TESTIMONY OF ARTHUR LEVITT, CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING FINANCIAL MODERNIZATION AND H.R. 10, THE FINANCIAL SERVICES COMPETITION ACT OF 1997 BEFORE THE COMMITTEE ON COMMERCE, SUBCOMMITTEE ON FINANCIAL AND HAZARDOUS MATERIALS U.S. HOUSE OF REPRESENTATIVES July 17, 1997 Chairman Oxley, Congressman Manton, and other Members of the Committee: I appreciate the opportunity to testify on behalf of the Securities and Exchange Commission ("Commission") regarding H.R. 10, the Financial Services Competition Act of 1997, reported out of the House Banking Committee and now before you. I thank you, Chairman Oxley, for holding this hearing early in your consideration of H.R. 10, and for requesting the Commission's views on H.R. 10. Before I begin, the Commission would like to acknowledge the efforts of the House Banking Committee in producing H.R. 10. That Committee appears to have labored very hard to address the many complex issues raised by the rapidly evolving financial services industry. The bill reported out of the House Banking Committee would have a profound effect on the regulation of many participants in the securities markets, both today and ======END OF PAGE 1====== in the future. Building on these efforts, Congress has an extraordinary opportunity to craft a set of laws that will adapt to future changes in the financial services industry, as well as to update existing laws to address changes that already have occurred. I. Overview The Commission supports the primary goal of H.R. 10 -- modernization of the legal framework for regulating financial services. The statutory framework governing financial services regulation, enshrined in the 60 year-old Glass-Steagall Act, has not kept up with market developments. For example, over the last decade: * In 1987, Chase Manhattan, Citicorp, and other major banks, began underwriting equity securities through newly established "Section 20" affiliates; * In 1994, Mellon Bank acquired the Dreyfus Corporation, one of the largest mutual fund complexes in the United States; and * This year, Bankers Trust New York Corporation is acquiring Alex. Brown Inc., a major underwriting firm. Expansive regulatory interpretations by federal banking regulators have allowed banks to enter into a wide range of securities activities, most of which were once believed to be off-limits under the Glass-Steagall Act. Today, a bank may engage in securities activities with customers ranging from the most sophisticated institutional clients to a small family farmer in Ohio. A bank is as likely as a broker-dealer to sell securities to a first-time investor. And banks increasingly advise, sponsor, and sell mutual funds. ======END OF PAGE 2====== While banks now enjoy additional flexibility to engage in income- generating securities activities, they do so outside the scope of the federal securities laws. When a bank engages in securities activities it is not subject to most federal securities laws and regulations because it is exempt from the definitions in the securities laws of "broker," "dealer," and "investment adviser." Instead, securities activities conducted by banks are governed by the federal banking statutes. Banking regulation, however, is not an adequate substitute for securities regulation, especially when a bank fully engages in a public securities business. Banking regulation focuses on the safety and soundness of banking institutions and prevention of bank failure. In contrast, securities regulation focuses on disclosure, investor protection, and the maintenance of fair and orderly markets. Furthermore, securities regulation encourages innovation on the part of securities firms. It relies on market discipline, rather than a federal safety net. Securities firms have the freedom to grow -- or fail. As the Committee considers changes to the Glass-Steagall Act, it is important to consider the significant differences in approach between banking and securities regulation, as well as the impact of reform on the securities markets. American businesses today depend on our capital markets to support their exceptional growth. In 1996 alone, thousands of businesses raised approximately $1.2 trillion from investors, through the entrepreneurial and risk-taking efforts of securities firms, without the benefit of federal deposit insurance.1 At the same time, we are moving ======END OF PAGE 3====== from a nation of savers to a nation of investors -- today, individuals have more money invested in mutual funds than they hold in bank savings accounts.2 The American public has the confidence to invest in securities because of the strong investor-oriented regulation of those markets. Together, risk-taking and public confidence make our securities markets the most vibrant and fair markets in the world. The Commission urges this Committee, as the debate on financial reform moves forward, to consider the effects that new laws governing financial services would have on the securities markets and the investors in those markets. H.R. 10 will likely have a profound effect on investors, the securities industry, and the securities markets generally, as well as on banks. Regrettably, H.R. 10 approaches financial services reform largely from the banking perspective. Specifically: * H.R. 10 does not adequately protect investors because it does not provide meaningful functional regulation to ensure that investors receive the same protection whether they deal with banks or securities firms. * H.R. 10 inhibits risk-taking by securities firms by applying bank-oriented safety and soundness proscriptions to securities firms affiliated with banks, rather than limiting bank safety and soundness regulation to traditional banking services. ======END OF PAGE 4====== * H.R. 10 imposes new layers of regulation on securities affiliates of banks, in the form of a National Financial Services Council, dominated by banking regulators. * H.R. 10 does not provide to all firms providing financial services equivalent competitive opportunities in the form of a "two-way street." * H.R. 10 perpetuates competitive disparities between banks and broker-dealers by giving banking regulators discretion to decide which securities products can be sold by banks outside the federal securities laws. This Committee has the opportunity to forge a new scheme for financial services regulation that balances more appropriately the needs of the banking and securities sectors. Such legislation should provide flexibility to encourage future innovation by both banking and securities firms, without losing sight of investor protection and the integrity of the securities markets. The remainder of this testimony discusses the historical basis for the separation of banking and securities activities and comments more fully on specific provisions of H.R. 10. The testimony also suggests improvements to H.R. 10 that the Commission believes would constructively address our concerns. ======END OF PAGE 5====== II. Background of the Glass-Steagall Act Before enactment of the Glass-Steagall Act in 1933, bank securities affiliates sponsored over 50% of all new securities issues, and commercial bank assets were heavily invested in securities or securities-related loans.3 The significant level of involvement by banks in the securities markets came under close scrutiny after the 1929 market crash. The Pecora hearings of 1933 focused on the causes of the crash and the subsequent banking crisis. The hearings uncovered a wide range of abusive practices on the part of banks and bank affiliates. These included a variety of conflicts of interest; the underwriting of unsound securities to pay off bad bank loans; and "pool operations" to support the price of bank stocks.4 Revelations about these and other abuses reinforced concerns about the role that banks had played in the speculative fever of the 1920s. The hearing record also compounded fears that the securities activities of bank affiliates threatened bank safety and soundness. Ultimately, strong public reaction to the hearings prompted the enactment in 1933 of the Glass-Steagall Act and the separation of commercial from investment banking.5 Congress, assuming that the Glass-Steagall Act barred banks from engaging in most securities activities, the next year excluded banks from the statutory scheme establishing regulation of securities brokers and dealers in the Securities Exchange Act of 1934 ("Exchange Act").6 ======END OF PAGE 6====== As you well know, much has changed in the 64 years since the Glass- Steagall Act became law. Economic expansion, new technologies and innovative financial products have resulted in the exceptional growth in the U.S. capital markets. While the statutory provisions of the Glass- Steagall Act have not changed, regulatory interpretations have permitted banks to participate in this growth, engaging in activities that were once thought foreclosed by the Glass-Steagall Act.7 III. Functional Regulation 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 registered investment advisers. However, as noted above, the securities laws exempt banks from the definitions of "broker," "dealer," and "investment adviser," thereby exempting banks from the securities regulatory schemes applicable to broker-dealer and investment adviser activities. The result is that banking law applies to banks engaged directly in securities activities. Notably, at present, banking regulation does not specifically address important investor protection aspects of bank securities activities.8 For example: * Banking statutes and rules neither comprehensively address sales practice issues nor impose express duties to supervise bank securities sales personnel; * Bank employees who sell securities are not subject to the same qualification and continuing education requirements applicable under the securities laws;9 ======END OF PAGE 7====== * Banking statutes do not provide private rights of action;10 * Bank securities customers have no forum to address grievances comparable to the Commission's supervised arbitration forum available to customers of securities firms; and * Banking regulators' disciplinary actions are not fully disclosed, depriving investors of basic information with which to protect themselves.11 As a result, an investor who purchases securities from a bank receives a different, and in our view, lower standard of protection than does an investor who buys securities from a registered broker-dealer. The Commission believes that this distinction ill-serves investors. Investors deserve equally high protection regardless of whether they invest through banks or through broker-dealers. For more than a decade, the Commission has urged Congress to adopt a system of functional regulation for all participants in the securities markets.12 The Commission believes that the same rules should apply to the same activities in the financial marketplace -- particularly when the rules are designed to protect investors. The Commission continues strongly to support the principle of functional regulation. Although H.R. 10 tries to implement the concept of functional regulation, in our view, it does so without success. This is not entirely surprising -- investor protection is not one of the express purposes of the bill. Discussed below are the "functional regulation" provisions of H.R. 10, together with our comments and suggestions for improvement.13 Bank Broker-Dealer Activities ======END OF PAGE 8====== H.R. 10 eliminates the general exemption for banks from the definitions of "broker" and "dealer" in the Exchange Act. At the same time, H.R. 10 introduces 16 new exemptions for specific activities banks may continue to engage in outside the securities regulatory scheme. The net effect of this approach is that banks will continue to perform significant securities activities, including activities with the retail public, without the benefit of securities regulation. Exemptions. The Commission has serious concerns about the number and nature of the exemptions provided in H.R. 10. We do not object in principle to exemptions for activities that represent traditional bank activities, such as bona fide trust activities, transactions for affiliates' accounts, certain safekeeping and custody services, and limited accommodation trades in securities for customers. In addition, we recognize that bank transactions in certain exempted securities are already regulated under separate sections of the Exchange Act and that additional broker-dealer regulation of such activities may be duplicative. We are very concerned, however, about broad exemptions in H.R. 10 for bank sales of asset-backed securities and sales of annuities and other insurance products that are securities. These are areas of significant market growth that raise real investor protection concerns. We also are extremely concerned about an open-ended exemption for sales of "banking products," which we discuss in detail below, that would permit banks to effect transactions in almost any security, including securities-based derivatives products, outside of the securities laws. ======END OF PAGE 9====== In our view, fewer, and more narrowly crafted, exemptions would preserve the ability of banks to provide traditional services.14 At the same time, fewer and narrower exemptions would ensure that most securities activities are carried out within the framework of the federal securities laws.15 Banking Products. As mentioned above, H.R. 10 would exempt from broker-dealer regulation all bank transactions in "banking products." This term is defined in H.R. 10 to include traditional, core, non-securities banking services, such as deposit and savings accounts and credit card debit accounts. These products are not securities, and the Commission does not object to exempting them from broker-dealer regulation. However, the "banking product" provision also would exempt from broker-dealer regulation transactions by banks in so-called "qualified financial contracts."16 This term, which is defined by reference to the banking statutes governing liquidation of FDIC-insured banks, is an overly broad term that potentially could include any securities contract, and in H.R. 10 expressly includes credit and equity swaps.17 H.R. 10 would further extend the banking product exemption to any additional product found by the Federal Reserve Board to be a "banking product." As noted above, the Commission supports an explicit exemption for the traditional banking services included in "banking products," such as taking deposits and making loans. The Commission has never sought to characterize these as securities and has never stated that they should be subject to the securities laws. Notably, certain traditional banking products that could ======END OF PAGE 10====== be characterized as securities, such as commercial bills and bankers acceptances, already are exempted from broker-dealer regulation.18 The Commission adamantly opposes, however, the open-ended exemptions in H.R. 10 for qualified financial contracts and other securities deemed by the Federal Reserve Board to be "banking products." These exemptions perpetuate the lesser scheme of investor protection for significant bank securities activities. Moreover, they would perpetuate the competitive disparities between banks and broker-dealers engaged in the same activities. Bank Registration as a Broker-Dealer. The Commission has long argued that banks that actively engage in widespread public securities business should separate those activities from their traditional banking business. This promotes investor protection by eliminating customer confusion. H.R. 10 would permit a bank to register directly as a broker-dealer, without segregating its securities activities from its banking business. Moreover, H.R. 10 would not apply full broker-dealer regulation to those banks that do choose to register. The bill would exempt such banks from securities financial responsibility rules,19 and also would exempt banks that register as broker-dealers from SIPC membership, raising issues of competitive disparity, investor protection, and customer confusion.20 This approach would impede Commission examination and oversight of a bank entity registered as a broker-dealer. The bill would not require the ======END OF PAGE 11====== bank to distinguish the operations of its registered bank securities business. A bank registered as a broker-dealer could engage at the same time in securities activities that are "exempted" under the 16 categories discussed above. Potentially, a bank could engage in "registered" and "exempt" activities with the same customers, but only the "registered" activities would be subject to Commission oversight.21 Furthermore, a separate provision would arbitrarily limit the Commission's authority to examine and oversee the bank's securities activities subject to Commission regulation. To be an effective regulator, the Commission must look at a whole entity, not just its parts. Otherwise, the Commission cannot follow transactions from start to finish. Indeed, when a broker-dealer joins the National Association of Securities Dealers ("NASD"), the NASD has the ability to examine all the broker-dealer's activities, even those not requiring broker-dealer registration.22 The Commission believes, optimally, that banks actively engaged in public securities business should do so within a separate entity that complies fully with the securities laws.23 Parallel Regulatory Schemes. H.R. 10 does display some sensitivity to the need to augment the current bank regulatory scheme with additional "consumer" protection. Towards that end, H.R. 10 includes two provisions that are supposed to provide the investor protection that securities regulation provides, without imposing the full weight of securities regulation on bank securities activities. Unfortunately, these provisions fall short of the mark. They are confusing and duplicative. It is unclear whether they apply to bank "exempted" activities, or whether they would ======END OF PAGE 12====== overlay or abrogate federal securities regulation for banks that do register as broker-dealers. As a result, the practical impact of these "parallel" provisions is difficult to determine. One provision would require the federal banking regulators to issue "consumer protection" regulations governing the retail sales of nondeposit investment products (e.g., securities, insurance products, mutual funds) by banks (and their subsidiaries). The intent of this provision is to provide more disclosure to bank customers purchasing securities, to improve training and qualification of bank personnel selling securities, to improve bank sales practices, and to create a consumer grievance process.24 Under this provision, the banking regulators would adopt their own separate rules, after consultation with the Commission, with respect to these issues. The Commission believes that this provision would represent a step forward if it were limited to exempted bank securities activities. However, the provision also would apply to bank securities activities that would not be exempt under H.R. 10 and that, therefore, would be subject to Commission regulation. As a result, this provision would apply bank regulation to entities already subject to Commission and self-regulatory organization ("SRO") requirements. The possibility for a conflicting and/or duplicative overlay of bank securities rules onto Commission- regulated entities is both unnecessary and troubling. ======END OF PAGE 13====== Another provision would subject bank employees engaged in the offer and sale of securities to the retail public to the same rules and regulations of a SRO, presumably the NASD, that apply to employees of securities firms. Again, the scope of the provision is confused by the fact that, under a separate provision in H.R. 10, banks would register directly as broker-dealers for certain of their securities activities. Such bank-registered broker-dealers, as well as their employees, presumably would be subject to SRO rules -- for their "registered" activities. Moreover, the H.R. 10 Committee report states that the rules must be "the same type"25 of rules and regulations as NASD rules that govern the offer and sale of securities by banks to the retail public, suggesting that banking regulators would adopt and apply rules mirroring NASD rules. Finally, the provision does not state whether the NASD or banking regulators would enforce the rules. While the Commission applauds the goals of these provisions, the provisions fall short of providing investors with full protection. While H.R. 10 would require bank regulators to adopt rules comparable to the Commission's (at least in some areas), the rules would not be the same rules, interpreted and enforced in the same manner. This approach has not worked well in the context of section 12(i) of the Exchange Act,26 and the Commission has serious concerns about extending its application. The Commission is the expert securities regulator, with over 60 years of experience. Replicating the Commission's work in several banking agencies also does not make sense in a cost-conscious government environment. ======END OF PAGE 14====== Investment Adviser Activities The Commission has similar functional regulation concerns with respect to bank investment advisory activities. In recent years, banks have dramatically expanded their investment advisory activities. For instance: * As of December 31, 1996, 119 banks advised 2857 mutual funds (including individual classes), representing approximately 28% of all funds registered with the Commission; and * As of December 31, 1996, assets of bank-advised funds totaled $493.2 billion, or 15% of total mutual fund assets.27 Nevertheless, banks today remain exempt from the definition of "investment adviser" in the Investment Advisers Act of 1940 ("Advisers Act"). Consequently, banks that advise registered investment companies are not subject to the substantive requirements applicable to other investment advisers pursuant to the Advisers Act. The exemption for bank advisory activities has an important practical effect. It hampers effective Commission oversight of bank-advised mutual funds by depriving Commission examiners of access to all the books and records normally available during the examination of a fund whose adviser is registered with the Commission. In addition, banks that act as advisers to registered investment companies are not subject to a number of substantive requirements applicable to registered investment advisers, including regulation of performance fees, procedures to prevent misuse of non-public information, and the anti-fraud provisions.28 ======END OF PAGE 15====== H.R. 10 would address many of the concerns raised by the increased involvement of banks in investment company activities. With some reservations, more fully described below, the Commission generally supports the approach taken in H.R. 10 to regulation of bank investment advisory activities. Registration of Banks that Advise Mutual Funds. H.R. 10 would require banks, or their separately identifiable departments or divisions, that advise registered investment companies to register as investment advisers. This would ensure application of the federal securities laws and regulations to these activities, and permit the Commission to see a more complete picture of investment adviser activities in its examination of mutual funds. Although the Commission has reservations regarding the registration of banks directly as broker-dealers, the investment advisory provisions do not raise the same concerns. The Commission recognizes that banks have historically provided investment advice to their customers, subject to the principles of fiduciary law. H.R. 10 would require Commission oversight of a relatively new bank advisory activity -- advice to registered investment companies -- in a way that would permit the Commission to obtain the regulatory information needed to fulfill effectively its responsibilities in regulating investment company activity. Conflicts of Interest. Currently, the Investment Company Act places some restrictions on transactions between investment companies and their ======END OF PAGE 16====== affiliates, whether or not those affiliates are banks. Special conflicts of interest are raised, however, with the advent of increased bank involvement in the mutual fund business. H.R. 10 contains a number of helpful provisions that target the conflicts of interest resulting from bank involvement in mutual funds activities. The Commission generally supports the provisions in H.R. 10 that address the conflicts that may exist when banks and affiliated investment companies do business with each other. For example, H.R. 10 would prohibit a bank affiliated with a registered investment company, and any affiliated person of such bank, from lending money to such investment company in contravention of any rules and regulations that the Commission may adopt. The Commission supports the thrust of these and other provisions, but recommends that the Committee consider clarifying certain language and more closely conforming these provisions to existing language in the Investment Company Act.29 Two conflicting provisions in H.R. 10, relating to customer confusion when banks sell securities, deserve special attention, however. Specifically, one provision, amending the Investment Company Act, would require all persons selling mutual fund shares to disclose, in accordance with Commission rules, that the mutual fund shares they sell are not covered by deposit insurance, are not guaranteed by an affiliated bank, and are subject to the risk of loss of principal. Elsewhere in H.R. 10 is another provision, amending the Federal Deposit Insurance Act, that would ======END OF PAGE 17====== direct banking regulators to adopt rules requiring banks to make the same disclosure about all securities they sell. The Commission agrees that these disclosures are necessary for bank sales of all securities, not just mutual fund shares, because customer confusion is equally likely, regardless of the security being sold. The Commission does not think, however, that these disclosures have any relevance or usefulness for non- bank entities advising or selling securities, including, but not limited to, mutual fund shares. National Council on Financial Services Regulation To further complicate the regulatory horizon, H.R. 10 would create the National Council on Financial Services, a new "super" regulator with jurisdiction over all firms engaged in financial activities. The National Council on Financial Services would have the authority to impose on all firms engaged in financial activities substantive regulation in addition to that imposed by a firm's functional regulator. With a majority of banking regulators in its membership, any regulations imposed by the Council likely would focus on banking concerns, such as safety and soundness, rather than on encouraging innovation. The Council is contrary to functional regulation, because it removes decision-making from the hands of the expert regulator. A substantive regulator does its job best with clear responsibilities and clear lines of authority. IV. Structuring a Regulatory System to Provide Flexibility Now and in the Future ======END OF PAGE 18====== Effective financial services modernization reform should allow for vigorous competition between all market participants. Securities firms and banking firms alike should have meaningful opportunities for market participation. The Commission recognizes that H.R. 10 would go a long way towards improving the competitive environment between banks and securities firms. The Commission believes, however, that the bank-centered regulatory structures contemplated in H.R. 10 for bank-securities affiliations would not allow sufficient flexibility for securities firms to assume the risks necessary to ensure their continued vitality. For reform to be meaningful, securities firms must be able to continue to engage in entrepreneurial, risk-taking activities crucial to the capital formation process, without the constraints of bank-like regulation. As a result of recent Federal Reserve Board action, more and more banks are likely to acquire securities firms active in the capital formation process.30 Therefore, it will become increasingly necessary to ensure that risk-taking is not inhibited by unnecessary comprehensive safety and soundness regulation. H.R. 10 would impose some measure of bank safety and soundness restrictions on an entire organization made up of banks, securities firms, insurance companies, and other financial service providers. Even when the largest part of the organization's activities are securities-related, safety and soundness restrictions would apply. ======END OF PAGE 19====== The Commission believes that safety and soundness regulation should be focused expressly on the banking functions that require this type of regulation, leaving the non-bank affiliates to more market-style regulation. If holding company regulation is needed, it should follow the "risk supervision" approach discussed more fully below. Holding Company Regulation. The regulatory model offered by H.R. 10 is based on the existing "top-down" regulatory model of the Bank Holding Company Act administered by the Federal Reserve Board. This model provides for comprehensive regulation of all activities in holding company affiliates, with the ultimate goal to ensure that the affiliates' activities do not threaten the safety and soundness of affiliated banks. The traditional holding company model of regulation has never applied to securities holding companies and appears to be less and less appropriate for many of the non-bank activities now conducted by banks and their affiliates.31 H.R. 10 would contemplate comprehensive oversight by the Federal Reserve Board of securities firms that affiliate with banks. H.R. 10 would require any holding company that includes a bank, including a company that derives most of its income from securities activities, to be a bank holding company. Although H.R. 10 takes steps to reduce the current weight of Federal Reserve Board regulation on bank holding companies and their affiliates, the bill still provides the Federal Reserve Board with significant, over- ======END OF PAGE 20====== arching authority over securities affiliates of banks.32 Among other things, H.R. 10 would authorize the Board to examine all holding company affiliates, to impose reporting requirements, and to impose consolidated capital requirements on a holding company based on risk-taking activities of subsidiaries, including securities activities. It is unclear why, as contemplated in H.R. 10, a securities entity that has functioned effectively without Federal Reserve Board umbrella regulation suddenly needs that regulation when it affiliates with a bank. For instance, Alex. Brown Inc. has operated successfully for more than 150 years without Federal Reserve Board supervision. Is such oversight really necessary now, just because Alex. Brown is owned by Bankers Trust? The Commission acknowledges that banking regulators have an important obligation to this nation, to ensure the safety and soundness of our banking system. However, functional regulation and strong firewalls, if applied rigorously and consistently, can provide that assurance. Safety and soundness restrictions should be strictly applied to depository institutions. They should not be applied to affiliated securities firms, and should not have to be, if the bank is adequately regulated and strong firewalls are enforced. Risk Supervision Oversight. In place of comprehensive regulation by the Federal Reserve Board, risk-oriented supervision is more appropriate when activities in a holding company are as diverse as contemplated by H.R. 10. Risk-oriented supervision gives regulators a clear understanding of ======END OF PAGE 21====== the interrelationship of the activities of related entities, and firewalls set appropriate limits on the extent to which related entities can look to each other for services for themselves and their customers. The Commission believes that a supervisory framework for holding companies substantially engaged in securities activities would permit securities firms the flexibility to innovate and keep pace with the rapid change in today's capital markets, while preserving the safety and soundness of bank affiliates. Specifically, we recommend a framework expanding on the Commission's current risk assessment program, containing the following four elements: 1) the ability to monitor internal accounting controls and risk management controls at the holding company level; 2) books and records examination requirements at the holding company level; 3) the ability to measure capital adequacy at the holding company level; and 4) an independent audit requirement to verify financial statements of the holding company and to verify that the controls described above are operating appropriately. The Commission believes that holding companies with both securities and banking activities that are primarily engaged in securities activities should be overseen by the Commission. In recent testimony before the House Banking and Financial Services Committee, Chairman Greenspan agreed.33 The Commission believes that if the largest part of the subsidiaries' business activities are securities-related, and particularly if securities activities of the registered broker-dealer are larger than the banking activities of the U.S. bank, the Commission should oversee the holding ======END OF PAGE 22====== company. If the largest share of activities of a holding company with a bank affiliate are not securities-related, a federal banking authority would be the appropriate lead regulator. Regardless of the lead regulator at the holding company level, all subsidiaries would continue to be directly regulated, along functional lines, by the appropriate primary regulator. Furthermore, the Commission recommends that the Committee consider amending H.R. 10 to allow securities firms that do not have a U.S. bank affiliate to elect to subject their holding company activities to consolidated oversight by the Commission. Securities firms in the United States increasingly conduct a world-wide business. Today, a broker-dealer doing business in London may be affected as much by the activities of its New York or Singapore affiliates as by conditions in the U.S. markets. We understand that foreign regulators increasingly are concerned that the absence of a central authority overseeing the global activities of U.S. securities firms may pose risks to local investors. Consolidated oversight under the risk supervision model that we recommend here could substantially alleviate these concerns and increase our own understanding of the global activities of these firms. Firewalls. Effective use of firewalls is key to financial services reform. Firewalls should address not only bank safety and soundness concerns, but also conflicts of interest presented by bank securities activities. For example, Congress deemed it prudent in the Exchange Act to prohibit a broker-dealer from overreaching by lending funds to investors to ======END OF PAGE 23====== purchase securities being underwritten by their brokerage affiliates.34 A similar firewall should be applied to banks. Firewalls should be strong enough to protect the federal deposit insurance fund, to prevent banks from passing on any possible funding advantages to their affiliates, and to restrict any possible self-dealing and improper conflicts. To the extent that firewalls are predicated on bank safety and soundness, the Commission generally defers to Congress and the banking regulators. Firewalls generally, however, should be structured to permit flexibility in their administration. The Commission generally supports the firewalls in H.R. 10. The Commission has reservations, however, about the way that firewalls would be administered. The bill would place sole authority in the banking agencies to modify existing firewalls and to impose additional firewalls. In order for firewalls to work effectively, however, securities and banking regulators both must examine for compliance and must communicate with each other about the effectiveness of the firewalls from each side. V. Ensuring Competitive Opportunities Are Available to All Financial Service Providers H.R. 10 would remove many barriers to banking firms entering securities and other markets. The bill would not, however, enable securities firms to enter banking markets with the same freedom. ======END OF PAGE 24====== The Commission supports legislative efforts to permit affiliations among all types of financial firms. To the extent that banks are allowed to own securities firms, securities firms should be allowed to own banks. Alternatively, if they choose, securities firms should be able to have access to banking functions, such as the payments system, through limited purpose entities that are fully subject to banking regulation, but without taking on intrusive holding company regulation. If legislation paving the way for a "two-way street" is not enacted, securities firms will find themselves at the wrong end of a "one-way street." This would be due to banking regulators' interpretations giving banks and bank holding companies the ability to own securities operating subsidiaries and affiliates -- options with no corresponding parallel for securities firms. Such a "one-way street" also creates competitive inequalities within the securities industry -- between those securities firms affiliated with banks (having competitive advantages due to access to the payments system, for example) and those without any bank affiliation. "Woofies". H.R. 10 would permit some level of competition by providing securities firms with the authority to acquire wholesale financial institutions -- also known as "Woofies" -- that only can take deposits over $100,000 and that do not carry FDIC insurance. A securities firm with an affiliated Woofie could provide the full range of commercial banking services to customers, provided that the deposit size limitations were satisfied. ======END OF PAGE 25====== As a general matter, the Commission strongly supports the creation of Woofies. After a securities firm acquires a Woofie, however, the securities firm would become a bank holding company, subject to comprehensive oversight by the Federal Reserve Board, regardless of how little the Woofie contributes to the bottom line of the securities firm. The Commission suggests that if securities activities dominate an organization that includes a Woofie, bank holding company regulation is not necessary. Rather, the Commission would replace bank holding company regulation with strong functional regulation of the Woofie by a banking regulator, accompanied by effective risk supervision by the Commission if the holding company is primarily engaged in securities activities, as described earlier in this testimony. Commerce and Banking Affiliations. The issue of mixing commerce and banking directly affects the viability of any "two-way street" proposal. The Commission appreciates that mixing commerce and banking is a difficult issue from the banking perspective. Viewed from the securities perspective, however, the Commission has no objections to allowing commercial entities to engage in the securities business. Broker-dealers are presently affiliated with insurance companies; they may also hold equity investments in commercial firms as a result of merchant banking activities. These commercial affiliations have not impaired the Commission's ability to oversee the registered broker-dealers and do not appear to have resulted in the potential abuses of concern to banking regulators. ======END OF PAGE 26====== The Commission has no objection to the mix of commercial and financial activities approved by the House Banking Committee -- namely a 15% basket of commercial activities for financial firms. We are cautiously examining the proposal for a 15% "reverse basket" of banking activities for commercial firms. Among other things, we note that with the "reverse basket" H.R. 10 will impose less supervisory regulation on commercial firms that acquire banks than on securities firms that acquire banks. VI. Conclusion The Commission supports financial services modernization. The Commission believes, however, that certain improvements must be made to H.R. 10 in order to address the needs of our nation's investors and the securities markets in which they invest. Any financial services modernization legislation must delineate a rational system of functional regulation. Financial services legislation also must recognize the inherent differences between banking and securities activities and refrain from imposing banking regulation on securities entities that are affiliated with banks. * * * ======END OF PAGE 27====== Again, we thank you for offering us the opportunity to appear here today and to provide our thoughts for your consideration. The Commission and its staff stand ready to provide the Committee with assistance as the financial modernization debate continues. ======END OF PAGE 28====== ENDNOTES 1. This figure includes firm commitment public offerings and private placements, and does not include best efforts underwritings. (Securities Data Company) 2. Specifically, at the end of 1996, $3.6 trillion was invested in mutual funds. Data compiled by Office of Economic Analysis, U.S. Securities and Exchange Commission, based on January 1997 Federal Reserve Bulletin and 1997 Mutual Fund Fact Book; see Remarks by Eugene A. Ludwig, Comptroller of the Currency, before the Exchequer Club, Nov. 20, 1996 (OCC News Release 96-127). 3. See Susan E. Kennedy, The Banking Crisis of 1933, 212 (1973); Donald C. Langevoort, Statutory Obsolescence and the Judicial Process: The Revisionist Role of the Courts in Federal Banking Regulation, 85 Mich. L. Rev. 672, 694 (1987). Banking and bank affiliates by 1930 also claimed a 61% market share of new bond issue participations. See Edwin Perkins, The Divorce of Commercial and Investment Banking, 88 Banking L.J. 483, 495, 527 (1971). 4. Congress was concerned, for example, about the use of bank loans to support bank affiliates and affiliate-underwritten securities, and about bank incentives (in giving investment advice) to promote affiliate-underwritten securities. 5. There is a broad spectrum of views on the degree to which the Glass-Steagall Act actually responded to the causes of the banking crash. See, e.g., ICI v. Camp, 401 U.S. 617 (1971) (Act was intended to protect bank safety and soundness by preventing abuses of securities affiliates); Langevoort, supra note 3 (Act reflects then-orthodox banking theory that banks should concentrate on commercial lending, combined with a need to respond to the public outcry that followed the Pecora hearings); William C. Isaac and Melanie L. Fein, Facing the Future -- Life Without Glass-Steagall, 37 Cath. U. L. Rev. 281 (1988) (no link was ever shown between securities activities and the collapse of the banking system; Act responded to public outcry rather than hard evidence). 6. See Stock Exchange Regulation Hearings on H.R. 7852 and H.R. 8720 Before the House Comm. on Interstate and Foreign Commerce, 73rd Cong., 2d Sess. 82, 86 (Feb. 16, 1934) (statement of Thomas G. Corcoran, an administration spokesman and a principal drafter of the Exchange Act). Later, the Investment Advisers Act of 1940 also excluded ======END OF PAGE 29====== banks and bank holding companies from regulation as investment advisers. 7. At the same time, the Commission acknowledges that securities firms have entered into some aspects of banking business. For instance, securities firms offer cash management accounts, which often include check-writing privileges, and extend bridge financing to corporate clients. 8. The federal banking regulations do contain limited recordkeeping and confirmation requirements relating to bank securities transactions. See, e.g., 12 C.F.R.  12.1-12.9, 12.101-102, 208.24, and 344.1-344.10. In addition, the federal banking regulators have issued guidelines that address some sales practice issues. See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency and Office of Thrift Supervision, "Interagency Statement on Retail Sales of Nondeposit Investment Products" (Feb. 15, 1994). As the Commission has testified before, while these guidelines represent an important step forward, they are advisory and therefore not legally binding, and may not be legally enforceable by bank regulators or customers. See Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning The "Financial Services Competitiveness Act of 1995" and Related Issues, Before the House Comm. on Banking and Financial Services (Mar. 15, 1995). 9. The banking regulators have jointly proposed to require very limited testing of bank employees directly involved in selling securities. See Qualification Requirement for Transactions in Certain Securities, 61 Fed. Reg. 68824 (Dec. 30, 1996) (to be codified at 12 C.F.R.  208 and 211, 12 C.F.R.  342). This proposal, however, would provide only a fraction of the regulation of securities sales that has developed over the years to protect investors. It does not address supervisory testing and supervision. It also fails to address enforcement of violations by bank employees who have passed qualifying examinations. 10. See, e.g., In re Fidelity Bank Trust Fee Litigation, 839 F. Supp. 318 (E.D. Pa. 1993), aff'd, 43 F.3d 1461 (3d Cir. 1994); In re Corestates Trust Fee Litigation, 837 F. Supp. 104 (E.D. Pa. 1993), aff'd, 39 F.3d 61 (3d Cir. 1994). Banks are subject, however, to the anti-fraud provisions in section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Therefore, bank customers presumably can bring private actions alleging fraud against banks under these provisions. But see Simpson v. Mellon Bank, N.A., [1993-94 Transfer Binder] Fed. Sec. L. Rep (CCH) 98,027 (Dec. 17, 1993) (the ======END OF PAGE 30====== presence of banking regulation precluded reliance by plaintiffs on securities laws in a private action against trustee bank regarding the legality and reasonableness of fees). 11. The banking agencies are required to "publish and make available to the public" final orders issued in connection with enforcement proceedings. 12 U.S.C.  1818(u). The releases usually do not describe the nature of the violation and the enforcement action taken, however. Rather, they list enforcement actions, and typically include the docket number, names of the parties involved, type of action taken, date of the action and whether the action was by consent. The banking agencies also publish results of enforcement proceedings on their internet web sites. The information provided electronically generally is the same information available in the releases. In contrast, Commission and self-regulatory organization disciplinary proceedings are aggressively publicized. Commission press releases describe the nature of proceedings and the identities of the parties disciplined. In addition, as mandated by the Exchange Act, the NASD operates an "800" telephone number hotline, which allows investors to obtain information about the disciplinary and civil liability records of broker-dealers' registered representatives. 12. See, e.g., Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Services, Before the House Comm. on Banking and Financial Services (May 22, 1997); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Regarding H.R. 1062, The Financial Services Competitiveness Act of 1995, Before the Subcomm. on Telecommunications and Finance and the Subcomm. on Commerce, Trade and Hazardous Materials of the House Comm. on Commerce (June 6, 1995); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 3447 and Related Functional Regulation Issues, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (April 14, 1994); Testimony of Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Services Modernization, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (July 11, 1990); Memorandum of the Securities and Exchange Commission (under Chairman David Ruder) to the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, Concerning Financial Services Deregulation and Repeal of the Glass-Steagall Act (Apr. 11, 1988); Testimony of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Structure and Regulation of the Financial Services Industry, Before ======END OF PAGE 31====== the Subcomm. on Telecommunication and Finance of the House Comm. on Energy and Commerce (Oct. 5, 1987). 13. In this regard, Commissioner Wallman has noted that, as distinctions between securities and non-securities financial products diminish, other forms of financial service regulatory reform may be worthy of long-term consideration. Remarks of Commissioner Steven M. H. Wallman before the SIA Conference on the National Securities Markets Improvement Act of 1996 (Jan. 9, 1997). 14. It is important to note that the statutory exemptions could be substantially narrowed without cutting off the opportunity for further exemptions in the future. As a result of the National Securities Markets Improvement Act of 1996, the Commission has broad general exemptive authority for purposes of the Securities Act and the Exchange Act. See 15 U.S.C.  77z-3, 78mm. Therefore, if the Commission determines that a product can be sold outside the scheme of securities regulation, the Commission has the authority to exempt the product, and/or the parties selling the product, from specific, or all, aspects of the securities regulation. 15. More detailed comments on the exemptions in H.R. 10 are set forth in the appendix to this testimony. 16. See 12 U.S.C.  1821. 17. This definition must be broad for liquidation purposes to maximize the number of parties that are authorized to exercise their rights (including rights of termination and offset) against a bank in liquidation. This definition is not appropriate for the purpose of bank sales of securities, however. 18. 15 U.S.C.  78o(a)(1). 19. H.R. 10 would limit this exemption to "well-capitalized" banks. Because a bank is unlikely to be able to comply with the securities net capital requirements, the effect of this limitation is to restrict the option to register as a broker-dealer only to "well-capitalized" banks. 20. Therefore, customers purchasing securities from a bank, whether or not registered as broker-dealers, have no protection in the event of the bank's failure. 21. This troubling approach appears to be anticipated for use by a bank that has a registered broker-dealer operating subsidiary. For example, Zions First National Bank ("Zions") recently applied for authority for its operating subsidiary to underwrite, deal in and invest in municipal ======END OF PAGE 32====== revenue bonds (activities in which the bank itself cannot engage). 62 Fed. Reg. 19171 (Apr. 18, 1997). The operating subsidiary, which would be registered with the Commission, would nominally "underwrite" the bonds. According to the application, however, bank employees (rather than employees of the registered broker-dealer) would actively market and sell the underwritten securities. Customers purchasing from bank employees would be customers of the bank, not the broker-dealer. In addition, Zions plans to place all back- office functions connected to the underwriting activity in the bank, including clearing, settling and issuing confirmations. Under this approach, although the operating subsidiary and its activities would be subject to Commission regulation and oversight, it would perform few, if any, of the activities that the Commission regulates. The activities taking place in the bank would be subject to banking regulation, rather than securities regulation. 22. See Profile of the NASD, NASD Manual, 151-52 (July 1996). 23. Commissioner Wallman notes that, provided appropriate protections to ensure functional regulation are in place, the particular form of entity -- subsidiary or affiliate -- should be irrelevant. 24. This provision would not provide a complete investor protection-oriented regulatory regime. Notably, H.R. 10 would not impose on banks standards for qualifying supervisors or a duty to supervise bank securities sales forces. It also would not provide for self-regulatory organization inspections and oversight, or review of mutual fund advertising and fee disclosure. 25. Report on H.R. 10, "The Financial Services Competition Act of 1997," House Comm. on Banking, Rep. No. 105-164, 105th Cong. 1st Sess. 40 (July 3, 1997) . The Report also states that the banks would not become subject to full NASD regulation. 26. Section 12(i) of the Exchange Act assigns to the banking regulators authority to administer and enforce the most important disclosure and reporting provisions of the Exchange Act (i.e., sections 12, 13, 14, and 16) with respect to publicly held banks and thrifts. The effect of this provision is that some 500 banks and thrifts file their periodic and other reports with the federal banking regulators, rather than with the Commission. This arrangement is unique: all other public companies, including 1200 bank and thrift holding companies, file their reports with the Commission. The Commission has long urged the repeal of Section 12(i) as a means of ending the ======END OF PAGE 33====== anomalous treatment accorded to routine issuer-related securities filings by banks and thrifts. One set of rules could eliminate inconsistencies in interpretations and disclosure documents. Repeal of Section 12(i) has been supported by a variety of government-wide studies, beginning with the Bush Task Force in 1984. 27. Lipper Analytical Services, Inc., Lipper Bank-Related Fund Analysis (1996). By contrast, banks in 1990 advised 517 funds with total assets of $85.9 billion. 28. Banks are subject, however, to the provisions of the Investment Company Act of 1940 ("Investment Company Act") that apply to advisers to investment companies. 29. We would be glad to provide the Committee with technical assistance upon request. 30. 61 Fed. Reg. 68750 (Dec. 30, 1996) (final rule raising from 10% to 25% the revenue limit applicable to certain securities activities conducted in banks' securities affiliates). The Federal Reserve Board's action is expected to generate many more mergers involving major banks and major securities firms. In addition to the Bankers Trust New York Company acquisition of Alex. Brown Inc., in the four months since the Federal Reserve Board's action became effective, announcements have been made that Swiss Bank Corporation will acquire Dillon Read & Company, NationsBank Corp. will acquire Montgomery Securities, and BankAmerica Corp. will acquire Robertson Stephens & Company. Anita Raghavan, "NationsBank in Talks to Buy Montgomery," Wall St. J., June 27, 1997, at A3; Peter Truell, "NationsBank Confirms a $1.2 Billion Deal for Montgomery," N.Y. Times, July 1, 1997, at D5. 31. H.R. 10 also would offer the "operating subsidiary" regulatory model, which would permit special operating subsidiaries of banks, subject to oversight by the Comptroller of the Currency, to engage in activities that are not "part of or incidental to the business of banking," including underwriting, dealing in and distributing securities of any type and organizing and advising mutual funds. The Commission believes that the same concerns regarding consolidated supervision arise whether a bank and securities firm are affiliates or the securities firm is an operating subsidiary. 32. The bill would, however, require the Federal Reserve Board to defer to the Commission with regard to the application and enforcement of the securities laws to the activities of affiliated broker-dealers, investment advisers and investment companies. ======END OF PAGE 34====== 33. Hearing on Financial Modernization Before the House Comm. on Banking and Financial Services (May 22, 1997). See also Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Regarding H.R. 268, The Depository Institution Affiliation and Thrift Conversion Act, Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 13, 1997). 34. 15 U.S.C.  78k(d)(1). ======END OF PAGE 35======