Senate Banking, Housing and Urban Affairs Committee

Hearing on H.R.10 - "The Financial Services Act of 1998"
(Second Hearing in a Series)

The laws that separate mutual funds, securities, insurance and banking are no longer appropriate in light of the modern financial services marketplace. In order to correct this problem, Congress should:

• permit banks, securities firms, mutual fund companies and insurance companies to affiliate with one another;
  
  
• provide for functional regulation of each entity;
  
  
• create an oversight system for financial services holding companies that protects the public interest without imposing bank-like regulation on mutual funds and other functionally regulated nonbank entities; and
  
  
• permit financial holding companies to accommodate nonfinancial affiliates of securities and insurance firms.

The Federal Reserve Board's role as umbrella regulator of the new financial holding companies should be shaped by the fact that it will no longer simply be the umbrella regulator of banks and affiliates that engage in activities closely related to banking. Instead, the Board will monitor organizations that will engage in a broad array of mutual fund, securities, and insurance activities in addition to banking.

Because other federal and state regulators with functional expertise in these areas have successfully overseen these activities for decades, there is no need for the Board to govern the day-to-day nonbanking activities of financial holding companies. Instead, the Board's regulatory authority should be centered on banks and should not be used to impose bank-like regulation on mutual funds and other functionally regulated entities. H.R. 10 should be amended to make this more clear.

H.R. 10 also should be amended to ensure that federal banking agencies other than the Federal Reserve Board do not attempt to impose bank-like regulation on affiliates of banks.

Mutual fund companies and other securities and insurance firms should not be placed at a competitive disadvantage relative to banks simply because they currently engage to some extent in nonfinancial activities. Nonbank entities such as mutual funds have never been subject to activities restrictions like those contained in H.R. 10, and should not be penalized if they now become subject to its provisions. Accordingly, H.R. 10 should be amended to allow financial holding companies to engage in a limited amount of nonfinancial activities.

I. Introduction

My name is Matthew P. Fink. I am President of the Investment Company Institute, the national association of the American investment company industry. The Institute's membership includes nearly 7,000 open-end investment companies ("mutual funds"), 437 closed-end investment companies and 9 sponsors of unit investment trusts. The Institute's mutual fund members have assets of about $5 trillion, accounting for approximately 95 percent of total industry assets, and have over 62 million individual shareholders. The Institute's members include mutual funds advised by investment counseling firms, commercial banks, broker-dealers, insurance companies and affiliates of commercial firms.

The Institute has been an active participant in the debate on financial services reform and has testified before Congress on subjects directly relating to financial services reform more than twenty times over the last twenty-three years. I am pleased to be here today on behalf of the Institute to testify with respect to H.R. 10, the "Financial Services Act of 1998."

II. Background

A. Growth and Regulation of the Mutual Fund Industry

Since 1940, when Congress enacted the Investment Company Act, the mutual fund industry has grown steadily from 68 funds to over 7,000 funds today, and from assets of $448 million in 1940 to about $5 trillion today. These include nearly 3,300 equity funds with over $2.8 trillion in assets, much of which is invested in start-up companies and other growing enterprises in cities and towns in every corner of the nation.

Many factors have contributed to the growth of the mutual fund industry over the years. They include the capital appreciation of portfolio securities, additional purchases by existing fund shareholders, new products and services designed to meet changing investor needs, the growth of the retirement plan market, increased investment by institutional investors, new distribution channels, and a shift by individuals from direct investment in securities to investment through mutual funds.

In our view, however, the most important factor contributing to the industry's growth and success is that mutual funds are subject to stringent regulation by the United States Securities and Exchange Commission under the Investment Company Act. The core objectives of the Act are to: (1) ensure that investors receive adequate, accurate information about mutual funds in which they invest; (2) protect the integrity of the fund's assets; (3) prohibit abusive forms of self-dealing; (4) restrict unfair and unsound capital structures; and (5) ensure the fair valuation of investor purchases and redemptions. These requirements--and the industry's commitment to complying with their letter and spirit--have produced widespread public confidence in the mutual fund industry. In our judgment, investor confidence has been and continues to be the foundation for the success that the industry now enjoys.

The mutual fund industry has always spoken out against legislation that would impair this effective and time-tested regulatory system. For example, we continue to strongly oppose the imposition of bank-type regulation on mutual funds.

B. Differences Between Bank Regulation and Mutual Fund Regulation

If financial services reform is to succeed in producing more vibrant and competitive financial services companies, it must provide a regulatory structure that respects and is carefully tailored to the divergent requirements of each of the business sectors that comprise the financial services marketplace. The securities, mutual fund, banking and insurance industries all historically have been and presently are subject to extensive governmental oversight. But for reasons that continue to make good sense even in this era of consolidation and conglomeration, the regulations governing each of these businesses rest on different premises, have different public policy objectives and respond to distinct governmental and societal concerns.

Our mutual fund and securities markets are based on transparency, strict market discipline, creativity and risk-taking. The federal securities laws, including the Investment Company Act, reflect the nature of this marketplace and, accordingly, do not seek to limit risk-taking nor do they extend any government guarantee. Rather, the securities laws require full and fair disclosure of all material information, focus on investor protection and the maintenance of fair and orderly markets, and prohibit fraudulent and deceptive practices. Securities regulators strictly enforce the securities laws by bringing enforcement actions, and imposing substantial penalties--in a process that by design is fully disclosed to the markets and the American public.

Banks, by contrast, are supported by federal deposit insurance, access to the discount window and the overall federal safety net. Therefore, regulation imposes significant restraints and requirements on the operation of banks.

It may well be that this regulatory approach is prudent and appropriate when it comes to the government's interest in overseeing banks. But it would be fundamentally inconsistent with the very nature of the mutual fund and securities markets to impose bank-like regulation on mutual fund companies and other securities firms affiliated with banks. To do so could profoundly impair the ability of mutual funds and securities firms to serve their customers and compete effectively. More worrisome, it could compromise the continued successful operation of the existing securities regulatory system.

Finally--and perhaps most importantly--imposing bank-like regulation on an industry for which it was not designed could even jeopardize the functioning of our broad capital markets. This would risk the loss of a priceless and valuable national asset. As SEC Chairman Arthur Levitt has stated, "[o]ur capital markets must remain among our nation's most spectacular achievements . . . . Those markets, and investors' confidence in them, are a rich legacy we have inherited, but do not own. They are a national asset we hold in trust for our children, and for generations of Americans to come."⁽¹⁾

III. Principles of Successful Financial Services Reform

To most observers, it is now abundantly clear that the laws that separate mutual funds, securities, insurance and banking are no longer appropriate in light of our modern and fiercely competitive financial services marketplace. In order to correct the mismatch between these rigid and atrophied laws and the reality of today's dynamic financial services marketplace, the Institute believes that financial services reform legislation should include four key elements. Simply put, Congress should:

• permit banks, securities firms, mutual fund companies and insurance companies to affiliate with one another in diversified financial holding companies;
  
  
• provide for functional regulation of each entity (bank, mutual fund, insurance company, etc.) within the resulting diversified organization;
  
  
• create an oversight system governing organizations owning securities firms, mutual fund companies, insurance companies and commercial banks that maximizes the public interest in protecting consumers of financial services while not imposing ill-fitting, one-size-fits-all bank-like regulation on mutual funds and other nonbank entities within the holding company; and
  
  
• permit financial services holding companies to accommodate nonfinancial affiliates of securities firms, mutual fund companies and insurance companies.

S. 298, the "Depository Institutions Affiliation Act," as introduced by Chairman D'Amato, reflects many of these key elements for successful financial services reform. In particular, S. 298 embraces the concept of true functional regulation without a single umbrella regulator and allows unrestricted mixing of banking and commerce. H.R. 10, the "Financial Services Act of 1998," in many respects also reflects elements of successful financial services reform. More changes, however, are needed.

In particular, H.R. 10 should clarify and tighten the proposed role of the Federal Reserve Board as umbrella regulator of the new diversified financial holding companies. H.R. 10 also needs to be revised to provide for true functional regulation that recognizes the differences between bank regulation and mutual fund regulation. And H.R. 10 should better recognize the reality of the evolving financial services marketplace and permit mutual fund companies and other securities firms to continue to engage, to some extent, in nonfinancial activities.

IV. Rationalizing the Role of the Federal Reserve Board

A. Clarifying its Role as Umbrella Regulator

The Federal Reserve Board currently serves as the umbrella regulator of bank holding companies under the Bank Holding Company Act. Under current law, in general, bank holding companies and their nonbank subsidiaries may only engage in activities that the Board has determined to be closely related to banking. Additionally, the banks owned by a bank holding company are only required to be adequately capitalized. Thus, the Board's principal role as a bank regulator is centered on protecting taxpayers and the banking system by restricting banks and ensuring that bank holding companies only engage in activities under bank-like regulation.

However, under H.R. 10, financial holding companies and their subsidiaries would be allowed to engage in a much broader array of financial activities, including mutual fund, securities and insurance activities. Because federal and state regulators other than the Board--with functional expertise in these areas--have successfully overseen these financial activities for decades, there is no need for the Board to govern the day-to-day nonbanking activities of a financial holding company. Moreover, Board oversight of nonbank affiliates is unnecessary given that banks owned by a financial holding company must be well capitalized and well managed. Additionally, as discussed above, imposing bank-like regulation on mutual funds and securities firms would likely harm innovation, damage our capital markets, and hurt our growing population of investors.

Effective oversight for diversified financial services organizations operating in a highly competitive global economy should be shaped by three basic concepts: functional regulation, bank-centered supervision and enforcement, and effective regulatory coordination. Functional regulation envisions that each subsidiary of the financial holding company will be separately regulated by function with, for example, the Securities and Exchange Commission acting as the primary regulator of mutual funds and securities firms, the states acting as the primary regulator of insurance companies, and the appropriate federal banking agency acting as the primary regulator of banks. Bank-centered supervision and enforcement refers to a system in which regulatory actions considered necessary to protect the safety and soundness of individual banks and the payment system are imposed directly on banks, rather than spread to other functionally regulated entities affiliated with banks. Effective regulatory coordination means providing mechanisms for communication and cooperation among the functional regulators to avoid duplicative and unnecessary oversight in carrying our their regulatory responsibilities.

H.R. 10 is based on the premise that the Federal Reserve Board should serve as an umbrella regulator for new financial holding companies that own both banks and nonbanks, to monitor and protect against risks to individual banks and the payments system. While we believe that other equally effective regulatory structures could be implemented, we understand Congress's concern that a single regulator be responsible for monitoring the entire financial services organization. We believe, however, that it is equally important that this regulatory authority be clearly defined to center on banks. It must be made explicit that this authority does not extend to regulating the day-to-day activities of other functionally regulated nonbank entities within the holding company, such as securities firms and mutual funds that are regulated by the SEC, simply because those entities are within a financial holding company structure.

B. Provisions of H.R. 10 Concerning Federal Reserve Board Authority

H.R. 10 attempts to balance these concerns by including certain provisions that delineate the Federal Reserve Board's authority to regulate and examine financial holding companies and their functionally regulated subsidiaries. In particular, H.R. 10: (i) clarifies the Board's authority to require reports from, examine, and impose capital requirements on functionally regulated subsidiaries of financial holding companies;⁽²⁾ (ii) makes the SEC the exclusive federal agency authorized to examine any mutual fund that is not a bank holding company;⁽³⁾ and (iii) clarifies the Board's rulemaking, supervisory and enforcement authority with respect to the business of functionally regulated subsidiaries of financial holding companies.⁽⁴⁾ While these clarifications of the Board's authority are very important in addressing the concerns cited above, certain additional changes to H.R. 10 are necessary to ensure that bank-like regulation is not imposed on functionally regulated subsidiaries of financial holding companies.

Actions Against Functionally Regulated Affiliates

Section 116 of H.R. 10 limits the Board's authority to impose restraints or requirements on functionally regulated affiliates of banks, such as investment advisers to mutual funds, broker-dealers or insurance companies. In general, the Board may not take actions against functionally regulated affiliates unless there is an unsafe or unsound practice that poses a material risk to the financial safety and stability of an affiliated depository institution or the payments system. Although this provision allows some protection to functionally regulated affiliates from day-to-day regulation of their activities by the Board, greater clarification is needed.

In particular, the types of "material risk" that can trigger Board action are not clear under the legislation. We are also concerned that the Board could bypass this test to allow it to prevent or impede mutual funds from engaging in activities that are completely permissible under the securities laws. For example, we do not believe that the Board should be allowed to prohibit the creation of a mutual fund that invests in high yield bonds simply because those investments may entail certain risks to investors. The Board should not regulate the business operations or day-to-day activities of a functionally regulated affiliate unless it engages in an activity that poses a serious risk to its affiliated bank or the payments system. Accordingly, we believe that H.R. 10 should be amended to add a statutory provision that sets forth Congress's intent of what would constitute a "material risk" for these purposes.

Deference to Other Functional Regulators

Section 111 of H.R. 10 grants the Board authority to conduct certain examinations and require certain reports from functionally regulated affiliates of banks, such as investment advisers to mutual funds, broker-dealers or insurance companies. However, the Board is required to defer to the SEC with regard to the interpretation and enforcement of all federal securities laws governing SEC-regulated entities, and to the states with regard to all state insurance laws governing insurance companies and agents. The Board also is required to defer to other functional regulators' examinations and reports, such as the SEC's examinations of, or reports on, mutual funds. The Institute strongly supports the concept of Board deference to examinations, reports and securities law interpretations by the SEC. Without such deference, the Board could apply the securities laws in a manner that is inconsistent with the prior interpretations of the SEC.⁽⁵⁾

Holding Company Capital Requirements

The Institute also believes that H.R. 10 should prohibit the imposition of capital requirements on financial holding companies. Because banks, broker-dealers and insurance companies are already subject to capital standards, it is unnecessary and redundant, as well as inconsistent with the notion of functional regulation, for H.R. 10 to require financial holding companies to maintain an additional layer of capital. Moreover, in order to engage in a broad array of financial activities, all of the bank subsidiaries of a financial holding company must be well capitalized and well managed, eliminating the need for bank-like holding company capital requirements.

If the Board has authority to impose capital requirements, it could restrict innovative product development by functionally regulated affiliates. For example, the Board could require higher capital as the price for offering a wider array of mutual funds. The holding company capital requirement should not be used to deter nonbanking product development.

V. Rationalizing the Role of the Other Federal Banking Agencies

The provisions discussed above only address the regulatory authority of the Federal Reserve Board with regard to functionally regulated affiliates of banks. Regrettably, there are no parallel provisions in H.R. 10 that limit the authority under current banking laws of other federal banking agencies to regulate functionally regulated affiliates of banks, including mutual fund companies. We believe that provisions similar to those that clarify the Board's authority with respect to functionally regulated subsidiaries of financial holding companies should also apply to the other federal banking agencies. Otherwise, these agencies may claim to have broader authority relating to functionally regulated entities than the Board. Given that the Board is intended to be the umbrella attempting to engage in the day-to-day regulation of functionally regulated nonbank affiliates, the legislation should make clear that the banking agencies' authority is not broader than the Board's authority.

Indeed, history demonstrates that bank regulators have asserted authority over securities affiliates of banks and have imposed requirements that are inconsistent with fundamental tenets of securities regulation. For example, the FDIC adopted a rule in 1984 that limited certain state nonmember bank securities affiliates to underwriting investment quality securities.⁽⁶⁾ The release accompanying the rule stated that the FDIC's purpose in adopting the rule was to address the risk associated with bank subsidiaries underwriting securities. The release also stated the FDIC's view that it had the authority to address, on a case-by-case basis, practices, acts or conduct of the securities affiliate that it found to constitute unsafe or unsound practices not specifically addressed by the rule.

As discussed above, applying bank-like regulations to mutual funds and the securities markets generally could profoundly impair the continued successful operation of the existing securities regulatory system and damage our capital markets. If the banking agencies have authority to impose restrictions on the activities of securities affiliates of banks based on whether such activities meet bank safety and soundness standards, such a result could occur. Accordingly, it is critical that H.R. 10 be amended to rationalize the role of the banking agencies with regard to mutual funds and securities firms in order to protect the existing securities regulatory system and the capital markets.

The danger also exists that a banking agency might be tempted to stifle innovation and preclude new product developments by a securities affiliate on the ground that they may compromise the competitive standing of banks. For example, Professor John C. Coffee, Jr. observed that a single financial services regulator might have barred or restricted the growth of money market mutual funds in the 1970s because of the competition these funds posed to bank accounts. Such an outcome not only would have been anticompetitive, but also a notable disservice to consumers and the capital marketplace.

VI. Nonfinancial Activities

An important objective of any financial services reform legislation is to create competitive equality among banks, mutual funds, securities firms and insurance companies. Unfortunately, H.R. 10 falls short in this respect because it retains the strict separation between "banking" and "commerce." Specifically, mutual fund firms, securities firms or insurance companies would only be able to acquire banks by becoming financial holding companies and divesting their nonfinancial activities within 15 years. This approach would introduce competitive inequities: all banks could enter the securities and insurance businesses, but not all securities firms and insurance companies could own commercial banks.

To provide a fair and balanced competitive environment, the Institute recommends that H.R. 10 be amended to allow financial holding companies to engage to some degree in nonfinancial activities. This would create a financial services holding company that reflects the realities of today's marketplace. For example, many mutual fund companies are affiliated with entities involved in some degree in commercial activities. For these companies fully to participate in the landmark regulatory realignment contemplated by this legislation, they must be permitted to have some part of their business involved in nonfinancial activities. While the versions of H.R. 10 passed by the House Banking and Commerce Committees contained provisions for limited commercial activities by financial holding companies, the version passed by the full House did not.⁽⁷⁾ Mutual fund companies and other securities firms have never been subject to activities restrictions like those contained in H.R. 10, and should not be penalized if they now become subject to its provisions. Accordingly, we would support adding back into H.R. 10 a provision allowing financial holding companies to engage in a limited amount of nonfinancial activities.

VII. Conclusion

The Institute continues to support efforts by Congress to modernize the nation's financial laws. H.R. 10 represents a major step in this direction by permitting affiliations of banks, mutual fund companies, securities firms and insurance companies in diversified financial holding companies.

However, any change in financial services law needs to recognize the reality of today's financial services marketplace. Financial services companies are engaging in a broad array of mutual fund, securities and insurance activities, as well as banking. Because federal and state regulators have successfully overseen these activities for decades, there is no need to impose bank-like rules and regulations on the mutual fund, securities and insurance industries. In fact, imposing a bank-like regime on the mutual fund industry could destroy the highly successful regulatory system that is a major cause of the success that our industry enjoys today.

Accordingly, modifications are needed to H.R. 10 to ensure that regulatory principles that may be appropriate for banks and bank holding companies are not inappropriately applied to mutual funds to the detriment of the investing public and our capital markets. Additionally, H.R. 10 needs to recognize the reality of today's financial services marketplace and not create barriers to entry for financial services companies engaged to some extent in nonfinancial activities. We strongly encourage the Committee to carefully consider these issues as it moves forward with the legislation.

We thank you for the opportunity to present our views and look forward to working with the Committee as H.R. 10 moves forward.

Notes:

¹ "A Declaration of (Accounting) Independence," Remarks by Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, before The Conference Board, New York, New York (Oct. 8, 1997).

² See Financial Services Act of 1998 § 111.

³ See id. § 115.

⁴ See id. § 116.

⁵ The Institute has drafted certain technical changes to Section 111 of H.R. 10 that we believe help clarify the scope of the Board's deference to SEC examinations, reports and securities law interpretations.

⁶ See 12 C.F.R. § 337.4.

⁷ H.R. 10 does, however, permit the "grandfathering" of certain limited nonfinancial activities of companies that become financial holding companies after the bill's enactment for up to 15 years. See Financial Services Act of 1998 § 103(a).

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