Remarks Of Richard Y. Roberts Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "Current Issues Involving Bank Securities Activities" The Bankers Roundtable Lawyers Council Meeting Washington, D.C. May 18, 1995 ____________________ */ The views expressed herein are those of Commissioner Roberts and do not necessarily represent those of the Commission, other Commissioners or the staff. I. Introduction I appreciate the opportunity to participate in this Bankers Roundtable's Lawyers Council Meeting. When I appeared before the Bankers Roundtable last fall, I shared with the audience my concerns pertinent to bank mutual fund and other securities activities. Today, I will revise and update those remarks, and then review the current initiatives to reform the Glass-Steagall Act. II. Bank Mutual Fund Activities I will begin with bank mutual fund activities. Bank entry into this area, both in terms of managing mutual fund assets and selling mutual fund shares, has increased substantially over the last decade. The increased competition and convenience offered by bank involvement in the mutual fund area should benefit consumers, and I personally welcome such involvement. But for bank share of the investment company market to continue to grow, investor confidence must be maintained. In this regard, bank mutual fund participants should not only be mindful of their own individual mutual fund operations, but should be willing to point out questionable practices that may be occurring in connection with other bank mutual fund activities, such as identifying those stretching too far for short-term yield or engaging in inappropriate sales practices. The federal banking regulators are now focusing more attention on bank mutual fund sales practices. In 1994, the federal banking regulators issued a joint "Interagency Statement" concerning bank sales of mutual funds and other securities which replaced guidelines issued by each agency. While I support many of the objectives of this Interagency Statement, I am troubled that the guidelines included therein may not be legally enforceable by either the regulatory agencies or by bank customers. Moreover, I am concerned that application of the guidelines by the banking agencies may result in overlapping and potentially conflicting layers of regulatory oversight for those registered broker-dealers that sell securities and provide services to bank customers. At the very least, greater coordination of regulatory activities between the Commission and the federal banking regulators is needed to prevent such overlaps and conflicts from occurring. I note in this regard that the staff of the Commission and the Office of the Comptroller of the Currency have discussed conducting joint inspections of banks that advise mutual funds, and the funds themselves. An announcement on this matter is expected shortly and perhaps efforts such as these will ease my concerns regarding regulatory conflict and overlap that are potentially raised by the Interagency Statement. Of course, the larger issue of regulatory duplication at the federal level over bank securities and mutual fund activities has become an increasing problem which has yet to be satisfactorily resolved, and this problem will remain a challenge in the future for federal financial services regulators to overcome. Along similar lines, I understand that the NASD also has stepped into the fray, proposing rules that would oversee the activities of broker-dealers selling securities on bank premises. The NASD's proposal appears to be targeted at easing customer confusion with respect to such sales. The NASD proposal would, among other things, require broker-dealers to: provide services physically separate from where retail deposits are taken; establish and enforce procedures for supervising services provided on bank premises; comply with restrictions on the activities and compensation of unregistered employees; and make specific disclosures to customers. It is my further understanding that the NASD proposal generally follows certain principles set forth in a 1993 Commission staff no-action letter (to Chubb Securities Corp.) regarding networking arrangements between depository institutions and registered broker-dealers. The NASD has received 300 or so comments so far on its proposal, and I have been informed that the comments from the banking industry have been uniformly negative. Since the NASD currently is reviewing its position and has not submitted a final proposal to the Commission, I hesitate to comment too much thereon. Nevertheless, I would like to see agreement on proposed rules which provide reasonable investor protections, and the NASD appears to me to be the appropriate regulator to impose such rules. I will close on the subject of bank mutual fund activities by renewing a frequent call to eliminate the definitional exemption in the Advisers Act for banks acting as advisers to investment companies. Bank investment advisers are not required to register with the Commission and are not subject to Commission oversight under the Advisers Act, although bank advisory relationships with mutual funds are subject to the Investment Company Act. Consequently, Commission examiners do not gain access to all the books and records normally available when advisers register. Banks also are not subject to the substantive requirements applicable to registered investment advisers, such as the regulation of performance fees, procedures to prevent misuse of non-public information, and the Advisers Act anti- fraud provisions. The current Advisers Act exemption, much like the Exchange Act exemption from the definition of broker and dealer for banks, appears to have its origin in the fact that the enacting legislators believed that these exemptions were appropriate because the Glass-Steagall Act prohibited banks from entering the mutual fund business. Since this rationale no longer exists, neither, in my view, should the exemptions. III. Bank Securities Activities The various investor protection issues arising from expanded bank securities activities, including mutual fund operations, have continued to spark debate over the appropriate regulation of such activities. For example, Congress, the Commission, and the federal banking regulators have expressed concern as to the scope of federal deposit insurance protection. While there has occurred vast improvements in investor understanding recently in this area, concerns linger that some investors continue to misunderstand the uninsured status of bank sold securities and mutual funds. Some customers also apparently continue to be confused about the protections afforded by the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation. Further, I personally am troubled by the status of nonbank purchasers of bank loan participations under the federal securities laws. In my view, purchasers of similar financial instruments, such as loan notes and commercial paper, should not receive vastly dissimilar information on their investments. Although most of the legislative and regulatory focus this year has been on broader Glass-Steagall reforms, several ongoing or recent initiatives focus more directly on concerns with respect to bank securities activities. For example, two separate GAO studies are examining bank mutual fund practices and bank securities regulation. In addition, two bills have been introduced in the 104th Congress which directly address bank mutual fund and securities activities. Congressmen Gonzalez and Schumer have introduced a bill that would codify and in some instances supersede the banking regulators' guidelines for bank sales of "nondeposit investment products," including mutual funds. Senator Pryor has introduced legislation which also seeks to address concerns with bank sales of mutual funds and other "nondeposit investment products." It is my understanding that an attempt to add all of the provisions of the Gonzalez-Schumer bill to a broader Glass-Steagall reform proposal failed at the House Banking Committee level, but that Congressman Flake successfully offered several provisions similar to those in the Gonzalez-Schumer bill at the Committee level. Another issue, one that has become even more significant in the context of Glass-Steagall reform, is whether banks should conduct their securities activities in subsidiaries or affiliates. In recent Congressional testimony, a majority of the Commission supported the concept that bank securities activities should be limited to nonbank affiliates of the bank holding company. I joined in this view because I believe that there are important operational differences between subsidiaries and affiliates under federal banking law. For example, I understand that a subsidiary of a bank is considered to be an extension of the bank itself under federal banking law. Thus, the nonbank subsidiary's capital is generally included in the calculation of the parent bank's capital. A nonbank affiliate of a bank holding company, on the other hand, is separate from the affiliate bank. The bank holding company must separately capitalize the nonbank affiliate, and the nonbank affiliate's capital is not counted as the capital of any affiliate bank. Furthermore, bank subsidiaries are not subject to the conflict of interest and self-dealing restrictions that are applicable to bank holding company affiliates under Sections 23A and 23B of the Federal Reserve Act. Bank brokerage and underwriting activities also have raised concerns and prompted scrutiny. In response to allegations that banks are "tying" underwriting services and credit products, the GAO is actively investigating the extent of bank tying practices, as well as the effectiveness of the anti-tying statute. In fact, the GAO is scheduled to meet with me on this subject tomorrow, May 19. Of course, current federal banking law imposes prohibitions and restrictions on banks against tying arrangements and other noncompetitive practices in connection with their securities and mutual fund activities. The tying complaints of which I have been made aware in the past usually involved allegations that banks, through over- aggressive employees, were unfairly competing for municipal securities underwriting business by tying their credit enhancements to an underwriting or some other role. For whatever reason, banking regulators apparently have initiated only two enforcement actions in this area as of the end of last year, and I believe that I was the source of both cases. In my view, taxpayer guaranteed funds should be walled off from supporting securities activities and mutual fund activities of banks or their affiliates. Otherwise, banks and their affiliates may have a substantial advantage in competing for underwriting and other services, and this is an inappropriate use of the federal deposit insurance system. If banks are able to tie extensions of credit to the use of their affiliates' underwriting or other services, the availability of taxpayer- backed deposits may give banks a large advantage over independent underwriters lacking access to federally insured funds. I am inclined to be of the view that this circumstance is more likely to occur on the regional or local level than at the national level, where customers have a wider range of credit alternatives available. IV. Glass-Steagall Reform Legislative Initiatives Debate on broad-based Glass-Steagall reform has eclipsed all other banking issues in the 104th Congress. Legislative proposals have been introduced to reform Glass-Steagall in the House by Chairman Leach and in the Senate by Chairman D'Amato. Further, the Treasury Department has issued an outline of its own proposal. All of the proposals would likely facilitate bank securities activities, which is a concept, by the way, that I do support. Although I will try to give a sense of my own views on these proposals, time restraints may prevent me from going into any real detail. But let me make a general point up front: the Commission has not in the past, nor should it in the future, support any Glass-Steagall reform proposal that does not move generally towards the concept of "functional regulation." In my view, only a general system of functional regulation, in which each entity ordinarily is regulated according to the particular activity that it undertakes and not according to its charter, can achieve the twin goals of equal protection for all investors and reduced regulatory costs. Of course, there are exceptions to any general rule, and I see no reason, for example, why banks should not be allowed to underwrite both general obligation and revenue municipal bonds under the current municipal securities structure. The experience of bank underwriting of municipal general obligation bonds has demonstrated no safety or soundness problems of which I am aware, and I do not understand the distinction between underwriting municipal general obligation bonds and municipal revenue bonds. I understand that the bill reported out of the House Banking Committee last week generally would allow banks to acquire securities firms through financial services holding companies and to conduct significant securities activities in the bank or through "separately identifiable departments of banks." Securities firms could acquire uninsured wholesale banks through an investment bank holding company structure with separately capitalized broker-dealer affiliates. The reported bill also contains provisions that would remove the blanket definitional exclusions for banks under the Exchange Act and the Advisers Act and would create a financial services policy-making interagency council comprised of the heads of the banking agencies, the Treasury, the CFTC and the Commission. The reported bill further would allow well-capitalized banks to underwrite municipal general obligation and revenue bonds and would require networking standards, similar to current banking standards, for bank brokerage of securities and annuities. In testimony on an earlier version of the reported bill, the Commission supported the concept of financial services modernization generally and praised the earlier version for moving towards a functional regulation approach. Certainly, banks and their affiliates should be allowed to engage in other business activities. Nevertheless, our testimony raised significant concerns with the earlier version of the bill. First, a host of provisions would grant banks extensive exemptions from broker-dealer regulation and thereby depart from functional regulation principles. Second, the provisions regarding oversight and examination of bank-affiliated securities activities would appear to have the effect of increasing the likelihood of regulatory overlap and conflict. Finally, the provisions do not appear to provide a real "two-way street" for securities firms that desired to acquire banks. The bill reported out of the House Committee included several amendments to the earlier version which responded to Commission concerns in the investment company area and with respect to the "two-way street" issue, but did not respond to the Commission's other chief concerns. As for functional regulation, the reported bill was not as strong on this point as it was initially, and now would permit even more securities activities to remain within the bank. The bill also appears to overlay bank safety and soundness regulation on securities firms in a manner that could impact the vitality of the securities marketplace. Further, prospects for "regulatory arbitrage" appear to have increased in the reported bill. In other words, it appears to provide more options for banks to move securities activities into and out of different entities based upon the level of regulatory oversight imposed on each such entity. Finally, the interagency council is problematic to the Commission because it may undermine the agency's ability to craft appropriate financial responsibility standards for broker-dealers. Due to the disproportionate representation of banking regulators on the council, it is likely that the council's mandate will be bank safety and soundness and not investor protection. In the Senate, Chairman D'Amato's bill is virtually identical to bills that the Senator introduced in the late 1980s. A new framework for regulating "financial services holding companies" would be created, and that framework would permit the mixing of banking, securities, insurance and commercial activities. The holding company parent generally would be unregulated, and certain firewalls and anti-tying restrictions would limit affiliated transactions between the insured bank and other holding company affiliates. The various "affiliates" in this structure would be regulated by their "functional" regulator. The D'Amato bill also would provide for a joint committee on financial services, although I believe that it would have a slightly different make-up than the one called for by the House Banking Committee. The Commission has not yet had a formal opportunity to comment on Chairman D'Amato's bill, either in this Congress or in its previous incarnations. In general, the bill would appear to have several positive aspects, particularly with respect to the "two-way street" and certain functional regulation concerns, although I do not believe it would provide for functional regulation for existing bank securities activities where a bank elects not to be part of a financial services holding company. To my knowledge, Chairman D'Amato has not scheduled hearings on his bill, but has stated his willingness to entertain revisions. Should it become the subject of hearings or further debate, I hope that the Chairman will consider the Commission's views. Treasury's proposal on Glass-Steagall reform would permit affiliations between banks and other firms engaged in "financial activities," including insurance companies and securities firms, but would not allow for affiliations between banks and commercial companies. It too would create an interagency council, but apparently more to serve as a policy forum rather than as a regulator. The Treasury proposal would permit banks to establish or acquire securities subsidiaries; and, as you may recall from comments that I made earlier, I have significant reservations about a subsidiary approach. Many of the other aspects of the Treasury proposal are not yet clearly defined, so I do not believe that I could comment responsibly thereon. V. Conclusion While there appears to be strong support in Congress for Glass-Steagall reform, it is not clear what form any final package will take, or even whether a single reform package can be agreed upon that will be acceptable to the House, the Senate, and the Administration. As members of this audience probably recall, Congress has taken steps towards reforming Glass-Steagall at least two times in recent years, and the previous efforts failed for reasons that are likely to reappear this year, and they are issues concerning the insurance industry, firewalls, and jurisdiction.