Current Legal Issues Affecting Central Banks, Volume IV.

11D. Report from the Office of Thrift Supervision

Robert Effros
Published Date:
April 1997
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Several current legal issues concerning the regulation of the U.S. savings and loan industry are the focus of this chapter. To put the issues in context, the evolution of the thrift industry over the past five years needs to be understood. The thrift industry was in crisis only a few years ago. Now, it is profitable but also much smaller. Three areas of regulation mirror various aspects of this evolution. First, the enforcement activity and approach of the Office of Thrift Supervision (OTS) reflect this dramatic shift in the condition of the industry. In 1994, the OTS adopted a new enforcement policy responding to the changes in the thrift industry.2 Second, amendments were made to the OTS’s regulation of mutual savings associations that wish to convert to the stock form of ownership.3 Again, the amendment was made in response to the changed condition of the industry. Finally, the OTS’s regulation of savings associations’ uninsured products, such as mutual funds and annuities, is addressed.

OTS’s Enforcement Policy

Where did the thrift industry stand before the passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)?4 How has it rebounded? In 1988, there were nearly 3,000 savings and loans with about $1.4 trillion in total assets. That same year, the industry lost $13.3 billion. In 1989, the year that the U.S. Congress created the OTS, the industry lost yet another $6.8 billion. With the expanded enforcement authorities granted by FIRREA, the OTS went to work to clean up the industry. The OTS closed over 700 insolvent savings and loans and successfully pursued those persons responsible for the crisis, including savings and loan officers, directors, lawyers, and accountants. The OTS is in the final stages of that cleanup effort.

The savings and loan industry today is very different from the industry that the OTS regulated in 1989. It is much smaller, and it is now profitable. Between 1988 and 1993, the industry shrank by about 43 percent. At the end of 1993, the industry consisted of 1,669 thrifts with $775 billion in total assets. In the last year or so, this shrinkage has been due to mergers and charter conversions. After four years of losses, the industry has been profitable for four consecutive years, from 1992 to 1995. In 1992, the industry earned $5.1 billion. In 1993, the industry earned another $5 billion. At the end of 1993, 99 percent of OTS-regulated thrifts met the requirements for an adequately capitalized thrift, and 93 percent were well capitalized, as defined by the Federal Deposit Insurance Corporation Improvement Act.5 About 93 percent of all the OTS-regulated thrifts were profitable in 1994, compared with only 68 percent in 1989. Part of this is due to favorable interest rates. However, another major reason is the closure of hundreds of shaky and insolvent institutions that were placing competitive strains on healthy institutions.

The enforcement work of the OTS reflects these industry changes. Its enforcement work, which skyrocketed as it responded to the crisis, has tapered off as it worked through the cases associated with failed institutions. With a healthier industry engaged in more traditional thrift activities, there are fewer occasions for taking enforcement actions. In 1990, the OTS completed 348 enforcement actions. In 1991, it completed 876 enforcement actions, an increase of 152 percent. This was the peak of its enforcement activity. In 1992 and 1993, the OTS completed 668 and 299 enforcement actions, respectively. It expects a further reduction in the number of enforcement actions in the coming years.

Responding to these changes in the savings and loan industry, the OTS announced a new enforcement policy in the spring of 1994.6 It designed the new policy to maximize the agency’s efficiency in regulating a sounder and smaller thrift industry by focusing on enforcement actions that will promote a sound industry. The OTS will rely increasingly upon the Resolution Trust Corporation and, after that corporation’s closure in December 1995, the Federal Deposit Insurance Corporation (FDIC) to seek restitution from those persons responsible for the dwindling number of thrift failures. Under the new enforcement policy, the OTS gives a high priority to cases involving the recovery of substantial sums in restitution that will have a significant impact on the health of a thrift. The OTS enforcement actions involving closed institutions generally will focus on prohibiting dishonest and untrustworthy individuals from participating in the banking and thrift business or on modifying a person’s future practices through a cease and desist order.

OTS’s Thrift Conversion Rules for Mutual Savings Associations


The conversion of mutual savings associations to the stock form of ownership is a matter of current interest. Congress, account holders, and consumer groups have voiced significant concerns about the conversion of well-capitalized associations because of the compensation and stock benefits that management typically gets in such transactions. The OTS responded to these and other concerns by amending the regulations governing mutual-to-stock conversions.7

Mutual-to-stock conversions are not new. The OTS’s predecessor, the Federal Home Loan Bank Board (FHLBB), first adopted regulations allowing mutual associations to convert to the stock form of ownership in 1974.8 Since then, over 1,000 mutual savings associations have converted to the stock form of ownership, raising about $16 billion in new capital. However, the reasons that prompt associations to convert have changed, and with those changes has come the current controversy.

During the 1980s, most mutual associations were marginally capitalized, and many were insolvent. As a result, the FHLBB changed its regulations to provide significant incentives to management to convert their associations to the stock form of ownership.9 Many associations availed themselves of these benefits and recapitalized, thereby saving the insurance fund the cost of closing them.

In 1994, however, although most of the 798 mutual associations were healthy, these associations were converting to the stock form of ownership in increasing numbers. This development raises new concerns because the mutual associations obviously have not been converting to meet regulatory capital requirements. Instead, they are raising capital to expand operations or to establish stock benefit plans for management and employees. The public, Congress, and the OTS are concerned about the perception that the management of converting associations has reaped windfall profits.

In addition, the issue has been particularly controversial because some states offer insiders of state-chartered savings banks the opportunity to gain potentially greater benefits and more generous compensation packages than the OTS’s rules allow. In 1994, Congress considered legislation to set minimum federal standards for conversions by state savings banks and limitations on management benefits in conversions.10 Suggestions also have been made that some capital raised in a conversion ought to be used to provide low- and moderate-income housing in the association’s community.

Amendments to Thrift Conversion Regulations

To address these and other concerns, the OTS amended its regulations governing mutual-to-stock conversions of insured savings associations to change the regulatory inducements for conversions.11 The OTS will apply the regulations to all associations, including those with pending applications. The OTS published the amendments to its conversion regulations as an interim final rule because of the critical need to ensure an equitable conversion process while still providing converting associations access to the capital markets.12

The OTS’s amendments made five key changes to its mutual-to-stock conversion regulations. First, the regulations prohibit the use of the conversion stock itself to fund management stock benefit and recognition plans (MRPs).13 The FHLBB introduced MRPs when many thrifts were undercapitalized. The purpose of MRPs was to retain good management and to deter hostile takeovers of converting associations by providing an opportunity for management to obtain equity stock in its associations. However, in today’s environment, the OTS is concerned that thrift insiders may be tempted to support a conversion to buy significant amounts of conversion stock at the lowest price through various benefit plans. Under the prior regulations, part of the conversion stock was distributed to MRPs and stock option plans. Under the current regulations, management must seek shareholder approval after a conversion is completed to issue new stock and set up an MRP.14 The OTS believes that this decision should be left to the shareholders, who must weigh dilution of their stock value against the need to reward management.

Second, the local community now has more of a chance to participate in conversions than it did under the prior regulations because eligible “local” account holders have first priority to buy conversion stock.15 To qualify for the priority, the individual must have been a depositor for at least a year before the conversion application and must live in the converting association’s local community or within 100 miles of the association’s home or branch office or offices.16 The regulations define “local community” to include

all counties in which the converting association has its home office or a branch office, each county’s standard metropolitan statistical area or the general metropolitan area of each of these counties, and such other similar local area(s) as provided for in the plan of conversion, as approved by the OTS.17

Third, the OTS prohibited the use of “running” proxies in the conversion vote to increase the incentive for the management of converting thrifts to solicit depositors to consider and vote on conversions.18 An association’s management obtains a running proxy to vote the depositor’s interest when a depositor opens an account. By prohibiting the use of running proxies, the association’s membership should have significantly greater participation in the conversion process.

Fourth, the OTS believes that the integrity of the conversion process rests in large part on the accuracy of the appraised value on which the initial stock price of the association is based. Increasingly, the OTS has found that stock prices have jumped dramatically in the aftermarket. Accordingly, the OTS revised its appraisal standards to require a full appraisal, including a complete and detailed description of the elements that make up the appraisal report.19 The OTS also has put appraisers and the thrift industry on notice that the appraisals submitted must accurately reflect the pro forma value of the institution and that, if the OTS finds a significant underappraisal, it will reject the application. Where an appraiser has a pattern of underappraisals, the OTS will consider debarment or other enforcement action.

Fifth, the regulations prohibit a mutual association from converting to the stock form of ownership as part of a merger with, or acquisition by, another entity, except in supervisory cases.20 The OTS believes that such transactions may be too prone to enrich insiders through favorable employment contracts and other benefit plans provided by the acquiring institutions as inducements to convert. The OTS was so concerned about this phenomenon that it imposed a moratorium on such transactions on January 31, 1994.21

The OTS also published a proposed regulation that would require the agency to consider whether the conversion would benefit the convenience and needs of the communities that the association serves.22 That judgment would include an assessment of how well the association had complied with the Community Reinvestment Act23 and how the association would use the proceeds of the conversion to meet the needs of the community.24 Under the Community Reinvestment Act, regulated financial institutions must demonstrate that their deposit facilities serve the convenience and needs of the communities in which they are chartered to do business, including through both credit and deposit services.25 A converting association is required to submit a business plan as part of its application, and the OTS proposal would have the association address how it would devote resources to lending programs and related customer services to address the needs of their local communities, including low- and moderate-income communities, consistent with the principles of safety and soundness.

The OTS believes that the amendments to the conversion regulations, along with the above-mentioned proposed rule, address the need to balance the interest of account holders with those of management and employees, and the need to give the local community a more meaningful opportunity to participate in all conversions.

OTS’s Regulation of the Sale of Uninsured Products

With the increasing competition in the marketplace for offering financial services, insured depository institutions must be more versatile in order to survive. Sales of uninsured products, such as mutual funds, provide benefits in retaining and attracting customers, but they also create risks.

Sales of such products can increase a thrift’s competitiveness by enabling it to offer “one-stop shopping” for various financial services. However, there are risks when the customers do not understand what they are buying. Surveys have shown that customers purchasing investment products in depository institutions are more likely to consider the product as “safe” or “insured.” Because of inadequate disclosure, misleading marketing, or blind faith that the government will protect them, customers unfamiliar with mutual funds, annuities, and similar products may not understand that the FDIC does not insure these products. Another risk is that the customer will invest in a product without fully understanding its risks. The OTS’s concern in this area is heightened because the public is shifting an increasing portion of its savings into mutual funds, in which the customer’s risk of loss is substantially higher than in a certificate of deposit or a money market mutual fund.

Thrifts that engage in securities brokerage activities do so indirectly through either service corporations or lease arrangements with third-party broker-dealers. Service corporations may register as broker-dealers themselves, or they may contract with third-party broker-dealers to conduct sales activities. A service corporation may sell uninsured products on the premises of the savings association or off the premises. OTS-regulated entities selling uninsured products are subject to a comprehensive regulatory regime.

The OTS’s predecessor, the FHLBB, approved the first application to engage in discount brokerage activities through a service corporation about 12 years ago. Over the years, the OTS developed standards to reduce the confusion that can occur when an insured institution sells uninsured products. For example, sales activities must take place in a separate and distinct area. The physical separation and signs must express visually that the activities are different from the institution’s banking activities. The advertising of uninsured products also must be distinguishable from that of the association and may not indicate or imply that the securities are insured or that the insured institution itself is issuing or selling the securities. The OTS does not allow tellers to be involved in the sale of investment products, except to refer depositors who want to discuss investments to the brokerage area.

The OTS also regulates the sale of securities issued by a savings association or its affiliates in the offices of an association. It generally prohibits the on-premises sale of a thrift’s own securities or those issued by its affiliates. An exception allows an association to sell equity securities issued by the association or an affiliate in a mutual-to-stock conversion, subject to various safeguards. These safeguards minimize potential customer confusion and the danger of customer deception regarding the nature of securities sold at a savings association’s offices while still preserving an effective means for a savings association to raise capital in the conversion process. For example, there are prohibitions against paying commissions or bonuses to any employee of the association or its affiliates, using common sales areas, and employing fraudulent or misleading advertising. The customer must receive an offering circular and must sign a form stating that he or she knows the security is not insured by the FDIC. In addition, in order to avail itself of the sale of its securities on the premises, the association must be in compliance with all of its capital requirements upon completion of the conversion.

More generally, in February 1994, the OTS and the other federal banking agencies issued an Interagency Statement on Retail Sales of Nondeposit Investment Products to ensure that all depository institutions follow the same standards.26 The Interagency Statement addresses concerns about customer confusion and safety and soundness. It applies to the sale of retail nondeposit investment products on the premises of thrifts or banks, no matter whether the sales activities are conducted by employees of the institution, its service corporation, or any third-party broker-dealer. The statement also covers sales resulting from a customer referral by the institution to a third party when the depository institution receives a benefit for the referral.

The Interagency Statement sets out the fundamental elements of a sound, well-managed sales program for uninsured products.27 These elements include the policies and procedures that a savings association should adopt on disclosures to customers, the location of sales, the separation of duties, referral fees, and the training, suitability, and qualifications of sales representatives.

If a thrift decides to sell uninsured products through a third party, the thrift should first conduct an appropriate review of the third party.28 The thrift should also have a written agreement with the third party that, among other things, should describe clearly the duties and responsibilities of each party and specify that the third party will comply with all applicable laws and regulations.29

In addition, brokers should disclose to their thrift customers that the security is (i) not insured by the FDIC; (ii) not a deposit or other obligation of, or guaranteed by, the depository institution; and (iii) subject to investment risks, including possible loss of the principal investment. Disclosures during sales presentations may be oral, but they should be in writing by the time that an investment account is opened. Thrifts should conduct sales of nondeposit investment products in a physical location distinct from the area where they take retail deposits. Thrifts should use signs and other means to distinguish the investment sales area.

These safeguards are less stringent than the rules that the OTS applies to the sale of the institution’s own securities. This is because the sale of an association’s own securities (or those of its affiliates) on the premises of a savings association carries a greater risk for customer confusion. Therefore, such sales are subject to safeguards beyond those that apply to the sale of securities generally.

Thrifts, thrift service corporations, or affiliates that buy or sell securities for the accounts of depositors and other retail customers must register with the Securities and Exchange Commission and must also be a member of the National Association of Securities Dealers.30 In addition, in contrast to its treatment of banks, the Securities and Exchange Commission regulates thrifts that are investment advisors to mutual funds under the Investment Advisors Act of 1940.31


Those involved in the regulation of the thrift industry face constant change as the thrift industry evolves to keep pace with the times. The problems faced today are very different from the problems faced in the 1980s, when efforts were concentrated on thrift failures and the abuses that led to those failures. Today, the OTS is gearing its efforts to regulate a healthy and much smaller thrift industry in order to ensure that a crisis never happens again.



This comment seeks to place some of the important regulatory issues affecting U.S. banking in a wider international policy context. It is unlikely that U.S. regulatory experience is directly applicable to banking regimes in other countries. There are few countries that match the U.S.’s complex bank regulatory structure. Nevertheless, many of the major issues are the same, and an appreciation of the advantages and disadvantages of the U.S. system is helpful.

It is a truism to note that the business of banking is changing rapidly. This is not true everywhere. For example, the pace of change dictated by competition, technology, and cost pressures is greater in the United Kingdom and the United States than, for example, in the Caribbean and Africa, where the traditional forms of banking continue to thrive. Nevertheless, at the international level, banking is generally evolving at a quick pace. This is reflected in the makeup of balance sheets, both on the asset and liability side, and in the way that banks are reorganizing management structures in fundamental ways or combining with other banks or financial institutions.

The health of any banking system, however, is directly affected by the regulatory scheme that applies to it. In the United States, there is dissatisfaction with the present arrangements. The current Administration has given notice of its desire to overhaul the structure of regulatory supervision by creating a single supervisory agency.1 Others believe that overhauling the structure of banking supervision before considering the restructuring of the whole financial services industry is putting the cart before the horse.

William McDonough, President of the Federal Reserve Bank of New York, has stated:

[t]he financial services industry today is segmented both in terms of its structure and its regulatory environment. This segmentation increasingly makes less sense as banks, securities firms, insurance companies, and other financial firms compete with one another in offering similar or related products to the same customers. Moreover, the regulation of the financial services industry is a patchwork of market and institutional regulation that reflects not any carefully defined and forward-looking process, but rather a series of ad hoc responses to historical developments, with no central theme. As such, the structure has become outmoded and is badly in need of change.2

These are blunt words from a central banker. He goes on to make the second point that this fragmentation, at both the structural and regulatory levels, “has had worrisome effects on the competitiveness of our financial institutions.”3 He speaks here of U.S. institutions, but what he says is applicable elsewhere.

Mr. McDonough’s recommendation is that, in light of this extensive fragmentation of the financial services industry and its adverse competitive effects, financial market reform efforts should be based on the needs of the customer and user of financial services. In the United States, for example, this approach might lead to support for banks’ ability to under-write and sell life insurance through their extensive branch networks. Bill Isaac, former Chairman of the Federal Deposit Insurance Corporation, has said that this could lead to reductions in premium costs for consumers of 20–50 percent, because the banks could distribute this product so much more efficiently than life insurance companies.4

Regulatory Consolidation

The Federal Reserve and the Department of the Treasury considered a plan of consolidation of the federal banking agencies. There would be benefits and efficiencies from consolidation, without doubt. However, the primary effort should be to reform the function of the financial services market, not the function of the regulators. The principal question should not be who regulates banks, but rather how they are regulated.

The consolidation debate in the United States has nevertheless raised issues that are pertinent to all central bankers. For example, what is the role of the central bank? There is little debate about two core functions, namely, conducting monetary policy and overseeing the payments system. However, what should be the central bank’s role in bank supervision?

At the core of the Federal Reserve’s opposition to the Administration’s proposal was the argument that its core functions would be seriously compromised by the absence of an active involvement in bank supervision. However, not all countries assign a supervisory role to their central banks. This issue of supervision gets tied up with the related issue of central bank independence from political influence. The consensus appears to be that central bank autonomy is the better path,5 and the European Community, in the aftermath of the Treaty on European Union (the Maastricht Treaty), reflects that direction.6

In the United States, certainly, the autonomy of the Federal Reserve is jealously protected. However, there is also a strong sense, rooted in the populist culture of the United States, that the people must control the banks, and the people, of course, speak through their elected officials. It is easy in these circumstances to find a ready audience for the proposition that bank supervision should be controlled by elected officials (or their appointees), for example, the Department of the Treasury. It is a worthy debate, and a fertile topic for international discussion.

A related question raised by the consolidation debate in the United States is, How many regulatory agencies are needed? Four federal supervisory agencies are represented in this chapter on U.S. banking regulation. Representatives from the 50 state banking authorities, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and any number of other regulatory agencies could also have been represented. Does this plethora of regulators help or hinder banks? Does it increase or reduce the safety and soundness of our financial infrastructure? This, too, is a worthy debate, and the better answers may be counterintuitive.

Initially, the multiplicity of regulators seems to make little sense. However, some argue persuasively that, to cite one example, U.S. savings and loan losses in the 1980s were attributable, in part at least, to the concentration of supervisory and deposit insurance authority in a monolithic, efficient regulator, the Federal Savings and Loan Insurance Corporation. Some proponents of consolidation, however, fear a “competition in laxity,” with institutions forum-shopping for the most permissive regulator. Bankers would probably argue that what they have seen recently is rather a “competition in ferocity,” with regulators attempting to demonstrate how much more diligent they are than their peers! However, bankers themselves certainly do not want a lax regulatory environment, and the existence of multiple forums for raising regulatory issues has encouraged substantive debate about the best way of balancing regulatory concerns against the business needs of banks. The need for this active balancing of interests is critical to an era of rapid innovation in banking products, such as derivatives.

Deposit Insurance

The availability of deposit insurance and the absence of market discipline supported and arguably encouraged a great deal of the misguided investments by savings and loan institutions in the 1980s. Furthermore, deposit insurance imposes a franchise cost on insured institutions and results in an overly restrictive attitude in the U.S. Congress, which is concerned that regulatory reform may have catastrophic consequences for the insurance funds. Some observers have asked why the scope of insurance accounts should not be severely cut back, and market discipline and supervision allowed to play a greater role in ensuring the safety and soundness of customers’ funds. People today have significant amounts invested in uninsured accounts, such as mutual funds and 401(k) plans,7 so the concept is not necessarily radical at all. To the extent that insurance coverage can be cut back, the cost of the social franchise can be reduced, allowing banks to compete more effectively with their nonbank brethren. This step would also enable Congress to take a less suspicious view of product innovation.

Foreign Bank Supervision

U.S. regulators are committed to the principle of national treatment. They usually bend over backward to give foreign banks a fair shake. What is critical with banks operating across borders is the exchange of information, so that a level of confidence is built concerning the ability of diverse regulatory regimes to adequately police their banks. No central bank has a monopoly on best practice, and what is to be expected is a continuing convergence toward standards of best practice.

One question that remains at the forefront is, How can branches of banks outside their home countries best be regulated? In the past few years, it was proposed by some that foreign banks should be required to convert their U.S. banking operations into separately capitalized subsidiaries. The issue was thought to have been put to rest by a study by the Department of the Treasury and the Federal Reserve supporting the branch concept.8 However, the issue came to the fore again in the Senate’s version of the legislation permitting interstate banking, which would have required foreign banks to act through subsidiaries if they wanted to take advantage of the new legislative authority.9 The very arguments supporting the ability of U.S. banks to branch nationwide, which have now been accepted by Congress, support the rationale for allowing international banks to branch worldwide. These persuasive arguments are accepted by most regulators.

It is nevertheless the case that branch operations in host countries pose many conceptual issues. In the United States, for example, the regulatory paradigm is the bank holding company, and direct branch operations do not always match that paradigm easily. Regulators at both the federal and state levels are making efforts to come to grips with these issues, such as how to handle the insolvency of a U.S. branch of a foreign bank. Many solutions require international dialogue. For example, what approach is best for supervising a branch? In the European Community, under the Second Banking Directive, the host country defers significantly to the home country regulators with respect to branch operations.10 In the United States, in contrast, regulators are developing specific guidelines for U.S. branches of foreign banks to follow in conducting their operations. There is definitely a divergence in approach here. Furthermore, what is a branch? U.S. regulators tend to treat branches as stand-alone entities, which are expected to contain within themselves internal control systems similar to those found in U.S. banks. However, the control systems may exist in the home country outside the branch, even though they effectively reach the branch. Credit decisions, for example, may be made at the head office or in a non-U.S. office that has overall credit control over a multinational company. U.S. regulators, however, require that the credit decision be within the branch’s control, as their supervisory oversight or responsibility does not reach the offshore point.

It is very important that the branch concept be supported worldwide, but an active dialogue on the consequent supervisory issues is essential. That dialogue falls properly within the central bank lawyer’s sphere of responsibility. In addition, bankers should continue to be included in the discussions because of the significant practical consequences of the resolution of this issue.

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