring that any foreign bank seeking to
enter the United States be subject to consolidated home country supervision.
Subsequent history has confirmed that judgment. As I've noted, virtually all of the large
holding companies now operate as integrated units and are managed as such. Thus, the
Federal Reserve remains convinced that one supervisor must have the task of evaluating the

organization as a whole.
This view is now commonly accepted around the world. The idea has for some time been
endorsed by the Basle Committee on Banking Supervision, and many countries are adopting
similar approaches.
Still, I can certainly understand why some advocates of a more diversified financial services
holding company would wish to abandon consolidated supervision. Consolidated supervision
raises hard questions -- the kind of questions that can bog down legislation and splinter
coalitions -- and questions that engage us even now. What authority should a consolidated
supervisor have over non-financial activities, if they are allowed? How should the
consolidated supervisor work with the primary supervisor of a bank, or a broker-dealer, or
an insurance company? How much burden must consolidated supervision entail?
As we all pursue the answers to these questions, perhaps the Federal Reserve's risk-based
approach to supervision can provide insights into how umbrella supervision of an expanded
organization could work.
Regulatory Changes
Just as with supervision, the regulatory side of the Federal Reserve has undergone profound
changes of late.
Just a few weeks ago, the Board approved a comprehensive streamlining of Regulation Y
that should substantially diminish the regulatory burden on bank holding companies and
foreign banks wishing to expand or innovate in the United States.
First, the Board concluded that review of an application should focus on how the proposed
acquisition or activity would affect the organization. The application should not become a
vehicle for comprehensively evaluating and addressing supervisory and compliance issues at
the applicant organization. This principle is also the basis for recent Congressional action to
eliminate the prior approval requirement for engaging in Board-approved nonbanking
activities under section 4 of the Bank Holding Company Act, provided the company meets
specified standards for capital and management at the time of its last examination. As a
result, the Board has significantly streamlined the process for well-capitalized, well-run
companies to acquire a bank or nonbank and eliminated the prior approval process for such
companies to engage de novo in Board-approved nonbanking activities.
Second, the Board concluded that bank holding companies should be permitted to conduct
nonbanking activities to the fullest extent permissible under the Bank Holding Company
Act, and that Regulation Y should be sufficiently flexible to allow for industry changes in
permissible activities without requiring additional regulatory filings. Accordingly, the Board
removed restrictions on investment advisory activities, derivatives trading activities, leasing,
and other activities whenever those restrictions impeded efficiency or imposed costs without
conferring corresponding benefits to safety and soundness. The Board also permitted a data
processing or management consulting subsidiary to derive up to 30 percent of its revenue
from nonfinancial data processing or nonfinancial management consulting. And the Board
has indicated that it will be pro-active in approving new activities.
The next area where the Board has been particularly active concerns firewalls between a
bank and an affiliated securities firm, better known as a section 20 affiliate. Experience with
these section 20 affiliates, and other affiliates engaging in similar activities without such
restrictions, led the Board to conduct a comprehensive review of the firewalls. Much of the

potential for conflicts of interest between a bank and a securities firm is addressed by other
laws such as the registration and disclosure requirements and the anti-fraud provisions of the
securities laws. Legislative and regulatory enactments, many adopted since the Board's
initial 1987 section 20 order, also provide important insulation between a bank and a section
20 affiliate by imposing qualitative and quantitative limits on inter-affiliate transactions and
requiring that a customer receive disclosures detailing the identity of its counterparty and the
product being purchased.
Accordingly, the Board has repealed its restriction on cross-marketing between a bank and a
section 20 affiliate, eliminated a blanket restriction on employee interlocks, and scaled back
a blanket restriction on officer interlocks to include only a chief executive officer. The
Board has also proposed to eliminate a firewall prohibiting a bank from providing any
funding to a section 20 affiliate and three restrictions on a bank's extending credit or offering
credit enhancements in support of securities being underwritten by its section 20 affiliate.
The Board's proposal recognized that as financial intermediation has evolved, corporate
customers frequently seek to obtain a variety of funding mechanisms from one source. By
prohibiting banks from providing routine credit enhancements in tandem with a section 20
affiliate, the existing firewalls hamper the ability of bank holding companies to operate as
one-stop financial services providers, thereby reducing options for customers. Instead, the
Board has proposed to require that internal controls and operating standards ensure that a
bank use independent credit judgment whenever it is acting in tandem with its section 20
Finally, the Board has taken action to allow greater packaging of products by bank holding
companies. Since the 1970s, banks and bank holding companies have been prohibited from
packaging their products unless the arrangement involved a traditional bank product. While
this exception softened the impact of the statute, bank holding companies were nonetheless
at a considerable disadvantage to their competitors, particularly as bundling of services has
become a marketing imperative on both the retail and wholesale side of the business.
After reviewing its experience with the statute, the Board recently repealed a regulation that
had extended to bank holding companies and their nonbank subsidiaries the statutory
prohibition on tying arrangements by banks. Experience taught us that these non-banks did
not have the type of market power that Congress presumed banks possessed when it enacted
an anti-tying statute. The Board has also created exceptions to the statute to allow package
arrangements between bank holding company affiliates to the same extent as the statute
allows them within the bank.
Lastly, and perhaps of greatest interest to you, the Board created a safe harbor to clarify that
any transaction with a foreign customer was not covered by the statute. Thus, for example, a
U.S. branch of a foreign bank can participate in a syndicated loan to a European firm, even
if the loan is offered only as part of a package of services that would otherwise run afoul of
the anti-tying law.
The Effect of the Regulatory Climate on Legislation
I think it worth noting how all these reforms may affect the debate about the corporate
structure of bank holding companies -- specifically whether bank holding companies should
be granted the option of moving activities prohibited to the bank into a subsidiary of the
bank, and thereby funding those activities with subsidized funds.
Descriptions of how the subsidy works and examples of the funding advantages it confers

are plentiful. But I believe that it is so ingrained in our thinking that we sometimes take it for
granted. Think how obvious the subsidy would be if it involved another industry -- for
example, if the government guaranteed that commercial paper holders of the automobile
industry would be repaid in full. To complete the other strands of the safety net -- the
discount window and the payment system -- let us assume that automobile companies
experiencing liquidity problems could borrow from the Federal Reserve for the purpose of
repaying commercial paper, and that they are able to achieve risk-free settlement. The
effects of extending such a subsidy are not difficult to imagine. Automakers would find it
very easy to place their commercial paper, and would be able to pay a below-market yield.
And, to the extent the hypothetical allowed, I would not be surprised to see automakers use
this funding advantage to enter other businesses.
So it is with banks -- and with subsidiaries of banks. Regulators can limit a bank's ability to
subsidize its subsidiary through loans by capping their amount or regulating the rates the
subsidiary must pay. But although one can limit the aggregate investment a bank can make
in its subsidiary by requiring that such injections be deducted from the capital of the bank,
the equity investment in the subsidiary is still funded from subsidized resources, and that
subsidy transfer cannot be eliminated.
Thus, both analytically and practically, I think it difficult to deny that banks and their
subsidiaries benefit from a federal subsidy, and benefit in ways that an affiliate of the bank
does not. Nevertheless, some argue that a parent-subsidiary structure is more efficient than a
sibling structure, and must be allowed for a broader range of activities. But in light of the
recent regulatory changes that I have described, I believe that this argument is now
questionable. A bank and an affiliate can now avoid a redundant work force and duplication
of effort by having employees serve in a dual capacity, or by allowing reporting lines to
cross. For example, a common back office or treasury can be maintained. Furthermore, the
two companies can market their products jointly to both retail and corporate customers.
With these regulatory changes, banks and bank holding companies have opportunities to
make considerable adjustments to their organizational structures and operating procedures as
well as to offer new products to customers in new ways.
Let me conclude by pointing out that the legislative debate has only just begun. Opinions are
still developing, new ideas are still being presented, and positions are not yet cast in
concrete. But even as new legislation is being debated, those of us who must try to interpret
and administer existing laws recognize that we must do so in a developing global
marketplace. I believe that the steps the Board has taken to make its regulatory and
supervisory systems less burdensome and more risk focused will stand us in good stead in
this changing financial environment. Nevertheless, comprehensive financial reform
legislation is still needed to allow banking and other financial institutions to compete
internationally and to offer the full range of financial services needed and demanded by their
customers. Thank you.
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