Hearing on Financial Services Modernization

Prepared Testimony of Mr. William L. McQuillan
City National Bank
Greeley, Nebraska

10:00 a.m., Thursday, February 25, 1999

Good morning, Mr. Chairman and Members of the Committee. I am Bill McQuillan, president of the Independent Bankers Association of America and president of City National Bank in Greeley, Nebraska. I have just completed my second three-year term as an elected director on the Board of Directors of the Federal Reserve Bank of Kansas City. The IBAA represents some 5,500 independent community banks nationwide that hold nearly $445 billion in insured deposits, $524 billion in assets and more than $314 billion in loans to customers, small businesses and farms in the communities they serve. We employ more than 200,000 people in our communities.

Thank you very much for inviting IBAA to testify on the staff draft on financial modernization.

Merger and Acquisition Wave Continues

Like bills already introduced in the House (H.R. 10 and H.R. 665), the staff draft would permit common ownership of the largest banks, securities firms and insurance underwriters in the United States. This major public policy shift has been largely overshadowed by more controversial provisions.

We are worried about the potential anti-competitive effect these mergers are already having on ATM networks and credit and debit card markets. Earlier this month, Citigroup Co-Chairman John Reed stunned the credit and debit card world by announcing his resignation from the Visa board. As reported by the Wall Street Journal on February 10, Citigroup plans "to pull as much of its credit-card business as possible from Visa," a move which would undermine the Visa brand over time. Clearly, the erosion of this brand would undercut the competitive entry of thousands of community banks, thrifts and credit unions into the credit and debit card markets. Even now, 80 percent of credit card lending is concentrated among the 10 largest issuers.

And the merger and acquisition wave that continues to sweep through the banking industry and broader financial services industry is inevitably concentrating total domestic banking assets. There is a public policy issue here -- more too-big-to-fail institutions are being established at the very time when the Federal Reserve's actions last September in orchestrating the bailout of Long Term Capital Management (LTCM) underscore the nature of the systemic risk that now faces our financial sector. It is worth recalling that LTCM wasn't a depository institution covered by deposit insurance, yet the Fed took the unprecedented action to assure a bailout.

As noted in greater detail below, we are particularly concerned that the staff draft would not shut the door to commercial firms using the unitary thrift loophole to acquire banking operations. Moreover, provisions "under discussion" would even permit commercial firms to enter the banking business by buying one national bank. This provision, joined with language permitting commercial banks to own a substantial basket of commercial firms over a ten-year time frame, opens the door to the two-way street of substantial cross-ownership of banks and commercial firms. Mr. Chairman, the community banks of this nation join Fed Chairman Greenspan and Treasury Secretary Rubin, among others, in strongly urging that these bridges not be crossed for the sake of our diversified financial system which is the envy of the world.

Progress on Financial Modernization

During the second session of the 105th Congress, significant strides were made to address the concerns of not only the banking industry, but also the interests of community banks. The bill that was reported on a bipartisan 16-2 vote by this Committee last September contained a number of hard-fought compromises that were unopposed by any major sector of the financial services industry, including the IBAA.

Before getting into specifics, IBAA wants to note positive reactions to certain items in the staff draft. One provision would require an expedited GAO study on expanding community-bank access to S corporation treatment -- a long-standing IBAA priority. Sen. Allard plans to introduce an S-corporation expansion bill which hopefully will be acted upon quickly by the Senate Finance Committee. We have worked closely with Sen. Allard and his staff on this measure and want to acknowledge our appreciation. Likewise, Mr. Chairman, we thank you for adding the GAO study provision to the staff draft, as IBAA believes its inclusion will help to spur further Congressional action.

We also support the provision which would permit municipal revenue bond underwriting directly in a bank.

Another provision under discussion would extend for three years the differential between BIF and SAIF members for FICO obligations. We appreciate the inclusion of this language in the staff draft, as the extension will slightly reduce the banker burden for the S&L-cleanup mess. Our initial analysis is that it will only save the median IBAA-member bank (with approximately $50 million in deposits) about $16,500 over three years. It is thus a welcomed provision, but it certainly does not alleviate our concerns over the mixing of banking and commerce or narrowing the unitary thrift loophole.

As part of our ongoing analysis of financial modernization legislation, IBAA policy committees have developed seven standards that reflect our concerns and guide our policy considerations. These are:

Banking and Commerce

1. Banking and Commerce. The IBAA cannot support, and will oppose, any legislation that permits or encourages the common ownership of commercial banks and commercial firms. The case against banking and commerce is well established. As noted above, both Chairman Greenspan and Secretary Rubin have raised serious concerns about moving in this direction at this time. Yet provisions under review in the staff draft contemplate a 25 percent basket ultimately for both banks and commercial firms -- the latter via a "unitary bank holding

company" structure under which a commercial firm could own and operate one national bank.

Allowing the common ownership of banks and commercial firms would encourage financial institutions to engage in the kind of crony capitalism that has undermined the economies of Japan, Brazil and a number of Pacific Rim nations. It would be ironic, indeed, if the U.S. Congress followed this policy path at the very time these nations continue to struggle with an enormous economic and financial crisis fueled by this crony capitalism.

Mixing banking and commerce would jeopardize the impartial allocation of credit, which is the very foundation of our highly successful economic and financial system. It could stretch the deposit insurance safety net to unintended areas, potentially weakening the linchpin that undergirds community banking and the stability of our banking system. Ultimately, it also puts into play scenarios where money-center banks could acquire Fortune 500 companies and vice versa -- a troublesome prospect given the broad changes and further consolidation of our nation's financial system which would be driven by passage of this legislation.

For these reasons, Mr. Chairman, we will oppose any legislation that mixes banking and commerce.

Unitary Thrift Holding Company Loophole

2. Unitary Thrift Holding Company Loophole. IBAA cannot support, and will oppose, any legislation that does not narrow the unitary thrift holding company loophole. This unfortunate provision of law permits unitary thrifts to be owned by any firm, including commercial firms, thereby breaching the banking and commerce wall.

Unfortunately, the staff draft is silent on the unitary thrift loophole.

Equally worrisome, however, are the above-referenced unitary bank holding company provisions. If such an entity were created, community bankers would not only be faced with the thrift loophole, but also a "bank loophole" through which commercial firms could conduct banking activities and potentially endanger the deposit insurance safety net. This "reverse basket" concept was summarily rejected last year by both this Committee and the full House of Representatives.

We support the provisions from last year's Committee-reported bill establishing a prospective restriction on commercial affiliations for any unitary thrift that was in operation on or before October 7, 1998, or had an application on file by that date and later became operational. This provision is certainly more than fair to existing unitaries, which may continue their existing activities and may even acquire additional non-financial firms in the future. We also support language to prohibit grandfathered thrifts from being sold to a non-financial firm in the future.

One recommendation we could make is that the cutoff date be moved back to the date that H.R. 10 passed the House -- May 13, 1998 -- because firms were clearly on notice at that time that Congress intended to close this loophole. We do not believe that those firms which have applied for a unitary charter in the interim should be permitted to take advantage of the commercial loophole. As noted above, however, we do not begrudge the legitimate concerns of those commercial firms who acquired thrifts, often at the federal government's behest, during the S&L crisis.

Federal Home Loan Banks

3. Federal Home Loan Bank Reforms. IBAA believes that any financial modernization bill must include provisions for meeting the funding and liquidity needs of institutions that serve local markets and communities, but don't have access to capital markets. Last year, the Committee included Federal Home Loan Bank System reform language meeting this test, and we urge you to add similar provisions now under discussion in the staff draft to the bill this year. We want to thank Senators Hagel and Bayh for their expected introduction of legislation on this issue. In particular, I want to commend my home state Senator for his tireless work on this critical issue during the last several years.

Community banks are under enormous competitive pressures for core deposits from mutual funds and other non-bank investment instruments. In light of the increased difficulties of attracting and maintaining their core deposit base, community banks need a reliable source of funds to meet the credit demands of the communities they serve. Community banks need the type of long-term funds that the Federal Home Loan Bank System can provide to match long-term lending needs.

Thousands of community banks have joined a Federal Home Loan Bank, but others have been unable to do so because they cannot meet the current System membership test requiring at least ten percent of assets to be mortgage-related. Additionally, many community banks do not have sufficient eligible collateral to support the System's advance requirements. Language granting automatic eligibility to institutions with $500 million or less in assets and expanding the collateral base to pledge against advances to include agricultural and small business loans would be an important step to long-term community bank viability.

Insurance Provisions

4. Non-Discriminatory Insurance Language. Any financial restructuring bill should include new retail powers for banks, including, within the parameters of safety and soundness, unrestricted insurance agency powers and the power to sell mutual funds and other financial products and services, including annuities. Such retail sales authority presents little risk and we see no reason why it shouldn't be exercised either through a holding company affiliate or an operating subsidiary of a bank.

While we are still analyzing the insurance-related provisions in the staff draft, we are pleased that the so-called "13 safe harbors" have been removed from last year's Committee-reported bill. We believe that any roll back of an existing insurance-related authority of banks, whether chartered at the federal or state level, is anti-competitive and would reduce choice for consumers.

We are concerned, however, that the staff draft doesn't preserve the judicial deference of the OCC in interpreting the insurance sales authority of national banks under the National Bank Act, almost assuring a series of protracted court battles which are not in the interest of community banks.

Protecting the Deposit Insurance Fund

5. Protecting the Federal Deposit Insurance Fund. Our future regulatory and supervisory structure must be designed to insure that the FDIC's deposit insurance funds are protected from being utilized should a huge financial conglomerate collapse. As referenced at the beginning of my testimony, we believe this proposal would lead to the emergence of large financial conglomerates including, for example, a large commercial bank and a firm underwriting property and casualty insurance -- a very risky business. If the property and casualty firm were to fail, it would negatively impact the financial condition of the parent. In that case, it would be imperative that there be maximum insulation of the insurance firm from the federal safety net unique to banks, including deposit insurance. We are concerned that such insulation can never be complete.

We recognize and appreciate the genuine attempt at compromise in your proposal, Mr. Chairman, by prohibiting such conglomerates from conducting activities in operating subsidiaries not currently permissible for national banks to engage in directly, while allowing banks under $1 billion in assets to conduct any activity except real estate development in an operating subsidiary. At this point in time, our policy bodies have not yet had the opportunity to review the proposed compromise. It is unlikely, however, that many banks under $1 billion in assets would have an interest in securities or insurance underwriting, or merchant banking. We would also observe that the intellectual argument used to support the restriction on large banks could also apply to small banks.

We also question the argument that sufficient firewalls can be erected to protect insured deposits. In hearings on financial modernization last year, this Committee heard ample testimony questioning the efficacy of firewalls. Even Chairman Greenspan has warned against placing too much faith in firewalls, testifying in 1995 that "under stress they tend to melt."

In testimony earlier this month before the House Banking Committee, Chairman Greenspan reminded the Committee that the rapid loss of capital in First Options, a wholly owned subsidiary of Continental Illinois, contributed to the 1984 failure and eventual bail-out of that financial institution. Chairman Greenspan said he was convinced that the operating subsidiary structure posed significant safety and soundness concerns and a threat to the deposit insurance fund. The SEC also testified in opposition to the op sub structure.

We believe it is crucial to protect the FDIC fund from risky non-bank activities conducted by financial conglomerates. Accordingly, we have supported language that would prohibit bank subsidiaries, regardless of the size of the bank, from engaging in activities or to own an interest in a company that engages in activities not permissible for national banks to engage in directly, such as insurance or securities underwriting, real estate investment activities, or merchant banking.

Umbrella Regulator

6. Role of the Federal Reserve. The IBAA strongly supports the establishment of an umbrella regulator for diversified financial services firms and feel the only federal regulator equipped for this job is the Federal Reserve. The staff draft meets this important test, with the exception of the regulation and supervision of unitary thrift holding companies. A unitary with a commercial affiliate would be considered a diversified financial firm that would warrant Fed oversight because of its complexity and risk to the financial system.

Consumer Regulations

7. Insuring Even-Handed Consumer Regulations. IBAA believes that the level of regulation should be commensurate with the risk institutions present to the financial system and the economy. Consumer protection regulation, in turn, should be even-handed and either lifted for all or applied to all, since it represents a competitive cost factor.

The staff draft requires the federal banking agencies to prescribe customer protection regulations that apply to retail sales practices, solicitations, advertising or offers of any insurance product by any insured depository institution or any person so engaged on the premises of the institution. This section appears to codify the existing anti-tying laws and the Interagency Statement as they are applicable to bank insurance sales. We question whether it is necessary to codify this law and guidance because insured depository institutions are already subject to these restrictions.

Before concluding, Mr. Chairman, I want to make some brief observations on CRA. I run a $18 million bank serving a small, agricultural community. As you know, there are hundreds of similar banks in Texas. We all have to deal with CRA -- and the costs of CRA compliance are disproportionately high for small banks. My main competitors are credit unions and the Farm Credit System, neither of which needs to worry at all about CRA. My competitive position will be hurt if I continue to remain under CRA and my competitors are not. More significantly, there is no guarantee that the large financial conglomerates moving into Main Street America share community-banker commitment to lending within these communities, or that branches of these conglomerates would ever see a CRA examiner. That is not fair.


We believe significant strides have been made over the last year, strides that led to an important change in IBAA's position on financial modernization last fall. The banking industry worked hard to help move last year's bill through the Committee and the Senate -- a remarkable change of position given the fact that just a few months earlier a united banking lobby came within one vote of defeating H.R. 10 on the House floor. We would like to again support moving a bill through your Committee, but the staff draft falls considerably short of meeting the standards established by IBAA policy bodies.

Mr. Chairman, we look forward to working with you and others on the Committee to develop a product that can meet the principles that we have outlined in our testimony.

Thank you for the opportunity to testify today.

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