TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING H.R. 1062, THE "FINANCIAL SERVICES COMPETITIVENESS ACT OF 1995" BEFORE THE SUBCOMMITTEES ON TELECOMMUNICATIONS AND FINANCE AND COMMERCE, TRADE, AND HAZARDOUS MATERIALS OF THE COMMITTEE ON COMMERCE U.S. HOUSE OF REPRESENTATIVES June 6, 1995 Chairman Fields and Members of the Subcommittees: I appreciate this opportunity to testify on behalf of the Securities and Exchange Commission regarding H.R. 1062, the "Financial Services Competitiveness Act of 1995." In March 1995, the Commission testified on an earlier version of this bill before the House Committee on Banking and Financial Services. Significant changes have been made in the bill since the time of the Commission's earlier testimony, and today I will outline our views on the revised bill.-[1]- I. Introduction As the Commission stated in its earlier testimony on H.R. 1062,-[2]- we support the bill's principal purpose -- to modernize the financial services regulatory framework by reforming the 60 year-old Glass-Steagall Act. Glass-Steagall reform would provide the banking and securities industries with greater flexibility and new avenues for innovation. Reform also could improve financial services providers' competitiveness at home and abroad. In weighing Glass-Steagall reform, however, Congress also needs to consider carefully the needs of investors, as well as the overall impact on the U.S. capital markets as a whole. The U.S. securities markets are the deepest, most liquid, and strongest in the world, with $830 billion raised in 1994 alone. This capital was raised from investors, through the entrepreneurial and risk-taking efforts of securities firms, without the benefit of federal deposit insurance. The continuing success of our capital markets requires that we preserve the securities industry's ability to assume risks, and maintain a strong system of investor protection to support public confidence in the securities markets. The Commission finds much that it can support in H.R. 1062. -------- FOOTNOTES -------- -[1]- H.R. 1062, introduced on February 27, 1995, is a revised version of a bill originally introduced by Chairman Leach on January 4, 1995, as H.R. 18. H.R. 1062 was marked up by the House Banking Committee on May 9, 1995, and was subsequently referred to this Committee. -[2]- Commission Testimony Concerning the "Financial Services Competitiveness Act of 1995" and Related Issues Before the House Committee on Banking and Financial Services, March 15, 1995 (hereinafter cited as "March 1995 Testimony"). -------------------- BEGINNING OF PAGE #2 ------------------- Chairman Leach's bill, by opening up the present debate on Glass- Steagall reform this year, already has made an important contribution. In addition, the bill proposes a number of useful changes to the regulation of financial services -- for example, a flexible yet effective framework for addressing conflicts of interest that may arise when banks advise or sell mutual funds. Looking at H.R. 1062 as a whole, however, the Commission continues to have reservations regarding the bill. We feel that it still does not strike an optimal balance between preserving bank safety and soundness, and the needs of investors and the marketplace as a whole. Our primary concerns can be summarized as follows: INVESTOR PROTECTION. The Commission is concerned that H.R. 1062 would impair investor protection by allowing banks to continue to conduct a wide range of securities activities outside the broker-dealer regulatory scheme under the federal securities laws. Over the past two decades, banks -- by virtue of expansive regulatory interpretations of the Glass-Steagall Act -- have dramatically increased the scope and volume of their broker-dealer activities.-[3]- Because of the 60 year-old bank exclusions, however, this piecemeal expansion has occurred largely outside the legal framework governing all other entities that engage in broker-dealer activities. H.R. 1062, rather than taking a fresh look at the bank exclusions, would preserve the range of securities activities that can be conducted in banks. As a result, investors who deal with banks would receive a different standard of protection than those who deal with securities firms. In this connection, the Commission believes that H.R. 1062's creation of a "separately identifiable department" of a bank, or "SID," is not the same as full functional regulation. By establishing a SID, a bank could engage in significant securities activities directly, rather than in a separately incorporated broker-dealer. Because SIDs would not be subject to the Commission's net capital requirements, banks that trade securities would operate under a different standard than applies to their broker-dealer competitors. Bank SIDs could also present some practical problems relating to securities examination and enforcement efforts. Nonetheless, requiring securities activities to be performed in a registered broker- dealer SID is preferable to allowing these transactions to be conducted solely in the bank. IMPACT ON CAPITAL FORMATION. The Commission is concerned that H.R. 1062 could significantly alter the climate that has fostered the successful capital-raising activities of the U.S. securities markets. The -------- FOOTNOTES -------- -[3]- Bank securities powers originally were conceived as encompassing essentially brokerage services provided as an accommodation for existing bank customers and small town banks. Actually, however, bank securities powers long ago expanded beyond those bounds. See Reports on Bank Securities Activities of the Securities and Exchange Commission Pursuant to Section 11A(e) of the Securities and Exchange Act of 1934 (Public Law 94- 29), August 1977. -------------------- BEGINNING OF PAGE #3 ------------------- bill's proposed regulatory structure does not fully take into account some of the real differences between the securities and banking industries and the regulatory environment appropriate to each. Banks have traditionally operated subject to regulatory restrictions imposed in the interests of bank safety and soundness. The regulatory and enforcement programs of the federal banking agencies, similarly, focus on protecting the viability of banking institutions and the solvency of the federal deposit insurance system. Banking regulation uses the tools of "confidential supervision"-[4]- rather than market discipline: for example, it imposes pervasive restrictions on bank lending and other lines of business, and addresses violations of law largely through the confidential examination process rather than through widely publicized enforcement proceedings. In contrast, the securities industry may be viewed as more market-oriented. Securities firms, and the securities markets generally, specialize in entrepreneurial and risk-taking activities.-[5]- For this reason, securities regulation does not, and should not, seek to insulate securities firms from the risks they incur in their business activities. Instead, the securities regulatory framework seeks to protect investors and maintain fair and orderly markets by imposing specific capital, supervision, disclosure, antifraud, and similar requirements on securities firms. Within these parameters, risk-taking is largely left to market control, not to governmental management.-[6]- H.R. 1062, however, proposes to bring securities affiliates within a complex regulatory structure that would include bank-type activity restrictions and could thereby rigidly constrain the operations of securities firms.-[7]- The Commission, to summarize, does not oppose Glass-Steagall -------- FOOTNOTES -------- -[4]- See Alfred Dennis Mathewson, From Confidential Supervision to Market Discipline: The Role of Disclosure in the Regulation of Commercial Banks, 11 J. Corp. L. 139, 140-41 (1986). -[5]- Banking activities, of course, also involve risk. See Testimony of Ricki Helfer, Chairman, Federal Deposit Insurance Corporation ("FDIC"), on the "Financial Services Competitiveness Act of 1995" and Related Issues Before the House Committee on Banking and Financial Services, Feb. 28, 1995, at 3-4. Inadequate loan diversification and overly-rapid growth in lending, for example, can affect the bank lending function and lie at the root of a significant number of bank failures. See id. at 8-9. But such risks are also subject to close monitoring and regulation by the banking agencies: bank regulatory restrictions limit bank loans to one borrower, loans to insiders, loan concentrations, and asset growth. By contrast, the risk-taking activities of securities firms are limited primarily by market discipline. -[6]- The securities industry has generally managed to remain strong and healthy, notwithstanding the lack of all- encompassing safety and soundness regulation: for example, there were only two broker-dealer failures last year that required intervention by the Securities Investor Protection Corporation ("SIPC"). -[7]- See discussion infra at 19-24. -------------------- BEGINNING OF PAGE #4 ------------------- reform; to the contrary, we remain strong supporters of financial services modernization. On balance, however, we believe that the regulatory framework contemplated by H.R. 1062 could be improved. We believe that H.R. 1062, by sweeping certain securities activities WITHIN the umbrella of banking regulation and others OUT from the framework of the federal securities laws, would not best serve the interests of investors and the U.S. capital markets. II. Summary of H.R. 1062 H.R. 1062 would amend the Glass-Steagall Act to allow affiliations between banks and securities firms through a bank holding company structure, subject to "firewalls" intended to protect bank safety and soundness and to address certain conflicts of interest. The bill would also authorize banks to engage directly in the underwriting of municipal revenue bonds. The bill attempts to create a "two-way street" for banks and securities by, among other things, creating a new class of "investment bank holding companies" with broader powers than are now available to bank holding companies (or securities firms). Similarly, H.R. 1062 would liberalize the permissible activities for bank holding companies (renamed "financial services holding companies," or "FSHCs"), and would take steps to streamline Federal Reserve oversight over such companies. H.R. 1062 would also make significant amendments to the federal securities laws. The bill would replace the existing blanket bank exclusions from broker-dealer regulation with numerous exceptions for specific securities activities. As a result, banks could engage in the excepted activities directly or (in some cases) through a "separately identifiable department or division" of the bank. In addition, H.R. 1062 would: make useful amendments to the Investment Company Act of 1940; amend the margin provisions of the Exchange Act of 1934 to ease broker- dealer borrowing for ordinary business purposes; and create a new, interagency committee charged with improving the regulation of the financial services industry. III. Functional Regulation The Commission has given extensive testimony before this Committee regarding the need for functional regulation.-[8]- Under existing law, banks and securities firms that offer the same range of securities services are regulated differently, based on who they are rather than on what they do.-[9]- As a -------- FOOTNOTES -------- -[8]- See, e.g., Commission Testimony Before the Subcommittee on Telecommunications and Finance of the House Energy and Commerce Committee Concerning H.R. 3447 and Related Functional Regulation Issues (April 14, 1994); Commission Testimony Before the Subcommittee on Telecommunications and Finance of the House Energy and Commerce Committee Concerning H.R. 797 (June 20, 1991); Commission Testimony Before the Subcommittee on Telecommunications and Finance of the House Energy and Commerce Committee Concerning Proposed Amendments to the Securities Exchange Act of 1934 (Aug. 2, 1990). -[9]- Although direct bank securities activities fall largely outside the purview of the federal securities laws, banks also may engage in securities activities (continued...) -------------------- BEGINNING OF PAGE #5 ------------------- result, investors who buy securities from banks receive a different standard of protection than do investors who purchase securities from broker-dealers. The Commission believes that this distinction ill-serves investors; for almost a decade we have urged Congress to adopt a system of functional regulation for all participants in the securities markets in order to close the existing gaps in investor protection.-[10]- The different regulatory schemes for bank and broker-dealer securities activities grew up around assumptions formed 60 years ago. At the time the federal securities laws were written, it was widely assumed that the Glass-Steagall Act barred banks from engaging in most securities activities.-[11]- Consistent with that understanding, banks were excluded from the definitions of "broker" and "dealer" in the Exchange Act. Banks were also excluded from Commission oversight under the Investment Advisers Act of 1940. The assumption underlying the bank exclusions, however, no longer holds true. Today, banks engage in a wide range of broker-dealer and investment advisory activities that are comparable to, and competitive with, the services of registered securities firms and investment advisers.-[12]- But because the bank exclusions remain, only federal banking law and the antifraud provisions of the federal securities laws apply to banks that engage directly in these activities.-[13]- -------- FOOTNOTES -------- -[9]-(...continued) indirectly. For example, a bank may conduct its sales or investment advisory activities through subsidiaries registered with the Commission. The securities activities of bank subsidiaries -- unlike internal bank securities activities -- are subject to the federal regulatory schemes for broker-dealers and investment advisers. -[10]- Bank municipal and government securities activities already are subject to separate, limited regulatory schemes under the Exchange Act. Those schemes were premised on the fact that bank dealers were not affiliated or able to be a part of a full-service brokerage business and had not developed the sales force that characterizes other aspects of the brokerage business. They were developed at a time when there was a small number (less than 300) of bank government securities dealers, who were in a business that was largely dominated by fully regulated broker-dealers. The limited regulatory schemes that were developed, thus, were premised for the most part on limited bank activity. -[11]- See March 1995 Testimony at 5. -[12]- For example, in 1994, 119 banks provided investment advice or other services to over $312 billion in mutual fund assets (representing approximately 15% of total mutual fund assets). In the same year, over 1800 banking firms sold mutual funds to their customers. See March 1995 Testimony at 6. -[13]- A bank exclusion is not contained in the Investment Company Act, however, and therefore bank advisory relationships with investment companies are subject to that Act. -------------------- BEGINNING OF PAGE #6 ------------------- H.R. 1062 would move toward a system of functional regulation for certain new bank securities activities.-[14]- Banks that seek to engage in most corporate equity underwriting activities, for example, would have to do so through separately incorporated, separately capitalized, registered broker-dealers. H.R. 1062 would also eliminate the bank exclusion from the definition of investment adviser to a registered investment company. The Commission strongly supports these provisions. At the same time, however, H.R. 1062 would depart in several key respects from the principle of functional regulation. It would give banks numerous new exceptions from broker-dealer regulation with respect to specific securities activities. In addition, H.R. 1062 would permit banks to engage in significant securities activities (such as underwriting asset-backed securities) in "separately identifiable departments or divisions" of the banks. The bank exceptions from broker-dealer regulation -- together with liberal capital and firewalls treatment of SIDs -- could provide incentives for financial services firms to move securities activities out of broker-dealers and into affiliated banks, away from the regulatory framework established under the federal securities laws.-[15]- The exceptions would also put broker-dealers that are not part of banks, particularly small and regional brokerages, at an unfair competitive disadvantage. 1. EXCEPTIONS FOR BANK BROKER-DEALER ACTIVITIES The Commission strongly supports removal of the bank exclusion from the broker and dealer definitions. Today, by virtue of the bank exclusion: * banks do not have to register or provide information regarding their securities activities, or to satisfy special financial responsibility requirements as a condition of engaging in direct securities activities; * bank securities salespersons do not have to meet -------- FOOTNOTES -------- -[14]- The bill also would authorize banks to underwrite municipal revenue bonds pursuant to the existing municipal securities regulatory scheme. The Commission supports this provision. -[15]- The Commission is concerned that the firewalls provisions of H.R. 1062 could provide further incentives for such a migration. As currently drafted, the firewall provisions apply only to bank transactions with securities affiliates and do not extend to direct bank securities activities. Thus, the bill generally would prohibit a bank from providing credit enhancements for a securities issue underwritten by its securities affiliate, but would allow a bank to provide credit enhancements for a securities issue that is underwritten by the bank itself (including issues underwritten by a bank SID). Yet the hazards that firewalls are designed to prevent -- conflicts of interest, aggressive sales practices, or exposure of the insurance fund to losses -- are still present when the bank engages in securities transactions directly. For these reasons, we believe the firewalls -- and particularly the restrictions on extensions of credit - - should apply to situations in which a bank effects securities transactions directly. -------------------- BEGINNING OF PAGE #7 ------------------- specific qualification and continuing education requirements; * bank securities salespersons with disciplinary histories are not subject to statutory disqualification from the securities business; * long-established Commission and self-regulatory organization ("SRO") sales practice standards do not apply to banks, and banks are not subject to a statutory duty to supervise securities salespersons; and * bank securities customers have no formal avenue of redress for complaints.-[16]- H.R. 1062 would replace the blanket bank exclusions contained in existing law with eleven new exclusions for specific bank brokerage activities and five new exclusions for bank dealer activities.-[17]- The Commission has both general and specific concerns about these new exemptions. Most significantly, the bill's numerous new exemptions would leave a significant number of bank securities activities outside the regulatory framework and investor protections established under the federal securities laws. Instead, H.R. 1062 would direct the federal banking regulators to adopt their own sales practice, disclosure, training and qualification, and other -------- FOOTNOTES -------- -[16]- See March 1995 Testimony at 9-10; Proposed Mellon- Dreyfus Merger: Hearings Before the Subcomm. on Oversight and Investigations of the House Comm. on Energy and Commerce, 103d Cong., 2d Sess. 906-72 (1994). -[17]- The bill's eleven limited exemptions from the definition of "broker" and five limited exceptions from the definition of "dealer" would permit banks to engage in many securities-related activities without being subject to securities regulation. Exemptions from the definition of "broker" are provided for: (i) banks that engage in brokerage activities in connection with "networking arrangements," (ii) certain trust activities, (iii) transactions in exempted and similar securities, including government securities, (iv) transactions in municipal securities, (v) transactions in connection with employee and shareholder benefit plans, (vi) "sweep" transactions, (vii) affiliate transactions, (viii) private placements, (ix) a de minimis number of transactions, (x) safekeeping and custody services, and (xi) transactions in securities that the Federal Reserve Board has determined are more appropriately treated as banking products. Exceptions from the definition of "dealer" are provided for banks that engage in transactions involving: (i) exempted and similar securities, (ii) municipal securities, (iii) bank and trust department transactions for investment purposes, (iv) (under limited circumstances) certain categories of asset-backed securities, and (v) securities that the Federal Reserve Board has determined are more appropriately treated as banking products. -------------------- BEGINNING OF PAGE #8 ------------------- standards. Banks engaging in securities activities under this separate scheme would be subject to "standards" rather than enforceable rules; the bill, moreover, would not require those standards to be substantially similar to requirements under the federal securities laws.-[18]- Similarly, banks would not be charged with an express duty to supervise their employees' securities activities (a key investor protection). The practical effect would be that investors who buy securities through their banks would continue to receive a different standard of protection than other investors. Moreover, the Commission is concerned that H.R. 1062 would place no aggregate limits on the number of transactions banks could conduct pursuant to the exceptions, and would in fact permit even a large broker-dealer affiliate of a bank to transfer a significant volume of exempted activities to the bank. For example, broker-dealers that became affiliated with banks would have a strong incentive to transfer their government securities business to the bank in order to gain access to the Fed Wire and the discount window.-[19]- Similarly, such broker-dealers would have an incentive to shift their asset-backed securities into the bank. Asset-backed securities are of growing importance in the securities market, particularly since they can be structured to pay interest in a way that replicates the performance of the equity markets. Thus, the unintended effect of H.R. 1062 could be to channel securities transactions to banks, with the result that more securities transactions would be done outside the basic securities regulatory system for broker-dealers than ever before. The potential for the movement of certain securities activities away from the securities regulatory scheme raises concerns with respect to fair and orderly markets and the protection of investors. -------- FOOTNOTES -------- -[18]- See H.R. 1062 111. This provision follows the approach taken by the federal banking agencies when they adopted "guidelines" in their 1994 Interagency Statement. As the Commission observed in earlier testimony, however, the guidelines provided in the Interagency Statement do not create a comprehensive securities regulatory scheme for banks. They are advisory rather than legally binding, and may not be legally enforceable by the bank regulators or by bank customers. Furthermore, the guidelines do not establish precise standards of conduct; banks are given wide latitude to establish procedures and policies to implement them. See March 1995 Testimony at 10. Finally, the guidelines create regulatory confusion and overlap because they purport to apply to registered broker-dealers that sell securities in association with banks. If H.R. 1062 goes forward in its present form, it should at a minimum expressly provide that the banking agency guidelines and standards apply only to direct bank securities activities. -[19]- As of January 1995, 37 of the 38 primary dealers in government securities were registered with, and regulated by, the Commission. In addition, 2,156 registered broker-dealers dealt in government securities as part of a broader business. Only 310 banks dealt in government securities. The Office of the Comptroller of the Currency is the primary regulator for the majority of banks (198) that are bank government securities dealers. -------------------- BEGINNING OF PAGE #9 ------------------- 2. SIDs Certain of the bank broker-dealer exceptions proposed by H.R. 1062 would allow a bank to conduct certain securities activities directly, through a "separately identifiable department or division" of the bank, even if the bank has a securities affiliate. For example, a bank with a securities affiliate could conduct activities in private placements and deal in certain asset-backed securities in a SID, rather than in its affiliate.-[20]- The SID would be an artificial entity created by drawing an imaginary line around portions of the bank. According to H.R. 1062, a bank broker-dealer SID would be a unit (1) under the direct supervision of a specifically designated bank officer, (2) that maintains records that can be segregated from those of the bank, and (3) that would be subject to Commission rulemaking -- but not to broker-dealer net capital rules. The SID itself would be required to register as a broker-dealer and would be subject to oversight by a securities self-regulatory organization.-[21]- While the Commission would have the ability to regulate and examine the activities of SIDs, as a practical matter, effective oversight of the SID would be more difficult than oversight of a comparable separate broker-dealer. Currently, the Commission has the authority to inspect the whole range of a broker-dealer's activities. In contrast, the Commission's ability to effectively examine the SID would be limited. -------- FOOTNOTES -------- -[20]- Specifically, a bank (with or without a securities affiliate) would have to use a SID if it sought directly to engage in (1) transactions involving securities that the Federal Reserve determined to be more appropriately treated as banking products, or (2) issuing or selling asset-backed securities, pursuant to H.R. 1062's new bank exceptions. A bank with a securities affiliate would have to use a SID if it sought to sell private placements directly (i.e., other than through its securities affiliate); however, a bank with no securities affiliate could conduct such activities directly, without segregating them in a SID. -[21]- Under current law, a separate SID structure already applies to banks that deal in municipal securities. The Securities Act Amendments of 1975 required municipal securities dealers (including bank SIDs) to register under Section 15B of the Exchange Act. Section 15B established the Municipal Securities Rulemaking Board ("MSRB") as a self-regulatory organization for broker-dealers in municipal securities. The MSRB has rulemaking authority over all municipal securities broker-dealers in the United States. Unlike other SROs, however, the MSRB does not have inspection and enforcement powers. Instead, the federal banking agencies have enforcement authority regarding the MSRB's rules over bank municipal securities dealers and the National Association of Securities Dealers ("NASD") has enforcement authority over non-bank dealers. The Commission has both rulemaking and enforcement authority over bank SIDs. The Commission does not object to the continuation of this scheme for municipal securities. -------------------- BEGINNING OF PAGE #10 ------------------- For example, the activities of the SID would not be performed in a separate area of the bank, or as a separate part of a bank's organizational structure. A SID, for example, could take the form of an organizational chart that identifies individuals scattered over different business areas who engage in a particular type of securities activity. Banking activities and the SID's securities activities could be intermingled throughout the bank. Moreover, a bank might well conduct other excepted securities activities (for example, pursuant to H.R. 1062's other broker-dealer exceptions) within the bank but just outside the artificial boundaries that define the SID. These activities could influence, or be related to, the SID's activities, yet because of the SID's limited scope they would remain inaccessible to the securities regulators who examine the SID. Securities regulators would have to define the scope of their examinations according to the organizational plan adopted by the bank for its SID -- and not according to the interrelated securities activities actually undertaken by the bank.-[22]- Similarly, because the SID might have little relation to the organizational structures that actually support the business activities of the bank, a SID's recordkeeping systems would reflect regulatory rather than business purposes. As such, they may be less comprehensive or less rigorous than systems maintained as an integral part of a firm's business operations. In addition to these matters, broker-dealer SIDS under H.R. 1062 would be exempt from the Commission's net capital rule and the Commission's customer protection rule. Presumably, the bank SID, as a registered broker-dealer, would be subject to coverage under the Securities Investor Protection Act of 1970 ("SIPA"). The Commission's financial responsibility rules work in combination with the SIPA provisions to maintain the liquidity of a broker dealer, limit use of customer funds to finance the broker-dealer's proprietary trading in securities, and protect customer funds and securities if a broker-dealer fails.-[23]- If -------- FOOTNOTES -------- -[22]- The regulators' examination and enforcement efforts would be further complicated if a single bank established multiple SIDs in order to conduct different securities activities. -[23]- When broker-dealers fall below mandated capital levels, they must cease securities activities until the capital deficiency is corrected. Because of the potential effects on customers or the public securities markets, they cannot continue to operate. In addition, strict limitations on broker-dealers' use of customer funds and securities have resulted in broker-dealer failures on average costing the SIPC fund very little. The largest single payout in the history of that fund was only $30.7 million. And the number of liquidations by the SIPC been very small, both quantitatively and in relationship to the number of SIPC members. The operation of the Commission's net capital and customer protection rules, the examination and oversight mechanisms of the Commission and self-regulatory organizations, and annual auditing by independent public accountants have (continued...) -------------------- BEGINNING OF PAGE #11 ------------------- SIDs were excluded from the Commission financial responsibility rules, only the SIPA provisions would apply. Although the SID would be subject to bank capital standards focused on credit risk, it would not be subject to market risk-based capital requirements. Although the Commission is hopeful that recent efforts by the banking regulators will help address this concern, bank market risk standards are yet to be implemented following recent agreement of the Basle Committee on Banking Supervision.-[24]- In the event of the failure of a bank operating a SID, the interplay of the SIPC and FDIC bankruptcy provisions, with their potentially inconsistent customer and depositor protection standards, is unclear. Moreover, although the bank SID would be subject to bank capital standards, exempting SIDs from net capital rules would be highly significant from the standpoint of fair competition in comparable activities. Broker-dealers constantly consider the consequences of their activities under the net capital rules: every deal, every major trade, is evaluated in light of its effect on capital. For banks to perform similar functions under different rules with different consequences on a per trade, per deal basis would create the potential for unfair and unequal competition. This, combined with the ability of broker-dealers and banks to affiliate, could lead to securities activities being shifted between entities purely on the basis of disparities in capital treatment. In our view, this potential capital arbitrage, combined with the inherent awkwardness of the SID structure, argues for requiring most bank securities activities to be conducted in a separately incorporated entity that is registered as a broker-dealer.-[25]- The Commission's concerns about SIDs are exacerbated by the recent addition of an exemption to H.R. 1062 that would authorize the Federal Reserve to permit banks, through SIDs, to effect transactions in any security that the Federal Reserve determined is "more appropriately treated as a bank product." Because this -------- FOOTNOTES -------- -[23]-(...continued) permitted the Commission and the self-regulatory organizations successfully to wind down broker-dealers, including large firms such as Drexel Burnham Lambert Inc. and Thomson McKinnon Securities Inc., without the need for SIPC intervention. In the Thomson self-liquidation, over 450,000 active customer accounts with property totalling $10 billion were transferred to other broker-dealers, thereby avoiding a SIPC liquidation. -[24]- Basle Committee on Banking Supervision, Proposal to Issue a Supplement to the Basle Capital Accord to Cover Market Risks (April 1995). -[25]- The Commission believes that a SID structure may be appropriate for a fee-based, advisory business, such as the investment advisory business, because such activities generally do not require capital or the handling of customer funds and securities to the same degree as a broker-dealer business and, therefore, may more easily be separated from the rest of the bank. Capital, however, is essential to the business of trading in securities and the capital requirements imposed on a broker-dealer are integral to the regulation of broker-dealer conduct. -------------------- BEGINNING OF PAGE #12 ------------------- exemption is largely within the Federal Reserve's discretion,-[26]- it could ultimately allow an unforeseeable range of securities products to be traded and brokered by bank SIDs. While the Commission strongly supports innovation in the securities markets, our concerns about SIDs are compounded by the potential breadth of their activities. Finally, the Commission is concerned that its ability to take enforcement action against a SID could be compromised by concerns relating to bank safety and soundness. Because SIDs would not be separate entities, with separate capital, the capital of the bank as a whole would be at risk if the Commission brought an enforcement action against a SID that involved significant penalties and/or disgorgement on behalf of investors. By permitting banking and securities activities to be intermingled in this way, the bill could result in broadening the exposure of the deposit insurance fund to include risks associated with securities activities. * * * In summary, H.R. 1062 would represent progress toward functional regulation for some securities activities, particularly bank investment advisory activities. For other securities activities, however, H.R. 1062 would preserve the STATUS QUO, and would provide opportunities and incentives (less stringent capital requirements, relief from firewalls, and access to bank funding) for banks and securities firms alike to move activities out of registered broker-dealers and into banks. The Commission believes that more can be done to rationalize the financial services regulatory system. IV. Regulatory Structure For financial modernization reform to be truly effective, it must allow securities firms and their financial services competitors to engage in the risk-taking activities so critical to the capital formation process. Reform also must provide equal opportunities for market participation to banks and securities firms alike, with competition occurring on the basis of market performance, not differential regulation. Moreover, wherever possible, reform legislation should seek to promote competition and should avoid imposing arbitrary limits on the business activities of financial services providers. H.R. 1062 falls short of meeting these standards. The bill's regulatory provisions aim to fit securities firms that are affiliated with banks into a structure modelled on the traditional bank regulatory framework. The regulatory provisions, moreover, are highly complex and would create considerable new regulatory burdens. In their complexity and bank-orientation, the bill's regulatory provisions would continue to pose obstacles to a true "two-way street." Finally, H.R. 1062 does not go far enough to eliminate existing problems of overlap (and potential conflict) in the oversight and examination of bank-affiliated securities activities. -------- FOOTNOTES -------- -[26]- Thus, the Federal Reserve could determine to treat a particular security as a banking product to be effected in a SID based on considerations wholly unrelated to the purposes of the federal securities laws. -------------------- BEGINNING OF PAGE #13 ------------------- A. CONSOLIDATED REGULATION Consistent with the Bank Holding Company Act ("BHCA") model, H.R. 1062 would give the Federal Reserve authority to define and restrict the permissible activities of securities firms affiliated with banks. Furthermore, the Federal Reserve could set consolidated capital requirements for FSHCs (perhaps even for securities affiliates)-[27]- and could limit holding company transfers of capital to securities affiliates.-[28]- By following a bank holding company model, H.R. 1062 would focus on bank safety and soundness without fully taking into account the realities of the securities markets. For example, H.R. 1062 would impose restrictions on a securities firm on the basis of capital or management problems in an affiliated bank. Specifically, the bill would require the Federal Reserve to curb the activities of a securities firm in the event that an affiliated bank becomes undercapitalized or is determined to be poorly managed. This requirement would apply even if the broker- dealer were well-managed and well-capitalized -- the "crown jewel" of the holding company. As a result, a provision intended to promote bank safety and soundness could, by penalizing the healthy broker-dealer, actually undermine the condition of the holding company as a whole. The Commission, of course, recognizes that bank affiliations with securities firms may raise bank safety and soundness issues. However, it would be misguided to seek to control these risks by imposing an overlay of bank-type "safety and soundness" regulation on bank securities affiliates -- as consolidated bank holding company regulation does. For one thing, such an approach is likely to fail. As the Treasury Department noted just four years ago: [I]t is practically infeasible for a bank supervisor to effectively regulate a complex and diverse range of businesses. Bank regulation should be concentrated on the bank, which CAN be effectively regulated, and not on protecting a diversified [financial services holding company] that should be subject to normal market discipline.-[29]- -------- FOOTNOTES -------- -[27]- See Report of the House Committee on Banking and Financial Services to Accompany H.R. 1062, Section-by- section analysis, at 24 ("It is expected that the Board will not require a securities affiliate to hold more capital than is required for securities broker-dealers, or that is comparable to securities industry norms") (emphasis added). -[28]- At present, securities affiliate capital is not counted towards bank holding company capital. Although H.R. 1062 would generally follow this principle, some language in the bill suggests that a portion of a securities affiliate's capital could in fact be counted toward the holding company's capital requirements. We request clarification of the bill's language on this point. -[29]- U.S. Department of the Treasury, Modernizing the Financial System: Recommendations for Safer, More Competitive Banks (Feb. 1991) at 61 (emphasis in original). -------------------- BEGINNING OF PAGE #14 ------------------- In addition, imposing bank-oriented, safety and soundness regulation on securities affiliates would constrain their ability to respond quickly to market movements; this in turn could change the character of the securities business and affect the capital formation process. With respect to the "two-way street," the Commission recognizes that H.R. 1062 would present securities firms with a number of options they do not have today. Among other things, H.R. 1062 would create a new category of "investment bank holding companies" ("IBHCs") that could engage in a wider range of activities than is generally permitted for bank holding companies.-[30]- In another effort to provide for a true "two- way street," the revised bill would take steps to streamline Federal Reserve supervision of FSHCs and IBHCs engaged primarily in nonbanking activities.-[31]- While these provisions move in the direction of a "two-way street," they do not go far enough. The provisions are highly complex and would impose arbitrary limitations on the business of firms that affiliate with banks. Moreover, even though H.R. 1062 would provide some relief from the restrictions and supervisory provisions contained in existing bank holding company law, it would still closely follow the BHCA approach. That model of consolidated, "top-down" regulation is not well-suited for securities firms and other companies that seek to compete vigorously in new lines of business and fast-moving markets. Prior notice and approval requirements, limits on merchant banking activities and commercial investments, and similar requirements of H.R. 1062 would create significant new regulatory obstacles for securities firms used to competing in a rapidly changing, market-oriented environment. Furthermore, securities firms that already are subject to comprehensive regulation by the Commission under the federal securities laws would, under H.R. 1062, have to submit to new regulatory costs entailed by additional Federal Reserve examination, reporting requirements, and supervision. -------- FOOTNOTES -------- -[30]- IBHCs could be approved to engage in any activity the Federal Reserve determines to be financial in nature. Such companies would be barred from controlling "retail" banks (i.e., banks that accept insured deposits); they could control only "wholesale financial institutions," defined as uninsured state banks that are regulated by the Federal Reserve. Wholesale financial institutions would have access to Fed Wire and the Federal Reserve's discount window; moreover, transactions between these institutions and their securities affiliates would not generally be subject to the firewalls that apply in the bank holding company context. -[31]- This would include (i) FSHCs with bank (and foreign bank) assets less than 10% of the consolidated total risk-weighted assets of the holding company and that are less than $5 billion or (ii) IBHCs with bank assets less than 25% of the consolidated total risk weighted assets of the holding company and that are less than $15 billion, provided that all depository institutions controlled by such entities are well-capitalized and well-managed. -------------------- BEGINNING OF PAGE #15 ------------------- In lieu of consolidated holding company regulation, the Commission believes it would be preferable to rely on strong functional regulation, with banking and securities functions conducted in separate entities; on effective firewalls between banking and securities activities; and on enhanced regulatory coordination. Under this approach, each entity in the holding company complex would be separately incorporated and regulated by its expert regulator in accordance with the principle of functional regulation. The federal banking regulators (consistent with their special expertise) would apply their requirements to banks in order to contain the potential risks to safety and soundness (and the federal deposit insurance fund) that may arise as a result of bank affiliations with other entities. The Commission and the SROs, consistent with our statutory mandate and particular expertise, would regulate any securities entities, enforcing investor protection and providing market oversight. In this manner, duplicative and potentially inconsistent regulation could be avoided. In order to address issues of systemic risk, the functional regulator should be able to receive information concerning the activities and exposures of related entities. This would enable the functional regulator to monitor the risks to which the regulated entity is exposed.-[32]- Thus, a bank regulator would have access to "risk-assessment" information about a securities entity or an information technology affiliate. A bank regulator could not, however, dictate or restrict business activities of securities entities. Instead, the bank regulator would use risk- assessment information, together with back-up authority to conduct targeted examinations of related entities, in order to monitor and regulate a bank's exposure to risks arising from those entities' activities. B. REGULATORY OVERLAP AND DUPLICATION The Commission has stressed in prior testimony that existing law requires bank-affiliated securities firms and investment companies to comply with overlapping and potentially inconsistent regulatory requirements and examinations.-[33]- For example, the Office of the Comptroller of the Currency ("OCC") -- in implementation of the recent guidelines -- has begun to examine registered broker-dealers that sell securities in association -------- FOOTNOTES -------- -[32]- A model for such a system already exists in the federal securities laws. Pursuant to the Market Reform Act of 1990, the Commission adopted rules establishing a risk assessment program that requires broker-dealers to file quarterly reports on their affiliates within a holding company group whose business activities are reasonably likely to have a material impact on the financial and operational condition of the broker-dealer. Under the Commission's risk assessment rules, the Commission receives essentially the same information that an affiliated bank holding company of a registered broker- dealer is required to file with the Federal Reserve Board. We view the information gathered under the risk assessment program as a significant complement to the Commission's existing broker-dealer authority. -[33]- See, e.g., March 15 Testimony at 10-11; Testimony Concerning H.R. 3447, supra note 8, at 11-12. -------------------- BEGINNING OF PAGE #16 ------------------- with national banks. This kind of duplication confuses the industry, imposes unnecessary costs, impairs industry competitiveness, and wastes scarce government resources. The Commission and the federal banking agencies have taken some steps to address the problem of overlapping regulation through better cooperation and coordination. For example, the Commission staff has had ongoing discussions with the NASD and the banking regulators regarding procedures to facilitate the coordination of examination efforts. In January 1995, the NASD and the federal banking regulators announced that they had reached an agreement in principle to facilitate the coordination, and enhance the effectiveness, of their examination efforts. Similarly, the Commission and the OCC have agreed in principle to a framework for conducting joint examinations of mutual funds and advisory entities in which both agencies have regulatory interests. We also expect the Commission's arrangement with the OCC to serve as a model for future discussions with other banking regulators. The Commission hopes that these efforts will improve coordination and communication with the banking agencies, resulting in more efficient oversight of bank securities activities. At the same time, however, we recognize that these efforts cannot, in the long run, substitute for institutional relationships grounded in sound public policy and written into law. H.R. 1062 would make some progress in this area. By requiring banks to conduct certain securities activities in separate affiliates, subject to Commission regulation, the bill would improve the regulation of those specific activities. Other provisions in the bill would also facilitate coordination between bank and securities regulators in a way that would promote functional regulation. For example, Section 104 of H.R. 1062 would create an information-sharing and compliance program to enforce compliance with the bank holding company provisions of H.R. 1062, most notably the firewall provisions, as well as the bank broker-dealer exceptions to the securities laws. This provision would also seek to coordinate examinations of entities that are regulated by both banking and securities regulators, as well as enforcement actions. The Commission strongly supports the thrust of these provisions.-[34]- The Commission is concerned, nonetheless, that many of the inefficiencies and overlap inherent in today's regulatory structure for bank securities activities would carry forward under H.R. 1062. We understand that the banking agencies have a valid interest in obtaining information about related entities' operations to the extent that such operations affect a bank's safety and soundness. But it is not necessary to subject regulated affiliates to further, comprehensive examination by the banking regulators of their securities activities (as may currently occur under the banking regulators' interpretation of -------- FOOTNOTES -------- -[34]- The Commission believes, however, that these provisions (particularly those that deal with examinations) are currently inconsistent with similar provisions added later to the Bank Holding Company Act. We recommend that these provisions be strengthened by importing the concepts and language used in the later provisions. -------------------- BEGINNING OF PAGE #17 ------------------- their guidelines). In our view, H.R. 1062 should more directly address this issue. In particular, the bill should clearly detail how, how often, and to what extent, bank regulators can examine a regulated securities entity that is related to a bank. We recommend that the bill require the banking regulators to use Commission and SRO examinations to the fullest extent possible in their oversight of bank-related securities entities. The bill should further provide that if a banking regulator needs additional information, the regulator should (as a first step) ask the Commission to obtain such information before making its own examination of the securities entity. H.R. 1062 would also create an interagency "Financial Services Advisory Committee," composed of Treasury, the federal banking regulators, the Commission, and the Commodity Futures Trading Commission, with the aim of improving supervision of the financial services industry. As a general matter, the Commission is concerned that the disproportionate representation of banking regulators on the Committee would effectively tilt the Committee's mandate toward bank safety and soundness rather than investor protection. This in turn could undermine the Commission's independence and ability to maintain an appropriate regulatory framework for broker-dealers, including financial responsibility standards and other requirements designed to further investor protection and market oversight rather than bank safety and soundness. Finally, the Commission notes that the formal interagency council, as contemplated by H.R. 1062, would unnecessarily duplicate the activities of the President's Working Group on Financial Markets. The Working Group already serves as an effective vehicle for interagency coordination on issues surrounding the evolution of the financial markets. V. Bank Investment Advisory Activities H.R. 1062 would amend the Investment Company Act and the Advisers Act to address a number of issues raised when banks manage and provide other services to registered investment companies. Most importantly, the bill would amend the Advisers Act to remove the exclusion for banks and bank holding companies that provide investment advice to funds. Because banks currently are not required to register with the Commission as investment advisers, Commission examiners may not have access to all the books and records normally available when the adviser is registered. In addition, under existing law, banks are not subject to a number of substantive requirements applicable to other investment advisers, including regulation of performance fees, procedures to prevent misuse of non-public information, and the Advisers Act anti-fraud provisions.-[35]- Under H.R. 1062, a bank or a holding company that serves as an adviser to a fund would be regulated in the same manner as any other investment adviser to a fund. The Commission strongly supports this change. The bill would allow a bank to segregate its fund investment -------- FOOTNOTES -------- -[35]- Commission records indicate that approximately 58% of bank-affiliated investment companies are managed by investment advisers not subject to full Commission oversight. Thus, even though they provide advisory services to funds identical to those provided by registered advisers, most banks are not subject to registration and regulation under the Advisers Act. -------------------- BEGINNING OF PAGE #18 ------------------- advisory activities in a separately identifiable department or division, and to register the SID (rather than the bank as a whole) as an investment adviser.-[36]- The Commission's objections to the use of broker-dealer SIDs (as noted above) do not apply in this instance because an advisory business does not pose the same kind of supervisory issues as do broker-dealer operations: a fee-based advisory business does not require the same kind of capital,-[37]- or involve the handling of customer funds and securities to the same degree as a broker-dealer business. Therefore, the Commission supports the measure in H.R. 1062 that would provide for the registration of banks or their investment advisory SIDs. H.R. 1062 also would add provisions to the Investment Company Act that are designed to address conflicts of interest and other potential abuses that may exist when banks advise registered investment companies. Because the Investment Company Act and the Advisers Act did not contemplate that banks would be active participants in the fund industry, the statutes do not specifically address these conflicts of interest. The Commission agrees that these statutes should be updated to reflect the greater involvement of banks in the fund business. We are pleased that H.R. 1062 has been modified, as we urged in our March testimony,-[38]- to provide the Commission with the tools necessary to address conflicts of interest involving funds and affiliated banks without imposing rigid statutory prohibitions. As currently drafted, the bill would give the Commission authority to define and deal with those conflicts by rule or order. This authority would allow the Commission to strike a balance between protecting investors from abusive conflict of interest situations and enabling funds to engage in transactions that could be beneficial to shareholders. This approach would also avoid the necessity of time-consuming case- by-case applications for exemptions from outright prohibitions, which could be expensive for regulated entities and could drain -------- FOOTNOTES -------- -[36]- The primary benefits of requiring banks and SIDs that advise investment companies to register under the Advisers Act would be the application of the following provisions: (1) the regulation of performance fees under Section 205; (2) the requirement of Section 204A to establish procedures designed to prevent the misuse of non-public information; and (3) the Section 206 anti-fraud provisions, which are somewhat broader than the anti-fraud standards under other applicable securities laws. Registration would also improve the Commission's ability to inspect bank-advised funds by requiring banks and SIDs to provide the Commission with additional information regarding the investment management of these funds. -[37]- In recent years, several fund advisers, including banks, have purchased from funds certain instruments that had precipitously declined in value or that arguably were unsuitable for the fund. These transactions may place the adviser's capital at risk. Such purchases, however, are relatively infrequent and generally are not legally required. Rather they are undertaken voluntarily by the adviser to preserve the value of a fund's portfolio. -[38]- March 1995 Testimony at 23. -------------------- BEGINNING OF PAGE #19 ------------------- Commission resources. We strongly support the conflict of interest provisions of H.R. 1062 as reported by the House Banking Committee. In addition, H.R. 1062 would address the issue of investor confusion by (1) giving the Commission explicit authority to adopt rules to prevent the use of misleading names by investment companies, and (2) authorizing the Commission to adopt rules or issue orders to prevent or limit funds and their affiliated banks from sharing common names.-[39]- The bill also would amend the Investment Company Act to authorize the Commission to mandate disclosures by investment companies that securities they issue are not deposits, are not insured by the FDIC, and are not otherwise obligations of any bank. Again, the Commission strongly supports the flexible approach of H.R. 1062 in this area. The House Banking Committee, however, adopted one amendment to H.R. 1062's investment company provisions that we view as problematic. As originally drafted, H.R. 1062 would have largely codified the Commission's long-standing interpretation of the bank common trust fund exception in the Investment Company Act. Specifically, the bill would have excepted a bank common trust fund from the definition of "investment company" only if the bank, among other things, did not charge the common trust fund any fees that would cause the total fees paid by a participant account to exceed those that the account would have paid absent an investment in the fund. The bill would have permitted a fund to be charged for the bank's expenses for the prudent operation of the fund consistent with determinations by the federal banking regulators. This approach was consistent with the Commission's interpretation that a bank relying on the common trust fund exception must operate the fund solely as an administrative device for serving BONA FIDE pre-existing trust clients of the bank. As reported by the House Banking Committee, H.R. 1062 would permit a bank to charge a common trust fund any fees and expenses consistent with state and federal fiduciary law. We believe that this provision is not only inconsistent with the purpose of the bank common trust fund exception, but also may create an incentive for banks to place fiduciary accounts into these funds in order to generate additional fees. We urge the Committee to modify this provision to restrict the fees that banks may charge to common trust funds that are not subject to the Investment Company Act. VI. Margin Provisions Section 204 of H.R. 1062 would remove current restrictions -------- FOOTNOTES -------- -[39]- This issue has long concerned the Commission. Two years ago, the Commission staff advised investment companies that the use of common names is presumptively misleading. See Letter to Registrants from Barbara J. Green, Deputy Director, SEC Division of Investment Management (May 13, 1993). This letter noted that the presumption could be rebutted through appropriate disclosure. The letter requires bank-sold and bank- advised funds to disclose prominently in their prospectuses that fund shares are not deposits or obligations of, or guaranteed or endorsed by, the bank and that the shares are not federally insured. -------------------- BEGINNING OF PAGE #20 ------------------- on lending to broker-dealers collateralized by securities for use in the ordinary course of the broker-dealers' business. The bill would preserve restrictions on lending to broker-dealers to purchase securities for their own accounts. In addition, H.R. 1062 would permit broker-dealers to borrow using securities as collateral from any person agreeing to observe applicable rules of the Federal Reserve Board. The evolving nature of our financial markets, including greater reliance on non-bank sources of financing, has made current limitations on broker-dealer borrowing collateralized by securities unnecessary. We believe H.R. 1062 appropriately loosens the restrictions on lending to broker-dealers to finance their securities operations and expands the sources from which broker-dealers may borrow. We would suggest certain changes to H.R. 1062. We believe the amendments to the lending restrictions should apply only to loans to broker-dealers: (1) a substantial portion of whose business consists of transactions with customers other than brokers or dealers or (2) to finance the activities of brokers or dealers as market makers or as underwriters. Federal Reserve regulations already permit loans to broker-dealers, collateralized by securities, for the purpose of securities market making or underwriting. We believe the bill further should permit loans to broker-dealers collateralized by securities for other purposes. We believe, however, that the Federal Reserve should retain the authority to restrict such lending to those purposes which are consistent with the broker- dealer's role in serving a public securities market or for purposes of protecting the safety and soundness of the financial markets. VII. Conclusion The Commission supports the goal of financial services modernization, as well as many of the specific ideas and provisions contained in H.R. 1062 -- for example, the functional regulation of bank investment advisers to registered investment companies. Overall, however, we are concerned that the bill does not go far enough to accommodate the needs of investors and the markets. Functional regulation and investor protection would be furthered by eliminating provisions of H.R. 1062 granting banks extensive exemptions from broker-dealer regulation. Moreover, H.R. 1062 should do more to simplify the regulatory framework for financial services firms and, in so doing, address existing problems of regulatory overlap and duplication. Finally, H.R. 1062 should provide a more effective "two-way street" for securities firms that seek to acquire banks, to avoid the risk that the operation of the U.S. capital markets could be adversely affected through inappropriate constraints on risk-taking activities. The Commission looks forward to working with the Commerce Committee on this important initiative. We will forward to you some suggestions for improving the bill which both move in the direction suggested by this testimony and are consistent with the objectives of H.R. 1062 as reported by the Banking Committee.