Statements to Congress.

Statement by Griffith L. Garwood, Director, Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, US. House of Representatives, June 19, 1996

The Board of Governors of the Federal Reserve System appreciates this opportunity to comment on issues concerning the coverage of electronic benefit transfer (EBT) programs under the Electronic Fund Transfer Act (EFTA) and the Board's Regulation E. Under amendments to Regulation E adopted by the Board in February 1994, EBT programs are subject to modified Regulation E requirements scheduled to take effect on a mandatory basis on March 1, 1997.

This hearing will examine the potential impact of applying Regulation E to these programs, particularly the potential costs of compliance with the rules that limit a recipient's liability for unauthorized transfers. I will discuss coverage of EBT programs under the EFTA, which the Board is responsible for implementing; address the states' concern that the costs of complying with Regulation E could impede the development of EBT programs; and make some comments about legislative proposals.

Government agencies have developed EBT programs in which recipients use plastic cards and personal identification numbers (PINs) to access food stamp benefits at point-of-sale (POS) terminals in food stores and cash benefits at either automated teller machines (ATMs) or at POS terminals. The Board supports the nationwide effort to provide public benefits--such as social security, food stamps, and Aid to Families with Dependent Children--to citizens electronically.

The electronic transfer of benefits offers numerous advantages over paper-based delivery systems, both for recipients and for program agencies. For recipients, these advantages include faster access to benefits, greater convenience in terms of times and locations for obtaining benefits, improved security because funds may be accessed as needed, lower costs because recipients avoid check-cashing fees, and greater privacy and dignity. For agencies, EBT programs offer a single, integrated system that can more efficiently deliver benefits for both state and federal programs by reducing the cost of benefit delivery, facilitating the management of program funds, and helping to reduce fraud.

As EBT programs developed in the early 1990s, the Board considered whether, and in what manner, Regulation E ought to apply. The objective was to provide legal certainty so that agencies could make informed decisions about developing or expanding programs. The EFTA, enacted in 1978, provides the basic framework that establishes the rights and responsibilities of participants in electronic payment systems. The Congress directed the Board to prescribe regulations implementing the law and to demonstrate--to the extent practicable--that the consumer protection of the regulation outweighs the compliance costs necessary to provide this protection.

Transfers covered by the act and Regulation E include transfers initiated through ATMs, point-of-sale terminals, telephone bill-payment systems, or home banking programs. The act and regulation restrict the unsolicited issuance of ATM cards and other access devices. They provide for disclosure of the terms and conditions of an EFT service, limitations on consumer liability for unauthorized transfers, error resolution, and documentation of transfers through terminal receipts and periodic statements.

Under the EFTA, the Board has a broad mandate to determine coverage when electronic services are offered by entities other than traditional financial institutions. Section 904(d) of the act provides that if EFT services are made available to consumers by a person other than a financial institution holding a consumer's account, the Board shall ensure that the act's provisions are made applicable to such persons and services. It was under this mandate that the Board considered whether, and how, government agencies that offer EBT programs should be required to comply.

The legislative history of the EFTA provided guidance on the Board's authority to determine if particular services should be covered by the act. Under section 904(c), rules issued by the Board "may contain such classifications, differentiations, or other provisions--as in the judgment of the Board are necessary or proper to effectuate the purposes of this title, [or] to prevent circumvention or evasion thereof. . . ." In discussing section 904(c), a Senate Banking Committee report stated that "since no one can foresee EFT developments in the future, regulations would keep pace with new services and assure that the act's basic protections continue to apply."(1)

In February 1993, the Board proposed amendments to Regulation E providing modified coverage of EBT programs. In February 1994, the Board adopted final amendments. In adopting the amendments, the Board noted that the act's legislative history, the language of the act and regulation, and the strong similarity of EBT systems to other EFT services supported coverage of EBT programs under the act and regulation. From a public viewpoint, an EBT program functions much like a checking account with direct deposit of government benefits and ATM and POS services available to access the benefits.

The Board considered the arguments presented by governments and agencies on why Regulation E ought not to apply. Agencies suggested, for example, that it was inappropriate for Regulation E to apply because government agencies differ from private-sector financial institutions in a number of ways related to how compliance costs can be borne. Despite these arguments, the Board determined that all consumers using EFT services are entitled to receive substantially the same protections under the EFTA and Regulation E and that this includes recipients of government benefits. Thus, the Board's rules provide benefit recipients much the same rights that are available to other users of electronic payment mechanisms and apply to government agencies requirements that are largely equivalent to those that govern private-sector EFT services. In essence, the Board rejected the idea of treating benefit recipients differently from other citizens by denying them the rights and protections of the Electronic Fund Transfer Act.

To facilitate compliance, the Board made certain modifications to Regulation E as it would apply to EBT. Under the rules that go into effect next March, modified requirements apply to EBT programs that recognize their special characteristics. First, an agency must disclose a recipient's liability for unauthorized transfers, the types of transfers the recipient may make, a notice about error resolution procedures, and certain fees that may be imposed; generally, EBT programs provide training for benefit recipients that includes written disclosures. Second, an agency must document EFTs through receipts at ATMs and POS terminals; EBT programs generally use existing payment systems or dedicated terminals, and both provide receipts. To address the cost concerns of program agencies, the Board provided an exception from the periodic statement requirement under certain circumstances. Instead of sending monthly statements, EBT programs may provide account balance information by telephone or at a terminal and a written account history upon request. The purpose of this modification was to eliminate paper. The attached chart summarizes the applicable provisions.(2)

To enable states that are interested in EBT to test and implement their programs, the Board delayed the date of mandatory compliance with the final rule to March 1, 1997. The Board approved the delay in response to a request made by the Federal EBT Task Force and endorsed by the Vice President. The task force--which represents all the major federal agencies with benefit programs--has been working toward a nationwide system for the electronic delivery of government benefits. The task force asked for the three-year delay so that, in cooperation with the states, the agencies could take the necessary measures for implementing EBT programs in compliance with Regulation E.

The Board was, and remains, aware of the states' concern that the costs of complying with Regulation E could impede the development of EBT programs. Before adopting the final rule, the Board specifically solicited comment on the operational and cost impacts of coverage, particularly in the areas of liability for unauthorized transfers and error resolution. In its proposal, the Board stated that any comments opposing application of Regulation E on the basis of cost should be supported by substantial and persuasive data. While many states submitted cost estimates in response to the proposal, the Board was not persuaded that a case had been made for exempting programs from Regulation E.

Today, many states continue to assert that the application of Regulation E would make EBT prohibitively expensive, primarily because of the rules that limit the recipient's liability for unauthorized transfers. Generally, Regulation E limits liability to $50 if the recipient notifies the agency within two business days of learning of the loss or theft of the card. States express concern that potential losses from fraud and misuse could force them to discontinue EBT programs when compliance with Regulation E becomes mandatory next March.

Without minimizing the states' concern, it is important not to overstate the risks. Regulation E does not mandate an automatic replacement of benefits when a claim of lost or stolen funds is made by a consumer. The agency will investigate the claim, consider the available evidence, and make a determination about whether a transfer was unauthorized or was made by the recipient or by someone to whom the recipient furnished access. If it turns out that a recipient has given a family member or someone else access to benefits, the recipient is fully liable for transfers. And although an agency may not routinely reject a claim because the recipient has filed a claim previously, the agency could factor in previous claims and losses by the recipient in deciding whether to honor a claim of unauthorized use.

The Board recognizes that there are legitimate concerns about the need to control for fraudulent claims. But there are means that an agency may adopt to help minimize fraudulent claims that do not conflict with Regulation E, means that exist today in the paper-based system. For example: the agency could put recipients on restricted issuance (such as crediting the recipient's benefits biweekly, rather than monthly); restrict the sites at which the recipient could receive benefits; or appoint a representative payee. The agency could also place the recipient on a paper back-up system. Although these limitations may be desirable only in certain circumstances, such measures are possible approaches for dealing with recipients who misuse the EBT system.

Since 1994, states have had an opportunity to develop effective management controls and operating rules to control the cost of compliance with Regulation E. This has provided a chance to find other practical solutions to the liability exposure. In addition, the Department of Agriculture has carried out test programs that should provide useful data about the actual costs of coverage.

The Board is aware of the various bills that would exempt EBT programs from the EFTA. The "Personal Responsibility and Work Opportunity Act of 1995," H.R.4, which was passed by the Congress and vetoed by the President, would have exempted EBT programs that distribute needs-tested benefits and are established or administered by states or localities. Other bills remain under consideration.

Whether these legislative proposals to exempt EBT programs from the EFTA are wise is obviously a decision for the Congress should it choose to amend the law, and the Board would not object to such action. However, the Board offers one observation. If an exemption is granted, limited to a particular category of EBT programs (such as needs-tested programs administered at the state and local level) without applying to EBT programs across the board, varying rules for different government benefit programs would result. This could make it very difficult to implement the multipurpose, one-card, unified national delivery system envisioned by the Congress and by the federal government. Either the federal and state programs would have to issue separate cards or they would have to explain to recipients how and why different rules apply depending on the source of the funds.

In conclusion, the Board believes that coverage of EBT programs by the EFTA and Regulation E is appropriate under the law as it currently exists. The EFTA provides that all consumers using electronic fund transfer services have certain rights and responsibilities in connection with the transfer of their funds. Thus, the rule extends to benefit recipients the same rights that are available to other users of electronic payment services. The rule applies to government agencies requirements and responsibilities equivalent to those that apply to private-sector EFT services. Therefore all citizens, regardless of the source of their electronic transactions, are covered by essentially the same rules.

The Board also believes that it should be possible to implement EBT programs in conformity with Regulation E and EFTA and at the same time maintain the integrity of the programs and their accountability for public funds. But to the extent that it is necessary to balance the consumer protection afforded by the EFTA against concern about the potential effect of the law's compliance costs on the nationwide delivery of EBT, the Congress may wish to reexamine the scope of the law's coverage. Today's hearing provides a very useful forum for that examination, and we appreciate the opportunity to participate.

Statement by Edward W. Kelley, Jr., Member of the Board of Governors of the Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises, Committee on Banking and Financial Services, US. House of Representatives, June 26, 1996

It is a pleasure to appear before this subcommittee to discuss the supervision of bank sales practices on behalf of the Federal Reserve. The recent publication of various survey results has focused attention on the performance of the banking and securities industries in educating customers about the critical differences between FDIC-insured deposits and uninsured investment products sold on bank premises.

The Board has a long history of concerns about possible customer confusion between insured deposit instruments and uninsured investment products sold on bank premises. We have worked and continue to work diligently to minimize customer confusion through a number of supervisory and educational initiatives. These initiatives include coordination among the banking agencies to formulate clear and comprehensive guidelines governing the conduct of sales programs for nondeposit investment products offered on bank premises; the development of detailed examination procedures covering all aspects of sales of nondeposit products; and the development and implementation of an ambitious, multifaceted education program for consumers and for banks. We also have developed a productive relationship with the National Association of Securities Dealers (NASD) that includes the coordination of examinations of bank-affiliated broker--dealers and the sharing of examination information in appropriate circumstances. Finally, the banking agencies and the securities self-regulatory organizations have been working together to extend the same professional qualification standards found in the securities industry to bank sales personnel.

Before discussing these matters in more detail, I believe it would be helpful to discuss briefly the continuing growth of the banking industry's sale of mutual funds and other nondeposit investment products that has occurred since early 1994, when the Board last testified on this subject.

MUTUAL FUND SALES

It is estimated that there were $3.1 trillion of mutual funds outstanding as of April 1996, up about 50 percent from year-end 1994. Of this amount, bank proprietary funds accounted for about $420 billion, about 60 percent of which were money market funds. As you can see, the banking industry's share of total mutual funds outstanding is relatively small, particularly when money market funds are excluded.

With respect to sales volume, excluding money market funds, banks sold about $32 billion of equity and debt funds in 1995, up from $29 billion in 1994. These uninsured investment products--whose prices are most susceptible to changes in interest rates and other market factors--generate the most concern that customers understand they could lose the principal that they invested. Over the years, the banking agencies have consistently sought to protect and educate customers who might incorrectly believe that such investments are insured deposit instruments.

INTERAGENCY STATEMENT

In February 1994, the banking agencies jointly issued an Interagency Statement on the Retail Sales of Nondeposit Investment Products. The interagency statement calls for banks selling such products on their premises to intensify their disclosure efforts to advise retail customers that the investments are not deposits insured by the FDIC, are not guaranteed by the bank, and are subject to the risk of loss of principal. These three disclosures are quite similar to those that have been required by the Federal Reserve since 1972, when it issued interpretations of Regulation Y pertaining to bank holding company sales of uninsured investment instruments such as commercial paper. Banks were required to provide disclosures that were intended to enhance customer awareness and minimize the mistaken notion that an investment product purchased on bank premises was the same as an insured deposit.

The interagency statement also formalized the agencies' expectation that sales of investment products would take place in an area of the lobby distinctly separate from teller windows and other locations where deposits could be made. Moreover, advertisements and account statements that contain information about both insured deposits and uninsured investment products must separate the information and provide the three disclosures I mentioned earlier. Appropriate standards for training, compensation, suitability, and supervision also were discussed.

Finally, the interagency statement addressed the relationship between banks and third parties that sell investment products on bank premises--by far the most typical scenario, because approximately 87 percent of all sales on bank premises occur through broker-dealers.

EXAMINATION PROCEDURES

Shortly after issuing the interagency statement, the Federal Reserve developed detailed examination procedures for use in state member banks that sell mutual funds to retail customers. The procedures are intended to enhance the supervision of these activities and to ensure bank compliance with the guidelines contained in the interagency statement. The procedures focus on the adequacy of disclosure, the physical separation of securities sales from deposit-taking activities, and other procedures intended to avoid customer confusion and ensure customer protection.

In the two years since implementation, our examiners have found that banks generally have procedures in place that comply with the guidelines in the interagency statement. In some cases, examiners have identified material deficiencies in sales programs and instructed that they be corrected. Although the Federal Reserve is prepared to initiate an enforcement action against any bank found to operate a sales program in a manner not consistent with principles of safety and soundness, in each case in which problems were discovered the bank responded promptly. In some cases this included a temporary suspension of sale activities until deficiencies were corrected. We have also found many banks to be proactive in their efforts to operate investment sales programs in a safe and sound manner, and our staff answers frequent inquiries concerning compliance with the requirements of the interagency statement.

NASD COORDINATION

In January 1995, the banking agencies entered into an Agreement in Principle with the NASD to coordinate the supervision and examination of bank-affiliated broker--dealers between the NASD and the banking agencies. In the interest of functional supervision and to avoid duplicative efforts to supervise and examine entities subject to the legal jurisdiction of both the NASD and the banking agencies, arrangements were made to share examination schedules, coordinate examinations, and share pertinent findings relevant to the retail securities sales activities of such firms.

Pursuant to the agreement, the Federal Reserve has worked closely with the NASD on several occasions to address supervisory issues arising from the examination of a state member bank and an affiliated broker--dealer that conducts retail sales activities on the bank's premises. While the Federal Reserve has addressed the issues with the bank to seek corrective action in response to the problems, the NASD has addressed the matter with the affiliated broker--dealer, thereby ensuring that all parties to the business activity are responding to the supervisors' collective concerns.

Most important, we have established effective lines of communication and a cooperative working relationship with the NASD. We think that this relationship has made our supervisory programs more effective.

NASD PROPOSED RULEMAKING

In late 1994, the NASD proposed new rules governing sales of securities on bank premises by member firms. The Federal Reserve worked with NASD staff and provided extensive comments on the proposal, many of which were incorporated into its revised rule. The NASD also relied on the expertise of the many commenters as well as on the advice of a newly created committee of bank-affiliated broker--dealers and third-party providers that sell through banks. The result is that the NASD's proposed rule now is generally consistent with the interagency statement with respect to the important issues of separation and disclosure. We informally have communicated with NASD representatives on issues, such as use of confidential information, that need additional clarification. The extensive communication in connection with this rulemaking demonstrates the commitment of both the industry and the regulators to achieve consistency in rules and guidelines governing this area. Our goal is to maximize the benefits and minimize the burdens resulting from our joint jurisdiction in this area.

BANKING AGENCIES PROPOSED RULEMAKING ON PROFESSIONAL QUALIFICATIONS

The staff of the banking agencies is nearing completion of a proposed rule to establish a professional qualifications program for banks selling securities to retail customers that closely follows securities industry requirements. We believe the establishment of professional qualification requirements is in the best interests of the banking industry and of consumers.

Briefly, the proposed rule would require bank employees to take and pass a securities industry professional qualification examination before beginning to sell securities to retail customers. This will ensure that bank securities representatives are appropriately trained and educated as required by the interagency statement and will enhance the ability of banks to serve their retail securities customers. Continuing education requirements, such as those required of broker dealers and their employees, also would be imposed to ensure continued familiarity with industry practices, securities issues, and regulatory requirements. Finally, bank sales personnel would be subject to a registration process under which employment and certain disciplinary and customer complaint information could be accessed by members of the public. The banking agencies are working with the NASD to arrange for the NASD's new Central Registration Depository to maintain registration information filed with the banking agencies.

In our discussions with the trade organizations and industry participants, we have encountered strong support for the proposed rule. We will encourage the banking industry to participate by commenting on the proposal as the banking agencies work closely with the securities self-regulatory organizations to bring this proposal to fruition.

MARKET TRENDS SURVEY

The FDIC recently released the results of its market trends survey, which show that some banks and securities firms selling on bank premises need to improve their efforts to advise customers of the risks associated with nondeposit investment products. We agree. While there have been various consumer surveys that have shown an increasing awareness among the investing public that mutual funds and other investment products purchased at banks are not FDIC-insured, more can be done. For those investors who do not understand the risks associated with the lack of FDIC insurance, point-of-sale disclosures remain important. In this regard, the Federal Reserve is working closely with the other federal banking agencies to promote disclosure by banks through the examination process, promote greater consumer understanding through education, and promote professional qualification standards for bank sales personnel. We also will continue to work with the NASD to obtain further improvements in disclosure by broker dealers selling securities on banks premises. As I noted earlier, approximately 87 percent of all securities sold on bank premises are through sales representatives of NASD-registered broker--dealers.

EDUCATION INITIATIVES

In an effort to help bank customers understand that not all products sold at banks are insured by the federal government, the Federal Reserve launched a multidimensional, national education program designed to deliver this message to consumers. In addition to the interagency statement, for the past eighteen months the Federal Reserve has been engaged in an intensive education program aimed at both retail customers and bankers. Mutual Funds: Understand the Risks, as the program is known, is quite comprehensive. It includes material for both a consumer seminar presentation and a banker compliance program; a video that can be used by bankers and other professionals in their dealings with retail customers; and compliance checklists to help bankers operate in a manner that complies with the interagency statement.

The goal of the consumer seminar program is to help retail customers understand the differences between insured deposits and uninsured investments; the goal of the banker education program is to increase compliance with the interagency statement, which in turn will help inform and protect customers. The program has been well received and has been discussed in numerous publications. The American Bankers Association has featured the program in its newsletter and has broadcast the video on its Skylink System.

To date, seventy consumer seminars and forty-seven banker training programs have been held around the country, reaching more than 7,500 consumers--including a seminar in Spanish to an audience in Puerto Rico--and nearly 1,400 bankers. Materials have been distributed to another 3,150 consumers via exhibits and town meetings sponsored by the Securities and Exchange Commission. Nearly 10,000 copies of the video, more than 7,000 copies of the compliance checklists, and approximately 1,500 copies of the consumer outreach package have been distributed. The materials have been shared with federal and state regulators and are available from the Board. Selected materials have been translated into Spanish.

These seminars and educational initiatives appear to work. A comparison of knowledge levels before and after a consumer seminar indicates that individuals seem to have a better understanding of the risks associated with nondeposit investment products: 91 percent know these products are not FDIC-insured, compared with 65 percent before the seminar; 87 percent know these products carry the risk of loss of principal, compared with 72 percent before the seminar. Bankers who attended our training sessions report that they feel better able to comply with the interagency statement, especially with respect to disclosure and the physical separation of the investment sales area from deposit-taking activities.

We intend to do more. We have completed a video public service announcement that will be distributed this summer to 145 stations in the top forty national television markets. Materials for the bankers training program are currently being updated, and we hope to initiate another round of banker education programs soon.

CONCLUSION

The continuing growth in bank sales of mutual funds and other uninsured investments necessitates a commitment on the part of the banking industry and bank supervisors to the principle that effective disclosure of risks is in the best interest of the customer and the banking organization. Banks can best ensure that their sales staffs are operating in a manner consistent with this objective if they develop comprehensive training programs and effectively monitor compliance with policies and procedures governing sales of nondeposit products. The Federal Reserve will continue to seek ways to strengthen its educational and supervisory programs to promote compliance with the guidelines in the interagency statement so that bank customers are served in a safe and sound manner consistent with principles of customer protection.

(1.) Fair Fund Transfer Act, Senate Report 95-915, 95 Cong. 2 Sess. (GPO, 1978). (2.) The attachment to this statement is available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.