13A. Current Financial Modernization Proposals in the United States


The U.S. Congress currently is considering historic legislation that would significantly alter and modernize the laws governing banks and other financial intermediaries in the United States. Any legislation brought to the House floor likely will be based substantially on the compromise version of H.R. 10, the Financial Services Act of 1998, that the House Republican leadership released on March 10, 1998.1 This compromise bill seeks to resolve the significant differences between the bills passed by the House Committee on Banking and Financial Services (Banking Committee) and the House Committee on Commerce (Commerce Committee) in June 1997 and October 1997, respectively.2

The compromise bill represents only the latest effort by the U.S. Congress to achieve an important and necessary goal—comprehensive modernization of the laws governing U.S. banks and other financial intermediaries. Existing laws prohibit or significantly restrict the ability of banks to affiliate with companies engaged in securities or insurance activities. Section 20 of the Glass-Steagall Act prohibits banks that are members of the Federal Reserve System from being affiliated with any entity “engaged principally” in underwriting or dealing in securities, other than limited types of bank-eligible securities.3 The 1982 insurance amendments to the Bank Holding Company Act of 1956 (BHC Act) also generally prohibit a bank holding company from engaging in, or controlling a company engaged in, insurance underwriting or sales activities.4 These laws also restrict the ability of foreign banks with a banking presence in the United States to acquire U.S. securities firms or insurance companies.

These walls between the banking, insurance, and securities industries were enacted when bank products and services could practically and functionally be separated from those offered by securities and insurance firms. Rapid advances in computer and telecommunications technology, however, have led to the development of new financial products that blur the traditional line between banking, securities, and insurance products and services. This, in turn, has led consumers to seek the convenience and flexibility to obtain most of their financially related products and services from a single “supermarket” provider.

While these changes are transforming the financial services marketplace, banking organizations and other financial intermediaries in the United States increasingly find their ability to meet the demands of their customers for the full range of functionally similar financial products and services restricted by outdated laws that prohibit the establishment of unified financial services companies. For example, without changes to existing laws, the organization resulting from the recently announced merger of Citicorp and Travelers will likely have to divest its insurance underwriting activities. These outdated laws also hurt the United States and foreign institutions by forcing foreign banks that wish to purchase U.S. insurance companies to divest their U.S. banking operations. Such divestitures reduce employment, commercial activity, and the availability of credit in the United States, diminish the role of the United States and New York City in particular as the financial center of the world, and unnecessarily interfere with the business plans and operations of foreign institutions.

In light of these problems, practically all interested parties in the United States agree that something must be done to revise existing U.S. financial laws and prepare the U.S. financial system for the twenty-first century. In this regard, the banking, insurance, and securities industries; the Treasury Department; the three federal banking agencies—the Federal Reserve Board (Fed), the Office of the Comptroller of the Currency (Comptroller), and the Federal Deposit Insurance Corporation (FDIC); and the Securities and Exchange Commission (SEC) all support legislative efforts to modernize the financial system.

If a general consensus exists that legislative reform is necessary, why then has financial modernization been so difficult to achieve in the United States? Financial modernization necessarily involves the consideration of a wide array of important policy issues, some of which involve questions that are peculiar to the U.S. financial system. For example, legislative reform efforts in the United States require the consideration of whether this nation’s long-standing policy of separating banking and commercial organizations should be relaxed or eliminated; the proper role and regulation of banks in the sale of securities and insurance; the appropriate level of federal supervision of the proposed financial holding companies that have bank, securities, and insurance affiliates; and the most appropriate manner of ensuring that any structural revision to our financial system occurs in a safe and sound manner without undue extension of, or risk to, the federal safety net.

Although the various industries and supervisory agencies generally agree that these issues need to be addressed, they have differing views on precisely how they should be resolved. Not surprisingly, many entities involved in the current debate have sought to preserve those aspects of the current regulatory structure that provide their own industry with some form of competitive benefit, while at the same time seeking to break down those barriers that restrict their ability to enter other fields. In addition, each industry has sought to assure that any future regulatory framework is as consistent as possible with the policies that have guided its particular industry in the past. The debate between banks and insurance agents is the most prominent example of these conflicts—while banks generally believe that financial modernization legislation should expand (or at least not restrict) the ability of banks to sell insurance or insurance-like financial products, insurance agents believe that any legislation should curtail the insurance activities of banks and subject any such activities to regulation by the states.

In addition to these inter-industry issues, financial modernization efforts in the United States also involve significant issues related to the regulation of the banking, securities, and insurance activities. During the current modernization debate, the SEC has sought to expand its ability to regulate the securities activities of banks; the Comptroller has sought to broaden the powers of national banks, which fall under its supervision; the Fed has sought to maintain its ability to supervise the financial system and major bank holding companies; and the Treasury Department has sought to expand its role in the regulation of financial holding companies. These positions may, to some extent, reflect the fact that banks, securities firms, and insurance companies and agents are regulated by different authorities in the United States. Banks are supervised at the federal level by the Fed, the Comptroller, or the FDIC; companies that control banks are supervised on a consolidated basis by the Fed; securities firms are supervised primarily by the SEC; and insurance companies and agents are supervised primarily by the relevant insurance authority of the individual states.

This complex matrix of policy, economic, and supervisory interests has made it difficult for members of Congress to fashion a financial modernization proposal that enjoys sufficient support to assure passage. This tangle of issues and interests also has made it difficult for persons outside the United States to gain a clear understanding of the major issues involved with financial modernization and the progress that the Congress has made to date in addressing these issues. Accordingly, this article provides an overview of the major policy issues associated with financial modernization in the United States and discusses the positions of the relevant industries and supervisory agencies on these issues. This article also discusses how these issues are addressed by the compromise version of H.R. 10.

Current Regulatory Framework

To understand the issues associated with financial modernization in the United States, it is first necessary to have a working knowledge of the existing U.S. regulatory structure governing the financial services industry.

Banks, Bank Holding Companies, and Foreign Banks

The United States maintains a dual banking system, which means that commercial banks may obtain a charter from either a state (state-chartered banks) or the federal government (national banks). Under current law, the powers of national banks are generally limited to those authorized by the National Bank Act of 1864 (NBA),5 as amended. The NBA permits national banks to engage in the “business of banking” and to exercise those incidental powers necessary to carry on the business of banking.6 The Glass-Steagall Act of 1933, however, provides that national banks may not purchase equity securities for the bank’s own account or underwrite or deal in debt or equity securities, except for limited types of “bank-eligible” securities.7 The NBA separately authorizes national banks located in places with a population of 5,000 or fewer to act as agent in the sale of insurance policies underwritten by unaffiliated insurance companies.8 As traditionally interpreted, these provisions significantly limited the ability of national banks to engage in securities activities as principal or to engage in widespread insurance activities.

The BHC Act of 1956 limits the permissible activities and affiliations of companies that control state-chartered or national banks.9 As a general matter, the BHC Act allows bank holding companies to engage in, or control a company engaged in, any activity that the Fed determines is “closely related to banking.”10 Because commercial or industrial activities are not closely related to banking, bank holding companies may not engage in, or control companies engaged in, such activities. Furthermore, in response to several actions by the Fed in the 1970s and early 1980s permitting bank holding companies to sell certain types of insurance,11 the insurance industry persuaded Congress to pass the Garn-St. Germain Act of 1982, which specifically provides that the Fed cannot consider the sale of insurance, as principal or agent, to be an activity that is “closely related to banking.”12 As a result, the Fed may no longer authorize bank holding companies to engage in, or affiliate with companies engaged in, the underwriting or sale of insurance.

Section 20 of the Glass-Steagall Act also prohibits bank holding companies that control member banks from controlling any entity that is “engaged principally” in underwriting or dealing in bank-ineligible securities.13 The Fed has interpreted the “engaged principally” language to permit bank holding companies to acquire or establish subsidiaries that underwrite or deal in bank-ineligible securities, if such subsidiaries do not receive more than 25 percent of their revenue from underwriting or dealing in bank-ineligible securities.14 Nevertheless, section 20 continues to prevent many large securities firms that cannot meet the 25 percent revenue limitation from acquiring (or being acquired by) a banking organization.

Any foreign bank that owns a subsidiary bank in the United States or that operates a branch, agency, or commercial lending company in the United States is subject to the nonbanking limitations contained in the BHC Act and, thus, must limit its activities in the United States to those permissible for U.S. bank holding companies.15 Certain exceptions to this general rule exist. For example, the International Banking Act of 1978 (IBA) permits a foreign bank to continue to engage in any nonbanking activity that the foreign bank was conducting in the United States as of July 26, 1978.16 Several foreign banks have operated securities affiliates in the United States pursuant to these IBA “grandfather rights.” In addition, under section 2(h) of the BHC Act, a commercial company that is principally engaged in business outside the United States and that is controlled by a qualifying foreign banking organization may engage in commercial activities in the United States if those activities are related to the company’s commercial activities overseas.17 Section 2(h) is designed to restrict the extraterritorial reach of the U.S. banking laws by permitting a qualifying foreign banking organization to own a commercial company overseas, even if the commercial company engages in activities in the United States that are not permissible for a bank holding company. Many foreign banks, particularly from European countries, control commercial firms in their home country that engage in extensive commercial activities in the United States pursuant to section 2(h) of the BHC Act.

Savings Associations

Savings associations or “thrifts” comprise another type of depository institution in the United States. Under current law, thrifts and companies that control thrifts are subject to a regulatory framework different from that of commercial banks and bank holding companies. In this regard, federally chartered thrifts are supervised by the Office of Thrift Supervision (OTS), rather than the Comptroller. Although federally chartered thrifts were initially restricted to mortgage-related lending, today they may make consumer and commercial loans (within certain limits) and may engage through subsidiary “service corporations” in a wide variety of commercial activities.18

Companies that control more than one thrift, like bank holding companies, generally may engage in only a limited set of financial activities.19 Current law, however, does not place any restrictions on the activities or affiliations of so-called “unitary thrift holding companies,” which are companies that control only one savings association.20 Under this unitary thrift loophole, industrial entities, securities firms, and insurance companies may control a single savings association.

Securities Firms and Insurance Companies

Companies that are engaged in buying or selling securities, either as agent or principal, must register with the SEC as a broker or dealer under the Securities Exchange Act of 1934 (Exchange Act),21 and are subject to regulation primarily by the SEC. Currently, banks are excluded from the definition of “broker” and “dealer” in the Exchange Act and, thus, may conduct those securities activities permissible under federal or state banking laws without registering as a broker or dealer with the SEC.22 This registration exemption also is generally available to the branches and agencies of a foreign bank operating in the United States, provided certain conditions are met.23 Accordingly, under existing law, the securities activities of banks, including branches and agencies of foreign banks, are primarily regulated by their appropriate federal or state banking supervisors.

On the other hand, companies engaged in underwriting or selling insurance are regulated primarily by the insurance authorities of the individual states. Congress codified this state-oriented regulatory approach to insurance in 1945 when it passed the McCarran-Ferguson Act,24 which reserves to the states the authority to define and regulate insurance activities. Under this authority, the states have adopted a variety of laws regulating insurance activities, including licensing and qualification requirements for insurance companies and sales personnel, standards relating to sales practices, and rules relating to permissible investments by insurance underwriters.

Significant Issues Associated with Financial Reform

Banking and Commerce

Just a few years ago, much of the debate in the United States regarding financial modernization focused on whether banks should be permitted to affiliate with securities firms, insurance companies, and other entities engaged in financial activities. Now, it is generally accepted that banks should be permitted to affiliate with other financial service providers and the debate has shifted to the corporate and regulatory structure under which such affiliations should occur and whether banks should be permitted to affiliate with companies engaged in nonfinancial or commercial activities.

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.

Expanded Financial Affiliations and Powers

Although there is great debate as to whether the mixing of banking and commerce should be permitted, there is, as noted, a general consensus in the United States that any legislation should authorize banking organizations to affiliate with a broad spectrum of entities engaged in financial activities, including securities brokers and dealers, investment advisers, and companies engaged in underwriting and selling insurance products. In light of this general consensus of opinion, the compromise bill would significantly expand the range of financial activities that may be conducted by bank holding companies and their nonbank affiliates.

In particular, the bill would repeal section 20 of the Glass-Steagall Act, which currently restricts the ability of bank holding companies to affiliate with securities firms.37 In addition, the bill would repeal those provisions of the Garn-St. Germain Act that prohibit bank holding companies from engaging in, or being affiliated with a company engaged in, insurance underwriting or agency activities.38 In place of these restrictions, the bill would specifically authorize any bank holding company that met the criteria to be a financial holding company to engage in, or affiliate with companies engaged in (i) securities underwriting and dealing activities, (ii) merchant banking activities, and (iii) insurance underwriting, brokerage, and agency activities.39 In addition, the bill would specifically allow the insurance company affiliates of a financial holding company to make portfolio investments in other companies in the ordinary course of the insurance affiliate’s business, provided that the bank holding company did not participate in the day-to-day management or operation of the portfolio company. The effect of these changes would be to permit the affiliation of banking, insurance, and securities firms under the aegis of a financial holding company.40

The bill also would permit financial holding companies to engage in other financial activities that are specifically listed in the bills, including providing financial, investment, or economic advisory services, and any other activities that are determined to be “financial in nature” (or incidental to financial activities) by the Fed in the future. The financial in nature test is substantially more flexible than the “closely related to banking” standard contained in current law, and the bill contains very broad language concerning the factors that the Fed may consider in determining whether future activities are financial in nature.

Any foreign bank that meets the criteria to be a financial holding company would be eligible to take advantage of the expanded types of activities and affiliations permitted by the bill in the United States. For example, under the compromise bill, a foreign bank could acquire an insurance company or investment bank in the United States without divesting its U.S. banking operations. Because the bill significantly expands the types of financial companies that a foreign bank may control in the United States, the compromise bill substantially reduces the need for foreign banks to continue to hold U.S. companies under the grandfather rights established by the IBA.

In light of this fact, the compromise bill includes certain provisions designed to assure competitive equality between those foreign banks that have a grandfathered nonbanking affiliate in the United States and domestic financial holding companies. Specifically, the bill provides that a foreign bank that engages in nonbanking activities in the United States pursuant to IBA grandfather rights will lose those rights if it elects to be treated as a financial holding company.41 The bill gives foreign banks that engage through an IBA-grand fathered affiliate in activities that are permissible for a financial holding company two years to file a declaration to be treated as a financial holding company. If the foreign bank fails to elect to be treated as a financial holding company within that period, the bill would authorize the Fed to impose restrictions on the activities of the foreign bank’s grandfathered affiliate that are comparable to those that may be applicable to domestic financial holding companies conducting the same activities.42

Supervision of Financial Holding Companies

Proposals to allow banks to affiliate with securities firms and insurance companies in the United States necessarily raise the issue of how such new holding companies should be supervised. Under existing law, the Fed acts as the “umbrella” supervisor of all bank holding companies. As such, the Fed has the authority to obtain reports from and examine any bank holding company or subsidiary of a bank holding company and to take enforcement action against any such company or subsidiary for violations of law or unsafe or unsound practices. To ensure that bank holding companies have adequate resources to support their operations, the Fed also has adopted capital adequacy guidelines that require bank holding companies to maintain adequate levels of capital on a consolidated basis.

The Fed also acts as the umbrella supervisor of the U.S. operations of any foreign bank that owns a subsidiary bank in the United States, or that operates a branch, agency, or commercial lending office in the United States. The Fed’s authority with respect to the U.S. operations of a foreign bank essentially parallels the Board’s supervisory authority with respect to bank holding companies. Accordingly, the Fed may obtain reports from or examine the U.S. operations of a foreign bank and has established capital adequacy guidelines, consistent with the Basle Capital Accord, for such organizations.

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.

Wholesale Financial Institutions

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.

Securities Activities of Banks

One of the more technical and contentious issues related to financial modernization in the United States is the extent to which the securities activities of banks should be functionally regulated and thus subject to SEC supervision. As noted above, banks currently are excluded from the definition of “broker” and “dealer” in the Exchange Act.61 As a result, banks may conduct those securities activities permissible under federal or state banking laws without registering as a broker or dealer with the SEC and without complying with the capital and other regulations adopted by the SEC for registered brokers and dealers.62

The blanket exemption for banks from the definitions of broker and dealer was enacted by Congress in 1934. At that time, following passage of the Glass-Steagall Act, the securities activities of most banks were limited to executing brokerage transactions for their trust or fiduciary accounts or for other customers on an accommodation basis. Since 1934, however, banks have become increasingly active in the securities business. For example, many banks today offer brokerage services to the general public, engage in the sale of mutual funds, assist issuers in the private placement of their securities, issue asset-backed securities representing interests in loans originated or purchased by the bank, or act as principal in the sale of derivative instruments that may have certain characteristics of a security.

The growth of bank securities activities has occurred largely in response to the natural development of traditional bank services and bank efforts to stem the loss of their valued corporate customers to nonbank competitors. For example, U.S. banks today provide a wide variety of securities processing services in connection with their role as trustee or custodian for corporations, mutual funds, and public and private retirement, profit-sharing, and stock purchase plans. In addition, U.S. banks developed the ability to privately place securities as a mechanism to retain their relationships with major corporate clients, who were increasingly satisfying their need for operating capital by issuing commercial paper rather than obtaining short-term bank loans.

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.

Insurance Activities of Banks

The insurance provisions of the proposed bill are clearly the most contentious. At heart are two basic questions regarding the insurance activities of banks: (i) what financial products are “insurance” that a bank cannot provide as principal,65 and (ii) to what extent should the insurance activities of national banks be subject to regulation by state insurance authorities.

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.

Operating Subsidiaries

Another issue that has engendered considerable debate is whether national banks should be permitted to engage indirectly through a so-called “operating subsidiary” in activities that national banks are not authorized to conduct directly. Although expanding the range of permissible activities and affiliations of bank holding companies would greatly reduce the need to resolve this issue legislatively, recent administrative actions by the Comptroller have kept this question on the forefront of congressional debates on financial modernization.

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.


As the foregoing illustrates, the web of issues and interests facing Congressional efforts to reform the financial laws of the United States is formidable. Although the compromise version of H.R. 10 makes significant progress in addressing many of these issues and balancing the relevant interests, the bill has not yet received sufficient public support to assure passage before the 105th Congress adjourns. Any further compromises must address several contentious disputes—including the questions regarding bank insurance and securities activities—that have successfully evaded the conciliation efforts of many over the years. Nevertheless, hope springs eternal that the 105th Congress will overcome these challenges and fashion financial modernization legislation that not only satisfies the necessary political interests, but also places this nation’s financial system on sound footing for entering the twenty-first century.

13B. Financial System Modernization in Emerging Markets: Asia and Latin America


Financial modernization in emerging markets is a broad topic currently much discussed in light of the recent financial crises in Asia and their potential spread to Russia and Latin America. In addition, any discussion of this topic must take account of the trend toward globalization of world financial markets and of financial services, including crossborder investment in financial services.

I have spent much of my professional life providing technical assistance to governments in the design of financial reform, in assisting them to deal with financial crises, and in restructuring and strengthening their financial systems. I lived through the external debt crisis while working at the Federal Reserve in the early 1980s, and it became necessary to expel the Banco de Brasil from CHIPS. Subsequently, I lived through the Mexican financial crisis of 1994 and, more recently, the Asian financial crisis. In my current position I have been asked to examine the financial sector both in the context of examining the extent of systemic risk in relation to our overall macroview of a country and in the evaluation of potential financial-service investments by our hedge funds. This work has been concentrated in Latin America, in Turkey, and in some eastern European countries. In light of this experience, it is my intention to provide the perspectives of a government employee who must formulate laws, regulations, and institutional arrangements bearing on the financial sector, and of an investor operating in an increasingly global capital market.

Experience has taught me, above all, the critical importance of a multi-disciplinary approach to designing financial system reform where the economic analysis of law and the use of incentives play a critical role. I would like to address five questions in this brief talk.

  1. What is meant by financial system modernization and development in emerging markets?

  2. What is the state of financial system development in Asia and Latin America?

  3. What laws and regulations appear essential in designing a blueprint for financial sector modernization in emerging market economies?

  4. How can financial sector reforms be prioritized and sequenced?

  5. Can hedge funds and the proprietary trading of many large financial conglomerates now being formed worldwide create incentives for more rapid financial modernization?

Financial System Modernization and Development

Today, there are almost as many definitions of financial development or crisis as there are persons deployed to deal with these issues. A whole series of papers have attempted to define financial system development and explain how it relates to the promotion of commerce. In fact, recent work is linking financial sector development to economic growth. Many persons measure financial sector development by financial depth, where credit in relation to GDP is used to gauge depth. Others use measures of liquidity (e.g., bid/ask spreads). Still others examine the spreads between lending and borrowing rates, using balance sheets and income statements of banks or actual data on indicative borrowing (funding) and lending rates. Finally, some have noted that financial sector development is associated with a very high market capitalization or very high price-to-book ratios for banks or financial service entities.

Experience teaches that great care must be exercised in using any one of these measures to gauge the extent of modernization of a financial system. Definitions should provide guidance in how to interpret different measures of financial system modernization. The primary function of a financial system is to facilitate the allocation of resources across space and time in an uncertain environment. This function can be broken into five more narrowly focused functions:

  • facilitating the trading, hedging, diversifying, and pooling of risks;

  • allocating resources;

  • monitoring managers and exerting corporate control;

  • mobilizing savings; and

  • facilitating the exchange of goods and services.

Many emerging market financial systems have performed these functions poorly. Moreover, measuring the efficiency with which financial systems can play this essential role is a nontrivial exercise. In addition, such a definition highlights the age-old fact that financial system modernization is linked to development of contracts that help economic agents make difficult economic investment decisions under uncertainty. How then can this abstract definition serve as a guiding principle in the design of financial sector reform in emerging markets, and what limitations are inherent in this form of definition?

First, accepting the above definition has a profound implication for the design of financial sector reforms. The law and regulation governing the financial services industry should aim at facilitating these five primary functions. Reforms must create strong incentives for shareholders, managers, government regulators, debtors, and investors to carry out these five primary functions. To do this usually requires striking a careful balance between preserving incentives for prudent risk management and not promulgating complex regulations that might damage government credibility if they are difficult to enforce. Such regulations can impede rather than promote competition and can compromise the five essential functions of a financial system.

Second, a definition of this type can fail to recognize the public good aspect of the financial system, the need to maintain the payment system and its integrity. It also needs to account for the fact that some financial services are characterized by nonexcludability, so that private provision of the service can be nonoptimal, and government regulation must account for such “rare” special cases.

Third, the definition highlights the fact that in a global financial system with rapid technological advance, achieving the five functions of a modern financial system will not be independent of how much free trade in financial services is permitted in emerging markets.

As will be discussed later, the silver lining in recent financial crises has been the recognition that the regulation and supervision of financial entities must fundamentally change within specific countries. Let me now present to you a somewhat outdated picture of what has been happening in Asia and Latin America.

Financial System Development in Emerging Markets

I pay particular attention to financial system development in Asia and Latin America in order to highlight some of the overall trends driving modernization of financial services even in emerging markets. The following major trends in emerging market financial systems shape how legal and regulatory frameworks will need to be developed.

Global capital flows are becoming larger in both directions (inward and outward) and often dwarf the size of countries’ international reserves (a theme I will return to at the end of my talk). This is partially compensated for by multilateral and bilateral lending. However, the implications of this for Brazil, Mexico, and Argentina will be more moderate economic growth and the need for further fiscal cuts. In Asia, real growth rates are collapsing.

Increased liberalization of financial services and competition in provision of financial services are occurring across national boundaries. This is manifest in the direct entry of banks in Latin America and Asian countries, as well as in the provision of cross-border services in asset management, insurance, and custody.

Rapid technological advances are having profound implications for providing banking services. The use of the Internet and sale of financial services via different platforms and bundling of products can be expected to increase worldwide. The use of technology to process information about customers and to target products is becoming far more sophisticated.

Corporate and financial institutions are experiencing financial distress in Asian countries, including Japan, owing to systematic overleveraging where peak nonperforming loans in East Asia, Japan, and China are estimated to be on the order of almost US$1.5 trillion (see Table 1). In these cases, corporate debt restructuring and troubled debt restructuring for banks will become ever more important during the next few years. This will present opportunities for investors and for governments to implement much needed “new” approaches to the legal and regulatory framework and institutions relating to corporate distress and restructuring. The opportunity for countries to use the crisis to finally improve the possibility for collateralized lending and overall efficiency of capital allocation via financial sector reform will be significant. It is essential, however, that these institutional arrangements do not harm incentives for voluntary workouts between borrowers and lenders, and that they not increase incentives for debtor nonrepayment.

Table 1.

Estimated Nonperforming Loans (NPLs)

article image

As a percentage of gross loans.

Sources: Salomon Brothers, Goldman Sachs, Warburg Dillon Read, and SFM LLC estimates.

Because of the historic run-up in the U.S. stock market, any changes in interest rates and asset prices in the United States that cause a rebalancing of portfolios will have implications for the liquidity of emerging market financial systems and for consumption and economic growth in the United States. In the United States personal savings rates of households have fallen to 0.1 percent of disposable income (see figure), while holdings of equity have increased to almost 40 percent of total household financial assets as of the time of this talk.

Demographic trends will result in U.S. and many European residents dissaving as the population becomes older. This will happen more quickly in developed than in emerging markets, with implications for the future of asset management and insurance business. It also suggests that non-banking services will become more important in both Latin America and Asia in the years ahead.

Incentives and Legal and Regulatory Reform

How do these trends affect the priorities for regulatory and legal reform? There is a need to focus on the issues relating to the following.

Asset Disposition and Resolution. These include bank secrecy (Mexico, Philippines, Thailand); immunity of receiver or conservator (Thailand, Indonesia); the establishment of Asset Management Corporations (AMCs) and Financial Restructuring Agencies (FRAs) (Mexico, Thailand, Korea, Indonesia, and Japan); the role of creditors and other classes of corporate liability holders; and the treatment of equity holders in voluntary wind-downs initiated by creditors as well as their role as “minority” shareholders.

Liquidity Provision, Open Bank Assistance, and Open Market Operations. In many of the crisis countries, processes for limiting provision of liquidity to financial intermediaries in distress in ways that could stem a crisis at its early stages and prevent it from becoming systemic were not in place. In most Asian economies as well as in Latin America, extensive efforts have been devoted to developing procedures for use by central bank staff in determining when and under what conditions to grant liquidity. New processes are being put in place or already are in Thailand, Korea, Mexico, Argentina, and Indonesia.


U.S. Personal Savings Rates

(As percent of disposable income)

Bankruptcy and Foreclosure Process. This is a problem in many countries that do not permit the process of bankruptcy for banks to be extrajudicial. Bankruptcy processes that impact loan workout processes ought to be revised and applied to corporate or individual borrowers, as defined in either the commercial code or separate bankruptcy statutes.

Governance. Examination of governance arrangements for banks and arrangements for corporate borrowers via cross-debt guarantees (e.g., chaebols in Korea) their links to treatment of minority shareholders, and the extent of director liability should all be on the agenda. Governance arrangements for central banks and supervisory agencies and what should be meant operationally by “independence” and appropriate “checks” need to be carefully examined in the design of financial sector reforms.

Fit and Proper Tests and Entry Policy. This area is often politicized in emerging markets, and in extreme cases—for example, Indonesia—entry is almost free. Quality of capital and its form must become a greater concern. Implications also arise here for consolidation that will occur in many crisis countries. Here again, careful steps are needed to avoid creating large “bad banks.”

Deposit Insurance and Redesign of Safety Nets. Phasing out all-encompassing liability coverage is difficult but is a key lesson from recent experience with banking crises in Mexico and in many of the Asian crisis countries.

Disclosures and Incentives for Auditors. Crises in Latin America led to a redoubling of efforts to improve disclosures on many levels. First, entry by foreign financial service entities (effective control by foreign banks in Argentina, Peru, and Venezuela amounted to almost 40 percent) raises disclosure standards, particularly in local capital market offerings. Second, the efforts to change the legal framework and regulations will begin to reduce financial incentives for nondisclosure and will in many cases strengthen the hand of outside auditors.

Foreign Entry and Failure Resolution. In Asian countries experiencing crisis and countries that have recently experienced systemic banking problems, foreign entry and failure resolution are important issues. In most countries, entry by foreigners occurs gradually in the aftermath of a systemic banking crisis. Countries need to develop strategies along with multilateral lenders to strike the right balance between providing comfort to prospective investors and preserving proper “incentives.”

Reform packages in any of these areas must be customized for the country, given its legal customs and the performance of its courts. An effort must be made to look at how reforms impact incentives of shareholders, managers, debtors, and regulators.

Lessons from Financial Crises for Timing and Sequence of Modernization Reforms

It has become very popular to discuss the causes and the lessons of the many financial crises. In keeping with this popularity, I want to outline nine lessons from the East Asian and Mexican financial crises, but first, regarding the causes of crises:

  • Borderless finance and “event risks” have acted to trigger and, in some cases, exacerbate what was already a financial crisis.

  • Financial derivatives and leverage of hedge funds and proprietary trading desks of large banks have at times exacerbated the movement of key macroeconomic variables and triggered crises.

  • During crises, owners and managers have incentives not to disclose the size of losses.

  • Regulators often do not have incentives to take swift and timely action and are often restrained legally and by economic constraints related to the ownership structure of financial institutions. In addition, human capital and managerial expertise is often lacking to place conservators in a large number of banks.

  • Regulation and supervision regimes are lax, so self-discipline by the market does not take effect.

  • Nontransparent ownership structures, connected lending, and asset stripping often characterize the crisis.

Lesson 1. The extent of crisis and its severity are often profoundly affected by the lack of managerial capability of the authorities and by what can be described as “political economy” considerations. Crisis resolution will not work without managerial aptitude and vision on the part of key authorities. Perhaps even more important are the political will and backing to take the tough action required, which can often involve complete dilution of the shareholdings of some of the wealthiest segments of a nation.

Lesson 2. Do not sell commercial banks for the highest price per se and ensure that fit and proper tests are the norm. The Mexican case provides ample evidence of why this principle is important. As a corollary, the Asian financial crisis suggests that better “fit and proper tests” are critical when incentives are created for bank consolidation. Moreover, the tendency to support finance companies and banks often leads to strong incentives to relax rather than tighten these guidelines and (e.g., Mexico, Korea, Turkey) larger and worse banks can end up being formed.

Lesson 3. Try to have an explicit deposit insurance system in place before the crisis. This was not the case in Mexico and Thailand. Specific problems include

  • the complexity of unwinding these systems (as the Mexican case highlights);

  • limited options for bank restructuring;

  • larger LLR and other potential fiscal costs of financial crisis prevention; and

  • reduced discipline imposed by large liability holders on bank managers and owners.

Lesson 4. Have explicit processes where actions are taken that result in resolutions—not necessarily the FDICIA.1 Here, a graduated approach must be implemented when excessive recourse to liquidity is followed swiftly by holding actions involving restructuring of asset growth, nonpayment of dividends, and the placing of central bank or supervisory staff on the board of the bank.

Lesson 5. Improve the base and quality of information. Regulatory reforms can create greater hurdles for the producers of information such as auditors, accountants, commercial bank staff, and actuaries. Raising the minimum standard is critical. Valuation and disclosure guidelines are essential. Enforcement powers of agencies, regulatory accounting standards (including valuation and asset classification), and self-regulatory associations (e.g., accountants, auditors, appraisers, actuaries, financial and bank analysts, and credit bureaus) need attention.

Lesson 6. Strengthen regulation and supervision of financial services. In most emerging markets the use of certain instruments (e.g., management letters) to discipline management needs to be initiated. In addition, consolidated supervision and conflicts of interest must be tackled.

Lesson 7. Preserve incentives for lender and borrower discipline. This area is one of the most complex to deal with, particularly in a systemic crisis, as increasing numbers of bank borrowers do not have incentives to repay. The lessons of previous crises is that the legal framework and institutional framework for dealing with a systemic number of nonperforming loans must preserve incentives for borrowers to repay loans. Often voluntary processes with well-defined guidelines for troubled-debt restructuring will be preferred to “wholesale schemes” as the experiences of Chile in the 1980s and Mexico in the 1990s exhibit vividly. In addition, proper use of fiscal incentives to trigger the voluntary restructuring process is warranted.

Lesson 8. Undertake payment system reform early. Systemic risks and problems entailed in unwinding positions add to risk if a modern system of executing large value transfers or trading securities is not in place. Mexico provides a striking example as a lack of a system of debit caps or collateral for daylight overdrafts increased systemic risk during the 1994—95 crisis. Some banks were leveraged by eight times capital and more “within a day.”

Lesson 9. Use the auditing and inspection process to alter management and shareholder incentives. Actions here can include

  • redefining tough capital adequacy guidelines;

  • discussing condition management letters with commercial bank Board members against actions to remedy problems found; and

  • eliminating legal barriers to the rapid sale or seizure of “intervened banks.”

In the aftermath of the Asian financial crisis, there were frequent calls for regulating capital flows and mitigating the impact of rapid capital flow reversals that are often viewed as contributing to the crisis and leading to exchange rate overshooting. It is argued that hedge funds actively contributed to these problems by precipitating speculative attacks on currencies and that if these funds are viewed as astute, a kind of “herding” takes place. Others have also warned of these problems, including those in the industry. In addition, there is increasing sentiment among public officials in emerging market countries to reverse financial services liberalization and not make this an integral part of the present financial sector restructuring efforts.

A recent IMF study2 has suggested that hedge funds alone cannot be viewed as the source of market volatility. The same study argues that there may be a case for imposing large position reporting requirements on hedge funds or even a certain form of overall position limits. One has to ask, however, how the current operations of the proprietary desks of large investment banks and hedge funds in particular are impacting financial sector development in emerging markets. It is more likely that the extension of credit by banks to proprietary trading desks and hedge funds should be carefully scrutinized. The problems of Long Term Capital Management (LTCM) vividly illustrate this point.

I see four interrelated channels, via which hedge funds can and do play a positive role in financial sector development.

  1. Large funds and proprietary desks create incentives to filter and process information, and this in turn leads to whole industries competing to offer better services and produce better information. If coupled with tough minimum regulatory standards for valuations, accounting, and audits, this trend will act to discipline private and sovereign issuers!

  2. Large funds operating offshore have been accustomed to a certain standard for information disclosure, and this has led to an increase in the number of companies issuing and trading offshore with attendant improvements in information.

  3. Hedge funds and investors place a high premium on the liquidity of local and offshore financial markets. This is the case for the trading of all classes of securities and puts more pressure on authorities to take action that will permit the natural development of these markets. Development of local debt markets can act as a “shock absorber” and is a critical element in reform packages in the aftermath of the Asian crisis.

  4. The role of investors in price discovery cannot be underestimated. At present, outside or inside valuations to assess whether to purchase assets are essential in making a market. Policymakers need to think through the trade-off between the sale of banks and assets and how to utilize best the private sector in working out of the present crisis.


I have tried to point out that financial sector reform and modernization will present challenges but that the globalization of financial markets and greater financial integration can actually act as a stabilizing force. In fact, it can create ever greater incentives for a more homogeneous and stronger legal and regulatory framework for the provision of financial services. In essence, greater integration of financial systems worldwide will require stronger and more vigilant supervision and regulation putting pressure on market participants to impose proper self-regulatory safeguards.

However, lest you think that anything I have said today is new, I would like to close my presentation by harkening back to advice given to a group of new bankers by Hugh McCulloch in December 1863. He was the Comptroller of the Currency in the United States at that time and later became the Secretary of the Treasury. He proposed seven principles for sound banking that are as relevant today as they were over 100 years ago.

  • “Let no loans be made that are not secured beyond a reasonable contingency. Do nothing to foster and encourage speculation. Give facilities only to legitimate and prudent transactions.”

  • “Distribute your loans rather than concentrate them in a few hands. Large loans to a single individual or firm although sometimes proper and necessary are generally injudicious, and frequently unsafe. Large borrowers are apt to control the bank; and when this is the relation between a bank and its customers, it is not difficult in the end to decide which in the need will suffer.”

  • “Treat your customers liberally, bearing in mind the fact that a bank prospers as its customers prosper, but never permit them to dictate your policy.”

  • “If you doubt the propriety of discounting an offering, give the bank the benefit of the doubt and decline it; never make a discount if you doubt the propriety of doing it. If you have reasons to doubt the integrity of a customer, close his account.”

  • “Pay your officers such salaries as will enable them to live comfortably and respectably without stealing; and require of them their entire services. If an officer lives beyond his income dismiss him.”

  • “The capital of a bank should be a reality, not a fiction; and it should be owned by those who have money to lend, and not by borrowers.”

  • “Pursue a straightforward, upright, legitimate banking business. Never be tempted by the prospect of large returns to do anything but what may be properly done under the National Currency Act.”



It’s a little daunting to try to sum up two such different topics. At least they appear different on the surface. We have also heard a detailed discussion of the proposal in the United States to reform U.S. financial service law. We were lucky to have the benefit of the experience that Tom Glaessner brings to the table. His observations are very good and useful in how to approach financial modernization. The success of both financial modernization in the United States and modernization anywhere else in the world really depends on the underlying principles that were detailed in Mr. Glaessner’s presentation.1

The success of much of what government does and specifically what supervisors do depends upon the legal structure of the country in which the supervisor operates. I think it’s very appropriate in a legal seminar that there finally seems to be recognition of this fact on the part of supervisors, economists, and financial analysts around the world. It can’t be emphasized enough that supervisors need the legal tools to carry out their responsibilities—something as basic as being able to take action to correct deficiencies in the supervised entities—in order to force a bank to change its policies, to restrict its dividends. The supervisor must be able to do that and do it free of fear of legal recrimination. I think we’ve all heard tales that there are some countries in which supervisors who have tried to carry out their responsibilities in good faith have themselves been subject to legal action and in some instances even been jailed.

It’s important that supervisors have the ability to take whatever actions are necessary. As a lawyer, I think it’s useful for you to bring this view back home—that all aspects of the legal structure affect whether or not the financial system in your country is going to do well in the modern era. Does the legal system provide for enforcement of contract rights? After all, in a free market system you have to assure that anyone willing to lend money has to be confident of getting his money back.

This leads to almost universal calls for greater disclosure of financial information both by individual companies and by governments. Greater transparency on the part of individual institutions, banks, financial institutions, lenders, and others can only help investors and lenders to make rational decisions and contribute to greater prosperity. All of us, as central bankers and supervisors, have an interest in the stability of the financial system, which needs an effective legal structure.

However, supervision is not a static profession. In the United States, certainly, we think that we have effective supervision of the various financial sectors of the economy. Certainly we have an extremely well-developed bank regulatory system. We have what we would like to think of as the world’s leader in securities regulation in the rules and regulations of the Securities Exchange Commission (SEC). Our insurance companies are subject to the various rules of the insurance regulators around the United States. So we think that there is good supervision of each type of financial industry, but none of these industries stay the same. It’s what we have seen this past 20 to 25 years in the United States, and that’s why we are in the position of having to consider financial modernization legislation now. The demands of customers and of the market have caused banks, security companies, and insurance companies to change their products in order to meet these demands. Thus, customers of securities companies found it would be very useful if, in addition to providing capital markets services to the customers, security firms also provided loans. Banks see that they are losing these loan customers to the securities industry, and they try to win those customers back by providing capital market services. The insurance companies are issuing products that look much more like securities than they used to, and securities firms are issuing products that look very much like insurance. The lines are constantly blurring. As a result, supervision has to keep up with the dynamics of the industry that it regulates. Gerry Corrigan, the former chairman of the Federal Reserve Bank of New York and the head of the Basle Supervisory Committee, often said that it’s natural for supervisors to be two steps behind the market because the market is doing its business and changing. He could live with being two steps behind. What he couldn’t live with is for a supervisor also to be four steps behind the market, because at that point you have no control, you don’t know what is going to happen.

Supervisors must be able to change with the dynamics of the industries they supervise. U.S. financial modernization legislation intends to let supervisors deal with the reality of the market place. First and foremost, it’s trying to eliminate legal barriers preventing banking organizations from owning an insurance company or a security company, or vice versa. For a long time in this country there has been this separation, and one reason that modernization is so difficult, as was mentioned earlier, is that the industries want to preserve their own competitive advantages. Insurance companies like the fact that they are the only providers of insurance services, but they would also like to get access to the payment system. And securities companies like being the only ones that can deal in the capital markets but, as it happens, they think access to the payment systems is a good thing too.

The banks may have access to the payment system, but they see their core business being nibbled away by these other types of companies. The rest of the world clearly is ahead of the United States in this regard, since other countries do not have a lot of these artificial barriers. As noted, the legislation is intended to allow banks to have securities affiliates and insurance affiliates. There is debate about the best way to do that. The bill being considered in the next two days says that the best way to do that is to have a holding company parent own the bank, a broker dealer, and an insurance company. In the Federal Reserve’s view this is the best solution because it limits government support extended to these other industries.

In the United States right now, there is no explicit government support for the securities industry. There is no explicit government support for the insurance industry. Banks, however, have federal deposit insurance. They have access to the payment systems in which the Federal Reserve guarantees immediate settlement, and they have access to the Federal Reserve as the lender of last resort. So banks are different from companies in the other two industries in that they have governmental support.

We recognize that we have to change the laws to allow banks to own these other kinds of affiliates. The Federal Reserve’s view is that it is important to make sure that insurance and securities services are offered in separate companies and not under the bank. If these different services are offered within or under the bank, the government will be implicitly extending the government subsidies and support to those sectors that would then be operated by the banks. This is the Federal Reserve point of view: this is the best way to achieve modernization because it gets rid of the legal prohibitions against ownership. But at the same time, this solution limits the government’s subsidies, thereby limiting the moral hazard of government involvement in what should be a private enterprise industry.

There are those who say that we ought to allow banks to own securities and insurance companies under the banks. There are different ways to limit the government subsidy that would flow from the bank as the parent. And we agree to a certain extent. You can put restrictions on the ability of the bank to support its subsidiary and you can restrict the ability of creditors of that subsidiary to go after the bank’s assets. But the Federal Reserve considers ownership by the bank as extending an implicit government support to the subsidiaries of the bank and that in itself can distort the market. Allowing banks to have securities and insurance subsidiaries might induce customers to want to deal with subsidiaries of a bank. The counterparties may believe that if anything goes wrong with the insurance company or with the security company, at least the government is on the hook because the government regulates and supports the parent. That’s the basic reason why the Federal Reserve prefers ownership through the holding company structure rather than through the bank.

It is difficult to achieve compromise in this area because each industry wants to preserve its competitive advantage. But I think that from the public policy point of view, it is difficult for the U.S. government to achieve the appropriate compromise. We are all trying to eliminate inefficiencies and we want to make sure that U.S. consumers have access to the best array of products and services. But another concern we have is to try to make sure that these other sectors don’t simply become an arm of the banking industry. We think that the historic separation in the United States between commercial banking and investment banking has contributed greatly to the depth and breadth and liquidity of the U.S. financial markets. Another reason that we prefer this structure for modernization is to maintain the benefits achieved from separation of these industries in the past and not to lose the competitive aspect between the different sectors of the financial services industries.

I’ll close with just these remarks on supervision. One aspect of this legislation that should be emphasized is that it also proposes a different approach to supervision of financial conglomerates from that which has existed previously in the United States. This legislation will not change the way the U.S. bank is regulated or supervised. All the laws and regulations currently existing with respect to the bank itself will still exist after this legislation. But the law as to how the holding company and its affiliates are supervised will change. The concept is not to impose bank-like supervision or regulation on the holding company or the securities affiliate or the insurance affiliate, but rather to let the insurance regulator take care of the insurance company, let the broker dealer be taken care of by the SEC, and let the banking agencies oversee the bank. This legislation provides for a so-called umbrella supervisory agency that would regulate and supervise the holding company on a consolidated basis. In this way, at least one governmental authority can look at the group as a whole and try to determine where the greatest risks to the bank are. If a company is offering a particular product—a portion of which is offered through the bank, part in the broker dealer, and part in the insurance company—you want one agency to be able to look at the flows and transactions among the various affiliates.

This legislation directs the Federal Reserve to really focus its supervisory attention on the consolidated group that might present a material risk to the depository institution within the group and risk to the overall stability of the financial system as well. This is a bit more of the background of the financial modernization legislation in the United States, and although the details are very specific to the United States, I think that the interest behind the particular approach we are taking is common to all countries as they consider their own financial modernization.


See Proposed Substitute for H.R. 10, released by House Republican leadership on March 10, 1998 (“H.R. 10 Substitute”).


See Financial Services Competition Act of 1997, in H.R. Rep. No. 105–164, Part 1 (version passed by Banking Committee); Financial Services Act of 1997, in H.R. Rep. No. 105–164, Part 3 (version passed by Commerce Committee).


See 12 U.S.C.A. § 377 (1989).


See Garn-St. Germain Depository Institutions Act of 1982, Pub. L. No. 97-320, 96 Stat. 1469 (1982) (“Garn-St. Germain Act”).


See Act of June 3, 1864, 13 Stat. 100 (1864) (codified primarily at 12 U.S.C. § 21 et seq.).


See 12 U.S.C.A. § 24 (Seventh) (Supp. 1999).




See 12 U.S.C.A. § 92 (Supp. 1999).


12 U.S.C.A. § 1841 et seq. (1989 & Supp. 1999).


See id. at § 1843(c)(8).


See Alabama Assoc. of Ins. Agents v. Board of Governors of the Federal Reserve System, 533 F.2d 224 (5th Cir. 1976), on rehearing, 558 F.2d 729 (5th Cir. 1977), cert. denied, 435 U.S. 904 (1978) (discussing Fed’s actions authorizing bank holding companies to engage in certain insurance activities). Interestingly, the BHC Act as originally enacted in 1956 specifically permitted bank holding companies to engage in any activity that the Fed determined to be of a financial, fiduciary, or insurance nature. Act of May 9, 1956, Pub. L. No. 84-511, 70 Stat. 133, § 4(c)(6) (1956).


See 12 U.S.C.A. § 1843(c)(8) (Supp. 1999). Certain limited exceptions to this general prohibition are provided.


12 U.S.C.A. § 377 (1989). The term “member bank” refers to a state-chartered or national bank that is a member of the Federal Reserve System. All national banks are required to be members of the Federal Reserve System. 12 U.S.C.A. § 282 (1989).


See Revenue Limit on Bank-Ineligible Securities Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing In Securities, 61 Federal Register 68,750 (Dec. 30, 1996); J.P. Morgan & Co. Incorporated, et al., 75 Federal Reserve Bulletin 192 (1989), aff’d sub nom. Securities Industry Ass’n v. Board of Governors of the Federal Reserve System, 900 F.2d 360 (D.C. Cir. 1990).


See 12 U.S.C.A. §§ 1841(a)(1), 3106(a) (1989 & Supp. 1999).


12 U.S.C.A. § 3106(c) (1989).


See 12 U.S.C.A. § 1841(h) (1989); 12 C.F.R. § 211.23 (1999).


See 12 U.S.C.A. § 1464(c) (Supp. 1999).


See 12 U.S.C.A. § 1467a(c) (Supp. 1999).


12 U.S.C.A. § 1467a(c)(3), (m) (Supp. 1999). The thrift subsidiary of a unitary thrift holding company must comply with the “qualified thrift lender” (QTL) test, which generally requires that the thrift be predominantly engaged in housing-related activities.


15 U.S.C.A. § 78a et seq. (1997 & Supp. 1999).


See 15 U.S.C.A. § 78c(a)(4) and (5) (1997).


The definition of “bank” in the Exchange Act does not include a branch or agency of a foreign bank. Id. at § 78c(a)(6). Nevertheless, the SEC has stated that a branch or agency of a foreign bank will be considered a “bank” for purposes of the registration exemption if (i) the branch or agency is supervised and examined by federal or state banking authorities, and (ii) a substantial portion of the business of the branch or agency consists of receiving deposits or exercising fiduciary powers similar to those permitted for national banks. See Exchange Act Rel. No. 20717, reprinted in [1988–1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 84,428.


Pub. L. No. 79-15, 59 Stat. 33 (1945) (codified at 15 U.S.C. § 1011 et seq.).


As discussed above, the NBA generally restricts national banks to the “business of banking” and incidental financial activities. See 12 U.S.C.A. § 24 (Seventh) (Supp. 1999). Similarly, the BHC Act generally prohibits banks from affiliating through a holding company structure with firms engaged in activities that are not “closely related to banking.” See 12 U.S.C.A. § 1843(c)(8) (Supp. 1999).


See Cornyn, Hanweck, Rhoades & Rose, An Analysis of the Concept of Corporate Separateness in BHC Regulation from an Economic Perspective, in Structure and Regulation of Financial Firms and Holding Companies: Hearings Before the Commerce, Consumer and Monetary Affairs Subcommittee of the House Committee on Government Operations, Part 1, 99th Cong., 2d Sess. 468 (1986) (Appendix 2-C).


Id. at 476.


See note 45 infra (discussing the effectiveness of firewalls).


Financial Services Modernization: Hearings Before the Subcommittee on Financial Institutions and Consumer Credit of the House Committee on Banking and Financial Services, 105th Cong. 433, 446 (1997) [hereinafter House Subcommittee Hearings] (statement of Alan Greenspan).


See Financial Modernization: Hearings Before the House Committee on Banking and Financial Services, Part I, 105th Cong. 8 (1997) (statement of James L. Bothwell, Chief Economist, General Accounting Office). Although unitary thrift holding companies are permitted to engage in commercial activities, only a relatively small number of such holding companies currently exist, and, as the OTS itself has recognized, supervisory experience with the combination of banking and commerce through these entities is limited. See Financial Modernization: Hearings Before the House Committee on Banking and Financial Services, Part II, 105th Cong. 519, 526 (1997) (statement of Nicholas Retsinas, Director, Office of Thrift Supervision).


House Subcommittee Hearings at 446 (statement of Alan Greenspan).


House Subcommittee Hearings at 461 (statement of Eugene A. Ludwig, Comptroller of the Currency) and 503 (statement of Ricki Helfer, Chairman, FDIC).


H.R. 10 Substitute, § 103. A bank holding company would qualify as a “financial holding company” if all of its subsidiary depository institutions are well capitalized and well managed and have a “satisfactory” or better rating under the Community Reinvestment Act, 12 U.S.C. § 2901 et seq (CRA), and if all of the company’s subsidiary insured depository institutions engaged in retail banking activities offer low-cost “lifeline” basic banking accounts. The financial holding company also must file a declaration with the Fed certifying that it meets these requirements. Id. As a practical matter, it is anticipated that most bank holding companies would meet the criteria to be financial holding companies.


H.R. 10 Substitute, § 103.


The compromise bill would also allow companies that become financial holding companies to retain any nonfinancial investments and activities that the company held as of September 30, 1997, provided that the revenues derived by the holding company from such grandfathered nonfinancial activities at no time exceed 15 percent of the company’s gross revenues. Existing bank holding companies and foreign banks would not be eligible for these grandfather rights.


As noted earlier, among the criteria to be a financial holding company is a requirement that all of the bank holding company’s subsidiary depository institutions be well capitalized. The compromise bill requires that the Fed establish comparable capital standards for foreign banks that seek to qualify as a financial holding company, giving due regard to the principle of national treatment and equality of competitive opportunity. See H.R. 10 Substitute, § 103.


H.R. 10 Substitute, § 101. The bill would also repeal section 32 of the Glass-Steagall Act (12 U.S.C. § 78), which prohibits officer, director, and employee interlocks between a company “primarily engaged in the issue, flotation, underwriting, public sale, or distribution” of bank-ineligible securities and any member bank, except as authorized by the Fed. Id.


See H.R. 10 Substitute, § 103.


H.R. 10 Substitute, § 103.


Bank holding companies that failed to meet the criteria to be a financial holding company would generally be limited to engaging in those activities that are permissible for bank holding companies under existing law, with certain exceptions. See H.R. 10 Substitute, § 102.


See H.R. 10 Substitute, § 151.




See House Subcommittee Hearings at 441–42 (statement of Alan Greenspan) and 567 (statement of Paul A. Volcker, Chairman, James D. Wolfensohn, Inc.); Financial Modernization: Hearings Before the House Committee on Banking and Financial Services, Part I, 105th Cong. 8 (1997) (testimony of James L. Bothwell, Chief Economist, General Accounting Office).


12 U.S.C.A. §§ 371c, 371c-1 (1989).


For example, in December 1996, the Comptroller authorized Continental Illinois National Bank and Trust Company of Chicago (Continental Bank) to acquire First Options of Chicago, Inc. (First Options). In connection with this approval, the Comptroller imposed a condition that the bank’s investment in and loans to First Options not exceed the amount that the bank could lend to an unaffiliated entity under 12 U.S.C. § 24. Following the stock market crash of October 19, 1987, First Options experienced severe financial difficulties. Continental Illinois responded to this crisis by providing First Options with an unsecured loan of approximately $130 million, even though this loan violated the funding “firewall” imposed by the Comptroller and even though the Comptroller’s office informed the bank before the loan was made that the transaction would violate the firewall. See Volatility in Global Securities Markets: Hearing Before the Subcommittee on Oversight and Investigations of the House Committee on Energy and Commerce, 100th Cong. 10 (1988) (statement of Emory W. Rushton, Deputy Comptroller of the Currency for Multinational Banking).


The Fed obtains periodic reports from section 20 subsidiaries to monitor the subsidiaries’ compliance with the 25-percent revenue limitation imposed pursuant to section 20 of the Glass-Steagall Act. As noted above, however, the compromise bill would repeal section 20 of the Glass-Steagall Act.


See 12 C.F.R. Part 225, Appendices A and B (1999).


H.R. 10 Substitute, § 111.


Id. The Fed also could conduct an examination of a financial holding company or a subsidiary to monitor compliance by the company with the BHC Act and the provisions of federal law governing transactions between depository institutions and their affiliates. Id.


The Fed could not, however, examine a nonbank subsidiary of a financial holding company that was registered with the SEC as a broker or dealer, or was subject to supervision by a state insurance authority unless (i) the Fed had reasonable cause to believe that the subsidiary was engaged in activities that pose a material risk to an affiliated depository institution, or (ii) the Fed had reasonable cause to believe that the subsidiary was not in compliance with the BHC Act or the laws governing transactions with affiliated depository institutions and the Fed could not determine such compliance through the examination of the holding company or its subsidiary depository institutions. Id.




See H.R. 10 Substitute, § 136. A WFI could receive initial deposits of less than $100,000 on an incidental and occasional basis, but any such deposits could not represent more than 5 percent of the institution’s total deposits at any time.


The compromise bill would allow a WFI holding company to control certain limited-purpose FDIC insured banks, such as institutions that engage only in credit card activities or in trust or fiduciary activities and that are excluded from the definition of bank in the BHC Act. See H.R. 10 Substitute, § 131; 12 U.S.C.A. § 1841(c)(2)(D), (F), and (G) (1989 & Supp. 1999).


H.R. 10 Substitute, § 136. Nationally chartered WFIs also would be supervised by the Comptroller. All WFIs would be subject to the CRA. Id.


H.R. 10 Substitute, § 136.


H.R. 10 Substitute, § 131. The compromise bill would, however, provide that the Board could impose only risk-weighted capital requirements on WFI holding companies (i.e., no leverage ratio).


See H.R. 10 Substitute, § 131.


The bill would also grandfather the existing commercial activities of WFI holding companies to the same extent as financial holding companies, but WFI holding companies would be permitted to grow such grandfathered commercial activities through internal growth (but not acquisition) without limitation. H.R. 10 Substitute, § 131. Financial holding companies, on the other hand, could not expand their grandfathered commercial activities through internal growth if such growth would cause the holding company’s commercial revenues to exceed 15 percent of its total revenues.


The assets of a WFI holding company devoted to such commodity-related activities may not exceed 5 percent of the company’s total consolidated assets, or such greater percentage as the Board may allow.


As noted above, under the bill, WFI holding companies would not be permitted to control any FDIC-insured bank or thrift, other than limited-purpose institutions engaged solely in trust or credit card activities. The compromise bill would also allow a foreign bank that seeks to be treated as a WFI holding company to control such limited-purpose institutions, as long as the foreign bank did not otherwise hold any FDIC-insured deposits.


See 15 U.S.C.A. § 78c(a)(4) and (5) (1997).


Bank securities activities are, however, subject to the general antifraud provisions of the federal securities laws.


The compromise bill defines “traditional banking products” to include deposits, letters of credit, loan participations (subject to certain limitations), and certain derivative instruments, including derivatives on or relating to foreign currencies (except options on foreign currencies that trade on a national securities exchange) and interest rate swaps.


The term “qualified investors” would include banks, thrifts, broker-dealers, insurance companies, foreign banks, and certain employee benefit plans (other than self-directed plans). The term would also include companies and individuals that own and invest at least $10 million, but solely for the exemptions involving private placements and sales of asset-backed securities and loan participations.


The NBA does not authorize national banks to underwrite insurance, and federal law generally prohibits state-chartered banks from engaging in any insurance underwriting activities that are not permissible for national banks. See 12 U.S.C.A. § 1831a(b) and (d) (Supp. 1999).


Pub. L. No. 79-15, 59 Stat. 33 (1945) (codified at 15 U.S.C. § 1011 et seq.).


These concerns are much like those expressed by the SEC and some members of the securities industry concerning the securities activities of banks, with the SEC and members of the securities industry concerned that banks may derive a competitive advantage in conducting securities brokerage and dealing activities because banks are exempt from the federal securities law requirements governing registered broker-dealers.


See Barnett Bank v. Nelson, 517 U.S. 25 (1996) (Barnett Bank); NationsBank v. Variable Annuity Life Insurance Company, 513 U.S. 251 (1995) (VALIC).


H.R. 10 Substitute, § 121.


H.R. 10 Substitute, § 305.


H.R. 10 Substitute, § 304(c).


H.R. 10 Substitute, § 304(b). This authorization would not apply to annuities, which national banks would be prohibited from providing as principal.


H.R. 10 Substitute, § 304(c)(2).


See, e.g., VALIC.


H.R. 10 Substitute, § 307.


H.R. 10 Substitute, § 104(a).


H.R. 10 Substitute, § 104(b)(2).


See “Act Authorizing and Regulating the Sale of Insurance by Financial Institutions,” codified at 215 III. Comp. Stat. 5/1400 et seq. This act, among other things, requires financial institutions selling insurance to obtain a license from the state; requires the licensing of personnel selling insurance on behalf of a financial institution; requires that a financial institution selling insurance do so through a separate subsidiary or division of the institution; prohibits a financial institution from conditioning the grant of a loan on the customer also purchasing insurance from the bank or an affiliate; and prohibits employees of financial institutions from selling insurance to a loan customer from the same desk where the loan transaction is conducted (this last limitation applies only to institutions or branches with $100 million or more in deposits). Accordingly, state laws that impose similar or less restrictive requirements on the insurance activities of national banks or other insured depository institutions would not be preempted by the bill.


H.R. 10 Substitute, § 104(b)(1).


See 12 C.F.R. § 5.34(f) (1999).


See Decision of the Comptroller of the Currency on the Application by Zions First National Bank, Salt Lake City, Utah, to Commence New Activities in an Operating Subsidiary, Dec. 11, 1997.


See Letter from William W. Wiles, Secretary of the Federal Reserve Board, to the Honorable Eugene Ludwig, Comptroller of the Currency (May 5, 1997).


See, e.g., Bevis Longstreth and Ivan E. Mattei, Organizational Freedom for Banks: The Case in Support, 97 Colum. L. Rev. 1895, 1917–19 (1997) (reviewing evidence that banks do not receive a net subsidy from their access to the federal safety net and concluding that the ultimate value of the safety net is marginal, if not negative, to all but the smallest of banking institutions).


See House Subcommittee Hearings at 72–74 (testimony of Alan Greenspan). A recent study by economists at the Federal Reserve Board also concluded that banks receive a net subsidy through their access to the federal safety net. See Myron L. Kwast and S. Wayne Passmore, The Subsidy Provided by the Federal Safety Net: Theory, Measurement and Containment (December 1997).


See 12 C.F.R. § 5.34(f)(2), (3) (1999).


See supra note 45 (discussing supervisory experience with the First Options subsidiary of Continental Bank).


H.R. 10 Substitute, § 121.


H.R. 10 Substitute, § 121.


Federal Deposit Insurance Corporation Improvement Act of 1991, Public Law No. 102-242, § 404(a), 105 Stat. 2236 (1991).


See Barry J. Eichengreen et al., Hedge Funds and Financial Market Dynamics (International Monetary Fund, 1998).


See herein Thomas Glaessner, Financial System Modernization in Emerging Markets: Asia and Latin America, Chapter 13B.