Statements to the Congress.
My remarks will have to be fairly general in nature. The situation is still unfolding and remains in many respects quite sensitive. As you know, Drexel, in cooperation with the authorities, is endeavoring to unwind its business. This process is being undertaken in what we hope will be the least disruptive manner to the markets and to Drexel's creditors. As I will be detailing later, markets appear to have taken the Drexel problems well in stride, but we cannot be certain that the full repercussions are as yet entirely apparent. While it is still too early to draw conclusions, the events of the past few weeks do suggest some issues that might merit further consideration, and I shall indicate what some of those are. One further caveat is necessary: These views are my own and do not necessarily represent those of the Board of Governors, which has not had an opportunity to consider the contents of this testimony owing to the short time between your invitation and the hearing. BACKGROUND The Federal Reserve, especially the Federal Reserve Bank of New York, has been giving the situation at Drexel extra attention for some time. In that time frame, difficulties arising out of criminal indictments involving key Drexel personnel raised concerns about potential risks to the financial health of the firm. The seriousness of those risks deepened as the problems multiplied for issuers in the junk bond market-a market in which Drexel had played a leading role and a market that itself loomed so large in the fortunes of the firm.
The interest of the Federal Reserve in Drexel grew, in part, out of our business relationship with its government securities subsidiary. This subsidiary is a primary dealer-that is, it was sufficiently strong financially and sufficiently active in the government securities market to warrant its use as one of the forty-four firms with which the Federal Reserve Bank of New York conducts transactions relating to open market operations. The Federal Reserve Bank of New York carefully monitors the condition of all the primary dealers to ensure that they remain sound counterparties and reliable marketmakers.
Our concern about the condition of Drexel also reflected our more general interest in the continued smooth overall functioning of the financial markets. The Congress has given us authority to act as lender of last resort through our discount window for depository institutions, recognizing their central position in the payments system and their use as a repository for a key portion of the wealth of households and businesses. Our direct authority to lend outside of depositories is severely circumscribed-and we have not done so since the 1930s.
But we do recognize a broader responsibility to the financial system. After the stock market break of 1987, we carried out this responsibility by providing an extra measure of funds through open market operations. These operations were designed to meet any unusual demands for liquidity, and, more importantly, by doing so in an open manner, to assuage fears and bolster confidence. At that time, we also monitored carefully the provision of credit in securities markets. Then, as now, our concern was not with the fortunes of a particular firm; rather it was and remains the orderly operation of the financial markets because that is a prerequisite for the orderly functioning of the economy. We were monitoring Drexel in part to ascertain whether its difficulties, should they mount, might have more general implications for the functioning of financial markets. THE DEVELOPING SITUATION AT DREXEL AND THE ROLE OF THE FEDERAL RESERVE Against this background, late last year and early in 1990 the Federal Reserve Bank of New York began to receive reports that creditors and counterparties to Drexel were becoming more cautious in the amounts, terms, and conditions of credit extensions-including intraday credit-to Drexel. In this same period, Drexel's commercial paper was downgraded, effectively reducing its access to this source of funds. It also came to our attention that as funding for the parent corporation ran off, the firm was upstreaming excess capital from its broker-dealer subsidiary. Consultations were stepped up among concerned agencies and parties, including the Federal Reserve Bank of New York, the Board of Governors, the Securities and Exchange Commission (SEC), the U.S. Treasury, and the New York Stock Exchange (NYSE), as well as Drexel.
By early this month, it became apparent that Drexel had lost the confidence of many of its lenders and clients. In these circumstances, it is important to note that the precise financial condition of the firm rested on an evaluation of a large portfolio of loans and securities-including bridge loans and "junk" bonds-whose worth was difficult to assess. Moreover, the ongoing profitability of the firm was likely to be impaired by the declining prices and dwindling activity in junk bonds. As doubts emerged about the ability of Drexel to meet its obligations in a timely and predictable way, it suffered what in banking terms would be called a " run. " The run extended across the various units that make up Drexel--including both regulated and unregulated affiliates, and including affiliates that seemed to be solvent, as well as those whose status was in doubt. It is important to recognize the depth and breadth of the problem. To be sure, the firm defaulted on a relatively small proportion of its obligations, but this was seen by many as only the tip of the iceberg, an indication that many more such problems and difficulties would be forthcoming absent drastic action. Continuous and unimpeded access to credit is the lifeblood of any financial concern, which must, in effect, refinance itself on a daily basis, and creditor confidence is the foundation on which such access is built.
Drexel recognized the need for action to restore confidence in its ability to continue as a going concern over the longer run. The firm apparently explored several options, including raising fresh external capital and selling all or a portion of its operations. In the face of its lack of success, the government authorities, after careful and frequent consultation, determined that consideration should be given to an orderly shrinkage of the firm to minimize the chance of spillovers from Drexel's difficulties, helping to maintain the integrity and smooth functioning of our financial system more generally. There were likely to be some dislocations caused by the dissolution of Drexel, for creditors, employees, and customers. Nonetheless, the fundamental structure and soundness of the securities markets and financial system and its ability to channel funds to those who could make the best use of them was unlikely to be impaired by the failure of this single firm, provided it was carried out in a generally orderly way.
Consequently, the Federal Reserve, working with other federal authorities, the NYSE, and numerous private parties, focused on an orderly winding down of Drexel's business, especially that done in the regulated entities-the government securities subsidiary and the broker-dealer. These entities were not included in the bankruptcy filing of the parent corporation. The Federal Reserve gave particular emphasis to efforts aimed at the orderly shrinkage of the government securities affiliate, in light of our primary dealer relationship with this affiliate, and our heavy involvement in this market as a key participant and fiscal agent for the Treasury, and continuing concern for its orderly functioning. The Federal Reserve Bank of New York issued a statement to let the market and the public know that we were monitoring the situation carefully, and its staff was in close and continuing contact with Drexel and other market participants to help facilitate the orderly winding down of its position. Moreover, we cooperated closely with the SEC, the NYSE, banks, and other market participants as they worked to resolve the broker-dealer. Throughout this process there was close and continuous consultation among the federal authorities, including the Treasury Department and the SEC, to exchange information and discuss issues.
Our activities had several dimensions. For one, we kept our wire facilities open unusually long hours, as did the banks that cleared for Drexel. Through extraordinary efforts of both the private and public sectors, the complex mechanisms for transferring securities and funds worked, at least in a mechanical sense. Other problems arose, however, that threatened to derail the process of winding down the firm. Many firms doing business with Drexel, quite naturally and understandably, were exercising extreme caution in their transactions with Drexel. One effect of this attitude was a possible "gridlock" in the exchange of securities, foreign exchange positions, and cash, which could have hindered the orderly sale of assets and unwinding of positions. We had numerous discussions with the private parties involved in these transactions to determine what the problems were and solicit suggestions for their resolution. In our discussions we made it clear that these parties needed to make their own strategic and business judgments. We looked for ways in which we could be helpful to facilitate the resolution of problems, including offering to provide space at the Federal Reserve Bank of New York where parties could meet. In addition, we had in place detailed contingency arrangements to assist directly in the exchange and settlement of mortgage-backed securities and other instruments had such arrangements proved necessary.
Owing to the efforts of all concerned, substantial progress has been made in winding down the firm. The government securities entity has little remaining on its balance sheet and has very small residual financing needs, which should be reduced even further in coming days. The broker-dealer also is considerably smaller than a few weeks ago, and important off-balance-sheet positions have been transferred to other parties or unwound. Still, the process is far from complete, both in the regulated entities and elsewhere in the firm. With the easiest and cleanest transactions having naturally been completed first, remaining positions may be slower and more difficult to resolve.
The orderly nature of the unwinding process probably has contributed to the relatively calm reaction in financial markets. In addition, Drexel's difficulties had been building for some time, and in certain respects were well known. As a result, the firm's demise was not entirely a surprise, though the particular timing and speed of the downfall may have been. There was a small flight to government securities when the situation seemed particularly uncertain, but that was quickly reversed. In the market in which Drexel had been most prominent, that for junk bonds, price reaction also was fairly mild. Drexel had begun to reduce its participation in this market some time before, and the market was focused on the effects of the difficulties of some prominent issuers rather than those of investment banks.
This market reaction tends to validate the judgment that the failure of Drexel, while a tragedy for the many involved, did not present undue risks to the orderly functioning of the financial system or the economy. It is highly likely that other firms will step in to fill the gaps left by Drexel, including picking up that part of the issuance of high-yield bonds that represents a legitimate source of funds for smaller and riskier businesses. Yet, complacency would be a mistake. Lenders to investment banks and other intermediaries may become more cautious. In moderation, this caution should promote greater efforts to enhance the soundness of these borrowers, by capital infusions and other means, but a more general and indiscriminate loss of confidence would impair the ability of institutions and markets to perform needed functions. I stress that we see no evidence of this, but clearly it is a situation that will have to be carefully monitored. Moreover, the task of winding down a firm of this size is always one that entails at least some risk of more generalized problems and dislocations. ISSUES FOR FURTHER CONSIDERATION As I noted in my introduction, it is far too early to draw hard conclusions for public policy from the experience with Drexel. Nonetheless, certain issues have emerged that might merit further consideration.
First, is the need for our financial institutions to have ample capital and to have arrangements in place to obtain more capital in an emergency. Capital, and in particular tangible net worth, is the bedrock of lender confidence that funds can be repaid. To the extent that a financial intermediary is holding assets that may be hard to liquidate on short notice, or whose price may fluctuate or is difficult to determine, greater levels of capital will be required to maintain the needed degree of confidence. Capital adequacy is an issue that we have stressed in our oversight of the banking system, and it has been a key element in the SEC's regulation of broker-dealers, but it is a more general problem in our economy-for both financial and nonfinancial firms.
A second set of issues arises out of the structure of Drexel. Drexel was a holding company with both regulated and nonregulated subsidiaries, separately incorporated and capitalized, though engaged in complex transactions among themselves. Problems in one area of the firm could not be isolated and quickly spilled over into other areas, some of which may have been fundamentally sound. The government securities affiliate, for example, seems to have been adequately capitalized, and engaged in no unusually risky activities. Yet it, too, found its access to credit curtailed when questions were raised about the health of the parent company and other affiliates.
This experience raises several questions about the separation of activities in financial holding companies and about the possible need for an overview of the entire holding company, both regulated and nonregulated entities. In this regard, collecting information from the nonregulated entities to get a fix on their risk profile, though not without its pitfalls, might be a sensible first step to consider.
A third category of issues arises from our experience with the various clearing and settlement systems as the firm was unwound. The combination of huge positions on the balance sheet and substantial off-balance-sheet activity for any diversified financial intermediary implies massive flows of funds and securities on a daily basis. The clearing and settlement systems for these flows work reasonably well in the ordinary course of business. As in October 1987, it takes extraordinary circumstances to bring to the fore potential problems with these systems. As Drexel attempted to sell its securities positions, to unwind its foreign exchange book, and to manage various positions in commodities markets, it became clear that the time lag between exchanges of financial instruments and the delivery of payment for those instruments in most settlement systems was a problem when parties to the transaction were concerned that an event, like bankruptcy, might intervene. One system that did not experience such problems was the book-entry system for government securities. This system works on the basis of payment against delivery, eliminating the time lag, and facilitating deliveries in the unusual circumstances prevailing. Although it would embody a major change to current practices, thought might be given to the feasibility of extending this type of settlement and bookkeeping procedure to other markets. * Statement by Wayne D. Angell, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Consumer and Regulatory Affairs of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 1, 1990. I am pleased to appear today to discuss the Expedited Funds Availability Act. This act limits the length of a hold an institution may place on its customers' deposits, requires disclosure of an institution's funds availability policy, and gives the Federal Reserve Board the authority to make improvements to the check-clearing system. We have now had eighteen months of experience with this new law, and I agree that it is time to undertake an assessment of its effect on both depository institutions and their customers. I believe that it is particularly appropriate to assess what changes to the act should be adopted to decrease the costs and risks to depository institutions without jeopardizing the act's objectives.
I would like to begin by discussing the objectives of the act and whether these objectives have been met. Next, I will describe several amendments to the act that the Board recommends that the Congress adopt. I will conclude by relating some lessons that I believe can be learned from our experience with the act.
First, I believe it is important to evaluate whether the objectives of the Expedited Funds Availability Act have been successfully achieved. The central objective of the act is to ensure prompt availability of funds deposited in transaction accounts. The minority of institutions that, before the act, had been placing very long holds on their customers' deposits (sometimes of several weeks or more) must now make funds available to their customers for withdrawal in much shorter time frames. Thus, the abusive practices of a few institutions that prompted the Congress to enact this law have been eliminated. Surveys that have been conducted in the wake of the act indicate that most institutions-75 percent or more-provide their customers with same-day or next-day availability and therefore do not impose holds as long as those permitted by the act, except in unusual circumstances. The remaining institutions place blanket holds on their customers' deposits, because they perceive a higher risk of fraud loss from making funds available for withdrawal before having an opportunity to learn whether deposited checks are being returned. These holds are limited by the availability schedules of the act. Overall, most institutions did not need to make significant changes to their availability policies to comply with the act's requirements. Of particular concern to me, however, is the evidence that some institutions actually lengthened the holds that they place on deposits in response to the act. Some bankers have indicated that this phenomenon is due to the fear that disclosure of a prompt availability policy would increase the risk of fraud loss.
The second primary objective of the act is to inform customers of when funds they deposit in transaction accounts will be available for withdrawal. The act requires an institution to disclose its specific funds availability policy to new customers when an account is established; institutions provided this disclosure to existing customers when the act became effective. Notices of the availability policy of an institution must also be posted in its branches, at automated teller machines (ATMs), and on deposit slips. If an institution delays availability of a particular deposit beyond the times established in its general policy, it must notify the customer of the imposition of the longer hold. In addition, institutions must provide a copy of their availability policy disclosure to any person upon request. This requirement facilitates comparison shopping for those customers that consider availability an important criterion in selecting an institution in which to establish a transaction account.
Examinations of institutions by the federal bank regulatory agencies have shown a high level of compliance with the act's availability and disclosure requirements. Of course, requiring institutions to provide disclosures to customers will not ensure that the customers will read them. A recent survey conducted by TransData Corporation for the American Banker revealed that only 53 percent of consumers were aware that their institution had a formal funds availability policy. Nonetheless, customers who are interested have access to information regarding when they may start drawing against their deposited funds. Therefore, disclosure of an institution's funds availability policy is a very important achievement of the act.
Improved access to customers' funds and improved information as to when funds are available for withdrawal may enhance economic efficiency if the benefits exceed the cost. To the extent that these goals have been achieved without a corresponding increase in risk and cost to banks in their provision of payment services, they represent a positive step in the development of our payments system. In recognition of the importance of achieving these benefits without increasing risks, the act's third main objective is to minimize the increase in risk to institutions from making funds available for withdrawal promptly by giving the Board authority to improve the check collection and return system The Board has used this authority to implement changes to expedite the collection of checks an the return of unpaid checks. These rules appear in Subpart C of the Board's Regulation CC.
Before the implementation of Regulation CC the check return system was a slow, labor intensive operation that relied on visual inspection of endorsements on the check instead of machine-readable information that allows for high-speed automated processing. In addition returns were often transported by mail rather than by courier, further slowing their trip to the institution of first deposit. A check was generally returned through each of the institutions that collected the check, even though this may not have been the most efficient path to route the return. Under the old check return procedures, most returned checks would not have been received by the institution of first deposit by the time the act requires that funds be made available for withdrawal under the temporary schedule. An even higher percentage would not have been returned within the time frames established in the permanent schedule.
Under the rules established in Subpart C of Regulation CC, institutions have a responsibility to return checks expeditiously. The regulation is designed to encourage the return of checks by the most direct route (rather than returning a check through each institution that handled the check for forward collection), to encourage the use of couriers rather than the mail to transport returned checks, and to provide for the automated processing of returned checks. These rules have generally speeded the return of unpaid checks. They also have increased the cost to institutions handling returned checks, particularly during this transition period. This increased cost is offset, at least in part, by the fact that a given returned check is now handled by fewer institutions than was the case before the implementation of the new procedures. We believe that as banks become more familiar with the new procedures, and as further efficiencies are introduced, the cost of handling returned checks will decline.
A recent survey of returned checks processed by the Federal Reserve indicates that institutions receive most checks that are returned unpaid by the day on which they must make funds available for withdrawal under the temporary availability schedule. More than 90 percent of nonlocal returns and nearly two-thirds of local returns surveyed were delivered to the institution of first deposit by the day funds must be made available for withdrawal under the temporary schedule. The situation changes dramatically, however, when the shorter permanent schedule established by the act becomes effective in September 1990. While almost three-quarters of nonlocal checks in the survey were returned to the institution of first deposit by the day funds must be made available for withdrawal under the permanent availability schedule, virtually no local checks were returned within this time frame (although it may be possible to return many checks that are exchanged directly through local clearinghouse arrangements within this time). I should note, however, that the act requires that funds be made available for withdrawal by the start of business on the day specified in the availability schedules and that few returned checks are delivered to the institution of first deposit by the start of its business day.
We believe that the improvements already made have helped to control the level of check fraud that could have resulted from the temporary availability schedule; however, we cannot be sanguine regarding the potential for fraud that could occur after the permanent schedule becomes effective in September of this year. It is difficult to assess the magnitude of check losses in the industry because these losses are often aggregated with other types of losses and are difficult to isolate. The Board does not have any industrywide data on how the act has affected check losses. The anecdotal evidence that we have received indicates a very disparate impact from institution to institution. While some institutions have stated that their losses after the implementation of the act are relatively unchanged from those experienced before the act took effect, other institutions have reported very large increases in fraud losses. The results suggest that while the act has not encouraged widespread check fraud, some banks have been subject to increased losses, and continued attention needs to be devoted to this issue.
Generally, the act envisions two mechanisms to protect institutions from risk of loss when they must make funds available for withdrawal on a prompt basis. First, the act permits institutions to extend the hold on deposits in certain specified higher-risk situations. These "safeguard exceptions" include deposits to new accounts, large-dollar deposits, deposits to accounts of repeated overdrafters, and deposits that the institution has reasonable cause to believe are uncollectible. However, the act does not allow institutions to apply these safeguard exceptions to certain check deposits that must be given next-day availability. This risk exposure is addressed in the Board's recommended amendments to the act, which I will discuss shortly.
Second, the act attempts to link the availability schedules (with the exception of the next-day availability requirements) with the time that most returned checks would be received by the institution of first deposit. A depositor attempting to defraud an institution should not be able to rely on the availability schedules to ensure that funds are available for withdrawal before a fraudulent check is returned. As noted earlier, institutions will not be protected by this second mechanism with respect to most local checks under the permanent schedule.
Overall, the Board believes that the act already has increased somewhat the
risk exposure to institutions, despite efforts to improve the check return process. The act places upward pressure on institutions' costs, and provides greater incentives for institutions to consider customers' creditworthiness before allowing them to establish transaction accounts. These factors may have curtailed services to customers, and undoubtedly will do so to a greater degree in the future.
The Board believes that the Congress can alleviate some of these risks without jeopardizing the objectives of the act and hopes you will amend the act to reduce compliance costs and otherwise further its purposes. In this regard, the Board has recommended several proposed amendments to the act. These amendments have been described in reports to the Congress that have been submitted by the Board pursuant to the act.
For example, when the act was adopted, the Congress indicated that the requirements related to the availability of funds deposited at nonproprietary ATMs should be reassessed and directed the Board to study this issue and report to the Congress on its findings. During consideration of the act, banks reported to the Congress on the processing limitation associated with accepting deposits at nonproprietary ATMS; specifically, that the account-holding institution does not have information regarding the composition of the deposit that is necessary to place differential holds. Given this limitation, the act, in effect, allows the account-holding institution to treat any such deposits as though they were composed of nonlocal checks under the temporary availability schedule. The Congress anticipated that technological advances would eliminate the need for special treatment of these deposits, once the permanent schedule became effective. The Board has investigated a number of potential alternatives with ATM networks and participating institutions and has concluded that there is currently no viable solution to address this processing limitation.
Based on this analysis, the Board recommends that the Congress amend the act to treat nonproprietary ATM deposits under the permanent schedule in the same manner as they are treated under the temporary schedule. This treatment would help ensure that deposit-taking at nonproprietary ATMs is not restricted or discontinued by those institutions that believe they need the flexibility to place longer holds on these deposits to limit their risk exposure. If such an amendment were enacted, consumers would continue to be able to choose between the convenience of making a deposit at a nonproprietary ATM and the marginally prompter availability that may be provided if the deposit were made by other means.
Besides this amendment, the Board recommends that the act also be amended in several other respects. Specifically, the Board recommends amendments that would accomplish the following:
* Expand the scope of the safeguard exceptions to include deposits of checks subject to next-day availability.
* Provide the Board with greater flexibility to tailor the requirements of the exception hold notices to the exception invoked.
* Apply the same condition to next-day avail ability of Treasury checks and "on-us" check as is currently applied to other deposits (including deposits of cash, state and local government checks, and official checks) that generally must receive next-day availability.
* Resolve the long-run operational and disclosure difficulties associated with the determination of whether payable-through checks are local or nonlocal checks.
* Clarify the Board's ability to allocate liability among depository institutions as well as among other participants in the payments system and clarify the damages for which payments system participants may be liable.
* Provide for direct review in the U. S. Court of Appeals of any Board regulation or any other Board order issued pursuant to this act.
The appendix to this testimony includes th specific amendments proposed by the Board an the rationale for their adoption. (1)
In conclusion, I believe that we have learned several lessons from our experience in implementing the Expedited Funds Availability Act. The first lesson is that, in legislation as well a regulation, there are costs and benefits that must be balanced but that are often unrecognized at the time the laws or rules are adopted. In this instance, the act has imposed, and will impose, significant costs on all institutions including those institutions that were already in substantial compliance with the law's requirements. Most depository institutions provide prompt availability before the implementation of the act; only a small portion of institution imposed the unduly long holds on their customers' deposits that were the impetus of the legislation. Virtually no institution, however, had a policy that was in complete conformance with the detailed requirements that were subsequently included in the act. Compliance with the act required all institutions to analyze the implementing regulations, make certain policy and operational changes, issue numerous types of disclosures, and conduct extensive staff training. Surveys have indicated that the cost of this compliance was not inconsequential. Over the long term, institutions are likely to pass these costs on to their customers and may become more selective in determining the customers they will serve.
The second lesson learned is that the specificity of the act has limited the ability of the Board to adopt regulations that carry out the intent of the law in the most efficient, cost-effective manner. Had the act provided greater flexibility to the Board in carrying out the law's objectives (as was the case with the Senate version of the act), many of the problems identified by the Board could have been resolved by regulation rather than by statutory amendment. While we believe that the act's objectives, for the most part, have been achieved, these lessons suggest that they might have been accomplished at a lower cost. Finally, our experience with implementing the act indicates that the short lead time between enactment and the effective date of the law further increased the industry's and the Federal Reserve System's implementation costs, particularly given the complexity of the act's requirements. As is often the case, if you need something fast, you usually pay more for it.
I appreciate this opportunity to discuss our experience in implementing the Expedited Funds Availability Act and to suggest certain modifications that should be made to the act. *
1. The attachments to this statement are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551. Statement by Clyde H. Farnsworth, Jr., Director, Division of Federal Reserve Bank Operations Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions Supervision, Regulation and Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, March 8, 1990. I am pleased to appear before the Subcommittee on Financial Institutions Supervision, Regulation and Insurance to comment on proposed legislation related to money laundering.
As indicated to the subcommittee in recent correspondence, the Federal Reserve places a high priority on supporting efforts to attack the laundering of proceeds from illegal activities. In an effort to further increase its contribution to stopping money laundering, the Federal Reserve is exploring ways of using resources more effectively within the framework of current law.
We have reviewed the various legislative proposals, and we appreciate the opportunity to provide you with comments on these proposals. REVOCATION OF CHARTERS AND TERMINATION OF INSURANCE The Federal Reserve recognizes that depository institutions are typically used in money laundering transactions. For this reason, we also recognize that it is necessary for depository institutions to take an aggressive role in the battle against money laundering. However, we believe that H.R. 3848, the "Depository Institution Money Laundering Amendments of 1990," poses risks to the nation's financial system. While we recognize that the intent of H.R. 3848 is to place the responsibility for policing for possible money laundering violations with the depository institutions, we believe that the potential harm associated with the implementation of H.R. 3848 outweighs the benefits of giving depository institutions an increased incentive to detect money laundering activity.
H.R. 3848 would require the mandatory revocation of a federally chartered depository institution's banking license or the mandatory termination of federal insurance for a state-chartered depository institution convicted of money laundering or a cash transaction reporting offense. While there may be circumstances in which the revocation of the charter or termination of insurance of a depository institution may be an appropriate sanction for money laundering violations, we believe that this sanction should not be mandatory. Moreover, any proposed sanctions should take into consideration the nature of the violation and the effect of the sanction on the depositors and creditors of the institution. Further, the procedures for imposing any such sanctions should take into consideration requirements for due process.
It should be self-evident that the sanction of revocation of an institution's charter or termination of its insurance would not be appropriate when the violation was due to the totally unauthorized acts of mid- or low-level employees and did not involve conscious corporate activity. To do so would inflict unjust and detrimental punishment on an institution.
Similarly, it may not be appropriate to revoke the charter or terminate the insurance of an institution when the revocation or termination would lead to sudden and immediate closure and liquidation of the institution. Such a liquidation could cause serious liquidity problems and, possibly, losses for creditors of the closed institution. These creditors may include depositors and other insured depository institutions whose solvency may be jeopardized by the closing. If other institutions must be closed because of their relationship with the institution whose charter was revoked, the federal deposit insurance funds may ultimately bear the costs of these closings. The insurance funds and the public should not become indirect victims of efforts to curtail money laundering.
When the Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, federal bank regulators were given significantly enhanced enforcement powers. These powers include the authority to accomplish the following: (1) remove and permanently prohibit from association or involvement with any financial institution a wider variety of individuals who are associated with financial institutions and who may commit violations of criminal laws, as well as civil statutes and regulations; and (2) impose extremely large civil money penalties, ranging up to $1 million per day, against any institution or individual who knowingly violates a law, such as the money laundering statutes or the Bank Secrecy Act, and as a result causes a substantial loss to the institution or causes the individual to receive a substantial pecuniary gain. An expansion of these enforcement powers, coupled with the banking regulators' traditional cease-and-desist authority would permit banking regulators to eliminate the ability of persons and institutions to continue the illegal practices and to deter others as intended by H.R. 3848 without inequitable and severe effects, as well as costs associated with the mandatory sanctions.
As an alternative to mandatory sanctions against institutions, we believe that the Congress might consider enhancement of the banking agencies' enforcement powers over individuals of banking organizations. As a means of deterring money laundering and permanently barring wrongdoers from the banking industry, the existing authority for bank regulators to remove bank officials from association with their financial institutions could be expanded. These authorities could include mandatory suspension, removal, and permanent prohibition from involvement with any financial institution for money laundering or significant violations of the Bank Secrecy Act; or suspension, removal, and prohibition without showing that the institution suffered loss and that the violator profited, as is now required. This expansion of authority can easily be accomplished by simple amendments to the banking agencies' existing suspension, removal and prohibition authority.
Charter revocation or insurance termination could be an additional tool in the arsenal of weapons available to federal regulators if regulators have the discretion to invoke such sanction after (1) reviewing the particular facts regarding the violation; (2) considering factors regarding the soundness of the institution and the convenience and needs of the communities served by the institution, including the potential harm to depositors and creditors of the institution; and (3) affording the institution the same due process protections available before the imposition existing penalties. WIRE TRANSFER RECORDKEEPING The design of recordkeeping requirements for wire transfers is a very complex and technic undertaking. Given the potential ramifications to the payments systems, the Federal Reserve believes that the ongoing rulemaking process wire transfers by the Department of the Treasury is the most efficient means by which to regulate this complicated area. In addition, a regulatory, rather than a statutory, approach provides the flexibility that is often needed to adapt requirements to an evolving environment. The Congress could specify the general goals of such recordkeeping requirements and direct the Treasury Department to implement regulations to carry out these goals.
H.R. 4044 and H.R. 4064 would impose comprehensive recordkeeping requirements on institutions involved in wire transfers. The Federal Reserve has a continuing interest in ensuring the efficiency and integrity of the payments system. In this context, we agree that it may be beneficial to use information from wire transfers to help detect money laundering, to investigate such activity once detected, or to trace the proceeds of such activity. Although information from wire transfers may be useful for all these purposes, each purpose is likely to be best served by different information or different approaches to collecting or using the information.
The nature of wire transfers makes the development of requirements for recordkeeping significantly more complex than those for currency transactions. Whereas information that institutions must report regarding currency transactions can be obtained from the institution's customer, the proposals under consideration require recording of information pertaining to wire transfers that is not within the purview of the institution subject to the requirements for recordkeeping. While a currency transaction is essentially a two-party transaction, a wire transfer generally involves four or more parties, including institutions and customers with no relationship to the institution that would be required to keep records.
The formats used by the nation's large-dollar wire transfer systems already accommodate the general categories of information required by the proposals; however, the current message size does not allow for the very detailed nature of the information that is envisioned. Wire transfer messages are designed to provide information necessary to complete the payment and to enable the beneficiary to determine the source of the payment. The proposed recordkeeping requirements would necessitate substantial modifications to the information transmitted through the wire transfer systems to ensure that institutions required to keep records of such wire transfers will have all of the necessary information available to produce such records. Such modifications would entail major systems changes, both for the Fedwire and Clearinghouse Interbank Payments System (CHIPS) networks and for the thousands of depository institutions that have automated their wire transfer operations. The cost of these changes would be substantial, and their implementation would require substantial lead time for wire transfer systems, the institutions that use them, and their customers. Even with these modifications to the wire transfer systems, there is no assurance that wire transfers originating in foreign countries will contain information sufficient to satisfy the proposed recordkeeping requirements.
The additional data collection and data entry that would be required by these proposals could impede the origination of wire transfers, thereby impeding the efficiency of the hundreds of trillions of dollars of economic transactions that are made over these systems annually. It is important that the impact of any recordkeeping requirements for wire transfers be carefully assessed to ensure that they do not result in a degradation in the efficiency and attractiveness of the nation's large-dollar payment systems. Extensive recordkeeping requirements could cause parties engaged in legitimate transactions to use less efficient means of payment, such as checks.
More important, these requirements could have adverse consequences for the competitive position of U.S. financial institutions and, at the margin, for the attractiveness of the dollar as a vehicle for international payments. For example, overly burdensome requirements could drive transactions tied to money laundering into offshore clearing systems where they would be even more difficult to detect. These burdensome requirements could also drive legitimate transactions offshore as well. Networks have already been established in several foreign countries to facilitate the transfer of dollar-denominated payments.
Finally, we are very concerned about the potential negative impact on the government securities market if these recordkeeping requirements are also intended to apply to the Federal Reserve's book-entry transfer system. If such recordkeeping requirements are intended to apply to these transactions, we believe that it is even more important that such regulations be developed through the Treasury rulemaking process.
The Federal Reserve will continue to offer its assistance to the Treasury Department in its development of rules to achieve the objectives of the Congress in the most effective manner. FEDERAL RESERVE ANALYSIS OF CURRENCY SURPLUS H.R. 4044 also includes a provision requiring that the Federal Reserve provide currency surplus data to the Attorney General. The Federal Reserve currently provides currency flow data to various units of the Department of Justice, as well as to the Department of the Treasury.
On a monthly basis, the Federal Reserve provides data on currency receipts and payments for each Federal Reserve office to the following: the Department of the Treasury, Financial Crimes Enforcement Network; the Department of the Treasury, Office of Financial Enforcement; the U.S. Customs Service; the Department of Justice, Criminal Division; and the Drug Enforcement Administration. These law enforcement agencies have consistently indicated that the information from the Federal Reserve is useful for statistical analysis and as potential targeting information for their investigations. Also, on a case-by-case basis, additional information has been provided by the Federal Reserve Banks in support of major law enforcement initiatives.
We continue to engage in a meaningful dialogue with federal law enforcement officials regarding the types of data collected by the Federal Reserve System and the utility of such data to law enforcement. This dialogue, along with internal Federal Reserve initiatives, serves to refine and produce meaningful information and permit the law enforcement community to focus on important investigative matters rather than be burdened by large amounts of useless data.
The Federal Reserve willingly provides available currency flow data, at any level of detail, to all federal law enforcement agencies on request, and, therefore, it is unnecessary to mandate the provision of this information. STUDY OF METHODS FOR TRACING FEDERAL RESERVE NOTES H.R. 4044 would require a study of various methods for the tracing of Federal Reserve notes. The Federal Reserve is fully prepared to participate in a study to determine appropriate and viable methods of tracing Federal Reserve notes and the costs associated with those methods if it is the sense of the Congress that such a study is appropriate. UNIFORM STATE LICENSING AND REGULATION OF CHECK-CASHING SERVICES The Federal Reserve believes that it is important for states to adequately supervise the providers of financial services, including money transmitters and check-cashing services, to ensure that they do not serve as a vehicle for avoiding the controls applicable to financial institutions. Nevertheless, the form of supervision must recognize the importance of these services to those segments of the community that might choose not to use banking services and must ensure that the supervisory burdens do not discourage the availability of legitimate services. The proposed bills would likely bring under licensing and regulation such businesses as supermarkets and other establishments that provide check-cashing services as a courtesy to their customers but that are ancillary to their primary business. CONCLUSION In closing, let me state that we realize that the Congress faces a difficult task of improving the ability of the law enforcement authorities to detect money laundering activities while, at the same time, protecting the public from overly intrusive and potentially harmful laws. I want to reaffirm the Federal Reserve's commitment to deter money laundering and to be cooperative in providing assistance to law enforcement officials who are charged with the very important task of uncovering money laundering wherever it may exist. * Statement by Manuel H. Johnson, Vice Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on General Oversight and Investigations of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, March 19, 1990. I appreciate the opportunity to be here today to present the views of the Federal Reserve Board on the report by the General Accounting Office (GAO) entitled "Bank Powers: Activities of Securities Subsidiaries of Bank Holding Companies." I should say at the outset that this report provides an excellent discussion of the approach that the Board has taken with respect to expanded securities activities for banking organizations as well as of some of the outstanding issues regarding these activities. The report also includes some initial statistical information on securities activities that should serve as good baseline data for those who seek to track the development of these activities.
The GAO study concurs in the overall initial approach taken by the Board, the principal elements being the reliance on the holding company structure and a careful, incremental expansion of securities activities within that structure to insulate affiliated banks and thrift institutions, and the resources of the federal safety net, from any potential risk arising from the activity, to minimize harmful conflicts of interest, and to address competitive equity issues.
In my remarks today, I will provide a brief summary of the Board's decisions with respect to expanded securities activities for bank holding companies as well as a discussion of the rationale underlying the structure adopted by the Board. I will then address the issues raised by the GAO report and the committee's invitation letter. BOARD'S DECISIONS ON SECURITIES SUBSIDIARIES In April 1987, the Board approved applications by three bank holding companies for separately incorporated and separately capitalized nonbank subsidiaries of the holding companies to underwrite and deal in municipal revenue bonds, mortgage-related securities, and commercial paper. These are securities that, under the Glass-Steagall Act, may not be underwritten or dealt in by a member bank directly. The underwriting of these securities is, however, functionally similar to securities activities conducted by banks. The Board's decision, as well as its subsequent decision authorizing the underwriting of consumer-receivable-related securities, was based on section 20 of the Glass-Steagall Act, which allows affiliates of member banks-but not the member banks themselves-to participate in otherwise impermissible securities underwriting and dealing activity so long as the affiliates are not "engaged principally" in this activity. It is from this provision of the Glass-Steagall Act-section 20-that the underwriting subsidiaries authorized by the Board have derived their name-the so-called section 20 subsidiaries.
Because of the precedent-setting nature of the applications, the Board reached its decision only after considerable deliberations and debate, extending nearly two years. During that time, the statutory language, the legislative history, and the implications of these proposals for banking organizations, the financial markets generally, and the federal safety net were carefully analyzed by the Board. As part of this analysis, a hearing was conducted before the Board members to obtain the most thorough public comment possible on these issues.
The ability of bank holding companies to enter the underwriting field depended in large measure on the meaning of the term "engaged principally" in section 20 of the Glass-Steagall Act. The Board devoted a considerable effort to evaluation of the factors that should be used to determine the level of underwriting and dealing activity that would not exceed this "engaged principally" threshold. The Board concluded that a member bank affiliate would not be engaged principally in underwriting or dealing in ineligible securities if those activities were not a substantial part of the affiliate's business. In particular, the Board found that when an affiliate's gross revenue from ineligible securities activities did not exceed a range of between 5 to 10 percent of the total gross revenues of the affiliate, the ineligible securities activities would not be substantial. The Board initially allowed only a 5 percent threshold, consistent with its view that a conservative, step-by-step approach was most appropriate in addressing the issues raised by these new activities.
In addition, although not required by the Glass-Steagall Act, the Board exercised its authority under the Bank Holding Company Act to establish capital adequacy requirements, as well as a number of prudential limitations or fire walls," for holding companies engaging in expanded securities activities. These fire walls limit transactions between a section 20 subsidiary and its affiliates to address the potential risks, conflicts of interest, and competitive issues raised by the activity. The Board's decisions on these section 20 applications were upheld by U.S. courts of appeals.
In January 1989, the Board expanded the range of securities that could be underwritten in a section 20 subsidiary to include any debt or equity security except shares of mutual funds. Because of the broadened range of activities permitted, the Board felt it prudent to strengthen further the capital requirements for holding companies seeking to enter this field as well as the fire walls between the section 20 subsidiary and its affiliates. Also, the Board required that before the section 20 subsidiaries could commence the expanded securities activities, they must have in place policies and procedures to ensure compliance with the operating conditions of the Board's order, and demonstrate that they possess the necessary managerial and operational infrastructure to conduct the activity. The Board delayed for one year the commencement of equity activities to allow adequate time for the section 20 subsidiaries to establish, and gain experience with, the managerial and operational infrastructure and other policies and procedures necessary to comply with the requirements of the 1989 order.
The 1987 and 1989 orders were the most important determinations by the Board establishing the structure for allowing bank holding companies to engage in securities underwriting and dealing activities in the United States. The Board has more recently made several determinations that have adjusted the provisions of these earlier orders. For instance, in September 1989, the Board raised from 5 to 10 percent the revenue limit on the amount of total revenues that a section 20 subsidiary could derive from underwriting and dealing in ineligible securities. Under this higher limit, the ineligible securities activities are still relatively small compared with the bank-eligible securities activities of a section 20 company. The Board also permitted, under certain narrow conditions, the underwriting of asset-backed securities issued by affiliates.
In January 1990, the Board approved applications by three foreign banking organizations to establish U.S. section 20 subsidiaries. These decisions required a careful balancing of two somewhat competing concepts: (1) national treatment on the one hand, and (2) limiting the extraterritorial effects that might be caused by full application of the fire walls on the other.
Finally, in February this year, the Board authorized the Federal Reserve Bank of New York to conduct, as its supervisory resources permit, the infrastructure reviews required by the Board's January 1989 order before section 20 companies could commence the equity securities underwriting and dealing activities approved in that order. RATIONALE GOVERNING THE BOARD'S DECISIONS The Board has long been of the view that banking organizations should, to maintain their basic competitiveness, be permitted to expand their activities in response to the challenges and opportunities that market forces and recent advances in computer and communications technology are creating in the financial services marketplace, both domestically and abroad. Broadened securities powers, besides helping to maintain the domestic and international competitiveness of U.S. banks, may also produce the potential for other substantial public benefits. These include increased competition through de novo entry of banking organizations into what can sometimes be moderately concentrated securities markets. Such entry may be expected to reduce concentration levels, lower customer and financing costs, increase the availability of investment banking services, foster product innovation to meet customer financing needs, and enhance liquidity in these markets. Greater customer convenience and gains in efficiency may also be realized through possible economies of scale and scope from coordinated commercial and investment banking business.
The Board recognized at the outset, however, that this expansion of powers must be soundly grounded upon a framework that ensures that new activities are conducted in a manner fully consistent with traditional and essential U.S. concepts of bank safety and soundness; the avoidance of conflicts of interest, partiality in the credit-granting process, and unfair competition; and the minimization of undue risk to the resources of the federal safety net. After considerable reflection on the complex issues of expanded powers in light of these fundamental concepts, the Board concluded that an expansion of the securities powers of banking organizations in a manner that is faithful to these essential public policy objectives could be achieved within the current constraints of the law. This decision took into account four principal factors: (1) the separation of the new activity from federally insured affiliates that could be achieved through the bank holding company organizational structure, (2) the need for prudential limitations to manage risks and harmful conflicts of interest, (3) the necessity for strong capital, and (4) the need for careful supervision of the entry by banking organizations into the expanded activities.
1. Bank Holding Company Structure. The applications presented to the Board proposed that the expanded securities activities be conducted in a subsidiary of the holding company. The applicants did not seek to engage in the activity directly through the insured bank or a subsidiary of that bank. This holding company structure was dictated in major part by the constraints of the Glass-Steagall Act, which, as I have noted, generally prohibits a bank from underwriting and dealing in securities (other than certain government securities) and limits the affiliation of a member bank with a company engaged principally in such activities.
The holding company structure also lends itself to a phased-in and prudent approach to expanded securities activities. The holding company organizational format provides an effective structure to address the potential for risk and harmful conflicts of interest and competitive inequities that might flow through close association of the expanded activities with the resources and support, direct or indirect, of the federal safety net. The effectiveness of the bank holding company format for this purpose derives from the fact that it offers the ability to separate from the bank the ownership and the financial, managerial, and operational control of the expanded activity. Thus, the potential for transference of risk and other harmful effects to the bank, and to the federal safety net, is thereby reduced. An important element in this analysis is that in a bank holding company structure, losses in a subsidiary are isolated from the bank and are not reflected in the bank's financial statements and capital accounts.
The structure also takes advantage of the benefits of functional regulation. A section 20 subsidiary-as a nonbank entity separate from its affiliated banks and thrift institutions-is required under the Securities Exchange Act of 1934 to register with the Securities and Exchange Commission (SEC) as a broker-dealer. Under this regulatory system, the section 20 subsidiary is subject to the net capital rules and other regulations of the commission and will be supervised by that agency and self-regulatory bodies operating under its purview.
2. Prudential Limitations. Building on the advantages of corporate separateness achieved through the holding company structure, the Board developed certain prudential limitations on transactions between the subsidiary engaging in the expanded securities activities and its insured bank affiliates. These fire walls are designed to ensure that the potential for risk and conflicts of interest and other adverse effects of the activity do not spill over to the insured affiliate through lending or other intercorporate financial transactions, and that the benefits derived by the bank from the federal safety net are not inappropriately extended to the section 20 subsidiary.
As I have noted, an important element in the Board's decision was the belief that synergies could be achieved and banking competitiveness maintained, with the potential for substantial public benefits, through the combination of investment and commercial banking. The Board recognized, however, that certain of the prudential limitations implemented to curtail risk could lessen somewhat the anticipated synergies, as well as increase the cost of doing business for a bank-affiliated securities company. Nevertheless, the Board believed that it was important to proceed cautiously in these areas, and that until sufficient experience was gained, the effect of the prudential limitations on the attainment of the expected synergies was to be balanced against potential risks to the federal safety net.
The Board's decision was not, however, intended to be static. The Board recognized the need to reformulate the limitations on the basis of experience. Thus, the Board's orders state that when experience shows that adjustments to the fire walls are warranted, by way of tightening, loosening, or other modification, the Board retains the flexibility to do so, consistent with the underlying goals of the Board's order. In this vein, the Board has already made several adjustments to the fire walls in which it determined that certain transactions between the section 20 subsidiary and its affiliated banks or thrift institutions could be permitted without increasing the risks to these institutions.
The GAO has recognized the importance of this process and has endorsed this approach in its report. The report states, "When bank holding companies can demonstrate adequate capital, effective internal controls, and ability to manage new powers in a responsible manner, consideration can be given to reducing regulatory burden by relaxing some of the fire walls in light of the other regulatory controls that are in place and provided that sufficient regulatory resources are available. "
3. Capital Adequacy. It has long been Board policy that strong capital is indispensable to any proposal for banking expansion. A sound capital base is fundamental in ensuring the safety and soundness of individual institutions, and thereby providing real protection for its customers and the resources of the federal safety net. Equally important in the Board's mind, the requirement for a strong capital base promotes sound and responsible operation, and controls the moral hazards, such as undue risktaking, that tend to arise when an institution operates in reliance on the resources of the federal safety net rather than with its own funds at stake.
Thus, it is not surprising that the Board adopted as a prerequisite to expanded debt and equity securities activities the requirement that there be no impairment of the capital strength of the banking organization. To ensure that essential banking capital is not diverted to support the new activity, a holding company is required to deduct from its consolidated primary capital any investment that it makes in the underwriting subsidiary. This requirement serves to ensure that even if there should be losses resulting from the new activity, the losses do not detract from the capital needed to support the organization's banking operations.
In addition, in authorizing the debt and equity underwriting powers in 1989, the Board required a bank holding company to deduct from its capital any credit that it extends to an underwriting subsidiary unless such lending is fully secured. The Board also took the additional step of requiring a bank holding company seeking to avail itself of these powers either to demonstrate that it is strongly capitalized and will remain so after the required capital deductions or to raise additional capital to support the expanded activity. In most cases the applicants were required to raise additional capital to offset the investment in the section 20 subsidiary.
4. Supervision. The final element in the Board's decision on expanded securities powers has been a phased-in approach based on the section 20 subsidiary's experience, including a demonstrated managerial and operational infrastructure, and the development by the Federal Reserve of appropriate procedures for supervising these new activities. This gradual approach allows review of the growth and operations of the section 20 subsidiaries and provides opportunities for adjustments and modifications to the conditions placed on the activities, as circumstances warrant.
The Board believes that its approach is appropriate when the alternative-the large-scale introduction of new activities-could have a potentially deleterious effect on the institutions and the resources of the federal safety net. In this regard, the Board has also required annual inspections of section 20 subsidiaries to ensure compliance with the prudential limitations. Moreover, examiners are required to monitor the risk profile and financial condition of a bank holding company's section 20 subsidiary to evaluate its impact on the consolidated banking organization. GAO REPORT While the GAO has not endorsed the Board's entire system of prudential limitations as an essential part of expanded securities activities for bank holding companies, the GAO found that the overall approach of the Board was consistent with that suggested by the GAO in a 1988 report on repeal of the Glass-Steagall Act. The GAO suggests, however, several areas in which the Board might consider the need for further changes in the operations of section 20 subsidiaries. I will discuss the major areas cited by the GAO.
Organizational Structure. The GAO report supports, at least in the near term, using bank holding company subsidiaries-as opposed to subsidiaries of banks-to expand the securities powers of banking organizations. While not endorsing any particular organizational structure in the long run, the GAO would advocate the following: (1) retaining a separate corporate identity for the firm engaging in the ineligible securities activities; (2) regulation of the banking and securities affiliates by a federal bank regulator and the SEC respectively; and (3) regulation by the Federal Reserve of the financial holding company that owns the bank and securities affiliates. As discussed, these are all positions with which the Board agrees.
The GAO states that there is currently some legal question regarding the extent to which a bank holding company may be required to use nonbanking assets to support bank subsidiaries, and therefore funds upstreamed to the parent bank holding company may not be available to support a bank subsidiary if the parent decides not to so invest them. The GAO states, "Clarification of the operational basis of this source of strength policy would help in providing a clearer perspective on how the fire walls and source of strength policy work together in strengthening banks affiliated with a Section 20 firm."
The Federal Reserve Board agrees with the GAO that clarification in this area is desirable and would support efforts to ensure that bank holding companies and their subsidiaries continue to serve as a source of strength to troubled subsidiary banks.
Purposes, Regulatory Burden, and Effectiveness of Fire Walls and Other Limitations. The GAO report states that it is important that each of the fire walls and the purpose served by each of the limitations on the powers of section 20 companies be as clear as possible. In its lengthy orders, the Board has tried to set forth in detail its rationale for each such limitation. In addition, the Board has been, and will be, reviewing the fire walls periodically, on the basis of holding company experience in the activity, to ensure that they serve the intended purpose without unnecessarily hampering the operations of the section 20 subsidiary. In this regard, the Board has modified or interpreted several of the fire walls to allow certain transactions that would not be deemed to cause any financial risk to affiliated banks and, in its January 1990 order, the Board stated that it would review the fire walls regarding management interlocks and marketing as well as the condition requiring prior approval for additional holding company financial support of a section 20 company.
With respect to the amount of securities activities allowed, the GAO noted that the Office of the Comptroller of the Currency and the Association of Bank Holding Companies, in comments on the GAO report, suggested that either a higher limit could be set, or alternative measures could be explored, for defining "engaged principally." The GAO stated, however, that it agreed with the Board's policy of using the revenue limit to phase in bank-ineligible securities activities. The GAO did not have a position on the percentage of revenue that ultimately should be allowed.
The Board devoted considerable effort to evaluating the factors that should be used to determine the level of ineligible underwriting and dealing activity that would not exceed the substantiality threshold incorporated in the "engaged principally" language in section 20 of the Glass-Steagall Act. The Board determined that the 5 to 10 percent limit was an appropriate quantitative level of ineligible activity under that statute. This measure has been reviewed by several courts of appeals and found to be consistent with the statutory provision.
Except for the "engaged principally" language in the Glass-Steagall Act, the Board would not have chosen to have a revenue limit on the level of ineligible securities activity of a section 20 subsidiary. While this limit has a prudential effect, it was placed on the section 20 subsidiaries for legal, not prudential, reasons. Although one might disagree with the precise level of ineligible activity that may be allowed and still be within the "engaged principally" test in section 20 of the Glass-Steagall Act, only the Congress, by amending or repealing that provision, can remove the requirement entirely.
International Perspective. The GAO report points out that U.S. banking organizations engage in securities activities overseas in a different structural framework than has been required in the United States. What the report does not state is that one of the basic reasons for these differences is that the Glass-Steagall Act does not apply overseas, and that there are virtually no statutory restrictions on the activities in which U.S. banking organizations may engage abroad. Moreover, the Edge Act directs the Board to create a regulatory climate in which Edge corporations may compete effectively with foreign banks. Because direct competitors of U.S. banks in foreign markets offer not only commercial banking but also capital market services, the Board has permitted U.S. banking organizations to engage in securities activities abroad to be in a position to compete with local banks. This authority may be exercised through indirect subsidiaries of a member bank as well as through bank holding company subsidiaries.
It should be noted, however, that the equity underwriting and dealing activities of U.S. banking organizations have been constrained overseas, with dealing positions for a U.S. banking organization being limited to $15 million in the securities of any one issuer, and underwriting limits not covered by binding commitments by subunderwriters also being limited to that amount. Proposals regarding these limitations are to be presented to the Board in the near future, and a question that is logically raised by any expansion of this authority is the extent to which a section 20 approach should be required overseas. This issue and its ramifications for U.S. bank competitiveness will be considered when the Board requests comments on amendments to the current rules.
The GAO report also notes that in its January 1990 order allowing three foreign banks to establish securities subsidiaries in the United States, the Board did not apply the fire walls exactly the same way that it had applied them to U.S. bank holding companies one year earlier. Those applications raised substantial issues of national treatment, primarily because most foreign banks do not have a holding company parent but rather hold their U.S. investments through the foreign bank itself. Because the foreign bank also acts as a bank holding company, the Board had to decide whether the bank holding company fire walls or the bank fire walls were more appropriate. This is further complicated by the fact that the rationale for some of the fire walls, such as protecting the federal safety net, does not apply when the holding company in question is a foreign bank.
The Board examined carefully how the fire walls should be applied to foreign bank applicants, making sure to the greatest extent possible that pertinent safety and soundness and competitive equity considerations were fully taken into account, while at the same time trying to limit the extent to which application of the fire walls would interfere with the responsibilities of the home country supervisor and the non-U.S. operations of the foreign banks. Admittedly, this task cannot be accomplished perfectly, and one might argue that under the Board's order it is easier for foreign organizations to fund their U.S. securities operations than it is for U.S. bank holding companies, although the foreign banks would argue otherwise. The Board, however, stated in its January 1990 order that it would review for both domestic and foreign banking organizations the prior approval requirements for all funding of securities subsidiaries and the capital deduction for unsecured lending by a bank holding company to a securities subsidiary.
Reciprocal Treatment of Securities Firms. The GAO notes that an issue that needs to be studied is whether there are comparable opportunities for domestic securities firms to expand into domestic banking. The GAO recommends that any structure that is adopted needs to include appropriate controls over the entire holding company comparable to the Federal Reserve's current control over bank holding company operations.
As recognized by the GAO, the ability of investment banks to affiliate with commercial banks-while possible under the current state of the law-is best accomplished by legislation. The repeal of the Glass-Steagall Act would open the opportunity for the Congress to determine how these relationships should be structured.
Besides asking for comments on the GAO report, the committee's letter also asked for our views on whose responsibility it should be to enforce the fire walls and how they should be enforced. In the bank holding company context, the Federal Reserve Board is the appropriate agency to enforce the fire walls separating a section 20 company from its affiliated banks and nonbanks. As the agency responsible for supervising and regulating the holding company on a consolidated basis, the Board is also the appropriate agency to review the operational and managerial infrastructure of the section 20 company to ensure that the fire walls are in place and being observed. This does not mean, however, that the Board would be examining those companies to ensure that they are in compliance with the securities laws and regulations. As I discussed earlier, the Board's orders rely on functional regulation; as a broker-dealer, the section 20 company is and should be subject to regulation by the SEC. Indeed, the Board's supervisory procedures are designed, to the extent feasible, to avoid duplicating the efforts of a section 20 subsidiary's designated self-regulatory organization. This dual regulation by function is a concept endorsed by the GAO report.
With respect to how these fire walls should be enforced, the Board believes it has adequate authority under the Bank Holding Company Act and other enforcement laws, especially in light of the increased penalty provisions contained in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, to ensure that bank holding companies adhere to the requirements of Board orders. CONCLUSION In the absence of legislation establishing a comprehensive framework for the conduct of securities underwriting activities by banking organizations, the Board is required, as provided in existing law, to act on applications within mandated time periods. In acting on applications by bank holding companies to engage in expanded securities activities, the Board is proceeding cautiously and with due regard to the potential for risk to federally insured institutions and the federal safety net. The Board believes that this is appropriate when banking organizations are expanding their powers into nontraditional activities. This process is a continuing one, and the Board will be reviewing periodically the operations of the section 20 subsidiaries and the effect that the prudential limitations have on their operations. * Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 29, 1990. It is a pleasure to appear on this panel this morning to discuss issues involving the regulation of securities markets. While your committee is addressing a broad range of matters in this area, you have asked me to focus on whether the existing split regulation of equities and index futures may have contributed to market volatility, interfered with the process of innovation, or led to enforcement problems. You also have asked for comment on certain proposals for regulatory consolidation. I would like to focus my remarks on three major issues: first, the adequacy of margin requirements on stock index futures as a prudential safeguard and the impact of existing margin-setting procedures and other differences in regulation on market volatility; second, existing impediments to innovation; and third, whether there is a need to modify the existing regulatory system for stocks and stock derivatives. My evaluation will be done against the objective of a regulatory structure that, while limiting risks to the system, results in highly efficient and innovative U.S. financial markets that can compete effectively in the global marketplace.
As I will discuss in more detail, the Board does not believe that the existing division of regulatory authority has increased volatility in the securities markets, nor in this regard is it a threat to the capital-formation process. We continue to view the primary purpose of margins to be to protect the clearing organizations, brokers, and other intermediaries from credit losses that could jeopardize contract performance. While we think that federal oversight of margins is appropriate for prudential purposes, there are different views among Board members on whether that authority is best vested in the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC).
On the broader issue of consolidating jurisdiction for stocks and stock index futures (or all financial futures) in one agency, there are good arguments for and against such a consolidation and, accordingly, differences of views on whether such consolidation would, on balance, be beneficial. We believe some changes to the existing regulatory system are necessary to avoid the prospect that jurisdictional disputes among regulators will impede innovation in our financial markets, but consolidation of jurisdiction is not necessary to achieve this objective. FEDERAL MARGIN REGULATION A prominent area of disagreement among those interested in the smooth functioning of our capital markets has been the appropriate level of margins for stock index futures and the need for federal authority over such margins. In part, these disagreements reflect different views as to the purposes of margins and the appropriate objectives of federal margin regulation. Accordingly, at the outset I would like to clarify the position of the Board of Governors on these issues.
We continue to believe that the primary objective of federal margin regulation should be to protect the financial integrity of market participants and thereby ensure contract performance. Margins should be adequate to protect clearing organizations, brokers, and other lenders from credit losses arising from changes in securities prices. As such, they are one important element of a package of prudential safeguards, including capital requirements, liquidity requirements, and operational controls, aimed at limiting the vulnerability of the financial markets to losses or disruptions arising from the failure of one or more key participants. The failure of, or even the loss of public confidence in, a major intermediary in any of the stock, futures, or options markets could immediately place significant strains on other markets, their clearing systems, and on our nation's payment system.
The Board remains skeptical, however, of whether setting margins on stock index futures at levels higher than necessary for prudential purposes will reduce excessive stock price volatility. We, too, are concerned about what seems to be a higher frequency of large price movements in the equity markets, but we are not convinced that such movements can be attributed to the introduction of stock index futures and the opportunities they offer for greater leverage. Although available statistical evidence on the relationship between margins and stock price volatility is mixed, the preponderance of that evidence suggests that neither margins in the cash markets nor in the futures markets have affected volatility in any measurable manner. Moreover, we are concerned that raising maintenance margins on stock index futures to levels well above those necessary for prudential purposes could substantially reduce futures market liquidity or drive business offshore. Thus, in the Board's view, the critical question is whether margins on stock index futures have been maintained at levels that are adequate for prudential purposes. Although no futures clearinghouse has ever suffered a loss from a default on a stock index futures contract, certain actions by futures exchanges and their clearinghouses in recent years raise questions about the adequacy of futures margins from a public policy perspective. Specifically, we have concerns about the tendency for these organizations to lower margins on stock index futures to such a degree in periods of price stability that they feel compelled to raise them during periods of extraordinary price volatility. While such a practice has heretofore protected the financial interests of the clearinghouses and their members, it tends to compound already substantial liquidity pressures on their customers, on lenders to their customers, and on other payment and clearing systems. In the Board's view, somewhat higher margin levels on stock index futures would obviate the need to raise them in a crisis and thereby reduce concerns about the reliability of our market mechanisms, especially clearing and payment systems, in times of adversity.
The Board believes that federal oversight is appropriate to ensure that margins on stocks and stock index futures are established at levels that are adequate under a wide range of market conditions. Futures self-regulatory organizations (SROs) should continue to have primary responsibility for developing and refining margin policies. But the appropriate federal agency should have both the authority to initiate changes in margins on stock index futures and the authority to veto changes proposed by the relevant SRO. That authority should not be limited to emergency authority such as the CFTC currently has over futures margins.
Either the CFTC or the SEC could play this role. The principal argument in favor of assigning oversight responsibility for stock index futures to the CFTC is that it has overall responsibility for prudential supervision of futures exchanges and clearing organizations and futures commission merchants (FCMs). Assignment of oversight responsibility to the CFTC would avoid certain regulatory burdens and potential conflicts that could arise if responsibility for critical aspects of prudential oversight of such entities were divided between the CFTC and the SEC. The principal argument for assigning oversight responsibility for stock index futures margins to the SEC is that it would foster consistency of margins in the stock and stock derivative markets. The Board believes that margins in these markets should be consistent in the sense that they provide comparable protection against adverse price movements. The degree of protection provided by margin requirements depends on the magnitude of potential future price volatility. Although studies of past price movements can shed light on potential movements in the future, the forecasting of future volatility necessarily involves elements of judgment. Because different agencies are likely to come to different judgments, there is a case to be made for having only one regulator with margin authority over all the equity products markets to achieve consistency of margins across these markets. On balance, the Board does not see a clear basis for choosing between CFTC and SEC oversight of stock index futures margins. The Board feels strongly, however, that authority should not be given to the Federal Reserve because it does not have overall prudential responsibility for any of the futures commission merchants (FCMs), broker-dealers, or clearing organizations that margins are intended to protect. The existing margin authority for stock and stock options assigned to the Board under the Securities Exchange Act of 1934 should be transferred to the SROs and the SEC. ISSUES OF REGULATORY JURISDICTION The question of regulatory responsibility for margins is one element of the broader question of regulatory jurisdiction over futures and options markets. In light of the strong linkages among the markets for futures, options, and their underlying instruments, some have argued that the division of oversight responsibilities among agencies may impede the effective regulation and supervision that is essential to ensure sound and efficient financial markets.
One particular concern relates to volatility. It is frequently argued that leveraged trading in stock index futures and options, encouraged by low margin requirements on derivative products, has led to increased volatility in the prices of the underlying stocks. More generally, it has been suggested that other inconsistencies in market mechanisms involving, for example, circuit breakers and short-selling rules, contribute to market instability. It is feared that increased price volatility, in turn, will reduce the attractiveness of equity markets and could impede the capital-formation process. These concerns have prompted calls for one regulator who will take steps to remove inconsistencies that may contribute to sharp price swings.
The Board does not share the view that split regulatory authority over equity instruments has in any meaningful way contributed to volatility. As I noted earlier, we have found no substantial evidence linking margin levels to price volatility in the cash or the index product markets. Nor have studies revealed a clear understanding of how circuit breakers and other market rules affect price movements in the different markets.
In a more fundamental sense, we believe that it is counterproductive to lay blame on one sector, in this case the market for stock index derivatives, for the increasing occurrence of wide and rapid price swings in equity markets. Rather, the volatility we observe reflects more basic changes in economic and financial processes prompted by technological advances and the increasing concentration of assets in institutional portfolios. The delegation by the public of the management of a large proportion of its assets to professional managers through pension funds and other institutions and the desire of these managers for low-cost methods to manage risk and adjust portfolios has spurred growth in the new instruments; improvements in telecommunications and computer technology mean that information on economic fundamentals will be received and translated by these managers more quickly into market prices. To the extent that price movements reflect these basic forces, efforts to restrain volatility by imposing more restrictions on particular markets or instruments could have unintended effects, resulting in significant costs to the system and a shifting of transactions activity offshore.
A second issue frequently raised in evaluating the adequacy of our current regulatory system concerns product innovation. Many of the new products being developed on futures and options markets are not easy to classify. They have important similarities to, or are otherwise linked to, a variety of existing instruments subject to different regulators; and, as a consequence, various uncertainties and frictions have emerged about the appropriate exchanges that should trade these instruments and the agencies that should provide regulatory oversight. One recent example involves the "index participation" or IP contracts that were introduced by several of the stock exchanges, approved by the SEC for securities trading, and, in essence, disapproved when the courts ruled that IPs were futures products subject to the exclusive jurisdiction of the CFTC and could not be traded off exchanges regulated by the CFTC.
Under the Commodities Exchange Act (CEA), any commodity contract with an element of futurity cannot be entered into except on a CFTC-regulated exchange. Moreover, this act defines the term "commodity" very broadly to include not only physical commodities, like corn and wheat, but intangible contractual interests, including financial instruments. This restriction, when interpreted broadly, serves to discourage the development of new financial products that might be offered outside of the futures exchanges and tends to stifle the innovation process. In a very general sense, all financial instruments have an element of futurity in them, in that their value depends on future events. We believe that the CEA can be modified in ways that preserve the public safeguards that motivated this provision, while preventing conflicts in this area from having to be dealt with by the courts and without impeding the process of innovation in equity and other instruments. Such modifications might include an exemption for transactions subject to other regulatory safeguards, sophisticated trader exemptions, or more stringent fraud liability. ALTERNATIVE REGULATORY STRUCTURES As I have noted, a case can be made for having only one federal agency with oversight authority over margins in the equity and equity derivative markets. This case rests not on the issue of volatility but on the fact that setting prudential margins requires judgments concerning potential future price volatility in the linked markets for stocks and derivative products. One regulator would provide a single view of potential future volatility in these markets and thereby foster consistency of margins across the various segments of the equity markets. Others would go further and transfer all regulatory authority over stock index futures and options on such futures to the SEC. This alternative is one of the possibilities recently identified by Treasury Secretary Brady.
This would help achieve consistent prudential regulation across these tightly linked markets for equity instruments. However, such a measure would result in two regulators of futures exchanges and futures clearinghouses, and hence would still require a considerable amount of coordination on the part of the SEC and the CFTC. One must recognize that stock index futures are but one of many futures contracts offered by these organizations-indeed, only one of many financial futures contracts. Should losses from stock index futures trading-to be subject to SEC regulation under this alternative-jeopardize the financial integrity of a clearing organization or futures brokerage firm (FCM), it would threaten contract performance on all of the futures traded by the entity, including tangible commodity futures. Similarly, a failure in the commodity futures markets could, because of the effects on the clearing organization or brokerage firm, have consequences for the equity markets. In another area, many exchange rules related to trading and clearing cut across a wide range of contracts rather than being specific to stock index contracts, and close coordination between the SEC and the CFTC would be important in evaluating such rules. Thus, the SEC would have an important interest in other aspects of futures market regulation while the CFTC would continue to have a strong interest in the regulation of stock index futures. The logic of transferring stock index futures to the SEC because of their tight linkage to the cash market suggests that futures contracts on other instruments also might be regulated differently. That is, Treasury futures would be regulated by the Treasury and Eurodollar and foreign currency futures by the Federal Reserve. Such a change, however, would increase the regulatory fragmentation in the securities markets and would not appear to be a particularly useful realignment. Consequently, the benefits of transferring regulatory jurisdiction to the SEC for purposes of achieving more consistency of regulation across equity instruments must be balanced against these drawbacks, and there is scope for legitimate differences of view on whether such a measure would be a net improvement.
Secretary Brady also has suggested much more far-reaching measures to deal with the jurisdictional issue-the transferring of all financial products to the SEC or the merging of the two agencies. We would urge caution in considering these alternatives. A full merger of the two agencies would avoid many of the problems just mentioned about overlapping jurisdiction in the regulation of exchanges and clearinghouses, and the transfer of all financial instruments to the SEC might be accompanied by the separate clearing of all financial futures subject to only one regulator. However, these solutions would concentrate a great deal of regulatory authority over the financial system in a single agency and this has been a concern of the Congress for a long time. Besides the potential management difficulties of a larger organization, there is the risk that bureaucratic inertia in a larger agency could be an impediment to the process of innovation. We should not lose sight of the fact that under the existing system of split jurisdiction over financial instruments, our financial markets have been the most innovative in the world, with many of the new products spurred by the introduction of index futures and other futures. *
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|Title Annotation:||policy statements by members of Federal Reserve System|
|Author:||Johnson, Manuel H.|
|Publication:||Federal Reserve Bulletin|
|Date:||May 1, 1990|
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