Donald L Kohn: Regulatory relief
Testimony by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, before the Committee on Banking, Housing, and Urban Affairs, United States Senate,
Washington DC, 1 March 2006.
* * *
Chairman Shelby, Senator Sarbanes, and members of the Committee, thank you for the opportunity to
discuss the Federal Reserve's views on regulatory relief. The Board commends the Committee for its
continued focus and work on this important issue. In particular, I'd like to recognize and thank Senator
Crapo and his staff for their ongoing efforts to coordinate the many regulatory relief proposals that
have been advanced to date by the federal banking agencies, financial trade associations, and others.
The regulatory requirements imposed on our nation's banking organizations have grown over time.
Often the impact of these requirements falls hardest on our nation's community banks, which have
fewer resources than larger organizations to meet the challenges posed by new or additional
regulations. Although the individual requirements and restrictions imposed by federal law may well
have been justified at the time of adoption, changes in the marketplace, technology and, indeed, in the
federal banking laws themselves may well have altered the balance of the cost-benefit analysis that
should underlie each requirement and restriction. Unnecessary regulatory burdens hinder the ability of
large and small banking organizations to meet the needs of their customers, operate profitably,
innovate, and compete with other financial services providers. That is why the Board periodically
reviews its own regulations and why it is so important for Congress to periodically review the federal
banking laws to determine whether there are any provisions that may be streamlined or eliminated
without compromising the safety and soundness of banking organizations, consumer protections, or
other important objectives that Congress has established for the financial system.
The Board, working with the other banking agencies, has been, and will continue to be, a strong and
active supporter of Congress' regulatory relief efforts. In 2003, the Board provided this Committee with
a number of legislative proposals for inclusion in a regulatory relief bill. Since then, in response to
requests from Senator Crapo, the Board has reviewed numerous other regulatory relief proposals
included in the Matrix of Financial Services Regulatory Relief Proposals (Matrix) compiled by Senator
Crapo's staff that may affect the Federal Reserve or the organizations we supervise. As a result of that
process, I am pleased to report that the Board now supports more than 35 legislative proposals. These
proposals would meaningfully reduce regulatory burden, improve the supervision of banking
organizations, or otherwise enhance the federal banking laws without compromising the fundamental
goals of bank regulation and supervision. A complete listing and summary of the proposals supported
by the Board is included in the appendix to my testimony. We believe these proposals provide an
excellent starting point for any regulatory relief legislation, and we look forward to working with the
Committee as you develop and perfect such legislation.
In my remarks, I will highlight the three items that are the Board's highest regulatory relief priorities.
These 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 proposals may well sound
familiar to you and they should. The Board has supported these amendments for many years because
we believe each of them would improve the operation of our financial system. I should note that these
three amendments form the core of S. 1586, the Interest on Business Checking Act of 2005, which
was introduced last year by Senators Hagel, Reed and Snowe. The Board strongly supports passage
of S. 1586, either independently or as part of a broader regulatory relief bill.
In addition to these priority items, I will highlight a few other legislative proposals that we believe would
provide meaningful regulatory relief to banking organizations as well as some steps that the Board has
taken on its own to reduce regulatory burden. Finally, I will discuss several matters related to industrial
loan companies (ILCs). This topic has been raised by some regulatory relief proposals, but it has
much broader policy implications for the structure and supervision of the banking industry.
Interest on reserves and reserve requirement flexibility (Matrix Nos. 1 and 2)
The first two of the Board's priority items relate to reserve requirements, which exist to assist the
Federal Reserve conduct monetary policy. Federal law currently obliges the Board to establish reserve
requirements on certain deposits held at depository institutions and mandates that the Board 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 required 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.
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 has long supported legislation that would authorize the Federal Reserve to pay depository
institutions interest on the balances they hold at Reserve Banks. As we previously have testified,
paying interest on 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. Having the authority also to
pay interest on contractual clearing and excess reserve balances as well as required reserves would
enhance the Federal Reserve's ability to efficiently conduct monetary policy. In addition, it 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
Federal Reserve 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 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 generally
would not 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,
the ability to do so would be a potentially useful addition to the monetary policy toolkit of the Federal
Reserve.
Interest on demand deposits (Matrix No. 3)
Another priority item for the Board would repeal the statutory restrictions that currently prohibit
depository institutions from paying interest on demand deposits. Repealing these restrictions would
improve the overall efficiency of our financial sector, assist small banks in attracting and retaining
business deposits, and allow small businesses to earn direct interest on their checking account
balances. As a practical matter, these restrictions currently do not impede the payment of interest on
consumer deposits because depository institutions generally are permitted to offer individuals interest-
bearing negotiable order of withdrawal (NOW) accounts, which are checkable transaction accounts
similar to demand deposits.
To compete for the liquid assets of businesses, however, 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 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 to their large and small business customers and many small businesses do
not benefit from these programs.
For these reasons, 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. The amendment would
eliminate the need for banks to operate, and business customers to pay for, sweep and compensating
balance arrangements to pay or earn interest on demand deposits. As I will explain a little later,
however, the Board opposes amendments that would separately authorize ILCs that operate outside
the supervisory and regulatory framework established for other insured banks to offer, for the first time,
transaction accounts to business customers.
The Board believes that, once enacted, the authorization for depository institutions to pay interest on
demand deposits should become effective promptly. S. 1586 would achieve this goal by requiring that
the authority to pay interest on demand deposits become effective no later than 90 days after
enactment. The Board, however, does not advocate the provisions of S. 1586 or other bills that 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. These provisions would
permit banks to sweep balances from demand deposits into MMDAs each night, pay interest on them,
and then sweep them back into demand deposits the next day. This type of twenty-four-transfer
MMDA likely would be useful only during the transition period before direct interest payments were
allowed. Moreover, as the Board has explained in previous testimonies, this type of account would
represent an inefficient, more costly and less readily available alternative to interest-bearing demand
deposits.
De novo interstate branching
The Board also strongly supports 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 good for
consumers and the economy as well as banks. 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.
without
However, the Riegle-Neal Act permitted banks to open a branch in a new state 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-two states and the District of Columbia have
enacted some form of opt-in legislation, while twenty-eight 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 by allowing banks to establish interstate
branches on a de novo basis. 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. While the Board supports expanding the de novo branching authority of banks,
the Board continues to believe that Congress should not grant this new branching authority to ILCs
unless the corporate owners of these institutions are subject to the same type of consolidated
supervision and activities restrictions as the corporate owners of other full-service insured banks.
Small bank examination flexibility (Matrix No. 68)
The Board also supports expanding the number of small institutions that may qualify for an extended
examination cycle. Federal law currently requires 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 less than $250 million 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.
Importantly, this change would not exempt any insured depository institution from routine safety and
soundness examinations, and would not lengthen the examination cycle for institutions experiencing
financial or managerial difficulties. This change is unanimously supported by the federal banking
agencies and potentially would allow approximately an additional 1,200 insured depository institutions
to qualify for an eighteen-month examination cycle. The Board believes this change would provide
meaningful relief to small, financially strong institutions without compromising safety and soundness.
The Board's supervisory experience, however, indicates that institutions with assets approaching $1
billion tend to have more complex risk profiles and are more likely to operate business lines on a
regional or national basis than institutions with assets of less than $500 million. For these reasons, the
Board is not comfortable raising the asset threshold for an eighteen-month examination cycle to $1
billion, as items No. 112 and No. 169 in the Matrix would do. The Board also does not support
proposals, such as item No. 42 in the Matrix, that would allow a federal banking agency to extend the
examination cycle for a potentially indefinite period of time for institutions of any size. 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. If an
agency is experiencing shortages in its examination resources, we believe it would be better to
address these constraints through the supplementation of the agency's resources, rather than by
extending the mandated frequency of safety and soundness examinations.
Other Board legislative proposals and actions to reduce regulatory burden
In addition to these proposals, the Board supports a variety of other regulatory relief amendments
included in the Matrix. These amendments, which are discussed more fully in the Appendix, would
among other things:
•
Restore the Board's ability to determine that nonbanking activities are "closely related to
banking" for purposes of section 4(c)(8) of the Bank Holding Company Act (BHC Act) and,
thus, permissible for all bank holding companies to conduct directly or through a nonbank
subsidiary (Matrix No. 137(a));
• Streamline the process for insured banks to acquire savings associations and trust companies
in interstate merger transactions (Matrix No. 138);
•
Modify the cross-marketing restrictions that apply to the merchant banking and insurance
company investments of financial holding companies (Matrix No. 139);
•
Eliminate certain reporting requirements imposed on banks and their executive officers and
principal shareholders that do not contribute significantly to the monitoring of insider lending or
the safety and soundness of insured depository institutions (Matrix No. 4);
•
Streamline the inter-agency consultation process for transactions under the Bank Merger Act
(Matrix No. 5);
•
Shorten the post-approval waiting period for bank acquisitions and mergers where the
Attorney General and the relevant federal banking agency agree the transaction will not have
a significant adverse effect on competition (Matrix No. 6);
•
Simplify the restrictions governing dividend payments by national and state member banks in
a way that would not adversely affect the safety and soundness of member banks (Matrix No.
31); and
•
Facilitate the flow of information during the supervisory process by clarifying that depository
institutions and others do not waive any privilege they may have with respect to information
when they provide the information to a federal, state or foreign banking authority as part of the
supervisory process (Matrix No. 100).
In our discussions with banking organizations about regulatory relief, one topic that frequently comes
up is the Bank Secrecy Act (BSA). We recognize that provisions of the BSA require considerable effort
by the banking industry to obtain, document and provide information to law enforcement. To further
promote the uniform application of BSA and anti-money laundering (AML) requirements, the federal
banking agencies, working with the Financial Crimes Enforcement Network of the Treasury
Department, recently issued a joint BSA/AML Examination Manual that is designed to promote the
effective and consistent examination of BSA/AML compliance. The Board will continue to work with
our fellow banking agencies and FinCEN to address key issues related to BSA/anti-money laundering
compliance. With respect to currency transaction reports (CTRs), we support the efforts of the
Treasury Department and others to develop ways of reducing the burdens imposed on banks in a
manner that would not adversely affect the ability of banks to manage their risk or unintentionally
impede the investigative tools available to law enforcement.
Before moving on, I'd like to mention some recent changes that the Board itself has made to its Small
Bank Holding Company Policy Statement ("Policy Statement") and capital guidelines that we believe
should provide significant relief to community banking organizations. The Board adopted the Policy
Statement in 1980 to help facilitate the transfer of ownership of small, community-based banks.
Currently, the Policy Statement applies to bank holding companies that have consolidated assets of
less than $150 million and that meet certain qualitative criteria. These qualitative criteria are designed
to ensure that a small bank holding company does not qualify for the Policy Statement if it engages in
significant activities outside its supervised bank subsidiaries. Small bank holding companies that
qualify for, and operate under, the Policy Statement also are subject to several additional restrictions
and conditions that are designed to ensure that they do not present an undue risk to the safety and
soundness of their subsidiary banks.
Last week, the Board approved an amendment that increases to $500 million the asset size threshold
for determining whether a bank holding company may qualify for the Policy Statement and the related
exemption from the Board's capital guidelines for bank holding companies. The Board also has
proposed to make conforming revisions to its regulatory reporting framework, which should further
lower reporting and compliance costs for small bank holding companies. The Board believes these
actions properly balance the goals of facilitating the transfer of ownership of small banks, on the one
hand, and ensuring capital adequacy and access to necessary supervisory information on the other
hand. The Board, however, does not support amendments, like item No. 116 in the Matrix, that
potentially would require the Board to raise the asset size threshold in the Policy Statement to $1
billion.
Industrial loan companies
As I noted earlier, the Board strongly supports amendments that would allow depository institutions to
pay interest on demand deposits and allow banks to open de novo branches on an interstate basis.
The Board, however, believes that, because the corporate owners of ILCs operate outside the
prudential and legislative framework applicable to the corporate owners of other types of insured
banks, ILCs should not be authorized to offer transaction accounts to business customers or branch
de novo across state lines. Our position on these matters is long-standing and based on the broad
policy issues presented by the special exemption in current law for ILCs chartered in certain states.
ILCs are banks; specifically, they are state-chartered FDIC-insured banks. However, due to a special
exemption in the federal BHC Act, 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 consolidated supervisory requirements that apply to bank holding companies.
ILCs were first established early in the twentieth century to make small loans to industrial workers.
When the special exemption for ILCs initially was granted in 1987, ILCs were still mostly small, local
institutions that had only limited deposit-taking and lending powers. For example, in 1987, most ILCs
had less than $50 million in assets and the largest ILC had assets of less than $400 million. Moreover,
in 1987, the relevant states were not actively chartering new ILCs. Utah, for example, had a
moratorium on the chartering of new ILCs at the time the exemption was enacted.
However, as the Government Accountability Office (GAO) recently documented, the ILC exemption
has been actively exploited in recent years, resulting in a significant change in the character, powers
and ownership of ILCs. For example, one ILC operating under the exception now has more than $60
billion billion
in assets and more than $52 in deposits, and an additional nine exempt ILCs each have
more than $1 billion in deposits. The aggregate amount of estimated insured deposits held by all ILCs
has grown by more than 500 percent since 1999, and the total assets of all ILCs has grown from $3.8
billion in 1987 to $140 billion in 2004. Several large, internationally active commercial companies now
own ILCs under this exception and use these banks to support various aspects of their global
commercial operations.
While only a handful of states have the ability to charter exempt ILCs, there is no limit on the number
of exempt ILCs these grandfathered states may charter in the future. In addition, due to the limited
restrictions that apply under federal law to the ILCs operating under this exemption, an exempt ILC
legally may engage in the full range of commercial, mortgage, credit card and consumer lending
activities; offer payment-related services, including Fedwire, automated clearing house (ACH) and
check clearing services, to affiliated and unaffiliated persons; and accept time and savings deposits,
including certificates of deposit (CDs), from any type of customer.
Why does this growth and potential further expansion of ILCs matter? Simply stated, it has the
potential to undermine several important policies that Congress has established for the banking
system. Let me explain.
Congress has established a prudential framework for banking organizations in the United States that is
based both on the supervision of insured banks and the supervision of their corporate owners on a
group-wide or consolidated basis. Consolidated supervision refers to the legal framework that provides
a supervisor the tools it needs--such as reporting, examination, capital and enforcement authority--to
understand, monitor and, when appropriate, restrain the risks associated with an organization's
consolidated or group-wide activities. Consolidated supervision of the organizations that control banks
not only helps prevent bank failures, it also provides important tools for managing and resolving bank
failures if and when they do occur. In fact, following the collapse of Bank of Commerce and Credit
International (BCCI), which lacked a single supervisor capable of monitoring its diverse and global
activities, Congress amended the BHC Act in 1991 to require that foreign banks demonstrate that they
are subject to comprehensive supervision on a consolidated basis prior to acquiring a bank in the
United States.
For a variety of reasons, Congress also has long sought to maintain the general separation of banking
and commerce in the United States. This position was reaffirmed by Congress in the Competitive
Equality Banking Act of 1987 and again in the GLB Act of 1999. In fact, in each of these acts the
Congress took affirmative action to close the main loophole then being used by commercial firms to
acquire FDIC-insured depository institutions--the so-called "nonbank bank" loophole in 1987 and the
unitary thrift loophole in 1999.
ILCs have developed and expanded in recent years outside this framework that governs banking
organizations generally. Because of their special exemption in federal law, any type of company may
acquire an FDIC-insured ILC that is chartered in certain states without regard to the activity restrictions
that Congress has established to maintain the general separation of banking and commerce. The
exemption also allows a company to acquire an FDIC-insured bank and avoid the consolidated
supervisory framework--including consolidated capital, examination and reporting requirements--that
applies to the corporate owners of other full-service insured banks under the BHC Act. In addition, the
exemption allows a foreign bank to acquire a U.S. bank engaged in retail banking activities 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.
As insured banks, each ILC is supervised by the FDIC as well as by its chartering state. The Board
has never questioned either the need for, or the adequacy of, this supervision of an ILC. However,
experience has led Congress to determine that supervision of a full-service insured bank is not
sufficient, by itself, to protect the taxpayer and the financial system when the bank operates as part of
a larger corporate organization. The FDIC does not have the authority to supervise the corporate
owners of ILCs and their affiliates in the same manner that bank holding companies and their nonbank
affiliates are supervised under the BHC Act. The GAO recently concluded that, due to these
differences in authority, exempt ILCs may pose more risk to the deposit insurance funds than banks
operating in a bank holding company structure.
The exemption for ILCs in the BHC Act also permits a diversified securities, insurance or financial firm
to acquire an FDIC-insured bank without complying with the enhanced capital, managerial and
Community Reinvestment Act (CRA) requirements established by Congress in the GLB Act for
financial holding companies. In addition, although the USA PATRIOT Act requires the Board to
consider the effectiveness of a company's policies in combatting money laundering prior to approving
the company's application to acquire a bank, this requirement does not apply to companies that seek
to acquire an exempt ILC.
Affirmatively granting ILCs the ability to offer transaction accounts to business customers or open de
novo branches nationwide would significantly expand the powers of exempt ILCs, increase the
attractiveness of the current loophole, and eliminate any vestige of a distinction between ILCs and
fullservice insured banks. This result would be inconsistent with both the historical functions of ILCs and
the terms of their special exemption in current law. These proposals individually and collectively also
would exacerbate the competitive advantage that the corporate owners of ILCs have over other
banking organizations that operate within the supervisory framework established by Congress.
The Board believes that the important principles governing the structure of the nation's banking
system--such as the separation of banking and commerce, consolidated supervision, and the
supervisory criteria applicable to companies that seek to own or control a bank--should be decided by
Congress and, once established, should apply to all organizations that own a bank in a competitively
equitable manner. We are concerned that the expansion and exploitation of the ILC exemption is
undermining the prudential framework that Congress has carefully crafted and developed for the
corporate owners of insured banks. Importantly, these changes also threaten to remove from
Congress' hands the ability to determine the direction of our nation's financial system with regard to
the mixing of banking and commerce.
Congress should not permit the nation's policy on these important issues to be decided for it on a de
facto basis through the expansion of a loophole that is available to only one type of institution
chartered in a handful of states. Rather than expanding the powers of ILCs that operate under this
special exemption in a regulatory relief bill, we believe it is important for Congress separately to
conduct a thorough review of the special exemption for ILCs and its potential to change the landscape
of our financial system and create an unlevel competitive playing field.
Conclusion
I appreciate the opportunity to discuss the Board's legislative suggestions and priorities concerning
regulatory relief. The Board looks forward to working with the Committee and your staffs in developing
and advancing meaningful regulatory relief legislation that