Mark W Olson: Financial markets regulation in the United States
Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve
System, at the Second Financial Summit: Challenges and emerging risks facing the financial industry,
Madrid, 8 July 2002.
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First, my thanks for being invited to participate in the Second International Financial Summit on
Financial Regulation. Today I would like to share our experiences in the United States in dealing with
this important issue. We are increasingly participating in a world economy, and our financial
institutions are increasingly global in scope. Today's sharing of experiences and observations is
therefore more than an interesting intellectual exercise. We, indeed, have a shared obligation to
understand the evolving nature of our respective industries and to learn from each other's best
practices. My opening comments will be brief as they are intended only to stimulate discussion among
the panel members and audience.
In my remarks, I want first to identify the major trends driving change in the financial services industry.
These trends will not be new to you, as they are global, but they will help define our current
environment. I will then discuss briefly some issues that may be specific to the United States. As with
every country, the financial services industry in the United States is a product of numerous influences.
In my country, the most notable of those influences was our Founding Fathers' determination to
decentralize authority and to limit the federal government's influence and to place the law and
rulemaking responsibility for commercial activities with the various states. I will move from there to the
major trends in U.S. financial regulation and conclude with a brief description of the evolving regulatory
role of the Federal Reserve.
Drivers of change
Several common forces are influencing financial services industries around the world. Perhaps most
dominant is the extraordinary leap forward in technology that has changed every facet of these
industries. The first major technological changes, almost forty years ago, dramatically changed
backoffice processing. In recent years, technological improvements have changed the delivery of retail
financial products to such an extent that our traditional definitions of deposit gathering and lending are
in continual need of updating.
A second major driver of change is the growing complexity of our largest financial institutions. This
complexity is a combination of increased size driven significantly by industry consolidation and by the
creation of more-sophisticated financial instruments.
A third major change is the continued blurring of lines between financial products and financial
industries. In the United States we have, in past years, devoted a great deal of regulatory and legal
attention to sorting financial products by industry designation and attempting to confine products with
certain characteristics to specific industries. For example, in the 1980s and 1990s we devoted
considerable attention to the manner in which a money market fund account with third-party access
offered by a securities firm differed from a bank-sponsored interest-bearing checking account. Another
cross-industry debate focused on whether fixed or variable rate annuities were fundamentally
insurance products, bank products, or simply annuities. Consumers, not surprisingly, have indicated
minimal interest in these legal and regulatory squabbles and have just made their own evaluation of
how the product characteristics fit with their personal financial needs.
These three factors, the advanced technology, the move toward larger and more complex institutions,
and the blurring of financial products--in turn have also substantially changed the manner in which
institutions measure and manage risk. Those management innovations, themselves, are not only of
great interest and importance to regulatory agencies, but they also are forces driving further change.
Simply because institutions can measure and manage risk better, they are able to create products that
make markets more efficient.
Issues peculiar to the United States
In the United States, our tradition of separating the financial, securities, and insurance industries and,
more broadly, separating banking and commerce has consumed a significant portion of our regulatory
attention in a manner not required of European countries that have adopted the Universal Bank
concept. In addition, we have a tradition of multiple chartering options for full-service banks. This
tradition flows from the previously described dispersion of legal and regulatory authority. Therefore,
not until the Abraham Lincoln Administration in 1864 was our national banking authority created, and
only after the 1929 Wall Street panic, was a national securities regulator created. Today, although
nationally chartered banks hold the majority of U.S. banking assets (55 percent), the states continue to
charter most insured commercial banks (74 percent). We continue to have very active state bank
chartering authorities in all fifty states. The insurance industry is the last bastion of a financial services
industry without a federal regulator. To this day, insurance regulation continues under the direction of
state insurance regulators.
Fundamental regulatory changes
In whatever form, financial services regulation is adapting to the fundamental changes under way in
our respective industries. A dramatic change affecting all of the financial services industries is the shift
from a paper-based to an electronic commerce environment. This change requires new definitions for
certain basic business practices--for example, a redefinition of what constitutes finality of a sale when
the entire transaction is conducted electronically. Other examples are determination of what
constitutes a signature in a fully electronic transaction or of how state law applies to electronic
business transactions, some of which are conducted by multiple parties in multiple states. Other
regulatory issues arise when technological advances allow new entities to leapfrog traditional
institutions and command major market positions. This phenomenon is most clearly defined in the
securities industry, where the electronic communication networks (ECNs)--now only six years
old-account for 50 percent of the transactions that take place on NASDAQ. These changes, in turn, have
important regulatory implications for banking organizations. The definition of what is or should become
a "banking business" can rapidly change and in many cases should change if banks are to remain
competitive and innovative in financial markets.
A second fundamental change involves bank supervision--it is the shift from a transaction-based to a
risk-based focus. As financial institutions increased in size and complexity, it became clear that
examiners could not keep pace in the historic manner of examining transactions. Instead, examiners
needed to evaluate large, complex institutions' ability to identify and manage risk. For example, in
evaluating credit-risk exposures, examiners first determine how credit risk is managed. They look, for
example, at such basic elements of risk management as the way the institution establishes its risk
parameters and more specific elements of credit administration and credit review. They evaluate
riskmanagement models or tools that the institution uses and their suitability to the relative sophistication
of the institution's loan portfolio. Determining the level of individual transaction testing depends, in part,
on the results of the initial assessment. Banking regulators are still shifting from transaction-based to
risk-based examination procedures, but our ability to keep pace with the increasing size and
sophistication of our largest institutions necessitates that we successfully make that transition.
Besides looking at credit risk, the Federal Reserve also specifically evaluates banks for market risk,
liquidity risk, operational risk, legal risk, and reputational risk. The potential exposure of reputational
risk has become quite apparent after the recent experiences of Enron and Arthur Andersen.
Current role of the Federal Reserve
Three years ago, the Congress concluded more than twenty years of negotiation and produced a
major reform of financial services laws and regulations. In very brief summary, this new law allows
banks, securities firms, and insurance underwriters to function using common ownership by a newly
authorized entity called a financial holding company. The new law also provides a mechanism for
determining prospectively which products or services fit the definition of "financial in nature" or
"incidental to financial activity" and therefore qualify as appropriate for a financial holding company.
The Federal Reserve has been accorded a major role in deciding these issues and has also been
assigned the role of umbrella supervisor of financial holding companies. As such, the Federal Reserve
will rely as much as possible on the functional regulators of a company's subsidiary banks, securities
firms, and insurance entities, but will oversee the financial soundness of the consolidated organization,
including the activities that are otherwise unregulated. Our focus is the potential risk these nonbank
activities can present to banks.
In addition, the Fed, in conjunction with the Treasury Department, will respond to requests for
determination as to whether new products and services meet the test for "financial in nature" or
"incidental to financial activity" to be approved for financial holding companies. This change has made
our laws more consistent with changes that occurred in the marketplace and has provided a
mechanism for allowing new products as the marketplace evolves.
Conclusion
The past decade has been a time of dynamic change in the financial services industry, and there are
no signs that the pace of change will abate. An important component of this change is the growing
global reach of many of our financial entities. Financial regulators throughout the world will need to
continue responding to these marketplace changes and providing oversight consistent with our safety
and soundness responsibilities. For that reason, I look forward to today's discussion of financial
markets regulation.