Mark W Olson: Functional regulation and financial modernization
Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve
System, at the annual meeting of the National Conference of Insurance Legislators, Santa Fe, New
Mexico, 22 November 2003.
* * *
Introduction
My thanks to the National Conference of Insurance Legislators (NCOIL) for inviting me to speak to you
today, and special thanks to my former senator, Cal Larson, for being my host.
You've asked me to provide some thoughts on financial modernization and functional regulation, and
to discuss more specifically how these issues may, from the perspective of the Federal Reserve
Board, relate to insurance. I'd like to discuss first the importance of cooperation between the Federal
Reserve System and state insurance supervisors. Then I'll describe some of the lessons we at the Fed
have learned as participants in the dual banking system. I hope that hearing about our experiences
will be useful as you consider initiatives to enhance the state insurance supervisory system. My
comments today are my own and do not necessarily represent the views of my fellow Board or Federal
Open Market Committee members.
Cooperation between the Federal Reserve and the state insurance supervisors
The McCarran-Ferguson Act has long kept supervision of insurance within the exclusive domain of the
states. For most of the past century, we - that is, the Federal Reserve and state insurance
professionals - have traveled in completely different circles for practical reasons as well. The Federal
Reserve has had very little to do with insurance issues because the banks and bank holding
companies for which we are responsible have had little involvement in insurance. In fact, the federal
legislation that charges the Federal Reserve with supervising bank holding companies - the Bank
Holding Company Act of 1956 - was enacted in large part to prevent the affiliation of one of the largest
banks in this country with a large insurance underwriter. Congress went on to strengthen the
separation of banking and insurance in 1982 with an amendment to that act generally prohibiting bank
holding companies from engaging in insurance agency activities. At that point the insurance
underwriting and sales activities of banking organizations were constrained to four limited categories:
Banking organizations were permitted to underwrite and sell credit-related insurance; some
statechartered banks could engage in insurance sales under state law that either granted explicit
permission or contained implicit authority for these activities; national banks could engage in insurance
sales from small towns; and a limited number of bank holding companies were grandfathered and thus
were allowed to continue insurance activities that they had started prior to enactment of the 1982
amendment.
The historic statutory separation of banking and insurance was altered in 1999 when the Congress
enacted the Gramm-Leach-Bliley Act (GLB Act) and allowed well-managed and well-capitalized banks
to affiliate with insurance underwriters and insurance agencies. That brings the Federal Reserve and
state insurance professionals into the same circle.
To date, about 630 bank holding companies have chosen to become financial holding companies, the
vehicle under the GLB Act through which bank, insurance, and securities affiliations may take place.
Of those, about 165 (more than 25 percent) use the new GLB Act authority to engage in insurance
agency activities while only 26 (fewer than 5 percent) are engaged in underwriting insurance that is
unrelated to credit. All of these companies must comply with state laws governing the sales and
underwriting of insurance.
The significant interest by banking organizations in selling insurance makes sense. The banking
system is still dominated, in number, by small banking organizations. More than 90 percent of the
banks in this country have total assets of less than $500 million each. Banks of all sizes have quite
large branch networks - as of the end of last year there were almost 67,500 branches of the more than
7,800 commercial banks in this country. Entering the insurance market as an agent, not as an
underwriter, fits naturally with the nature of banking as an industry dominated by smaller providers.
More broadly, banking organizations have developed good networks and systems for delivering
financial products to consumers - a business model that does not always require manufacture of the
product. Insurance is increasingly viewed not just as a product that stands on its own, but as an
important item on a menu of financial vehicles that help consumers create a portfolio of financial
assets, manage their financial risks, and plan for their financial security. Many consumers prefer to
make their financial decisions and purchase financial planning products at a single location that offers
a full package of financial services. Thus, banking organizations are a natural alternative delivery
system for insurance underwriters looking to expand their customer base.
The affiliation of banks and insurance underwriters has been more modest. One large banking
organization has affiliated with a large insurance underwriter, and one large insurance underwriter has
acquired a small bank. In addition, several foreign banks with insurance operations abroad have
begun to offer both insurance and banking products in the United States. Before the GLB Act, these
foreign banking organizations were required to choose between operating as a bank in the United
States or engaging in insurance activities in the United States; they generally could not do both.
Whether the affiliation of insurance underwriters and banking organizations will become more common
is unclear. Insurance underwriting involves a much larger commitment of resources than insurance
sales and, apart from underwriting credit insurance, seems so far to have little synergy with banking.
Banks and insurance companies so far seem not to have determined whether it makes business
sense to mesh the manufacturing and distribution of insurance with the manufacturing and distribution
of more traditional banking products. The experimentation has begun in ways you would expect. For
example, insurance companies have long thought that the trust and fiduciary powers of banks would
offer them an opportunity to manage insurance payouts and other assets of large estates. And a few
banking organizations are experimenting with manufacturing the insurance products they deliver.
These trial runs need time to work themselves out. What is important is that federal law no longer
prevents the marketplace from evolving and the industry from experimenting. The result can only be
beneficial to consumers.
With these developments have come new supervisory challenges. As I mentioned earlier, we at the
Federal Reserve have little expertise in supervising insurance companies. While some types of risks
are common to both banking organizations and insurance companies, the products, business
practices, and historical framework of the insurance industry are unique and outside our experience.
Similarly, the risks and operations of banks and bank holding companies, which are in our area of
expertise, are quite different from those typically seen in the domain of insurance supervisors.
The obvious supervisory approach suggested by these different risks and regulatory schemes is
cooperative functional regulation that matches supervisory expertise with the risks encountered by the
regulated entity. This cooperation and a functional regulatory scheme are required by the GLB Act. But
they also make good supervisory and business sense.
It is crucial that supervisors talk to each other in order to understand the risks posed by functionally
regulated entities, one to the other. It is also important that supervisors not overburden organizations
with duplicative and conflicting regulation that destroys the very cost savings and consumer benefits of
affiliation.
Consequently, we do not examine insurance underwriters or the insurance agency business of bank
holding companies. Instead, we defer to the appropriate state insurance authorities. We also rely on
reports and other information that insurance companies provide to state insurance authorities to
understand the activities and financial strength of the insurance company, rather than imposing our
own reporting requirements on insurance companies.
Importantly, we have established very successful partnerships with the National Association of
Insurance Commissioners (NAIC) and with many state insurance supervisors to enhance our mutual
understanding of our supervisory frameworks and to facilitate the sharing of supervisory information
and consumer complaints. To date, we have information-sharing agreements with nearly all of the
states and the District of Columbia. While not all of these agreements have been spurred by an
important affiliation that requires information sharing, the process of establishing these agreements
has introduced us to the appropriate authorities in these states and begun a relationship that will
improve our supervisory cooperation and effectiveness if difficulties develop down the road. It is
important to have open lines of communication among supervisors and a framework and relationship
with the states that prepare us to respond to developments as needed.
We are also working with the NAIC and the state insurance supervisors to compare supervisory
approaches for identifying and resolving troubled organizations. Banks and insurance companies must
comply with very different minimum capital requirements - requirements that are tailored to their
businesses. It is important that in circumstances in which affiliated banks and insurance companies
are experiencing financial stress, the bank and insurance supervisors be able to work cooperatively to
resolve that stress without taking steps that help one regulated institution at the expense of the other.
We think that efforts to understand each other's supervisory tools and processes for identifying and
resolving troubled institutions will allow functional regulators to work more effectively and cooperatively
to find an early and effective solution to troubled institutions.
To improve our own understanding of the issues developing in the insurance industry, we have also
established resource centers at the Board and at the Federal Reserve Bank of Boston to monitor
developments in the insurance industry. We particularly value the fruitful relationships that we have
had with organizations such as the NAIC, which has welcomed our input and worked to help educate
us on important insurance issues, and with various state insurance supervisors, who have fostered
cross-training opportunities for us.
State regulation of multi-state entities
When Senator Neil Breslin, chairman of NCOIL's State-Federal Relations Committee, testified earlier
this month before the House Financial Services Committee, he identified several initiatives that the
states are taking to address issues involving modernization of state insurance regulation. NCOIL is to
be commended for initiating these efforts. While there are many structural differences between the
banking and insurance industries, I would like to share with you the experience of the banking
supervisors in maintaining a viable state banking supervision option in an increasingly interstate
banking environment.
Until the early 1980s, banks were prohibited by a combination of federal and state law from
establishing branches, or even bank affiliates, across state lines. In the mid-1980s, several states
began to experiment with interstate compacts that allowed banks to affiliate with banks in other states.
By 1994, there was consensus that interstate banking was important enough to both banks and
consumers that Congress repealed the federal prohibition on interstate affiliations and established a
framework for interstate branching. At the same time, Congress greatly limited the ability of states to
restrict interstate entry by out-of-state banks.
As a result, the banking industry has flourished and customers have benefited. Banks can now provide
products and services seamlessly to customers nationally, including customers that have wide
geographic operations and customers that move geographically. And customers have gained the
convenience afforded by banks that have a wide footprint of branches.
At the same time, interstate expansion has posed challenges for us as supervisors. Although the
Federal Reserve is not limited geographically, we partner in our supervisory efforts with state
authorities that are constrained by state lines. Interstate expansion in a supervisory framework tied to
state boundaries means that state-chartered banks that operate on an interstate basis face the
possibility of regulation by their chartering state as well as by each state in which the bank establishes
a branch office, plus an overarching federal supervisor. In addition to the potential for conflict and
burdensome duplication that having multiple supervisors presents, state banks operating on a
multistate basis must compete with nationally chartered banks that are supervised on a national basis
by a single regulator.
To meet this challenge, we have worked with the state supervisors to develop a more uniform and
seamless approach to supervision. Under the auspices of the Conference of State Bank Supervisors,
the various state banking supervisors have developed a protocol for cooperation in examining and
collecting information from multistate banks. This protocol deals with examinations of two types.
Responsibility for safety and soundness examinations rests with the chartering or "home" state for the
bank. However, the protocol recognizes that the states into which a bank has branched - the so-called
host states - also have a legitimate interest in monitoring the safety and soundness of banks that
operate within their borders. Thus, it allows host states to conduct safety and soundness examinations
of out-of-state banks that branch into the state. It contemplates however that the host state will
conduct safety and soundness examinations only in emergency situations or as part of the
examination conducted by the home-state supervisor. The protocol relies on robust information
sharing and coordination between state supervisors and the federal banking agencies to take the
place of these examinations.
Responsibility for compliance with applicable consumer protection laws is divided among state
supervisors, with each state supervisor responsible for monitoring compliance with local law by local
offices. Examination for compliance with federal consumer laws in some instances is left to the federal
banking agencies and in others is shared with state bank supervisors.
In addition to building on the strength of our system of state bank supervisors, we realized that
supervising large interstate operations requires different and significantly more sophisticated
techniques than we employ for our smaller local banks. For example, our bank examination practices
for many years focused on the review of a sizable number of individual loan files at each bank. This is
an amazingly intrusive and time-consuming process. And it became increasingly obvious that as
institutions grew in size, the technique was not practical on a large scale.
Over time, we have had to develop more-sophisticated sampling techniques as well as methods for
identifying and focusing our examinations on areas of greatest risk to the banking organization. We
continue to review the policies and efforts that each bank employs to identify the risks it faces, to set
and implement standards to address those risks, and to monitor the effectiveness of its
riskmanagement practices. This approach involves the examination of policies and procedures and the
review of statistics on loan default experiences for entire portfolios rather than large numbers of
individual transactions.
We are in the process of developing a more-sophisticated approach to capital as well. The current
"Basel" capital standard was developed in 1988 through negotiations conducted by bank supervisory
authorities under the auspices of the Bank for International Settlement in Basel, Switzerland. Current
efforts to replace this capital accord with a new version (called Basel II) take a decidedly more
riskfocused approach to measuring risk. The proposed approach would build on techniques used by the
largest banks worldwide and should produce results that are much more consistent than the existing
standard with market perceptions of risk. It would separate risks into their component parts and should
give supervisors important new tools for evaluating not only the level of risk, but also the performance
and responsiveness of bank management. Although the proposed standard will be a challenge to
implement and enforce, it will also provide important and necessary incentives to managers of our
largest institutions to adopt more-sophisticated practices for measuring and managing risk.
We have also developed more risk-focused techniques for reviewing compliance with applicable
consumer and other laws. At the same time, we - like the state insurance commissioners - have
established consumer complaint divisions in each of the federal banking agencies to monitor and
investigate individual consumer complaints.
To be sure, our system of risk-focused supervision of banking organizations relies heavily on
cooperation among multiple state and Federal supervisors, and it is not perfect. But it is working, and
we think working effectively. State-chartered banks remain competitive and strong, and the asset
share of state-chartered banks has remained relatively constant. While the banking industry's
continued consolidation is widely recognized and the total number of U.S. commercial banks continues
to decline, less evident is the consistent chartering of new banks - roughly one new charter for every
three consolidations. Seventy-five percent of these newly chartered banks are state banks. The state
charter is apparently no less attractive than before banks gained new powers to expand nationwide.
Certainly, we could not have postponed interstate banking until we had devised the perfect system for
supervising it. The marketplace was moving, and we had to adjust our role to take account of that. The
system we have developed in the banking arena is an evolutionary one, and one we will continue to
work to improve.
I know that you have been working hard at similar efforts in the insurance industry. I understand that
here in Sante Fe, you have a number of important efforts underway, including proposals involving
model laws that would govern Market Conduct Surveillance and Property and Casualty Insurance
regulation.
The institutions we supervise face the same challenges: competition on a growing number of fronts
from unregulated entities, and consumers who are more sophisticated about choosing financial
products. Regulated institutions must be allowed to respond to changes in the marketplace or they will
not survive. Less-regulated institutions will prevail and in the process diminish the very protections that
the regulations sought to preserve. At the same time, of course, we cannot forget that we are required
by law to supervise the entities under our jurisdictions, to protect the public, and to preserve the
strength of the financial system.
To conclude, I will offer one final thought on the important subject of financial regulation and
legislation. While we as regulators and legislators have the responsibility for setting and maintaining
standards of safety and soundness for the benefit of consumers, we cannot ignore the power of
market forces to cause the continual development of consumer financial products. Improvements in
technology and consumer techno-literacy have prompted dramatic changes in all financial industries.
Yet with all the changes we have seen, we are likely still in the early stages of realizing the full benefit
of technological innovation. Our efforts as regulators and legislators will continue to be relevant only
when they are consistent with these changing market forces.