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Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, U.S. House of Representatives, April 14, 1994.

I am pleased to appear on behalf of the Federal Reserve Board before the Subcommitee on Telecommunications and Finance to discuss the Board's views of H.R.3447, "The Securities Regulatory Equality Act," and to comment generally on what is termed functional regulation.

As banks have been expanding the level of securities services they make available to their customers, attention is being focused again on the express exemptions the Congress has provided for banks from the framework in the securities laws that govern nonbank securities firms. In 1991, the Board testified in support of a Treasury Department legislative proposal that would have repealed the Glass-Steagall Act restrictions on the securities activities of banking organizations and, as an integral part of that reform modified the blanket execptions for banks from broker-dealer regulation. The Board supported modification of the bank exemptions at that time because that legislative proposal would have lifted the existing restricitions on the scope of securities activities permitted to banking organizations and would have allowed banks to continue to provide directly to their customers certain banking service that banks have offered safely and soundly for many years. We continue to believe that modification of the bank exemptions is most appropriately considered as part of a comprehensive approach that permits banking organizations to engage in the full range of securities activities that nonbank firms may conduct and that provides appropriate exceptions so as not to curtail unnecessarily certain traditional bank securities activities.

We are not convinced that a compelling case has been made at this time for legislative action that does not thoroughly address the basic framework that governs the securities activities of banks. Only a relative handful of banks currently provide brokerage services without the participation of a broker-dealer that is subject to regulation under the securities laws. The securities activities that are directly conducted by banks are subject to policies and procedures designed to address concerns relating to the conduct of these activities, including requirements that govern adequate disclosures to bank customers and appropriate training and sales practices. Moreover, these activities are, and traditionally have been, reviewed by the bank regulators in the course of regular, on-site examinatios of these institutions.


Generally, the activities of banks, including those securities activities that are conducted in the bank, are regulated under the banking laws by the banking regulators, and securities firms are regulated under the securities laws by the Securities and Exchange Commission (SEC) and self-regulatory organizations (SROs). SROs are formed by industry members who adopt rules and have inspection and enforcement authority for those rules, subject to SEC oversight of their activities.

There is, of course, some crossover in regulatory authority; the SEC oversees subsidiaries of banks and bank holding companies that are registered broker-dealers or investment advisers. However, the bank regulators also have jurisdiction over these entities and have broad authority to regulate and examine these companies, including authority to determine the scope of their activities, limit transactions between these entities and bank affiliates, establish capital standards for these entities, and enforce compliance by these entities with all applicable laws.

This regulatory arrangement reflects both history and accommodation to a changing marketplace. Securities activities have traditionally been viewed as part of the business of banking, and banks have been conducting securities activities for customers since before enactment of the federal securities laws. The Securities Exchange Act, adopted in 1934, specifically exempted banks from the definitions of broker and dealer, thereby exempting brokerage and dealing activity conducted within a bank from regulation under that act. In addition, banks providing advice within the bank are exempt from the provisions of the Investment Advisers Act (1940), although the SEC has some authority under the Investment Company Act (1940) to regulate the activities of banks that serve as investment advisers to mutual funds.

The exemptions from the securities laws for banks were originally adopted in recognition of the comprehensive supervisory and regulatory scheme governing the activities fo banks. Because the federal banking agencies already had broad supervisory and regulatory authority, it was deemed unnecessary in the eyes of the Congress to add a second layer of regulation that covered securities activities of banks. Some have suggested that the Congress adopted the bank exemptions from the securities laws based on the perception that banks were not permitted to engage, and were not engaging, in most securities activities. However, the legislative history of the Securities Exchange Act indicates that banks did in fact engage in a broad range of securities activities in 1934 and that the Congress was aware of this. In fact, the types of securities activities that banks conducted in 1934 are similar to the type of securities activities that banks conduct today.

The bank regulatory structure reflects the philosophy that the supervision and regulation of banks must be done on the basis of the full range of products and services that banks provide to their customers, not on a piecemeal pasis. Because banks offer a muriad of financial services and products to the same customer, often at the same time, bank regulators must have authority to regulate all aspects of that relationship. Moreover, banks take positions across products and instruments, and the risk to the organization must be evaluated on a consolidated basis, not by the legal form or structure of the individual entities in the banking organizations. Thus, the federal banking agencies have full authority to restrict the activities that banks may conduct, the manner in which they conduct these activities, the ability of banks to combine these activities and provide customer discounts, the policies and supervisory structure that banks must have in place to conduct these activities, and their risk management strategies and controls as well as all other aspects of the activity. The federal banking agencies also have full authority to examine any and all activities conducted by banks and to take any appropriate enforcement action to assure that the activity is conducted in compliance with law and safely and soundly.

It was been suggested that the federal banking agencies are limited, both in their authority and in their mission, by the concept of "safety and soundness." We do not view it that way at all. The federal banking agencies have, since their establishment, recognized that the concept of safety and soundness is broad and encompasses protecting bank customers from conflicts of interest, misleading or inaccurate information, and improper sales activities. This authority is key to maintaining public confidence in individual banks and in the banking industry and is the very definition of "safe and sound" operation.


The Federal Reserve has had extensive experience and has developed considerable expertise in addressing safety and soundness issues, including customer protection issues, arising from the securities activities of banks and their affiliates. Federal Reserve examiners review, on a regular basis, bank securities-related functions, such as providing discount and full service brokerage, dealing in municipal and government securities, providing investment advisory services, and selling nondeposit investment instruments (for example, commercial paper and other bank debt instruments).

When a banking organization conducts securities activities outside the bank, through a subsidiary or an affiliate that is a broker-dealer, it is subject to the jurisdiction of both the banking agencies and the securities regulators. For example, the Board has permitted bank holding companies to own nonbank "section 20 affiliates," which are registered broker-dealers subject to SEC oversight that engage in a very limited volume of underwriting and dealing of corporate securities as well as other securities activities permissible for banks. Generally, the organizaion is not subject to duplicative examinations or regulations because the Federal Reserve avoids repeating those tasks performed by the SEC or an SRO. The SRO examination focuses on the section 20 affiliate's compliance with SRO rules and the federal securities laws. Our annual examination of a section 20 affiliate focuses not only on its financial condition but also on its compliance with the Glass-Steagall Act and the effectiveness of its internal controls addressing Board-imposed firewall requirements. Although our examiners consult with the SROs to assure effective coordination of examination activities, there is little overlap between the content of our examinations and those of the SROs except in the area of reviewing the maintenance of adequate capital.

Banks that underwrite and deal in U.S. government securities and specific types of municipal obligations are generally subject to the same regulatory regime that applies to nonbank government securities dealers. With regard to other types of securities activities, such as mutual fund sales, our informal surveys indicate that the great majority of retail securities sales that take place on the premises of state member banks are conducted through an arrangements with a nonbank broker-dealer. Under these arrangements, the securities sales are conducted by a third party thiat is fully regulated under the securities laws. Thus, as far as we have been able to determine, a relatively small number of state member banks directly sell nongovernment securities to retail customers.

The Federal Reserve is sensitive to the need that bank customers be fully informed when engaging in securities sales on the premises of banks, whether the brokerage services are offered by the bank's employees or those of a broker-dealer. Concerns about investor protection and the safety and soundness of the banking organizations prompted our efforts to update and unify previous guidance developed over the past ten years for sales of various securities and other uninsured investment products.

The federal banking agencies concluded this review and update in February and jointly issued uniform guidelines that govern the sale of nondeposit investment products on bank premises, including mutual funds and other securities. The interagency statement addresses retail sales practices and incorporates many of the same principles of fair practice applicable to broker-dealers. The interagency statement goes a step furher than the rules that apply to nonbank brokerdealers by specifying additional steps banks must take to ensure that customers are made aware--through specific written and oral disclosures and through other means--of the differences between insured deposits and uninsured investments and by further limiting the incentive compensation of certain bank employees. moreover, banks must comply with these guidelines even when the investmetn products are being sold by an SEC regulated broker-dealer.

The Federal Reserve is committed to closely monitoring banks' securities sales practices. Examining for compliance with the interagency statement and with other Board regulations is part of the annual safety and soundness examination we conduct in state member banks. In cases warranting remedial action, appropriate endorcement measures can and are initiated, including issuing orders to cease unsuitable practices, assessing civil money penalties, and barring from the industry those individuals who have seriously abused their responsibilities.

Besides their examination and enforcement tools, the Consumer and Community Affairs Division and the office of Public Affairs of the Federal Reserve are considering several educate investors and bankers about the issues raised by the interagency statement. These initiatives would be incorporated into the consumer and banker education programs currently sponsored by the Reserve Banks.


H.R.3447 would prohibit banks from directly conducting most securities activities. The Board has several concerns about this approach.

H.R.3447 would prohibit banks from acting as general securities brokers, municipal securites brokers and dealers, and private placement agents for most securities. The Board believes that the effects of these prohibitions would be to stifle competition in the marketplace for these services, which views many of these services as alternatives to lending transactions and traditionally has sought these services from banks. The provisions woul dalso limit consumer's ability to use their banks to accommodate all of their financial services needs. In addition, they would curtail access to capital markets for small municipal issuers that rely on local dealer banks to underwriter their debe securities.

These prohibitions would also significantly increase costs to small banks without improving superision of their securities activities. Small banks often provide securities brokerage vices as an accommodation to their customers and may not find it feasible to continue to provide any securities services if required to bear the cost of establishing a broker-dealer affiliat. Several small banks also make mutual funds available to customers under arrangements with fund distributors, but do not engage in active sale programs. In many cases, it would not be feasible for these banks to create broker-dealer subsidiaries, nor is the volume of business high enough to justify a partnership with a third party broker-dealer. The Board is concerned that H.R.3447 would have the effect of forcing many small banks--particularly those located in small and rural communities--to abandon all brokerage services, even isloated "accommodation trades," to the detriment of customer service.


H.R.3347 would also require municipal securities dealer banks (dealer banks) to incur the expense and administrative burdens of moving their municipal dealer departments out of the banks into separate brokerage firms. This requirement appears unnecessary, however, given the current law. Under the Securities Exchange Act, dealer banks and municipal securities firms are required to register with the SEC and are subject to a comprehensive set of fair practice and uniform practice rules administered by an SRO, the Municipal Securities Rulemaking Borad (MSRB). Banks register their dealer departments with the SEC as prescribed by SEC rule 15Ba2-1. The MSRB's rules, which must be approved by the SEC, encompass the same areas covered by SRO rules applicable to broker-dealers for corporate securities. The MSRB, unlike other securities SROs, does not have inspection or enforcement authority. Those duties were delegated to the existing regulators for the securities and banking industries. Accordingly, the banking agencies have priimary inspection and enforcement authority for MSRB rules with respect to dealer banks. The SEC also retains direct enforcement authority oveer dealer banks.

We are not aware of any problems with this system of regulation. I note that, in many banks, the government and municipal securities activities are conducted by the same personnel, and disrupting this arrangement would involve considerable personnel costs for banks without any certain corresponding greater protection for bank customers.

Small dealer banks may not find it cost-effective to create a separate broker-dealer subsidiary, as would be required by H.R.3447. Consequently, these dealers could be derven out of the market. This action could have an adverse effect on smaller municipalities that traditionally rely on community banks to assist in structuring and underwriting their debt securities to raise necessary capitlal. Frequently, the local dealer bank, becuse of its commitment to the community, is the only participant in the financial service industry that is willing to address the needs of such an issuer.

Prior legislation addressed these and similar concerns by including several carefully drawn exemptions that would have permitted banks to continue to conduct certain securities activities that banks have directly conducted safely and soundly for many years. Among the kinds of exemptions that the Congress should consider are exemptions for private placement activities, for municipal securities activities, and for the brokerage activities of small banks. We note that H.R.3447 already contains an exception that appears designed to permit banks to continut to conduct certain brokerage activities in connection with their trust activities.


The Board believes that a comprehensive proposal that repeals the outdated restrictions of the Glass-Steagall Act and that modifies the bank exemptions to the securities laws, while making provision for banks to continue to conduct certain limited traditional banking activities and for small banks to continue to serve the needs of their customers, has merit. The Borad does not believe, however, that it is necessary or appropriate to take the step of forcing a reorganization of bank securities activities solely for the purpose of bringing these activities within the SEC's supervision and regulation.
COPYRIGHT 1994 Board of Governors of the Federal Reserve System
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1994, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Statements to Congress
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Jun 1, 1994
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