FROM THE OFFICE OF PUBLIC AFFAIRS

Overview of Concerns

The Treasury Department has been a strong proponent of financial modernization. H.R. 10, the Financial Services Act of 1998 (the "bill"), would remove some archaic restrictions on our financial system. However, the bill falls short of meeting the overarching goal of financial services modernization: a financial services system that allows our nation's citizens and communities access to the widest possible array of financial products at the lowest possible cost. The bill thus denies consumers the benefits of an efficient, full-service financial services system.

For example:

The bill would force much financial innovation out of banks and their subsidiaries and into bank holding company affiliates. These needless restrictions would hinder banks from responding to changes in the market. They would harm consumers by limiting the benefits of improved services, lower costs, increased access, and greater innovation that result from increased competition. Moreover, restrictions on where banks conduct activities and on what financial activities they conduct could impair safety and soundness by limiting a bank's ability to diversify and encouraging the bank to take on greater risks to maintain earnings. We believe that efficiency and market competition should determine the best form of organization.

The bill would undermine the Community Reinvestment Act by forcing financial innovation to occur in holding company affiliates. A bank's capacity to help meet community credit needs depends on the size of its consolidated assets, which include assets in subsidiaries.

By generally requiring innovation to occur outside the bank, the bill would result in the wholesale transfer of assets beyond the purview of the CRA -- thus denying communities important benefits they would otherwise have reaped from financial modernization.

The bill would seriously discriminate against the national bank charter -- undermining the dual banking system and denying customers the full benefits of competition. For example, the bill would continue to encumber national banks' direct sales of insurance with a prohibition against selling insurance from places with more than 5,000 people, but would impose no such limit on state banks. National banks should not have to establish a subsidiary to do what many state banks can do directly.

The bill would strip away the benefits of the thrift charter without extending them to all depository institutions. While the bill retains the federal thrift charter, the bill would deprive it of key benefits -- most notably the longstanding right of unitary thrift holding companies (companies that own a single thrift institution) to engage in any lawful business. Eliminating these broad affiliation rights and other attributes of the thrift charter would diminish competition in financial services and reduce consumer choices and benefits.

The bill would perpetuate rather than correct fundamental problems in the Federal Home Loan Bank System. The System has structural flaws that raise serious policy and safety and soundness concerns. Changes in housing finance, technology, and the System's membership have rendered the System's 65-year-old structure obsolete, and raise questions about the allocation and effectiveness of the System's federal subsidy.

Many of the bill's insurance provisions are discriminatory and anti-competitive. For example, the bill would not only fail to preclude states from discriminating against the insurance activities of banks and their affiliates, but would actually open up new avenues for such discrimination. It could impede innovation by permitting state insurance regulators to characterize a wide range of new financial products as "insurance" -- even products whose banking or other features predominated. It would also overturn established principles of judicial deference to federal agencies -- recognized by the Supreme Court in the Chevron case -- with respect to federal agency interpretations of critical matters relating to banking and insurance.

Subsidiaries of Banks

A bank may expand its financial activities through two basic structures: (1) a subsidiary of the bank itself; or (2) a holding company affiliate structure, in which a bank holding company owns both banks and other companies.

The choice between the subsidiary structure and the holding company affiliate structure should be a business decision, not a governmental dictate. Allowing the subsidiary structure has manifest advantages. First, a bank's conduct of new activities in a subsidiary diversifies the bank's assets and income -- providing a cushion against losses in other lines of business. Second, conduct of activities in a subsidiary may allow bank management to better direct the activity. Indeed, a recent OCC study concludes that overseas subsidiaries of banks earned higher returns and ran lower risks in conducting securities activities than did holding company affiliates. Third, if the bank were to fail, the FDIC could sell the subsidiary and use the proceeds to protect depositors -- something it could not do if the activities were conducted in an affiliate. Taxpayers would thus be better insulated from loss. Finally, flexibility in organizational structure maximizes the potential for synergy with existing financial products -- better enabling market participants to meet their customers' full range of financial services needs. While for some companies an affiliate structure may be optimal, for others it may be the subsidiary structure.

Moreover, forcing a financial services company -- as a prerequisite for engaging in new activities -- to transfer resources from its bank to its holding company would deplete the bank's resources, leave the bank's earnings less diversified, and thus increase risk to the deposit insurance funds.

Notwithstanding the benefits of the subsidiary structure, section 121 would severely restrict its use and instead dictate that new financial activities generally be conducted only in Federal Reserve-regulated holding company affiliates.

Section 121 would specifically prohibit subsidiaries of national banks from conducting new financial activities as principal, other than activities permissible for the bank itself.

None of these restrictions on subsidiaries can be justified by safety and soundness or other policy concerns.

As Chairman Helfer of the FDIC stated last year: "From a safety and soundness standpoint, both the holding company model and the bank subsidiary model are viable approaches to expanding the powers of banking organizations. The safeguards that are necessary to protect the insurance funds are similar for either structure. If these safeguards are in place and enforced, either approach will work to protect the insured bank and the deposit insurance funds." And: "With appropriate safeguards, allowing banks to generate earnings from activities in bank subsidiaries lowers the probability of failure. Earnings from bank subsidiaries provide greater protection for the insurance funds than do earnings from activities in bank holding company affiliates, because the earnings of the subsidiary accrue to the benefit of the insured bank parent. This is because diversification often leads to less volatile earnings."

The Banking Committee bill required a bank to remain well-capitalized after deducting any investment in a subsidiary engaged in bank-impermissible activities from its regulatory capital. Thus, the bank could lose its entire investment in the subsidiary and still remain well capitalized. The bills also required any extensions of credit from the bank to such a subsidiary to conform to the inter-affiliate lending limits of sections 23A and 23B of the Federal Reserve Act. Thus, a bank could not lend more than 10 percent of its capital to any one subsidiary, and could not lend more than 20 percent of its capital to all its subsidiaries and affiliates combined. With these protections in place, a bank's potential exposure to a subsidiary should not exceed its exposure to an affiliate.

Subsidiaries of banks (including national banks) have long engaged overseas in underwriting and dealing in securities, venture capital, merchant banking, and other financial activities. These so-called Edge Act subsidiaries have a clear record of success. Indeed, the Federal Reserve, which regulates these subsidiaries, on December 18, 1997 proposed a significant expansion in the type and amount of securities activities in which such subsidiaries may engage.

Subsidiaries of state nonmember banks (regulated by the FDIC) and subsidiaries of thrifts (regulated by the OTS) already successfully engage in activities not permitted to their parent depository institutions.

Proponents of allowing new financial activities to be conducted only in holding company affiliates have contended that only the affiliate form can effectively prevent banks from transferring to these activities any federal subsidy they receive from deposit insurance. There is no merit to this contention.

Even assuming that such a subsidy exists, the argument completely ignores the effect of requiring a capital deduction and limiting extensions of credit (as the Banking Committee bill did). The benefits of any subsidy that may exist may already be transferred to holding company affiliates through the up streaming of dividends by the bank, or through the absorption (in a consolidated financial statement) of lower returns in an affiliate that does not directly receive the subsidy. The capital "haircut" and limits on lending would allow a bank no more latitude to fund a subsidiary than an affiliate.

Finally, this argument runs counter to a long-standing structure for U.S. banks operating overseas, under which the Federal Reserve permits subsidiaries of banks to underwrite and deal in securities and engage in merchant banking activities. There is no justification for denying to domestic subsidiaries of national banks the benefits accorded to overseas subsidiaries.

Moreover, if one truly believes that the bank subsidiary structure allows an improper spreading of a subsidy, it would be a perverse rule that allowed the benefits of that subsidy to be conveyed only to foreign consumers while denying American consumers the benefits of this structure.

Effect on the Community Reinvestment Act

The Community Reinvestment Act (CRA) requires banks to serve the communities in which they operate. As a general matter, a bank's ability to meet credit needs depends on the size of its assets, including the assets of its subsidiaries. Permitting banks to conduct a full range of financial activities through subsidiaries would benefit communities by allowing them to share in the enhanced profitability of the banking system. As financial modernization allowed banks to grow, banks' commitment to the community would also be expected to grow.

Under H.R. 10, however, communities would not share in the benefits of financial modernization through the CRA. Because the bill generally requires financial services organizations to conduct new financial powers outside a bank or its subsidiaries, the assets devoted to these activities would be transferred beyond the reach of the CRA. Significantly, those arguing in favor of forcing new financial activities into holding companies do not propose that CRA follow these activities.

CRA has proven its worth. It is working to restore healthy markets in distressed communities. Nonprofit community groups estimate that since 1992 the private sector has pledged over $397 billion in loans going forward for community development, which represents over 89 percent of CRA pledges made since CRA's enactment in 1977. In 1996 alone, large commercial banks made nearly $18 billion in community development loans, in addition to the affordable housing loans reported under the Home Mortgage Disclosure Act and small business loans reported under CRA.

The remarkable progress that has been made in the areas of urban economic revitalization and financing for affordable housing and small businesses would be stymied if Congress now enacts a law that would restrict the ability of CRA-covered institutions to increase their assets through new financial activities.

As we work to modernize the financial system, we need to make sure the financial system works for all communities.

Discrimination Against National Banks

Although examples of how H.R. 10 discriminates against national banks and the national charter are throughout this paper, we believe it is important to note the cumulative effect of this discrimination: to undermine the dual banking system through the wholesale disparagement of the national charter. The dual banking system has benefitted American consumers of financial services by stimulating innovation and competition, and retaining the vitality of the national charter is of great importance. Nonetheless:

The bill would constrain the financial activities of OCC-regulated national bank subsidiaries far more strictly than FDIC- or Federal Reserve-regulated state bank subsidiaries, or even Federal Reserve-regulated Edge Act subsidiaries of national banks.

The bill would continue to limit the conduct of national bank direct insurance agency activity to places with under 5,000 people while applying no parallel restriction on state banks.

The bill would prohibit national banks and their subsidiaries, but not state banks and their subsidiaries, from conducting de novo insurance agency activities. National banks could conduct such activities only by acquiring existing agents.

The bill would strip the national bank regulator of deference in interpreting key sections of the National Bank Act, thus creating uncertainty for banks relying on these interpretations and inviting costly litigation.

The bill would impose limits on national bank sales of title insurance that would not apply to state banks.

Permissible Financial Activities

Section 103 would grant to the Federal Reserve exclusive jurisdiction to determine what new activities are "financial in nature" and therefore generally permissible for companies affiliated with banks. (By contrast, the Banking Committee bill would have created an inter-agency council for this purpose.) We oppose excluding this and future Administrations from this vital responsibility for the future direction of financial modernization. In the absence of an inter-agency council, such determinations about what constitutes a financial activity should be made jointly by the Federal Reserve and the Treasury.

Thrift Charter

While retaining the federal thrift charter, the bill would deprive this viable, useful, and flexible charter of key benefits. If the bill made the benefits of the thrift system generally available in the interest of competition and innovation, then a melding of charters and of holding company regulation could make sense. The bill, however, manifestly fails to provide such benefits.

The unitary thrift holding company permits commercial affiliations with depository institutions whose commercial lending authority is limited (federal thrifts' commercial lending activities are limited to 20 percent of assets, with half of that amount required to be in small business loans). The bill's elimination of the unitary structure and other advantages of the thrift charter, unaccompanied by broader financial services reform, would remove a useful structure for financial modernization and reduce consumer choices and benefits. There appears to be no sound public policy justification for such a step.

Finally, we note that making the thrift provisions effective on January 1, 2000 would appear to be inopportune, given the year 2000 computer issue which will occupy substantial resources as that date approaches.

Federal Home Loan Bank System

The Federal Home Loan Bank System has structural flaws that raise serious policy and safety and soundness concerns. Changes in housing finance, technology, and the System's membership have rendered the System's 65-year-old structure obsolete, and raise questions about the allocation and effectiveness of the System's federal subsidy.

The FHLBank provisions contained in the bill would likely expand the size of the System without increasing its focus on meeting a clearly defined public purpose. The bill contains some positive provisions such as eliminating mandatory membership and fixing the REFCorp allocation formula, and adding a risk-based element to FHLBank capital requirements. However, the bill would open FHLBank membership to insured depository institutions with less than $500 million in assets without any limit; significantly increase the membership and advance activity of large financial institutions; place only modest limitations on investments, and then only at the discretion of the Finance Board; and create 12 different capital structures. The net result of these amendments would likely be an unfocused increase in FHLBank advance activity (especially to large financial institutions) and only limited reform of the FHLBanks' huge investment-arbitrage portfolios.

We continue to believe that comprehensive reform of the FHLB System should be reserved to another time so that Congress can focus clearly on the needs of the System.

Insurance Powers and Regulation

Title III-A, dealing with state regulation of insurance, is discriminatory and anti-competitive. Consumers of insurance products would not realize the gains, in the form of increased choices and lower prices, that true financial modernization would bring.

Inadequate Protection Against Discriminatory State Laws

While purporting to protect against discriminatory state laws, section 104 would permit state regulators to discriminate against banks by preserving any state law that applies to insurance underwriting affiliates of banks "in the same manner" as to insurance

underwriters not affiliated with banks. Unlike the standard established in the Supreme Court's Barnett decision, this language would permit, and perhaps invite, state laws designed to disadvantage insurance companies affiliated with banks. For example, in determining risk-related capital requirements for insurance underwriters, a state could apply its capital requirement to insurance holding companies and prohibit counting loans other than real estate loans as assets. Even though the requirement would apply to insurance companies affiliated with banks "in the same manner" as to those not affiliated with banks, it would discriminate against companies owning banks because banks have large loan portfolios. The bill should not allow states to deprive customers of the full benefits of bank competition in the insurance underwriting market.

Providing Discriminatory Insurance Agency Limitations

The bill would preserve the discriminatory and anti-competitive rule restricting direct national bank insurance sales to a place of 5,000 or fewer people, without imposing a similar rule on state banks. In addition, section 305 would prohibit national banks and their subsidiaries -- but not state banks and their subsidiaries -- from commencing insurance agency activities in a new state; it would, instead, limit them to purchasing existing agents. These requirements are blatantly discriminatory and anti-competitive.

Nullifying Judicial Deference

Since 1809, the Supreme Court has given weight to the construction of federal statutes by the Executive Branch officials charged with administering those statutes. Over the years, the Supreme Court has refined this concept of judicial deference, culminating in the landmark 1984 decision in Chevron v. Natural Resources Defense Council. Two recent Supreme Court decisions have upheld the doctrine with particular application to national banks: NationsBank v. Variable Annuity Life Insurance Co. and Smiley v. Citibank.

The basis of these precedents -- the public policy interest in political accountability, agency expertise, and familiarity with regulated industries, and the need for finality and uniformity of regulatory decisions -- strongly counsels against impairing judicial deference for federal agency interpretations of law.

That is particularly true for federal banking agencies' interpretations involving the knotty intersection of banking and insurance. It is precisely when difficult questions of policy and law arise, such as the question where to draw the line between insurance and banking services, that the need for judicial deference to agency interpretations is greatest.

Anti-competitive Limitations on Insurance Underwriting

Section 304 would generally prohibit banks and their subsidiaries from providing as principal new products deemed "insurance" in a state, and would allow each state to determine what products constitute "insurance." Section 304 would create a safe harbor for many products previously permissible for national banks to provide as principal, but states would be free to deem any future product to be "insurance" and thereby place it off limits to banks.

Financial innovation often involves hybrid features that combine elements of different kinds of products. Certain types of financial options, for example, could have characteristics of a security and of insurance. Derivatives can be indistinguishable from insurance. Section 304 would have a potentially chilling effect on financial innovation by freeing state regulators to take an overly expansive view and characterize hybrid products as "insurance."

Moreover, allowing 50 different state insurance regulators to distinguish insurance from banking, and regulate the new activities they determine to be insurance, would invite chaos. The result would be a plethora of litigation and a patchwork of legal requirements that would unjustifiably disadvantage banks and their customers.

Providing Protectionist Limitations on Title Insurance Activities

The bill singles out for restriction national banks' authority to sell title insurance in states that permit that activity for state banks after January 1, 1997. There is no reason for this blatant discrimination against national banks and their customers.

State Preemption of Federally Mandated Disclosures to Insurance Customers

Section 308 would require the federal banking agencies to prescribe a series of consumer protections for bank sales of insurance products: e.g., a disclosure that insurance products are not FDIC-insured. We support this step.

However, section 308 would also make these consumer protections inapplicable whenever a state law, regulation, or interpretation is "inconsistent with or contrary to" the federal regulations. Section 308 thus appears to allow states to nullify the consumer protections by adopting more lenient requirements. This license to nullify is as unjustified as it is unprecedented. We see no reason, for example, why a state commissioner should be able to use an interpretation of state law to deprive consumers of a disclosure that insurance products are not FDIC-insured.

Unnecessary Codification of Rules of Construction

Sections 301 and 303 are unnecessary and could have unintended consequences.

Section 301 would affirm that the McCarran-Ferguson Act remains the law. Section 303 would declare that insurance sales shall be functionally regulated by the states. The reason for the reiteration of McCarran-Ferguson is unclear, and the term "functionally regulated" is undefined. Thus, courts could at some point give these provisions an unintended meaning.

National Association of Registered Agents and Brokers

We see logic in establishing a self-regulatory organization for insurance agents and brokers, as under Title III-C. But such an organization must not become a means by which one group of competitors gives itself an advantage over others -- e.g., by discriminating against agents and brokers because they are affiliated with depository institutions. Consumers deserve the benefits of the most robust possible competition for their business.

Title III-C would not only fail to prohibit such discrimination but would actually facilitate it. The new self-regulatory organization (NARAB) could adopt licensing standards for sellers of products that any state labels as "insurance." Because NARAB would derive its rulemaking powers from Congress, depository institutions could not use the principles articulated in the Supreme Court's Barnett decision to resist NARAB rules that were discriminatory. Although section 325 would prohibit the NARAB from adopting "special categories of membership" or "distinct membership criteria" for insured depository institutions and their employees, nothing would prohibit NARAB from enacting a general rule that would have a disparate impact on depository institutions.

Wholesale Financial Institutions

Sections 131, 132, 133, and 136, dealing with wholesale financial holding companies and wholesale financial institutions (WFIs), are seriously flawed. In addition, section 152's requirement that foreign banks convert to WFIs differs from that applied to domestic banks, raising national treatment concerns.

Our specific concerns are as follows:

Comptroller of the Currency's Role in Policy-Setting

Section 136 of the bill would eliminate any role for the Comptroller of the Currency in policy relating to WFIs -- including rulemaking, other standard-setting, and exemptions -- even for WFIs with national bank charters. This undermines the dual banking system and inappropriately denies the Comptroller of the Currency a role in rulemaking regarding such matters as capital standards, capital categories for prompt corrective action, and exemptions from other laws. The Federal Reserve should have unilateral authority only to protect the payments system by taking into account the financial condition of a WFI's affiliates when setting credit limits or by prescribing special clearing balance requirements for WFIs.

Inadequate Safeguards

Section 136 contains inadequate safeguards to protect consumers, the payments system, and the taxpayers. The Federal Reserve would have broad authority to exempt WFIs from other laws -- including capital requirements, prompt corrective action, limits on transactions with unregulated affiliates, CRA, and consumer protections -- so long as the exemption was "not inconsistent" with a vague set of objectives, which would include "the protection of the deposit insurance funds" and "the protection of creditors and other persons . . . engaged in transactions with" WFIs.

Section 136 would in effect permit uninsured WFIs to deal with retail customers who may expect deposit insurance and consumer protections. It would forbid only an "initial deposit" of $100,000 or less in a WFI, unless such receipt occurred "on an incidental and occasional basis," but would at the same time permit the WFI to derive up to 5 percent of its total deposits from accounts with initial deposits of less than $100,000. Thus, the bill does not screen out retail customers -- those that may not fully understand or be able to bear the risks of placing their savings with WFIs.

Section 136 would purport to apply to WFIs the prompt corrective action provisions of the Federal Deposit Insurance Act. But those provisions have as their lodestar the purpose expressed in section 38(a)(1) of that Act: namely, "resolving the problems of insured depository institutions at the least possible long-term loss to the deposit insurance fund." Because WFIs are uninsured, this purpose would logically not apply; it certainly would fail to provide clear guidance for dealing with WFIs.

Insolvency

Failed WFIs should be resolved under the Bankruptcy Code, not under conservatorship provisions designed for the insolvency of insured depository institutions. By choosing the latter route, the bill potentially sends a misleading signal to capital markets that creditors of WFIs may expect troubled WFIs to receive special treatment, as if they were too big to fail.

Regulation of Owners of WFIs: Wholesale Financial Holding Companies

The bill would subject companies that own a WFI (but not an FDIC-insured depository institution) to regulation as a wholesale financial holding company, regulated under the Bank Holding Company Act. Such a company could not engage in more than a very modest amount of non-financial activities (unless it had pre-existing non-financial business). The Federal Reserve would have explicit authority to set capital requirements for these companies.

With adequate safeguards, there should be no need for holding company regulation for WFIs with no FDIC-insured affiliates.

Functional Regulation

Broker-Dealer Regulation of Banking Products

Sections 201 and 202 include exemptions for "traditional banking products" from broker-dealer regulation. The definition of "traditional banking product" in section 206 does not include an elasticity clause allowing regulators to expand the definition by rulemaking or on a case-by-case basis. Instead, section 206 in effect would authorize the SEC to apply broker-dealer regulation to banks providing "new banking products" if, after considering the views of the federal banking agencies, it determined that such regulation was necessary or appropriate in the public interest and for the protection of investors.

In order to ensure that regulatory uncertainty does not prevent banks from offering innovative banking products, we support including a statutory mechanism for determining whether bank products not otherwise enumerated should be subject to broker-dealer regulation. However, such a mechanism should not vest sole authority in the SEC. Doing so, even with a consultation requirement, would leave the banking regulators without a role in shaping policy on an issue directly affecting safety and soundness and other fundamental objectives of banking regulation.

Regulation of Bank-Issued Securities

Unlike sections 205 and 206 of the Treasury's June 1997 proposal, the bill would not transfer oversight of bank-issued securities from the banking agencies to the SEC. We see no justification for continuing the present system of overlapping and duplicative functions by four banking regulators and the SEC.

For the most part the banking regulators already administer these functions comparably to the SEC. Where different treatment of banks and nonbank issuers might be necessary for safety and soundness or other reasons, the SEC could make appropriate adjustments after consulting with the appropriate banking regulator. Thus, consolidating these functions in the SEC would promote efficiency in government and reduce regulatory costs. It would be consistent with the goals of functional regulation by ensuring uniformity of regulation and enforcement.

Push-Out and Restriction of Activities

The bill would place many restrictions on a bank's ability to continue to engage in its activities after the current bank exemptions from SEC broker and dealer regulation are removed. These additional limitations would affect important activities including loan participations and private placements. We see no reason for these restrictions, which may force activities out of banks or make the activities difficult for banks to provide. In addition, these restrictions reduce the product diversity of banks. Bank customers are protected by strong regulation and enforcement, and these restrictions are unnecessary.

FDIC Board

In the context of combining the OTS with the OCC, we support restoring the FDIC's Board of Directors to the three-member configuration it had for 56 years until 1989 (when the OTS was established). This included 12 years with a three-member board fully subject to the Government in the Sunshine Act.

Section 434 of the bill would, at an additional cost of over $1 million annually, maintain a five-member Board of Directors. No showing has been made that the FDIC needs a five-member board to get its work done. Indeed, the only case that has been advanced for the five-member size has been the agency's desire to avoid the constraints of the Government in the Sunshine Act.

We believe that to be an inadequate reason tojustify the expenditures involved. The federal government currently includes at leastseven three-member boards: the Farm Credit Administration, Merit Systems ProtectionBoard, National Credit Union Administration, National Mediation Board, Occupational Safety and Health Review Commission, Railroad Retirement Board, and TennesseeValley Authority.