Donald L Kohn: Regulatory relief
Testimony of Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, before the Subcommittee on Financial Institutions and Consumer Credit, Committee on
Financial Services, US House of Representatives, Washington DC, 9 June 2005.
* * *
Mr. Chairman and members of the Subcommittee, thank you for the opportunity to testify on issues
related to regulatory relief. The Board strongly supports the efforts of Congress to review periodically
the federal banking laws to determine whether they can be streamlined without compromising the
safety and soundness of banking organizations, consumer protections, or other important objectives
that Congress has established for the financial system. In 2003, at Chairman Oxley's request, the
Board provided the Committee with a number of legislative proposals that we believe are consistent
with this goal, and the Board recently agreed to support several additional regulatory relief proposals.
A summary of the proposals supported by the Board is included in the appendix to my testimony. In
my remarks, I will highlight those that would provide the most meaningful regulatory relief.
For its part, the Board strives to review each of our regulations at least once every five years to identify
those provisions that are out of date or otherwise unnecessary. The Board also has been an active
participant in the ongoing regulatory review process being conducted by the federal banking agencies
pursuant to the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA). EGRPRA
requires the federal banking agencies, at least once every ten years, to review and seek public
comment on the burden associated with the full range of the agencies' regulations that affect insured
depository institutions. The Board and the other banking agencies are in the midst of the first ten-year
review cycle, and I am pleased to report that we are on track to complete this process by the 2006
deadline. The agencies already have solicited comments on five broad categories of regulations -
including those governing applications, activities, money laundering, and consumer protection in
lending transactions - and have conducted outreach meetings throughout the country to encourage
public participation in the EGRPRA process. In response to these efforts, the agencies have received
comments from more than 1,000 entities and individuals on ways to reduce the regulatory burden on
banking organizations. The Board will consider and incorporate the comments relevant to our
regulations as we move forward with our own regulation review efforts.
While the banking agencies can achieve some burden reductions through administrative action,
Congress plays a critical role in the regulatory relief process. Many proposals to reduce regulatory
burden require congressional action to implement. Moreover, the Congress has ultimate responsibility
for establishing the overall regulatory framework for banking organizations, and through its actions
Congress can ensure that regulatory relief is consistent with the framework it has established to
maintain the safety and soundness of banking organizations and promote other important public policy
goals.
Interest on reserves, reserve requirements and interest on demand deposits
I am pleased to note that some of the Board's most important regulatory relief suggestions - including
those authorizing the Federal Reserve to pay interest on balances held by depository institutions at
Reserve Banks, enhancing the Board's flexibility to set reserve requirements, and permitting
depository institutions to pay interest on demand deposits - recently were passed by the House as part
of H.R. 1224, the Business Checking Freedom Act of 2005. Let me briefly explain why the Board
supports passage of these amendments, either in a stand-alone bill or as part of a broader regulatory
relief bill. I will also discuss a little later why the Board does not support those aspects of H.R. 1224
that would, for the first time, authorize industrial loan companies that operate outside the supervisory
framework established for other insured banks to offer interest-bearing transaction accounts to
business customers.
For the purpose of implementing monetary policy, the Board is obliged by law to establish reserve
requirements on certain deposits held at depository institutions. Because the Federal Reserve does
not pay interest on the balances held at Reserve Banks to meet reserve requirements, depositories
have an incentive to reduce their reserve balances to a minimum. To do so, they engage in a variety of
reserve avoidance activities, including sweep arrangements that move funds from deposits that are
subject to reserve requirements to deposits and money market investments that are not. These sweep
programs and similar activities absorb real resources and therefore diminish the efficiency of our
banking system. H.R. 1224 would allow the Federal Reserve to pay depository institutions interest on
their required reserve balances, which would remove a substantial portion of the incentive for
depositories to engage in reserve avoidance measures. The resulting improvements in efficiency
should eventually be passed through to bank borrowers and depositors.
Besides required reserve balances, depository institutions also voluntarily hold two other types of
balances in their Reserve Bank accounts - contractual clearing balances and excess reserve
balances. H.R. 1224 would authorize the Federal Reserve to pay explicit interest on these balances as
well. This authority would enhance the Federal Reserve's toolkit for efficiently conducting monetary
policy.
In order for the Federal Open Market Committee (FOMC) to conduct monetary policy effectively, it is
important that a sufficient and predictable demand for balances at the Reserve Banks exist so that the
System knows the volume of reserves to supply (or remove) through open market operations to
achieve the FOMC's target federal funds rate. Authorizing the Federal Reserve to pay explicit interest
on contractual clearing balances and excess reserve balances, in addition to required reserve
balances, could potentially provide a demand for voluntary balances that would be stable enough for
monetary policy to be implemented effectively through existing procedures without the need for
required reserve balances. In these circumstances, the Board could consider using the authority
granted in H.R. 1224 to reduce - or even eliminate - reserve requirements, thereby reducing a
regulatory burden for all depository institutions, without adversely affecting the Federal Reserve's
ability to conduct monetary policy.
Having the authority to pay interest on excess reserves also could help mitigate potential volatility in
overnight interest rates. If the Federal Reserve was authorized to pay interest on excess reserves, and
did so, the rate paid would act as a minimum for overnight interest rates, because banks would not
generally lend to other banks at a lower rate than they could earn by keeping their excess funds at a
Reserve Bank. Although the Board sees no need to pay interest on excess reserves in the near future,
and any movement in this direction would need further study, the ability to do so would be a potentially
useful addition to the monetary toolkit of the Federal Reserve.
The Board also strongly supports the provisions of H.R. 1224 that would repeal the statutory
restrictions that currently prohibit depository institutions from paying interest on demand deposits.
Repealing the prohibition of interest on demand deposits would improve the overall efficiency of our
financial sector and, in particular, should assist small banks in attracting and retaining business
deposits. To compete for the liquid assets of businesses, banks have been compelled to set up
complicated procedures to pay implicit interest on compensating balance accounts and they spend
resources - and charge fees - for sweeping the excess demand deposits of businesses into money
market investments on a nightly basis. Small banks, however, often do not have the resources to
develop the sweep or other programs that are needed to compete for the deposits of business
customers. Moreover, from the standpoint of the overall economy, the expenses incurred by
institutions of all sizes to implement these programs are a waste of resources and would be
unnecessary if institutions were permitted to pay interest on demand deposits directly.
The costs incurred by banks in operating these programs are passed on, directly or indirectly, to their
large and small business customers. Authorizing banks to pay interest on demand deposits would
eliminate the need for these customers to pay for more costly sweep and compensating balance
arrangements to earn a return on their demand deposits.
H.R. 1224 contains a provision that is intended to address the potential federal budgetary impact of
this proposal by requiring the Reserve Banks to transfer some of their capital surplus to the Treasury
to cover the budgetary costs of paying interest on required reserves through 2009. As the Board has
consistently pointed out, these transfers would not provide any true offsets to budgetary costs.
Although these transfers would allow the Treasury to issue fewer securities, the Federal Reserve
would need to lower its holdings of Treasury securities by the same amount to make the required
transfers. Thus, the level of Treasury debt held by the public sector would be unchanged, and the
Treasury's interest payments, net of receipts from the Federal Reserve, would be unaffected.
De novo interstate branching
The Board has proposed an amendment that would remove outdated barriers to de novo interstate
branching by banks. Since enactment of the Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994 (Riegle-Neal Act), all fifty states have permitted banks to expand on an interstate basis
through the acquisition of an existing bank in their state. Interstate banking is not only good for banks,
it is good for consumers and the economy. While the number of banks has fallen in recent years, the
number of branches has risen sharply to more than 71,000 in 2004 compared with approximately
50,000 in 1990. More than 2,000 branches were opened by banks in 2004 alone. The creation of new
branches helps maintain the competitiveness and dynamism of the American banking industry and
improve access to banking services in otherwise under-served markets. It results in better banking
services for households and small businesses, lower interest rates on loans, and higher interest rates
on deposits. Interstate branching also increases convenience for customers who live, work, and
operate across state borders.
However, the Riegle-Neal Act permitted banks to open a branch in a new state without acquiring
another bank only if the host state enacted legislation that expressly permits entry by de novo
branching (an opt-in requirement). To date, twenty-one states and the District of Columbia have
enacted some form of opt-in legislation, while twenty-nine states continue to require interstate entry
through the acquisition of an existing bank.
This limitation on de novo branching is an obstacle to interstate entry for all banks and also creates
special problems for small banks seeking to operate across state lines. Moreover, it creates an unlevel
playing field between banks and federal savings associations, which have long been allowed to
establish de novo branches on an interstate basis.
The Board's proposed amendment would remove this last obstacle to full interstate branching for
banks and level the playing field between banks and thrifts. The amendment also would remove the
parallel provision that allows states to impose a minimum requirement on the age of banks that are
acquired by an out-of-state banking organization. These changes would allow banks, including in
particular small banks near state borders, to better serve their customers by establishing new
interstate branches and acquiring newly chartered banks across state lines. It also would increase
competition by providing banks a less costly method for offering their services at new locations. The
establishment and operation of any new interstate branches would continue to be subject to the other
regulatory provisions and conditions established by Congress for de novo interstate branches,
including the financial, managerial, and community reinvestment requirements set forth in the
RiegleNeal Act.
Small bank examination flexibility
Another amendment that the Board has supported would expand the number of small institutions that
qualify for an extended examination cycle. Federal law currently mandates that the appropriate federal
banking agency conduct an on-site examination of each insured depository institution at least once
every twelve months. The statute, however, permits institutions that have $250 million or less in assets
and that meet certain capital, managerial, and other criteria to be examined on an eighteen-month
cycle. As the primary federal supervisors for state-chartered banks, the Board and Federal Deposit
Insurance Corporation (FDIC) may alternate responsibility for conducting these examinations with the
appropriate state supervisory authority if the Board or FDIC determines that the state examination
carries out the purposes of the statute.
The $250 million asset cutoff for an eighteen-month examination cycle has not been raised since
1994. The Board's proposed amendment would raise this asset cap from $250 million to $500 million,
thus potentially allowing approximately an additional 1,100 insured depository institutions to qualify for
an eighteen-month examination cycle.
The proposed amendment would provide meaningful relief to small institutions without jeopardizing the
safety and soundness of insured depository institutions. Under the proposed amendment, an
institution with less than $500 million in assets would qualify for the eighteen-month examination cycle
only if the institution was well capitalized, well managed, and met the other criteria established by
Congress in Federal Deposit Insurance Corporation Improvement Act of 1991. The amendment also
would continue to require that all insured depository institutions undergo a full-scope, on-site
examination at least once every twelve or eighteen months. Importantly, the agencies would continue
to have the ability to examine any institution more frequently and at any time if the agency determines
an examination is necessary or appropriate. Despite advances in off-site monitoring, the Board
continues to believe that regular on-site examinations play a critical role in helping bank supervisors
detect and correct asset, risk-management or internal control problems at an institution before these
problems result in claims on the deposit insurance funds.
Permit the Board to grant exceptions to attribution rule
The Board has proposed another amendment that we believe will help banking organizations maintain
attractive benefits programs for their employees. The Bank Holding Company Act (BHC Act) generally
prohibits a bank holding company from owning, in the aggregate, more than 5 percent of the voting
shares of any company without the Board's approval. The BHC Act also provides that any shares held
by a trust for the benefit of a bank holding company's shareholders or employees are deemed to be
controlled by the bank holding company itself. This attribution rule was intended to prevent a bank
holding company from using a trust established for the benefit of its management, shareholders, or
employees to evade the BHC Act's restrictions on the acquisition of shares of banks and nonbanking
companies.
While this attribution rule has proved to be a useful tool in preventing evasions of the BHC Act, it does
not always provide an appropriate result. For example, it may not be appropriate to apply the
attribution rule when the shares in question are acquired by a 401(k) plan that is widely held by, and
operated for the benefit of, the employees of the bank holding company. In these situations, the bank
holding company may not have the ability to influence the purchase or sale decisions of the
employees or otherwise control the shares that are held by the plan in trust for its employees. The
suggested amendment would allow the Board to address these situations by authorizing the Board to
grant exceptions from the attribution rule where appropriate.
Reduce cross-marketing restrictions
Another amendment proposed by the Board would modify the cross-marketing restrictions imposed by
the Gramm-Leach-Bliley Act (GLB Act) on the merchant banking and insurance company investments
of financial holding companies. The GLB Act generally prohibits a depository institution controlled by a
financial holding company from engaging in cross-marketing activities with a nonfinancial company
that is owned by the same financial holding company under the GLB Act's merchant banking or
insurance company investment authorities. However, the GLB Act currently permits a depository
institution subsidiary of a financial holding company, with Board approval, to engage in limited
crossmarketing activities through statement stuffers and Internet websites with nonfinancial companies that
are held under the act's insurance company investment authority (but not the act's merchant banking
authority).
The Board's proposed amendment would allow depository institutions controlled by a financial holding
company to engage in cross-marketing activities with companies held under the merchant banking
authority to the same extent, and subject to the same restrictions, as companies held under the
insurance company investment authority. We believe that this parity of treatment is appropriate, and
see no reason to treat the merchant banking and insurance investments of financial holding
companies differently for purposes of the cross-marketing restrictions of the GLB Act.
A second aspect of the amendment would liberalize the cross-marketing restrictions that apply to both
merchant banking and insurance company investments. This aspect of the amendment would permit a
depository institution subsidiary of a financial holding company to engage in cross-marketing activities
with a nonfinancial company held under either the merchant banking or insurance company
investment authority if the nonfinancial company is not controlled by the financial holding company.
When a financial holding company does not control a portfolio company, cross-marketing activities are
unlikely to materially undermine the separation between the nonfinancial portfolio company and the
financial holding company's depository institution subsidiaries.
Industrial loan companies
As I noted earlier, the Board strongly supports allowing depository institutions to pay interest on
demand deposits and allowing banks to branch de novo across state lines. The Board, however,
opposes proposals that would allow industrial loan companies (ILCs) to offer business NOW accounts,
as H.R. 1224 does, or open de novo branches nationwide if the corporate owner of the ILC takes
advantage of the special exemption in current law that allows the owner to operate outside the
prudential framework that Congress has established for the corporate owners of other types of insured
banks.
ILCs are state-chartered FDIC-insured banks that were first established early in the twentieth century
to make small loans to industrial workers. As insured banks, ILCs are supervised by the FDIC as well
as by the chartering state. However, under a special exemption in current law, any type of company,
including a commercial or retail firm, may acquire an ILC in a handful of states - principally Utah,
California, and Nevada - and avoid the activity restrictions and supervisory requirements imposed on
bank holding companies under the federal BHC Act.
When the special exemption for ILCs was initially granted in 1987, ILCs were mostly small, local
institutions that did not offer demand deposits or other types of checking accounts. In light of these
facts, Congress conditioned the exemption on a requirement that any ILCs chartered after 1987
remain small (below $100 million in assets) or refrain from offering demand deposits that are
withdrawable by check or similar means.
This special exemption has been aggressively exploited since 1987. Some grandfathered states have
allowed their ILCs to exercise many of the same powers as commercial banks and have begun to
charter new ILCs. Today, several ILCs are owned by large, internationally active financial or
commercial firms. In addition, a number of ILCs themselves have grown large, with one holding more
than $50 billion in deposits and an additional eight holding more than $1 billion in deposits.
Affirmatively granting ILCs the ability to offer business NOW accounts and open de novo branches
across state lines would permit ILCs to become the functional equivalent of full-service insured banks
and operate across the United States. This result would be inconsistent with both the historical
functions of ILCs and the terms of their special exemption in current law.
Because the parent companies of exempt ILCs are not subject to the BHC Act, authorizing ILCs to
operate essentially as full-service banks would create an unlevel competitive playing field among
banking organizations and undermine the framework Congress has established for the corporate
owners of full-service banks. It would allow firms that are not subject to the consolidated supervisory
framework of the BHC Act - including consolidated capital, examination, and reporting requirements -
to own and control the functional equivalent of a full-service bank. It also would allow a foreign bank to
acquire control of the equivalent of a full-service insured bank without meeting the requirement under
the BHC Act that the foreign bank be subject to comprehensive supervision on a consolidated basis in
its home country. In addition, it would allow financial firms to acquire the equivalent of a full-service
bank without complying with the capital, managerial, and Community Reinvestment Act (CRA)
requirements established by Congress in the GLB Act.
Congress has established consolidated supervision as a fundamental component of bank supervision
in the United States because consolidated supervision provides important protection to the insured
banks that are part of a larger organization and to the federal safety net that supports those banks.
Financial trouble in one part of an organization can spread rapidly to other parts. To protect an insured
bank that is part of a larger organization, a supervisor needs to have the authority and tools to
understand the risks that exist within the parent organization and its affiliates and, if necessary,
address any significant capital, managerial, or other deficiencies before they pose a danger to the
bank. This is particularly true today, as holding companies increasingly manage their operations - and
the risks that arise from these operations - in a centralized manner that cuts across legal entities.
Risks that cross legal entities and that are managed on a consolidated basis simply cannot be
monitored properly through supervision directed at one, or even several, of the legal entities within the
overall organization. For these reasons, Congress since 1956 has required that the parent companies
of full-service insured banks be subject to consolidated supervision under the BHC Act. In addition,
following the collapse of Bank of Commerce and Credit International (BCCI), Congress has required
that foreign banks seeking to acquire control of a U.S. bank under the BHC Act be subject to
comprehensive supervision on a consolidated basis in the foreign bank's home country.
Authorizing exempt ILCs to operate as essentially full-service banks also would undermine the
framework that Congress has established - and recently reaffirmed in the GLB Act - to limit the
affiliation of banks and commercial entities. This is because any type of company, including a
commercial firm, may own an exempt ILC without regard to the activity restrictions in the BHC Act that
are designed to maintain the separation of banking and commerce. While H.R. 1224 attempts to
address concerns related to mixing banking and commerce by placing certain limits on the types of
ILCs that could offer business NOW accounts, the limits in H.R. 1224 do not adequately address this
issue. For example, H.R. 1224 would allow any ILC that received FDIC insurance before October 1,
2003, or had an application for deposit insurance pending on that date, to offer NOW accounts to
business customers so long as the institution does not experience a change in control. Thus, the bill
would allow the commercial and retail firms that acquired an ILC before October 1, 2003, to transform
the institution into the functional equivalent of a full-service insured bank. The bill also would allow any
ILC that was established or acquired after October 1, 2003, to offer business NOW accounts so long
as the ILC's appropriate state supervisor determined that the companies controlling the ILC derived at
least 85 percent of their annual gross revenues from activities that are "financial in nature or incidental
to a financial activity."
Importantly, the bill does not define these terms by reference to the GLB Act or otherwise establish
any standards for a state authority to use in determining what activities are "financial in nature or
incidental to a financial activity." Instead, the bill leaves this important determination - which has the
potential to undermine the nation's longstanding policy of maintaining the separation of banking and
commerce - to the discretion of the ILC's state supervisor. Moreover, unlike the grandfather provisions
of the GLB Act on which the ILC provisions of the bill purportedly are based (see 12 U.S.C. § 1843(n)),
H.R. 1224 would not require a company that acquires an ILC after October 1, 2003, to divest its
non-financial, commercial activities within a specified period of time.
The limits contained in H.R. 1224 also do not address the other risks and issues presented by ILCs.
For example, the bill fails to address the supervisory issues associated with allowing domestic firms or
foreign banks that are not subject to consolidated supervision to own and control the functional
equivalent of a full-service insured bank.
Let me be clear. The Board does not oppose granting ILCs the ability to offer business NOW accounts
or open de novo branches if the corporate owners of ILCs engaged in these expanded activities are
covered by the same supervisory and regulatory framework that applies to the owners of other
fullservice insured banks. Stated simply, if ILCs want to benefit from expanded powers and become
functionally indistinguishable from other insured banks, then they and their corporate parents should
be subject to the same rules that apply to the owners of other full-service insured banks.
The Board believes that important principles governing the structure of the nation's banking system -
such as consolidated supervision, the separation of banking and commerce, and the maintenance of a
level playing field for all competitors in the financial services marketplace - should not be abandoned
without careful consideration by the Congress. In the Board's view, legislation concerning the payment
of interest on demand deposits or de novo branching is unlikely to provide an appropriate vehicle for
the thorough consideration of the consequences of altering these key principles.
Conclusion
I appreciate the opportunity to discuss the Board's legislative suggestions and priorities concerning
regulatory relief. The Board would be pleased to work with the Subcommittee, the full Committee, and
their staffs as you move forward in developing and considering regulatory relief legislation.
Appendix:
Regulatory Relief Proposals Supported by the
Board of Governors of the Federal Reserve System1
1. Authorize the Federal Reserve to pay interest on balances held at Reserve Banks*
Amendment gives the Federal Reserve explicit authority to pay interest on balances held by
depository institutions at the Federal Reserve Banks.
2. Grant the Board additional flexibility in establishing reserve requirements*
Amendment provides the Federal Reserve with greater flexibility to set the ratio of reserves that a
depository institution must maintain against its transaction accounts below the current ranges
established by the Monetary Control Act of 1980.
3. Authorize depository institutions to pay interest on demand deposits*
Amendment repeals the provisions in current law that prohibit depository institutions from paying
interest on demand deposits. If adopted, the amendment would allow all depository institutions that
have the authority to offer demand deposits to pay interest on those deposits.
4. Ease restrictions on interstate branching and mergers in a competitively equitable manner
Amendment affirmatively authorizes national and state banks to open de novo branches on an
interstate basis. Currently, banks may establish de novo branches in a new state only if the state has
affirmatively authorized de novo branching. This existing limitation places banks at a disadvantage to
federal savings associations, which currently have the ability to branch de novo on an interstate basis.
The amendment also would remove a parallel provision that allows states to impose a minimum
requirement on the age of banks that are acquired by an out-of-state banking organization.
The amendment would not allow industrial loan companies (ILCs) that operate under a special
exemption in federal law from opening de novo branches on a nationwide basis. The corporate owners
of these ILCs are not subject to the type of consolidated supervision and activities restrictions that
generally apply to the corporate owners of other banks insured by the Federal Deposit Insurance
Corporation (FDIC). Granting exempt ILCs nationwide branching rights also would be inconsistent with
the terms of their special exemption in federal law.
5. Small Bank Examination Flexibility
Amendment would expand the number of small institutions that may qualify for an eighteen-month
(rather than a twelve-month) examination cycle. Under current law, an insured depository institution
must have $250 million or less in total assets to qualify for an eighteen-month examination cycle. See
12 U.S.C. § 1820(d). The amendment would raise this asset cap to $500 million, thereby potentially
allowing approximately an additional 1,100 institutions to qualify for an extended examination cycle.
6. Permit the Board to grant exceptions to the attribution rule concerning shares held by a trust
for the benefit of a bank holding company or its shareholders or employees*
The amendment would allow the Board, in appropriate circumstances, to waive the attribution rule in
section 2(g)(2) of the Bank Holding Company Act (BHC Act). This attribution rule currently provides
that, for purposes of the BHC Act, a company is deemed in all circumstances to own or control any
shares that are held by a trust (such as an employee benefit plan) for the benefit of the company or its
shareholders or employees. The amendment would allow the Board to waive the rule when, for
example, the shares in question are held by a 401(k) plan that is widely held by the bank holding
company's employees and the bank holding company does not have the ability to control the shares
held by the plan.
7. Modification of the cross-marketing restrictions applicable to merchant banking and
insurance company investments*
Amendment allows the depository institution subsidiaries of a financial holding company to engage in
cross-marketing activities with portfolio companies that are held under the merchant banking authority
in the Gramm-Leach-Bliley Act (GLB Act) to the same extent as such activities are currently
permissible for portfolio companies held under the GLB Act's insurance company investment authority.
The amendment also would allow the depository institution subsidiaries of a financial holding company
to engage in cross-marketing activities with a portfolio company held under either the merchant
banking or insurance company investment authority if the financial holding company does not control
the portfolio company.
8. Allow insured banks to engage in interstate merger transactions with savings associations
and trust companies*
The amendment would allow an insured bank to directly acquire, by merger, an insured savings
association or uninsu