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Speeches and Testimony |
RICKI HELFER, CHAIRMAN ON
FINANCIAL MODERNIZATION AND H.R. 268, BEFORE THE
SUBCOMMITTEE ON FINANCIAL INSTITUTIONS & CONSUMER CREDIT
10:00 A.M.
Madam Chairwoman and members of the Subcommittee, I
appreciate this opportunity to present the views of the Federal
Deposit Insurance Corporation on financial modernization, H.R.
268, the Depository Institution Affiliation and Thrift Charter
Conversion Act, and related issues. I commend you, Madam
Chairwoman, and Congressman Vento for placing a high priority on
the need to modernize and strengthen the nation's banking and
financial systems. H.R. 268 represents a thoughtful approach
toward meaningful reform that will serve us well in developing
balanced, constructive legislation.
On behalf of the FDIC, I also want to express our sincere
gratitude to you, to members of this Subcommittee, and to other
members of the Congress for passing legislation providing
immediate financial stability to the Savings Association Insurance
Fund (the SAIF). The health and stability of the financial
industry are in the interest of everyone -- participants,
regulators, banks and thrifts. Sound deposit insurance funds
contribute to that health and stability.
The Deposit Insurance Funds Act of 1996 (the Funds Act)
capitalized the SAIF and solved its immediate financial problems.
The Funds Act also recognized the need for a merger of the deposit
insurance funds. The FDIC strongly supports a merger of the Bank
Insurance Fund (the BIF) and the SAIF as soon as practicable. The
SAIF insures far fewer, and more geographically concentrated,
institutions than does the BIF, and, therefore, faces potentially
greater long-term risks.
A merger of the BIF and the SAIF is a necessary component of
a solution to long-term structural problems facing the thrift
industry, and consequently the industry's deposit insurance fund.
A combined BIF and SAIF would have a larger membership and a
broader distribution of geographic and product risks; a combined
fund would be stronger than the SAIF alone. Under the Funds Act,
Congress has made the merger of the BIF and the SAIF contingent
upon the creation of a common bank charter.
I am pleased to have this opportunity to testify on
financial modernization against the backdrop of two fully
capitalized deposit insurance funds and record bank earnings.
Although final numbers are still being tabulated, early
indications are that annual earnings for commercial banks
surpassed $50 billion for the first time in 1996. Average equity
ratios are at their highest levels in more than 50 years, and
nonperforming assets are well under one percent of total assets,
the lowest level in the 15 years that banks have reported
nonperforming assets.
Private sector thrifts have earned more than $6 billion each
year since 1991, when the industry returned to profitability.
Thrift earnings in 1996 may have exceeded the record $7.6 billion
of 1995 if thrifts had not paid a special assessment to capitalize
the SAIF. Equity ratios remain near 40-year highs, and
nonperforming assets are down to approximately one percent of
total assets, the lowest level in the seven years that thrifts
have reported nonperforming assets.
Only six insured institutions, with aggregate assets of $220
million, failed in 1996. Also, the number and aggregate assets of
institutions on the FDIC's "problem" institution list have
declined sharply over the past five years. At the end of 1991,
there were 1,426 institutions with total assets of $819 billion on
the "problem" list. This was the highest level of "problem" list
assets in the history of the FDIC. Since 1991, the "problem" list
has steadily declined. As of September 30, 1996, only 125
institutions, with assets of $15 billion, were on the list -- a
fraction of the highest level.
From 1980 through 1994, 1,617 banks failed or received
financial assistance from the FDIC. These banks accounted for
almost three-fourths of the failures that have occurred since the
inception of federal deposit insurance in 1933. These failed
banks had combined assets of $317 billion, and cost an estimated
$36.4 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 five bank failures in
1996 were the fewest since four banks failed in 1974, and
demonstrate the significantly improved financial condition of the
banking industry.
In recent years, banks and thrifts have benefited from
continued economic expansion and low inflation. These favorable
conditions have produced strong loan demand and have contributed
to wider net interest margins. The resulting growth in revenues
has enabled banks and thrifts to reduce their inventories of bad
assets while boosting profits.
Although banks have been making record profits recently,
evidence suggests that increasing numbers have turned to somewhat
riskier investments as they have lost business to competitors.
Loan-loss rates in today's favorable environment remain
significantly higher than in pre-1980 nonrecessionary periods.
Bank performance has varied greatly during the past ten years.
Figures 1 and 2 illustrate annual returns on assets and net
charge-offs as a percentage of average loans since 1960. The
volatility of earnings in the 1980s is readily apparent, as is the
relationship between recessionary periods and net charge-offs. In
the past ten years, the banking industry achieved both its highest
return on assets (1.20 percent in 1993) and its lowest annual
return on assets (0.10 percent in 1987) since 1934.
As we consider financial modernization, current favorable
economic conditions provide both an opportunity and a challenge.
We have the opportunity to merge the deposit insurance funds at a
time when both funds are fully capitalized. The challenge for us
is to recognize that good times may not last forever. We must
evaluate any financial modernization proposal by determining
whether it will operate effectively during times of stress for
financial institutions. As deposit insurer, the FDIC brings a
unique perspective to the financial modernization question.
Events of the past decade have demonstrated how costly bank
failures can be for the insurance fund, for communities across
America, and for our economy. The BIF and the banking industry
spent approximately $36.4 billion to resolve failing banks from
1980 through 1994. The General Accounting Office has estimated
that from 1986 through 1995, the thrift crisis cost an estimated
$160 billion to resolve (including tax benefits); approximately
$132 billion of this amount was paid by the taxpayers. Thus, it
is imperative that we learn from the past and proceed deliberately
as we contemplate a substantial expansion of powers available to
banking organizations.
Let me turn now to a discussion of the issues before us
today. First, my testimony will briefly discuss the need for
financial modernization. Second, I will outline lessons the FDIC
has learned from studying the banking and thrift crises of the
1980s and early 1990s. And finally, I will suggest guiding
principles for financial modernization.
THE NEED FOR FINANCIAL MODERNIZATION
Modernization of the financial system is necessary to
achieve an efficient and competitive financial services industry
able to meet current and future challenges. The financial markets
have changed dramatically since the 1930s when many of our
nation's laws governing financial services were enacted.
To a greater extent than ever before, businesses have been
by-passing traditional financial intermediaries to access the
capital markets directly. Large corporations now frequently meet
their funding needs by issuing commercial paper, debt securities
and equity, rather than by borrowing from banks. The shrinking
role of banks in lending to business is illustrated by the
declining proportion that bank loans represent of nonfinancial
corporate debt. This share declined from about 28 percent in 1975
to 21 percent at year-end 1995.
In addition to their shrinking role as providers of
traditional financial intermediation services, banks and thrifts
also are experiencing increasing competition from nonbanking firms
that now offer financial products that once were the exclusive
domain of banks and thrifts. Banks have also grown much less
rapidly than other financial intermediaries during the past 10
years. For example, from 1986 through 1995, banking assets grew
at an average annual rate of 5.7 percent, compared to growth rates
of 19.0 percent and 8.5 percent for mutual funds and pension
funds, respectively.
This relative decline in market share and relatively slower
growth do not paint the complete picture. Traditional market
share measures, which are based on asset holdings, generally do
not reflect the growing importance of bank income from
off-balance-sheet products and services. The rise in the
noninterest income share of bank earnings indicates less reliance
on traditional lending activities. It also indicates that banks,
too, are innovating and adapting to a changing marketplace.
Nevertheless, banks have experienced a relative decline in
market shares and relatively slower growth. Financial
modernization should strengthen banking organizations by allowing
diversification of income sources and better service to customers,
which would promote an efficient and competitive evolution of the
U.S. financial markets.
LESSONS FROM THE PAST
When I became FDIC Chairman, I initiated a project that I
called the "Lessons of the Eighties" to answer the question, "Did
we, as bank regulators, learn the correct lessons from the banking
and thrift crises of the 1980s and early 1990s?" At the time the
project began, the banking and thrift industries were recovering
from the worst period of bank failures since the 1930s. It is
essential that we thoroughly analyze and understand the factors
that led to those crises in order to be prepared for the problems
that could occur in the future.
The lessons we have thus far learned could be instructive to
this Subcommittee in its deliberations on financial modernization.
My testimony will focus on two broad lessons in particular: (1)
geographic and product constraints on insured institutions can
result in inadequate diversification of income sources; and (2)
rapid expansion of insured institutions into unfamiliar
activities, without adequate supervision, can have undesirable
consequences. In the context of this hearing, what these lessons
demonstrated to us is that we cannot attribute all the losses from
the failures of financial institutions in the 1980s and early
1990s to economic events or to poor management of depository
institutions. A significant share of the responsibility must be
assigned to overly restrictive laws, changes in the law providing
little time for adjustment, poorly planned deregulation and
deficiencies of the supervisory process.
Geographic and Product Constraints
Geographic and product restrictions have constrained the
activities of U.S. depository institutions for much of their
history. Although these restrictions insulated them, at least for
a time, from competition, they also hindered banks from expanding
their sources of income and from developing portfolios that
reflected product and geographic diversity.
The impact of product restrictions is most notably seen in
the experience of savings and loan associations. For years,
thrifts were limited to providing only savings deposits and home
mortgages to their customers. This created an inherently unstable
situation -- of borrowing short-term deposits to fund long-term
mortgages -- that became apparent in the late 1970s and early
1980s when short-term interest rates rose above long-term rates.
This was the beginning of the savings and loan crisis that in time
led to the demise of the Federal Savings and Loan Insurance
Corporation. Although banks provided a broader range of products,
commercial lending was their primary focus and this market also
came under pressure during this period. As the commercial loan
market declined, and the commercial paper and junk-bond markets
grew, banks were forced to find new sources of income since they
were restricted in their ability to adapt to their customers'
needs.
The impact of geographic restrictions is evident in the
relatively high failure rates in states where branching was
prohibited or severely restricted, such as Texas, Kansas and
Illinois. This impact is also evident in the vulnerability of
banks to regional economic problems. Because most U.S. banks
serve relatively narrow geographic markets, regional and sectoral
recessions have frequently had a severe impact on them. There
were four major regional or sectoral economic downturns during the
1980s and early 1990s, and each resulted in increased bank
failures. The first accompanied the downturn in farm prices in
the early 1980s. Agricultural prices increased steadily during
the boom years of the 1970s. This ended, however, in the late
1970s as interest rates soared, significantly increasing farm
operating costs. At the same time, export demand decreased
sharply due to worldwide competition. These events contributed to
a collapse in real farm income in 1980. Then, as inflation
declined, land values collapsed. Ultimately, this downturn took
its toll on many agricultural banks. In 1985, these banks
accounted for 48 percent of bank failures. The second downturn
occurred in Texas and other major energy-producing states in the
Southwest following the collapse of oil prices in 1981 and again
in 1985. Texas banks, for example, had rapidly increased their
commercial and industrial loans in the 1970s as strong worldwide
demand for oil and OPEC-restrictions on supply brought on a sharp
rise in oil prices. Following the oil-generated cycle were wide
swings in real estate activity that contributed significantly to
the downturn in the economies of Texas and other states in the
Southwest and the sharp rise in bank failures in this region. The
experience in Texas and certain other states was aggravated by the
large number of new banks chartered during the 1980s, and by the
fact that newer banks failed more frequently than existing
institutions.
Boom and bust conditions in real estate activity also
contributed to the third downturn, in the Northeast. In this
regional recession, mutual institutions that had converted to the
stock form of ownership failed with greater frequency than mutuals
that had not converted. Of the mutuals that converted in the mid-
and late-1980s, 21 percent failed during the period 1990 through
1994. This compared with eight percent of all mutuals that
existed as of the end of 1989 and had not converted. The final
downturn was a recession in California -- a state without
geographic branching restrictions -- following defense cutbacks in
the early 1990s. In this downturn we found higher failure rates
among smaller and newer banks that were more closely tied to their
local economies. The large California banks that operated
statewide were less affected.
The lesson we draw from these events is that attempts to
ensure the safety and soundness of insured institutions by
limiting market competition ultimately fail. In the long run,
geographic constraints and product restrictions do not insulate
depository institutions from competitors, who will eventually find
ways to enter markets.
Congress eliminated many geographic constraints by enacting
the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994. Slowly, over the years, Congressional action, agency
initiatives and court decisions have removed some product
constraints. Nevertheless, barriers, such as the Glass-Steagall
Act, that prevent financial organizations from diversifying -- and
from responding quickly and efficiently to changes in the
marketplace -- remain. To maintain the safety and soundness of
the financial system, institutions must be allowed to diversify.
Use of Expanded Powers and Supervision
In response to the deepening crisis in the thrift industry,
the early 1980s were dominated by actions to deregulate the
product and service powers of insured depository institutions.
The resultant rapid expansion of insured institutions into
unfamiliar activities without adequate supervision resulted in
significant losses for the industry. For example, many banks and
thrifts adopted a highly aggressive posture with respect to
commercial real estate lending. Large increases in the early
1980s in real estate investment produced a boom in commercial
construction and in bank and thrift commercial real estate
lending. Further stimulus was provided by legislation that
greatly enhanced the after-tax returns on real estate investment
and by the expansion of nonresidential lending powers of savings
and loan associations implemented through banking legislation.
Other factors led to increased risks in the 1980s as well.
During this time, chartering standards were lowered, the
inappropriate use of brokered deposits increased, and capital
standards were reduced for thrift institutions.
Relaxed chartering policies led to approximately 3,300 new
banks being chartered from 1980 through 1990. Of these new
institutions, 15 percent subsequently failed; this compared with a
7.7 percent failure rate for banks in existence as of year-end
1979. The influx of new charters created markets that were
overbanked, which created more competition for good loans. This,
in turn, created incentives for banks to loosen underwriting
standards and take on more risk. The increase in charters also
diluted the available management talent necessary to operate a
sound institution.
Insolvent thrifts were allowed to use brokered deposits to
stay in operation and, indeed, to grow their assets or engage in
new activities that could not have been funded through traditional
sources. At the same time, regulatory accounting standards for
thrifts were adopted allowing many to exist with little or no
capital. These institutions, with little or no capital on the
line, and access to fully-insured brokered deposits, in many cases
took extraordinary risks that resulted in large losses to the old
Federal Savings and Loan Insurance Corporation fund, which was not
managed by the FDIC, and, ultimately, to taxpayers.
While powers were being expanded, insufficient attention was
being paid to safeguards against risky behavior. In the late
1970s and early 1980s, regulators increased their reliance on off-site monitoring and prioritized examinations to focus primarily on problem banks. This was attributable in part to efforts to limit
the size of the federal government. As a result, intervals
between examination cycles for healthy banks increased on average
from annually to as long as three years, and even longer for some
institutions, and the number of examiners was reduced. From 1979
to 1984, examination staffs declined by nearly 20 percent at the
FDIC and the Office of the Comptroller of the Currency, while the
Federal Reserve's examiner staff increased slightly.
Additionally, state examiner ranks declined 12 percent during this
period. These actions ultimately resulted in weakening the
ability of bank supervisors to detect and to respond to problems
as failure rates began to soar.
The lesson we learned from these events is that deregulation
must be accompanied by adequate safeguards and strong supervision
and monitoring by the regulators. Unfortunately, in the 1980s
this did not occur. In addition, during that period, legislation
was passed in a crisis situation without a full understanding of
the consequences of the changes being undertaken.
Diversification of income sources by depository institutions
remains a desirable goal and will contribute to stronger, more
competitive financial markets. With these lessons in mind -- and
in the absence of crisis conditions -- we have the opportunity to
design an appropriate analytical framework that addresses
competitive as well as supervisory issues.
PRINCIPLES OF FINANCIAL MODERNIZATION
Any financial modernization proposal must balance numerous
public policy goals. Financial reform must ensure the safety and
soundness of insured depository institutions and the integrity of
the deposit insurance funds. It also must allow insured
depository institutions to generate sufficient returns to attract
new capital essential for normal growth and expansion into new
areas. To achieve these goals, insured depository institutions
must be able to compete on an equitable basis with other
businesses, and to evolve with the marketplace, consistent with
safety and soundness. Equally important, concerns about the
potential for credit judgments to be made on preferential terms to
affiliated companies or other conflicts of interest between
banking and nonbanking affiliates and the effects of undue
concentration in the economy must be addressed. Moreover, any
financial modernization proposal must be examined for its effect
on small communities, isolated markets, and customers of insured
depository institutions.
The FDIC has a vital interest in the safety and soundness of
insured depository institutions and the integrity of the deposit
insurance funds. It is from the perspective of insurer of U.S.
bank and thrift deposits that we evaluate the proposals for
financial modernization. We believe the following principles are
critical components in achieving a financial modernization
proposal that balances the public policy goals.
Activities
First, with limited exceptions, an insured institution
should be permitted to engage in any type of financial activity,
whether banking, securities, or insurance. The exceptions would
consist of those activities that: (1) pose significant safety and
soundness concerns; (2) represent an unwarranted expansion of the
federal safety net provided by deposit insurance, access to the
Federal Reserve's discount window, and Federal Reserve oversight
of the payments system; or (3) harm consumers or small businesses.
Structure
Second, a financial institution should have flexibility to
choose the corporate or organizational structure that best suits
its needs, provided safeguards protect the insurance funds and
prevent expansion of the federal safety net. If an activity
raises safety and soundness concerns or would unduly expand the
federal safety net, the activity should be confined to a
subsidiary or an affiliate.
With respect to expansion of the federal safety net, there
is no question that federal deposit insurance, the discount
window, and access to the payments system continue to provide
banks with a gross funding subsidy -- a funding advantage before
taking account of offsetting costs. However, the relevant
question for purposes of organizational structure is not whether
banks receive a gross subsidy. The relevant questions are whether
banks receive a net subsidy -- a funding advantage after taking
account of offsetting costs such as reserve requirements,
regulatory expenses, and regulatory restrictions -- and whether
banks could pass on a net subsidy to a bank subsidiary or holding
company affiliate given restrictions that protect the safety and
soundness of the insured bank and inhibit undue expansion of the
safety net.
There are two organizational structures with which we have
experience in the United States that can be used to combine
traditional commercial banking with new activities. These are:
(1) conducting each activity in separate organizations owned and
controlled by a common "parent" organization (the "bank holding
company" model); and (2) conducting each activity in a separate
organization, one of which owns and controls the other entity (the
"bona fide subsidiary" model). A third model -- the conduct of
both activities within the same entity (the "universal banking"
model) -- has been used in some other developed countries,
although not with unmitigated success in recent years. We 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 or prevent the
unwarranted expansion of the federal safety net.
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 under the bank holding company umbrella.
Within this framework, banking organizations have been permitted
to engage in an increasing array of financial and related
services, including securities, mutual funds and insurance.
In terms of the criteria for safeguards set forth earlier,
the bank holding company model has considerable merit. The
advantages include:
The disadvantages of the bank holding company model
include:
Bona Fide Subsidiary Model. The FDIC has permitted bona
fide subsidiaries of insured nonmember banks to engage in
securities activities since December 1984 (12 CFR 337.4). A "bona
fide" subsidiary of an insured nonmember bank must be adequately
capitalized. Its operations must be physically separate and
distinct from the operations of the bank. It must maintain
separate accounting and other corporate records, and observe
corporate formalities such as separate board of directors
meetings. It must share no common officers or employees with the
bank and must compensate its own employees. A majority of its
board of directors must be composed of persons who are neither
directors nor officers of the bank. It must conduct business in a
way that informs customers that the subsidiary is separate from
the bank and that its products are not bank deposits and are not
insured by the FDIC, nor guaranteed by the bank. Additionally,
restrictions are placed on loans, extensions of credit and other
transactions between an insured bank and its securities
subsidiary.
From a practical perspective, there has been much less
experience with the "bona fide" subsidiary form of organization
than with the bank holding company form. However, the experience
discussed later in this testimony supports the view that direct
ownership of a nonbank 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:
However, on the negative side:
Securities Activities Under the Bona Fide Subsidiary Model.
While the experience of the FDIC with bona fide securities
subsidiaries of insured nonmember banks has been limited, these
subsidiaries generally have not posed safety and soundness
concerns. Only one FDIC-supervised institution owns a subsidiary
actively engaged in the full range of securities activities
permitted by the FDIC, but over 400 insured nonmember banks have
subsidiaries engaged in more limited securities-related
activities. These activities include management of the bank's
securities portfolio, investment advisory services, 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.
It is clear that there are advantages and disadvantages to
both the bank holding company and the "bona fide subsidiary"
models. Legislation based on a progressive vision of the
evolution of financial services need not mandate a particular
structure, as long as the insured bank is protected.
Moreover, activities that banks currently conduct should be
left undisturbed. To require that these activities be moved to a
subsidiary of either the bank or the holding company, in the
absence of compelling public-policy reasons, could cause
unnecessary disruption and contribute to market inefficiencies.
Moreover, if banks have historically conducted the activities in
the insured institution with minimal negative consequences, there
is no compelling safety and soundness reason to require that such
activities be conducted in a subsidiary or affiliate. 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.
Safeguards
The third principle of financial modernization is that
safeguards should prohibit inappropriate transactions between
insured institutions and their subsidiaries and affiliates. If
these safeguards are inadequate or the resources are unavailable
to enforce them, the deposit insurance funds, the financial
system, and the public could suffer. Transactions between an
insured institution and a related firm pose several risks. First,
an insured institution may be used to benefit a related firm
inappropriately, for example, through unwarranted fees paid to an
affiliate or subsidiary, or through excessive direct equity
injections to a subsidiary, or perhaps upstreaming of excessive
dividends to a parent that are used to inject equity to an
affiliate. Second, when an insured institution is in danger of
failure, the owners and creditors of related entities may try to
extract value from the insured entity to minimize their own
losses, thereby increasing losses to the deposit insurance funds.
The past decade has provided examples of a number of instances
where transactions were proposed or consummated that served to
advantage a holding company or an affiliate at the expense of a
failing insured bank.
Third, the business relationship between the insured entity
and its subsidiary or affiliate may create a misperception that
the products of the subsidiary or affiliate 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 a subsidiary or affiliate in the event the subsidiary or
affiliate fails.
Sections 23A and 23B of the Federal Reserve Act place
certain restrictions on transactions between banks and their
affiliates. These restrictions are intended to safeguard the
resources of federally insured banks against misuse for the
benefit of an affiliate of the bank. Section 23A was designed to
prevent a bank from risking too large an amount in affiliated
enterprises and to ensure that if a bank extends credit to an
affiliate, the collateral behind the extension of credit is
sufficient to ensure recovery by the bank. Section 23A,
therefore, regulates certain "covered transactions" with
affiliates of an insured bank and does so primarily in two ways.
First, the section places limits on the dollar amount of
loans a bank may make to, or investments it may make in, any
individual affiliates, and to or in all affiliates. Second, it
requires that the loans or extensions of credit meet certain
standards as to collateral. In addition, banks generally may not
purchase low quality assets from affiliates.
Section 23B essentially expands section 23A. Section 23B
requires that certain transactions between a bank and its
affiliate must be carried out "at arms length," under terms and
conditions comparable to the terms of similar transactions between
unaffiliated entities. The transactions subject to this
comparability requirement include: certain sales of securities or
other assets by a bank to its affiliate; payments or provision of
services by a bank to its affiliates under a contract; and certain
transactions between a bank and a third party where an affiliate
acts as a broker or agent.
Any financial modernization proposal should continue the
safeguards of Sections 23A and 23B and apply them to dealings
between an insured bank and any subsidiary of the bank engaged in
nonbanking activities. Exceptions under these safeguards should
be allowed rarely. 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 --
beyond that required for a well-capitalized bank -- not through
relaxations of restrictions on intercompany transactions.
Existing restrictions on intercompany transactions as defined by
Section 23A and 23B should not be relaxed.
In addition, we believe that any financial modernization
proposal should require that an insured institution's capital
adequacy be determined after deducting the institution's
investment in subsidiaries. Consideration also should be given to
requiring timely reporting of intercompany transactions, as the
Securities and Exchange Commission currently requires.
Functional Regulation
The fourth principle for financial modernization is that
regulation should be commensurate with risk -- no less and no
more. With this principle in mind, the FDIC believes that
regulation along functional lines may be preferable to the current
practice of regulating individual banking entities based on
charter or corporate structure. Properly implemented, functional
regulation could avoid the layers of regulation and duplication
that may result from subjecting financial institutions to the
jurisdictions of multiple agencies. It also ensures that the
appropriate degree of expertise is brought to bear on each
activity. However, functional regulation will add to the
regulatory burden of financial institutions if it becomes solely
additive.
Functional regulation must be seamless, permitting no gaps
that might threaten the insurance funds, and yet must avoid
burdening banks with regulatory overlap. Caution will need to be
exercised to ensure that functional regulation does not result in
an artificial restructuring of banking operations and services
based on function, rather than historical practice or along
strategic or market-based lines. Such artificial restructuring of
banking operations would undermine the flexibility in corporate
structure that efforts at financial modernization should strive to
achieve.
Care must also be taken to ensure that key transactions
between insured banks and their affiliates and subsidiaries
activities can be reviewed by regulators as part of the regular
examination process for insured banks. Because organizations
under stress have strong incentives to circumvent restrictions on
intercompany transactions, any regulatory structure must assure
that these transactions can be properly reviewed. Finally,
functional regulation must assure that an insured institution
maintains adequate capital to guard against the risks posed by
each activity and by the combination of all activities.
Banking and Commerce
Fifth, easing the broad range of restrictions on activities
of banking organizations beyond those that are financial in nature
should proceed cautiously. Banking organizations have expertise
in managing financial risks, but little or no experience in some
of the activities that would be permissible under H.R. 268. The
affiliation of savings associations with commercial firms under
the unitary savings and loan holding company umbrella has been
limited, although beneficial in adding capital to thrift
affiliates during the period of the thrift crisis. Few large
commercial firms have established long-term relationships in this
fashion. Consequently, the experience of savings and loan holding
companies containing commercial firms may not provide a clear
model for the immediate merger of banking and commercial
activities, although it is a starting place for analysis. H.R.
268 offers an incremental approach, which is one option that
should be considered.
First and foremost, financial reform must ensure that the
safety and soundness of insured depository institutions and the
integrity of the deposit insurance funds and other elements of the
safety net will not be compromised. Additionally, a decision to
grant expanded access to the federal payments system should be
reviewed to assure that the implications and ramifications are
well understood.
Attached is a copy of my letter of December 16, 1996 to
Chairman Roukema that provides comments on a previous version of
H.R. 268. I would note that there have been changes to the bill
since my letter. We would be happy to provide the Subcommittee
with additional comments.
CONCLUDING SUMMARY
Current restrictions on the financial activities of banking
organizations are outdated. Their elimination 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. However, we should
proceed cautiously in easing the broad range of restrictions on
activities of banking organizations beyond those that are
financial in nature. History demonstrates that an expansion of
the powers available to insured institutions must be accompanied
by appropriate safeguards for the insurance funds.
Any financial modernization proposal should permit financial
organizations to engage in any type of financial activity, whether
banking, securities, or insurance, unless the activity poses
significant safety and soundness concerns, represents an
unwarranted expansion of the federal safety net or harms consumers
or small businesses.
A financial institution should have flexibility to choose
the corporate or organizational structure that best suits its
needs, provided safeguards protect the insurance funds and prevent
undue expansion of the federal safety net. If an activity raises
safety and soundness concerns for the insured bank, the activity,
if otherwise prudent, should be confined to a subsidiary or an
affiliate.
There are two organizational structures with which we have
experience in the United States that can be used for engaging in
new nonbanking activities -- the holding company model and the
bona fide subsidiary model. There are advantages and
disadvantages to each model. On balance, from a safety and
soundness perspective, I do not believe the case for or against
either approach is strong enough to warrant dictating to banks
which approach they must choose, provided adequate safeguards are
in place to protect insured institutions and the deposit insurance
funds.
Any financial modernization proposal should continue the
safeguards of Sections 23A and 23B of the Federal Reserve Act and
apply them to dealings between an insured bank and any subsidiary
of the bank engaged in nonbanking activities. We believe that any
financial modernization proposal should require that an insured
institution's capital adequacy be determined after deducting the
institution's investment in subsidiaries. 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, nonbanking affiliates, or to subsidiaries of
the bank.
The FDIC believes that regulation along functional lines may
be preferable to the current practice of regulating individual
banking entities based on charter or corporate structure. We must
ensure, however, that functional regulation is seamless and does
not result in duplicative regulation or in the artificial
restructuring of banking operations and services. We must also
take care that key transactions between insured banks and their
affiliates and subsidiaries activities can be reviewed by
regulators as part of the regular examination process for insured
banks.
H.R. 268 is a constructive approach to evaluating how best
to reform our financial system. The FDIC stands ready to assist
the Subcommittee with this important effort.
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Last Updated 06/25/1999
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