LC «£4.19/3: 99+, as 27- «me 87-411E cRs REPORT FOR coNcRE‘ss,s~,;,_ ,. em PUb“¢a“°“$ .,‘,»_ , ,. 3} pi V ».-{2 2,4 : n ‘V? ‘R "11 ’=J1 €31 .. ' " "i"!-~v-4"‘; 4:».t\‘-..—¢'; ‘a5g._E _mk -$1 ,‘l/‘:7"“"_t.. "my [$2-«~,, ._;r\,...—_$‘ . ,‘,‘,_L‘ ,._...L ._. ’. . I ,1; 1994 J 2. is .. ~ .s~ an K. - ,4 L. . ; ‘*9 W _ .. .-‘If. (gt £3’ ‘}’{%JJ V _§t_‘"_‘_,'q} Ml_:"a__ I‘ N [MEVEN@&1‘g£s“‘“f,{g“{53§§’5a"°‘ 1. ‘v if? ‘'1; ‘ DEPOSITORY FINANCIAL IN§§LIfii;Q_ Y\$,§, FEDERAL vs. STATE REGULATION AND PRODUCT ‘D’l‘VE1RS’I*F'IC§ ‘CO 1 - F“, . I t’ ‘ -1-.i1i6xg%:. K .5 During recent years, rapid changes and innovations in the Nation's financial markets, coupled with a dual system of reg- ulation for depository financial institutions, have resulted in increasing divergences in activities permitted State and federally chartered institutions. This report gives examples of how these divergences are occurring and examines associated policy issues. by F. Jean Wells Specialist in Money and Banking Economics Division April 30, 1987 ‘ ’ u\\\i\’\'\ii\j }i)1l}I\;i\l§fij§i;i\g\;T\;l‘flii um 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 eir respective fields of expertise. CRS-iii CONTENTS O O O O O O O O I O O O I O I O O O O O O O O O 0 POLICY ISSUES . . . . . . . . . . . . . . . . ... . . . . . General Principles of Federal versus State Regulation Distinctions Among Activities on the Basis of Risk . . Separate Subsidiary Approach . . . . . . . . . . . . . Similarities and Differences Among Various Types of Institutions . . . . . . . . . . . . . . . . . . O I O O O O O I O O O O O O i O O O O I O V obww DEPOSITORY FINANCIAL INSTITUTIONS: FEDERAL VERSUS STATE REGULATION AND PRODUCT DIVERSIFICATION Divergences in Federal and State laws and regulations governing permis- sible activities for depository financial institutions have led to recent congressional interest and deliberation. The divergences have been particu- larly noticeable among commercial banking organizations and savings institu- tions. At issue is the question of whether Federal or State law should pre- vail in instances where differences develop. This report examines the question of Federal versus State regulation in two ways. First, it explains some of the ways divergences have come about. Second, it examines some of the issues surrounding the question of the ex- tent to which activities should be made to conform. If FINDINGS Differences in laws and regulations arise because of the dual system of regulation for depository financial institutions in the United States. Un- der this system, commercial banks, savings institutions, and credit unions may be chartered either on the Federal or State level. An institution's charter determines whether its primary regulator will be a Federal or State agency. In recent years, the Nation' s financial markets have been experiencing rapid innovations and changes which have accentuated differences in some State and Federal laws and regulations. In some cases, the States have pro- vided broader powers for State-chartered institutions than Federal authori- ties have provided for federally chartered institutions. In response to State initiatives, Federal authorities have sometimes attempted to limit expansion of powers by State-chartered institutions in instances where the institutions are also subject to Federal regulation. In other instances, one or more of the Federal regulators for depository financial institutions has attempted to accommodate the trend toward more liberal powers reflected in the laws of some States. This kind of response can itself increase distinctions among institutions. y This report is a revision of CR8 Report No. 85-169 E, Diversifica- tion of Financial Services: The Regulatory Roles of Federal and State Gov- ernment. CRS-2 Some of the areas in which changes are occurring include Federal and State legislative and regulatory actions dealing with insurance, securities, and real estate powers for bank holding companies and banks, and a wide range of activities engaged in by savings institutions in various States. The most widely known issue is probably that of insurance powers for banking organizations due to what has become known as "the South Dakota loophole." This issue came about when some bank holding companies attempted to broadentheir permissible insurance activities through the use of favora- ble State law in South Dakota. Specifically, South Dakota law now permits banks chartered in the State to engage in all facets of the insurance business. Moreover, out-of-State bank holding companies would be permitted to acquire in-State banks, for purposes of engaging in the insurance business, as long as they do not com- pete with the insurance business in South Dakota. The full implications of the change in law by South Dakota have not been experienced, however. Following the change, some banking organizations applied to the Federal Reserve to operate insurance activities through South Dakota bank subsidiaries. The Federal Reserve indicated reservations about the approach and the banking organizations have not pursued their applica- tions. « The question of the relationship among Federal and State laws and regu- lations governing permissible activities of depository financial institu- tions is of interest for several reasons. First, concern is expressed about the possible risks of broader powers to the financial system. In many cases, the institutions which are able to engage in broader activities as a result of State charters also are federal- ly insured and/or have access to credit facilities attached to the Federal financial regulatory authorities. Thus, both Federal and State authorities have a direct stake in the performance of the institutions. The question of the effect of broader powers on risk is itself quite controversial. In some cases, broader powers may be seen as increasing risks because of the nature of the activities being undertaken; in other cases, they may be seen as mitigating risks through portfolio diversifica- tion. A related issue is whether the particular structural arrangements for an institution within which an activity is undertaken can make a difference in the possible exposure to risk. It is also not clear whether different or similar activities' provisions should be made for commercial banks and savings institutions whose roles have been distinguished in the past but which are becoming more alike at present. Underlying many of the specific questions, too, is the identification of the general principles that should guide decisions concerning Federal/ State relations with regard to permissible activities for depository finan- cial institutions. The remainder of this report deals with that issue. CRS+3 POLICY ISSUES Several factors affect views about how the responsibilities for deter- mining permissible activities for depository financial institutions should be allocated between the Federal and State governments. These include de- terminations about the appropriate balance between Federal responsibilities and States‘ rights, the degree of risk that various types of activities are thought to entail, the structural arrangements which may be stipulated for certain activities, and the extent to which cotrmercial banks and savings in- stitutions are viewed as alike or different. Each of these issue areas is examined in turn below. General Principles of Federal versus State Regulation Finding the right balance between Federal and State regulation of per- missible powers is not easy. On the one hand, different objectives of Fed- eral and State legislators and regulators can lead to problems within the financial industries; on the other hand, different approaches can also lead to advances within the industries. Thus, the appropriate balance at a par- ticular time is partially subjective, depending on one's views of how the costs and benefits of particular arrangements net out. Arguments for increased Federal involvement in setting activities‘ lim- its for State-chartered institutions stem primarily from those who believe that a main function of regulation of depository financial institutions is to protect the Nation's financial system. They argue that decisions about the functions appropriate for the Nation's commercial banking organizations and savings institutions have significant implications for the safety and soundness of these institutions and are, therefore, a matter for Federal de- termination. Financial problems of individual institutions could lead to substantial costs for the Federal Government. Both commercial banks and savings insti- tutions have access to Federal credit facilities. The primary credit source for commercial banks is the Federal Reserve discount window; for savings in- stitutions, it is the Federal Home Loan Bank Board advance system. In addi- tion, most commercial banks and savings in-stitutions are insured by the Federal deposit insurance funds which bear a financial burden in the case of institution failures. On the other hand, States‘ rights proponents argue that as a general rule the determination of appropriate functions for commercialbanks and savings institutions should be left to the States. They point to the dual system of regulation as a source of innovations and advances in the finan- cial system. Another concern is that if regulatory power were further concentrated on the Federal level, too much emphasis might be placed on "safety and soundness" and too little on competition within the financial system. An example in recent years of a financial institution product which was devel- oped among State institutions and later adapted through Federal legislation for all institutions is the NOW (negotiable order of withdrawal) account, a form of interest-bearing checking account. CRS-4 Sometimes the advantages for one State in expanding permissible activi- ties may disappear if a new activity is approved for several States. Thus, actions of individual States and actions resulting in changes for the Nation as a whole may have different consequences. For example, in the case of "the South Dakota loophole," changes in State laws to enable bank holding companies to offer insurance activities through State-chartered bank subsid- iaries were widely seen as a means of bringing jobs to South Dakota. If bank holding companies were generally permitted to offer insurance activi- ties, then there would be no particular advantage of locating in South Da- kota for such purposes. Distinctions Among Activities on the Basis of Risk One approach which could aid in determining when Federal intervention in State activities regarding permissible activities might be warranted would be to base decisions about intervention on evaluations of the riski- ness of the activities in question. 1/ Among the powers that have been the most controversial have been those involving the real estate, insurance, and securities businesses. Several distinctions can be made about the various kinds of activities that take place within those broad categories. For example, the relationship between an institution and a customer will differ, depending on the particular service being performed. An insti- tution offering real estate, insurance, or securities services may have an agency relationship, provide advice, engage in underwriting, or make invest- ments. The risk would differ depending on whether the transaction involved a commitment of an institution's funds, and, if so, the manner in which they were placed. An agency relationship would not involve commitments of funds but would simply result in placing orders by customers. Similarly, "best efforts" un- derwriting would not put an institution's funds at risk. But direct invest- ment or the more typical form of underwriting, whereby the underwriter agrees to purchase a securities issue fromthe issuer for resale, would in- volve company funds. Different degrees of risk exist depending on the particular type of business being undertaken as well. In the insurance business, the two main lines are life-health insurance and property-casualty (liability) insurance. Underwriters in the two lines have had different earnings experience in the past several years, with particular problems among property-casualty under- writers. Various segments of the securities business are often distinguished by whether the issuer is a public or private entity -- the U.S. Government, a municipality, or a corporation. Differences in underwriting risk depend ;_/ Risk is used here in the general sense of the likelihood of an ac- tivity' s contributing to or detracting from an institution's profits. For a survey of many of the ways of measuring risk applicable to expanding powers of depository institutions, see Wall, Larry D. , and Robert A. Eisenbeis. Risk Considerations in Deregulating Bank Activities. Federal Reserve Bank of Atlanta Economic Review, May 1984. p. 6-19. CRS-5 primarily on the salability of the individual issue. Salability can be af- fected both by the standing of the individual issue and by market condi- tions. Another distinction which becomes important when holding securities is that between bonds and stocks. Government and municipal securities are in the form of debt instruments, the principal of which is due to be repaid at maturity; corporations offer both bonds and stocks. Stocks reflect an equi- ty, or ownership, position in a corporation. with stocks, the principal is most often recaptured through sale of a security at the existing market price. Even if a security is in a form which requires repayment of princi- pal at a certain time, as with a bond, the value of the security may vary over its life with market conditions. The underlying worth of any security is, of course, a reflection of the issuer's financial strength. In the real estate business, the risk attached to development is char- acterized by the necessity of finding financing for the project once it is completed in order to recoup the initial investment; investment in real es- tate can be risky, since real estate sales are cyclical and property values may change due to many factors. So far, evaluating the risk of the possible addition of powers for de- pository financial institutions has been looked at in terms of individual activities. In addition, it is important to look at the risk associated with the mix of activities undertaken by an institution. Some would argue that a broader activities‘ base for depository financial institutions is warranted so that the institutions may diversify their portfolios and lessen their vulnerability to downturns in any one kind of activity. Others would argue that the addition of other activities may cause the riskiness of the entire portfolio to increase and, therefore, be undesirable. Risk is also dependent on how institutions choose to use their powers. Savings and loan associations in some States have ventured into a wide vari- ety of activities not generally available to depository financial institu- tions, due to changes in some States’ laws. In some cases, institutions have taken advantage of the latitude in certain States’ laws to place their assets largely outside of mortgage-related assets by concentrating in one type of non-housing investment. At issue here are those institutions that, in placing their assets, have diversified out of housing but have not gener- ally diversified their portfolios. Supporters of this approach argue that the institutions will move in and out of housing, or other businesses, as favorable circumstances for those businesses develop. Others argue that the institutions remain at high risk if the particular type of activity in which they have placed the major- ity of their assets suffers a downturn. Even if risk is agreed on as a means of evaluation, risk evaluations themselves can be subject to controversy. The degree of risk of various kinds of businesses may change, depending on changes in economic circum- stances. This point was illustrated in the late 1970s when the economic climate changed. The inflationary environment and high interest rates con- tributed to heavy losses in the savings industry, due to its holdings of long-term, low-interest-rate, mortgages. CRS-6 Further, disagreements may exist about the degree of risk which insti- tutions offering deposit services may appropriately undertake. The differ- ences in view will, in part, hinge on one's opinion about whether direct regulation or competition in a market environment may do more to encourage the "safety and soundness" of the institutions. Even in a more competitive environment , regulatory agencies must follow and evaluate institutions‘ con- ditions, which requires that they have adequate staff trained to monitor in- stitutions' activities, however varied. Other considerations also enter into decisions about what activities are appropriate for depository financial institutions. For example, politi- cal considerations play a part. Interest groups which represent other busi- nesses and which feel that their member firms may be taken over if banking organizations and savings institutions are allowed into the businesses, typ- ically attempt to forestall broader activities for depository financial in- stitutions. It is sometimes argued that depository financial institutions may -have advantages over other firms in a business because of their access to large financial resources. The potential for tie-ins and conflicts of interest are also often cited as reasons why depository financial institutions should not be permitted to diversify into other forms of businesses. Alternatively, depository financial institutions argue that they should have broader powers to be able to compete better against other kinds of firms offering diversified financial services and that customers would be better served through greater choice. They also argue that potential prob- lems such as concentration, tie-ins, and conflicts of interest could be con- trolled through law and regulation. Underlying institutions‘ performance, too, is managerial capacity, which will differ from institution to institu- tion, whatever the product mix. T Separate Subsidiary approach In order to resolve some of the conflicts that could arise from many types of activities, including depository activities, being conducted in one firm, an oft-made suggestion is that nonbanking activities be conducted in separate subsidiaries of a holding company, or, in the case of independent institutions, in subsidiaries or affiliates of the institution. Some also suggest that if additional activities are to be authorized for holding com- panies, the activities should be performed not by subsidiaries of depository institutions but instead by holding company affiliates of the depository in- stitutions. From the standpoint of Federal/State relations, it has sometimes been argued that the "separate subsidiary" approach would permit some latitude for varying the treatment of institutions' powers, since it would result in nonbanking activities being structurally separated from banking activi- ties. 3_/ However, the "separate subsidiary" approach has both its support- ers and detractors. §/ The term "nonbanking businesses" as used here applies both to corn- mercial banks and savings institutions. CRS-7 Proponents of the "separate subsidiary" approach for holding companies argue that setting up nonbanking businesses in separate subsidiaries of a holding company would protect depository institutions from any problems that might occur in affiliated lines of business. They argue that any tendency to give preferential treatment to affiliates could be controlled through le- gal restrictions on financial and like transactions. Opponents of the "separate subsidiary" approach as an effective means of insulating a depository institution from other activities of a holding company argue that, despite laws and regulations to restrict intercompany financial transactions which could weaken the depository institution, such legal restrictions could be difficult to enforce. Further, it is argued that the public most often perceives an organization as an entity and that a depository institution could, therefore, be adversely affected by public reaction if related businesses were to suffer reverses. The separate subsidiary approach for independent institutions has been seen by some as having advantages similar to those for subsidiaries of hold- ing companies. Activities would be separated under these conditions form those of the depository institution and crosslines of activity could be more carefully controlled. Small institutions argue that the separate subsidiary approach is not feasible for them, however, because of the costs involved. According to them, requirements to engage in certain activities through sep- arate subsidiaries would unfairly preclude them from engaging in such activ- ities. Similarities and Differences Among Various Types of Institutions A final issue is whether commercial banks and savings institutions should, as a matter of national policy, be treated alike or differently with regard to permissible activities. Initially, commercial banks and savings institutions developed to serve different purposes. Over the past several years, the powers afforded banks and savings in- stitutions though Federal legislation have resulted in the institutions be- coming more alike. Savings institutions may now offer services traditional- ly associated with commercial banks , such as checking accounts and consumer loans to individuals and commercial loans to businesses, in addition to their personal savings accounts and residential mortgage loans. Even so, Federal legislation limits the amounts of assets that savings institutions may hold in non-mortgage based loan forms, such as consumer and commercial loans. Some would argue that the somewhat broader powers for savings institu- tions enacted in the early 1980s on the Federal level exist only to give in- stitutions a degree of diversification that will allow them to counteract housing cycles. According to this view, the primary role of savings insti- tutions should remain residential finance, and laws and regulations dealing with powers for these institutions should reflect this orientation. Others argue that institutional distinctions impede competition and that all depository institutions should be treated similarly. According to this view, any broader powers deemed suitable for either banking organiza- tions or savings institutions should be made available to the other type of CRS-8 institutionauswell; likewise, any prohibitions should be imposed on both types of institutions. a Yet others argue that differences in State and Federal laws and regula- tions should be permitted to allow institutions to adapt to changing condi- tions in an evolutionary fashion. . J RELATED CRS PAPERS U.S. Library of Congress. Congressional Research Service. Depository financial institutions: alternative regulatory approaches, by F. Jean Wells. [Washington] 1986. 9 p. (Report no. 86-174E) ----- Financial deregulation in the United States: an introduction, by F. Jean Wells. [Washington] 1985. 30 p. (Report no. 85-41E) ----- Merchant banking: opportunities or problems for U.S. banks?, pby Walter Eubanks and William Jackson. [Washington] 1987. 14 p. (Report no. 87-351E) fjw LIBRARY — I OF WASHINGTON UNIVERSITY ,sT.A LOUIS - Mo. :__.__.