Chairman D'Amato, Senator Dodd, and Members of the Committee:
It gives me great pleasure to testify on behalf of the Securities and Exchange Commission ("Commission") regarding H.R. 10, the Financial Services Act of 1998, which was passed by the House of Representatives on May 13, 1998, and subsequently referred to the Senate for your consideration. I thank you, Chairman D'Amato, for holding this hearing early in the Senate's consideration of H.R. 10, and for requesting the Commission's views on this bill.
I. Overview
Glass-Steagall reform is a significant issue that has defied consensus for almost two decades. During this session, the members of the House of Representatives, and in particular of the House Banking and Commerce Committees, have worked hard to produce a compromise bill that is carefully balanced to allow a stronger and more progressive financial services industry. The drafters of H.R. 10 put great effort into crafting a bill out of several earlier bills that took very different approaches. The bill before you not only opens up opportunities for our nation's banks, but also provides significant protections for investors, and strives for a level playing field for all financial market participants, including securities firms.
The delicate balance inherent in H.R. 10 is key to the Commission's support. From the Commission's perspective, H.R. 10 cannot be viewed simply as a banking bill that will provide banks with greater flexibility and new avenues for innovation. In fact, H.R. 10 will profoundly affect the way that securities activities are conducted, and the way that investors are protected, in the decades to come. The Commission urges this Committee, therefore, as the debate on financial reform moves forward, to consider carefully the impact this legislation will have on investors as well as on the U.S. capital markets as a whole.
Today, our nation's capital markets are in a period of exuberant growth. In 1997 alone, businesses raised approximately $1.6 trillion from investors, through the entrepreneurial and risk-taking efforts of securities firms, without the benefits of federal deposit insurance.(1) We are moving from a nation of savers to a nation of investors: American families today are putting more of their savings in mutual funds than in insured bank accounts.(2) The success of our capital markets requires that we preserve the securities industry's ability to assume risks -- and even to fail. At the same time, it is essential to maintain a strong system of investor protection to support public confidence in the securities markets.
To maintain the Commission's support for H.R. 10, the Senate version must continue to strike an appropriate balance. We urge the Committee to preserve what we believe are crucial components in the bill. Specifically:
Investor Protection. The Commission strongly believes that investors should receive the same level of protection whether they deal with banks or securities firms. H.R. 10 contains "functional regulation" provisions that are designed to make many bank securities activities -- especially those aimed at retail investors -- subject to the important investor protections contained in the federal securities laws. At the same time, banks are permitted to continue to engage in significant securities activities that are associated with traditional banking functions.
A Competitive "Two-Way Street." The Commission believes that opportunities for competition and market participation should be provided to banks and securities firms alike. In its version of the "two-way street," H.R. 10 permits banks to own and affiliate with securities firms, but also permits securities firms to access banking functions through uninsured banks called "Wholesale Financial Institutions," or "WFIs."
Market Discipline -- not Safety and Soundness Regulation -- for Securities Firms. The Commission believes that financial modernization legislation must take into account the real differences between the securities and banking industries. Securities firms need to engage in risk-taking and entrepreneurial activities without taking on restrictive banking-style regulation that focuses on bank safety and soundness. H.R. 10 acknowledges that the functional regulator of an affiliate will oversee the affiliate's day-to-day business operations, and limits the intrusive banking-style oversight by the overall holding company regulator. (These are referred to as the "Fed lite" provisions.)
In addition, the Commission would like to draw one provision to the Committee's attention that was apparently dropped from H.R. 10 for non-substantive reasons. Specifically, the Commission has advocated, with support from Chairman Alan Greenspan of the Board of Governors of the Federal Reserve ("Federal Reserve Board"),(3) that financial services firms primarily engaged in securities activities, with a small uninsured banking component in their overall services, would be more appropriately regulated under the more flexible market-oriented provisions of the federal securities laws than the intrusive, "top down" banking system of safety and soundness regulation. Towards that end, the two agencies collaborated in developing a "small wholesale financial institution holding company model," which was included in the House Commerce Committee version of H.R. 10. Notwithstanding the "Fed lite" provisions contained in H.R. 10, the Commission remains concerned that consolidated banking oversight aimed at ensuring bank safety and soundness could inhibit the entrepreneurial spirit that has driven the exceptional growth in the securities industry. The Commission believes that the restoration of the small wholesale financial institution holding company model to H.R. 10 will strengthen H.R. 10's "two-way street" and help ensure the continued vitality of the securities markets.(4)
This Committee has the opportunity to build on the efforts of the House of Representatives over the past year, and enact a bill that provides an intelligent blueprint for regulation of financial services in the coming years. The Commission supports H.R. 10 because it strikes an appropriate balance: it provides flexibility to encourage future innovation by banking and securities firms, and at the same time preserves core investor protections and concepts of market integrity that have been enshrined in the federal securities laws for the past 65 years.
The remainder of this testimony comments in greater detail on specific provisions of H.R. 10 of interest to the Commission.
II. Functional Regulation
A. Bank Securities Activities: Historical Background
Today, a bank may engage in securities activities with customers ranging from sophisticated institutional clients to elderly, retired couples on a pension. In fact, a bank is as likely as a broker-dealer to sell securities to a first-time investor. And banks increasingly advise, sponsor, and sell mutual funds.
An investor who purchases securities from a bank does so, however, without receiving the same investor protections as a customer who buys the same security from a broker-dealer. This is due to a historical anomaly. When Congress enacted the Securities Exchange Act in 1934, just a year after the Glass-Steagall Act, it excluded banks from the securities regulatory schemes for broker-dealers (as well as for investment advisers) on the grounds that bank securities activities were tightly circumscribed by the Glass-Steagall Act.(5) Although that presumption may have been warranted at the time, it is no longer valid. Expansive interpretations of the Glass-Steagall Act by federal banking regulators have permitted banks to engage directly in a wide range of securities activities, and today they compete directly and aggressively with securities firms for customers and business.
In the mid-1970's, the Senate Banking Committee was among the first to recognize the issues raised by the growing participation of banks in the securities markets, and the disparities between securities regulation and the bank regulatory scheme applicable to bank securities activities. Unlike the federal securities laws, banking laws contain no investor protection mandate, and the Committee questioned whether there was a bank regulatory scheme in place that would appropriately govern the conduct of bank securities sales. Thus, in 1977, this Committee requested that the Commission study and analyze the disparities between the banking and securities regulatory scheme.
In its comprehensive Bank Study,(6) the Commission concluded that bank securities customers lacked important investor protections and recommended the enactment of legislation that would require the promulgation of specific rules governing the conduct of banks engaged in securities activities, with a mandate to provide investor protection. Notably, because bank securities activities were far less extensive in 1977 than they are today, the Commission did not recommend full securities regulation for banks engaging in securities activities.
In response to the Bank Study, the federal banking regulators indicated that they could adopt the necessary regulations without a Congressional mandate. However, the regulations ultimately adopted contained only limited recordkeeping and confirmation requirements for securities transactions.(7) Neither sales practice regulations nor employee training requirements -- or other recommendations of the Bank Study -- have been implemented as of today.(8)
Since 1977, banks (directly or through subsidiaries or affiliates) have been permitted to engage in an ever-growing panoply of securities activities. They include:
Most recently, the announced merger between Travelers and Citicorp -- which would create the world's largest financial services concern, and the most diverse set of financial businesses under one roof in America since before the Depression -- demonstrated how anachronistic the Glass-Steagall Act has become. Yet, the statutory framework governing bank securities activities, enacted over 60 years ago, has not changed.
Today in 1998, even with these expanded bank securities activities, there are still no enforceable banking rules that protect investors who purchase securities from banks. The significant differences between banking and securities regulation include:
Banking statutes and rules neither comprehensively address sales practice issues nor impose express duties to supervise bank securities sales personnel;(9)
Bank employees who sell securities and their supervisors are not subject to equivalent qualification and continuing education requirements applicable under the securities laws;(10)
Banking statutes do not provide private rights of action,(11) and bank securities customers have no forum for grievances comparable to the Commission's supervised arbitration forum available to customers of securities firms; and
Bank regulators' disciplinary actions are not fully disclosed, depriving bank customers of basic information with which to protect themselves.(12)
Even if rules that apply to banks selling securities were today equivalent to the securities regulatory scheme, it is critical how these rules are monitored and enforced. Furthermore, the securities regulatory scheme is dynamic: an equivalent bank securities structure would inevitably lag behind, or permanently differ from, the developing securities requirements.(13)
The Commission believes that the time is long overdue for Congress to adopt a system of functional regulation for all participants in the securities markets. Banks are now full players in the securities markets -- their involvement in securities activities is no longer incidental or sporadic. Under functional regulation, all securities market participants will be subject to a single set of standards, consistently applied by an expert regulator. This is important to provide consistent investor protections to all investors. Functional regulation also promotes competition based on market performance, rather than differences in firms' charters. Finally, as the regulator charged with oversight of the securities markets, the Commission needs functional regulation to have a comprehensive view of the market and participants in it.
H.R. 10 contains a scheme of functional regulation that the Commission can support. Although the Commission would craft fewer and narrower provisions if it were drafting H.R. 10, in the interest of progress on financial reform we support H.R. 10, including its functional regulation provisions.
B. Bank Broker-Dealers
As noted above, the federal securities laws contain statutory exemptions for banks from the definitions of "broker,"(14) and "dealer,"(15) thereby exempting banks from the securities regulatory schemes applicable to broker-dealers. H.R. 10 eliminates these blanket statutory exemptions found in the Securities Exchange Act. This has the effect of bringing bank securities activities under the securities regulatory schemes for brokers and dealers unless otherwise specifically excepted under the bill.
H.R. 10 then goes on to include numerous exceptions for specifically described bank securities activities. Many of these are associated with "traditional" banking functions that also have a securities component. The bill developed in the House of Representatives is the result of significant compromises between interested parties to this debate. In particular, the Commission has made significant concessions in order to meet the concerns of the banking industry. As currently formulated, the functional regulation provisions are targeted to bring within the ambit of the securities laws many bank securities activities directed at the retail public, where the need for investor protections is the greatest. As described in greater detail below, the Commission thinks that H.R. 10's functional regulation provisions should increase investor protection. However, the Commission strongly believes that these provisions can not endure further compromise if Congress intends to keep investor protection a priority.
One specific exemption -- for so-called "traditional banking products" -- is of particular concern to the Commission. An early version of H.R. 10 would have exempted from securities regulation all transactions in "banking products," as that term would have been defined by banking regulators. The Commission has no objection to clarifying the status of traditional, non-securities banking products that have never been thought to be subject to broker-dealer regulation (e.g., bank deposits and letters of credit). However, we object to an open-ended exemption for sales of "banking products" that could have permitted any products sold by banks -- even IBM stock -- to be purchased by investors without the protections of the securities laws. H.R. 10 contains a finely-balanced compromise on this issue, more fully described below, that (i) exempts certain "traditional banking products" that have not been regulated as securities from broker-dealer regulation, and (ii) requires the Commission to engage in a rulemaking process, in consultation with the bank regulators, if it seeks to regulate a new securities product that is sold by banks as a security under the Exchange Act -- subject to the securities investor protections provided by broker-dealer regulation.
Some of the more significant exceptions contained in H.R. 10 for bank securities activities are discussed below.
1. Trust Activities
Americans have entrusted the futures of their families to bank trust departments for many years. Traditionally, these departments have functioned at the highest levels of responsibility: those of trustees.(16) Over time, various other functions were added to bank trust departments that were not subject to strict trust standards. For example, some banks engaged in discount brokerage and "managing agency" accounts in their trust departments, but these activities were not subject to the same strict fiduciary standards as bank trust activities. H.R. 10 ensures that a bank trust department could continue to effect transactions in a trustee or fiduciary capacity without being considered a broker or dealer under the federal securities laws, provided that:
The activities in the bank trust department are subject to, and regularly examined by a bank regulator for compliance with, fiduciary principles and standards; and
Compensation to the bank is primarily an annual fee, a percentage of assets under management, or both, but is not brokerage commissions exceeding the bank's execution costs.
Early versions of H.R. 10 sought to recognize this important, traditional banking activity, but were drafted so broadly that they appeared to permit banks to operate full-service brokerage departments technically housed in trust departments but not subject to bank trust law restrictions. This greatly concerned the Commission, because, without either bank trust law restrictions or federal securities regulation, investor protection could not effectively be monitored. The Commission supports the provisions of H.R. 10, which require rigorous, focused examinations by bank trust examiners of bank fiduciary activities that are excepted from federal securities regulation. The Commission considers this important to protecting the investors who rely on bank trust departments.
Earlier versions of H.R. 10 also would have permitted bank employees to receive brokerage commissions for transactions effected for trust and fiduciary customers. Commissions give a person selling securities a "salesman's stake" in the transaction, and increase the risk that the seller will promote securities that generate larger commissions, but may not be appropriate for customers. Federal securities regulation constrains such behavior.
If trustees and fiduciaries can earn sales commissions without any overlay of federal securities regulation, customers are not protected from sales incentives. For this reason the Commission believes it is appropriate to limit brokerage commissions to the bank's execution costs.(17) The exception for trust and fiduciary activities will still allow bank trustees and fiduciaries to benefit from the still very lucrative fees for assets under management and/or annual fees.
2. Municipal Revenue Bonds
Under current law, banks are expressly permitted to underwrite general obligation municipal bonds, but there is no similar provision for municipal revenue bonds. Combined with the bank underwriting restrictions in the Glass-Steagall Act, this has the effect of prohibiting banks from underwriting municipal revenue bonds. H.R. 10 would permit well-capitalized banks to underwrite municipal revenue bonds pursuant to the regulatory structure already in place under Section 15B of the Securities Exchange Act for bank municipal securities activities. The Commission considers this a sensible approach to addressing a historical anomaly in the Glass-Steagall Act.
3. Private Placements of Securities and Sale of Asset-Backed Securities
Private placements of securities and sales of asset-backed securities have become an extremely lucrative business for banks and securities firms. Indeed, in 1998, banks and bank affiliated broker-dealers were among the most active private placement agents in the United States.(18) Banks also control a substantial amount of the business of selling asset-backed securities.
Bank regulators have permitted banks to engage in these activities because they believe that, as agency activities, private placements(19) pose minimal risk to a bank. Similarly, sales of asset-backed securities(20) increase the quality of a bank's balance sheet and thereby strengthen the bank. Banking regulators have not, however, weighed equally the risk to investors who buy these securities through banks. Asset-backed securities can be complex and hard for investors to understand. Moreover, the Commission has brought a number of enforcement actions for sales practice abuses in connection with the sales of these kind of securities.(21)
A bank acting as private placement agent or selling asset-backed securities presently is not regulated as a broker-dealer and therefore is not subject to the regulations that provide protection to investors. The Commission has had strong concerns that any statutory exemption for bank sales of privately placed securities or asset-backed securities must limit the customers with whom banks engage in the business to truly sophisticated investors. H.R. 10 limits these activities to "qualified investors" -- institutional investors, market professionals, and individuals and corporations with at least $10 million in assets invested in securities.
The private placement and asset-backed securities provisions contained in H.R. 10 represent other significant compromises that reduce the Commission's concerns. Specifically, H.R. 10 requires banks that have securities affiliates to move their private placement activity into these affiliates -- which would put larger banks on a more level competitive playing field with registered broker-dealers. Moreover, asset-backed securities sold by a bank must consist predominantly of bank assets. Otherwise, banks could easily undermine the exception -- and simply purchase assets that then are securitized and sold off to others -- the equivalent of pure "dealing" activity.
The Commission has ongoing concerns with these exceptions, however. Generally, the Commission could not support a bill that (i) permitted banks with securities affiliates to engage in private placement activities; or (ii) permitted banks to act as dealers in a full range of asset-securitization activity. Nor could the Commission support legislation that further liberalized the definition of "qualified investor." The Commission would consider such changes detrimental to investor protection. In particular, the Commission would view with concern the ability of banks to privately place securities, or sell asset-backed securities, to retail customers.
4. Derivatives
H.R. 10 takes a sensible approach to regulation of sales of derivatives products. Today, banks and other non-securities firms effect transactions in a wide range of derivatives products that are not and would not likely ever be deemed securities.(22) The bill allows banks to continue dealing in many derivatives, whether or not individually negotiated, as traditional banking products.
H.R. 10 also acknowledges, however, that certain derivative products, such as options on securities, are securities, and others, such as "forward" contracts, may involve the purchase or sales of securities to be settled in the future. The bill therefore requires that banks' securities derivatives transactions with retail-type investors (e.g., individuals and small corporations) be effected through registered broker-dealers if the derivatives are securities (other than government securities). This approach permits banks to effect transactions in securities derivatives products directly with more sophisticated "qualified investors," while providing the investor protections of the federal securities laws when banks effect derivative securities transactions with less sophisticated investors. It also requires all transactions that provide for physical delivery of securities (other than a derivative instrument or government security) to be effected through a registered broker-dealer. Otherwise, the securities regulatory scheme could be easily undermined.
The Commission supports the approach the bill takes to regulation of sales of derivatives that are securities.
5. Banking Products
As noted above, the Commission expressed strong objections to a proposed open-ended exception from broker-dealer regulation for sales by banks of so-called "banking products." This exception was viewed by the Commission as a "kitchen sink" exception that created a loophole through which banking regulators effectively could except from securities regulation virtually any bank securities activity.
H.R. 10 now includes a compromise exception that satisfactorily addresses the Commission's concerns. The exception refers to "traditional banking product," not the broader term "banking product."(23) The bill attempts to preserve the Commission's ability to determine what is a "security" under the federal securities laws by putting what is not regulated as a security for the purposes of the functional regulation provisions in a stand-alone statute -- rather than in either the federal securities laws or banking laws. Furthermore, H.R. 10 no longer authorizes the banking regulators to override a Commission determination that a product is a security that should be sold pursuant to the federal securities laws.
In addition, H.R. 10 satisfactorily resolves fears voiced by the banking industry that the Commission not opine on whether a new banking product is a "security" for the first time in the context of an enforcement action. It requires the Commission to determine through a formal rulemaking process that a product is a security before the Commission requires a bank to sell the product in compliance with the broker-dealer regulatory provisions of the federal securities laws. During that process, the Commission is directed to consider a product's characteristics, the effects on investors, and to consider the effects of the product on competition and capital formation. In addition, the Commission is required to consult with and consider the view of the banking agencies concerning the proposed rules.
6. De Minimis Exception
The de minimis exception contained in H.R. 10 would permit a bank to effect up to 500 securities transactions (in addition to other excepted bank activities). The exemption is intended to permit banks to engage in a small number of brokerage activities without registration. Notably, a 1995 General Accounting Office study found that the majority of banks that sell securities directly to the public effect fewer than 25 securities transactions in a month, or 300 per year.(24) The Commission believes that this exception should be particularly useful for small banks.
7. Bank Consumer Protection Provisions
At the behest of numerous consumer groups, H.R. 10 includes a substantial range of consumer protection provisions to cover bank securities activities that are excepted from regulation under the federal securities laws.(25)
The Commission supports these provisions that provide a degree of investor protection for retail customers of banks. Having said that, we are concerned that these provisions establish a "separate but equal" regulatory system for identical activities -- an approach that will surely perpetuate disparities between the bank and securities regulatory schemes. The Commission notes that this approach has not been truly successful in the 12(i) context.(26) While Congress is right in seeking to protect investors regarding the securities activities conducted in a bank, this approach is not a workable alternative when banks publicly solicit customers or compete with regulated broker-dealers.
8. Bank Compliance with the Conditions of the Exceptions
The Commission notes that H.R. 10 has incorporated a very sensible provision from the House Commerce Committee draft bill. Specifically, bank regulators must establish recordkeeping requirements for banks that rely on the exceptions to the definitions of "broker" and "dealer" created by H.R. 10. Records kept pursuant to the requirements should be sufficient to demonstrate compliance with the exceptions. The Commission may request these records to review a bank's compliance with the exceptions' conditions.
This provision of H.R. 10 affirms that this Congress is serious about providing investor protection, even when activities are excepted from federal securities regulation. Without this monitoring provision, the new exceptions could be interpreted so broadly by banks as to vitiate the functional regulation provisions completely. The Commission therefore endorses this provision of H.R. 10.
C. Bank Investment Advisory Activities and Other Issues Related to Investment Companies
H.R. 10 also introduces functional regulation in the area of bank investment advisory services to mutual funds. Today, banks participate in the mutual fund industry at a level, and in roles, not imaginable 20 years ago. Banks have affiliated mutual funds, directly advise mutual funds, and provide a wide range of other services to mutual funds. The importance of mutual funds has also grown. More than 65 million people (representing over 37% of U.S. households) own mutual funds.(27) The mutual fund industry accounts for 16% of total retirement assets, and almost 40% of 401(k) assets.(28) Investor protection should remain a significant concern as laws are reshaped to govern the relationship of banks and mutual funds.
The functional regulation provisions applicable to bank mutual fund activities are strongly supported by the Commission. We believe that they will promote investor protection and fairness in the mutual fund industry. These provisions are not controversial, and we hope that they will soon become the law of the land.
1. Bank Investment Advisers
Like the definitions of "broker" and "dealer" in the Securities Exchange Act, the definition of "investment adviser" in the Investment Advisers Act of 1940 ("Advisers Act") presently includes a blanket exemption for banks that act as investment advisers.(29) As a result, banks that act as investment advisers are not subject to a number of substantive requirements of the Advisers Act applicable to registered investment advisers, including regulation of performance fees, procedures to prevent misuse of non-public information, and the anti-fraud provisions.
H.R. 10 narrows the blanket exemption in the definition of "investment adviser" so that it no longer covers banks that advise investment companies. Under H.R. 10, when a bank advises an investment company, either the bank, or a separately identifiable department of the bank, must register as an investment adviser and become subject to all applicable requirements under the Advisers Act.(30) This is especially important for the protection of investors because of the crucial role that mutual funds have assumed in the finances of millions of Americans. Notably, since 1990, the number of dollars directed into mutual funds now exceeds the total number of dollars saved by U.S. households.(31)
As banks increasingly advise mutual funds, the Commission has grown concerned that its examiners do not have ready access to information regarding bank advisory activities that could affect the bank's affiliated mutual funds. The Commission therefore supports provisions in H.R. 10 that would provide it with access to the books and records of bank advisers, as well as provisions that would permit it to obtain bank examination reports of bank investment advisers that advise mutual funds.
2. Bank Conflicts of Interest
Finally, H.R. 10 amends the Investment Company Act of 1940 to address for the first time the unique conflicts of interest that are raised by increased bank involvement in the mutual fund business. The bill contains a number of helpful provisions that target such conflicts of interest. For example, H.R. 10 would, among other things, prohibit a bank affiliated with a registered investment company, and any affiliated person of such bank, from lending money to such investment company in contravention of any rules and regulations that the Commission may adopt.
H.R. 10 generally does not prohibit, or mandate specific regulations pertaining to, such conflicts. Instead, it authorizes the Commission to engage in rulemaking in the event that the Commission determines that rulemaking is appropriate. The Commission appreciates this measured approach, and intends to use the authority given only in the event that a need arises, as contemplated by the bill.
III. The "Two-Way Street"
The Commission long has advocated that any legislation to modernize regulation of financial services must create a "two-way street" to ensure that all financial service firms, not only banks, benefit from the modernization. This simply means that if banks can acquire securities firms, securities firms should be permitted to acquire banks.
If legislation paving the way for a "two-way street" is not enacted, securities firms will find themselves at the wrong end of a "one-way street." This is because interpretations by banking regulators have given banks and bank holding companies the ability to own securities operating subsidiaries and affiliates -- options with no corresponding parallel for securities firms. As a result, banks currently can acquire securities firms, but securities firms with a wide range of investment activities cannot acquire a bank without eliminating businesses and undergoing a vastly different form of supervision.
H.R. 10 moves substantially toward a two-way street. Elimination of the Glass-Steagall Act provisions removes the statutory impediment to bank ownership of securities firms. At the same time, H.R. 10 provides securities firms with access to banking functions by permitting them to acquire a wholesale financial institution or "WFI." A WFI is a new kind of bank that can only accept deposits in excess of $100,000 and the deposits of which are not insured by the FDIC. These limited-purpose entities must be well-capitalized and well-managed, and otherwise would be fully subject to banking regulation. A securities firm with an affiliated WFI could provide a full range of banking services to its customers, so long as the deposit size limitation is satisfied.
A securities firm that acquires a WFI would become a "wholesale financial holding company," subject to a more limited bank holding company structure, and with the ability to continue a range of commercial affiliations. Although the Commission does not favor consolidated bank-style supervision of securities firms, the Commission respects the balance contained in H.R. 10, which would not require full holding company regulation of wholesale financial holding companies.
IV. Limitations on Bank Holding Company Regulation
The Commission has serious concerns regarding the application of the existing "top-down" regulatory model of the Bank Holding Company Act to securities firms that become affiliated with banks. The Bank Holding Company Act currently provides for comprehensive regulation of all activities in holding company affiliates, with the ultimate goal of ensuring that the affiliates' activities do not threaten the safety and soundness of affiliated banks. As a practical matter, this means that the business of securities firms would come under a system requiring extensive regulatory approvals by the Federal Reserve Board before new businesses could be commenced or acquired. This traditional model of holding company regulation has never applied to securities holding companies, and would constitute a radical change in their regulatory supervision.
At present, securities firms and the securities markets as a whole specialize in entrepreneurial and risk-taking activities. Securities firms compete vigorously in new lines of business and fast-moving markets. It is through taking on market risks that securities firms are able to serve as a powerful engine for U.S. capital formation. Securities regulation does not seek to prevent securities firms from taking on risks; instead, it relies on a combination of disclosure, market discipline, and carefully tailored requirements designed to protect investors and maintain fair and orderly markets. Under the market discipline imposed by the federal securities laws, securities firms can and do fail -- and the Commission believes that this philosophy has served our markets well. Prior notice and approval requirements, limits on business activities, and similar safety and soundness requirements embedded in the Bank Holding Company Act, will create significant obstacles for securities firms used to competing in a rapidly changing, market-oriented environment.
The Commission acknowledges that banking regulators have an important obligation to this nation to ensure the safety and soundness of our banking system. However, it would be misguided to seek to control these risks by imposing an overlay of safety and soundness regulation on bank securities affiliates. Safety and soundness regulation should be strictly applied to banks. Any risk of bank "contagion" from its affiliates should be addressed through true separation between a bank and its affiliates, interaffiliate restrictions imposed on the bank, and a strong system of functional regulation for the affiliate.
The Commission believes that H.R. 10 moves in the right direction by reducing the burden of Federal Reserve Board oversight of holding companies with well-capitalized banks, including, as noted above, wholesale financial institutions. In the Commission's view, even this modified bank holding company oversight is not the most appropriate form of oversight for holding companies that primarily engage in, and derive revenue from, securities activities. The Commission remains concerned that bank safety and soundness regulation could easily stifle the risk-taking activities that make securities firms vibrant, independent competitors.
The Commission has, in previous testimony, suggested that a financial services holding company that includes a bank should be overseen by the regulator with responsibility for the activities that comprise the bulk of the holding company's activities.(32) Under this model, a holding company with revenues generated primarily by securities activities would be overseen primarily by the Commission, even if the holding company included a bank. Consistent with functional regulation, each subsidiary would be regulated by the appropriate regulator, so that any bank would be regulated directly by the appropriate banking regulator.
The Commission worked cooperatively with the Federal Reserve Board to develop a "broker-dealer holding company model" that was included in the House Commerce Committee draft of H.R. 10. If the Committee considers possible changes to the House version of H.R. 10, the Commission urges you to consider this model, which was endorsed by Federal Reserve Chairman Alan Greenspan.(33) Notably, this model would have preserved for the Federal Reserve Board "back-up" examination and enforcement authority for broker-dealer holding companies, without imposing the full panoply of bank safety and soundness regulation on securities firms.
The Commission notes that H.R. 10 would allow independent securities firms (without bank affiliates) to elect to subject their holding companies to a global form of oversight by the Commission. Securities firms in the United States increasingly conduct a world-wide business. We understand that foreign regulators have indicated an interest in a central authority overseeing the global activities of U.S. securities firms. At present, independent U.S. securities firms must acquire a bank to obtain this form of consolidated oversight. H.R. 10 would permit U.S. securities firms an alternative to becoming bank holding companies, permitting them to operate under Commission oversight. The Commission expects that its oversight will be based more on the risk assessment model that is currently used under the Exchange Act to provide the Commission with risk information regarding a broker-dealer's affiliates. Significantly, unlike the bank holding company model, the risk assessment model does not require the preapproval of business activities. The Commission supports this provision.
V. Commercial Activities
The Commission understands that the mixing of banking and commerce is a difficult issue from the banking perspective, and respects the arguments for a cautious approach. Under H.R. 10, financial holding companies could expressly engage in merchant banking activities through their registered broker-dealer affiliates. The bill prohibits other commercial activities after an extended "phase-out" period of 10 to 15 years. In theory, at least, Congress will have a 10 to 15 year period to observe whether the problems envisioned by commercial affiliations come to fruition. If problems have not arisen during that time, Congress can revisit this issue to determine whether to allow some mix of commercial and banking activities in a holding company structure.
VI. Conclusion
The Commission has testified many times during the past decade in support of financial modernization legislation.(34) In the debate surrounding this issue, the Commission's primary concern has been investor protection. H.R. 10 represents a significant step forward towards eliminating the statutory obstacles that have created the present inconsistencies in financial services regulation.
The compromises reflected in H.R. 10 recognize that modernization of financial services regulation is not only a "banking" issue. The bill that ultimately becomes law will change the face of the securities industry as profoundly as it changes the face of banking and insurance. For this reason, although the Commission would craft certain provisions differently if it were drafting H.R. 10, we think that the bill moves toward addressing functional regulation and the inherent differences between banking and securities regulation. For this reason, as the regulator responsible for protecting investors and the integrity of the securities markets, the Commission supports H.R. 10.
We thank you for offering us the opportunity to appear here today, and to provide our thoughts
for your consideration. The Commission and its staff stand ready to provide the Committee with
assistance as the financial modernization debate continues.
1. This figure includes firm commitment public offerings and private placements, and does not include best efforts underwritings. (Securities Data Company).
2. As of February 28, 1998, mutual fund assets totalled $4.8 trillion and insured commercial bank deposits totalled $2.8 trillion. See Investment Company Institute; May, 1998, Federal Reserve Bulletin, Table 1.21, Money Stock, Liquid Assets, and Debt Measures, at A13.
3. Hearing on Financial Modernization Before the House Comm. on Banking and Financial Services (May 22, 1997). See also Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Regarding H.R. 268, "The Depository Institution Affiliation and Thrift Conversion Act," Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 13, 1997).
4. Notably, H.R. 10 retains a broker-dealer holding company amendment to the Securities Exchange Act of 1934 ("Exchange Act") that should facilitate the international competitiveness of broker-dealers that do not affiliate with banks or WFIs. See text at pp. 31-32.
5. See Stock Exchange Regulation: Hearings on H.R. 7852 and H.R. 8720 Before the House Comm. on Interstate and Foreign Commerce, 73d Cong. 82, 86 (Feb. 16, 1934) (statement of Thomas Gardiner Corcoran, an administration spokesman and a principal drafter of the Exchange Act). Later the Investment Advisers Act of 1940 ("Advisers Act") also excluded banks and bank holding companies from regulation as investment advisers.
6. See Report on Bank Securities Activities of the Securities and Exchange Commission Pursuant to Section 11A(e) of the Securities Exchange Act of 1934 (Public Law 94-29), Aug. 1977.
7. See, e.g., 12 C.F.R. §§ 12.1-12.9, 12.101-102, 208.24, and 344.1-344.10.
8. The federal banking regulators have issued guidelines that address some bank sales practice issues. See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision, "Interagency Statement on Retail Sales of Nondeposit Investment Products" (Feb. 15, 1994). As the Commission has testified before, while these guidelines represent an important step forward, they are advisory and therefore not legally binding, and may not be legally enforceable by bank regulators. See, e.g., Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning the "Financial Services Competitiveness Act of 1995" and Related Issues, Before the House Comm. on Banking and Financial Services (Mar. 15, 1995).
9. See note 8.
10. The banking regulators have jointly proposed to require very limited testing of bank employees directly involved in selling securities. See Qualification Requirements for Transactions in Certain Securities, 61 Fed. Reg. 68824 (Dec. 30, 1996) (codified at 12 C.F.R. §§ 208, 211, and 342). This proposal, however, would provide only a fraction of the regulation of securities sales that has developed over the years to protect investors. It does not address supervisory testing. It also fails to address supervision of, and enforcement actions against, bank employees who have passed qualifying examinations.
11. See, e.g., In re Fidelity Bank Trust Fee Litigation, 839 F. Supp. 318 (E.D. Pa. 1993), aff'd, 43 F.3d 1461 (3d Cir. 1994); In re Corestates Trust Fee Litigation 837 F. Supp. 104 (E.D. Pa. 1993), aff'd, 39 F.3d 61 (3d Cir. 1994). Banks are subject, however, to the anti-fraud provisions in section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Therefore, bank customers presumably can bring private actions alleging fraud against banks under these provisions. But see Simpson v. Mellon Bank, [1993-94 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,027 (E.D. Pa. Dec. 17, 1993) (the presence of banking regulation precluded reliance by plaintiffs on securities laws in a private action against a trustee bank regarding the legality and reasonableness of fees).
12. The banking agencies are required to "publish and make available to the public" final orders
issued in connection with enforcement proceedings. 12 U.S.C. § 1818(u). The releases usually
do not describe the nature of the violation and the enforcement action taken, however. Rather,
they list enforcement actions, and typically include the docket number, names of the parties
involved, type of action taken, date of the action and whether the action was by consent. The
banking agencies also publish results of enforcement proceedings on their Internet web sites.
The information provided electronically generally is the same information available in the
releases.
In contrast, Commission and self-regulatory organization disciplinary proceedings are aggressively publicized. Commission press releases describe the nature of proceedings and the identities of the parties disciplined. In addition, as mandated by the Exchange Act, the NASD operates an "800" telephone number hotline, which allows investors to obtain information about the disciplinary and civil liability records of broker-dealers' registered representatives.
13. See Michael P. Malloy, The 12(i)'ed Monster: Administration of the Securities Exchange Act of 1934 by the Federal Bank Regulatory Agencies, 19 Hofstra L. Rev. 269, 285 (1990).
14. 15 U.S.C. § 78c(a)(4).
15. 15 U.S.C. § 78c(a)(5).
16. See, e.g., 12 U.S.C. § 92a and 12 C.F.R. pt. 9.
17. This approach is consistent with trust and fiduciary principles, which would frown on a trustee acting with a salesman's stake in a trust transaction.
18. See, Investment Dealers' Digest, p. 15, Table, "Overall Private Placements, Jan. 1, 1997-Dec. 31, 1997," (Mar. 2, 1998).
19. See Federal Reserve Board Staff Study, Commercial Bank Private Placement Activities (1977). See also Propriety of National Bank Private Placement Activity in Light of the Glass-Steagall Act, Office of the Comptroller of the Currency Staff Interpretive Letter No. 32, [1978-1979 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 85,107 (Dec. 9, 1977).
20. See, e.g., National Bank May Underwrite and Deal in Certain Mortgage-Backed Pass-Through Certificates, Office of the Comptroller of the Currency Staff Interpretive Letter No. 257, [1983-1984 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 85,421 (Apr. 12, 1983).
21. See, e.g., In the Matter of Prudential Securities Inc., 51 S.E.C. 726 (Oct. 21, 1993). In this settled action, the Commission alleged that Prudential engaged in fraudulent sales practices and failed reasonably to supervise its personnel regarding the sale of more than 700 limited partnership units and other investments over a ten-year period. Prudential consented to pay a total of over $371 million in claims and fines (including an open-ended claims fund).
22. For instance, foreign currency and interest rate swap contracts, as well as commodity options, regularly are negotiated between non-broker-dealers and other counterparties, and are intermediated by non-broker-dealers without an overlay of federal securities regulation.
23. The bill defines "traditional banking products" to include products that traditionally have not been regulated as securities, such as deposit accounts, letters of credit, credit card debit accounts, certain loan participations and certain derivative instruments.
24. U.S. General Accounting Office, Report to Congressional Requesters: Banks Securities Activities -- Oversight Differs Depending on Activity and Regulator, GAO/GGD-95-214, at 34 (Sept. 1995).
25. Specifically, H.R. 10 requires that banking regulators, in consultation with the Commission, set up procedures for customer grievance proceedings, and that customers have at least six years to make complaints. Furthermore, customers cannot be made to pay for the costs of the proceedings. The bill also requires banking regulators to prescribe regulations governing retail securities transactions by insured banks and their non-broker-dealer affiliates. The bill specifies that these regulations must be substantially similar to the NASD Rules of Fair Practice.
26. Under section 12(i), banking regulators are required to adopt rules "substantially similar" to the Commission's within 60 days after the Commission's publication of its final rules. However, one commentator has noted "final action by the regulators in promulgating 'substantially similar' 1934 Act rules has been delayed in some cases over five years after pertinent SEC amendments have been issued. Failure to meet the deadline mandated by section 12(i) of the 1934 Act has been a uniform feature of the agencies' administration of the 1934 Act." Michael P. Malloy, The 12(i)'ed Monster: Administration of the Securities Exchange Act of 1934 by the Federal Bank Regulatory Agencies, 19 Hofstra L. Rev. 269, 285 (1990).
27. Based on data from the Investment Company Institute, 1998 Mutual Fund Fact Book, at 36, 40.
28. Investment Company Institute, Press Release dated Oct. 14, 1997.
29. Banks are subject, however, to the provisions of the Investment Company Act of 1940 that apply to advisers of investment companies.
30. The Advisers Act generally requires large investment advisers to register with the Commission, file annual reports with the Commission, provide disclosure documents to their clients, make certain books and records, institute and enforce procedures designed to prevent insider trading, and to refrain from engaging in fraudulent conduct.
31. On average, from 1990-1997, for every dollar saved by U.S. households, $1.06 has been invested in mutual funds. See Federal Reserve Flow of Funds, Chart F.9; Investment Company Institute, Mutual Fund Fact Book (various editions).
32. See, e.g., Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Modernization and H.R. 10, "The Financial Services Competition Act of 1997," Before the Subcomm. on Finance and Hazardous Materials of the House Comm. on Commerce (July 17, 1997).
33. Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Regarding H.R. 268, "The Depository Institution Affiliation and Thrift Conversion Act," Before the Subcommittee on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 13, 1997).
34. See, e.g., Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Modernization and H.R. 10, the "Financial Services Competition Act of 1997," Before the Subcomm. on Finance and Hazardous Materials of the House Comm. on Commerce (July 17, 1997); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Modernization, Before the House Comm. on Banking and Financial Services (May 22, 1997); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Regarding H.R. 1062, the "Financial Services Competitiveness Act of 1995," Before the Subcomm. on Telecommunications and Finance and the Subcomm. on Commerce, Trade and Hazardous Materials of the House Comm. on Commerce (June 6, 1995); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning the "Financial Services Competitiveness Act of 1995" and Related Issues, Before the House Comm. on Banking and Financial Services (Mar. 15, 1995); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 3447 and Related Functional Regulation Issues, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (Apr. 14, 1994); Testimony of Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Services Modernization, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (July 11, 1990); Memorandum of the Securities and Exchange Commission (under Chairman David Ruder) to the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, Concerning Financial Services Deregulation and Repeal of the Glass-Steagall Act (Apr. 11, 1988); Testimony of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Structure and Regulation of the Financial Services Industry, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (Oct. 5, 1987).