SPEAKERS CONTENTS INSERTS
Page 1 TOP OF DOC
CURRENT AND FUTURE BANK EXAMINATION
AND SUPERVISION SYSTEMS
FINANCIAL INSTITUTIONS AND CONSUMER CREDIT
COMMITTEE ON BANKING AND FINANCIAL SERVICES
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
OCTOBER 8, 1997
Printed for the use of the Committee on Banking and Financial Services
Serial No. 10539
HOUSE COMMITTEE ON BANKING AND FINANCIAL SERVICES
JAMES A. LEACH, Iowa, Chairman
BILL McCOLLUM, Florida, Vice Chairman
Page 2 PREV PAGE TOP OF DOCMARGE ROUKEMA, New Jersey
DOUG K. BEREUTER, Nebraska
RICHARD H. BAKER, Louisiana
RICK LAZIO, New York
SPENCER BACHUS, Alabama
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
TOM CAMPBELL, California
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
JACK METCALF, Washington
ROBERT W. NEY, Ohio
ROBERT L. EHRLICH Jr., Maryland
BOB BARR, Georgia
JON D. FOX, Pennsylvania
SUE W. KELLY, New York
RON PAUL, Texas
DAVE WELDON, Florida
JIM RYUN, Kansas
MERRILL COOK, Utah
VINCE SNOWBARGER, Kansas
BOB RILEY, Alabama
RICK HILL, Montana
PETE SESSIONS, Texas
STEVEN C. LaTOURETTE, Ohio
Page 3 PREV PAGE TOP OF DOCDONALD A. MANZULLO, Illinois
MARK FOLEY, Florida
WALTER B. JONES, Jr., North Carolina
BILL REDMOND, New Mexico
HENRY B. GONZALEZ, Texas
JOHN J. LaFALCE, New York
BRUCE F. VENTO, Minnesota
CHARLES E. SCHUMER, New York
BARNEY FRANK, Massachusetts
PAUL E. KANJORSKI, Pennsylvania
JOSEPH P. KENNEDY II, Massachusetts
FLOYD H. FLAKE, New York
MAXINE WATERS, California
CAROLYN B. MALONEY, New York
LUIS V. GUTIERREZ, Illinois
LUCILLE ROYBAL-ALLARD, California
THOMAS M. BARRETT, Wisconsin
NYDIA M. VELÁZQUEZ, New York
MELVIN L. WATT, North Carolina
MAURICE D. HINCHEY, New York
GARY L. ACKERMAN, New York
KEN BENTSEN, Texas
JESSE L. JACKSON Jr., Illinois
CAROLYN C. KILPATRICK, Michigan
Page 4 PREV PAGE TOP OF DOCJAMES H. MALONEY, Connecticut
DARLENE HOOLEY, Oregon
JULIA M. CARSON, Indiana
ROBERT A. WEYGAND, Rhode Island
BRAD SHERMAN, California
ESTEBAN EDWARD TORRES, California
BERNARD SANDERS, Vermont
Subcommittee on Financial Institutions and Consumer Credit
MARGE ROUKEMA, New Jersey, Chairwoman
BILL McCOLLUM, Florida, Vice Chairman
DOUG K. BEREUTER, Nebraska
PETER T. KING, New York
TOM CAMPBELL, California
EDWARD R. ROYCE, California
JACK METCALF, Washington
ROBERT L. EHRLICH Jr., Maryland
BOB BARR, Georgia
SUE W. KELLY, New York
RON PAUL, Texas
DAVE WELDON, Florida
JIM RYUN, Kansas
Page 5 PREV PAGE TOP OF DOCBILL REDMOND, New Mexico
BRUCE F. VENTO, Minnesota
JOHN J. LaFALCE, New York
CHARLES E. SCHUMER, New York
CAROLYN B. MALONEY, New York
THOMAS M. BARRETT, Wisconsin
MELVIN L. WATT, North Carolina
LUCILLE ROYBAL-ALLARD, California
GARY L. ACKERMAN, New York
KEN BENTSEN, Texas
CAROLYN C. KILPATRICK, Michigan
C O N T E N T S
Hearing held on:
October 8, 1997
October 8, 1997
Wednesday, October 8, 1997
Ghiglieri, Catherine A., Banking Commissioner, State of Texas
Page 6 PREV PAGE TOP OF DOC
Kwalwasser, Edward A., Group Executive, Vice President, Regulation, New York Stock Exchange
McCool, Thomas J., Director, Financial Institutions and Markets Issues, General Government Division, U.S. General Accounting Office, accompanied by Susan Westin, Associate Director
Retsinas, Hon. Nicolas, Acting Director, Office of Thrift Supervision
Sibears, Daniel M., Vice President, Member Regulation, National Association of Securities Dealers
Roukema, Hon. Marge
Maloney, Hon. Carolyn B.
Ghiglieri, Catherine A.
Hove, Hon. Andrew C., Jr.
Kwalwasser, Edward A.
Ludwig, Hon. Eugene A.
McCool, Thomas J.
Phillips, Hon. Susan M.
Retsinas, Hon. Nicolas
Richards, Lori A.
Page 7 PREV PAGE TOP OF DOCSibears, Daniel M.
Additional Material Submitted for the Record
Ludwig, Hon. Eugene A.:
OCC Banking Circular, July 24, 1997
Written update of pilot joint examinations requested by Hon. Douglas K. Bereuter
Richards, Lori A.:
Written responses to questions from Hon. Douglas K. Bereuter
CURRENT AND FUTURE BANK EXAMINATION AND SUPERVISION SYSTEMS
WEDNESDAY, OCTOBER 8, 1997
House of Representatives,
Subcommittee on Financial Institutions
and Consumer Credit,
Committee on Banking and Financial Services,
The subcommittee met, pursuant to call, at 10:32 a.m., in room 2128, Rayburn House Office Building, Hon. Marge Roukema, [chairwoman of the subcommittee], presiding.
Present: Chairwoman Roukema; Representatives McCollum, Bereuter, Campbell, Vento, LaFalce, C. Maloney of New York, Watt, Kilpatrick, Bentsen, and Weygand.
Page 8 PREV PAGE TOP OF DOC
Chairwoman ROUKEMA. Let me make an announcement here. I do appreciate your patience. There was good reason for having to delay the hearing by one-half an hour. We are going to wait a few more minutes until we find Mr. Vento. He has a division of labors here. He has had major legislation on the floor, both last night and this morning, where he has major responsibility on his Department of Interior responsibilities. So we are investigating his whereabouts. So if you will be patient, we will know in a few minutes when the hearing can begin.
Thank you very much.
Chairwoman ROUKEMA. We have been informed that Mr. Vento is en route, so it should only be a few more minutes.
Chairwoman ROUKEMA. All right. Thank you very much. Again, thank you for your patience, and I believe we are ready to begin here today. We are holding this hearing today on bank examination and the supervision systems. And I am very pleased to do that. It is certainly timely.
As we in this subcommittee, and certainly our audience here today know, in the 1980's and the 1990's, we have endured a period of turmoil in U.S. financial institutions, and during this period more than 1,600 commercial banks and savings associations were closed or had to receive financial assistance from the FDIC.
Page 9 PREV PAGE TOP OF DOC
Certainly all of usmany of us on this subcommittee witnessed firsthandI know Mr. Vento certainly did, as well as I, witnessed this problem firsthand. And as noted in the November 1996 GAO report on bank oversight structure, one major contributing cause of the problems in the thrift industry was the increased power granted to the thrifts in a period during which the Federal Home Loan Bank Board supervision was scaled back.
As a consequence, the bank examination and supervision system came under intense scrutiny, and, in response, Congress passed FIRREA and the Federal Deposit Insurance Corporation Improvement Act of 1991I am sorry; FIRREA was 1989, and subsequently, in 1991, was FDICIA. These two bills provided the regulators with strengthened examination and enforcement authority.
Given the record profits experienced by the banking industry presently and the fact that there are significantly fewer troubled institutions, it appears that this authority has been carried out with positive results. Nonethelessand I want to stress thisit is always important to remain vigilant in maintaining an effective examination system that keeps pace with the industry.
Recognizing the evolving nature of the banking business, the regulators have modified their examination systems to put greater emphasis on the overall risk that an institution is exposed to in addition to focusing on capital adequacy and asset quality. But this hearing is not only about the present and the past, but I would hope that we are directing our efforts toward the future.
Page 10 PREV PAGE TOP OF DOC If I have my wayand there are some that say, ''You are not going to,'' but if I have my way, this Congress will enact landmark legislation to modernize our financial services laws across the board.
As everyone is aware, or probably everyone is aware, H.R. 10, the Financial Services Competition Act of 1997, was reported by the full Banking Committee last June. This landmark legislation would repeal provisions of Glass-Steagall and would permit broad affiliations between banks, securities firms, and insurance companies. Expansion of such affiliations places greatly increased responsibilities on the regulatory system under our banking and securities laws.
The responsibility includes understanding the risks associated with such affiliations and conducting their supervisory responsibilities in an effective and efficient manner that implements the principles of safety and soundness and investor protection without placing unnecessary burdens on the affected banks and broker-dealers.
Supervisory responsibilities will require well-trained examiners, thoughtful and thorough examinations, and certainly effective coordination with other regulators. And some of us know that this particular issue has been a problem resolving and one of the impediments of getting the bill to the floor of the House of Representatives, but all is not lost.
However, this hearing will focus on how the agencies with examination authority are examining insured depository institutions and whether the supervisory practices are in place to accurately assess the risks these institutions are taking in today's brave new financial marketplace. In addition, it is important to determine whether the agencies are coordinating efforts to ensure consistency in the issuance of ratings in order to prevent what we know as ''agency shopping'' by the banks.
Page 11 PREV PAGE TOP OF DOC
I note that in 1993, the GAO issued a report that found gross disparities existed between the examiners. Today the subcommittee will request that the GAO undertake a formal review of each of the four Federal bank and thrift supervisory agencies' examination programs as a follow-up to the 1993 report.
Testimony today will also focus on whether the examination procedures and practices of these agencies will be capable of adequately examining institutions if Congress passes a financial services modernization bill that would allow the broad affiliations that have been outlined, not only with the banks, the securities and insurance firms, but also perhaps some commercial entities.
Therefore, this subcommittee is particularly interested in hearing from the SEC and self-regulatory organizations, SRO's, to explain how they coordinate their efforts in this supervision and examination of affiliated broker-dealers. The subcommittee will want to evaluate whether the affiliated broker-dealers are adequately examined and whether the SRO's have the supervisory tools necessary to ensure safety and soundness in this evolving marketplace.
With that said, I will turn to my Ranking colleague, Mr. Vento, who has been very close to this issue for some time.
[The prepared statement of Hon. Marge Roukema can be found on page 46 in the appendix.]
Mr. VENTO. Thank you, Madam Chairwoman.
Page 12 PREV PAGE TOP OF DOC
I apologize for being a few minutes late at the start of the hearing.
I appreciate you holding this hearing. I think it is enormously important with regard to banks and securities regulation and supervision. It is not only imperative that the subcommittee ascertain whether the regulators and self-regulatory organizations have the tools should we pass financial services modernization legislation, but also that they have the tools and expertise in the current fast-paced financial services environment today. For example, as banking regulators expand operating subsidiary powers in Section 20, percentage limits, will we have the OCC and Federal Reserve Board change their supervision with regard to safety and soundness?
Further, I would note that the regulators also have to respond to the marketplace it has been adjusted to, and with the Interstate Branching and Banking Law, this has altered and will continue to alter the landscape. Certainly bank exams and supervision have changed to keep pace with the industry. What has that experience taught us? Can we translate these lessons to the potential changes coming with charter modernization?
Madam Chairwoman, this is a timely hearing, even though the jury is still out on whether our committee product down the hall or a product of a task force will be considered by the House.
We have recently heard from the GAO on the final segment of our request in response to DAIWA. Another subcommittee of our committee held a hearing last week on the Financial Accounting Standards Board's proposed derivative accounting scheme and how that would affect risk mitigation activities of financial institutions.
Page 13 PREV PAGE TOP OF DOC
We passed some powerful and empowering laws for banks in late 1989 and 1991. They seem to be working. But are we prepared for a bear market? Are we prepared for mixing bank and commerce in a basket or a reverse basket? Are we prepared for the global revolution in terms of financial relationships, electronic banking, and many, many other aspects as we look at the global economy? Are we properly safeguarded against currency fluctuations, for instance, that are taking place in the Pacific Rim today? All of this revolves around and speaks to what needs to be done and what should be done and what is anticipated and is being done today in the context of regulatory activities.
I appreciate you holding the hearing, Madam Chairwoman, and look forward to hearing from our witnesses today.
Chairwoman ROUKEMA. Thank you.
Mr. BEREUTER. No opening statement. I look forward to the testimony today, Madam Chairwoman.
Chairwoman ROUKEMA. I thank you very much.
Page 14 PREV PAGE TOP OF DOC
Mr. WATT. I also pass, Madam Chairwoman.
Chairwoman ROUKEMA. All right. Thank you.
Mrs. Maloney has just arrived.
Do you have an opening statement?
Mrs. MALONEY OF NEW YORK. I am going to put mine in the record.
Chairwoman ROUKEMA. Thank you. I appreciate that. And certainly it is in consideration of our panelists here today.
Mrs. MALONEY OF NEW YORK. Put it in as read.
[The prepared statement of Hon. Carloyn B. Maloney can be found on page 48 in the appendix.]
Chairwoman ROUKEMA. Without exception, so moved.
Let me introduce our first panelist, Mr. Thomas McCool. Mr. McCool is representing the General Accounting Office. As has been referenced in the opening remarks, there have been several reports on all aspects of banking examination supervision, and he is the Director of the GAO's Financial Institutions and Markets Issues Division.
Page 15 PREV PAGE TOP OF DOC
And I understand you have accompanying you today Ms. Westin, who is on your staff and has done a good amount of research work, who may be here for technical questions or other observations.
Mr. McCool, we are very happy to have you here today. Will you enlighten us?
STATEMENT OF THOMAS J. McCOOL, DIRECTOR, FINANCIAL INSTITUTIONS AND MARKETS ISSUES, GENERAL GOVERNMENT DIVISION, U.S. GENERAL ACCOUNTING OFFICE; ACCOMPANIED BY SUSAN WESTIN, ASSOCIATE DIRECTOR
Mr. MCCOOL. I will try to, Madam Chairwoman.
Yes, I want to introduce Susan Westin. She is actually an Associate Director in the Financial Institutions group.
Madam Chairwoman and Members of the subcommittee, we are pleased to be here today to discuss bank and thrift supervision and examination. The combination of regulatory and legislative changes, along with market forces, has expanded the number and scope of activities undertaken by insured depository institutions, particularly the largest ones, and thus the risk they assume. These expanded activities include offering and/or dealing in a range of nontraditional bank products, such as mutual funds and securities underwriting. The resulting complex institutions represent a major supervisory and regulatory challenge. In keeping with the changes in the banking environment, Federal bank and thrift regulators have recently announced that bank examinations will explicitly include an assessment of how effectively banks manage risk and a rating on their sensitivity to risks posed by a variety of market factors.
Page 16 PREV PAGE TOP OF DOC
Although we have not yet fully assessed the implementation of most of the recent changes of the supervisory and examination policy, they appear to address some of our concerns about examinations in the aftermath of bank failures in the 1980's and early 1990's.
Now, as the Chairwoman has already suggested, as a result of those changes, Congress passed two major laws. The first, FIRREA, in 1989, which responded to the bankruptcy of the Federal Savings and Loan Insurance Corporation and the troubles in the thrift industry.
The second law was the Federal Deposit Insurance Corporation Improvement Act of 1991, which was enacted, in part, because of the concerns that the exercise of regulatory discretion during the 1980's did not adequately protect the safety and soundness of the banking system or minimize insurance fund losses. FDICIA contains several safety and soundness provisions based on a simple principle: If a depository institution fails to operate in a safe and sound manner, it should be subject to timely and forceful supervisory response, including, if necessary, prompt closure. Also, FDICIA requires a number of reforms to strengthen corporate governance, improve financial reporting, and aid early identification of safety and soundness problems.
Last year, we reported that inherent limitations of Section 38 requirements, and the regulatory implementation of Section 39 of FDICIA, raise questions about their potential for effectively ensuring that regulators act early and forcefully enough to prevent or minimize losses to the insurance funds. Section 38 requires regulators to take specific, increasingly severe regulatory action as an institution's capital drops to lower levels. Although this requirement should strengthen oversight in several ways, it is inherently limited as a tool for early intervention to correct problems and thus safeguard the insurance funds, because impaired capital levels often do not appear until after a bank has experienced problems in other areas, such as asset quality and management.
Page 17 PREV PAGE TOP OF DOC
Section 39 allows regulatory action before capital is impaired. However, Section 39, as implemented, appears to do little to reduce regulatory discretion. The implementing guidelines and regulations do not establish clear and specific definitions of unsound conditions or practices nor link those conditions or practices to specific mandatory regulatory actions.
Let me now turn to our past work on examination issues. Before regulators can initiate an enforcement action, they must identify problems within an institution. The primary tool regulators use for this is the full-scope safety and soundness examination.
In the past, we have identified a number of issues and concerns about the examination process. Let me just talk about a few of those.
One was a lack of comprehensive internal control assessments. We have consistently found that weak internal controls were a common characteristic of failed banks and thrifts. And the importance of timely detection of inadequate controls which can provide early warning of problems is especially necessary to take action before these problems can seriously erode asset quality and capital. Our past reports on the examination process found examiners did not systematically test critical internal controls.
We also found some weaknesses in detecting and ensuring corrective action relating to insider lending. Loans to insiderssuch as bank directors, officers, or principalsshould pose no greater risk than transactions with other bank customers. In 1994, we reported that examiners faced numerous impediments to determining the full extent of insider problems at banks, that such problems were not always corrected as a result of examinations.
Page 18 PREV PAGE TOP OF DOC
In addition to problems with examinations as performed, we also found some issues having to do with examination quality control. We regard these quality controls as essential, because examiners have broad discretion and must exercise considerable judgment in planning and conducting examinations and then drawing conclusions about bank safety and soundness.
We concluded that regulators need to establish policies to ensure that there was sufficient documentation of the analysis done during an exam and that there was thorough supervisory review of all examination inspection procedures. The regulators have made a number of changes in an effort to improve their examinations since the banking and thrift crises.
In general, these changes appear appropriate and consistent with recommendations we have made. However, we have not fully addressed the effectiveness of their implementation.
When evaluating these changes, it is important to note that they have occurred during favorable economic conditions that have contributed to strong bank and thrift profits. The true test for these changes will be whether the information they provide in the examination reports will lessen the severity of problems for banks and thrifts during any future economic downturn.
One of the most significant efforts at improvement involves changes in examinations to account for the dynamic banking environment in which institutions can rapidly reposition their portfolio exposures. Regulators have recognized that in such an environment, periodic assessments of the condition of financial institutions based on transaction testing alone are not sufficient for ensuring the continued safety and sound operation of financial institutions. Regulators have changed the system they use to rate the safety and soundness of banks and thrifts to reflect an increasing emphasis on risk management and internal controls.
Page 19 PREV PAGE TOP OF DOC
On December 9, 1996, the Federal Financial Institution Examination Council added an ''S'' to the CAMELS rating. The ''S'' rating component is to represent the result of combined assessment of both the institution's level of market risk and its ability to manage that risk.
I should also mention that in regulators' examinations of U.S. branches of foreign banks, an emphasis on risk management and internal controls began in 1994 with implementation of a rating system known as ROCA, which stands for Risk Management, Operational Controls, Compliance, and Asset Quality.
As I noted earlier, we have recommended that the condition of the bank or thrift's system of internal controls receive explicit consideration in a determination of the institution's examination rating. Increased attention to internal controls and risk management, if effectively implemented, should help enhance the regulators' ability to keep pace with the changing banking environment. Supervisors' effective implementation of these initiatives is essential to the success of their examination programs.
Let me just skip. There are a few otherin my written statement, there are a few more details, and I would like to have that introduced into the record. Let me just move forward and talk about a few things we want to talk about going forward.
We think that there are a number of issues going forward, one of which is the issue of supervisory expertise. As banking activities have become more complex, bank examinations have required increasingly broader expertise. As a result, another issue that regulators will continue to face is the need to build and maintain the expertise needed for supervising these more complex organizations.
Page 20 PREV PAGE TOP OF DOC
The second issue is the supervisory coordination and consistency issue. The nontraditional lines of business and interstate branching will bring increasing numbers of depository institutions under the jurisdiction of several regulatory agencies. And if the current regulatory structure with its multiple agencies continues, coordinating their activities and ensuring consistency in their regulations and enforcement action will remain difficult issues.
The regulatory agencies have several initiatives underway that are intended to better coordinate their activities and ensure consistency. Ultimately, these initiatives should be judged by their results, particularly on the quality of examinations.
The last issue has to do with the examination of complex financial institutions. With the passage of the Interstate Banking and Branching Act and the increased reliance of banks on lines of business other than traditional lending, we anticipate the task of bank management will become more difficult. The bank regulatory agencies will face a similar challenge ensuring that their examinations and enforcement strategies lead to sound management practices as banks increasingly rely on nontraditional lines of business.
In addition to the coordination issue, other issues that are likely to become increasingly common have to do with issues such as securities activities in banks and bank holding companies. We issued a report two years ago that noted that most of the banks provided security services in affiliates that are regulated primarily by securities regulators. However, some securities activities are overseen by bank regulators. So the potential for inconsistent oversight does exist.
Page 21 PREV PAGE TOP OF DOC In our recent work on internal controls, we noted the deficiencies in internal controls at foreign branches and agencies. The Federal bank regulators are aware of these deficiencies and have initiatives underway that they believe will address the problems.
We noted in our report that the regulators do not have plans to evaluate the results of these initiatives. This is a particularly important concern going forward for this and other bank regulatory programs. It will be important for regulatory officials to develop a strategy including objective measures for assessing the progress they are making to their efforts to improve the examination process and to ensure that the procedures and systems necessary to collect the data relevant to those measures are in place and operating. Such objective evaluation should be useful in determining whether the examinations are achieving their intended results or whether additional initiatives may be needed.
Madam Chairwoman, this concludes my statement. My colleague and I will be pleased to answer any questions you may have.
[The prepared statement of Thomas J. McCool can be found on page 49 in the appendix.]
Chairwoman ROUKEMA. Thank you very much.
That was quite a bit of in-depth analysis, and I am not quite sure I caught everything, but we will go over that in a little bit. I really have a couple of observations to make, but let me start with the last question first, at least the last one that came to my mind.
Page 22 PREV PAGE TOP OF DOC
As you were talking about going forward, and, as I said in my opening statement, this is not only about the past and the present, but it is about the future and whether or not we have a bit of legislation. There are dramatic changes taking place, and you pointed out that you were looking toward the future in going forward.
You particularly pointed out about the supervisory expertise. I would love to have a little more information on that. How do you do that? That is another question that perhaps we will ask our second panel as well about that. But what do we do about thisI think you referred to ''coordination of supervision.''
This particular issue, without going into a lot of excruciating details here, but this particular issue has become a problem, not only within the Banking Committee definition and the Financial Services Council as we set it up and try to meld the Financial Services Council with the need for functional regulation, and that got into the State insurance question, put that aside. Put that aside. There is always a question both in our committee and now in the Commerce Committee, about the umbrella regulator being the Fed and putting the authority in the Fed.
Do you have, on the basis of your examination, your study here, any insights here as to how we deal with that problem of not only inconsistent oversight, but overlapping oversight? Do we do it with the council approach, or do we go the umbrella route? Or do you not want to comment on it?
Mr. MCCOOL. Well, I mean, I can comment at least
Page 23 PREV PAGE TOP OF DOC
Chairwoman ROUKEMA. Based on your report, based on the revelations in your report and your understandings, how would you advise us?
Mr. MCCOOL. Well, I think that some sort of formalized arrangement for coordination would be useful. I don't know enough about the details of the council to be able to know whether that is the right mechanism or not, but I think that there is some evidence that the regulators, the banking regulators, the securities regulators, have been working together to coordinate their activities, but I think that some sort of formalized arrangement to do that could be useful.
Now that is a little bit different from the issue of an umbrella regulator because, again, GAO has taken the position that in any kind of a financial services holding company, there should be somebody looking at the whole company. Again, whether that should be the Fed or someone else, that sort of depends on a number of factors, and we haven't taken a position on that.
But the idea that there should be someone knowing where the money is flowing across an organization is something that we do believe should be in place. Again, it is not necessarily the same as saying that should be the council. That is a slightly different issue.
Chairwoman ROUKEMA. Thank you. Then you understand our problem?
Mr. MCCOOL. Yes, I do.
Page 24 PREV PAGE TOP OF DOC Chairwoman ROUKEMA. Thank you. I don't think it is beyond reconciliation here, but it has become a problem.
Now, forgive me if I didn't understand completely your point here. Could you amplify a little bit on how you believe that FDICIAwhether it is adequate or limited in the present circumstances with respect to quality control? And you were talking about various other aspects of evaluating it. Have you been specific in your report as to how that has to be enhanced or targeted more directly? I didn't get it from your testimony.
Mr. MCCOOL. I think there are sort of two issues. One issue had to do with our look at the prompt regulatory action provisions of FDICIA
Chairwoman ROUKEMA. Yes.
Mr. MCCOOL.Which was a specific set of provisions. And in that, we did find that the capital trip-wires are in place, and they seem to be performing well.
Chairwoman ROUKEMA. They are?
Mr. MCCOOL. The noncapital trip-wires, we have some concerns about the extent to which they are a little bit vague and, therefore, may not operate, in fact, as trip-wires. And that is something, again, we discuss in detail in our report.
Now the other issue has to do with examination procedures, and that is not so much a FDICIA issue, but what the regulators have done to try to improve their processes, and this new risk-based approach that the regulators are taking to examinations, which again, from sort of a conceptual perspective, makes a lot of sense to us. We haven't, however, gotten in and looked at how it is being implemented, with the exception of the cases having to do with the foreign branch and agency work that we have just completed.
Page 25 PREV PAGE TOP OF DOC
Chairwoman ROUKEMA. Yes. Would Ms. Westin want to add anything to that? I saw you nodding your head. Do you want to add anything?
Ms. WESTIN. I think that we did look at several bank examinations under the new risk-based system. We looked at almost 200 exams in the foreign branches and agency work that were under the ROCA system, slightly less than half of the exams that we looked at. And the Federal Reserve Board told us that they now have about 400 exams completed under the new CAMELS system, but we haven't looked at those yet.
Chairwoman ROUKEMA. But are we making progress?
Ms. WESTIN. Well, I think that Tom was right in saying that, conceptually, a risk-based approach and looking at the entire organization makes a lot of sense.
And when you are looking at the issue of an umbrella regulator or whether it is a council, I think some of the evidence we have seen looking at the foreign banking organization program, shows it is important to look at the entire FBO with all its parts. And we have also learned, in talking with regulators and with some banks, that financial institutions are managed on a global basis, or if they are into interstate branching, they are managed that way, and there is a good case to be made they need to be regulated that way.
Chairwoman ROUKEMA. Thank you very much. Much appreciated.
Page 26 PREV PAGE TOP OF DOC
Mr. VENTO. Thanks, Madam Chairwoman.
You know, as I looked at this and I read the statement, I think you did a good job in your statement, and, you know, hopefully we will get some positive response action, constructive analysis, I would say, to the regulators in terms of what is right and perhaps what is wrong.
I think the question on examination, just from a cursory look at this, it looks like they are making some efforts. It seems sort of a work in progress. But there are some other questions that jump out at me in terms of this.
That is, it occurs to me, and I am sure that you know, the whole character in terms of commercial banking has changed in the sense that the instruments are more alike. We have security-like instruments or indemnity-type instruments that are being put out. Banks hold less assets that are more difficult, they are involved in more transactions, and so that is inherently where the risk is. You know, it is almost a moving target in terms of what the corpus of this particular institution is.
So, the case would be here where, in fact, although this isn't the breadth of what you did, but that insurance regulators in the States then, the securities regulators at the Federal and State level, and the banking regulators, all really are doing some of the same things now; isn't that correct? They have the same sorts of instruments before them. They have the same sorts of problems before them. Is that correct, Mr. McCool?
Page 27 PREV PAGE TOP OF DOC Mr. MCCOOL. I think that is true. I think there is a lot of evidence that the difference of the products across industries is now becoming less and less, and there is a question, and I guess we don't know the answer to the extent that they are effectively regulated differently. I think there were differences in approach from the bank regulator to the securities regulator, and I would presume to an insurance regulator, but we don't know how that translates into the effect on the way those products are treated.
Mr. VENTO. So on one side of the bar graph, I have that, and then on the horizontal axis, I have all the rapidity of change going on, and it sort of makes for a rather interesting flaw and one that have a lot of possibilities that may take place.
Of course, the issue here, I think, Mr. McCool and Ms. Westin, is that GAO has historically resisted having sort of one supreme regulator. In fact, as I recall some of the work that we were doing on laws, it seemed to me that they were always very interested in having some oversight function to, in fact, self check, to balance out in terms of the powers granted under FIRREA, or at least under FIRREA, I specifically remember that.
So do you think that it would be appropriate, in other words, to in fact have more than one regulator dealing in these areas even though their functions may be somewhat similar
Mr. MCCOOL. Well
Mr. VENTO.Some redundancy, I guess.
Page 28 PREV PAGE TOP OF DOC Mr. MCCOOL. I guess we have taken a position that we are not sure there needs to be four different regulators for banks and thrifts. I don't know if we have taken any position at all about whether we should attempt to merge the bank regulators and securities regulators. I don't think we have touched that one.
Mr. VENTO. My impression had been that the GAO wanted some redundancy in terms of regulation, in terms of obviously not giving this or relying solely on a single regulator, and not just in financial institutions as well as, I suppose, for securities.
My time is about to run out, but I did notice two questions. First, I wanted to point out that you seem to come out in favor of the Bentsen Amendment that we have in terms of common requirements for securities transactions within banks, that some and separate affiliates seem to have different qualifications.
Congressman Bentsen offered an amendment that actually got us into some difficulty because there were concerns with regard to whether that power would be used in a way that would be inappropriate, and so the banks became very nervous about it. But your testimony seems to leadI couldn't find it in the testimony as I look back in it, but I am sure thatI will give you a chance to respond briefly.
Mr. MCCOOL. I am not exactly sure what the amendment
Mr. VENTO. Well, I know that, but, I mean, you are asking for a commonality of qualifications for people that are dealing in securities
Page 29 PREV PAGE TOP OF DOC
Mr. MCCOOL. Yes.
Mr. VENTO.Within the banks. I mean, with those SEC requirements.
Mr. MCCOOL. Right.
Mr. VENTO. That is what the Bentsen Amendment, I think, in essence tried to do.
The other is, of course, one of sampling risk, and I thought that that wasthese are specific weaknesses, incidentally, as well as some weaknesses pointed out with regard to the holding company model, with regard to affiliates.
But I at least wanted to get on to the issue of sampling risks. Can you just address this sampling of risks, because it seems to me that sampling of risks is a lot more important, because, historically, at least, I have had this sort of impression that banks and financial institutions are more interested in measuring everything and coming to a balanced bottom line, sort of to speak, with regard to all of the assets that they have and all the transactions that they have.
But what you are saying here isand I think that this must flow from some of the models of larger financial institutions, where you simply cannot go through every transaction and measure every single asset.
Page 30 PREV PAGE TOP OF DOC
So, do you want to talk about sampling for risk that you talk about in your paper further?
Mr. MCCOOL. Well, I think the idea simply is, the examiners can't look at every transaction or every activity and they have to choose wisely. One of the things the new approach tends to do is give them an overall sense of the way the institution is managed and therefore allow them to target their activities in a more reasonable way, and that may involve sampling more or less from a particular institution with particular types of activities.
So, I think it is a sort of better prepared and betterand a sampling approach that is better, based on sort of an overview of the risk management of the institution.
Mr. VENTO. ''Sampling'' is good science. This doesn't apply to the census, I guess, but we can accept it here. There is a little radioactivity in this word these days.
Well, Madam Chairwoman, my time has expired. Thank you.
Chairwoman ROUKEMA. Yes. Thank you.
We are going to go on with the questioning. I will advise my colleagues that we expect in about 20-, 25-minutes, a vote on the rule, so we will see if we can conclude, but I don't want my colleagues to feel as though they are limited in their questioning.
Page 31 PREV PAGE TOP OF DOC Mr. VENTO. Madam Chairwoman.
Chairwoman ROUKEMA. But just keep that timing in mind.
Yes, Mr. Vento.
Mr. VENTO. I wanted to point out, my question on this securities, similar types of qualifications, is on page 20 that I spoke about in your testimony.
Chairwoman ROUKEMA. Thank you.
Mr. BEREUTER. Thank you, Madam Chairwoman.
Mr. McCool, thank you very much for your testimony.
In the cover statement on your testimony, you indicate that GAO has noted that regulators have begun to put greater emphasis on risk management processes and operational controls in the examination of these financial institutions. And you go on to suggest that among the several critical tasks now given more importance would be ensuring staff expertise.
In light of the possibility we would actually approve something like reverse basket, it would seem to me this would be a particularly difficult assessment to make, an important assessment, nevertheless, to evaluate the risks thenbasically, personnel would have to be able to evaluate the risks on potentially every kind of business in the United States.
Page 32 PREV PAGE TOP OF DOC
When we look at what happened to the thrift industry as they gained significant new powers in the early part of the 1980's, it is commonly thought that many of these thrifts did not have on their staff the kind of personnel that were well prepared to take on those new responsibilities.
I am wondering if you think our banking regulators are, first of all, prepared to begin to make or place greater emphasis at least on looking at staff expertise, and I am wondering what you might think we should have learned from the problems we saw in the thrift industry, what banking regulators should have learned, and whether or not they put any of that insight into practice?
Mr. MCCOOL. Well, I think that we haven't actually assessed the expertise of the bank regulators, per se. But it is clear that the bank regulators are aware of this issue and are focused on this issue, and they know it is an important thing going forward. They, in all our discussions with them, were often the one to first bring this issue up. We didn't have to ask them about it. They know it is important to them in this risk management environment to have people who are capable of going into an institution and actually looking at the overall risk profile of this institution.
Mr. BEREUTER. But, Mr. McCool, my point is with the expertise that exists in the financial institution staff itself.
Mr. MCCOOL. I understand.
Page 33 PREV PAGE TOP OF DOC Mr. BEREUTER. Are they accustomed to going in and examining the expertise of personnel in the financial institutions? Isn't that pretty difficult? Isn't it all very subjective?
Mr. MCCOOL. I think it would be very difficult, yes.
Mr. BEREUTER. But you are saying it needs to be done.
Mr. MCCOOL. I think that would be part of any examination of the risk management system of the institution, would be to get some sense of whether the people who are running that institution understand the risks they are undertaking.
Mr. BEREUTER. And if we have reverse basket, wouldn't that make it an even more complicated requirement?
Mr. MCCOOL. It sure would.
Mr. BEREUTER. Well, how do we cope with that? How do the financial institution regulators do that duty in that kind of environment?
Mr. MCCOOL. I don't think I have an answer to that, I am sorry.
Mr. BEREUTER. Does anybody have the answer?
Mr. MCCOOL. Not that I know of.
Page 34 PREV PAGE TOP OF DOC
Mr. BEREUTER. I think you are right. I think that is it.
Chairwoman ROUKEMA. Thank you.
Mr. WATT. Thank you, Madam Chairwoman.
Did you ask Mr. LaFalce?
Chairwoman ROUKEMA. Well, we normally go in order of the time of appearance. However, if you would like to defer to Mr. LaFalce, that would be fine.
Mr. WATT. I am happy to defer to my senior Member.
Chairwoman ROUKEMA. All right. Thank you.
Mr. LAFALCE. I thank the gentleman.
I am curious about the regulatory scheme that the bank regulators have as opposed to the SEC. I am wondering what efforts they make to coordinate, if you have had an opportunity to analyze that?
Page 35 PREV PAGE TOP OF DOC
And then second, how could the bank agency examinations of security activities, whether done in an affiliate or within the bank, compare with the SEC's examination of broker-dealers, taking into consideration scope, focus, thoroughness, frequency, and so forth? Could you address that issue?
Mr. MCCOOL. Well, we have done work on both bank securities activities and bank sale of mutual funds. And in that work, we did look at a lot and discussed a number of the issues of coordination.
Again, there are many efforts between SEC and NASD and the bank regulators to coordinate efforts, as that report indicates, and I think it is true going forward, some of those efforts have been very successful and others have not, and there are still some tensions in certain areas.
We have not really looked at the bank regulators' examinations of these activities and done a comparison of what the bank regulators do compared with the securities regulators, either SEC or NASD, in terms of the actual examination process. That is something we haven't done.
Mr. LAFALCE. Do you think that it is something that you should be doing?
Mr. MCCOOL. It is something we could do.
Page 36 PREV PAGE TOP OF DOC Mr. LAFALCE. Well, that wasn't my question. Do you think it is something you should be doing? If you were left to your druthers, your own, do you think that that would be helpful?
Mr. MCCOOL. It is an issue that has some importance, yes. I think it is something that, amongst the number of priority issues, it is probably one that is worth doing.
Mr. LAFALCE. I thank you.
Chairwoman ROUKEMA. Mr. McCollum.
Mr. MCCOLLUM. Thank you, Madam Chairwoman.
I don't have a lot of questions for you, Mr. McCool, because I think you made an excellent presentation. I wasn't here to hear it, but I read it, and I guess that is equally important.
But I do have one concern. Historically, banks and other institutions, financial institutions, have complained about duplication in bank examinations and oversight supervisory responsibilities among the various agencies and entities that look at them.
Sometimes, I know, I have been in a bank and they can show me where they have had people in there layered three times over in a very short period of time from different agencies doing almost the same thing, though obviously for their particular agency's interest, be that the FDIC or Comptroller or somebody else.
Page 37 PREV PAGE TOP OF DOC
Have you, in your review of these matters of recent, had an occasion to assess to what degree the various agencies have been able to adequately administer some reform in this regard to avoid, A, duplication, or, B, excessive examination overlap?
Mr. MCCOOL. Well, I think that the most recent experience we have is in the area of the foreign banks and foreign branches agency work that we just completed. I think that is an area where the regulators have made a very impressive effort to try to coordinate their activities and to make sure that duplication is minimized.
Now, in terms of the efforts on the domestic side, we haven't looked at that issue recently, so it is harder for me to
Mr. MCCOLLUM. There are no plans for you to look at that, as such?
Mr. MCCOOL. I think we may have some plans.
Mr. MCCOLLUM. OK. That is fair enough. I think it really is a very important factor.
I believe first and foremost is safety and soundness, and nobody on this subcommittee would want to lead you to a different impression. I don't want anybody to think we should not have thorough examinations. We should. But I am always concerned when I hear people say, as they do occasionally, that there has been that kind of effort in overlaying and overlapping too much. So I don't know, to what extent it still exists, how widespread it is, but from time to time we hear that.
Page 38 PREV PAGE TOP OF DOC
I don't have any questions from your testimony, and I appreciate the Chairwoman's offering the opportunity.
Chairwoman ROUKEMA. Thank you.
Mr. WATT. Thank you, Madam Chairwoman.
Mr. McCool, examination and supervision typically have to do more with more than simply bean counting and safety and soundness issues. So I was a little surprised that neither your testimony nor the written presentation made any reference whatsoever to the extent to which banks are complying with the CRA regulations and how those new regulations, the newly modified regulations that we spent so much time on, are impacting the ability to measure compliance with CRA and what-have-you.
Does that light mean my time is almost up? I am talking slower than I thought I was talking.
Chairwoman ROUKEMA. I am sorry. Continue, Mr. Watt. I think our staff forget to reset the time.
Page 39 PREV PAGE TOP OF DOC Mr. WATT. OK.
Chairwoman ROUKEMA. Continue. We will judge you accordingly.
Mr. WATT. I thought I was talking in slow motion. Most people think I am most of the time, anyway.
I am just wondering whether that was an oversight on your part or whether we treat CRA as a stepchild, or whether you didn't view it as being part of what your role was to study in this instance, or is there some other study being done of that?
Mr. MCCOOL. Well, I guess the answer is that we thought that the focus of these hearings was on safety and soundness examinations, and so that is what we focused on in our testimony.
We have done work in the CRA area, but nothing in the last few years. We did a number of pieces of work leading up to the period when the regulators came out with their new regulations. We haven't looked at how they have actually been affecting the CRA examination process. So we haven't done any recent work in the last two years or so. But, it wasn't an intended oversight, other than the focus of the hearing from our perspective was to be on safety and soundness issues.
Mr. WATT. Perhaps I should follow up to Mr. LaFalce's question and ask you whether you think it is important for the GAO to do such a study, especially in light of the fact that we have the new regulations in place, and we now have had a period of time where those can be tested, and, wouldn't it be appropriate to do some review at this point?
Page 40 PREV PAGE TOP OF DOC
Mr. MCCOOL. It certainly would be appropriate. Unfortunately, the number of resources we have to look at issues is limited, and we have to decide going forward and in terms of what we need to do first and what we need to do second.
Mr. WATT. Where would you put that on the list of priorities, about 8 or 10?
Mr. MCCOOL. We need to work through that.
Mr. WATT. What about going forward? There was some discussion in the financial modernization hearings and markups. There was some debate about whether non-banks, financial institutions, securities firms might ought to have some CRA obligations. How would the regulatory scheme and examination scheme measure the ability or the performance of non-banks, other financial institutions, in this area?
I realize this is solely a theoretical discussion that I am engaged in at this point. I think Mr. Ludwig has done some studies and made some speeches about that possibility.
Mr. MCCOOL. It certainly is an issue, a competitiveness issue.
I don't exactly know how you would go about determining a CRA requirement for non-banks, but I presume that it is doable.
Page 41 PREV PAGE TOP OF DOC Mr. WATT. All right.
Thank you, Madam Chairwoman. I yield back the balance of my time.
Chairwoman ROUKEMA. Thank you.
And I am going to call on Ms. Kilpatrick next. But I am also going to turn the chair over to Mr. Bereuter. I have an unavoidable conflict with an exceedingly important markup in another committee, and Mr. Bereuter will take the chair for the time.
Ms. KILPATRICK. Thank you, Madam Chairwoman.
I have two concerns, and I was detained, so you may have covered this, Mr. McCool. So please, if you have to repeat it, I just need to know for my own information. Chairperson Roukema was questioning you in terms of the supreme regulator, who that should be as we report out H.R. 10. I wasn't clear on your response on that. Would you go over it again?
Mr. MCCOOL. Well, I guess the response was, again, GAO has taken the position that there needs to be an umbrella regulator. There needs to be in any financial services holding company, there needs to be someone who is in charge of looking at the overall flows of the institutioncrossing with abetween particular parts of an institution. What we are not necessarily so explicit about is whom that should be.
Page 42 PREV PAGE TOP OF DOC
Ms. KILPATRICK. And that is the question. I mean, that is the question.
Mr. MCCOOL. Well, there are people who don't necessarily think there should be one at all.
Ms. KILPATRICK. So you take a little step there and say you think there should be one.
Mr. MCCOOL. We think there should be one. But, again, for many types of institutions, the standard bank holding company, the Federal Reserve has done the job and is probably the right person to do it in the future.
There is a question, however, about other types of institutions where a bank may not be the primary part of the financial services holding company, and, again, it is a question of whether the Fed is the only one who can do it, and that is where we are not willing to necessarily say that.
Ms. KILPATRICK. Who do you think should say that? I think that is where
Mr. MCCOOL. Congress needs to determine who that should be. We are not going to say that. What we are saying is, there are other options that probably could work.
Page 43 PREV PAGE TOP OF DOC
Ms. KILPATRICK. OK. So you do recognize that there ought to be one; that is a half a step that way; actually naming who that should be with the preference to the Federal Reserve is kind of what I hear; is that right?
Mr. MCCOOL. Well, as I said, the Federal Reserve has done it for the major bank holding companies, and probably if the bank is the primary part of the financial services holding company, it might make sense to keep them in that role.
For situations where some other type of institution is the primary part of a holding company, financial services holding company, the Fed can probably do it, but it doesn't have to be the Fed.
Ms. KILPATRICK. As in insurance companies or securities?
Mr. MCCOOL. Insurance companies or securities firms, sure.
Ms. KILPATRICK. I see.
As H.R. 10 was reported out of this committee and now in Commerce, I want to call it the National Council for Financial Services has now been removed as it works its way through the process. What was your reaction on that council, and did you think it was adequate? It might be moot at this point, but if you would respond.
Mr. MCCOOL. Again, I am not sure I have complete knowledge of what the council's purpose was. From the standpoint of having a mechanism to coordinate and make consistent regulations across the various regulators involved and regulating the financial services holding company, that probably makes sense. Whether the coordination function is sufficient to be a substitute for an umbrella regulator is, I think, a different question. I don't know whether it would serve that purpose.
Page 44 PREV PAGE TOP OF DOC
Ms. KILPATRICK. And did not look at that, particularly the council, in that vein.
And then, finally, I think this whole safety and soundness question has to do with, will the current modernizationand we still don't know what it looks like as it goes through this Congress, and I am told it has been worked on for several years. And someone told me last night since 1935, a year after Glass-Steagall was passed, Mr. Glass himself tried to modify it and was unable, and here we are 60 years later and still have not been able to do that.
As it relates to safety and soundness, do you think it will be or will not be a strain on the current regulating system, and ought we to do something specifically to make sure that whatever this modernization looks like, the regulating apparatus is intact and effective?
Mr. MCCOOL. Well, there is no doubt that, you know, this is going to require effective and potentially some sort of enhanced monitoring, at least in the initial years, as these firms do more things and combine with one others. Eventually maybe it will become normal procedure and we will need to pull back on some of the degree of vigilance, but I think certainly in the initial years, there needs to be a lot more and close oversight of it.
Ms. KILPATRICK. Thank you, Mr. Chairman.
Mr. BEREUTER [presiding]. Thank you very much.
Page 45 PREV PAGE TOP OF DOC We now have a new Member of the committee. Mr. Weygand is here, not assigned to subcommittees yet, as I understand it, but we welcome you to the committee.
Mr. WEYGAND. Thank you, Mr. Chairman. No questions.
Mr. BEREUTER. No questions. This will then complete our panel, panel one.
Mr. McCool, Ms. Westin, thank you very much for your testimony. We very much appreciate your being here with us today.
We will have a vote soon. I would like to begin the next panel. And, as a matter of fact, hoping that panel three is here, at the suggestion of Mr. LaFalce, a good suggestion, I think, in light of an opportunity to maximize involvement of Members, I think we are going to combine, and we will combine the two panels. So hoping that the three persons from the securities sector are here as well, I would invite those listed as panel two and three to take the witness table.
Mr. LAFALCE. Mr. Chairman, I want to thank the Chair for combining the two panels. I personally would like to see the committee adopt a policy that all future hearings will have but one panel.
Mr. BEREUTER. In order to facilitate our proceedings here, I am going to introduce the panelists as they come forward.
Page 46 PREV PAGE TOP OF DOC Susan Phillips is a Governor of the Federal Reserve System, no stranger to this subcommittee, expert on examination and supervision, of course.
Eugene Ludwig is the Comptroller of the Currency, whose office, of course, includes examination and supervision of all our national banks. He is no stranger to the subcommittee, having testified here on financial services modernization issues several times.
Andrew Hove is the Acting Chairman of the Federal Deposit Insurance Corporation, most importantly, a native Nebraskan, also a strong advocate of financial services modernization, which will need a strong examination system. We welcome his remarks.
Nicolas Retsinas is the Acting Director of the Office of Thrift Supervision and is in charge of supervision of our national S&L's. We are particularly interested in hearing his views on examination of thrifts and unitary thrift holding companies, especially if we should eliminate the thrift charter.
Catherine Ghiglieri is the Banking Commissioner for the State of Texas. She can help us by shedding some light on how State-chartered institutions are being examined, especially in light of increased interstate banking and branching.
And on panel three, hoping that they are in fact here, Lori Richards, Director of the Office of Compliance Inspections and Examination for the Securities and Exchange Commission. She can give us some insight on the examination of the affiliate broker-dealers of banks.
Page 47 PREV PAGE TOP OF DOC Daniel Sibears is Vice President for District Oversight and Coordination for the National Association of Securities Dealers. Mr. Sibears can share his views on the coordination involved and the examination of affiliated bank broker-dealers.
And Edward Kwalwasser is Group Executive and Vice President for Regulation in the New York Stock Exchange and has, of course, large examination authority over bank-affiliated broker-dealers.
I would like to say to all of the many people that are gathered at the table that of course your entire statements will be made a part of the record in their entirety. We encourage you to summarize and to focus on the parts that you really want this subcommittee to hear most loudly and clearly. So with that in mind, we will call first on Susan Phillips.
Governor Phillips, you may proceed
STATEMENT OF HON. SUSAN M. PHILLIPS, MEMBER, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Ms. PHILLIPS. Thank you, Mr. Chairman, Members of the subcommittee. I am pleased to be here today to discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes as well as the challenges ahead, both in the banking system and the supervisory process.
I will keep my remarks brief this morning. My written testimony contains more details on the issues raised in your invitation letter.
Page 48 PREV PAGE TOP OF DOC
To begin, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur. Our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly, either to the insurance fund or the financial system as a whole.
We believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability.
During the 1980's and 1990's, banks and businesses throughout the world were dealing with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth.
They also, however, have raised other concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions. It is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised, for it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk.
In addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline brought to bear worldwide on banks and other financial institutions dealing in these new products. The scrutiny among counterparties in the global market has contributed to improvements in capital positions and in overall risk management practices.
Page 49 PREV PAGE TOP OF DOC
For our part, the risk-focused approach is a supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of U.S. and world financial markets, and the techniques employed for managing and controlling risk.
As banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come. Today, as in the past, the Federal Reserve has emphasized periodic on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems.
In that connection, the Federal Reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct examinations with appropriate frequency and depth. That approach appears to have provided us with some consistent success. There is, however, no shortage of challenges facing the Federal Reserve as a bank supervisor despite the virtually unprecedented strong condition of the U.S. banking system today.
A key challenge in adopting the risk-focused approach is to strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk. The risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review.
Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition and also to evaluate its internal control process and its own ability to identify and resolve problems.
Page 50 PREV PAGE TOP OF DOC
How effective is this risk-focused process? Since economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to fully test bank risk management systems or supervisory practices. Nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980's and early 1990's.
The risk-focused approach is helping to identify certain deficiencies early before they translate into bank capital, asset quality, or earnings problems. One example is our supervisory experience with the U.S. branches of foreign banks.
Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991, our examinations uncovered a number of entities with internal control and audit weaknesses. The Federal Reserve has emphasized the adequacy of management practices during our examinations of the U.S. offices of foreign banks, and these efforts appear to be having positive effects.
Beyond the risk-focused approach, the Federal Reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce the burden on banks. These efforts include the development of a PC-based work station in coordination with the FDIC and State banking departments. We are also designing a similar application for large domestic and foreign banks.
One of the clearest reminders that managing technology is a challenge is the need for banks to resolve the year 2000 problem. U.S. banks appear to be taking this matter seriously, and we are generally well underway toward identifying their individual needs and developing action plans.
Page 51 PREV PAGE TOP OF DOC
The Federal Reserve and other Federal bank supervisors are reviewing the industry's efforts through their examinations to ensure that adequate progress is being made. The year 2000 matter is also gaining more attention internationally, in part through the efforts of the Basle Supervisors Committee.
The consolidation and transformation of the U.S. banking system are also affecting our supervisory approach. To deal with the challenges presented by interstate banking and branching, the Federal Reserve, the FDIC, and the State banking departments began on October 1, a common risk-focused process for the examination of State-chartered community banks.
Another initiative has been the State/Federal Supervisory Protocol which commits the various banking agencies to work toward a seamless and minimally burdensome oversight process. Similar coordination efforts are necessary and underway in an international context to develop not only prudential capital and other regulatory standards, but also to promote sound practices over a broad range of banking issues.
A final supervisory challenge relates to the Federal Reserve's need to continue attracting, training, and retaining expert staff, especially in the areas of capital markets and information technology where we have experienced increased staff turnover. The Federal Reserve's supervisory strategy requires that we maintain staff that can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls.
In conclusion, I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past 10 years, specifically about the need to actively monitor, manage, and control risks.
Page 52 PREV PAGE TOP OF DOC
Nevertheless, conditions can always change, and we will be continually challenged to anticipate and avoid new kinds of problems. We must recognize that a risk-focused approach to supervision is a developing process, and however successful it may be, there will again be bank failures. Indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth.
Through our supervisory process, the Federal Reserve seeks to maintain the proper balance, permitting banks maximum freedom while still protecting the safety net and maintaining financial stability. We must devote adequate attention to banking practices and conditions and respond promptly as events unfold. We intend to do that now and in the years ahead.
Thank you very much, Mr. Chairman.
[The prepared statement of Hon. Susan M. Phillips can be found on page 73 in the appendix.]
Mr. BEREUTER. Thank you, Governor Phillips.
Now we will hear from Comptroller Eugene Ludwig. You may proceed.
STATEMENT OF HON. EUGENE A. LUDWIG, COMPTROLLER, OFFICE OF THE COMPTROLLER OF THE CURRENCY
Mr. LUDWIG. Thank you, Mr. Chairman and Members of the subcommittee. I appreciate this opportunity to testify on bank examination and supervision systems of the OCC. Supervision is our primary tool for making sure national banks remain safe, sound, and competitive, and the industry continues to support the citizens, communities, and economy of the United States. I want to commend Members of this subcommittee for holding this important hearing. I have a written statement I would like to submit for the record. In the interest of time, I will summarize some of the key points.
Page 53 PREV PAGE TOP OF DOC
Since the OCC was founded in 1863, the banking industry has, of course, changed dramatically in response to advances in technology, enhanced competition, and changes in consumer preferences. New risks have arisen, and traditional risks have re-emerged in new forms. As the industry has changed, the OCC has adapted its supervision to keep pace.
During the 1980's in particular, regulators learned some hard lessons about traditional credit risks. We learned just how critical regular, on-site examinations are to ensuring a safe and sound banking system. And we also learned that supervision is much less effective if it is based on looking only at the current condition of an institution. What is needed is forward-looking supervision that identifies the problems that are emerging and how to manage them. In other words, effective supervision cannot be limited to treating the disease; we also need preventive medicine.
When I took office over 4 1/2 years ago, the banking industry was feeling the aftershocks of the 1980's and still going through some fairly challenging times. There were numerous bank failures, complaints about a credit crunch, and concerns about excessive regulatory burden. Community organizations were concerned about fair lending compliance, and both community organizations and banks agreed that the CRA regulations were not as effective as they should be.
Today, our banking system is not only highly profitable but also far better capitalized than at any time in recent memory. At the end of the first half of this year, the equity-to-total-asset ratio for commercial banks averaged 8.44 percent, its highest level since the 1960's. Bank failures in 1996 were at a 20-year low. Total commercial bank loans have increased nearly 39 percent over the four years ending June 1997.
Page 54 PREV PAGE TOP OF DOC
Access to financial services at national banks has also increased. Beginning in 1993, the OCC strengthened its enforcement of fair lending laws, and, working with the other regulators, we revised the CRA regulations in 1995. The increase in mortgage lending to low- to moderate-income individuals has been dramatic. Since CRA became law in 1977, we have witnessed over $215 billion in loan commitments for community development. Remarkably, $175 billion of that total, more than 80 percent of the total, was made in the past 3 1/2 years.
This strong performance by the banking industry does not mean we can afford to be less vigilant. Bank regulators today face significant challenges because of the way the banking industry is evolving.
Technology has increased competition for banks from both traditional and nontraditional competitors. At the same time, the lines between financial products have blurred.
This change is showing up in a recent wave of acquisitions and mergers. Banks are acquiring brokerage and securities firms. Several insurance companies and brokerage firms have acquired insured depository institutions.
And the structure of the banking industry itself is changing. Since I took office in April 1993, the number of commercial banks has fallen from more than 11,000 to slightly more than 9,300 as of June 1997. Consolidation also seems to be dividing the banking industry into two segments: community banks and larger institutions, with fewer medium-sized banks left over.
All of these changes in the industry mean that bank supervision must also change. To that end, the OCC has revised both its structure and its supervision to give us greater flexibility in responding to the evolution of the banking industry. More specifically, we have developed a supervision-by-risk system that is forward-looking and improves our ability to identify and address potential problems before they become crises. Risk-based supervision allows us to analyze and respond to risks across different financial products and activities and across different banks with different specialties. To carry out this supervision, we have hired talented people from a variety of disciplines, such as capital markets. We have hired economists who work with examination teams to assess banks' computer risk-based modeling approaches. We have improved our examination training to make sure we have the expertise to address industry changes in a timely manner. We have also restructured our organization to make it easier to respond to future changes in the banking industry.
Page 55 PREV PAGE TOP OF DOC
And we have not forgotten the lessons of the past. We have increased the number of larger banks where we maintain a year-round, full-time, on-site dedicated examiner staff. As Congress has rightly required, all banks, no matter how small, receive on-site examinations at least every 18 months. In addition, each community bank has an examiner-in-charge who monitors the bank and regularly talks with bank management between on-site examinations. If a bank shows any indication of a problem, we step up the frequency of on-site examination. And we are strengthening our quality assurance program to make sure these examinations are truly effective.
The continued overall health of the banking industry is good news for everyone, and we are proud of our contributions to banking's strong performance. At the same time, however, we cannot be complacent. Now, while the industry is healthy, we must remain vigilant to address emerging risks. That is why, this past Sunday, I announced initial steps designed to help banks address slippage in underwriting standards that could lead to future problems in their credit portfolios if not addressed now.
The maintenance of sound credit standards and supervisory vigilance today will have little or no noticeable impact on economic growth now and will avoid more serious consequences in the future. Working in close cooperation with other financial institution regulators, our goal is to ensure the banking industry is prepared to continue serving the diverse needs of American consumers, businesses, and communities in the next century.
I appreciate the opportunity to testify on these core issues, and I will be happy to answer any questions you and your colleagues may have.
Page 56 PREV PAGE TOP OF DOC
[The prepared statement of Hon. Eugene A. Ludwig can be found on page 92 in the appendix.]
Mr. BEREUTER. Thank you very much, Mr. Ludwig.
We are just debating here how to proceed. We have two votes coming up. But I think we ought to hear from the Acting Chairman from the FDIC, Mr. Andrew C. Hove, Jr. You may proceed.
STATEMENT OF HON. ANDREW C. HOVE, JR., ACTING CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION
Mr. HOVE. Thank you very much, Mr. Chairman and Members of the subcommittee. I welcome this opportunity to present the views of the Federal Deposit Insurance Corporation on the future of bank supervision and to discuss how we are addressing trends that affect the industry and the regulators.
In the interest of time, I have a detailed written statement to submit for the record. Before turning to your questions, I will briefly describe our approach to bank examination and supervision.
The bank and thrift crisis of the late 1980's and the early 1990's taught us a number of lessons. At the FDIC, we took three lessons especially to heart: One, there is no substitute for regular on-site examinations of depository institutions. Two, regulators need sufficient resources to maintain an adequate level of bank supervision. Three, adequate supervision requires a surveillance system that can identify and track emerging risks.
Page 57 PREV PAGE TOP OF DOC
Historically, we focused our examination and supervision efforts on determining a bank's current financial condition rather than on determining the riskiness of the behavior of the bank's management. Our historical approach limited our supervisory responses when we were faced with emerging risks that were not yet evident in a bank's financial statements.
We have takenand are takinga number of steps to address that limitation by focusing more on risk. One important step was refining the examination process to emphasize a bank's risk management systems and the risks each individual bank faces. Our refined process allows examiners to look beyond the static condition of the bank to how well it can respond to changing market conditions, given its particular risk profile.
Another important step was the establisment of our Division of Insurance in 1995 to monitor trends in both the financial services industry and the economy more intensively. Currently, our Division of Insurance is working closely with FDIC examiners on several initiatives that will help examiners assess emerging risk exposure for individual banks and groups of banks. One such initiative is providing more timely and comprehensive regional economic data to examiners, in part through the publication and distribution each quarter of a regional outlook for each of our eight regions.
A third important step is our ongoing underwriting standards survey. At the conclusion of each safety and soundness examination, the examiners review underwriting standards with the senior management of the bank and discuss any loans that require particular attention. Our examiners then complete an underwriting survey that requires an assessment of how a bank's underwriting standards on various types of loans have changed since the previous examination. Examiners also assess how those standards compare with standards of other area banks. Results of the underwriting surveys are used to detect emerging trends in the underwriting standards by type of loan and by geographic area. These trends are relayed to examiners in the field and outside banking organizations through various publications, such as our Report on Underwriting Practices and our Survey of Real Estate Trends.
Page 58 PREV PAGE TOP OF DOC
These and other initiatives improve the FDIC's ability to identify and monitor risks.
To control risks, the Federal Deposit Insurance Corporation Improvement Act called on the regulators to implement set standards for safety and soundness that enhance our ability to take supervisory action against risky behavior before it harms the condition of the bank. In 1996, these standards were fully implemented by the agencies and should improve our efforts to address problems before they grow into crises.
Mr. Chairman and Members of the subcommittee, several trends pose supervisory challenges to the banking regulators, including industry consolidation, new technologies, new and complex financial products, globalization of the financial markets, and increasing competition from non-bank financial services providers. Some of these trends could benefit the banking system greatly; all of them carry some risk. They all have important implications for the supervision of banking organizations.
These developments will continue, whether or not there is legislation to modernize the financial system. Our risk-based approach to examination and supervision will allow us to address the changes the future holds and to help provide for a stable banking industry.
I thank you very much and will be happy to address your questions.
[The prepared statement of Hon. Andrew C. Hove Jr. can be found on page 125 in the appendix.]
Page 59 PREV PAGE TOP OF DOC
Mr. BEREUTER. Thank you very much, Mr. Hove.
We have a 15-minute vote now underway, plus a 5-minute vote. The predictions are, we will then have one hour without interruption. I am going to suggest that we will reconvene at 12:20. And in no case will the hearing, including questions, go beyond 1:15. I apologize for keeping you during this period of time, but I do want Members to have a chance to come back and ask questions.
The hearing is in recess until 12:20.
Mr. BEREUTER. The hearing will resume.
If we can have the witnesses return to the witness table, we will proceed, amazingly, as promised, on schedule.
Next we will hear from Mr. Nicolas Retsinas, Acting Director of the Office of Thrift Supervision.
As I mentioned to you previously, your entire statements, all of them, will be made a part of the record.
Mr. Retsinas, you may proceed as you wish.
Page 60 PREV PAGE TOP OF DOC
STATEMENT OF HON. NICOLAS RETSINAS, ACTING DIRECTOR, OFFICE OF THRIFT SUPERVISION
Mr. RETSINAS. Thank you, Mr. Chairman and Congressman Vento. Thank you for inviting me here today to discuss the examination and supervisory systems of the Office of Thrift Supervision.
Our approach to examination supervision is predicated on risk assessment. It is at the heart of our statutory mission. As you know, however, assessing risks can be difficult, particularly when the risks facing depository institutions are constantly changing. As a result, supervisors and examiners have to be ever vigilant to new risks and to shifts in the environment in which these institutions operate.
As we all know, the thrift industry that we regulate today is not the same industry that was in place before FIRREA was enacted in 1989. They are enjoying the best period of sustained health and profitability in 35 years. In fact, 96 percent of all thrifts earned a profit in the second quarter of this year, and troubled institutions hold less than .50 of 1 percent of industry assets. Capital levels are at an all-time high.
Many factors have contributed to the thrift industry's remarkable recovery over the past eight years, including statutory reforms that mandated higher capital levels, uniform regulatory requirements, and prompt corrective action.
New supervisory tools and powers have enabled us to act more quickly and forcefully when problems develop in an institution. Our upgraded risk-focused approach to supervision has also contributed, I believe, to the industry's comeback.
Page 61 PREV PAGE TOP OF DOC
As the industry has changed, so, too, the Office of Thrift Supervision is different from the agency it replaced in 1989. Today we have a staff of highly experienced, well-trained examiners who have, on the average, at least 10 years experience. Our examiner training emphasizes new and potential areas of thrift expansion such as small business and consumer lending, with a special emphasis on emerging technologies.
We rely on a regulatory process that utilizes institution examinations, not only to identify existing regulatory violations, but perhaps more importantly, to anticipate potential problems, prevent unsafe operating practices, and effect timely resolutions of existing problems. This type of supervision which evaluates future needs and potential risks helps to ensure the success of our financial system over the long term.
Among the more useful measures we have to evaluate institution risk exposure is capital. As I indicated, thrift industry capital is at an all-time high. However, capital can sometimes be a lagging indicator of potential problems. In addition to monitoring capital adequacy, we have a system in place that identifies potential risks not directly linked to capital. The system includes a comprehensive supervision and examination program designed to evaluate risk exposure at an institution, management's ability to control that risk, and the thrift's ability to absorb losses that could result from the risk.
The process combines on-site examination and off-site monitoring. We conduct on-site examinations at most institutions annually regardless of their CAMEL rating. Healthy, well-managed, well-capitalized smaller thrifts are examined every 18 months. More frequent examinations are scheduled when necessary. Our examinations are designed to focus on the most significant risks associated with each thrift business's strategy, financial condition, and unique circumstances. This promotes efficiency without compromising accuracy.
Page 62 PREV PAGE TOP OF DOC
Examinations focus on the effectiveness of management in controlling risk and an institution's internal controls, including the extent to which controls are maintained and followed. If deficiencies in either exist, the scope of an examination is expanded to determine whether there are underlying material problems such as increased loan delinquencies or inconsistent earnings.
The effectiveness of our examinations is evaluated through an internal quality control process in which supervisory personnel review examination reports for accuracy and consistency. We also utilize off-site monitoring programs to identify significant changes in an institution's financial condition or business activities between regular examinations.
Special attention, of course, is paid to institutions that have subpar CAMELS ratings, low capital levels, heavy exposure to high-risk loans or investments, high loan delinquencies, or high levels of interest rate risks.
Because of their specialized mortgage lending focus, the heart of risk assessment for thrift institutions is interest rate risk, the risk that an institution's earnings and capital will be adversely affected by changes in interest rates. To address this, we have developed a comprehensive interest rate risk program, which includes an interest rate risk model that has proved to be a valuable supervisory tool and also is very useful to our institutions.
The procedures we have in place have served us well in maintaining the safety and soundness of the thrift industry. In today's changing industry, however, we must constantly review and update our systems and approach. The keys to this are technology, training, and interagency coordination. Training and interagency coordination enable us to stay abreast of emerging issues and share our experiences, but it is technology that offers both the most promise and the most exposure to our supervisory responsibilities.
Page 63 PREV PAGE TOP OF DOC
We are currently in the midst of a technological make-over that is reshaping how we do our job. We are adopting technologies that enable our examiners to better evaluate institution risk. As we implement technologies, so too are the thrifts. Thus, technology also affects our overall supervisory approach. We must and do ensure that the thrifts have proper infrastructure in place for using these systems, including adequate controls, safeguards, and contingency plans.
Technology is also central to another issue of critical importance, electronic banking. The range of financial services that may be delivered via electronic banking is limited only by the ability of institutions to incorporate new technologies that include adequate security measures. Our objective in this area is to facilitate the development of innovative approaches to the delivery of financial services by institutions consistent with market forces and the maintenance of safety and soundness.
Another area which you reference in your remarks, Mr. Chairman, is the increased interest in the thrift charter by various financial companies, including insurance companies, investment banks, credit unions, and other commercial enterprises. Although the number of applications for thrift charters has markedly increased, the applications do not raise novel issues of review for the agencies, nor do they result in or involve supervisory challenges with which we are unfamiliar. We are prepared to monitor these new thrift institutions and their affiliations to ensure the safety and soundness of the institutions.
A final area of focus for the OTS is monitoring the expanded commercial, credit card, and small business lending activities authorized for thrifts by Congress last year. Again, although none of these lending areas presently represents a significant portion of aggregate thrift lending activities, our objective is to stay abreast of these gradually increasing activities and to work with thrifts exploring these lending areas.
Page 64 PREV PAGE TOP OF DOC
The risk-focused approach to examination supervision that I have described is particularly valid today. Rapid and constant changes in local economies and financial markets, the development of new financial products, and the continual development and spread of new technologies all pose challenges both to institutions and their regulators. To address these challenges, the tools used must also evolve.
The examination process and off-site monitoring activities have become extremely sophisticated. We no longer send examiners to institutions that count cash, and our regulations no longer describe the width of a vault's wall. Instead, we grapple with interest rate risk models and issues raised by electronic banking. The tools that we have developed and methods we employ in the examination supervisory process enable us to evaluate today's risks and permit us to remain vigilant in preparing for the challenges of tomorrow.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Nicolas Retsinas can be found on page 159 in the appendix.]
Mr. BEREUTER. Thank you, Mr. Retsinas.
On that high sounding note at the end, we will now turn to the Banking Commissioner for the State of Texas, Catherine Ghiglieri.
Thank you very much for coming to present your testimony. You may proceed as you wish.
Page 65 PREV PAGE TOP OF DOC
STATEMENT OF CATHERINE A. GHIGLIERI, BANKING COMMISSIONER, STATE OF TEXAS
Ms. GHIGLIERI. Thank you, Mr. Chairman, Mr. Vento.
My name is Catherine Ghiglieri. I am the Texas Banking Commissioner, and I am very pleased to be here today on behalf of the Conference of State Bank Supervisors to discuss the role of State bank supervision in bank examination.
Through CSBS, the 54 U.S. banking departments have worked together to coordinate examination procedures among the States as well as with the Federal regulatory agencies, and CSBS is also the central source of bank examiner training for the States.
Through landmark cooperation and coordination, smarter use of technology, improved examiner training, and an enhanced accreditation program of State banking departments, the State banking system is better poised than ever to handle supervisory and economic challenges.
A particular attribute of the State banking system worth highlighting is the experience that the banking departments have regulating and supervising a broad range of financial entities. States have developed their own models of functional regulation, but we have no single model of what functional regulation should look like. For example, in Texas, State banking and securities regulators have cooperated in investigations, enforcement proceedings, and information sharing.
Page 66 PREV PAGE TOP OF DOC Now that the banks are in the insurance business in Texas, we have instituted a similar process with the State Insurance Department. It has been our experience that cooperation and communication, not agency turf concerns, best protect the citizens of our State.
With that said, we continue to believe strongly that one regulatory agency must retain responsibility for the overall safety and soundness of any financial institution. Functional regulation works well when examining an institution from the bottom up, but there is no substitute for reviewing the institution from the top down.
In 1991, FDICIA required annual Federal or State examinations for certain banks. In 1992, to standardize this system, CSBS led the development of a system of cooperative examination among the State and Federal agencies. Under these working agreements, State and Federal regulators accept each other's examinations as their own. Healthy State-chartered banks are generally examined on an alternating basis, and others are examined on a joint or concurrent basis.
A benefit of the dual banking system has been the innovation and experience that varying State and Federal regulatory approaches have brought to bank examination and supervision.
While the experiences of the banking industry in the 1980's have demonstrated that off-site monitoring is no substitute for on-site examination, both State and Federal regulators now use a combination of on-site and off-site monitoring. In fact, CSBS helped pave the way for coordination between Federal regulators in developing a number of new automated examination tools that will both strengthen the exam and allow better use of on-site time.
Page 67 PREV PAGE TOP OF DOC
In 1992, in anticipation of interstate banking and branching, CSBS, on behalf of the State bank supervisors, began a collaborative State-Federal project to create a seamless supervisory system for State-chartered banks operating on an interstate basis. To help accomplish this, CSBS formed with the FDIC and the Federal Reserve the State-Federal Working Group. The group's goal was to minimize conflicts and duplication among the State and Federal regulators in supervising interstate State-chartered banks.
Separately, and through the State-Federal Working Group, the State banking departments adopted two agreements, the nationwide cooperative agreement among the State banking departments and the nationwide State-Federal supervisory agreement for the coordination of multistate State-chartered banks. The result has been an enormous reduction in regulatory burden for State-chartered banks.
Basic and continuing examiner education is a key factor of quality supervision. With limited resources, all regulators face a continuing challenge in balancing the need for training with the need to maximize examiner productivity. More than three years ago, CSBS set out to address its challenge with the development of a revolutionary new training method designed to minimize examiner time outside the department while maximizing comprehension and retention. CSBS now offers 19 separate computer-based training programs in a multimedia format that allows examiners to work on a timeframe that meets the department's needs.
To measure and enhance the professionalism of State banking departments and their personnel, CSBS sponsors a comprehensive State banking department accreditation program. CSBS developed this program to recognize and encourage excellence in State regulation. The accreditation process includes a rigorous investigation of department administration and finances, personnel policies and practices, training programs, examination policies and practices, supervisory procedures, and statutory powers. The State bank supervisors and CSBS have refined and approved our supervisory system to allow us to protect and foster the Nation's State banking system in good times and bad.
Page 68 PREV PAGE TOP OF DOC
Again, we appreciate the opportunity to testify on this very important subject, and I would be glad to answer any questions that you have.
Thank you, Mr. Chairman.
[The prepared statement of Catherine A. Ghiglieri can be found on page 194 in the appendix.]
Mr. BEREUTER. Thank you, Commissioner.
Now we will hear from Lori A. Richards, Director of the Office of Compliance Inspections and Examinations from the Securities and Exchange Commission.
Welcome, Ms. Richards. You may proceed.
STATEMENT OF LORI A. RICHARDS, DIRECTOR, OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS, U.S. SECURITIES AND EXCHANGE COMMISSION
Ms. RICHARDS. Thank you.
Mr. Chairman, Congressman Vento, I appreciate this opportunity to testify today on behalf of the Securities and Exchange Commission regarding its examination program and oversight of securities firms affiliated with banks.
Page 69 PREV PAGE TOP OF DOC
In the commission's written testimony, we have provided an overview of how the commission conducts its on-site examinations. We describe the program areas of most relevance to bank affiliates, and we describe how we coordinate our efforts with those of the bank regulators.
While my written testimony describes the specifics of our program, I would like to emphasize a few points. For more than 60 years, the primary mission of the SEC has been to protect investors and to maintain fair and orderly capital markets. To achieve these goals, we conduct on-site examinations as part of the commission's overall compliance program. We focus on registrants' compliance with their legal and regulatory duties under the Federal securities laws. We don't interfere with the competitive discipline of the marketplace. To use Adam Smith's words, our mission is to ''hold the ring'' in which securities firms compete. So long as they play by the rules, securities firms are free to innovate, free to enjoy the profits of creativity, and also free to fail.
As Chairman Levitt has testified in prior hearings, there is a fundamental difference between our program and that of the bank regulators. Bank regulators are necessarily concerned with the safety and the soundness of the banking institutions and the prevention of bank failure. The commission and the securities self-regulatory organizations, on the other hand, focus on protecting investors and maintaining fair and orderly securities markets.
We are very interested in the risks posed to securities firms by their significant affiliated companies, but our fundamental mission is the same whether the securities firm is affiliated with a bank, an insurance company, or whether it has no affiliations at all.
Page 70 PREV PAGE TOP OF DOC
In essence, the work of the commission's examination program is a practical application of the principle of functional regulation. Because our authority is generally coextensive with the securities markets, except for banks that directly perform securities functions, our examiners can follow the evidence wherever it may lead.
In other words, we have the authority to examine the underwriter who brought the securities to market, the traders who maintained the secondary market, the investment advisor who recommended the product, the registered representative who made the sale, the broker-dealer who hired and supervised the registered representative, the mutual fund that bought the security, and the self-regulatory organization that allowed the registered representative to enter the business. Because we see almost every part of this process, we are able to track down the source of any compliance problems.
We are also continuing and expanding our efforts to coordinate with other regulators, including foreign regulators, which Chairman Levitt has emphasized as a high priority. As an integral part of these efforts, we have worked to enhance our coordination with the Federal bank regulators.
In recent months, we have met with representatives of the Federal Reserve and the Office of the Comptroller of the Currency regarding our respective examination programs. I hope that these discussions will continue and that they will lead to enhanced routine coordination of our programs.
We have also entered recently into a memorandum of understanding with the OCC to conduct joint examinations of mutual funds advised by national banks and the trust departments that provide investment services to funds.
Page 71 PREV PAGE TOP OF DOC
We have also been cooperating with bank regulators for many years with respect to transfer agents. And, finally, the commission communicates with bank regulators whenever we find that bank-affiliated registrants have committed serious securities laws violations such that public enforcement action is warranted.
Through these processes, we have established a long-term working relationship with all of the Federal bank regulators. We recognize and respect the mandate of bank examiners, and we defer to them on issues related to bank functions. At the same time, because we believe that investors deserve a regulator whose primary mandate is to protect their interests above all else, and because of our expertise in the securities markets, we expect that bank regulators will defer to us with respect to the functions that we oversee.
The commission is committed to increased coordination with bank regulators where each of our functions is coordinated in the public interest. This is both the most effective and the most efficient way to provide compliance oversight of the securities business.
Again, thank you for offering me this opportunity to appear today and testify about our examination oversight. We stand ready to provide you with any further assistance that you may require.
[The prepared statement of Lori A. Richards can be found on page 218 in the appendix.]
Mr. BEREUTER. Ms. Richards, thank you very much for your testimony.
Page 72 PREV PAGE TOP OF DOC
Next we will hear from Daniel M. Sibears, Vice President, District Oversight and Coordination, National Association of Securities Dealers.
I don't know if I am pronouncing your name correctly, but correct me if I am wrong.
Mr. SIBEARS. It is pronounced Sibears.
Mr. BEREUTER. Sibears. Thank you very much. You may proceed.
STATEMENT OF DANIEL M. SIBEARS, VICE PRESIDENT, MEMBER REGULATION, NATIONAL ASSOCIATION OF SECURITIES DEALERS
Mr. SIBEARS. Thank you, Mr. Chairman. I am pleased to be here today to provide the subcommittee with information on the NASD and its examination programs.
The NASD, through its subsidiary NASD regulation, has examination responsibilities for all of its more than 5,500 members. It conducts two distinct types of examinations. Cause examinations address particular problems or identified events that are brought to the attention of our staff through a variety of sources. Cycle examinations follow a periodic schedule, with frequency based on the type and scope of business conducted by the member, the extent of customer exposure, past regulatory history. All cycle examinations are conducted on site at the member's place of business.
Page 73 PREV PAGE TOP OF DOC
NASDR's on-site examinations cover a broad scope of NASD rules and regulations as well as those of the SEC and the Municipal Securities Rulemaking Board. For example, NASDR examiners inspect a member's sales and training practices, including reviews for suitability, unauthorized training, churning, best execution, fair pricing, supervision, and fair dealing with customers.
The cycle examination approach combines the major areas of regulatory risk of each member with global issues applicable to virtually all members and is executed through standard modules and instructions.
Turning to the NASD's proposed bank broker-dealer role, the NASD has proposed new requirements enforceable by the NASD to establish clear standards for NASD members operating on financial institution premises where retail deposits are taken. Now at the SEC for review, these proposals evolve through the comment process and cover physical setting, networking, and brokerage affiliated agreements, customer disclosure, public communications, and notification of terminations. A pilot NASDR examination module has been field tested and will be used for examinations under this rule. In this regard, NASD has had significant experience with bank broker-dealer inspections.
As previously referenced, NASDR regularly examines all of its members, including the 228 firms that are affiliated about banks and the approximately 100 members that have third-party networking arrangements. During 1996, NASDR conducted 55 routine examinations and 338 cause examinations of bank affiliated broker-dealers.
Page 74 PREV PAGE TOP OF DOC The subcommittee also asked us to describe our examiner training. The NASD examiner training program, CornerStone, incorporates the knowledge and best practices of NASD experts nationwide into a system that uses computer-based training, self-paced training, and on-site mentors.
The subcommittee further asked us to describe how we coordinate examinations with other regulatory organizations. We have implemented our coordination efforts in large part through the November 1995 memorandum of understanding entered into with the SEC, the North American Securities Administrators Association, and other securities self-regulators. Under this memorandum, joint members are provided an opportunity to opt for coordinated examinations. In 1996, we coordinated examinations of 90 percent of those firms requesting them.
Even prior to the memorandum of understanding among securities regulators, we made special efforts to coordinate our examinations with bank regulators. To minimize duplication, promote regulatory consistency, and to reduce unnecessary burdens, the banking agencies and the NASD agreed to foster cooperation and information sharing by signing an agreement in principle on January 1995. Our coordinated efforts have yielded tangible results, the periodic communications between our 13 district offices and the banking agencies. More than two dozen coordinated examinations have been conducted between the NASD and the bank regulators.
While the regulatory community has worked toward improving coordination, we believe that cooperation and coordination between the bank regulators and the securities regulators can be enhanced. For our part, we intend to integrate our current decentralized coordination efforts with bank regulators into the national program that manages coordination with the other securities regulators.
Page 75 PREV PAGE TOP OF DOC
Moreover, we can eliminate unnecessary regulatory overlap by deferring to each other in areas of our respective expertise, an approach that will better utilize all of our resources and knowledge, eliminate unnecessary regulatory burdens, and fully protect the investing public.
Thank you for this opportunity to address the subcommittee today. I would be pleased to answer any questions that you might have.
[The prepared statement of Daniel M. Sibears can be found on page 247 in the appendix.]
Mr. BEREUTER. Thank you, Mr. Sibears.
And, finally, we will hear from Edward Kwalwasser, Group Executive Vice President for Regulation, New York Stock Exchange. You may proceed as you wish.
STATEMENT OF EDWARD A. KWALWASSER, GROUP EXECUTIVE VICE PRESIDENT, REGULATION, NEW YORK STOCK EXCHANGE
Mr. KWALWASSER. Thank you. Thank you for the opportunity to appear before the subcommittee to discuss the exchange's role as a self-regulatory organization in the examination and supervision of broker-dealers.
Page 76 PREV PAGE TOP OF DOC The New York Stock Exchange is committed to a strong and effective regulation of our member firms, to protect investors, the health of the financial system, and the integrity of the capital formation process.
Regulation of the securities industry in the United States relies heavily on self-regulation. While self-regulatory responsibilities begin with the broker-dealer, the exchange plays a crucial role by maintaining an extensive system for monitoring and regulating the activities of its membership, with oversight by the SEC.
We are very proud of our regulatory program, to which the exchange devotes fully one-third of its staff resources. Member firms that are affiliated with banks are, of course, subject to the same rigorous review and standards as any other exchange member. We are unaware of any problems that have occurred with regard to our oversight of bank affiliated broker-dealers. On the contrary, we believe our program has proven itself to be a highly cost effective way to promote investor protection and ensure the financial integrity of all of our member firms.
In particular, we are very proud of the extremely low failure rate of securities firms which hold customer funds or securities. Less than .1 of 1 percent have failed over the past 10 years. Moreover, of the 68 firms which have failed over that period, only two were members of the New York Stock Exchange.
The exchange oversees approximately 300 member firms that deal with the public. They serve nearly 50,000,000 customer accounts, operating from over 12,870 branch offices around the world, and employ approximately 160,000 registered personnel. The firms that we regulate account for more than 90 percent of the public customer accounts carried by broker-dealers in the United States.
Page 77 PREV PAGE TOP OF DOC
Member firms affiliated with banks represent a growing percentage of our membership. Currently, such firms account for 17 percent of the capitalization of New York Stock Exchange member firms dealing with the public, and serve approximately 4.8 million customer accounts, or about 10 percent of those accounts served by NYSE member firms.
Member firms that do business with the public are required to file with the exchange annual audited financial reports as well as monthly financial reports. Through these reports, periodic surveys, and discussions with the firms, our financial surveillance staff maintains knowledge about the firms to which they are assigned responsibility. When problems arise, meetings are held with firm management, which may lead to intensified surveillance and a corrective plan of action.
The exchange conducts annual on-site examinations of every firm that deals with the public. Our primary objectives are to address the safety of customer assets, the firm's financial and operational viability, and its sales practice compliance. To carry out these responsibilities, we use a broad range of techniques that include comprehensive computer analysis as well as in-field visits.
Every examination includes an opening meeting with the firm's management to understand the firm's procedures, controls, type of records maintained, and management reports produced. Through questioning, observation and testing, the examiners assess compliance with the rules covering net capital computations, operations, customer reserve formula, possession and control of customer securities, sales practices, and numerous other NYSE and SEC regulations. In addition, they seek to identify any material risk at the firm. The examination also includes an exit review with the firm's management.
Page 78 PREV PAGE TOP OF DOC
A written report is generally issued within 35 days, citing any findings as well as corrective action indicated. Firms are required to respond in writing to confirm that such corrective action has been taken or is going to be taken. Serious or repeat violations are referred to the exchange's enforcement division to consider possible disciplinary action. Any formal disciplinary action is made public to caution other firms to avoid similar problems.
Broker-dealers are often members of more than one SRO. In order to reduce duplication, the SEC has allocated among SRO's the responsibility for financial and operational regulation. The New York Stock Exchange is the designated examining authority for almost all of our member firms.
A memorandum of understanding between the SEC and the SRO's provides for information sharing and, to the extent practical, simultaneous on-site examinations of those broker-dealers which request such examinations.
The MOU has been effective in increasing SRO coordination, and more than 90 percent of those firms requesting simultaneous examinations have received them. Coordination of examinations as provided by the MOU was endorsed by Congress last year in the National Securities Markets Improvement Act.
The SEC conducts vigorous and continuing oversight of our examination program. We provide the agency with copies of our examination reports and keep them apprised of our examination cycle. In addition, they often perform inspections and reviews of specific functions of the exchange.
Page 79 PREV PAGE TOP OF DOC
The exchange is committed to a strong program of regulation of our member firms which we believe is best achieved by following the principle of functional regulation. All firms that engage in securities activities should be subject to the same rules, regulations, and enforcement, regardless of the type of institution involved.
In this regard, we have some concerns about H.R. 10. We are concerned that the bill would permit banks to engage in a wide range of securities transactions without being registered as broker-dealers. We are also concerned that the bill fails to require that bank securities activities be conducted in a separately capitalized broker-dealer. H.R. 10 would open the door for such activities to be melded into the bank, impeding our ability to efficiently examine and oversee those activities. To provide effective oversight, we must have the ability to look at the whole entity, not just its parts.
We support financial modernization that will enhance competition and increase the global competitiveness of U.S. financial services providers. However, we believe that any such legislation should protect the exchanges's ability to live up to our commitment to customer protection and the integrity of our market.
The current system of securities firm oversight has proven itself to be highly effective in protecting the interests of investors as well as the financial health of our member firms and the securities market as a whole. We urge Congress not to pass any legislative measures that would alter or destroy that system.
Page 80 PREV PAGE TOP OF DOC
[The prepared statement of Edward A. Kwalwasser can be found on page 270 in the appendix.]
Mr. BEREUTER. Thank you very much, Mr. Kwalwasser.
I want to recognizeor notethat we understand to some extent, and need to appreciate more than we do, how much work has gone into your testimony, not only yourself, but your staff as well.
We have received detailed information from you on how you are proceeding with your regulatory responsibilities, or your industrial sector responsibilities. I think that is very important to us to have that information, and to also provide public exposure. I think it does serve a public purpose to have this recitation and to know that the details are here to reassure us and to help us conduct, if necessary, oversight that is aggressive.
Since there are only the two of us now, I would like to turn to the Ranking Democratic Member of the subcommittee, and we are going to allow 10 minutes so that we can hopefully proceed to ask a more coherent set of questions. And so I turn to the Ranking Member, Mr. Vento, for his questions.
Mr. VENTO. Well, thank you, Mr. Chairman.
Even then, obviously, I think your comments with regard to preparation of the testimony is quite appropriate. Unfortunately, these days are very busy, and I have been in and out, and this testimony deserves a lot more analysis than what I have had time to give it. Yesterday, we were on the floor here for about 14 hours.
Page 81 PREV PAGE TOP OF DOC
In any case, one of the ongoing issuesand I think that we gain some insight into this in terms of the overlapping. I am especially interested in that. You see this merger going on, and mergers go on and will probably go on whether we approve modernization or not, and I hope that we do, but will provide for merger between the different financial types of entities; that is, banks, insurance, and securities groups.
And, of course, Mr. Kwalwasser suggests that he needs to have all the information. But the question is, can you rely on one another? In other words, how does this all get woven together?
There may be some that have visions of one omnipotent regulator. You know, there is even the threat of that, and one obviously gets very concerned. That is why I tried to draw out of the GAO the issue about, they had historically been in favor of some redundancy, or at least some check and balance system, within the regulatory scheme. But increasingly it is true that you need to rely upon one another in order to provide holistic type regulation. We call it ''functional'' regulation in some spheres.
Nevertheless, there is an effort to say, when you get information from a self-regulatory organization, or you are getting information from the SEC or the Federal Reserve Board, that it is reliable.
Mr. Ludwig, would you like to speak to that particular issue for me?
Mr. LUDWIG. Yes. I agree very strongly, Congressman Vento, that the key to regulation in the future is coordinating, more importantly than having a coordinator.
Page 82 PREV PAGE TOP OF DOC
In that regard, as you can see from the testimony here today, there has been a tremendous movement over the last several years toward MOU's, joint examinations, sharing of information, and joint referrals. I have learned to have a heightened respect for my fellow regulators at the other banking agencies as well as for the securities and insurance regulatory processes and regulators. And bank regulators, through the FFIEC, have demonstrated an increasing amount of cooperation. There have also been two very significant MOU's that have involved the SEC and the NASD. So, coordination is clearly going on.
I agree with you, I think it is critical. In terms of whether or not the information that is provided is reliable, our experience is that it has been, and, as I say, I have an enhanced respect for the work of the other agencies.
Mr. VENTO. Let me ask another question in a different vein of Ms. Phillips, Governor Phillips.
We had worked quite hard in 1991 on systemic risk and ''too big to fail'' issues under the FDICIA law and had come to some understandings. But with the mergers that are going on today, what does that say to the issue? In the end, it seems like more and more banks are going to be ''too big to fail.'' Doesn't that offer new risks in terms of that issue?
Ms. PHILLIPS. Well, certainly, that is a challenge. And I think that the trends that you cite are really an extension of something that has been going on for quite a while in terms of mergers and firms seeking to try to find economies of scale. Also, globalization affects this.
Page 83 PREV PAGE TOP OF DOC
So, in addition to the coordination efforts that must go on among the bank regulators. and with the functional regulators such as the SEC and the insurance regulators, I think we also have to be concerned about the quality of our counterparts in other countries and to what extent can we rely on their regulatory processes. So we have had to, in fact, extend this cooperation on a global basis.
In terms of the systemic risk questions, obviously that is something that we give a lot of credence to as an issue. And some of the reforms that were put into place, such as prompt corrective action and so on, have been of assistance. I do think that some of the legislative efforts have addressed some of the ''too big to fail'' kinds of questions.
Mr. VENTO. Well, some of the best ideas in legislation probably have come from the regulators. So, you know, we are probably taking it, I might say, with regard to the reason why I was smiling when you were talking about the global issue, because we have got a few global issues up. I just suggest that none of you identify yourself or work with the UN. It seems to be a radioactive problem these days. So I don't agree with it, but coming from the home State of Hubert Humphrey and Harold Stassen, but others have problems with it.
Mr. BEREUTER. Mr. Vento had a particularly difficult day yesterday, so we will forgive him for that reference.
Mr. VENTO. Anyway, the GAO. In the September 1997 report, Governor Phillips reported on the adequacy of internal controls and audits of foreign banking organizations, which of course, you didn't respond to my question. Which leads me into another area, although that was principally not the purpose of the merger question.
Page 84 PREV PAGE TOP OF DOC
But, U.S. supervisors have developed and implemented several initiatives to improve supervision. However, a strategy to evaluate the results, including objective measureseveryone is for standards when it comes to school testing, they justto schools, they are all for standards, they just don't want us to use testing.
I am just trying to understand how we were going to determine whether or not anyone had achieved the standards? It is just a little bit of a dilemma for me. In any case, it is a dilemma for you, too. In other words, we are for standards, but how can we measure them? The GAO suggests we haven't got objective measures yet that have been developed.
Would you comment on that, Governor Phillips?
Ms. PHILLIPS. Surely. That was one of the suggestions that was made in that report, that we develop more systematic measurements. And we agree, and we will be looking at that.
I might mention that, as you know, shortly after we started examining the foreign banks and branches, we went into them, and found that many of these banks are not subject to the same kind of supervision that is extant in domestic regulation. And we did find a number of problems and, in fact, have had to take a number of corrective actions with respect to foreign banks and branches.
We are trying to measure our progress, and, in response to the GAO's suggestion, took a look to see what kind of improvement there has been in the ROCA ratings for foreign banks and branches. We have, in fact, seen some improvement in the ratings, not only for the operational portion, which would address specifically the internal controls, but in overall ratings. ROCA ratings peaked in 1992, and we have seen some improvement since then in those ratings.
Page 85 PREV PAGE TOP OF DOC
Mr. VENTO. Yes. I see that identified in the testimony.
Director Richards, what would you comment? Because equally would be securitization. I might say that with regard to the hearing we had the other day on the financial FASB issue with derivatives that, of course, one of the solutions suggested was that we have more definition of them. If you have more definition in their sale, they can be sold in the secondary market.
So these derivatives, two-thirds of which are held by banks today, the more definition, the more easily they move into type of security. I mean, by defining them, you actually change the character of the market to some extent, one of our concerns with that, I might say. And you might want to respond to that.
But my question is, what is the SEC's role in terms of securitization abroad? We have both banks and foreign banks that are operating here that have obviously securities activities, brokerage activities, abroad.
Ms. RICHARDS. Well, first, let me say happily I was not involved in the FASB discussion last week, but that the commission is concerned with the global oversight of securities firms.
There are several ways that we have addressed this. First, we conduct on-site examinations of the U.S. broker-dealers operations here. And part of our review is to determine the adequacy of their capital which must be maintained in the United States. In addition, broker-dealers have an obligation to make their records available to us in the United States even if they are maintained in a foreign country.
Page 86 PREV PAGE TOP OF DOC
Congress addressed the issue of how to monitor a global firm with the Market Reform Act of 1990. On the basis of that act, in 1992, the Commission adopted its risk assessment rules, which require the material affiliates and holding companies of primarily the largest broker-dealers to provide to us financial information on a quarterly basis to allow us to determine, as sort of an early, early warning system, whether or not the activities of the material affiliates at the holding company level may have an impact on the operations or the capital of the United States broker-dealer.
As an enhancement to the risk assessment program, in 1995 the SEC formed its Derivatives Policy Group to address a range of issues pertaining to the OTC derivatives markets. And finally, we actively participate with our foreign regulatory authorities to address issues surrounding the supervisory oversight of global financial institutions.
Mr. VENTO. Well, my time has expired, and I would ask unanimous consent to be able to submit written questions to the witnesses, Mr. Chairman.
Mr. BEREUTER. Without objection, that will be the order for all Members. Thank you, Mr. Vento.
I am going to slip back, say to the staff, to the 5-minute rule in order to keep the promise here.
Mr. Ludwig, unless you already submitted and I simply missed it, would you mind submitting a little information about the pilot joint examination process you have between the OCC and the SEC regarding mutual funds by national banks. I would ask you to do that now, but I think in light of the fact I have got a number of other questions, is that something you can readily provide?
Page 87 PREV PAGE TOP OF DOC
Mr. LUDWIG. Absolutely.
Mr. BEREUTER. Thank you very much.
[The information referred to can be found on page 117 in the appendix.]
Mr. BEREUTER. Mr. Hove, I have the understandingmy guess is not completely correct, perhapsthat there is an agreement between the FDIC and the OCC that you will not examine a national bank without the OCC's permission. If so, that seems like it might not be consistent with the intent of Congress. What is the real story there?
Mr. HOVE. The agreement was made between the OCC and the OTS and the FDIC and the Federal Reserve that we would discuss the institutions that needed to be examined among our regional directors and their counterparts with the various agencies.
We would make a list of the institutions that needed to be examined, discuss them with the regional director's counterparts in these different agencies, and then go in on a cooperative, consolidated basis with their examination staff. In order to reduce the burden on the institution, we would go in as a joint examination rather than our going in and their going in at different times.
In the current condition of the banking industry, it appears to be working quite well. If things deteriorate, I would expect that we will do more of these joint examinations than we have in the past. The cooperation among the agencies has been very good on this.
Page 88 PREV PAGE TOP OF DOC
Mr. BEREUTER. Chairman Hove, I certainly like the direction and the objectives, and I think it is what Congress had hoped would happen, but I hope that you also ultimately preserve independence of agencies to proceed without the agreement of the others.
Mr. HOVE. Thank you. I appreciate your comment.
Mr. BEREUTER. Mr. Kwalwasser, could you briefly explain how, if at all, your stock exchange interacts with NASD and the SEC during a typical exam?
Mr. KWALWASSER. Sure. We have gone out to all of our members and asked them whether they would like a coordinated, simultaneous examination, not only among the SEC and the NASD, but if they are an options firm, also the options exchange that they are a member of.
With respect to those, we, on a monthly basis, get together and have a plan of when we are going to go in and do an examination. We will go in together. Out of all of the firms that requested both this year and last year that they have a simultaneous coordinated exam, over 90 percent of those firms have received an exam.
When we go in and do that, we will all be in at the same time, but will be doing different activities. We will be looking at the financial and operational part of the firm, the NASDR will be looking at the over-the-counter markets and different things they look at, and the options exchange will look at options transactions.
Page 89 PREV PAGE TOP OF DOC The SEC oversees our exam. So they don't, as a routine matter, go in with us. But some months after we have been in, they will come in and do an examination to determine whether our examinationand they will do that on some basis that Lori probably could tell you better than I, but they will make a determination as to whether we have found everything that we should have found, whether our program is appropriate, and whether any changes ought to be made.
Mr. BEREUTER. Thank you very much.
Commissioner, I was going to ask you a question about the challenges interstate banking and branching provide State supervisory agencies, but I am going to keep my promise here and let you respond to that later if you want to.
I turn to the gentleman from Texas, Mr. Bentsen, for his 5 minutes.
Mr. BENTSEN. Thank you, Mr. Chairman.
And, actually, it would be a unique answer coming from Texas and how we deal with interstate bankingor don't.
But I do want to welcome Catherine Ghiglieri, who is the State Banking Commissioner and head of their association. I want to point out for the record that I think at this point now both the head of the State banking regulators and the head of State securities regulators associations are both from Texas, and they both are women, which has a lot to say about Texas, I think. And I appreciate you being here.
Page 90 PREV PAGE TOP OF DOC I have had a long concernwell, I know this hearing is focusing both on where the regulators have come per examination since the 1980's and early 1990's, and free of FDICIA and other acts. But I have a concern as we go forward looking at regulatory changes that have been made, both with the OCC and the Fed, with the continuing consolidation or affiliation that is occurring in the market between securities firms and banking firms, and with the rumor that there might be financial modernization on the horizon, although I think that is highly unlikely, at least in this session of the Congress.
My concern is that consumers are adequately protected as banks are offering new financial products. And while we focus on the level and depth of examinations of banks and what the SEC and the NASD and the NYSE do with respect to broker-dealers, we now have a melding that is occurring between securities firms and banks, and we have some carve-out of what were otherwise broker-dealer activities in banks.
Now, in 1995 the GAO put out this report which raised serious questions about banks' ability and the regulators' ability to properly enforce consumer protection as it related to mutual fund sales. I think the same risks are possible as it relates to securities sales.
And I noted in Mr. Kwalwasser's testimony that the New York Stock Exchange has great concern about H.R. 10 and its protection of consumers vis-a-vis securities sales, although I would remind you, after a great deal of work, we did include language that would at least put all bank securities sales, including eligible securities, under the SRO regulation. And, in fact, the language could be interpreted to be much broader than that. The SEC might interpret that it includes them as well.
Page 91 PREV PAGE TOP OF DOC
But I guess my question would be for Ms. Richards.
Do you at the SEC and those on the securities side have a concern that we are moving to carve out more and more securities activities which will hamstring your abilities to protect consumers and ultimately safety and soundness concerns as we have more of these affiliations occur?
Ms. RICHARDS. Well, yes, the Commission has always advocated that as financial modernization moves forward, that the principle of functional regulation be foremost considered. It is hard for me as an examiner to tell you what we are not seeing, because we don't have the ability to see it.
I think one of the benefits of coordinating with our fellow regulators, and particularly with the OCC in conducting the examinations of bank trust departments, is that for the first time we were able to conduct our typical examination procedure that we would conduct for investment advisors. And I think that is, in particular, an area where we see that the lack of securities regulation can be a detriment to investors.
Mr. BENTSEN. I know there have been a number of interagency agreements with respect to mutual fund sales; there is now with respect to securities sales; and on its face, that appears to be sufficient. But my concern, and anyone who would want to answer this, my concern is, even though you provide the testing, even though you provide the Series 7, NASD allows for the Series 7, what you don't have is the enforcement mechanism in place.
Page 92 PREV PAGE TOP OF DOC And my concern, unless the bank regulators can correct me on this, is, where is the enforcement mechanism for either mutual fund sales, investment advisory services, or securities sales, to ensure that consumers are protected and, quite frankly, ultimately, the bank is protected both in terms of safety and soundness or contingent liability from fraudulent sales practices?
Ms. RICHARDS. Well, if I could just address that, I think you have highlighted a very significant difference between securities regulators and bank regulators. And that is that one of the underpinnings of securities regulation is that we believe investors have a right to know whether or not their registered representative, or the securities firm that they are dealing with, has been engaged in misconduct.
So, we have a very active and aggressive enforcement program both at the SEC, and the self-regulatory organizations do as well, and we publicize the results of our enforcement actions. The NASD has an 800 phone number that allows investors to determine whether or not there has been an enforcement action taken against their registered representative or their securities firm before they do business with the firm. And it is one of the most important underpinnings of the Federal securities laws that we back up our system of securities laws with a very aggressive cop on the beat.
Mr. BEREUTER. The time of the gentleman has expired, but you may proceed, Mr. Ludwig.
Mr. LUDWIG. Thank you very much, Mr. Chairman.
Page 93 PREV PAGE TOP OF DOC Bank regulators do have, in fact, because we are in the banks all the time, a desire to see problems fixed as early as possible, before the investor is hurt. We do concern ourselves a great deal with how the investor is treated, because if you have poor treatment of the investor, you create a reputation risk problem for the institution, which has safety and soundness implications. Were there not to be compliance with important rules and regulations, that would be a safety and soundness matter subject to our 12 U.S.C. 1818 enforcement authority. So it is not the case that we don't have the enforcement weapons to deal with the issue.
Mr. BEREUTER. Thank you very much.
Before you arrived, Mr. Bentsen, I made a commitment for the subcommittee to keep this on a particular schedule, so I would encourage you to send any further questions with the bipartisan assistance of the staff here and all Members for additional questions.
In fact, I would say to Mr. Sibears that I would ask you if you could respond to one about bank employees taking Series 6 and 7 licensing exams, if you could provide us some facts on that in writing.
Mr. SIBEARS. I would be happy to do that.
Mr. BEREUTER. I want to thank all of you for your time, for your excellent testimony, and for your patience here today. We very much appreciate it.
The hearing is adjourned.
Page 94 PREV PAGE TOP OF DOC
[Whereupon, at 1:20 p.m., the hearing was adjourned.]
[insert offset folios 45 to 282 here]