Should Banking and Commerce Be Mixed?

The United States has a tradition of separating banking and commerce, i.e., not allowing the combination of banks and commercial or industrial firms within a single corporate structure.²⁵ This separation of banking and commerce in the American economy has been maintained for a variety of reasons. Traditionally, concern has existed that allowing the combination of banking and business interests could lead to the concentration of economic power in the hands of a small number of industrial-financial conglomerates. In addition, allowing banks to affiliate with commercial firms may produce conflicts of interest that interfere with the traditional role of banks as impartial financial intermediaries. For example, a bank affiliated with a commercial enterprise may face pressures to deny credit requests from a competitor of its commercial affiliate. Likewise, a bank affiliated with a commercial firm may face internal pressures to extend credit to the commercial affiliate on favorable terms or in situations when such credit would not normally be extended.

Allowing banks and commercial firms to affiliate also could lead to the expansion of the federal safety net—which refers to FDIC deposit insurance and access to the Fed’s discount window and payments system. Supervisory and empirical evidence suggests that holding companies act as unified business entities, obtaining resources from healthy affiliates to aid other affiliates in financial distress.²⁶ As Walter Wriston, the former Chairman of Citicorp once stated, “it is inconceivable that any major bank would walk away from any subsidiary of its holding company. If your name is on the door, all of your capital funds are going to be behind [the subsidiary] in the real world.”²⁷ Even if restrictions are placed on transfers between federally insured banks and their commercial affiliates, and such restrictions are effective,²⁸ the financial difficulties of a commercial affiliate could lead to a loss of confidence in the bank affiliate because consumers and the marketplace view holding companies as a single, unified entity.

Proponents of allowing combinations of banking and commerce in the United States contend that such consolidations would allow banking organizations to diversify their risk portfolios through expansion into nonfinancial industries. Some proponents also contend that the combination of banking and commerce would allow the resulting organizations to achieve economies of scale and synergies that currently are not possible through, for example, the cross-marketing of products. Others claim that eliminating the barriers between banking and commerce would allow banking organizations to attract new capital from other industries. Finally, some proponents assert that no significant regulatory problems have surfaced with unitary thrift holding companies, which currently are permitted to own a single savings association and engage in commercial activities.

Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, has expressed concern with those proposals that would permit the unlimited mixing of banking and commerce, noting that such a change “would be a profound and surely irreversible structural change in the American economy.”²⁹ Because existing law generally prohibits U.S. banking organizations from being affiliated with commercial entities, little empirical evidence exists to support the claims made in favor of mixing banking and commerce to an unlimited extent.³⁰ On the other hand, the recent difficulties of financial institutions in certain Asian nations that permit extensive ties between financial and commercial firms suggest that such combinations present tangible risks. In addition, the U.S. banking industry currently is well capitalized by historical standards and, thus, does not as a general matter require large-scale capital infusions from other sectors of the economy. In light of the irreversible nature of such a change, and the continuing debate as to whether such a change would result in net public benefits, Chairman Greenspan has suggested that Congress should move cautiously in considering whether to allow combinations of banking and commerce,³¹ a position supported by the Comptroller and FDIC.³²

Some parties to the financial modernization debate, however, argue that a limited mixing of banking and commerce may be necessary to allow consolidations in the financial services industry itself. For example, some limited “basket” of nonfinancial activities may be needed to allow securities firms and insurance companies, which frequently have limited nonfinancial holdings, to acquire banks. Given this need, others have argued that fairness would require that bank holding companies also receive the benefit of any limited nonfinancial basket granted securities and insurance firms.

Current Legislative Proposals Regarding Banking and Commerce

The compromise bill would allow the mixing of banking and commerce in the United States subject to certain limits. In particular, the bill would allow any bank holding company that qualifies as a “financial holding company” to receive up to 5 percent of its worldwide revenues or $500 million, whichever is less, from commercial activities.³³ The $500 million revenue limit is designed to prevent banks from affiliating with any of the approximately 1,500 largest industrial firms. This revenue limit is a continuing limit and, thus, would prohibit a nonfinancial affiliate of a financial holding company from growing, either internally or through acquisitions, if such actions would cause the nonfinancial revenues of the holding company to exceed $500 million.

The compromise bill also would prohibit financial holding companies from acquiring the shares of any commercial company that has total consolidated assets of more than $750 million at the time of acquisition.³⁴ This asset limitation is designed to prevent the establishment of excessively large financial-industrial conglomerates by prohibiting the combination of banking organizations with any of the largest 1,000 commercial companies. Unlike the revenue limit discussed above, this asset limit would apply only at the time of acquisition of a nonfinancial company. Thus, if a financial holding company acquired a nonfinancial company with $749 million in consolidated assets, the nonfinancial company could expand its assets through internal growth or other acquisitions that themselves fell within the asset limit, provided that the revenue derived by the financial holding company from nonfinancial activities did not exceed the $500 million revenue limit imposed by the bill.³⁵

A foreign bank subject to the nonbanking restrictions of the BHC Act would be able to take advantage of the limited commercial basket granted financial holding companies, if the foreign bank meets the qualifying criteria to be a financial holding company and observes the limitations discussed above.³⁶ To prevent the revenue limit on commercial activities from unduly restricting the overseas activities of foreign banks, however, the compromise bill provides a special method for computing a foreign bank’s compliance with the 5 percent limit on commercial revenues. Specifically, the bill provides that a qualifying foreign bank may engage in commercial activities in the United States, provided that the revenues derived from commercial activities in the United States do not exceed 5 percent of the gross revenues of the foreign bank’s U.S. branches, agencies, commercial lending companies, and subsidiary depository institutions, or $500 million, whichever is less. To assure competitive equality with domestic banking organizations, the bill also provides that a foreign bank may not engage in commercial activities in the United States under both the commercial basket provisions of the bill and section 2(h) of the BHC Act. Thus, the bill would allow a foreign bank to choose whether to conduct commercial activities in the United States under the commercial basket provisions of the bill or under section 2(h), whichever is more advantageous to the foreign bank.

The extent to which banking and commerce should be mixed remains a matter of debate in the House of Representatives, and it is likely that certain members of the House will offer amendments related to this issue if the bill is brought up for a vote by the full House. For example, Representative James Leach, the Chairman of the House Banking Committee, has indicated that he will seek to introduce an amendment that would eliminate the 5 percent commercial basket currently contained in the bill. On the other hand, Representative Marge Roukema has indicated that she will likely introduce an amendment that would increase the commercial basket to 15 percent of a financial holding company’s gross revenues and eliminate the $500 million revenue limit on such commercial activities. At this time, it is unclear whether either of these amendments would gain approval if introduced.

Need for Prudent Level of Umbrella Supervision

Some, including trade groups for the securities and insurance industries, have expressed concern that the existing bank holding company supervisory framework may not be the appropriate model for supervising organizations engaged in a wide range of banking and financial activities. They claim that a financial holding company and its subsidiaries should be subject to regulation solely on a functional basis. Under such a functional regulation scheme, the bank subsidiaries of a financial holding company would be regulated by the appropriate federal banking agency; any securities or investment adviser affiliate of the holding company would be regulated solely by the SEC; and any insurance affiliate would be regulated solely by the appropriate state insurance authority. The parent financial holding company, however, would not be subject to supervision on a consolidated basis.

According to proponents of such a system, the functional regulation of activities would continue to allow the federal banking regulators to protect a subsidiary bank from risks arising in other parts of the holding company through the imposition of capital requirements or restrictions on the subsidiary bank itself. In addition, proponents assert that a system based on functional regulation would obviate the risk that an umbrella supervisor would adopt duplicative, costly, and burdensome regulations affecting nonbank subsidiaries that are regulated by another federal or state agency. Some also have expressed concern that an umbrella regulator could significantly interfere with the operations of a securities or insurance affiliate by imposing more severe capital, reporting, or examination requirements on the affiliate than those imposed by the affiliate’s functional regulator.

In the view of Chairman Greenspan, Paul Volcker, former Chairman of the Fed, and the U.S. General Accounting Office, some form of umbrella supervision of a financial holding company with a significant banking presence is necessary to protect the financial system and guard against the misuse of bank resources.⁴³ Supervisory experience demonstrates that most holding companies operate as integrated organizations, both for operational and risk-management purposes. Thus, holding companies increasingly utilize centralized risk-management systems and procedures to monitor and manage the risks facing the holding company on a consolidated basis. Because a financial holding company also would likely utilize centralized risk-management systems to monitor its exposure on a consolidated basis, some form of umbrella oversight is necessary to allow federal supervisors to adequately understand and evaluate the potential risks facing the holding company and its subsidiary banks. In addition, as the recent experience of Barings PLC illustrates, financial troubles at one affiliate of a holding company can quickly spread to other affiliates. Umbrella supervision provides the federal supervisory agencies with the ability to identify problems within the organization as a whole, or at an affiliate of an insured bank, at an early stage and develop strategies to protect the insured bank before significant harm occurs. Although “firewalls” such as sections 23A and 23B of the Federal Reserve Act⁴⁴ are extremely important in protecting against the misuse of a bank’s insured deposits, experience has shown that such firewalls are not always fully effective, particularly in times of financial stress.⁴⁵ The effective enforcement of these firewalls, moreover, requires that federal supervisors have the ability to monitor both sides of transactions between an insured bank and its affiliates.

Finally, it is possible that many of the concerns expressed by members of the securities and insurance industries with respect to consolidated supervision may be based on a lack of familiarity with how the Fed exercises its current supervisory authority over bank holding companies. Although the Fed currently has the statutory authority to examine and require reports from the nonbank subsidiaries of bank holding companies, the Fed does not conduct routine or periodic examinations of non-bank affiliates under the BHC Act or require reports from such affiliates (other than section 20 subsidiaries).⁴⁶ In addition, although the Fed has adopted prudent capital requirements for bank holding companies that apply on a consolidated basis,⁴⁷ the Fed has not promulgated capital adequacy regulations for nonbank affiliates of bank holding companies.

Current Legislative Proposals

The compromise version of H.R. 10 seeks to strike an appropriate balance between the need for some form of umbrella supervision and the desire of all parties to avoid the unnecessary regulation of financial holding companies and their nonbank affiliates. In this regard, the bill would continue the Fed’s traditional role as umbrella supervisor of holding companies that control banks and of the U.S. operations of foreign banks that control U.S. subsidiary banks or that operate branches, agencies, or commercial lending companies in the United States.

The compromise bill would, however, place certain restraints on the ability of the Fed to receive reports from and examine and adopt capital guidelines for bank holding companies and foreign banks operating in the United States. These restraints, which are generally consistent with the Fed’s current supervisory practices, are designed to minimize potential disruptions to the activities of functionally regulated nonbank affiliates. For example, although the bill would continue to permit the Fed to require reports from financial holding companies and their subsidiaries,⁴⁸ the bill requires that the Fed accept, to the fullest extent possible, the reports filed by a financial holding company with other federal or state supervisors, such as the SEC, the Commodity Futures Trading Commission, or state insurance authorities. The bill would also require that the Fed, to the fullest extent possible, use information that is otherwise publicly available in lieu of any reporting requirement.

The bill also would specify that the Fed may conduct an examination of a financial holding company or a subsidiary thereof only for purposes of informing the Fed of the nature of the operations and financial condition of the company or subsidiary, or to inform the Fed of the nature of the financial and operational risks within the holding company system that may pose a threat to the safety and soundness of a subsidiary depository institution and the systems for monitoring and controlling such risks.⁴⁹ In addition, the bill would require that the Fed limit the focus of any examination to the parent financial holding company and those of its affiliates that, for specified reasons, may have a materially adverse effect on the safety and soundness of the holding company’s subsidiary depository institutions.⁵⁰ The bill would also require that the Fed accept, to the fullest extent possible, reports of examinations prepared by a nonbank affiliate’s appropriate functional regulator.

Finally, the bill would prohibit the Fed from imposing any capital adequacy requirements on any nonbank affiliate of a financial holding company that is an insurance company or registered broker or dealer, provided that the affiliate is in compliance with applicable capital requirements of its appropriate state insurance authority or the SEC, respectively.⁵¹ These restrictions on the Fed’s reporting, examination, and capital authority with respect to financial holding companies would also limit the Fed’s authority in these areas under the BHC Act with respect to the U.S. operations of foreign banks.

Expanding Access to the Payment System

Under current law, only banks and other depository institutions are permitted to maintain accounts with Federal Reserve Banks and thereby have direct access to the Federal Reserve’s payments system, including the Fedwire wire transfer system. For competitive reasons, nonbank providers of financial services—including large securities broker-dealers and insurance companies—would like to gain access to the Federal Reserve’s payments system. Such access would allow the firms to offer their customers an expanded range of payment-related services and take direct control of their own payment functions. An account at a Federal Reserve Bank would also give such firms an essentially risk-free place to deposit their own funds, which would reduce their exposure to the failure of third-party depository institutions in times of financial distress.

The compromise bill responds to these desires by authorizing the creation of a new form of depository institution—a wholesale financial institution (WFI). WFIs, which could be state-chartered or national banks, would be limited-purpose banks that have access to the Federal Reserve’s payments system. WFIs could not accept initial deposits in amounts of $100,000 or less, and any deposits accepted by a WFI would not be insured by the FDIC.⁵² It is anticipated that broker-dealers or insurance companies that desire to gain access to the payment system (without acquiring an FDIC-insured bank or thrift) would do so through the acquisition or establishment of a WFI.

The primary issue related to the creation of WFIs is how such institutions, and companies that control a WFI but do not control any FDIC-insured bank or thrift (WFI holding companies), should be supervised.⁵³ Some potential acquirors of WFIs, including certain securities and insurance companies, contend that WFIs and their holding companies should be subject to little or no federal supervision because WFIs would be prohibited from holding FDIC-insured deposits. Others contend that, if some degree of federal supervision is imposed, it should be restricted solely to the WFI and should not extend to any corporate owner or affiliates of the WFI. Some potential acquirors also assert that WFI holding companies should be permitted to engage in a wider range of financial and commercial activities than financial holding companies that own FDIC-insured depository institutions.

While it is true that WFIs would not benefit from FDIC deposit insurance, WFIs would have access to the other two components of the federal safety net—the Federal Reserve’s discount window and payments system. In light of this access, the failure of a WFI could have a significantly adverse impact on American taxpayers and the economy. For example, WFIs would have the ability to borrow money directly from the Federal Reserve, either through the discount window or by running an overdraft on their account at the local Federal Reserve Bank. If a WFI with an outstanding debit balance to the Federal Reserve failed, the losses incurred by the Federal Reserve would ultimately be borne by the American taxpayer. In addition, because WFIs likely would engage in a significant amount of payment-related activities, including the processing of payments for their affiliates and third parties, the failure of a WFI could have systemic consequences on the American economy.

In light of these risks, others believe that public policy warrants the creation of a prudent supervisory framework designed to assure that all WFIs remain financially stable and are operated in a safe and sound manner. Such a supervisory framework, it is argued, should give the appropriate supervisory agency the ability to supervise a WFI holding company on a consolidated basis, especially because the holding company likely would use its subsidiary WFI to provide payment- and deposit-related services to, and as agent for, other affiliates, and would fully integrate the WFI into its consolidated risk-management systems.

Legislative Responses

The compromise bill would generally subject WFIs and WFI holding companies to the supervisory framework applicable to banks and bank holding companies, with certain exceptions to take account of the uninsured status of WFIs. For example, the bill provides that all WFIs, whether national or state-chartered, would be supervised by the Fed under the Federal Reserve Act, which currently governs the supervision of state member banks.⁵⁴ The bill, however, would give the Fed authority to exempt a WFI from any provision of law generally applicable to state member banks if the Fed determined that such action would not be inconsistent with specified public interest factors.⁵⁵

Under the compromise bill, the Fed would also serve as the umbrella supervisor of all WFI holding companies and would have similar supervisory authority (i.e., reporting, examination, and capital), subject to similar restrictions, for WFI holding companies as for financial holding companies.⁵⁶ As a general matter, the compromise bill also would subject WFI holding companies to the same activity and affiliation limitations applicable to financial holding companies.⁵⁷ Nevertheless, the bill would grant WFI holding companies slightly greater flexibility to engage in commercial activities in the United States. For example, although WFI holding companies, like financial holding companies, would be permitted to derive no more than 5 percent of their revenue from commercial activities, the bill would not subject WFI holding companies to the $500 million cap on commercial revenues applicable to financial holding companies.⁵⁸ In addition, the bill would permit a company that becomes a WFI holding company and that was predominantly engaged in the securities business as of January 1, 1997, to retain any commodity-related investments and activities that the company held or engaged in as of that date.⁵⁹ This last provision is intended to permit certain investment banks to acquire a WFI without divesting their subsidiaries engaged in commodity-related activities.

The bill also would allow a foreign bank to take advantage of these additional nonbanking powers granted WFI holding companies under certain circumstances. In particular, the bill would permit a foreign bank that owns a WFI, or that operates uninsured branches in the United States, but does not own an insured bank or thrift, to exercise all the nonbanking powers granted WFI holding companies with the Fed’s approval. This provision is intended to allow foreign banks that, like a WFI holding company, have no FDIC-insured banking presence in the United States to engage in the same types of nonbanking activities in the United States as a WFI holding company.⁶⁰ To assure competitive equality with domestic WFI holding companies, the bill also provides that a foreign bank that elects to be treated as a WFI holding company may no longer engage in nonbanking activities in the United States pursuant to section 2(h) of the BHC Act.

Calls for Functional Regulation

The substantial growth of bank securities activities has led the SEC and certain other groups to call for the elimination of the bank exemption from the definitions of broker and dealer in the Exchange Act. Proponents of such a change contend that the securities activities of banks should be functionally regulated, i.e., subject to the federal securities laws and SEC regulations to the same extent as the securities activities of nonbanking organizations. According to proponents of this view, functional regulation is necessary to assure that all purchasers of securities benefit from the consumer protection provisions applicable to registered brokers and dealers. These rules include the SEC’s minimum net capital requirements and the Rules of Fair Practice adopted by the National Association of Securities Dealers, which impose certain qualification and training obligations on securities sales personnel. Subjecting bank securities activities to these rules and regulations, it is argued, would enhance consumer protection and create a level playing field among all entities engaged in securities activities.

Although the debate on this issue is frequently characterized as one pitting “functional regulation” against the desire of the banking industry to retain an outdated exception to the securities laws, the debate in reality is considerably more limited and focused. The banking industry for the most part has acknowledged that the blanket exemption provided banks in the Exchange Act may no longer be appropriate. Banks, however, insist that any revocation of this blanket exemption must be accompanied by changes that permit banks to continue to conduct those securities activities that are integrally related to traditional bank functions—such as trust, custody, and safekeeping operations—within the bank. Accordingly, the current debate focuses on the types of securities transactions that a bank should be permitted to engage in without registering as a broker or dealer.

Legislative Responses

The compromise bill would eliminate the blanket exemption provided banks from the definitions of “broker” and “dealer” in the Exchange Act. Instead, the bill would allow a bank to avoid registration as a broker or dealer only if the bank limited its securities activities to specified types of “exempted” transactions or activities. The precise list of “exempted” transactions and activities has and continues to engender substantial debate between the Banking and Commerce Committees, the banking industry, and the SEC.

The exemptions currently contained in the compromise bill are fairly broad and would encompass many of the securities activities currently conducted by banks in connection with their traditional banking operations. For example, the compromise bill would allow a bank, without registering as a broker-dealer, to establish networking arrangements with third-party, broker-dealers, to effect securities transactions in connection with its traditional trust, fiduciary, custody, and safekeeping activities, to engage in securities transactions in bank-eligible securities (e.g., U.S. government securities) and municipal securities, to engage in up to 500 other brokerage transactions per year that are not otherwise exempt, and to broker or deal in specified “traditional banking products,” even if such products are considered securities under the federal securities laws.⁶³ The compromise bill also would allow banks to issue, buy, or sell other types of derivative instruments, privately place securities, and underwrite and sell asset-backed securities supported by assets originated by the bank or an affiliate, if the bank engages in such transactions only with “qualified investors,” as defined by the bill.⁶⁴

Certain members of the banking industry, however, contend that the exemptions contained in the compromise bill are too restrictive. For example, the exemptions in the compromise bill would not cover a bank engaged in private placement activities if the bank was affiliated with an SEC-registered broker-dealer or a bank engaged in a general securities brokerage business (i.e., more than 500 securities transactions per year for brokerage customers). The bill would, as a practical matter, require banks engaged in such activities, or other nonexempted transactions, to transfer or “push out” the activities to an affiliate. This is because banks cannot feasibly meet the SEC’s minimum net capital rules and thus cannot register as a broker or dealer with the SEC. Accordingly, some in the banking industry have asserted that the compromise bill would unnecessarily cause banks to transfer to an affiliate existing bank functions, such as private placement and securities brokerage activities, resulting in the artificial bifurcation of tasks and imposing additional costs on banks.

Finally, a significant point of concern for many banks is how the proposed legislation would address the ability of banks to sell new products that are developed in the future. These banks have expressed concern that the SEC could stymie their ability to provide new financial products that might be developed in the future (and that are not included in the list of “traditional banking products”) by classifying such products as securities for purposes of the federal securities laws. The compromise bill seeks to address this concern by providing that a bank, without registering as a broker or dealer, may offer or sell a product that is developed in the future and that is not contained in the list of “traditional banking products” unless the SEC determines through a formal rulemaking process that the product is a security. The bill also provides that the SEC must consider the views of the federal banking agencies in connection with any proposed rulemaking in this area, including their views as to the effect the proposed rule would have on the banking industry.

Divergent Perspectives of the Insurance and Banking Industries

The insurance industry approaches these issues from the perspective of the McCarran-Ferguson Act,⁶⁶ which has reserved to the states the authority to define and regulate insurance activities. Insurance companies and state insurance regulators believe that states should have the ability to define what financial products are “insurance,” and thus cannot be provided by banks as principal. Insurance agents also are concerned that any erosion or preemption of state insurance regulation—including rules governing licensing, continuing education, and sales practices—by a federal banking agency could put insurance agents at a competitive disadvantage. Insurance companies worry that differences between insurance and bank capital requirements and regulation could similarly give banks that choose to underwrite insurance products directly an advantage over insurance companies, particularly as new products are developed that may be hybrids of banking and insurance products.⁶⁷

The banking industry, on the other hand, approaches these issues armed with two Supreme Court decisions that allow national banks to conduct insurance agency activities despite state statutes prohibiting affiliations between banks and insurance companies or agents and that could permit the Comptroller to determine what products are “insurance” for purposes of the NBA’s prohibition on insurance underwriting.⁶⁸ The banking industry has been adamant that legislation not erode these decisions. In particular, the banking industry is concerned that allowing full functional regulation of bank insurance activities by state insurance supervisors could permit certain states to adopt onerous regulation designed effectively to prohibit banks from conducting insurance activities. Banks, like the insurance industry, are also aware that the financial marketplace is rapidly changing, and are very concerned that banks not be frozen out of developing new banking products that might have some of the aspects of, or be replacements for, insurance products.

The opposing positions of the insurance and banking industry on these issues highlight the tension caused by the interplay between state insurance laws and federal modernization legislation. A state insurance supervisor may have valid reasons for defining a new product to be an insurance product, including allowing insurance companies to offer that product under the supervision of the state. However, if national banks are bound by a state insurance supervisor’s determination that a product is insurance, then the supervisor’s decision could force national banks to cease providing the product in the state—even if banks had originally developed the product in question. This problem is particularly acute for banks with operations in several states because at worst it is unclear how an insurance supervisor’s decision in one state would affect the bank’s business in another state, and at best the situation creates the potential for a patchwork of state insurance definitions that would make it extremely difficult for the bank to offer its products on an interstate basis.

Legislative Response

The compromise bill would permit subsidiaries of national banks to engage in general insurance agency activities.⁶⁹ The bill, however, would require a bank that is not currently engaged in insurance agency activities in a new state to begin its insurance agency activities in that new state by acquiring a company that has been licensed for at least two years to conduct insurance agency activities in that state.⁷⁰

The compromise bill would also prohibit national banks (or their subsidiaries) from underwriting non-credit-related insurance. This prohibition raises the crucial question, “What is insurance?” The bill begins with a relatively noncontroversial core definition—insurance is defined as any product that was regulated under state law as insurance as of January 1, 1997, and any annuity that qualifies for tax deferred status under the Internal Revenue Code.⁷¹ The bill would, however, grandfather the current insurance underwriting activities of national banks by allowing them to continue to provide as principal any insurance product that national banks were authorized to provide as principal as of January 1, 1997.⁷²

The more controversial part of the bill’s definition of insurance deals with the classification of new products that are developed after January 1, 1997. The compromise bill includes a very complicated framework, worked out with input from members of the banking and insurance industries, for determining whether products developed after January 1, 1997, are banking products—and thus can be provided by national banks as principal—or are insurance products—and thus cannot be provided by national banks as principal. Briefly, the bill would prohibit a national bank from providing as principal any product that is developed after January 1, 1997, and that is regulated as insurance by the relevant state, unless (i) the product is also a traditional banking product (defined to be a deposit product; loan, discount, letter of credit, or other extension of credit; a trust or other fiduciary service; a qualified financial contract; or a financial guaranty), and (ii) either (A) the product would not qualify for tax treatment as life insurance under the Internal Revenue Code if offered by an insurance company, or (B) if the product is a deposit or trust or fiduciary product or service, the product would not qualify for the special loss treatment provided other types of insurance under the Internal Revenue Code.⁷³ It is still unclear whether this approach will resolve the dispute between the banking and insurance industries about future products.

Because the insurance definition is key to the development of future products for both the insurance and the banking industries, the compromise bill also establishes a special procedure for handling definitional disputes. Attempting to establish a dispute resolution process meant grappling with the question of whether any agency should be granted deference in interpreting the statutory definition of insurance. The banking industry was loath to give up the success achieved in several recent Supreme Court decisions that confirm that the Comptroller is entitled to deference in interpreting banking laws under the Comptroller’s jurisdiction.⁷⁴ On the other hand, the insurance industry demanded that any dispute resolution process be neutral.

The compromise bill would establish an expedited procedure for the federal courts of appeal to resolve any disputes that may arise between a federal banking regulator and a state insurance regulator concerning whether a particular product is a banking or an insurance product.⁷⁵ Because of the insurance industry’s concern that the courts would defer to the interpretation of the federal bank supervisory agencies on the question of whether a new product was a banking product, the insurance provisions of the bill would be enacted as freestanding provisions (i.e., not as an amendment to the federal banking laws that are within the interpretive purview of a federal banking agency). In addition, the compromise bill would require that the reviewing federal court resolve any definitional dispute between a state insurance regulator and a federal banking regulator without granting “unequal deference” to the positions of either regulator.

The compromise bill also seeks to address the second major issue related to bank insurance activities—whether, and to what extent, states may regulate the insurance affiliations and activities of national banks. As an initial matter, the compromise bill would broadly preempt any state law that prevents or restricts an insured depository institution or WFI from being affiliated with any entity where federal law permits the affiliation.⁷⁶ Because the compromise bill specifically allows a financial holding company to own an insurance company and a national bank to own an operating subsidiary engaged in insurance agency activities, the bill would preempt those existing state laws that prohibit such a bankaffiliated insurance company or agent from selling insurance in the state.

The compromise bill would also preempt any state law regulating the sale and solicitation of insurance (including licensing requirements) if the law prevents or significantly interferes with the ability of a national bank (or other insured depository institution) to engage in such activities, either directly or in conjunction with an affiliate.⁷⁷ Interestingly, the bill specifies that a state law will not be deemed to “prevent or significantly interfere” with the insurance sales and solicitation activities of an insured depository institution if the law is no more restrictive than an existing Illinois statute regulating the insurance activities of financial institutions.⁷⁸ On the other hand, state laws that regulate insurance activities other than sales and solicitations generally would be preempted if the law prevents or restricts a national bank (or other insured depository institution) from conducting any activity that is permissible for the bank to conduct under federal law.⁷⁹

These affiliation and activity preemption provisions have proven very controversial and remain the subject of intense debate. For example, certain members of the insurance industry currently are seeking amendments to the bill that would clarify that a state insurance authority could prohibit an insurance company from becoming affiliated with a bank if the insurance authority had bona fide reasons for believing that the affiliation would endanger the financial health of the insurance company. The banking industry, however, remains wary of such proposals out of concern that they could be used by a state insurance authority to prohibit all bank–insurance company affiliations.

Conclusion Regarding Insurance Provisions

The insurance issues pose the most difficult obstacle to the passage of financial modernization legislation. Although the compromise bill reflects the progress of efforts to resolve the differences between members of the banking and insurance industries, the issues have so far defied resolution. Progress made in this area may be the bellwether for financial modernization legislation as a whole. Indeed, many believe that the other issues involved with the compromise bill could be resolved relatively quickly if a solution to the insurance puzzle could be worked out.

Precipitating Actions of the Comptroller

In 1997, the Comptroller adopted regulations authorizing national banks to establish operating subsidiaries to engage in activities that a national bank cannot engage in directly.⁸⁰ Acting under this new regulation, the Comptroller, in December 1997, approved the application of a national bank to engage, through an operating subsidiary, in underwriting and dealing in municipal revenue bonds—an activity that the Glass-Steagall Act prohibits a national bank from conducting directly.⁸¹ The Comptroller also is considering two proposals by another national bank to establish operating subsidiaries to engage in real estate development and real estate leasing activities, and the Comptroller’s regulation is broad enough to permit operating subsidiaries of national banks to engage in other types of financial or nonfinancial activities.

Several members of Congress have criticized the Comptroller’s actions in this area and have questioned whether existing law permits a national bank to control a subsidiary that engages in activities that the bank cannot conduct directly. The Fed also has expressed serious doubts that Congress intended to create a statutory scheme that would allow the Comptroller to override express statutory prohibitions on the activities of national banks by administrative action.⁸² Although some observers believe that the Fed’s position on this matter represents merely a “turf” battle with the Comptroller, the Comptroller’s operating subsidiary regulation has serious public policy implications related to the proper role of the federal safety net.

Banks, unlike other forms of business organizations, benefit from the direct and indirect government guarantees provided through the federal safety net (i.e., FDIC deposit insurance and access to the Federal Reserve’s discount window and payments system). While these governmental guarantees protect depositors and reduce the likelihood of damaging bank runs, they also allow banks to borrow funds at a lower cost than other nonbank entities. Although some contend that this funding benefit is offset by the special regulatory costs imposed on banks,⁸³ Chairman Greenspan has testified that access to the federal safety net, and the explicit and implicit government guarantees associated therewith, provides banks with a net subsidy that is not available to other organizations.⁸⁴

Operating subsidiaries that are established or funded with low-cost funds raised by the parent bank also benefit indirectly from the federal safety net. Accordingly, the Comptroller’s proposal to permit operating subsidiaries of national banks to engage in activities impermissible for banks to conduct directly could result in the indirect expansion of the federal safety net to cover a range of activities that Congress has decided should not be protected by governmental guarantees. In addition, operating subsidiaries that are funded with low-cost funds raised by the parent bank would have an unfair competitive advantage over other business organizations that lack access to the federal safety net.

Furthermore, allowing operating subsidiaries of national banks to engage in activities that are not permissible for national banks could increase the risk of loss to the bank and the FDIC insurance funds. In this regard, a national bank would likely face significant pressure to support an operating subsidiary in financial difficulty. This is especially true because any losses at the subsidiary would have to be consolidated with the parent bank’s financial statements under generally accepted accounting principles and, thus, would have a negative impact on the bank’s consolidated earnings and financial reports provided to investors and the public. Even if a parent bank did not provide financial support to an operating subsidiary in distress, any publicity concerning the financial difficulties of the subsidiary could cause depositors or creditors to lose confidence in the parent bank.

The Comptroller contends that these risks and concerns are adequately addressed by limitations or conditions contained in the proposal, including a requirement that transactions between a national bank and its operating subsidiary comply with sections 23A and 23B of the Federal Reserve Act, and a requirement that a national bank deduct its equity investment in an operating subsidiary from its capital and total assets for purposes of determining the bank’s compliance with regulatory minimum capital guidelines.⁸⁵ The Comptroller’s proposal, however, does not subject a national bank’s equity investment in an operating subsidiary to the limits contained in section 23A and, thus, would not limit the amount of low-cost capital that a national bank could downstream to an operating subsidiary. Moreover, sections 23A and 23B do not today cover the complete range of financial relationships that may exist between a national bank and an operating subsidiary and, as noted above, are not always fully effective in protecting a bank from the risks arising from transactions with affiliates, especially in times of financial stress.⁸⁶ The restrictions proposed by the Comptroller also would not fully address the contagion risks that necessarily arise from allowing a national bank to control and manage an operating subsidiary whose financial condition will necessarily be reflected in the parent bank’s public financial statements, i.e., the risk that losses at the operating subsidiary will cause depositors or creditors to lose confidence in the subsidiary’s parent bank.

Furthermore, although the Comptroller’s proposal would require that a national bank’s equity investment in an operating subsidiary be deducted from the bank’s capital and total assets for purposes of determining the bank’s regulatory capital, it is unclear whether the proposal would require a similar deduction for the retained earnings of the operating subsidiary. Under generally accepted accounting principles, the retained earnings of a subsidiary would be consolidated with the capital account of the parent bank. Accordingly, if the Comptroller’s proposal does not require that the operating subsidiary’s retained earnings be deducted from the parent bank’s capital, then a significant portion of the bank’s regulatory capital could consist of the retained earnings of an operating subsidiary and, thus, be at risk to losses incurred by the operating subsidiary.

Legislative Responses

In light of the risks discussed above, the compromise bill would generally prohibit subsidiaries of national banks from engaging in any activity that national banks are not permitted to conduct directly, unless otherwise specifically authorized by a federal statute.⁸⁷ Thus, a national bank would continue to have the authority to control Edge Act corporations. In addition, as noted earlier, the bill would specifically authorize national banks to control operating subsidiaries engaged in general insurance agency activities.⁸⁸ Agency activities generally involve little risk and require only minimal capital investments. Authorizing operating subsidiaries to engage in general insurance agency activities thus would not appear to significantly increase the risks to the deposit insurance funds or create significant funding advantages for national banks.

The Treasury Department and some members of the banking industry, however, have sought amendments to the compromise bill that would allow operating subsidiaries to engage in activities that national banks cannot conduct directly, such as securities underwriting and dealing and insurance underwriting activities. At this point in time, it is unclear whether Congress will successfully resist these efforts in light of the substantial public policy concerns and risks associated with the proposals.