Speech

For release on delivery 9:00 a.m. EDT June 11, 1986 RESEARCH LIBRARY Federal Reserve Bank Louis Of Sta 5 vssn Statement by Paul A. Volcker Chairman, Board of Governors of the Federal Reserve System before the Subcommittee on Commerce, Consumer & Monetary Affairs of the Committee on Government Operations United States House of Representatives June 11, 1986 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I appreciate the effort of this Subcommittee to undertake a full review of the basic approach toward banking, and bank holding company legislation and regulation. This is a large subject, filled with controversy in its particulars and fr with new questions arising about the philosophical * underpinnings. In addition to the Bank Holding Company Act itself, the issues are relevant to the Savings and Loan Holding Company and the Glass-Steagal! Acts. This statement, supplemented with detailed appendices, is an attempt to place the issues in a broad perspective, with full treatment of the underlying public policy issues. I hope you find it useful. I have repeatedly expressed my conviction that Congress should move with a sense of urgency to reform the existing statutes governing banking organizations. The public is entitled to the assurance that the powerful forces of change at work today in the financial services marketplace are channeled in a manner consistent with the broad public Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis — p —> interest — the need to maintain a safe and sound financial system, to assure equitable and competitive access to financial services and credit by consumers and businesses large as well as small, to maintain an efficient and safe domestic and international payments system, and to preserve an effective mechanism for transmitting the influence of monetary, credit and other policies to the economy. The simple fact is that such assurance is lacking today* The Congress has been debating the issues for several years, but every attempt to address them has been stymied due, at least in part, to the efforts to block legislative change by those who perceive a strong particular interest in one part or another of the status quo or in exploiting an existing loophole* However, our concern has to be about the coherence and wisdom of the whole. And changes in the financial system will not wait on legislation. The system Is changing - haphazardly and without direction — in response to a variety Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -3- of economic and other forces. What is clearly lacking is Congressional guidance to assure that the important public policy concerns are dealt with in a constructive manner. Before turning to a review of the fundamental financial industry policy issues, I want to stress that there is, in my view, an opportunity for Congressional action this year in important areas. Comprehensive banking legislation, including provisions to close unintended and unwise loopholes in banking and thrift holding company statutes and to provide certain new products and services for bank holding companies, has been thoroughly debated, reviewed and analyzed over a number of years and is long overdue, The recently introduced emergency acquisition legislation for institutions in danger of failing is urgently needed and currently being debated, should be ready for action shortly, as is the case with legislation to strengthen the FSLIC. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -4- I sense a theme in these hearings of frustration at the lack of Congressional action, which I clearly share. There is danger that this frustration would drive the legislative process to accept a direction of change that would not be constructive, but would instead further undermine some basic principles that have stood the test of time. For instance, one reaction to the legislative gridlock is to suggest that it is appropriate and even desirable that the evident anomalies of the nonbank bank loophole should be resolved by allowing any kind of business to own banks, rationalized as a service to consumers and. a source of funds to capital-starved institutions. We find some commercial banks willing to tolerate and even encourage use of the nonbank bank loophole for their own purposes, particularly to achieve interstate entry. At the same time, those banks, quite unrealistically and dangerously from my perspective-, may feel that Congress, overwhelmed by loophole exploitation, will in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -5- the end and for that reason alone, lower the legal barriers on bank holding company entry into nonbanking activity. But instead, that course would be a process of legislation by loophole exploitation, with a strong possibility that the issue of new products and services for existing bank holding companies will be by-passed indefinitely, with the result of weakening the banking system. That would be a most unfortunate result, abandoning useful principles that have worked well to strike out on a course that has clearly foreseeable pitfalls. We should not be beguiled by claims of what has been termed by some as a "Brave New World" for banking without examining just what we would be getting into. That was precisely the warning delivered by Aldous Huxley's famous fable about the future. As regulators and legislators, our task is to respond to real needs in the marketplace, while assuring that the system remains sensitive to abiding and valid concerns of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis re- public interest. There is still time, but not much time. But I cannot emphasize too strongly that left unattended the process of change now underway is not adequately addressing these concerns. Basic principles of public policy are being bypassed or ignored as market pressures and competitive instincts play against a legal and regulatory structure that has been undermined by officially sanctioned conduct designed to evade its basic tenets. The longer we postpone difficult decisions about the direction in which change should be encouraged or discouraged by public policy, the more difficult those decisions will ultimately become, and the greater the risk that continuing policy concerns --- including the safety and soundness of the banking system -- will be eroded. In reviewing these matters with you today, I would like to focus on underlying strengths as well as weaknesses of the present system, the problems for the future, and the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis fundamental policy considerations that should be our beacons as we navigate through uncharted, and possibly stormy seas, will stress the reasons why I feel it continues to make good sense to maintain a basic separation between banking and commerce, even though the line of separation is inevitably fuzzy at the edges. Finally, I would like to broadly describe the changes we would like to see made to maintain a stable and efficient banking industry, able to compete effectively and respond to the needs of a rapidly changing economy. It is important, as we look at the future of banking, that we approach the problems with care, both preserving what is essential, while making changes where change is necessary,, The_RoleofBanks and the Importance pf_the_Banking Structure At the outset, I referred to some general criteria that should guide the process of change. I would like to be more specific about certain basic points against which proposals for changes in the depository institution holding company acts should be tested: Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -8- first, the unique role of banks in the economy; second, the related needs for federal surveillance and federal support, given the key role of banks; and third, the linking of the parts of a bank holding company organization into an intregal whole. Commercial banks, and increasingly thrifts as they have gained banking powers, are operators of the payments system, custodians for the bulk of the liquid savings in the economy, still by far the most important suppliers of credit, and the link between monetary policy and the economy. All of these functions are imbued with a public interest, and in combination account for the explicit public concern over the years with the strength and stability of depository institutions. The nation's payments systems — the clearing of checks, wire transfers, automated payment arrangements, and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -9- securities clearances — collectively process over a trillion dollars in transactions each day. The orderly, quick, and assured operation of that system is essential to the efficient operation of markets and the economy as a whole. Because these systems have operated without really significant disruption for almost as long as we can now remember, we have come to take their effectiveness for granted. Certainly, a high degree of automation has made the system more efficient. But it is also true that there are inherent risks in operating the system and the speed and volume of payments increase those risks. That is why as supervisor, regulator, and participant in the system, the federal government has to be concerned about who operates this system, the terms of access to it, and the kinds of risks being undertaken. The consequences of breakdown and collective miscalculation are serious. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -10- These concerns derive in substantial part directly from the fact that the individual components of the banking and payments system are closely linked and, to a large extent, mutually dependent. A sudden failure of one institution, particularly of substantial size, can interrupt a long chain of payments and dramatically and unexpectedly affect other unrelated institutions, some of whom may not even have a business relationship with the institution in difficulty and have themselves been well managed and sound. While secondary and tertiary effects are, of course, present in some degree in the failure of any business firm, the effects are never so potentially contagious or so disruptive as when the stability of the banking system or the payments mechanism is suddenly called into question. Then, serious implications for overall output, employment, and prices -- indeed, for the entire fabric of the economy -- are apparent. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -11- Because of their critical role in the economy, the deposit liabilities of banks, and the stability of depository institutions generally, have long been protected to a degree by official supervision and regulation and by a governmental "safety net." Of course, the first and most important line of defense for a safe and sound banking system must be the interest of banking institutions themselves in maintaining the confidence of their customers. But long ago, in establishing national banks, the Federal Reserve System, the FDIC, and the FSLIC, the government determined that normal market incentives and protections needed to be supplemented by official supervision and, later, by a support apparatus. Because of the interdependence of the system, the necessity for confidence, and the nature of banking liabilities, experience repeatedly showed that the market ajjpnj^ could not be relied upon to assure banking stability and the stability of the economy as a whole* Indeed, if market discipline were to become fully effective^ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -12- the government would have to be prepared to see a banking crisis spread widely through the system. It has been a long time since that has been the case. The support apparatus provided the banking system -- importantly reflected in access to the discount window at the Federal Reserve and to deposit insurance -- provides advantages in the competition for the public's funds. But there are offsetting costs as well in, for instance, reserve requirements, insurance premiums and compliance with regulatory standards. Achieving a balance between those costs and benefits is one of the continuing challenges of public policy. More broadly, the protection provided by deposit insurance and the discount window lessens the discipline of the marketplace, potentially changing attitudes and behavior over time with respect to risk-taking. Consequently, the logical extension of the public concern with the stability of the banking system is a continuing interest in limiting certain Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -13- risks and in increasing the level of supervision. There are a number of restrictions on how banks (or thrifts) and their holding companies can do business. The operations and assets of banking institutions are also examined periodically as part of a continuing supervisory process. Concern about the activities of a bank holding company as a whole flows from the earlier points. In the nature of things, parts of an organization under common management and in public perception related to each other, will, to a considerable degree, be affected by the fortunes of other important parts of the same organization. Consequently, concern about the activities undertaken within a bank holding company is a natural and legitimate extension of interest in the safety and soundness of the bank itself. The nonbanking activities need not be frozen in a fixed historical pattern. They may not require the same intensity or degree of supervision as a bank, and they may be regulated differently. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -14- But experience and logic alike strongly point to the need for surviellance and limitations on the range of activities of the entire organization. Implications for Depository Institutions Holding Company Acts The concerns outlined above about the role of banks in the economy are widely acknowledged. Some have, however, come to challenge the proposition that the presence of a supervised, regulated and protected bank within a larger business structure requires a degree of surveillance of the larger organization and concerns about the range and nature of its activities. The argument is made that perhaps the relationship between the bank and its affiliates can be so closely regulated that the safety and soundness of the bank can be insulated and other abuses effectively forestalled. To properly evaluate this argument, ] believe we need to review again the objectives Congress was trying to achieve through the Bank Holding Company Act and to see whether these same objectives, if still valid, can in fact Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -15- be accomplished by relying entirely on insulating a bank from its parent and affiliates. The United States has had a long tradition of legislative separation of banking and commerce (See Appendix A), The Congresses that enacted holding company legislation, beginning in 1933, continuing in 1956, and again in 1970, built on this tradition. They were essentially concerned about potential threats to the critical role that banks play in the economy and to safety and soundness. In the face of a new thrust toward linking banking with commercial activities made possible by the bank holding company, they foresaw the possibility that credit would be abused for the benefit of the owners and they were concerned about possible discrimination in the allocation of credit to the benefit of other parts of the holding company. In transmitting one bank holding company legislation to Congress in 1969, the Administration articulated a related trend of continuing concern: Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -16- Legislation in this area is important because there has been a disturbing trend in the past year toward erosion of the traditional separation of powers between the suppliers of money -~ the banks -- and the users of money -- commerce and industry. Left unchecked, the trend toward the combining of banking and business could lead to the formation of a relatively small number of power centers dominating the American economy. This must not be permitted to happen; it would be bad for banking, bad for business, and bad for borrowers and consumers. The strength of our economic system is rooted in diversity and free competition; the strength of our banking system depends largely on its independence. Banking must not dominate commerce or be dominated by it. In making the judgment that the health of the banking system and the economy required the regulation of companies that own banks, and the limiting of the range of their nonbanking activities, the Congress also rejected the alternative of allowing the diffuse ownership relationships to exist, but regulating them to prevent abuses. Congress has, in fact, provided rather explicit direction as to how relationships between a bank and its affiliates should be monitored and controlled. But it also limited bank holding companies in 1970 to banking and managing and controlling banks and to activities Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -17- that are "so closely related to banking as to be a proper incident thereto." These words, as interpreted from the start, conveyed a limited grant of authority but also a somewhat unusual requirement that these activities meet a public benefits test — that any adverse effects be outweighed by public benefits. In effect, the compromise that was struck was to permit bank holding companies to engage in a range of financial activities, but, even within that framework, with strong limitations on underwriting and insurance activities. Congress also provided the Federal Reserve authority to supervise the nonbanking activities to assure managerial adequacy and financial soundness. The Board has administered its mandate by authorizing k a variety of activities "closely related to banking" and meeting the public benefits requirements that Congress laid down as a prerequisite. I have attached, as. Appendix B, a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -18- description of the evolution of this supervisory role from 1970 to the present. Our practical experience in supervising bank holding companies confirms the Congressional concerns. We have found that the practical realities of the marketplace and the internal dynamics of a business organization under central direction drives bank holding companies to act in greater or lesser degree as one business entity, with the component parts drawing on each other for marketing and financial strength. Certainly the market conceives of a bank holding company and its components in that way. And if market participants tend to consider the bank holding company as an .integrated entity, problems in one part of the system will inevitably be transmitted to other parts. The evidence of leading bankers themselves on the point seems to me rather conclusive, Walter Wriston, former chairman of Citicorp, said 8!. . it is inconceivable that any Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -19- major bank would walk away from any subsidiary of its holding company. If your name is on the door, all of your capital funds are going to be behind it in the real world. Lawyers can say you have separation, but the marketplace is persuasive, and it would not see it that way." More recently, in a thoughtful lecture dealing with new directions in banking, Sir Jeremy t Morse, the Chairman of Lloyds Bank and distinguished ex-Deputy Governor of the Bank of England, strongly stressed the obligation of banks entering into rapidly evolving and highly competitive new markets to stand behind their affiliates. Business theory and empirical evidence indicate that holding company managers, to attain real or perceived efficiencies in production, operations, marketing, and funding will want to coordinate all of these activities. For instance, bank holding companies acquiring commercial finance companies have typically leveraged those subsidiaries much more than independent finance companies, suggesting implicit or explicit Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -20- reliance on the strengths of the related bank and holding company, even if there are no other business relationships among them. Indeed, if such linkages did not exist, it is not entirely clear what benefits bank holding company managers would perceive from expansion into new activities (or from commercial firms entering into banking) other than perhaps satisfying a pure size or growth objective. In any event, effective coordination of the various operations of bank holding companies and their bank subsidiaries will necessarily link the financial fortunes of the banks to the rest of the organization. I know that when we, as regulator, question the capital adequacy of a particular subsidiary of a bank holding company, its managers inevitably point to the capital of the consolidated enterprise as evidence of the necessary financial strength* Nevertheless, to gain the maximum benefits from distancing the bank as much as possible from the nonbank Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -21- activities of its holding company, the Board has sought, in considering applications for approval of new activities, to require that the holding company have the managerial capacity to undertake the activity and the financial resources to capitalize it in accordance with standards prevailing in that industry generally, with the aim of assuring, to the extent feasible, that the new activity can support itself on a stand-alone basis• Experience clearly indicates, however, that when a subsidiary or even a related business enterprise (such as a real estate investment trust) of a bank holding company experiences financial problems, strength will be drawn from other parts of the organization (including banking subsidiaries) to protect the reputation of the entire organization. Examples are described in a paper attached as Appendix C. That paper concludes, after examining the evidence, that the financial problems of a parent or its Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -22- nonbank affiliates will typically affect the financial position of affiliated banks even though certain provisions of law provide a degree of insulation. Perhaps most pointedly, those of us who live in this area are familiar with the problems encountered in the Maryland and Ohio thrifts. Those institutions were not federally regulated, but their problems strongly emphasize the temptations to exploit depository institutions for the benefit of parent companies and their affiliates. Maryland and Ohio had few limitations on the activities of the owners of financial institutions, a situation that itself made supervision of the depositories more difficult. In the event, a number of those depositories were used as a financing tool and to provide credibility and support to poorly conceived, poorly executed, and even fraudulent commercial and financial schemes of their owners and their affiliates. It is suggested that the blatant abuses found in Ohio and Maryland reflected an Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -23- absence of sufficient legal and regulatory insulation between the depository institution and its affiliates,, I would agree. But regulators and supervisors cannot be everywhere, and the relevant question is how many temptations and how much pressure events will put on management and the system as a whole. There is the sad story of the Amoco Cadiz, a large oil tanker that spilled its cargo on the beaches of France after breaking up in a storm. Its owners had been careful to incorporate the ship's operation and separate its corporate structure. In the ensuing litigation over liability, I was intrigued to find that as the drama unfolded, crisis management took over, corporate forms were ignored, and the top leadership of the parent directed all of the activities of the ship-owning subsidiary. The court found the parent fully liable for its subsidiary's environmental disaster. Is it reasonable to expect different approaches when a financial disaster faces a bank holding company? I think not. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -24- Congress can of course legislate barriers between a bank and its affiliates, and has in fact done so by limiting inter-affiliate loans under section 23A of the Federal Reserve Act. But, under pressures to maintain the viability of their organization, management can and does find ways to support an affiliate that does not involve intercorporate lending,, Simply strengthening section 23A in the expectation that this would enforce true corporate separateness is naive, particularly where the parent and its affiliates are unregulated and unexamined so that enforcement is much more difficult. Only if Congress required such limitations as completely different names for holding companies and affiliates, no management interlocks, explicit disclaimers on affiliate obligations, no tandem operations, and other such efforts to enforce true corporate separateness, would market participants -- including management itself — really begin to think of bank subsidiaries as separate and not put at risk by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -25- the activities of their affiliates. Such limitations, however, would turn the nonbank affiliates of regulated bank holding companies into portfolio investments. Without the perception or reality of synergy between the bank and its affiliates, interest in such affiliates would surely decline sharply. Conversely, the strong interest by some commercial or financial firms in banks, or by bank holding companies in a more fully diversified financial services structure, reflects the perception of "synergy" and inter-relationships. Evaluation of the Arguments for Linking Banking and Commerce Much criticism of the present regulatory approach toward banking emphasizes the narrowness — and arbitrariness -- of the definitions of activities that are "closely related to banking." It is argued that the basic structure and the protections built into law can be maintained while expanding the permissible range of activities of the owners of banks to areas of related activity and expertise, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -26- thus allowing the owners of banks and other financial businesses to be more competitive with firms that offer a broad array of financial services to the public. Essentially, this position recognizes on the one hand the need to maintain the protections of present arrangements and on the other hand the feasibility and desirability of expanding the scope of bank holding company activities. As I stressed at the outset, and will explain at the conclusion of my testimony, we strongly support legislation to adapt by that means the present system to a changing environment. There are others who would go much further -- they seem to question the basic premises of any limitations on the activities of owners of banks and would permit any enterprise to own a bank or bank-like thrift. They essentially question whether the safeguards built into the present system to protect depositors1 funds and banks from abuse need to be implemented Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -27- through limitations on ownership, I would like to analyze the major arguments that have been advanced in that connection: that banking, as we know it now, is no longer competitive as evidenced by the trends in bank profitability and market share and, accordingly, banking must be combined with other businesses to make it successful; that technology has made it impossible to segregate banking from other businesses; that the synergies created by combining banking with other products are competitively too strong to resist; that the present system has been irretrievably undermined by market developments such as nonbank banks, and the present situation is irreversible; and that it is essential to bring down the barriers between the linking of banking and commerce in order Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -28- to obtain an infusion of commercial capital into the capital-strained thrift and banking industries. Banking Industry Performance in Perspective With increasing frequency, some serious analysts of banking have expressed concern about the future viability of banks as effective competitors* They point to increased competition from other financial and flnonf inancial" institutions facilitated by improvements in computers and communications, to inroads into banking through loopholes and exploitation of other anomalies in the system, to statutory and regulatory restraints on banking, and to data on a decline in profitability and market share for banks* Clearly banking is facing problems® One obvious symptom is the fact that bank failures have been running at record rates in the past few years and overall, profitability has been declining, at least until 1985. These are serious problems that require careful attention, but it is, of course, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -29- necessary to examine the data carefully to diagnose accurately the problems and to develop effective remedies. During the first half of the 1980s, commercial bank profitability slid rather persistently from the recovery peaks reached in 1979 (Chart 1). During that period, overall bank,., profitability remained well below its 1979 level, and there were particularly acute problems for some very smalJL and very large banking institutions. To some extent, these developments may be cyclical, but both the deregulation of interest rates and the adjustments in the 1980s to disinflation clearly played a role. Certainly banks have been adversely affected by a substantially changed economic climate; an unusually large number of borrowers, especially energy, agricultural, real estate and international borrowers, sustained dramatic reverses. To deal with this problem, provisions for loan losses were raised sharply (Chart 2). By last year these provisions were being added at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -30- more than five times the 1970 pace. In fact, loan loss provisions to average assets has reached a new peak for all sized banks (Chart 3). The result has been pressure on earnings, even though interest margins and fee income have been relatively well maintained. What no statistical analysis of that sort can demonstrate is the extent to which banks, induced by years of relatively fair lending weather and inflationary expectations, engaged in unduly risky lending practices at home and abroad. To that extent, an ultimate penalty on profits is a natural market discipline. It is also important to note that for a major portion of the banking system — all banks with over $100 million in assets — profitability over the past ten years, as measured by the return on assets, has varied in a relatively narrow range. The lowest rate of return on assets for this group was 0.60 percent in 1984, a year that was distorted by the net loss Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -31- of one billion dollars by a single company — the largest loss in banking history. This bad year for this group was immediately followed, however, by a year which, even after substantial interest rate deregulation and additional very large but isolated losses, provided the highest rate of return on assets during this decade. The only pronounced downward trend has been in the return on equity for the largest money center banks, declining each year for the past five years. Even here the trend is reversed when the data excludes certain banks experiencing exceptional losses. Considering the underlying economic difficulties and imbalances, the ability of the banking industry to build reserves and capital and maintain profitability does not suggest an irreversible loss of competitive strength. There are other indicators of underlying resiliency: for example, apart from one data series heavily weighted with some large troubled banks, most indexes of bank stocks have performed as Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -32- well as or better than broader stock market indicators thus far this decade (Chart 4) . Net returns on assets of the largest banks have remained within historical ranges despite record loan loss provisions (Chart 5). It is also significant that large regional banks, as a group, recovered so well last year that measures of their profitability now equal or exceed recent peaks. In sum, the data summarized in Appendix D do not support an assumption of irreversibly declining bank profits. However, one must be careful in judging the level of profitability solely based upon the raw statistical measures of ROE and ROA as they may not fully gauge the relative change in the level of risk in bank portfolios. Certainly, the extent of any increase in portfolio risk must be taken into account in evaluating the profitability data. Those risks must also be taken into account in reviewing the data on banks1 share of the credit markets. In general, those data suggest an ability of banks "to hold their Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -33- own11 in a number of markets despite increasingly tough competition. In the last four years, the bank share of credit extended to domestic nonfinancial businesses has, on average, exceeded that of the preceding two decades (Chart 6) . In the credit market for households, both consumer installment and residential mortgage credit shares have declined modestly since the late 1970s, but remain higher than throughout most of the 1960s. The loss in consumer installment lending share has been mostly at the expense of thrifts given new consumer lending powers by the Garn-St Germain Act. The bank share has declined sharply in the markets for credit extended to the Treasury and state and local governments. These are not areas that those who want to enter banking have indicated that they find particularly attractive. Nonetheless, the apparent choice of banks not to acquire such assets -- or their ability to do so profitably — does have implications for their overall liquidity posture. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -34- Moreover, in one area, the record does demonstrate a strong adverse trend. The bank share of short- and intermediate-term business credit markets has declined (Chart 7), Larger prime borrowers — traditionally the strongest customers of money market and other large banks — have shifted to the cheaper commercial paper and Euro markets and to foreign banks in the United States. The impact on the biggest "money center" banks is particularly notable; from 1975 to 1985, the C&I loans of the nine largest banks dropped from 25 to 15 percent — a relative decline of 40 percent -- of one broad measure of short-term credit extended to nonfinancial businesses (Chart 8), It is this area that has been the source of much concern; apart from loss of profitable business, the erosion of one traditional lending area may have the effect of driving lending into other areas of substantially greater risk than in the past* Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -35- The contrast between declining shares of short- and intermediate-term business credit and maintained shares of total business credit appears to reflect lower sales of long-term debt by corporations in recent years. Moreover, the effects of "securitization" of corporate lending on the largest banks have been accompanied by a strong effort to participate in "off-balance-sheet" financial guarantees to support short-term market borrowings. Many bankers have begun to question, however, whether the returns on their off-balance-sheet guarantees, and perhaps on commercial mortgages as well, fully compensate for the risks involved. Moreover, direct credit extensions by banks may be concentrated more largely among borrowers with lower credit ratings than formerly. The domestic bank loss of short-term credit market share is explained by an increase in the shares of both commercial paper and foreign banks. The commercial paper Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -36- market has grown rapidly in recent years, and increased as a percentage of short- and intermediate-term credit to nonfinancial businesses from just under 6 percent in 1975 to nearly 15 percent last year. U.S. agencies and branches of foreign banks also have made significant inroads into this market, doubling their market share to 8 percent in the period from 1972 to 1985. Viewed in a broader perspective, including the 25 percent or more owned U.S. subsidiaries of foreign banks, as well as their U.S. branches and agencies, the share of total nonfinancial business credit of these banks substantially exceeded that of commercial paper. The appropriate public policy response to marked changes in the relative shares of domestic and foreign banks may be quite different with respect to the commercial paper market. For instance, foreign bank competition might point to the need for intensified international cooperation on capital Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -37- adequacy standards. Account should also be taken of the U.S. bank penetration in foreign markets. More fundamentally, it is essential to ask why U.S. banks may be more expensive suppliers of credit than others to large corporations. Banks bear certain costs — reserve requirements, deposit insurance premiums, and a regulatory compliance burden — that are not applicable to other lenders. On the other hand, banks are the beneficiaries of the federal safety net that is undoubtedly a factor in reducing their borrowing costs. Whatever the reasons, a significant cost differential appears to exist today. If banks are at a long-term basic competitive disadvantage in supplying short-term funds to borrowers, there would of course be major implications for the structure and size of banking, for the safety of the financial system as a whole, and for monetary policy. So far, the data does not unambiguously indicate that this is the case, but developments Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -38- do need to be carefully studied and the implications appreciated. Such implications would not seem to include a need to change the longstanding policy of separating commerce and banking, a development that could well aggravate the trend. Certain approaches responding to the increased "securitization" of the short-term credit market — not just for business credit — does seem relevant to the legislative process. The Board has long supported an approach that, within the scope of appropriate rules to limit potential conflicts of interest and to assure safe and sound operation of securities affiliates, would permit subsidiaries of bank holding companies to engage in underwriting and distributing commercial paper. The Board has similarly supported authorization for underwriting mortgage-backed securities, revenue bonds, and mutual funds. We have held this view for some time. The area of corporate underwriting, in which U.S. banks do participate abroad, is much more difficult; I must point out that the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -39- integration of international capital markets, and the growth of U.S. bank participation in the Euro markets, make the present difference of treatment between domestic and foreign markets stand out. In closing this section of my testimony, I would like to note the rapid movement of the states toward expanded interstate banking. The expansion of the regional arrangements has proceeded faster than anticipated. Twenty-six states have adopted some kind of regional authorization. I am also encouraged by the movement in many states toward phasing out the regional arrangements and opening their borders to nationwide banking — fourteen states (including seven with initial regional pacts) have now removed most restrictions on interstate acquisitions or will soon do so. The task is now for the states to complete the effort and avoid the possible Balkanization of the banking industry that initially seemed to be the consequence of limited regional Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -40- compacts. A transition to interstate banking should help assure that banks are able to compete with other firms, operating nationwide, that can bring the most advanced technology to bear in serving customer needs. '• The Role of Technology Another concern that needs careful analysis is that advances in technology somehow place the banking industry at a major competitive disadvantage. It is said burgeoning developments in building computers with extraordinary power, and high speed communications systems permitting instantaneous transmission of voice, data and documents, make it much easier to manage and process a broad range of financial transactions, thereby permitting nonbanking companies to compete in areas previously within the exclusive domain of banks. In considering the kinds of changes in public policy that are necessary to respond to these developments, it seems to me that we should bear in mind that banking institutions are Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -41- already primary beneficiaries of computer and communications technology. They have creatively applied these technologies to global markets and have made possible almost instantaneous payments of hundreds of billions of dollars every day. They have permitted banks to respond to the market place with new services to meet the demands of corporate cash managers and for a broad array of new consumer products — including 24-hour banking through ATMs, home banking, telephone bill paymerft, and credit and debit cards. Some banks may have been a little slower to adapt to the very latest technology because, as premier financial data processors, they had invested so heavily in the technology of an earlier time and because of branching and interstate restrictions. But they are bringing their systems to the "state of the art," and developments suggest that banks can be as adept at harnessing new technology as any other business. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -42- Moreover, the long experience and direct presence of banks in local markets, for all its imbedded costs, carries advantages as well. I was interested to see that one company that publicly reported it intended "to develop and market innovative financial services on a nationwide basis" relying principally "on direct marketing, mail and telephone rather than on branches and salesmen" later decided to sell its nonbank bank because it was unable to "get a piece of the market." One mistake doesn't make a case, but certainly the relative competitive advantages and disadvantages remain an open question. Synergy Technology may also make possible a melding of products and cross selling to establish synergies unavailable to those who are limited by law to banking or certain financial services alone. That thought has apparently spawned acquisitions of nonbank banks, nonthrift thrifts or other Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -43- financial service firms by retailers, insurance underwriters, securities brokers and underwriters, and now industrial firms. We need to be captious about whether these claims justify abandoning the broad separation of banking and commerce. I am bemused when nonbanking firms, including retailers, seek in banking the growing markets and profitability that they apparently question in their own industries, when at the same time, banks raise red flags about prospects in the banking industry. Synergism is hard to measure and demonstrate. Some skepticism seems to be justified by the mixed results that conglomeration appears to have achieved in nonfinancial areas, where, over the past several years, we are seeing the spin-off and sale of a great many companies that had been brought under a single management. Newly combined financial enterprises have complained about the difficulties of coordinating the joined Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -44- activities, and do not appear to have demonstrated consistent higher levels of profitability. 1. Anomalies and Irreversibility There is also the argument that things have already gone too far to reverse, that too many nondepository institutions are already in the banking business and that these companies with their superior range of product offerings will simply outcompete the remaining banks. But despite all the publicized acquisitions and product introductions, the facts on market share, profitability, and technological innovation do not seem to support this thesis. Certainly there are large anomalies in the present system. The acquisition of nonbank banks by insurance, securities and commercial firms, while bank holding companies cannot do the opposite, is surely competitively unfair. Nonthrift thrifts and state grants of powers to their own institutions for interstate competitive reasons even when those Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -45- powers are questionable from the point of view of safety and soundness and ruled out for bank holding companies are other examples. At this point, these developments are still minor in their overall impact. They are an indication of the need for action, but they do not point to the inevitability of accepting and enlarging what has happened. In fact, the announced intention of the Banking Committees of the Senate and House to have a retroactive grandfather date provides fair warning to those who have exploited the nonbank bank loophole. At some point, the process could be practically difficult to reverse or end. Again, that is an argument for decision and action, not in itself an argument for reversing basic principles that have guided the system. >. Fulfilling Capital Needs The final argument for allowing any company to own a bank or thrift seems to me a counsel of despair; only Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -46- commercial businesses can and will provide necessary capital to troubled thrifts and banks. In fact, any expectations that nondepository institutions are eager and prepared to invest large amounts in resuscitating large troubled institutions is questionable. In many cases, the objective seems to me to obtain access to federally insured deposits, payments system services, and the ability to export a uniform credit card interest rate throughout the country without taking on large fixed costs. The emphasis often seems to be on acquisition of a new or small institution with relatively minimum initial capital requirements, particularly as compared with the size of its parent commercial firm. Moreover, if companies are generally permitted to own nonbank banks, or if access to bank ownership is to be more open to commercial firms more generally, existing interest in taking on the heavy capital and management burden of acquiring large troubled thrift institutions would Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -47- presumably drop away, sharply limiting any contribution to easing the burden faced by the FSLIC. More basically, it would be anomalous to recommend a solution for the difficulties of problem institutions by potentially creating a situation fraught with adverse consequences for the system as a whole. To take just one example, many of the most serious problems among thrifts do not arise today because of their traditional business but because those businesses have been combined with risky real estate development. Increasing the ties between depository and commercial firms more broadly could well aggravate matters. The Consumer Bank Question The argument is made that so-called consumer nonbank banks are needed in order to make available to consumers products and services that are not otherwise available to them. As typically proposed, these banks could engage in all the functions of banks except making direct commercial loans Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -48- (they could make loans through the purchase of commercial paper and money market instruments). They would be different from ordinary banks in as much as they could be owned by commercial firms and engage in cross selling of affiliates1 products and services. It is, of course, an essential objective of any banking system to provide efficient, competitive and innovative services and products to the consuming public. Any banking structure must be designed to assure the achievement of this goal. But it is difficult, indeed, to argue the United States banking system, without commercial ownership, can not or will not meet that need. Federal and state policies have encouraged a multiplicity of small depository institutions that serve a public that is almost completely composed of small businesses and families. A country that has over thirty-five thousand depository institutions — banks, thrifts and credit unions — Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -49- can hardly be said to ignore the needs of consumers. In fact, the overwhelming number, more than 95 percent, of these institutions are none other than family banks serving the needs of small business, families and individuals. Almost one-quarter of commercial banks have 5 percent or less of their assets in C&I loans and over three-quarters have less than 20 percent of assets in these loans. However beguilingly labeled, so-called consumer banks are essentially a device for breaching the wall that now separates banking and commerce. Those who would breach it in the presumed interest of competition and the consumer should, it seems to me, be asked to carry a heavy burden of proof. Do we really want, for example, a retail business to be able to gather deposits under the protection of federal insurance and to use those deposits to fund a credit card they sponsor more cheaply than retailing competitors? Is it wise policy to encourage banking arrangements in which a retailer has an Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -50- incentive to prefer its customers in the provision of loans? Is the converse -- favoring retail customers of a particular bank -- any better? Are there risks in reducing credit standards in an effort to induce nonbanking business, with the financial risks passed on in part to the federal safety net? Do we want to encourage joint marketing efforts and "tie-ins,11 implicit or explicit? Obviously, we can try to write complicated laws to deal with these possibilities. But it strains credulity about human behavior to suggest they would be entirely effective, any more than restrictions on intra-corporate affiliates. That is particularly true in the event the parent holding company and its nonbanking affiliates are unsupervised and unexamined. I believe that, should Congress authorize the so-called consumer bank or make it clear that it did not intend to close the nonbank bank loophole, some rather dramatic changes in our banking structure would occur in relatively Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -51- short order. Some banks, in reassessing the circumstances, could be induced to take the radical step of formally dividing their existing banking institution into two pieces, placing demand deposits and consumer banking in one subsidiary and commercial lending in another. Neither subsidiary would be a "bank11 according to the definition of the Bank Holding Company Act, and the holding company would then be free to engage in any business activity. New entrants into a market are ordinarily associated with more competition, at least for a time. But there is essentially free entry into banking today, and any firm can provide credit cards and consumer loans. The question is whether there are significant added gains by marrying banking and commerce. Certainly policy judgments cannot reasonably be made based upon the activities of the few, and perhaps unrepresentative, commercial companies participating in banking today. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis J^rcElAgfLfcloJlJL ^or ^e Payments System I emphasized earlier the importance of dealing with risks to the nation's payments system. Advocates of broader access to that system argue that risks arising from increased direct access by nonbanking firms can be adequately controlled through restrictions such as section 23A of the Federal Reserve Act which limits extensions of credit to, and other transactions by insured banks with their regulated, supervised and examined affiliates, or through overdraft limits under the Federal Reserve Board's Policy Statement Regarding Risks on Large-Dollar Wire Transfer Systems. These arguments fail to take into account a number of crucial aspects of the payments system: the immediacy and finality of wire and book-entry transfers^ the importance of independent credit judgments in protecting the integrity of the system^ the difficulty of monitoring compliance with rules to prevent abuse by affiliates without substantially and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -53- unacceptably delaying all payments and without examination authority, and the potential for opening access to the discount window to commercial firms generally. Fedwire transfers are made in very large dollar volumes. They involve over 181,000 large dollar payments every day with a total daily value of over $400 billion. Similarly, there are over $200 billion in book-entry securities transfers every day. Most of these transfers are processed through on-line linkages to the Federal Reserve, by terminals or computers on banks1 premises, immediately and finally. These systems can generate large overdrafts — in the multi-billions of dollars —• in a very short period of time. The main protection against the rippling effects of a default is both the standing of the bank itself and its capacity and willingness, in its own interest, to make an independent credit judgment about its customers. Such an independent judgment is hardly feasible when a bank is ordered to make payment by a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -54- parent or an affiliate. And, in the last analysis, if the bank or its parent is unable to cover the payment, the public, through the Federal Reserve and the FDIC, bears a large part of the risk. The risks inherent in parent-affiliates relationships would be exacerbated by the financial formula likely to be followed by a commercial parent seeking access to the payments system through ownership of a nonbank bank: token capitalization of the bank relative to both the size of the parent and affiliates and to the very high dollar volume of transactions functioned through the bank. Such an arrangement seems to be implied by a number of actual or proposed nonbank banks. The combination of banking and commerce in the provision of payment services would also raise important questions about the availability of Federal Reserve credit, now essentially reserved for supervised and regulated depository Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -55- institutions under carefully circumscribed conditions. In a situation in which commercial firms had direct access to the payments mechanism through captive nonbank banks, the Federal Reserve would be put in the dilemma of either funding large overdrafts generated by a nonbank bank parent or rejecting funding requests at the risk of impairing payments to innocent third parties and the functioning of the overall system. Any competitive advantage of access to Federal Reserve credit would certainly push more firms toward bank ownership; yet, I do not believe that Congress intended that the safety net should inure to the advantage of nonbanking companies. It has been suggested that the exceptional provision of payments system facilities to the Chrysler Corporation during the period when the government guaranteed loans to that company demonstrates that this technique can be safely used® But that rescue to me is the exception that proves the rule. Payments facilities were provided to the Chrysler Corporation Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -56- in 1981 when it was already in a real sense under government protection. That access was provided in recognition of the fact that banks exercising independent credit judgments would not accept Chrysler payment orders in the normal course. Direct access to the payments system through a specially chartered bank was provided only because Congress had established a policy of supporting the survival of the Corporation, and because its debt had been guaranteed by the United States by an act of Congress. That does not seem to me any precedent for firms without official support. Appendix E discusses payments system risks in some detail as well as why regulatory approaches to deal with, these risks, particularly as they are presented by nonbank banks, are not satisfactory. This is a technical, detailed matter. But It is nonetheless a matter that lies at the heart of maintaining an efficient, safe financial system. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -57- Foreign Experience As a matter of law and tradition, combinations of banks and other businesses are present in some countries. Those very few countries that have banking systems in which such arrangements are prevalent are generally characterized by the dominance of a relatively few large banks. Such a situation presents a very different regulatory and supervisory framework, among other things making it possible for bank supervisors to maintain a direct review of, and close contact with, those who are operating the banking system. But there also appear to be major costs in this kind of a system in terms of tendencies toward cartelization, slower innovation, and narrower financial markets. These are not patterns that we would wish to emulate. Policy for the Future The burden of my testimony is that the basic banking system is sound, embodying important principles — important Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -58- for safety and soundness, for competitive open markets, and for innovation. This system has withstood enormous strains and demonstrated resilient strength in recent years. Certainly, the technological and market forces pressing upon the structure are significant and important. But I believe they can be channeled in a manner consistent with longstanding purposes of public policy toward banking and consistent with a more competitive, responsive, and stable financial system. Congress has the capacity to choose the kind of system that we are to have. The time to exercise that choice is now. You can refrain from action, but that will not stop change. Then we will see a proliferation of nonbank banks and nonthrift thrifts; increasing combinations of banking and commerce with only limited safeguards to prevent excessive risk, conflicts of interest and concentration of resources; and more anomalies and uneven competitive conditions. In sum, a failure to lead, a failure to establish an orderly environment Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -59- for the conduct of financial business, will have consequences that are both serious and real. Alternatively, Congress could decide to legalize combinations of banking and commerce, regulating that relationship in such a way as to limit the scope for risk, conflicts of interest and concentration of resources. Much of my testimony is that I do not believe that that arrangement will work effectively. If the restraints on intra-corporate relationships are so strong as to deal with the risks, the competitive benefits from, and incentives to create, such relationships will be exceedingly small. Alternatively, a closely regulated bank as part of an unregulated bank holding company would dwindle in importance. It would be used only to provide such services as could only be provided in the form of a bank -- insured deposits and access to the payments system. Other services financial or otherwise^ would gravitate outside # Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -60- the supervised framework. I cannot see how that can be good for banking, for business, or for stability. You have a third choice -- to preserve the basic elements of the present system, while adapting it to meet the requirements of changed circumstances. There is nothing static about the bank holding company concept? Congress intended to allow it to be adapted over time. We and others came to the conclusion some years ago that this could best be done by broadening somewhat the scope of permissible nonbanking activities of bank holding companies to include a greater variety of financial and brokerage services, all within a framework that assures that the public interest in safe and sound banking is maintained® We have urged that bank holding companies, through their affiliates, be able to engage in a variety of activities such as underwriting commercial paper and other instruments I mentioned earlier, real estate and insurance brokerage and travel services® Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -61- We believe that the holding company and its affiliates should be subject to official surveillance, with the right of inspection. Indeed, most of the proposed activities are, one way or another, already subject to official supervision, and that should be rationalized. Such an arrangement would be perfectly neutral and reciprocal, favoring neither bank holding companies nor the financial industry competitors. If it is permissible under the law for bank holding companies to own an insurance, brokerage or securities firm, it would be equally permissible for these firms to own banks. It has thus far not been possible, for a variety of reasons, for Congress to adopt this approach. Within the Congressional forum, it is difficult to resolve specific competitive issues. That was true in 1970 when Congress could not decide to adopt either a positive list of specific bank holding company activities, or a list of those that were Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -62- specifically prohibited. Instead, the Gordian knot was cut by Congress giving the Federal Reserve Board the administrative discretion to determine specific activities under a general, but limited, standard that required the careful weighing and balancing of the public interest. Perhaps one way to break today's gridlock would be, sixteen years later, to adopt the same approach. Instead of the Congress trying to resolve specific industry issues, the Board might be given a somewhat expanded, but still circumscribed, mandate to allow broader ownership of financial businesses by bank holding companies and for these same kinds of financial businesses to own banks. To protect th.e reasonable interest of all parties, including both applicants and protestants, any such new authority should be limited by the same public interest standard as required by present law, with the same procedural protections provided by the right to an administrative hearing as well as judicial review of Board Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -63- decisions. In addition, I believe a new safeguard would be desirable; the effective date of any new activity approved by the Board should be delayed for six months so that the proposed action could be reviewed by Congress before it went into effect. However, that would be a second choice. We look to Congress to provide more specific legislative direction, including review of the present restrictions of the Glass-Steagall Act. In any event, I hope Congress will act, and act soon. The financial system is too important, too interwoven into the fabric of the economy as a whole, to be allowed to evolve in a haphazard manner* Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 1 Net income after Taxes Insured Commercial Banks Percent Percent .85 16 RETURN ON ASSETS Left Scale 15 Excluding Selected Banks .75 14 13 RETURN ON EQUITY .65 Right Scale 12 Excluding Selected Banks 11 % • \ I I I i l i i .55 10 1970 1975 1980 1985 1. Excluding six banks that sustained significant earnings shortfalls in 1983, 1984, or 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Source: Report of Condition and Income. Federal Reserve Bank of St. Louis Chart 2 Components of Net income Insured Commercial Banks NET INTEREST MARGIN Percent of assets 3.5 3.0 1 1 1 2.5 1 NET NONINTEREST MARGIN Percent of assets -2.0 I I I I I I -2.5 LOAN-LOSS PROVISION Percent of assets 1.0 .5 l_L_l_L 1970 1975 1980 1985 1. Excluding loan-loss provision. Source: Report of Condition and Income. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 3 Loan Loss Provision Insured Commercial Banks (By Size of Bank) BELOW $100 MILLION Percent .9 .6 .3 I I I I I I I I I $100 MILLION TO $1 BILLION Percent .9 .6 / ./ .3 I I I I I I I I I I I I S OTHER $1 BILLION OR MORE Percent .9 .6 'ytr df* .s'**. ^f- J*. .3 Excluding Selected Banks1 J_J_J__L_1 I I J_J_l_i__L_ 9 MONEY CENTER Percent .9 .6 .3 1970 1975 1980 1985 1. Excluding four banks that sustained significant earnings shortfalls in 1983, 1984. or 1985. 2. Excluding two banks that sustained significant earnings shortfalls in 1983, 1984, or 1985. Source: Report of Condition and Income. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 4 Levels of Selected Stock Indexes (December 1978=100) 450 400 / / / / — 350 / / / NASDAQ INDEX OF 100 REGIONALBANKS / 300 -^ «> / / / / 250 _ / NYC ;/=- f 1 BANKS \ j/ / / _ / — 200 -^\ ^ S&P 500 / —. —— 150 V X 7 — 100 OUTSIDE NYC BANKS 1 I L i i I I I 50 1979 1980 1981 1982 1983 1984 1985 1. S&P Indexes of six New York City banks and ten iarge banks outside New York City, weighted by shares outstanding. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Return on Assets Insured Commercial Banks (By Size of Bank) BELOW $100 MILLION Percent 1.2 1.0 .8 .6 I I I I I I J I I .4 $100 MILLION TO $1 BILLION Percent 1.2 1.0 .8 .6 I II 1__L__L_1 I I I .4 OTHER $1 BILLION OR MORE Percent 1.2 1.0 Excluding Selected Banks '. J&/~~m .8 "•"-^^o-..^-"°' / / L _ i± I I i A 9 MONEY CENTER Percent 1.2 1.0 .8 Excluding Selected Banks ^ m -®- .6 ,4 1970 1975 1980 1985 1. Excluding four banks that sustained significant earnings shortfalls in 1983, 1984, or 1985. 2. Excluding two banks that sustained significant earnings shortfalls in 1983, 1984, or 1985. Source: Report of Condition and Income. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 6 U.S. Banks9 Share of Credit Extended to Domestic Nonfinancia! Sectors Percent 50 STATE AND LOCAL GOVERNMENT 45 40 35 30 25 \ ^ stto *s. X7 FEDERAL GOVERNMENT \ V / •• 20 / \ \ V 15 /\ V \ \ I I I 1 1 i 1 i I i I I I I I I I I I I I I 1 1 I I 10 1952 1957 1962 1967 1972 1977 1982 1985 Source: Flow of Funds. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 7 U.S. Banks' Share of Credit Extended to Domestic Nonfinancial Corporations TOTAL Percent 38 36 34 32 30 28 1 1 1 1 1 I 1 1 1 1 1 11 1 1 1 1 1 1 1 1 JL1 J I J I L L! I ll 26 1952 1957 1962 1967 1972 1977 1982 1985 SHORT- AND INTERMEDIATE-TERM 2 Percent 90 85 80 75 70 65 I I M I I I I i ! I I I I I I I I I I I I I I I I I I I I I I I 55 1952 1957 1962 1967 1972 1977 1982 1985 1. U.S. chartered commercial bank holdings of total loans, including those backed by real estate, extended to nonfinancial cor- porations, plus their holdings of short- and long-term securities issued by those corporations, all as a share of the total credit market debt of the domestic nonfinancial corporate sector. 2. U.S. banks' holdings of nonmortgage loans and short-term paper issued by nonfinancial corporations as a share of nonfinancia! Digitized for FRASER corporations' total nonmortgage loans plus short-term paper outstanding. http://fraser.stlouisfed.oSrogu/r ce: Flow of Funds. Federal Reserve Bank of St. Louis Chart 8 Shares of Short- and Intermediate-Term Business Credit1 9 MONEY CENTER BANKS Percent 26 22 18 I I I I 14 OTHER U.S. BANKS Percent 68 64 60 I I I I I ! 56 U.S. BRANCHES AND AGENCIES OF FOREIGN BANKS Percent 12 I I J I I L COMMERCIAL PAPER 12 1975 1980 1985 Digitized for FRASER 1. Commercial and industrial loans and commercial paper issued by nonfinancial businesses. http://fraser.stlouisfed.oSrogu/r ce: Report of Condition and Income, and Bank Credit data. Federal Reserve Bank of St. Louis //: • *i* vmt V- V; <:j^ - :a: r > Appendices to the Statement by Paul A. Volcker, Chairman Board of Governors of the ^ ^ Federal Reserve System - ? ^ *v ■ j before the t;/..va. . A-..!'- 'V : ' • a y / • 5 J 1 . a v-’- v ; ^ \ - .a- a , - Subcommittee on Commerce, ; . Consumer & Monetary Affairs of the; - vj't >*a' a ' ' v Committee on Government Operations 1; • ; of the a a - / ^ a a ^ a t V a t - ^ United States House of Representatives Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table of Contents Page Page A-l Appendix A D-l Appendix D The Separation of Banking and Commerce in Bank Earnings and Market Shares American Banking History 1970 to 1985 B-l Appendix B E-l Appendix E The Federal Reserve Board’s Oversight of the Payment System Risk Domestic and International Activities of U.S. Banks and Bank Holding Companies C-l Appendix C An Analysis of the Concept of Corporate Separateness in BHC Regulation from an Economic Perspective Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A-l The Separation of Banking and Commerce In American Banking History It has been asserted that there is no traditon o f separat­ their own. The real bills doctrine was accepted as the ing banking and commerce in the United States. Based “best rule of thumb” for banks to follow.5 on a review o f historical treatises, articles, state and The separation of banking and commerce was a federal statutory materials, legislative histories, court necessary corollary of the real bills doctrine. Under the orthodox view, the assets of a commercial bank decisions, bank charters, and other materials enumer­ had to be capable of ready liquidation. Bank invest­ ated in the bibliography, this paper concludes that the ments in real estate and corporate stock or other en­ separation o f banking and commerce has been a terprises were inconsistent with this view.* prevailing principle applied to commercial banks in Early state and federal bank charters were patterned America since colonial times. after the charter granted by Parliament to the Bank of England in 1694. The Bank of England was pro­ hibited from “directly or indirectly dealing or trading I. 18th Century Banking or permitting anyone on their behalf to deal or trade, with any of the money, stock or effects of the corpo­ ration, in buying or selling any goods, wares or mer­ Commercial banks developed in colonial times to fill chandise whatsoever.”' Treble damages were imposed the need for money as a medium of exchange and as for violations of this stricture. This charter restriction a source of liquid capital.1 Bank activities generally was deemed necessary to avoid “the hazard of bank­ were limited to issuing currency, accepting deposits, ruptcy” as well as to allay fears of merchants that the and making loans to business and government. Be­ bank's powers would give it an unfair competitive ad­ cause the money creating function of banks affected vantage and monopoly control.* the larger economic welfare, banks were regarded as quasi-public institutions and were subject at an early date to an unusual degree of government supervision The Bank of North America and regulation.* The early American concept of banking was in­ The first incorporated bank in the United States es­ fluenced by the "real bills" doctrine enunciated by tablished the principle of banks as a type of public util­ Adam Smith in The Wealth o f Nations published in ity operating in close relation to government needs and 1776. Smith wrote that the proper function of a bank the public interest with limited powers that separated was limited to making short-term, self-liquidating them from commerial enterprises. The Bank of North loans to finance the conversion of raw materials into America, chartered by the Continental Congress in goods and move them to market.’ This doctrine was 1781 to help finance the Revolutionary War and rein­ necessitated by the demand nature of bank funds. A corporated by Pennsylvania in 1786, was limited to is­ bank could not meet its obligation to pay its liabilities suing demand notes, accepting deposits, making short­ term loans, and acting as fiscal agent of the federal on demand if its assets were tied up in long-term, illi­ government. Echoing the Bank of England’s charter, quid assets. Early bank charters typically limited the the bank was specifically prohibited from trading in duration of loans to 30 days, 45 days, or generally no merchandise and from owning real estate except as more than three months, with some states restricting necessary for its place of business and for loan col­ loan renewals.4 lateral. These provisions, and a 14-year limit on the The real bills doctrine had as its primary objective bank’s charter, were intended to keep the bank the stabilization of the banking system. In the 18th and “closely within the reach of the state.”* 19th Centuries, there was no federal safety net and banks had to remain liquid, solvent, and profitable on First Bank of the United States Digitized for FRASER Alexander Hamilton’s “Treasury Report on a National http://fraser.stlouisfedM.oerlga/n ie L. Fein, Senior Counsel, was primarily responsible for the Bank” in 1790 reflected the concept of banking as ------— nt thit naner. M. Michele Faber, Attorney, assisted in Federal Reserve Bank of St. Louis A-2 short-term loans for business purposes and clearly did By the end of the first quarter of the 19th Century, not contemplate the bank’s involvement in commer­ the notion that banks should be separated from com­ cial enterprises.'• The 1791 Act establishing the First mercial ventures was well established. Willis and Bo- Bank of the United States on the basis of Hamilton’s gen state that "[t]he primitive condition of the coun­ Report was modeled after the Bank of England and try, the preponderant importance of trade, and the specifically provided that the bank could not “directly requirements of state laws caused these banks to re- or indirectly deal or trade in any thing, except bills of stria their aaivities almost entirely to purely commer­ exchange, gold or silver bullion, or in the sale of goods cial banking transaaions.”14 really and truly pledged for money lent and not The charter of the Second Bank of the United States redeemed in due time; or of goods which shall be the in 1816 included provisions similar to those of the First produce of its lands.” ” The bank’s powers to invest Bank limiting its involvement in nonbanking aaivi- in real estate were limited to that “as shall be requi­ ties. *° State chartering laws also included similar pro­ site for its immediate accommodation in relation to hibitions. Typical of the state statutes was the Penn­ the convenient transacting of its business, and such as sylvania Act of 1814 which chartered 41 banks with shall have been bona fide mortgaged to it by way of identical charters. The banks were prohibited from securities, or conveyed to it in satisfaction of debts dealing or trading in any manner in merchandise or previously contracted in the course of its dealings.’’11 stock, except for bank stock, government securities, A description of the First Bank’s activities in the Re­ bills of exchange, and gold or silver bullion.” New port of the Secretary of the Treasury in 1809 indicated York banks in 1823 were authorized to “carry on the that the bank was not engaged in any activities other business of banking by discounting bills, notes, and than narrowly circumscribed banking activities. The other evidences of debt; by receiving deposits; by buy­ Report depicted the Bank as engaged strictly in the ac­ ing gold and silver bullion and foreign coins; by buy­ ceptance of deposits, the issuance of bank notes and ing and selling bills of exchange, and by issuing bills, credits as a circulating medium, the payment of drafts notes, and other evidences of debt” and were to have drawn on the bank by individuals, and the payment “no other powers whatever.”” of dividends to shareholders. The property of the Bank consisted of “1st, outstanding debts, consisting prin­ cipally of notes payable at sixty days, which have been Internal Improvement Banks discounted at the bank; 2dly, specie in the vaults; 3dly, buildings necessary for the institution.*’’* The separation of banking and commerce was not strictly adhered to in the second quarter of the 19th Century. Industrialization and the opening of the II. 19th Century Banking south and west generated vast capital needs to sup­ port the nation’s rapid internal growth. The states By 1800, 29 commercial banks were operating in the began to freely grant bank charters to fill this need. United States, mainly on the Hamiltonian model.14 As Charters were granted to any group of individuals who the banking system developed in the 19th Century, the had the necessary capital and met other minimum concept of banking as limited to issuing currency, ac­ qualifications. cepting deposits, and making loans continued. This period, known as the “free” or “wildcat” Because of the recognized importance of banking banking era, saw widespread speculation throughout to the larger economic welfare and the need to ensure the country, particularly in the frontier states. Numer­ the safety of deposits, regulation of banks came to be ous banks sprang up “willing to finance almost any one of the essential functions of government.'9 Bank­ conceivable proposal.” ” It was not uncommon for the ing generally was not permitted without express “less financially orthodox” states to charter internal government authorization and had to be conducted in improvement companies to build canals, railroads, an incorporated entity.14 Early restraining acts typi­ hotels, and turnpikes with powers to issue notes in cally prohibited unincorporated entities from issuing order to raise capital or to require banks to invest in notes or otherwise engaging in banking activities. Later the stocks of various public works projects.” laws prohibited corporations from exercising banking The experience of these ventures tended to en­ powers unless expressly authorized to do so. By 1830, courage the view that banking could not be safely com­ almost all of the states had confined the right to en­ mingled with nonbanking aaivities. The assets of the gage in banking to incorporated banks.” Nearly all internal improvement banks were devoid not only of of the states required banks to organize either under liquidity but frequently of value. When a business ven­ Digitized for FRASERs pecial acts or under a general banking law that ture failed, as many of them did in the Panic of 1837, http://fraser.stlouisfedd.oifrfge/ red materially from the general business incorpo- so much of the bank’s assets were lost that the bank Federal Reserve Bank of St. Louis ___. ___________________*________a ______________a_____i. as A-3 Although the interna] improvement banks no doubt state banks remained thus limited throughout the helped to finance and construct a number of valuable remainder of the 19th Century and into the 20th public works projects, these companies were so inse­ Century.” cure as banks that historians have described their oper­ It was not uncommon for state banks to be char­ ations as “building America through bankruptcy,” tered to serve special economic groups. In 1860, there “disastrous,” and a “nightmare.”’* The National were more than 60 banks for farmers, 30 for Monetary Commission, in assessing the combination mechanics, 45 for merchants, 20 for traders, 13 for of railroads and banking in Mississippi, concluded that manufacturers, and various banks for lumbermen, grocers, importers, miners, wheat growers, reapers, Mississippi was gridironed with imaginary rail­ millers, and whalers.” The banks financed these bus­ roads and beridden with railroad banks. In these inesses through loans or the purchase of bonds, but enterprises there was more watered stock sold than there were cross-ties laid; reckless specula­ did not engage in the business of the borrowers. tion brooked nothing as prosaic as the actual con­ struction of railroads, on the successful operations of which it was supposed fabulous dividends Private Banks, Savings Banks, and would be declared.’7 Trust Companies In 1836, Pennsylvania rechartered the Second Bank State institutions that combined banking powers with of the United States as a state bank with a directive broader activities developed outside of the commer­ that the bank invest in public works projects. Symons cial banking structure in the post-Civil War period.” reports that “[tjhere was hardly a commercial enter­ Private banks were unincorporated banks that ac­ prise in the United States in which this bank did not cepted deposits but, unlike commercial banks, were either directly or indirectly invest.’' •* When the value free to pursue any activity because they did not issue of the bank’s investments declined, the bank failed notes as a form of currency.” Most of the private spectacularly, losing S35 million in capital. The Penn­ banks were small institutions that opened in localities sylvania bank was the last 19th Century bank of its that could not support a bank with the minimum cap­ kind as “state governments gradually realized that ital required by law and confined their activities to nor­ granting banks the power to invest in a broad range mal banking operations. Although they were referred of commercial enterprises simply created an intoler­ to as banks, many states prohibited them from using able risk of bank failures.”’* the name “bank”.” A small but significant number of private banks, particularly in the larger cities, combined banking ac­ Development of State Banks tivities with mercantile, real estate, and securities in­ vestment, brokerage, and underwriting operations.” The six years following the Panic of 1837 saw approxi­ These private bankers generally accepted deposits only mately one fourth of the total number of banks fail.” from their corporate clients, friends, and employees, This experience encouraged states to limit the involve­ and rarely from the general public, and dealt in ment of banks in nontraditional activities: bankers’ acceptances, commercial paper, letters of credit, and foreign exchange. Among their ranks were The experience of the wildcat banks resulted in a general disposition to curtail banking activity, names such as J.P. Morgan A Co., Kuhn, Loeb A Co., and especially to demarcate commercial and in­ Goldman, Sachs, J. A W. Seligman, Lehman Brothers, vestment banking. In the southern states, for ex­ Kidder, Peabody, and Brown Brothers A Co. These ample, where some of the worst examples of un­ private banks became the investment bankers that sound banking had occurred, amendments were dominated the investment banking business in the early generally passed severely restricting investments by banks in real estate and securities. There was 20th Century. Their deposit taking activities were ter­ a general disposition to recognize the essential minated with enactment of the Glass-Steagall Act in differences between banking with liquid and illi­ 1933.” quid assets, and doubtless the experience of the Savings banks also developed in the 19th Century, panic period played an important role in making primarily as home lenders in the New England states. relatively complete the segregation of commer­ cial and investment banking institutions in this These banks accepted savings deposits but, unlike com­ country.” mercial banks, generally did not accept demand deposits or make commercial loans. Their activities Bank powers again were confined to issuing notes, were less restricted than commercial banks, and some accepting deposits, and making loans. With the excep­ of these banks made significant stock investments in Digitized for FRASER tion of issuing notes, which were taxed into retirement nonbanking companies. A spate of savings bank fail­ http://fraser.stlouisfed.org/ by the National Currency Act of 1863, the powers of ures following the panic of 1873 led to more con­ Federal Reserve Bank of St. Louis A-4 servative practices, however. In addition, the mutual to place depositors’ funds at risk by engaging in un­ form of many savings banks limited the opportunities authorized nonbanking activities and allowed the for private gain. These banks thus did not significantly banks to raise the defense of ultra vires in order to depart from the separation of banking and commerce escape liability for their involvement in unauthorized principle.” activities. Trust companies expanded their business beyond Fi­ In First National Bank v. Converse, 200 U.S. 425 duciary activities in the latter part of the 19th Century. (1906), a national bank participated with creditors of It was not uncommon for commercial banks to or­ a failed manufacturing company in organizing a new ganize as trust companies in order to acquire trust corporation to assume the business of the failed com­ powers otherwise denied to them as well as to take ad­ pany. The U.S. Supreme Court ruled that a national vantage of less restrictive regulation.4' Trust compa­ bank had no power to engage in or promote a purely nies frequently were organized under the general busi­ speculative business. ness law rather than the banking law and were free In Cress v. Village of Ft. Loramie, 125 N.E. 112 to accept deposits and engage in any business activity, (Ohio 1919), the court ruled that it would be ultra vires although most confined their activities to the banking for a bank to operate a railway. In Cooper v. Hill, and trust business.4' 94 F. 582 (Col. 1899), it was held ultra vires for a na­ By the early 20th Century, a significant number of tional bank to carry on an ordinary mining, manufac­ trust companies were active in the securities business. turing, or trading business, or a speculative venture Many of them became affiliated with large investment such as prospecting for ore. Similarly, in First National houses or, like the large private banks, became invest­ Bank v. Stokes, 203 S.W. 1026 (Ark. 1918), it was held ment bankers themselves. Trust company affiliates ultra vires for a national bank to engage in buying and provided a vehicle for commercial banks and life in­ selling cattle. surance companies to engage indirectly in securities ac­ Like state banks, national banks were expressly pro­ tivities prohibited to them. The securities activities of hibited from owning real estate except for bank these companies eventually were prohibited in the premises and real estate acquired through foreclosures Class-Steagall Act in 1933.** and debts previously contracted.41 Unlike state banks, which could make real estate loans subject to certain restrictions, national banks were barred from making 111. The National Banking System loans secured by real estate.44 The purpose of the res­ trictions on national bank real estate powers was stated The policy of separating banking and commerce was to be embodied in the national banking system established threefold; ... to keep the capital of the banks in 1864. The National Bank Act of 1864 reflected the flowing in the daily channels of commerce; to de­ limited concept of banking that confined banks to is­ ter them from embarking in hazardous real estate suing currency, accepting deposits, and making short­ speculations; and to prevent the accumulation of term commercial loans. National banks were limited large masses of such property in their hands, to to exercising be held, as it were in mortmain.4’ all such incidental powers as shall be necessary National banks were not authorized to engage in to carry on the business of banking by discount­ securities activities other than investment in federal and ing and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by state government securities, although they could make receiving deposits; by buying and selling ex­ call loans repayable on demand with stock as col­ change, coin, and bullion; by loaning money on lateral.4' In this regard, the national banking system personal security; by obtaining, issuing, and cir­ followed the traditional English concept: culating notes according to the provisions of this act. . . In its early history, the American banking system, at least in theory, held to the traditional English This language has remained in the National Bank Act view—i.e., that banks which accepted deposits essentially unchanged since its original enactment. from the public should not engage in investment banking. During the latter half of the 19th Cen­ The courts interpreted the National Bank Act strictly tury, the national banking system generally fol­ to allow national banks to exercise only those powers lowed, albeit imperfectly, the English practice of expressly conferred or those incidental to their express separating commercial and investment banking powers.44 The scope of national bank powers was functions.44 tested in several early cases involving attempts by na­ tional banks to engage in broad commercial activities. A divergence from a strict separation began when the Digitized for FRASERG enerally, the courts refused to allow national banks courts interpreted the clause *‘by discounting and http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A-5 negotiating promissory notes ... and other evidences banks and their affiliates participated in the distribu­ of debt” in the National Bank Act to give national tion of 61 percent of all bond issues and had become banks implied power to invest in state, municipal, and “the dominant force in the investment banking corporate bonds." Once national banks could invest field."" in municipal and corporate securities, it was difficult Congressional concern over the commingling of to distinguish underwriting and the Comptroller al­ commercial banking and investment banking w as first lowed the banks to underwrite bonds to the extent they aroused in 1912 by the Pujo Committee hearings were permitted to invest in them.’1 Courts held it be­ focusing on the concentration of money and credit in yond the power of a national bank, however, to pur­ the so-called “money trusts.” The Pujo Committee chase or underwrite equity stock of corporations or recommended that national banks be prohibited from other national banks," or to engage in securities underwriting corporate securities." brokerage activities." No Congressional action was taken to limit the secu­ The real bills doctrine continued to be the best “rule rities activities of banks or their affiliates until after of thumb” for banking safety and soundness. Comp­ the collapse of the stock market in 1929 and the wave troller of the Currency Knox in 1875 stated, “a bank of subsequent bank failures in the early 1930s. Con­ is in good condition just in proportion as its business gressional hearings on the securities practices of banks is conducted upon short credits, with its assets so held disclosed that bank affiliates had underwritten and as to be available on brief notice.” Comptroller Tren- sold unsound and speculative securities, published holm in his 1888 annual report stated that national deliberately misleading prospectuses, manipulated the banks constituted “a body of bankers exclusively price of particular securities, misappropriated cor­ devoted to the collection, the safekeeping and employ­ porate opportunities to bank officers, engaged in in­ sider lending practices and unsound transactions with ment in temporary loans of the private capital of the affiliates." Evidence also pointed to cases where banks country.”’4 had made unsound loans to assist their affiliates and Among the regulations applied to national banks by to protea the securities underwritten by the affiliates. the National Bank Act was a limit on loans to a single Confusion by the public as to whether they were deal­ borrower ui ten percent of capital." This regulation, ing with a bank or its securities affiliate and loss of which provided a model fot similar provisions in state confidence in the banking system were also cited as laws, reflected the dangers inherent in the combina­ adverse consequences of the securities affiliate system. tion of banking and commerce through control of These abuses led to the Glass-Steagali Act prohibit­ banks by individuals and corporations engaged in non­ ing banks from underwriting or purchasing securities banking businesses. The National Monetary Commis­ for their own account, with exceptions for government sion remarked on this aspect of the lending limits: securities and certain investment securities, and ban­ [Ijn many banks a controlling interest is held by ning affiliations and interlocks between member banks a person, firm, or corporation that is actively en­ and companies primarily or principally engaged in gaged in other business enterprises-----One con­ securities aaivities." sequence of the close identification of interests thus brought about between banking and other business enterprises is the probability that loans will be made directly or indirectly to some one V. Bank Holding Companies borrower to an amount larger than a proper dis­ tribution of risks would justify." Bank holding companies developed as significant in­ stitutions in the banking industry only relatively re­ cently in our history. Group banking, as bank hold­ IV. Securities Affiliates and the ing companies originally were known, was dependent Giass-Steagaii Act upon the enaament of state laws authorizing corpo­ rations to hold stocks of other companies. The Adam A major departure from the separation of commer­ Hannah Company, organized in 1900 in Minnesota, cial banking and investment banking occurred with the was the first company established to hold stock in development of securities affiliates in the early 20th banks.*1 Except to the extent holding companies were Century. National banks formed securities affiliates used to establish securities affiliates of national banks, as vehicles to avoid restrictions on their direct securi­ however, group banking did not become significant ties activities, particularly underwriting. Peach states, until the 1920s.*1 “(t]he simple effect of allowing national banks to or­ The early regulatory and Congressional concern Digitized for FRASER ganize affiliates... was to defeat the purpose of the over bank holding companies seems not to have been http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis «a»n ,’*7 Rv 1030. commercial SO much with resnea to their nonbankina activities— A-6 with the obvious exception of securities activities—as separation doctrine is dearly stated in the Senate Com­ with potential abuses of their subsidiary banks and the mittee report in 1955: opportunities for unlimited geographic expansion and concentration of banking resources. In general, the philosophy of this bill is that bank holding companies ought to confine their activi­ Beginning with its 1927 Annual Report to Congress, ties to the management and control of banks and the Federal Reserve Board expressed concern about the that such activities should be conducted in a man­ use of holding companies to evade state branching laws ner consistent with the public interest. Your com­ and the lack of supervision or regular examination by mittee believes that bank holding companies state or federal authorities over such companies.*4 In ought not to manage or control nonbanking as­ sets having no dose relationship to banking.’4 1930, a staff sudy by the Federal Reserve Committee on Branch, Group, and Chain Banking concluded that The Committee report recognized as a basis for this “JtJhe chief weakness of the holding company device philosophy the quasi-public role of banks as the cus­ as an instrument for strengthening the banking struc­ todians of the bulk of liquid savings: ture lies in its manipulative possibilities, and the difficulties of adequate supervision.”*’ The study did The combination under single control of both not indicate bank holding company involvement in banking and nonbanking enterprises (permits] nonbanking activities to any substantia] extent. departure from the principle that banking insti­ Significant combinations of banking and industrial tutions should not engage in business wholly unre­ or manufacturing sectors generally did not occur un­ lated to banking. Such a combination involves the lending of depositors’ money, whereas other types til later in the 20th Century.** Concerns over the de­ of business enterprise, not connected with bank­ velopment of a conglomerate system thus were not ing, do not involve this element of trusteeship.” voiced until later and—other than with respect to securities activities—the nonbanking activities of The Act and its 1970 Amendments aimed at four bank holding companies were not restricted until specific adverse effects that the Congress believed were the 1936 Bank Holding Company Act and its 1970 likely to arise when banking and nonbanking interests Amendments.*’ are combined: undue concentration of resources, con­ Bank holding companies as a percentage of total flicts of interest, unfair competition, and exposure of commercial banking resources was somewhat modest banks to increased risks, and unsafe and unsound prior to enactment of the Bank Holding Company Act. banking practices. In 1955, information provided by the Federal Reserve Board to the House Banking and Currency Commit­ tee reported the existence of 114 bank holding com­ Concentration of Resources panies controlling 452 banks, representing 5.87 of to­ tal commercial bank deposits.** Forty-six of these Concentration of resources resulting from corporate companies were subject to regulation under the Bank ownership of banks was a foremost concern expressed Holding Company Act of 1956;** only five were in the Senate Committee report in 1955: affected by the divestiture requirements.’* Despite the relatively modest growth of bank hold­ (B]ecause of the importance of the banking sys­ ing companies,’1 the potential of the holding company tem to the national economy, adequate safeguards device to undermine the historic separation of bank­ should be provided against undue concentration of control of banking activities. The dangers ac­ ing and commerce and result in a concentrated bank­ companying monopoly in this field are particu­ ing system was of such concern to the Congress that larly undesirable in view of the significant part the restrictions of the Bank Holding Company Act played by banking in our present national econ­ were deemed necessary. omy. The extensive use of bank checking accounts in modem commerce exerts an influence on the value of money, which the Constitution empowers the Congress to regulate. Moreover, banking ac­ Bank Holding Company Act tivities are carried on to a large extent by the use of depositors’ funds rather than by the use of The House Banking and Currency Committee Report equity capital subscribed by bank shareholders.’* on the Bank Holding Company Act of 1956” reported that “(e]vidence developed during the hearings has The danger of concentration of resources was again convinced your committee that bank holding compa­ articulated by former President Nixon in 1969 when nies are not in accord with the very precepts upon he submitted legislation to Congress to extend the Digitized for FRASERw hich our banking system rests.” ” That Congress in­ Bank Holding Company Act to one-bank holding http://fraser.stlouisfedt.eonrgd/ ed the Bank Holding Company Act to embody the companies: Federal Reserve Bank of St. Louis A-7 Left unchecked, the trend toward the combining try’s business firms clustering about banks in of banking and business could lead to the forma­ holding company systems in the belief that such tion of a relatively small number of power centers affiliation would be advantageous, or perhaps dominating the American economy. This must even necessary to their survival.” not be permitted to happen; it would be bad for banking, bad for business, and bad for borrowers and consumers. The strength of our economic system is rooted Increased Risks and Unsafe and in diversity and free competition; the strength of Unsound Practices our banking system depends largely on its inde­ pendence. Banking must not dominate commerce The Bank Holding Company Act also reflects a Con­ or be dominated by it.” gressional concern to avoid exposure of banks to the risks of unregulated activities of their parent compa­ nies and affiliates and the potential for unsafe and un­ Conflicts of Interest sound banking practices. The House Committee Report in 19SS cited several Another goal of the Act was to avoid potential con­ instances where the condition of subsidiary banks had flicts of interest that undermine the role of banks as been adversely affected as a result of the activities or impartial granters of credit. The House Committee Re­ practices of their parents and affiliates. The Commit­ port in 19SS expressed concern about preferential treat­ tee cited cases in which banks had lent heavily to their ment of a bank’s affiliates: officers to finance speculation in the stock of their par­ If banks were permitted to own nonbanking bus­ ent holding companies and to the parent companies inesses they would be compelled in many instances to finance speculative dealings, and had been com­ to extend credit to such businesses to the detri­ pelled to pay unwarranted dividends in the face of ment of other competitive businesses in the com­ operating losses to enable holding companies to main­ munity and possibly also to a degree which would tain their dividend policies.10 While acknowledging be unsound from a banking viewpoint. A bank should always be at arms’ length with its bor­ that the Banking Act.of 1933 addressed some of these rowers and such a position could not be main­ abuses, notably the section 23A limitations on trans­ tained were banks permitted to own nonbanking actions with affiliates, the Committee nevertheless con­ businesses and make credit available to them.’* cluded that Bank Holding Company Act regulation was necessary. The Senate Banking Committee Report in 1955 re­ Unfair Competition ferred to “the danger to a bank within a bank hold­ ing company controlling nonbanking assets, should the Congress also sought to guard against unfair compe­ company unduly favor its nonbanking operations by tition that results when the recipients of preferential requiring the bank’s customers to make use of such credit treatment compete with companies that do not nonbanking enterprises as a condition to doing busi­ have access to captive banking resources. The poten­ ness with the bank.” " The Committee similarly noted tial for unfair competition to arise from the commin­ that gling of banking and commerce was cited by the Sen­ ate Committee in its report on the 1970 Amendments: While it is true that banks within a bank holding company system are subject to Federal or State If a holding company combines a bank with a supervisory authority (and sometimes both), fear typical business firm, there is a strong possibility has been expressed that, improperly but within the that the bank’s credit will be more readily avail­ present law, a bank holding company may take able to the customers of the affiliated business undue advantage of one or more banks in its sys­ than to customers of other businesses not so affili­ tem. This it might do by discounting commercial ated. Since credit has become increasingly essen­ paper at the bank with a resulting profit to the tial to merchandising, the business firm that can bank holding company itself but at an unwar­ offer an assured line of credit to finance its sales ranted risk to the bank and its shareholders.'1 has a very real competitive advantage over one that cannot. In addition to favoring the business firm’s customers, the bank might deny credit to Conclusion competing firms or grant credit to other bor­ rowers only on condition that they agree to do business with the affiliated firm. This is why The separation of banking and commerce has been a ... if we allow the line between banking and com­ prevailing regulatory principle applied to banks since Digitized for FRASER merce to be eased, we run the risk of cartelizing colonial times. Early federal and state bank charters http://fraser.stlouisfed.orogu/ r economy___Just as we have seen the coun- Federal Reserve Bank otfr Sv'tc. Liosrueisest hanks ioin the new wave of one-bank granted only limited banking powers and expresslv A-8 in goods and merchandise. This policy was continued eral government. Early instances of commingling of throughout the 19th Century and into the 20th Cen­ banking and commerce tended to occur outside of the tury. The separation policy appears to have been dic­ banking structure through trust companies and un­ tated by the demand nature of bank obligations, which regulated private banks owned by individuals—the required a high degree of liquidity of bank invest­ forerunners of today’s investment banks—or public ments, as well as by the limited concept of banks as improvement companies such as water, canal, and rail­ public utilities whose proper role was confined prin­ road companies that issued notes to raise capital. The cipally to accepting deposits, providing a system of experience with these ventures tended to discourage the monetary exchange, and making loans. notion that banking could be safely combined with There are notable periods in our history when the other business activities. When banks have diverged separation of banking and commerce was not as significantly into nonbanking areas, Congress and the strictly enforced as during other periods. State govern­ states have reaffirmed the separation of banking and ments have not applied the policy as strictly as the fed­ commerce by imposing specific statutory limitations. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A-9 Footnotes 24. James, The Growth of Chicago Banks 13 (1938); Green, Finance and Economic Development in the Old South 1804-1861 113-14 (1972); Smith, Economic Aspects of the Second Bank of the !. Miller, Banking Theories in the United States Before I960, United States 60(1953). State Banking Before the Civil War, 51-53. 11-14 (1927); Hammond, Banks and Politics in America from the For example, New Jersey chartered the Morris Canal and Banking Revolution to the Civil War 69 (1957). Company in 1824; Connecticut in 1832 chartered the Quinebaug 2. Hammond, 594. Bank as an adjunct to the Boston, Norwich and New London Rail­ 3. Smith, An Inquiry Into The Nature and Causes of The Wealth road. In 1835, Michigan conferred banking powers on four railroad of Nations (Carman ed.) 287 (5th ed. 1930); Luckett, Money and companies. The first railroad in Texas was the Texas Railroad, Navi­ Banking (3d ed.) 190-91 (1984). gation and Banking Company. Louisiana chartered the New Orleans 4. Barnett, State Banking Before the Civil War, S. Doc. No. 581, Gaslight and Banking Company in 1829, the Atchafalaya Railroad 61st Cong., 2d Sess. 183-84, National Monetary Commission (1911). and Banking Company in 1834, and in 1836 granted banking powers 5. Luckett, 191; Krooss and Blyn, A History of Financial Inter­ to the Pontchartrain Railroad. Between 1835 and 1837, South Caro­ mediaries 48-51 (1971). lina, Georgia, Mississippi, and Louisiana chartered sixteen combined 6. Id. banking and railroad companieis. Klebaner, Commercial Banking 7. Shull, “The Separation of Banking and Commerce: Origin, in the United States: A History 32 (1974). Development, and Implications for Antitrust," Antitrust Bulletin 25. SrnKh, 60; James, 117-160; Symons 8l White, Banking Law 260 (Spring 1983); Hammond, 128-30. 9 (1984). 8. Id. 259-62. The Act establishing the Bank of England stated 26. Reed, “Boom or Bust: Economic Outlook of the 1830Y', the purpose of the prohibition to be “that their Majesties subjects Louisiana History, vol. IV 49 (1963), cited in Green, 34; James, may not be oppressed by the said corporation by their monopolir- 143, 160; Carosso, Investment Banking 3 (1970). ing or engrossing any sort of goods, wares or merchandise.*' Id. 260. 27. State Banking Before the Civil War, 52-53. 9. Hammond, 63; Senate Committee on Banking and Currency, 28. Symons, 689. “Proceedings in Congress on Bank of North America,** Federal 29. Id. Banking Laws and Reports 1780-1912,1-6 (March 15,1963); Lewis, 30. Klebaner, 48. History of the Bank of North America 73 (1882). 31. Willis and Bogen, 166-67. Symons and White give a similar 10. Report of Secretary of Treasury (Alexander Hamilton) on assessment: “It was determined that banks should be provided a National Bank, Dec. 14,1790, reprinted in Federal Banking Laws powers that enabled them to assist in the functioning of the econ­ and Reports 7. omy and in serving enterprise, but stopped them from becoming 11. Act of February 25, 1791, (7(X), 1 Statutes at Large 191, so involved in enterprise that they could be destroyed by it.” Symons 1st Cong., 1st Sess. (1791), reprinted in Federal Banking Laws and and White, 11. Reports 66,70. Treble damages were provided for violations of this 32. State Banks and Trust Companies, 12. See generally, Well- stricture. Id. {8, 71. don (ed.), Digest of State Banking Statutes, National Monetary Com­ 12. Id. f 7(VIIi), 69. mission (1910). 13. Report of the Secretary of the Treasury on the Subject of 33. Trescott, Financing American Enterprise 36 (1963). a National Bank (1809), reprinted in Clarke and Hall, Legislative 34. In 1889, there were 2,097 state banks, 4,215 private banks, and Documentary History of the Bank of the United States 116-120 and 63 trust companies. By 1900, there were 4,405 state banks, 5,287 (1832). private banks, and 492 trust companies; and by 1909, there were 14. Hammond, 142-144. 11,292 state banks, 4,407 private bimks, and 1,079 trust companies. 15. Hammond states, “Legislators hesitated about the kind of State Banks and Trust Companies, 248, 250, 260. conditions under which banking should be permitted but never about 35. Banking was synonymous with note issue until the mid-19th the propriety and need of imposing conditions.... The issue was Century. Redlich, 60-84,178. Note issuance was considered the most between prohibition and state control, with no thought of free en­ important banking function because it involved the circulation of terprise. . . . The impression was general that the exercise of the money. Symons, 9. Deposits did not become significant as a form banking function without express authorization from the sovereign of money until after the National Bank Act of 1864. Redlich, 66,175. power was improper, if not impracticable.** Hammond, 185-86. 36. Trescott, 34-35; Klebaner, 58; Krooss and Blyn, 33-34; State 16. In early American history, all corporations were held to be Banks and Trust Companies, 213. of a public character. Redlich, The Molding of American Banking, 37. According to Carosso, in 1902 there were 675 private bankers vol. 11 60 (1951). engaged in investment banking activities. Carosso, Investment Bank­ 17. Hammond, 27-28; Barnett, George E., State Banking Before ing (1970). the Civil War, 143, 147. 38. Id. 85, 89. 18. Barnett, Ceorge E., State Banks and Trust Companies Since 39. Krooss and Blyn, 81,113,128; State Banks and Trust Com­ the Passage of the National Bank Act S. Doc. No. 659,61st Cong., panies, 10. 2d Sess. 33-34, National Monetary Commission (1911). 40. National banks were not granted trust powers until the Fed­ 19. Willis and Bogen, Investment Banking 156 (1929). eral Reserve Act of 1913. In addition, reserve requirements for trust 20. “An act to incorporate the subscribers of the Bank of the companies were less restrictive than for state and national banks. United States’* 1(11-12, reprinted in Krooss and Sarouelson, See generally, State Banks and Trust Companies, 12-22, 234-40; Documentary History cf Banking and Currency in the United States Digest of State Banking Statuter, Krooss and Blyn, 102-103. 460 (1969). 41. Despite their libera] charters, there is no evidence suggesting 21. Symons, “The Business of Banking: A Historical Perspec­ that trust companies were extensively engaged in nonbanking ac­ tive,” 51 Geo. Wash. U. L. Rev. 688 (1983). An exception to this tivities other than securities activities and some real estate develop­ general proscription on nonbanking activities was made for bank ment and management. Carosso states that trust companies “ac­ investments in Pennsylvania internal improvement companies. Id. cepted deposits; made loans; participated extensively in reorganizing 22. Hammond, 593. In a few cases, state legislatures granted railroads and consolidating industrial corporations; acted as trustees, banking powers to companies whose stated purpose was other than underwriters, and distributors of new securities; and served as the banking, such as the Manhattan Company, chartered by the New depositories of stocks, bonds, and titles. Frequently they acted as York legislature as a water company, and the Wisconsin Marine and attorneys for individuals and companies. Corporations regularly ap­ Fire Insurance Company, referred to as an “illegal bank.” Ham­ pointed them as registrars or fiscal and transfer agents. Very often mond, 153-55, 171; Golembe, State Banks and the Economic they also owned and managed real estate.” Carosso, 98. Development of the West 1830*44 29-30 (1978); Reubens, “Burr, 42. Perkins, “The Divorce of Commercial and Investment Bank­ Hamilton and the Manhattan Company**, 72 Political Science Quar­ ing: A History,*’ 88 Banking Law J. 483,487-89 (1971); Treasury Digitized for FRASERte rly, 578 (1957). Department, Public Policy Aspects of Bank Securities Activities, http://fraser.stlouisfed.o2rg3./ Willis and Bogen. 165. Appendix 3 (1975). Federal Reserve Bank of St. Louis A-10 43. Act of June 3, 1864, 13 Stat. 99, §8, reprinted in Federal 63. Savage, “A History of the Bank Holding Company Move­ Banking Laws and Reports, 351. ment, 1900-78,” The Bank Holding Company Movement to 1978: 44. See Weckler v. First National Bank, 42 Md. 581 (1875); A Compendium 25 (1978). The legality of bank holding companies Mathews v. Skinker, 62 Mo. 329 (1876); Logan County Nat 7Bank was somewhat in doubt prior to 1933. In 1911, the Solidtor General v. Townsend, 139 U.S. 67 (1890); and other cases dted in Peach, of the United States issued an opinion declaring bank bolding com­ 39, n.2. panies unlawful. No action was taken to prevent the formation of 45. Act of June 3, 1864, (28, reprinted in Federal Banking Laws bank holding companies, however. Opinion of the Solidtor General, and Reports, 359. Nov. 6,1911, reprinted in Stock Exchange Practices, 2030; see Peach, 46. National banks were not permitted to make loans on real es­ 144-48. tate until 1913. One-year mortgages on nonfarm property were per­ 64. Board of Governors of the Federal Reserve System, Annual mitted in 1916; five-year mortgages in 1927; 25-year mortgages in Report 32 (1927). 1964; and 30-year mortgages in 1970. 65. Board of Governors of the Federal Reserve System, Branch, 47. National Bank v. Matthews, 98 U.S. 621 (1878). Group, and Chain Banking, Vol. I, 54 (1930). 48. Peach, The Securities Affiliates of National Banks, 43-44 66. By 1968, one bank holding companies were engaged in a wide (1941); Lyons v. Lyons Nat 7 Bank, 19Blatchford 279 (N.Y. 1881). variety of nonbanking activities, including coal mining, fanning, 49. Department of Treasury, Public Policy Aspects of Bank Secu­ electronics, manufacturing, railroads, telephone communications, rities Activities, Appendix 2 (1975). motion pictures, hospitals, and window deaning. “The Growth of 50. First National Bank v. Bennington» 16 Blatchford 53 (N.Y. Unregulated Bank Holding Companies—Problems and Perspec­ 1879); Newport National Bank v. Board of Education of Newport, tives,” House Committee on Banking and Currency (Staff Report) (1969). Most of these companies were formed after 1965. Congres­ 70 S.W. 186 (Ky. 1902). The Comptroller of the Currency concurred sional Record 9111-990$ (Oct. 21,1969) (data compiled for Cong. in this interpretation. Report of the Comptroller of the Currency Patman). 8-9 (1909), cited in Public Policy Aspects of Bank Securities Ac­ 67. The Banking Act of 1933 required corporate owners of mem­ tivities , Appendix 4. ber banks to obtain a voting permit from the Board before voting 51. Redlich, 389. their bank stock and to submit to supervision and examination by 52. See First Natl Bank of Charlotte v. Nat’l Exchange Bank the Federal Reserve Board but did not restrict their nonbanking ac­ of Baltimoret 92 U.S. 122, 128 (1875); Barron v. McKinnon, 196 tivities. Banking Act of 1933, ch. 89, (19, 48 Stat. 162. F. 933 (Mass. 1912); Chapman v. First Natl Bank, 285 S. W. 1118 68. H. Rep. No. 609, 84th Cong., 1st Sess. 8 (1955). (Tex. 1926); Cassat v. First Natl Bank, 156 A. 278 (1933); First 69. S. Rep. No. 1095, 84th Cong., 1st Sess. 2 (1955). Natl Bank v. Hawkins, 174 U.S. 364 (1899); Shaw v. Natl 70. Savage, 49. German-American Bank, 199 U.S. 603, affg 132 F. 658 (1905); 71. Bank holding companies did not grow significantly during Metropolitan Trust Co. of New York v. McKinnon, 172 F. 486 the decade following enactment of the 1956 Act. From 1966 through (1909). 1970, howeverthe number of multibank holding companies dou­ 53. Weckler v. First National Bank, 42 Md. 581 (1875); Smith bled. Savage, 54. The number of one bank holding companies rose v. Philadelphia Natl Bank, 1. Walk. 318 Pa. (1879); Farmers* and from 117 in 1956 to 550 in 1965 and to approximately 1400 by 1970. Merchants* Natl Bank v. Smith, 77 F. 129 (1896); First Natl Bank Savage, 56. The rapid growth of one bank holding companies has v. Hock, 89 Penn. St. 324 (1879); and other cases dted in Peach, 46. been attributed to, among other things, the usefulness of holding 54. Redlich, 175; Klebaner, 75, 79. companies in allowing diversification into activities prohibited to 55. Act of June 3,1864, (29, reprinted in Federal Banking Laws banks. Id. SI. and Reports 359-60. 72. 12 U.S.C. 1841 at seq. 56. State Banks and Trust Companies, 86. 73. H. Rep. No. 609, 84th Cong., 1st Sets. 1-2 (1955). 57. Peach, 52. The first security affiliate was established in 1908. 74. S. Rep. No. 1095, 84th Cong., 1st Sess. 1 (1955). The number of banks having securities affiliates increased to 18 in 75. Id. 2 (citing Federal Reserve Chairman Martin), The House 1922,62 in 1926, and 180 in 1930. Id. 83. In addition, many banks Banking Committee also articulated the historical separation doc­ engaged directly in the securities business through their bond trine. H. Rep. No. 609, 7. departments. 76. S. Rep. No. 1095, 1. 58. Perkins, 495; Peach, 87-93. 77. Statement of President Richard Nixon of March 24, 1969, 59. Report of the Committee to Investigate the Concentration reprinted in H. Rep. No. 1747, 91st Cong., 2d Sess. 11 (1970). of Money and Credit, 62nd Cong., 3d Sess. 151-52, 170 (1913). 78. H. Rep. No. 609, 7 (1955). 60. Stock Exchange Practices: Hearings Before a Subcommittee 79. S. Rep. No. 1084,91st Cong., 2d Sess. 3 (1970) (quoting Fed­ of the Senate Committee on Banking and Currency, 73rd Cong., eral Reserve Chairman Martin). 2d Seu. (1933). •0. H. Rep. No. 609, 4-5 (1955). 61. 12 U.S.C. 24 (Seventh), 78, 377, 378. 81. S. Rep. No. 1095, 5. 62. Cartinhour, Branch, Group, and Chain Banking 90 (1931). 82. Id. 4. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A-ll Bibliography Dillistin, William H. (ed.). Historical Directory of the Banks of New York. New York: New York State Bankers As­ soc., 1946. The following materials were reviewed in the preparation of this paper: Domett, Henry W. A History of The Bank of New York Adams, Donald R. Jr. Finance and Enterprise in Early 1784-1884 (3rd ed.). New York: Privately published, 1884. America. Philadelphia: University of Pennsylvania Press, Dovell, J. E. History of Banking in Florida, 1828-1954. 1978. Orlando: Florida Bankers Association, 1955. Andersen, Theodore A. A Century of Banking in Wiscon­ Edwards, George W. The Evolution of Finance Capitalism. sin. Madison: Vail-Balou Press, 1954. New York: Longmans, Green A Co., 1938. Barnett, George E. State Banking Before the Civil War. S. Eliason, Adolph O. The Rise of Commercial Banking Insti­ Doc. 581, 61 Cong., 2 Sess. Publication of the National tutions in the United States. Minneapolis: University of Monetary Commission. Washington, D.C.: Government Minnesota, 1901. Printing Office, 1910. Fischer, Gerald C. American Banking Structure. New York: ____________ . State Banks and Trust Companies Columbia University Press, 1968. Since the Passage of the National Bank Act. S. Doc. 659, Foulke, Roy A. The Sinews of American Commerce. New 61 Cong., 3 Sess. Publication of the National Monetary York: Dun A Bradstreet, Inc., 1944. Commission. Washington, D.C.: Govemnment Printing Office, 1911. Friedman, Milton and Schwartz, Anna J. A Monetary His­ tory of the United States, 1867-1960. Princeton, N.J.: Board of Governors of the Federal Reserve System. The Princeton University Press, 1963. Bank Holding Company Movement to 1978: A Compen­ dium,. Staff Study. Washington, D.C.: Board of Gover­ Golembe, Carter H. State Banks and the Economic Develop­ nors of the Federal Reserve System, Sept. 1978. ment of the West 1830-44, Ph.D. dissertation, Columbia University, 1952. New York: Arno Press, 1978. _____________Branch, Chain and Croup Banking. Staff Report. Washington, D.C.: Board of Governors of Gouge, William M. A Short History of Paper Money and the Federal Reserve System, 1933. Banking in the United States. Philadelphia: T.W. Ustick, 1833. Brantley, William H. Banking in Alabama, 1816-1860. Bir­ mingham: Birmingham Printing Company, 1961. Grant, Joseph M. and Crum, Lawrence L. The Development of State Chartered Banking in Texas. Austin, Tex.: Bu­ Cable, John R., Banks of the State of Missouri, Ph.D. dis­ reau of Business Research, The University of Texas at sertation, New York: Columbia University Press, 1923. Austin, 1978. Caldwell, Stephen A. A Banking History of Lousiana. Ba­ Green, George D. Finance and Economic Development in ton Rouge: State Univ. Press, 1935. the Old South 1804-1861. Stanford, Calif.: Stanford University Press, 1972. Carosso, Vincent P. Investment Banking in America. Cam­ bridge: Harvard University Press, 1970. Hackley, Howard H. “Our Baffling Banking System.*’ Vir­ Cartinhour, Gaines T. Branch, Group, and Chain Banking. ginia Law Review, vol. 52, May 1962, 565-632. New York: The Macmillan Company, 1931. Hague, George. Banking and Commerce. New York: The Bankers Publishing Co., 1908. Catterall, Ralph C. H. The Second Bank of the United States. Chicago: University of Chicago Press, 1902. Halaas, Eugene T. The Banking Structure in Colorado: Chemical National Bank. History of the Chemical Bank, Historic Development and Recent Changes. Denver: The University of Colorado, 1969. ‘ 1823-1913. New York: Privately printed, 1913. Clain-Stefanelli, Elvira and Vladimir, (ed.). Chartered for Hammond, Bray. Banks and Politics in America from the Progress—Two Centuries of American Banking. Washing­ Revolution to the Civil War. Princeton, N.J.: Princeton University Press, 1957. ton, D.C.: Acropolis Books, Ltd., (1975). _____________“Jackson, Biddle and the Bank of the Clarke, M. St. Clair and Hall, D. A. Legislative and United States." Journal of Economic History, vol. 7, Documentary History of the Bank of the United States: May, 1947. including the Original Bank of North America. Washing­ ton, D.C.: Gales and Seaton, 1832. Harr, Luther and Harris, W. Carlton. Banking Theory and Clough, Shepard B. A Century of American Life Insurance, Practice. New York: McGraw-Hill Book Company, Inc., 1936. 1843-1943. New York: Columbia University Press, 1946. Holdsworth, J. T. and Dewey, D. R. "The First and Sec­ Committee on Money and Banking. Money and Banking. ond Banks of the United States." Sen. Docs. 571, 581, New York: Pitman Publishing Corp., 1957. Publication of the National Monetary Commission, vol. Dawes, Charles G. The Banking System of the United States. 4. Banking in United States Before Civil War. Washing­ Chicago: Rand, McNally and Co., 1894. ton, D.C.: Government Printing Office, 1910. Department of Treasury. Public Policy Aspects of Bank Huntington, Charles C. A History of Banking and Currency Securities Activities. Washington, D.C.: Department of in Ohio Before the Civil War. Columbus, Ohio: The F. Treasury, Nov. 1975. J. Heer Printing Co., 1915. Digitized for FRASERD ewey, Davis R. Financial History of the United States. Lon­ James, F. Cyril. The Growth of Chicago Banks, vol. 1. New http://fraser.stlouisfed.odrgo/n : Longmans. Green A Co.. 1934- V*»L>. U — ~ i. n------ Federal Reserve Bank of St. Louis A-12 Kkbaner, Benjamin J. Commercial Banking in the United Shade, William G. Banks or No Banks: The Money Issue States: A History. Hinsdale, 111.: The Dryden Press, 1974. in Western Politics 1832-1865. Detroit: Wayne State University Press, 1972. Knox, J. J. A History of Banking in the United States. New York: Bradford Rhodes & Co., 1903. Shull, Bernard. “The Separation of Banking and Commerce: Origin, Development, and Implications for Antitrust." Krooss, Herman E. and Blyn, Martin R. A History of Finan­ cial Intermediaries. New York: Random House Pub­ The Antitrust Bulletin, Spring 1983, 225-279. lishers, 1971. Smith, Adam. An Inquiry Into the Nature and Causes of Krooss, Herman E. and Samuelson, Paul A. Documentary the Wealth of Nations. (Cannan, ed.) London: Methuen History of Banking and Currency in the United States, A Co. Ltd. 5th ed., 1930. vols. 1-3. New York: Chelsea House/McGraw-Hill Book Smith, Walter B. Economic Aspects of The Second Bank Co.. 1969. of the United States. Cambridge, Mass.: Harvard Univer­ sity Press, 1953. Lanier, Henry W. A Century of Banking History in Hew York. New York: Gilliss Press, 1922. Starnes, George T. Sixty Years of Branch Banking in Vir­ Lewis, Lawrence, Jr. History of the Bank of North America. ginia. New York: The MacMillan Company, 1931. Philadelphia: J.B. Lippincott A Co., 1882. State of New York. Joint Committee of the Senate and As­ Luckett, Dudley G. Money and Banking, 3rd ed. New York: sembly. Report of the Joint Committee of the Senate and McGraw-Hill Book Co.. 1984. Assembly of the State of New York Appointed to Inves­ tigate the Affairs of Life Insurance Companies, Assem­ Madeod, Henry D. The Theory and Practice of Banking, bly Doc. 41. Albany: Brandow Printing Company, 1906. 4th ed. vols. 1 and 2. London: Longmans, Grum, Reader, Sylla, Richard E. The American Capital Market 1846-1914. and Dyer, 1883. New York: Amo Press, 1975. Meulen, Henry. Free Banking, An Outline of a Policy of Symons, Edward L. Jr. “The Business of Banking: A Histor­ Individualism. London, MacMillan and Co., 1934. ical Perspective." The George Washington University Law Miller, Harry E. Banking Theories in the United States Be­ Review, vol. 51, no. 5, Aug. 1983, 676-726. fore 1860. Cambridge, Mass.: Harvard University Press, 1927. Symons, Edward L. Jr., and White, James J. Banking Law, 2nd Ed. Minneapolis: West Publishing Co., 1984. Mints, Lloyd W. A History of Banking Theory in Great Brit­ Taylor, George R., “A Brief History of the Second Bank ain and the United States. Chicago: University of Chicago of the United States," in The Economic History of the Press, 1945. United States, Vol. 4. Boston: D.C. Heath & Co., 1949. Nevins, Allan. History of the Bank of New York and Trust Company, 1784 to 1934. New York: Privately printed, Trescott, Paul B. Financing American Enterprise. New York: March, 1934. Harper A Row, 1963. Peach, W. Nelson, The Security Affiliates of National Banks. U.S. Congress. Report of the Committee to Investigate the Baltimore, Md.: Johns Hopkins Press, 1941. Concentration of Money and Credit. 62 Cong., 3 Sess., 1913. Perkins, Edwin J. “The Divorce of Commercial and Invest­ U.S. Congress. House. Committee on Banking and Cur­ ment Banking.** The Banking Law Journal, vol. 88, no. rency. Control and Regulation of Bank Holding Compa­ 6 (June 1971). nies, Hearings before the Committee on Banking and Cur­ Redlich; Fritz. Molding American Banking; Men and Ideas, rency of the House of Representatives, 80 Cong., 1 Sess., 1781-1840. New York: Hofner Publishing Co., Inc., 1947. 1947. _____________The Molding of American Banking; U.S. Congress. House. Committee on Banking and Cur­ Men and Ideas, 1840-1910. New York: Hafner Publish­ rency. The Growth of Unregulated Bank Holding ing Company, Inc., 1951. Companies—Problems and Perspectives, Staff Report. 91 Cong., 1 Sess., 1969. Reubens, Beatrice G. “Burr, Hamilton and the Manhattan Company.** Political Science Quarterly, vol. 72, no. 4, U.S. Congress. House. H. Rep. 609,84 Cong., 1 Sess., 1955. 578-607; vol. 73, no. 1, 100-125, 1957. U.S. Congress. House. H. Rep. 1747, 91 Cong., 2 Sess., Robinson, Roland I. (ed.). Financial Institutions. Home- 1970. wood, 111.: Richard D. Irwin, Inc. 1960. U.S. Congress. Senate. Committee on Banking and Cur­ Salley, Charles D. “Origins of the Regulatory Supervision rency. Operation of the National and Federal Reserve of Banking and Commerce.** The Banking Law Journal, Banking Systems, Hearings before the Senate Commit­ vol. 93, no. 2, Feb. 1976, 196-206. tee on Banking and Currency, 72 Cong., 1 Sess., 1932. Savage, Donald T. “A History of the Bank Holding Com­ U.S. Congress. Senate. Committee on Banking and Cur­ pany Movement, 1900-78,** The Bank Holding Company rency. Stock Exchange Practices: Hearings Bgfort the Sen­ Movement to 1978: A Compendium. Staff Study. ate Committee on Banking and Currency, 73 Cong., 2 Washington, D.C.: Board of Governors of the Federal Sess., 1933. Reserve System, Sept. 1978. U.S. Congress. Senate. Committee on Banking and Cur­ Digitized for FRASER http://fraser.stlouisfedS.ocrrgo/g gs, William O. A Century of Banking Progress. New rency, Federal Banking Laws and Rennn. r van- tor* ee Federal Reserve Bank of St. Louis n ----m — A-13 U.S. Congress. Senate. S. Rep. 1095,84 Cong., 1 Sess. 1955. Cases U.S. Congress. Senate. S. Rep. 1084,91 Cong., 2 Sess. 1970. Barron v. McKinnon, 196 F. 933 (Mass. 1912). Usher, Abbott P. Early History of Deposit Banking in Med­ Cassat v. First National Bank, 156 A. 278 (1933). iterranean Europe. Cambridge, Mass.: Harvard Univer­ sity Press, 1943. Chapman v. First National Bank, 285 S.W. 1118 (Tex. 1926). Van Fenstermaker, J. The Development of American Com­ Cooper v. Hill, 94 F. 582 (Col. 1899). mercial Banking 1787-1837. Kent, Ohio: Kent State Farmers9 and Merchants'National Bank v. Smith, 77 F. 129 University, 1965. (1896). Wainwright, Nicholas B. History of the Philadelphia Na­ First National Bank v. Bennington, 16 Biatchford 53 (N.Y. tional Bank, A Century and a Half of Philadelphia Bank­ 1879). ing, 1803-1953. Philadelphia: Wm. F. Fell Co., 1953. Welldon, Samuel A. (ed.) Digest of State Banking Statutes. First National Bank of Charlotte v. National Exchange Bank Washington, D.C.: Government Printing Office. S. Doc. of Baltimore, 92 U.S. 122 (1875). 353,61 Cong., 2 Sess., 1910. Publications of the National First National Bank v. Converse, 200 N.S. 425 (1906). Monetary Commission. First National Bank of Hawkins, 174 U.S. 364 (1899). Willis, H. Parker and Bogen, Jules I. Investment Banking. New York: Harper 8c Bros., 1929. First National Bank of Hock, 89 Pa. 324 (1879). Willis, H. Parker and Edwards, George W. Banking and First National Bank of Stokes, 203 S.W. 1026 (Ark. 1918). Business. New York: Harper 8c Bros., 1925. Grass v. Village of Ft. Loramie, 125 N.E. 112 (Ohio 1919). Logan County National Bank v. Townsend, 139 U.S. 67 (1890). Lyons v. Lyons National Bank, 19 Biatchford 279 (N.Y. 1881). Matthews v. Skinker, 62 Mo. 329 (1876). Metropolitan Trust Co. of New York v. McKinnon, 172 F. 486 (1909). National Bank v. Matthews, 98 U.S. 621 (1878). Newport National Bank v. Board of Education of Newport, 75 S.W. 186 (Ky. 1902). Stow v. National German-American Bank, 199 U.S. 603, afrg 132 F. 658 (1905). The People v. The President and Directors of the Manhat­ tan Company, 9 Wendell 351 (N.Y. 1832). Weckler v. First National Bank, 42 Md. 581 (1875). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-l The Federal Reserve Board’s Oversight of the Domestic and International Activities of U.S. Banks and Bank Holding Companies Introduction ing activities in which bank holding companies may engage. In carrying out its regulatory and supervisory respon­ More specifically, as the agency charged with ad­ sibilities for bank holding companies, the Federal Re­ ministering the Bank Holding Company Act, the Fed­ serve has been guided over time by the principal pur­ eral Reserve conducts the following activities: poses embodied in the Bank Holding Company Act. 1. Establishes, by regulation or order, the nonbank These were to prevent undue concentration of eco­ activities in which bank holding companies may nomic resources, conflicts of interest, and unfair com­ petition and to preserve the soundness of banks by engage; limiting their exposure to undue risks from the unregu­ 2. Establishes procedures for bank holding companies lated activities of affiliates. In order to carry out these to apply for approval to acquire banks and non­ purposes, the Act confined the activities of bank hold­ bank firms and acts upon such applications; ing companies to those of banking and managing or 3. Supervises bank holding companies through on-site controlling banks and a limited range of other related inspections, off-premise surveillance, and the issu­ activities. ance, when appropriate, of supervisory enforce­ The legislation passed in 19S6 defined bank hold­ ment actions; and ing companies as companies that owned or controlled two or more banks and established a relatively nar­ 4. Promulgates supervisory policies and guidelines row test for determining the nonbank activities in designed to limit undue risk-taking, protect the which holding companies could engage. The 1970 financial health of subsidiary banks, and provide Amendments brought companies that owned just one guidance on supervisory concerns to the banking bank under the definition of bank holding companies industry. and established a more flexible standard for defining In carrying out these responsibilities, a major objec­ permissible nonbank activities. While these amend­ tive of the Federal Reserve is to ensure that bank hold­ ments gave the Board broader authority to approve ing companies serve as a source of financial and nonbank activities, they continued the fundamental managerial strength to their subsidiary banks. principle of the separation of banking and commerce. The Federal Reserve’s domestic supervisory and The Bank Holding Company Act as amended pro­ regulatory activities should be considered in the con­ vides that bank holding companies may only engage text of two significant trends within the holding com­ in nonbanking activities that are so closely related to banking or managing or controlling banks as to be pany movement. First, as illustrated in Attachment considered a proper incident to banking. In determin­ I-A, the number of bank holding companies and the ing whether a particular activity is a proper incident percentage of commercial bank assets controlled by to banking, the Board must consider whether its per­ such companies have increased significantly since the formance by a holding company may reasonably be passage of the 1970 Amendments. By bringing com­ expected to produce benefits to the public, such as panies that owned just one bank under the statutory greater convenience, increased competition or gains in definition of bank holding companies, these Amend­ efficiency, that outweigh possible adverse effects, such ments increased the number of such companies super­ as undue concentration of resources, decreased or un­ vised by the Federal Reserve from 121 in 1970 to 1,567 fair competition, conflicts of interest, or unsound in 1971. In 1975, there were 1,821 bank holding com­ banking practices. Consequently, consistent with the panies controlling 69 percent of all commercial bank purposes of the Bank Holding Company Act, a ma­ assets. By 1985, the number of companies had in­ jor responsibility of the Federal Reserve has been to creased to 6,453, and such companies controlled over define, and then supervise and regulate, the nonbank- 90 percent of all commercial bank assets. As shown in Attachment I-B, while the overwhelming majority of bank holding companies have consolidated assets Digitized for FRASERT his paper was prepared by staff of the Division of Banking Super­ of less than S150 million, over 80 percent of aggregate http://fraser.stlouisfedv.iosirogn/ and Regulation and the Legal Division of the Federal Reserve holdins comoanv asset* are helH Kv 1 area woiAnol *r»/4 Federal Reserve BanBko oafr dS.t. Louis B-2 multinational companies with consolidated assets in I. Domestic Operations of Bank excess of SI billion. Holding Companies A second important development is the increase in Establishment of Permissible Bank Holding the variety and volume of nonbank activities in which Company Activities bank holding companies have been permitted to en­ gage (Attachments 1-C and I-D). The process of Closely Related and Proper Incident Tests reviewing and approving new activities for bank hold­ ing companies, as discussed below, has been a dynamic Section 4(c)(8) of the Bank Holding Company Act one that has responded to changes and developments authorizes bank holding companies to engage directly within the banking system. The volume of permissi­ or through a subsidiary in activities that the Federal ble nonbank assets of the larger bank holding compa­ Reserve Board determines are closely related to bank­ nies (for this purpose defined as those with consoli­ ing or managing or controlling banks. Over time, the dated assets over $150 million) has increased from Board and the courts have established the following approximately $26 billion in 1976, representing about guidelines for determining whether a nonbanking ac­ 3 percent of the consolidated assets of such holding tivity is closely related to banking:1 companies, to approximately $132 billion at year end 1. whether banks have generally provided the service; 1984. While the relative size and importance of non­ 2. whether banks generally provide services that are banking activities varies significantly from company operationally or functionally so similar to the pro­ to company, in the aggregate, nonbanking assets of posed service as to equip them particularly well to holding companies still represent a modest percentage provide the proposed service; or of aggregate holding company assets. Thus, at year 3. whether banks generally provide services that are end 1984, nonbank assets constituted approximately so integrally related to the proposed service as to 6.4 percent of the aggregate consolidated assets of the require their provision in specialized form. larger bank holding companies. In addition, the Board may consider other factors With respect to foreign activities of U.S. banking in deciding what activities are closely related to bank­ organizations, the Board administers several different ing.’ Once a positive determination has been made that statutes, including provisions of the Federal Reserve a proposed activity is “closely related to banking or Act dealing with establishment of foreign branches and managing or controlling banks,” the Board must also the chartering of Edge corporations, that is, special­ find that the activity is a “proper incident” to bank­ ized banking vehicles that engage only in foreign ing before the activity is deemed permissible for bank financing, investment and related activities. The Bank holding companies. As already noted, in making this Holding Company Act also provides for direct invest­ judgment, the Board must determine that performance ment in foreign companies by U.S. bank holding com­ of the activity by a bank holding company can rea­ panies, and governs the U.S. nonbanking activities of sonably be expected to produce benefits to the pub­ foreign banks. lic, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse These statutes and the Board’s implementing regu­ effects, such as undue concentration of resources, lations and policies are described in the second part decreased or unfair competition, conflicts of interest, of this study. These laws generally recognize that for­ or unsound banking practices. The guidelines and eign economic and regulatory structures may differ procedures for approving new activities, as well as the from that of the United States and give the Board dis­ list of permissible activities, are contained in the cretion to approve financial and related activities Board’s Regulation Y which establishes the regulatory abroad that permit U.S. banks to remain competitive framework for the Federal Reserve’s administration with foreign banks and enable them to serve better the of the Bank Holding Company Act. interests of U. S. trade and commerce. The statutes, however, do not permit such activities to be conducted in the United States. Despite the broader range of per­ Approved Activities missible activities, virtually all overseas activities of U.S. banking organizations are of a banking or finan­ The list of nonbanking activities approved by regula­ cial nature. The second half of this study also gives tion as generally permissible for bank holding com­ data on the extent to which U.S. banks operate abroad panies has expanded over time and now contains eight­ and includes a description of the statutes and regula­ een items. (See Attachment I-D.) Some activities are tions governing foreign bank activities in the United limited in scope (e.g., management consulting to Digitized for FRASER States. depository institutions or underwriting certain credit- http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-3 related life and disability insurance), while others are Most of the approvals via Board order have involved more broadly written and hold the potential for a wider activities of special interest to individual bank hold­ scope of operation (e.g., data processing). Eight of the ing companies or were designed to permit a company activities were approved as part of the original list in to complete an existing line of products and services. 1971, and three more were added by the mid-1970s. In approving new activities by regulation or order, Included in these early activities were such credit- the Board has attempted to recognize and be respon­ related functions as consumer and commercial Finance, sive to changes and innovations in financial markets, mortgage banking and leasing, activities in which consistent with the requirements of the Bank Holding banks themselves have traditionally engaged. An im­ Company Act. Thus, the range of activities conducted portant reason for conducting these activities at the by bank holding companies has expanded over time holding company level was to avoid some of the geo­ as organizations have sought and received approval to graphic and operating restrictions that apply to com­ offer new products and services. mercial banks, such as limitations on branching. In approving new activities, the Board has used its In light of the recession in the mid 1970s and the rulemaking authority to incorporate within its regu­ Board’s concern over the condition of some banking lations appropriate limitations and restraints on the organizations, the Board did not approve any new ac­ conduct of the activities. In doing so, the Board has tivities by regulation in the period 1975 through 1977. sought to permit holding companies to engage in new This hiatus gave banking organizations time to con­ nonbank activities while limiting the possibility of any solidate the nonbank expansion undertaken in the early adverse effects arising from the conduct of the activi­ 1970s and to address weaknesses resulting from the ties. In this regard, the Board has most commonly steep recession and problems in the real estate sector sought to preclude conflicts of interest and undue risk during this period. taking. For example, the Board requires that finan­ Over the past seven years, seven new items have been cial institutions that are clients of bank holding com­ added to the list of permissible activities by regulation. pany management consulting subsidiaries must, among Most of these have been of a non-credit granting na­ other things, be provided with the names of all deposi­ ture, affording banking organizations the latitude to tory institutions that are affiliates of the consulting earn additional fee income without involving signifi­ subsidiary. Similarly, in arranging commercial real es­ cant credit risk. The emphasis has been on the role of tate equity financing, the bank holding company may the bank holding company as a broker of financial not also provide financing to the investor for the same services, responding to evolving structural changes and real estate project, nor may the holding company have practices in financial markets. For example, arrang­ an interest in managing, developing or syndicating the ing commercial real estate equity financing, approved same project. Another example involves futures com­ in 1984, was an outgrowth of the increased emphasis mission merchants. Futures commission merchants by permanent investors on the use of equities to fi­ must have fully adequate capitalization and may not nance real estate projects, rather than long-term debt. extend credit except in limited circumstances. Further, Similarly, acting as a futures commission merchant in a futures commission merchant subsidiary may not be­ financial instruments, also approved in 1984, was un­ come a clearing member of any exchange that would heard of fifteen years ago, but has been adopted in require its parent to also become a clearing member response to new developments in the trading markets unless a waiver has been granted. for these instruments.* In addition to the activities already approved by Apart from amending the list of permissible activi­ regulation or order, the following nonbanking activi­ ties contained in Regulation Y, the Board has also per­ ties have been proposed by individual bank holding mitted individual companies to engage in certain non­ companies: banking activities on a case-by-case basis through • Underwriting and dealing in certain securities company-specific Board orders. This procedure has • Acting as issuer’s agent in the placement of com­ been used when there is only limited interest on the mercial paper part of bank holding companies to engage in the ac­ • Offering of investment advice in connection with tivity or when the Board is reluctant to designate the securities brokerage activities activity as generally permissible for all bank holding • Credit bureau and credit reporting activities companies. (Also see Attachment I-D). Two-thirds of this class of activities was approved in the 1980s, These currently pending proposals, particularly reflecting innovation and expansion in the financial those involving certain securities-related activities, raise cervices sector. The bulk of these activities has not a number of important policy questions. In consider­ raised significant policy issues with the obvious excep­ ing these proposals, the Board must take into account Digitized for FRASERti ons of nonbank and other limited purpose banks and restrictions contained in the Glass-Steagall Act as well http://fraser.stlouisfedt.hoerg /l imited number of thrift acquisition proposals. as the provisions of the Bank Holdino rv«mnonv am Federal Reserve Bank of St. Louis B-4 As discussed above, nonbanking activities of bank quarter of the activities denied over time (See Attach­ bolding companies by law must be closely related to ment I-E). These activities are insurance (mostly non­ banking and must pass a net public benefits test. The credit related), real estate, finandal/securities services, only exceptions to this general rule are a limited num­ and general business activities. The Board is precluded ber of instances, where Congress specifically exempted by law from expanding the insurance activities of hold­ certain companies from the nonbanking prohibitions ing companies, and, in this connection, recently of the Bank Holding Company Act. In doing this, declined to publish for comment the conduct of title Congress stated that it did not believe that companies insurance activities. Consistent with the Bank Hold­ that acted in good faith under existing law should be ing Company Act, activities have been denied when subjected to extreme ex post facto consequences. In they have been found not to be closely related to bank­ enacting the grandfather clause, Congress noted that ing, such as owning a travel agency, or not to meet such companies were not exempt from the registration the proper incident test,such as acquiring a healthy sav­ requirements of Regulation Y or supervision by the ings and loan association. Regarding the proper inci­ Federal Reserve. dent test, a major concern has been the adverse effects The 1970 Amendments to the Bank Holding Com­ stemming from potential conflicts of interest asso­ pany Act provided certain bank holding companies ciated with a holding company’s conduct of an ac­ with exemptions generally referred to as "permanent tivity. This was illustrated in 1985 when the Board re­ grandfather rights.” These companies were granted fused to allow a large bank holding company to engage specific exemptions for certain of their nonbanking ac­ in the business of providing credit ratings on bonds tivities provided that these activities were engaged in and commercial paper. The reason for this decision on or before June 30, 1968 and continuously con­ was that the provision of such ratings by a major lend­ ducted since that date. Presently, there are about 128 ing organization could involve pervasive conflicts of bank holding companies conducting nonbanking ac­ interest. tivities under the authority of the grandfather provi­ sions. The aggregate consolidated assets of such com­ panies represent about one percent of aggregate U.S. Procedures for Adding Activities to banking assets. The overwhelming majority of these Permissible "Laundry" List companies are in fact engaged in financially related activities—for the most part general insurance; only Federal Reserve procedures provide that proposals to a small number of companies are engaged in activi­ engage in activities listed as permissible by regulation ties that would otherwise be prohibited under the Act. (the so-called ’’laundry list” activities) are promptly Even in these latter situations, the grandfathered ac­ published for public comment in the Federal Register tivities represent a very small percentage of the hold­ for a period not to exceed 30 days. The publication ing companies’ consolidated assets. of other proposed nonbanking activities, including Congress also exempted a small number of closely those not previously considered, and those previously held family corporations that owned a bank prior to considered and denied, requires specific authorization June 30,1968, as well as nonbanking businesses, and by the Board. Regulation Y requires the Board to make that were formed to facilitate joint family ownership a determination as to whether to publish within ten and distribution of income. Thus, section 4(cXii) of business days of acceptance of the application by the the Bank Holding Company Act provides that such Reserve Bank, although the Board may extend this companies would be exempt from the nonbanking pro­ hibitions so long as the companies remained under period for up to an additional 30 calendar days upon family control, which was defined as 83 percent owned notice to the applicant. by members of the same family or descendants. There Regulation Y directs the Board to cause notice to are approximately 100 such companies that continue be published unless it determines that the applicant has to be exempted from the nonbanking prohibitions of not demonstrated that the activities could be found to the Act. These companies, most of which control small be permissible (i.e., closely related to banking and a banks located in the midwest, have total assets proper incident thereto). By publishing a proposal for amounting to less than one-half of one percent of ag­ comment, the Board does not reach a decision on the gregate U.S. banking assets. merits of the proposal. Rather, the Board determines that the applicant has made a reasonable showing that the proposal should be considered on its merits and Denied Activities that public comment would be beneficial in this pro­ cess. The comment period is usually for 30 days, al­ Digitized for FRASER http://fraser.stlouisfedA.ocrtgiv/ ities denied by the Board can be divided into four though more complex proposals with broad policy im- Federal Reserve Banbkr oofa Sdt . cLaotueisaories. each of which represents about a irficationsmav.he-jjublii>vi/'vJ~r~—.—r~A:. ~r — . B-5 Once the comment period expires and all timely prospects for the companies involved are favorable. comments have been received, the Reserve Bank and Trends in the examination ratings of the holding com­ Board staff summarize the comments and evaluate the pany and its subsidiary banks, and trends in their earn­ merits of the proposal. The actual decision is made ings, capital, and asset quality, combined with analy­ by the Board, and every effort is made to conclude sis of the risk factors surrounding the organization, the process within the 60 calendar day internal process­ weigh heavily toward the determination of whether the ing period. In many cases, however, the length of the future prospects of the organization are satisfactory. comment period, the number of comments received, Such a favorable determination is required for the and the complexity and public policy implications of Board to approve an application. the proposal require an extended processing period. The Board has established certain standards for In any event, the application is automatically approved sound banking practices, and proposals that do not if it is not acted on within the statutory 91 day period meet these standards are identified in the applications that commences with the completion of the record. process. The analysis of a proposal rests, in signifi­ Applicants are notified whenever the processing period cant part, on the prospective capital position of the is extended. applicant organization. The Board evaluates the capitalization of banks and bank holding companies in relation to its published Capital Adequacy Guide­ Review and Processing of Applications lines and, for organizations with assets of less than $130 million, its Small Bank Holding Company Policy Two of the most fundamental provisions of Regula­ Statement. For organizations in an expansionary pos­ tion Y (and of the Act) are the requirements that a ture, or those whose condition suggests some addi­ company apply to the Federal Reserve System before tional risk, the Board generally requires that the mini­ acquisition of a bank, and that existing bank holding mum capital levels expressed in the guidelines be companies apply for or give notice prior to the acqui­ exceeded on a pro forma basis. sition of certain types of nonbanking companies. The other major factor considered in evaluating the Through the evaluation of such applications or notifi­ financial and managerial aspects of a proposal is the cations, the System furthers the objectives of the Act record and qualifications of the proposed manage­ by (1) limiting nonbanking activities to those permit­ ment. This analysis includes assessment of their ex­ ted by the Bank Holding Company Act and Regula­ perience with the applicant organization or, if new tion Y, (2) assessing the financial and managerial management is proposed, assessment of their record resources and future prospects of the applicant and with other financial institutions or companies. It is es­ target companies, and (3) ensuring that proposed sential that the proposed management be capable in transactions would not be significantly anticompeti­ order for the Board to determine that the future tive and that the convenience and needs of the com­ prospects of the organization are satisfactory. munity would be served. The applications process affords the Board the op­ When a company applies to conduct a new activity, portunity to assess the financial and managerial the Board evaluates the proposal for consistency with resources of an applicant organization at a time when the Bank Holding Company Act, Regulation Y and its level of risk is particularly likely to increase—that other banking legislation, such as the Glass-Steagall is, when it undergoes an expansion. In these situations, Act, in order to carry out the Congressionally- the Board assesses the likely effects of the proposed mandated policy of the separation of banking and transaction on the organization and disapproves pro­ commerce. In this regard, the applications process is posed acquisitions that would create an unacceptable the primary method by which the Board regulates the degree of risk to the holding company and, ultimately, nonbank activities of bank holding companies; to the bank affiliates. This process is, of course, com­ In evaluating applications under the Act, the Board plemented by other supervisory functions, such as on­ is required to take into consideration “the financial site inspections, which serve to monitor proposals after and managerial resources and future prospects of the they are approved. The applications approval process, company or companies and the banks concerned.” however, is an important first step in limiting the risk The evaluation of financial and managerial factors in­ undertaken by bank holding companies. volves analysis of 1) pro forma capital and debt ratios, The scrutiny involved in the applications process 2) the financial condition and historical performance provides an important discipline on the behavior of of the banks and companies involved, and 3) the rec­ banking organizations. Thus, applicants are often ord and qualifications of the proposed management. responsive to suggestions from the Federal Reserve for From this information, which is gathered from super­ improvements in their condition or for changes to their visory authorities and reported financial data, the proposals in order to limit adverse effects and thereby Digitized for FRASER http://fraser.stlouisfedB.ooragr/ d makes a judgment as to whether the future increase the chances for annroval. Annlieant* nf»i*n Federal Reserve Bank of St. Louis B-6 take action to improve their condition even before fil­ at 2516 in 1983. The ability to handle this volume of ing proposals, in recognition of the Federal Reserve’s applications is due in significant part to the measures, standards for approval. In addition, while only a rela­ discussed below, to decrease processing time and en­ tively small percentage of proposals is denied, a sig­ hance processing efficiency. nificant number are modified after filing. Others are withdrawn, at least until remedial changes can be effected. Through this process, banking organizations Processing Time are encouraged to constrain their expansion to ap­ propriate levels, to avoid excessive risk-taking and, if The Bank Holding Company Act provides that an ap­ necessary, to improve their condition. plication must be acted on within 91 days from the date Policies carried out in the context of the applica­ of submission to the Board of the “complete record” tions process also assist in protecting the public interest on the application. The Board recognizes that delays through analysis of the competitive effects of proposed in processing proposals can result in additional expense transactions and consideration of the needs of the com­ for the applicant and delays in the delivery of benefits munity to be served by the applicant holding company. to the public. Accordingly, the Board has attempted In enumerating the statutory criteria for approval, over time to process applications as expeditiously as Regulation Y notes that the commencement or expan­ possible, without compromising its responsibilities un­ sion of a nonbanking activity de novo is presumed to der the Bank Holding Company Act. result in benefits to the public through increased com­ The Board’s Regulation Y and internal operating petition. The Bank Holding Company Act further procedures make timeliness a principal objective in the states that the Board shall not approve any proposed applications process. Although the Act provides that bank acquisition “whose effect in any section of the the Board may take up to 91 days after the submis­ country may be substantially to lessen competition sion of the complete record, procedures were volun­ ... unless it finds that the anticompetitive effects of tarily developed in 1971 that established internal the proposed transactions are clearly outweighed in the processing periods substantially shorter than those re­ public interest by the probable effect of the transac­ quired by statute. Since that time, the internal goal of tion in meeting the convenience and needs of the com­ 90 calendar days has been reduced to 60 days and munity to be served.” The “proper incident” test processing efficiencies have continued. In addition, the described above provides comparable assurance for Board has developed a “notification” process for cer­ nonbanking acquisitions. The application of these tain bank holding company proposals that normally standards helps to ensure that the public will have ac­ do not present any issues. Thus, a bank holding com­ cess to a sufficient number of competitive providers pany need only notify the Reserve Bank—rather than of financial services. receive prior approval—for the acquisition of a de In the evaluation of each application, the Board con­ novo permissible nonbanking firm, the acquisition of siders the potential effect on competition in the rele­ a “small” nonbanking going concern, or the redemp­ vant geographic and product markets through analy­ tion of the bank holding company’s shares. After a sis of market shares, concentration ratios and waiting period of 15-30 days from acceptance, the pro­ inter-industry overlap of products. The views of the posal may be consummated unless objected to by the U.S. Department of Justice are also sought. The Board Reserve Bank. Several hundred such proposals are must conclude that the proposal would not result in processed by the System each year. a significant reduction in competition that is not off­ As indicated above, the Board has, over time, been set by other public benefits. concerned that applications be processed in as timely In applications to acquire a bank, the Board also a manner as possible, and in the early 1970s established considers the record of the applicant organization in an objective of processing 90 percent of all applica­ meeting the credit needs of the community. This in­ tions within 90 days. The Board modified this goal in cludes evaluation of its compliance with the Commu­ 1983 to process 90 percent of all applications within nity Reinvestment Act and other consumer legislation 60 days. These processing objectives have been met ev­ and regulations. Such an evaluation helps to ensure ery year since 1977. In 1985, the Federal Reserve that bank holding companies, whose subsidiaries are processed 96 percent of all applications within the entrusted with deposits of the public, will serve their 60-day period. communities in the public interest. The volume and breakdown by type of applications processed by the Federal Reserve Board and Reserve Delegation to the Reserve Banks Banks since 1971 is shown in Attachment I-F. The number of applications processed annually has in­ Subsequent to the enactment of the 1970 Amend­ Digitized for FRASER http://fraser.stlouisfedc.orerga/s ed significantly since the early 1970s and peaked ments to the Bank Holding Company Act, the Board Federal Reserve Bank of St. Louis B-7 delegated certain authority to Reserve Banks to pro­ provided that the processing period for Board action cess bank holding company applications. This new applications would be reduced from 90 to 60 days af­ authority was added in an effort to identify and expe­ ter acceptance; and that the processing period for dite the processing of problem-free applications. In delegated action applications would be reduced from 1971, rules regarding delegation of authority were for­ 60 to 30 days. In addition, the Board continually mally adopted to cover the formation of one-bank reviews and, when necessary, revises its applications holding companies. In 1972, the Board expanded this forms in order to collect necessary information while authority to include the acquisition of de novo banks. minimizing undue burden on applicants. In 1973, the Board again expanded the authority to The Board monitors industry developments in an ef­ include the formation of multi-bank holding compa­ fort to maintain efficient administrative and analyti­ nies and acquisitions of existing banks. These delega­ cal methods, and has issued several policy statements tions were designed to reduce the Board’s workload, to communicate regulatory priorities to the banking and to improve the timeliness of applications process­ industry. The principal objective of these statements ing. The rules also included restiictive parameters, is to make banking organizations and the public aware which if exceeded, would require Board action on the of current regulatory policies and concerns. The Small application. In 1972, approximately 40 percent of all Bank Holding Company Policy Statement and the applications were processed by Reserve Banks under Board’s Capital Adequacy Guidelines are two such delegated authority. The rules were amended on statements. Through the issuance of these statements, several occasions between 1974 and 1979. In 1979, the bank holding company applicants are better able to Federal Reserve’s guidelines were substantially revised plan corporate objectives and prepare applications that to permit the delegation of most applications, provided are consistent with the Board’s regulatory objectives. that they met certain policy, competitive, and finan­ In addition, orders issued by the Board on signifi­ cial and managerial criteria. In recent years, an aver­ cant cases provide the public with additional policy age of approximately 83 percent of all applications guidance. have been processed by Reserve Banks under delegated The Board has also developed an Information Se­ authority in about one-half the time necessary for more ries Booklet—Processing an Application Through the complex cases acted on by the Board. Federal Reserve System. This Booklet explains in lay­ The Board has developed procedures under which man’s terms the steps that need to be taken in prepar­ roost applications that are processed under delegated ing and filing an application and the factors the Board authority are subject to review by Board staff and cer­ must consider in processing an application. tain Board members prior to approval. This review promotes consistency of action and maintenance of high analytical standards among the Reserve Banks. Supervisory Programs The Board has also developed internal procedures which permit the processing of some delegated appli­ On-Site Inspections cations without this review if the characteristics of these applications fall within certain predefined In addition to establishing permissible activities and parameters. During 1983, 623 applications were acting on applications to engage in these activities, the processed under this procedure with an average Federal Reserve has, under authority granted in the processing time of only 23 days after acceptance. Bank Holding Company Act, developed programs to supervise the activities of bank holding companies. This is accomplished primarily through the conduct Other Steps to Improve Applications Efficiency and Responsiveness of on-site inspections of parent companies and their nonbank subsidiaries and through analysis of finan­ As indicated above, the Board has, over time, revised cial and regulatory reports which holding companies its internal procedures and Regulation Y to promote are required to submit periodically. Through these the timely processing of applications. In 1983, the means the System is able to evaluate the financial con­ Board approved a substantial revision to Regulation dition of holding companies, to assess their impact on Y that, for the first time, imposed strict timing stan­ affiliated banks, and to determine their compliance dards on the pre-acceptance review period for appli­ with banking laws and regulations. Generally, the Fed­ cations. These revisions provided that, under normal eral Reserve has limited its on-site inspection activi­ circumstances, only 10 business days could be used by ties to the parent company and its nonbank subsidi­ the Reserve Bank to review initially an application for aries; for information on a bank subsidiary, the Digitized for FRASER http://fraser.stlouisfedle.ogrga/l and informational sufficiency, prior to accep- Federal Reserve relies on examinations conducted by Federal Reserve Bank of St. Louis B-8 The System’s inspection program was developed in or credit-extending nonbank subsidiaries. Problem in­ the 1970s, partly in response to evolving supervisory stitutions were to be inspected at least annually. views of the potential risks to banks stemming from Other changes in the inspection program have been holding company activities, and partly in response to made over the years with the goals of bringing more developments within the banking system. Following large companies with leverage and nonbank subsidi­ the passage of the 1970 Amendments to the Bank aries under the annual frequency mandate, of focus­ Holding Company Act, a number of institutions, par­ ing more supervisory attention on problem institutions ticularly the larger regional and money center compa­ and of incorporating surveillance and monitoring data nies, began to expand through their holding compa­ into the conduct of on-site inspections in order to im­ nies into various permissible credit-related activities prove the efficiency of the inspection process. As a such as mortgage banking, leasing and consumer and matter of policy, most small “shell” holding commercial finance. companies—that is, companies with assets of less than During the recession of the mid 1970s, many hold­ S150 million that do not own credit-extending nonbank ing companies experienced severe asset problems in subsidiaries—have been inspected much less frequently than large institutions since such companies normally their mortgage banking and other nonbank subsidi­ pose fewer risks to their subsidiary banks. Shell com­ aries which, in a number of instances, created serious panies with significant weaknesses, however, have been problems for affiliated banks.4 In some cases, hold­ inspected on a more frequent basis than nonproblem ing company banks attempted to assist their troubled companies. affiliates in order to forestall the affiliates’ collapse Last year, the Board tightened the general inspec­ and to preserve the holding companies’, and the tion frequency requirement for all non-shell bank hold­ banks’, reputations. In the process, some of these ing companies and, in particular, mandated more fre­ banks became saddled with poor quality assets. In quent on-site reviews of large and troubled bank other cases, the close association in the public’s eye holding companies. The purpose of these changes was between the banks and their troubled nonbank affili­ to intensify the degree of oversight of institutions pos­ ates, often reinforced by common name identification ing the greatest potential risks to their banking affili­ and by the realization that both were under common ates and the banking system generally. Thus, the Fed­ holding company management, raised questions about eral Reserve now conducts one full scope and an the financial capacity, funding and strength of the additional limited-scope or targeted inspection of the affiliated banks. large regional and multinational institutions each year. Thus, both the experience of the mid 1970s and the Problem institutions are generally inspected semi­ nature of the relationship between a bank and its hold­ annually. ing company affiliates demonstrated the practical dif­ The development and expansion of the Federal ficulty of completely insulating a bank from the health Reserve’s inspection program is reflected in the in­ of its nonbank affiliates and provided a compelling crease over time in the number of on-site inspections. rationale for the Federal Reserve’s implementation of In 1975, the System conducted 228 inspections; by 1980 an on-site inspection program for bank holding com­ this number had expanded to 866. Last year, the Sys­ panies. The principal purposes of on-site inspections tem performed a total of 1778 inspections of holding were to determine the financial condition of the hold­ companies and their nonbank subsidiaries (Attach­ ing company and its subsidiaries, and the potential im­ ment I-G). pact of these entities on the subsidiary banks. These Federal Reserve inspection procedures require an objectives were a natural extension of the Board’s con­ assessment of the quality of the assets of the parent cern that holding companies serve as a source of finan­ company and its nonbank subsidiaries and an evalua­ cial and managerial strength to their subsidiary banks. tion of the parent company’s debt, liquidity and cash The Federal Reserve began conducting on-site in­ flow. Experience has suggested that each of these fac­ spections of bank holding companies on an informal, tors can have a significant impact on the health of the as needed basis in 1974 and 1975. This process was for­ holding company and, in turn, on the condition of sub­ malized in 1976 with the adoption of a requirement sidiary banks. In the course of each inspection, ex­ that most large holding companies be inspected at least aminers also evaluate and rate the major components once every three years. The inspection program was of the holding company, /.*., the bank subsidiaries, strengthened considerably in 1977 with the adoption the nonbank subsidiaries and the parent company, and of a uniform report format and more comprehensive appraise the earnings and capital of the holding com­ inspection procedures throughout the System. To­ pany on a consolidated basis. These steps, together Digitized for FRASERg ether with these changes, a more strict frequency regi­ with a review of the transactions between the bank and http://fraser.stlouisfedm.oergn/ was also mandated that called for an annual in- other holding company entities, including the payment Federal Reserve Bank of St. Louis —.4* < f .' .A. L.. a| I___I ^i ______. ____tt. r* j B-9 era! Reserve examiners to make an evaluation of the In its efforts to ensure that bank holding compa­ overall impact of the holding company on the finan­ nies remain a source of strength to their banks, the cial condition of the subsidiary banks. In making this Federal Reserve has actively utilized its formal enforce­ evaluation, Federal Reserve examiners pay particularly ment authority to issue written agreements or cease and close attention to the possibility of any non arms- desist orders. Such authority has been used to require length transactions with bank holding company in­ holding companies to terminate certain imprudent siders that could have a potentially harmful effect on funding or lending practices, to divest of certain assets the subsidiary bank. that were eroding the financial health of the holding Another important objective of the on-site inspec­ company, and to take certain steps to assist the sub­ tion is to determine a company’s compliance with rele­ sidiary bank, such as reducing the level of bank divi­ vant banking laws, including the Bank Holding Com­ dends or injecting additional capital into the bank. As pany Act and Section 23A of the Federal Reserve Act. the Federal Reserve’s inspection program has ex­ Thus, Federal Reserve examiners seek to determine panded over time, the use of enforcement actions in­ that holding companies have obtained appropriate volving bank holding companies, nonbank affiliates regulatory clearances for the activities in which they and individuals participating in the affairs of holding are engaged and to ascertain whether the companies companies has increased dramatically, and has played are conducting any impermissible nonbank activities. a critical role in the System’s overall supervisory effort. Examiners also look for any illegal tie-in arrangements in which the provision of one service or product to a customer is tied to or conditioned upon the customer’s Supervisory Reports and Surveillance acceptance of other holding company services. In ad­ dition, examiners check for compliance with any com­ Another important element in the Federal Reserve’s mitments made by an organization in connection with supervisory program has been the requirement that the Board’s grant of approval that organization to bank holding companies file periodic financial and expand its activities or acquire additional subsidiaries. regulatory reports. Such reports have played an im­ As part of its iupto - •-> * rocess, the Federal Re­ portant role in supplementing the System’s on-site in­ serve has developed a comprehensive tn»nu*l of super­ spection activities and in monitoring an institution’s visory and on-site inspection procedures. Tziz man­ financial condition and compliance with the Bank ual cites the laws and regulations pertaining to bank Holding Company Act. holding companies and provides guidance to e '^miners Bank holding companies are required to file an an­ for assessing different types of nonbank activities, nual report generally comprising 1) free-form finan­ evaluating key risk factors at the parent and nonbank cial statements (income and balance sheets) on the par­ levels, and determining the overall condition of the ent company, its nonbank subsidiaries and the bank holding company. The Federal Reserve has also consolidated bank holding company; 2) structure in­ developed an internal rating system that provides for formation on the ownership of and investments in non­ the evaluation of each component of the holding com­ bank entities; 3) information on the directors and prin­ pany and requires the assignment of a composite or cipal shareholders of the holding company; and 4) data summary financial rating to the consolidated holding on nonbank activities that were commenced or termi­ company. nated during the year. These reports are reviewed to The Federal Reserve has continually reviewed the determine if there have been significant changes within adequacy and effectiveness of its inspection program the year in an organization’s financial profile or in the and procedures over time. In the late 1970s and early nature of its operations. 1980s, the Federal Reserve, together with the other fed­ In 197S, the System instituted a series of financial eral banking agencies, implemented a number of pro­ reports on the parent and consolidated companies grams to better coordinate examinations of holding designed to collect more frequent information on large companies and their lead bank subsidiaries. Within the holding companies in a standardized format. This per­ last year, the System strengthened its methods for com­ mitted certain financial data on holding companies to municating inspection findings to boards of directors be computerized for the purpose of compiling and by requiring the preparation of a special directors sum­ evaluating financial developments and trends involv­ mary report to highlight important supervisory issues ing large numbers of institutions. In the mid 70s, the and concerns. The Federal Reserve has also tightened Federal Reserve also established a requirement that its procedures for assessing the liquidity and cash flow holding companies report on their significant inter­ of the parent bolding company in order to reduce the company transactions. This report obligated large possibility that funding problems at the parent level holding companies to inform the Federal Reserve of Digitized for FRASERw ill undermine the stability of the holding company significant loans and other transactions between the http://fraser.stlouisfedo.orr git/ s subsidiary banks. subsidiary bankfsl and other hnldinc mmnanv affilt- Federal Reserve Bank of St. Louis B-10 ates. The purpose of this report was to alert supervi­ This letter reiterated the Board’s view that the purchase sory authorities of potentially risky transactions be­ of poor quality assets by a subsidiary bank from a tween the banks and their holding company affiliates. holding company affiliate in a non arms-iength trans­ Within the last several years, the System has devel­ action could be a violation of Section 23A of the Fed­ oped a bank holding company performance report, eral Reserve Act, which establishes limits and collateral comparable in many respects to the uniform bank per­ conditions on bank loans to affiliates. The Board also formance report used by the three federal bank regula­ indicated that Federal Reserve personnel would closely tory agencies. The performance report contains a con­ scrutinize transactions between subsidiary banks, their siderable amount of current and historical financial affiliates and other related institutions, and would in­ information, including data on trends in financial ra­ itiate formal enforcement action, including the issu­ tios and peer group comparisons. These reports are ance of cease and desist orders, when necessary to pro­ used by examiners and supervisory analysts to evalu­ tect the subsidiary banks. Consistent with these ate the performance of individual holding companies concerns, the Board instituted, as already noted, a over time and to pinpoint those financial factors that reporting requirement that holding companies report may require additional supervisory attention. The Fed­ significant loans and transactions between subsidiary eral Reserve has also developed financial screening and banks and other holding company affiliates. In con­ surveillance techniques designed to highlight those junction with these actions, the Federal Reserve also companies whose performance deviates in an adverse made a review of transactions between the bank and direction from that of their peers. Organizations fail­ its holding company affiliates a critical component of ing surveillance screens are subject to additional su­ the on-site inspection. pervisory scrutiny and, if necessary, on-site inspection. The Federal Reserve has also developed supervisory In light of recent developments in the banking sys­ policies addressing the possible diversion of subsidi­ tem, the Federal Reserve has within the last year ex­ ary bank income and assets to holding company affili­ panded the frequency and content of the standardized ates. In 1978, the Board issued a policy statement per­ financial reports it receives from holding companies taining to certain income tax accounting transactions and has strengthened its surveillance and screening between subsidiary banks and their parent holding techniques. Large companies are now required to re­ companies. This statement expressed the Board’s con­ port quarterly (rather than semiannually), and the cern over intercorporate tax payment arrangements reports filed by these companies have been broadened that 1) transfer assets and income from subsidiary to encompass additional information on capital ade­ banks to the parent company without offsetting quacy, nonperforming loans, and off-balance sheet benefits to the banks, and 2) leave banks owned by risks. In addition, reporting requirements involving the holding companies filing consolidated returns less well volume and composition of a holding company’s non­ off from a tax standpoint than the banks would be if banking assets have been expanded. they filed on a separate entity basis. In 1979, a related policy was adopted that set forth the Federal Reserve’s concerns over other practices that had the effect of in­ Supervisory Policies and Guidelines appropriately diverting income from subsidiary banks to other holding company affiliates. This statement The Federal Reserve has issued a number of policy alerted Federal Reserve supervisory personnel to the statements and supervisory guidelines over the years potentially harmful effects of the payment by a bank whose goal has beat to assure the safe and sound oper­ to any affiliate of management and service fees that ation of bank holding companies and to protect the were not reasonably related to the value of services financial health of affiliated banks. These supervisory received by the bank. The policy also addressed other policies have served to inform the managers of hold­ payments or practices that had the effect of benefit- ing companies of what is considered appropriate and ting the holding company to the detriment of the sub­ acceptable banking practice, provided guidance to sidiary bank. Taken together, the policy statements on holding company examiners in assessing holding com­ intercorporate tax payments and income diversion pany actions, and established standards or criteria practices underscored the Federal Reserve’s concern against which the need for formal enforcement action over the possibly adverse effect of certain holding com­ could be determined. A major element of the on-site pany transactions on bank subsidiaries and have served inspection is to ascertain a bank holding company’s as a framework for evaluating the broad range of compliance with these supervisory policies. transactions between subsidiary banks and their hold­ Concern over potential bank exposure arising out ing companies. of transactions with nonbank affiliates led the Board In 1981, the Board issued capital adequacy guide­ to distribute a policy letter to the chief executive lines that established minimum levels of capital to total Digitized for FRASERo fficers of all bank holding companies in early 1976. assets for bank holding companies on a consolidated http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-l 1 basis as well as for state member banks. The guide­ plemented in 1981, capita] ratios for the largest organi­ lines applicable to large organizations were raised in zations have increased considerably, although this im­ 1983, and the regulatory agencies’ authority to enforce provement needs to be viewed in light of the changing minimum capital requirements was strengthened by risks to which banking organizations are exposed. Congress in passing the International Lending Super­ Early this year, the Board published for comment a vision Act of 1983. The establishment of minimum proposal to implement a supplemental adjusted capi­ capital guidelines for bank holding companies on a tal ratio. This ratio is designed to be more sensitive consolidated basis reflected 1) the realization that to the various risks inherent in a banking organiza­ financial markets tended to view holding companies tion’s assets and, for the first time, to take explicit and their affiliates, both bank and nonbank, as one account of certain off-balance sheet activities. Imple­ organization and 2) the supervisory concern, based mentation of the proposal should provide better guid­ upon experience, that weaknesses in the consolidated ance to bank managers and examiners on what con­ organization’s financial profile can have an adverse stitutes adequate capital, and should encourage impact on the stability or funding of the affiliated banking organizations who seek to expand their risk- banks. bearing activities to support such activities with ade­ The Board’s capital guidelines, as revised over time, quate capital. This supplemental ratio guideline would also address the question of appropriate capital posi­ apply to state member banks and bank holding com­ tions for nonbank subsidiaries of bank holding com­ panies on a consolidated basis. panies. In this regard, the Board has stated that such nonbank subsidiaries generally should maintain capi­ tal levels that are consistent with the industry norms II. International Banking Activities of U.S. or standards applicable to similar companies that are Banking Organizations not affiliated with bank holding companies. This ap­ proach was motivated by a desire to avoid extending Foreign Activities of U.S. Banking Organizations the high leverage characteristic of commercial banks to nonbank subsidiaries with higher or different risk Statutory Background profiles. One objective of assuring adequate capital in nonbank subsidiaries is to reduce the likelihood that The Federal Reserve Board has jurisdiction over most serious problems will emerge in these subsidiaries to foreign operations of U.S. banking organizations. The the potential detriment of the holding company or its Board regulates foreign activities and investments of affiliated banks. Nonetheless, the Federal Reserve’s member banks, Edge and Agreement corporations, capital guidelines place primary emphasis on the cap­ and bank holding companies. The Board does not ital position of the consolidated holding company in regulate the foreign operations of nonmember insured recognition of the practical difficulty of insulating the banks. condition of bank subsidiaries from the public’s per­ The statutes governing the foreign activities of U.S. ception of the strength and stability of the consolidated banking organizations have evolved over a period of banking organization. time since 1913. As part of the original Federal Re­ Last year, the Federal Reserve reiterated, in the form serve Act, national banks were, with the Board’s per­ of a policy statement, its long-standing position on the mission, given the power to establish foreign branches. payment of cash dividends by state member banks and In 1916, Congress amended the Federal Reserve Act bank holding companies experiencing financial to permit national banks to invest in international or difficulties. Such organizations were urged to conserve foreign banking corporations known as “Agreement” their capital and reduce or eliminate cash dividends corporations, because such corporations were required on common stock if such dividends were not funded to enter into an agreement or understanding with the by current earnings or if the organization’s prospec­ Board to restrict their operations to international ac­ tive rate of capital retention was inadequate in light tivities. In 1919 the enactment of section 25(a) of the of its financial health. Bank holding companies, in par­ Federal Reserve Act (the “Edge Act”) permitted na­ ticular, were encouraged to review the effect of their tional banks to invest in federally-chartered interna­ dividend policies on bank subsidiaries in order to avoid tional or foreign banking corporations (so-called Edge placing undue pressure on bank earnings and capital. corporations) which may engage in international or This policy’s emphasis on the potential adverse impact foreign banking or other international or foreign of holding company dividends on the condition of sub­ financial operations. In 1966, Congress amended sec­ sidiary banks is consistent with the fundamental prin­ tion 25 of the Federal Reserve Act to allow national ciple that holding companies are to be a source of banks to invest directly in the shares of a foreign bank. financial strength to their subsidiaries. The Bank Holding Company Act of 1956 permit­ Digitized for FRASER Since the supervisory capital guidelines were im­ ted bank holding companies to invest in foreien bank­ http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-12 ing companies engaged principally in the banking busi­ necessary with respect to securities issued by any “for­ ness outside the United States. In 1970, the BHC Act eign State” as defined in section 25(b) of the Federal was amended to provide that a bank holding company, Reserve Act (12 U.S.C. 632). with the Board’s approval, may acquire a foreign com­ The Board regulations permit foreign branches of pany that does not engage in business in the United member banks to perform certain functions not per­ States where the investment would not be substantially mitted to national banks in the United States. These at variance with purposes of the Act and would be in include issuing guarantees on occurrence of readily the public interest. ascertainable events and subject to monetary limits; Therefore, the Board has a broad grant of discre­ investing in certain foreign government securities; act­ tionary power to determine the overseas activities in ing as insurance agent or broker; and entering into cer­ which U.S. banking organizations may engage through tain repurchase agreements on securities and commodi­ affiliates. In addition, the Edge Act was amended in ties that are the functional equivalents of extensions 1978 to include a Congressional declaration of pur­ of credit. pose which stated that the Edge Act is intended “to provide for the establishment of international Direct investments. A member bank generally may banking and financial corporations operating un­ not invest in the stock of companies. Section 25 of the der federal supervision, with powers sufficiently Federal Reserve Act, however, authorizes a national broad to enable Edge corporations to compete ef­ bank to invest in the shares of a foreign bank. The fectively with similar foreign-owned institutions purpose of this provision was to allow member banks in the United States and abroad.” 12 U.S.C. 61 la. to do business in those foreign countries that pro­ hibited entry by means of branches although it is not limited to those circumstances. Member Banks The Board has defined “foreign bank” in section 211.2(g) of Regulation K as Foreign Branches. Under section 25 of the Federal Reserve Act, the Board is given the authority to ap­ “an organization that is organized under the laws prove the establishment of foreign branches of na­ of a foreign country; engages in the business of tional banks (12 U.S.C. 601). Under section 9 of the banking; is recognized as a bank by the bank su­ Federal Reserve Act, State member banks, which have pervisory or monetary authority of the country the requisite power to establish foreign branches under of its organization or principal banking opera­ tions; receives deposits to a substantial extent in State law, may establish and operate such foreign the regular course of its business; and has the branches with the Board’s approval and on the same power to accept demand deposits.” terms and conditions and subject to the same limita­ tions and restrictions as are applicable to the estab­ This definition assures that a member bank’s direct lishment of foreign branches by national banks (12 investments will be in entities that are engaged in the U.S.C. 321). The Board thus has regulatory authority business of commercial banking. over the establishment and operation of foreign The Board has recently amended Regulation K to branches of both national and State member banks. permit a member bank to invest with the Board’s ap­ Foreign branches of national banks are, however, ex­ proval in the shares of a wholly-owned company lo­ amined by the Comptroller of the Currency. cated in the country where the bank operates a branch Through foreign branches, member banks have been if the company engages only in activities permitted to permitted by the Board to exercise the normal bank­ the member bank itself. ing powers that they enjoy domestically under the fed­ A member bank may also hold directly the shares eral or State laws under which they are chartered and of Edge and Agreement corporations, discussed be­ as limited by the Federal Reserve Act. They may also exercise certain enumerated additional powers to the low, and may make indirect investments through these extent such powers are usual in connection with the vehicles. business of banking in the foreign countries where those branches transact their business. 12 U.S.C. 604a. Indirect investments. A national bank may, with the The Federal Reserve Act, however, provides that a Board’s permission, invest in the stock of either an foreign branch cannot engage in the general business Edge corporation, organized under section 25(a) of the of producing, distributing, buying or selling goods, Federal Reserve Act (12 U.S.C. 611-631), or an Agree­ wares or merchandise; nor may a foreign branch en­ ment corporation, operating under an agreement with gage or participate, directly or indirectly, in the busi­ the Board pursuant to section 25 of the Federal Re­ ness of underwriting, distributing, or selling securities, serve Act (12 U.S.C. 601), so long as the aggregate Digitized for FRASER http://fraser.setlxouciespfetd t.oor gs/u ch limited extent as the Board may deem amount of stock held in all Edge and Agreement cor­ Federal Reserve Bank of St. Louis B—13 porations does not exceed 10 percent of the bank’s cap­ each case, any reference to activities conducted or in­ ital and surplus (12 U.S.C. 618). State member banks vestments acquired and held by an Edge corporation may, with the Board’s permission, also acquire and includes activities conducted or investments acquired hold shares of these corporations if permissible under and held by an Agreement corporation. State law. State nonmember banks seeking to organize Pursuant to its authority under the Edge Act, the an Edge corporation must also obtain the Board’s ap­ Board has adopted and promulgated Regulation K, proval since such corporations are chartered by the which sets forth regulations governing the organiza­ Board. tion of Edge corporations, their activities, and their investments. These regulations are discussed below. Edge and Agreement Corporations Bank Holding Companies Edge corporations are chartered with the Board’s ap­ proval for the purposes of engaging in international The Board has discretion under section 4(c)(13) of the or foreign banking or other international or foreign Bank Holding Company Act (“BHC Act”) to permit financial operations either directly or through the brnk holding companies to acquire and hold stock of agency, ownership, or control of local institutions in companies that do no business in the United States ex­ foreign countries (12 U.S. C. 611). Edge corporations cept as an incident to such companies’ international may also, with the Board’s consent, acquire and hcla or foreign business, if the Board concludes that such stock of any companies that are not engaged in the an exemption would not be substantially at variance general business of buying or selling goods or com­ with the purposes of the BHC Act and would be in modities in the United States and that do not transact the public interest (12 U.S.C. 1843(c)(13)). any business in the United States except as may be in­ Since its enactment, the Board has interpreted sec­ cidental to such companies’ international or foreign tion n 'c)(13) as permitting a bank holding company business (12 U.S.C. 615). Thus, through their Edge to engage in the same activities and stake the same in­ corporation subsidiaries, U.S. banks may engage in­ vestments as are authorized for Edge corporations. directly in international or foreign banking or other international or financial operations abroad; in addi­ tion, U.S. banks may indirectly acquire sto'k of for­ Rt'gulatO'y Background eign companies through their Edge corporation subsidiaries. Regttlation K sets forth the standards that the Board Agreement corporations are banks o. corporations expects to be followed in the conduct of fore'gr oper­ chartered or incorporated under the laws of the United ations. Section 211.5(a) stares States or of any State thereof principally engaged in international or foreign banking, or banking in a de­ Activities abroad, whether conducted directly or pendency or insular possession of the U.S., either indirectly, shall be confined to those of a bank­ directly, or through the agency, control, or ownership ing or financial nature and those that are neces­ of local institutions in foreign countries, or in such de­ sary to carry on such activities. In doing so, in­ pendencies or insular possessions (12 U.S.C. 601). In vestors shall at all times act in accordance with high standards cf banking or financial prudence, order for a member bank to invest in the shares of an having due regard for diversification of risks, Agreement corporation, the corporation must enter suitable liquidity, and adequacy of capital. Sub­ into an agreement with the Board to restrict its opera­ ject to these co/isiderations and the other provi­ tions or conduct its business in such manner or under sions of this section, it is the Board’s policy to such limitations as the Board may prescribe for the allow activities abroad to be organized and oper­ place or places whete it transacts business (12 U.S.C. ated as best meets corporate policies. 603). The Board has by regulation limited the activi­ ties and investments of Agreement corporations to Section 211.5 also contains application procedures those permissible for an Edge corporation. Thus, a that are designed to reduce the burden on banking or­ member bank through an Agreement corporation sub­ ganizations that conduct overseas operations by sidiary may conduct the same foreign activities and minimizing the numbers and kinds of routine invest­ hold the same foreign investments that it may conduct ment applications that must be acted on by the Board. and hold through an Edge corporation, unless the The regulation requires specific Board consent for in­ Agreement corporation is subject to other specific re­ vestments that, because of their size, novelty or some quirements in its agreement with the Board or is other­ other aspect such as the financial condition of the wise limited by State law. Because the regulatory stan­ banking organization, deserve Board consideration. Digitized for FRASER dards governing these corporations are identical in Other investments may be made under general http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-14 sent or prior notification procedures. The general con­ pany activities, the giving of investment and financial sent procedure allows a banking organization to make advice, providing bookkeeping and data processing investments of up to SI5 million in subsidiaries and services, and acting as insurance agent or broker, the joint ventures as long as they are engaged in certain Board did not impose conditions set forth in Regula­ permissible activities listed in the regulation (12 C.F.R. tion Y, which were designed for the domestic market. 211.5(d)). The general consent also allows portfolio Generally, foreign affiliates of U.S. banks could en­ investments (i.e., noncontrolling investments in any gage in such financial activities to the extent permit­ type of company, regardless of the nature of the pro­ ted competing foreign institutions in the foreign posed activity) up to that same dollar amount. Beyond country. that, an investor may invest up to 10 percent of its cap­ The Board also approved by order other foreign ital in subsidiaries and joint ventures engaged in listed operations that are not considered closely related to activities, after 45 days’ prior notice to the Board. All banking donxsticaliy. For example, foreign affiliates other investments, including those involving large dol­ of U.S. banks may engage in management consulting lar amounts or unlisted activities, require specific activities abroad, subject to the condition that such Board approval. services relating to the U.S. market will be confined to the initial entry of foieign companies into the mar­ ket. They may also manage foreign mutual funds, sub­ Overseas Activities Permitted To ject to the condition that shares of any such funds will U.S. Banking Organizations only be sold to nonresident aliens and that such funds will not directly or indirectly control or participate in As discussed above, the Board has broad discretion the management of any company. The Board also per­ with respect to the t>pes of activities that it may per­ mitted foreign affiliates of U.S. banks to engage in mit U.S. banking organizations to engage in overseas. travel agency and warehousing services in certain coun­ Before the Board amended Regulation K in 1979, the tries. While none of these activities were permissible Board exercised that discretion by permitting in­ domestically under Regulation Y, the Board approved dividual organizations, on a case-by-case basis, to c.-j • these activities abroad for foieign affiliates of U.S gage in particular activities overseas. Any proposal by banks in particular countries in order to keep U.S. an Edge corporation or a bank holding company to banks competitive with their foreign counterparts. invest more than S500.000 or acquire more than 25 per­ Such activities are either generally performed by banks cent of the shares of a foreign company required the as part of their international financial operations, or Board’s approval. The Board’s policy has been to are performed by foreign banks in certain countries. authorize activities, which can be conducted through Before 1979, the Board also specifically denied re­ such foreign companies, of a banking or financial quests to engage abroad in underwriting general in­ nature. surance, in customs house brokerage and freight for­ In reviewing activities, the Board sought to permit warding activities, in purchasing and selling of land, activities of general importance to international bank­ real estate development, participating as a joint ven­ ing that should be capable of being performed by for­ ture partner in real estate development, hotel owner­ eign affiliates of U.S. banks anywhere outside the ship and management and other “non-financial” ac­ United States in order to make them competitive with tivities. These requests were denied because the Board foreign banks. The Board thus approved these activi­ determined that these activities were not “financial ties, including the underwriting of stocks and bonds operations” within the meaning of the governing stan­ as “international financial operations,’’ referenced in dard, and U.S. banks would not be harmed competi­ the Edge Act. The Board also approved applications tively abroad if they could not engage in such activities. by U.S. banking organizations to engage overseas in activities that the Board had determined to be “closely 1979 Revisions to Reoulation K. In its June 1979 related to banking” under Regulation Y. In some amendments to Regulation K, the Board, for the first cases, such as foreign leasing activities, the Board re­ time, included a list of activities it had determined to tained the restrictions imposed domestically under be permissible for foreign subsidiaries of U.S. bank­ Regulation Y on the activity because the restrictions ing organizations. This list included activities that had relate to ensuring the financial nature of the activity. previously been approved by Board order in particu­ Thus, foreign affiliates of U.S. banks may not engage lar cases for foreign subsidiaries of Edge corporations in leasing operations abroad that did not involve full- and bank holding companies. payout, because the Board had not determined these The activities that the Board has determined are Digitized for FRASERa ctivities to be financial operations. In the case of the usual in connection with the transaction of banking http://fraser.stlouisfedm.oargj/o rity of section 4(c)(8) activities, such as trust com­ or other financial -«----■ . . . Federal Reserve Bank of St. Louis B-15 permissible overseas in section 211.5(d) of Regulation related to banking under section 4(c)(8) of the K, are: BHC Act; and 16. With the Board’s specific approval, engaging in 1. Commercial and other banking activities. other activities that the Board determines are usual 2. Financing, including commercial financing, in connection with the transaction of the business consumer financing, mortgage banking, and of banking or other financial operations abroad factoring. and are consistent with the FRA or the BHC Act. 3. Leasing real or personal property, or acting as agent, broker, or advisor in leasing real or per­ The activities listed in section 211.5(d) of Regula­ sonal property, if the lease serves as the functional tion K are, in many cases, related to those activities equivalent of an extension of credit to the lessee in Regulation Y that have been determined by the of the property. Board to be closely related to banking for the purposes 4. Acting as fiduciary. of section 4(c)(8) of the Bank Holding Company Act. 5. Underwriting credit life insurance and credit ac­ As discussed above, the restrictions that are applied cident and health insurance. to the activity if engaged in domestically do not neces­ 6. Performing services for other direct or indirect sarily apply to the activity when engaged in abroad. operations of a United States banking organiza­ Some restrictions on the U.S. operations of bank­ tion, including representative functions, sale of ing organizations stem from concerns with the safety long-term debt, name saving, holding assets ac­ and soundness of the U.S. banking organization, as quired to prevent loss on a debt previously con­ well as with potential conflicts of interest, which are tracted in good faith, and other activities that are also relevant to the operations of U. S. banks abroad. permissible domestically for a bank holding com­ Accordingly, the Board has balanced its concerns pany under sections 4(a)(2)(A) and 4(c)(1)(C) of regarding safety and soundness and conflicts of in­ the BHC Act. terests with its objective of allowing U.S. banking or­ 7. Holding the premises of a branch of an Edge cor­ ganizations to compete effectively in other countries poration or member bank or the premises of a di­ with different kinds of banking systems. Thus, the rect or indirect subsidiary, or holding or leasing Board permits U.S. banking organizations to engage the residence of an officer or employee of a branch to a limited extent in underwriting, distribution and or subsidiary. dealing in equity securities abroad. Uncovered under­ 8. Providing investment, financial, or economic ad­ writing commitments are, however, limited to $2 mil­ visory services. lion and to no more than 20 percent of the capital and 9. General insurance agency and brokerage. surplus or voting stock of the issuer. The Board has 10. Data processing. permitted U.S. banking organizations to participate 11. Managing a mutual fund if the fund’s shares are fully in the underwriting of debt securities overseas, not sold or distributed in the United States or to not only for competitive reasons but also to per­ United States residents and the fund does not ex­ mit U.S. banking organizations to serve the credit and ercise managerial control over the firms in which working capital needs of their U.S. corporate it invests. customers. 12. Performing management consulting services when Most of the large internationally-active U.S. banks rendered with respect to the United States market have merchant or investment banks in London (At­ shall be restricted to the initial entry. tachment II-C-1) that seek underwiting business. Ac­ 13. Underwriting, distributing, and dealing in debt cording to Euromoney, subsidiaries of five major U.S. and equity securities outside the United States, banks or bank holding companies ranked among the provided that no underwriting commitment by a world’s 30 largest underwriters of Eurobonds in 1985, subsidiary of an investor for shares of an issuer with Morgan Guaranty ranking third among lead may exceed S2 million or represent 20 percent of managers. In addition to Morgan Guaranty, these the capital and surplus or voting shares of an issuer companies are Bankers Trust, Bank of America, unless the underwriter is covered by bind ing com­ Citicorp and Chase Manhattan. Combined, these five mitments from subunderwriters or other companies underwrote as lead manager or as co­ purchasers. manager issues representing S18.4 billion, or about 10 14. Operating a travel agency provided that the travel percent of the amount underwritten by the top 30 to­ agency is operated in connection with financial tal organizations. See Attachments Il-C-2 and 3. Simi­ services offered abroad by the investor or others. lar merchant or investment bank subsidiaries in Hong 15. Engaging in activities at the Board has determined Kong, Australia, and other countries also actively un­ by regulation in 12 CFR 225.25(b) are closely derwrite corporate debt, although to a much lesser ex­ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-16 tent than those located in London where the Eurodol­ businesses. Tables referred to in this section are at lar market is centered. Attachment II-D. Several U.S. banking organizations have also made As shown in Attachment II-D-1, U.S. banks and significant investments in British securities firms that bank holding companies can operate, or invest, abroad are now possible following recent changes in British either by acquiring or investing in foreign companies laws. These changes liberalized the ownership of secu­ or by establishing foreign branches. Regarding invest­ rities companies and also enabled stock-brokerage ments, the direct investments of member banks are re­ firms to act as principals or market makers in securi­ stricted by statute to foreign banks. However, in­ ties traded on the London Stock Exchange. Security directly through an Edge corporation or a foreign bank Pacific, Citicorp, and Chase Manhattan have recently subsidiary, a member bank may invest in financial ac­ acquired controlling interests in several such firms. tivities and in small noncontrolling interests in non- financial activities. A U.S. bank holding company also has the full range of foreign investment powers of Edge Other Activities corporations. The forms of U.S. banking organiza­ tions operations abroad, described below, include: In its revision of Regulation K in 1979, the Board, in 1. branches; addition to listing activities that U.S. banking organi­ 2. subsidiaries (majority-owned or otherwise con­ zations could engage in overseas without prior Board trolled); approval, provided the investment amounts were 3. joint ventures (20 to 50% ownership and not other­ within the regulatory limits, also stated that it would wise controlled); and entertain requests from U.S. banking organizations to 4. “portfolio” investments (investments representing engage in appropriate additional activities overseas. less than 20 percent of a company’s voting shares). To obtain Board approval of such activities, the ap­ plicant would have to show (1) that the proposed ac­ tivity is usual in connection with the transaction of the Branches business of banking or other financial operations abroad, and (2) that the activity is consistent with the While the powers of branches are more limited than Federal Reserve Act (in the case of Edge corporation those of separately incorporated foreign companies, subsidiaries) or the Bank Holding Company Act (in branches dominate the foreign activities of U.S. bank­ the case of bank holding company subsidiaries). Evi­ ing organizations in terms of assets, and are generally dence that the activity is itself financial in nature or the preferred form of operation for U.S. banks. In that banking organizations engage in the activity in addition to conducting the general banking activities connection with their banking or financial operations that are permitted to their home offices within the to a material extent in the proposed market in another United States, foreign branches of member banks can country is required to meet the first standard. Under conduct a limited range of other activities when they the second standard, the Board examines whether the are determined to be “usual in connection with the risks of the proposed activity, or the potential conflicts business of banking in the country where it transacts of interest posed by it, are inconsistent with the su­ business.” The following activities are among those pervisory or regulatory purposes of the Bank Hold­ the Board has permitted within this context: ing Company Act or the Federal Reserve Act. A list 1. guaranteeing customer debts; of activities that the Board has approved or denied by 2. investing in institutions “necessary” to the effec­ specific order is found at Attachment U-A. A com­ tive operation of the branch; and parison of permissible foreign and domestic activities 3. underwriting debt securities of the national and lo­ is found at Attachment II—B. cal governments where the branch is located. Generally, however, foreign branches conduct tradi­ Methods of Overseas Operations tional consumer and commercial banking, much as Of U.S. Banking Organizations they do within the United States. Foreign branches cannot, for example, underwrite equity securities, even While the range of activities permissible to U.S. bank­ though that activity can be performed by some for­ ing organizations is somewhat broader outside the eign banks. Large banks with international networks United States than it is in this country, the activities operate full-service branches. Most other U.S. banks conducted overseas are virtually all of a banking or operate only “shell” branches in the Caribbean for financial nature. Only relatively small and noncontroll- the purpose of raising funds in the Eurocurrency mar­ ing investments are permitted in foreign non financial ket, while incurring very low overhead costs. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-17 Subsidiaries Portfolio investments Ownership of foreign subsidiaries allows U.S. bank­ The term portfolio investments refers to relatively ing organizations to acquire established foreign banks small investments that represent less than 20 percent and other financial institutions and to perforin a of the voting shares of a company. The Board has broader range of activities than is permissible through taken a generally permissive approach toward these in­ branches. Perhaps the most notable additional power vestments in order to give U.S. banks flexibility in is that of underwriting corporate debt and equity secu­ structuring a financing package, a limited voice in the management of the borrower, and a way to compete rities, the latter of which is strictly limited. Subsidi-. in markets where small equity participations are aries can commit to underwrite no more than S2 mil­ common. lion or 20 percent of the issuer’s shares without binding U.S. banking organizations can hold portfolio in­ commitments from sub-underwriters or other pur­ vestments in virtually any foreign company, provided chasers. As a result, the foreign subsidiaries of U.S. the total amount of such investments in companies that banking organizations underwrite relatively few equity conduct otherwise impermissible activities does not ex­ issues, but have a larger role in underwriting corporate ceed 100 percent of the investor’s equity capital. For debt. this purpose the “investor” is the bank holding com­ Foreign subsidiaries also allow U.S. banking organi­ pany (BHC), the bank, or the Edge corporation sub­ zations to benefit from local tax laws and regulations sidiary making the investment. No foreign company and, in some cases, also to gain entry into countries in which a U.S. banking organization holds more than that prohibit branches of foreign banks. For all these 5 percent of the shares, however, may conduct any and other reasons, U.S. banks and bank holding com­ business in the United States that is not incidental to panies own almost 900 foreign subsidiaries (most of its foreign business. them quite small) that have assets currently of about Attachment II-D-4 shows the amount and types of SI00 billion. Attachment II-D-2 shows the amount foreign companies in which U.S. banking organiza­ U.S. banking organizations have invested in foreign tions have made portfolio investments. Slightly over subsidiaries based upon the principal activity of the one-half of the amount invested in these relatively subsidiary. Investments in banking activities, includ­ small holdings is in banking and other lending activi­ ing merchant and investment banks, account for ap­ ties, and another 20 percent is invested in activities of proximately 94 percent of all their investments in for­ the type generally permissible to bank holding com­ eign subsidiaries. Investments in other financially panies under section 4(c)(8) of the Bank Holding Com­ pany Act. While the remaining 30 percent is invested related companies accounts for virtually all the remain­ in nonfinancial businesses, even many of these invest­ ing balance. ments are similar to those that would be allowed for a small business investment company subsidiary of a bank or BHC. Joint ventures Noncontrolling investments that represent 20 to 50 per­ Supervision of Foreign Operations cent of the voting shares of a company are regulated as “joint venture” investments. Because the level of The foreign operations of U.S. banking organizations ownership is noncontrolling, and in order to permit are examined by their primary federal regulatory banks to compete effectively abroad in making such agency: the Federal Reserve in the case of bank hold­ investments, the Board has applied more liberal stan­ ing companies, State member banks and Edge and dards to the permissible activities of joint venture com­ Agreement corporations, or the Office of the Comp­ panies than it has to the activities of branches and troller of the Currency (“OCC”) in the case of na­ subsidiaries. tional banks and their direct foreign subsidiaries. Rela­ Joint ventures must remain predominately banking tively few nonmember banks have foreign activities, or financial in nature, but they can have up to 10 per­ and those that do typically have only “shell” branches, cent of their assets or revenues attributed to otherwise which do not conduct a full-service deposit and loan impermissible activities. Most joint ventures are banks operation. or finance or leasing companies, although some are In most cases, the foreign activities of a bank are real estate brokers and securities brokers. At year-end examined during the examination of the “parent” in­ 1984 U.S. banking organizations held over 100 for­ stitution, that is, the regular examination of the U. S. eign joint venture investments valued at about $680 bank. Banks are required, as a condition of approval million. See Attachment II-D-3. for their foreign offices, to maintain, at their head Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-18 offices adequate documentation about their foreign ac­ The Federal Reserve also collects quarterly repons tivities so that examiners can review the condition of of condition (and annual income statements) for bank­ these foreign offices. In the case of shell branches, ing Edge corporations, and annual condition and in­ whose business is conducted from the head office, full come reports from all foreign subsidiaries and non­ credit files are readily available. (See policy statement banking Edges. A short condition report is also at Attachment II-E.) submitted annually to either the OCC or the Federal The Federal Reserve often examines major foreign Reserve by all foreign branches of member banks. offices on-site, especially in the United Kingdom, West Germany, France, and Japan. Federal Reserve ex­ aminers have also gone to other major European coun­ Export Trading Companies tries, Australia, and Hong Kong, although not rou­ tinely. In recent years, a special effort has been made The Bank Export Services Act to review the activities of the large London merchant bank subsidiaries of U.S. banks and bank holding The Export Trading Company Act of 1982 was enacted companies. The OCC maintains a full-time staff in on October 8, 1982. Its purpose was to help promote London to examine the branches and subsidiaries of exports by facilitating the formation and operation of the major national banks. The Federal Reserve exa­ export trading companies. mines the foreign activities of state member banks and Title II of this legislation is entitled the Bank Ex­ those held directly by bank holding companies by peri­ port Services Act (“BESA”). It provides for equity odically sending teams of examiners from the various investments by bank holding companies and certain Reserve Banks. other types of banking organizations in export trad­ In addition to examining foreign branches and sub­ ing companies. As stated in the BESA, the purposes sidiaries of state member banks, the Federal Reserve of the legislation were to: has supervisory authority over Edge and Agreement corporations, including those of national banks. There 1. provide for the establishment of export trading are two types of Edge or Agreement corporations: companies with powers sufficiently broad to enable banking and nonbanking (sometimes called “invest­ them to compete with similar foreign-owned insti­ ment”) Edges. Banking Edges accept deposits and con­ tutions in the United States and abroad; duct a full range of banking business, provided the 2. afford to United States commerce, industry, and transactions are linked to a foreign or international agriculture, especially small and medium-size firms, transaction. Nonbanking Edges are essentially hold­ a means of exporting at all times; ing companies for foreign investments. By law, each 3. foster the participation by regional and smaller Edge corporation is required to be examined annually banks in the development of export trading com­ by the Federal Reserve. panies; and At year-end 1985 there were 89 banking Edges with 4. facilitate the formation of joint venture export trad­ total assets of SI6.7 billion. There were an additional ing companies between bank holding companies 52 nonbanking Edge corporations with assets of $4.6 and nonbank firms that provide for the efficient billion. combination of complementary trade and financ­ ing services designed to create export trading com­ panies that can handle all of an exporting com­ Reporting Requirements pany’s needs. (12 U.S.C. $1843 note). The international activities of all commercial banks are To facilitate the export of U.S. goods and services, reflected and disclosed separately in their quarterly Congress enacted the BESA despite its departure from consolidated reports of condition and income (their traditional banking legislation in permitting participa­ “call” reports). In addition, the Federal Reserve and tion by banking organizations in commercial ventures. the other regulatory agencies require a number of other At the same time, however, a number of prudential supervisory reports that focus on foreign or interna­ provisions were included to limit potential adverse tional banking. financial effects on banks affiliated with export trad­ One of the most important international reports is ing companies, such as limitations on the banking or­ the quarterly Country Exposure Report (FFIEC 009), ganization’s aggregate loans to and investments in its which identifies the amount and characteristics of the affiliated export trading companies. reporting bank’s exposure to foreign borrowers. Ag­ The statute provides that a bank holding company gregate figures showing lending for various groups of may invest in an export trading company after provid­ U.S. banking institutions are published each quarter ing notice to the Federal Reserve Board. The Federal in the Country Exposure Lending Survey. Reserve is required to review the notice in order to de­ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-19 termine whether the proposal may result in unsafe or ing that “more than one-half” of an export trading unsound banking practices, undue concentration of company’s revenues be derived from exporting or resources, decreased or unfair competition, or conflicts facilitating exports. This revenues test was designed of interest, or whether the investment would have a to ensure that the chief efforts of an ETC are directed materially adverse effect on the safety and soundness to exporting U.S. goods and services, as Congress in­ of a subsidiary bank of the bank holding company. tended, rather than to trading outside the United States. The legislative history of the Act states: [W]hile it is understood that ETCs will periodi­ The Board’s Regulations cally have to engage in importing, barter, third party trade, and related activities, the managers The Board’s regulations are brief and were designed intend that such activity be conducted only to fur­ to clarify some areas of ambiguity in the statute and ther the purposes of the Act. set forth procedures for Board review of proposed investments. To allow flexibility for an export trading company to develop an international trade business, especially in Definition of an export trading company. The stat­ the formative stages of the company, this threshold ute requires that an export trading company engage test is applied over each consecutive two-year period “exclusively” in activities related to international trade rather than on an annual basis. and engage “principally” in exporting U.S. goods or services or facilitating the export of U.S. goods or serv­ Bank lending to affiliated ETCs. The BESA pro­ ices produced by others. The Board concluded that vides that transactions between a bank and its affiliated Congress, in enacting the BESA, intended to facilitate ETC are covered by section 23A of the Federal Re­ banking organization investment in companies acting serve Act (12 U.S.C. §371c). Section 23A generally as trade intermediaries to further the foreign market­ provides that a bank may extend credit to an affiliate ing and sales of U. S. goods and services produced by subject to certain amount and collateral restrictions. others. A bank may lend to an affiliate only on a fully secured Therefore, the Board’s regulations provide that an or a more than fully secured basis. The purpose of sec­ export trading company in which a bank holding com­ tion 23A is to limit the ability of banks to make un­ pany may invest must derive more than one-half of sound loans to related entities. While it cannot by it­ its revenues from exporting or facilitating the export self fully insulate a bank from the condition of the of goods and services produced in the United States consolidated organization, section 23A is a linchpin by persons other than the export trading company or of efforts to prevent self-dealing by banking organi­ its subsidiaries. This definition allows export trading zations and lending by banks on other than an arm’s companies to engage in a diverse range of activities length basis. including the following export trade services, as de­ In adopting final regulations, the Board determined fined in the BESA: that some additional latitude in application of the sec­ tion 23A collateral requirements was possible without consulting, international market research, adver­ tising, marketing, insurance (other than acting as creating undue risk to the affiliated bank. The regu­ principal, agent or broker in the sale of insuracne lations incorporate a waiver from the strict collater­ on risks resident or located, or activities per­ alization standards of section 23A where an export formed, in the United States, except for insurance trading company proposes to take title to goods against covering the transportion of cargo from any point a firm order for sale, and where the affiliated bank of origin in the United States to a point of final destination outside the United States), product re­ takes a security interest in the goods or the proceeds search and design, legal assistance, transportion, from the sale of the goods. including trade documentation and freight for­ warding, communication and processing of for­ eign orders to and for exporters and foreign pur­ Capital Adequacy. The Board does not impose specific capital requirements on bank-affiliated export chasers, warehousing, foreign exchange, financing, and taking title to goods. trading companies. However, the Board recognizes that capital adequacy is a critical determinant of the This list is not exhaustive and these types of services financial strength of an ETC and of its ability to with­ may be provided to facilitate exports, imports, or stand unexpected adverse developments. This capital third-party trade. cushion is necessary to prevent an ETC’s difficulties The statute also requires that the export trading from affecting the financial resources of the parent company must be “principally” engaged in exporting. holding company or the safety and soundness of affili­ The regulations implement this provision by requir­ ated banks. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-20 As a general matter, the Board takes the view that lishing offices in more than one state and engaging capital levels should be commensurate with the risk through affiliates in a wide range of nonbanking ac­ of the company’s activities. tivities. In addition, they operated under some restric­ tions not imposed on U.S. banks, such as being in­ Procedures. The procedures adopted for review of eligible to obtain federal deposit insurance and to notices of proposed investments in export trading com­ acquire Edge corporations. panies were designed to minimize the burden on the The IBA, the first federal statute to deal specifically investing bank holding company while allowing ade­ with foreign banking organizations having U.S. quate Federal Reserve review of the proposals in light branches and agencies, extended the dual banking op­ of the statutory factors. tion to foreign banks and explicitly adopted the U. S. In December 1983, after having reviewed 15 notices, policy of “national treatment.” National treatment the Board revised the regulation to provide that, un­ operates on the principle of equality of competitive op­ der certain circumstances, a notice to invest in an ex­ portunity and requires, to the extent possible, that for­ port trading company can be reviewed by the appropri­ eign and domestic banking organizations be treated ate Federal Reserve Bank under delegated authority. equally. In implementing this policy, the IBA estab­ The specific criteria are: (1) the proposed export trad­ lished a federal regulatory framework governing for­ ing company is to be a wholly-owned subsidiary, or eign bank activities in the United States that would be ownership is to be shared only with individuals in­ nondiscriminatory in its effect on domestic and for­ volved in the operation of the export trading company; eign banks. (2) the bank holding company investor and its lead Any foreign bank that operates a bank, branch, bank meet the minimum capital adequacy guidelines agency or commercial lending company in the United of the Board and the Comptroller of the Currency or States is subject to the nonbanking provisions of the have capita] enhancement plans acceptable to the ap­ Bank Holding Company Act (“BHC Art” or “Art”). propriate supervisory authority; (3) the proposed ex­ The Art provides that a company subject to its provi­ port trading company will take title to goods only sions may not engage in any activities other than those against firm orders, except that the company may of banking or managing or controlling banks and other maintain an inventory of goods of up to S2 million; subsidiaries authorized by the Act and those activities (4) the proposed activities of the company do not in­ permitted under section 4(c)(8). clude product research or design, or product modifi­ In addition to the activities that may be conducted cation; (5) the proposed leveraging of the export trad­ under section 4(c)(8), foreign banks may engage in ing company (assets: capital) does not exceed 10:1; and other activities under certain exemptive provisions of (6) the proposal raises no significant policy issue on the Art that are designed to limit the extraterritorial which the Board has not previously expressed a view. application of the Art. The exemptions are set out in In sum, the Board’s regulations and procedures are sections 2(h) and 4(c)(9) of the Act. designed to promote the purposes and objectives of Section 4(c)(9) authorizes the Board to exempt by the BESA, including maintaining the safety and sound­ regulation or order the investments or activities of a ness of banks affiliated with export trading companies. foreign institution the greater part of whose business A list of bank holding companies that have invested is conducted outside the United States if the Board de­ in ETCs is found at Attachment II—F. termines that the exemption would not be “substan­ tially at variance with the purposes of [the] Act and would be in the public interest.” U.S. Activities of Foreign Banks Section 2(h) of the BHC Act provides the other ex­ emption for foreign institutions. Section 2(h) gener­ Statutory Background ally permits a foreign bank to own shares of a foreign nonbanking company that engages in business in the Prior to enactment of the International Banking Act United States as long as the company engages in the of 1978 (“IBA”), federal regulation of foreign banks same line of business as it conducts overseas. The ex­ was confined mainly to governing foreign banks that ception afforded by section 2(h) is available only to became bank holding companies by acquiring U.S.- foreign institutions that are “principally engaged in chartered commercial bank subsidiaries. Regulation of the banking business outside the United States.” It ap­ foreign bank operations through branches or agencies plies solely to the ownership of shares of foreign com­ resided primarily with the banking authorities of those panies and not to direct nonbanking activities by the states (New York, California and Illinois, principally) foreign institution itself. that allowed foreign banks to enter through direct In addition, in order for the parent foreign bank to offices. As a result, foreign banks enjoyed certain be able to take advantage of the exemption, the sub­ liberties not available to U.S. banks, such as estab­ sidiary nonbanking company must be principally en­ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B—21 gaged in business outside the United States. The U.S. derive significant advantages over domestic banks as business of that subsidiary must be “in the same a result of these exemptions and carrying out the legiti­ general line of business as the investor company or in mate purpose of not disrupting the foreign bank’s a business related to the business of the investor affiliations with overseas organizations where the law company.” of the foreign bank’s home country permits such This broad exemption was added by the IBA be­ affiliation. cause many foreign banks that became subject to the Under section 2(h), a QFBO may hold shares of a nonbanking restrictions of the BHC Act for the first foreign nonbanking company that engages in the same time as a result of the IBA are permitted in their home business in the United States as it conducts abroad, countries to have commercial and idustrial affiliates. as determined by reference to the 4-digit establishment Thus, like section 4(c)(9), section 2(h) limits the extra­ number of the Standard Industrial Classification territorial application of the nonbanking restrictions. (“SIC”). The regulation provides that certain enumer­ One purpose of this exception was to avoid preclud­ ated activities will be considered to be “financial” for ing desirable investment in the United States by for­ purposes of the statute and regulation, including in­ eign nonbanking firms because of foreign bank owner­ surance and most real estate and data processing ac­ ship of such firms. The example most often cited is tivities, and prior Board approval is required before that of Daimler Benz, the German automobile manu­ a QFBO can engage in such activities in the United facturer, which is more than 25 percent owned by States. Deutsche Bank. Without some exemption from sec­ Under the regulations implementing section 4(c)(9), tion 4 of the Act, Daimler Benz would be precluded a qualifying foreign banking organization may engage from doing business in the United States so long as directly or indirectly in any activity outside the United Deutsche Bank did a banking business here and vice- States; it may hold shares of any company that engages versa. in activities in the United States that are incidental to To protect U.S. banks from unfair or inequitable foreign business; and it may hold a noncontrolling in­ competition in financial activities, the IBA provided terest in any chiefly foreign company, regardless of that a foreign bank may not use the section 2(h) ex­ the company’s U.S. activities (except that the company emption to engage in financial operations in the United may not engage in U.S. securities activities beyond States without the Board’s approval. what is permitted to a bank holding company). The IBA also provided specific grandfathering for In addition to these self-executing exemptions, a for­ foreign banks that conducted nonbanking activities eign bank that does not qualify as a QFBO or that prior to July 26, 1978. Those activities may continue wishes to engage in an otherwise impermissible activity to be conducted by the foreign banks unless the Board may apply to the Board for permission under section determines that their continued conduct would result 4(c)(9). It is the policy of the Board, however, that a in adverse effects, such as undue concentration of foreign bank will not be permitted to engage in activi­ resources, decreased or unfair competition, conflicts ties under section 4(c)(9) that are not permitted under of interest, or unsafe or unsound banking practices. section 4(c)(8) or otherwise give foreign institutions a Under the grandfather exemption of the IBA, foreign competitive advantage over U.S. bank holding banks conduct certain activities that are not permit­ companies. ted to U. S. banking organizations in the United States, including securities activities. Supervision of Foreign Banks Operating in the United States Regulatory Background Under the Board’s regulations, the exemptions The International Banking Act (IBA) established a afforded by these sections are available only to a framework for Federal participation in the supervision qualifying foreign banking organization (“QFBO”)— of the U.S. operations of foreign banks. The U.S. a foreign banking organization more than half of presence of foreign banks has grown dramatically since whose worldwide business is banking and more than passage of the IBA in 1978. As of December 31,1985, half whose banking business is outside the United 255 foreign banks from 55 countries operated 420 States. This assures that only organizations whose chief state-licensed branches and agencies and 82 branches business is banking will conduct banking operations and agencies licensed by the OCC. Of these offices, in the United States and that the exemptions will be 51 had FDIC insurance. Foreign banks also directly afforded only to organizations that are not chiefly owned 22 Edge corporations and 10 commercial lend­ domestic. The Board's regulations strike a balance be­ ing companies. In addition, foreign banks held a Digitized for FRASERt ween attempting to assure that foreign banks do not majority interest in 71 U.S. commercial banks. These http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-22 foreign banks together control approximately 15 per­ Reporting Requirements cent of U.S. banking assets. The IBA gave the Federal Reserve broad residual Branches and Agencies. Several supervisory reports examination and oversight authority for the supervi­ are now required of the U.S. offices of foreign banks. sion and regulation of foreign banks that engage in The Quarterly Report of Assets and Liabilities (FFIEC banking in the United States through branches, agen­ 002) filed by each branch and agency of a foreign bank cies, commercial lending companies, or subsidiary was instituted in June 1980 and revised in 1985. This commercial banks. Although the OCC, the FDIC and report is similar to the “call” report prepared by all the states are the primary regulators of the U.S. insured domestic banks and provides information branches and agencies of foreign banks, the Federal needed to monitor the condition of the U.S. opera­ Reserve is the residual supervisory authority and is tions of individual foreign banks, as well as for mone­ authorized to review all banking operations conducted tary policy purposes. In addition to this branch and agency “call” report, in the United States by foreign banks. It is the federal a new report has recently been adopted—the Country agency specifically concerned with the consolidated Exposure Report for U.S. Branches and Agencies of U.S. activities of foreign banking organizations. Re­ Foreign Banks (FFIEC 019). This report will require view of these operations is carried out through a num­ branches and agencies of foreign banks to report quar­ ber of methods. In addition, the Federal Reserve and terly their exposure to their home country and to the the other banking agencies have adopted policy state­ five other foreign countries to which they have the ments that set forth the standards under which the U.S. greatest exposures. operations of foreign banks will be supervised. See At­ tachments II-F and II-G. Parent Foreign Banks. In addition to the banking agencies’ supervisory program developed to review the U.S. operations of foreign banks, the Board also Examinations monitors the condition of the respective “parent” banks, as the ultimate responsibility for the U.S. oper­ Examination responsibilities for branches and agen­ ations resides with these institutions. Therefore, the cies of foreign banks are divided among the three fed­ Federal Reserve requires foreign banking organizations eral agencies in a way similar to that for examining to submit financial and managerial information to per­ domestic commercial banks. The OCC examines the mit the Federal Reserve to assess the organization’s branches and agencies that it has authorized to oper­ ability to be a continuing source of strength and sup­ ate under federal license; the FDIC examines state port to its U.S. banking operations. licensed offices that have been granted FDIC insur­ To this end, two reports were developed which pro­ ance coverage; and the Federal Reserve has primary vide consolidated information on the foreign parent federal authority for examining state licensed unin­ bank. They are the Annual Report for Foreign Bank­ sured branches and agencies. The IBA, however, in­ ing Organizations (F.R. Y-7) and the Annual Foreign structs the Federal Reserve to rely on State authori­ Banking Organization Confidential Report of Opera­ ties, to the maximum extent possible, to conduct these tions (F.R. 2068). The F.R. Y-7 contains financial and examinations. Accordingly, the Federal Reserve’s in­ managerial information on the parent organization as volvement in the examination process varies widely de­ well as information about its activities conducted in pending upon the scope of state examination programs the United States. and the state’s desire for Federal Reserve assistance The F.R. 2068 is filed by all foreign organizations and support. except those with a limited presence in the U.S. money In 1985, the Federal Reserve participated in the ex­ markets. These foreign organizations are required to amination of 101 branches and agencies. Aside from . provide detailed information on their earnings, loan routine examinations, the Federal Reserve has the loss experience, gains or losses on the sale of debt and authority to examine, at its own initiative, specific equity securities, and inner reserves not disclosed in problem institutions. The branch and agency exami­ the F.R. Y-7. The information submitted in the F.R. nation report was revised in 1985 and is currently be­ 2068 is treated as confidential by the Board under sec­ ing used by the three Federal agencies and most states. tion (b)(8) of the Freedom of Information Act. Edge corporations are all examined by the Federal In these reports, the foreign organizations are also Reserve while commercial lending companies are ex­ required to provide an organization chart of their amined by the respective states. U.S banks owned by direct and indirect investments in foreign companies foreign banks, along with their holding companies, are and to provide financial data on material foreign Digitized for FRASERe xamined under normal domestic procedures. subsidiaries. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-23 Nonbanking Activities. The Federal Reserve has es­ also report any direct activities in the United States tablished procedures to monitor the U.S. nonbanking commenced during the quarter by one of its foreign activities of foreign banks. The F.R. Y-7 report re­ subsidiaries. quires information concerning activities conducted in the United States by the foreign banking organization, Affiliate Transactions. In addition to monitoring either directly or indirectly, so that compliance with compliance with regard to nonbanking activities, the applicable statutes and regulations can be assured. For­ Federal Reserve also reviews loans to U.S. or foreign eign banking organizations are also required by sec­ affiliates made by the U.S. offices of foreign banks. tion 211.23(h) of Regulation K to report on a quar­ These transactions are reviewed during the examina­ terly basis any acquisitions of shares of companies tion process and through several of the regular reports engaged, directly or indirectly, in activities in the required of these offices. To date, there have been no United States. The foreign banking organization must significant abuses detected. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis B-24 Footnotes ii) Check guaranty services, iii) Consumer financial counseling, iv) Tax planning and preparation services, v) Operating a credit bureau and collection services, vi) Armored car services, and vii) Appraisal 1. National Courier Association v. Board of Governors, 516 F. of personal property. The Board has also proposed to amend Regu­ 2d 1229 (D.C. Cir. 1975). lation Y to define the types of insurance activities permissible under 2. Alabama Association of Insurance Agents v. Board of Gover- nors, 533 F. 2d 224 (5th Cir. 1976), cert, denied, 435 U.S. 904 (1978). the Garn-St Germain Depository Institutions Act of 1982, and has 3. In addition to the activities already incorporated in Regula­ requested public comments on whether to initiate rulemaking on tion V, the Board has sought public comment on adding the fol­ real estate development activities. lowing activities to the so-called “laundry list” (some have already 4. See: Cornyn, Hanweck, Rhoades and Rose, “An Analysis of been approved by order for individual holding companies): i) Ad­ the Concept of Corporate Separateness in Bank Holding Company visory services related to commodity trading and FCM activities, Regulation from an Economic Perspective.” Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-A Number of Bank Holding Companies and Percent of CCmnercial Bank Assets Controlled by Bank Holding Companies in Selected Years 1970-1985 Percent of Aggregate No. of Catmercial Bank Assets Year BHCs Controlled 1970 121* 16 1971 1567 57 1975 1821 69 1980 3056 78 1981 3702 81 1982 4558 85 1983 5410 88 1984 6102 90 1985 6453 92 * Includes only ocnpanies owning or controlling tvro or more banks Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-B Breakdown of the Assets of Bank Holding Company Groups By Size Class as of 12/31/85 No. of Total Assets As Percent of All Consolidated Asset RHC Groups In Size Class Bank Holding Ccnpany Size Class In Size Class ($ billions) Assets Under S150 million 5121 $239.3 9.5 $150 million to $500 million 509 131.7 5.2 $500 million to $1 billion 112 80.0 3.2 SI billion to $10 billion 205 673.2 26.8 Over $10 billion 43 1390.1 55.3 Total 5990 2514.3 Note: The total number of bank holding company groups in this Table differs slightly from the total number of bank holding companies shewn in Table I-A. This is due to the fact that this Table counts a bank holding company only once, that is, as one group, even if the holding company itself owns another bank holding company. Thus, a multi-tiered bank holding company is counted as one holding company group for the purpose of this Table. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-C Combined Assets in Nonbank Subsidiaries as Reported by Bank Holding Companies With Consolidated Assets in Excess of $150 Million 1976-1984 ($ Amounts in Millions) As Percent of Aggregate Aggregate Nonbank Consolidated Assets of Year Assets Bank Holding Companies 1976 $26,510 3.1 1977 31,619 3.3 1978 39,968 • 3.6 1979 42,428 3.4 1980 51,276 3.7 1981 61,458 4.0 1982 71,007 4.1 1983 83,500 4.4 1984 132,313 6.4 NOTE: These totals do not include assets in subsidiaries of holding oenpany banks. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-D X I Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-D (Continued) 0} S' £ (0 05 cr. s to 05 C u to ft3 rs •H 03 r • - H 4 - 8 H I I I 4J -H a> -P fl3 ro u 75 2 “ S t 8 e s s & 8 £ W O Q $i a) 4J 3 m >M~1 0) $ Q> Jd W P CO i > sa “ 8-3 S ft? m S > To u) 2 Jh S' 0) O £> rH H O MH 00 S'l'S °S H <0 0J g M </> Q C S O Q (I w ) C I -H I »Q iJrg 3 ~ S w JB O co CO c co w «o 0) S IJni I£ I^ !,* 8 g 1 t—I o w u o VO 00 ON O rH CM m r- r- r- 00 00 00 00 00 On ON ON ON ON ON ON ON ON rH rH rH rH rH rH rH rH rH detimil a hguorht "knab knabnon" a gnitarepO egarekorb seitiruceS .retrahc knab laicremiac esoprup Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-E (Ccntinued) fe w ■P 03 O 1n 03 03 O 03 ti E 0) •H 5 * <0 «tJ -P fH 03 «P 3 •H s IS • C 03 •3 £ *8 -P •H o> > o o x; •E 'o 03 *H > ti -P y S E •H *o ■8 03 t a 8 - 8 P « t H .j. «P *H I :» E* 03 03 tp f o a 03 C •H § g £ •H •H £ 8£ 4J 03 'H 03 rH 03 03 <3 1 P 03 3 * £ f£ 4 & J * S H 3 <0 3 (0 8 0) . 03 *8 N & § 8 £ ^ * £ Q 03 • 03 S || 03 c 4J *8^5 c -P U -H O 03 P g> Ij > O 0 r 3 . O 03 3 C ft P 8 <o ,8 o ft X il M o: P o3 2 *H 03 rH P g ££■ 03 8 P U U P *H Q «P C I X3 C in a o •H 0) VM • > 3 i l la I'S <0 (it cl o to U 03 Er v a W 8 ■o jj 8 ■°iJ in V0 oo 00 On ON Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I- j? 1 I fH CM CM CM CM CM CO CO r- r- r* r- r* I Os OS Ch as os Os OS as H H H H fH r-l fH fH % detneserp ecnedive dna tseretni fo kcal .gnikamelur ta seinapmoc gnidloh knab Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-E (Continued) •H «H o tn •H .fl 2$ = 0} 3 & o 0) 0) rp . 0) 05 I? • flj u -P *H 35 ro c > L 2 P *51 O O-tJcM 8 •p it3 *H *H 0) <U P, w x: h &1 p d^-P 5 O *H 0) U r f - O H U in 5 £ U-l 5 3 - < H P c; fi 05 HH O U'O- n- rd „ s J 5 3 •H <D b « : « O 4-» r- 05 C r- cn (3^ D*H m I r—l (1) HJ rH fl) 4. J 4, J £) *H -P a j l f l 2 S 3 S in VO 00 o on r o * n O r- N r O - N r O - N f O * N 0 O 0 N Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-E (Continued) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis citsemcD fo epyT dna rebnuN snoitacilppA ynapnaO gnidloB knaB knaB evreseR dna draoB yb desseon 5891-1791 Attachment I r r - - V 0 O 0 C i M n C 0 O 0 r i H n o i IT n i vo in r t— H 4 V V O O *o* on i—4 rH co CO CM uo m on rH VO in o in 00 O 00 rH rH CN r* in ino in Os nr m CN CO rH CM hi* H in v i o n v C o M r 0 H 0 o r- r C H M O CM C rH rH CM CO O CM on CO rH (NCO CO r* O CM osrH CM CO HT 00 m CO00 ON o\cn CN r* on rH CO CO CMVO VO fH rH rH CO r- r- VO 00*3* 04 CM VO o Is* o in CN voVO VO ON rH HJ»in CO CMvo VO a rH CM CO 00rH V0 in rH rH CO ** in vo CM CNCM O rH CM CM CN rH CM CM rHjCO CO H rH i r- ooin o oo oo oo ] co o\ vo in c C m M I m cm rH rH m o | -P 0) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-F (Continued) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I-G Kurber of Federal Reserve On-Site Inspections of Bank Holding Companies, 1975-198? Year No. of Inspections 1985 1778 1984 1568 1983 1398 1982 1273 1981 1119 1980 866 1979 698 approx 1978 581 1977 473 1976 352 1975 228 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-A NONBANKING ACTIVITIES ABROAD PERMITTED BY SPECIFIC ORDER*/ Date Activity Reasons 1975 Insurance underwriting in Australian companies Australia. within two years to cease underwriting lines of insurance not "finan­ cial" in character or engaging in other non-“financial" activ­ ities (real estate development, hotel management, etc.). 1977 Underwriting comprehensive Underwriting comprehensive motor vehicle insurance and motor vehicle insurance chattel title insurance in found integrally-related Australia. to auto financing in Australia; competitive harm to applicant seen if activity not permitted. Conditions include: auto liability insurance barred; and majority of underwriting to be related to credit extension or auto dealer financing by affiliates of underwriter. *J The Board's Regulation K contains a list of activities in which a U. S. banking organization may engage. The list, found at section 211.5(d) of Regulation K, is made up of those activities that the Board had found to be usual in connection with foreign banking or financial operations. A banking organization may also engage overseas in activities listed in Regulation Y. This table describes activities that either are not on the list or were added to the list after 1979. Prior to 1979, each acquisition, regardless of the activity, required specific Board approval. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II (continued) 2 Date A c tiv ity Reasons 1981 Underwriting in Australia Activity is financially- credit life, health and related and does not accident insurance unrelated involve risks different to extensions of credit by from underwriting insur­ underwriter's affiliates. ance that is directly re­ lated to credit extensions by bank or its affiliates; applicant experienced in management of such risks. 1982 Brokerage with respect to Activity found usual in gold bullion on London connection with foreign Gold Futures Market and with banking or financial op­ respect to U.K. government erations in the U. K.; bonds and Eurodollars and relied on fact that appli­ sterling deposit interest cant was not to trade for rate futures on London its own account, had in International Financial.*/ place good credit approv­ al procedures, and had demonstrated expertise in proposed activity; also the nature of futures exchanges reduced risk through guarantees supplied by a clearing house. 1983 Provision of travel Services are offered by related services in Argentine banking organi­ Argentina in connec­ zation in connection with tion with credit card credit card operations, operations.♦♦/ provision of such services does not pose undue risk or threaten diversion of capital or managerial resources from U. S. bank­ ing. j*/ Activity subsequently added to list of activities in Regulation Y (12 C.F.R. 225.25(b)(18)). **/ Activity subsequently added to list of activities in Regulation K (12 C.F.R. 211.5(d) (14)) . Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-A (continued) -3 - Date A c tiv ity Reasons 1984 Underwriting life Activity is usual for insurance in united U. K. financial institu­ Kingdom. tions; Board relied on fact that company was small, its projected growth moderate, and restrictions on.loans to affiliates would apply; risks are actuarially pre­ dictable and life insur- underwriting is regulated in U. K. 1984 Underwriting general life Activity usual in connec­ insurance in Germany and tion with banking or Australia. finance in each country because activity is financially-related and there are affiliations in each country between banks and insurance companies. Risks are actuarially predictable, each subsidiary is small and adequately capital­ ized, and projected future growth is moderate. For­ bidding activity would re­ sult in competitive dis­ advantage for applicant. Underwriting is subject to supervision by regula­ tory authorities in Germany and Australia. 1984 Underwriting in Belgium Activities are financially and Luxembourg of: credit related and, with excep­ insutance not directly tion of savings comple­ related to extensions of tion insurance, already credit by applicant's engaged in by Belgian organisation; savings banks; applicant experi­ completion insurance; and enced in managing the home loan life insurance risks involved; subsidi­ and endowment life insurance aries involved in activity related to mortgage lending are small, adequately activities of applicant's capitalized, with mod­ organization. erate projected growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-A (continued) -4- Date Activity Reasons 1985 Real estate brokerage in Activity found to be Hong Kong. usual in connection with banking services in Hong Kong, and engaged in by applicant's competitors. Risk is slight, involving little exposure of capital or financial resources, as brokerage is fee-based and non-leveraged. Applicant is not to deal in real estate for its own account, and will also have no involvement in credit approval proce­ dures for properties it handles. 1985 Pension fund administration Activity found usual in and underwriting of related connection with banking life and disability insur­ or financial services ance in Chile in connection based on nature of activ­ with Chilean mandated worker ity and fact that Chilean pensions. banks have engaged in the activity; acquisition consistent with Chilean law; underwriting is limited to that required by pension fund adminis­ tration; amounts insured are small, and reinsur­ ance is to be obtained for large claims. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-A (continued) -5 - NONBANKING ACTIVITIES ABROAD DENIED BY SPECIFIC ORDER Date Activity Reasons 1974 General insurance under­ Insurance underwriting writing in Switzerland requires large amount of capital and specialized managerial resources which could be diverted from U. S. banking activ­ ities. Approval could also result in blurring of the line between bank­ ing and commerce in the U. S. and record does not show that competitors en­ gage in insurance under­ writing. Proposal in­ volves joint venture with a large U. S. insurance company wholly owned by one of largest 0. S. re­ tailers and, if approved, might result in undue con centration of economic re sources in the U. S. 1974 General insurance under­ General insurance under­ writing in Brazil writing involves un­ familiar risks and could divert capital and mana­ gerial resources from domestic banking activ­ ities. Also, the other main investor in the underwriter is a major U. S. insurer, which raised same issues as described above. 1974 Freight forwarding and Proposed activities are customs brokerage activities not "international or in Brazil and Canada, foreign financial respectively. operations.” Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-A (continued) -6- Date Activity Reasons 1981 Physical commodities Activity is not financial futures trading in in character and also Australia entails risks not normally associated with banking. 1984 Underwriting property and Underwriting property and and 1985 casualty insurance in casualty insurance in­ Australia volves risks that are qualitatively different from both banking and life insurance underwriting. In addition, local regu­ lators would require the subsidiary carrying on the activities to be held in chain of ownership of bank, rather than through the bank holding company. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis SNOITAZINAGRO GNIKNAB .S.U ROF ELBISSIMREP SEITIVITCA GNIKNABNUN NGIEROF DNA CITSEMOD FO NOSIRAPMOC Attachment II-E XI c >1 O' n c * 4 0 - 1 > 901 c «o U *n to c •— a *o tfr- o * L>.% — a L n . — 01 IO (A 41 O MB 40 L. C l-p-O — 01 Oi O 4-1 U <4-1 U U- >u u •P- «p— 3 La c 4-i i/l 9 01 01 >S*Q1 01 U - S an «/) (_ t 1 i — G-*- JD § — o 01 1 | i U 01 o o > — an *X5 an U — U 4* IO 01 an s • o p— t o . > 9C x 4- : 1 z 1 »/ 0 * 4 U 0 *-> *0 4J O u U L. O C u o — 41 ■ O C ' O 01 c — o • 4 — 1 4 0 / 1 1 IA<V L 041 4/1 3 c ai o o- u 01 MB o E c 9 c £ u 4 f / O 1 O O p 0-1 — c * o * « 3 4- o 5 z oi O) Z 01 z IA an p-4 m an an >u <*mp C fO >v an e >1 01 Z 01 JO — O <4-1 JO JO E 4-> u > — -p- ^P» 4-» e An — an » un un 1/1 4/1 <—* 40 — CM CM 01 4-1 —* c- 9 U N 4J • • > -p- ri 3 01 < — U un m C 4/1 W 4/1 L. C < CM CM o —* c u U AQ CM CM 3. 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IA 40 4/1 4/1 m • c 01 IA Lm Z oi e x —i ji— 91*p- 9. 01*-* 9 an — o U C L O p— T9 4A •— an •*- C T9 t- o 0- e «n e <o «m» an o oi u n O. 01 40 m •p- 01 > 40 f- un l e u z z * — • z an • g 40 40 m- 4J ^ n o P-4 01 an ^ 40 p4 S e w 40 o U C — p-4 u e 4/1 o un CM 3 *8 < 40 9 CM *a- T9 O 40 an n • -p 40 91 91 91 e 4/1 e m-4 S &. 01 e t. 40 4- 4/1 01 an f* 9s an an 910 OC 91 01 01 ^ CM U- -a* e •a* C -9 S • 9. > 40 T9 w 40 T9 01 01 91 C •p- 9 S 91 L» > 01 •p— 01 9 0. C -m- J* — c t 01— U- »* u L —■ O c U c f- O 4/1 9 U an a u u u. nc "O 40 C O -x a-- cr U T9 u C 01 -a- u e —* •— 01 aim oi 91 <0 01 IP JO 40 CM 40 4/1 O SL m» e 20 f- — • * 9 w 01 40«— o -p- an 40 91 91 L. 01 2 e u 4/1 an — • U •p* c e 0 )0 — c o CL 40 4/1 C/) 4/1 u •a- -a- 91W 91 o — Z D 4/1 • 01 L. u u lo un C 01— m o 91 «m -99 01 C C 291 • — z an C Z e u u E i 40 o ane4 4/1 an U 01 an «p» 01 E 01 t O . 4 4 / 0 1 5 1 • e p a e - c O - N -a 4 0 0 1 *- 9 e a K n w a u n 9 9 O. H- 09 U.W m 01 O < nI tnemeriuqer "gniknab ot setailiffa stI dna ynapmoc gnidloh knab snoisnetxe ot detaler ecnarusnI rof dna )8()c(4 noitces )9()b(52.522( . ))5()d(5.1121 tiderc fo taht snosaer evititepmoc .saesrevo gniraeb on evah Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ytivitcA citsemoD suogolanA woH seitivitcA nyleroF elbissimreP noitazinagrO gniknaB .S.U rof snoitazinagrO gniknaB .S.U rof yna fI ,ecnereffiD rof nosaeR ytivitcA ngieroF morf sreffiD K noitalugeR nI debircseD sa Attachment II-B (continued) • «L sz a 20 4-J — 3 *-> 3 * ^ >» 4» oi 3 3 31 —v w X — 4-> sz jj C <J •*- > u u *w— > c — •*—+•> 1/1 — jr3 ^ — Q 4- L. i/>3 L. 4^ c o Z *-»— V. 4-> C 3 4J — 3 3 e o 4-> O < i V m /> 3 t a o / i i i o t > / - ) 4 L 0 / . 1 1 4 3 * /1 — • 0 * 5 - * 3 3 3 /> j 4 O - Q » •40 o O -m> j t 0 o d ) c 0 C O 1 • — * T - 1 1 1 >> o >s u U U 3 4-»O V. 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Louis 0 4 3 t- 4 - — u 3 - 3 3 :o 0 — 4 3 M -* * 0 e 3 4 4 - - 3 3 o ^ ^ 3 < 3 /l 3 C O 3 — c 5 : — 3 3 0 1 4 3 O - - - O c X 3 — L ft A & O > - - i 3 « . — H C — M — 3 3 C * * C — - M < 4 44 3 -11 ytivitcA citsemoD suogolanA woH seitivitcA ngieroF elbissimreP noitazinagrO gniknaB .S.U rof snoitazinagrO gniknaB *S.U rof yna fI ,ecnereffiD rof nosaeR ytivitcA ngieroF morf sreffiD K noitalugeR nI debircseD sa Attachment II-B (cont.) 9k tA 9 — C — tAlA — T9 9 >> lA J* 9 *0 l 1 • io 44 9 to 44 io C C 9k 3 — — o 44 o c o o jQ AS 44 AS 9 U C - L IO 3 44 — 9 «A > jO 9 *• Q. — g U O < 3 0 H J P O J 4 Z 4 ( C A -o — © C k. 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IA ^ 01 9 O « S OS k 9 — 9 y» 9 1 — — O A e w O 9 w p c - 4 L 9 4 - — — 4 . * JC O 44 JC 9 tA 9- C J3 — — -9 *4 I/) w 2^ f * • - " 9 * O - 9 ® 9 C 0 0 C g 0 9 m 4 > * 1 9 — « y »* C 9k — W >* — S C 3 3 C I 3 A i 9 ° a — — 5 44 t 0 A <_ >* 9 5 _ i 3T • IA 44 IO U XJtww- 44 9 O « L 9 *0-4 L 3 C _ - 44 O c c 5 9 0 l 4 C A 4 * - e 0 0 - 9 9 1 9 — IA « ~ w to * g e 9 1 x g o 4 0 l o a c 9 i i g « g o • - g — e v- g c e 4 0 « o 4 e i f J 3 - O 9 0- X 4 9 „ » X 4 9 e 4 J 4 > Q 4 % J | m 0 O A . 4 C e M * 4 0 o C 4 1 m L 9 c» >9 1 P 9 - 03 9 C 3 0 M w 1- > •— a> xc oi 0) m a ip 01 • 9 okt/> 0 0 9 44 S OO U O O l O . 9 4 3 S 3 4 t 9 1 A 0 • c m-t 9 9 A4 9 9 4 X 4 9 4 C ^4 M S I e e O9 O > e 9 £ 4 9 4 4 4 o 4 41 o 9. 4 4 - 4 ^ CM 9 • J 4 9 O 4 4I O3 A4 — 9 ‘S B — E 4 o 9 4 9 9 9 9 X 3 S 99 L i 4 " > o S 4 “ — I t 3 A A • I 9 * A * 9 5E 9 » X t1 9 9 A0 — • A O c c O 3 O k k x -T t I A 9 c : A S A 3 • * A 4 9 4 t 3 m 9 A 4 — 4 t 4 © 9 O A 4 • • * * • I 3 c 9 C o - 9 3 A — 4 9 9 9 O c O O > 4 — • 4 4 t I 9 C > 4 A 4 4 A - « w C 9 9 O 9 C f O 4 L » i k « I I 9 9 9 > 9 ^ 9 4 A A » t 9 I 9 9 9 > A A • 4 4 9 t 2 9 o o A 4 4 . • 4 ?4 9 t 9 9 9 4 A 4 4 - 4 9 9 A e > O 4 3 k — 3 J 4 4 e O ^ e B 4 3 4 m * w W 4 c 4 i 4 4 f 4 m 4 4 t • 4 ■ ■ 9 I 4 9 9 * 9 2 I 4 " 4 * * * S 4 — ^ 9 1 e O e * 9 k * • 4 0 3 9 9 9 9 I 4 4 4 A — - I 4 4 A 9 « C 9 o A > 4 4 S L — — ? 4 9 B 9 8 I 4 9 A 9 e I e 9 > - A 3 — I I 9 3 9 f 3 > A A i * C 4 0 9 9 9 9 9 1 e M 4 9 — 0 3 0 9 3 C O l 0 J 40 I 0 9 0 e h 4 - Q C 4 9 4 3 9 9 % 9 C 9 9 - 4 — 4 + I 9 a e I E 8 | 4 4 A J 4 O 9 9 o 3 9 O Z 4 . Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ytivitcA citsemoD suogolanA woH seitivitcA ngieroF elbissimreP noitazinagrO gniknaB .S.U rof snoitazinagrO gniknaB .S.U rof yna fI ,ecnereffiD rof nosaeH ytivitcA ngieroF morf sreffiD K noitalugeR nI debircseD sa Attachment II-B (continued) C o VI C>1 —* t- *4 91 IQ vi m c iq IQ4-> C V k 0 ) . ) — O C * — - I 4 9 Q » . 2 D 0 Q i 0 . 1 . C o — .c* 4-1 oi 4-> 9 • O Vi iQ «Q > |Q * >* — JO J * Z 4 o •* K » l 0> c 91 — 4 I - Q 1 >1 o 0m « m o I C Q V a-> ^ f 4 « U j 4- c > O c 4-» s 9 91— C — 01 9 •* 6 c m V 9 ) o k — VI x (Q > V v cu i* a c 9 ) I 9 Q 1 4 I 0 - Q 1 1 C VI 91 a-A 9 6 — mm oi — : e r 5 01 01 t > L 01 VI 01 <0 9 s oi o u — iQk.a-»coi4-» — ^ > js a o o a> — #0 V» 3 m o 2 O ^ L o t c l < 0 ( u A U < Nq C * U q ) « o *- — U O •S o Im C i/jS 4* 9^- t) C 4-1 01*-* vi v g ? £ ? 01 >1 to W ~ c li p k > §>•£ o» *51 ‘■g IkQ «> 4U-» kw — e >**- +> lm 01 O u 6 0) «l c IQ C VI • C VI 01 o 0) O 01 k V w %- JC U o 01 01 u O 4-> — JZ 9 e > 4-» 01 CiJm - L 01—* O V) k 0 <0 01 « IQ 2 •^rpiA +* *J Q> IQ 4J — k p o o — OD 01 4» k *m» — e ioq IQ_ C 01 S 2 |i* an a — o —• m 9 o»o S k 91 01 91 XT i- VI — X2 CM e jz oiOk- UJ 4-1 L. V o Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-C-1 Table II-C-1 Major merchant or investment banking subsidiaries of U.S. banking organizations, by location United Kingdom Bank of America International Limited Bankers Trust International Carolina Bank Limited 1/ Chase Manhattan Limited Chemical Bank International Limited Citicorp International Bonk Limited First Chicago Limited First Interstate Capital Markets Limited Irving Trust International Limited Manufacturers Hanover Limited Morgan Guaranty Limited Vella Fargo Limited Australia BT Australia Limited 2/ Chemical Australia International, Ltd. Citicorp Capital Markets Australia Ltd. Morgan Guaranty Australia Ltd. Security Facific Australia Limited Hong Kong Asia Facific Capital Corporation Ltd. 3/ BA (Asia) Limited 4/ BT Asia, Limited 2/ Chemical Asia, Limited Citicorp International Limited Manufacturers Hanover Asia, Limited Singapore Citicorp International (Singapore) Ltd. Morgan Guaranty Facific Limited lepublic Hational Bank of Mev York (Singapore) Ltd. Security Facific Bank Asia, Ltd. 8vitserland Chase Manhattan Bank (Svitserland) Chemical Bank (Suisse), S.A. Citicorp Bank (8uitserland) A.G. Morgan Guaranty (Svitserland) Ltd. 1/ Ovned by Hortb Carolina Hational Bank 2/ Ovned by Bankers Trust 3/ Ovned by Citicorp 4/ Ovned by BankAmerica Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-C-2 Table Il-C-2 Underwritings of top 30 Eurobond lead managers, 1985 1/ Share of 8.S. bank Humber of Amount total Kank affiliate Inst itut ion issues (Million $) market 1 Credit Suisse First Boston 222 $15,160 11.2X 2 Merrill Lynch 133 8,168 6.0 3 Tea Morgan Guaranty 155 7,762 5.7 4 Salomon Brothers 160 7,378 5.5 5 Deutsche Bank 138 7,109 5.3 6 Morgan Stanley 135 4,900 3.6 7 SG Varburg 73 4,437 3.3 8 Onion Bank of Switzerland 88 3,874 2.9 9 Nomura Securities 119 3,536 2.6 10 Swiss Bank Corporation 97 3,452 2.6 11 Goldman Sachs 74 3,276 2.4 12 Sherson Lehman Bros. Int'l 56 2,884 2.1 13 Banque Paribas 93 2,804 2.1 14 Orion Royal Bank 91 2,680 2.0 15 Lloyd s 23 2,553 1.9 16 County Bank 16 2,522 1.9 17 Commer sbank 62 2,201 1.6 18 Tea Cit icorp 49 2,106 1.6 19 Daiwa Securities 90 1,933 1.4 20 Samuel Montagu 11 1,925 1.4 21 Tea Bank of America 25 1,690 1.2 22 Banque Rationale de Faria 45 1,623 1.2 23 Tea Bankers Trust 53 1,602 1.2 24 Dreadner Bank 50 1,514 1.1 25 Societe Generale 40 1,341 1.0 26 Industrial Bank of Japan 39 1,224 0.9 27 Credit Commercial de France 34 1,211 0.9 28 Bank of Tokyo 34 1,200 0.9 29 Tea Chase Manhattan 29 1,110 0.8 30 Barclays Bank Group 9 1,103 0.8 Total, top 30 2,243 $104,278 77.OX Total, 8.8. banks 311 $14,270 10.5X 8ource: Euromoney, "Annual Financing Import 1986," Marcb, 1986. 1/ 8.8. bank affiliataa performed a relatively amaller role among co-managers. Only tvo 8.8. banka mere among the top 30 co-managers in 1985, and they mere responsible for only $4.1 billion of underwritings in this capacity, or 5.6Z of the total underwritten by the top 30 co-managers. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-C -3 Table II-C-3 U.S. banking organisationa that were among the top 50 Euronote underwriters during 1985 Share of Humber of Amount total Rank Institution issues (Million $) market 6 Bankers Trust 51 $707 1.02 9 Bank of America 36 654 0.9 22 First Interstate 23 500 0.7 24 C it icorp 44 484 0.7 29 Chase Manhattan 34 408 0.6 30 First Chicago 28 407 0.6 31 Security Pacific 24 404 0.6 33 Chemical Bank 25 403 0.6 42 Continental Illinois 15 297 0.4 43 Morgan Guaranty 19 287 0.4 49 Manufacturers Hanover 18 243 0.3 Total 319 $4,794 6.72 Source Euromoney, "Annual Financing Report 1986," March, 1986. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-D -1 Table II-D-1 Foreign offices and investments of U.S. banking organisations, Tear-end 1985 Amounts in billions U.S. $ Estimated assets 1/ Type of office Book value or investment Gross Het of investment Branches $458 $280 Hot applicable Subsidiaries 100 77 $9.4 Joint ventures 2/ 20 20 0.7 Portfolio investments 3/ H.A. H.A. 0.3 1/ Assets are gross and net of claims on other offices of the "parent" hank. Branch figures are from Federal Reserve Bulletin. Other figures are estimated based on 1984 data. 2/ Estimated assets assume that investments of U.S. investors account for one-third of a joint venture's equity and that the joint ventures have an average capital ratio of about 10 percent. 3/ These are investments representing less than 20 percent of the foreign company's voting shares. H.A. means not available. 8ource: Federal Reserve data Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-D -2 Table II-D-2 Investments of O.S. banks and bank holding companies in foreign subsidiaries by principal activity, December 31, 1984 1/ Amount invested Humber of Type of activity investments Book value Percent of of subsidiary > $50 thousand (million $) total Commercial banks 154 $3,920 45.32 Investment/merchant banks 68 1,240 14.3 Funding vehicles 14 980 11.3 Consumer finance companies 32 900 10.4 Lessing companies 96 580 6.7 Commercial finance companies 58 280 3.2 Mortgage banks 6 60 0.7 Factoring companies 9 40 0.5 Other financisl activities 100 150 1.7 Subtotal, lending 537 8,150 94.2 Trust companies 28 110 1.3 Securities brokers 4 dealers 23 90 1.0 Real estate 23 60 0.7 Insurance underwriters 4 55 0.6 Export/import company 6 15 0.2 Insurance agency/brokerage 9 5 0.1 Mutual fund managers 4 4 0.0 Investment, economic, and management consulting 45 90 1.0 Subtotal, financially related activities 142 429 5.0 Ron-financial services 2/ 7 25 0.3 Other nonfinancial companies 3/ 32 50 0.6 Subtotal, nonfinancial activities 39 75 0.9 Grand total 718 $8,654.0 100.02 1/ Includes investments made through Edge and Agreement Corporations. 2/ Bank premises companies and companies acquired through loan defaul 3/ Mostly shipping companies acquired through loan defaults. Source: Federal Reserve data Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-D -3 Table II- D - 3 Foreign joint venture investments of U.S. banks and bank bolding companies by principal activity, December 31, 1984 Amount invested Number of Type of activity investments Book value Percent of of joint venture > $50 thousand (million $) total Commercial banks 33 $413.9 60.92 Investment/merchant banks 24 151.0 22.2 Leasing companies 13 33.0 4.9 Commercial finance companies 8 20.4 3.0 Other financial activities 7 14.0 2.1 Factoring companies 2 5.0 0.7 Consumer finance companies 2 2.4 0.4 Subtotal, lending 89 639.7 94.1 Bolding companies 3 18.0 2.6 Beal estate 5 1/ 6.1 0.9 Trust companies 2 4.0 0.6 Insurance agency/brokerage 1 2.0 0.3 Mutual fund managers 1 1.0 0.1 Securities brokers & dealers 2 1.0 0.1 Investment, economic, and management consulting 3 1.0 0.1 Subtotal, financially related activities 14 32.1 4.7 Non-finaneia1 services 7 5.0 0.7 Manufacturing 3 3.0 0.4 Subtotal, nonfinancial activities 10 8.0 1.2 Grand total 113 $679.8 100.02 1/ In addition, there are numerous very small investments. Source: Federal Eeserve data Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-D -4 Table II- D - 4 Foreign portfolio investments of V.S. banks and bank bolding companies by principal activity, December 31, 1984 Amount invested Number of Type of investment s Book value Percent o activity over $50,000 (million $) total Commercial banks 25 $52.9 21.5 Investment/merchant banks 23 50.1 20.3 Leasing companies 7 3.2 1.3 Consumer finance companies 11 2.7 1.1 Industrial banks 8 2.5 1.0 Factoring companies 2 0.8 0.3 Other financial activities 20 14.0 5.7 Sub total, lending 96 126.2 51.2 Insurance underwriters 37 15.6 6.3 Holding companies 1 14.0 5.7 Investment, economic, and management consulting 19 13.0 5.3 Securities brokers and dealers 5 3.0 1.2 Export/import 3 1.9 0.8 Real estate 4 1/ 1.9 0.8 Mutual funds managing 4 1.0 0.4 Data processing 1 0.6 0.2 Sub total, financially related activities 74 51.0 20.7 Manufacturing 58 40.8 16.6 Mining and drilling 16 9.0 3.7 Nonfinancial services 3 3.2 1.3 Construction companies 3 2.9 Retail trading companies 3 1.2 0.5 Transport., commun., electric, gas or sanitary services 7 0.7 0.3 Other nonfinancial activities 15 11.3 4.6 Sub total, nonfinancial activities 105 69.1 28.1 Grand total 275 $246.3 100.0J 1/ In addition, there are many very small investments Source: Federal Reserve data Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment Il-E SUPERVISION—Policy Statement on Availability of Information Concerning Foreign Operations of Member Banks al of the quality, of loans and other exten­ For ihe guidance of member banks having for­ sions of credit. Coverage should extend to eign operations, the Board publishes the fol­ a substantial proportion of risk assets in lowing statement of policy regarding availabil­ the branch or subsidiary, and include the ity of information pertaining to member status of ail large credit tines and of credits banks* foreign branches and subsidiaries to to customers also borrowing from other enable proper supervision of those operations: offices of the bank. Information on credit The Board of Governors of the Federal Re­ extensions should include (i) a recent fi­ serve System, as a central hank, is properly nancial statement of the borrower and concerned with the preservation and promo­ current information on his financial condi­ tion of a sound hanking system in the United tion; (ii) credit terms, conditions, and col­ States. The Board of Governors and other fed­ lateral; (iii) data on any guarantors; (iv) eral banking supervisory authorities have been payment history; and (v) status of correc­ given specific statutory responsibilities to as­ tive measures employed. sure that banking institutions are operated in 2. Liquidity. To enable assessment of local a safe and prudent manner affording protec­ management’s ability to meet its obligations tion to depositors and providing adequate and from available resources, reports should efficient banking services to the public on a identify the general sources and character continuing basis. These responsibilities and of the deposits, borrowings, etc* employed concerns are shared by central banks and in the branch or subsidiary with special bank supervisors the world over. reference to their terms and volatility. In­ Under sections 25 and 25(a) of the Federal formation should be available on sources of Reserve Act, the Board has particular respon­ liquidity—cash, balances with banks, mar­ sibilities to supervise the international opera­ ketable securities, and repayment flows— tions of member banks in the public interest. such as will reveal their accessibility in time In carrying out these responsibilities, the and any risk elements involved. Board has sought to assure that the interna­ 3. Contingencies. Data on the volume and tional operations of member banks would not nature of contingent items such as loan only foster the foreign commerce of the Unit­ commitments and guaranties or their equiv­ ed States but that they would also be conduct­ alents that permit analysis of potential risk ed so as not to encroach on the maintenance exposure and liquidity requirements. of a sound and effective banking structure in 4. Controls. Reports on the internal and ex­ the United States. In keeping with the latter ternal audits of the branch or subsidiary consideration, the Board believes it incumbent in sufficient detail to permit determina­ upon member banks to supervise and adminis­ tion of conformance to auditing guide­ ter their foreign branches and subsidiaries in lines. Such reports should cover (i) verifi­ such a manner as to assure that their opera­ cation and identification of entries on fi­ tions are conducted at all times in accordance nancial statements; (ii) income and ex­ with high standards of hanking and financial pense accounts, including descriptions of prudence. significant charge-offs and recoveries; Proper administration and supervision of (iii) operation of dual-control procedures foreign branches and subsidiaries require the and other internal controls; (tv) confor­ use of effective systems of records, controls, mance to head office guidelines on loans, and reports that will keep the bank's manage­ deposits, foreign exchange activities, ment informed of the activities and condition proper accounting procedures, and discre­ of its branches and subsidiaries. At a mini­ tionary authority of local management; mum, such systems should provide the (v) compliance with local laws and regu­ following:1 lations; and (vi) compliance with applica­ ble U.S. laws and regulations. 1. Risk assets. To permit assessment of expo­ sure to loss, infomtatson furnished or 1973 Fed Res. Bull 449; 12 CFR 211.110; available to head office should be sufficient 1 5635. to oermit periodic and systematic apprais­ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-F LIST OF BANK HOLDING COMPANIES AND AFFILIATED ETCs NOITFTCATICN TO ESTABLISH ECPCRT TRADING COMPANIES Date of Bank Bolding Company Report Trading Company System Action Current Status Security Pacific Corporation, Security Pacific Export 5/09/83 Operating San Francisco, CA Trading Ccnpany Los Angeles, CA Citicorp, Citicorp International 5/31/83 Operating New York, NY Trading Ccnpany, New York, NY Walter E. Heller International Heller Trading Ccnpany 6/13/83 Closed Corporation, Chicago, 2L Chicago, IL First Interstate Bancorp, First Interstate Trading 6/15/83 Operating Los Angeles, CA Ccnpany, Los Angeles, CA First Kentucky National First Kentucky National 7/25/83 Inactive Corporation, Trading Ccnpany, Louisville, KY Louisville', KY Onion Bancorp, Inc., StanChart Export Servioes 7/25/83 Operating Los Angeles, CA Company, Inc., Los Angeles, CA Crocker National Corporation, Crocker Pacific Trade 8/30/83 Closed San Francisoo, CA Corporation, San Francisoo, CA Ramapo Financial Corp., Banoorps' International 9/14/83 Operating Wayne, NJ; Trading Corporation, Ultra Bancocporation, Sanerset, NJ Bridgewater, NJ; and New Jersey National Corporation, Trenton, NJ State Street Boston Corporation, State Street Trade 9/19/83 Sold Boston, MA Development Corporation, Inc. ► 9 Boston, MA International Bancshares IBC Trading Ccnpany, 10/03/83 Not Activated Corporation, Laredo, TX Laredo, TX United Midwest Bancshares, United Midwest International Closed Inc., Corporation, Cincinnati, CB Cincinnati, GB Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-F (continued) -2- Date of Sank Bolding Caaoany Export Trading Caroany Systan Action Currant Status u.S. Bancorp, U.S. World Trade Corporation, , 11/17/83 Inactive Portland, OR Portland, OR First Chicago Corporation, First Chicago Trading 11/21/83 Operating Chicago, IL Caipany, Chicago, IL Rainier Bancorporation, Rainier International 12/07/83 Operating Seattle, WA Trading Ccnpany, Seattle, WA Shawnut Corp., Shavaut Export Corporation, 12/12/83 Operating Boston, MA Boston, MA Hongkong and Shanghai Equator Trading Catpany 12/27/83 Operating Banking Corporation, Limited, Hong Kong Hartford, CT BankAmerica Corporation, BankAmerica World Trade 02/02/84 Inactive San Francisco, CA Corporation, San Francisco, CA Bankers Trust New York Bankers Trust International 02/02/84 Operating Corporation, Trading Corporation New York, NY New York, NY First National State First International Trading 02/13/84* Operating Bancorporation, Co., Newark, NJ Newark, NJ Zhase Manhattan Corp., Chase Trade, foe., 02/21/84* Operating New York, NY New Yodc, NY Society Corporation, • Bcport Partnership for 03/04/84 Operating Cleveland, OH International Trade, foe., Cleveland, OH leet Financial Group, Inc. Fleeting Trading Ccopany, 03/19/84* Inactive Providence, RI Providence, RI irst National Bancshazes, Inc. First Bcport Corporation, 04/06/84* Operating Houma, LA Houna, ZA anufacturers Hanover C.I.T. International 04/24/84 Operating Corporation, Sales Corporation, New York, NY New York, NY irst Onion Corporation, First Uhion Btport 05/07/84* Operating Charlotte, NC Trading Caapany, Charlotte, NC toted upon fayReserve Banks pursuant to Delegated Authority. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-F (continued) -3- Date of Bank Bnlriinq Ccnpany Export Trading Ccnpany System Action Current. Status Alaska Mutual Bancorporation, Mutual International 06/06/84* Operating Anchorage, AK Corporation, Anchorage, AK Frontier Bancorp, Interbank Trading Ccnpany, 07/30/84* Not Activated Vista, CA San Diego, CA Florida Park Banks, Inc. Park Servioes 09/19/84 Closed St. Petersburg, FL International, Inc., St. Petersburg, FL Capital Bancorp, Capital Trade Servioes, Inc., 09/20/84* Operating Miami, FL Miami, FL CoreStates Financial GoreStates Export Trading 10/13/84* Operating Lancaster, PA Ganpany, Philadelphia, PA Morth Valley Bancorp, Casia-Pacific Ccnpany, 10/18/84* Operating Redding, CA Redding, CA Maryland National Corporation, MN Trade Corporation, 12/18/84* Operating Baltimore, MD Baltimore, M3 iarine Corporation, Marine Financial Services, Inc. , 12/31/84* Operating Milwaukee, HI Milwaukee, WI amapo Financial Corp., Florida Interbank Trading 01/07/85 Operating Wayne, NJ; Cozpany, Inc., ritra Bancorporation, Jacksonville, FL Bridgewater, NJ; and ew Jersey National Corporation, Ttenton, NT irst Wisconsin Corp., InterContinental Trading 02/11/85 Operating Milwaukee, WI Co., Inc., Rolling Meadows, XL atmeroe onion Corporation, CcmneroB Trading Corporation, 03/22/85 Operating Nashville, TN Nashville, TN alley National Corporation, Valley Internation Trading 04/16/85* Operating Phoenix, AZ Company, Phoenix, AZ Acted upon by Reserve Banks pursuant to Delegated Authority, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-F -4- (continued) Date of Bank Bolding Ccroany Export Trading Canoany Systan Action Current Status Manufacturers Hanover Manufacturers Hanover World 04/21/85* Operating Corporation, Trade Corporation, New York, NY New York, NY Marine Midland Banks, Inc., Marine Midland Trade, Inc., 04/21/85* Operating Buffalo, NY New York, NY United Bancorp of Arizona, United Bank Export 07/05/85 Operating Phoenix, AZ Trading Caipany, Phoenix, AZ InterFirst Corporation, InterFirst World Trade — Pending Dallas, Texas Corporation, Dallas, Texas •Acted upon by Reserve Banks pursuant to Delegated Authority Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis SNOITACIFITON YNAPMOC GNIDART TROPXE REHTO Attachment II-F (continued) 4* c m C 0 0 O' •H X •o E c 43 0 0 •H 0 •a tj* O' & c m rH X M X X rH X c 0 M 4J 0 0 M X 0 C 0 C rH C 0 C o c 0 C 14 O' m 0 * G o M X 0 C 0 E C 0 0 B 0 G 0 B C 0 0 E IS £ ® M 0 0 C 0 E 0 > M •• 0 C O 0 ' P 0 M M X «H X O X M 5 C G •H 43 0 r* 0 & & > X 0 X 0 M 0 X 0 •H M M 4J 0 *3 M n O' • ® X -H •H 0 •H 0 4* 0 •H 0 0 X •H 0 43 c c a 0 X «G > •o > M > •o > 4i M 0 •o > 0 0 ** 0 0 a •0 C •0 G •C C •O C 0 0 > •0 c 0 43 M < < H < H •O M < H 0 4J < H 0 ji o X < > 0 0 •£.43 0 C M u O' G M iH G 2 43 M o C 2 -H IM 0 o H M X rH CJ,H 0 C Tj X c 0 • 0 •H in in in in in in rH 7l c a 4 0 4 X 5 * C v D » CD CD CD V CD * CD CD A VO 0 0 02 0 A x ® < H CD C o N © in o c\ I o N \ O CD H o\ VO a 0 a ^ 4 o 3 c • ^ V CN o X 0 13 9 rH m nr CN u 4» 0 Q X o © o o O H H IN a M 0 X 0 O u * 0 X 0 P c CO] X 43 2 0 c o * A -H X n m in in in in in in 0 43 c %4 OD CD CD CD CD CD CD a 43 * 0 0 o s '•N* U G B 0 H m 10 C\ x O H c X-H X 0 M IN CN O H o rH n o 0 W*M • X X V* V* «H M < i 0 0 H rH CN f) 10 o\ O rH 43 O 43 A 1 Cl z M O O O O o rH rH G 43 0 A 0 0 M CA G T1 0 X j- « 0 0 •o • • 0 q MX X 14 0 i-4 G rH G ® X 43 B c 0 u 0 C 0 C 0 M 43 0 0 44 £-i C M c M c X U n & • 0 o 0 ^ 0 IH 6 a ^ o M 0 * «r4 0 * •o S o na 0 M 0 u X •o • 4» *3 • • 0 0 c 44 u o X X 0 0 O 0 0 0 G X S ® p O 0 C o* c u u C u u C w o M cr 44 M 0 G 14 X lH X M 0 q O'O rH G •H • 0 G «H 0 • 4J 0 • 43 > H a® 0 •H o o C -H 03 4* O 41 G 4J O 4> C * u ^ M 43 U •0 0 u X X 0 c u 0 0 C O 0 0 0 0 P 43 0 04 |4 C 14 M ® B M 0 B •o 0 *2 a n u w O' 0 O X O* u a O* u a 0 0 o X X G A o a c 4* o a c 43 O 14 A S 0 M 44 X M M U % M M COM U *H CO <H X O x® X M *3 X 0 • O o«o 0 o «o 0 rH « x a 0 m u m U X O X G 0 0 > G 0 0 > 0 0 0 O p m 0 C C 0 t4 M 41 0 •H U 43 0 0 M 0 * 0 £ a o X Cum m p X X 0 a 4i X 0 O 0 0 X 0 0 K m X & M 4* •H 43 X *o X 0 M X K CO 0 0 a CO o CO u 0 ■H X 0 h 0 43 M 0 XT1 ► P % 0' >M O’ •H * • X e *H X 0 H * 0 C a 43 M c c X o c c u ^ G ® 0 o O'M 0 o o «» 4i 0 0 & 8 o u < " 4 H 1 0 C 4 0 1 4 0 * 4 0 3 u 0 G g o x H X C M 0 S x u o 0 c C X U 4H * % MO 0 p x m X A 0 X 0 2 « •h c m O a SB as 43 X 43 2 _ , *M & G 0 G M O ® rH U CL *0 • « G o u 0 * 4 0 } 2 X «. 4 0 3 X < 4 0 3 * e 0 2*2 ° r X H M a x ® o e ® u o* 0 X 0 X X M 2 -u ® rH •a 0 O* a 0 c » u t4 % + u u % C M e<h a 0 rH >1 M C rH 0*0* O a o 4* C a o 43 * C 0 O X _ E O 0 0 X Q < >i 0 C C 0 M X CO * 0 u x A • 0 X X G M 0 «h a X > 0 H o _ 0U4> o ^ a 43 0 c M u ® 0 0 X X 0* G % 0 U 0 o * 0 U 0 0 * 0 •H X X P o 0 •H H 0* C C M 0 4J 0 0 •H 0 43 0 0 0 0 XM G G O G h G U C 0 o 41 X ® u <n 4* SB 0 U A 0 Z C C M M 0 m m C 0 O 0 0 a o s a s M a C 4 O » • u H A 43 X u rH M CN M O C * P M in X Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-G FOREIGN-BASED BANK HOLDING tion as required for domestic organizers of COMPANIES—Policy Statement on hanks and bank holding companies. The Supervision and Regulation of Board also believes that foreign banks should The Board of Governors has a number of su­ meet on a continuing basis these standards of pervisory responsibilities over the operations safety and soundness if they are to be a source of foreign banking organizations in the United of strength to their U.S. banking operations. At the same time, the Board is cognizant States under the Bank Holding Company Act that foreign hanks operate outside the United and, more recently, under the International States in accordance with different hanking Banking Act of 197S. During the past year the practices and traditions and in different legal Board has undertaken a major review of its and social environments. The Board also rec­ supervisory and regulatory policies toward ognizes that its supervisory responsibilities are foreign bank holding companies. Major ele­ for the safety and soundness of U.S. banking ments underlying that review were the growth operations. Its supervisory concerns for the in number and total assets of U.S. banks operations and activities of foreign banks out­ owned by foreign banks and other foreign side the United States are, therefore, limits companies and the experience gained in regu­ to their possible effects on the ability of those lating foreign holding companies since banks to support their operations inside the the 1970 Amendments to the Bank Holding United States. As embodied in both the Bank Company Act. In the course of the review, the Holding Company Act and the International International Banking Act of 197S was Banking Act of 1978, it is the general policy passed, thereby broadening the Board’s super­ of the Board not to extend U.S. bank supervi­ visory responsibilities over the Ui. operations sory standards extra-temtorially to foreign of foreign banks and establishing certain legis­ bank holding companies. The Board will give lative policies over their operations in this due regard to these factors in applying the country. In order to inform the public and the principle of national treatment banking industry, the Board is tssuidg this The Board has jurisdiction over foreign en­ statement setting forth its policy toward regu­ try in the case of foreign organizations seeking lating foreign bank holding companies in the to acquire U.S. hanks. Whenever a foreign United States and describing initiatives that bank applies to become a hank holding com­ are underway in order to implement this poli­ pany, the Board will seek to assure itself of the cy more effectively. foreign bank’s ability to be a source of finan­ Bank supervision in the United States has cial and managerial strength and support to as a principal objective the promotion of the the U.S. subsidiary bank. In reaching this safety and soundness of banking institutions judgment the Board will analyze the as going concerns serving depository and condition of the foreign organization, evaluate credit needs of their communities and the the record and integrity of management as­ economy as a whole. To this end, a number of sess the role and standing of the bank in its standards have been established governing do­ home country, and request the views of the mestic entry into the banking business and on­ bank regulatory authorities in the home coun­ going supervision of banking operations of do­ try. In connection with its financial analysis, mestic banks and bank holding companies. the Board will require sufficient information In urging legislation to provide for federal to permit an assessment of the regulation of foreign banks m the United strength and operating performance of the States, the Board endorsed the principle of na­ foreign organization. Information will consist tional treatment, or nondiscrimination, as a of reports prepared in accordance with local basis for the rules governing the entry and practices together with an explanation and subsequent operations of foreign banks in this reconciliation of major differences between lo­ country. The International Banking Act of cal accounting standards and U.S. generally 1978 generally incorporates that principle m accepted accounting procedures fan its provisions. information on earnings, capital, charge-oak, and reserves. The Board will also continue to The Board continues to believe that the work with bank supervisory authorities of principle of national treatment should be the other mqjor countries to improve overall co- guiding rule in administering the Bank Hold­ <«peratiou in international bank regulation. ing Company Act and the International Bank­ Since the Board believes that foreign bank ing Act of 1978 as they affect foreign banks. holding companies should he strong reputable Following this rule, the Board believes that in organizations with banking experience, the general foreign banks seeking to establish Board is considering an amendment to tighten banks or other hanking operations in the the definition by which a foreign company can United States should meet the same general qualify under section 4(c)(9) of the Bank standards of strength, experience and reputa- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-G (continued) -2- Holding Company Act tor exemption from In addition to the examination process, the the prohibitions on ownership of nonbanking Board will require foreign bank holding com­ companies. For the purposes of section panies to report quarterly on transactions be­ 4(c) (9), section 225.4(g) of Regulation Y tween the U.S. subsidiary bank and its foreign defines a foreign bank holding company as a parent This reporting system is currently un­ company chartered abroad -more than half of whose consolidated assets are located, or con­ der development and will be implemented in solidated revenues derived, outside of the the near future. The report will be similar to United States.- The Board will propose for one currently required from domestic bank public comment a change in that regulation holding companies but will be designed to which would require the company to be pri­ take into account the particular nature of the marily engaged in banking abroad. This U.S. operations of foreign banks. The Board will also require submission of would essentially reserve section 4(c)(9) for sufficient financial information to enable it to foreign organizations that were principally assess the operations and general condition of. banks or banking institutions. As a result, the parent institution. To this end, the Board both the foreign and domestic operations of is in the process of amending its Annual Re­ foreign nonbank companies acquiring U.S. port for Foreign Bank Holding Companies would either have to be divested or meet the more restrictive tests for exemption (F.R. Y-7) to require more financial informa­ under section 4(c)(1) or section 4(c)(13) of tion on the foreign parent In particular, foil information on earnings, reserves and capital the act will be required along with an explanation of In connection with the Board’s overall re­ major material differences between U.S. and view of its regulations and the implementation foreign accounting practices. In its use and of the International Banking Act, a general handling of the information, the Board will revision of the regulation governing section take into acoount the fact that much of the 4(c)(9) will also be proposed later in 1979. information required may be confidential Once a foreign bank holding company has commercial information that is not generally been established. Board supervisory proce­ disclosed. dures will be primarily directed at promoting This statement of policy applies to foreign the safety and soundness of the subsidiary bank holding companies and their U.S. bank US. banks. Examinations carried out by the subsidiaries. However, the Board has directed relevant federal and/or state supervisory au­ its staff to review supervisory policy with re­ thority will continue to be the primary instru­ spect to the branches, agencies, and commer­ ment for this purpose. Special attention wQl cial lending companies of foreign banks in the be given to transactions and correspondence United States in fight of the Board’s expanded between the U.S. subsidiary bank and its for­ supervisory responsibilities under the Interna­ eign parent and to monitoring credits by the tional Banking Act of 197S. At the conclusion U5. to parties that are also customers of of this review, the Board will isnie a statement the parent In particular, federal bank supervi­ addressing the supervision of these offices. sors will expect the U.S. bank to maintain suf- STATEMENT of Feb. 23, 1979. ficient information on all borrowers to permit both the US. bank and bank examiners to make an independent appraisal of the bank’s credits. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II-H FOREIGN BANKS—Policy Statement the United States and that ultimate responsi­ on Supervision of U.S. Branches and bility for branch and agency activities resides Agencies of in head offices overseas. Consequently, the agencies will seek to assure themselves that The recently International Banking the parent institutions are financially sound. Act of 1978 (IBA) gives the three federal To this end, they plan to collect information hank regulatory agencies expanded superviso­ on the consolidated operations of the foreign ry authority and responsibility with respect to banks, as described bdow, and to expand their the operations of foreign banks* UJS. branch* contacts with senior managements of the es» igntirinft and commercial lending compa­ banks. Additionally, United States authorities nies.* It provides for the establishment of fed­ are now working and will continue to work eral branches and agencies by the Office of the with bank supervisory authorities of other na­ Comptroller of the Currency and permits US. tions to improve both the coordinated ex­ branches to apply for insurance coverage by change of banking information and the com­ the Federal Deposit Insurance Corporation patibility of international banking regulation. (FDIC). It also subjects these U.S. offices to The IBA MiMfatre* that the federal regula­ many provisions of the Federal Reserve and tory agencies cooperate closely with state Bank Holding Company Acts. banking authorities in examining U.S. offices In order to insure adequate supervision of of foreign banks. In furtherance of this man­ these offices within the present federal-state date, a uniform approach to examining these regulatory framework, the IBA provides that offices is being developed through the FFTEC the Comptroller, the FDIC and the various in order to minimize dual examinations and to state authorities will have primary examining facilitate joint federal-state examinations, authority over the offices within their jurisdic­ when desirable. In exercising their responsibil­ tions. Additionally, the act gives the Federal ities, the agencies will ensure that each U.S. Reserve Board residual examining authority office of a foreign bank is examined regularly over all U.S. banking operations of foreign by either state or federal authorities. hmnkc, fimii*r to its existing authority over The federal regulatory agencies through the US. subsidiary banks of bank holding compa­ FFTEC, in consultation with the relevant state nies. This distribution of responsibilities calls authorities, are also developing joint financial for dose coordination of the efforts of the rele­ reporting requirements for these U.S. offices. vant authorities. Accordingly, the Comptrol­ The information required -will be similar ler, the FDIC snd the Board, in coordination to that required of U.S. banks while taking with the Federal Financial Institutions Exam­ into account their different organizational ination Council (FFTEC), are issuing this structure. joint statement to inform the public and the To gain information on the consolidated banking industry of their supervisory policy hank, the agencies will also develop new re­ toward these UJS. offices. porting requirements for the foreign parent in­ stitutions. These information requirements The agencies* supervisory interests in the will be similar to those for foreign bank hold­ operations of U-S. branches and agencies of ing companies, including specific information foreign hanks are directed to the safety and on earnings, reserves, and capital, and an ex­ soundness of those operations m serving the planation for material differences between needs of borrowers and depositors and ocher U.S. and foreign accounting practices In the creditors in the United States. For this reason, use and handling of this information, the the regulatory agencies will place primary em­ agencies will take into account the fhet that phasis on — the Sf wgMii well-being of tome of the information required may be con­ the U.S. offices. They wQl also be concerned fidential commercial information that is not with adherence to U.S. law and regulation by generally disclosed. These new reporting re­ these offices. quirements for both the U.S. offices and the At the same time, the agencies recognize foreign banks are planned to be unoiemented that, even more than in the case of U.S. bank early in 19W, with some possibly in effect for subsidiaries of foreign banks, the strength of the reporting period ending Daoember 31, these branches and agendas devolves from 1979. Detailed requirements and instructions their head offices and organizations outside will be issued prior to implementation. Jointly prepared by the Board pf Gammon of the Federal Resene System, the Comptroller of •The i the Currency, and the Federal DepasB Insure is refer is i once Corporation and adopted by the Federal XQ at tfcs New Yoct Sure I U», i Financial Institutions Courted. July 20. 1979. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-l An Analysis of the Concept of Corporate Separateness in BHC Regulation from an Economic Perspective I. Introduction This study examines economic theory and evidence on the question of corporate separateness as it relates This paper proceeds from the basic assumption that to BHCs. The theory is equally relevant to nonbank- certain banking functions are essential so that bank bank HCs though the phenomenon is so new that there safety and soundness is critical to the smooth func­ is no direa evidence on these organizations. The sec­ tioning of the economic system.1 The issue analyzed ond, third, and fourth seaions examine the way in in this study is whether bank holding company (BHC) which BHC management, the public, and the regula­ banks are presently effectively insulated from finan­ tors, respeaively, view the BHC corporate form of or­ cial problems of BHC nonbank affiliates and the par­ ganization. The fifth and final seaion provides a sum­ ent BHC. The analysis applies to nonbank-bank hold­ mary of the issues and evidence, and states the ing companies (HCs) as well as traditional BHCs. The conclusion of the study. nation’s largest BHCs, which operate the nation’s larg­ est banking enterprises, engage most extensively in nonbank activities. Furthermore, market forces and public policy are moving toward expanded product II. The Bank Holding Company as lines for BHCs, and nonbank-banks with very large Viewed by Management commercial affiliates or parents have been established. Consequently, this is an important policy with impli­ The perception of market participants (i.e., BHC cations for the future safety and financial soundness managers, and the investing and depositing public) and of the banking system. regulators regarding the separability of the various In the context of BHC regulation, the legal doctrine components of a BHC is a critical determinant of the of corporate separateness is proposed by some as a extent to which the bank subsidiaries are insulated workable means of insulating bank subsidiaries from from the financial problems in other parts of a BHC, the operations of nonbank affiliates and the parent regardless of the effeaiveness of the legal doarine of holding company.1 The chief proponents of this view corporate separateness. This seaion and the two fol­ contend that the legal principle of corporate limited lowing sections focus on how the BHC is viewed by liability—along with supporting statutes and regula­ market participants and regulators, and the economic tions that limit transactions between banks and their rationale for these views. The evidence examined in affiliates and parents—generally can be relied on to these seaions is generally consistent. It suggests that achieve corporate separateness and protea banks and both market participants and regulators tend to look their depositors from risks occurring within the cor­ upon the BHC as a single corporate entity rather than porate family but outside of bank affiliates. Those of as a conglomeration of separate corporate units. This an opposing view contend that banks cannot be effec­ section explores the views of management by focus­ tively insulated because the investing public, large depositors, and BHC management consider all units ing on management’s motivations, behavior, and oper­ of the BHC to be interdependent.’ Consequently, pub­ ating policies. lic confidence in bank affiliates of a BHC is linked to confidence in their nonbank affiliates. In this view, the legal doctrine of corporate separateness may not Management Motivation and Behavior offer a practical means of insulating banks from the actions of their nonbank affiliates and parent Theory and evidence outlined below suggest that companies. whaher BHC or nonbank-bank HC management is motivated by profit maximization or other objectives, This paper was prepared by Anthony Cornyn, Gerald Hanw eek, there will generally be an incentive to integrate opera­ Stephen Rhoades, and John Rom. Rom is at Baylor University now tions. This is important because while profit maximi­ but made his contribution to the project while employed by the zation is commonly assumed, there is good reason to Board. The views expressed herein are those of the authors and do not necessarily reflea-the views of the Board or its staff. question this assumption. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-2 Management Behavior Assuming ings performance.' Such diversification is often accom­ the Profit Motive plished by mergers.* As noted, evidence suggests that BHC management It is usually taken for granted that geographic and may be motivated to achieve large size and some de­ product-line diversification increase the value of the gree of BHC diversification rather than pure profit BHC firm to shareholders—that is, that such strate­ maximization. Recent BHC behavior appears consis­ gies on the part of BHC management are undertaken tent with the size and diversification motives. This is so as to maximize BHC profits. If management be­ reflected by BHCs’ active pursuit of growth and geo­ lieves there are economies of scale or scope, profit graphic diversification through domestic nonbank maximization would dictate centralized control over companies, foreign banking, nonbank subsidiaries, operations. Similarly, if BHC management believes and interstate expansion. Furthermore, within the last that the overall image of the company is dependent five years, BHCs have been particularly active in lob­ on the financial soundness of its various parts, bying to expand into securities activities prohibited by the Glass-Steagall Act and to conduct insurance un­ management may be motivated to exercise control of derwriting. More recently, some large banks are ex­ subsidiaries’ activities and operations, and to support panding by opening nonbank banks and acquiring fail­ ailing subsidiaries. This would also reflect rational ing savings and loan associations." profit maximizing behavior. Like profit maximization, other objectives pursued by BHC management will have implications for the extent to which BHC operations are centralized and Management Behavior Assuming integrated. It seems likely that managers of large or Nonprofit Motives diversified firms will seek to centralize important oper­ ations to ensure that basic management objectives are Although rational profit maximizing behavior could being met. The types of operations that are particu­ well lead to management treating the BHC as an inter­ larly suited to integration include funds management, dependent organization, there is reason to question the advertising, data processing, EFT, legal, corporate assumption of pure profit maximization. If this as­ planning, purchasing, personnel management, and ac­ sumption is questioned, it is necessary to examine the counting. Within most BHCs, the largest unit and the likely effect of alternative management motivation on one with the most diverse management skills and ad­ the degree of BHC integration. The economics litera­ ministrative apparatus is the bank subsidiary. Thus, ture has long recognized the separateness of owner­ it appears that the organizational structure of the BHC ship and management in large corporations and the makes the lead bank a key element in the overall oper­ potential for differences in the objectives of corporate ation of the BHC. managers and shareholders.4 The history of banking The key point that emerges from this discussion of since the 1930s suggests a considerable movement away BHC management’s motivation and behavior is that from the owner-managed bank that once character­ whether BHC management seeks to maximize profits ized even the largest banking firms. Today, hired or other objectives, such as size and diversification, managers rather than owners operate large banking or­ it appears that there will be an incentive to integrate ganizations, and due to the dispersion of ownership operations. To the extent that such integration occurs, through stock, owners have limited control of manage­ the lead bank, being the dominant element in the or­ ment. Furthermore, evidence suggests that managers ganization, will play a major role. have objectives other than profit maximization.1 In particular there is some indication that managers will maximize size and diversification subject to maintain­ Management Operating Policies ing an acceptable level of profits. The level of management compensation is more As has been argued above, there appear to be incen­ closely tied to size than to profitability though profit­ tives for BHC management to adopt policies that cen­ ability is important in determining bonuses and stock tralize control. In this section, a number of studies that options.4 The evidence suggests that management’s have examined the operating policies of bank holding compensation will increase if the firm grows and is companies are reviewed. These studies provide evi­ profitable. However, management’s employment, dence on the degree to which holding company reputation, and future benefits may be adversely ef­ managers operate their organizations as integrated fected if the firm does poorly. Thus, managers have units. a long-run incentive to diversify the operations of their Studies pertaining to holding company operating firm in order to increase firm size and to reduce em­ policies may be conveniently divided into three ployment risk7 that may result from fluctuating earn­ groups. The first group consists of studies that are Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-3 based on survey evidence of bank holding company First, the recession [of the mid-1970s] caused operating practices and focuses on the degree of par­ operating problems at a number of banking in­ stitutions, so many holding companies increased ent company (or lead bank) control over bank and internal operating and financial controls and de­ nonbank subsidiaries. The second group of studies ex­ veloped standardized procedures where practical. plores the effect of organizational centralization on the Second, the rate of acquisition expansion slowed, performance of multibank holding company systems. so resources became available for improving the Finally, the results of several recent papers that exam­ internal operating policies of holding companies. [Finally], the dramatic growth of government ine the funds movement practices of bank holding regulation of bank holding companies provided companies are reviewed with regard to their implica­ an added thrust toward more centralized policies, tions for holding company integration. which were believed necessary in order to deal effectively with legal compliance requirements.'’ Degree of Operating Control Overall, studies of the degree of BHC centralization of operating policies are generally consistent and find Six early studies of bank holding company operating that BHC management tends to centralize at least some policies were reviewed in a 1978 compendium on the operations. While the degree of centralization varies, bank holding company movement.11 One of the studies it tended to increase during the 1970s. reviewed examined bank holding company operating policies with respect to nonbank subsidiaries while the other five focused on multibank holding company sys­ Centralization Policy and Multibank tems. Though the evidence is limited, the reviewer con­ Holding Company Performance cluded that it suggests that bank holding companies tend to operate their organizations more like single, A number of studies have explored the relationship be­ integrated entities than like collections of commonly tween multibank holding company centralization owned but autonomous companies. This tendency is policy and holding company performance. These demonstrated by attempts bank holding companies studies are relevant because if they indicate that BHC typically make to exercise control over the manage­ performance is enhanced by centralization, it would ment philosophy and broad operating policies of their appear that there is an incentive to centralize opera­ subsidiaries. In addition, bank holding companies tions. The first study, by Mayne, examined the associ­ usually exert some direct control over specific opera­ ation between the performance of individual bank sub­ tional areas (e.g., securities and federal funds manage­ sidiaries and a holding company centralization index ment, budget policies, and capital management), using a sample of 636 banks divided equally between though this practice generally seems to be less preva­ subsidiaries of multibank holding companies and in­ lent with bank subsidiaries than with nonbank subsidi­ dependent banks." Several areas of bank performance aries. 11 Full integration of the holding company units were observed over the period 1969-72 and related to appears to be partly constrained by section 23A of the various independent variables, including holding com­ Federal Reserve Act, which restricts financial trans­ pany centralization, using multiple regression analy­ actions between a bank and its bank and nonbank sis. Data for the centralization index were obtained affiliates." from Lawrence, who had constructed the index from Two more recent studies of the operating policies the results of a 1969 survey of bank holding company of multibank holding companies shed further light on operating policies." Contrary to expectations, Mayne the integration issue. The first study, by Murray, is found generally no relationship between the degree of based on discussions with seven bank holding compa­ holding company centralization and subsidiary bank nies and survey responses from 16 holding compa­ performance. A possible explanation, she suggested, nies.14 The second study relies on survey evidence from was that ‘‘regardless of the formal internal organiza­ 63 multibank holding companies located in 12 states." tional structure, identification with the group may re­ Evidence presented in the two studies is generally con­ sult in informal but effectively unifying operating poli­ sistent with that reported in the earlier works and sug­ cies.” Another possible explanation is that the effects gests that, while the degree of centralization varies con­ of holding company centralization oh subsidiary bank siderably across organizations, holding companies performance may be observed-only with a time lag. exert at least some effort to centralize and integrate Thus, the effects may not have been evident in the the operations of their subsidiaries. Moreover, the evi­ 1969-72 period covered by the study when the multi­ dence from both studies indicates that the extent of bank holding company movement was still in its in­ centralization within bank holding companies gener­ fancy. It is also possible that the effects of centraliza­ ally increased during the 1970s.“ Murray offers three tion may be less observable at the subsidiary level than Digitized for FRAS r E e R as ons for this trend. for the holding company as a whole, due to various http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-4 intraorganizational effects, such as interaffiliate finan­ terbank differences in funds transferred from subsidi­ cial transactions.21 Finally, it is possible that the effects ary banks to the parent holding company, using a of centralization at the subsidiary level may vary with sample of 874 banks from 140 bank holding compa­ the size of the bank; Mayne did not test for any inter­ nies, and data for 1975-76.” Upstreamed funds in­ active effect between centralization and subsidiary cluded cash dividends, interest, and management and bank size.” service fees paid to the parent. Using regression anal­ In recognition of the potential problems with ysis, Mayne found the combined payment of divi­ Mayne's level of observation, Whalen regressed con­ dends, interest, and fees by the banks to their parents solidated holding company profit performance against to be positively influenced by both the degree of finan­ several indexes of centralization policy and other in­ cial leverage of the parent company and the extent of dependent variables, using a sample of 62 multibank diversification by the holding company into highly holding companies.12 The centralization indexes were leveraged nonbank activities (e.g., mortgage banking, constructed from the results of his 1979 survey work.24 commercial and consumer finance, factoring, and leas­ Holding company profitability was measured alterna­ ing). She concludes that “the evidence is consistent tively by the valuation ratio and the aggregate rate of with the premise that BHC’s operate as integrated en­ return on subsidiary bank equity, for different time tities and that this interdependence among component periods between 1979 and 1980.” Regression results firms may affect the safety and soundness of affiliated indicated a positive, significant relationship between banks.”22 holding company profitability and internal structural The second study, also by Mayne, takes a broader centralization, for all profit measures and centraliza­ look at interaffiliate cash flows by examining both up­ tion indexes. These results suggest that multibank stream and downstream funds transfers between the holding company efforts to manage their subsidiary parent company and its bank and nonbank subsidi­ banks as a single enterprise have yielded benefits for aries.2* Cash flows include interest and dividends from the consolidated holding company even if performance subsidiaries, management and service fees paid to the effects of centralization are not observable at the sub­ parent, and loans and advances between the parent and sidiary bank level. its subsidiaries. Mayne also examines parent company More recently, Whalen has examined the effect of borrowing from subsidiaries. Regression analysis is holding company centralization policy on the profita­ used to examine the effect of various holding company bility of individual bank subsidiaries.24 His analysis is characteristics on each of the different types of inter­ based on a sample of 1,210 banks, divided equally be­ nal funds transfers. The sample consists of 160 bank tween holding company affiliates and independent holding companies and uses data for 1976. Mayne banks. Using regression analysis, he estimated a bank reports several findings consistent with a single-entity profit function with 1979 data. The degree of holding view of bank holding companies. For example, she company centralization is captured by dummy vari­ finds that management fees from bank subsidiaries are ables and is based on the results of his survey work. usually higher in multibank holding companies than In contrast to Mayne’s findings, the results of this in one-bank holding companies, suggesting that more study indicate that subsidiary bank performance is services for bank subsidiaries tend to be centralized affected by holding company centralization policy. in the parent in the case of multibank organizations. Specifically, the results suggest that subsidiary banks She also reports that long-term borrowing by the par­ of relatively centralized holding companies tend to ent tends to be heaviest (1) for multibank holding com­ record higher profits than both independent banks and panies whose smaller banks have limited access to cap­ subsidiaries of decentralized organizations. ital markets and (2) for bank holding companies with Overall, findings of studies of the effects of the de­ a relatively large amount of assets in highly leveraged gree of BHC centralization on financial performance nonbank subsidiaries. Finally, she finds that a signifi­ are mixed but probably suggest that centralization cant factor in determining the amount of bank lend­ yields higher profits. This suggests there may be a ing to a parent, as well as in the amount of parent lend­ profit incentive to centralize. ing to nonbank subsidiaries, is the amount of holding company diversification into highly leveraged nonbank firms. Funds Transfers Within Bank The last study to be reviewed examines financial Holding Companies transactons between holding company hank* and their nonbank affiliates (defined to include the parent com­ A third set of studies dealing with bank holding com­ pany and nonbank subsidiaries of the parent).** The pany operating policies examines the movement of study is broader in scope than Mayne's in that it in­ funds between different units within the holding com­ corporates flows of funds between holding company Digitized for FRASER pany system. In the first study, Mayne explored in­ banks and affiliated nonbank firms. At the «amt» time. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-5 the focus is on financial transactions only, which is bank holding company units often have similar names, narrower than that of Mayne’s work. In order to de­ and, as noted earlier, many holding companies man­ termine the flow of funds associated with financial age their subsidiaries as integrated entities. This per­ transactions between holding company banks and their ception may also reflect the fact that BHCs typically nonbank affiliates, Rose and Talley compiled annual report financial data for only the consolidated entity.11 data on two major types of financial transactions— extensions of credit and transfers of assets—for 224 bank holding companies over the period 197S-80. The Consolidated Entity as the They found a net flow of funds from the nonbank sec­ Focus of Financial Analysis tor to the bank sector of a holding company through both types of transactions each year, with a consis­ While there is-widespread agreement among financial tently larger net flow through extensions of credit. analysts that a thorough analysis of a bank holding Moreover, of the total nonbank-to-bank credit exten­ company should include an analysis of the major seg­ sions, most came from the parent company, while the ments or units of the enterprise, this is not always pos­ bulk of the bank-to-nonbank credit extensions went sible given the available data. As a result, analysts typi­ to nonbank subsidiaries of the parent. The authors at­ cally limit their attention to the financial statements tribute the stronger nonbank-to-bank net flow of funds of the consolidated organization.11 associated with credit extensions to the collateral re­ This emphasis is not entirely the result of data limi­ quirements imposed by section 23A of the Federal Re­ tations. It also reflects the widely held view, within the serve Act on bank lending to affiliated companies.11 accounting profession, that the consolidated account­ In any event, all .three studies of intercompany trans­ ing statements of a bank holding company are more meaningful than those of the parent company or its actions lead to the conclusion that BHCs are operated subsidiaries. In fact, in 1959, the American Institute as integrated entities. of Certified Public Accountants (AICPA) concluded In summary, this discussion of management moti­ that consolidated financial statements can be presumed vation and operating policies generally suggests that to provide analysts with a clearer picture of the over­ management will operate a BHC or nonbank-bank HC all condition and operating results of a multicorporate as an integrated entity. Specifically, with respect to organization than can be obtained from the financial motivation, it appears that whether managers seek statements of individual units of the organization.14 profit maximization or size and diversification they The position of the AICPA is to caution financial have an incentive to integrate operations. Regarding analysts to be wary of separate financial statements operating policies, research into the existence of cen­ of the individual corporations in a multicorporate en­ tralized policies has found that centralization is com­ terprise because of the arbitrary way in which com­ mon, but studies of the effect of centralization on mon costs can be allocated and transfer prices can be financial performance yield mixed results. Studies of set. Common costs are costs such as advertising and the intercompany transactions of BHCs suggest that overhead that are jointly shared by two or more busi­ BHCs tend to be operated as interdependent units. The ness units of the same enterprise, and transfer prices results of this literature are generally consistent with are prices charged for goods and services that are trans­ the argument that, In spite of the uncertain benefits ferred from one unit of an enterprise to another. By for financial performance, most bank holding com­ manipulating the allocation of common costs and panies integrate the operations of their various units varying transfer prices, a holding company can dis­ to some degree, within the confines of regulatory tort the “true” financial condition and performance restrictions. of a subsidiary. The focus on consolidated statements also reflects the financial disclosure requirements of the Securities III. The Bank Holding Company as Viewed and Exchange Commission (SEC). Under the Securi­ by Market Participants and the Public ties Exchange Act of 1934, bank holding companies meeting certain requirements must file periodic finan­ This section discusses the approach used by financial cial reports with the SEC and adhere to extensive dis­ analysts in evaluating BHCs and evidence on the per­ closure requirements. The requirements governing the ceptions of market participants and the public regard­ form and content of financial statements filed with the ing the components of BHCs. This discussion suggests Commission are set forth in Regulation S-X. The SEC that market participants—large depositors, equity and requires bank holding companies to file consolidated credit analysts, and the public in general—tend to view financial statements. Separate financial statements for bank holding companies as tingle entities. In part, this bank and nonbank subsidiaries are not required, nor perception may be attributed to the operating policies are separate financial statements mandated for the par­ Digitized for FRASERo f the holding companies themselves. Specifically, ent company.11 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-6 The emphasis on the consolidated entity is further consolidated leverage structure of the holding com­ reflected in the financial statements that bank hold­ pany does not appear to systematically influence share ing companies provide to shareholders in their annual price.” In addition, ”... of the three major holding reports. A survey of bank holding company report­ company components—banking affiliates, nonbank­ ing practices conducted by Peat Marwick and Mitch­ ing subsidiaries and the parent company—only the ell & Co., a major public accounting firm, revealed financial structure of banking affiliates was found to that most bank holding companies do not provide sep­ influence investors.”” arate financial statements on bank or nonbank sub­ A study by Beighley analyzed the risk perceptions sidiaries in annual reports to stockholders.” Specifi­ of those who hold debt in lead banks and BHCs.” A cally, Peat Marwick reviewed the 1982 annual reports sample of 56 issues of 42 different banking firms from for the 100 largest banking organizations in the United 1972 to 1974 was used; 35 issues were parent-firm ob­ States. The findings showed that only 5 of the 100 or­ ligations, while the other 21 were obligations of the ganizations presented any financial statements for non­ lead bank. Beighley concluded that “... there is some bank subsidiaries. Moreover, of the 100 organizations, evidence in support of the hypothesis that creditors are only 38 included balance sheets of subsidiary banks concerned about the financial structure of the lead in their annual reports and only 10 included bank in­ Gargest) banking firm in the BHC.” He added that come statements. As these findings suggest, the report­ ”... debtholders appear to be indifferent with regard ing practices of bank holding companies make it dif­ to the location of debt in the BHC (parent firm or lead ficult, if not impossible, for market participants to bank).”40 This last conclusion provides support for analyze the separate corporate entities that comprise the contention that the market is mainly concerned a bank holding company organization. with the consolidated BHC, as the debtholders look Although only a very small number of bank hold­ to the strongest component of the holding company ing companies disclose financial information about the for ultimate protection. bank and nonbank components of their organization The two studies discussed above suggest that holders in shareholders reports, individual financial statements of long-term debt and equity issues focus on BHCs of subsidiary banks and parent company financial or the lead bank. However, experience suggests that statements of bank holding companies are available bank liability holders may now pay closer attention to the public from bank regulatory agencies. While to the financial condition of nonbank subsidiaries. In bank holding companies provide the bank regulators the mid-1970s, Hamilton National Bank of Chatta­ with financial statements of their nonbank subsidi­ nooga was forced by the parent holding company to aries, such statements are provided on a confidential buy a large amount of low quality mortgages from a basis and are not made available to the public. The severely distressed mortgage banking affiliate of the reluctance of bank holding companies to make bank holding company. These purchases far exceeded the and nonbank subsidiary information directly available amount permitted by law and resulted in the subse­ to the public through reports to shareholders tends to quent failure of the bank. This experience would seem preclude anything other than a single entity approach to provide several reasons for holders of bank and to bank holding company analysis. BHC debt and equity to look beyond the condition of the BHC and the lead bank. First, these investors know that essentially the same group manages the Evidence on the Perceptions of Market major units of most holding companies. Consequently, Participants and the Public it is reasonable to assume that if a nonbank unit of the holding company is so mismanaged that it fails, Even though a great deal of data are available to the the affiliated bank may also be mismanaged and could public on the consolidated holding company and bank­ be in unsatisfactory condition. Second, even if the ing subsidiaries, the evidence suggests that most atten­ bank’s liability holders suspect that the bank is in satis­ tion is placed on the performance of the consolidated factory condition, they may not want to be subject to BHC. A study by Jacobs, Beighley, and Boyd supports possible criticism by continuing to do business with the hypothesis that the investing public focuses on the an organization whose reputation has been tarnished. consolidated bank holding company entity rather than Third, bank liability holders may be concerned that on the individual components of the holding com­ the bank may be used in an attempt to aid troubled pany.” In that study, the authors applied a cross- affiliates. Even though current statutes are designed section regression model to 100 BHCs over a four year to protect banks from abuse, bank liability holders period, 1970 through 1973. From their empirical might still be concerned because the holding company results, the authors concluded that .. investors are might violate these statutes in a time of crisis. paying increasing attention to the consolidated finan­ In addition to the evidence suggesting that the in­ cial structure of holding companies” and ”... the un­ vesting public may regard the units of a BHC as inter- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-7 dependent, there is both direct and indirect evidence estate investment problems were transferred to the that depositors may assume such interdependence. The sponsoring bank. This support was provided even most vivid direct evidence arises from the Beverly Hills though the banks were under no legal obligation to Bancorp episode in 1973. Beverly Hills Bancorp, the do so.4J parent of Beverly Hills National Bank, had loans to A common method by which bank sponsors pro­ a real estate developer that were funded with sales of vided support to their advised REIT was to acquire commercial paper. When the developer could not re­ assets from the REIT through asset swaps or straight pay the loans, the holding company was unable to pay asset purchases. Examples of this activity involved pur­ off its maturing commercial paper obligations. The ad­ chases of assets from advised REITs by Wisconsin verse publicity that accompanied this default resulted Corporation and by Chase Manhattan Bank.41 First in large-scale runs on the Beverly Hills National Bank. Wisconsin Corp. purchased assets from its advised These runs prompted the bank supervisors to merge REIT that it would not otherwise have bought, if not this previously sound bank into another California for its role as an advisor. First Wisconsin and the REIT bank. The strong name identification of the bank with entered into an agreement on June 27, 1974, whereby the holding company and the fact that the parent com­ the Trust agreed to defer litigation against First Wis­ pany had sold its commercial paper to customers of consin Mortgage Co. (its advisor), First Wisconsin the bank undoubtedly contributed to the bank's Corp., and First Wisconsin National Bank. In return, downfall.41 First Wisconsin Corp. agreed to purchase certain loans The actions of BHC management in response to and to provide $5.5 million of future support involv­ financial problems of the parent or nonbank affiliates ing certain losses that the Trust might realize. Chase appear to provide the market with ample reason for Manhattan Bank, in 1976, agreed to purchase $160.6 being concerned about the ultimate effect on the bank. million of its advised REIT’s assets in order to save In such situations, the holding company management the REIT from bankruptcy. The funds from this pur­ typically tries to save the troubled affiliate by trans­ chase were used by the Trust to pay creditors. Finally, ferring sufficient resources to the affiliate to meet its it is notable that the bank regulators may have en­ obligations. There may be a variety of reasons for these couraged the market’s perception of BHCs as inte­ managerial decisions, but the major reason appears to grated entities by supporting efforts to save some be avoidance of serious reputation damage to the hold­ REITs. ing company organization and its bank. There have The financial assistance provided by First National been several instances in recent years where banking Bank of Chicago to Institutional Liquid Assets (ILA) organizations have gone to great lengths to preserve is indicative of the apparent incentive of BHC manage­ their reputation in the marketplace. Perhaps the best ment to assist financially troubled firms that they ad­ known case involved United California Bank in 1970. vise even though there are no ownership ties. Specifi­ In that situation, the bank voluntarily assumed respon­ cally, in October 1980, the First National Bank of sibility for the debts of its Swiss bank subsidiary, which Chicago and Salomon Brothers provided financial as­ failed after incurring losses of nearly $40 million from sistance to ILA, a Chicago-based institution-only unauthorized speculation in cocoa futures. Legally, the money market fund that was experiencing liquidity bank could have walked away from this failure, but problems due to an unusually long asset maturity struc­ it did not apparently out of concern over possible dam­ ture combined with a rise in interest rates.44 It should age to its reputation in the marketplace. be emphasized that ILA was not a subsidiary of either Other examples of banking organizations taking sig­ First National Bank of Chicago or Salomon Brothers. nificant steps to preserve the public’s perception of First Chicago was ILA's investment advisor, and Salo­ their reputation and financial strength are situations mon Brothers the fund’s administrator and seller. involving BHC-sponsored real estate investments trusts Nevertheless, both First Chicago and Salomon acted (REITs) in the mid-1970's. In 1971, the Board ruled to assist ILA. The reported ILA rescue package in­ that bank holding companies could serve as advisors cluded the purchase by Salomon from ILA of $228.5 to REITs. While all REITs performed poorly during million of securities at a price about $700,000 above this period, unpublished evidence compiled by Board market value and the return to ILA by First Chicago staff (based on a sample of 80 REITs) shows that, dur­ of $1 million of previously paid advisory fees. In addi­ ing 1974-77, bank-sponsored REITs had a higher per­ tion, First Chicago and Salomon agreed to waive their centage of nonearning assets than nonbank-sponsored usual fees for an indefinite period and Salomon REITs in each of those years. Most notably though, Brothers agreed to purchase additional securities, at in a number of cases, the bank sponsors provided a loss, if necessary.45 support to their REITs on a non-arms length More recent evidence regarding the perceptions of basis to avoid the adverse publicity which a related market participants and BHC management is provided REIT bankruptcy would bring. As a result, the real by the Drysdale experience in 1982. In that case, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-8 Chase Manhattan Bank and Manufacturers Hanover, poration and Sunbelt Bank and Trust, both of Tulsa, acting simply as intermediaries between Drysdale Oklahoma. The case involved a “run” on a bank that Government Securities, Inc. and a number of par­ was triggered by the collapse of a group of nonbank ticipants in the government securities market, agreed companies that were formerly affiliated with the bank. to make the interest payments that Drysdale was un­ On March 1,1984, Republic Bancorporation changed able to make. Specifically, on May 17, 1982, Chase its name to Sunbelt Bancorporation and its bank sub­ Manhattan informed the Federal Reserve that Drys­ sidiary, the Republic Bank and Trust Company, dale did not forward $160 million in interest payments changed its name to Sunbelt Bank and Trust. Shortly to Chase Manhattan. These payments were due to thereafter Sunbelt Bancorporation decided to divest other firms that had loaned government securities to itself of its “nonbank” subsidiaries, Republic Finan­ Drysdale, using Chase Manhattan as an intermediary, cial Corporation and Republic Trust and Savings. The under repurchase agreements. The following day, divestiture occurred on June 29, 1984.4* Republic Manufacturers Hanover announced that it had not Financial and Republic Trust and Savings were sold received nearly $30 million in interest payments from to Republic Bancorporation, Inc., and the three enti­ Drysdale under the same circumstances. Market pres­ ties became known as the “Republic group.” All le­ sures built for both banks to make good on the interest gal ties between the so-called “Republic group” and payments. For a complex variety of reasons, includ­ Sunbelt were severed. On September 24,1984, Repub­ ing both considerations of legal liability and the mar­ lic Bancorporation, Inc. and its two subsidiaries, ket pressures, within days, both firms made the interest Republic Trust and Savings Company and Republic payments. Financial Corporation, filed for reorganization under Even more recently, the First Chicago Corporation chapter 11 of the Federal Bankruptcy Code. Oklahoma took losses on a Brazilian subsidiary that far exceeded state banking and securities officials attributed a ma­ its investment in the subsidiary. In 1985, First Chicago jor cause of the reorganization to a last-ditch transfer held a 44.5 percent ownership interest in Banco Denasa of more than $8 million of deposits and loans from de Investiment S.A., a Brazilian investment bank Republic Financial Corporation, a nonbank finance which had assets of about $180 million. Banco Denasa company, to its affiliate, Republic Trust and Savings had a sizable exposure to the financial and real estate Company. Many of the loans that were transferred sectors of the Brazilian economy which, according to were considered to be problem loans by the state bank First Chicago, had come under pressure as a result of commissioner.$s A key point is that despite the earlier the efforts of the Brazilian government to deal with divestiture, the collapse of the Republic group trig­ the long-term structural problems of the economy. The gered a “run” on the Sunbelt Bank and Trust Com­ downturn in those sectors led First Chicago in the first pany even though the two companies were no longer quarter of 1985 to write down virtually all of its in­ affiliated. On October 1, only a week after the Repub­ vestment in Denasa, which amounted to approximately lic bankruptcy filing, the president of Sunbelt Bank $15 million.4* and Trust held a press conference and announced that Denasa’s condition continued to worsen into the sec­ there had been a run on the bank, which had resulted ond quarter. The majority shareholder was unable to in the withdrawal of about $10 million of deposits. By provide additional capital support to Denasa. Conse­ mid-October the Bank’s president had reported that quently, to prevent a run, First Chicago decided to take withdrawals had grown to about $15 million, lower­ over the management and control of the bank and pro­ ing the bank’s deposit base to $95 million.*' By the vide the needed financial support. Although First end of November, Sunbelt Bank and Trust Company Chicago was obligated under a special agreement to was acquired after approval by the Federal Reserve recapitalize the bank by an amount equal to its 44.5 Board. percent interest in the bank, it decided to provide sup­ To summarize, this section has focused on the way port over and above that amount. As reported in the in which BHCs are perceived by market participants Wall Street Journal, Barry F. Sullivan, the Chairman and the public. The evidence and studies show that of First Chicago Corporation, said, 44We believe it was professional financial analysts and investors concen­ important for us, as a major international bank, to trate on the consolidated BHC, partly dqe to data limi­ stand behind Banco Denasa and that we must bear the tations. Past experience suggests that investors and financial consequences of such support.”47 The finan­ depositors have concerns about the affiliate banks cial consequences were a $131.1 million loss on the $15 when financial problems are encountered elsewhere in million investment in Banco Denasa.4* the BHC. Furthermore, experience suggests that BHC Another recent experience suggests that it is not pos­ management will draw on the financial resources of sible to ensure insulation through corporate separate­ the bank to assist a troubled nonbank subsidiary. ness because of the perceptions of BHC managers and Taken together, this evidence and experience suggests the public. This involves the case of Republic Bancor- that the BHC organization is generally perceived as Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-9 an integrated entity. In this regard, it is notable that Other regulatory agencies and the courts have Walter Wriston has observed: adopted a position in this matter that is similar to the Board’s. For example, in commenting on proposed If the National Bank Act was amended to say bank holding company acquisitions, the U.S. Depart­ that everything a bank holding company can do, ment of Justice has consistently considered the hold­ the national bank can do, I’d be extremely happy. It would simplify administration and would make ing company organization as a single entity, given a it perfectly clear to the customers that our $7 bil­ product and geographic market. The courts have regu­ lion of capital is behind everything that we do. larly followed this approach as well. In addition, in reviewing mergers among affiliated banks in the same Furthermore, Wriston notes: holding company, both the Comptroller of the Cur­ rency and the FDIC, along with the Federal Reserve For example, it is inconceivable that any ma­ Board, have indicated that they view such mergers as jor bank would walk away from any subsidiary essentially corporate reorganizations having no effect of its holding company. If your name is on the door, all of your capital funds are going to be be­ on competition.” hind it in the real world. Lawyers can say you have separation, but the marketplace is persua­ sive, and it would not see it that way.” Bank Holding Companies, Reserve Requirements, and Deposit Rate Ceilings IV. The Bank Holding Company as While federal law and regulation generally treat sister Viewed by Regulators bank subsidiaries within a multibank holding company system as separate units for purposes of reserve re­ This section examines how federal regulators, partic­ quirements,” the Federal Reserve Board has tradition­ ularly the Federal Reserve Board, treat bank holding ally viewed the bank and nonbank sectors of a hold­ companies, i.e., whether regulators treat holding com­ ing company organization as a single entity for such panies as single entities or as collections of commonly purposes. The Board first employed the single-entity owned but autonomous companies. The section view of bank holding companies in a regulatory mat­ reviews the historical evidence in three areas: (1) the ter relating to monetary policy in 1970. Prior to that manner in which regulators treat affiliated units for time, the proceeds from bank holding company com­ purposes of competitive analysis of holding company mercial paper issues could be downstreamed to either acquisitions, (2) regulatory treatment of banks and bank or nonbank subsidiaries without being subject their parent holding companies for purposes of mone­ to reserve requirements. Beginning in 1970, however, tary policy, and (3) the development of the regulatory the Board made any such proceeds obtained by mem­ and supervisory apparatus for ensuring the soundness ber banks fully subject to Regulation D, pursuant to of holding company banks. The evidence indicates authority granted to the Board the previous year.” The that, consistent with the perceptions of holding com­ objective of this policy was to preclude banks from pany management and the public, federal authorities using the holding company structure as a vehicle for generally view bank holding companies as single, inte­ raising nonreservable funds. By imposing Regulation grated entities. D on such funds, the Board made clear that it intended “... to maintain the effectiveness of the reserve re­ quirement” and ”... to put instruments of this kind Bank Holding Companies and Merger Policy [r.e., bank-related commercial paper] on a more equal footing with negotiable CD’s issued by banks.” ” The As a policy matter, the Board has long considered all effect of the Board’s action was subsequently deter­ of a holding company's bank affiliates operating mined to have reduced bank use of bank holding com­ within the same local market as a single banking en­ pany downstreamed commercial paper funds by 39 tity for purposes of competitive analysis.” The Board percent during the first two months following the has taken this position even though it generally has policy change.” Over a longer period (1970-77), the maintained that multibank holding companies are not proportion of bank holding company commercial legally branch banks.'4 In addition, in considering paper proceeds downstreamed to bank subsidiaries hank holding company applications to acquire non­ dropped from 99 percent to less than 5 percent.” bank firms engaged in permissible activities such as In the early 1970s, several large holding companies mortgage banking, the Board has traditionally based began to issue small-denomination, floating-rate thrift its competitive analysis on the total business of the con­ notes in order to circumvent Regulation Q restrictions. solidated holding company in that activity in the rele­ The Congress, in 1974, authorized the regulators to vant geographic market. limit interest rates on holding company debt obliga­ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-10 tions (other than commercial paper) that could serve loans and extensions of credit to affiliates be fully se­ as substitutes for consumer deposits issued by deposi­ cured.** As stated by a Senate committee, tory institutions, regardless of the intended use of the The loan relationship as it exists between the proceeds of the debt.** bank and its affiliate differs from that prevailing In 1977, the Board recognized another avenue by with the general run of the bank's customers in which BHCs could be used to evade reserve require­ an essential respect. When dealing with its affili­ ments. That situation involved an application by a ate, the bank is really dealing with itself, in view of the identity of ownership and management that bank holding company to issue, through a nonbank is established. As a result there tends to be a subsidiary, variably denominated payments instru­ breakdown of those limitations on the extension ments (essentially, traveler’s checks).*2 (Variably of credit which the bank sets up in other cases denominated payments instruments are fully reserv- to guard against the making of excessive or able if issued by a commercial bank but are reserve- poorly-secured loans.*7 free if issued by a nonbank institution.) The Board, however, was concerned that such instruments, if non- When Congress enacted the Bank Holding Com­ pany Act of 19S6, it specifically addressed the issue reservable, could potentially have an adverse effect on of bank transactions with holding company units. Its the reserve base due to the erosion of the reservable deposits of the banking system. The Board approved decision, codified in section 6 of the Act, was to pro­ the application on competitive grounds. However, to hibit intrasystem investments and extensions of credit by banks in holding company systems. The only ex­ minimize the potentially adverse effect on the reserve emption to this prohibition pertained to certain base, it imposed a $1,000 maximum face value on such noninterest-bearing deposit transactions between sister instruments.*2 Recently, in response to another bank bank subsidiaries. As indicated by Congressional com­ holding company application, the Board increased the mittee reports, the purpose of section 6 was to pre­ maximum face value on such instruments to SI0,000. vent “unsound banking practices” and to preclude the In so doing, however, the Board made clear that it parent company from taking “undue advantage of the would closely monitor the effects of the proposal and resources of its subsidiary banks.”** might later impose reserve requirements if it appeared However, the 1966 amendments to the Bank Hold­ that the proposal was reducing significantly the reserve ing Company Act repealed the section 6 prohibition base or otherwise adversely affecting the conduct of and substituted for it a provision whereby a holding monetary policy.*4 company bank became subject to section 23A’s limi­ tations on transactions with its parent company and other subsidiaries of the parent. In addition, the pur­ Bank Holding Companies and chase of loans on a nonrecourse basis from an affili­ Bank Supervisory Policy ated bank (along with certain noninterest-bearing de­ posit transactions) was exempted from the restrictions Historically, the bank regulatory and supervisory ap­ of section 23A. This exemption was recommended by paratus has focused on the financial soundness of in­ the Board on the grounds that both banks in any trans­ dividual banks in order to protect the stability of the action would be under the supervision and examina­ banking system and to safeguard bank depositors. tion of the bank supervisory authorities and that such While this continues to be the primary focus of pub­ transactions would allow bank portfolio adjustments lic policy, the scope of regulatory and supervisory con­ in response to changes in deposits and loan demand, cern has expanded over time to give greater attention in effect permitting more integrated operations of mul­ to the soundness of the entire holding company or­ tibank holding company systems without a substan­ ganization. The history of this apparatus can be tial increase in risk to the banks involved.** roughly divided into three periods: 1933-1972, Further evidence of Congressional concern with the 1973-1979, and 1980-present.*5 integrated nature of the bank holding company organi­ zation is seen in section 3(c) of the Bank Holding Com­ pany Act of 1956. That section directed the Federal 1933-1972 Reserve Board, in judging bank acquisitions by hold­ ing companies, to consider, among other things, “(1) Concern with affiliation between banks and nonbank the financial history and condition of the company or affiliates was expressed initially in 1933 when the Con­ companies and the banks involved, (2) their prospects, gress enacted section 23A of the Federal Reserve Act. [and] (3) the character of their management.” The Section 23A was designed to shield bank resources 1966 Amendments to the Act changed the language from abuse by placing quantitative limitations on bank of this section but maintained the intent by directing transactions with affiliates and by requiring that bank the Board to consider in every bank acquisition case Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-ll .. the financial and managerial resources and fu­ damage to the organization’s reputation or to forestall ture prospects of the company or companies and the lawsuits alleging that the trust recdved “bad” or, per­ banks concerned.” haps, even self-serving advice from the organization. Beginning in 1972, the Federal Reserve Board re­ The Board’s proposal ultimately served as the basis quired each bank holding company to submit finan­ for the Banking Affiliates Act of 1982, which made cial statements for the consolidated organization, the important, substantive changes to section 23A to limit parent holding company, and all nonbank subsidiaries the potential for bank abuse by affiliates.74 of the parent.” At the same time, the Board began to In addition to amending the law to tighten section articulate a policy that holding companies should be 23A at several places, the Banking Affiliates Act liber­ a ‘‘source of financial and managerial strength” to alized the statute to facilitate greater interaffiliate their subsidiary banks. As it noted in August 1972, financial transactions (and thus potentially increased “The Board believes it is essential that bank holding integration of the holding company organization) companies and their nonbank subsidiaries be soundly where policymakers believed that such transactions financed so that they will, if anything, be in a posi­ would not increase significantly the risk to subsidiary tion to add to the strength of their affiliated banks and bank soundness. Most notably, the amended statute in no way dilute or trade on’ that banking strength.”71 (1) exempts most transactions between sister bank sub­ Finally, in the same year, the Board recommended that sidiaries of a multibank holding comply from the section 23A be extended to cover some additional types major restrictions of the law and (2). provides an ex­ of transactions, including “some purchases of assets panded list of eligible collateral. The first amendment by banks from affiliates, sales by banks to affiliates, is designed to treat a multibank holding company or fees or other charges paid to affiliates,” in order much like a branch banking system with respect to to prevent misuse of bank resources.71 These actions intraorganizational funds transfers among bank affili­ by the Board in the early 1970s reflected an emerging ates; the second is intended to allow holding company belief that the financial soundness of holding company banks to lend to all their major nonbank affiliates. subsidiary banks is closely linked to the financial con­ Federal regulators took a number of steps in 1978 dition of the rest of the holding company system, and 1979, analogous to the restrictions imposed by sec­ thereby necessitating at least some regulatory oversight tion 23A, to protect subsidiary banks from abuse by of the entire holding company organization. holding company affiliates. First, in 1978, the Comp­ troller of the Currency criticized the practice of some national banks of paying management and other fees 1973-1979 to holding company affiliates (and other insiders) in excess of the value of goods and services received.77 Prudential regulation of bank holding companies in­ Also, at about the same time, the Federal Reserve creased substantially during the period 1973-79.71 This Board criticized intraholding company income and tax development may be attributed to the general finan­ accounting transfers “that have the effect of transfer­ cial strains of the mid-1970s coupled with a growing ring assets and income from the subsidiary banks to concern among regulators that financial problems in the parent company without offsetting benefits to the the nonbank sector of a bank holding company can bank.”74 Finally, in 1979, the Board enumerated a adversely affect subsidiary banks through either ad­ number of “diversion of bank income practices” verse transactions or reputation damage. which it considered “inappropriate and, potentially In 1976, section 23A came under formal review by unsafe and unsound.”77 The Board indicated that such the banking committees of the Congress and the fed­ practices would be subject to examiner criticism or, eral bank supervisory authorities. This review was in cases where they are likely to have an adverse im­ prompted by the discovery that several relatively large pact on the bank’s condition, would be met with “for­ banks tod been adversely affected by transactions with mal supervisory actions (i.e., written agreements and their affiliates.74 In response, the Federal Reserve cease and desist orders)... to terminate the prac- , Board proposed amendments to section 23A designed, . rices and require restitution or affirmative remedial in part, to dose a number of loopholes in the statute action.”** Vand to expand the coverage of the law to indude trans- In 1979, the Board introduced a uniform system of -actions between a bank and a company that is spon- rating bank holding companies. This rating system, sored and advised by the bank or its affiliate.71 This known as BOPEC, is designed to evaluate the finan­ latter recommendation was made in view of the ex­ cial condition of each of the major holding company perience of the mid-1970s when, in a number of cases, units—Bank subsidiaries, Other (nonbank) subsidi­ a financially troubled real estate investment trust aries, and /Parent company—as well as the Earnings received significant financial assistance from its advi­ and Capital adequacy of the consolidated organiza­ Digitized for FRASEsoRr y banking organization, presumably to prevent tion.*' Thus, by the end of the 1970s, the federal bank http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-12 authorities clearly had in place a regulatory and super­ the linkages baween the financial condition of subsidi­ visory apparatus that treats the bank holding company ary banks and that of the rest of the holding company organization as an integrated unit and focuses on the organization. In recognition of the existence of those financial condition of all the units of that organiza­ linkages, the Federal Reserve Board has sought to use tion, even while seeking primarily to protect subsidi­ the vehicle of the holding company to isolate the bank ary banks. This regulatory apparatus refleas the view as much as possible from the nonbanking aaivities of that the actions and financial soundness of the vari­ its holding company affiliates. This has been done in ous units of a BHC are interdependent. part by insisting, in considering applications to engage in nonbanking activities, that the aaivity be capital­ ized at least as well as other Arms in the same indus­ 1980-Present try that are unaffiliated with bank holding companies. Recent steps taken by federal regulators to coordinate their aaions reflea a perception that the BHC is oper­ V. Summary and Conclusion ated as an integrated entity.'1 In December 1979, the federal banking agencies agreed to coordinate the in- The legal doarine of corporate separateness has been spection of a bank holding company and its lead bank proposed as a means of insulating banks and their in all cases for holding companies with consolidated depositors from problems of nonbank BHC affiliates assets in excess of $10 billion and those in need of spe­ (including the parent company). However, a number cial supervisory attention and in other cases, whenever of economists contend that the legal doarine of cor­ possible." This agreement was expanded, in 1982, by porate separateness is only one faaor in determining the Federal Reserve Board and the Comptroller of the the insulation of banks from their affiliates. They Currency to include annual, concurrent examinations argue that the investing public, large depositors, and of all bank holding companies with consolidated as­ BHC management view the BHC as an interdependent sets in excess of $1 billion and lead bank subsidiaries entity. Thus, regardless of legal corporate separate­ which were national banks.*4 ness, severe problems in nonbank affiliate earnings or Similar coordination between the Federal Reserve financial condition may be perceived by these groups and the Comptroller of the Currency is seen in the as having an adverse effea on bank affiliates. This per­ bank capital-adequacy guidelines issued jointly by the ception would arise from a belief that if an affiliate two agencies in late 1981 for national banks, state is in trouble, the bank may also have problems because member banks, and bank holding companies that are they have common management and because the in satisfaaory financial condition." The Federal Re­ bank’s resources may be used to bolster the troubled serve made clear that, in the case of bank holding com­ nonbanking operations in an effort to maintain the panies, the guidelines are to be applied both to in­ reputation of the BHC. For these and other reasons, dividual banks in the holding company as well as to it is maintained that bank insulation cannot be effec­ bank holding companies on a consolidated basis. The tively achieved simply by enforcing the legal doarine justification for this policy is that “. . . the public of corporate separateness. Accordingly, proponents of usually views the bank and the holding company as this view recommend that BHCs be regulated as in­ a single entity and links their fates." " The announce­ tegrated entities. ment of these guidelines not only demonstrated the Theory, evidence, and regulatory policy appear to cooperation of the two agencies in supervising bank be consistent with the inseparability view of the BHC. holding companies, but also showed further their com­ An analysis of BHC management motives and avail­ mitment to regulating bank holding companies as con­ able evidence indicates that funds do flow among BHC solidated units. affiliates and that BHC management is generally in­ Overall, evidence from a number of areas—competi­ clined to support ailing nonbank affiliates by using tive analysis of bank holding company acquisitions, available resources—including those of bank affiliates. monetary policy, and the regulatory and supervisory In many cases, the justification for supporting ailing apparatus for ensuring the soundness of holding com­ affiliates is to maintain the credibility ^nd reputation pany banks—indicates that federal bank regulators of the BHC and banking affiliates. BHC management generally view bank holding companies as single, inte­ perception may be correa because additional evidence grated entities. With respea to competitive analysis suggests that large depositors, bank and BHC bond­ and monetary policy, the single-entity approach has holders and stockholders, and securities rating firms long been employed by the regulators, at least to some and analysts tolerate problems in one part of the com­ degree. By contrast, adoption of the single-entity view pany for a time but, if unresolved, they aa as if they for supervisory purposes has occurred largely through believe the entire organization could be in difficulty. Digitized for FRASER an evolutionary process as regulators have observed It is also notable that the bank regulators have, on http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-13 occasion, assisted banks that have experienced prob­ conclusion and the fact that market forces and public lems with their REITs and other affiliates. Such ac­ policy are moving in the direction of expanded prod­ tion may have encouraged the view that the BHC is uct lines for BHCs has implications for the direction an integrated entity. Finally, BHC regulatory policy that should be taken in regulating bank holding com­ has been consistent with the perceptions of BHC panies including the extent of product line expansion management and market participants. For example, that should be allowed. It is emphasized that this con­ limitations have been imposed on bank affiliate ex­ clusion is not based on an evaluation of the potential posure to nonbank affiliates via section 23A of the for designing legislation and regulation so as to make Federal Reserve Act to insulate banking affiliates from corporate separateness an effective vehicle for insulat­ problems in the parent and nonbank affiliates. It is ing banks. Rather it is an evaluation of the effective­ notable that this analysis applies with equal force to ness of corporate separateness as it works today. traditional BHCs as well as nonbank-bank HCs (which The policy issue of bank separateness has been own depository institutions with commercial bank muted by the fact that most nonbank assets of BHCs charters and FDIC insurance). have been in activities very closely related to banking In sum, it appears that BHC management, market and, for most BHCs, nonbank assets have accounted participants, and regulators view the fortunes of a for less than 5 per cent of the total. If, however, BHCs BHC subsidiary bank as linked with the BHC and non­ were permitted to enter the activities now being de­ bank subsidiaries of the BHC. The conclusion which bated by public policymakers, they would be moving emerges from this study is that the legal doctrine of farther away from traditional banking activities and corporate separateness is not the only factor involved the percentage of BHC assets in nonbanking would in insulating BHC banks from the financial problems be likely to increase. Similarly, the problem would be that may be en countered by its nonbank affiliates or exacerbated to the extent that nonbank-banks (with the parent BHC. Regardless of the effectiveness of the commercial bank charters and deposit insurance) are legal concept of corporate separateness as an insula­ allowed, because they may be owned by commercial tor, evidence suggests that today BHC management, enterprises in which case the commercial activity is regulators, and market participants (/.«., the invest­ likely to account for a large percentage of the entire ing and depositing public) perceive the entire BHC or­ organization. Because of the very uncertain implica­ ganization as a financially interdependent entity. Con­ tions for bank risk, this prospect makes bank separate­ sequently, it seems likely that the financial problems ness a fundamental issue in considering the direction of a parent BHC and/or its nonbank affiliates would of BHC regulation in the future—perhaps the near affect the financial position of affiliated banks. This future. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-14 Footnotes Holding Companies,” Research Report No. 48 (Federal Reserve Bank of Boston, March 1971), pp. 254-63; and D. C. Mueller, et. 1. This view has been elaborated at length by E. Gerald Corri­ ai. The Determinants and Effects of Mergers: An International gan, “Are Banks Special?” Annual Report, 1982 (Federal Reserve Comparison (Cambridge, Massachusetts: Oelgeschlager, Gunn 8t Bank of Minneapolis), pp. 1-18 and Paul A. Volcker, Statement Hain, Publishers, Inc., 1980), pp. 308, 312-314. before the Committee on Banking, Housing, and Urban Affairs, 10. See the statement by C. T. Conover, Comptroller of Currency, U.S. Senate, September 13, 1983. A similar but more general view on establishing a moratorium on nonbank banks, Office of the is presented by a former member of the Securities and Exchange Comptroller of the Currency, May 9,1984. Presently, there are ap­ Commission, Bcvis Longstreth, “In Search of A Safety Net for the plications before the bank regulators for 334 nonbank charters. Financial Services Industry,” Bankers Magazine (July/August 1983), 11. John T. Rose, “Bank Holding Companies as Operational Sin­ pp. 27-34. An opposing view is presented by James L. Pierce, “An gle Entities,” The Bank Holding Company Movement to 1978: A Essay on the Expansion of Banking Powers,” Ch. 2 in Ingo Walter, Compendium (Federal Reserve Board, 1978), pp. 69-93. ed., Deregulating Wall Street: Commercial Bank Penetration of the 12. The issue of centralized control in one operational area- Corporate Securities Market (New York: John Wiley and Sons, funds management—is examined in some detail in Jarratt Robert 1985), and Anthony Saunders, “An Economic Perspective on Bank Devereux, “Central Management of Funds in a Regional Multibank Uniqueness and Corporate Securities Activities,” mimeo (New York Holding Company,” unpublished thesis, Stonier Graduate School University, May 1984), though Saunder’s questioning of the unique­ of Banking, June 1978. Devereux argues that “centralized manage­ ness of banks is considerably more cautious and less sweeping than ment of funds in a regional bank holding company can free assets Pierce’s. for more profitable use; secure the greatest benefit from the assets 2. Samuel Chase and Donn L. Waage, “Corporate Separateness involved; and obtain funds at the lowest cost; thus, improving overall As A Tool of Bank Regulation,” Samuel Chase & Company, for earnings of the holding company” (p. 108). the American Bankers Association, October 1983; and Golembe 13. Section 23A limits a bank’s financial transactions (including Associates, Inc., “Product Expansion by Bank Holding Compa­ loans, extensions of credit, and purchases of assets) with any single nies,” prepared for the Association of Bank Holding Companies, affiliate to no more than 10 percent of the bank’s capita) and sur­ January 1982, p. 27. plus, and with all affiliates combined to no more than 20 percent. 3. Statement by Robert A. Eisenbeis, Hearings Before the Sub­ In addition, the statute requires that all bank loans and extensions committee on Securities of the Committee on Banking, Housing and of credit to affiliates be fully secured. Section 23A was substantially Urban Affairs, 97th Cong., 2nd Sess. (GPO, 1982), pp. 70-84; and amended in 1982, in part to facilitate greater transactions between George A. Kaufman, Edward J. Kane, and Paul M. Horvitz, State­ banks and affiliated units within a holding company. See also John ments Before the Committee on Banking, Housing and Urban Af­ T. Rose and Samuel H. Talley, “The Banking Affiliates Act of 1982: fairs, 98th Cong., 1st Sess. (GPO, 1983), Part II, pp. 893-954. Amendments to Section 23A,” Federal Reserve Bulletin, vol. 68 4. Adolf Berle and Gardner Means, The Modem Corporation (Federal Reserve Board, November 1982), pp. 693-99. and Private Property (New York: MacMillan, 1932); Herbert Si­ 14. William J. Murray, Bank Holding Company Centralization mon, “Theories of Decisionmaking in Economics and Behavioral Policies. Prepared for the Association of Bank Holding Compa­ Science,” American Economic Review, 49 (June 1959), pp. 253-83; nies by Golembe Associates, Inc., February 1979. R. M. Cyert and J. G. March, A Behavioral Theory of the Firm 15. Gary Whalen, “Operational Policies of Multibank Holding (Englewood Cliffs, NJ: Prentice Hall, 1963); and M. C. Jenson and Companies,” Economic Review (Federal Reserve Bank of Cleve­ W. H. Meckling, “Theory of the Firm: Managerial Behavior, Agency land, Winter 1981-82), pp. 20-31. Cost, and Ownership Structure,” Journal of Financial Economics 16. Also, within the last few years several multistate, multibank (October 1976), pp. 305-60. holding companies appear to have increased the integration of their 5. There is some evidence in banking of this difference in objec­ bank subsidiaries by adopting common names and logos for all their tives. See C. Glassman and S. A. Rhoades, “Owner vs. Manager bank units. Examples include the transition of Western Bancorpo- Control Effects on Bank Performance,” Review of Economics and ration to First Interstate Bancorp; Financial General Bankshares, Statistics (May 1980), pp. 263-70. Inc. to First American Bankshares, Inc.; and Northwest Bancor- 6. For interesting insights and a large number of references to poration to Norwest Corporation. this literature, see F. M. Scherer, Industrial Market Structure and Despite the trend toward greater centralization within multibank Economic Performance (Chicago: Rand McNally Publishing Com­ holding companies, integration of subsidiary banks is still less ex­ pany, 1980), pp. 34-41. tensive than that of branch offices of a branch banking system. The 7. J. L.Treynor and F. Black, “Corporate Investment Derisions” evidence on pricing behavior of Florida multioffice banking firms in S. C. Meyers, ed., Modem Development in Financial Manage­ indicates a movement toward more centralized pricing following the ment (New York: Praeger Publishers, 1976), and Y. Amihud and consolidation of multibank holding companies into limited branch B. Lev, “Risk Reduction as a Managerial Motive for Conglomer­ banking systems in the years since Florida liberalized its branching ate Mergers,” Bell Journal of Economics, vol. 12, No. 2, (Autumn law in 1976. See David D. Whitehead, III, “Home Office Pricing: 1981), pp. 605-17. The Evidence from Florida,” Working Papa Series (Federal Reserve 8. For example, Jensen and Meckling view management’s desire Bank of Atlanta, August 1980). to reduce their risk through the firm in terms of agency cost. They 17. Murray, op. cit., p. 4. A recent study of scale economies in note that “If under bankruptcy the shareholders have the right to compliance costs for consumer credit regulations at commercial fire the management, the management will have some incentives to banks reports economies of scale at levels of output up to 375,000 avoid taking actions which increase the probability of this event (even consumer credit accounts, beyond which there are small disecono­ if it is in the best interest of the equity holders) if they (the manage­ mies of scale. (Among the sample banks, those that have 350,000 ment) are earning rents or if they have human capital specialized to 400,000 accounts have total assets between $1.9 billion and $8.0 to the firm or if they face larger adjustment costs in finding new billion.) See Gregory Ellichauscn and Robert Kurtz, “Economies employment.” Jensen and Meckling, op. cit., p. 352. of Scale in the Cost of Complying With the Truth in Lending and 9. A number of studies has concluded that mergers in banking Equal Credit Opportunity Laws,” mimeo (Federal Reserve Board, as well as in other industries do not generally result in as great a February 1984). firm value as would be expected from the union and some found 18. Lucille S. Mayne, “Management Policies of Bank Holding that the stockholders of the acquired firms gain from the acquisi­ Companies and Bank Performance,” Journal of Bank Research, tion while stockholders of the acquiring firm lose. For example, see vol. 7 (Spring 1976), pp. 37-48. Other studies have reported per­ G. J. Benston, “Conglomerate Mergers: Causes, Consequences and formance differences across holding company-affiliated banks that Remedies,” Working Paper No. 7914 (Graduate School of Manage­ are unique to the particular holding company organization. How­ ment, University of Rochester, September 1979); M. Firth, ever, these studies have not attempted to relate such differences to “Takeovers, Shareholder Returns and the Theory of the Firm,” individual holding company characteristics such as the degree of Quarterly Journal of Economics (March 1980), pp. 235*60; T. R. "holding company centralization. See, for example, Arthur G. Ftaas, Piper, “The Economics of Bank Acquisitions by Registered Bank The Performance ofIndividual Bank Holding Companies,Staff Boo- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-15 nomic Studies, 84 (Federal Reserve Board, 1975), and Peter S. Rose nies in the group directly or indirectly has a controlling interest in and William L, Scott, “Heterogeneity in Performance Within Bank other companies.” See Accounting Research Bulletin No. 51, “Con­ Holding Company Sector: Evidence and Implications,’* Journal of solidated Financial Statements” (New York: American Institute of Economics and Business, 36 (February 1984), pp. 1-14. Certified Public Accountants, August 1959). 19. Robert J. Lawrence, Operating Policies of Bank Holding 35. In 1981, the SEC eliminated the requirement for separate, Companies: Part /, Staff Economic Studies, 59 (Federal Reserve complete financial statements for the parent company and now re­ Board, 1971). quires that only condensed financial information about the parent 20. Mayne, op. cit., p. 48. company be presented in the footnotes to a bank holding company's 21. For recent discussions of the different intraorganizatonal consolidated financial statements. effects that may serve to increase the profitability of the consoli­ 36. Peat Marwick and Mitchell & Co., Principles and Presenta­ dated holding company, but which may not be observed at the sub­ tion: Banking, A Review of1982 Annual Reports (July 1983) p. 24. sidiary level, see Larry A. Frieder and Vincent P. Apilado, “Bank 37. D. P. Jacobs, H. P. Beighley and J. H. Boyd, “The Finan­ Holding Company Expansion: A Refocus on its Financial Ration­ cial Structure of Bank Holding Companies,” Association of Re­ ale,’’ Journal of Financial Research, vol. 6 (Spring 1983), pp. 67-81, serve City Bankers, 1975. and John T. Rose and Samuel H. Talley, Financial Transactions 38. Jacobs, Beighley, and Boyd, op. cit., pp. 47-48. Within Bank Holding Companies, Staff Studies, 123 (Federal Re­ 39. Beighley, H. P., “The Risk Perceptions of Bank Holding serve Board, 1983). Company Debtholders,” The Journal of Bank Research (Summer 22. In a 1978 review of the literature dealing with bank holding 1977), pp. 85-93. company affiliation and cost efficiency, Burke concluded that 40. Beighley, op. cit., p. 93. “banks that affiliate with holding companies incur some expense 41. Samuel B. Chase, Jr., “The Bank Holding Company—A Su­ due to costs of centralization. Small unit banks may not achieve perior Device for Expanding Activities?,” in Policies for a More levels of output sufficient to offset these expenses. However, as affili­ Competitive Banking System (Federal Reserve Bank of Boston, ated banks become larger (over $30 million to $40 million in de­ 1972), p. 77. posit size), economies of affiliation enable them to achieve lower 42. Even though the REIT problems have passed. Standard & average costs than independent banks of similar size.” Jim Burke, Poor’s considers the strength of the link between the REIT and “Bank Holding Company Affiliation and Cost Efficiency,” in The its sponsor an important rating consideration. They argue that Bank Holding Company Movement to 1978: A Compendium (Fed­ “... if the REIT bears the sponsor’s name there is a definite eco­ eral Reserve Board, 1978), p. 128. nomic incentive for the sponsor to keep the REIT solvent and avoid 23. Gary Whalen, “Multibank Holding Company Organizational any negative publicity.” SAP, Credit Overview (August 1983), p. 59. Structure and Performance,” Working Paper 8201 (Federal Reserve 43. These examples are taken from “Bank and Bank Holding Bank of Cleveland, March 1982). Company Involvement with Real Estate Investment Trusts,” David 24. Whalen, “Operational Policies of Multibank Holding Com­ C. Hamilton, mimeo (Federal Reserve Board, May 19, 1978). panies,” pp. cit. In this same study, Whalen also examined various 44. There were also some other “technical” problems, primar­ factors that might account for interholding company differences in ily the accounting method I LA used to value its assets. centralization. Using regression analysis, he found the degree of cen­ 45. Wall Street Journal (October 8, 1980), p. 3. tralization to be a function of a number of characteristics of the 46. See press releases from First Chicago Corporation dated April holding company and its subsidiary banks. By contrast, Lawrence 12, 1985 and July 12, 1985. (op. cit.) earlier found no relationship between the extent of cen­ 47. Wall Street Journal (June 18, 1985), p. 8. tralization and various organizational or economic characteristics 48. First Chicago Corporation, Annual Report to Shareholders of the holding company. (1985), pp. 2-3. 25. The valuation ratio is defined as the ratio of the market value 49. Tulsa World (October 21, 1984). of the holding company’s stock to its book value. 50. Tulsa World (October 6, 1984). 26. Gary Whalen, “Holding Company Organizational Form and 51. Tulsa World (October 21, 1984). Efficiency,” Working Paper 8302 (Federal Reserve Bank of Cleve­ 52. Walter Wriston, then Chairman of Citicorp, Hearings Be­ land, July 1983). fore the Senate Committee on Banking, Housing and Urban Affairs, 27. Lucille S. Mayne, “Bank Holding Company Characteristics Part II, 97th Congress, U.S. Government Printing Office (October and the Upstreaming of Bank Funds,” Journal of Money, Credit 29, 1981), pp. 589-90. and Banking, vol. 12 (May 1980), pp. 209-14. 53. A survey of the earliest Board decisions pursuant to section 28. Ibid., p. 214. 3 of the Bank Holding Company Act of 1956 reveals that the Board 29. Lucille S. Mayne, “Funds Transfer Between Bank Holding has always used this approach in its competitive analysis. See, for Companies and Their Affiliates,” Journal of Bank Research, example, Board orders denying the applications by Northwest vol. 11 (Spring 1980), pp. 20-27. Bancorporation, Minneapolis, and Wisconsin Bankshares Corpo­ 30. Rose and Talley, Financial Transactions Within Bank Hold­ ration, Milwaukee, to organize de novo bank subsidiaries. Federal ing Companies, op. cit. Reserve Bulletin, vol. 44 (Federal Reserve Board, January 1958), 31. Amendments to section 23A enacted subsequent to the period pp. 11-12, 15-16. covered in the Rose and Talley study substantially expanded the list 54. See, for example, Board order approving the application by of collateral that banks can accept when lending to affiliates. To United Missouri Bancshares, Inc., Kansas City, to acquire a bank. the extent that this facilitates greater lending by holding company Federal Reserve Bulletin, vol. 64 (Federal Reserve Board, March banks to their nonbank affiliates within the holding company organi­ 1974), pp. 224-226. zation, the flows of funds within bank holding companies in the 55. See Comptroller of the Currency, Annual Report, 1977, S5ff; future may be significantly different from the general patterns ob­ FDIC, Annual Report, 1977, p. 15; and Letter from the Federal served by Rose and Talley. Reserve Board’s Division of Ranking Supervision and Regulation 32. In a typical annual report to shareholders, the identity of in­ to the Officers in Charge of Examinations, Legal and Research dividual bank and nonbank subsidiaries is almost impossible to find. Departments at all Federal Reserve Banks, October 7, 1977 Bank bolding companies generally do not provide any financial data (BHC-127). on individual subsidiaries. 56. For example, Federal Reserve reserve requirements are ap­ 33. See James H. Wooden and Thaddeus W. Paluszek, “Dis­ plied to each bank subsidiary individually. In a regime of gradu­ closure Needs of Financial Analysts: Large Bank Holding Compa­ ated reserve requirements, this means that the total amount of nies,” Economic Review (Federal Reserve Bank of Atlanta, Novem­ reserves required of a multibank holding company is less than if ber 1983), p. 77. all the sister bank subsidiaries were aggregated to a single banking 34. According to the American Institute of Certified Public Ac­ entity. countants, ‘There is a presumption that consolidated statements 57. In December 1969, the Congress specifically authorized the are more meaningful than separate statements and that they are Federal Reserve Board to apply both reserve requirements and in­ Digitized for FRASERu sually necessary for a fair presentation when one of the compa­ terest rate controls to funds received by member banks from the http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C-16 issuance of commercial paper by the bank’s holding company (U.S. proposed a complete redrafting of the statute in 1977, as discussed Code Congressional and Administrative News, 91st. Cong., 1st Sess. later in this section. (1969), vol. 1, pp. 392-400,1472-1473,1521). See also Federal Re­ 73. For a discussion of the heightened interest of the Federal Re­ serve Bulletin, vol. 56 (Federal Reserve Board, January 1970), serve in holding company supervisory policy during this period, see pp. 35-37, 105-106. Carter H. Golembe, “The Supervision and Regulation of Bank 58. Board of Governors of the Federal Reserve System, Annual Holding Companies: An Assessment of Objectives and Implemen­ Report, vol. 57 (1970), pp. 75-76. See also Federal Reserve Bulle­ tation,*’ prepared for the Association of Bank Holding Companies tin, vol. 56 (Federal Reserve Board, August 1970), p. 657. by Golembe Associates, Inc., November 13, 1978, pp. 53-56. See 59. David B. Humphrey and Donald T. Savage, “Bank Use of also Lucille S. Mayne, “New Directions in Bank Holding Company Downstreamed Commercial Paper and the Impact of Reserve Re­ Supervision,*’ Banking Law Journal, vol. 95 (September 1978), quirements in Controlling Liability Usage,** Journal of Economics pp. 729-742. and Business, vol. 33 (Winter 1981), pp. 109-114. 74. Probably the best known case involved Hamilton National 60. Ibid. Bank of Chattanooga, which failed after having purchased a large 61. U.S. Code Congressional Administrative News, 93rd Cong., amount of low-quality mortgages from a mortgage banking sub­ sidiary of the bank’s parent holding company. Recall the discus­ 2nd Sess. (1966), Part I, pp. 1793-1794, and Part II, pp. 6249-6252, sion of these problems in the previous section of this study. 6264-6265. 75. See Board of Governors of the Federal Reserve System, 62. Variably denominated payments instruments include money Annual Report, vol. 64 (1977), pp. 372-373. orders and similar payments instruments, such as cashier’s checks 76. Recent amendments to section 23A are discussed in John T. and certified checks. Rose and Samuel H. Talley, “The Banking Affiliates Act of 1982: 63. See Board Order approving the application by Citicorp., New Amendments to Section 23A,’’ Federal Reserve Bulletin, vol. 68 York, to engage in the activity of issuing and offering on a con­ (Federal Reserve Board, November 1982), pp. 693-699. signment basis general purpose, variably denominated payments in­ 77. See Phil Battey, “CofC Tells Banks Not to Enrich Insiders struments. Federal Reserve Bulletin, vol. 63 (Federal Reserve Board, with Exorbitant Fees,” American Banker (September 11, 1978), p. 1. April 1977), pp. 416-419. 78. Board of Governors of the Federal Reserve System, “Policy 64. See Board Order approving the application by BankAmerica Statement Regarding Intercorporate Income Tax Accounting Trans­ Corporation, San Francisco, to engage de novo in the issuance and actions of Bank Holding Companies and State-Chartered Banks That sale of payments instruments and related activities. Federal Reserve are Members of the Federal Reserve System,” Press Release (Sep­ Bulletin, vol. 70 (Federal Reserve Board, April 1984), p. 364. tember 25, 1978). 65. The discussion in this section focuses on domestic bank hold­ 79. Among the possible diversion of income practices listed by ing companies. Regulation of foreign bank holding companies is the Board are “(1) management or service fees, or other payments much narrower in scope and generally concentrates on the domes­ assessed by the parent company or any affiliated entity and paid tic subsidiaries of those holding companies. by the bank, that bear no reasonable relationship to the fair mar­ 66. Initially, section 23A applied only to banks that were mem­ ket value, cost, volume, or quality of services rendered by the affili­ bers of the Federal Reserve System. However, in 1966, the Con­ ate to the subsidiary bank; (2) balances maintained by the subsidi­ gress amended the Federal Deposit Insurance Act to extend cover­ ary bank primarily in support of parent borrowings without age to insured nonmember banks. appropriate compensation to the bank; (3) prepayment of fees to 67. Digest of Hearings Before a Subcommittee of the Senate Com­ the parent or other nonbank affiliates for services that have not yet mittee on Banking and Currency pursuant to S. Res, 71st Cong., been rendered; and (4) non reimbursed expenses incurred by the bank 3d Sess. (1931); Operation of the National and Federal Reserve Bank­ that primarily support a nonbank activity.” See letter from the ing Systems, p. 1066. Board’s Division of Banking Supervision and Regulation to the Offi­ 68. See Bank Holding Company Act of 1955, Report No. 609, cer in Charge of Examinations at each Federal Reserve Bank, March House Committee on Banking and Currency, 84th Cong., 1st Sess. 19, 1979 (SR-533). (May 20,1955), pp. 17-18; and Control of Bank Holding Compa­ 80. Ibid. nies, Report No. 1095, Senate Committee on Banking and Currency, 81. See Board of Governors of the Federal Reserve System, 84th Cong., 1st Sess. (July 25, 1955), p. 15. Annual Report, vol. 66 (1979), p. 276. 69. “Report under Bank Holding Company Act,” op. cit., p. 793. 82. Two reports issued by the General Accounting Office in 1980 70. Section 5(c) of the Bank Holding Company Act authorizes and 1981 emphasized the integrated nature of the bank holding com­ the Federal Reserve Board to acquire reports from bank holding pany organization and suggested that bank supervisors treat hold­ companies as well as to examine each holding company and each ing company systems as single entities. The GAO offered a number subsidiary thereof. Financial statements for each bank subsidiary of recommendations, including better coordination of supervisory efforts among the three federal bank regulatory agencies. See Comp­ are filed with the bank’s primary federal supervisor. troller General of the United States, Federal Supervision of Bank 71. Board Order approving the application of NCNB Corpora­ Holding Companies Needs Better, More Formalized Coordination, tion, Charlotte, N.C., to acquire a mortgage banking company. Fed­ GGD-80-20, February 12, 1980; and Federal Reserve Could Im­ eral Reserve Bulletin, vol. 48 (Federal Reserve Board, September prove The Efficiency of Bank Holding Company Inspection, 1972), p. 844. To demonstrate its commitment to the principle that GGD-81-79 (August 18, 1981). holding companies should be a source of strength to their subsidi­ 83. Federal Reserve Board, Annual Report (1979), p. 277. See ary banks, the Board has denied applications that it felt were incon­ also Federal Reserve Bulletin, vol. 66 (Federal Reserve Board, Janu­ sistent with this objective, pursuant to section 3(c) of the Bank Hold­ ary 1980), p. 35. ing Company Act, as amended. See, for example, Board Orders 84. See letter from the Board’s Division of Banking Supervision denying the applications by SeOon, Inc., Toledo, Ohio, to acquire and Regulation to the Officer in Charge of Examinations at each a bank holding company, Federal Reserve Bulletin, vol. 48 (Fed­ Federal Reserve Bank, February 1, 1982 (SR 82-6 (FIS)). eral Reserve Board, August 1972), pp. 729-730 and First Lincoln- 85. See Federal Reserve Bulletin, vol. 68 (Federal Reserve Board, wood Corp., Lincolnwood, Illinois, to form a bank holding com­ January 1982), pp. 33-34. See also Federal Reserve Bulletin, vol. 69 pany, Federal Reserve Bulletin, vol. 62 (Federal Reserve Board, (Federal Reserve Board, July 1983 and December 1983), pp. 539-540 February 1976), pp. 153-154. The First Lincolnwood Corp. deci­ and 898. sion was challenged in court but was eventually upheld by the U.S. 86. Samuel H. Talley, Bank Capital Trends and Financing, Staff Supreme Court. (Board of Governors of the Federal Reserve Sys­ Studies 122 (Federal Reserve Board, 1983), p. 16. An exception to tem v. First Lincolnwood Corp., Supreme Court of the United the consolidation rule is that in the case of relatively mall holding States, No. 77-832, December 11, 1978.) companies (consolidated assets under $150 million) the guidelines 72. See Board of Governors of the Federal Reserve System, An­ •pply to the bank only, provided that the company does not en­ nual Report, vol. 59 (1972), p. 200. The same recommendation also gage in any nonbank activity involving significant leverage and that appeared in the Board’s Annual Report for 1973 (p. 237). The Board no significant debt of the parent holding company is held by the Digitized for FRASERm ade no further recommendations regarding section 23A until it general public. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis D-l Bank Earnings and Market Shares 1970 to 1985 This appendix first discusses recent trends in market Measures of market share in the short-term business shares of U.S.-chartered commercial banks, follow­ credit market have become less meaningful as U.S. ing that with an analysis of banking industry profits banks increasingly originate assets for distribution over the past several years. rather than holding the assets in their own portfolios until maturity. A number of money center and regional banks have greatly expanded their sales of participa­ Commercial Banking Market Shares tions in domestic business loans recently, a large por­ tion of which has been to foreign banks. Consequently, As shown in chart 1, U.S. banks* shares of overall if market share were measured in terms of originations credit extended to the household and nonfinancial of short-term credit rather than asset holdings, the business sectors have been well maintained in recent share of U.S. banks would be somewhat higher. years.' Indeed, the share of U.S. commercial banks Since the late 1970s there has been a mild erosion in total credit extended to domestic nonfinancial bus­ in banks' share of household sector debt, but over a inesses has trended up over the past 10 years. By dis­ longer period their share of this sector’s total debt has aggregating a bit further and excluding the debt in­ displayed little trend. One type of household lending curred by farms and nonincorporated businesses from in which the banks’ share had displayed a strong long­ the nonfinancial business sector referred to above, we term uptrend is consumer credit (see top panel of chart find that the share of U.S. commercial banks in total 4). More recently, however, commercial banks have debt of domestic nonfinancial corporations, shown at lost some market share in both consumer credit and the top of chart 2, has risen eiratically over a longer residential mortgage lending, areas in which thrift in­ horizon extending back several decades. Despite all the stitutions have made important inroads. For example, attention paid recently to the phenomenon of securiti­ savings and loan associations have greatly boosted zation, the share of credit obtained by such corpora­ their consumer lending since the Garn-St Germain Act tions through distribution of debt in open markets— expanded their powers in this area. including bank loans sold to nonbanks—actually has Commercial banks’ relative importance in total declined since the late 1970s. A reduction in long-term mortgage lending to all borrowers has continued to obligations has been responsible for this drop, as high grow since the early 1960’s. Flow-of-Funds data, interest rates probably discouraged bond issuance. shown in the bottom panel of chart 4, illustrate the However, at the same time that banks’ share of total ongoing increase in banks' share of real estate backed credit extended to domestic nonfinancial corporations loans. Moreover, the actual market share may be generally has strengthened, their share of short- and understated since these figures exclude bank holdings intermediate-term credit (also shown in chart 2) has of securities backed by mortgage pools, such as those declined, reflecting increased competition from the issued by GNMA and FNMA. commercial paper market and from foreign banks. Banks’ shares of the credit market debt of the two This decline has been most evident at the top nine government sectors depicted in chart 1 have registered money center banks. Their share of a measure of short- significant declines in recent years. Their loss of mar­ and intermediate-term business credit, shown at the ket share in state and local government obligations top of chart 3, has been on a downtrend since the dates from the early 1970s; instead households and mid-1970s. These largest banks have been losing mar­ mutual funds have acquired an increasing proportion ket share while the commercial paper market and U.S. of those obligations. U.S. banks* share, of total credit agencies and branches of foreign banks, displayed at market claims on the federal government has been on the bottom of chart 3, have increased in importance. the decline for several decades. In'regent years, the Although U.S. chartered banks other than the nine most rapid growth in holdings of Treasury securities largest, shown in the second panel of the chart, had has occurred in the portfolios of other private finan­ also lost market share, during recent years they have cial institutions, and state and local governments; in regained a portion of those losses.2 dollar toms, both groups’ holdings have risen more than five-fold since the end of the 1970s. The decline in hanks’ share of borrowings by all Digitized for FRASER levels of government accounts for the entire reduction This paper was prepared by Board staff. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis D-2 in banks’ share of total credit extended to all domes­ which in any case was milder than that of the other tic nonfinancial sectors that has occurred since the large banks—but it also lifts their 1985 return on as­ mid-1970s. As noted earlier, over longer periods of sets significantly. The bottom panel of chart 7 also in­ time commercial banks have maintained or increased cludes the unadjusted figures for the nine money cen­ their share of credit extended to nongovernmental ter banks. Their average return on assets, which earlier borrowers. had displayed only a mild down trend, dropped by an In the market for retail deposits, U.S. commercial eighth last year. A modest improvement in their net banks have regained the share that they had lost dur­ interest margin and strong growth in noninterest in­ ing the high interest rate era of the 1970s and early come in recent years have been insufficient to offset 1980s. As shown in chart S, since the introduction of the need to raise loan-loss provisions. of money market deposit accounts in December 1982, These divergent moves in profitability at the top banks’ proportion of retail nontransaction accounts money center banks and at other large banks are also has risen sharply to exceed its 1970 peak as the inroads apparent in the results of the parent bank holding com­ that have been made by money market mutual funds panies. Chart 8 displays the average return on assets have ultimately come entirely at the expense of thrift at the ten largest bank holding companies and at the institutions. next forty, with last year’s downturn at the money cen­ ter banks and upturn at other large banks mirrored there. Commercial Bank Profitability The upturn in overall banking industry profitabil­ ity in 1985 occurred despite continued rapid growth The profitability of insured commercial banks turned in loan-loss provisions. These provisions represent cur­ higher last year, offsetting a portion of the persistent rent revenues that commercial banks have diverted decline during the early 1980s that had dragged profit­ from profits in order to raise or replenish their reserves ability down from near post-war peaks. As shown in for loan losses. The loan-loss reserve, in turn, is a chart 6, over the five years to 1984, the industry’s re­ balance-sheet item that must be maintained at a level turn on assets fell by one fifth and its average return adequate to absorb anticipated losses, and it may not on equity dropped by a quarter—both to their lowest be allowed to dip below zero when bad loans are levels since at least 1970, the first year for which pre­ charged off against it. Recent experience with loan- cisely comparable data are available. This downturn loss provisions has shown them to be closely related was, however, exaggerated by the earnings shortfalls to same-year charge-offs of loans. And charge-offs, suffered by a handful of large banks, which continued which had generally been related to the cyclical posi­ to depress the industry’s results somewhat in 1985. tion of the economy, have risen steadily so far in the Earnings excluding these selected banks are also plot­ 1980s. ted in chart 6—by the lines punctuated with circles— Burgeoning loan losses more than accounted for the and show the rest of the industry experiencing a milder decline in commercial bank profitability between 1980 initial decline in returns and a more sustained rebound and 1984; the aggregate return on assets dropped by recently. 0.16 percentage point and loan-loss provisions rose by Last- year’s improvement in banking industry about double that amount over those five years. And profitability stemmed entirely from a substantial rise in 1985, loan losses continued to grow unabated even in profits at one size class of banks. As shown in the as profitability turned higher. At this stage of the busi­ third panel of chart 7, large banks, excluding the top ness cycle, the continued increase in charge-offs—and nine money center banks, scored such a sizable increase consequently in additions to loan-toss reserves—is very in profitability last year that their average return on unusual. Loan quality tends to improve with a con­ assets ended up well above its 1979 level. This group siderable lag after a cyclical downturn, but the lag this of banks registered an especially large increase in in­ time appears to have been compounded by the effect terest margins last year, benefiting from lower mar­ on borrowers of a number of factors, such as the ket interest rates, which also prompted the recogni­ severity of the last recession, large changes in the dol­ tion of gains on securities from investment portfolios. lar’s foreign exchange value, the uneven nature of the Deleting selected banks that have experienced earnings recovery, and the declines in inflation rates of the last difficulties does not appreciably change the 1985 fig­ several years. Certainly, declining commodity prices ure for average return on assets of these large banks, have been a significant factor in losses on credits ex­ but, as shown in the third panel of chart 7, it does elim­ tended to the agriculture, energy, and other primary inate much of the earlier decline. goods industries. In addition, the deregulation of Making a similar adjustment to the figures for the several important U.S. industries caused some painful nine money center banks, shown in the bottom panel restructurings during this period, as firms adapted with of that chart, not only eliminates the earlier decline— greater or lesser success to the changed environment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis D-3 Loan-loss provisions by size of bank are shown in to regain its share of the retail deposit-type market and chart 9.J The inverse relationship in recent years be­ allowed a number of commercial banks to reduce their tween these additions to reserves and the profitability reliance on more expensive, wholesale money. measures in chart 7 are quite clear. The sustained Also shown in chart 10, the industry's negative upward trend in loan-loss provisions at the smallest noninterest margin (excluding loan-loss provisons) banks and the corresponding slide in their return on changed little on balance over, the early 1980s. Around assets in the 1980s (shown in the top panels of charts 1979, both noninterest income and noninterest ex­ 9 and 7, respectively) represent probably the most ob­ pense, shown separately in chart 11, began to acceler­ vious example, since larger banks were able to offset ate, but at approximately equal rates, leaving the mar­ the impact of loan losses to various extents by widen­ gin unchanged. The recent rapid growth of noninterest ing their interest margins and boosting noninterest in­ income can be traced in large part to increased fee in­ come more than noninterest expenses. Thus, shown come. As bankers have “unbundled” financial ser­ in chart 7, the small banks suffered a far sharper vices, a process probably hastened by deregulation, profitability downturn in the first half of this decade they have increasingly charged explicitly for services. than did other banks. But this outsized decline simply Service charges on deposit accounts have risen, becom­ brought them into line with other groups, since small ing an important source of income, especially at banks had traditionally recorded the highest return on smaller banks. In addition, banks have expanded their assets. menu of financial products, earning more from such While even nonagricultural small banks posted a de­ off-balance-sheet items as loan participations, interest cline in profitability well in excess of that for the whole rate swaps, and credit enhancement (primarily through industry, part of the recent problems at small banks the issuance of standby letters of credit). Profits from is no doubt due to their heavier concentration in agri­ trading account activities and foreign exchange trans­ cultural lending. Taking just those small banks which actions have also contributed to the growth of nonin­ have relatively large amounts of agricultural loans on terest income. their books, we find that their return on assets dropped Noninterest expenses were likely boosted by these from a very profitable 1.28 percent in 1979 to 0.74 in efforts to capture fee income, as specialized person­ 1984 and 0.57 percent in 1985. Agricultural banks are nel and equipment were necessary to handle new finan­ also appearing more often on the lists of banks that cial products. Wage and salary expenditures were have failed. Bank failures in general have soared re­ responsible for a good portion of the overall increase cently, to 50-year highs, but of the 118 insured com­ in expenses. The undifferentiated “other noninterest mercial bank failures last year, 68—or more than one- expense” on the banking Report of Income also rose half—were agricultural banks. significantly, and although no direct data are avail­ Unlike the small banks, medium-sized banks, with able, it is likely that this reflects increased promotion total assets between $100 million and $1 billion, did of new consumer accounts over the period, as well as not experience an uninterrupted deterioration in stepped-up marketing, automation, and new product profitability in the 1980s. As shown in chart 7, the development in general. average return on assets at these banks dipped in 1981 As shown in chart 12, the Standard and Poor stock and 1982, but then stabilized. Their continued increase index for ten large banks outside New York, which is in loan losses thereafter was balanced by a successful heavily weighted with banks experiencing earnings effort to hold down other noninterest expenses and, shortfalls in recent years, has not fully recovered from in 1985, significant gains on securities sold from in­ its early-1984 decline. But other bank stock indexes vestment portfolios. have performed as well as, or better than, broader For the banking industry as a whole, the increase stock market indicators thus far this decade. The Stan­ in loan-loss provisions so far in the 1980s has been dard and Poor index for six large New York City offset to an extent by a widening of the margin be­ banks, although dipping in response to international tween interest income and interest expense. This grow­ credit problems, has exceeded the Standard and Poor ing net interest margin, displayed in the top panel of 500 since the end of 1985. The even more dramatic rise chart 10, suggests that the removal of regulatory-ceil­ shown for the NASDAQ index of 100 regional bank ings on deposit interest rates did not have a direct nega­ stocks over the last three years no doubt reflects their tive effect on aggregate profitability, or that any nega­ underlying earnings strength. In general, financial mar­ tive effect was offset fortuitously by other factors. kets appear to have been very receptive to U.S. com­ Deposit rate deregulation raised the cost of many re­ mercial banks' efforts to bolster their capital positions tail deposits, but it also allowed the banking industry in recent years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis D-4 Footnotes 3. The steep upturn in loan-loss provisions in the early 1980s was spread across all size classes of banks. Unlike the 1973 to 1975 period, in which loan-loss increases were more prevalent at larger banks, 1. Data are from Flow of Funds and, hence, market shares are after the latest recession the smallest banks (those with under $100 for commercial banks and the commercial banking activities of bank million in assets) saw as large a rise in loan-loss provisions as did holding companies; Flow-of-Funds data for nonbank subsidiaries the nine money center banks. Indeed, the sharp increase at the money are allocated to other financial sectors. center banks during the recent period was not much out of line with 2. Among this group of other U.S. banks, large banks (exclud­ the hike in provisions during the earlier episode; loan-loss provi­ ing the top nine) have registered a sustained increase in their share sions at those banks in 1985 were on average just above their 1975 of short- and intermediate-term business credit over the past decade level (see chart 9). It is the experience of the other groups of banks and a half. that sets the recent period apart. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis srotceS lalcnanifnoN citsemoD ot dednetxE tiderC fo erahS ’sknaB .S.U in 8 CM CoD> h- a> CM CD oC>D CM $ £ CM in CD .sdnuF fo wolF :ecruoS Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 2 U.S. Banks’ Share of Credit Extended to Domestic Nonfinanciai Corporations TOTAL1 Percent SHORT- AND INTERMEDIATE-TERM 2 Percent 1 2 1. US. chartered commercial bank holdings of total loans, Including those backed by real estate, extended to nonfinanciai cor­ porations, plus their holdings of short- and long-term securities Issued by those corporations, all as a share of the total credit market debt of the domestic nonfinanciai corporate sector. 2. US. banks' holdings of nonmortgage loans and short-term paper issued by nonfinanciai corporations as a share of nonfinanciai Digitized for FRASER corporations' total nonmortgage loans phis short-term paper outstanding. http://fraser.stlouisfed.org/ Federal Reserve Bank oSf oSut.r cLeo: uFislour of Funds. Chart 3 Shares of Short- and Intermediate-Term Business Credit1 MONEY CENTER BANKS Perct 26 22 18 14 ant 68 64 60 56 ant 12 8 4 I l l l J___I___I___I___I___I___I___I___l 0 OMMERCIAL PAPER Percient 16 12 8 4 Digitized for FRASER 1 Commercial and Industrial loans and commercial paper Issued by nonfinanclal businesses. http://fraser.stlouisfed.Soorgur/ ce: Report of Condition and Income, and Bank Credit data. Federal Reserve Bank of St. Louis Chart 4 Commercial Bank Share of Selected Credit Markets CONSUMER CREDIT Percent TOTAL MORTGAGE CREDIT Percent Source: Flow of Funds. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1stnuoccA snoitcasnartnoN liateR fo erahS ’sknaB .S.U if> O) o $ n- a> © o> in <D o> m $ .serahs dnuf lautum tekram yenom dna snoitutitsnI yrotisoped lla ta stisoped emit llams dna sgnivas sa denifed era stnuocca snoitcasnartnon liateR .1 .sdnuF fo wolF :ecruoS Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis sexaT retfa emocnI teN sknaB laicremmoC derusnI IW f mm. i i E 3 1 C at 1 1 1 I s I 25 ? I o e 11 i______ i______ i______ i___:___ i______ 1 i is £ 8 S Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 7 Return on Assets Insured Commercial Banks (By Size of Bank) 1. Excluding four banks that sustained significant samings shortfalls in 1963,1964, or 1665. Digitized for FRASER http://fraser.stlouisfed2..o rEgx/ cluding two banks that sustained significant samings shortfalls in 1963,1964, or 1965. Federal Reserve Bank of St. Louis 8 trahC stessA no nruteR seinapmoC gnidloH knaB tsegraL I________1________l________l________l .seinapmoC gnidloH knaB eht fo stroper launna dehsilbup dna )9-Y mroF( tnemelppuS laicnaniF ynapmoC gnidloH knaB :ecruoS Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 9 Loan Loss Provision Insured Commercial Banks (By Size of Bank) 9 MONEY CENTER Percent Digitized for FRASER1 . Excluding four banks, that sustained significant earnings shortfalls m 1963,1984, or 1965. http://fraser.stlouisfed.org/ 2. Excluding two banks that sustained significant earnings shortfalls In 1983,1964, or 1965. Federal Reserve Bank of St. Louis Chart 10 Components of Net Income Insured Commercial Banks NET INTEREST MARGIN Percent of assets 1. Excluding loan-kwa provision. Digitized for FRASER http://fraser.stlouisfed.orSgo/ urce: Rsport of Condition and Incoma. Federal Reserve Bank of St. Louis Chart 11 Components of Noninterest Margin Insured Commercial Banks NONINTEREST INCOME Percent of assets Sourer. Report of Condition and Income. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 trahC sexednI kcotS detceleS fo sleveL 8 8 8 T* CM s I .gnidnatstuo serahs yb dethgiew ,ytiC kroY weN adlstuo sknab sgral nat dna sknab ytiC kroY woN xis fo sexednI P&8 .1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis E-l Payment System Risk This appendix will discuss the mechanics of the oper­ tlements, particularly those involving private large dol­ ation of the payments system and the risks that arise lar wire systems where transactions are settled after from depository institutions’ use of the payments sys­ they occur. These settlements raise the specter of a tem. It will also address the special risks that arise due failure to settle requiring the reversal of numerous to depository institutions’ processing of payments on payments and thereby affecting a large number of behalf of their affiliates and the inadequacy of cur­ transactions and potentially the solvency of other rent controls in dealing with these risks. Finally, it will institutions. discuss how depository institutions* use of Federal Re­ The Federal Reserve must balance risks to the Fed­ serve payments services can, in effect, provide non- eral Reserve against its responsibility to insure orderly depository institution affiliates of the depository in­ markets and the smooth and safe flow of funds stitutions with access to the discount window. through the payments system. For example, although Depository institutions using Federal Reserve pay­ the Federal Reserve could seek to avoid risks by refus­ ment services create certain risks to the Federal Reserve ing to process certain payments, if such a refusal is and to other users of Federal Reserve payments apparent to the markets it could suggest that the Fed­ services because of the potential for a failure of an in­ eral Reserve will no longer extend credit to the insti­ stitution before its payments are settled. Some of these tution. Such a market perception could trigger a loss risks arise because payments transactions may result in confidence in the institution. A refusal to process in final and irrevocable debits to depository institu­ payments for an institution could also trigger prob­ tions’ accounts either before the Federal Reserve can lems in other depository institutions in the case of net determine whether the institution whose account is to settlements, particularly settlements for large dollar be debited has sufficient funds in its account to cover transfer systems. In order to avoid these problems, the the debit or the institution can post adequate collateral Federal Reserve may wish to process payments result­ at the discount window to cover any deficiency in the ing in overdrafts but with the expectation that they will account. be covered at the end of the day by adequately secured This type of risk is most acute in the case of Fed- discount window loans. In order to fully appreciate wire funds transfers where large volumes of high dol­ these risks, it is necessary to examine the mechanics lar transactions are initiated by depository institutions of the individual payment systems. with on-line computer or terminal links to the Reserve Banks. These transactions are final and irrevocable when made. Similarly, book-entry government secu­ Funds Transfer rities transfers against payment involve a large volume of high dollar on-line funds and securities transfers. In processing funds transfers on Fedwire, Federal Although book-entry government securities transfers Reserve Banks transfer funds on the order of the trans­ are technically reversible, they may not be reversible feror depository institution from its account at a Fed­ in practice in the event of a bank failure because of eral Reserve Bank to the account of the transferee the inter-relationships of these transactions in the depository'institution at a Federal Reserve Bank. Un­ government securities market. Other types of trans­ der Board regulations, the payment is final when the actions such as payments by check and automated funds are transferred to the account of the transferee clearing house also pose risks although generally these risks are currently less significant, either because the depository institution or when a Reserve Bank advises dollar volume is currently low (ACH) or because the the transferee depository institution of the credit to transactions are reversible (checks). its account. Funds transfers are generally large dollar In addition to risks arising from individual trans­ transfers and have the highest potential risk. On an actions, significant systemic risks arise from net set- average day, depository institutions send 181,000 Fed­ wire funds transfers with a total value of S435 billion and an average size of $2.4 million. Ninety-nine per­ cent of these transactions are on-line, Le., are initiated Thu paper was prepared by Oliver I. Ireland, Associate Oeoeral at terminals or computers at depository institutions r’ntmMii for Monetary and Reserve Bank Affairs in the Federal linked to Federal Reserve Bank computers. Reserve Board's Legal Division. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis E-2 The institution sending a funds transfer on behalf the Federal Reserve in 1985. Daily overdrafts from of its customer is at risk if the customer does not have book-entry transfers also exceed $40 billion. collected funds in its account to cover the transfer at There is risk to the Federal Reserve in book-entry the time the transfer is made. The sending institution security transfers that the transferee depository insti­ is committed on a Fedwire funds transfer when it is tution does not have sufficient funds in its reserve ac­ sent; the institution does not have a right to retract count to cover the amount of securities being pur­ the transaction if the customer is unable to cover the chased, and will be unable to cover the amount of the transfer by the end of day. transfer in its reserve account by the end of the day. On a Fedwire funds transfer there is a risk to the To a great extent, the Federal Reserve relies on the in­ Federal Reserve that the sending bank will be unable stitution receiving the transfer to police its customers’ to cover the transfer in its reserve or clearing account activity. While the Federal Reserve could attempt to at the end of the day. During the day, an institution take a security interest in these securities, it might not could overdraft its account by millions, or even bil­ be able to obtain a perfected security interest because . lions, of dollars. Fedwire funds transfer overdrafts ex­ of conflicting interests of customers of the transferee depository institution who have paid that institution ceed $40 billion per day. The sender net debit caps for the purchased securities. Assuming that the Fed­ established by the Board as part of its Policy State­ eral Reserve could perfect a security interest in the ment Regarding Reduction of Risks on Large-Dollar securities, it still would be exposed to a market risk Transfer Systems are designed to address this risk. A that the selling price of the securities would be less than depository institution’s board of directors must review the “purchase” price. the institution’s ability to control, monitor and evalu­ For example, when the Bank of New York had com­ ate its daylight overdraft exposure and evaluate the in­ puter problems in November of 1985, the Federal Re­ stitution’s creditworthiness before the institution may serve was able to make a loan of $22.6 billion to that incur daylight overdrafts on Fedwire. The Federal Re­ bank to carry it through until the computer problem serve monitors the depository institutions’ position ex was repaired. Although at the time that the loan was post and counsels those that exceed their cap. Current made, the Federal Reserve Bank of New York was not capabilities do not permit real time monitoring of all able to determine the proportion of the securities in institutions’ accounts. Consequently, generally only which it could obtain a perfected security interest, it financially troubled institutions are monitored on a was able to secure the loan with $13 billion of other real time basis so that overdrafts can be prevented be­ assets as well as the purchased securities that had fore they occur. The Federal Reserve controls its risk created the overdraft. Such “other assets” may not be with respect to other institutions by keeping track of available in the case of an institution created solely to their overall condition. obtain access to the book-entry system for an affiliate. There is no risk to receiving institutions on Fedwire The transferee depository institution would be ex­ funds transfers since the Federal Reserve provides im­ posed to similar risks if its customer purchasing the mediate finality for these transfers. securities cannot cover the amount of the transaction. A diagram of a funds transfer is set forth in Attach­ First, the security interest in the securities may not be ment A. perfected, and second, if the interest is perfected, the securities may be sold at a price less than the transfer amount. Book-Entry Government Securities Transfers The Board did not include book-entry overdrafts in the risk reduction program that became effective in In book-entry government securities transfers over March of this year because of concerns about poten­ Fedwire, transfers of securities are generally initiated tial impacts on the government securities market. The by a depository institution representing a seller of secu­ Board expects to consider new proposals to bring rities. The securities are transferred from the book-entry government securities overdrafts within the transferor-seller depository institution to the account ambit of this policy this summer. A diagram of a book- of the transferee depository institution acting on be­ entry securities transfer is set forth in Attachment B. half of the buyer. The transferee depository institu­ tion’s funds account is debited in the amount of the sale and the transferor institution’s funds account is Automated Clearing House (ACH) Transactions credited. If the transferee has insufficient funds in its account, a daylight overdraft occurs. A transferee ACH transactions include both credit and debit trans­ depository institution may reverse erroneous transfers. actions. In credit transactions, on the order of an Approximately $47 trillion in securities wereirans- originating depository institution, funds are trans­ ferred in eight million book-entry transactions through ferred from the originating depository institution’s ac- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis E-3 count to the account of a receiving depository institu­ ter, it is unlikely that the Federal Reserve would re­ tion. These transfers are processed in batches and the verse ACH credit entries on the settlement day. payment information is distributed prior to a settle­ Risks to an institution originating ACH debits arise ment date. ACH credit transfers are generally treated when it makes funds available to the payee before it as final at the opening of business on the settlement is assured that the debit transfers will not be returned. date; however, a Reserve Bank may be able to reverse The likelihood of a loss to the Federal Reserve on debit such transfers up until the time that they are posted transfers is relatively small. When the Federal Reserve on the settlement date. 'ACH debit transfers involve delivers ACH debits to the receiving institution, it debits to the receiving depository institution’s account debits the reserve or clearing account of the receiving that are initiated by the originating depository insti­ institution, and credits the account of the originating tution. The receiving depository institution has until institution. If.the receiving institution returns some of midnight of the banking day following the settlement the debit items, the Federal Reserve would credit the day to reject any such debits. receiving institution for the amount of the returned ACH transactions account for only a very small items, and debit the account of the institution that fraction of the total dollar value of interbank funds originated the items. If the return items were destined transfers. The ACH is primarily a small dollar pay­ to an institution that had failed subsequent to its origi­ ments mechanism although, increasingly, large dollar nation of the debit transfers, the Federal Reserve payments are made through it, and the aggregate would be at risk for the amount of the return items amount of a credit or debit ACH Hie originated by destined to the failed institution. an institution’s corporate customer can be quite sig­ There is no appreciable risk to the institution receiv­ nificant. The Board is concerned about the increase ing ACH debit items. The receiving institution has in large dollar payments, particularly debits, over the until midnight of the next banking day to return an ACH and is evaluating the increased risk implications ACH debit. Thus, its only risk lies in failing to return of these transactions. In 1985, the Federal Reserve on a timely basis an ACH debit that cannot be posted. processed 283 million commercial ACH transactions Diagrams of ACH credit and debit transactions are valued at $1.8 trillion. set forth in Attachment C. The risks to the depository institutions initiating ACH credit transactions are conceptually similar to those for Fedwire funds transfers. Although the dol­ Checks lar risk on ACH is typically lower than in Fedwire funds transfers, the temporal risk is greater. ACH Checks are the most common form of payment in this credit payments are submitted and processed one or country, with the exception of cash. Forty billion two days prior to settlement, and the exposure to the checks are written annually, with an estimated value originating institution extends from this time until the of $36 trillion dollars. The Federal Reserve processed account of the originating customer is funded to cover approximately 16 billion checks in 1985. the transfers... , ■ ‘ The depository institution receiving a check is at risk The Federal Reserve’s risk from ACH credit pay­ if it makes funds available to its depositor before suffi­ ments begins on the opening of business on settlement cient time has elapsed to be relatively sure that the day, and stems from the possibility that the sending checks deposited will not be returned. This risk could bank may be unable to cover the transfers in its re­ be significant in the case of large dollar checks used serve account at the end of the day. to transfer corporate account balances between deposi­ The receiver of ACH credit transfers processed by tory institutions for cash management purposes. The the Federal Reserve is at risk if the originator of the risk to the Federal Reserve arises where it is holding transfers fails on the settlement day and the Federal return items destined to a payor institution that has Reserve is unable to debit the originating institution’s failed. The Federal Reserve would have a claim on the account for the amount of the transfers. In this situa­ assets of the faded institution and could pursue the tion, the Federal Reserve reserves the right to reverse drawer of the check. However, in certain cases, such the credit entries, debiting the receiving institution's as where a depository institution processes a large dol­ account, until the end of the settlement day. The Na­ lar volume of checks deposited by a customer that has tional Automated Clearing House Association guide­ also failed and the failure of the customer has caused lines strongly urge institutions to make credit entries the drawers of the checks to stop payment on them, available to depositors at the opening of business on these risks may be substantial and such remedies may settlement date. Thus, the receiving institution is at risk not be available. Generally the risks to the payor in­ to the extent that it is unable to recover the funds from stitution relate primarily to its failure to properly dis­ Digitized for FRASER th e depositors receiving the credits. As a practical mat­ honor or pay an item. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis E-4 A diagram of a check collection transaction is set dependent credit judgment concerning overdrafts in­ forth in Attachment D. itiated by their affiliates as they do on their unaffiliated commercial customers. In the case of payments serv­ ices provided by depository institutions for their un­ Net Settlements affiliated customers, institutions generally review the credit risk associated with providing these services and The Federal Reserve is also at risk on private funds generally monitor at least some of their accounts. A transfer networks or other private payments systems review of institutions’ practices indicates a variety of for which it settles. Further, these systems generate sys­ approaches to monitoring their own customers, rang­ temic risks for their participants. These systems range ing from monitoring all corporate customers, monitor­ from large dollar wire transfer systems such as CHIPS ing on-line customers, monitoring large transactions to local check clearing house exchanges. In such sys­ or monitoring customers with deteriorating credit qual­ tems, payments messages or checks are transferred be­ ity. The Board’s daylight overdraft policy requires tween institutions during the day and the Federal Re­ depository institutions to be in a position to monitor serve settles these payments at the end of the day with and control their customers’ overdraft positions. The a single net entry to each institution’s account. If one Reserve Bank processing the payment may, in turn, of the participants on a private payments system were make an evaluation of the institution making the pay­ unable to settle its net debit position at the end of day, ment. In the case of troubled institutions, Reserve the settlement would be recast without the transfers Banks may make individual decisions on a case-by-case of that participant. This may worsen the financial po­ basis as to whether to process payments for such in­ sition of other participants. An institution in a net stitutions. These decisions are based on the balance credit position before the settlement was recast could in the institution’s account, the availability of collateral find itself in a net debit position. On a large dollar wire to cover any overdrafts, supervisory materials, includ­ system, the debit position could be far in excess of its ing examination materials on the institution and its capital in the recomputed settlement, triggering the in­ affiliates, as well as additional market factors bear­ stitution’s inability to settle. Thus, a failure to settle ing on any potential decision not to process a particu­ by one institution could result in a systemic chain reac­ lar payment. tion of failures by other network participants. The There are practical reasons to conclude that a Federal Reserve could be forced to "rescue” the set­ depository institution will not apply such controls to tlement through a discount window loan to reduce the their affiliates or will disregard them when processing systemic risk that the failure of one institution to set­ payments on behalf of its affiliate. There is no reason tle would jeopardize the financial positions of other to believe that depository institutions processing pay­ network participants. Daily CHIPS overdrafts of ap­ ments for their affiliates are any less subject to undue proximately $35 to $45 billion reflect the extent of this influence by the affiliate in processing such payments risk. than they are in extensions of credit and other trans­ Finally, there is risk to the receiver of a funds trans­ actions that Congress has specifically limited under fer that is sent over a private wire network. Funds sent section 23A of the Federal Reserve Act and other on a private wire network do not become final until legislation. the end of the day. If a sending bank were unable to Second, the affiliate may take advantage of its rela­ settle, the receiving bank is at risk if funds sent by the tionship with the depository institution in order to ob­ failed bank are withdrawn by the payee and not reco­ tain credit from the institution for itself or its cus­ vered. To reduce and control the risk to receiving in­ tomers contrary to safe and sound lending policies. stitutions, the Board has called on participants in pri­ Such abuses are particularly likely in times of finan­ vate networks to establish bilateral credit limits, to cial stress on the affiliate when an affiliate may force limit the potential exposure a receiving institution has credit extensions by overdrafting the depository insti­ against each sending institution, and network sender tution’s account. These abuses may threaten the safety net debit caps applicable to each network in order to and soundness of the depository institution and may limit the maximum overdrafts on such systems by in­ precipitate its failure. dividual institutions. Third, risks to depository institutions and, through them, to the payments system are increased by the Fed­ eral Reserve’s lack of familiarity with some depository Relations with Affiliates institution affiliates. Where depository institutions are affiliated with companies that are not subject to the Payment system risks may be increased by depository same level of scrutiny as bank holding companies, the institutions dealings with their affiliates. First, it is un­ company may fail with little prior notice to the Fed­ Digitized for FRASERli kely that a depository institution will make an in­ eral Reserve. The company’s failure may, in turn, http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis E-5 precipitate the failure of the depository institution and ments while the status of the account was checked and attendant effects on the payments system. The lack of manually updated. prior notice makes it more difficult for the Federal Re­ Second, the implementation of real time monitor­ serve to arrange to monitor the institution’s account ing would inevitably result in the rejection or delay of on a real time basis or to evaluate collateral offered funds transfers that would be discemable by the mar­ at the discount window in order to obtain adequate kets and might precipitate problems for the institution, funds to cover the institution’s payments until it can or its affiliates, whose transfers were delayed or be closed or sold in an orderly fashion. stopped. Thus, while solving the problem of the risk created by an individual transaction, real time monitoring creates the potentially greater problem of Inadequacy of Current Controls loss of confidence in monitored institutions and injects an element of instability into the markets. Current statutes and procedures do not adequately Third, real time monitoring would not address the address the risks arising from relations with affiliates. issue of book-entry securities overdrafts because they Section 23A of the Federal Reserve Act, which limits are not subject to overdraft caps. Even if such caps transactions between insured banks and their affiliates, were established, rejection of those transactions des: and similar provisions applicable to federally insured tined for a buying-receiving institution would be im­ mediately apparent to the selling-sending depository thrift institutions, have not been interpreted to apply institution. to daylight overdrafts. Further, section 23A does not In sum, regulatory controls on the relationship be­ apply to provision of immediate credit for checks in tween a depository institution and its affiliate either the process of collection or extension of credit to the extent that they are secured by government securities provide illusory protection, e.g., an extension of sec­ tion 23A to cover overdrafts, or, as in the case of re­ as may be the case in book-entry securities overdrafts jection or delay of transfers, while solving certain by an affiliate. Further, section 23A is only enforced problems such as the risk from the rejected or delayed on an ex post basis and cannot prevent transactions, transaction, creates greater problems in terms of loss such as overdrafts, that threaten the safety and sound­ of confidence in the payments system. The risks ness of an institution before they happen even if it were created by affiliate relationships are most effectively interpreted to apply to such overdrafts. addressed by restricting the potential relationships that Similarly, the current daylight overdraft risk reduc­ arise to those that are subject to ongoing supervision tion program, which is based on caps enforced through and regulation that will provide prior notice of de­ ex post monitoring, does not address the problem of veloping problems and permit regulatory limitations overdrafts occurring in times of financial stress on the to be tailored to the individual situation. affiliate. At such times, the affiliate may prevail on the depository institution to make transfers in excess of its caps, which the affiliate is unable to cover. It Discount Window Issues is such transfers that are the essence of the risks presented by the institution’s use of Federal Reserve A loan to a depository institution to cover overdrafts services and it is such transfers that ex post monitor­ of an affiliate, as might occur where a depository in­ ing is powerless to control. stitution is established primarily to serve the payments Real time monitoring of a depository institution’s needs of its affiliates, is in effect a loan to the non­ accounts and rejection or delay of transactions that depository institution affiliate. Under section 13 of the would create overdrafts would address the problem of Federal Reserve Act, loans to nondepository institu­ overdrafts in times of stress, but even real time tions such as individuals, partnerships and corpora­ monitoring has a number of shortcomings. First, only tions on the security of collateral other than United three Reserve Banks have automated real time moni­ States Government and agency securities can only be toring systems in place. The other Reserve Banks rely made in unusual and exigent circumstances and require on manual systems. An automated system is generally an affirmative vote of five members of the Board. necessary to process a large volume of payments. All Regulation A further specifies that such loans should the Reserve Banks are scheduled to have an automated only be made where failure to do so will adversely capability by March of 1987. Until the automated affect the economy (12 C.F.R. (201.3(c)). No loans monitoring arrangements are in place at all Reserve have been made under this authority since the 1930s. Banks, real time monitoring in some Reserve Banks For example, an affiliate may purchase book-entry would require that all funds and book-entry securities govenment securities and incur an overdraft at its ac­ transfers be processed on an off-line, or manual, basis. count at the depository institution. This overdraft may Such off-line processing could substantially delay pay­ result in an overdraft at the depository institution’s Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis E-6 account at a Federal Reserve Bank. If the Reserve affiliate. The ready extension of credit to nondeposi­ Bark must ultimately cover the overdraft with a dis­ tory institutions through affiliated banks is contrary count window loan to the depository institution, the to longstanding Congressional policy and would seri­ Reserve Bank has effectively extended credit to the ously distort the purposes of Federal Reserve credit. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ATTACHMENT A FUNDS TRANSFER Risk to sending bank * Risk that customer sending transfer will not have sufficient funds to pay for the transaction. Risk to Federal Reserve * On a Fedwire transfer, risk that the sending bank will be unable to cover transfer in its reserve account. * $40 billion in daylight overdrafts per day. * Fed could be forced to "rescue" settlement of provate network through discount window accommodation. Risk to receiving bank • On a private network, risk that sending bank will be unable to settle at end of day and funds made available to payee might not be recovered. Funds flow Payments instructions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ATTACHMENT B BOOK ENTRY SECURITIES Risk to Federal Reserve • Risk that there may not be a perfected security interest in the securities being transferred, and the security purchaser's bank cannot cover the amount of securities being purchased. * Assuming a perfected security interest in the securities, and the securities purchaser's bank's inability to cover, there is a risk that the selling price of the securities would be less than the "purchase" price, (market risk). ° $40 billion in daylight overdrafts per day. Risk to securities purchaser's bank * Risk that there may not be a perfected security interest in the securities being transferred, and the purchaser of the securities cannot cover the amount of securities being purchased. * Assuming a perfected security interest in the securities, and the securities purchaser's inability to cover, interest rate risk that the securities could sell for less than the amount of the transfer. Funds flow * Securities flow Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ATTACHMENT C-l ACH CREDIT PAYMENTS (Direct Deposit of Payroll) Risk to originating bank • Risk that payor will not be able to cover transfer on the settlement date. Risk to Federal Reserve • On ACH transactions sent through the Federal Reserve, the Fed may be at risk if the sending bank is unable to cover transfers in its reserve account on settlement date. Risk to receiving bank • On ACH transactions not processed through the Fed, risk that originating bank will be unable to settle at end of day and funds made available to payee might not be recovered. Security risk * Since ACH is not a totally electronic environment, it is not as secure as funds transfer networks. Manual controls are less effective than automated controls. Multiple handlings due to physical delivery of tapes result in greater exposure to error and fraud. Funds flow Payments instructions flow Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ATTACHMENT C-2 ACH DEBIT PAYMENTS (Insurance Premium Payment) Risk to originating bank * Risk of payee withdrawing funds prior to finality of settlement, due to possibility that a receiving bank may be unable to settle. * Risk of payee withdrawing funds before originating bank is assured that debit transfers will not be returned. Risk to Federal Reserve * Federal Reserve is at risk on return items destined to a failed institution. Risk to receiving bank * No appreciable risk, since receiving bank has until its midnight deadline to return an ACH debit (only risk in failing to return an ACH debit that cannot be posted). Security risk * Since ACH is not a totally electronic environment, it is not as secure as funds transfer networks. Manual controls are less effective than automated controls. Multiple handlings due to physical delivery of tapes result in greater exposure to error and fraud. Funds flow 4 Payments instructions flow Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ATTACHMENT D CHECK COLLECTION Risk to depositary bank * Bank makes funds available to its depositor from check that is dishonored. Risk to Federal Reserve * Federal Reserve may be at risk on return items destined to a failed institution. Risk to payor bank * Bank does not properly honor stop payment order. * Bank does not return check drawn on an account with insufficient funds by its midnight deadline. * Bank pays a check with a forged drawer's signature. Funds flow Payments instructions flow Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1986, June 10). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19860611_volcker

@misc{wtfs_speech_19860611_volcker,
  author = {Paul A. Volcker},
  title = {Speech},
  year = {1986},
  month = {Jun},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19860611_volcker},
  note = {Retrieved via When the Fed Speaks corpus}
}