Mark W Olson: Regulatory relief
Testimony of Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve
System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC,
21 June 2005.
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Chairman Shelby, Senator Sarbanes, and members of the Committee, thank you for the opportunity to
testify on issues related to regulatory relief. The Board is aware of the current and growing regulatory
burden that is imposed on this nation's banking organizations. Often this burden falls particularly hard
on small institutions, which have fewer resources than their larger brethren. 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 Shelby's request, the Board provided the Committee with a number of
legislative proposals that we believe are consistent with this goal. Since then, the Board has continued
to work with the other federal banking agencies and your staffs on regulatory relief matters 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 the Board's three highest priority proposals. These three proposals
would allow the Federal Reserve to pay interest on balances held by depository institutions at Reserve
Banks, provide the Board greater flexibility in setting reserve requirements, and permit depository
institutions to pay interest on demand deposits. These amendments would improve efficiency in the
financial sector, assist small banks and small businesses, and enhance the Federal Reserve's toolkit
for efficiently conducting monetary policy. I also will mention a few additional proposals that the Board
supports and that would provide meaningful regulatory relief to banking organizations. The Board
looks forward to working with Congress, our fellow banking agencies and other interested parties in
developing and analyzing other potential regulatory relief proposals as the legislative process moves
forward.
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 four 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 and reserve requirement flexibility
For the purpose of implementing monetary policy, the Board is obliged by law to establish reserve
requirements on certain deposits held at depository institutions. By law, the Board currently must set
the ratio of required reserves on transaction deposits above a certain threshold at between 8 and
14 percent. 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. The Board's proposed
amendment would authorize the Federal Reserve to pay depository institutions interest on their
required reserve balances. Paying interest on these required reserve balances would remove a
substantial portion of the incentive for depositories to engage in reserve avoidance measures, and 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. A depository institution holds contractual clearing balances when it needs a higher level of
balances than its required reserve balances in order to pay checks or make wire transfers out of its
account at the Federal Reserve without incurring overnight overdrafts. Currently, such clearing
balances do not earn explicit interest, but they do earn implicit interest in the form of credits that may
be used to pay for Federal Reserve services, such as check clearing. Excess reserve balances are
funds held by depository institutions in their accounts at Reserve Banks in excess of their required
reserve and contractual clearing balances. Excess reserve balances currently do not earn explicit or
implicit interest.
The Board's proposed amendment would authorize the Federal Reserve to pay explicit interest on
contractual clearing balances and excess reserve balances, as well as required reserve balances.
This authority would enhance the Federal Reserve's ability to efficiently conduct monetary policy, and
would complement another of the Board's proposed amendments, which would give the Board greater
flexibility in setting reserve requirements for depository institutions.
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, if authorized, could consider reducing -
or even eliminating - 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 payment of interest on required reserve balances, or reductions in reserve requirements, would
lower the revenues received by the Treasury from the Federal Reserve. The extent of the potential
revenue loss, however, has fallen over the last decade as banks have increasingly implemented
reserve-avoidance techniques. Paying interest on contractual clearing balances would primarily
involve a switch to explicit interest from the implicit interest currently paid in the form of credits, and
therefore would have essentially no net cost to the Treasury.
Interest on demand deposits
The Board also strongly supports repealing the statutory restrictions that currently prohibit depository
institutions from paying interest on demand deposits. The Board's proposed amendment would allow
all depository institutions that have the legal authority to offer demand deposits to pay interest on
those deposits. As I will explain a little later, however, the Board opposes amendments that would
separately authorize industrial loan companies that operate outside the supervisory and regulatory
framework established for other insured banks to offer, for the first time, interest bearing transaction
accounts to business customers.
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. The payment of interest on demand deposits
would have no direct effect on federal revenues, as interest payments would be deductible for banks
but taxable for the firms that received them.
Some proposals, such as H.R. 1224 - the Business Checking Freedom Act of 2005 - which recently
passed the House, would delay the effectiveness of the authorization of interest on demand deposits
for two years. The Board believes that a short implementation delay of one year, or even less, would
be in the best interest of the public and the efficiency of our financial sector. A separate provision of
H.R. 1224 would, in effect, allow implicit interest to be paid on demand deposits without any delay
through a new type of sweep arrangement, but this provision would not promote efficiency. It would
allow banks to offer a reservable money market deposit account (MMDA) from which twenty-four
transfers a month could be made to other accounts of the same depositor. Banks would be able to
sweep balances from demand deposits into these MMDAs each night, pay interest on them, and then
sweep them back into demand deposits the next day. This type of account would likely permit banks to
pay interest on demand deposits more selectively than with direct interest payments. The
twenty-fourtransfer MMDA, which would be useful only during the transition period before direct interest payments
were allowed, could be implemented at lower cost by banks already having sweep programs.
However, other banks would face a competitive disadvantage and pressures to incur the cost of
setting up this new program during the transition for the one-year interim period. Moreover, some
businesses would not benefit from this MMDA. Hence, the Board does not advocate this
twenty-fourtransfer account.
Small bank examination flexibility
The Board also supports an amendment that 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 the 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,
riskmanagement, or internal control problems at an institution before these problems result in claims on
the deposit insurance funds. The mandatory twelve- or eighteen-month on-site examination cycle
imposes important discipline on the federal banking agencies, ensures that insured depository
institutions do not go unexamined for extended periods, and has contributed significantly to the safety
and soundness of insured depository institutions. For these reasons, the Board opposes alternative
amendments that would allow an agency to indefinitely lengthen the exam cycle for any institution in
order to allocate and conserve the agency's examination resources.
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. The Board, however, opposes proposals that would allow industrial loan companies
(ILCs) to offer interest-bearing, negotiable order of withdrawal (NOW) accounts to business customers
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 six holding more than $1 billion in deposits.
Affirmatively granting ILCs the ability to offer business NOW accounts would permit ILCs to become
the functional equivalent of full-service insured banks. 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.
H.R. 1224 attempts to address the banking and commerce concerns raised by allowing ILCs to offer
business NOW accounts by placing certain limits on the types of ILCs that may engage in these new
activities. However, as Governor Kohn recently testified in the House on behalf of the Board, the limits
contained in H.R. 1224 do not adequately address these concerns. Moreover, H.R. 1224 fails to
address the supervisory issues associated with allowing domestic firms and foreign banks that are not
subject to consolidated supervision to 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
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 full-service 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. For the same reasons discussed above,
the Board opposes amendments that would allow exempt ILCs to open de novo branches throughout
the United States.
not
Affirmatively granting exempt ILCs the authority to offer business NOW accounts also is necessary
to ensure or provide parity among insured banks. The Board's proposed amendment would allow all
depository institutions that have the authority to offer demand deposits the ability to pay interest on
those deposits. Thus, the Board's proposed amendment would treat all depository institutions equally.
Separately granting exempt ILCs the ability to offer the functional equivalent of a corporate demand
deposit, on the other hand, would grant new and expanded powers to institutions that already benefit
from a special exemption in current law. Far from promoting competitive equity, these proposals would
promote competitive inequality in the financial marketplace.
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 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 Committee and your staffs as you seek
to develop and advance meaningful regulatory relief legislation that is consistent with the nation's
public policy objectives.
Appendix:
Regulatory Relief Proposals Supported by the
Board of Governors of the Federal Reserve System
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 m