Susan Schmidt Bies: Financial supervision issues
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Securities Industry Association Annual Meeting, Boca Raton, Florida,
5 November 2004.
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I want to thank you for the invitation to speak at this annual meeting of the Securities Industry
Association (SIA). The financial services industry continues to evolve to meet the challenges posed by
mergers, new financial instruments, and changing regulatory frameworks. The Federal Reserve Board,
as the umbrella supervisor of financial holding companies, has been working with other regulators and
financial institutions to improve the effectiveness and relevance of regulation and supervision in this
changing environment. Some of the issues that we have been dealing with recently are of mutual
concern to both broker-dealers and commercial bankers - albeit they may represent different sides of
the coin. Others involve reconciling the differing perspectives and regulatory environments of
investment firms and commercial banks around similar financial products and activities in the wake of
financial conglomeration. Today I would like to bring you up-to-date on three such issues, as well as
highlight some aspects of the Federal Reserve's proposed anti-tying guidelines. In all of these areas, I
encourage your participation as we work toward new regulatory guidance.
Accounting for securities
The first supervisory issue I would like to discuss involves accounting for investment securities. The
recent accounting guidance, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments, or EITF 03-1, has raised serious questions about accounting for investments that
are held in available-for-sale portfolios. As many of you are aware, when the Emerging Issues Task
Force (EITF) of the Financial Accounting Standards Board (FASB) came to its consensus earlier this
year, it was not intending to dramatically change accounting practices for debt securities. But in early
August, the public accounting firms began interpreting the guidance very differently. Specifically, if a
security was sold from the available-for-sale investment portfolio at a loss, the new interpretation
called into question the facts and circumstances that should be used to determine if the remaining
portfolio should be viewed as "other than temporarily impaired," and thereby marked down to the lower
of cost or market through earnings (LOCOM).
At the Federal Reserve, we were concerned about the interpretation since most banks use their
available-for-sale portfolio to manage their net interest margin on longer-term, fixed-rate deposits and
funding. A LOCOM accounting model applied to such instruments is not consistent with this important
management function. For asset-liability management purposes, historical cost accounting better
reflects the use of the available-for-sale portfolio to hedge this type of interest rate risk. We have
always expected banks to regularly review the fair values of all their securities. But the concept of
"tainting" due to realized losses from the available-for-sale portfolio had not been widely applied in
such a narrow way.
I commend FASB for listening to questions raised by preparers, auditors, and bank regulators and for
agreeing to defer the effective date of the impairment guidance in this interpretation. FASB has also
issued some implementation guidance, and its comment period ran until October 29. To be sure, the
fixed-income research groups of a number of SIA members have played an important role in educating
their commercial bank customers on the issues surrounding EITF 03-1 over the past few months.
However, more work may be needed and I would encourage you to closely monitor FASB's
deliberations. Pay particular attention to the facts and circumstances that should be considered. Note
that the guidance allows sales of available-for-sale securities at a loss for the same reasons sales of
held-to-maturity securities are permitted without tainting the remaining portfolio. For example, mergers
or changes in regulatory capital justify untainted sales. The guidance also permits sales for
unexpected and significant changes in liquidity needs or for increases in interest rates.
In practice, EITF 03-1 should make all organizations that have available-for-sale securities review their
procedures for identifying impairment. Clearly, investors should continue to monitor for credit
downgrades and changes in prepayment speeds, especially for interest-only strips and
mortgage-backed securities booked at a premium. But the trigger for recognizing impairments for
changes in interest rates under EITF 03-1 would no longer be an intent to sell, but rather whether the
investor no longer intends to hold the security until fair value recovers to its amortized cost.
Also note that the disclosure aspects of EITF 03-1 do apply to third-quarter financial statements. The
major change is separate disclosure of securities whose fair value is below carrying cost.
Organizations must now disclose separately the amount of securities that have been in a continuous
unrealized loss position for more than one year, and in the narrative discuss why the loss has not yet
been recognized.
As dealers in investment securities for banks and other investors, your organizations should be aware
of the importance of remaining informed about emerging accounting interpretations that deal with
longaccepted practices - not only in the context of providing products and services to your customers, but
also in your own bank-like entities that may be affected as investors.
Regulatory capital issues
Let me now move on to some accounting issues that relate broadly to the new capital framework for
the largest U.S.-based financial institutions, including broker-dealers who wish to have consolidated
supervision for purposes of meeting European Union requirements. In general, this entails
brokerdealer implementation of Basel II capital requirements. As you know, the Basel II effort to revise bank
risk-based capital standards is now in its final stages and moving toward implementation. Importantly,
that effort has adopted an approach to credit risk for instruments held in the banking book that differs
from the current capital rules applied to instruments held in the trading book under the 1996 Market
Risk Amendment (MRA) to the Basel Accord. Clearly, the fair valuing or "marking to market" of
commercial bank trading portfolios and the implied short-term holding periods of such positions factor
into the different approaches. We must remember, however, that the MRA was adopted at a time
when bank trading portfolios looked very different from today. Significant growth in structured
transactions, collateralized debt obligations, and credit derivatives are just a few examples of the
significant developments over the past several years. Moreover, the MRA was structured with
commercial banks in mind and not broker-dealers who, as you know, mark most of their balance
sheets to market. Also, both banking organizations and investment firms appear to be holding
less-liquid instruments at fair value over longer time horizons than has been traditionally associated
with the concept of a commercial bank trading account. Taken together, these industry and regulatory
dynamics suggest that the time may have arrived for supervisors to begin to review the
appropriateness of the 1996 MRA for commercial bank trading accounts and investment firm
fair-valued holdings.
In an initial effort to fully identify the types and characteristics of instruments that banks hold in their
trading accounts, and that securities firms hold at fair value, a joint subgroup of the International
Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision is
surveying the industry. This survey seeks to gain a better perspective on the range of techniques
financial institutions are developing to more robustly measure the risk these instruments entail. The
information acquired in the survey is to be fully incorporated in supervisors' review of the current
adequacy of the MRA. However, this effort to review the MRA is still in its early stages. As yet, it is
uncertain whether the effort will result in minor revisions or significant changes to the current MRA.
Challenges in securities accounting and auditing
Both of these securities-accounting issues that I have just discussed should also be viewed in light of
broader issues that are challenging corporate management, independent accountants, and regulators.
Fair value accounting for securities, whether in the income statement or in disclosures, relies on key
assumptions, modeling techniques and judgment. For example, modeling techniques are commonly
used in valuing mortgage-backed securities. The present value of the estimated future net cash flows
attempts to anticipate prepayments of mortgages due to forecasted changes in interest rates.
Changes in the assumptions used in the modeling approach for any instrument or product will affect
the resulting values. For example, if property values are rising rather than falling, the resulting buildup
of home equity can affect a borrower's desire to refinance the loan or use the equity to purchase a
more expensive home.
Thus, the auditing of model-based fair values for accounting purposes requires a high level of
specialized knowledge. The auditor must fully understand how modeling or other sophisticated
techniques are used to determine fair value, whether the assumptions used in the models are
appropriate, and whether the data have integrity. Furthermore, "fair value" is not always clearly defined
or easily determined for some products or instruments. The lack of observable market prices,
differences in modeling assumptions, expectations of future events and market conditions, and
customer behavior make the task of assigning appropriate valuations very difficult. Certainly, a
noncomplex instrument that is highly liquid and that has an observable market price is easier to value
with more precision than a highly complex, illiquid instrument. Given the myriad of complex financial
instruments that currently exist and that are constantly being created, developing verifiable and
auditable fair value estimates is a major concern. And because fair value models are forward looking,
an auditor has an additional challenge: determining what is the normal variability in expectations that
surrounds any forecast and what is earnings manipulation.
To its credit, FASB has recently issued an exposure draft on fair value measurement. The proposal
provides a framework for fair value measurement objectives, and it is just the initial phase of a
long-term fair value project. The initial phase is generally intended to apply to financial and
nonfinancial assets and liabilities that are currently subject to fair value measurement and disclosure.
It is not intended to expand the use of fair value measurements in financial statements at the present
time.
In my view, the proposal is a good first step in enhancing fair value measurement guidance, but I
believe additional guidance is warranted. The proposal should address reliability issues more
comprehensively. Most important, FASB should develop additional guidance and conduct more
research and testing to enhance the reliability of fair value measurements before the use of fair value
is significantly expanded in primary financial statements. Furthermore, FASB should work with other
organizations including the Public Company Accounting Oversight Board (PCAOB), the American
Institute of Certified Public Accountants (AICPA), and accounting firms to enable the development of
robust guidance that ensures fair value estimates can be verified and audited.
Anti-tying restrictions on banks
Finally, I want to discuss the nature of anti-tying regulations for financial institutions, an issue that can
be very confusing to nonbankers. As innovations create new financial instruments, services, and
markets, and as banks expand the scope of the financial services they offer, the process banks use to
make business decisions is similar to the process many of you apply in your own business. Financial
institutions are trying to build customer loyalty by offering a broader menu of financial services to
corporate customers. Some of these financial services are more profitable than others, and thus, add
greater shareholder value. The concern addressed by anti-tying restrictions is that banks may force
customers to take unwanted products in order to obtain needed services - primarily loan products.
As a brief background, a special anti-tying statute applies to banks. The statute generally prohibits a
bank from conditioning the availability or price of one product on a requirement that a customer also
obtain another product that is not a traditional bank product from the bank or an affiliate of the bank.
For example, a bank may not inform a customer that it will provide the customer with a loan only if the
customer engages the bank's securities affiliate for an underwriting or obtains some other product or
service that is not a traditional bank product from the bank or an affiliate. The words "that is not a
traditional bank product" are important. Not all tying arrangements are illegal ties. The statute and the
Federal Reserve Board's regulations expressly permit a bank to condition the availability or price of a
product or service on a requirement that the customer also obtain one or more traditional bank
products from the bank or an affiliate. For example, banks for many years required customers
obtaining construction financing to maintain compensating balances. A traditional bank product
generally is defined as any "loan, discount, deposit, or trust service," and the Board's proposed
interpretation provides guidance on what types of products fall within the scope of these terms.
In light of the complexities of the anti-tying restrictions, the Board has published and received public
comment on both an interpretation of the anti-tying statute and on related supervisory guidance. The
proposed interpretation was published to help banking organizations and corporate customers clarify
permissible practices under this complex statute in today's financial services environment. Importantly,
the interpretation proposes guidelines that a bank should follow when it seeks to engage in traditional
"relationship banking," that is, serving its customers on the basis of the profitability of the overall
customer relationship with the entire banking organization. The proposed supervisory guidance
communicates our expectations as to the types of policies, procedures, internal controls, and training
programs that should help banks comply with the anti-tying restrictions. The proposed guidance also
emphasizes the importance of the compliance and internal audit functions in ensuring compliance with
the law and regulations. Ensuring compliance can be an extremely difficult endeavor because there is
no prohibition against cross selling products or aggressive marketing. The goal is to ensure that banks
don't cross the line between offering choices and illegally tying products and services.
The Federal Reserve Board and the other federal banking agencies have long required that banking
organizations establish and maintain policies and procedures to ensure compliance with the anti-tying
restrictions, and the agencies monitor these policies and procedures through the supervisory process.
Admittedly, at times it can be difficult to determine whether a violation of the anti-tying statute has
occurred. As I mentioned, some forms of tying by banks are expressly permitted, and the statute does
not apply to tying arrangements imposed by a bank's nonbank affiliates. Moreover, divining whether a
bank imposed a prohibited tie often requires a close review of the facts and circumstances associated
with a particular transaction. A prohibited tie, for example, may be conveyed orally and not
memorialized in transaction documentation.
Our supervisory reviews indicate that banks generally understand and have implemented systems to
ensure compliance with the anti-tying provisions to which they are subject. In addition, although we
have encouraged customers that believe they have been the subject of an illegal tie to come forward,
we have received few complaints from bank customers. Moreover, few customers have sought to
challenge their banks directly, although they are granted a private right of action under the statute and
may obtain triple damages if successful. A 2003 report by the Government Accountability Office (GAO)
on bank tying practices found that the available evidence did not substantiate claims that banks were
engaging in illegal tying, but the report did note that borrowers were reluctant to file formal complaints.
The GAO recommended that the Board consider taking additional steps to enforce compliance with
the anti-tying provisions. Our proposed interpretation and guidance are intended to help banks and the
customers understand this rather complex compliance area.
I should mention that we also received a comment letter on the proposed interpretation from the
Department of Justice. This letter, which is available on the Department's web site, expresses concern
that the bank anti-tying statute itself may suppress competition and harm consumers, especially as it is
applied to large customers. The Justice Department recommends that the Board interpret the bank
anti-tying statute in a manner similar to the federal antitrust laws. Under federal antitrust laws, which
apply to independent broker-dealers, a showing of market power is essential to support a finding that a
company has coerced its customer to purchase an unwanted product or service. In contrast, the courts
historically have found that the special anti-tying statute that applies only to banks generally does not
require a showing of market power to support a violation. Alternatively, the department recommends
that the Board exercise its statutory authority to exempt large, corporate customers from the reach of
the bank anti-tying statute. These are all issues the Board will have to carefully consider as it moves
toward finalizing the anti-tying interpretation and guidance.
Conclusion
I know that the SIA and your financial firms have been devoting time to many of the regulatory issues
that have made the headlines in the past several years. I hope that my comments today will also
remind you that the evolution of the industry and financial products creates challenges that you are
likely to encounter in the more normal course of business.