\__c;lU.lY/31 gP,«_# 27- 42.! a 87-421 E 3 N . V ‘a %‘W %%l§”§ . — €l i ",9 . ,- :1 , .‘. k in ’t3t~..J"“r 5 i ‘%-\.,.M‘ ~‘- ‘‘ Q";-r-:3 ‘ J ‘ - r _ '. 5‘ '3.‘ ' v xv ;u;::§..§‘;“"-+ ,»'<.- *.‘~ “XI, CRS REPORT FOR CONGRESS iggl 7% 5 ..-...-I .rL "‘¥',~ 73-.....‘ .';‘..:"‘f 3! 5"-.~{i"‘-Yw . ;G9§,{e'{‘£'3‘?l‘fi i:f?E*»!?l'%a§¢L9Q$;z' 2 e 3:’ nu ~' E-- . " ’ > "K ‘-§"‘{'[ X.) 1!. AA AUG 1 7 I994 Washmgton University Libraries NONBANK BANKS IN 1987 St. Louis. MO 63130 Marketplace experiments are resulting in new or- ganizational arrangements for offering banking services. Developments such as the nonbank bank are bringing into question long-standing rules limiting product lines of banking organizations and interstate banking. New ways banking services are being offered raise public policy issues. by F. Jean Wells Specialist in Money and Banking Economics Division May 13, 1987 IlllllfififlliffllflifiliflmlflflifiililIII! The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- bers, and their staffs. The Service makes such research available, without parti- san bias, in many forms including studies, reports, compila- tions, digests, and background briefings. Upon request, CRS assists committees in analyzing legislative proposals and issues, and in assessing the possible effects of these proposals and their alternatives. The Service’s senior specialists and subject analysts are also available for personal consultations in their respective fields of expertise. * CRS-iii CONTENTS DEVELOPMENT OF NONBANK BANKS . . Banking Institutions . . . " o 0 0 0 0 0 0 POLICY CONSIDERATIONS . . . . . Safety and Soundness of the Banking Conflicts of Interest and Tie-Ins . Concentration . . . . . . . State and Federal Authorities . . . ADDITIONAL READING . . . . . . . System ®\lO\U'|-5 DON)!-d 10 NONBANK BANKS IN 1987 Financial deregulation and innovations have resulted in many new configurations of financial services in recent years. '1‘his paper examines some of the marketplace experiments with new organizational arrangements for providing banking services and associated policy questions. Specifical- ly at issue is whether long-standing rules limiting product lines of organizations offering banking services and interstate banking should be reaffirmed or relaxed. The nonbank bank is the best known of the new structural arrange- ments for offering banking services. Although a few nonbank banks existed prior to 1981, the formation of such institutions accelerated in the early 1980s. By fashioning a bank offering limited banking services, an institution is created which in itself does not make the bank's parent company subject to traditional banking regulation. As a result, conglo- merate organizations are able to combine multifaceted businesses and deposit-taking services. Banking organizations are also attempting to use nonbank banks to operate deposit-taking offices interstate. In the case of innovations breaking down traditional product-line limits for institutions offering banking services, major policy concerns relate to the possible effects on the safety and soundness of the banking system. Other concerns relate to whether conglomerate organizations offering banking services would exploit possible competitive advantages over other firms, through tie-ins and conflicts of interest, for example. The possibility of commingled financial services being offered by firms operating nationwide especially raises questions about concentration. A question running through all these issues is how State and Federal regulatory authority should be allocated. DEVELOPMENT OF NONBANK BANKS Nonbank banks are being used by conglomerate organizations as a means of combining multifaceted businesses and deposit-taking services. Until recent years, banking law had generally been considered to limit ownership of banking organizations to firms engaged primarily in banking. Now such diverse firms as Sears, Roebuck & Co., better known as a retail firm; and Merrill Lynch.& Co., Inc., better known as a securities firm; own and operate nonbank banks. Bank holding companies also view the nonbank bank device as a means of expanding interstate banking operations. The term nonbank bank has come to be synonymous with an institution which offers banking services on a limited basis, so that its parent company does not become subject to the banking provisions of the Bank Holding Company Act. A popular means of fashioning a nonbank bank has been to strip a bank of part of its operations so that it does not meet the technical definition of bank under the Bank Holding Company Act. Some firms have also attempted to expand into the banking field by acquiring CRS-2 institutionssdfixfl1have bank-like characteristics but which traditionally’ have not been considered banks. D Bankingilnstitutions The Bank Holding Company Act governs all bank holding companies: organizations which control stock interests in one or more commercial banks, and often in subsidiaries engaged in related activities as well. The law was originally enacted in 1956 and has been amended several times since then. The Board of Governors of the Federal Reserve System is responsible for implementing and interpreting the Act and regulates and supervises bank holding companies. Subsidiary banks may be chartered either on the Federal or State level with the appropriate chartering authority; On the Federal level, the Comptroller of the Currency charters and is the primary regulatory agency for National banks. State-chartered banks may also be subject to Federal regulation. Their primary Federal regulator is the Federal . Reserve if they are members of the Federal Reserve System and the Federal Deposit Insurance Corporation if they are not members of the Federal Reserve System but are federally insured. Whether or not banks are members of the Federal Reserve System, they must maintain reserves on deposit accounts according to regulations of the Federal Reserve. In turn, they have access to the Federal Reserve discount window and other Federal Reserve services. Among the important strictures of the Bank Holding Company Act relevant to current developments are those which effectively restrict ownership of banking subsidiaries and limit interstate banking. In the case of ownership, the Bank.Holding Company Act generally prohibits bank holding companies from owning or controlling nonbanking companies or engaging in nonbanking activities, except for activities determined by the Federal Reserve Board to be closely related to banking. This has the effect of preventing industrial and commercial firms as well as many types of firms offering financial services from owning banks. The Douglas Amendment to the Bank Holding Company Act, enacted as part of the 1956 legislation, governs interstate banking by bank holding companies. It prohibits a bank holding company or its subsidiaries from acquiring a bank located outside the State in which the holding company's bank or banks conduct their principal operations unless such an acquisition is specifically authorized by the laws of the State of the bank to be acquired. A temporary authority contained in the Garn- St Germain Depository Institutions Act of 1982 permitted interstate and interindustry acquisitionscH?troubled.financial institutions under certain conditions. Although a few nonbank banks existed prior to the 1980s, the formation of such institutions accelerated early in this decade. Several types of organizations formerly not thought to be eligible to offer banking services entered into the business by structuring banking operations to avoid provisions of the Bank Holding Company Act limiting ownership of banks. Among securities firms and other financial services organizations owning nonbank banks are Dreyfus Corp., Merrill Lynch & Co., Inc., and Prudential-Bache Securities Inc. Gulf & Western Corp. is an example CRS-3 of an industrial conglomerate owning a nonbank bank; retail companies include J.C. Penney Company, Inc. ' Many large bank holding companies attempted to expand their interstate banking operations by using the vehicle of the nonbank bank‘. Nonbanking corporations also used the nonbank bank vehicle to acquire several or- ganizations offering banking services and avoid the legal constraints on interstate banking. These developments have raised questions of a policy nature about the extent to which ownership of banking organiza- tions should be regulated. Congress has been actively involved in overseeing developments and debating the policy issues. Proposals have been made both to limit and to expand laws dealing with ownership and operation of banks. 1/ Estimates differ as to exactly how many nonbank banks may be in existence, partly because of differences in definitions. The Senate has considered legislation dealing with nonbank banks in 1987 and it was indicated in floor debate that about 160 nonbank banks would be affected by the legislation. In May 1987, the American Banker, the daily financial services newspaper, published a list of nonbank banks owned by diversified companies, and that list totals 100 institutions. Q] The nonbank or- ganizations listed there include commercial banks, industrial banks and thrifts. ' Earlier in this decade, about 400 nonbank bank applications were received by the Comptroller of the Currency. The development of nonbank banks has been curtailed since the first part of 1985 as a result of an injunction by a Federal District Court in Florida prohibiting the Comptroller of the Currency from chartering such institutions (Independent Bankers Association of America v. Comptroller of the Currency). As a result, the population of nonbank banks has pretty well stabilized at the level existing in 1984. Further court actions are pending so that the situation could change as a result of judicial activities. "Near-Banks" The term nonbank banks, narrowly defined, refers specifically to institutions chartered as banks which do not meet the definition of "bank" under the Bank.Holding Company Act because of the limited nature of their activities. Among the public policy issues raised by the development of nonbank banks is whether this innovation conflicts with regulatory control. when the issue of nonbank banks is viewed from this broader perspective, then it becomes of interest to identify the various ways restraints on ownership of institutions offering banking 1] In the 100th Congress, S. 790, passed by the Senate in March 1987, would limit nonbank banks by tightening language in the Bank Holding Company Act; S. 790 also would mandate that a presidential commission be established to study possible restructuring of the financial services industry. 2] Nonbanks owned by diversified companies. American Banker, May 7, 1987. p. 48. CRS-4 services and interstate banking are being tested, even if not technically as a result of the creation of a nonbank bank. A principal alternative firms have found to offering expanded banking services has been through the acquisition of institutions, some of whose activities closely resemble those of banks. As an example, the expansion of powers of savings institutions to include banking functions has made the possibility of purchasing a savings institution an increasingly attractive option for acquiring deposit-based services or commercial lending powers. Federal laws permit such purchases in specified instances. The Savings and Loan Holding Company Act, the Federal law governing savings and loan holding companies, does not prohibit holding companies owning only one savings and loan association from operating diversified businesses. Sears, Roebuck & Co. is a well-known example of a savings and loan holding company which operates nonrelated businesses. A few banking organizations have also acquired savings institutions, primarily under the emergency provisions of the Garn-St Germain Depository Institutions.Act of 1982 which provide for interstate and interindustry . acquisitions of troubled financial institutions. The most notable acquisi- tions for a bank holding company have been those of Citicorp, the Nation's largest bank holding company. After public hearings, the Federal Reserve approved in January 1984 Citicorp's acquisition of two large troubled savings and loan holding companies located in Florida and Illinois. These.acquisitions had been approved by the Federal Home Loan.Bank Board, the regulatory and supervisory agency for federally chartered savings institutions, previously. Earlier, Citicorp was permitted to acquire a large troubled savings and loan association located in California.v ~POLICY CONSIDERATIONS The development of nonbank banks has led primarily to questions about regulatory control over firms operating these institutions. The issue is usually looked at in terms of the Bank Holding Company Act since that is the Federal law governing firms owning banks. According to the legislative histories of the Act: The purposes of the Bank Holding Company Act are to provide Federal regulation and supervision over bank holding companies, to prevent the undue concentration of commercial banking act- ivities, and to maintain the traditional separation between banking and nonbanking concerns in order to prevent abuses in the allocation of commercial credit. Q] At present, the main points at issue relate to coverage of the Act and to the effectiveness of the Act when some firms offering bank- like services are not subject to provisions of the Act. Among the questions under debate are what kinds of organizations should be able to own and §/ U.S. Library of Congress. Congressional Research Service. Nonbank Banks Under the Bank Holding Company Act: A Legal Analysis, American Law Division report by Raymond Natter. Washington, 1983. p. 1. CRS-5 operate a bank, and what kind of regulatory arrangements are appropri- ate for banks’ parent companies in the current environment? These questions are examined in more detail below. It is recognized that over time banking practices change. ]k1fact, the Bank Holding Company Act has been revised from time to time to amend its coverage. It is also unlikely that at any time, all bank-like activi- ties will be subject to equivalent regulatory control. Nonetheless, the degree of innovation recently experienced has led to questions about whether further revisions need to be made in banking laws, taking into account current developments. Some of the reasons for concern are explored below. They include questions about howrpermitting broader ownershipnmight affect the safety and soundness of the banking system. Competitive balance is also an issue. There is concern that relaxing ownership rules could result in conflicts of interest and tie-ins in organizations offering banking services. The possibility of deposit-taking services being offered by firms with offices located nationwide raises questions about concentra- tion. A question running through all these issues is how State and Federal authority should be allocated. These issues are examined in turn, below. Safety and Soundness of the Banking System The effects of product diversification on the safety and soundness of the financial system revolve around the special nature of the banking system and the risk implications of coumingling banking with other financial services and unrelated enterprises. Some argue that diversification is desirable since they see it as helping to spread risk and thus con- tributing to the financial stability of the banking system. Others argue that banks perform special functions that require substantial regulation; therefore, banking organizations should be treated differently than other types of companies. The view that banks are special and that they and their holding companies should be regulated.differently than other forms of enterprise has been most forcefully expressed by E. Gerald Corrigan, a Federal Reserve official. When he was President of the Federal Reserve Bank of Minneapolis, he expressed his views in a well-known essay which appeared in the Bank's 1982 annual report. He singles out for special mention the following distinctions: banks’ ability to offer transaction accounts, their importance as a backup source of liquidity for all other bank in- stitutions, and their link to monetary policy. Q/ 3/ Corrigan, E. Gerald. Are Banks Special? In Federal Reserve Bank of Minneapolis“ .Annual Report 1982. [Minneapolis. 1983] p. 1-24. More recently Mr. Corrigan, now President of the Federal Reserve Bank of New York, has expressed his views in a statement entitled Financial Market Structure: A.Longer'View'(hereafter referred to as Corrigan 1987). This essay appears in the Bank's 1986 annual report. . CRS-6 More recently, he has expanded on his views to present a proposal wh1¢hii“wou1ai‘iipermiEssme’ iicofmmi nfgling” of blanking ‘and other services. 1 According to the plan, three types of holding companies might exist: a bank or savings institution holding company, a financial holding company, or a commercial-financial company. Regulatory treatment and permitted services’-would differ for these three categories. The bank or savings institution holding company could offer the full range of banking services but its other activities would Ibe limited. The financial holding company could offer some kinds of banking services as well as other financial services; however, it could not offer insured transaction deposits and would not have access to the full range of Federal Reserve services. The commercial-financial company could offer certain bank-like services, but it could not own a bank or savings institution; thus the separation of banking and com- merce would be maintained. 1 B B Others argue that banking services can be offered within more diversi- fied firms without detriment. Various kinds of plans can be summarized under two types of approaches. Some trade groups and regulators are considering ways of broadening ownership provisions with structural arrangements to safeguard banking operations. Different kinds of activities might be conducted in various subsidiaries of a holding company, or nonbanking activities might be downstreamed to subsidiaries of a bank.§_/ A more far reaching proposal put forth by some students of banking or- ganization is that deposit functions of diversified financial firms be placed in a separate unit, with the deposits to be secured by Government securities. Other activities would be carried out in other units of the organization. Z_/ I Supporters of diversification argue that banking firms need broader powers if they are to coexist successfully with less regulated firms. Other supporters of further deregulation point out that increased competi- tion should result in reduced costs and improved services, thereby bene- fitting customers. 9 Conflicts of Interest and Tie-Ins A particular concern about the commingling of banking and nonbanking services relates to possible abuses resulting from access to substantial funding sources. Examples include tie-ins and conflicts of interest. Such possible abuses raise competitive and consumer protection issues. _5_/ Corrigani1987. §/ Naylor, Bartlett. Bankers Rethink Financial Industry Framework. American Banker, January 19, 1987. p. 1, 22. 1/ The idea of separating deposit and other services, with deposits to be backed by safe securities, has been popularized by Robert Litan of the Brookings Institution. See, for example: Litan, Robert. Taking the dan- gers out of bank deregulation. The Brookings Review, Fall 1986. p. 3-12. CRS-7 Those who argue against further deregulation on the basis of conflicts of interest are concerned both about possible competitive disadvantages for nonconglomerate firms and possible risk to banking organizations that are part of conglomerate enterprises. It is argued that conflicts of interest could arise within conglomerate firms offering banking services as a result of preferential treatment of affiliated operations over outside companies in the granting of credit as well as provision of other banking services. According to this view, the impartial credit-granting process of banks could be more easily compromised with further deregulation. Further, there is concern that there would be increased opportunities for internal transfers of funds from the banking component of a conglomerate enterprise to shore up affiliates, depending on need. Such transfers could weaken the financial position of the banking component. On the other hand, it is argued that potential abuses could be cared for through legal restrictions. Such restrictions could include direct pro- hibitions, for example. , In addition, those who support further deregulation suggest that legal structuring arrangements could be used to guard against conflicts of interest. According to this view, if different lines of busi- ness were to be placed in separate subsidiaries of a holding company, then conflicts of interest would be minimized. Many recent proposals for further deregulation have combined legal safeguards of a direct nature with a legal structuring approach. Another concern has been that customers may be forced to buy a com- bination of products from a financial conglomerate if they wish to receive favorable consideration for extensions of credit. The example most often cited is that of customers being forced to buy insurance from the same firm offering them credit, if combining banking and insurance services were to be generally permitted. In turn, tie-in arrangements are seen as disadvan- taging competitors. Those who support further deregulation argue that tie-ins, like conflicts of interest, can be prohibited through legal restrictions. They also argue that conglomerate organizations offering banking services are not likely to have sufficient market power to force such services on customers; thus, competitors should not be unduly affected. Concentration The extent to which concentration might result from possible abuses, such as conflicts of interest and tie-ins, has been examined in the previous section. The creation of nonbank banks has also raised questions about concentration that could result from the increased size and scope of firms engaging in interstate banking or combining banking services and other forms of enterprise. In the case of interstate banking, the McFadden Act requires National banks to comply with State branching laws, just as the Douglas Amendment to the Bank Holding Company Act defers to State laws with regard to the establishment of "full-service" interstate banking operations by bank holding companies. Until recently, most States had not encouraged interstate banking. However, recent developments in the financial system are leading some States to change their laws. In a few instances, States CRS-8 allow out-of-State banks or bank holding companies to establish "full- service" deposit-taking and lending operations in their States without reciprocity; more typical are regional reciprocal arrangements. wi th the incremental development of "full-service" interstate banking, some have expressed concern that if the development of nonbank banks is not curtailed, a few large enterprises offering banking services could overwhelm local and regional institutions. In turn, it is argued that this could disadvantage some classes of customers such as small businesses and consumers who may perceive local institutions as being more responsive to their needs than nationwide institutions. According to this view, the authorization of further deregulation without appropriate safeguards would undo gradualist approaches to interstate banking designed to provide time for adjusting to a more competitive environment. Others argue that the regional interstate compacts are themselves monopolistic, since banking organizations not headquartered in an inter- state-banking region are prevented from acquiring or establishing banking offices there. Moreover, it is argued that additional competition result- ling from freer entry could improve local banking services. Proponents of these views often argue that interstate banking should be addressed on the Federal rather than the State level, on the grounds that interstate banking presumes the creation of a National banking system. Both the development of interstate banking and combination of banking with other financial and nonfinancial businesses raise questions about whether economies of scale or scope exist which could lead to undue concentration. Recent studies suggest that substantial economies of scale do not exist in banking. §/ Since banking and nonbanking combinations are not common in this country, there is much less evidence to suggest what might occur if firms were to be permitted to offer both banking,and nonbanking;services nationwide. 2] However, one approach to dealing with possible problems that could occur with further product diversification would be to provide for some kinds of limits on combinations of services or institutions through legislation. State and Federal Authorities The nonbank bank issue has also raised questions about Federal and State authorities both with regard to interstate banking and permissible _8_/ Recent studies of economies of scale in banking are suumarized in Kolari, James, and Asghar Zardkoohi. Bank Costs, Structure, and Perform- ance. Lexington, Mass., D.C. Heath and Co, 1987. 241 p. 2/ A study which examines the experience with conglomerate mergers in the industrial sector in the 19605 as well as other factors and their rele- vance for today's financial markets is: Rhoades, Stephen A. The Implica- tions for Bank Merger Policy of Financial Deregulation, Interstate Banking, and Financial Supermarkets. [Washington] Board of Governors of the Federal Reserve System. [1984] 8 p. (Staff Studies, 137) CRS-9 activities for banks and bank holding companies. The dual banking system, whereby banks may be chartered on either the State