[Senate Hearing 108-880]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-880

 
                 EXAMNATION OF THE CURRENT CONDITION OF
                THE BANKING AND CREDIT UNION INDUSTRIES

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                                   ON

  IMPROVED RISK-MANAGEMENT PRACTICES OF BANKS, THE CURRENT STATUS AND 
    DIRECTION OF REGULATORY EFFORTS TO REVISE CAPITAL STANDARDS FOR 
  INTERNATIONALLY ACTIVE BANKS, DEPOSIT INSURANCE, AND CONSOLIDATION 
                  WITHIN THE DOMESTIC BANKING INDUSTRY

                               __________

                             APRIL 20, 2004

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                       Mark F. Oesterle, Counsel

             Martin J. Gruenberg, Democratic Senior Counsel

                  Aaron D. Klein, Democratic Economist

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        TUESDAY, APRIL 20, 2004

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Allard...............................................     2
        Prepared statement.......................................    47
    Senator Bunning..............................................     2
        Prepared statement.......................................    47
    Senator Crapo................................................     2
        Prepared statement.......................................    47
    Senator Johnson..............................................     3
    Senator Reed.................................................    18
    Senator Sarbanes.............................................    23
    Senator Carper...............................................    25
    Senator Corzine..............................................    28
    Senator Schumer..............................................    30

                               WITNESSES

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................     4
    Prepared statement...........................................    48
    Response to a written question of Senator Santorum...........   103
John D. Hawke, Jr., Comptroller of the Currency, U.S. Department 
  of the Treasury................................................     7
    Prepared statement...........................................    54
    Response to written questions of Senator Schumer.............   104
Donald E. Powell, Chairman, Federal Deposit Insurance Corporation     8
    Prepared statement...........................................    65
    Resposne to written questions of Senator Bennett.............   114
James E. Gilleran, Director, Office of Thrift Supervision........    11
    Prepared statement...........................................    72
Dennis Dollar, Chairman, National Credit Union Administration....    11
    Prepared statement...........................................    82
Kevin P. Lavender, Commissioner, Tennessee Department of 
  Financial
  Institutions, on Behalf of the Conference of State Bank 
    Supervisors..................................................    13
    Prepared statement...........................................    98

                                 (iii)


                             EXAMINATION OF
                      THE CURRENT CONDITION OF THE
                  BANKING AND CREDIT UNION INDUSTRIES

                              ----------                              


                        TUESDAY, APRIL 20, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 2:34 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    I want to thank our witnesses for being here today. The 
purpose of this hearing is to examine the current state of the 
banking and credit union industries. This, I recognize, 
involves consideration of numerous other issues. I think this 
is a particularly worthwhile endeavor for this Committee, 
though, because of the tremendous significance of so many of 
the matters facing the industry.
    On the broadest level, the performance of the banking 
system is critical to the function of the overall economy. So 
critical, in fact, that Congress created a backstop for the 
system that potentially gives it direct access to the wallet of 
the American taxpayer.
    On a more basic level, the system provides consumers credit 
and other financial services.
    There are also issues associated with the banking system 
which go beyond economic matters. As the principal means for 
movement of financial resources throughout the world, the 
system is something that terrorists would readily exploit to 
further their murderous endeavors.
    Furthermore, while examining these issues in relation to 
the system, we must keep in mind that it is not comprised of a 
simple, monolithic entity. Rather, the ``banking system'' is 
made up of thousands of different firms of various sizes with 
different regulators, which are vigorously competing in 
extremely complex and dynamic national and international 
markets.
    Thus, in light of the significant macro and microeconomic 
and national security issues associated with the performance of 
the banking system, I think that it is important for the 
Committee to address some basic questions.
    For example, how healthy is the banking system today?
    What are the present risks that could compromise the 
performance of the system?
    What future risks are looming on the horizon?
    What can be done to strengthen the system against these 
risks?
    I have long supported ongoing review of the regulatory 
structure governing the banking system. I think it is important 
to closely monitor these laws and rules because, due to the 
fast-paced nature of changes in the financial service industry, 
they can readily outlive their intended purposes and become 
inefficient and very burdensome.
    In the past, I have worked directly on regulatory relief 
legislation. I am happy to note that Senator Crapo has taken up 
this effort on this Committee and is working on his own 
regulatory relief measure. I commend him for this. I look 
forward to working with Senator Crapo and others and hope that 
today's hearing will prove helpful to their efforts.
    Before moving on, I want to recognize the contributions of 
Chairman Dollar, who will soon be leaving his post at the 
National Credit Union Administration. Good luck in your future 
endeavors. And I thank all of you for being here today.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman. I really do not 
have any opening statement. I do have a short one I will just 
put in the record because I am anxious to hear from the panel.
    Chairman Shelby. It will be made part of the record, 
without objection.
    Senator Allard. I would just like to thank all of you for 
taking the time to testify before our Committee and I look 
forward to what you have to say.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. I just would like permission to put my 
statement in the record.
    Chairman Shelby. Without objection, your complete statement 
will be made part of the record in its entirety.
    Chairman Shelby. Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. I will make my statement a part of the 
record as well, Mr. Chairman. I look forward to working on reg 
relief and the other critical issues before us today. Thank 
you.
    Chairman Shelby. Senator Crapo, I do not know if you were 
here a minute ago. I did acknowledge your work in the 
regulatory relief area because as we all know and as you 
especially know, there are a lot of laws and regulations that 
have no meaning in today's financial world, except to add a 
burden of cost to people.
    Senator Crapo. You are correct, Mr. Chairman, and I did 
have a statement on that. I am not going to give it all because 
I have questions for the panel, and I would like to get into 
those. But I appreciate the Chairman's recognition of that and 
the Chairman's willingness to work with me on developing that 
legislation.
    Chairman Shelby. Absolutely.
    Senator Johnson.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. Well, thank you, Mr. Chairman, and I will 
be brief because we do need to move on to the panel. And I 
welcome all of them to this hearing.
    I want to thank you and Ranking Member Sarbanes for holding 
this hearing. My constituents in South Dakota are extremely 
fortunate to benefit from a stable mix of large and small 
financial institutions. We have more than 100 small banks and 
credit unions scattered throughout the State, reaching into the 
most remote of our communities. These small banks and credit 
unions provide critical financial services to these communities 
which might otherwise be underserved. And as I have noted in 
the past, deposit insurance is a critical component to the 
financial services provided in those communities.
    I remain hopeful that this Committee will work together 
over the next few remaining months to pass once and for all 
comprehensive deposit insurance reform to ensure the continued 
health of the system. With the number of legislative days 
waning, we are up against the clock. At this point the major 
hurdle appears to be getting the Administration and others to 
look at the facts behind the need for increased retirement 
coverage. I strongly believe that the retirement coverage issue 
deserves distinct analysis, and that is why in November 2001, I 
held a Subcommittee hearing on that topic alone. Health care 
costs are exploding, corporations are taking away benefits from 
retirees in too many instances, and it is no longer absurd to 
suggest a person might need more than $100,000 to make it from 
age 65 through the remainder of their life.
    We have agreement, just about everyone, on all the other 
components of our proposed legislation, and we have a strong 
bipartisan team committed to reform, including Senators Hagel, 
Reed, Enzi, Stabenow, and Allard. The time to adopt 
comprehensive deposit insurance reform is now, and I expect we 
will hear today that the FDIC and NCUA funds and the banking 
and credit system as a whole seem to be doing quite well. The 
last thing we want to do is wait to legislate during a crisis, 
and this issue first gained traction because of concern over 
the declining insurance fund ratios, particularly in the Bank 
Insurance Fund. I do not think anyone is sorry to see these 
ratios rise since the whole point of this discussion is the 
safety and soundness of America's financial system.
    In addition, nothing changes the fact that new entrants 
into the marketplace, large security firms that have recently 
chosen to sweep large deposits into insured accounts, continue 
to receive deposit insurance for free. The uptick in ratios is 
simply no excuse for Congressional inaction in the face of what 
everyone agrees is a system that needs revision.
    Coming from a rural State, I know firsthand how bleak the 
situation would be if community banks and credit unions did not 
provide the first-rate services that they do. We need to make 
sure that Congress does not turn a blind eye to marketplace 
distortions that allow enormous corporate entities to 
manipulate the system to their advantage, and the banking 
industry continues to generate record profits year after year. 
Capital levels have remained steady, problem institution levels 
remain at historic lows, and the deposit insurance fund ratios 
are growing.
    During this period of stability in the system, our 
financial institution regulators have had the opportunity to 
focus on the future, and we here in the Committee need to do 
the same.
    I look forward to listening to the panel testimony today, 
and I thank the panel members for joining us.
    Chairman Shelby. Thank you, Senator Johnson. I just want to 
briefly respond to your request.
    A lot of us are interested in deposit insurance reform. I 
am particularly interested in about four or five items there, 
but I do not think reform is necessarily reaching back and 
running the insurance rate up. And others, I think, tend to 
agree with me on that. I do not know if it is a majority, but I 
would be glad to sit down with you and work and see if we could 
look at something prospectively in the future.
    Senator Johnson. Thank you, Mr. Chairman.
    Chairman Shelby. I know you have worked hard in this area.
    We are honored to have again before the Committee a 
distinguished panel: Alan Greenspan, who really needs no 
introduction, Chairman of the Board of Governors of the Federal 
Reserve System; John D. Hawke, Jr., Comptroller of the 
Currency; Donald E. Powell, Chairman of the Federal Deposit 
Insurance Corporation; James E. Gilleran, Director, Office of 
Thrift Supervision; Dennis Dollar, Chairman of the National 
Credit Union Administration; and Kevin Lavender, the Tennessee 
State Bank Commissioner, Tennessee Department of Financial 
Institutions, testifying on behalf of the Conference of State 
Bank Supervisors.
    Gentlemen, we welcome all of you here. Your written 
testimony will be made part of the record in its entirety and 
be part of the hearing process.
    We will start with Chairman Greenspan because I think 
people would like to hear from you and have a chance to 
question you.
    Chairman Greenspan.

             STATEMENT OF ALAN GREENSPAN, CHAIRMAN

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Chairman Greenspan. Thank you very much, Mr. Chairman.
    Chairman Shelby, Members of the Committee, I am pleased to 
be here this afternoon to discuss the condition of the U.S. 
banking system and related matters.
    Three years ago, bank asset quality, mainly in the 
corporate sector, began to decline, but banks were well 
positioned to deal with emerging problems. Their capital 
position was strong, the industry's overall asset quality was 
high, and banks had made significant progress in diversifying 
their sources of revenue.
    As the economy slowed, the industry was quick to act in 
addressing its emerging asset problems. Household credit demand 
stayed high and earnings remained at or near record levels, 
while assets continued to expand.
    Importantly, the recession was mild and short-lived, making 
the necessary adjustments easier. Strong capital positions and 
a mild recession were probably the most important factors, but 
the benefits of an ongoing effort by banks to improve risk 
measurement and management and the maturing of new techniques 
for shifting risk should not be ignored.
    The basic thrust of recent efforts to improve the 
management of risk has been better quantification and the 
creation of a formal and more disciplined process for 
recognizing, pricing, and managing risks of all types. Earlier 
detection of deviations from expectations now can, and does, 
lead to earlier corrective actions by bank managers and, as 
necessary, by bank supervisors as well.
    Better methods for measuring credit risk also have spurred 
growth in secondary markets for weak or problem assets which 
have provided banks with a stronger basis for valuing these 
credits and an outlet for selling them and limiting future 
losses.
    The result is greater liquidity for this segment of bank 
loan portfolios and the earlier transfer of weakened credit 
from bank balance sheets. Portfolio risks also have been 
increasingly hedged by transactions that do not require asset 
sales, such as derivatives that transfer credit risk.
    Recent initiatives of the Basel Committee on Banking 
Supervision to revise international capital standards have 
helped focus attention on risk measurement practices and have 
encouraged further investment in this area. In my view, such 
efforts are crucial to extending the progress that the industry 
has already made. We need a more accurate, more risk-sensitive 
measure of capital adequacy to provide our large, complex 
banking institutions with appropriate risk management 
incentives and to provide the regulators with a more reliable 
basis for supervising them in a way that focuses on true risks. 
In the process, such a measure should also enhance our efforts 
in taking prompt corrective action.
    For all these reasons, I believe the U.S. banking agencies 
must remain committed to the process of developing and applying 
a revised regulatory capital standard and a new capital accord, 
Basel II, for the world's international banks.
    In reflection of public comments on last summer's advanced 
notice of public rulemaking on such a revision to the U.S. 
capital rules, the agencies have been successful in extending 
the negotiation period at Basel and incorporating into the 
proposal significant revisions as described in my statement.
    There are still some important details to be worked out 
among the U.S. agencies, mainly on the capital treatment of 
credit cards. The Federal Reserve for its part will continue to 
make every effort to reach a consensus on this issue that is 
both risk-sensitive and workable. If successful, a new Basel 
proposal then could be published on schedule at mid-year that 
could be tested among larger U.S. banks later this year and 
could be the basis for a good-faith notice of proposed 
rulemaking next year.
    Our basic goal, shared with all the other agencies, is to 
develop a revised accord that reflects 21st century realities, 
that meets our needs for a safe, sound, and competitive banking 
system, and that addresses the legitimate concerns of the 
industry. Among the legitimate concerns of some banks that must 
be addressed is ensuring that the application of Basel II in 
the United States to only our largest banks does not upset the 
domestic competitive equilibrium. As explained in my statement, 
we are carefully studying this issue and have, in fact, 
uncovered some potential problems between large banks that 
choose not to adopt Basel II in this country and those that are 
required to do so or opt in. We are studying other markets to 
see if there are similar problems.
    We will not go forward on Basel II until policies are 
adopted that mitigate such effects, where appropriate. We 
cannot, however, respond to unsubstantiated and generalized 
fears of change. Such concerns should not halt the evolution of 
regulatory capital standards for large, complex banking 
organizations that play such an important role in domestic and 
global financial markets.
    The significant bank consolidation that began 20 years ago 
reflects technological, global, and statutory and regulatory 
changes and has resumed in recent months after a period of 
relative inactivity. This ongoing consolidation of the U.S. 
banking system has not, in my judgment, harmed the overall 
competitiveness of our banking and financial markets. Although 
they have facilitated and fostered consolidation, the reduced 
legal barriers to entry--such as the relaxation of interstate 
banking laws, along with technological advances such as the use 
of ATM's and electronic banking--have provided net competitive 
benefits to American consumers of financial services.
    Developments such as these have stimulated competition 
among depository institutions and between depositories and 
nonbank providers of financial services. Moreover, it is worth 
emphasizing that measures of concentration in local markets, 
both urban and rural, have declined modestly since the mid-
1990's as most mergers are for the purpose of expanding into 
new markets. Importantly, it is in local markets where most 
households and small and medium-sized businesses, those 
customers that may have the fewest alternatives for acquiring 
financial services, obtain the vast majority of their banking 
services.
    Briefly, Mr. Chairman, let me say in answer to the question 
in your invitation letter that the Federal Reserve still 
supports the merger of the deposit insurance funds, enhanced 
flexibility in setting deposit insurance premiums, and 
especially wider latitude for risk-based pricing. However, we 
still do not support higher deposit insurance coverage limits.
    Finally, I want to reiterate that the past decade is one in 
which the banking industry has recorded persistent record 
profits while providing an ever wider range of products and 
services to much more diverse groups. The industry's experience 
during the past several years in dealing with clear weakness in 
key economic sectors reinforces the importance of strong 
capital positions and robust risk management practices. Bank 
supervisors worldwide are working to encourage both through 
more accurate and more effective regulatory capital standards 
based on even better internal risk management procedures.
    Thank you very much, Mr. Chairman. I look forward to your 
questions.
    Chairman Shelby. Thank you, Chairman Greenspan.
    Mr. Hawke.

                STATEMENT OF JOHN D. HAWKE, JR.

                  COMPTROLLER OF THE CURRENCY

                 U.S DEPARTMENT OF THE TREASURY

    Comptroller Hawke. Chairman Shelby and Members of the 
Committee, I appreciate this opportunity to review the 
condition of the national banking system. I would like to make 
two key points in my oral testimony this afternoon.
    First, by virtually every measure, the national banking 
system, which consists today of about 2,100 financial 
institutions, is in excellent health. Earnings have been at 
historically high levels for a decade. In 2003, national banks 
set records for both return on equity and return on assets. 
Loan growth has also been strong overall. In 2002 and 2003, 
total loans grew by 7.8 and 7.6 percent, respectively.
    The rise in bank assets has been fueled by the growth in 
bank deposits that one might expect to see in a low interest 
rate environment. Deposits in national banks grew at an average 
7.4 percent over the past 3 years. But asset growth has not 
come at the expense of asset quality. The noncurrent loan ratio 
for national banks in the second quarter of 2002 was 1.6 
percent. At a comparable point in the last economic cycle, it 
was 4.4 percent.
    Data on failures and new entrants similarly reflects the 
banking system's health and dynamism. In 2003, only two 
commercial banks failed--one national and one State-chartered 
institution. By contrast, 100 commercial banks, including 33 
national banks and 67 State banks, failed in 1992--the first 
year of recovery after the 1991 recession. Last year also saw 
111 new commercial bank entrants.
    By historical standards, the system is also exceedingly 
well capitalized. Today, all national banks, with minor 
exceptions, have risk-based capital above 8 percent, and less 
than 1 percent of national banks have risk-based capital below 
10 percent.
    Concerns have been expressed about declining demand for 
consumer loans and loans backed by commercial and residential 
real estate in a rising interest rate environment, as well as 
the impact of such a development on bank earnings, to which 
they have made such an important contribution. And, as recent 
events have taught us, operational, strategic, and reputational 
risks posed by bank activities can have just as serious an 
impact on bank soundness as changes in a bank's financial 
condition.
    Yet I am optimistic about the ability of the banking system 
to overcome these challenges, just as it overcame the 
challenges of the recent recession. Our optimism is based on 
two factors. The first is the dramatic improvement in the 
tools, techniques, and processes available to financial 
institutions to manage just such risks. Banks increasingly look 
at risk in more comprehensive terms rather than on a 
transaction-by-transaction basis.
    Risk management has also benefited from the use of tools 
that enable banks to better adjust and manage their risk 
profiles. The growth of the syndicated loan market has enabled 
banks to more broadly distribute credit exposures within the 
banking system, as well as to foreign banking organizations and 
nonbanks. The expanding asset securitization market has 
provided banks with a way of managing concentration risk and 
diversifying funding sources. And growth in the derivatives 
markets has given banks additional tools to manage their credit 
and interest rate risk exposure.
    OCC supervision provides the national banking system with a 
second layer of protection against the challenges posed by our 
changing economy and provides a second reason for optimism. Our 
risk-based approach involves supervisory policies and processes 
that tailor OCC oversight to the key characteristics of each 
bank, including asset size, products offered, markets in which 
the bank competes, and the board's and management's appetite 
for risk.
    In response to the growing importance of nonfinancial 
risks, we have strengthened our supervision in the critical 
areas of audit and corporate governance. New supervisory 
guidance, developed both in conjunction with other the U.S. 
banking agencies and independently by the OCC for national 
banks, set forth our expectations that well-planned, properly 
structured, and independent auditing programs are essential to 
effective risk management and internal control systems.
    Finally, I would like to comment briefly on developments 
relating to the Basel II process. This is an enormously complex 
and important project in which the OCC has been deeply involved 
for more than 5 years, together with our sister regulators. 
Even so, some important substantive issues have not yet been 
resolved, and we continue to work hard on those issues.
    The important thing to understand is that the Basel process 
is far from over. Before we adopt final implementing 
regulations for national banks, a number of important domestic 
processes will need to be completed. We will need first a new 
quantitative impact study to provide good and reliable 
estimates of what the actual impact of Basel II will be on the 
capital of our banks. The economic impact analysis required by 
executive order will also give us a better idea of the 
implications of Basel II for our economy. And, of course, we 
will need to continue the dialogue with this Committee and its 
House counterpart on the progress of the process.
    Only when all of these steps have been completed will we be 
in a position to draft and then put out for comment our final 
implementing regulations. Clearly, it will be a major, if not 
impossible, challenge to get this done in time to meet the 
current implementing date of year-end 2006.
    In conclusion, Mr. Chairman, the national banking system is 
sound, and its recent performance has been strong. It 
successfully weathered the recent recession and is responding 
in dynamic fashion to the changes in the financial services 
marketplace. The OCC, too, is keenly focused on keeping pace 
with change and improving our approach to supervision. We look 
forward to working productively with you, with Members of this 
Committee, and with State officials as we pursue our efforts to 
achieve that goal. Thank you.
    Chairman Shelby. Mr. Powell.

                 STATEMENT OF DONALD E. POWELL

        CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

    Chairman Powell. Thank you, Mr. Chairman, for the 
opportunity to present the views of the FDIC.
    FDIC-insured institutions are as healthy and sound as they 
have ever been. Improvements in underwriting and risk 
management practices helped to limit the effect of credit 
losses on industry earnings during and after the recession. 
Meanwhile, strong growth in mortgage loans, a steep yield 
curve, new sources of fee income, and cost containment efforts 
helped boost the net operating income of the industry. Record 
earnings 2 years in a row, record returns on assets, and a 
strong capital foundation are all indicators that banks not 
only weathered the recent economic downturn, but also have been 
a source of significant strength for the economy and for the 
American consumer.
    This strength is mirrored in the strength of the FDIC 
insurance funds. At year-end 2003, the combined funds stood at 
1.33 percent of estimated insured deposits, eight basis points 
higher than the statutory target of 1.25. While several 
factors, outlined in my submitted testimony, may bring this 
number down a bit, the fund will likely remain strong for the 
foreseeable future.
    As you are aware, my concerns about the deposit insurance 
system relate to the way it is structured. We cannot price 
deposit insurance based upon risk. We cannot manage the fund 
size relative to our exposure. And we maintain two funds even 
though the historic rationale for doing so has gone away.
    There is broad agreement on the key elements of the deposit 
insurance reform package, and the FDIC remains willing to work 
with this Committee to achieve reform as soon as possible.
    While the industry is strong and the outlook is favorable, 
we should not overlook the potential risks in the system. 
Furthermore, we should be aware of several fundamental trends 
in the industry that will bring significant consequences for 
bankers, regulators, and policymakers.
    One area of general concern involves household balance 
sheets. While households have been an engine for growth, they 
also have accumulated debt to a historical high of 112 percent 
of disposable, personal income. Further, households took out 
$1.4 trillion of new mortgage debt since the end of 2001. 
Escalating household debt raises questions about the 
sustainability of consumer spending and the ability of 
borrowers to meet obligations when interest rates rise. Our 
concerns are tempered, however, by the strength of the 
household assets and the strengthening job and wage data we 
have seen in recent months.
    Second, vacancy rates for office, retail, and warehouse 
space are near historic highs, yet commercial real estate 
concentration in banks are high and increasing. We have not 
seen any significant deterioration in loan performance thus 
far, but higher interest rates could yield problems in some 
areas of the country, and we are implementing enhanced 
procedures to monitor and better understand this area of the 
economy.
    Third, it is important to recognize the volatile nature of 
financial markets and the potential for disturbance to spread 
throughout the system. In today's interconnected financial 
system, problems that initially appeared to be localized could 
lead to a more widespread loss of confidence with a resulting 
impact on liquidity throughout the system. This issue bears 
watching to ensure that financial market disruptions do not 
produce significant banking problems going forward.
    I am gratified that the banking industry is facing these 
risks with a strong foundation of capital. The industry's 
capital base has led it to a position of unparalleled strength 
and competitiveness in the worldwide banking marketplace. It is 
the best hedge against the unexpected and the unknowable. We 
must ensure, as we move forward with Basel II and other 
important initiatives, that we do not erode this base or the 
regulatory framework it is built upon.
    In addition to these specific issues, the FDIC is working 
hard to understand the long-term trends that are driving the 
industry and looking ahead to the policy questions that may 
arise. While the rate of decline in the number of banks and 
thrifts has been slowing in recent years, the pattern of 
industry consolidation is leading to a greater divide between 
large and small bank organizations and is likely to create 
pressures on the existing regulatory structure and existing 
regulatory barriers. It also has the potential to pose unique 
challenges for the FDIC.
    Community banks, while numerous, represent a relatively 
small exposure to the deposit insurance funds, and it would 
take a major crisis among small banks to do serious harm to the 
funds. On the other hand, there are a few large institutions 
that represent an increasingly significant share of the FDIC's 
exposure.
    A continuing challenge is how best to protect the stability 
of the system as customers' choices continue to expand and bank 
deposits become less important in the overall financial system. 
Federal deposit insurance works very well for traditional 
community banks. For the largest banking organizations, as they 
increasingly engage in diverse, nontraditional activities, it 
makes sense to consider whether different safety-net 
arrangements would be more suitable for this segment of the 
industry. Since some aspects of our regulatory system already 
are tailored to recognize the differences between large and 
small institutions, we should consider the explicit creation of 
a two-tiered safety-net that better addresses these 
differences.
    In addition to potentially broad implications for the 
safety-net arrangements, the large/small divide in the banking 
industry will pose other interesting questions for 
policymakers. For example, the FDIC could look more to market 
instruments like reinsurance contracts, or catastrophe bonds to 
help us assess our large-bank exposure. We also should ensure 
that regulatory burden does not weigh too heavily on community 
banks and stifle the innovation and consumer choice that are 
hallmarks of our system.
    Finally, as this banking transformation matures, we will 
see the remaining regulatory barriers come under pressure. 
Issues such as the 10-percent deposit cap and the remaining 
barriers between banking and commerce will need to be 
addressed. As the market pressure in this area intensifies, I 
believe policymakers will need to find ways to accommodate 
consumer demands while constructing arrangements that address 
these issues. We hope that, as this Committee and others deal 
with these important issues, we can be a resource to you. Thank 
you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Mr. Gilleran.

                 STATEMENT OF JAMES E. GILLERAN

             DIRECTOR, OFFICE OF THRIFT SUPERVISION

    Director Gilleran. Thank you, Mr. Chairman. It is a 
pleasure to be with you today. I am happy to report that the 
thrift industry has come off the last 3 years in the finest 
shape it has ever been, and we have reached a situation where 
we are at an all-time high in the dollars worth of assets in 
the system and the system is at its best profitability level 
that it has ever been at. Loan loss reserves are well adequate 
to cover all expected losses. Capital is the highest that it 
has ever been. And even though we as regulators focus on all of 
the risk factors already mentioned about the credit quality and 
the interest rate risk and the compliance risk, et cetera, none 
of these risks right now looks like it will be overwhelming to 
the system, at least in the near future, as far as we can see. 
In fact, we believe that when we total up the first-quarter 
results for 2004, they again will be a very strong quarter for 
the thrift industry, even though the refinancings dropped 
substantially, that the increase in homeownership in America 
and the continual support of the homeownership area by the 
public, it looks like it is going to be another good year.
    I agree with Chairman Greenspan that we, too, support going 
forward with the Basel II Accord. We look forward to the test 
that has to be made in the future to determine whether or not 
it is a reliable system to be able to regulate the banking 
system. At the OTS, however, we believe that we as regulators 
should be allocating additional resources to see whether or not 
we can take some of the concepts that have been devised in 
Basel II and see if we can make Basel I more risk-sensitive for 
those other 9,000 banks in the system that Basel II will not be 
touching.
    Mr. Chairman, there are some things that we would like to 
have changed. We would continue to like to have parity with the 
national banks in terms of selling investment products, and to 
this date we have not been able to receive the same exemption 
from the SEC that the national banks have. This is creating a 
competitive disadvantage for our thrifts. So we would like to 
have the Committee address that going forward.
    Thank you very much, sir. Glad to be with you.
    Chairman Shelby. Thank you, Mr. Gilleran.
    Mr. Dollar.

                   STATEMENT OF DENNIS DOLLAR

         CHAIRMAN, NATIONAL CREDIT UNION ADMINISTRATION

    Mr. Dollar. Chairman Shelby, Ranking Member Sarbanes, and 
Members of the Committee, I want to thank you for the 
invitation to testify before you today on behalf of the 
National Credit Union Administration regarding the condition of 
the credit union industry in America and the National Credit 
Union Share Insurance Fund that insures the deposits of credit 
union members nationwide.
    I am pleased to report to the Committee that the state of 
the credit union industry remains strong and healthy, with all 
indicators clearly portraying a safe and sound industry, 
serving over 82 million Americans and well-positioned for 
continued strength and vitality in our Nation's financial 
marketplace, both now and in the future.
    At this point I would like to just provide a brief 
discussion of a couple of key ratios and trends that have been 
compiled from call report data submitted by Federal credit 
unions to NCUA as of December 31, 2003.
    The average net worth-to-asset ratio of all federally 
insured credit unions remains extremely strong at 10.72 
percent, even though there has been a significant share growth 
of over 15 percent in 2001, almost 11 percent in 2002, and just 
over 9 percent in 2003. Such a strong share deposit growth 
would normally bring about a significant decrease in the net 
worth ratio were not the credit unions managing these increased 
shares effectively and continuing to build net worth.
    For example, over the course of 2003, credit union net 
worth, which we need to recognize is built solely from the 
retained earnings of credit unions--credit unions cannot issue 
stock, cannot issue subordinated debt--has increased in total 
dollars by 9.6 percent. This growth in actual dollars of net 
worth results in the highest level in history of total industry 
net worth, currently at $65.4 billion as of December 31.
    Return on average assets is 0.99 percent, which, even with 
a historically high growth in shares during a low interest rate 
environment, compares very favorably with the recent historical 
trends.
    Loan volume increased by 9.75 percent in 2003, but yet the 
credit unions' overall delinquency ratio remains steady at 0.77 
percent and is lower than the ratios recorded in the previous 2 
years.
    Savings grew to $528 billion in 2003, an increase of over 9 
percent. Total assets grew to an all-time high of $610 billion, 
again, an increase of over 9 percent.
    Member business lending in credit unions increased $8.9 
billion, and although this category of credit union lending has 
increased over the past years, member business lending still 
represents only 2.3 percent of all loans in federally insured 
credit unions.
    First mortgage real estate loans grew over 16 percent to 
$117.5 billion, thus credit unions continue as a source of 
access to the American Dream of homeownership for millions of 
their members.
    New auto lending increased over 5 percent; used auto 
lending, indicating the economic times that we are in, 
increased by a higher percent, 12.5 percent.
    These ratios and trends, of course, taken as a whole I 
think are indeed indicative of a healthy and robust industry.
    We are closely monitoring a number of emerging key issues 
and some of the same ones that my colleagues have mentioned 
here today--challenges specifically affecting the credit union 
industry, some of them; others are those related to the overall 
financial marketplace: interest rate risk and net margin 
compression; increased competition for consumer lending; 
information systems and technology risk. These are all items 
that I discuss more in depth in my written testimony.
    I would like to briefly address, before I conclude, the 
condition of the National Credit Union Share Insurance Fund, 
which provides Federal share insurance, coverage on credit 
union accounts generally up to $100,000 per member in a single, 
federally insured credit union.
    As of December 31, there were $479 billion in insured 
funds, with a 1.29-percent equity ratio at the end of the first 
quarter of 2004. Earnings have been sufficient to keep the fund 
well capitalized well into the future. But dividends to insured 
credit unions, that are allowed by statute when the fund equity 
level exceeds the established operating level are not likely to 
return, nor have they been able to be paid over the last 
several years. They are not likely to return at least until 
interest rates rise sufficiently to allow earnings to return to 
the historical levels of the previous 6 years in which a 
dividend was paid.
    Losses are anticipated to remain low, and extraordinary 
losses are certainly not anticipated. Based upon our ongoing 
examination and supervision program, we feel that credit unions 
are indeed positioned to have all-time record lows in losses.
    As of December 31, there were 217 problem credit unions out 
of a total of right about 10,000.
    Chairman Shelby. What were the sizes of those credit 
unions?
    Mr. Dollar. The overwhelming majority of them, Senator, are 
smaller credit unions, with risk to the fund very minimal. We, 
of course, take seriously the status of small credit unions as 
well as large ones, but the overwhelming majority are small.
    Chairman Shelby. Would you close those troubled ones?
    Mr. Dollar. There are 217 of them that are coded CAMEL 4 or 
5. We are watching those very closely. Where the market will 
lead, or whether our prompt corrective action will be required, 
will be taken--we would love to bring those credit unions back, 
Senator. But some of them will not make it, and that is a part 
of the difficult part of our job. But that is our job, 
nonetheless.
    In 2003, we were called upon to liquidate, merge, or 
arrange a purchase and assumption for 13 federally insured 
credit unions. And this number is trending lower than in the 
past 10 years when we were averaging about 27 to 28 credit 
union mergers, liquidations, purchases, and assumption per 
year. So although there are ongoing losses, it is trending 
downward.
    In closing, let me just, without going into the in-depth 
detail that I did in my written testimony, refer you to a 
number of our agency initiatives that we think the Committee 
will find of interest, as well as our position in response to 
your earlier letter for regulatory relief suggestions. We made 
seven specific regulatory relief suggestions that we hope the 
Committee will give consideration to, and, again, thank you for 
the opportunity to testify today. And I look forward to 
answering any questions and serving as a resource for the 
Committee.
    Chairman Shelby. Thank you, Mr. Dollar.
    Mr. Lavender.

                 STATEMENT OF KEVIN P. LAVENDER

             COMMISSIONER, TENNESSEE DEPARTMENT OF

              FINANCIAL INSTITUTIONS, ON BEHALF OF

            THE CONFERENCE OF STATE BANK SUPERVISORS

    Mr. Lavender. Thank you very much, Chairman Shelby, Members 
of the Committee. My name is Kevin Lavender. I am the 
Commissioner of Financial Institutions for the State of 
Tennessee, and I am also the Chair of the Regulatory Committee 
for the Conference of State Bank Supervisors, better known as 
CSBS. Again, I thank you for giving CSBS the opportunity today 
to testify on the condition of the State banking system.
    As you have heard from my colleagues, the general health of 
the banking industry is excellent. State-chartered banks, which 
make up approximately three-quarters of the Nation's commercial 
banks, have shared in the industry's record levels of 
prosperity. Net income of State-chartered commercial and 
savings banks at year-end 2003 reached $44.2 billion, which is 
an 18-percent increase over the previous year's record levels. 
State banks' aggregate equity capital ratio stands above 9 
percent. This level exceeds the industry aggregate and 
regulatory requirements and has risen steadily over the past 3 
years. State banks' ratio of nonperforming assets to assets 
continues to decline and stands even lower than the industry's 
overall level.
    Even some areas of concern have shown improvement in recent 
quarters. We saw deposits in State-chartered banks grow for the 
last 2 consecutive years. Our banks are still finding good 
loans to make, and we saw strong growth in earning assets in 
2003.
    We never forget, however, that these record levels of 
prosperity are occurring in an environment of historically low 
interest rates. Our examiners are paying special attention to 
our banks' vulnerability due to interest rate changes. My 
colleagues and I have also been particularly concerns about 
banks' internal control systems because experience has shown us 
that nothing disguises bad management as well as a good 
economy.
    As you have also heard, consolidation of the banking 
industry continues, raising our concerns about concentration of 
risk and the range of meaningful choices available to 
consumers. The Nation's 50 largest banks now hold almost 90 
percent of banking assets nationwide. In Tennessee, the six 
largest banks hold more than 50 percent of local banking 
assets, and in my hometown, the capital of Nashville, that 
percentage jumps to more than 80 percent.
    Consolidation has in many ways benefited not only the 
institutions involved, but also the consumers. But my 
colleagues and I also worry about declining diversity in our 
banking system and about the forces driving this latest round 
of consolidation. A steady stream of new bank charters and 
conversions has partially offset the number of institutions 
lost to mergers over the past several years. However, as I 
mentioned before, the banking system's assets are increasingly 
concentrated in a small number of institutions held by a 
national charter.
    Our Nation's financial system and its financial services 
policies have always emphasized the need for diversity, 
balance, and opportunity. Our State banking system encourages 
entrepreneurship, creating opportunities for new credit 
providers to enter the market and to find new ways to serve 
their communities.
    Senators, State banks in Tennessee and nationwide are very 
healthy. The State banking system, however, faces a threat, and 
I ask your help today in restoring the necessary balance.
    A key element of this balance is the question of Federal 
preemption of State authority. Federal preemption can be 
appropriate, even necessary, when genuinely required for 
consumer protection and competitive opportunity. But few 
matters of Federal preemption meet this high standard. One that 
did was the permanent extension of the FCRA amendments, which 
we congratulate you on enacting last year.
    The Comptroller's recent actions do not seem to meet this 
standard. The regulations usurp the power of the Congress and 
stifle States' efforts to protect our citizens. They threaten 
not only the dual banking system but also the public confidence 
in our financial services industry. They also seem to encourage 
consolidation among our largest institutions, concentrating 
financial risk in a handful of gigantic institutions that may 
become, if they are not already, not only too big to fail but 
also perhaps too big to supervise effectively.
    Maintaining a local role in consumer protection and a 
strong banking system is more important than ever in the wake 
of the current rounds of mergers among our Nation's largest 
financial institutions. Centralizing authority of financial 
power in one agency or a small group of narrowly regulated 
institutions would threaten the dynamic nature of our economy.
    The State banking system is now stronger in many ways than 
it was 10 years ago before the passage of the interstate 
branching and financial modernization. The States have 
developed models for interagency information sharing, 
cooperation, and coordination that benefit the entire financial 
services industry.
    Our work shows that the dual banking system remains a vital 
and essential dynamic for promoting new financial services 
while offering new approaches for consumer protection. Our dual 
background acknowledges the needs of multi-State banks and 
financial service firms while protecting consumers. We have 
worked hard to develop a system of supervision that allows for 
innovation while ensuring safety, soundness, and economic 
stability. The strong condition of our 6,400 State-chartered 
banks and 400 State-regulated offices of foreign banks is the 
best evidence of our success.
    CSBS looks forward to working with the Congress to find 
additional ways to address the needs of an evolving nationwide 
financial services system in a way that maintains the strong 
condition, minimizes unnecessary regulatory burden, and ensures 
that all Americans retain their access to the broadest possible 
range of financial opportunity.
    At CSBS, we look at this relationship very much in 
partnership not only with the Congress but also with our 
Federal counterparts. And given the history and importance of 
the dual banking system, we again thank you for the opportunity 
to testify today on the condition of the State banking system.
    Chairman Shelby. Thank you.
    Chairman Greenspan, I cannot resist this question, since 
you are the Chairman of the Fed. Do you still feel optimistic 
about the economy? And do you agree with most economists that 
we will continue to add jobs in the next 5, 6, 7, 8 months?
    Chairman Greenspan. I do, Mr. Chairman.
    [Laughter.]
    That is what I wanted to hear from you.
    [Laughter.]
    Chairman Shelby. But only that is in keeping with about 
dozens of other economists. You are an economist that feels 
that we are going to add on average 180,000 jobs a month. I 
know it will come down and go up some. Do you agree with that, 
or is that guessing?
    Chairman Greenspan. Mr. Chairman, I do not want to get into 
specific numbers. Indeed, I am going to be getting into these 
data in some detail tomorrow before the Joint Economic 
Committee.
    Chairman Shelby. I know.
    Chairman Greenspan. However things are changing. We 
evidenced some slowing down in the middle of the first quarter, 
and it is fairly apparent from the data since that things have 
picked back up again. March was a good month. We moved into 
April with retail sales doing reasonably well. Motor vehicle 
sales looked as though they were doing quite well in the 
beginning of the month. New orders are moving along at a 
reasonably rapid pace.
    Chairman Shelby. Does that include durable good orders?
    Chairman Greenspan. Basically durable goods.
    Chairman Shelby. Okay.
    Chairman Greenspan. It is more anecdotal than it is 
statistical at this particular point, but the anecdotes are 
fairly convincing at this particular stage.
    It is fairly apparent that pricing power is gradually being 
restored, and as I will indicate tomorrow, threats of 
deflation, which were a significant concern last year, by all 
indications are no longer an issue before us. But, clearly, it 
is a change that has occurred in recent weeks, and it is a 
change, as best I can see, that has been long overdue and most 
welcome.
    Chairman Shelby. Are you concerned about some of the 
commodity pricing? I know that is just part of the PPI and CPI.
    Chairman Greenspan. Yes, we are looking at the full detail 
of the cost structure, of which the commodity price inputs are 
a relatively small part. And remember that more than two-thirds 
of the consolidated, underlying domestic costs in the United 
States are unit labor costs. And, clearly, the productivity 
patterns that we have observed in recent months are still quite 
impressive and still not fully understood by us. We know what 
is happening and we know why it is happening, but we have very 
little capability of projecting into the future how this is all 
going to resolve.
    So the inflationary pressures will be reasonably well 
contained, so long as productivity is moving at a reasonably 
good clip. And unit labor costs, as best we can judge, are 
still going down, but going down at a slower rate than they had 
previously.
    There are a lot of data that are involved in putting all of 
this together, and I will try to make it clearer tomorrow, and 
go over into some detail about the mix of issues of costs, 
jobs, pricing, and the like, and try to suggest where we think 
we are coming out, with the full recognition that in periods 
like this, forecasting is less than perfect.
    Chairman Shelby. It is maybe an art and a science.
    Chairman Greenspan. Yes, sir.
    Chairman Shelby. Do you feel good basically from what you 
have said about the overall thrust of the economy, putting it 
in the total picture?
    Chairman Greenspan. I do, Senator.
    Chairman Shelby. Thank you.
    I want to touch quickly on Basel. Chairman Greenspan, Basel 
II, we had a hearing about a year ago, I guess it was here, and 
there were some differences of opinion on Basel. Senator 
Sarbanes and I were in Europe back in August, and that was 
raised everywhere we went, other than Sarbanes-Oxley. Those 
were the two main issues we talked about. But do you feel real 
good about Basel II? Are you still looking at it to see how 
this model will work that they propose?
    Chairman Greenspan. Well, I think it is important to 
recognize certain issues that created Basel II, indeed created 
Basel I. The international financial community is advancing at 
a fairly impressive clip. The changes have been unquestionably 
to the benefit of the United States and the rest of the world, 
and it is in our interest to see if we can create a regulatory 
structure which essentially produces a level playing field 
throughout the world.
    This basically means that we have really three choices in 
front of us: One, we can stay with Basel I. The problem with 
that is that it is increasingly obsolescent and increasingly 
unrelated to the extraordinary changes that have occurred in 
the banking system in recent years. We can go to Basel II, 
which is where we want to go. Or we can decide we cannot do 
anything and go back to the pre-Basel I period, which, in my 
judgment, would be very dangerous so far as the structure of 
international finance is concerned.
    Since I rule out Basel I, my general conclusion--and that 
of my colleagues, and I trust the rest of the international 
banking community--is to make Basel II work. It is not an easy 
job, as my colleagues have indicated to you here. But we are 
all working together to make certain that whatever comes out 
works for the United States.
    None of us, as I understand where we all stand, will 
recommend to the Congress something which we do not believe is 
to our advantage, indeed to the advantage of the international 
financial community, or, most importantly, that will not work.
    Chairman Shelby. Mr. Hawke, many, if not most, of the Basel 
II participant nations do not have minimum capital 
requirements. Is it possible that the Basel II Accord, the new 
Accord, will start us down a path toward elimination of that 
leverage ratio?
    Comptroller Hawke. I certainly hope not, Mr. Chairman.
    Chairman Shelby. Is that one of your concerns here?
    Comptroller Hawke. I have concerns about Basel, but I want 
to state emphatically that we will not do anything that erodes 
or impairs the vitality of our existing Prompt Corrective 
Action regime. I think it is enormously important, and it is 
one of the things that distinguishes our system of bank 
supervision from that in other countries. I think it is 
enormously important for us to maintain that regime.
    The big unknown in Basel II right now is exactly what the 
impact is going to be on banks' capital. That is one of the 
reasons that we have been very insistent on conducting a fourth 
quantitative impact study.
    Chairman Shelby. Mr. Powell, do you have a comment on that.
    Chairman Powell. I could not agree more. I think the 
minimum regulatory leverage capital ratio is critically 
important.
    Chairman Shelby. Mr. Gilleran.
    Director Gilleran. I agree.
    Chairman Shelby. Mr. Dollar.
    Mr. Dollar. Credit unions are not under Basel.
    Chairman Shelby. I know that.
    Mr. Dollar. But, we would like to talk about a risk-based 
capital standard for credit unions.
    Chairman Shelby. But you are interested in capital.
    Mr. Dollar. We are, and we are interested in risk-based 
capital. And I think although Basel is not a proper fit for 
credit unions because it is oriented more toward for-profit 
institutions, I do think the need to get away from a one-size-
fits-all prompt corrective action for credit unions over into a 
risk-based system is good public policy.
    Chairman Shelby. Mr. Lavender, have you studied this issue, 
Basel II?
    Mr. Lavender. Mr. Chairman, I have not studied it, but I 
know CSBS has been pleased and proud to be at the table to 
discuss it with our Federal counterparts.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman.
    Chairman Greenspan, taking the opportunity to ask you a 
question about the overall economy, it seems that personal 
wages increased by less than inflation in 2003, and that real 
wages fell by about 0.3 percent. This is in contrast to those 
stories we all read about very high compensation, nonwage 
compensation for executives and other wealthier individuals.
    Are you seeing an economy that is becoming bifurcated, that 
working families who are working for wages are seeing their pay 
diminish while those individuals through their talent or luck 
or whatever, who are at the top of the organization chart, are 
reaping extraordinary benefits? And is not that a concern if 
that is the case?
    Chairman Greenspan. Senator, I am concerned about the 
increased concentration of income, but the major problem is not 
in the very few people who are at the top, but the significant 
income differences that are emerging in this country between 
the highly skilled workforce and those with lesser skills. I 
addressed this issue in an earlier presentation, and the point 
I tried to make is that we seem to be exhibiting a marked 
change over the past 20 years in which as the technology of the 
capital stock of the United States moves forward at a very 
rapid pace, the level of skill of our workforce on average is 
not moving up comparably. And a consequence, we are turning out 
to have a shortage of high-skilled people and, hence, an 
increase in their relative wage, which shows up very 
significantly in increased premiums between college-educated 
workers and those with a high school or less educational 
experience.
    And what this means basically is that there is a large 
number of people below the median income whose real wages have 
not changed at all over the last 20 years. And it strikes me, 
as I have indicated in other testimonies, that it is important 
that we confront this issue, enhance the capability of our 
educational system to effectively move a significantly larger 
number of people through our high schools and into colleges 
where their educational capabilities will bring them higher 
skills, and increase the supply of highly skilled workers, 
which will bring down their relative wage and decrease the 
excess supply of people with lesser skills and raise their 
wages.
    So, yes, I am concerned, Senator, that there is an 
increasing concentration of income, and that is not good for a 
democratic society. I think the issue is broader than the 
relatively small group whose incomes, as you point out quite 
correctly, have gone up very materially relative to the 
average. But I think that is a small part of a much larger 
problem.
    Senator Reed. Well, there is, I think, a further 
complicating element. I think the theory that most of us have 
is similar to yours, Mr. Chairman, which is if we just educate 
our people better, they will be increasingly competitive in the 
world market. But that is being confounded now by this question 
of outsourcing, whereas I think the image of most of my 
contemporary back in Rhode Island, if their son or daughter got 
a good degree as an accountant, they would be all set because 
that is college and beyond. Then you read where more and more 
tax returns are being prepared in India and other places.
    I believe in a closed system your remedy might work, but 
this system is not exactly closed any longer. And I also think 
it adds further complexity to the dilemma you have charted.
    Let me just follow that line of questioning with a very 
specific question to Mr. Hawke and his colleagues, and that is, 
there is indication now that there are third-party vendors 
abroad that are working for financial institutions in the 
United States, which raises issues of privacy. In fact, I have 
a story--this is medical privacy, but it is a story about a 
woman in Pakistan who is protesting her pay by indicating that 
she would post the private medical records of people on the 
Internet if she did not get paid, which is cyber-extortion. But 
that is an example, probably a very melodramatic example, of 
what could happen.
    But, Mr. Hawke, what are you doing to ensure that customers 
are being notified if their records are being sent overseas, 
and regulation, are you inspecting facilities overseas to 
ensure that privacy is maintained?
    Comptroller Hawke. We have done a number of things, Senator 
Reed. We have put out several advisories to our banks about 
making appropriate risk assessments concerning the maintenance 
of privacy with respect to customer records and security of 
customer records, where processing has been outsourced to 
foreign servicers. This is an issue that we have focused a fair 
amount of attention on. It is also an issue that the Basel 
Committee is considering through one of its subsidiary 
organizations.
    Senator Reed. My time has expired. Could I ask the rest of 
the panel to submit a response to the record about what your 
agencies are doing with respect to this, Mr. Chairman?
    Chairman Shelby. Absolutely. You want to do it now?
    Senator Reed. Mr. Gilleran has a comment.
    Chairman Shelby. If you want to comment, do it now.
    Director Gilleran. Senator, outsourcing to another country 
is no different than any of the other outsourcing that a 
financial institution or any other company is doing, but when 
you are dealing with the public the way banks are, financial 
institutions must satisfy themselves that whoever they 
outsource to have the controls and the procedures that are 
necessary in order to properly deal with the customer 
relationship. So therefore, regulators are going to be expected 
in the future, in my opinion, to be able to satisfy themselves 
that outsourcing to foreign countries is as reliable as 
outsourcing to an organization in the United States. If they 
are not, I think it calls into question whether or not that 
outsourcing is appropriate.
    Senator Reed. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Greenspan, the Federal Reserve Bank of Dallas 
wrote an article in their January/February issue of Southwest 
Economy, title ``Small Bank Competitors Loom Large,'' which 
discusses the problems small banks are facing. In your 
testimony you talked about pressure small banks are facing. 
What can be done to help small banks both through regulation or 
statute, which are critical to the financial institutions and 
health of my State, the smaller institutions in my State?
    Chairman Greenspan. Senator, I think that the community 
banking industry of the United States is one of the jewels of 
the international financial system in the sense that it does 
not really exist anywhere else, and has served us exceptionally 
well, and I think it is very important that we continue to 
support that system as it goes forward.
    I am concerned, as all regulators are, that these 
institutions are particularly vulnerable to heavy regulation, 
because they do not have staffs and cost structures which 
enable them to address it. It is important that we be careful 
in balancing how we regulate these institutions because it is 
important that they continue viable and support our 
communities, which in large measure they have done.
    This is not a simple issue because we have numbers of 
regulations that apply to all banks and the ability of 
differing banks to handle them must be judged in a manner that, 
one; advances the purposes of the laws which the Congress has 
put forward, but second; does so in a manner which is most 
efficient and effective in maintaining the stability of our 
system.
    Senator Bunning. This is a question for anyone who would 
like to answer it.
    Director Gilleran. Senator, just to respond, we did a study 
in the last year to determine why certain thrifts do better 
than others, and it is very interesting that we isolated about 
87 thrifts under a billion dollars in size, and these thrifts 
have been able to achieve in excess of 1.50 on assets over a 
long period of time, in excess of 10 quarters, and they all 
have some very interesting similarities. One is they are very 
well-diversified, that is, they are in all kinds of lending. 
They offer all kinds of products, but in addition to that, they 
are extremely well-managed, and their boards of directors are 
very strong, and on top of that, they have excellent 
relationships with their regulator, which is a similarity which 
we like to see, of course, but these institutions are 
institutions that are flourishing because of good business 
practices, and therefore, we are quite confident about the 
ability of smaller institutions to compete and survive.
    Senator Bunning. So you call an institution, a thrift under 
a billion dollars small? In other words, my $15 million bank in 
Northern Kentucky, what is that?
    Director Gilleran. That would be in the same group, but I 
mean it is under a billion, but some of these institutions are 
smaller than a billion dollars.
    Senator Bunning. Yes, they are, a lot of them.
    Director Gilleran. Lots of them are.
    Senator Bunning. In fact, most of the ones in Kentucky are 
under a billion dollars.
    Director Gilleran. But still we find the same 
characteristics hold true.
    Senator Bunning. Okay. Let me ask all the regulators here, 
can any of you give me an update on the steps financial 
institutions are taking to guard against terrorist threats, 
cyber, whatever? Nobody wants to answer?
    Chairman Powell. I will address it.
    Senator Bunning. Mr. Powell.
    Chairman Powell. There is a joint effort, Senator, among 
all the regulators, to make sure that every insured institution 
has in place policies and procedures that will deter any cyber 
or any other information breakdown by terrorists. The FDIC has 
sponsored some symposiums, as recently as last week, that was 
in cooperation with all the regulators, wherein we bring bank 
management, directors, and interested parties together to in 
fact make them aware of procedures and policies that would 
inhibit any terrorist strike against the system. I think there 
is a keen awareness among the regulators, I think among all 
regulators, and part of it is an educational effort and part of 
it is working with other regulatory agencies within the Federal 
Government and also the State governments.
    Senator Bunning. My time has expired.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Senator Crapo was here earlier.
    Chairman Shelby. He is going to defer to you because you 
were here earlier, Senator Crapo.
    Senator Crapo. Thank you very much, Senator.
    I would like to first direct a question to Mr. Powell, Mr. 
Gilleran, and Mr. Lavender. As I indicated when I came in, I am 
very focused on the regulatory reform legislation we are 
developing. One of the issues there relates to industrial loan 
banks, and the question I have is that concerns have been 
raised about the fact that owners of industrial loan banks are 
not regulated as Federal bank holding companies. Some critics 
have charged that industrial banks, their depositors, and 
perhaps the deposit insurance system are endangered by the 
bank's affiliation with unregulated parent companies. Can you 
describe the regulatory regime that applies to industrial loan 
banks and their parent companies and what authority do the 
FDIC, OTS, and State banking regulators have to look into 
activities of industrial banks, holding companies, and their 
affiliates?
    Mr. Powell.
    Chairman Powell. Yes, Senator. Our safety and soundness 
examination is not any different with industrial loan companies 
than it is with any commercial bank. The same procedures, 
policies that we adhere to at the FDIC are applied to 
examinations conducted at the ILC. I am convinced that we have 
the ability at the FDIC and the willingness to make sure that 
we examine those institutions from a safety and soundness 
standpoint as we would any bank.
    Furthermore, we are not restricted by law, and we will from 
time to time enter into the parent, and look at the parent's 
situation and have questions and answers as it relates to their 
support of the insured institution. There is no barrier there 
that I can detect at all.
    Senator Crapo. Thank you.
    Director Gilleran.
    Director Gilleran. Senator, we have 650 holding companies 
that the OTS is responsible for, and some of those holding 
companies own industrial loan companies, and we have the same 
supervisor role responsibilities for those holding companies 
that we have for the ones that own thrifts, and we examine them 
in the same fashion and we have the same authorities over them 
as we would have under any holding company situation. So our 
authorities are complete.
    Senator Crapo. Mr. Lavender.
    Mr. Lavender. Thank you, Senator. I agree with both of my 
colleagues here at the table. There are only a handful of 
States that actually license ILC's. Tennessee in fact is not 
one of them. However, the CSBS and the States that do regulate 
them, look at them no differently than the other institutions 
that regulate and work very closely with our Federal 
counterparts to apply the same standards of safety and 
soundness.
    Senator Crapo. Thank you.
    Mr. Greenspan, for years industrial loan banks have had 
authority to basically offer NOW accounts to individuals and 
corporations. In the context of the question that I just asked 
of Mr. Powell, Mr. Gilleran, and Mr. Lavender, are you aware of 
any risk of threat of injury to depositors, competitors, or the 
deposit insurance system as a result of the way this industrial 
loan bank system operates?
    Chairman Greenspan. I do not think that is where the 
problem that concerns us resides.
    Senator Crapo. Please elaborate.
    Chairman Greenspan. I was looking at some of the commentary 
that I have been involved with over the years, and if I may 
just read a note that relates to this, it is something that is 
part of the testimony I gave before this Committee in 1998, 
relating to the issue of whether or not we should open up the 
prohibition between commerce and banking. The general view that 
the Federal Reserve had at that time would best be described by 
part of my testimony, which said that technology was in the 
process of eroding any bright line between commerce and 
banking. Nonetheless, we concluded that the free and open legal 
association of banking and commerce would be a profound and 
surely irreversible structural change that should best wait 
while we absorb the significant changes called for by financial 
modernization.
    Since Gramm-Leach-Bliley passed, which is essentially 
moving in the direction that the testimonies back in 1998 were 
indicating, the key issue here is that arguments relevant to 
industrial loan companies concern how far the Congress wishes 
the banking system to move toward increased integration of 
commerce and banking.
    As I indicated back in 1998, over the very long run that is 
going to happen largely because of the technological changes 
which inevitably are going to occur and alter irreversibly the 
structure of 
finance. But I think we have not given the existing Gramm-
Leach-Bliley Act and all of the other types of regulatory 
structures which the Congress has put in place, a chance to 
work, to see how this gradual evolution is evolving, 
recognizing that once we move in a direction, it is very 
difficult to reverse. So my judgment is that what we need here 
is caution, and what the ILC issue ultimately comes down to is 
breaching the line between commerce and banking, and that I 
think is premature.
    Senator Crapo. Thank you very much. I see that my time is 
up, and I will not go further at this point. I do appreciate 
the answers that you gentlemen have given me on one of the 
critical issues we deal with in reg reform.
    Mr. Chairman, if I could, I would like to just ask one 
question of all members of the panel, that I would ask that 
they respond to in writing, if I could do so. That is, as has 
been indicated, we are in the process right now of putting 
together a regulatory relief package, and we have here in front 
of us virtually all the regulators. I would just like to ask 
each of you if you could respond to me in writing, and to the 
Committee in writing, about what you believe the top two or 
three items that we should consider in a regulatory relief 
package should include.
    Chairman Shelby. Senator Crapo, would you include your 
request, respond to you because you are the leader here, but 
also to the Committee Members?
    Senator Crapo. Yes. In fact, I meant to say that, Mr. 
Chairman.
    Chairman Shelby. Will you all do that?
    Senator Crapo. Thank you very much.
    Chairman Shelby. Thank you, Senator Crapo, and I thank you 
for your leadership in this area because as I said earlier 
before you came in, there are so many regulations and a lot of 
laws, that we wonder what they are still doing on the books, do 
we not? Because Chairman Greenspan talked about, and all of the 
witnesses have talked about, how far the financial service 
industry has moved in the last 10, 12 years, or the last 5 
years.
    Senator Sarbanes is recognized.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. Before 
I turn to the panel, I want to commend you for scheduling this 
hearing. It has been my long-held view that the oversight 
function of this Committee is actually one of its most 
important responsibilities, and it is very clear that is a 
responsibility you take very seriously, and this is but one in 
a series of hearings you have held addressed really to meeting 
the Committee's oversight responsibility, and I want to thank 
you for that focus.
    I want to just follow up on Senator Crapo very briefly 
before I turn to the other areas I had here. Mr. Powell, is it 
your position that the FDIC conducts regular, annual holding 
company examinations? I know the Fed does, but I was not under 
the impression that the FDIC does so.
    Chairman Powell. Is it the holding company of the ILC's you 
are referring to, Senator?
    Senator Sarbanes. Do you do regular, annual examinations of 
the holding company?
    Chairman Powell. No, sir.
    Senator Sarbanes. I mean the process you follow does not 
begin to be the equivalent in terms of reviewing banking 
practices to the one that is followed by the Federal Reserve; 
is that correct?
    Chairman Powell. That is correct. I was referring to the 
ability to look into the ILC's parent company.
    Senator Sarbanes. But you do not review on a regular basis 
the holding companies that have ILC's in them, do you?
    Chairman Powell. We do not.
    Senator Sarbanes. Does the Fed review them on a regular 
basis, Chairman Greenspan?
    Chairman Greenspan. You mean the ILC's?
    Senator Sarbanes. No, the holding companies that hold the 
ILC's.
    Chairman Greenspan. Yes, we do.
    Senator Sarbanes. That is what I thought.
    Now, let me ask, I want to go to this issue of money 
laundering first and how effective the regulators have been in 
overseeing and giving proper priority to compliance with the 
Bank Secrecy Act, especially the rules of Title 3 of the USA 
PATRIOT Act. Of course, this is designed to counter money 
laundering and the financing of terrorism, but I think it can 
only be effective if its mandates are not an afterthought but 
that the regulators are testing the adequacy of bank reporting 
and recordkeeping in real time.
    Just on Sunday,the Washington Post had a report about the 
asserted failure of Riggs Bank to follow the Bank Secrecy Act's 
suspicious transaction reporting rules in a case involving 
possible ramifications for U.S. antiterrorist efforts. They 
state ``FBI scrutiny of Riggs' international business began 
soon after the September 11, 2001 attacks,'' but according to 
the article, the inquiry ``widened to include parallel probes 
by the OCC and Riggs itself after a Newsweek report in November 
of 2002.'' The article goes on. It says ``in the course of the 
inquiries, bank and Federal investigators found tens of 
millions of dollars in questionable transactions that had not 
previously been reported. That led to the flurry of suspicious 
activity reports filed by the bank.'' But the article also 
stated, ``Riggs failure to file reports had been noted by 
regulators years ago, but no action was taken. In annual bank 
exam reports for 1999, 2000, and 2001, OCC officials outlined 
problems in Riggs' procedures to guard against money laundering 
or other illicit activities by bank customers, but the OCC 
never fined or sanctioned the bank, sources familiar with the 
examinations said.''
    Comptroller Hawke, obviously, you are first in line to 
address this question. What is your comment about this article 
which just appeared, especially about the relationship between 
the annual examination reports and what appears to be a delay 
of extensive examination in this area until 2002? How does a 
situation reach this point in a bank that is subject to 
continuous examination, and that does a significant level of 
international business?
    Comptroller Hawke. Senator Sarbanes, I am a bit limited in 
what I can say about Riggs specifically, because it is a matter 
of ongoing enforcement action by the OCC. But I can say that, 
particularly after September 11, there was increasing concern 
about the internal controls over one segment of Riggs' banking 
operations and increasingly heavy emphasis by the OCC on taking 
corrective action. Last year, we did get a consent cease-and-
desist order from Riggs that was intended to bring about 
significant change in the way that they administer certain 
aspects of their business, and it is a matter of ongoing 
enforcement involvement by the OCC.
    Senator Sarbanes. You have a 25-page written testimony here 
today. I admit I skimmed it but maybe I missed it. You could 
correct me, but I did not see any mention of the Bank Secrecy 
Act or any efforts by your agency to implement Title 3 of the 
USA PATRIOT Act to combat terrorist financing.
    I do not know what message that sends to the banks, 
frankly.
    Comptroller Hawke. Implementation of the USA PATRIOT Act is 
a matter of high priority, not only for us, but for all the 
agencies, and we are working on an interagency basis in the 
promulgation of a variety of regulations that are called for 
under the USA PATRIOT Act.
    In response to questions that Chairman Shelby raised at the 
hearing 2 weeks ago about Bank Secrecy Act concerns, yesterday 
I delivered a letter to the Chairman addressing some of those 
issues in great detail, and I would request that that letter be 
made part of the record, Mr. Chairman.
    Chairman Shelby. We will ask that it be made part of the 
record. We will share that with all the staff and Senator 
Sarbanes. We are both interested in this, in noncompliance of 
the Bank Secrecy Act.
    [Letter of Mr. Hawke:]
    Chairman Shelby. Do you have some more questions?
    Senator Sarbanes. I will defer to Senator Carper.
    Chairman Shelby. Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    To each of our witnesses, welcome. It is good to see all of 
you.
    Earlier in the hearing, Mr. Chairman, you asked a question 
of, I think it was Chairman Greenspan, and he gave a two-word 
answer to that question, and the words that he answered in 
response to your question were: I do.
    A number of years ago, Chairman Greenspan probably said 
those same 2 years to a woman named Andrea Mitchell, who is 
being honored this Saturday evening along with some other truly 
remarkable people from around the world at the Commonwealth 
Awards in Wilmington, Delaware at the Hotel Dupont. This is 
about the 25th year we have had the Commonwealth Awards. I just 
wanted everybody to know he said ``I do'' more than just today, 
and he said it to good effect at least on one other occasion. I 
know you are proud of her, and we look forward to hosting her, 
and maybe if we are lucky, maybe even you too. Congratulations, 
and convey that to her.
    What I would like to do is revisit some of the comments of 
Mr. Lavender. What do they call you back in Tennessee?
    Mr. Lavender. Commissioner. My wife calls me Kevin though, 
so whatever your please, Senator.
    [Laughter.]
    Senator Carper. Robert Glen is our Commissioner of Banking. 
I do not know if you know him, from Delaware, but he is a very 
able person. I was privileged to appoint him when I was 
Governor of Delaware.
    There was some back and forth between you and the 
Comptroller of the Currency, and Mr. Comptroller, good to see 
you too today. I am not going to ask Mr. Powell or Chairman 
Greenspan to referee this disagreement, but I would ask for 
them just to share their thoughts with us as the OCC preempts 
the ability of States to have the kind of say they have had in 
the past on State-chartered banks.
    Let me just ask Chairman Greenspan and Chairman Powell if 
you have any thoughts with respect to the impact on the dual-
banking system, of what is transpiring on this front?
    Chairman Greenspan. Senator, this is an issue which is 
really a question of the law, and courts at some point will 
resolve it. My only concern relevant to this issue is that 
however it is resolved, it not undercut the dual banking system 
which has been so critical an element in the development of 
banking in the United States and continues to be so.
    The dual banking system is a very unusual competitive 
structure for regulation, and it has served us well, and I am 
concerned that however we develop issues in the years ahead, 
that we be careful to maintain the appropriate balance of 
regulation between State and Federal agencies.
    Senator Carper. Mr. Powell.
    Chairman Powell. I agree with Chairman Greenspan that the 
dual banking system is vital to the banking industry in 
America. I, at one time, owned a State-chartered institution, 
and at one time had a national-chartered institution. I think 
it is also important to note that there continues to be strong 
appetite in the marketplace for a State banking charter, so 
that tells me the market perceives that there are some benefits 
to having a State banking charter.
    Also, I think it is important that on the issue of deposits 
and loans that there be national standards. I think it is 
important the way our society is today, as mobile as we are 
through interstate commerce, that those issues, deposits and 
lending, that we have some uniform standards. I also think it 
is important--and I understand and recognize that certain 
States, through their elected officials and legislatures, will 
have unique laws particular to that State, that do not 
necessarily deal with loans and/or deposits in interstate 
commerce. So, I recognize and understand that also is 
important.
    But the dual banking system is one of the things that 
distinguishes I think America from the rest of the world, that 
we should protect and that we should encourage it to continue 
to thrive.
    Comptroller Hawke. Senator, could I add one point? This is 
obviously an issue as to which there are deeply held views on 
each side.
    Senator Carper. I am starting to gather that.
    Comptroller Hawke. I wanted to refer to a table in my 
prepared statement. It plots on a graph the share of commercial 
bank assets held in the national banking system. The dual 
banking system has been enormously stable for many, many years. 
Preemption is something that has been around for as long as the 
national bank system has existed, 140 years, so it is not a new 
concept. The national bank share of total commercial bank 
assets has remained very, very steady over many years. For the 
past 15 years it has been at about 56 to 58 percent. It has 
held very stable, and we do not see any reason to think that 
there are going to be changes in that equilibrium that has 
existed for so long.
    Senator Carper. Commissioner Lavender.
    Mr. Lavender. Senator, you are absolutely right. I have 
only been a regulator for 15 months now, after having been a 
corporate lender with both a national-chartered institution and 
a State-chartered institution for 14 years.
    I would say the Comptroller's chart after this year will 
change dramatically. Being in this position for 15 months, I 
can attest and testify for you today that there have been at 
least 50 instances where national-chartered institutions or 
their subsidiaries have either turned in their charters or 
licenses to State regulators, or put us on notice that they 
would be supplying those to us, and those are institutions that 
range from the $15 million that this Senator mentioned over 
here, to as much as a billion dollar plus institutions. I think 
this charter is a little deceptive today. The preemption that 
was issued by the Comptroller's Office is far sweeping. It 
takes away the ability of States not only to enforce consumer 
rights regulations and laws, but also the capability to do 
things such as predatory--let me back up and say I agree with 
Chairman Powell. As a former banker, I think there should be a 
national standard, but I do not think the Comptroller's 
preemption, the rule that went into effect on February 12 goes 
far enough.
    When you say predatory lending in particular in this case, 
that the standard is simply do not lend based on the borrower's 
inability to repay, I do not think that goes far enough, when 
in today's environment we have all talked about historically 
low interest rates. Gentlemen, when there is a citizen of the 
State of Tennessee, that comes in and has a loan that in 
today's market is 24 percent, she had to pay 5 points to get in 
the loan, she has a prepayment for 7 years, that is predatory 
lending.
    As a new State regulator I would love the ability to set 
the standards with my Federal counterparts of what in fact 
defines predatory lending, what we can do jointly as Federal 
and State regulators to combat it, but I just do not think the 
Comptroller's rule goes far enough to protect the citizens, not 
only the great State of Tennessee, but also across the country.
    Senator Carper. My thanks to each of you.
    Thanks, Chairman Shelby.
    Chairman Shelby. Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman.
    To all the participants, welcome, and thank you for being 
here.
    My first question is, I would love to hear what the broad 
conceptual differences between Basel I and Basel II are, that 
we have had hearings on, and tried to have conceptualized to 
those of us that are a little farther away from the markets and 
do not fully understand. My question will get at whether we 
think risk-based capital is really the way that regulatory 
structure should be applied to financial institutions' balance 
sheets, what circumstances would lead us also to have second-
tier requirements like leverage rules?
    Comptroller Hawke. Let me take a crack at that. Senator 
Corzine, Basel I was a first effort at risk-based capital 
rules, and I think there is fairly general acceptance of the 
conclusion that it was a very coarse attempt. Various types of 
bank assets were classified into several risk buckets, and that 
was essentially the end-all of risk-based capital. The 
experience since Basel I has been that those buckets do not 
accurately reflect risk and they are easy to game.
    Basel II takes some very different approaches to risk-based 
capital. It looks at probabilities of default, exposure at 
default and loss given default, and calculates capital 
requirements under some much more sophisticated formulas. It 
also takes into account credit risk mitigation, that is, the 
extent to which risk may be mitigated by various devices, such 
as guarantees, collateral, and the like. It also takes into 
account operational risk, which is a subject that has been 
recognized by banks themselves for many years but has never 
been embodied in regulatory capital requirements. All told, I 
think that the basic conceptual differences between Basel I and 
Basel II are that Basel II takes a much more sophisticated and, 
frankly, much more complicated approach to the development of 
regulatory capital rules.
    You asked about the leverage ratio, and we discussed that a 
little bit earlier. I think we probably all share the view that 
the leverage ratio is an exceedingly important component of our 
approach to bank supervision. One of the concerns that has been 
raised is whether Basel II will reduce bank capital 
requirements to a point where the leverage ratio becomes the 
binding constraint, in other words, where capital ratios 
calculated under Basel II fall below the leverage ratio. An 
issue has been raised as to whether that will put pressure on 
us to reduce the leverage ratio in the interest of assuring 
that U.S. banks will not be put at a competitive disadvantage 
vis-a-vis foreign banks that do not have a leverage ratio.
    I think we probably all share the view here that the 
leverage ratio is an essential component of Prompt Corrective 
Action on which our whole system of bank supervision is based. 
If we find that Basel II does result in the lowering of 
regulatory capital requirements below what would be required by 
the leverage ratio, I am perfectly prepared to go back to the 
Basel Committee and seek recalibration of the capital 
requirements so that we do not have that anomaly.
    Senator Corzine. You would argue to raise the risk-based 
capital rules to conform with the leverage rules?
    Comptroller Hawke. I think that is what we would be faced 
with. Otherwise, our banks would be put at a competitive 
disadvantage vis-a-vis banks in countries that do not have a 
leverage ratio, and reducing the leverage ratio would undermine 
our whole system of Prompt Corrective Action, which is the 
foundation stone of our system of supervision.
    Senator Corzine. I would love to hear others' comment on 
this, but does that not strike at the heart of the value of 
risk-based capital, presuming that one has been intelligent 
enough to actually create a rule that reflects the various 
risks associated with managing a financial institution?
    Comptroller Hawke. I think there may be something of a 
disconnect there, but the leverage ratio and Prompt Corrective 
Action for more than 10 years have been the foundation stone on 
which our system of bank supervision is based. That reflects a 
fundamental difference between the United States' approach to 
bank supervision and that in most of the other Basel countries. 
I think we need to reach an appropriate accommodation where we 
try to make our basic system of regulatory capital rules more 
risk sensitive, but we should not do that at the price of 
dismantling or significantly impairing the basis for our 
supervision of U.S. banks.
    Senator Corzine. Anyone else like to comment?
    Chairman Powell. Senator, I think your comment is well 
said. That is assuming however that the models are perfect. I 
think the process will be dynamic as it goes forward. There 
will always be tweaking of those models based upon market 
conditions, based upon history, what we have got wrong. I think 
we all agree that those models are a marked improvement, but 
they are not an end to themselves. That is the reason we need 
the minimum regulatory capital.
    Senator Corzine. Mr. Chairman.
    Chairman Greenspan. I think the Senator has raised a 
fundamental question here because at roots, a risk-based system 
is an evolution from the earlier versions of any form of 
leverage-based system, and at the end of the day they are 
mutually exclusive. I think the problem, as the Senator is 
implying, is that we are in a transition stage, and as I think 
we all have to be aware that, at the end of the day, we would 
like our regulatory system to essentially merge into the 
economic-based system of risk management that the larger, more 
risk-managed institutions have. I think the question here is 
how, in this interim stage where we are still developing the 
technology and the economics of the type of risk management 
which is implicit in the Basel II system, do we manage this in 
a manner which does not create problems? Obviously you cannot 
manage the type of rules which the FDIC of necessity has to 
focus on, in a wholly risk-based system. But I do think it is 
important not to think that we are trending toward some merger 
of a leverage ratio and risk-based capital systems. That is not 
possible. I think it is a question of how we do it.
    Senator Corzine. It is just a matter of when the conflicts 
will occur, as we certainly have seen, I guess in the 
discussion of GSE's in particular, but these are really 
challenging elements because if one become preemptive of the 
other, and I think in many ways potentially undermines the 
credibility of the other because it sets a different kind of 
floor.
    I will end here, Mr. Chairman. I will say though that the 
complexity of the risk-based models, which I am fully 
supportive of, reflective of underlying economics, are really 
quite difficult for those of us that sit on this side of the 
table, maybe even on that side of the table, to understand 
whether they actually fit the reality of the circumstances that 
meet in the complexity of a balance sheet today, but it seems 
to me we are posing a major dilemma if we have a leverage ratio 
overlaid on top of a risk-based system.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman, and I want to 
thank our witnesses. My first question is to Comptroller Hawke. 
It is about the Riggs Bank situation. I have been very 
concerned about what has been going on here. You know that 
earlier this year the State Department revoked or refused to 
renew visas for 16 Saudis who were here under diplomatic cover, 
but in actuality worked in a Virginia school that was teaching 
terrorism. Similarly, in 2003, American officials deported a 
Saudi consular official in Los Angeles. I have a number of 
questions.
    First, did any of these individuals have accounts at the 
Riggs Bank or receive money from those accounts? If so, how 
much?
    Second, I would like to know if your review of the Riggs 
Bank accounts turned up any untoward activity. In your 
enforcement action on July 16, 2003, Riggs Bank was tasked with 
filing suspicious activity reports within 150 days in 
relationship to these accounts. Have these reports been filed? 
If so, how many?
    Then third, just generally, Riggs was passing money in 
violation of the Bank Secrecy Act for 2 years until all of this 
came up. What are you doing to tighten things up so that there 
is no future Riggs Bank doing that kind of thing?
    Comptroller Hawke. Senator Schumer, if we may provide a 
response to those questions in writing, I would be happy to do 
so, with the caveat that I gave a bit earlier. Because Riggs is 
the subject of ongoing supervisory action by the OCC, we are 
somewhat constrained in what we can say publicly about it, but 
I would be happy to do the best we can in addressing the 
questions.
    Senator Schumer. You could do those, and if you have to 
protect specific names, that is fine. I am not interested in 
the specific names of the case. I am interested in whether 
Riggs filed the reports and whether any of these people--I do 
not have to know which ones--were involved in the Riggs Bank. 
Of course, if all 16 were, then you cannot say that, but if it 
is one or two, you probably can without revealing identities.
    Second question. Hedge fund regulation. There have been two 
reasons given for hedge fund regulation, and that is one is to 
protect investors. I am not terribly sympathetic to that if, 
and only if, as they used to say in law school, hedge funds 
deal with people of great wealth. In other words, when the 
hedge funds try to find ways of getting people to make $5,000 
investments, they are going to make themselves more like mutual 
funds. But leaving that part aside, someone is putting a 
million dollars in, caveat emptor is okay with me. But second 
is the issue of systematic risk which relates more directly to 
this hearing, that if we do not have registration, if we do not 
have regulation, we get something like long-term credit and 
other things, systematic risk is a problem.
    I would like, I guess the most relevant people are Chairman 
Greenspan, Mr. Hawke, and Mr. Powell to talk about those, but 
anyone should feel free to answer.
    Chairman Greenspan. Senator, the hedge fund industry, which 
is made up of far more diverse types of institutions than 
originally existed, in the context of, as you put it, the 
million dollar investments, is a major contributor to the 
flexibility, stability, and liquidity of the overall system. 
They do not, in my judgment, pose any significant systemic 
risks largely because the people who lend them money, their 
counter-parties, are large institutions who basically know what 
they are doing and the system has worked rather well.
    I fully agree with the point that you make that hedge funds 
which endeavor to attract retail money in fact become mutual 
funds as far as I am concerned, and should be subject to all of 
the rules that exist for those institutions.
    I do, however, wish to point out that if we endeavor to 
regulate hedge funds merely for the sake of regulating hedge 
funds, it is not clear to me what the justification is, and 
indeed, I can see significant losses to the flexibility of our 
very sophisticated financial system were we to do that. So, I 
think in moving forward, the criteria which you point out, 
Senator, should be the criteria of the type of regulation which 
is imposed.
    Senator Schumer. I think the SEC did cite--I said the word 
wrong--systemic risk as one of their potential justifications. 
Did they consult with you on that before then?
    Chairman Greenspan. Not with me specifically. There may be 
systemic risks, but I have not found any yet.
    Senator Schumer. Anyone disagree with that?
    Comptroller Hawke. I would just add to what Chairman 
Greenspan said, Senator Schumer, that the discipline exerted by 
counter-parties is enormously important here. One of the 
failings that we saw in Long Term Capital Management was that 
counter-parties were not exercising the discipline that we 
would expect. Lending banks were waiving access to information 
when the borrower refused to give them that information. That 
is something that can be addressed through the normal bank 
supervisory process.
    Senator Schumer. Anyone else on that subject?
    [No response.]
    Last question, if I could, Mr. Chairman?
    Chairman Shelby. Go ahead.
    Senator Schumer. I guess I am asking Chairman Greenspan. In 
recent days, last month, as you noted, talking about the 
economy, the general condition of the economy seems to have 
picked up in a wide variety of ways, whether it is employment 
with the last month's jobs numbers, retail sales, 
manufacturing, et cetera. It seems when the markets hear the 
good news, they have a bifurcated reaction. On the one hand 
they say, ``Gee, this is good news.'' On the other hand they 
say, ``Inflation is around the corner. We had better watch 
out.'' I think that is a reasonable reaction because of the 
deficit that we have here, which to me is unprecedented in the 
short amount of time it has been created. I am wondering in 
light of recent market reactions, what your views are on this 
deficit? I know last time we talked about this, we got into 
Social Security, which I think is, at least for the near-term, 
a political nonstarter. The ability to cut Government costs, 
well, I voted against the prescription drug bill which was the 
greatest prescription cost around, making me a fiscal 
conservative around this place, but that has not happened for a 
while, and it just strikes me, given what I have seen in the 
last while, that supporting making these tax cuts permanent 
actually hurts the continued recovery, not over a 6-month 
period but over an 18- or 24-month period, rather than helps. 
Could you comment?
    Chairman Greenspan. The deficit problem that I think should 
give us pause is not the short-term one, which is a problem but 
is not in and of itself destabilizing. At least the markets 
certainly do not read it that way. There is a very significant 
problem which confronts us in the next decade, and that occurs 
because the very large baby-boomer population retires and 
doubles the aggregate number of people on various forms of 
retirement income. As best we can judge, the uncertainties 
associates with Medicare specifically are greater. I should say 
parenthetically that Social Security is a defined benefit 
program, it cannot be forecast in exact detail, but close 
enough. Medicare cannot. The range of possibilities is in my 
judgment sufficiently worrisome that it creates uncertainties 
in the longer-term fiscal system which I do not think we have 
come to grips with as yet. It has not yet impacted on the 
short-term markets clearly. You cannot find footprints of 
either the immediate deficit or the long-term deficit in long-
term Treasury yields as yet, but clearly, you cannot create a 
fiscal problem of the type that is potentially out there 
without ultimately impacting on the rate structure and 
impacting on economic activity and economic growth.
    There are all sorts of elements involved in what level of 
taxation you think is appropriate for the longer-term, what 
level of taxation creates problems for long-term growth. Those 
are issues which I think the Congress has to address at some 
point, in my judgment, sooner rather than later.
    Senator Schumer. Just one follow up. It seems to me, at 
least from the few people I have talked to, and obviously, you 
know much more about this than I do, that the market's reaction 
is not to the long-term worry about the Medicare and Social 
Security problem which obviously loom out there, but have been 
there for 5 or 10 years, but rather to the short-term, that 
because of the immediate year-to-year deficits we have even now 
before the baby-boomers retire, that they are greatly worried 
that the Fed will have to raise interest rates rather quickly 
and rather steeply as the economy begins to take off. Am I 
wrong in thinking that?
    Chairman Greenspan. The market commentary clearly is that 
in response to the fact that the economy is clearly coming 
back, and indeed as I mentioned earlier, the problems which we 
have confronted and the concerns that we had about deflation 
last year are no longer an issue, that there clearly is an 
emergence of views as to how this will all balance out. I will 
try to address that in testimony which I am scheduled to give 
tomorrow at the Joint Economic Committee, but the news is good. 
I mean if you look out at various economic scenarios that could 
have emerged out of the extraordinary events subsequent to 
September 11 with the corporate scandals and wars in 
Afghanistan and Iraq, we are doing rather well, and I think the 
question is, how do we manage that in a manner that we will 
continue to do well?
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Senator.
    I want to get back on the Riggs situation, Mr. Hawke. Do 
you believe that the examination process that you have 
currently in place is robust enough to ensure bank compliance 
of the Bank Secrecy Act?
    Comptroller Hawke. I do, Mr. Chairman, and I should say 
that we have all learned a lot in recent years about the 
importance of making that process even more robust than it is.
    The issue, for example, of transaction testing is one that 
we have been giving thought to. We do not, as a regular matter, 
do extensive transaction testing in Bank Secrecy Act 
compliance. We look primarily at a bank's own internal 
controls, their internal audit, the way that they manage their 
own compliance. We take a risk-based approach to it as well; we 
concentrate on those institutions that present the highest 
risk.
    Chairman Shelby. A lot of people that know a lot about 
fighting terrorism basically concluded that money, financing of 
terrorist activities, training, movement, everything, is 
central to their activities, so this plays right into the 
regulator, in the Treasury's hands as far as your obligation to 
root this out or try to root it out, does it not?
    Comptroller Hawke. I think that is clearly right.
    Chairman Shelby. Could you provide to the Committee, Mr. 
Hawke, a brief overview of how the issue of Bank Secrecy Act 
compliance is handled by your examiners? Specifically, do the 
examiners look at a general program, a list of activities or 
programs the bank engages in? Do the examiners ever look at 
individual transactions to gage a bank's compliance with the 
Bank Secrecy Act? Do you want to do that for the record?
    Comptroller Hawke. Mr. Chairman, that was one of the 
questions that you raised with us at the last hearing.
    Chairman Shelby. I know.
    Comptroller Hawke. It is addressed in the letter that we 
delivered yesterday.
    Chairman Shelby. Is it addressed fully? My staff wanted it 
addressed totally, not cursory.
    Comptroller Hawke. It is addressed in four or five pages of 
the letter. We would be happy to supplement that if there are 
additional questions.
    Chairman Shelby. Okay. Are there other banks besides Riggs, 
Comptroller Hawke, that you are currently watching, that have 
problems similar to Riggs? Out of your whole banking system, 
there are bound to be some.
    Comptroller Hawke. Riggs presented a special kind of 
situation because they----
    Chairman Shelby. Because of where they were located?
    Comptroller Hawke. Well, in part. They had made a specialty 
of embassy bombing----
    Chairman Shelby. That is because of where they were located 
too.
    Comptroller Hawke. They did it overseas, as well, but that 
was a specialty that they had developed. I think we all 
recognize that that product line, if you will, presents 
considerably higher risks than other types of banking 
relationships.
    Chairman Shelby. As far as other banks are concerned, I 
know they are here in Washington and they went after a lot of 
the diplomatic business and so forth, or maybe with the 
diplomat's bank among other things. But there are other banks 
in this country under your jurisdiction that I hope you are 
looking at too.
    Comptroller Hawke. We are, Mr. Chairman, and, as I said, we 
take a risk-based approach. We look at a number of different 
attributes that a bank presents, the extent to which they have 
foreign customers, the extent to which they are doing private 
banking, their location, the number of SAR's that are filed and 
so on. All of that gets factored into the decision as to how 
much----
    Chairman Shelby. Has the word gone out though from the 
Comptroller of the Currency, that it is not business as usual, 
that we are in a war against the terrorists and money is 
important to the terrorists? Also, is that one of your highest 
priorities?
    Comptroller Hawke. It is a high priority with us, Mr. 
Chairman, with respect to the training and incentivizing of our 
examiners, as well as with the banks that we supervise.
    Chairman Shelby. Mr. Powell, what about you?
    Chairman Powell. It is a high priority with us also, 
Senator.
    Chairman Shelby. Do you have some troubled banks similar to 
Riggs, like that, in dealing with the Bank Secrecy Act?
    Chairman Powell. I am sure we do. We have had something 
like----
    Chairman Shelby. Would you furnish that to the Committee 
for the record?
    Chairman Powell. Be happy to. I think we have had 24 
enforcement actions.
    Chairman Shelby. Twenty four enforcement actions.
    Mr. Gilleran, you have a lot of banks. I know a lot of them 
are all over the country.
    Director Gilleran. A lot of thrifts.
    Chairman Shelby. Well, thrifts and savings banks.
    Director Gilleran. We do not have any that we know of that 
are of the nature of the Riggs situation. We do see a problem 
for some of the smaller institutions in complying because the 
laws require special training for their employees, and special 
surveillance on the part of the organization, so that we are 
giving particular attention to how this is all being handled by 
smaller organizations.
    Chairman Shelby. Mr. Dollar, what are your responsibilities 
for the credit union?
    Mr. Dollar. We are not exempt from this one, Mr. Chairman.
    Chairman Shelby. I hope not. Thank you.
    Mr. Dollar. And although there is not much money laundering 
going through institutions as small as credit unions, 60 
percent of which----
    Chairman Shelby. We also have some huge credit unions. I 
know one in my State is well-run and a couple of billion 
dollars in size. I call that pretty good size.
    Mr. Dollar. Well, you do have, and the point I wanted to 
make is that we take it seriously, and we take it seriously to 
the point during the 6 years I have been on the NCUA Board, the 
single largest conservatorship that we have done of any credit 
union in the United States, Senator Schumer, was in your home 
State, and it was for Bank Secrecy Act violations. We do take 
it seriously.
    Chairman Shelby. Senator Sarbanes, thank you for your 
indulgence. You want to get back into this too.
    Senator Sarbanes. I have to tell you, David Aufhauser, when 
he was General Counsel to the Treasury Department, in testimony 
before this Committee, said that the Bank Secrecy Act part of 
the bank audit might be a stepchild to the rest of the audit 
and not receive the priority and primacy it deserves. Aufhauser 
went on to suggest that we might be better served if Treasury 
constituted a separate examination and compliance force in the 
area of bank secrecy. What is your reaction to that suggestion 
by Mr. Aufhauser?
    Comptroller Hawke. I am not sure that the problem of Bank 
Secrecy Act compliance is going to be addressed by just adding 
more examiners to the mix, Senator Sarbanes. I think that the 
fundamental aspect of Bank Secrecy Act compliance is very 
consistent with the fundamental approach to bank supervision 
generally, and that is to look, in the first instance, at the 
extent to which the institution has established the kind of 
controls and audit processes that are necessary for it to 
assure itself that it is complying with the law. That is the 
starting point for virtually all bank supervision. It is not by 
any means the end, but that is the starting point. And that is 
the thing that bank examiners are trained to do and do every 
day. In the course of several years of dealing with Riggs, 
there was an escalating response by the supervisors that 
started with a focus on the bank's own internal controls, on 
training, and on those fundamental aspects of bank supervision 
that we look at in other areas, as well.
    Senator Sarbanes. Yet, we are talking about the possibility 
of terrorist financing here. I mean, it goes from year to year. 
You are running along doing these reports every year, but at 
what point do you move to really move in there and correct it 
and make sure that this is not constituting access to funds for 
terrorist activities?
    Comptroller Hawke. As I say, there was escalating concern 
over a period of several years that culminated in the issuance 
of a cease-and-desist order last year.
    Director Gilleran. I can appreciate your concern, Senator 
Sarbanes. I do think, however, that the bank regulators should 
be given time to prove that they can regulate appropriately in 
this area, because I think in order to be effective in this 
area, you must understand bank procedures, bank controls, and 
bank systems. Therefore, the bank regulators have the best 
staff to do that with.
    I think it is not a question of our not having the staff to 
do it. I think you are concerned about whether or not we have 
sufficient emphasis on this important area and whether or not 
we are giving it the correct amount of attention. I can tell 
you that, for the OTS, I believe we are, but we have to prove 
ourselves in this area. And therefore, I would ask that 
Congress give us more time to prove that we can do this.
    Chairman Shelby. Do you have that time? Do we have the 
luxury of time?
    Director Gilleran. Well, I think that we have the best 
staff, I think, that you can look to us to get this job done, 
because these are people that know the financial institutions 
and know the systems and know what to look for. So you have the 
best people to do it here.
    Chairman Shelby. I understand that, but do we have that 
luxury of time in our war against terrorist financing?
    Director Gilleran. If you were to change the regulatory 
structure and create a new agency, it would be creating a 
hiatus of time.
    Chairman Shelby. No one has suggested that, that I know 
about.
    Director Gilleran. I think that is what this started from.
    Senator Sarbanes. Didn't the Inspector General of Treasury 
criticize the OTS last year for insufficient follow-up on Bank 
Secrecy Act problems?
    Director Gilleran. That was true, Senator, and I would say 
that we appreciated that review so that it turned us to a 
problem that I mentioned earlier, and that is the criticism 
that was made of us was that we had given some smaller 
institutions more than one examination period to correct their 
problem. For instance, the Act requires an institution to have 
a sufficient training program, it requires the institution to 
have sign-offs. In no instance was there any thrift that was 
involved in any money laundering, and that the criticism was to 
procedural items.
    Now, I agree with the GAO. They were criticisms. But the 
criticism was the fact that the thrift did not correct their 
lack of training or their lack of sign-offs within one 
examination period. We have since addressed ourselves to that 
criticism.
    Senator Sarbanes. Mr. Chairman, I mean, we have all the 
regulators here and of course the agenda is a full scope of 
their responsibilities, I guess, with a particular focus on 
safety and soundness. But I would suggest that we may want to 
do a hearing specifically addressed to money laundering and the 
Bank Secrecy Act. We could go through very carefully with each 
of them exactly what they are doing and where they may have 
fallen down on the job and what more needs to be done. This is 
an important area of activity, obviously, and if something 
happens, you can bet your life it is going to be an important 
area of activity.
    Chairman Shelby. I think it is a good suggestion and we 
would be properly prepared for it. Chairman Sarbanes wanted to 
comment.
    Senator Sarbanes. Chairman Greenspan.
    Chairman Shelby. Greenspan. I am saying Sarbanes. He was 
the Chairman. I do not want him to be the Chairman in the 
future.
    [Laughter.]
    But he could be, you know. If he is, I will be respectful.
    Chairman Greenspan. Mr. Chairman, I would just like to 
associate myself with some of the remarks of my colleagues. To 
be sure, we do not have time. But bringing in a third party at 
this stage, in my judgment, is not going to expedite this 
process. And the reason, essentially, is that enforcing the 
Bank Secrecy Act invariably requires that you, in the normal 
examination process, sense anomalies in the system, things that 
look just a bit off, things that do not seem to square. And it 
is when you dig into those fissures in the system that you come 
up with embezzlement, you come up with money laundering, you 
come up with illegalities which the process endeavored to hide. 
I do not think somebody coming in from the outside can do it by 
some shortcut method. They have to go through a whole 
examination process. I do not think you can separate 
examination of banks, under the Bank Secrecy Act, from the 
overall examination process.
    Chairman Shelby. In other words, what you are saying, as I 
understand it, have the right mentality, culture to do the job, 
it is just a question of adding this on to their work. Is that 
correct?
    Chairman Greenspan. Exactly, yes.
    Senator Schumer. Mr. Chairman.
    Chairman Shelby. Senator Schumer.
    Senator Schumer. I have just one question here, really, 
directed at Mr. Hawke. You said that you had a risk-based 
approach. In reference to the Chairman's comment, Riggs Bank 
was high-risk because of its location. And yet, it is my 
understanding that there were two checks on Riggs in relation 
to Bank Secrecy, one in 2000 and then one in 2003, and most of 
the bad stuff occurred between. Is it that you are 
understaffed? I mean, why, with a particularly high-risk bank, 
are we supposed to wait 3 years between examinations? Or am I 
wrong in the----
    Comptroller Hawke. I do not think that is right, Senator 
Schumer. Riggs was regularly examined by the OCC and, as I 
said, over----
    Senator Schumer. This was for Bank Secrecy Act violations.
    Comptroller Hawke. Over a period of 3 or 4 years, there was 
escalating concern about Bank Secrecy Act compliance issues at 
Riggs. In retrospect, one could easily wish that we had been 
tougher earlier. But it was not that issues of Bank Secrecy Act 
compliance went unnoticed. It was that supervisory attention 
focused initially on internal control systems and training, and 
concern gradually escalated over that period of time.
    Senator Schumer. If I am right--and maybe I am wrong, but 
if I am right that there was one examination for Bank Secrecy 
in 2000 and then the next one was 2003 for a particularly high-
risk bank would you say that would not have been enough?
    Comptroller Hawke. It probably would not have been enough. 
I do not think----
    Senator Schumer. Could you check and get back in writing 
about that?
    Comptroller Hawke. I would be happy to.
    Senator Schumer. That would be great.
    Chairman Shelby. Mr. Hawke, did your examiners call in the 
FBI or did the FBI call in your examiners? In other words, who 
got into Riggs first? Was it FBI or was it your examiners 
examining the bank because of possible violations of the Bank 
Secrecy Act?
    Comptroller Hawke. I cannot tell you definitively, Mr. 
Chairman.
    Chairman Shelby. Would you do that for the record?
    Comptroller Hawke. I would be happy to.
    Chairman Shelby. Okay, it is important.
    I want to move to deposit insurance. Senator Johnson is not 
here right now, but he made part of that his opening statement.
    Last year, I asked each one of you to work with the 
Treasury to develop a consensus deposit insurance reform 
proposal. I thought that the proposal that was produced would 
provide meaningful, comprehensive reform. Do you still support 
that proposal, Chairman Greenspan?
    Chairman Greenspan. We do, Mr. Chairman.
    Chairman Shelby. Mr. Hawke.
    Comptroller Hawke. Yes, Mr. Chairman.
    Chairman Shelby. Mr. Powell.
    Chairman Powell. Yes, sir.
    Chairman Shelby. Mr. Gilleran.
    Director Gilleran. Yes, sir.
    Chairman Shelby. Mr. Dollar.
    Mr. Dollar. Yes, sir. We seek parity with the other Federal 
insurance fund.
    Chairman Shelby. We have discussed many ways in which banks 
have become smarter--you know, they have learned, grown 
healthier and better able to operate in a safe and sound 
fashion. Should we be mindful of creating inappropriate 
incentives and disincentives in deposit insurance reform 
legislation? In other words, one of the statements around has 
been that if the reform package passed, it would increase basic 
coverage as well as coverage for retirement accounts, to 
amounts such as $150,000 to $250,000. Would banks lose some of 
their discipline here and management skills, and slip back? I 
do not know. And especially all that bothers me in view of the 
average savings account that is ensured across the country. I 
do not know exactly what it is. I would bet you would know. Is 
it less than $30,000?
    Chairman Powell. Yes, sir.
    Chairman Shelby. We are talking about running the rates up 
past $100,000--I am not, but others are. And then retirement 
accounts or whatever are even past that. And that is troubling 
to me. Somebody sat on this Committee during the thrift 
debacle, the former Chairman did.
    Chairman Powell. Mr. Chairman, a couple of comments. I was 
in the industry, on the other side.
    Chairman Shelby. So you know.
    Chairman Powell. And oversaw an institution that almost 
failed. A couple of comments. I cannot imagine a CEO of an 
institution who would take undue risks because coverage 
increased. Most CEO's have a vested interest in that 
institution in the form of ownership and reputation. It would 
be committing suicide----
    Chairman Shelby. But the insurance is really assuming part 
of the risk, is it not?
    Chairman Powell. It is assuming part of the risk, but I can 
assure you if the institution fails, your net worth goes to 
zero.
    Chairman Shelby. I understand.
    Chairman Powell. And also you are subject to some other 
issues. But our view at the FDIC has been clearly, from the 
very beginning, that the coverage issue should be indexed. I 
would hope that----
    Senator Sarbanes. Is that the position--the Chairman put a 
question earlier about the proposal that was----
    Chairman Shelby. That was not in the proposal.
    Senator Sarbanes. And you all said you were for that 
proposal and now you are telling us you differ on an important 
aspect of the proposal.
    Chairman Shelby. We did not--as I recall, that did not call 
for indexing, even retroactively or prospectively.
    Chairman Powell. I think it was silent on the coverage 
issue. I could be wrong about that.
    Chairman Shelby. It was not silent at the table.
    Chairman Powell. Our issue has always been that it should 
be indexed.
    Chairman Shelby. That is the FDIC you are speaking of.
    Chairman Powell. Yes, sir. I think it is unfortunate that 
this particular part of deposit insurance reform gets an 
enormous--and I am not saying it is not important, but it gets 
an enormous play when other parts of deposit insurance reform, 
in my view, are more critical to pass, that we can serve the 
industry, and that those components of deposit insurance reform 
be passed. I think it is past time that we need to focus on 
those issues that Senator Johnson and you have spoken about.
    Chairman Shelby. I know my time is running fast, but 
protection of the banking system generally. Chairman Greenspan, 
in your opening statement you referred to the interagency 
whitepaper on sound practices to strengthen the resilience of 
the U.S. financial system. Mr. Hawke, you similarly referred to 
the issue of resilience of the financial system, although 
within the context of Basel II. I would like to focus my 
question briefly on the whitepaper to which Chairman Greenspan 
referred.
    It has now been a year since the final report was concluded 
and 2 years since the draft report was on the street and 
available for industry comments. Sound practices outlined in 
the report set forth certain goals for recovery and resumption 
of operations following a major regional disaster. 
Specifically, business activities of core clearing and 
settlement organizations, according to the recommendations of 
the Federal Reserve Board, the Office of the Comptroller of the 
Currency, and the Securities and Exchange Commission, should be 
resumed within the same business day as the disruption, with 
the goal to resume operations within 2 hours.
    While I understand this goal is consistent with pre-
September 11 policy within the banking industry, I would be 
interested in hearing your views on the progress industry has 
made to date in meeting the key objectives of the whitepaper. 
Have the goals of the whitepaper been taken to heart by the 
industry, and are the recommendations being implemented? Have 
the legitimate considerations of cost proven prohibitive to 
meeting these goals and, if so, what measures, including 
incentives, would you recommend for facilitating progress?
    That is not too much for any of you. I will start with 
Chairman Greenspan.
    Chairman Greenspan. I think you should start----
    Chairman Shelby. Okay, you defer to Mr. Hawke.
    Chairman Greenspan. Go ahead. I will follow up on his 
remarks.
    Chairman Shelby. He handed you a good one, then. Go ahead.
    Comptroller Hawke. Well, I was waiting to hear what 
Chairman Greenspan had to say.
    The whitepaper set forth a number of expectations and time 
frames for financial institutions with respect to clearing and 
settlement activities, recovery and resumption objectives, and 
other criteria, as well. With respect to progress at national 
banks, all of our large national banks that are covered by the 
paper have either already satisfied those requirements or are 
making substantial progress in meeting those goals. Our 
evaluation is that they are all taking this effort very 
seriously and devoting substantial resources to complying with 
the parameters that were set out in the whitepaper.
    Chairman Shelby. Chairman Greenspan, do you agree with 
that?
    Chairman Greenspan. Yes, I do. I think we are fortunate in 
the sense that the price of technology has been coming down 
fairly dramatically and it has enabled redundant systems to be 
developed off-site in many different areas. And it is not only 
the individual banks who are addressing this issue, but also 
those of us who were involved in the payment systems, 
specifically the Federal Reserve banks, have also been engaged 
in an extraordinarily intensive endeavor to make certain that 
we insulate our systems from various different types of shocks. 
So far, we have, obviously, run into various different types of 
problems and they were handled well. We recovered remarkably 
well out of September 11 despite the fact that there were 
numbers of weaknesses in the system. And we seem to be 
gradually getting to the point where the flexibility and the 
resiliency of the system is increasing every month.
    Now, whether that means we will be able to come back 
immediately from any shock, I do not know the answer to that. 
But clearly, we are heavily involved in the payment system and 
the major banks in the system, which are all acutely tied to 
this problem. I think we are making major progress. Will we 
ever get to the point where we will say we are fully insulated? 
The answer is no, we will not.
    Chairman Shelby. Sure.
    Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. Just one brief 
question. This bothers me, so I want to come back at it a 
little bit with Chairman Greenspan. And that is, again, this 
deficit and how it is going to affect the medium-term nature of 
the recovery--not in the next 6 months, but in the next 18, or 
year or two.
    I want to mention an editorial from April 15 Financial 
Times, hardly a liberal mouthpiece or Democratic mouthpiece. 
They say, But as the Bush Administration chooses not to hear, 
the problem is not the short-term deficits run up now as a 
result of the global economic slowdown, but those that 
respectable economists predict will persist even when the U.S. 
economy has returned to full employment. The borrowing spree 
will push up real interest rates on dollar assets, constraining 
investment and consumption such that the net medium-term effect 
of the recent U.S. tax cuts on economic growth will probably be 
negative.
    Now, that seems to me to be--when I go around and talk to 
people on Wall Street and economists and experts, that is not 
the universal opinion, but I would say--it may not even be the 
majority opinion, but it is the mode. You see more people 
saying that than any other opinion. And it seems to me, that is 
what the markets are feeling right now.
    Should we be doing something about that now? Do we not have 
to worry that interest rates will--you will be forced to raise 
interest rates too quickly and the longer-term recovery that we 
had in the late 1990's, because of fiscal responsibility, will 
be cut short?
    Chairman Greenspan. Senator, I am concerned that we first 
put into place a process which will enable us to address not so 
much the short-term deficits, which I think are worrisome but 
the longer-term deposits. The short-term deposits pale against 
the problems in the longer-term future. I think it is probably 
not very fruitful to talk about programs or what we are going 
to do until we get a budget process in place with PAYGO back in 
the structure of the decisionmaking, and discretionary caps, 
which served us so well in the earlier period.
    Senator Schumer. Would you say those should be on the tax 
side as well as on the spending side?
    Chairman Greenspan. My view is that what we should 
reintroduce are the PAYGO and discretionary cap provisions 
which effectively expired in September 2002, which includes 
both spending and taxes. And if we fall short on that, we are 
going to find that we will not be able to maintain the degree 
of discipline which is going to be necessary to address what is 
a very significant problem out there.
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Mr. Powell, I want to ask you about payday lending. The 
OCC, the OTS, and the Fed have all taken action to ensure that 
payday lenders do not rent charters from the depository 
institutions which they supervise. Why does the FDIC continue 
to allow banks that it supervises to engage in payday lending 
practices when the other regulatory agencies strongly 
discourage partnerships between payday lenders and Federal 
thrifts, national banks, and State-charter members of the 
Federal Reserve? You are the only regulator who is turning a 
blind eye--more than turning a blind eye, really, allowing this 
rent-a-charter practice to go on. Why are you doing that?
    Chairman Powell. Senator, we supervise in excess of 6,000 
institutions. There are 11 institutions that currently have 
arrangements with payday lenders. We have examined those 
institutions on several occasions. We have issued guidelines 
for payday lenders that are much more harsh as relates to 
capital allocation, to procedures and policies, to 
discrimination, to fairness, to anything that might be illegal 
as it relates to the existing law. We have asked one of those 
payday lenders to discontinue that activity.
    Senator Sarbanes. Yes, but the others do not think they 
should be doing it at all. They are not allowing this rent-a-
charter practice to go on. The Center for Responsible Lending 
estimates that the debt trap of payday lending, those borrowers 
who have five or more payday loans per year, cost borrowers in 
excess of $3 billion a year.
    Chairman Powell. We have not----
    Senator Sarbanes. What are you doing about rollovers? What 
are your rules on that?
    Chairman Powell. We have stringent guidelines as it relates 
to rollovers. We look for violations of usury laws. We look for 
violations of any of the laws. And when we find those 
violations, we ask them to stop.
    Senator Sarbanes. What is your rule on the number of payday 
loans that can be made to the same borrower in a single year?
    Chairman Powell. I cannot answer that specifically----
    Senator Sarbanes. Do you have a rule?
    Chairman Powell. --but I will be happy to get to you----
    Senator Sarbanes. Do you have a rule on that issue?
    Chairman Powell. I cannot answer that. But payday lenders 
are----
    Chairman Shelby. Excuse me, Mr. Chairman, could you furnish 
that for the record and Senator Sarbanes?
    Chairman Powell. I would be happy to. Payday lenders are 
not unique to the FDIC, in that under the shared national 
credits, payday lenders are part of shared national credits. 
They have--and we participate in--shared national credits, 
together with OCC and the Federal Reserve. And payday lenders 
are part of the shared national credits. So they are not unique 
as it relates specifically to the FDIC.
    Senator Sarbanes. Of the 11 FDI-supervised banks partnering 
with payday lenders, how many of them have you examined?
    Chairman Powell. All of them.
    Senator Sarbanes. All 11?
    Chairman Powell. Yes, sir.
    Senator Sarbanes. Do you examine them every year?
    Chairman Powell. Yes, sir.
    Senator Sarbanes. So each of those 11 has been examined 
within a year?
    Chairman Powell. I cannot specifically tell you that they 
have been examined to the calendar year, to the point, but they 
are examined on a regularly scheduled basis as we would examine 
any other institution.
    I was just passed a note, Senator----
    Senator Sarbanes. Aside from the examining, what is the 
rationale for--all the other regulators do not think this 
practice should take place. You are the only one at the table 
who thinks it should go on. Now, what is your rationale to 
support your taking an odd-man-out position on this important 
issue?
    Chairman Powell. I think that the rationale is that they 
are meeting a need in the community that the marketplace has 
said is there. And it is our job to make sure there is no 
safety and soundness issues and no violation of the law.
    Senator Sarbanes. Without any regard to the exploitation 
that is taking place?
    Chairman Powell. Without any regard to----
    Senator Sarbanes. I mean, they are obviously coming in 
trying to use the Federal charter in order to get around State 
laws which control those practices. Is that not right, Mr. 
Lavender? Do you know about this issue?
    Mr. Lavender. I am familiar with the issue. And that is a 
concern that we have, that some institutions will----
    Senator Sarbanes. The States enact laws to guard their 
people from these payday lending practices, and then they go 
rent a Federal charter under the supervision of Federal 
regulatory authorities in order to get around those 
limitations. Is that not correct?
    Mr. Lavender. In Tennessee, the payday lenders are a duly 
licensed entity that we regulate, that we can regulate.
    Senator Sarbanes. Okay, you do it a different way, then.
    Mr. Lavender. Exactly, but----
    Senator Sarbanes. There are some States that prohibit them.
    Mr. Lavender. We do have a concern that as banks continue 
to express an interest in getting into that business that they 
will affiliate with some of our payday lenders and thereby 
avoid the State regulation.
    Senator Sarbanes. Mr. Chairman, my time is running and I 
want to ask one more question, if I might.
    Chairman Shelby. You may.
    Chairman Powell. Mr. Chairman, pardon me, I have not 
answered Mr. Sarbanes's question.
    Chairman Shelby. Go ahead.
    Chairman Powell. Our guidelines requires a 60-day mandatory 
charge-off for payday loans.
    Senator Sarbanes. I want to ask this question of the panel 
people. Since 1992, total assets in the banking system have 
doubled, from $4.5 trillion to $9 trillion. Deposits have grown 
from $3.5 trillion to almost $6 trillion. Over that same 
period, the assets held by the five largest institutions have 
increased more than fivefold, and the deposits held have 
increased by 460 percent. The issue, I guess, is better put if 
we say in 1992 the five largest banks had 12 percent of the 
total assets of the banking system; today they have 32 percent. 
That is assuming these two mergers that are now pending go 
through. Similarly, in 1992, the five largest banks had 11 
percent of the total deposits of the banking system, while 
today they have 31 percent. Does this level of consolidation 
and concentration cause any of you any concern?
    Comptroller Hawke. Mr. Chairman, Senator Sarbanes, let me 
take a first crack at that. There are two aspects to the issue. 
One is looking at it from a competitive point of view, in 
antitrust terms. The other is looking at it in terms of the 
ability to supervise and examine institutions of growing size.
    On the competitive side, the numbers you are looking at 
reflect nationwide concentration levels. While it is true that 
concentration nationwide has increased, concentration in local 
markets has actually decreased over this period of time. I 
think Chairman Greenspan may have mentioned this earlier. We 
find that local markets, which are critically important for 
consumers and small businesses, are becoming less concentrated 
and more competitive, even as concentration on the national 
level is increasing.
    From a safety and soundness point of view, there is no 
question that mega-banks present challenges for supervision. We 
already supervise some very, very large banks, and we have 
full-time resident teams of examiners in these banks with a 
variety of specialists who are trained in particular aspects of 
the bank's business, such as capital markets, asset management, 
and the like.
    The continued growth of mega-banks is certainly going to 
put a high premium on the training of specialists and on 
interagency cooperation. We will have to work closely with our 
colleagues at the Federal Reserve, as the holding company 
supervisor, and Chairman Powell has already mentioned the 
FDIC's concern with large banks, to make sure that we are 
taking a coordinated approach to supervision of these large 
banks. There is no question that the increased concentration in 
the banking system does present supervisory challenges. I think 
we are up to those challenges.
    Senator Sarbanes. Anyone else?
    Director Gilleran. My own reaction, Senator, is that having 
come from the smaller bank arena, having run one is San 
Francisco, I believe that a smaller institution has every 
capacity and capability of competing in the niches that it has 
selected for itself, and that a strategy of going head-to-head 
as a small bank against major banks and to compete on rates is 
not one that is successful very often.
    Therefore, there is definitely an arena to service 
America's financial needs for small banks, and, therefore, 
small banks will always be with us, as long as we permit them 
to be there. And on top of that, they are very profitable.
    So from the standpoint of the profitability of the 
investment, it is a good investment; and from the standpoint of 
servicing the public, it is very good because you must search 
for niches that the bigger banks are not servicing.
    I believe that the growth of the major banks is not 
something that we should be afraid of. It is really the growth 
of the kind of mass-produced services that credit cards 
represent and other types of lending. But there is a niche out 
there for smaller banks that will always be with us, and they 
are doing it very well.
    Senator Sarbanes. Well, I am trying to anticipate a trend. 
If the consolidation were to continue at the same rate that it 
has been taking place, and if the total amount of assets in the 
system were to grow at the same rate, in 10 years' time the top 
five banks would control 65 percent of the total assets of the 
system.
    Would that level of concentration be a matter of concern?
    Mr. Lavender. Chairman Sarbanes, as a State regulator I am 
concerned today about this level of concentration. I agree from 
a competitive standpoint that our small community banks do an 
excellent job, another year of record profits. From a 
standpoint of choice, while we continue to see a concentration, 
I do believe in free market enterprise where let the free 
market reign. And, therefore, citizens have to choose where 
they are going to do their banking.
    But I would like to go to the point Comptroller Hawke 
mentioned, and that is supervision and examination. As a State 
regulator, I am concerned that my Federal counterparts have the 
capacity, the staff, the budget, to continue examination, the 
depth of examination of these entities as they continue to 
consolidate.
    I hate to sound like a broken record today, but, again, 
looking at the preemption and the inability of not only this 
department but also Attorneys General to enforce consumer 
protection rights for our consumers, I am concerned not only 
about the bank and the industry; but I am also concerned about 
the consumer as well. And I do not have a comfort level today 
that with continued concentration the industry is positioned to 
supervise and examine adequately.
    Senator Sarbanes. Thank you very much.
    Chairman Shelby. Thank you, Senator Sarbanes.
    I am going to go back to Chairman Sarbanes--not Chairman 
Sarbanes. I have it on my mind, haven't I?
    [Laughter.]
    We have a roomful of people here and they are all chairmen.
    China, Chairman Greenspan, I have been told they consumer 
40 percent of the coal in the world, 25 percent of the scrap 
metal, and a similar amount of precious ores and other metals, 
not counting oil. I do not know how much oil and gas they are 
consuming, but as they continue to grow industrially, they will 
consumer more.
    Some people have said that because of China, not just 
because--that they have put--they have driven the price of 
scrap metal and other things up. I guess the question is: Will 
they absorb this because of their labor market, because there 
is no real pressure on them in the labor market, 1.3 billion 
people, a lot of people looking for work? Will they let their 
currency float within some kind of an upward band? Or what do 
you predict? Or you do not. You see what I am getting at?
    Chairman Greenspan. Yes. First of all, let us recognize 
that there has been a particular surge in the demand for metals 
which, to a large extent, reflects the marginal demand coming 
from China as it is endeavoring to move toward a market economy 
in some of the older industries. The reason they are absorbing 
such a significant part of the steel scrap in the world and, 
indeed, iron ore and coke and all of the basic ingredients, is 
that that industry has not been growing all that rapidly around 
the world, and they are now moving into a state of industrial 
advance which creates very heavy demands for what we 50 and 100 
years ago went through and others did as well.
    I think they are adjusting to an early stage of an 
industrial dynamic which is going to rapidly change. They are 
moving and in a very impressive way.
    The major problem that they have is not the reflection so 
much of the demand for commodities. It is that there is a 
concern increasing in China that they are overheating as a 
consequence of a fairly rapid increase in the money supply, 
which has been going up approximately 20 percent a year.
    They do not have the flexibility that we do. They have got 
still very significant proportions of their output produced by 
State-run enterprises, which by their very nature are rigid. 
They recognize this, and they are moving to try to find the 
appropriate balance. And implicit in that there is clearly 
going to be greater flexibility of their exchange rate, there 
is clearly going to be at some point, hopefully sooner rather 
than later, a reduction if not the ultimate removal of the 
capital controls that they impose on Chinese residents in the 
accumulation of foreign assets. But it is a very delicate 
process because their banking system is not in robust shape.
    So they are moving, as best as I can see, in the right 
direction in endeavoring to contain this, and I think it is in 
everybody's interest that China move forward but not move 
forward in a unbalanced way, which could create great 
difficulties for them. And if they run into trouble, they will 
create significant problems for Southeast Asian economies, for 
Japan, and indirectly for us.
    Senator Sarbanes. Mr. Chairman.
    Chairman Shelby. Go ahead.
    Senator Sarbanes. Mr. Chairman, is it the case that if they 
reset the peg rather than going immediately toward flexible 
rates, that that would avoid dangers to the banking system that 
are constantly put forth as a reason why they cannot move now 
or in the near future to flexible rates? But they could reset 
the peg without those problems, could they not?
    Chairman Greenspan. They could, but they would have to be 
careful where they set it, because if they set it with too 
small a change from where we are today, the markets would 
quickly presume that there are going to be further adjustments 
and they will get a very large increase in capital inflows, 
which will create even a greater problem.
    There is, I would agree, a peg level which probably 
prevents that from occurring. I do not know where that is. I am 
not sure that they do. But they are working toward some 
resolution of the type you are suggestion, as best I can judge.
    Chairman Shelby. Chairman Greenspan, when you use the term 
``peg,'' is that like trading within a certain band?
    Chairman Greenspan. Well, ``peg'' usually means a very 
narrow band, and the Chinese insist that they have a flexible 
exchange rate. But it is flexible in a very, very narrow range.
    Chairman Shelby. Gentlemen, thank you very much for your 
contribution. We look forward to a number of questions that we 
will ask you for the record, but we are also waiting, Mr. Hawke 
and Mr. Powell, both of you, for answers to some questions. 
Thank you.
    The hearing is adjourned.
    [Whereupon, at 5:14 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR WAYNE ALLARD

    Thank you, Chairman Shelby for convening this hearing on the 
current condition of the banking and credit union industry. I am 
pleased to have the opportunity to hear from our banking and credit 
union regulators to hear about issues facing the United States banking 
system both domestically and internationally. It has been nearly 3 
years since we have taken a look at the industry and many events have 
occurred that could have greatly shaken the economic stability of this 
country . Yet, the banking system remains strong and able to meet the 
demands of its customers.
    The year 2003 saw net profits of over $100 billion for commercial 
banks and the demand for household credit has remained strong. 
Additionally, the total volume of problem assets in commercial banks 
has declined steadily, and sustained confidence in the capital markets 
is evident through risk measures derived from prices of stocks, debt 
securities, and credit default swaps. The significant decline in loan 
losses and credit losses has signaled the industry's responsiveness to 
the lending experiences of the 1980's and 1990's. Overall, the banking 
industry remains strong, and that is credited to the good work of our 
Nation's banking and credit union regulators.
    In order to continue this pattern of success, it is imperative that 
we maintain a disciplined examination of both the banking system and 
the modernization of our entire financial system. I would like to thank 
the witnesses for appearing before the Committee today. I look forward 
to your testimony.

                               ----------
               PREPARED STATEMENT OF SENATOR JIM BUNNING

     Thank you Mr. Chairman for holding this hearing and I would like 
to thank all of our witnesses for joining us today.
     I believe holding these state of the banking industry hearings is 
a very fine and necessary tradition of this Committee. It is very 
worthwhile to hold these hearings, so during the good times, we are 
prepared for the bad times. I am very glad that all three of the 
Chairman during my tenure on this Committee have embraced this 
tradition.
     For the most part, the state of the industry seems pretty healthy. 
There are things we need to keep an eye on, but for the most part, the 
safety and soundness of our institutions is not a concern. I personally 
have some concerns about small banks, which are crucial to the 
financial health of Kentucky. There have been many mergers and 
acquisitions of small banks. My small banks are also becoming more and 
more concerned about the competing pressures they are facing. The small 
community banks are the only source of capital in many areas of my 
State, and it is crucial that ensure their health and safety.
     Once again deposit insurance is an issue we are facing. I fully 
support deposit insurance reform. However, I am very troubled by 
attempts to raise the insurance coverage limits. I have been Chairman 
Greenspan's most vocal critic on monetary policy. But I agree with him 
wholeheartedly on raising insurance coverage. I believe we agree so 
strongly about this, along with the Chairman and Ranking Member of this 
Committee, because all of us had to deal with the S&L bailout in the 
late 1980's. I think I can speak for all of us who were in the Congress 
at that time and say that none of us wants to go through that again.
     I am very interested to hear about your specific sectors of the 
industry, and if there is anything that we as Members of this Committee 
can do to help financial institutions grow and remain profitable with 
jeopardizing safety and soundness. All of you are the experts of the 
your sector. You know your sector much better than we do. I look 
forward to hearing your opinions.
     Thank you again for holding this hearing Mr. Chairman and I thank 
all of our witnesses for testifying today.

                               ----------
                PREPARED STATEMENT OF SENATOR MIKE CRAPO

    I look forward to your testimony on the condition of the banking 
and credit union industry. In addition, I am interested in what issues 
you believe should or should not be considered in a regulatory relief 
package to improve the condition of the banking and credit union 
industry. As you are all aware, the House recently passed the Financial 
Services Regulatory Relief Act by a vote of 392 to 25.
    A regulatory relief package should eliminate outdated, ineffective, 
or unduly burdensome regulations that are not justified by either the 
need to ensure safety and soundness or to provide consumer protection.
     Outdated laws and regulations only serve to squander scarce 
resources that could otherwise be used to provide financial services 
demanded by customers. The banking industry estimates that it spends 
somewhere in the neighborhood of $25 billion annually to comply with 
regulatory requirements imposed at the Federal and State levels.
     While finding a consensus on these issues may be difficult, I look 
forward to working with you and my colleagues on this Committee to 
begin the process of taking up regulatory relief in the Banking 
Committee.

                               ----------
                  PREPARED STATEMENT OF ALAN GREENSPAN
       Chairman, Board of Governors of the Federal Reserve System
                             April 20, 2004

    Chairman Shelby, Senator Sarbanes, and Members of the Committee, I 
am pleased to be here this morning to discuss the condition of the U.S. 
banking system and various related matters. They include improved risk-
management practices of banks, the current status and direction of our 
regulatory efforts to revise capital standards for internationally 
active banks, deposit insurance, and the ongoing consolidation process 
within our domestic banking industry.
    Growth in the size and complexity of the largest U.S. and foreign 
banking organizations, in particular, has substantially affected 
financial markets and the supervisory and regulatory practices of the 
Federal Reserve and other bank regulatory agencies around the world. It 
has, in part, required authorities to focus more than before on the 
internal processes and controls of these institutions and on their 
ability to manage risk. Only through steady and continued progress in 
measuring and understanding risk will our banking institutions remain 
vibrant, healthy, and competitive in meeting the growing financial 
demands of the Nation while keeping systemic risk at acceptable levels. 
Therefore, the regulatory authorities must provide the industry with 
proper incentives to invest in risk-management systems that are 
necessary to compete successfully in an increasingly competitive and 
efficient global market.
    When I last discussed the condition of the banking industry with 
this Committee in June 2001, the industry's asset quality had begun to 
decline, but from a relatively high level, and banks were generally 
well-positioned to deal with the emerging problems. Moreover, as early 
as the late 1990's, both the industry and bank supervisors had begun to 
address the slippage in credit standards that was one of the causes of 
the drop in asset quality. By most measures, this was an unusually 
early stage in the economic cycle to begin addressing such 
deterioration.
    Today, with the benefit of hindsight, we can see that the 
weaknesses I cited then have indeed been mild for the banking system as 
a whole and that the system remains strong and well-positioned to meet 
customer needs for credit and other financial services. During the past 
2 years, in particular, the industry extended its string of high and 
often record quarterly earnings. For the full year 2003, commercial 
banks reported net profits of more than $100 billion while maintaining 
historically high equity and risk-based capital ratios and enjoying 
brisk asset growth. Although the demand for business loans and the 
underwriting of equity securities have been weak over the past few 
years, banking organizations have continued to benefit from strong 
demand for household credit, not least for residential mortgage 
products as interest rates declined substantially.
    Moreover, the volume of problem assets in commercial banks declined 
each quarter last year, including a drop in the fourth quarter of 
nearly 10 percent, which brought the ratio of problem assets to total 
loans and foreclosed assets to less than 1 percent--its lowest level 
since year-end 2000. As a result of this favorable performance, both 
the size and the number of bank failures in recent years have been 
exceptionally small. Last year, for example, only two banks, with 
combined assets of just $1.5 billion, failed.
    The results of last year's interagency review of large syndicated 
loans and internal reports about the level and distribution of their 
criticized and classified credits lead us to expect still further 
improvement in the industry's asset quality this year. Notably, the 
pool of ``special mention'' credits that are weak but still performing 
(and which tend to produce the more serious problem assets) has shrunk 
both in the annual Shared National Credit review and in the quarterly 
bank reports.
    Risk measures derived from prices of publicly traded bank 
securities--stocks, debt securities, and credit default swaps--also 
signal that market participants are taking an increasingly positive 
view of the future of banks. Indeed, these measures suggest the lowest 
level of market concern about these companies that we have seen during 
the 5 years in which we have tracked them.
    The banking industry's relatively benign experience with loan 
losses these past few years may not be surprising given that the 
recession was mild by most measures. The experience is more notable, 
however, when one considers the broader range of shocks and 
developments that have occurred during this period, including the 
September 11 attacks, Argentina's credit default, the continuing shift 
by large and not-so-large firms in this country from bank to capital 
market financing, and the concentration of recent economic pressures on 
specific industries and business sectors. These events tended to reduce 
the overall quality of corporate loan portfolios at banks and 
contributed significantly to banks' efforts to improve their 
measurement and management of risks, especially after the substantial 
credit losses they suffered in the late 1980's and early 1990's. These 
efforts, aided by the continued trend toward industry consolidation, 
helped moderate previous concentrations of credit exposures in bank 
portfolios and fueled greater use of new methods of hedging and 
managing risk.
    At present, credit risk-management practices are perhaps least 
developed in measuring risk associated with exposures related to 
construction projects and to the financing of commercial real estate, 
which have grown rapidly, particularly among regional and community 
banks. At all banks, such lending represented nearly 19 percent of all 
bank loans at year-end 2003--the highest level thus far recorded--and 
accounted for essentially all the loan growth last year at banks with 
less than $1 billion in assets.
    Despite the limited development of formal risk-management 
practices, credit standards applied to these loans have apparently been 
quite high. At least, we see as yet no signs of rising credit losses 
from such lending, and supervisory and market sources indicate that the 
poor lending practices of the late 1980's and early 1990's have been 
largely avoided. Nonetheless, the historical record provides ample 
evidence of the risks associated with this form of lending and of 
accumulating large credit concentrations in any form of exposure. 
Supervisors continue to monitor these concentrations and the lending 
practices and market conditions that will ultimately determine their 
effects on the banking system.
    These and other gradual changes in the balance sheets of banks, 
along with the sustained decline in market rates, helped compress net 
interest margins at many banks, as they chose not to reflect the full 
effect of lower market rates into rates paid on deposits without a 
specified maturity. As a percentage of earning assets, net interest 
income of all insured commercial banks declined 27 basis points last 
year, to 3.80 percent, the lowest level in more than a decade. Although 
this compression eased slightly during the fourth quarter, we cannot 
yet tell whether margins have begun to rebound.
    This compression of margins needs to be understood in the fuller 
context of the banks' sensitivity to changes in interest rates and, in 
particular, the effect of historically low rates on banks' financial 
performance and condition. At the same time that declining rates were 
adversely affecting the industry's interest margins, they were also 
spurring growth in mortgage-related assets and associated loan-
origination fees and were producing significant capital gains in bank 
investment portfolios. Lower interest rates, along with the decline in 
equity valuations experienced during 2000-2002, also contributed to a 
substantial inflow of liquid deposits by lessening their opportunity 
cost.
    Under these circumstances, and with a steep yield curve, a banker's 
natural inclination might be to shift the credit mix and extend the 
maturity of assets in an 
attempt to bolster asset yields. To some extent such actions have been 
taken. Residential mortgage loans and pass-through securities have 
increased from 17.5 percent of assets in 2000 to 20 percent in 2003. 
But the manner in which this growth has occurred suggests a balanced 
assessment of risk. Call Report data indicate that a substantial 
portion of the increase in mortgage assets has been in adjustable-rate 
or shorter-term mortgages, particularly at smaller banks. For their 
part, large institutions also have significant capacity to offset on-
balance-sheet exposures through off-balance-sheet transactions.
    All told, the available data, industry and supervisory judgments, 
and the long and successful experience of the U.S. commercial banking 
system in dealing with changing rates suggest that, in general, the 
industry is adequately managing its interest rate exposure. Many banks 
indicate that they now either are interest-rate neutral or are 
positioned to benefit from rising rates. These views are based partly 
on specific steps that they have taken to adjust portfolios and partly 
on judgments about the effects that rising interest rates would have in 
easing pressure on interest margins. That is, many banks seem to 
believe that as rates rise--presumably along with greater economic 
growth--they can increase lending rates more than they will need to 
increase rates paid on deposits. Certainly, there are always outliers, 
and some banks would undoubtedly be hurt by rising rates. However, the 
industry appears to have been sufficiently mindful of interest rate 
cycles and not to have exposed itself to undue risk.
    In other areas, earlier concerns about the effect of the century 
date change on computer systems, the destruction of infrastructure in 
the September 11 attacks, and the increased volume and scope of banking 
transactions generally have also required financial institutions, 
particularly large institutions, to devote more effort and resources to 
contingency planning in order to ensure the continuity of their 
operations. Last fall's power outage and Hurricane Isabel may have 
offered only limited tests of the industry's improved procedures, but 
financial firms handled those challenges extremely well.
    As the Nation's central bank and as a bank supervisor, the Federal 
Reserve has a strong interest in the continued operation of the U.S. 
financial system after a disruptive event. To that point, last year, 
the Federal Reserve Board, the Securities and Exchange Commission, and 
the Office of the Comptroller of the Currency jointly issued an 
interagency paper, ``Sound Practices to Strengthen the Resilience of 
the U.S. Financial System.'' That paper provides guidance that 
supplements long-standing principles of business continuity planning 
and disaster recovery and is directed at the entities that pose 
systemic risk to the financial system, particularly in the context of 
their clearing and settlement activities. Through the Federal Financial 
Institutions Examination Council, we also issued revised examination 
guidance on business continuity planning. This guidance covers a 
variety of threats to business operations, including terrorism, and 
will be used in future examinations.
Improved Risk Management in Banks
    Independent of continuity planning for unusual events, the basic 
thrust of recent efforts to improve the management of risk has been 
better quantification and the creation of a formal and more-disciplined 
process for recognizing, pricing, and managing risk of all types. In 
the area of credit risk, by providing those involved with a stronger, 
more-informed basis for making judgments, this development has 
enhanced the interaction between lending and risk-control officers. 
Operating with better information does not mean that banks will 
necessarily reduce credit availability for riskier borrowers. It does 
mean that banks can more knowingly choose their risk profiles and price 
risk accordingly. Better, more-informed lending practices should also 
lead to a more-efficient allocation of scarce financial capital to the 
benefit of the economy at large.
    Greater internal transparency and quantification of risk have 
helped bank managers monitor portfolio performance and identify aspects 
of the risk-measurement and credit-granting process that begin to move 
off track. As risk-measurement and disclosure practices evolve, 
investors and uninsured creditors will also become more motivated and 
better positioned to understand the risk profile of banks and convey 
their own views of banking risks. Indeed, accommodating greater and 
moreinformed market discipline is an important goal of bank 
supervisors.
    Perhaps most important, better risk management has already begun to 
show real potential for reducing the wide swings in bank credit 
availability that historically have been associated with the economic 
cycle. Sound procedures for risk quantification generally lead to 
tighter controls and assigned responsibilities and to less unintended 
acceptance of risk during both the strengthening and weakening phases 
of the business cycle. Earlier detection of deviations from 
expectations leads to earlier corrective actions by bank managers and, 
as necessary, by bank supervisors.
    Better methods for measuring credit risk have also spurred growth 
in secondary markets for weak or problem assets, which have provided 
banks with a firmer, sounder basis for valuing these credits and an 
outlet for selling them and limiting future loss. Insurance companies, 
hedge funds, and other investors acquire these assets at discounts that 
they judge are sufficient to meet their expected returns and balance 
their portfolio risks. The result is greater liquidity for this segment 
of bank loan portfolios and the earlier removal of weakening credits 
from bank balance sheets. Portfolio risks have also been increasingly 
hedged by transactions that do not require asset sales, such as 
derivatives that transfer credit risk.
    With greater use, more-thorough review, and more-extensive 
historical data, risk modeling has improved in accuracy and will 
continue to do so. Supervisors are also learning these techniques and 
are pressing banks to improve their own methods and systems to keep up 
with the latest developments. In the United States, our leading banking 
organizations began the process years ago and, in many respects, were 
in the vanguard of the effort worldwide. Nevertheless, they and the 
risk-measurement process itself have much further to go.
    Recent initiatives of the Basel Committee on Banking Supervision to 
revise international capital standards have helped focus attention on 
risk-measurement practices and have encouraged further investment in 
this area. Moreover, the very 
improvements in technology that facilitated better bank risk 
measurement and management have undermined the current regulatory 
capital regime by creating transactions and instruments that were not 
conceived when the current regulatory standard was developed.
    Although these developments have sometimes helped banks circumvent 
existing rules, they have also enabled banks to hedge portfolio risk in 
ways that the current accord does not address well. As a result, the 
current regulatory capital standard is increasingly unable to establish 
capital requirements for our largest and most-complex banking 
organizations that reflect their true underlying risks. We need a more 
accurate, more risk-sensitive measure of capital adequacy to provide 
these institutions with appropriate risk-management incentives and to 
provide ourselves with a more reliable basis for supervising them in a 
way that focuses on true risks. In the process, such a measure should 
also enhance our efforts in taking prompt corrective action. For all 
these reasons, I believe the U.S. banking agencies must remain 
committed to the process of developing and applying a revised 
regulatory capital standard for the world's international banks.
Proposed Capital Standards
    Last summer, the U.S. banking agencies took another step toward 
adopting the new capital standard by issuing for public comment an 
advance notice of proposed rulemaking (ANPR). The conception and design 
of the proposed standard, referred to as Basel II, are based on 
techniques developed in recent years by the largest banks, especially 
those, as I noted, in this country. As the scale and complexity of 
their activities grew, the banks needed to find better and more 
efficient ways to understand, manage, and control their risk-taking 
activities; to promote and respond to the emergence of new markets, 
such as those for securitized assets; and to make greater use of 
available technology and financial theory in measuring and managing 
their risks.
    Before the agencies issued the ANPR, numerous changes in the 
proposed Basel II Accord had already been made in light of earlier 
comments. Reflecting the comments received on the ANPR, the Basel 
Committee agreed to extend the period for reaching an agreement in 
principle until mid-2004 to permit more time for revisions of the 
proposal to be formulated. Indeed, we have already negotiated some 
major changes in the international proposal to reflect U.S. public 
comments. These changes include the adoption of a framework based on 
unexpected loss and a revised set of rules on securitization. We have 
also modified the implementation process to ease the burden on banking 
organizations that operate across borders. These technical changes were 
high on the list of modifications suggested by commenters.
    The shift from a combined ``expected'' and ``unexpected'' loss 
framework to one that focuses on unexpected loss only is crucial to 
ensuring that the regulatory capital framework is consistent with 
standard internal banking practices, both here and abroad. That change 
will also simplify other parts of the proposal. The modification on 
securitization was imperative to permit U.S. banks to continue 
participating in important funding markets that they pioneered and to 
ensure a prudent risk-sensitive capital treatment for securitization 
exposures. Beyond these achievements, working groups in Basel are 
considering other U.S. proposals related to refining measures of 
expected loss, an issue that a number of commenters raised. The U.S. 
agencies are still trying to reach a consensus on a revised proposal 
for capital charges on retail credit to put before our colleagues in 
Basel. The Federal Reserve, for its part, will continue to make every 
effort to reach consensus on this issue that is both risk-sensitive and 
workable.
    I believe that all the Federal banking agencies are committed to 
achieving a revised accord that reflects the realities of the 21st 
century; that meets our needs for a safe, sound, and competitive 
banking system; and that addresses the legitimate concerns of the 
industry. The Federal Deposit Insurance Corporation has raised 
important issues about capital adequacy, and the Office of the 
Comptroller of the Currency has expressed significant concerns about a 
capital structure that may inadvertently disrupt retail credit 
operations of banks. All the agencies are addressing these concerns by 
jointly developing proposals to bring to Basel. In working to reach 
full agreement among ourselves, and ultimately with our colleagues 
abroad, we all seek a solution that promotes sound banking practices 
and that we can adequately implement and enforce. I hope that in the 
days ahead the agencies can close the gap on credit cards within such 
an overarching framework.
    If we can do so, the Basel Committee should be able to reach 
agreement in principle on a new proposal around mid-year, and the U.S. 
banking agencies expect to evaluate that proposal through another 
``quantitative impact study'' that we plan to conduct at large U.S. 
banks this fall. Committee Members are aware that this survey and 
public comments on a forthcoming Notice of Proposed Rulemaking may 
raise still further issues that will need to be addressed before we can 
implement Basel II in the United States. Of course, other countries 
have their own national and European Union-wide review processes to 
conclude, and those consultations too, may raise issues that will 
require additional attention.
    As this Committee knows, the U.S. agencies have proposed that in 
this country the most-advanced version of Basel II is to be required 
only of the largest, most-complex banking organizations, although we 
anticipate that some of the other larger banks also will choose to 
adopt that version. Non-adopters in the United States will continue to 
operate under the current capital rules. The current regulatory capital 
regime, as I noted, has become less effective for the largest 
organizations while consolidation has sharply increased the scale and 
scope of their activities. In this country, the Basel II proposal 
focuses on them. The current rules remain appropriate and prudent for 
other banking organizations in the United States, and the agencies have 
decided that imposing the cost of new rules on these banking 
organizations does not pass a cost-benefit test.
    Nonetheless, change in the procedures for calculating regulatory 
capital for larger banks creates uncertainty among those entities to 
which the new rules would not apply. The comments we received on the 
ANPR and from the Congress last year indicate that some smaller banks 
are concerned that their competitive environment will change. More 
specifically, these fears include the possibility that Basel II will 
induce adopters, who are likely to have reductions in regulatory 
capital requirements, to redeploy their capital by acquiring 
nonadopters or to gain a competitive advantage, particularly in the 
markets for small business and residential mortgage loans.
    To judge the merits of these concerns, the Federal Reserve 
conducted two technical and empirical analyses of the underlying issues 
and made the papers available to the public last month; Congressional 
staff members were also briefed. A third study will be completed 
shortly, and a fourth will commence soon.
    The first of these papers, dealing with mergers and acquisitions, 
found virtually no statistical support for the view that either the 
level of, or changes in, excess regulatory capital have played a role 
in past merger and acquisition decisions, which suggests that any 
future effect of Basel II on such decisions is also likely to be quite 
small. Moreover, reductions in regulatory capital requirements for 
adopters relative to the requirements for nonadopters are unlikely to 
lead to an acceleration in the pace of consolidation.
    The second study evaluated the likely effect of Basel II on the 
competition between adopters and nonadopters in the market for small- 
and medium-sized business loans. It estimated that the marginal cost of 
such loans at adopting banks would decline no more than about 16 basis 
points, on average, and is likely to decline by less than that in most 
cases.
    Importantly, the study also found that most small business loans 
made by community banks are sufficiently different from those made by 
either required or likely adopters of Basel II as to make any marginal 
cost differences virtually irrelevant. Moreover, being riskier, the 
small business loans made by most community banks are priced so much 
above the loans made by the large banks that the marginal cost benefit 
to adopters would not be a material competitive factor. The study did 
find, however, that the types of small- and medium-sized business loans 
made by adopters and other large banks are, indeed, similar and 
similarly priced, so that adopting institutions may have a competitive 
advantage in many cases over other large banks that choose not to adopt 
Basel II. I will return to the implication of this finding in a moment.
    A paper analyzing competitive effects in the residential mortgage 
market will be available later this spring, and once the U.S. agencies 
agree on a proposal regarding the treatment of credit cards, staff 
members can begin analyzing potential competitive effects of the 
proposal in that market, as well. All four papers will then be re-
evaluated early next year when new data become available from the 
agencies' next quantitative impact study.
    If the evidence following these reviews and a public comment 
process suggests that implementation of bifurcated capital standards in 
this country may affect competition in certain markets, the proposals 
for Basel II may need to be reconsidered. We may need, for example, to 
modify the application of Basel II in the United States, where 
permissible under the Basel agreement; negotiate further changes in the 
international agreement itself; or change the way the current capital 
rules are applied to institutions that do not adopt the new standard.
    In short, if we have sufficient indications that implementation of 
a new capital standard will distort the balance of competition, we can 
and will apply policies to mitigate this effect consistent with the 
risk profile of individual institutions. We cannot, however, respond to 
an unsubstantiated and generalized fear of change. Such concerns should 
not halt the evolution of regulatory capital standards for the large, 
complex banking organizations that play such an important role in our 
banking system and in global financial markets.
Bank Consolidation
    Legislation designed to deregulate U.S. banking markets, 
technology, and other factors have contributed to significant 
structural change in the banking industry and to a decline of nearly 40 
percent in the number of banking organizations since the mid-1980's, 
when industry consolidation began. Consolidation activity has slowed 
sharply in the past 5 years, but a recent uptick in merger 
announcements, including a couple of very large transactions, may 
signal a return to a more rapid pace of bank merger activity. Since 
1995, the 10 largest U.S. banking organizations have increased their 
share of domestic banking assets from 29 percent to 46 percent at year-
end 2003. Yet, over the past decade, roughly 90 percent of bank mergers 
have involved a target with less than $1 billion in assets, and three-
quarters have involved an acquiree with assets of less than $250 
million.
    This ongoing consolidation of the U.S. banking system has not, in 
my judgment, harmed the overall competitiveness of our banking and 
financial markets. Although they have facilitated consolidation, the 
reduced barriers to entry--such as were provided by the Riegle-Neal 
Act's relaxation of interstate banking laws--have provided net 
competitive benefits to U.S. consumers of financial services.
    Other economic forces, such as technological change and 
globalization, have stimulated competition among depository 
institutions and between depositories and nonbank providers of 
financial services. In addition to other credit-extending businesses, 
our system of depository institutions alone continues to be 
characterized by many thousands of commercial banks, savings 
institutions, and credit unions. Measures of concentration in local 
banking markets, both urban and rural, have actually declined modestly 
not just since 2000 but since the mid-1990's. Significantly, most 
households and small and medium-sized businesses obtain the vast 
majority of their banking services in such local markets.
Deposit Insurance
    I would like to turn now to the issue of deposit insurance reform 
and to the need for some legislative change in this area. As the 
Committee knows, most depository institutions have not paid any deposit 
insurance premiums since 1996, and in fact, some large institutions 
that have been chartered in the past 8 years have never paid them at 
all. Under current conditions, not only is a Government guarantee being 
provided free, but also depositories having similar or identical risks 
are exposed to potentially disparate treatment should one, but not the 
other, of the deposit insurance funds fall below its funding target. In 
that situation, the FDIC would be required to impose a charge on one 
set of depository institutions while continuing to provide free deposit 
insurance to those in the other fund. Because some depository 
institutions today have commingled BIF- and SAIF-insured deposits as a 
result of bank and thrift mergers, this disparate treatment could apply 
even to different deposit accounts within the same depository 
institution.
    At this time, the Congress has the opportunity to provide the FDIC 
with greater flexibility to charge risk-based premiums, possibly using 
market data (for example, rates on uninsured deposits) for the largest 
banks, to allow such premiums to increase or decrease in a gradual 
manner over a wider range of fund reserve ratios, and to treat all 
depositories with similar risk ratings equally and equitably. Such 
reforms should be implemented in a manner that does not unnecessarily 
create additional moral hazard and that strengthens, rather than 
erodes, market discipline.
    Higher coverage limits, for example, would exacerbate moral hazard 
problems without apparent and offsetting benefits. The current level of 
coverage seems adequate to meet the needs of an overwhelming majority 
of depositors. First, depositors have certain flexibility in 
distributing large balances among multiple accounts and depository 
institutions to obtain higher insurance coverage. Second, the Federal 
Reserve's latest survey of consumer finances indicates that at year-end 
2001 less than 4 percent of U.S. depositor households had any uninsured 
deposits. Moreover, the median bank IRA/Keogh account balance was only 
$15,000, well below the existing insurance limit. Finally, community 
banks have shown themselves just as adept as the largest banks in 
attracting uninsured deposits when necessary to fund customer loan 
demand.
Conclusion
    In closing, let me reiterate that the past decade has been one in 
which the banking industry has recorded persistent record profits while 
providing an ever-wider range of products and services to much more 
diverse groups. The industry's experience during the past several years 
in dealing with clear weakness in key economic sectors demonstrates the 
importance of strong capital positions and sound risk-management 
practices. Bank supervisors worldwide are working to encourage further 
progress in these areas, through more-accurate and more-effective 
regulatory capital standards based on even better internal risk-
management procedures.

                               ----------
                PREPARED STATEMENT OF JOHN D. HAWKE, JR.
      Comptroller of the Currency, U.S. Department of the Treasury
                             April 20, 2004

Introduction
    Chairman Shelby, Senator Sarbanes, and Members of the Committee, I 
appreciate this opportunity to review the condition of the national 
banking system. My written statement covers two principal areas.
    First is the continued strong performance and condition of the 
national banking system in the face of a changing banking environment. 
National banks continue to display strong earnings, improving credit 
quality following the recent recession, and sound capital positions. 
That continued strong performance reflects, in general, past good 
lending and investment decisions. In addition, to some extent, that 
performance reflects changes in business strategies and risk management 
practices. Banks have adopted better risk management techniques and 
have benefited from greater geographic diversification. Nonetheless, 
risks remain, including the growing importance of operating, strategic, 
and reputation risk as banking companies adapt to change by using 
technology, different products or strategies, or more complicated 
business structures.
    Second, we continue to adapt supervision to the changes in banking. 
Among the most important strategies we employ to maximize the 
effectiveness of our examination and supervision program is our risk-
focused approach to supervision, which is designed to address change. 
That risk-based approach has enabled us to turn increasing attention to 
operating, strategic, and reputation risk.
    The approach that the U.S bank regulators have taken to the effort 
to reform international bank capital standards, known as Basel II, 
provides a distinct example of how we are adapting to change. While we 
recognize that we can improve capital regulation to take into account 
changes in banking and risk management, we have advocated proceeding 
with appropriate caution. In my statement today, I will discuss the 
proposed capital reform and the commitment I have made that any reforms 
of the regulatory capital rules will be adopted in a prudent, 
deliberate fashion.
The Condition of the National Banking System
    The OCC supervises federally chartered national banks and federally 
licensed branches of foreign banks. As of year-end 2003, the national 
banking system consisted of approximately 2,100 banks (26 percent of 
all commercial banks). Of these, 2001 were FDIC-insured banks, holding 
total assets of $4.3 trillion. The rest were uninsured bank and trust 
companies. The OCC also supervises 53 Federal branches of foreign 
banks. While the number of national banks has declined for nearly two 
decades, and the assets of the system have steadily increased over the 
same period, the national bank share of total system assets has 
remained roughly constant, and now stands at 56.5 percent. The national 
banking system includes many of the largest banks by asset size, but 
community national banks are by far the most numerous in the system.



Financial Performance
    The financial performance and condition of the banking system is 
strong. Earnings have remained at historically high levels for a 
decade. Until 2002, aggregate net income for national banks had never 
exceeded $12.5 billion in a quarter, and the industry's average return 
on assets had never exceeded 11.5 percent, at least not since the 
quarterly reporting began in 1984. But since the beginning of 2002, 
national banks have exceeded both earnings milestones in every quarter 
but one. In 2003, national banks set new records for both return on 
equity and return on assets. Although the slow economy led to weakness 
in some areas, including business lending, the contractions in these 
areas were more than offset by growth elsewhere.



    Total loans held by banks continued to expand throughout the recent 
economic cycle, growing by 7.8 percent in 2002 and 7.6 percent in 2003. 
In contrast, starting with the recession of 1990-1991, total loans held 
by national banks fell for 10 consecutive quarters. Where the earlier 
recession affected all sectors of the economy, the recent recession was 
concentrated more extensively in the business sector, in part due to 
the fallout from the tech/telecomm bubble in the late 1990's. This 
caused a sharp fall in the demand for business loans, particularly at 
large banks.
    The reduction in corporate lending by banks also was due to the 
competitiveness of corporate bond issuance due to low interest rates. 
Many large and even medium-size firms have been able to access the bond 
market at very low rates throughout this economic slowdown, which has 
further reduced the demand for larger commercial loans. This has 
affected especially the lending activity at the largest banks, because 
they tend to have potential business customers who have greater access 
to other financial options. Community banks, in contrast, taking 
advantage of their knowledge of local markets and business needs, have 
maintained their business lending throughout this cycle, with increases 
reported in their commercial and industrial (C&I) and commercial real 
estate loan books.



    The mortgage and consumer sectors have been a strong source of loan 
growth for national banks. Residential real estate loans held by 
national banks rose at an annual rate of about 20 percent in both 2002 
and 2003. Within this broad category, home equity lending has grown 
particularly fast, rising by 21 percent in 2001, 38 percent in 2002, 
and 37 percent in 2003. Throughout this cycle, consumers have taken 
advantage of declining mortgage rates to extract funds from the 
increased value of their homes. Some of these funds from the 
refinancing and home equity loan activity have been used, however, to 
pay off higher interest credit card and installment debt.
    The low interest rate environment has been a plus and minus for 
banks. Smaller banks with their greater reliance on retail funding have 
seen steady erosion in their net interest margins. By contrast, the 
largest banks, which rely more on wholesale funding, until recently 
experienced relatively high net interest margins. As of December 2003, 
the net interest margin for banks in all asset size groups has fallen 
below their historic averages. Despite the decline in margins, banks 
have reported continued growth in net interest income due to the strong 
expansion in household lending. As long as margins remain compressed, 
however, this growth in income is vulnerable if the volume of activity 
in the consumer markets falls.
    The low interest rate environment also raises concerns about the 
extent to which banks may be taking on interest rate risk in an effort 
to maintain their interest income. Effective management of this risk 
will be important for banks in all asset size groups as the economy 
recovers, which is often accompanied by an increase in interest rates. 
We have alerted national banks to our concerns on this score and 
provided advice on approaches on how best to address this ``low rate 
set-up.''
    Deposits have continued to flow into banks, especially large banks, 
as might be expected when low interest rates hold down returns on 
alternative money market instruments. Deposits at national banks grew 
at 6.0 percent in 2001, 7.6 percent in 2002, and 8.6 percent (year-
over-year) in 2003. The increase in deposits has fueled growth in bank 
assets. The assets of national banks grew 9.8 percent in 2003 (year-
over-year), as compared to a 0.1 percent decline reported at this point 
of the recovery from the last recession. Nevertheless, we believe banks 
must be vigilant in their assessment of the potential sensitivity of 
their sources of funds to changes in the economic environment or, in 
some cases, the bank's own performance. The high level of liquidity in 
the banking system could be reduced rapidly if the relative yield on 
alternative investments increased sharply or if banks failed to 
maintain certain performance levels required to retain some sources of 
funds.



    While credit quality deterioration is typically an issue during 
recessions, the most recent experience for national banks was much 
better than during the previous recession. This may well reflect 
national banks' response to cautions issued by the OCC to bankers in 
the late 1990's to be vigilant about their underwriting standards. The 
noncurrent loan ratio for national banks (loans at least 190-days past 
due plus nonaccruals) reached a peak of 4.4 percent in 1991Q2; in 
contrast, at the peak in this economic cycle, reported in 2002Q2, the 
noncurrent ratio was 1.6 percent. For large banks (over $1 billion in 
assets), the noncurrent loan ratio has now declined to 1.3 percent, 
near prerecession levels. Smaller banks (under $1 billion in assets) 
were not as affected by the stresses in the nonfinancial corporate 
markets and thus experienced only a modest decline in credit quality 
during the recession. And while credit quality appears to be improving 
for the banking industry, the OCC continues to watch developments in 
areas that remain vulnerable, such as small business lending and 
certain real estate markets and property types.
    The data on bank failures and new entrants to the commercial 
banking system also reflects a dynamic and healthy banking system. In 
2003, two banks failed--one national and one State bank. By contrast, 
100 commercial banks--including 33 national banks and 67 state banks--
failed in 1992, the first year of recovery after the 1990-1991 
recession. The commercial banking system also had 111 new entrants in 
2003; this compares to 40 new banks in 1992.
    While the national banking system has displayed strong performance, 
even during the recent recession, history teaches us that we cannot 
know for certain what lies ahead, and banks' capital provides important 
protection against that uncertainty. National banks remain well-
capitalized and rest on a much firmer capital base than they did more 
than a decade ago. In 1990, for example, 6.3 percent of banks had risk-
based capital ratios below 8 percent, which we would now consider 
undercapitalized, and 18.3 percent were below 10 percent. Today, all 
national wholesale banks, with the exception of a few small banks under 
special supervision, have risk-based capital ratios above 8 percent, 
and more than 90 percent of national banks have risk-based capital 
ratios above 10 percent.
Continued, Gradual Change in Bank Strategies
    Like other businesses, banks adjust their strategies in response to 
the lasting changes in their business environments. Over past decades, 
bank business strategies in the United States have evolved in response 
to changes in household financial practices, advances in financial 
knowledge and information and communication technology, and the 
relaxation of constraints against interstate banking and allowable bank 
activities. Since such changes are gradual, they are sometimes hard to 
recognize. Nonetheless, they result in real changes in the nature of 
the business.
    For example, one change is an increase in the relative emphasis on 
lending to households, especially among the large banks. Over the last 
20 years, large banks have moved increasingly into retail lending to 
take advantage of cost-saving technologies and geographic 
diversification in a period of strong growth in the demand for retail 
products. In 1984, 30 percent of aggregate commercial bank loans were 
to households--residential mortgages, and loans to individuals. By 
2003, that ratio had risen to 46 percent. The increased emphasis on 
retail lending has been particularly pronounced in the largest banks. 
Among the largest 10 banks, the retail portion of bank loan portfolios 
has increased from 22 percent to 55 percent over the last two decades.



    Another strategic change in banking is the improvement in financial 
risk management--the tools, products, and processes. Since the last 
business cycle, banks have made substantial investments in this area. A 
fundamental shift in approach is occurring, from viewing risk on a 
transaction-by-transaction basis to a more holistic, portfolio view. 
Advances in technology have enabled banks to harness information to 
manage more proactively the risks in their portfolios. These include 
more sophisticated models to help banks underwrite and manage their 
credit risks and to conduct scenario analyses of their interest rate 
and liquidity risks.
    Concurrent with the adoption of these enhanced tools has been the 
development of independent risk management units with responsibility 
for enterprise-wide risks. These units, which typically reside at the 
highest level of the corporation, oversee portfolio risk, balance the 
risks and rewards of new business strategies and initiatives, and 
ensure that business units and the bank as a whole comply with 
established risk tolerances and limits.
    Risk management also has benefited from the broader array of 
products and tools that banks can use to adjust and manage their risk 
profiles. These tools help to foster deeper and broader financial 
markets and ultimately help to allocate risks to participants in 
accordance with their risk appetite and performance objectives. For 
example, banks have been particularly successful in reducing their 
exposures to credit concentrations. The growth of the syndicated loan 
market has enabled banks to more broadly distribute credit exposures 
within the U.S. banking system, as well as to foreign banking 
organizations and nonbanks. Similarly, the expanding asset 
securitization market has provided banks with another avenue to manage 
concentration risks and to diversify their funding sources and to 
provide greater access to underserved markets.
    The growth in the derivatives markets has provided banks with 
additional tools to manage their credit and interest rate risk 
exposures. Derivatives are also a valuable risk management product to 
help banks' institutional customers manage a broad array of risks 
arising from common business activities such as securing long-term 
funding or protecting the value of importing or exporting commercial 
goods. Banks' increased participation in residential real estate 
lending is one example of how derivatives have enabled banks to expand 
their product offerings while managing their risk profiles. Although 
residential real estate lending is typically associated with low credit 
risk as a consequence of diversification, solid collateral, and the 
borrower's vested interest, it can represent high exposure to interest 
rate risk. With the advent of products to hedge interest rate risk, 
such as interest rate swaps and options, banks have been able to expand 
their lending in this area while managing the risk of potential shifts 
in interest rates. In the absence of effective mechanisms to hedge such 
risks, it is unlikely banks would have been able to participate as 
actively in the growth of this sector.
Growing Importance of Operating, Strategic, and Reputation Risk
    Notwithstanding the strong financial performance and condition of 
the banking industry, and improvements in the management of key 
financial risks, critical challenges remain. Chief among these is the 
need for banks to avoid missteps, abuses, or perceptions that could 
undermine the confidence and trust of their customers or financial 
markets. Recent events have demonstrated that bank soundness is much 
more than just a function of financial strength and that the risks 
facing the banking industry extend beyond the financial risks--credit, 
liquidity, and interest rate risks--that have traditionally been the 
focus of bankers and regulators. Increasingly, bankers must be 
cognizant of and control the operational, strategic, and reputation 
risks posed by their activities and how their activities will be 
perceived by the markets and their customers. A thorough evaluation of 
those risks and their potential impact on a bank's longer-term 
strategic direction and its relations with its customers is paramount 
and must override pressures from management, analysts, or shareholders 
to increase short-term earnings at the expense of fundamental controls 
and safeguards.
    Many of the recently publicized problems facing the industry have 
stemmed from breakdowns in key governance and control areas: 
Insufficient oversight and due diligence in reviewing or considering 
complex financial transactions or new product lines; lapses in security 
controls and the safeguarding of customer information; over-reliance on 
third parties for critical services or product generation; and failure 
to adhere to sound internal audit and control procedures and processes. 
These breakdowns are not limited to banks of a specific size, market or 
product niche. Community banks have suffered losses stemming from over-
reliance on loans, investments, and services purchased from third-party 
vendors--often in an effort to augment otherwise lackluster loan 
demand. Several large banks have faced significant questions about 
their dealing with customers and alleged improper oversight and 
management of key product lines.
Keeping Pace with Change in the National Banking System
    Change is a consistent theme in the operation--and the 
supervision--of the national banking system today. National banks must 
evolve their businesses if they are to remain competitive in today's 
financial services markets. At the same time, the OCC must adjust its 
supervisory and regulatory approaches in order to ensure that national 
banks can avail themselves of all of the attributes of their charter 
safely and soundly. Among the most important strategies we have 
developed to maximize the effectiveness of our examination and 
supervisory program is our risk-focused approach to supervision.
The OCC's Risk-Focused Approach to National Bank Supervision
    OCC's supervision by risk approach dates back more than 10 years 
and involves supervisory policies and processes that tailor our 
oversight to the key characteristics of each bank, including asset 
size, products offered, markets in which it competes, and the board's 
and management's tolerance for risk. This process provides an effective 
means for the OCC to allocate our supervisory resources and to better 
communicate to senior bank management the areas where they may need to 
correct 
problems before they become entrenched.
    Risk-based supervision begins with an assessment of a banking 
organization's existing and emerging risks, and management's efforts to 
manage and control those risks, in nine specified risk areas: Credit, 
liquidity, interest rate, price, foreign exchange, transaction, 
compliance, strategic, and reputation. Based on that assessment, the 
OCC examiner-in-charge or portfolio manager will develop and implement 
a detailed, supervisory strategy for the bank, based on its risk 
profile and the complexity of its lines of businesses. Examiners 
identify areas of highest risk, assess what management is doing to 
address those risks, and communicate regularly with management to 
indicate where additional management actions are needed. In performing 
this evaluation, OCC examiners consider not only the activities of the 
bank and its operating subsidiaries, but also how the bank's risk 
profile is affected by the activities of other subsidiaries and 
affiliates.
    Our assessment of the integrity and effectiveness of a bank's risk 
management systems includes appropriate validation through transaction 
testing. If this produces concerns, we will ``drill down'' to test 
additional transactions. And if this reveals problems, we have a 
variety of tools with which to respond, ranging from informal 
supervisory actions directing corrective measures, to formal 
enforcement actions, to referrals to other regulators or law 
enforcement. The examination procedures implementing OCC's supervision 
by risk program are documented in the Comptroller's Handbook.
    Supervision by risk provides an effective way to supervise banks in 
the current rapidly changing environment. It also allows us to apply a 
consistent supervisory methodology across an increasingly diverse group 
of banks and bank activities. Because the design of this approach 
requires that we customize an examination based on a bank's underlying 
risk characteristics, it allows us to more effectively direct OCC 
resources to the banks or activities within banks exhibiting the 
greatest risk.
    In response to the growing divergence in the complexity and scope 
of operations between large and small banks, we have divided our day-
to-day supervisory operations into two lines of businesses--our 
Community and Mid-size Bank program and our Large Bank program.
    Our Community/Mid-size Bank line of business oversees over 2,000 
national banks and Federal branches and agencies through our network of 
district, field, and satellite offices. When examining this population 
of banks, examiners use a core set of examination procedures to draw 
conclusions about the magnitude of risk and the adequacy of the risk 
management system for each of the nine areas of risk. Even in low-risk 
banks, we sample, verify, and test the bank's policies, procedures, and 
systems. When risks are elevated; when activities, products, and 
services are more complex or present greater financial or compliance 
risks; or when issues or problems emerge, examiners will expand the 
scope of their supervisory activities using more detailed guidance 
found in topical booklets of the Comptroller's Handbook series. 
Periodic monitoring of community banks, another key element of the 
supervisory process, is also designed to identify changes in the bank's 
condition and risk profile, including new products or services, and to 
assess bank corrective action on outstanding supervisory concerns 
between formal onsite examinations. This quarterly monitoring process 
allows examiners to identify significant changes in the risk profile of 
the banks they supervise on a timely basis.
    Our Large Bank program focuses on the 24 largest national banks. 
The supervision of each large bank, overseen out of our headquarters 
office, is staffed by a resident examiner-in-charge and a team of 
examiners and specialists in areas such as commercial and retail 
credit, capital markets, bank technology, asset management, and 
compliance. These examiners and specialists track the quantity and 
quality of risk management in real time so that our assessments are 
forward-looking, as well as historical. This program allows the OCC to 
develop a more thorough knowledge of the bank than is possible through 
the traditional regime of periodic, discrete examinations. Over the 
years, we have also developed, tested, and refined this supervisory 
approach expressly to address the special financial and compliance 
challenges posed by bigger, more complex, and globally positioned 
banks. We are confident that this approach will be effective to 
supervise the ``mega-banks,'' those with assets of a trillion dollars 
or more, which are forming as a result of recent acquisition activity 
in the industry.
    Today's national banking system operates not just nationally, but 
globally. Our large banks all have operations or a presence overseas. 
The expansion of our large banks' operations across various legal 
entities and geographic boundaries puts an increased premium on 
coordinating our supervisory responsibilities with other domestic and 
foreign regulators. Domestically, we and the other banking agencies 
build upon each other's supervisory reviews and databases. We routinely 
share reports of examination and other agency-institution 
communications and provide each other with access to our organizations' 
structure, financial, and supervisory information. To help facilitate 
and coordinate our supervision of large, complex institutions, we share 
information on proposed examination and supervisory activities for the 
coming year and coordinate the planning and execution of those 
activities. When appropriate, we hold joint meetings with institutions 
involving matters of mutual 
interest and may conduct coordinated reviews or examinations where a 
business activity is conducted across legal entities. Our London office 
provides us with examiner expertise to interact with foreign 
supervisors and provides a platform to examine national bank branches 
overseas. Our London examiner staff provides a critical network to deal 
with home/host country issues, information sharing issues, and 
outsourcing issues. We also participate in the Foreign Banking 
Organization program (along with the Federal Reserve Board) to examine 
and supervise Federal branches and agencies in the United States.
    We also are deeply involved in the development of international 
bank supervision policy through our participation in the Basel 
Committee on Banking Supervision and in the Joint Forum, which is an 
international group of banking, securities, and insurance supervisors; 
through our regular dialogue with foreign banking regulators; and 
through our international and technical assistance programs that 
provide training and internship opportunities to bank supervisors. In 
fact, not long ago we detailed to the Treasury Department four 
experienced examiners who are now working in Iraq.
    To help meet the challenges of an ever more complex banking 
industry, our resident and field examiners and specialists are 
supported by a team of policy specialists, analysts, accountants, and 
economists in our headquarters office who monitor industry, market and 
economic trends, provide technical expertise, and develop analytical 
tools and models to support our examination functions. For example, our 
``Canary'' system monitors and identifies banks that may have high or 
increasing levels of credit, liquidity, or interest rate risks. Our 
credit risk and economics staffs have developed various analytical 
tools that assist examiners to identify portfolio or industry 
concentrations where risk may be increasing for more in-depth 
investigation. Our Risk Analysis unit--staffed by Ph.D. economists--
provides on-site technical assistance to our resident staff in 
evaluating banks' quantitative risk models and measurement systems. Our 
National Risk Committee serves as a coordinating body to gather and 
disseminate information from throughout the OCC and the financial 
markets on emerging risk issues and advises me and the OCC's Executive 
Committee on a quarterly basis of emerging issues and potential policy 
and supervisory responses.
    Our combination of continuous on-site supervision, with the 
``ground level'' intelligence it provides on each individual bank's 
activities and strategies, coupled with our broader, systemic risk 
analyses, allows us to quickly adjust our supervisory strategies to 
emerging risks and issues that may arise at individual institutions, 
within business segments or across the industry as a whole. It also 
allows us to leverage the diverse skill sets that are needed to 
supervise our most complex institutions effectively.
Response to the Growing Importance of Operating, Strategic, and 
        Reputation Risk
    To address the growing importance of these nonfinancial risks, we 
have taken a number of steps to strengthen our supervision and 
oversight in the critical areas of audit and corporate governance. In 
April 2003, we issued an updated examination booklet on Internal and 
External Audits. This booklet sets forth our expectations that well-
planned, properly structured, and independent auditing programs are 
essential to effective risk management and internal control systems. 
The revised booklet incorporates issues related to recent events 
related to audit programs, including the independence provisions of the 
Sarbanes-Oxley Act and the implementing rules and regulations of the 
Securities and Exchange Commission.
    We have also updated our booklet, ``Detecting Red Flags in Board 
Reports--Guide for Directors.'' This guide provides a bank's board of 
directors with an overview of information generally found in board 
reports and highlights various ``red flags''--ratios or trends--that 
may signal existing or potential problems.
    In response to the continued evolution of banking products and 
structures, the OCC's Committee on Bank Supervision has recently 
directed the formation of an internal group within the OCC to oversee 
and evaluate how new banking products and structures may affect our 
supervisory activities. This review committee will function similar to 
the new product review committees found at some of our larger 
institutions. The committee will have membership from our various 
supervisory operations, risk, legal, and information technology units.
    We have also taken steps with the other U.S. banking agencies in 
the areas of audit and corporate governance. For example, in August 
2003, the agencies issued final joint rules that strengthen their 
authorities to take disciplinary actions against independent public 
accountants and accounting firms that perform audit and attestation 
services required by Section 36 of the Federal Deposit Insurance Act. 
The rules establish procedures under which the agencies can, for good 
cause, remove, suspend, or bar an accountant or firm from performing 
audit and attestation services for insured depository institutions with 
assets of $500 million or more. In March 2003, the agencies issued an 
updated ``Interagency Policy Statement on the Internal Audit Function 
and Its Outsourcing'' to reflect provisions of the Sarbanes-Oxley Act 
and SEC rules regarding auditor independence. The revised policy 
statement also provides enhanced discussion of the responsibilities of 
a bank's board of directors and senior management with respect to 
internal audit and reiterates the need for banks to maintain strong 
systems of internal controls and high quality internal audit programs.
    More recently, the OCC has worked with the Federal Reserve Board 
and the Securities and Exchange Commission to develop an interagency 
statement on sound practices for conducting complex structured finance 
activities. These activities generally involve the structuring of cash 
flows and the allocation of risk among borrowers and investors to meet 
the specific objectives of the customer in more efficient ways. They 
often involve professionals from multiple disciplines within a 
financial institution and may be associated with the creation or use of 
one or more special purpose entities designed to address the economic, 
legal, tax, or accounting objectives of the customer. In the vast 
majority of cases, structured finance products and the roles played by 
financial institutions with respect to these products have served the 
legitimate business purposes of customers, and these products have 
become an essential part of U.S. and international capital markets. A 
limited number of complex transactions appear to have been used to 
alter the appearance of a customer's public financial statements in 
ways that are not consistent with the economic reality of the 
transaction, or to inappropriately reduce a customer's tax liability.
    The interagency statement, which we expect to soon publish in the 
Federal Register for comment, describes the types of internal controls 
and risk management procedures that can assist financial institutions 
to identify and address the reputation, legal and other risks 
associated with complex structured transactions. The statement, among 
other things, provides that financial institutions should have 
effective policies and procedures in place to identify those complex 
structured finance transactions that may involve heightened reputation 
and legal risk, to ensure that these transactions receive enhanced 
scrutiny by the institution, and to ensure that the institution does 
not participate in illegal or inappropriate transactions. The statement 
also emphasizes the critical role of an institution's board of 
directors and senior management in establishing a corporate-wide 
culture that fosters integrity, compliance with the law, and overall 
good business ethics.
    While regulatory and supervisory initiatives such as these are 
important to help banks manage operational, strategic, and reputation 
risks, it is incumbent on the banking industry to assume primary 
responsibility for its own conduct in these areas. In a speech last 
year before the American Bankers Association, where I discussed the 
issues of fair dealing and treatment of customers, I stressed that the 
ultimate protection for banks is to instill in all employees a 
dedication to the highest standards of fairness and ethical dealing; to 
make clear to employees that no loan, no customer, no profit 
opportunity is worth compromising those standards; and to take swift 
and decisive action where those standards are violated. The OCC is 
committed to be vigilant in this area and has and will continue to take 
responsive action when we discover abuses or weaknesses. I expect 
bankers to do the same.
Basel II Developments
    Because national banks have international as well as domestic 
operations, the OCC must--and we do--become involved in the development 
of approaches to bank supervision at the international level. 
Currently, the most significant of these approaches is the ongoing 
effort to revise the 1988 Basel Capital Accord. Let me just briefly 
provide you a status report on this effort. There have been a number of 
articles in the press in recent weeks about positions that U.S. 
regulators, and the OCC in particular, may be taking that I believe 
warrant some clarification and amplification.
    First, let me stress that my U.S. colleagues and I share an 
overarching goal that Basel II be implemented in a manner that is 
entirely consistent with the safety and soundness and continued 
competitive strength of the U.S. banking system.
    As I have said, banks' current financial and capital positions are 
strong, but as the industry continues to evolve, so does its risk 
profile. Recognizing and adapting to changing risk profiles and 
changing risk management practices is critical to maintaining those 
strengths. These observations inform our approach to negotiations in 
the Basel Committee on Banking Supervision regarding Basel II. However, 
while we recognize that we can and should improve capital regulation to 
take into account changes in banking and risk management, a basic tenet 
in our negotiations over reform of the international capital standards 
is to do no harm. U.S. banks are world leaders in many aspects of 
banking--credit cards and securitizations, for example--and we must 
assure that these important markets are not disrupted or impaired in 
the name of achieving international conformity in capital rules. In 
view of the fundamental strength and resilience of the U.S. financial 
system, we believe that reforms to our regulatory and supervisory 
structure must be adopted in a prudent, reflective fashion.
    Thus we are fully committed to three things: First, an open 
rulemaking process in which comments are invited and considered, good 
suggestions are heeded, and legitimate concerns are addressed; second, 
a reliable quantitative analysis in which we can assess the likely 
impact of Basel II on the capital of our banks prior to its adoption; 
and third, a prudent implementation in which we make well-reasoned and 
well-understood changes to bank capital requirements and incorporate in 
those changes appropriate conservatism. In this regard, I welcome the 
questions and issues that Members of this Committee and its staff have 
raised about this important project and I have repeatedly stressed to 
the Basel Committee the important role that Congressional oversight 
plays in our deliberative process.
    The U.S. agencies' insistence on a thorough and rigorous 
deliberative process already has resulted in important modifications to 
the Basel II proposals. One of the most significant of these issues--
and one that U.S. banks were virtually unanimous in criticizing in 
response to the Basel Committee's third consultative paper (CP-3)--
involved the fundamental question of what losses capital requirements 
should be designed to cover. CP-3 would have calibrated capital to 
ensure coverage of both expected losses (EL) plus unexpected losses 
(UL). However, banks in the United States today generally measure and 
manage their internal economic capital allocations by reference to UL 
only, and most banks consider EL to be covered by a combination of 
reserves and credit pricing. As we examined this issue, we became 
convinced not only that the banks were conceptually correct in their 
arguments, but that retaining the EL plus UL calibration would have 
severe ramifications--not the least of which might be to seriously 
jeopardize the industry's acceptance of Basel II framework as being a 
conceptually sound framework. While many on the Basel Committee 
resisted this initially, the Committee ultimately put forth a new 
proposal in October to modify the calibration of Basel II to UL only. 
This modification was strongly endorsed by industry participants and 
has now been agreed to by the Committee.
    The Committee announced several other important modifications to 
CP-3 in January that are responsive to numerous comments we received on 
CP-3 and the U.S. agencies' advanced notice of proposed rulemaking 
(ANPR) that was issued last August. These modifications include 
simplifying the proposed treatment for securi-
tizations and aligning it more closely to industry practice and an 
agreement to find a prudentially sound solution that better recognizes 
credit mitigation techniques used by the industry. Other issues are 
still under discussion by the Committee's various technical working 
groups and are scheduled to be considered by the Committee at its 
meeting in May.
    Probably the most difficult policy issue remaining involves the 
appropriate risk-based capital treatment of certain retail credit 
products--unused credit card lines in particular. This issue is 
critically important for national banks and for the cost and 
availability of consumer credit. It is also an area in which consensus 
has been hard to come by. Given the prominence of the retail lending 
business for U.S. banks, and for national banks in particular, there is 
little room for substantive compromise, and the OCC will not accept 
provisions that are likely to unduly disrupt or disadvantage 
established, well-functioning business practices. We believe that this 
issue will be resolved in a manner that appropriately addresses safety 
and soundness objectives without altering legitimate business 
practices.
    Notwithstanding the difficulty of these issues, the Committee's 
goal is to be in a position by mid-year to release a text that will 
provide the basis for each country's national implementation process. 
Let me reiterate that point: The release of the next round of proposals 
does not represent a final agreement or accord; rather, it is the 
platform from which we will launch our more in-depth domestic 
deliberative process. In the United States, that process will have 
several key steps.
    First, the U.S. agencies will conduct a fourth quantitative impact 
study (QIS 4) in the third and fourth quarters of this year. This study 
will be based on the Committee's mid-year release and will differ in 
some important aspects from the Basel Committee's earlier quantitative 
studies. QIS-4 will not only be conducted against the background of a 
more fully articulated proposal, but will also include a more prominent 
supervisory role to ensure greater reliability and consistency in 
survey results than has occurred in the past. We continue to believe 
that we cannot responsibly adopt final rules implementing Basel II 
until we have both determined with a high degree of reliability what 
the impact will be on the capital of our banks, and we have made the 
judgment that the impact is acceptable and conducive to the maintenance 
of a safe and sound banking system in the United States. We believe the 
results of QIS 4 will be more useful than any data we currently have in 
determining the magnitude of the impact of Basel II on bank capital and 
potential competitive inequities, as well as determining ultimately 
what to do about them.
    Second, in another effort to increase our practical understanding 
of the effects of Basel, the U.S. agencies have commenced an 
operational risk benchmarking review at a number of the largest 
institutions. Information obtained through this effort will enhance 
agency understanding of current qualitative and quantitative 
operational risk practices and will assist agency efforts to develop 
additional supervisory guidance and training materials for banks and 
examiners on the operational risk component of Basel II. Throughout 
this period we will continue our dialogue with banks and other 
interested stakeholders on various issues that Basel II may raise.
    Those projects and discussions will help us in the third key step 
in Basel implementation, developing a joint notice of proposed 
rulemaking (NPR) that will set forth the proposed regulatory text for 
Basel II in the United States. Currently we anticipate that such an NPR 
will be released for public comment in late 2005 or early 2006. At the 
OCC, we have made a preliminary determination that this rulemaking will 
be a ``significant regulatory action'' for purposes of Executive Order 
12866. Consequently, we will prepare and submit to the Office of 
Management and Budget's (OMB) Office of Information and Regulatory 
Affairs (OIRA) an economic analysis that includes:

 a description of the need for the rules and an explanation of 
    how they will meet the need; an assessment of the benefits 
    anticipated from the rules together with, to the extent feasible, a 
    quantification of those benefits;
 an assessment of the costs anticipated from the rules together 
    with, to the extent feasible, a quantification of those costs; and
 an assessment of potentially effective and reasonably feasible 
    alternatives to the planned regulation and an explanation why the 
    planned regulatory action is preferable to the identified potential 
    alternatives.

    We have begun discussions with the OMB's OIRA regarding how these 
analyses will be designed and conducted. Our analysis will be published 
as part of our notice and comment process.
    Finally, as the rulemaking process for the domestic implementation 
of Basel II moves forward, we and the other U.S. agencies are exploring 
the implications that Basel II may have on nonmandatory banks and what, 
if any changes we should make to our capital regulations for those 
banks. Any such changes will, of course, be subject to public notice 
and comment.
    As my testimony conveys, while we have made important strides in 
trying to develop a more risk-sensitive capital framework for 
internationally active banks, there is still a long way to go before 
Basel II is completed and adopted. As I have repeatedly stated before 
Congress and in the Basel Committee, a new accord cannot be completely 
finalized until national implementation procedures have been completed 
and I am committed to a notice and comment process that is open and 
fair and responsive to public comments. The OCC and other U.S. agencies 
have recognized the possibility that, even in the late stages, public 
comments might reveal flaws in the proposal that will need to be 
addressed before we can issue final implementing regulations. The OCC's 
ultimate willingness to sign onto Basel II is going to depend on 
whether we are satisfied with the final product.
Conclusion
    In conclusion, Mr. Chairman, the national banking system is sound, 
and its recent performance has been strong. It has successfully 
weathered the recent recession, and it is responding in dynamic fashion 
to the changes in the financial services marketplace. The OCC, too, is 
keenly focused on keeping pace with change--by improving the approaches 
we use to supervise the industry, and by striving to ensure that 
national banks remain the safe and sound, competitive, and high 
integrity engines of our economy that they were designed to be. We look 
forward to working productively with you, with the Members of this 
Committee, and with State officials as we pursue our efforts to achieve 
that goal.

                               ----------
                 PREPARED STATEMENT OF DONALD E. POWELL
            Chairman, Federal Deposit Insurance Corporation
                             April 20, 2004

    Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank 
you for the opportunity to testify on behalf of the Federal Deposit 
Insurance Corporation regarding the condition of FDIC-insured 
institutions and the deposit insurance funds. My testimony will briefly 
review the recent record earnings and outstanding financial performance 
of FDIC-insured institutions and the condition of the deposit insurance 
funds, touch upon potential risks to the industry, and discuss the 
implications of industry consolidation and some related questions that 
we believe will drive discussions among banking policymakers going 
forward.
Condition of FDIC-Insured Institutions and the FDIC Insurance Funds
    I am pleased to report that FDIC-insured institutions are as 
healthy and sound as they have ever been. The industry earned a record 
$31.1 billion in the fourth quarter of 2003, marking the fourth quarter 
in a row that earnings set a new high. The results for the fourth 
quarter also brought the industry's earnings for the full year to a 
record $120.6 billion, surpassing the previous annual record of $105.1 
billion set in 2002. The return on assets (ROA) in the fourth quarter 
and for the entire year was 1.38 percent, equaling the quarterly record 
set earlier in the year and easily surpassing the previous all-time 
annual high of 1.30 percent in 2002.
    Underlying the current financial strength of the industry have been 
the cumulative effects of the 10-year economic expansion of the 1990's 
and certain factors that tended to insulate banks from the most severe 
effects of the 2001 recession. Improvements in underwriting and risk 
management practices helped to limit the effect of credit losses on 
industry earnings during and after the recession. Meanwhile, strong 
growth in mortgage loans, a steep yield curve, new sources of fee 
income and cost containment efforts by banks helped boost the net 
operating income of the industry. Record earnings 2 years in a row, 
record returns-on-assets, and a strong capital foundation are all 
indicators that banks not only weathered the recent economic downturn--
but also have been a source of significant strength for the economy and 
for the American consumer.
    This strength is mirrored in the strength of the FDIC's insurance 
funds. As of December 31, 2003, the balance of $33.8 billion in the 
Bank Insurance Fund (BIF) represented 1.32 percent of estimated BIF-
insured deposits, well above the statutory target reserve ratio of 1.25 
percent. The Savings Association Insurance Fund (SAIF) ratio stood at 
1.37 percent at year-end 2003, with a balance of $12.2 billion. The BIF 
reserve ratio rose during 2003 as expected losses fell, while the SAIF 
reserve ratio remained essentially unchanged from year-end 2002. A 
combined BIF and SAIF fund would total $46 billion with a reserve ratio 
of 1.33 percent of estimated insured deposits.
    In November 2003, the FDIC Board of Directors voted to maintain the 
existing BIF and SAIF premium rate schedules for the first half of 
2004. The FDIC's analysis indicates that it is unlikely the reserve 
ratio for either fund will fall below the statutory target of 1.25 
percent in the near future. For example, with the BIF ratio at 1.32 
percent, assuming no deposit growth, insurance losses on the order of 
$1.8 billion would be required to drop the ratio to 1.25 percent. For 
insured deposit growth alone to reduce the ratio to this level, 
assuming no change in the BIF fund balance, growth of nearly 6 percent 
would be required. Neither BIF insurance losses nor BIF deposit growth 
has approached these magnitudes recently, and we do not foresee any 
combination of insurance losses and deposit growth that would drive the 
reserve ratio near 1.25 percent in the coming months, although these 
forces could result in a decline from current ratios. As a result, we 
do not foresee a need for additional premium income at this time.
    As you are aware, the FDIC's concerns about the deposit insurance 
system relate to the way it is structured. We cannot price deposit 
insurance based on risk, we cannot manage the fund's size relative to 
our exposure, and we maintain two funds even though the historic 
rationale for doing so has gone away. There is broad agreement on the 
key elements of a deposit insurance reform package and the FDIC remains 
willing to work with this Committee to achieve reform as soon as 
possible.
Potential Risks
    We cannot assume that the economic environment of the next decade 
will necessarily be as favorable to the industry as our recent 
experience. The world is changing in unprecedented ways and the FDIC 
continuously monitors economic conditions and emerging risks in the 
banking industry in order to maintain its 
preparedness. The primary vehicle for monitoring and addressing risk is 
the supervisory process, which has been enhanced significantly over the 
past decade. Moreover, as the banking industry has become more 
sophisticated, the FDIC has created cutting edge risk management 
techniques to identify, measure, and manage risk to the insurance 
funds. The cornerstone of FDIC's risk management philosophy and 
practice is an integrated, multidisciplinary approach that brings 
together economists, examiners, financial analysts, and others to 
analyze and respond to risks in the system.
    Using this approach, the FDIC expects continued good performance 
for the banking sector, based on the industry's solid fundamentals and 
generally favorable economic conditions. The economy grew at a 6 
percent annual rate during the last half of 2003 and is expected to 
grow at a 4 percent pace this year.
    Despite the generally positive recent economic news, our integrated 
analysis reveals several trends that could pose difficulties for the 
banking industry and the FDIC in the future. The FDIC analyzes risks 
that are generally known to exist as well as risks that appear to have 
a low probability of occurring, but would have a high impact if they 
did. The intent of our analysis is to ensure we are capturing all risks 
that could affect the banking industry and the deposit insurance funds.
    It is important to recognize the volatility of financial markets 
and the potential for disturbances to spread throughout the system. In 
today's interconnected financial system, problems that initially appear 
to be localized could lead to a more widespread loss of confidence with 
a resulting impact on liquidity throughout the system. This issue bears 
watching to ensure that financial market disruptions do not produce 
significant banking problems going forward. The major actors in the 
financial markets are large, well-diversified organizations that 
continue to grow. Later in my testimony, I will discuss the increasing 
shares of industry assets, deposits, and revenues held by just a few 
large banking organizations and the implications of this trend for the 
future of banking.
    Another area of concern is household balance sheets. The household 
sector has been the engine for banking growth through the 2001 
recession and beyond, but sources of concern include the near record 
pace of personal bankruptcies--exceeding 1.5 million in 2003--and 
rising household indebtedness. Total household debt is at an historical 
high of 112 percent of disposable personal income. The lowest mortgage 
rates in more than a generation have prompted households to take out 
$1.4 trillion in new mortgage debt since the end of 2001. Household 
indebtedness also increased as a result of a market and technology-
driven revolution in consumer lending that created a system with 
unprecedented access to credit and convenience in its use.
    Perhaps even more important than the absolute level of debt is the 
fact that the amount of money households must pay to keep debts current 
is increasing. This is occurring despite the prolonged period of low 
interest rates, which would normally be expected to lower debt service. 
Homeowners now use about 14 percent of disposable income to meet their 
major financial obligations, versus about 12 percent in 1993. The 
increase in renters' financial obligations is even more striking at 
about 31 percent of disposable income versus about 24 percent in 1993. 
Escalating household indebtedness raises concerns about the 
sustainability of the growth in 
consumer spending, especially when interest rates rise. A trail-off in 
consumer spending could also occur once the effects of the 2003 tax cut 
and 2003 mortgage refinancing boom run their course.
    Escalating household debt raises concerns about the sustainability 
of consumer spending and the ability of borrowers to meet obligations 
when interest rates rise. In particular, households that have a greater 
exposure to variable rate consumer loans and adjustable rate mortgages, 
and those with weaker credit histories and balance sheets, could 
experience some problems meeting their obligations. A related concern 
is that rising interest rates could cause some stress in certain 
housing markets, where prices have been more volatile than the rest of 
the Nation.
    However, this is uncharted territory. The commoditization of credit 
has created a much more sophisticated financial economy that may be 
able to tolerate higher and rising debt levels. Our concerns are 
tempered, however, by the strength of household assets and the 
strengthening job and wage data we have seen in recent months.
    In particular, I am concerned that those at the margins of the 
credit system will be adversely affected. Households that have greater 
exposure to variable rate consumer loans and adjustable rate mortgages 
and those with weaker credit histories and balance sheets could 
experience some problems meeting their obligations. Often, these are 
consumers who lack a basic understanding of how money works in our 
society--and therefore lack the tools necessary to save and manage 
money. That is why I believe that promoting the financial education of 
our society's unbanked segment is one of the FDIC's most important 
goals, and why the FDIC has developed the Money Smart financial 
literacy program.
    Since the rollout of Money Smart, FDIC has distributed more than 
111,000 copies of the curriculum and trained over 5,000 instructors. 
Money Smart is currently available in English, Spanish, Chinese, 
Korean, and Vietnamese. The FDIC has taken the lead in establishing 
financial education partnerships with communities and bankers. The FDIC 
has entered into over 600 local Money Smart Alliances across the 
country, including national partnerships with the U.S. Department of 
Labor, the U.S. Department of Housing and Urban Development, the 
Association of Military Banks of America, Goodwill Industries 
International, the National Coalition for Asian Pacific American 
Community, and the Internal Revenue Service. Last year, for example, 
the FDIC's work during the 2002 tax season with the ``Back of the 
Yards'' voluntary income tax assistance site in Chicago helped over 600 
families file tax returns and receive $1.1 million in earned income tax 
credit refunds. Many of these families also opened their first bank 
accounts through this initiative.
    Another challenge facing banks is high concentrations in commercial 
real estate. As of the fourth quarter 2003, national vacancy rates for 
office, retail, and warehouse space stood at or near historic highs of 
17.9 percent, 12.9 percent, and 10.5 percent, respectively, and were 
even higher in some markets. Nevertheless, commercial real estate 
concentrations at banks are high and increasing. The national median 
concentration of commercial real estate to capital is 164 percent, up 
from 92 percent in 1993. Moreover, concentrations are particularly 
heavy in the West and Southeast. In our San Francisco and Atlanta 
Regions, the median commercial real estate concentrations are 327 
percent and 284 percent, respectively.
    So far, poor commercial real estate fundamentals have not resulted 
in loan performance problems at banks--national charge off rates are 
below 0.1 percent and the nonperforming ratio is 0.8 percent. Improved 
underwriting and regulatory requirements, increased public ownership 
and transparency of commercial real estate transactions, and low 
interest rates have all acted to buffer banks from commercial real 
estate losses. Despite the good performance to date, given the 
significant problems that resulted from commercial real estate in the 
late 1980's and early 1990's, the FDIC has implemented enhanced 
commercial real estate monitoring programs, particularly in areas with 
very heavy concentrations.
    As with the household sector, there are concerns that some 
commercial real estate borrowers could be affected if debt service 
increases due to a rise in interest rates. On the other hand, rising 
interest rates are normally accompanied by resurgence in economic 
activity. For commercial real estate, that could mean an increase in 
potential renters and rental rates. Nevertheless, the high and rising 
``twin deficits''--national and trade debt--coupled with the ongoing 
fall of the dollar have raised some concerns about a dollar collapse. 
While a collapse seems unlikely, given foreign reliance on dollar 
holdings, among other factors, it could lead to a rise in rates without 
concurrent economic growth.
Implications of Industry Consolidation
    The ongoing consolidation of the banking industry means that there 
are a few very large institutions that represent an increasingly 
significant share of the FDIC's exposure. Once the recently announced 
mergers are complete, there will be three banking companies whose 
assets are in the range of $1 trillion each. Their combined assets will 
account for approximately 30 percent of the assets of FDIC-insured 
institutions. The next four largest holding companies will have assets 
in the range of $200 to $400 billion, and they will account for another 
13 percent of industry assets. The top 25 banking companies hold over 
one-half of industry assets, while the top 100 hold almost three-
quarters.
    The largest banking institutions are global, highly diversified 
organizations. They are positioned well to absorb losses from local 
economic problems or idiosyncratic risks in any particular lines of 
business. The external risks posed to these firms are essentially macro 
risks--reflecting the same factors that could threaten the entire 
financial system. Thus, the major risk the deposit insurance system 
faces is the risk that the economy or the financial system would suffer 
extreme deterioration.
    In the absence of extreme economic or financial disruption, the 
risk from these companies arises from the challenges of managing such 
large, complex organizations. Should these internal risks result in 
significant problems at a large bank, the situation could also pose 
risks to the system as a whole. This is why it is so important for 
owners, managers, and directors of these organizations to adhere to the 
standards of good corporate governance and risk management and for 
regulators to ensure that these standards are met.
    To enhance our understanding of the risks these institutions may 
pose, the FDIC has placed dedicated examiners in the eight largest 
institutions. These dedicated examiners work closely with the resident 
examination staff of the primary Federal regulator.
    One question we face is whether the consolidation of the banking 
industry has gone too far or will go too far in the future. Or 
conversely, is the 10 percent deposit cap increasingly an impediment to 
the appropriate market evolution of the industry?
    First, I would note that the degree of consolidation is a relative 
notion. Compared to the industry 20 years ago, banking is certainly 
more consolidated. But compared to other industries or banking systems 
in other countries, it does not appear to be. We are not close to 
having a banking organization with branches in all 50 States. A 
standard measure of industry concentration is the market share of the 
top five firms in an industry. Table 1 provides this measure for major 
U.S. industries. As the table shows, banking is a relatively 
unconcentrated industry by this measure. In fact, banking is less 
concentrated than the table would indicate, since the table compares 
only publicly traded companies and less than 10 percent of banks and 
thrifts are publicly traded.



    There appear to be several public policy reasons for the 10 percent 
deposit cap. One purpose of the cap is to protect bank customers from 
anticompetitive behavior that can result from a highly concentrated 
industry. This makes sense, but it is not clear why banks should be 
treated differently in this regard from other firms. The banking 
industry is highly competitive, and standard antitrust measures appear 
sufficient to ensure that it will continue to be competitive.
    Another purpose for limiting banks to a 10 percent share of 
national deposits is to limit the concentration of risk that any one 
bank poses to the deposit insurance system and the financial system in 
general. As mentioned earlier, the most significant risk to these banks 
is the risk of severe economic disruption, and I would offer two 
observations here. The first is that during the past two decades the 
economy has experienced longer periods of expansion and a milder 
recession. This reflects: (1) the benefits of what has been called the 
free-market consensus; (2) the ability of a transformed financial 
system to absorb economic shocks; and (3) generally sound monetary and 
fiscal policies. So long as these factors remain in place, it seems 
reasonable to expect performance over the business cycle to be 
generally favorable.
    Of course, we cannot rule out adverse scenarios. The question, 
then, is whether it matters under such scenarios if the assets of the 
industry are largely concentrated in a dozen or so banks or in just a 
handful.
    Putting aside risk stemming from the economy or overall financial 
system, the next question involves the risk posed by a single banking 
organization. The risk would seem to hinge on the tradeoff between the 
benefits of scale and diversification and the challenges of managing 
large complex organizations. The performance of large banks in recent 
years suggests the tradeoff has thus far been favorable.
    As we move forward, my sense is that regulators, policymakers, and 
market participants will be able to assess whether the tradeoff remains 
favorable. Put simply, if these banks show signs of becoming too-big-
to-manage, I would expect the market to slow, if not reverse, the 
course of consolidation and regulators to impose stricter sanctions. 
Ultimately, if these measures are absent or ineffective, I would expect 
policymakers to step in. This approach seems to be a better gauge of 
the appropriate scale of banking organizations than does an arbitrary 
fixed cap.
    My bias is to let market forces determine the evolution of the 
banking industry. I believe this has served us well in the post-crisis 
period and I expect that it will continue to be the best way to ensure 
that banks are meeting the needs of households and businesses.
    Having said that, it is apparent that continued consolidation will 
present challenges to how the FDIC administers the deposit insurance 
system. The fact that our risk is increasingly concentrated in the 
largest banks has implications for how we assess risk, the appropriate 
way to fund deposit insurance, and the implications of problems at, or 
the failure of, a large bank.
    In terms of assessing risk, the FDIC obviously relies heavily on 
the efforts of the bank examiners and supervisors at the FDIC and our 
sister agencies. This has served us well and I expect it will continue 
to do so. From a purely financial point of view, however, it seems that 
the risk the FDIC faces is not that dissimilar from the risks that the 
market prices on a regular basis. As large banks evolve, the FDIC could 
look more to market instruments--like reinsurance contracts or 
catastrophe bonds--to help us assess our large-bank exposure.
    With respect to funding deposit insurance, one question that often 
arises (and indeed did so the last time this panel appeared before this 
Committee) is whether the deposit insurance funds are adequate to 
handle the failure of a large bank. Some rough numbers may be helpful 
here. We have historical data on the losses per dollar of assets at 
failed banks. This loss rate has been lower for large banks than for 
smaller ones. The loss rate for larger banks has been in the 
neighborhood of 5 to 10 percent, although there are some caveats to 
note here. The first is that the largest failures involved banks in the 
range of $40 billion in assets--nothing approaching the size of the 
largest banks today. Second, this experience is largely from the period 
before prompt corrective action, least-cost resolution, and depositor 
preference. With that in mind, assuming a loss rate of 5 percent, the 
failure of a $1 trillion bank would cost $50 billion. This is just 
slightly more than the two deposit insurance funds combined.
    Of course, if a large bank were to fail, the question arises as to 
whether it should be handled under the systemic risk exception provided 
for in FDICIA. As you know, this provision requires that the FDIC 
Board, the Federal Reserve Board, and the Secretary of the Treasury be 
in agreement that the bank should be handled outside the bounds of the 
normal ``least-cost'' manner. I should stress that even if this 
judgment were made, it does not mean that shareholders and all 
creditors will be protected from loss.
    Suppose that, in our example, the finding of systemic risk resulted 
in a loss rate that approached the higher end of the range mentioned 
above. A 10 percent loss rate would result in a cost of $100 billion. 
Congress in FDICIA made it clear that this additional $50 billion would 
be funded by an ex-post assessment on the banking industry and placed 
more heavily on the larger banks.
    To put these amounts in perspective, FDIC-insured institutions 
earned $120 billion last year and hold additional capital above the 
well-capitalized level in the amount of nearly $200 billion. This 
capital stands behind the funds and would be available to shield 
taxpayers in the event of a large failure.
Related Questions for Policymakers
    While we are certainly pleased with the current condition of the 
industry and the strength of the bank safety net, banking is in the 
midst of a profound transformation. The role of banks in the 
marketplace has changed in the past 20 years and this transformation 
continues apace. There are some concerns that banks' share of the 
financial pie has been shrinking. While some have argued that banks are 
``dinosaurs,'' banks actually have been reforming their intermediary 
role in important ways that have propelled them to a more competitive 
position in the financial marketplace. They now provide better products 
and services for their customers, and deliver record earnings for their 
shareholders. Banking organizations remain a critical part of the 
modern flow of funds that has broadened the availability of credit in 
the U.S. economy.
    Nonetheless, while banking organizations have prospered, 
traditional banking--the combination of deposit-taking and commercial 
and industrial lending--has 
become a smaller part of the financial system and of banking 
organizations themselves. Bank commercial and industrial lending has 
declined sharply relative to total lending, falling from about 25 
percent of total nonfinancial business sector debt 50 years ago to 
slightly more than 15 percent. Traditional business lending also makes 
up a smaller share of commercial banking's loan portfolio. Operating 
loans to businesses now constitute less than a fourth of total 
commercial bank lending--down from 40 percent 20 years ago. Moreover, 
banks have lost ground in the competition for savers' funds. Since 
1980, the total value of money market, mutual fund, and deposit 
instruments in the United States grew from just under $2 trillion to 
some $11.6 trillion. During this time, the share of these instruments 
issued by money market funds and mutual funds increased from 7 percent 
to 55 percent, while the share issued by banks fell from 90 percent to 
41 percent.
    Along with the consolidation trend, these developments raise some 
fundamental questions for policymakers that relate to safety-net 
arrangements as well as bank regulation and supervision.
    Federal deposit insurance was designed specifically to protect 
traditional bank intermediation. A continuing challenge is how best to 
protect the stability of the system as savers' choices continue to 
expand and bank deposits become less important in the overall financial 
system. Federal deposit insurance works well for traditional community 
banks. For the largest banking organizations, as they increasingly 
engage in diverse, nontraditional activities, it makes sense to 
consider whether different safety-net arrangements might be more 
suitable for this segment of the industry. Since some aspects of our 
regulatory system already are tailored to recognize the differences 
between large and small institutions, we should consider the explicit 
creation of a two-tiered safety net that better addresses these 
differences.
    In many respects, we already have the makings of a two-tiered 
approach. First, large banks are supervised by teams of examiners who 
are in residence year-round while small banks are visited at regular 
intervals by either Federal or State regulators. Second, large banks 
are much more exposed to the discipline of the capital markets and the 
ratings agencies--both of which serve to assist regulators in gauging 
the banks' conditions. Third, current law permits a two-tiered system 
of pricing deposit insurance. Fourth, we are negotiating a capital 
accord, Basel II, which will result in a two-tiered system of capital 
regulation--one for large, internationally active institutions and one 
for all others. Finally, if a large bank gets into trouble and 
threatens the overall system, our laws contemplate the possibility that 
it could be resolved outside the bounds of our current ``least cost'' 
resolution procedures.
    We expect the gulf between large and small institutions--and the 
gulf between the kinds of business they are engaged in--to continue 
growing. This consolidation of the banking industry will pose 
interesting questions for policymakers. For example, I believe that we 
should now begin to think through the merits of moving further toward 
an explicit, two-tiered system that includes the possibility of having 
larger institutions in a separate risk pool. There are many issues to 
consider, including funding arrangements for problems that may arise in 
the separate risk pool for large institutions. The FDIC could also look 
more to market instruments--like reinsurance contracts or catastrophe 
bonds--to help us assess our large-bank exposure.
    We also should ensure that regulatory burden does not weigh too 
heavily on community banks and stifle the innovation and consumer 
choice that are hallmarks of our system. This can be unduly burdensome 
for community banks and threatens to deter new entry into banking. Low 
barriers to entry are key to ensuring continued innovation and customer 
service in the industry. From my own personal experience as a banker, I 
know all too well how heavy this burden can be.
    The FDIC is taking action to reduce undue regulatory burden to a 
minimum for institutions of all sizes. In addition, FDIC Vice Chairman 
John Reich is leading an interagency effort to identify unnecessary 
burden, duplication, and outmoded restrictions on both large and small 
financial institutions. Under the Economic Growth and Regulatory 
Paperwork Reduction Act of 1996 (EGRPRA), Congress required the Federal 
banking agencies and the National Credit Union Administration to review 
all regulations every 10 years for areas that are outdated, 
unnecessary, or unduly burdensome.
    The agencies have jointly published the first two of a series of 
notices soliciting comment on regulations in a number of areas, and 
have been conducting outreach sessions with bankers and consumer/
community groups. Armed with this input, the agencies will conduct a 
comprehensive review of banking regulations and will report to Congress 
on their findings and the actions they have taken, or plan to take, to 
reduce the level of burden. The agencies also anticipate sending this 
Committee a list of legislative areas for consideration.
    Another broad question facing policymakers will likely be how to 
handle the convergence of interests between banks and firms operating 
in the larger marketplace. As pointed out earlier, barrier after 
barrier has come under pressure over the years as the market provided 
the means to produce and deliver more innovative products to financial 
consumers. The repeal of branching laws and the Glass-Steagall Act is 
part of a market driven continuum that will lead us to the doorstep of 
the last remaining barrier--the barrier between banking and commerce.
    Linkages between banking and commerce exist for a number of 
grandfathered thrift holding companies, CEBA banks and some industrial 
loan companies. From a public policy standpoint, the benefits of this 
limited experimentation with the mixing of banking and commerce include 
a more competitive banking marketplace, more choices for consumers, 
and, to a limited extent, the existence of a laboratory for alternative 
modes of regulation. Concerns also have been expressed about allowing 
any expansion of the mixing of banking and commerce. These concerns 
have centered on concentrations of economic power, conflicts of 
interest, and a transfer of a subsidy from the insured bank to 
affiliates. These issues are present, of course, for any large 
financial conglomerate. Conflicts of interest are possible even for 
stand-alone community banks, where majority shareholders may have 
commercial business interests. The challenge is to ensure that 
supervisory and regulatory structures achieve the best of two worlds--
both allowing for continued market innovation and providing adequate 
protection for the bank safety net.
    Just as many structural and procedural concerns were addressed 
during the development of the Riegle-Neal Act and the Gramm-Leach-
Bliley Act, I believe the same is possible in this instance. As the 
market continues to mature in this area, the appropriate boundaries 
between banking and commerce will be a significant matter for 
discussion among policymakers going forward.
    A final fundamental question for policymakers in the area of bank 
supervision concerns the future of capital regulation. Capital is 
perhaps the single most important part of a bank's balance sheet. It 
promotes confidence in the organization as a going concern and enhances 
and diversifies the options available to bank management. Capital 
allows the bank to continue functioning in the face of unexpected 
events and errors in judgment, and in times of crisis or systemic 
difficulty.
    The challenge for policymakers, in this dynamic and complex 
financial services marketplace, is to get capital right. We must 
actively work to ensure that our definition of capital is limited only 
to those instruments that are able to effectively cushion the bank 
during times of distress. And we must ensure capital adequacy--that 
there is enough to absorb losses, ensure ongoing operations, and 
promote customer confidence during stressful periods.
    As the sophistication of the financial markets grows, and 
innovations allow for more complex transactions, the regulators must be 
vigilant and ensure that our core Tier 1 capital elements have the 
ability to cushion banks against loss on a going-concern basis. Tier 1 
should be the regulatory standard reserved for the highest quality of 
capital, and there is no secret of my concern about continuing to allow 
trust preferred securities to be included in that select category. 
Trust preferred securities are issued by bank holding companies and 
carry a cumulative obligation to pay dividends. Under a recent 
accounting change, they are now categorized explicitly as debt. For 
insured institutions, the appeal of these and other similar instruments 
is that they combine the tax advantages of debt with the regulatory 
stamp of approval of equity. Community banks that are members of 
holding companies like the idea of being able to tap capital markets 
with these securities. Yet they result in a regulatory definition of 
capital that is, under new accounting rules, more lenient than GAAP. If 
the bank regulators do not acquiesce to allowing banks this favorable 
capital treatment directly, there is the issue of regulatory capital 
rules that appear to provide an advantage to holding company 
membership.
    Weaning the banking system from reliance on a previously approved 
element of Tier 1 capital would, of course, raise a host of difficult 
transitional and grand-
fathering issues. We should make these difficult judgments with the 
benefit of industry comment, and arrive at a conclusion as to what 
types of hybrid capital instruments provide meaningful capital support 
against the prism of what truly is in the long-term best interest of 
banks, the financial system as a whole, and the bank safety net.
    With respect to the Basel II negotiations, the FDIC supports the 
underlying premise of the agreement and is working hard to complete our 
work and move toward implementation. Nevertheless, there remain some 
important issues at stake for the bank safety net, the regulatory 
structure, and Congress. The implementation of the Basel II agreement 
will certainly trigger an intensive public discussion of the workings 
of our domestic Prompt Corrective Action (PCA) framework--the 
underlying law that governs our system of capital regulation in 
America. I know of no disagreement among my U.S. regulatory colleagues 
that the outcome of this public debate will be a capital regulatory 
structure that combines the best elements of the PCA framework with the 
enhanced risk metrics of Basel II. Indeed, as the FDIC has indicated on 
many occasions, this must be the outcome.
    While policymakers must carefully navigate the intersection between 
PCA and Basel II in order to protect the safety net, we also believe 
our banking system would benefit from strong capital adequacy in other 
ways as well. Our banks are among the most well-capitalized in the 
world--and they are second to none in competitiveness, innovation, and 
market share. Yet their complexity seems to be attracting more and more 
oversight and regulation--and not necessarily only from the consumer 
protection side. A strong industry capital base will allow the 
regulators some room to permit the marketplace to take its course--both 
in terms of innovations that better serve consumers, but also in 
remaining competitive with firms overseas. Lowering capital in these 
institutions will increase the risk of an institution's failure and 
will lead to significant regulatory intrusion into the business of 
these large firms--and perhaps stifle many of the market driven 
benefits we have come to expect from the financial services industry.
Conclusion
    While America's banks--and the deposit insurance funds--are as 
healthy as they have ever been, it is nonetheless clear that the 
industry is undergoing significant structural change. Accordingly, our 
system of bank regulation will also have to change in order to meet the 
challenges posed by this dynamic financial environment.
    Banks are positioned to continue to play a vibrant role in the 
free-market economy and perform vital intermediary functions through 
the development of future products and services that are well beyond 
anything we can imagine today. As this process evolves, accompanying 
structural and regulatory changes will be needed to ensure the bank 
safety net remains effective and able to fully meet its public policy 
purpose. Further, our role as regulators is to protect consumers from 
abusive practices and promote safe and sound banking practices. This 
underlying mission will remain the same regardless of what is occurring 
in the marketplace, and our job is to ensure the right balance is 
struck as these innovations continue.
    Because so many of these changes could impact the deposit insurance 
funds, the FDIC will continue to provide this Committee with our 
analysis and views as we work together in the coming years to ensure 
the safety and soundness of a changing industry.
    This concludes my testimony. I will be happy to address any 
questions that the Committee might have.

                               ----------
                PREPARED STATEMENT OF JAMES E. GILLERAN
                 Director, Office of Thrift Supervision
                             April 20, 2004

Introduction
    Good morning, Chairman Shelby, Senator Sarbanes, and Members of the 
Committee. Thank you for the opportunity to testify on the financial 
condition and performance of the thrift industry. It is my pleasure to 
report on a thrift industry that is strong and growing in asset size. 
While we continue to maintain a watchful eye on interest rate risk in 
the thrift industry, profitability, asset quality, and other key 
measures of financial health are at, or near, record levels. The 
average equity-to-assets ratio is over 9 percent, and 99 percent of 
thrifts are well-capitalized.
    A favorable interest rate risk environment, accompanied by record 
mortgage originations and sales, has produced strong profitability for 
the thrift industry for the past 5 years. Equally important to this 
sustained period of profitability are good stewardship by thrift 
managers, earnings diversification, and good asset quality. Other 
important factors that have contributed to the industry's success are 
the statutory and regulatory reforms initiated to strengthen the 
banking system. The reforms--including comprehensive capital standards, 
stronger corporate governance and internal control standards mandated 
by the Sarbanes-Oxley Act, uniform standards for lending, operations 
and asset growth, and prompt corrective action (PCA) requirements--have 
significantly improved our banking system. In addition, the banking 
agencies have been effective in keeping pace with changes in the 
institutions we regulate. For its part, the OTS continually works to 
provide specialized training, rigorous accreditation and professional 
development programs, and other supervisory tools, to ensure that our 
staff is capably equipped to supervise a dynamic and growing industry. 
In addition, our employees are of long tenure and are well-seasoned, 
with an average 15 years of OTS experience.
Condition of the Thrift Industry
    As of December 31, 2003, there were 928 OTS-regulated thrifts, 
holding assets of $1.1 trillion. In addition, there were 485 State-
chartered savings banks that have the FDIC as their primary Federal 
regulator and the vast majority of which have operating strategies 
substantially similar to thrifts.\1\
---------------------------------------------------------------------------
    \1\ The number reported in a recent financial publication regarding 
the ratio of Federal versus State thrifts failed to include State 
savings banks. In the aggregate, as of the end of 2003, 42 percent of 
thrifts--including State savings banks--were State chartered and the 
remaining 58 percent federally chartered.
---------------------------------------------------------------------------
    While financial services consolidation continues to reduce the 
overall number of thrift institutions, industry asset growth remains 
strong. This is due to growth within existing thrifts and to the fact 
that various financial institutions continue to choose the thrift 
charter because of the advantages it provides in the delivery of 
financial services. Charter choice is a privilege available to American 
financial institutions, and it continues to flourish as institutions 
change and adapt their business strategies and focus.
    In addition to supervising 928 thrift institutions, OTS supervises 
thrift holding companies. As of the end of 2003, OTS regulated 605 
thrift holding company structures \2\ with consolidated assets of 
approximately $6 trillion. As the only consolidated Federal regulator 
both chartering the depository institutions and overseeing their 
holding companies, OTS has a unique supervisory role. This provides us 
with the opportunity to monitor and regulate all aspects of the 
institution's operations and holding company affiliate activities. The 
holding companies we oversee are quite diverse, ranging from large, 
multinational corporations to small ``shell'' companies with few assets 
other than their thrift charter.
---------------------------------------------------------------------------
    \2\ A holding company structure may contain more than one holding 
company. As of the end of 2003, these 605 OTS-supervised holding 
company structures operated 971 holding companies.
---------------------------------------------------------------------------
    The demographics of thrift institutions are also quite diverse. 
While numerous larger thrifts provide financial products and services 
nationwide or across sizable regional markets, most thrifts are 
generally smaller, community-based organizations that provide retail 
financial services in their local markets. As of the end of 2003, 66 
percent of thrifts had assets of less than $250 million. Although 
small, these institutions reach into many small American towns 
fortunate to have the option of a local community banker.
    Thrifts provide substantial services that encourage homeownership 
and affordable housing, and contribute to economic growth. Thrifts hold 
over $730 billion in housing-related loans and securities, including 
$540 billion in whole single-family loans, which comprise one half of 
total thrift assets. In addition, the industry maintains 60 million 
insured deposit accounts. Thrifts compete effectively with other 
financial services providers to deliver a wide range of products and 
services to American consumers.
    Thrifts utilize the secondary market effectively, selling 
approximately $769 billion in single-family mortgage loans to Fannie, 
Freddie and other secondary mortgage market participants in 2003. In 
addition, as of December 31, 2003, the Federal Home Loan Banks advanced 
$190 billion to thrift institutions, representing 17 percent of thrift 
liquidity.
Earnings and Profitability
    Recent earnings and profitability of the thrift industry have been 
strong, with consecutive annual records in 2001, 2002, and 2003. For 
2003, the industry reported earnings of $13.7 billion, eclipsing the 
prior record of $11.8 billion in 2002. Annual earnings were $10.2 
billion in 2001.
    The industry's annual return on average assets (ROA), a key measure 
of profitability, was a record 1.29 percent for 2003, breaking the 
prior record of 1.21 percent posted in 2002. Industry ROA was 1.07 
percent in 2001. This was the first time that industry ROA exceeded 1 
percent in 3 consecutive years since the mid-1950's.
    While the historic level of thrift earnings is partially 
attributable to record loan origination and sales volume, the 
underlying strength and stability of thrift earnings has also been 
driven by diversification of income sources and continued strong asset 
quality. The industry's success over the past decade in expanding its 
line of products and services, such as mutual fund and annuity sales, 
trust activities, and transaction accounts, has enabled it to diversify 
its income stream and generate more stable earnings. Income from these 
activities measured 0.94 percent of average assets for 2003, up more 
than 400 percent from 0.17 percent in 1990. Together with improved risk 
management techniques, higher proportions of noninterest income have 
helped stabilize thrift income and provide better insulation against 
interest rate fluctuations.
    The thrift industry was an active participant in the Nation's 
recent refinancing boom and homeownership expansion. Thrifts originated 
over $730 billion in single-family mortgages in 2003, accounting for 
one in every five mortgages made in the United States for this time 
period. Income from mortgage lending, loan servicing, and other 
mortgage banking activities helped boost recent earnings, and 
represented 0.80 percent of average assets in 2003 compared to 0.44 
percent in 1990.
    Looking forward, we anticipate that mortgage loan refinancing 
activity will decline from the current high levels, which will dampen 
loan origination volume and earnings. The level of new home 
construction starts and sales of existing homes remain strong, however, 
providing a potential counterbalance to recent declines in refinancing 
activity. Although interest rate risk is not an immediate threat for 
thrift institutions, OTS continues to closely monitor for changes in 
interest rate risk.
Asset Quality
    The quality of thrift loan portfolios continues to be very good, 
with key measures of problem loans relatively low, though up slightly 
from the historic lows set in 2000. Troubled assets (loans 90 or more 
days past due, loans in nonaccrual status, and repossessed assets) 
represented 0.67 percent of assets at the end of 2003. The ratio of 
troubled assets to total assets has remained below 1 percent since 
September 1997, but is slightly above the recent low of 0.58 percent 
reported at September 30, 2000.
    As might be expected, the level of delinquent loans generally 
increased through the duration of the recent economic slowdown. The 
increase was modest, however, particularly given the record low levels 
set in 2000. Moreover, the industry's noncurrent loan ratio declined in 
2003 to 0.58 percent of assets from a post-2000 high of 0.65 percent in 
December 2002. Less seriously delinquent loans--those 30-89 days past 
due--were 0.71 percent of assets as of the end of 2003, slightly lower 
than the level (0.74 percent) at the end of 2000. Loans 30-89 days past 
due have generally remained at these levels since 2000 despite some 
quarterly fluctuations.
    Loan charge-off rates have risen since 2000, reflecting the modest 
pace of economic activity. Net charge-offs as a percent of total assets 
were 0.26 percent in 2003, up from 0.24 percent in 2002 and 2001, and 
0.19 percent in 2000. Thrifts' charge-off rates are typically lower 
than those of commercial banks since thrift loan portfolios are heavily 
concentrated in single-family mortgages. Charge-off rates for single-
family mortgages are generally very low compared to other types of 
loans. The charge-off rate on all single-family mortgage loans was just 
0.05 percent in 2003, or $50 for each $100,000 in loans.
    Thrifts' provisions for loan losses generally increased in response 
to the rise in noncurrent loans and loan charge-offs. Total loan loss 
provisions were 0.21 percent of average assets in 2003, 0.30 percent in 
2002, and 0.28 percent in 2001--all up from 0.20 percent in 2000. 
Increased loan loss provisioning kept the industry's total loan loss 
allowance relatively stable despite increased charge-offs. Total 
allowances measured 0.60 percent of assets for 2003, down slightly from 
0.64 at the end of 2000. The slight declines in 2003 loan loss 
provisions and loan loss allowances reflect the improved economic 
outlook and signs of recovery from the most recent recession.
    As real estate financing activity surged in recent years due to 
historically low interest rates, OTS has monitored housing values 
across the United States. While there may be some regional pockets in 
the United States where a ``bubble'' could exist, this does not appear 
to be a nationwide problem. Because local economic and demographic 
factors are the primary influences on home prices, significant home 
price declines have occurred historically only in markets experiencing 
severe economic distress. Given the generally improving economic 
conditions nationwide, a recent FDIC \3\ study concludes, for example, 
``that a widespread decline in home prices appears unlikely, even when 
mortgage rates begin to rise from current low levels.''
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    \3\ FDIC Outlook, March 2, 2004.
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    This is not to say that mortgage lending is not without its risks, 
especially when mortgage interest rates rise. For example, highly 
leveraged borrowers and those in high-priced home markets tend to rely 
on adjustable-rate mortgages, making them vulnerable to interest rate 
``shock'' once short-term interest rates begin to rise. Likewise, home 
price appreciation may slow as rising mortgage rates make homes less 
affordable, especially higher-priced homes.
Capital
    Capital measures for the industry are strong, stable, and well in 
excess of minimum regulatory requirements. While industry growth can 
often pressure capital ratios, even as industry growth has continued, 
thrifts have maintained high levels of capital through prudent earnings 
retention and receptive capital markets. Equity capital was 9.1 percent 
of assets at the end of 2003. Ninety-nine percent of all thrifts, 
holding 99.9 percent of industry assets, exceeded the PCA well-
capitalized standards. Although the number of undercapitalized 
institutions fluctuates over time, only two thrifts were less than 
adequately capitalized at the end of 2003. One of which has since been 
recapitalized. Consistent with PCA, we are monitoring these 
institutions to ensure that management responds aggressively to resolve 
areas of supervisory concern.
Funding Sources
    The industry has become somewhat more reliant on wholesale funding 
as deposit growth slowed due to changing savings and investment 
patterns and robust competition from mutual funds. Although deposits 
remain the primary source of funding for the industry, the ratio of 
deposits to total assets declined steadily over the past decade. In 
1990, deposits funded 77 percent of thrift assets. By the end of 2003, 
the ratio had declined to 58 percent.
    With deposit levels declining, the thrift industry has accessed 
greater levels of wholesale funding, primarily in the form of Federal 
Home Loan Bank (FHLB) advances. At the end of 2003, FHLB advances 
funded 17.4 percent of total thrift assets, up from 7.4 percent in 
1991. In addition, other types of borrowings, such as repurchase 
agreements, subordinated debt, and Federal funds purchased, funded 11.3 
percent of assets, up from 5.5 percent in 1991.
Problem Thrifts
    The number of problem thrifts--those with composite safety and 
soundness examination ratings of ``4'' or ``5''--fluctuates over time 
but remained low in recent years. There were eight problem thrifts at 
the end of 2003--the lowest level since OTS's inception. Assets of 
problem thrifts comprised only 0.1 percent of industry assets at the 
close of 2003.
    Thrifts assigned a composite ``3'' rating, while not considered 
problem institutions, also warrant more than the normal level of 
supervisory attention. At the end of 2003, there were 57 thrift 
institutions assigned a 3 rating, which is unchanged from the prior 
quarter and down significantly from 72 one year ago. Of these 57 
thrifts, 98 percent were ``well-capitalized,'' and thus have a capital 
cushion that increases their ability to work through difficulties in an 
orderly manner.
    Supervisory attention is also focused on concerns identified at 
institutions in the areas of Compliance, Community Reinvestment Act 
(CRA), and Information Technology (IT). At the end of 2003, there were 
46 thrifts rated ``3'' or below in Compliance, including three thrifts 
with ``4'' ratings. Eight thrifts were rated less than 
satisfactory in their CRA examinations. Reflecting the rapid changes in 
technology, focus on privacy and security concerns, and increased 
demand for technological expertise, two thrifts were rated ``4'' or 
``5'' on their IT exam, and 36 thrifts were assigned ``3'' ratings. In 
all cases, we initiated prompt supervisory strategies to effect 
management corrective actions to address areas of concern. The vast 
majority of OTS regulated institutions are in compliance for CRA and 
IT.
Evolving Role of the Thrift Industry
Community Lenders with Residential Focus
    While thrifts provide a wide variety of loan products, including 
consumer and commercial loans, they continue to focus primarily on 
residential mortgage lending. Thrifts originated 21 percent of all 
single-family mortgage loans made in the United States in 2003. Thrifts 
are major originators of adjustable rate mortgage (ARM) loans. In 2003, 
about one-third (31 percent) of all new ARM's were originated by 
thrifts.\4\
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    \4\ Based on data from the Mortgage Bankers Association of America 
and Federal Housing Finance Board.
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    In 2003, the industry originated $730 billion in single-family 
mortgages, the highest annual volume on record, exceeding by more than 
50 percent the prior record of $472 billion in 2002. Since 1999, the 
thrift industry has originated over $2 trillion in single-family home 
loans; which, at an average home value of $200,000, represents 10 
million homes in America. Single-family mortgage loans and related 
securities comprised about 62 percent of thrift assets at the close of 
2003. Thrifts are also active lenders for multifamily lending. In 2003, 
thrifts originated $20.1 billion in multifamily mortgages. At the end 
of 2003, thrifts held in portfolio $53.7 billion, or 4.9 percent of 
their assets, in multifamily mortgage loans. This brings the percentage 
of assets held in residential-related loans and securities to 67 
percent.
    Thrifts also provide vital services to other segments of their 
communities by making commercial real estate loans to hospitals, 
nursing homes, farms, churches, and stores, and on other commercial 
properties. Such loans comprised 4.3 percent of thrifts' assets at the 
end of 2003.
    While thrifts continue to focus on mortgage lending, they have 
steadily expanded their product offerings in the areas of consumer and 
commercial business lending. The industry's ratio of consumer loans-to-
assets was 6.5 percent at the end of 2003, up from 4.5 percent at the 
end of 1990. Utilizing the expanded small business lending authority 
granted by the Economic Growth and Regulatory Paperwork Reduction Act 
of 1996, the industry's ratio of commercial loans-to-assets stood at 
3.6 
percent at December 31, 2003, up from 1.5 percent at the end of 1997. 
Based on our semi-annual subprime lending survey, there were 32 OTS-
regulated thrifts with subprime lending programs as of the end of the 
third quarter 2003. These thrifts have formal lending strategies 
directed to subprime borrowers as opposed to lenders that may make an 
occasional loan to a borrower with a low credit score, for example. 
Aggregate subprime lending for these 32 thrifts increased 11 percent to 
$14.8 billion at September 2003 from the prior year.
Diversified Financial Services Providers
    In addition to core lending products, thrifts continue to expand 
the range of savings and investment products offered to their 
communities. The thrift charter provides an excellent platform with a 
comprehensive and uniform regulatory structure that allows for the 
efficient delivery of a wide range of financial products and services. 
Thrifts have taken full advantage of the strength of their charter to 
serve retail customers both in their local communities and beyond.
    The success of thrifts in providing a broad range of financial 
services is evident in the industry's level of trust assets 
administered, which has risen dramatically over the past 8 years. The 
facility of the charter in this area has also attracted a number of new 
firms to use the thrift charter as the vehicle for providing these 
services. For 2003, trust assets administered by the industry totaled 
$563.5 billion versus $13.6 billion at the end of 1995.
Risks Facing the Thrift Industry
Credit Risk
    The thrift industry's sound financial condition permits it to 
address potential credit quality problems from a position of strength. 
Thrift industry credit risk is primarily driven by the performance of 
residential mortgage loans. Given the current strength of the housing 
market in most areas of the country, single-family residential loan 
delinquencies and charge-offs have remained at low levels.
    Future deterioration in any of the fundamentals that affect housing 
strength, such as worsening unemployment rates, could adversely affect 
thrifts' asset quality. As community-based lenders, the majority of 
thrifts' loans are made to consumers. Direct loans to consumers, 
including single-family mortgages, measured 55.9 percent of thrift 
assets at the end of 2003. Given this concentration, thrifts' asset 
quality is very dependent on stable real estate values and consumers' 
continued employment and ability to service their debt. We know of no 
major problems facing us in either regard.
    Thrift credit exposure is not limited to the consumer loan sector. 
Thrifts are also exposed to the business sector, with 3.6 percent of 
thrift assets held in commercial loans and another 12.0 percent of 
assets held in construction loans and nonresidential and multifamily 
mortgage loans. A slowdown in the economic recovery could pressure the 
cashflow of commercial borrowers. Alternatively, a strong recovery that 
spurs a steep rise in interest rates may also impact commercial 
borrowers, since business loans typically carry floating rates of 
interest. Credits that are highly dependent on low interest costs for 
positive cashflow would be most vulnerable to rapid increases in 
interest rates.
    Credit review is a significant priority in our examination process, 
with the scope of our review formed by economic trends and 
expectations. Our analysis shows that as interest rates rise after a 
trough, many mortgage lenders lower credit underwriting standards to 
maintain high loan origination volumes. Such vintages often 
significantly underperform other vintages. Consequently, as rates have 
begun to rise, OTS examiners have begun focusing even greater attention 
on thrifts' underwriting processes, credit quality, reserve policies, 
and capital adequacy. The loan monitoring, loan collection, and work-
out procedures of thrifts are also receiving increased scrutiny. Our 
best performing thrifts are diversified and we support the 
industry looking for ways to be less reliant on interest income. We 
emphasize, however, that expanding into new areas requires investment 
in the right people, systems, internal controls, and internal audits.
Interest Rate Risk
    OTS closely watches interest rate risk given the thrift industry's 
natural concentration in longer-term mortgage loans, which are 
generally funded with shorter-term deposits and borrowings. Since 
interest rates typically rise during economic 
recoveries, monitoring interest rate risk will be especially important 
in the upcoming quarters. Interest rate sensitivity can manifest itself 
in several ways in a rising rate environment, including a declining 
value of long-term assets with below market rates and increased funding 
rates which tends to compress thrifts' net interest margin.
    OTS maintains an interest rate risk sensitivity model that stress-
tests thrift portfolios to evaluate potential exposure to changing 
interest rates. We are unique in that regard. OTS regulations also 
require thrift management to monitor and manage interest rate risk on 
an ongoing basis and maintain exposure at prudent levels. With the OTS 
model and prudent thrift management practices, the industry is well-
positioned to assess and respond to portfolio sensitivity resulting 
from changes in interest rates.
    As of the end of 2003, under a simulated instantaneous 200 basis 
point rate shock, 80 percent of all thrifts were classified as having 
low levels of interest rate risk, 15 percent as having moderate levels, 
and 5 percent as having higher levels of interest rate risk. These 
numbers have trended higher the past two quarters because of the 
tendency of some institutions in a steep yield curve environment for 
institutions to invest in long-term assets (for example, 30-year fixed 
mortgages) and to fund such investments with short-term liabilities 
(for example, short-term certificates of deposit and short-term Federal 
Home Loan Bank advances). Approximately 50 percent of the mortgage 
instruments held in portfolio by OTS-regulated thrifts were originated 
in 2003.
    Institutions demonstrating higher levels of interest rate risk 
receive close supervisory scrutiny. Given that interest rates typically 
move in a more gradual fashion, thrift management often has significant 
opportunity to institute remedial actions to limit the potential impact 
of a changing interest rate structure. While the current interest rate 
environment and yield curve structure are generally favorable for 
thrifts' operations, the failure to react to rising interest rates that 
come with economic recovery or changes in the yield curve structure 
could adversely impact thrift earnings. We see no major problems in 
that regard at the current time.
    In 2003, many thrifts took advantage of the low rate environment to 
extend liability maturities at favorable terms. The lengthening of 
liability maturities provides a buffer for thrifts against the impact 
of rising rates. In addition to strategic funding decisions, mortgage 
loan demand has shifted thrift loan portfolios increasingly toward 
holding more fixed-rate loans with shorter-terms (10, 15, and 20 years) 
than the traditional 30-year product, and higher levels of adjustable-
rate loans and hybrid loan types.
    Shorter-term fixed rate mortgages amortize principal more quickly 
than traditional 30-year loans, which provides thrifts with greater 
cashflow to invest as rates rise. Adjustable-rate mortgage rates will 
reset to higher levels in a rising rate environment. Likewise, hybrid 
loan products that are fixed for periods of 3, 5, 7, or 10 years and 
then convert to adjustable rates will reset rates and provide a buffer 
against rising rates. Collectively, these asset/liability trends could 
mitigate some of the adverse impact that rising rates typically have on 
thrifts.
    Even with the favorable rate environment and strategic thrift 
asset/liability management, OTS remains cautious of the potential 
impact of a rapid increase in market interest rates. OTS employs a 
scenario-based modeling approach, applied on a quarterly basis, to 
estimate the potential exposure that thrifts have to various rate 
change scenarios. In addition, we require thrift management to monitor 
interest rate risk regularly, set appropriate risk limits, and manage 
potential exposure at acceptable levels. OTS will remain vigilant in 
monitoring institutions for adverse trends and ensuring that thrifts 
are properly focused on the potential impact of changing interest 
rates.
Compliance Risks
    Compliance risk is another risk that the industry faces and one 
that OTS also closely watches. The increased volume of consumer 
transactions, along with the increase in consumer protection and other 
regulations governing those transactions, necessitates an active 
compliance management function within financial institutions and in 
oversight programs within the banking agencies. Certainly in today's 
environment, the importance of effective compliance management is 
elevated by: (1) the need to ensure the privacy and security of 
consumer financial information as more information is shared and 
outsourced, and as the threat of identity theft persists; (2) the need 
to guard against money laundering and terrorist financing activities in 
a post-September 11 environment; and (3) the need to stem the tide of 
abusive lending practices and ensure fair and equal access to credit 
for all Americans.
    As with its management of other risks, OTS, due to recent internal 
examination restructuring and enhancements, is now in a stronger, more 
proactive position than ever to effectively examine for and address 
potential compliance problems and risks within a comprehensive 
examination context. We are training more examiners in the area of 
compliance, we are conducting compliance reviews more frequently, and 
we are using a risk-focused approach. The CORE components of all 
compliance examinations include a review of BSA/USA PATRIOT Act, 
Privacy and Fair Lending.
    Our fundamental examination objective is to ensure that 
institutions have in place the resources to support an effective 
compliance management program that is commensurate with the size, 
complexity, and risk profile of the institution. To promote and 
reinforce full compliance with these critical laws, OTS routinely 
conducts in-depth training for OTS examination staff.
Intense Competition
    Business convergence and continued consolidation in the financial 
services industry have created an increasingly competitive environment. 
This stimulates thrift managers to focus on strategies to improve 
efficiencies in the delivery of financial products and services, 
customize product offerings to meet customer needs, and ensure quality 
customer service. Some managers may seek to enter new business lines 
that are not fully served by the financial community. Subprime lending, 
whether home equity or credit cards, is one such business. Well-managed 
subprime lending, with responsible marketing, pricing, and terms, is an 
important element in improving and expanding credit access. We support 
subprime lending but are vigilant to assure ourselves that it is not 
delivered in a predatory manner. Any pattern or practice of predatory 
lending is immediately criticized and eliminated.
    Guiding an institution through lending expansion is, of course, the 
responsibility of each institution's management and board of directors. 
The willingness of management and directors to understand and manage 
risk is one of the primary under-
pinnings of a safe and sound operation. Thrifts must adopt prudent 
strategies to operate successfully in an increasingly competitive 
environment. We emphasize to our examiners and supervisory staff the 
need to focus on ensuring that thrifts have the requisite managerial 
expertise, sound policies and procedures, and adequate systems before 
entering new lines of business. We also encourage institutions to work 
with our examiners and supervisory staff when pursuing new business 
activities in order to address problems as they arise and to avoid 
surprises between examinations. Our best performing thrifts also have 
strong internal controls and internal audit procedures.
Business Transitioning
    We are closely monitoring how thrifts transition from the current 
intensive ``mortgage-banking'' mode to a more diversified lending 
environment. In recent periods, low mortgage rates have spurred 
refinancings and record origination volumes, and income from this 
increased lending has helped boost overall thrift profitability. As the 
economy continues to recover and interest rates rise, lending 
activity--especially refinancings--have declined. At the same time, 
thrift managers will continue to be pressured by shareholders to 
maintain current earnings levels despite reduced lending activity. 
These pressures may include reducing overhead costs to help maintain 
earnings or entering into new activities or reaching for greater fee 
income. While we expect some industry staff reductions in response to 
decreased lending volumes, our examination and supervisory staff will 
closely evaluate thrifts' responses to ensure that the quality of loan 
underwriting and internal controls is not compromised. We also follow-
up with thrift management to ensure that institutions effectively 
manage new business lines.
Technology/Operational Risks
    Operational risk, including the risk of loss due to technical 
failures and human error, seems to be an ever-present concern in the 
financial services industry. Advances in technology have created new 
opportunities for thrifts, especially in marketing and broadening 
customer services. Thrifts also utilize technology to increase their 
understanding of certain credits, enabling better product pricing. The 
growth of Internet banking, outsourcing of core banking functions, and 
the rapid pace of technological and financial innovation creates new 
challenges and concerns for thrift management. The use of technology 
for these purposes is encouraged.
    Our IT examiners, and, increasingly, specially trained safety and 
soundness examiners, focus on how well thrifts' use of technology is 
designed and monitored to minimize operational risk and ensure thrift 
and customer security and privacy. The lessons learned from financial 
difficulties experienced by many ``high tech'' companies, the 
widespread power disruptions in the Northeast last summer, and the 
impact of the September 11 attacks has illustrated the need for 
contingency planning. Thrift institutions' contingency planning, back-
up, and recovery programs are receiving increased supervisory attention 
from our examination and supervisory staff.
OTS Regulatory and Supervisory Focus and Strategies
Early Detection and Resolution Strategies
    OTS uses regular on-site examinations and quarterly off-site 
financial monitoring to identify thrifts that warrant closer 
supervision. When problem institutions are identified, OTS acts 
promptly to ensure thrift management and directors institute corrective 
actions to address supervisory concerns. In addition to a host of 
financial analytics and early warning systems, two processes that we 
use to monitor problem institutions are the Regional Managers Group 
meetings, which are held 10 times annually, and quarterly high risk 
case briefings. These meetings enable senior OTS staff and regional 
managers to discuss high risk or high profile institutions regularly 
throughout the year. The tools are invaluable to share our collective 
experiences, develop effective supervisory strategies and enhance 
consistency across the agency. These processes allow senior Washington 
staff to closely monitor problem institutions, while the regions retain 
primary responsibility for ongoing supervision.
    We have refined our off-site monitoring process by increasing early 
warning systems to help identify adverse industry trends and potential 
problem areas. We maintain dedicated financial analysts at our 
headquarters and in the regions to ensure that off-site tools are 
maximized. OTS examiners and analysts utilize our Risk Monitoring 
System (RMS) to assist off-site financial analysis. This risk 
identification model utilizes combinations of financial ratios to 
identify areas that need prompt attention and further analysis. The RMS 
also provides our examiners and analysts with direct links to thrift 
websites, thrift stock price data, securities filings, and general 
economic information, all used to closely monitor and analyze thrift 
operations between on-site exams. In addition to the RMS, we operate 
our Net Portfolio Value (NPV) model to simulate the potential interest 
rate risk exposure resulting from a variety of interest rate shock 
scenarios.
OTS Supervisory Initiatives
Consolidated Examination Structure
    Two years ago, OTS began to combine its separate safety and 
soundness and compliance examinations in order to attain greater 
efficiencies in its examination process, improve its assessment of risk 
within the industry, and provide examiners with broader developmental 
opportunities. OTS views compliance as a safety and soundness issue. 
Examination teams have recently begun to conduct joint examinations and 
to issue one examination report on both safety and soundness and 
compliance matters. OTS is now engaging in a more comprehensive 
assessment of an institution's risk profile by examining its compliance 
with consumer laws and regulations simultaneously with its prudential 
supervisory analysis as an integral part of the evaluation of an 
institution's business strategy, and over time, it expects to reduce 
the costs and burden of examinations on institutions. The majority of 
responses from institutions has been overwhelmingly favorable.
    During this time, safety and soundness and compliance examiners 
have been actively engaged in an intensive cross-training program to 
learn the full knowledge and skills needed to lead melded examinations. 
OTS continues to maintain a cadre of compliance experts, however, to 
assist examination teams in handling complex compliance matters. In 
addition, OTS program staff have been working to produce combined 
examination procedures, policies, and handbook manuals.
OTS Organizational Changes
    Following a major restructuring of regional and field operations in 
2002, OTS recently reorganized its Washington supervision oversight 
operations in order to manage the evolving direction of the thrift 
industry more effectively. OTS established three primary entities 
within a newly structured Office of Examinations, Supervision, and 
Consumer Protection. The first oversees the most complex institutions 
as well as holding companies with significant international operations. 
A second entity oversees the examination and supervision of all other 
regulated institutions. The third oversees all policy development 
affecting examination and supervision of institutions' activities, 
including capital markets, trust, consumer protection, accounting, and 
information technology. During the past year, OTS has also begun to 
participate on the Basel Committee on Banking Supervision in order to 
ensure that pending international capital standards take into 
consideration the various needs of thrift institutions. In addition, we 
are well along the path of securing equivalency status under the 
European Union's (EU) Financial Conglomerates Directive to provide for 
coordinated, consolidated supervision of thrift holding companies with 
European operations.
Regulatory and Supervisory Coordination
    Convergence in the financial services markets has been proceeding 
at a rapid pace in recent years and will continue as companies attempt 
to maximize synergies across business lines. OTS has supervisory 
responsibility for thrift institutions and thrift holding companies, 
many of which engage in insurance and securities activities. These 
activities are often conducted by multiple legal entities within a 
corporate structure and across numerous regulatory jurisdictions. Given 
the scope of activities in thrifts and thrift holding companies, it is 
critical that we maintain healthy relationships with all financial 
regulators and supervisors.
    OTS maintains regular contact with State and Federal functional 
regulators. Our goal is to coordinate supervisory activities and 
knowledge to limit overlapping regulatory efforts, and to identify 
regulatory gaps that may exist across functionally regulated business 
sectors. We have also expanded our regulatory contacts abroad to ensure 
effective supervision of thrift holding company structures that 
maintain significant operations in foreign markets.
Functional Regulator Coordination
    Domestically, our regional offices have working relationships with 
insurance and securities regulators in states where these companies 
conduct operations. Our coordination activities also involve meetings, 
regular communications, and joint activities and programs, often 
through various supervisory coordinating entities such as the National 
Association of Insurance Commissioners (NAIC), the National Association 
of Securities Dealers (NASD), and the North American Securities 
Administrators Association (NASAA).
    We have worked extensively with the NAIC to minimize regulatory 
overlap as more insurance companies acquire thrifts. These efforts 
resulted in the establishment of information sharing agreements with 
insurance regulators from 47 States and the District of Columbia. Our 
activities include shared attendance and participation in official 
agency programs, conferences, and training seminars. These events 
foster cross sector learning and provide opportunities to cultivate 
regulatory relationships.
    OTS staff also coordinates closely with regional counterparts at 
the NASD to identify issues of common interest involving securities 
activities by thrift service corporations engaged in securities 
brokerage activities. Similarly, we have developed relationships with 
staff of the NASAA that enable us to coordinate and leverage our 
resources to achieve success in areas of mutual interest. We continue 
to work with the Securities and Exchange Commission (SEC) on policy 
matters (such as the privacy regulations required under the Gramm-
Leach-Bliley Act) and, when appropriate, on matters involving specific 
institutions.
FFIEC and Federal/State Cooperation
    Domestic and international financial services supervisors know well 
that supervisory cooperation produces innovative solutions to industry 
issues and provides invaluable perspective on cross sector trends and 
risks. OTS works closely with the other Federal banking agencies 
(FBA's) and State bank regulators in various forums and capacities. For 
example, in connection with proposed OTS regulations on mutual savings 
associations and mutual holding companies, we have met with seven State 
banking commissioners. The Conference of State Bank Supervisors (CSBS) 
was very helpful in arranging these meetings. I currently serve as 
Chairman of the Federal Financial Institutions Examination Council 
(FFIEC), which has significantly increased uniformity among the FBA's 
in prescribing principles, standards, and report forms for examinations 
and the supervision of financial institutions.
Coordination on the Basel Process
    Internationally, although we are not currently a member of the 
Basel Committee,\5\ OTS attends--along with the other participating 
FBA's--the Basel Committee meetings and participates in key 
subcommittee meetings and working groups. The international community 
of financial services supervisors provides an excellent forum to share 
experiences and work cooperatively to develop innovative and effective 
supervisory guidance. Participation in these forums has been critical 
in understanding global trends that may impact or threaten thrifts or 
thrift holding companies.
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    \5\ As noted below (see Items for Legislative Consideration), OTS 
is actively seeking membership on the Basel Committee on par with that 
of the other FBA's.
---------------------------------------------------------------------------
    For example, our involvement in the Basel process has provided us 
with important insights into the potential domestic impact of the 
proposed Basel II changes. In particular, we are concerned that Basel 
II may be adopted in the United States before being sufficiently tested 
to assess its competitive impact. In addition to concerns regarding 
competitive equity, the Basel discussions and ensuing debate have 
highlighted deficiencies regarding the continued application of Basel I 
to the vast majority of institutions expected to continue to utilize 
it.
    We are particularly concerned about the safety and soundness 
implications of leaving thousands of small- to mid-sized institutions 
on a less risk sensitive regime while our largest institutions move to 
a more risk sensitive system. In such a bifurcated construct, Basel I 
institutions have an incentive to replace lower-risk assets with 
higher-risk assets since their capital requirement is apt to be too 
high for the former and too low for the latter, as measured against 
Basel II institutions. We therefore believe that FBA efforts and 
resources should be directed at borrowing from the lessons learned in 
Basel II to develop a capital adequacy system--applicable to all but 
the largest internationally active institutions--that is more risk 
sensitive than Basel I, but less complex and more accessible than Basel 
II.
    In addition to the international Basel Committee meetings, OTS 
actively participates in all domestic task force meetings on Basel.
OTS Role as Consolidated Coordinating Supervisor
    OTS has engaged in active dialogue with representatives from the EU 
on matters relating to the EU's directive on the supervision of 
financial conglomerates. The EU is seeking to ensure that financial 
conglomerates domiciled outside the EU member countries are subject to 
an equivalent level of consolidated supervision by foreign supervisors 
and to enhance coordination among relevant supervisors. OTS is the 
consolidated supervisor of U.S.-based thrift holding companies, 
including a number of financial conglomerates active in the EU. OTS is 
seeking equivalency status under the EU's Financial Conglomerates 
Directive (FCD).
    The FCD requires the designation of an equivalent consolidated 
supervisor to act as regulatory coordinator with the relevant EU 
supervisors. The FCD sets out certain broad review criteria in the 
areas of risk management and internal controls, in addition to more 
specific requirements for the reviews of capital adequacy, risk 
concentrations, and intragroup transactions. OTS has the regulatory 
authority and supervisory processes in place to collect relevant 
information and conduct the necessary supervisory reviews.
    OTS has initiated dialogue with several foreign supervisors to 
determine the scope of their interest thrift holding company 
activities. We will continue to work closely with relevant EU 
supervisors to ensure that there are no underlaps or overlaps in the 
supervision of thrift holding companies that are deemed to be 
conglomerates under the FCD.
Items for Legislative Consideration
    Among the factors that have contributed to the health and 
profitability of the thrift industry is a vibrant, flexible and dynamic 
community banking charter. I believe that the thrift charter is the 
preeminent community retail lending charter. It promotes homeownership 
while serving the diverse financial needs of retail customers in 
communities across America. Not only is it a charter worth preserving, 
but also worth improving. We have identified numerous areas that 
warrant legislative consideration to improve the thrift charter by 
reducing regulatory burden and improving OTS supervisory authority. 
Principal among these are the following:

 Eliminating the disparate treatment of thrifts under the 
    Federal securities laws. This includes eliminating the investment 
    adviser and broker-dealer registration requirements that apply to 
    thrifts, but not banks, under the Investment Advisers Act (IAA) and 
    the Securities Exchange Act of 1934 (1934 Act).
 Amending the International Lending Supervision Act (ILSA) to 
    support adding OTS to the Basel Committee. This includes extending 
    ILSA to thrifts to promote consistency in supervising the foreign 
    activities of insured institutions.
 Enhancing the ability of Federal thrifts to make small 
    business and other commercial loans by increasing the percentage of 
    assets limitations on these categories of lending. This will 
    enhance the ability of thrifts to contribute to economic recovery 
    and provide small and medium-sized businesses greater choice and 
    flexibility in meeting their credit needs. Specifically, we support 
    raising thrifts' aggregate commercial lending limit from 20 percent 
    to 40 percent of assets, and modifying the sub-cap for commercial 
    lending other than small business lending from 10 percent to 20 
    percent of assets.
 We also urge increasing the $250 million small institution 18-
    month examination exception up to $500 million.

    We look forward to working with you and your staff on these and any 
other legislative items that you want to address.
Conclusion
    The thrift industry has grown and diversified over the past several 
years while reporting excellent financial results. Thrifts continue to 
play a vital role in providing mortgage funding and other retail 
products and services to their communities. At OTS, we will continue to 
evaluate our policies, staffing, and infrastructure to ensure that the 
agency is well-prepared to handle new or emerging risks. We strive to 
provide the appropriate level of supervisory support to the 
institutions we regulate through guidance, industry training, and 
regular communications. We are confident the industry will continue to 
fulfill its primary focus of serving retail customers with mortgage 
funding and other financial services in a profitable and prudent 
manner.

                               ----------
                  PREPARED STATEMENT OF DENNIS DOLLAR
             Chairman, National Credit Union Administration
                             April 20, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for the invitation to testify before you today on 
behalf of the National Credit Union Administration (NCUA) regarding the 
condition of the credit union industry in America and the National 
Credit Union Share Insurance Fund (NCUSIF) that insures the deposits of 
credit union members nationwide.
Condition of the Credit Union Industry
    I am pleased to report to the Committee that the state of the 
credit union industry remains strong and healthy with all indicators 
clearly portraying a safe and sound industry serving over 82 million 
Americans and well-positioned for continued strength and vitality in 
our Nation's financial marketplace, both now and in the future.
    At this point I would like to provide a brief discussion of key 
ratios and trends compiled from call report data submitted to NCUA by 
all federally insured credit unions as of December 31, 2003.

 The average net worth-to-assets ratio of all federally insured 
    credit unions remains extremely strong at 10.72 percent, even 
    though there has been significant share growth of 15.27 percent in 
    2001, 10.77 percent in 2002, and 9.11 percent in 2003. Such a 
    strong share deposit growth would normally bring about a 
    significant decrease in the net worth ratio were not the credit 
    unions managing these increased shares effectively and continuing 
    to build net worth. For example, over the course of 2003, credit 
    union net worth, which is built solely from the retained earnings 
    of the credit union, has increased in total dollars by 9.57 
    percent. This growth in actual dollars of net worth results in the 
    highest level in history of total industry net worth, currently at 
    $65.4 billion as of December 31, 2003.
 Return on average assets (ROA) is 0.99 percent which, even 
    with a historically high growth in shares during a low interest 
    rate environment, compares favorably with recent historical trends 
    (1.07 percent in 2002 and 0.94 percent in 2001).
 Asset growth was 9.52 percent and share growth was 9.11 
    percent in 2003.
 Loan growth was 9.75 percent in 2003. Over the course of 2003, 
    share growth slowed and loan growth increased, resulting in a loan-
    to-share ratio of 71.2 percent, compared to 70.8 percent in 2002 
    and 79.5 percent in 2000. Total loans to credit union members 
    totaled $376.1 billion, up $104.5 billion since year-end 1999.
 Credit unions' overall delinquency ratio remains steady at 
    0.77 percent and is slightly lower than the ratios recorded in the 
    previous 2 years (0.80 percent in 2002 and 0.82 percent in 2001), 
    thus demonstrating effective risk management in the loan portfolios 
    during a period of economic downturn in many industries and 
    communities.
 Savings grew to $528.3 billion in 2003, an increase of 9.11 
    percent. Despite the increases in lending indicated earlier, much 
    of these increased savings are being placed in the conservative 
    investment options available to credit unions under applicable 
    Federal and State laws and regulations. Investments in Federal 
    agency securities grew 18.6 percent in 2003. Funds deposited in 
    corporate credit unions grew 9.4 percent during the same period, 
    and investments in banks, savings and loans, and savings banks 
    expanded 12.3 percent.
 Total assets grew to an all-time high of $610.2 billion, an 
    increase of 9.52 percent.
 Member business lending in credit unions increased by 32.9 
    percent to $8.87 billion. Although this category of credit union 
    lending has increased over the past year, member business lending 
    still represents only 2.36 percent of all loans in federally 
    insured credit unions.
 First mortgage real estate loans grew 16.63 percent to $117.5 
    billion, thus continuing the growth of credit unions as a source of 
    access to the American Dream of homeownership for millions of their 
    members.
 New auto lending increased 5.47 percent in 2003. Reflecting 
    both economic trends and market considerations, used auto loans 
    increased by 12.51 percent to $81.2 billion.

    The ratios and trends presented above are not unexpected in the 
present economic and marketplace environment; however, taken as a 
whole, they are indeed indicative of a healthy and robust industry.
Emerging Risks and Challenges for the Industry
    NCUA is closely monitoring a number of key issues and trends 
specifically affecting the credit union industry, as well as those 
related to the overall financial marketplace. The following issues are 
among those we have been closely monitoring:
Interest Rate Risk and Net Margin Compression
    Loan growth continues to be concentrated in fixed rate real estate 
loans being granted at the lowest rates in 40 years. In 2003, total 
real estate loans grew 13.9 percent and accounted for 44.6 percent of 
loans outstanding. At the same time, shares grew 9.11 percent, with 
growth concentrated in short-term, liquid accounts.
    The combination of high growth in fixed rate real estate loans and 
volatile, nonmaturity shares poses potential risk management challenges 
to credit unions, while also providing unique member service 
opportunities. If the economy continues to improve, equity market 
investing increases, consumer borrowing demand returns and interest 
rates rise, meaning potential interest rate risk, liquidity risk, 
credit risk, and earnings risk may increase, as well.
    While the volume of first mortgage loan originations has increased, 
so has the percentage of first mortgages sold, increasing from 29.2 
percent in 2000 to 43.1 percent as of December 2003. Credit unions sold 
$37.4 billion in first mortgages in the secondary market in 2003, 
compared to $25 billion in 2002. This indicates credit unions are 
appropriately managing, recognizing, and responding to the potential 
interest rate risk posed by these assets.



    To address the potential risks associated with high concentrations 
of fixed real estate loans held in portfolio, NCUA issued a Letter to 
Credit Unions in September 2003 to highlight these trends and to 
emphasize the need for prudent and diligent balance sheet management. 
In addition, NCUA continues to effectively utilize its regional capital 
market specialists to assist credit unions and examiners alike and to 
offer ongoing training and guidance to field examiners to address these 
risks from a safety and soundness perspective.
    The low interest rate environment likewise has resulted in 
compressed net interest margins for credit unions. This provides an 
increased likelihood for credit unions to consider moving out further 
on the yield curve to maintain net income levels. Interest rate risk 
and net margin compression in credit unions remain an oversight 
priority at NCUA and will continue to be closely monitored.
Increased Competition for Consumer Lending
    As mentioned earlier, the level of consumer borrowing has slowed 
somewhat in favor of real estate lending with credit unions continuing 
to search for new and innovative solutions to serve their members and 
to retain market share. To remain competitive for consumer loans some 
credit unions rely on indirect or third party lending which could 
result in potential risks from third party transactions if not managed 
properly. In a November 2001 Letter to Credit Unions, NCUA provided 
guidance on the level and degree of due diligence that should be 
exercised by credit unions when dealing with third party service 
providers.
Information Systems and Technology Risks
    Today more than half of all federally insured credit unions (5,106, 
representing 54 percent of all federally insured credit unions) have 
websites with approximately 1,100 more credit unions planning to 
implement sites in the future. As of December 2003, 15.1 million credit 
union members conduct transactions via the Internet, up from 5.6 
million as of December 2000.



    While credit unions are implementing new websites, the number and 
type of electronic services provided has grown steadily with 
considerable potential for additional growth. Potential transaction 
risk continues to increase as more credit unions move to transactional 
websites and increasingly complex e-commerce services.



    NCUA is fully committed to ensuring credit unions are properly 
prepared to safely integrate financial services and emerging technology 
in order to meet the changing needs of their members. NCUA implemented 
its Information Systems & Technology Examination Program (ISTEP) in 
fiscal year 2000. ISTEP represents a multiprong approach for 
identifying, measuring, and mitigating risks associated with 
information systems and technology (IS&T). This approach includes 
credit union IS&T examinations, credit union vendor reviews and 
examinations (NCUA and FFIEC), specialized IS&T examiner training and 
credit union guidance. Ongoing and further IS&T initiatives are 
outlined in greater detail in NCUA's strategic plan.
Corporate Credit Union Trends
    There are currently 30 retail corporate credit unions and one 
wholesale corporate credit union. Assets for all corporate credit 
unions total $108.9 billion. Retained earnings equal $2.354 billion 
with a retained earnings ratio of 2.19 percent. The core capital ratio 
is 2.95 percent and the total capital ratio equals 6.46 percent. These 
numbers reflect activity through December 31, 2003.
    Based upon the savings growth trends indicated earlier for natural 
person credit unions, corporate credit unions have found themselves 
flush with excess liquidity for the past 3 years. Since October 2000, 
when total assets were at a low of $53 billion, many corporate credit 
unions have seen their balance sheets double in size. The highest asset 
level was reported in May 2003, when total assets exceeded $126 
billion. Total assets have been fluctuating, but have consistently 
remained over $95 billion since March 2002. The liquidity trend in 
corporate credit unions coincides with consumer confidence in the 
economy. The flight to safety among investors has resulted in increased 
deposits in natural person credit unions. Many of these credit unions, 
seeking a safe place for their excess liquidity, are passing the 
deposits on to the corporate credit unions.
    The high levels of liquidity in the corporate system continue to 
have a significant impact on the various capital ratios. Even if 
liquidity should begin to flow out of the system, it will take time for 
the ratios to recover as they are based on 12-month moving daily 
average net assets (moving DANA) rather than month-end assets.
Key Issues Facing Corporate Credit Unions
    Increased Competition: NCUA expects a continued competitive 
environment among corporate credit unions. Corporate credit unions that 
have increased expenses due to expanded authority infrastructure 
acquisitions or the purchase of expensive item processing/imaging 
equipment will find it necessary to increase service volume to remain 
profitable. The increased volume will most likely come through 
marketing their services to credit unions outside their traditional 
service areas. The corporate credit unions that lose members to their 
competitors will have to decide whether to enhance their operations so 
they can also offer more complex products and services, focus on a 
niche product or service they can offer at a reasonable price or 
consider a viable merger partner. Conversely, the impact of competition 
may be somewhat softened as a number of corporate credit unions are 
looking at strategic alliances and partnerships as a means of offering 
some products and services.
    Net Worth/ALM: Corporate credit unions have found it increasingly 
challenging to remain profitable while maintaining a low-risk, highly 
liquid balance sheet. Economic and competitive factors will continue to 
put pressure on corporates to seek additional yield wherever possible. 
NCUA will continue to monitor corporate credit union modeling policies 
and procedures to ensure the information and reports produced provide 
reasonable information for decisionmakers of corporate credit unions.
Condition of the National Credit Union Share Insurance Fund
    The NCUSIF provides Federal share insurance coverage on credit 
union accounts generally up to $100,000 per member in a single 
federally insured credit union. As with FDIC coverage of deposits in 
banks and thrifts, depending upon the structure of the accounts, there 
is an opportunity to structure separate account coverage under the 
NCUSIF based on the number and nature of the accounts established.
    As of December 31, 2003, there were $479 billion in insured funds 
covered by the $6.163 billion NCUSIF, with a 1.27 percent equity ratio. 
At the end of the first quarter of 2004, the equity ratio in the NCUSIF 
was 1.29 percent.
    Under the Federal Credit Union Act (FCUA), the NCUA Board has the 
authority to determine the annual operating level of the fund between 
the statutorily prescribed parameters of 1.2 and 1.5 percent. This 
year, as in the last several years, the Board has set the operating 
level at 1.3 percent. If, at the end of the calendar year, the NCUSIF 
equity level is above 1.3 percent, the Board may declare a dividend. If 
it is below 1.3 percent, the Board may assess a premium. If the equity 
ratio falls below 1.2 percent, the FCUA requires a premium to be 
assessed. However, based upon the limited number of losses in federally 
insured credit unions, history has proven that in most years the fund 
level can be maintained without the assessment of a premium through the 
combination of the 1 percent of insured funds required deposit plus 
earnings on those deposits.
    Since the NCUSIF was capitalized in 1985, only one insurance 
premium has been assessed. That single premium assessment took place in 
1992 when the problems in New England area credit unions and in the 
real estate markets resulted in significant losses to the NCUSIF. Other 
than in that extraordinary situation, no 
premium assessments have been required. In fact, to the contrary, 
effective management of the NCUSIF and minimal credit union losses has 
resulted in the end-of-year equity ratio being above the required 
operating level in an amount sufficient to allow the NCUA Board to 
declare dividends to insured credit unions for six consecutive years 
beginning in 1995. Due to the high rate of share growth in 2001 and 
2002 during a period of declining earnings on the investments of the 
NCUSIF, the fund ended the year just below the 1.3 percent operating 
level and dividends were not paid in those years. This was also the 
case for 2003.
    There are two primary factors influencing the NCUSIF and its equity 
ratio at this time. First, the low interest rate environment of recent 
years has reduced the investment income to the NCUSIF. In December 
2003, gross income was $10.6 million, while in December 2002 gross 
income was $16.2 million. Investment earnings have been significantly 
reduced since many of the fund's older investments which yielded over 6 
percent have matured over the past several years. The funds are now 
being reinvested in Treasury Notes of similar maturities with yields 
less than 2 percent. During this same period, the yield of the NCUSIF 
has fallen over 300 basis points to 2.02 percent for December 31, 2003.
    Second, in July 2002 the NCUA Board adopted a policy of building 
its reserves for losses to the NCUSIF by transferring $1.5 million a 
month to the reserve account for incurred losses not specifically 
identified, in addition to reserves for specific cases and a pool for 
CAMEL Code 4/5 credit unions. The final $1.5 million transfer was made 
as of December 31, 2003 to the reserve account for incurred losses not 
specifically identified.
    Earnings on the fund principal have been sufficient to keep the 
NCUSIF appropriately funded into the future absent extraordinary 
losses, but dividends to insured credit unions that are allowable by 
statute when the fund equity level exceeds the established operating 
level are not likely to return until interest rates rise sufficiently 
to allow earnings to return to historical levels.
    Losses are anticipated to remain low and extraordinary losses are 
not anticipated based upon the ongoing examination and supervision of 
the credit unions NCUA regulates and insures.
    As of December 31, 2003, there were 217 problem credit unions coded 
CAMEL 4 or 5. Of the 217, only 10 are coded CAMEL 5. This number has 
remained quite constant over the last 4 years. For purposes of 
comparison, there were 338 problem credit unions in 1999 and, for a 10-
year indication, there were 319 in 1994.
    For 2003, NCUA was called upon to provide assistance to liquidate, 
merge or arrange a purchase and assumption for 13 federally insured 
credit unions. This number is trending lower than in the past 10 years 
when we averaged 27.8 such cases per year.
Agency Initiatives
    Over the course of the last 3 years, NCUA has taken several 
initiatives to help the agency address a rapidly changing and dynamic 
financial marketplace as well as bring more efficiency, accountability, 
and productivity to agency operations. These initiatives have been 
influenced by several factors. The overall number of credit unions is 
declining while assets and credit union membership are continuing to 
grow at record pace. Credit unions are becoming more complex and 
sophisticated as technology and member demands change and emerge. 
Economies of scale and availability of resources are likewise impacting 
the level and types of services offered. In recognition of these and 
other factors, the agency has taken a number of specific measures to 
address this changing financial and regulatory environment.
    In 2002, NCUA fully implemented a risk-focused examination program 
in conjunction with a system of risk-based scheduling of examinations. 
This change in examination emphasis and focus required an agency-wide 
effort to redesign and update the call report as well as other computer 
and informational system enhancements. In addition, NCUA embarked upon 
an aggressive and thoroughly enhanced training program for our field 
examiners, their supervisors, all regional office staff, and central 
office personnel in an effort to maximize productivity and to ensure 
the overall safety and soundness of the program. As a result of the 
risk-focused examination program, agency resources are now geared more 
than ever toward institutions and areas of risk requiring the most 
attention. Likewise, this approach permits examiners to direct their 
attention to areas of institutional risk and allows them to spend less 
time on issues presenting minimal or no risk to the credit union and 
the insurance fund. Risk-based scheduling of examinations has also 
provided NCUA flexibility to direct more of its resources to those 
institutions requiring additional supervision according to their 
individual risk factors while at the same time maintaining integrity in 
our first and foremost mission of ensuring safety and soundness. Not 
only has the program allowed NCUA to focus on true areas of risk, but 
it also has resulted in more efficient use of agency resources with 
fewer employees than were employed by NCUA 10 years ago.
    A key component of the risk-focused examination program was the 
NCUA Board's action to require the submission of quarterly call 
reports, known as 5300 reports, from all federally insured credit 
unions. Previously only credit unions over $50 million in assets were 
required to submit quarterly call reports. All other credit unions 
(79.8 percent of the 9,369 federally insured credit unions have less 
than $50 million in assets) were only required to submit call reports 
on a semi-annual basis. However, for the risk-focused examination 
program and risk-based scheduling to be 
effective and to properly monitor and identify areas of risk, NCUA felt 
it was necessary to require quarterly call reports from all federally 
insured credit unions so that the agency, and the State supervisory 
authority in the case of State-chartered, federally insured credit 
unions, could have the most current financial information available for 
analysis and review. In an effort to prevent unnecessary regulatory 
burden, a short form 5300 report was devised for the smallest credit 
unions with less than $10 million in assets for the interim first and 
third quarter reports. Call report data is analyzed and a financial 
performance report (FPR) is produced for every federally insured credit 
union, serving as the basis for ongoing risk analysis.
    Another component of the risk-focused examination program involves 
the designation of subject matter examiners. When areas with a greater 
opportunity for loss are identified, the risk-focused examination 
program relies upon staff to act as brokers for problem resolution. The 
increasing complexity of credit union operations and the advanced 
knowledge necessary to properly identify risk in some areas have made 
it increasingly difficult for a generalist examiner to resolve problems 
without more extensive knowledge and skills. Therefore, NCUA has 
developed an examiner structure where experienced examiners are 
designated and trained in a specific subject area of concentration such 
as IS&T and specialized lending. To further enhance the agency's 
examination program, NCUA is studying the creation of a large credit 
union examination specialty program based upon a pilot program now 
concluding. These programs are intended to ensure the necessary 
expertise is available to accomplish the more demanding examination 
skills required when examining more complex or larger institutions. By 
focusing staff development in certain areas, NCUA is able to accelerate 
the effective evaluations of technical subjects and maintain a current 
level of knowledge during periods of rapid industry development. This 
revised examiner structure will ensure that the sufficient skills and 
resources are available to timely identify and limit potential risk to 
NCUSIF.
    Beginning in 2001, NCUA initiated an internal agency self-study, 
known as the Accountability In Management (AIM) study, whereby agency 
management personnel were tasked with identifying potential areas of 
NCUA's internal operations where cost savings and greater efficiency 
and productivity could be realized within the strategic goals of the 
agency without sacrificing the safety and soundness of the credit union 
industry. This in-depth process was finalized over a 2-year period in 
two phases with the first portion focusing on the central office and 
the second phase focusing on the regional offices. The results of this 
process have been extremely positive both for agency effectiveness and 
efficiency. The overwhelming majority of the AIM recommendations have 
been implemented and others are presently in the process of 
implementation with a timetable of being fully implemented by the end 
of 2004.
    One of the most significant recommendations stemming from the AIM 
study was the realignment and reduction of NCUA's regional offices from 
6 to 5. Realignment has been accomplished, and in January 2004 one of 
NCUA's six regional offices closed while another regional office moved 
to a lower-cost area. This consolidation, along with the restructuring 
of several offices in both central and regional offices, is expected to 
save the agency and its stakeholders $27 million over the next 10 
years. Additionally, as part of this internal initiative, agency 
staffing levels have been reduced by 58 FTE's over the last 2 years 
without any adverse impact on the agency's safety and soundness 
responsibilities. All of the AIM staffing reductions were accomplished 
through attrition and without layoffs, forced retirements, or costly 
buyouts.
    The NCUA Board has successfully implemented a number of regulations 
and updates that are consistent with the spirit and requirements of the 
Federal Credit Union Act as amended by passage of the Credit Union 
Membership Access Act of 1998 and are resulting in stronger, safer, and 
sounder credit unions. These updates in areas such as field of 
membership, investment options, and member business lending, among 
others, have served to provide Federal credit unions with much needed 
diversification options required to remain competitive and financially 
strong in a constantly changing and rapidly evolving financial 
marketplace.
    Among the more notable initiatives undertaken by NCUA has been the 
successful Access Across America program which is designed to create 
economic empowerment for people from all walks of life, particularly 
those residing in underserved or unbanked neighborhoods and 
communities. This initiative has seen impressive results as 494 Federal 
credit unions across the United States have voluntarily adopted over 
1,021 CDFI-designated investment or underserved areas into their fields 
of membership since the beginning of 2000. As a result of their 
expanding into underserved areas, credit unions are required to be 
financially able to extend services to the entirety of the community, 
have an acceptable business and marketing plan to do so and establish a 
physical presence in the community. The result has been the extension 
of access to affordable financial services and products to over 64.7 
million Americans residing in underserved communities who previously 
lacked access to a not-for-profit, member-owned credit union as a 
alternative source of lower cost financial services in their local 
neighborhoods--neighborhoods which have become the home of countless 
higher cost lenders such as pawn shops, rent-to-own centers, check 
cashing outlets, and title loan companies.
    NCUA call report data indicates that the 494 Federal credit unions 
adding underserved areas to their field of membership since 2000 have 
grown their membership at an annual rate of 4.36 percent, which is 237 
percent greater than the annual membership growth rate of 1.29 percent 
for Federal credit unions overall during the same 4-year period. 
Lending growth increased at an annual rate of 12.5 percent in those 
Federal credit unions adopting underserved areas, and savings growth 
has increased 13.5 percent annually. These loan and savings rates are 
58 percent and 30 percent higher than the respective growth rates of 
these two categories in the Federal credit union community as a whole.
Recommended Regulatory Reforms
    In response to a request from Chairman Shelby, and on behalf of the 
Board of the National Credit Union Administration, I provided the 
Committee in June 2003 with seven specific recommendations to address 
unnecessary regulatory burden, improve productivity and other needed 
regulatory reforms for Federal credit unions. It is my understanding 
that each of my colleagues from Federal financial regulatory agencies 
represented here today likewise made their own recommendations in 
response to your letter. We are pleased that these regulatory relief 
issues, among others, are being evaluated for possible inclusion in 
legislation this Congress.
    The addendum to this testimony describes NCUA's proposals and the 
reasons for them. These proposals are consistent with the mission of 
credit unions and the principles of safety and soundness. They address 
statutory restrictions that now act to frustrate the delivery of 
financial services because of technological advances, current public 
policy priorities or market conditions.
    I would encourage the Committee to give serious consideration to 
NCUA's regulatory relief recommendations. As always, NCUA stands ready 
to work as a resource to the Committee on these and other matters 
impacting the delivery of financial services through and the safety and 
soundness of America's credit unions.
Conclusion
    Again, thank you, Mr. Chairman, for the opportunity to appear 
before you today on behalf of NCUA and my colleagues on the NCUA Board 
to discuss the state of the American credit union industry. I will be 
more than pleased to respond to any questions the Committee may have or 
to be a source of any additional information you may require.



                PREPARED STATEMENT OF KEVIN P. LAVENDER
      Commissioner, Tennessee Department of Financial Institutions
                            on Behalf of the
                  Conference of State Bank Supervisors
                             April 20, 2004

    Good morning, Chairman Shelby, Senator Sarbanes, and Members of the 
Committee. I am Kevin Lavender, Commissioner of Financial Institutions 
for the State of Tennessee, and Chairman of the Regulatory Committee of 
the Conference of State Bank Supervisors (CSBS). Thank you for inviting 
CSBS to testify on the condition of the State banking system.
    CSBS is the professional association of State officials who 
charter, regulate, and supervise the Nation's approximately 6,400 
State-chartered commercial and savings banks, and nearly 400 State-
licensed foreign banking offices nationwide.
    CSBS gives State bank supervisors a national forum to coordinate, 
communicate, advocate, and educate on behalf of the State banking 
system. We especially appreciate this opportunity to discuss the state 
of our Nation's banking system in general, and the state of the State 
banking system in particular.
Condition of the Industry
    As you have heard from my colleagues on this panel, the general 
health of the banking industry is excellent. State-chartered banks, 
which make up approximately three-quarters of the Nation's commercial 
banks, have shared in the industry's record levels of prosperity.
    Net income of State-chartered commercial and savings banks at year-
end 2003 reached $44.2 billion, an 18 percent increase over the 
previous year's record levels. State banks' aggregate equity capital 
ratio stands above 9 percent, a level that exceeds the industry 
aggregate and regulatory requirements, and has risen steadily over the 
past 3 years. State banks' core capital, or leverage ratios, are 
equally strong, and slightly higher than those of their federally 
chartered counterparts. State banks' ratio of nonperforming assets to 
assets continues to decline, and stands even lower than the industry's 
overall level.
    As regulators, we look for areas of concern, but even some of these 
areas have shown improvement over the last several quarters. We saw 
deposits in State-chartered banks grow from year-end 2001 to 2002, and 
again from year-end 2002 to 2003. And our banks are still finding good 
loans to make, and we saw strong growth in earning assets in 2003.
    We never forget that these record levels of prosperity are 
occurring in an environment of historically low interest rates, and 
examiners pay special attention to the vulnerability of our banks' 
portfolios to interest rate volatility. My colleagues and I have also 
been particularly concerned about banks' internal controls systems, 
because experience has shown us that nothing disguises bad management 
as well as a good economy.
    Consolidation of the banking industry continues, raising concern 
about concentration of risk and the range of meaningful choices 
available to consumers. The pace of consolidation slowed in 2003, but 
consolidations continue among the very largest institutions. The 
Nation's 50 largest banks now hold almost 63 percent of banking assets 
nationwide. In Tennessee, the six largest banks hold more than 50 
percent of local banking assets; this percentage jumps to more than 80 
percent in Davidson County, the area around Nashville.
    We expected consolidation in the wake of the Riegle-Neal Interstate 
Banking and Branching Efficiency Act. Consolidation has benefited not 
only the institutions involved, but also customers who live and work in 
more than one State or metropolitan area. In some cases, though not 
all, consolidation seems to have led to lower costs for consumers and 
more convenient access to services.
    My colleagues and I worry, however, about declining diversity in 
our banking system, and about the forces driving this latest round of 
consolidation. I will discuss these concerns at greater length later in 
my testimony.
    The number of State-chartered banks declined by just over 1 percent 
in 2003, compared with a consolidation rate of just over 2 percent in 
2002. A steady stream of new bank charters and conversions has 
partially offset the number of institutions lost to mergers over the 
past several years. Of the 117 new banks chartered last year, 100 chose 
a State charter. This rate--85 percent--shows that the banking industry 
and the business community continue to believe in the value of the 
State charter. Ten years after the enactment of the Riegle-Neal 
Interstate Branching Efficiency Act, the State banking system remains a 
vibrant and essential part of our Nation's financial services 
infrastructure.
    State-chartered banks make up just over 74 percent of all 
commercial banks nationwide. They tend to be smaller than national 
banks, holding in the aggregate just under 44 percent of U.S. banking 
assets.
    The State system does, however, include several large and complex 
institutions that operate across State lines. Over the past 10 years, 
State banking departments have worked with the FDIC and the Federal 
Reserve, as well as other relevant State and Federal regulators, to 
develop a seamless supervisory system that ensures oversight while 
minimizing supervisory burden. This system continues to evolve.
    Our Nation's financial system--and our Nation's financial services 
policies--have always emphasized the need for balance, diversity, and 
opportunity. Americans have traditionally been wary of monolithic 
authority in any form, whether it is a single oppressive ruler or one 
gigantic corporation. Chairman Greenspan has noted on many occasions 
that the diversification of our financial system has been an essential 
element in preventing the kind of lingering crises we have seen in Asia 
and Europe. Our State banking system encourages entrepreneurship in the 
banking industry, creating opportunities for new credit providers to 
enter the market and find new ways to serve their communities.
    As we have seen time and time again, however, not only in the 
banking industry but also in the business world at large, even the most 
entrepreneurial environment needs oversight, especially when public 
confidence is at stake.
    The State banking departments supervise and regulate a wide range 
of financial businesses in addition to commercial banks and savings 
banks. Most State banking departments, including my own, supervise 
State-chartered credit unions as well as thousands of nondepository 
financial businesses.
    The Tennessee Department of Financial Institutions, for example, 
licenses and supervises 749 industrial loan and thrift offices, 63 
insurance premium finance companies, 1,287 mortgage companies, 390 
check cashers, 1,196 deferred presentment services companies (payday 
lenders), and 42 money transmitters, as well as 159 State-chartered 
banks, 10 trust companies, two Business Investment Development 
Companies, and 129 State-chartered credit unions.
    Our mission is to provide the citizens of Tennessee with a sound 
system of State-chartered financial institutions. We do this by 
monitoring compliance with the State laws and regulations that promote 
sound business practices and safeguard depositors and consumers. We 
conduct onsite examinations not only of our depository 
institutions, but also of our nondepository licensees. An entire 
division of our department was recently formed and is dedicated to 
consumer resources; in fact, the department resolved 500 complaints in 
2003.
    Senators, State banks in Tennessee and nationwide are healthy. The 
State banking system, however, faces a grave threat, and I ask your 
help in restoring the balance that makes it possible for my department 
to fulfill its mission.
Role of Preemption in Maintaining the Health of the Banking System
    The balance between Federal and State authority over banking 
activities, and between large and small institutions in the 
marketplace, continues to evolve. If nearly 140 years of history have 
shown us anything, it is that the health of the American banking system 
depends on competition and meaningful choice: The availability of a 
wide range of options for both consumers and financial institutions.
    The Conference of State Bank Supervisors is committed to 
maintaining the competition and choice that have characterized our dual 
banking system. Competition and choice in our banking system remain 
strong despite the industry's consolidation, and the availability of 
the State charter is crucial to this balance. The largest institutions 
can and should grow to serve their customers and reach new competitive 
levels in a global market. As big institutions become even bigger, de 
novo chartering--again, primarily at the State level--continues to 
guarantee local banking options to all consumers. Even in this global 
economy, it remains true that one size does not fit all.
    A key element of this dynamic balance is the question of Federal 
preemption of State authority. My colleagues and I believe that Federal 
preemption can be appropriate, even necessary, when genuinely required 
for consumer protection and competitive opportunity.
    Few matters of Federal preemption meet this high standard. One that 
does is the permanent extension of the amendments to the Fair Credit 
Reporting Act, which we congratulate you on enacting last year. The 
CSBS Board of Directors determined that these amendments served the 
national interest, and we applaud the careful consideration that both 
houses gave that legislation.
    Many State banking departments and other State agencies have 
consumer protection mandates that they take just as seriously as their 
Federal counterparts do. As Securities and Exchange Commission Chairman 
William Donaldson has noted, Federal authorities ``cannot be 
everywhere.'' Our State-level consumer protection initiatives serve the 
public interest in their own right, but also complement Federal law 
enforcement efforts in a very important way.
    Many of the nondepository financial businesses that my office 
licenses have some affiliation with a larger, deposit-taking financial 
institution. In the wake of the Comptroller of the Currency's recently 
promulgated rules that preempt Tennessee authority over operating 
subsidiaries of national banks, these businesses have a powerful 
incentive to change their corporate structure for no reason other than 
to escape state oversight.
    The Comptroller of the Currency's recent regulations preempt almost 
all State laws that apply to these businesses, if they are operating 
subsidiaries of national banks. This regulation also tries to shield 
all national banks--and their operating subsidiaries--from oversight, 
inspection, and enforcement actions by any State authority, including 
the State attorneys general.
    The Comptroller has said repeatedly that these new regulations 
present no fundamental shift in the OCC's roles or responsibilities. He 
has called these regulations merely the next logical step in the OCC's 
interpretation of the National Bank Act, the Riegle-Neal Interstate 
Banking and Branching Efficiency Act, and Gramm-Leach-Bliley. The 
Comptroller has also said that these changes are incremental in nature 
and unlikely to have major effects on the banking industry or on 
consumers' experiences with financial institutions.
    These claims are simply not true. These regulations are not minor 
or incremental changes. Their scope is nearly unlimited, and their 
implications are potentially enormous. These regulations exceed the 
OCC's statutory authority and disregard Congressional intent. They 
effectively discard the oversight and consumer protection structure 
already in place for these businesses, and they ignore Congress's 
design for functional regulation.
    The OCC adopted these regulations over the strong objections of 
CSBS, the National Governors Association, the National Conference of 
State Legislatures and all 50 State attorneys general. The OCC also 
ignored requests from Members of Congress for extra time to consider 
their implications. Instead, the OCC issued a set of regulations that 
will affect millions of consumers across the country without a public 
hearing and without meaningful consultation with the parties these 
regulations would affect. We object strongly to the OCC's process in 
issuing these regulations, and we look forward to the findings of the 
General Accounting Office's study of this process.
    Technology is changing the delivery of financial products. Many 
large banks and some small banks look less like the old commercial bank 
and more like the diversified financial services providers envisioned 
by the Gramm-Leach-Bliley Act. We 
appreciate that the largest financial services providers want more 
coordinated regulation that helps them create a nationwide financial 
marketplace. These goals are understandable. The State of Tennessee and 
CSBS support coordinated regulation in order to promote modernization 
of financial services, healthy competition among providers, and greater 
availability of financial services to the public.
    The OCC's new regulations, however, usurp the powers of the 
Congress, stifle States' efforts to protect their citizens, and 
threaten not only the dual banking system but also public confidence in 
our financial services industry. They challenge the functional 
regulatory structure created by Gramm-Leach-Bliley and set the Office 
of the Comptroller of the Currency as the Nation's dominant regulator 
of financial institutions. They also seem to encourage consolidation 
among our largest institutions, concentrating financial risk in a 
handful of gigantic institutions that may become--if they are not 
already--not only too big to fail, but also too big to supervise 
effectively.
Importance of Decentralized Supervision
    Maintaining a local role in consumer protection and a strong State 
banking system is more important than ever in the wake of the current 
round of mergers among our Nation's largest financial institutions. 
These mergers make economic sense for the institutions involved, and 
may offer the customers of these institutions a larger menu of products 
and services at prices that reflect economies of scale. But the 
strength of our banking system is its diversity--the fact that we have 
enough financial institutions, of enough different sizes and 
specialties, to meet the needs of the world's most diverse economy. 
Centralizing authority or financial power in one agency, or in a small 
group of narrowly regulated institutions, would threaten the dynamic 
nature of our economy.
    State supervision and regulation are essential to our decentralized 
system. State bank examiners are often the first to identify and 
address economic problems, including cases of consumer abuse. We are 
the first responders to almost any problem in the financial system, 
from downturns in local industry or real estate markets to the 
emergence of scams that prey on senior citizens. We can and do respond 
to these problems much more quickly than the Federal Government.
    The Comptroller has argued that the laws and rules States have 
enacted to protect their citizens are burdensome to national banks. We 
are sensitive to regulatory burden, and constantly look for ways to 
simplify and streamline compliance. Your own efforts in this area, 
Senator Shelby, have greatly reduced unnecessary regulatory burden on 
financial institutions regardless of their charter. The industry's 
record earnings levels suggest that whatever regulatory burdens remain, 
they are not interfering with banks' ability to do business profitably.
Dual Banking System and History of Preemption
    The dual banking system is part of our democratic heritage. The 
phrase ``dual banking'' refers not only to the parallel systems of 
State and Federal banking regulation, but also to the interaction of 
State and Federal laws for the benefit of our national and local 
economies. Since the creation of our dual banking system in 1864, all 
banks, regardless of their charter, have been subject to a combination 
of Federal and State laws. The balance of State and Federal authority 
has evolved, shaped by new State and Federal statutes and by a growing 
body of case law.
    The 10 years since the passage of Riegle-Neal have transformed the 
financial services industry, and in this transformation we have seen 
the value and strength of our dual banking system. Many believed that 
nationwide banking would mean the end of the State regulatory system--
that the States would become irrelevant or be unwilling to compromise 
in order to supervise multi-State institutions. Instead, the State 
banking system is now stronger, in many ways, than it was 10 years ago. 
Interstate branching and financial modernization have compelled all of 
us at the State level to answer the hardest questions: What is the 
purpose of State supervision? What do we need to do to protect our 
citizens, and what have we been doing just because ``we always did it 
that way''? How can we leverage the resources of other agencies to 
improve our own performance and reduce regulatory burden? What 
authority do we truly need, and what is just a battle over turf ?
    Senators, these are issues that all regulators struggle with daily. 
Because so many powers originated at the State level, because the 
States were the first to pass interstate branching laws, and because 
Congress let the States control the phase-in to interstate branching, 
we have developed models for interagency information sharing, 
cooperation, and coordination that benefit the entire financial 
services industry.
    Many, even most, of the new Federal powers under Riegle-Neal and 
Gramm-Leach-Bliley originated at the State level. Over the past 10 
years, however, we have seen a new aspect of the dual banking system's 
value. As new products and services have emerged, so too have new 
opportunities for consumer confusion and, in some cases, abuse. The 
explosion of the mortgage industry created a new class of lenders for 
nonprime borrowers, and in some cases, these lenders engaged in 
predatory and fraudulent practices. Many States sought remedies through 
enforcement of existing State laws, new legislation, and financial 
education campaigns. Our efforts have reached thousands of borrowers 
and potential borrowers, punished and discouraged predatory lenders, 
and brought a national spotlight to this problem.
    Our experience in this area shows that the dual banking system is 
not a museum artifact, but a vital and essential dynamic for promoting 
new financial services while offering new approaches for consumer 
protection.
    Ten years after the passage of nationwide banking, the dual banking 
system is more important than ever. It ensures diversity in our 
financial services system, and it ensures that the regulatory system 
addresses local concerns as well as national concerns. In this case, 
that specifically means the interests of local borrowers and consumers.
    The traditional dynamic of the dual banking system has been that 
the States experiment with new products and services that Congress 
later enacts on a nationwide basis. We generally discuss this history 
in terms of expanded powers, but the States have been innovators in the 
area of consumer protection, as well. States enacted CRA and fair 
lending statutes before the Federal Government did, and States are now 
leading the way on predatory lending, identity theft, regulation of 
overdraft protection products, and privacy initiatives. These State 
laws, which the OCC sees as burdensome to national banks, are in fact 
providing all of us the opportunity to see what works and what does 
not, and find the appropriate balance before seeking legislation on a 
national level.
Conclusion
    Our highly diverse financial system is the envy of the world. 
American markets are flexible and responsive, and American banks are 
competitive globally as well as locally, in large part because of our 
decentralized regulatory system.
    We believe that our dual banking system acknowledges the needs of 
multi-State banks and financial services firms while protecting 
consumers. We have worked hard, within the State system and with our 
counterparts at the Federal banking agencies, to develop a system of 
supervision that allows for innovation while ensuring safety, soundness 
and economic stability. The strong condition of our 6,400 State-
chartered banks and 400 State-regulated offices of foreign banks is the 
best evidence of our success.
    CSBS looks forward to working with the Congress to find additional 
ways to address the needs of an evolving nationwide financial services 
system in a way that maintains this strong condition, minimizes 
unnecessary regulatory burden, and ensures that all Americans retain 
their access to the broadest possible range of financial opportunity.
    We thank you for this opportunity to testify, and look forward to 
any questions you and the Members of the Committee might have.

      RESPONSE TO A WRITTEN QUESTION OF SENATOR SANTORUM 
                      FROM ALAN GREENSPAN

Q.1. Chairman Greenspan, in the summer of 2002, I expressed 
concern with the potentially adverse competitive impact that 
the operational risk-based capital charge in the Basel Capital 
Accord will have on U.S. banks. Last fall, the leadership of 
the House Financial Services Committee also raised concerns 
with the charge for operational risk. What steps are being 
taken to ensure that these concerns, as well as other concerns 
raised by Members of Congress, are getting the attention this 
issue warrants? Can we expect to see any of these concerns 
addressed in the next version of the Accord?

A.1. The Federal Reserve Board and other Federal banking 
agencies take very seriously the concern about potential 
competitive effects the operational risk-based capital charge 
in Basel II will have on U.S. banks. Accordingly, the agencies 
have several initiatives underway to address this issue.
    The agencies are currently performing extensive reviews of 
the large U.S. banks' own internal assessment of the 
operational risks they face and the capital that they estimate 
would be needed to support those risks, using the proposed 
Advanced Management Approach (AMA). This benchmarking exercise 
will help U.S. supervisors better understand the preparedness 
of these banks to employ the AMA for estimating their 
operational risk capital charge. The three reviews performed to 
date indicate strong bank management support for the flexible 
implementation of internal processes and data collection 
efforts consistent with the AMA for operational risk.
    In addition to the extensive benchmarking exercise, staff 
from the banking agencies continue to evaluate the comments 
received on the Advanced Notice of Proposed Rulemaking and 
through subsequent discussions with banks' management. Based on 
the revised capital framework that the Basel Committee is 
planning to release in June, the agencies plan to perform a 
comprehensive quantitative impact study of all the components 
of Basel II capital charges for the large U.S. banks. The 
resulting analysis of this information should be useful in 
understanding the implications of the new framework on the 
overall capital requirements of banks as well as the 
competitive impact. This analysis may also lead to 
recalibration and revisions to the framework that would serve 
as the basis for a Notice of Proposed Rulemaking in 2005.
    In light of the concerns regarding potential competitive 
effects that an operational risk-based capital charge may have 
on U.S. banks, the Federal Reserve is also in the process of 
conducting an empirical study of such possible effects. The 
study will specifically address the potential competitive 
disadvantage that an explicit pillar one operational risk 
capital charge might create for U.S. banks vis-a-vis nonbank 
competitors, non-Basel II, U.S. banks, and foreign banks whose 
regulators allegedly might be less aggressive in applying Basel 
rules than the U.S. regulators. The results of this study 
should be available by the end of the year.
    In response to your final question on whether competitive 
concerns will be addressed in the next version of the Accord, 
the U.S. regulators note that the AMA has been included in the 
framework at the insistence of U.S. banks. In effect, the 
capital requirement for operational risk under the AMA would be 
based upon the banks' own internal economic capital estimate 
for such risk, as long as their processes are comprehensive and 
well-reasoned.

       RESPONSE TO WRITTTEN QUESTIONS OF SENATOR SCHUMER 
                    FROM JOHN D. HAWKE, JR.

Q.1. Did any of the 16 Saudis who were in the United States 
under diplomatic cover, but in actuality worked in a Virginia 
school that was teaching terrorism, or a Saudi consular 
official in Los Angeles who was deported in 2003, have accounts 
at Riggs or receive money from these accounts and, if so, how 
much?

A.1. Riggs has conducted a search of its account records and 
has identified a total of 17 accounts in the names of 11 of the 
16 Saudis that you reference. Five of these accounts have been 
closed leaving 12 open accounts in the names of 9 of the 16 
Saudis that you reference. The Virginia school that you 
reference had five accounts at Riggs that have recently all 
been closed. The Saudi consular official in Los Angeles did not 
have an account at Riggs. Riggs is conducting a review of 
transaction activity for each of the accounts identified, 
subject to the OCC's oversight. The OCC is in process of 
reviewing Riggs' actions relating to these accounts and 
determining whether their conclusions were adequate and 
consistent with the OCC's enforcement actions.

Q.2. In your enforcement action on July 16, 2003, Riggs Bank 
was tasked with filing suspicious activity reports within 150 
days in relationship to these accounts. Have these reports been 
filed? If so, how many?

A.2. I am precluded by law from disclosing the content or even 
the existence of a SAR. However, I can tell you that pursuant 
to the July 2003 cease and desist order, Riggs hired KPMG to 
conduct a study of its Saudi Embassy accounts and, as part of 
that study, identify transactions that were suspicious in 
nature and which required SAR filings.

Q.3. What are you doing to tighten things up so that there are 
no future Riggs Bank situations?

A.3. We have taken and we are in the process of taking a number 
of actions to improve our supervision in the anti-money 
laundering area. These include supplemental directions to our 
examiners and implementation of new systems that will enable us 
to enhance identification of high-risk banks, and flag 
situations that warrant follow-up supervisory or enforcement 
actions. I have described these steps in more detail in my 
written testimony that was provided to the Committee for the 
June 3 hearing. A copy is enclosed.

Q.4. It is my understanding that there were two checks on Riggs 
in relation to Bank Secrecy, one in 2000 and one in 2003, and 
that most of the bad stuff occurred between. Is it that you are 
understaffed? If I am right about this, would you say that 
would not have been enough?

A.4. Riggs has been under a great deal of scrutiny for several 
years. In fact, between 2000 and 2003, the OCC conducted nine 
examinations and reviews that were BSA-related. More 
information about these examinations and the history of our 
supervision of Riggs is set forth in more detail in my written 
testimony that was provided to the Committee for the June 3 
hearing. Neither the number nor the scope of the examinations 
that we performed at Riggs during the period in question was 
driven by staffing issues.




       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT 
                     FROM DONALD E. POWELL

Q.1. Concerns have been raised about the fact that the owners 
of industrial loan banks are not regulated as bank holding 
companies by the Federal Reserve. Some critics have charged 
that industrial banks, their depositors, and perhaps the 
deposit insurance system are endangered by the banks' 
affiliation with ``unregulated'' parent companies.
Q.1.a. Can you describe the regulatory regime that applies to 
industrial loan banks and their parent companies? What 
authority do the FDIC and State bank regulators have to look 
into the activities of industrial banks' holding companies and 
affiliates?

A.1.a. The FDIC and State bank supervisors regulate industrial 
loan companies and industrial banks in the same manner as other 
State nonmember banks. Industrial banks are subject to the 
FDIC's safety and soundness regulations (with the exceptions 
discussed below), as well as Federal consumer protection 
regulations. The FDIC's authority to pursue formal or informal 
enforcement actions against an industrial bank is the same as 
the FDIC's authority with respect to any other State nonmember 
bank, with limited exceptions pertaining to cross-guaranty and 
golden parachute payments (although legislative corrections are 
being pursued in the proposed Financial Services Regulatory 
Relief Act of 2003).
    Like all insured depository institutions, industrial banks 
receive regular examinations, during which compliance with 
regulations is reviewed and overall performance and condition 
are analyzed. For FDIC-insured, State-chartered banks that are 
not members of the Federal Reserve System, the FDIC, or the 
State authority conducts the examination. The FDIC has 
agreements with most States to conduct examinations under 
alternating schedules, although in the case of larger or 
troubled institutions, the FDIC and the State authority 
generally conduct joint or concurrent examinations.
    Aside from the differences noted above for which 
legislative corrections are being pursued, the FDIC's authority 
over insured industrial banks is essentially the same as its 
authority over other State nonmember banks, and is considered 
adequate to protect the deposit insurance funds.
    Although companies that control industrial banks are 
generally not regulated by any Federal banking agency,\1\ the 
FDIC and chartering State authorities directly supervise an 
insured institution's activities and other relationships with 
the parent company. An industrial bank must comply with 
Sections 23A and 23B of the Federal Reserve Act, which restrict 
or limit transactions with a bank's affiliates--including 
parent companies--and with established Rules and Regulations, 
including:
---------------------------------------------------------------------------
    \1\ An industrial bank can be owned by a bank holding company, in 
which case the parent company is subject to Federal Reserve 
supervision. Under a proposed rule, broker-dealers that own ILC's may 
soon be able to choose consolidated supervision by the Securities and 
Exchange Commission. See Alternative Net Capital Requirements for 
Broker-Dealers That Are Part of Consolidated Supervised Entities, 62 
Fed. Reg. 62872 (proposed November 6, 2003, to be codified at 17 CFR 
Part 240).

 Part 325 pertaining to capital standards,
 Part 364, which requires safe and sound standards of 
    operation,
 Regulation 0, governing credit to insiders and their 
    related interests, and
 Consumer protection and CRA regulations.

    As with all insured depository institutions, if an 
industrial bank becomes undercapitalized, its parent company 
must guarantee that the bank will comply with the capital 
restoration plan that the bank must submit under the Prompt 
Corrective Action provisions of the Federal Deposit Insurance 
Act. An industrial bank's parent company, however, is not 
subject to the penalties imposed on a financial holding company 
if a subsidiary bank has an impairment of capital or receives a 
less than satisfactory CRA rating. The industrial bank itself 
would be subject to standard administrative actions to resolve 
a capital impairment issue or a less than satisfactory CRA 
rating. The parent company of an industrial bank would not be 
subject to forced divestiture or legal restrictions that may be 
imposed on financial holding companies with such problems at 
the bank level.
    In examining any insured depository institution, the FDIC 
has the authority (under 12 U.S.C. Sec. 1820(b)(4)) to examine 
any affiliate of the institution, including its parent company, 
as may be necessary to determine the relationship between the 
institution and the affiliate and to determine the effect of 
such relationship on the institution. Consequently, the FDIC 
has the authority to examine the parent company of an 
industrial bank for the purposes of determining (i) the 
relationship between the industrial bank and its 
parent and (ii) the effect of such relationship on the 
industrial bank. In the case of a parent company that is 
subject to the reporting requirements of another regulatory 
body covered under the Gramm-Leach-Bliley Act of 1999, such as 
a State insurance commissioner, the FDIC has agreements in 
place to share information with the functional regulator.
    The vast majority of industrial bank parent companies are 
subject to the examination authority of their respective State 
supervisor. The States of Utah, California, and Nevada, which 
collectively supervise 47 of the 55 FDIC-insured industrial 
banks, have direct authority to conduct examinations of parents 
and affiliates. The Utah Department of Financial Institutions 
(DFI) requires all parent companies to register with the State 
under Section 7-8-16 of the Utah Code, and has authority to 
examine such companies under Section 7-1-510. California law no 
longer makes a distinction between banks and industrial loan 
banks; currently both entities are subject to the California 
State Financial Code. The 
California DFI has authority to examine parent organizations 
though Chapter 21, Section 3700 (specifically Section 3704) of 
the California Financial Code and to require reports and 
information through Section 3703 of the California Financial 
Code. In the State of Nevada, holding companies are required to 
register with the Secretary of State. The Financial 
Institutions Department for the State of Nevada has authority 
to conduct examinations of parent organizations in Section 
658.185.

Q.1.b. Does the FDIC use its authority to examine industrial 
banks' parent companies? What is the nature of this review? 
What has been the agency's experience?

A.1.b. As noted earlier, the FDIC has the authority to examine 
an industrial bank's parent for the purpose of determining (i) 
the relationship between the industrial bank and its parent and 
(ii) the effect of such relationship on the industrial bank. 
When it has been deemed necessary to review such relationships, 
the existence of this examination authority has greatly 
enhanced the FDIC's success in obtaining the information needed 
to make such determinations without any resistance from the 
parent organization. As a 
result, the FDIC has had only two cases where it had to use its 
authority to examine industrial banks' parent companies on-
site. These cases were problem situations that involved 
securitization activities run through the parent organization.
    It is important to note that industrial banks that have 
been rated 3, 4, or 5 had problems that are not unique to their 
charter, nor have troubled industrial banks had a history of 
unusual influence from parent companies or affiliates. The 
issues facing the troubled institutions have not been 
dissimilar from those encountered by the industry at-large, 
including those in a traditional bank holding company 
framework.

Q.1.c. Does the relationship of an industrial loan bank to its 
holding company involve risks that are not present with regard 
to commercial banks and bank holding companies? If so, what 
does the FDIC do to address them?

A.1.c. Most existing industrial banks are generally operating 
under a business model that is not dissimilar to those of 
commercial banks and bank holding companies. These models can 
be grouped into the following broad areas:

 Institutions serving a community niche--these 
    institutions often provide credit to consumers and small- 
    to medium-sized businesses. In addition to retail deposits, 
    funding sources may include commercial and wholesale 
    deposits, as well as borrowings. Institutions that operate 
    within a larger corporate organization also may obtain 
    funding through the parent organization.
 Institutions that focus on specialty lending programs, 
    including leasing and factoring-funding sources for this 
    relatively small number of institutions may include retail 
    and commercial deposits, wholesale deposits, and 
    borrowings.
 Institutions that are embedded in organizations whose 
    activities are predominantly financial in nature, or within 
    the financial services units of larger corporate 
    organizations--these institutions may serve a particular 
    lending, funding, or processing 
    function within the organization. A few institutions 
    restrict themselves to facilitating corporate access to the 
    payment system or supporting cash management functions, 
    such as administering escrowed funds.

    However, a few industrial banks do operate under a business 
model that does involve activities that directly support the 
parent organizations' distinctly commercial activities. These 
institutions largely finance retail purchases of parent company 
products, ranging from general merchandise to automobiles, fuel 
for rental car operations, and heating and air conditioning 
installations. Loan products might include credit cards, lines 
of credit, and term loans. Funding is generally limited to 
wholesale or money center operations, borrowings, or other 
options from within the parent organization. The FDIC ensures 
that these risks are addressed by the bank's risk management 
practices through the examination process and regulatory 
controls over affiliate transactions, requirements for safe and 
sound operations, minimum capital standards, and the other 
supervisory and regulatory authority described earlier.

Q.2. Concerns have also been raised about whether liberalized 
interstate branching authority, if approved by Congress for 
commercial banks, should also apply to industrial loan banks.
Q.2.a. Isn't it true that industrial loan banks currently have 
the same branching authority (and the same branching 
limitations) as other banks? To what extent have they used this 
authority in the past? Is any industrial loan bank operating a 
network of bank branches in the States where they are permitted 
to do so?

A.2.a. Industrial banks, like other State banks, get their 
power to branch from their chartering authority. Generally, 
industrial banks have the same branching authority (and are 
subject to the same branching limitations) as other State 
banks. Currently, the majority operate in Utah and California, 
which provide essentially the same branching authority to 
industrial banks as to other State banks. This authority has 
not been used to any significant extent.
    There are a few industrial banks with a relatively small 
network of branches (2,030 branches); however, these branches 
provide limited services (such as purchasing auto loans from 
local auto dealers) and do not operate as typical commercial 
bank offices. As of year-end 2003, industrial banks were 
either: (i) community focused with few, if any, branches; (ii) 
focused on specialty lending programs, such as credit cards, 
leasing, or factoring; or (iii) embedded in organizations whose 
activities are predominately financial in nature.
    All the largest industrial banks are subsidiaries of large 
financial firms (such as Merrill Lynch) and serve a specific 
lending, funding, or processing function within the 
organization. These entities tend to have very limited 
branching or none at all. For example, Merrill Lynch Bank USA 
has two branches. American Express Centurion Bank, UBS Bank 
USA, BMW Bank of North America, Volkswagen Bank USA, and Volvo 
Commercial Credit Corp of Utah have no branches.

Q.2.b. Has branching by industrial loan banks been harmful has 
there been injury to depositors, competitors, or the deposit 
insurance system?

A.2.b. Since branching by industrial banks has been limited, 
there are no identified problems in this area that have been 
harmful to depositors, competitors, or the deposit insurance 
system. While branching by industrial banks is limited, some 
industrial banks still engage in activities that are statewide, 
regional, or national in scope. However, these serve a narrow 
customer niche. This group of industrial banks has had few 
problems during their existence. Likewise, branching activity 
by this group has not been harmful to depositors, competitors, 
or the deposit insurance funds.

Q.2.c. If industrial loan banks, along with other banks, were 
given expanded de novo branching authority, would the FDIC and 
State regulators have the power to prevent abuses of this 
authority? Would this authority give industrial loan banks a 
competitive advantage over other banks or over bank holding 
companies? If it would create inequalities, could the FDIC do 
anything to address them?

A.2.c. The FDIC's ability to deal with potential abuses arising 
from expanded de novo branching authority for industrial banks 
would be the same as for any other State nonmember bank. Any 
branching activities by an industrial bank would be subject to 
the same application and approval process with the FDIC and 
State authorities as any other state nonmember bank. The FDIC 
and State bank supervisors regulate industrial banks in the 
same manner as other State nonmember banks. Industrial banks 
are subject to the FDIC's safety and soundness regulations 
(with the three exceptions discussed in the answer to question 
1.a., above), as well as Federal consumer protection 
regulations. The FDIC's authority to pursue formal or informal 
enforcement actions against an industrial bank is the same as 
the FDIC's authority with respect to any other State nonmember 
bank.

Q.3. What would be the impact of legislation allowing 
industrial loan banks to pay interest to corporate owners of 
NOW accounts (which did not repeal the current prohibition 
against offering checking accounts)?

A.3. If legislation is passed to allow industrial loan banks to 
pay interest on corporate NOW accounts, we would anticipate 
that some would offer these accounts. Currently, some 
industrial banks can and do offer demand deposits, and it is 
likely that if allowed to do so, some would offer corporate NOW 
accounts. The issue is one of competitive concern rather than 
one of regulatory concern.
    If legislation is passed that allows only commercial banks 
to offer interest-bearing demand deposits to their corporate 
customers, but does not repeal the current prohibition on 
industrial banks from offering NOW accounts to corporate 
customers, it would create disparity in the treatment of 
industrial banks and commercial banks. Currently, small 
industrial banks (those under $100 million) and those 
grandfathered under the Competitive Equality Banking Act of 
1987 (CEBA) may offer demand deposits. Such legislation would 
exclude them from being able to compete with commercial banks 
as they currently may do.

Q.3.a. Does the business model of industrial loan banks suggest 
that providing corporate NOW accounts is now, or would become, 
widespread? If so, does this raise regulatory concerns, and 
does the FDIC have the ability to address them?

A.3.a. The business model of most industrial banks precludes 
them from providing corporate NOW accounts because NOW accounts 
are only available to individuals, certain nonprofit 
organizations, and governmental units. Further, most industrial 
banks cannot offer demand deposits, either because their size 
precludes them from doing so or they were not grandfathered 
under CEBA.
    As one would predict from the restrictions cited above, the 
data on industrial loan companies show that few fund themselves 
through either demand deposits or NOW accounts. As of year-end 
2003, only 4 of 52 industrial banks funded more than 10 percent 
of their assets through noninterest bearing deposits. Another 
11 funded between 1 percent and 10 percent of their assets with 
noninterest bearing deposits. The vast majority of industrial 
banks did not rely on these deposits as a source of funding.
    The group of industrial banks offering NOW accounts was 
even more constricted. Only 14 industrial banks showed any NOW 
account activity. Of these, 8 funded more than 1 percent of 
their asset base with NOW accounts, and no institution funded 
more than 5 percent of assets with these accounts.
    Whether a change in the legislation would lead industrial 
banks to offer NOW accounts to corporate customers is unknown, 
as their current business models would not be focused on this 
as a source of funding.

Q.3.b. Would the offering of interest bearing NOW accounts to 
corporations raise regulatory concerns? If so, does the FDIC 
have the authority to address them?

A.3.b. As mentioned above, allowing industrial banks to provide 
corporate NOW accounts is an issue of competitive concern 
rather than one of regulatory concern. As with thrifts in the 
late 1970's and early 1980's, the ability to provide products 
that are similar to checking accounts brings new competition 
into the banking sector. Moreover, eliminating the prohibition 
would lead to greater economic efficiency for both banks and 
industrial banks as they would be able to charge explicitly for 
services they now provide for free or at a discount. The time 
and expense associated with transactions designed to circumvent 
the prohibition, such as interest-rate sweep accounts, would be 
reduced or eliminated.
    The FDIC does not anticipate that there would be any safety 
and soundness issues posed by the payment of interest on NOW 
accounts held by businesses. Extending the ability to pay 
interest on corporate NOW accounts will not pose a threat to 
the stability of the financial system. The FDIC currently 
supervises industrial banks and State-chartered, nonmember 
banks that offer NOW accounts. There should be no particular 
concern with these accounts beyond the normal supervisory 
concerns of requiring institutions to know their customers and 
manage the accounts in a safe-and-sound manner.

Q.4. Concerns have been raised about Wal-Mart acquiring a bank 
charter. Last summer, the FDIC conducted a symposium on banking 
and commerce to explore this issue.
Q.4.a. Is Wal-Mart an applicant for an industrial loan bank 
charter or any other bank charter?

A.4.a. We are not aware of any pending charter application by 
Wal-Mart. Neither Wal-Mart Stores, Inc., Bentonville, Arkansas, 
nor any of its subsidiaries, have filed an application or 
notice with the FDIC.

Q.4.b. Would the FDIC be involved in the process of approving 
such an application?

A.4.b. The FDIC would be involved in approving deposit 
insurance for any newly chartered bank. Although an application 
for a charter and for deposit insurance may be filed under a 
single interagency application, the FDIC retains full authority 
with regard to deposit insurance determinations.
    If a retail company sought to acquire control of any 
existing State, nonmember bank, under Section 7(j) of the FDI 
Act, 12 U.S.C. Sec. 1817(j), it would have to provide the FDIC 
written notice of that transaction. The FDIC would review and 
have authority to disapprove the proposed acquisition within 
the notice period provided under the law based on several 
statutory factors.

Q.4.c. Do the FDIC and State regulators have the authority to 
impose conditions on the approval of such an application (for 
example, limitation on the bank's activities or its branching 
authority)?

A.4.c. In approving deposit insurance, the FDIC has the 
authority to, and generally does, impose conditions on the 
approval. The FDIC's ``standard'' conditions, among other more 
routine requirements, require final approvals from other 
appropriate regulatory agencies and reserve authority for the 
FDIC to alter, suspend, or withdraw approval before 
consummation should any interim development be deemed to 
warrant such action.
    The FDIC also may impose restrictions or prudential 
conditions in addition to standard conditions. Examples of such 
safeguards include requiring adequate capital and liquidity, a 
business plan appropriate to the nature and complexity of 
activities conducted by the bank, on-site management, an 
independent board of directors, and policies and controls to 
ensure arm's-length transactions with the parent and other 
affiliates. In regard to branch authority specifically, the 
FDIC normally relies on the broad statutory framework governing 
branching activities embodied in Section 18(d) of the FDI Act, 
12 U.S.C. Sec. 1828(d).
    The specific conditions imposed generally depend on the 
purpose and placement of the institution within the overall 
organizational structure and reflect the statutory factors of 
Section 6 of the FDI Act, 12 U.S.C. Sec. 1816, that must be 
considered in reviewing all applications for deposit insurance. 
These factors are:

 The financial history and condition of the depository 
    institution;
 The adequacy of its capital structure;
 Its future earnings prospects;
 The general character and fitness of its management;
 The risk presented by such depository institution to 
    the deposit insurance fund;
 The convenience and needs of the community to be 
    served by the depository institution; and
 Whether its corporate powers are consistent with the 
    purposes of the FDI Act.

    The FDIC supports provisions in the Financial Services 
Regulatory Relief Act of 2003 that would clarify its existing 
authority to approve or disapprove a change in control notice. 
Specifically, Section 405 of the bill clarifies the Federal 
banking agencies' authority under Section 8 of the FDI Act, to 
enforce written conditions in connection with, among other 
things, any notice concerning a depository institution. Section 
409 clarifies the FDIC's authority to consider the risks 
inherent in a proposed business plan and to use that 
information in determining whether to disapprove a notice of 
change in control.

Q.4.d. What has the FDIC learned from its experience with other 
retailers who have owned banks in the past, such as Sears, 
Montgomery Ward, and JC Penny? What type of banking services 
did these banks provide? Did their relationship with their 
holding companies endanger consumers, communities, competitors, 
or the deposit insurance system?

A.4.d. Generally, our experience indicates that insured 
institutions owned by retail companies can be satisfactorily 
served by their relationships with their parent organizations, 
both financially and otherwise. Benefits include access to 
capital and liquidity, operational support and expertise, and 
an established pool of potential customers. Overall, these 
benefits flow to the communities in which the organization 
operates in the form of expanded financial options for both 
deposit and loan products. However, in our experience, these 
benefits have not proved so great that competitors--either 
banking or retail--have been endangered. Overall, our 
experience is that such relationships generally serve as a 
source of strength to the insured institution and the deposit 
insurance fund.
    The universe of insured institutions currently includes, as 
it has in the past, institutions controlled by retail 
organizations. These banking subsidiaries conduct traditional 
banking activities, generally operate from a single location, 
and market products and services through the parents' locations 
or operations. Receivables, predominantly credit card balances, 
are generally held by the institution or periodically sold to 
the parent organization. Deposits are comprised of parent 
company accounts, certificates of deposit solicited from the 
parent's customers, and/or funds acquired through the national 
markets.

Q.4.e. What regulatory concerns would arise if a retailer were 
to acquire an industrial loan bank? Is the FDIC empowered to 
address these?

A.4.e. The risk posed by any insured depository institution, 
whether owned by a retailer or otherwise, is a factor of the 
appropriateness of the business plan and model, management's 
competency in administering the institution's affairs, and the 
quality and implementation of risk management programs. 
Commercial firms have been allowed for many years to operate, 
or to acquire and control, existing or newly formed financial 
institutions exempted from the Bank Holding Company Act (BHCA). 
This exemption applies to institutions chartered as industrial 
loan companies as well as certain institutions covered by the 
Competitive Equality Banking Act (CEBA). Congress, in passing 
the Gramm-Leach-Bliley Act, lifted certain restrictions on the 
affiliations of banks and financial-services firms, and left in 
place the existing exemptions from the BHCA applicable to both 
industrial banks and CEBA institutions.
    Control of an institution by a retailer does raise the 
questions surrounding the mixing of banking and commerce. The 
FDIC believes that if adequate safeguards are in place, there 
is no compelling safety and soundness reason to preclude 
retailers from owning an industrial bank. To ensure safe and 
sound operations that protect the interests of industrial 
banks, their depositors, and the insurance fund, examinations 
necessarily involve a more complex analysis to ensure that the 
institution is especially diligent to:

 inform its customers of products that are not FDIC-
    insured;
 maintain physical separation in offering insured and 
    uninsured financial products; establish policies against 
    prohibited tying arrangements; and
 comply with the restrictions limiting transactions 
    between banks and their affiliates.

    As with any other insured institution, existing and newly 
insured industrial banks are subject to on-site examinations 
and other supervisory activities of the FDIC as well as the 
appropriate State chartering authority. Even if the institution 
is controlled by a commercial enterprise, a well-developed 
supervisory strategy can effectively insulate an insured 
institution from potential abuses and conflicts of interest.
    The FDIC's regulatory regime and supervisory authorities 
that apply to industrial banks and their parent companies are 
described in the answers to question 1.
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