Statements to the Congress.
I appreciate the opportunity to discuss with you today the issues raised by the recent events relating to the U.S. operations of Daiwa Bank and to provide you with our preliminary conclusions on these issues. I believe the basic facts are known and need not be recounted in detail. A short chronology is provided in an attachment, and I will briefly summarize the key events.(1) Of course, I would be pleased to answer, to the extent that I can, any questions that you might wish to ask regarding these events.
Very briefly, as background, on September 18, 1995, Daiwa Bank met with a Federal Reserve representative and reported that Daiwa's New York branch had incurred losses of $1.1 billion from trading activities undertaken by Toshihide Iguchi, a branch official, over a period of eleven years. These losses were not reflected in the books and records of the bank or in its financial statements, and their existence was concealed through liquidations of securities held in the bank's custody accounts and falsification of its custody records. Although Daiwa indicates that its senior management learned about these trading losses in July, they concealed the losses from U.S. banking regulators for almost two months thereafter. Moreover, they directed Mr. Iguchi to continue transactions during the two-month period that avoided the disclosure of the losses.
We understand that some officials at the Japanese Ministry of Finance were informed in early August about Daiwa's losses. They did not instruct Daiwa to inform the U.S. authorities; nor did they themselves do so. This lapse on the part of the Ministry of Finance is regrettable because open communication and close cooperation among supervisory authorities are essential to the maintenance of the integrity of the international financial system. Finance Minister Takemura has acknowledged the ministry's failure in this regard and has pledged that in the future the ministry will promptly and appropriately contact U.S. authorities on such matters of U.S. interest. We have been assured that the ministry is taking steps to implement this pledge. In addition, we have been pleased that once the Daiwa problem was disclosed, the Japanese authorities have fully cooperated with US. supervisors in dealing with the consequences.
On October 9, Daiwa also announced that its separate federally insured bank subsidiary in New York had incurred losses of approximately $97 million as a result of trading activities, at least some of them unauthorized, between 1984 and 1987. These losses should have been reflected in the books and records and financial statements of the subsidiary but were not. Instead, the losses were concealed from federal and state regulatory authorities through a device that transferred the losses to offshore affiliates, apparently with the knowledge of senior management.
On October 2, 1995, the New York Superintendent of Banks and the Federal Deposit Insurance Corporation (FDIC), together with the Federal Reserve Board, issued cease-and-desist orders against Daiwa requiring a virtual cessation of trading activities in the United States. On November 2, Daiwa was indicted on federal criminal charges. At the same time, the Federal Reserve, the FDIC, the New York Superintendent, and a number of other state banking authorities jointly issued consent orders under which Daiwa must terminate its banking operations in the United States by February 1996.
This matter has troubling implications for supervision and regulation in a world of multinational banking and increasing interrelationships of financial systems. Not only were bank employees able to conceal massive losses over an extended period of time, but senior management of Daiwa also took steps to conceal the events in question from US. regulatory authorities. This is particularly disturbing given that it would obviously have been in the best interest of both the bank and its management to have dealt with the problems openly and in compliance with host country regulations and operational standards.
The action taken by the Federal Reserve and the other regulatory authorities in terminating the U.S. operations of Daiwa was quite stem, particularly given that no US. depositor or U.S. counterparty ultimately lost any money. We, however, were united in the belief that this supervisory response was necessary because actions such as Daiwa's carry the threat of significant damage to a major asset of our nation the integrity of our financial system.
Trust is a principle of central importance to all effective financial systems. Our system is strong and vibrant in large part because we demand that financial institutions participating in our markets operate with integrity and that any information made available to depositors and investors be accurate. When confidence in the integrity of a financial institution is shaken or its commitment to the honest conduct of business is in doubt, public trust erodes and the entire system is weakened.
The need to trust other participants is essential in a complex marketplace. For example, on the basis of trust, counterparties typically trade millions of dollars on an oral commitment that may not be formalized for hours. A breach of that trust by failure to honor such commitments--presumably because markets turn adverse--would inevitably lead to an institution being drummed out of the marketplace. No set of statutes can ensure the effective functioning of a market if a critical mass of financial counterparties is deemed untrustworthy. Any risk that counterparties will not honor their obligations will be reflected in a widening of bid-ask spreads, a reduction in liquidity and, as a consequence, a less efficient financial system. Consequently, actions such as I have recounted in the Daiwa case cannot be tolerated. The potential cost to our financial system and hence to our economy is too large.
What is true for the financial system in general is particularly true for the supervision of financial institutions. Indeed, the whole system of supervision proceeds upon the basis of trust, whether in terms of the veracity of representations or reports filed by management or transparency with regard to any material developments affecting the financial condition of the institution. Supervisors need to trust the ability of bank management to carry out their duties in a responsible and honest manner with adherence to systems and operational controls designed to ensure the safe and sound conduct of business.
This is not to say that supervision can be based solely on trust. Supervisors must test a bank and its management in its compliance with law and sound business practice. This is, after all, one reason for the conduct of on-site examinations. An appropriate balance, however, must be struck between a supervisor's reliance on the institution's systems and management to function properly and the need to verify that its systems are being appropriately implemented and that management is addressing any significant problems. Without reliance on trust, an army of permanent resident examiners would be necessary to assure that the operations of a bank are conducted in a manner that is safe and sound and otherwise consistent with the requirements of law. Such an approach to supervision clearly would be counterproductive to the desired support of a vibrant, innovative banking system. For a supervisor to become a bank's internal auditor would either stifle the independence of management in the bank or create an unacceptably adversarial supervisory process.
In this context, we have sought to review the examinations in question in an effort to determine whether the supervision of Daiwa should have proceeded on a different basis and how such problems, to the extent that it is feasible, might be avoided in the future. Accordingly, we have reviewed the steps taken to implement the authority vested in the Federal Reserve Board in December 1991 in the Foreign Bank Supervision Enhancement Act (FBSEA) with regard to the examination and supervision of the operations of foreign banks in the United States. We have carefully reviewed the examination reports and other relevant documents that are presently available to seek to determine what, if anything, could or should have been done differently that might have brought to light the events in question at an earlier date.
A review of the Federal Reserve's three examinations of Daiwa's New York branch in the period between 1992 and 1994 indicates that the examiners identified and instructed management to address a number of internal control weaknesses at the branch. Specifically, when the examiners learned that a single person, Mr. Iguchi, was responsible for both securities trading and custody operations and some related back office functions, branch management was told that his duties should be separated. The examiners explored whether Mr. Iguchi was able to use his position as overseer of the custody account to gain improper advantage in carrying out the bank's own trading activities. The examiners, however, did not focus on the possibility that this breakdown in internal controls had the potential for the misappropriation of customer and bank funds.
The Federal Reserve accepted statements by branch management that the basic internal control problems, which in retrospect helped Mr. Iguchi to carry out his illegal activities, had been corrected. Obviously, the examiners and their supervisors did not at the time believe that employees of Daiwa's New York branch would be engaged in criminal activities.
With the benefit of hindsight, there were some clues that were missed in the examination of Daiwa. With a more robust follow-up, the problem might have been found sooner. Our examinations were conducted after the passage of FBSEA in the context of a rapid buildup of examination staff in 1992 and 1993 to meet our new responsibilities under that act. It is possible that we had not yet developed adequate experience to implement our new responsibilities. The Federal Reserve was still in the process of developing improved examination procedures and assessment systems (including, as I discuss below, an improved supervisory program, rating system, and examination manual). This was being done, following enactment of the legislation, to ensure that the U.S. banking operations of foreign banks are supervised with the same attention to safety and soundness issues as are domestic banks. Nonetheless, the bottom line is that we did not succeed in unearthing Daiwa's transgressions where we might have. Hopefully, this event will stiffen our resolve.
While internal controls have long been a focus of examinations, the growth in bank trading activities in the early 1990s also led to Federal Reserve initiatives to enhance our examination of trading activities. A number of these examination procedures address the need to have a proper separation of duties between the front office and the back office, as well as effective audit procedures. In the aftermath of Barings and Daiwa, our supervisory sensitivities have been heightened to the potential magnitude of the risks associated with a combination of trading and back office functions. Barings confirmed the importance of the increasing emphasis the Federal Reserve's supervisory staff had been placing upon the review of foreign bank's internal controls and risk management systems. The circumstances of the Daiwa case reinforce the need to pay close attention to these areas during examinations and to take heed of potential red flags that might suggest the possibility of rogue employees or a breakdown of internal controls. Both cases demonstrate the need, once serious deficiencies in internal controls are identified, to ensure that relevant books and records are reconciled and verified in an expeditious and thorough manner.
In the past two years, the Federal Reserve has implemented a number of initiatives that address these concerns. The Federal Reserve, together with the state banking departments and other federal regulators, has worked to coordinate better and enhance further the supervision of the US. activities of foreign banks. To that end, we have developed a new supervisory program for the U.S. operations of foreign banks. One important aspect of this program is to ensure that the information available to the U.S. supervisors is utilized and disseminated in a logical, uniform, and timely manner. The program was formally adopted earlier this year, and the implementation phase is now under way.
The new supervisory program also emphasizes enhanced contacts between U.S. supervisors and the home country supervisors of foreign banks. This case and the effect that it has had on Daiwa's activities, both in the United States and abroad, illustrate that problems of a bank in one market ultimately will affect its operations globally, including in its home country. In the end, there will be a mutuality of interest between home and host country supervisors that underscores the need for effective communication and increased cooperation. In this regard, although there were delays in the disclosure of Daiwa's problems to the U.S. authorities, once the matter was disclosed there was effective cooperation among U.S. and Japanese regulatory authorities in dealing with the consequences in an orderly manner that avoided losses to customers and systemic disruption.
I believe that, like ourselves, supervisors throughout the world recognize that more needs to be done to ensure better coordination and timely communication of material information. The Basle Committee on Banking Supervision has emphasized the importance of such international cooperation through issuance of international standards for supervision of multinational banking organizations and is discussing ways to broaden further and strengthen lines of communication. We will support those efforts and will continue our own initiatives to improve communication with foreign supervisors under the new supervisory program.
The Federal Reserve has also committed extensive resources over the past few years to enhancing the supervisory tools available to examiners and financial analysts to improve further our supervision of the U.S. operations of foreign banks. In 1994, the federal and state banking supervisory agencies adopted a new uniform examination rating system for U.S. branches and agencies of foreign banks that places higher priority on the effectiveness of risk management processes and operational controls. The new rating system, commonly referred to as the ROCA system, focuses on the following elements: Risk management, Operational controls, Compliance with U.S. laws and regulations, and Asset quality. The first three of these components evaluate the major activities or processes of a branch or agency that may raise supervisory concerns. The ROCA system will direct examiners' attention to the combination of front- and back-office duties, such as occurred in Daiwa, as a significant flaw in internal controls.
Another new supervisory tool is the Examination Manual for the US. Branches and Agencies of Foreign Banking Organizations. The Federal Reserve, in cooperation with state and other federal banking agencies, has developed the manual for conducting individual examinations of the U.S. branches and agencies of foreign banks. The manual serves as a primary, comprehensive reference source for examination guidelines and procedures and is beneficial to both new and experienced examiners. The manual is also being widely used as a reference tool by the foreign banking community in the United States to improve its own internal systems of controls.
In addition, in 1994, the Federal Reserve adopted a new Trading Activities Manual. Although the manual has been developed primarily for U.S. commercial banks, it also applies to the US. branches and agencies of foreign banks, many of which are actively engaged in transactions involving trading activities. This manual includes detailed examination procedures for evaluating controls in trading activities and emphasizes the importance of separation of duties in a trading operation such as Daiwa's.
The Federal Reserve has also taken steps to enhance training of examiners. For example, we have developed an internal controls school that was designed initially for examiners of branches and agencies of foreign banks and expanded to meet the needs of other examiners. We are also initiating a comprehensive capital markets examiner training program covering risk assessment, trading exposure management, and advanced derivative products. This program addresses skill needs at a variety of levels and utilizes instructors from the financial sector to supply expertise to train our examiners in these specialized areas.
Even given the new supervisory program and tools as well as our heightened sensitivity to possible red flags, no system of supervision will uncover all fraud. As the Board stated in 1991 in support of FBSEA, fraud is very hard for any regulatory authority to detect, especially when bank employees actively conspire to prevent official scrutiny. But if, after the fraud is discovered, swift and stern corrective action is taken by the supervisory authorities, financial institutions will hopefully recognize that deception pays no dividend. The FBSEA legislation was designed to minimize the potential for illegal activities by establishing uniform standards for entry by foreign banks, and, if illegal activities are suspected, to provide as many regulatory and supervisory tools as possible to investigate and enforce compliance. The Daiwa matter illustrates that the 1991 legislation provided the appropriate remedial tools to address serious failures to comply with law and regulation.
I believe that there are valuable lessons to be learned by bankers and supervisors from this unfortunate case. The loss of more than $1 billion suffered by Daiwa and the catastrophic losses suffered by Barings in Singapore because of a rogue trader illustrate the enormity of the damage that can be incurred by global trading banks when internal control systems are less than adequate. These losses and the institutional injury incurred are far greater than the losses banks have encountered from their authorized proprietary risk-taking positions. The lesson forcefully taught by these cases is that management must pay as much attention to such seen-tingly mundane tasks as back-office settlement and internal audit functions as to the more exotic high-technology front-end trading systems. Banks that neglect making the requisite investments in these areas do so at their peril. While the adequacy of internal controls has long been a point of major emphasis of supervisors, these recent events reinforce the need for supervisors to pursue rigorously the expeditious correction of internal control deficiencies in financial institutions. Moreover, in an era of mergers and aggressive cost control, supervisors must clearly emphasize to bank officials that key control and processing areas in banks must remain fully staffed by competent and experienced personnel.
Looking more broadly at the supervisory system and its functions within the international banking system, I would like to conclude by discussing a few general points that are raised by this case. No supervisory system can, nor should endeavor to, stop all losses. Any system that attempted to be fail-safe would impose intolerable costs on the public and the banking industry and almost certainly would stifle legitimate financial innovation. Moreover, in any supervisory regime, the ultimate responsibility for the protection of a privately owned bank must rest with the top management of the bank and its directors. After all, it is in their long-term interest to operate the bank in a safe and sound manner and to obey the law. Supervisors must, to some extent, rely on this mutuality of interest in performing their tasks. While good examiners are not naive and do not expect bankers to bare their souls, normally they must rely on a basic trust that they will not be deceived as they raise issues through successive layers of management. An assumption that most bankers are truthful should remain the rule, not the exception. However, when a bank has shown through repeated actions that it cannot be trusted, even at the highest levels of the corporation, supervisors should resort to extraordinary regulatory measures.
In such circumstances, the Congress has provided the supervisors with what I believe to be a full and appropriate range of powers, including cease-and-desist authority, civil money penalties, and, in the case of foreign banks, the authority to terminate their U.S. operations. This episode demonstrates that the supervisors will use these powers when, through a pattern of unacceptable behavior, the basic bond of trust that needs to exist between banks and their regulators is irreparably broken. However, if our further review of the events in question suggests additional authority is needed, we will of course convey that view to this committee.
We are considering a number of initiatives that may be implemented at an administrative level, especially with respect to internal and external audit standards. For example, we are presently reviewing our general policies in this area to determine the extent to which more specific guidance can be given to examiners for purposes of evaluating the adequacy of audit coverage. Consideration also will be given to requiring targeted external audits in banking institutions, whether foreign or domestic, when deficiencies in operations or concerns over the adequacy of internal audit have not been addressed. Clearly, we also need to fully implement our enhanced supervisory program in an expeditious manner. In doing so, the Federal Reserve will be reviewing the Daiwa case, Barings, and other major international banking events to identify further specific improvements to the supervisory process as it applies to both foreign and U.S. banks, as well as our existing statutory authority. We will report to the Congress on the conclusions of our review.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Telecommunications and Finance, Committee on Commerce, US. House of Representatives, November 30, 1995
Thank you for this opportunity to present the views of the Federal Reserve Board on securities margin requirements. The Board commends the subcommittee for its willingness to reconsider the public policy objectives of margin regulation and to consider amendments to the relevant statutes. Today, I shall present the Board's views on the objectives of Federal Reserve margin regulation and the need for statutory amendments to promote those objectives. As I shall discuss, the Board has concluded that federal oversight of securities credit is appropriate as part of comprehensive systems of oversight of safety and soundness of certain lenders--broker-dealers and banks. However, the Board is not convinced that the existing statutes authorizing Federal Reserve margin regulations--section 7 and subsection 8(a) of the Securities Exchange Act of 1934--effectively serve the purposes that apparently motivated their passage. Consequently, as it has for many years, the Board continues to believe that self-regulatory organizations should be given greater responsibility for margin regulation. Repeal of sections 7 and 8(a) of the Securities and Exchange Act of 1934 would leave federal oversight of securities credit extensions by broker-dealers to securities regulators, including self-regulatory organizations (SROs). It would also allow banking regulators to develop an approach to prudential oversight of securities credit extensions by banks that is more compatible with their overall system for overseeing bank safety and soundness.
We understand that implementation of this approach raises many important issues that would take some time to resolve. The Securities and Exchange Commission (SEC) has expressed concerns about the interplay of margin with other financial responsibility rules for broker-dealers, competition between market participants, the solvency of financial institutions, and systemic issues. We look forward to working with the SEC and with other members of the Working Group on Financial Markets to determine what other regulatory changes would be necessitated by repeal of sections 7 and 8(a). In addition, the SROs would need to work with the SEC to modify their margin rules, a process that likely would take some time. Therefore, if the Congress decides to repeal sections 7 and 8(a), it may wish to consider delaying the effective date of such action.
Objectives of Margin regulation
As I noted, the statutory basis for federal margin regulation is contained in the Securities Exchange Act of 1934, which gives the Federal Reserve Board the authority to regulate margins--that is, the minimum downpayments or, equivalently, the maximum collateral values for loans--on all securities other than government securities and other "exempted" securities. Reflecting views that were widely held when the 1934 act was passed, the Congress apparently intended this margin regulation to achieve three main objectives: (1) to constrain the diversion of credit from productive uses in commerce, industry, and agriculture to "speculation" in the stock market; (2) to protect unsophisticated investors from using margin credit to establish excessively risky positions; and (3) to forestall excessive fluctuations in stock prices.
The Board believes that experience and regulatory changes during the six decades since the passage of the 1934 act support the conclusion that margin regulation is not the best way to achieve those objectives. Concerns about a diversion of credit, which apparently weighed most heavily in 1934, were exaggerated. It is now widely recognized that the use of credit to finance securities does not materially reduce the amount of credit available for other uses. The borrowed funds do not disappear; rather, they are transferred to the seller, who reinvests the proceeds.
Customer protection concerns today are more reliably addressed by other regulations and policies applicable to the issuance and distribution of securities and to the conduct of broker-dealers. These include disclosure requirements, sales practices rules, and investor education efforts such as those recently initiated by the SEC.
Finally, the view that the existing margin statutes are necessary to control stock price volatility is not supported by empirical evidence that has accumulated since 1934. Numerous statistical studies of the relationship between margins and stock price volatility have been conducted, and the preponderance of that evidence suggests that changes in margins have not affected price volatility in any measurable way. To be sure, experience with the effects of changes in securities margin requirements is both limited and dated (initial margin requirements on equities have changed only about twenty times since 1934 and have not changed at all since 1974). But the view that changes in margin requirements do not affect asset price volatility is also supported by numerous studies of exchange-traded futures and options, including contracts on equities and equity indexes.
The Federal Reserve Board also has doubts about the effectiveness of margin regulation for achieving the purposes of sections 7 and 8(a) of the 1934 act. The underlying assumption is that the ability of investors to leverage can be restricted by regulating margins on loans collateralized by securities. Although in 1934 many investors may have had no other means of borrowing funds to invest in securities, today investors have many alternatives. With these alternatives available, margin requirements cannot effectively limit leverage.
In the Federal Reserve Board's view, federal oversight of securities credit makes sense only as part of broader systems to ensure the safety and soundness of financial institutions such as broker-dealers and banks. Safety and soundness oversight necessarily must address all sources of risk to those institutions. When such institutions make loans against collateral in the form of securities, the margin required is an important element in the risks they face and, as such, is an appropriate object of prudential supervision and regulation.
As I shall discuss later, however, the most effective approach to prudential oversight of securities credit depends on the nature of the overall safety and soundness regime applied to the financial institution. Indeed, there are several regulatory models for achieving safety and soundness--all potentially effective. U.S. authorities take quite different approaches to ensuring the safety and soundness of broker-dealers and banks, for example. Different approaches to oversight of securities credit may well be desirable. In any event, the best approaches to prudential oversight do not appear compatible with the statutory framework of sections 7 and 8(a) of the 1934 act, which, as I have noted earlier, was designed for entirely different purposes.
The Margin Provisions of H.R. 2131
The Board has evaluated the margin provisions of the Capital Markets Deregulation and Liberalization Act of 1995 (H.R.2131) against the view that the objective of margin oversight should be the safety and soundness of financial institutions subject to comprehensive prudential oversight. H.R.2131 would repeal section 8(a) of the 1934 act and amend section 7 substantially. The Board believes that repeal of section 8(a) is consistent with safety and soundness but has difficulty reconciling the amendments to section 7 with that objective.
Section 8(a) restricts broker-dealers from borrowing from lenders other than broker-dealers and banks when using exchange-listed equity securities as collateral. Removal of these financing constraints would promote the safety and soundness of broker-dealers by permitting more financing alternatives and hence more effective liquidity management.
Section 7 is the section that provides the Board with authority to regulate securities credit. Among the amendments to the section contained in H.R.2131, the Board views the restrictions on the authority of SROs to impose margin requirements on their members as fundamentally inconsistent with prudential objectives. The inclusion of these provisions in the bill evidently reflects dissatisfaction by some firms with their SRO's administration of margin requirements on debt instruments traded in the over-the-counter markets. If there have been problems in this area, those problems should be resolved by the members of the SROs, if necessary with the assistance of the SEC. The Board does not believe that the solution to these problems is to abandon the principle of self-regulation of broker-dealers.
Although we support a lowering of regulatory burdens in general, the Board finds it difficult to support the various exclusions from margin regulation that the bill would provide. These proposed exclusions would appear to reflect a view that the objective of margin regulation should be customer protection, an objective that I have indicated the Board believes is far more effectively addressed through other regulations and initiatives.
Ultimately, the Board has concluded that, because section 7 was originally enacted for completely different purposes, margin regulation cannot be successfully reoriented toward prudential objectives through amendments to that statute. Although regulatory burdens associated with the statute could be reduced through amendments, the residual framework would continue to impose compliance costs and would not effectively serve any public policy purpose.
An Alternative Approach to Margin Reform
Instead, the Board believes that the safety and soundness objective that is appropriate for margin oversight could best be achieved by repealing both section 7 and subsection 8(a) of the 1934 act. I have already discussed the case for repeal of subsection 8(a). Repeal of section 7 would promote safety and soundness by leaving responsibility for oversight of securities credit to those entities responsible for comprehensive oversight of financial institutions. Specifically, securities credit extended by broker-dealers would be overseen by the SEC and their respective SROs. Securities credit extended by banks would be supervised by their respective primary banking regulators. Extensions of securities credit by other entities would be subject to federal oversight only if their overall safety and soundness is subject to such oversight.
In the case of broker-dealers, the Federal Reserve Board sees no public policy purpose in it being involved in overseeing their securities credit extensions. The SROs and the SEC are much more likely to develop an oversight regime that is most consistent with their overall approach. The Board has already incorporated SRO rules into its margin regulations for some debt instruments and securities options. Whenever possible, the SROs have set margin requirements that better reflect the credit risks to lenders than the uniform and arbitrary initial requirements that currently apply to equities. The Board would expect that if the SROs were given responsibility for initial margins on equities, they would replace the existing requirements with more risk-sensitive standards. The self-interest of the SROs in the safety and soundness of their members and the integrity of their markets should ensure that such changes are consistent with safety and soundness. If these incentives proved inadequate, the SEC would have the authority to enforce changes in SRO oversight.
Just as oversight of the safety and soundness of SROs is best left to the SROs and the SEC, prudential oversight of banks is best left to the respective banking regulators. If section 7 were repealed, the Board would expect to work with the other federal banking regulators to develop a framework for the oversight of bank securities credit that is consistent with the overall framework of banking supervision and regulation. From its perspective as a banking regulator, the Board sees existing margin regulations under sections 7 and 8(a) as an anomaly, reflecting the nonprudential purposes underlying the existing margin statutes and regulations. These margin regulations involve a regulatory assignment of a maximum collateral value (or, equivalently, a minimum loan-to-value ratio) for securities. Banks make far larger volumes of real estate loans and auto loans than securities loans. But, except in limited instances required by statute, banking regulators do not regulate collateral values (or, equivalently, loan-to-value ratios) for such assets. Banking regulators typically leave such judgments to bank management and seek, through general policy guidance and on-site review of loans, to ensure that the banks' judgments are consistent with safety and soundness.
Given the opportunity, we would urge banking regulators to take a similar approach to the supervision and regulation of loans against securities collateral. General guidance on prudential considerations with respect to such lending might be provided in the form of a supervisory policy statement. Examiners could then ensure that lending decisions by banks were consistent with those prudential considerations. This approach would allow banks discretion in setting collateral requirements to take account of factors such as the price volatility and market liquidity of the securities, the time period allowed for borrowers to eliminate collateral deficiencies, and the general credit-worthiness of the borrower.
The Board sees no compelling public policy reason for federal oversight of securities credit extended by lenders that are not subject to comprehensive federal safety and soundness oversight. In any event, with the exception of loans involving employee stock ownership plans (ESOPs), securities credit extensions by lenders other than broker-dealers and banks currently are negligible (most recent data show credit extensions by such lenders totaled just over (400 million). Credit extensions that are part of ESOPs have already been exempted from most requirements of margin regulations, including minimum initial margins. Other lenders have been important in the past, but generally only when margin requirements have been set higher than currently and well above levels necessary for prudential reasons. If broker-dealers and banks are not required to set margins at levels higher than necessary for safety and soundness, it seems unlikely that other lenders would again play a prominent role.
Some may argue that the approach to margin regulation that the Board is advocating would not provide a level playing field for all providers of securities credit. It is not clear how relevant an issue that would be, if so. The Board does not believe that competitive equity requires that an identical oversight regime be applied to all players in a marketplace, provided competition from whatever source ensures adequate customer choice. Banks and broker-dealers already compete effectively with one another in a wide range of markets, including markets for credit secured by government securities, despite fundamental differences in approaches to prudential oversight of the two types of entities. In any event, the Board would expect that the repeal of section 7 would over time lead both the SROs and the banking regulators to adopt more flexible and more compatible approaches to prudential oversight of credit extensions collateralized by securities.
With respect to competition from other lenders, as I have argued, such competition is unlikely to be serious if securities and banking regulators do not handicap broker-dealers and banks by requiring margin levels higher than necessary for safety and soundness. More fundamentally, the Board is concerned by the implications of a view that the notion of a level playing field requires federal oversight of all providers of services that compete with services provided by regulated financial institutions. So long as we have a limited safety net for banking institutions, there will inevitably be some disparities in the competitive environment for financial institutions. However, we believe that their impact on overall competition is minor and that the endeavor to rectify them is far more costly than any perceived benefits.
In conclusion, the Board believes that the primary objective of federal oversight of securities credit should be the safety and soundness of institutions, such as broker-dealers and banks, which are subject to comprehensive prudential regulation. Subsequent experience, analysis, and regulatory and market developments support the conclusion that section 7 and subsection 8(a) of the 1934 act may not effectively serve the purposes for which they were originally enacted. Repeal of these sections would leave federal oversight of securities credit extensions by broker-dealers to their SROs and the SEC and would allow banking regulators to develop an approach to oversight of bank securities credit that is more compatible with their overall approach to bank safety and soundness.
The Board looks forward to working with the SEC and other members of the Working Group on Financial Markets to determine what other regulatory changes would be necessitated by repeal of sections 7 and 8(a). If the Congress decides to repeal sections 7 and 8(a), it may wish to consider delaying the effective date of such action to allow time for such interagency discussions and time for the SROs to modify their margin rules.
(1.) The attachment to this statement is available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 2055 1.
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|Title Annotation:||report on Daiwa Bank Ltd. and policy statement by Federal Reserve Board member|
|Publication:||Federal Reserve Bulletin|
|Date:||Jan 1, 1996|
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