Introduction
This paper addresses the expansion of products and services offered by United States commercial banks. While this topic was originally entitled “deregulation of banking in the United States,” the term “deregulation” is a misnomer. Even as changes have been made in the regulatory requirements imposed on commercial banks, overall supervision of banking is stronger now than in the past. Nonetheless, however this topic is described, it is a vitally important one, both for today and for the future.
The paper begins with an overview of the U.S. banking industry and regulatory framework. Next, it reviews the developments that cause the United States today to be contemplating a fundamental restructuring of its financial services industry and its regulatory framework. Finally, it addresses the concerns that must be dealt with as efforts to change go forward, as well as some of the alternatives for change that are being discussed.
Current Regulatory Framework for Commercial Banking
Dual Banking System
The United States has a dual banking system, which means there are two chartering authorities for commercial banks—national and state. National banks are chartered and regulated by the Office of the Comptroller of the Currency (OCC) under the authority of the National Bank Act.1 Since 1864, the National Bank Act has allowed national banks to engage in the business of banking by receiving deposits, making loans, dealing in currency and exchange, buying and selling evidences of debt, and engaging in such additional activities as are incidental to banking. OCC interpretations and literally hundreds of court cases over the years have helped to define what is properly characterized as “banking” within the meaning of the statute.
Each of the 50 states also charters banks, which are regulated by the relevant state banking supervisor. State banks have powers that generally parallel national bank powers, although there are some notable exceptions.
In 1913, Congress established the Board of Governors of the Federal Reserve System (Fed) to administer the nation’s central banking system.2 The Fed controls monetary policy and provides liquidity to the banking system through 12 district banks.
The Banking Act of 1933,3 enacted in response to the banking crisis of the Great Depression, established or reformed the basic features of the modern U.S. banking system. One of the most important achievements of that legislation was the creation of federal deposit insurance, which was administered by a new agency—the Federal Deposit Insurance Corporation (FDIC). The deposit insurance program was designed to protect savers, and by doing so, to avoid future runs on banks in response to perceived or real problems at individual institutions.
All national banks—currently about 4,500—are required to be members of the Federal Reserve System and to be insured by the FDIC. State banks have choices in this regard. About 1,000 of them, mostly the larger ones, are members of the Federal Reserve System and have their deposits insured by the FDIC. Virtually all of the remaining 9,000 state banks are not Fed members but do have FDIC deposit insurance.
With respect to national banks, the OCC carries out a full range of supervisory activities. The agency conducts continuing supervision, including on-site examinations; receives regular reports from banks; brings enforcement actions to interdict unsafe banking practices or violations of law; acts to approve or deny charter, branch, and merger applications; applies capital and dividends rules; regulates transactions with affiliated companies; and in general, exercises oversight authority on all important aspects of bank conduct. The Fed and the FDIC, in cooperation with state authorities, provide similar supervision to state member and nonmember insured banks, respectively.
Geographic and Product Limitations
Banks face both geographic and product constraints. Geographically, national banks are limited, in effect, to a single state for branch operations. The McFadden Act4 stipulates that a national bank can branch only in the state in which it is situated, and then only to the extent state banks in the same location are permitted to branch according to state law. Some states restrict banks to a single county or a few counties in their operations.
For the most part, state banks can branch only within their chartering state, although there are certain regional compacts that permit interstate branching by state banks. While significant limitations on full-service branch offices remain in effect, national and state banks can operate limited-purpose offices in other states as long as their operations do not constitute “core” banking activities, that is, receiving deposits, paying checks, or lending money.
For banking, the primary product and service constraint is predicated on the basis that banks can exercise only the powers set forth in their enabling legislation. This constraint isolates banks from other businesses. By contrast, most business organizations are incorporated under state law and engage in any activity they choose to include within their charter and bylaws. The separation of banking from other lines of commerce has been affirmatively reinforced by other federal legislation.
Glass-Steagall Limitations
One of the most notable of these product limitations was established by the Glass-Steagall Act, which is part of the Banking Act of 1933. The Glass-Steagall Act partially separates commercial banking from investment banking (or more generically, the securities business). One section limits national banks to the following types of securities activities: securities brokerage for customers, dealing in and underwriting U.S. government securities and local government general obligation bonds, and purchasing for their own account other local government obligations and corporate debt securities that satisfy the investment quality and marketability standards in OCC regulations. This same limitation is applicable to state member banks. The Glass-Steagall Act prohibits corporate and employee affiliations between national or state member banks and firms engaged primarily in the issuance, underwriting, or distribution of securities. And finally, the Glass-Steagall Act prohibits securities firms from taking deposits.
Bank Holding Company Act
The bank holding company developed after the 1920s as a vehicle for banks to escape the geographic or product restraints imposed by federal and state banking statutes. Through a holding company, it was possible to own a number of banks, not only within a state but in a number of states. The holding company could also, either directly or through nonbank subsidiaries, engage in activities prohibited to the bank. While a member bank could not affiliate with a securities firm because of the specific Glass-Steagall prohibitions, all other lines of financial services and commercial activity were potentially possible through the holding company structure.
The Bank Holding Company Act of 1956 (BHC Act),5 however, significantly narrowed this escape hatch for banking organizations. First, following enactment of the BHC Act, a bank holding company could own banks in more than one state only to the extent that states expressly permitted the interstate ownership. This limitation was designed to reaffirm the McFadden Act’s deference to state law on bank branch expansion matters. And second, a bank holding company that owned two or more banks could only engage in activities “closely related to banking.” In 1970, Congress amended the Bank Holding Company Act to cover unitary bank holding companies.6 This meant that ownership of a single bank subjected the company to the BHC Act’s nonbanking limitations, effectively preventing banks from affiliating with nonbanking firms.
Competition from Nonbanking Firms
From the 1930s to the 1970s, banks had a unique, valuable franchise that served them quite well. They were the only financial intermediaries that created money through the payments system and offered demand deposits to their customers. Moreover, federal law prohibited price competition on all banks’ insured deposits, mandating interest-free demand deposit accounts and low-interest savings accounts. Banks used their stable, inexpensive funds to make business loans and, to a lesser degree, real estate and consumer loans. They also, to a varying extent, invested in government securities, administered trust accounts, and offered ancillary banking services. This relatively simple, safe banking environment changed in the 1970s with inflation, rising interest rates, and the growth of competing financial intermediaries.
Thrifts
Until the 1970s, the most significant competitors of banks were savings and loan associations, mutual savings banks, and other thrift-type institutions (referred to collectively as “thrifts”). Thrifts specialized in offering savings deposits and making home mortgage loans. Since the early 1930s, when federal thrift supervision was created under the aegis of the Federal Home Loan Bank Board, the federal government had established incentives for home financing, provided deposit insurance for thrift savings accounts, placed the interest payable at a rate slightly above bank savings deposits to assure the thrifts a sufficient supply of funds, and exercised general oversight authority over the industry.
Money Market Mutual Funds
Both the banks and thrifts experienced a flight of deposit funds in the late 1970s, as savers sought market rates of interest on their money through other intermediaries. For example, securities firms offered money market mutual funds to the general public. These investment companies paid market rates of interest, placed the funds in safe, liquid investments, and allowed savers to withdraw money from their accounts with check-like instruments. Congress responded to this phenomenon in 1980 and 1982 by allowing depository institutions to offer competitive rates on their deposits. While this was a necessary response to marketplace realities, banks and thrifts could no longer rely on a secure, cheap source of funding for their operations.
Other Competitors
In recent years, banks have experienced growing challenges from other financial intermediation. Instead of relying on bank loans, large and even some medium-size corporations have gone directly to the capital markets by issuing commercial paper directly to fund their short-term capital needs. This has meant that banks have lost some of their prime corporate borrowers. Insurance companies and pension funds are large providers of business credit. Investment bankers make bridge loans to accomplish merger transactions or leveraged buyouts. General Motors, Ford, and Chrysler have finance companies that dominate the consumer automobile loan business. Retailers and oil companies issue credit cards to their customers. Mortgage loans are originated by a variety of lenders (including banks), packaged into pools, and “securitized,” that is, interests in the loans are distributed to the public. Credit card receivables, automobile finance paper, and other loan assets are also capable of being securitized. Because of the Glass-Steagall Act, banks’ participation in the loan securitization process has been limited.
Financial services to consumers are increasingly being offered by conglomerates that do not need, or want, a bank charter. For example, Sears is the nation’s largest retail firm. It sells on credit and also owns an insurance company, a securities firm, a real estate company, and a thrift. (Unlike the Bank Holding Company Act with respect to banks, the Savings and Loan Holding Company Act allows any company to own one thrift.) Merrill Lynch, American Express, and other large firms combine securities, insurance, thrift and other savings, credit, and investment intermediation within their organizations. And unlike banks, these other financial services firms can open offices wherever they wish throughout the country.
New Products and Services—Small Steps Forward
Legislative Impasse
Fundamental legislative reform of the banking system is sorely needed, but difficult to achieve. Although Congress did respond to deposit disintermediation by allowing banks (and thrifts) to offer market rates of interest on their accounts, there remains an impasse with respect to expansion of products and services banks might provide to their business and individual customers. That impasse is traceable to several factors. First, Congress has had to concentrate its attention on the crisis in the thrift industry, which has significantly reduced its appetite for other banking legislation. Second, although the opposition is not uniform and has been changing in recent years, trade competitors in the securities, insurance, and other financial services businesses have generally worked against bank entry into their domains. And finally, the banks themselves have not achieved consensus on what should be done. Together, these factors have made it difficult for Congress to fashion a comprehensive restructuring of the banking and financial services industries.
Regulatory Initiatives
In the absence of fundamental reform, the bank regulatory agencies have taken steps in interpreting existing law to expand bank participation in the financial services marketplace to help meet their customers’ needs. For example, pursuant to Section 20 of the Glass-Steagall Act,7 the Fed has permitted bank holding companies (but not banks) to own a securities firm, provided that the securities activities that cannot be performed by banks directly do not exceed 10 percent of the subsidiary’s total revenues. The Fed determined that such an arrangement does not violate the Glass-Steagall Act because the securities affiliate is not “primarily engaged” in impermissible securities activities. For safety and soundness purposes, a number of supervisory “fire walls” limit dealings between the holding company’s bank and the securities affiliate. There are also prohibitions on cross-marketing to customers. Moreover, the Fed’s action has been upheld in court.
Several recent OCC interpretations have allowed national banks to engage in new lines of business or types of transactions. The OCC ruled that a bank’s securities brokerage subsidiary could open offices on an interstate basis without regard to the McFadden Act’s branching restrictions, which apply to bank branch offices. It granted Security Pacific National Bank’s operating subsidiary permission to distribute in public offerings certificates representing interests in pools of the parent bank’s mortgage loans. The OCC accepted as legally permissible Chase Manhattan Bank’s proposal to offer savings deposits with interest tied to movements in the Standard and Poor’s 500-stock index and to hedge its interest rate exposure by buying stock index futures for its own account. The agency approved Citibank’s acquisition of AMBAC, a municipal bond insurance company, on the theory that municipal bond insurance is the functional equivalent of a stand-by letter of credit, a product traditionally provided by banks (municipal bond insurance is based on creditworthiness determinations of each municipal bond issuer and involves credit risk, rather than actuarial insurance calculations and other risks). Subsequently, the OCC approved national banks’ sales, as agent, of fixed- and variable-rate annuities to their customers. Even though, technically speaking, the annuity contracts are generally regarded as insurance products under local law, the OCC concluded that they are financial investment instruments and, therefore, permissible for banks to sell as agent. All of these interpretations have been upheld in the courts or are currently in litigation.
Increasing Need for Change
Many of the largest banks in the world have branches in many countries. There is a global market for financial services. The global integration of financial markets favors organizations with the ability to provide a full range of services to their customers. The United States is behind in the global arena.
Congress held hearings on the European Community’s program to complete a single market by the end of 1992. It is understood that when this program is implemented, a single license will enable banks to operate freely throughout the Common Market through branches and subsidiaries to deliver a broad range of services to corporate and retail customers. U.S. bank regulators, bankers, and economists have testified in favor of domestic reform so that U.S. banks can efficiently fulfill the financial needs and desires of customers in the global marketplace. Without going into further detail, it is fair to say that if U.S. banks are given enhanced financial services authority domestically, it should be easier for them to be strong, effective competitors in international markets. Both geographic and product constraints need to be addressed.
Expansion of Commercial Bank Activities
Reducing Geographic Barriers
A number of state legislatures in recent years have adopted statewide branching laws. There have also been several regional compacts where groups of states agree to permit bank holding companies to own banks throughout their multistate region. The removal of geographic barriers allows banks to grow in response to market conditions and in accordance with individual bank management preferences. It also allows them to achieve economies of scale, reduce their vulnerability to local economic shocks, become less dependent upon particular industrial sectors, and facilitate the flow of capital from areas of excess deposits to areas of excess loan demand.
Despite this progress at the state level, banks still operate under more substantial geographic restraints in the United States than they do in any other industrialized economy. Even within the United States, nonbank competitors generally are not subject to geographic limitations. The debate on geographic expansion is framed primarily as a “big bank versus small bank” issue. Advocates of continued barriers worry that smaller community banks will disappear if large banks are allowed to enter their local markets. Nevertheless, the available evidence to date suggests that liberalized opportunities for banking offices provide benefits to consumers, through enhanced competition, without driving many local institutions out of business. Congress has been reluctant to address this issue, but needs to consider the reduction of geographic barriers at the federal level seriously.
Products and Services
The Issue of Risk
With respect to new products and services, the debate always begins with the issue of risk. Because banks have federal deposit insurance, have access to the Fed discount window, and are crucial to the payments system, any proposal for expanded competitive opportunities will not be successful if it does not deal with the issue of exposing banks to greater risk. Although this is understandable and appropriate, there are several points to keep in mind about risk. First, maintenance of the status quo endangers the safety and soundness of the banking system because banks are increasingly being forced into more risky transactions as their prime corporate customers rely on other avenues for finance. Competition from other financial intermediaries in the retail markets also constricts traditional bank operations. Second, some new activities are clearly safe. For example, selling insurance as agent or broker would generate commission income without placing any bank assets at risk. Finally, it should be noted that some traditional banking functions already entail risk. Making long-term commercial loans and participating in foreign exchange trading are two prominent examples.
The thrift experience. In the 1980s, Congress allowed the thrifts, as well as commercial banks, to pay market rates of interest on their deposits. In an additional attempt to make thrifts more competitive, a number of the states and Congress also allowed them to engage in real estate development, to make consumer and commercial loans to supplement their mortgage lending, and to offer a variety of ancillary services.
Critics of bank reform tend to cite the thrift experience as evidence that Congress should not allow banks to offer new products and services. However, the thrifts did not suffer from expanded business opportunities. At the time they were allowed to offer these new loan products, many thrifts were already undercapitalized. Without the risk of loss of their own funds, that is, capital, many thrifts made unwise loans, invested in high-yield bonds (“junk bonds”), and financed insiders’ business activities. The federal regulator of thrifts, the Federal Home Loan Bank Board, was unable to prevent the unwise or abusive practices in many instances, and, because of an inadequate federal deposit insurance fund, could not close hundreds of institutions, thereby increasing government expense. In short, thrifts got into trouble from (1) a lack of capital requirements, (2) high-risk investments, (3) poor management of asset and liability, (4) insider abuse, and (5) too little supervision—not from too much diversity of business opportunity.
Moreover, there are significant differences between the thrift and banking industries. Banks have historically offered demand deposits; thrifts, only recently. Also, banks have engaged in a variety of lending and other credit activities, while thrifts specialized in home mortgage finance. With banks, the OCC grants federal banking charters and supervises national banks. The Fed provides liquidity to the banking system and regulates bank holding companies. The FDIC insures deposits. Each provides a check and balance for the others because of the somewhat overlapping jurisdictions of the three supervisory agencies. In the case of thrifts, all of these functions were concentrated under the Federal Home Loan Bank Board. There was no system of checks and balances in the federal thrift supervisory process. A mistake in one area was, in effect, multiplied in the other areas.
FIRREA. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)8 restructured the savings and loan supervisory system. Although FIRREA is popularly referred to as the “thrift bailout bill,” a number of its provisions also strengthen bank supervision. For example, the law grants enhanced enforcement authority to each of the federal bank regulatory agencies to bring cease-and-desist and civil money penalty actions against bank officials violating laws or engaging in unsafe or unsound practices. Another important change facilitates FDIC termination of deposit insurance in response to such practices.
New bank supervisory initiatives. The bank regulatory agencies have recently taken steps to strengthen bank supervision and enhance the safety of the banking system. Risk-based capital rules pursuant to an international agreement require all federally insured banks to maintain capital in relation to the risks of the assets they hold. In addition, these rules subject off-balance-sheet risks to capital standards. Moreover, the OCC no longer permits reserves for loan and lease losses to be considered in computing a bank’s dividend-paying capacity. This ensures that the reserve is available to cover losses in the bank’s portfolio. New insolvency regulations provide for the OCC to close troubled banks as soon as the bank’s equity capital is depleted, rather than only after the bank’s reserves have also been depleted, thereby minimizing loss to the FDIC insurance fund. The OCC has also changed its approach to bank supervision, providing ongoing supervision of every institution, in order to better monitor the condition of all of its banks and to target resources on those banks and activities reflecting the greatest risk. At the largest banks, examiners are frequently on the premises throughout the year. These supervisory initiatives place regulators in a stronger position to maintain a safe and sound banking system, while permitting structured changes to occur.
Corporate separateness. Some activities, such as insurance brokerage, can be conducted directly in the bank, without any assumable risk to the bank. For activities deemed risky, bank safety can be protected by placing such new activities in separate corporations affiliated with the bank. Sections 23 A and B of the Federal Reserve Act9 require that transactions between a bank and its affiliates be limited in amount; collateralized by high quality securities; and on a fair, arm’s-length basis. The bank regulatory agencies have a full arsenal of supervisory tools to ensure that banks comply with these requirements and do not place assets at any additional risk by virtue of their corporate affiliation.
In addition to specific statutory protections, there are a variety of measures which bank regulatory agencies can take to ensure that banks are insulated from risks. An agency can require that its approval be obtained before a bank enters into a corporate venture. It can assess the adequacy of the bank’s capital and management resources, the business plan, and the amount of investment, and can require the implementation of controls to assure that the bank’s exposure to loss will be limited to its initial investment. FIRREA authorizes significant sanctions for violations of a condition imposed in connection with an application. The agency would, of course, monitor subsequent developments to satisfy itself that the controls in place remain adequate and that the bank’s safety and soundness remain secure and, it is hoped, enhanced by the affiliation.
Other Concerns: Bank and Securities Firm Affiliation as a Test Case
Aside from the question of risk, some people have suggested that allowing banks to enter new lines of business will lead to (1) conflicts of interest, (2) undue concentrations of economic power and resources, and (3) unfair competition between banks and nonbank providers of financial services. Each of these concerns is expressed when Congress considers, as it has on previous occasions, modification or repeal of the Glass-Steagall Act. Let us look at bank-securities firm affiliation to test each of the concerns.
There are conflicts of interest inherent in the businesses that banks and securities firms currently conduct, yet this should not be grounds for prohibiting the services being provided. Bank trust departments administer large amounts of money on behalf of customers. There might be temptations to sell bank assets to the trust department, or invest trust funds in bank-related projects, on terms favorable to the bank. Banks have a fiduciary obligation to administer trust funds prudently and exclusively in the interest of trust settlors and beneficiaries. This legal obligation, enforced by bank regulatory authorities and perhaps buttressed by marketplace discipline, should be sufficient to handle conflict of interest situations. Similarly, securities firms operate under a panoply of securities laws administered primarily by the Securities and Exchange Commission that are designed to prevent fraud, self-dealing, and abusive transactions at the expense of the securities markets and investors. There is no reason to believe that a registered broker-dealer or underwriter would be more likely to violate these rules once it becomes affiliated with a bank.
Allowing banks to be affiliated with securities firms will not necessarily lead to an undue concentration of economic resources and power. Even though there are some very large banks, the presence of approximately 14,500 banks throughout the country belies the notion that the industry is likely to become too centralized or that credit will not be made available to securities firms that have no bank affiliate. Moreover, such affiliations should lead to increased competition in the capital markets. Currently, about ten investment banking firms dominate in their business. Entry by bank affiliates into full-service securities dealing or underwriting activities should open up those markets.
Fairness considerations also favor bank-securities firm affiliations, provided that the ownership can flow both ways. Some securities industry representatives have opposed bank expansion into investment banking on the theory that commercial banks have an unfair advantage because of their federally insured deposits and access to the Fed discount window. However, if a securities firm can own a bank, that contention evaporates. Such cross-ownership would require repeal or modification of the Bank Holding Company Act, as well as the Glass-Steagall Act, since now the ownership of a bank is limited to companies engaged only in activities closely related to banking.
Bank and securities firm affiliations do not impede functional regulation. The bank regulator could continue to examine, monitor, and supervise the conduct of the bank, including its investment in and transactions with the securities company affiliate. The focus would be the traditional one of assuring the prudent management and operation of the bank and its safety and soundness as an institution. The Securities and Exchange Commission could regulate the securities company, just as it currently regulates dealers, underwriters, and investment companies. Its mission would be directed to assuring the proper functioning of the capital markets, compliance of the firm with all applicable rules, and the protection of investors in their dealings with the firm.
Alternatives for Corporate Structure
Some have suggested that new activities, at least the ones deemed risky or in need of functional regulation, should be placed in subsidiaries owned by a bank holding company. An alternative, and for many institutions probably a better, arrangement would allow such new activities to be lodged in subsidiaries owned by the bank. The bank holding company phenomenon is based on historical developments, not market preferences, and is unique to the United States. There is no persuasive evidence that the bank holding company structure is the only way to insulate a bank or the public from possible misdeeds by, or losses of, an affiliate. It is relevant to note in this regard that all the leading banking nations of Europe and Asia permit banks to conduct all of their activities either in-house or through bank-owned subsidiaries. This appears to be recognized by the Fed in recent Section 20 applications approved for foreign banks—not holding companies.
A framework that allows banks to engage in new activities through subsidiaries as well as holding company affiliates would have several advantages. First, there could be cost savings, especially for smaller banks, in offering new products and services, because there would not be the additional expense of forming and maintaining a holding company and another subsidiary corporation to engage in new activities. Second, other savings could be achieved by avoiding duplicative regulation and reporting requirements under another federal regulatory scheme. This would enhance the ability of U.S. banks to compete both domestically and internationally by improving their cost efficiency. And finally, diversification of operations through subsidiaries can be more helpful to banks than diversification through holding companies because, through subsidiaries, banks receive directly the income flowing from the activities.
With appropriate regulatory safeguards, activities conducted in a bank subsidiary should not pose any greater threat to the bank than activities conducted in a bank holding company affiliate. Absent fraud, stripping of assets, undercapitalization, or other abuses, courts will not “pierce the corporate veil” and hold parent banks liable for obligations of their subsidiaries. It is abuse, rather than a particular corporate form, that causes a parent or other affiliate corporation to be held liable. The bank regulator should therefore assure that each affiliate is adequately capitalized when created and that each bank protects the corporate veil separating it from the affiliate.
A concern some have raised about the exercise of new powers in bank subsidiaries is that a bank, even if not directly liable for a subsidiary’s obligation, may be tempted to assume responsibility for the obligation voluntarily owing to public perceptions or market pressure. This type of problem is not limited to a bank-subsidiary relationship. The health of a bank’s subsidiaries, holding company, and affiliates all affect the public’s perception of the bank’s condition. Again, the appropriate response is not to prohibit bank subsidiaries or affiliates but rather to regulate the relationships. As noted above, the Federal Reserve Act restrictions on affiliate transactions could be applied to direct bank subsidiaries as well. Another way to insulate bank capital from the potential risks of affiliation is to deduct its investment in insulated subsidiaries when assessing the bank’s capital adequacy. This will ensure that, as long as the corporate veil remains intact, bank investments in affiliates will not threaten the adequacy of bank capital.
Conclusion
As we head into the twenty-first century, we must act to shape an appropriate banking system to utilize available technology and maximize the efficiency of financial services to corporate and individual customers. We must catch up with the dramatically evolving marketplace domestically and internationally. The regulators can make incremental improvements and continue to assure that supervision is thorough, sophisticated, and effective without being unduly burdensome. Fundamental change, however, awaits the development of a consensus in Congress. Hopefully, that consensus can be achieved without the need of a crisis in the banking sector of the U.S. economy.
Addendum
This paper discussed the expansion of products and services offered by U.S. commercial banks and the need for greater expansion through comprehensive statutory restructuring of the financial services industry. Since this paper was presented, there has been legislation that significantly strengthens bank supervision, and that has resulted in increased capital in the banking industry. There has not, however, been any structural reform, nor have the regulators made any significant enhancements in the area of products and services.