Your
annual meeting this year focuses on change--a theme echoing last month's
meeting of the American Bankers Association and, I suspect, one common to
other conferences, conventions, and meetings of financial institutions in
this country and abroad. The forces of globalization, technology, and
deregulation by the regulators and now by the Congress have drastically
modified the competitive landscape of financial institutions and markets.
Change will continue to be the one constant.
Life insurance companies have been at
the forefront of change and competitive response in the postwar period.
They created new products as substitutes for traditional insurance
policies when households began to demand more sophisticated portfolios of
financial assets. The insurance industry pioneered the private placement
market, which has served as a laboratory for developing and testing new
debt structures, such as securitizations. In the process, your industry
facilitated wider access to capital markets for smaller and
below-investment-grade borrowers. Insurance companies may be among the
oldest financial institutions in our country, but they are surely as
modern and as creative as any--a prerequisite to growth, if not survival.
The change in the rules of affiliation
in the Gramm-Leach-Bliley Act will create new opportunities and risks for
all financial institutions. It is clear that the consumer will benefit
from the wider permissible scope of activities by, and the more equal
competition among, financial entities. That is why the Federal Reserve
actively supported this legislation for so long. Management now will be
given greatly enhanced flexibility to determine the best way to deliver
its services to the market place, and the market will judge the
correctness of that choice.
Nonetheless, even with the wider scope
for markets, insurance companies, just as securities firms, must still
consider the regulatory implications of affiliation with a bank--de
novo or as either the acquirer or the acquired. Thus, it might be
useful if I addressed the issue of how your regulatory position would
change under those circumstances.
I. Limiting the Safety Net
Any change would reflect the bank safety net, which has always been the
major concern about financial reforms that would create broad financial
organizations that include an insured depository institution. By safety
net, I mean the government guarantee of deposits and the access to both
central bank credit through the discount window and to settlement on the
books of the Federal Reserve through our payment services. All of these
reduce the cost of funding the beneficiary bank and tend to insulate the
bank's management and shareholders from bearing the full cost of their own
mistakes or bad luck. The separation of portfolio risk from the cost of
funding that portfolio leads to an inefficient allocation of financial and
real assets. In the past, it has also tended to induce a level of
risk-taking that is neither consistent with the safety and soundness of
the insured entity nor that could be financed on either the same terms or
the same scale if it were not for the government guarantee.
The first concern about allowing wider
affiliations with banks was the potential spread of subsidy benefits to
institutions other than depositories. Our purpose was not to continue a
special break for banks, but to avoid increasing the moral hazard
distortion--and its associated risk. The second concern of designers of
the architecture for financial modernization was to avoid the spread of
the bank-like regulation that would soon follow extension of the safety
net. If market discipline were further blunted by extension of the safety
net, the government would be forced to act in place of the market as the
evaluator of the new safety net beneficiaries. Nonbank financial firms
have, quite understandably, sought to avoid bank-like regulation. Its
linkage to the safety net, however, is too often ignored.
The spread of bank-like regulation over
a wider ambit would bring with it not only constraints on innovation and
flexibility, but also less market discipline. Creditors and stakeholders
would assume that the regulators were ensuring safe and sound operations
and/or that the regulators would bail out the entity if there was a
problem. As a result, they would not feel the need to look out for their
own interests. In my judgment, extension of bank-like regulation would
increase--not decrease--risk in the financial system.
The Gramm-Leach-Bliley Act is designed
to limit extensions of the safety net, and thus to eliminate the need to
impose bank-like regulation on nonbank subsidiaries and affiliates of
organizations that contain a bank. Indeed, for insurance companies and
broker/dealers, the act makes clear that the first level supervisory
authority lies with the functional regulators--the state insurance
authorities and the SEC, respectively--as it should.
As I will discuss momentarily, the
Federal Reserve retains the overall responsibility for financial services
holding companies with bank subsidiaries. In exercising that
responsibility, however, the Board is required by the act to rely, to the
fullest extent possible, on public information and reports from, as well
as examinations conducted by, the functional regulator. In the course of
carrying out our supervisory responsibilities for the bank holding company
and its nonbank subsidiaries, these are to be the first and, whenever
possible, the sole sources of information about those bank-affiliated
entities that are already regulated by others. Only when the Board has
reason to believe that there is a material risk to the affiliated
depository institution--or to ensure compliance with a law, such as the
Bank Holding Company Act--may the Board directly examine a functionally
regulated nonbank subsidiary of a bank holding company. Identical
restrictions are placed on the other federal banking agencies.
It is clear from the letter and the
spirit of the Gramm-Leach-Bliley Act that bank regulators and the holding
company supervisor are to give great deference to the functional
regulators and to interject themselves only in critical circumstances. And
under no circumstances can a functionally regulated entity be forced to
assist a depository or any other affiliate over the objections of the
functional regulator. The limits placed on the Federal Reserve to examine
and obtain reports from regulated subsidiaries are a reasonable response
to the fear of excessive regulation. The Board believes that this
arrangement will work well, if and as the parties cooperate. We fully
expect that will be the case. There will understandably be some tensions
as we all move up the learning curve. But the Federal Reserve is committed
to working with the functional regulators to make this system a
cooperative and effective one.
II. Umbrella Supervision
It is important to understand, however, that the new act does not change
the key, dominant, and major responsibility of both the bank and the
holding company regulators: to contribute to the safety and soundness of
the insured depository institution. The Congress established this
responsibility both because of the role banks play in macroeconomic
stability and because of the moral hazards associated with the safety net
I described earlier. Just as functional regulators of insurance companies
and broker/dealers retain their prime supervisory authority over those
entities, bank subsidiaries of holding companies, too, may have a primary
regulator other than the Federal Reserve. But the Federal Reserve has a
central role as well in prudential oversight for bank subsidiaries of
holding companies.
The most critical of these is the
quantitative constraint on bank loans to, and asset purchases from,
affiliates and operating subsidiaries--sections 23A and B of the Federal
Reserve Act. These provisions also limit loans by a bank to certain
customers of affiliates. Sections 23A and B are the key constraints on
both the spreading of the safety net through subsidized funds flowing to
affiliates from banks and the risk that insured depositories might become
captive lenders to affiliates or their customers. To further limit risk
exposures of the bank, the new act also preserves the authority of the
Federal Reserve to fashion prudential restrictions on relationships
between banks and their affiliates. This authority is intended to allow
the Board to impose other limitations on relationships among the bank, its
affiliates, and the affiliates' customers, if necessary to protect the
depository from arrangements not covered by sections 23A and B. For
example, the Federal Reserve had required that Section 20 affiliates of
banks (the only corporate securities underwriting vehicles for banking
organizations prior to the new legislation) inform their customers that
the instruments purchased were not insured deposits.
The Federal Reserve also may protect
banks by requiring divestiture. If bank or holding company supervisors
believe that the activities of any affiliate or subsidiary-- functionally
regulated or not--are causing undue risk to an insured depository, they
can require that either the bank or the affiliate be divested from the
organization.
To avoid the risks of double leverage,
and to minimize pressure on the cash flow of banks to service parent or
affiliate debt, the Federal Reserve also retains the right to impose
consolidated capital requirements on organizations that include a bank. We
may have to modify our existing regulations to apply this provision in
order to make adjustments for capital requirements already imposed by
functional regulators on insurance companies, broker/dealers, and similar
businesses.
In order to protect the bank, umbrella
supervision must extend its oversight to the consolidated organization.
The need for the Federal Reserve to take a consolidated view of entities
with bank affiliates represents the reality that current and future bank
holding companies are not passive portfolio investors in their component
parts, but rather managers of a consolidated financial enterprise directed
from the center--the holding company. Thus, some authority must focus on
the entire--the consolidated--entity so that each of the component
regulators is aware of risks that may be unfolding elsewhere in the
organization that could affect the unit for which it is responsible. This
oversight is focused on implications for the bank but provides information
that will also be shared with regulators of nonbank affiliates as well.
The consolidated focus of the Federal
Reserve is increasingly on the risk management and control policies that
are virtually always established and maintained at the holding company
parent. I cannot over emphasize the critical importance that the Federal
Reserve places on evaluating risk management and control policies,
including the testing of such controls to ensure their effectiveness. An
integrated well-run organization, experience tells us, centrally
establishes and administers these programs. As umbrella supervisor, we are
also very interested in the interaffiliate transfers and credit
concentrations, the total effects of which may be clear only when viewed
at the overall level.
III. Conclusions
Affiliating with a bank will create some additional complexity for
insurance companies and broker/dealers--mainly reflecting the implications
of the bank safety net but also reflecting the special role banks play in
financial markets and macroeconomic stability. However, these complexities
can be over-emphasized. The Congress has placed real and effective limits
on the Federal Reserve's authority to supervise and regulate functionally
regulated entities. Moreover, the Federal Reserve has strong incentives,
beyond statutory restrictions, to avoid the extension of bank-like
regulation, namely the moral hazard that would be created. In addition, if
the bank is of a modest size absolutely, as well as relative to a
functionally regulated affiliate that dominates the organization, there is
little reason for the tail to wag the dog, as it were, and to apply
consolidated supervision in a burdensome way.
But all this having been said, if the
bank is large and/or a significant part of the organization, both law and
good supervisory and stabilization policies require an active umbrella
supervisor. That remains the role of the Federal Reserve under the
Gramm-Leach-Bliley Act. As umbrella supervisor, our major emphasis will be
on protecting the bank subsidiary and on the risk management of the
consolidated entity, but the information we generate may also be helpful
to functional regulators.
