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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Coordination and Consultation – Strengthening the Partnerships Among Regulators of Financial Institutions After Glass-Steagall Reform

Remarks by

Commissioner Laura S. Unger

U.S. Securities & Exchange Commission

Financial Services Roundtable

May 11, 2000

I. Introduction

I am happy to be here today to talk to you about some of the initiatives currently underway at the Commission that will significantly impact many financial service providers. Before I begin my remarks, I need to state that the views I express are my own and not the official views of the Commission.

Like you all, we’ve got plenty to do in the wake of Glass-Steagall reform. The Gramm-Leach-Bliley ("G-L-B") Act provides the theoretical underpinnings for supervising new financial conglomerates, but not the precise mechanics of the new regulatory framework. This is work that can’t be completed by the Commission and other financial regulators independently and then patched together in a crazy quilt system of regulation. Rather, the Act requires that the Commission work in conjunction with the banking and insurance regulators to design a fine tapestry of financial oversight. This tapestry must reflect effective regulation by the multiple agencies involved, yet not over- regulation.

Aside from implementing the G-L-B Act, I also want to update you on some of the SEC accounting initiatives that will affect financial institutions. Four "buzz words" would sum up the theme of my discussion about efforts to regulate the financial services industry today: conglomeration, cooperation, consultation and consistency. How’s that for alliteration?

There are probably a lot of jokes in your circles about how many regulators and working groups it takes to regulate a financial service provider. You’ll be much relieved to know that it is fewer than required to screw in a light bulb.

By my count, there are at least five different federal banking agencies, plus the Commission, and the state insurance regulators working together to figure out how best to regulate the new breed of consolidated financial service providers. You’ve also got the AICPA, FASB and accountants at the Commission and the banking agencies weighing in on accounting issues unique to financial service providers. Add to those a myriad of working groups (not to imply that the other groups are not working) -- for example, the Joint Working Group on loan loss allowances, the President’s Working Group on hedge fund issues, and the new Working Group established by the Fed to develop options for improving public disclosure of financial information by banking and securities organizations.

II. The Gramm-Leach-Bliley Act of 1999 (Nov. 12, 1999)

After a long, long wait for Glass-Steagall reform, Congress finally passed the G-L-B Act last November. As familiar as the issues are to me from my work on the Hill, I could not have predicted with certainty that I would now be dealing with the regulatory challenges this Act poses to the Commission.

Perhaps the most noteworthy – and most challenging – aspect of the Act is that it clearly will lead to greater cooperation between the Commission and the banking regulators. Some might say that cooperative regulation is a foreign approach for banking and securities regulators, but if implemented rigorously, it will be quite effective. Rather than have a single agency carry out disparate missions in regulating financial conglomerates, it makes sense for those agencies with the relevant expertise to jointly exercise oversight responsibilities. The biggest challenge will be striking the delicate balance that enables the various regulators to coordinate sufficient oversight without it becoming duplicative and burdensome. As you know, being duplicative and burdensome is something that we regulators can be quite adept at.

The G-L-B Act is based on a model of "functional regulation" – therefore, securities activities performed by a broker-dealer, registered investment adviser or registered investment company affiliated with a bank will continue to be primarily regulated by the Commission. The bank regulators’ authority over these entities is limited to situations that pose material risks to the affiliated insured depository institution or the domestic or international payment system.

Under the Act’s "Fed Lite" and "OCC Lite" authority provisions, the banking regulators can only examine or require reports from an SEC regulated entity if the information is not already available from the Commission. Even then, they need to work through the SEC to get the information. The Act carves out an exception to the "lite" provisions of the Act for the FDIC – the FDIC can examine SEC regulated entities "as necessary" to have full disclosure about the relationship between depository institutions and affiliates and the effect of the relationship on the depository institutions.

The G-L-B Act also contains limitations on the Federal Reserve. The Fed may not impose capital requirements on SEC regulated subs of bank holding companies if they:

  • are not insured institutions;
  • comply with the applicable state or federal capital requirements; and
  • are registered investment advisers (except that non-advisory activities may be subject to capital requirements)

Bank regulators can’t just walk in and inspect or examine non-bank holding company registered investment companies, but the Commission does have to share its exam results with the banking agencies.

While on the topic of compliance examinations of SEC regulated entities (broker dealers, investment advisers, investment companies), be aware -- and beware -- that the staff of the Commission’s Office of Compliance Inspections and Exams ("OCIE"), intends to actively inspect financial service provider subsidiaries of bank holding companies. Therefore, if management decides to shift risk management systems from the broker-dealer, investment company or investment advisor subsidiary to the parent bank holding company, OCIE will review these procedures in its exams.

Now I will turn briefly to some of the specific interpretive issues and rulemaking projects stemming from the G-L-B Act that are on the Commission’s "to-do" list.

A. Regulation S-P, Privacy of Consumer Financial Information

The first project on the list is to establish rules to protect the privacy of consumer financial information. My report on online brokerage includes a whole section about financial privacy concerns in the online environment. It notes that the rise of financial conglomerates and increasingly sophisticated data mining techniques have pushed privacy issues into the spotlight.

My report made two recommendations: (1) that the Commission obtain and evaluate the financial information collection practices of online firms – a project I am currently working on, with help from the NASD; and (2) that the Commission consider the data gathering practices of online firms in preparing with other functional regulators a joint report required by the G-L-B Act on the state of privacy regulation in the U.S. It will be important to consider the burdens that firms would incur by letting their customers opt out of information sharing, as well, of course, as the concerns raised by customers.

There are four main privacy components of the G-L-B Act:

  • A financial institution has to provide its customers with a notice of its privacy policies and practices.
  • A financial institution may disclose nonpublic personal information about a customer to unaffiliated third parties only if it notifies the customer about the potential disclosure and gives the customer the chance to opt out of the disclosure before it occurs – unless the third party markets products or services jointly with the financial institution.
  • The Act requires the financial regulators, including the SEC, to issue rules and standards to safeguard customer information and to conduct the privacy study I just mentioned.
  • Finally, the Act states that its privacy provisions do not supersede any state law that provides a higher level of privacy protection.

We’re already pretty far along with the project to adopt privacy rules requiring the financial entities we regulate to safeguard financial information -- the Commission issued a release soliciting public comment on proposed new Regulation S-P in March and likely will issue an adopting release in the very near future. The rules will require SEC regulated financial institutions to provide notice to consumers about their privacy policies and practices. They’ll also describe the conditions under which a financial institution may disclose nonpublic personal information about a consumer to an unaffiliated party and provide the "opt out mechanism" for consumers who object to such disclosure.

The Act required the financial regulators to "consult and coordinate" with one another to develop privacy rules that are "consistent and comparable." Therefore, you can expect the privacy rules issued by the Commission and banking agencies to bear a strong resemblance to each other. The examples included in the Commission release will differ from those used by the banking agencies to provide more specific guidance to the financial institutions that we regulate.

B. Investment Bank Holding Companies

The privacy rules are only the tip of the iceberg – one of the next big challenges for Commission staff is to create a regulatory framework for new "investment bank holding companies." These holding companies will own or control one or more broker-dealers but will not be affiliated with insured banks, savings associations or certain foreign banks. The new investment bank holding company structure would be similar to the Fed’s bank holding company structure and hopefully enable U.S. brokers to successfully compete with banks overseas. Because many foreign financial regulators subject financial institutions to consolidated regulation in their home countries, the G-L-B Act included provisions to enable broker-dealers to be supervised like banks without actually being subject to banking requirements that may not comport with their business models.

Consolidated regulation lends greater credibility to investment bank holding companies by providing assurance that the companies’ risk profiles are being considered as a whole – it’s important to foreign regulators to know that the home regulators are looking at the whole beast and not just its disparate parts, especially from a risk management perspective.

Basically, under the new, and voluntary, investment bank holding company structure, eligible entities could opt for Commission regulation, supervision and examination on a consolidated basis. Some of the elements of the new structure include a risk-based examination and reporting system, an evaluation of the entity on a consolidated basis and a potential capital relief provision for the entity’s subsidiary broker-dealer. Although the Act doesn’t give the Commission the authority to set capital standards at the holding company level, we could require an investment bank holding company to file reports "certifying" that if it had to calculate its capital on a consolidated basis in accordance with the Basel Capital Accord, as modified to apply to the business of securities firms, it would comply with those standards. This time, it would be the Commission’s turn to defer to other regulators that supervise and examine the investment bank holding company and its affiliates.

The Commission staff already has started a dialogue with firms that may want to establish investment bank holding companies. We welcome suggestions and comments that any of you may wish to offer as we shape the new regulatory framework, even in advance of issuing formal proposals.

C. Targeted Exceptions from Broker-Dealer Registration for Banks

The G-L-B Act eliminated the blanket exemption for banks from the definitions of "broker" and "dealer" in the Securities Exchange Act of 1934 but replaced it with a series of 13 "targeted exceptions" for certain bank securities activities. If banks meet the conditions for relying on the various exceptions, they can engage in the activities without having to register as brokers or dealers.

I’ll quickly tick through the list and mention six of the more notable exceptions:

  • Banks that provide third-party brokerage services;
  • Bank private placement activities for up to 25% of the bank’s capital, but only for banks not affiliated with a broker-dealer engaged in dealing, market making or underwriting activities;
  • Certain bank transfer agent activities in employee benefit plans, dividend reinvestment plans, and issuer plans;
  • De minimis (no more than 500) annual securities transactions;
  • Asset-backed products sold to qualified investors by banks’ non-broker-dealer affiliates; and
  • Swap agreements sold to qualified investors as defined under the G-L-B Act, including registered investment companies, hedge funds, banks, or companies or individuals that invest or own not less than $25,000,000 in investments

Although we’re still a year away from the effectiveness of these provisions – in fact, precisely one year and one day, questions already are being posed to the SEC staff about these exceptions. The staff is trying to anticipate and resolve many of the hard questions that will come up as to whether certain activities fit within the exceptions created by the Act.

One of the most commonly asked questions so far has been whether thrifts can rely on the same exceptions from broker-dealer registration available to banks. In case you didn’t already know -- the answer is no. Thrifts and commercial banks traditionally have been treated differently under the federal securities laws and the G-L-B doesn’t change this.

Other popular questions concern the exception that allows banks to run a traditional trust or fiduciary operation without registering as broker-dealer. That particular exception has several conditions: The bank must be "chiefly compensated" consistent with fiduciary principles and standards in one of several ways. One of the fundamentals in determining whether an entity needs to register as a broker-dealer involves how that entity will be compensated. Lots of questions are being raised as to the structuring of compensation arrangements and how the compensation condition will be administered.

Given my focus on technology issues at the Commission, I will be especially interested in resolving questions that have been raised about if and how the exception allowing banks to perform certain third-party brokerage services applies in cyberspace. Once again, cooperation among the regulators will be key – the G-L-B Act requires the banking regulators to establish record keeping requirements for banks that rely on the exceptions from the broker and dealer definitions. This will ensure that the bank regulators and the Commission can review compliance by the banks with the conditions for reliance on the exceptions. Again, with respect to these issues, the Commission welcomes your input as early as possible so that the staff can iron out some of this guidance before the exceptions take effect next year.

D. New Hybrid Products

One of the most contentious parts of the G-L-B Act was the one that will allow the Commission to decide whether banks that sell new hybrid products that are securities must register with the Commission. Rest assured, however, that in any rulemaking that the Commission undertakes in the future regarding hybrid products offered by banks, we first have to seek the Fed’s concurrence. Before adopting any rules, the Commission also would have to determine the product’s characteristics and effects on investors, and make findings regarding the appropriateness of the new product’s regulation under the federal banking laws.

III. Joint Working Group – Loan Loss Allowances

The Commission is working with federal banking regulators in other important ways. In March 1999, the SEC and the federal banking agencies formed a Joint Working Group to obtain a better understanding of bank procedures and processes used to determine the allowance for credit losses.

The Working Group’s loan loss allowance tasks include:

  • working with accountants and banks to develop guidance and enhanced disclosure;
  • supporting FASB’s guidance; and
  • supporting the AICPA’s Allowance for Loan Losses Task Force as it develops guidance on this subject.

IV. President’s Working Group on Financial Markets

The Commission’s accountants also are working hard to address a recommendation of the President’s Working Group on Hedge Fund Issues. The group recommended that all public companies, including financial institutions, be required to disclose a summary of direct material exposures to significantly leveraged financial institutions, including hedge funds. The main objective is to provide investors and market regulators with the most relevant information. We expect to issue the proposed disclosure for public comment sometime this fall.

V. New Fed, OCC, SEC Working Group on Disclosure Issues

Now I’ll bring up the last of the Working Groups. This one is actually a blue-ribbon panel. Just last month, the Fed, OCC and the Commission announced the establishment of a working group to develop options for the improving public disclosure of financial information by banking and security organizations. Walter Shipley, the former Chairman of Chase Manhattan Bank, is chairing the working group and will coordinate the efforts of the other 12 members. Like Walter, these members were drawn from banks and securities firms. The hope is that the private-sector panel will make recommendations that prompt the industry to voluntarily provide good public disclosure about risk exposure and risk management practices of large, complex financial companies as banks and securities firms merge. This group begins meeting this month and ultimately will release a report to the public including its recommendations and a description of industry best practices.

VI. Conclusion

We’re on our way in the brave, new world of financial industry consolidation. We just recently had the first filing come through the Commission relating to a brokerage firm’s election to become a financial holding company. A couple of weeks ago, Commission staff declared effective a registration statement filed by Charles Schwab regarding its proposed acquisition of US Trust Corp. and its bank and non-bank subsidiaries. The Fed approved of Schwab becoming a bank holding company on May 1 and announced that Schwab’s election to be a financial holding company will take effect when Schwab consummates the US Trust merger. While the difference between banking and securities may someday become obsolete, effective regulation of financial services activities will not. I look forward to joining with my fellow regulators to ensure the continued integrity of our financial system and capital markets. From a regulatory perspective, we’ll remain mindful that conglomeration requires cooperation, consultation and consistency. Thank you, and I’ll be happy to answer any questions.