Industrial Loan Corporations: Recent Asset Growth and Commercial
Interest Highlight Differences in Regulatory Authority
(15-SEP-05, GAO-05-621).
Industrial loan corporations (ILC) emerged in the early 1900s as
small niche lenders that provided consumer credit to low and
moderate income workers who were generally unable to obtain
consumer loans from commercial banks. Since then, some ILCs have
grown significantly in size, and some have expressed concern that
ILCs may have expanded beyond the original scope and purpose
intended by Congress. Others have questioned whether the current
regulatory structure for overseeing ILCs is adequate. This report
(1) discusses the growth and permissible activities of ILCs and
other insured depository institutions, (2) compares the
supervisory authority of the Federal Deposit Insurance
Corporation (FDIC) with consolidated supervisors, and (3)
describes ILC parents' ability to mix banking and commerce.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-621
ACCNO: A36857
TITLE: Industrial Loan Corporations: Recent Asset Growth and
Commercial Interest Highlight Differences in Regulatory Authority
DATE: 09/15/2005
SUBJECT: Bank management
Banking law
Banking regulation
Comparative analysis
Federal regulations
Financial institutions
Lending institutions
Regulatory agencies
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GAO-05-621
United States Government Accountability Office
GAO Report to the Honorable James A. Leach, House of Representatives
September 2005
INDUSTRIAL LOAN CORPORATIONS
Recent Asset Growth and Commercial Interest Highlight Differences in Regulatory
Authority
a
GAO-05-621
[IMG]
September 2005
INDUSTRIAL LOAN CORPORATIONS
Recent Asset Growth and Commercial Interest Highlight Differences in Regulatory
Authority
What GAO Found
The ILC industry has experienced significant asset growth and has evolved
from one-time, small, limited purpose institutions to a diverse industry
that includes some of the nation's largest and more complex financial
institutions. Between 1987 and 2004, ILC assets grew over 3,500 percent
from $3.8 billion to over $140 billion. In most respects, ILCs may engage
in the same activities as other depository institutions insured by the
FDIC and thus may offer a full range of loans, including consumer,
commercial and residential real estate, small business, and subprime. ILCs
are also subject to the same federal safety and soundness safeguards and
consumer protection laws that apply to other FDIC-insured institutions.
Therefore, from an operations standpoint, ILCs pose similar risks to the
bank insurance fund as other types of insured depository institutions.
Parents of insured depository institutions that provide similar risks to
the bank insurance fund are not, however, being overseen by bank
supervisors that possess similar powers. ILCs typically are owned or
controlled by a holding company that may also own other entities. Although
FDIC has supervisory authority over an insured ILC, it has less extensive
authority to supervise ILC holding companies than the consolidated
supervisors of bank and thrift holding companies. Therefore, from a
regulatory standpoint, these ILCs may pose more risk of loss to the bank
insurance fund than other insured depository institutions operating in a
holding company. For example, FDIC's authority to examine ILC affiliates
and take certain enforcement actions against them is more limited than a
consolidated supervisor. While FDIC asserted that its authority may
achieve many of the same results as consolidated supervision, and that its
supervisory model has mitigated losses to the bank insurance fund in some
instances, FDIC's authority is limited to a particular set of
circumstances and may not be used at all times. Further, FDIC's authority
has not been tested by a large ILC parent during times of economic stress.
An exemption in federal banking law currently allows ILC parents to mix
banking and commerce more than the parents of other depository
institutions. Three of the six new ILC charters approved during 2004 were
for commercial firms, and one of the largest retail firms recently applied
for an ILC charter. While some industry participants assert that mixing
banking and commerce may offer benefits from operational efficiencies,
empirical evidence documenting these benefits is mixed. Federal policy
separating banking and commerce focuses on the potential risks from
integrating these functions, such as the potential expansion of the
federal safety net provided for banks to their commercial entities. GAO
finds it unusual that a limited ILC exemption would be the primary means
for mixing banking and commerce on a broader scale and sees merit in
Congress more broadly considering the advantages and disadvantages of a
greater mixing of banking and commerce.
United States Government Accountability Office
Contents
Letter
Results in Brief
Background
ILCs Have Grown Significantly and Are No Longer Small, Limited
Purpose Institutions ILC Business Lines and Regulatory Safeguards Are
Similar to Other Insured Financial Institutions
FDIC's Supervisory Authority Over ILC Holding Companies and Affiliates Is
Not Equivalent to Consolidated Supervisors' Authority
FDIC Actions May Help Mitigate Potential Risks, but Supervision of ILC
Holding Companies and Affiliates Has Only Been Tested on a Limited Basis
in Relatively Good Economic Times
ILCs May Offer Commercial Holding Companies a Greater Ability to Mix
Banking and Commerce Than Other Insured Depository Institution, but Views
on Competitive Implications Are Mixed
Recent Legislative Proposals May Increase the Attractiveness of
Operating an ILC Conclusions Matters for Congressional Consideration
Agency Comments and Our Evaluation
1 5 10
16
21
27
48
65
76 79 81 82
Appendixes
Appendix I:
Appendix II:
Appendix III:
Appendix IV:
Objectives, Scope, and Methodology
Comments from the Board of Governors of the Federal Reserve System
Comments from the Federal Deposit Insurance Corporation
GAO Contact and Staff Acknowledgments
87
90
92 98
Tables Table 1: Comparison of Permissible Activities Between State
Nonmember Commercial Banks and ILCs in a Holding
Company Structure 23
Table 2: The Extent of Selected FDIC Authorities 38
Table 3: Affiliate Related Examination Procedures 50
Table 4: Comparison of Examination Resources and Organizational
Structure of State Banking Supervisory Office 56
Contents
Table 5: Causes of Material ILC Failures and FDIC's Response to Failures
and Other Industry Conditions 60
Number and Total Assets of ILCs
Figures Figure 1: Figure 2: Percentage of ILC Assets Held by 19 20
Individual States
Figure 3: Percentage of Estimated FDIC Insured
Deposits Held by
ILCs 21
Figure 4: Comparison of Explicit Supervisory
Authorities of the
FDIC, Board, and OTS 35
Contents
Abbreviations
BHC Act Bank Holding Company Act
Board Board of Governors of the Federal Reserve System
CEBA Competitive Equality Banking Act
CIBA Change in Bank Control Act
CSBS Conference of State Banking Supervisors
FDI Act Federal Deposit Insurance Act
FDIC Federal Deposit Insurance Corporation
FDIC-IG Federal Deposit Insurance Corporation Office of Inspector
General FFIEC Federal Financial Institutions Examination Council Fund Bank
Insurance Fund GLBA Gramm Leach Bliley Act HOLA Home Owners Loan Act IAP
Institution-Affiliated Party ILC Industrial Loan Corporation IT
information technology NCUA National Credit Union Association Nevada DFI
Nevada Division of Financial Institutions NOW Negotiable Order of
Withdrawal OCC Office of the Comptroller of the Currency OTS Office of
Thrift Supervision QTL Quality Thrift Lender SEC Securities and Exchange
Commission Treasury Department of the Treasury Utah DFI Utah Department of
Financial Institutions
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A
United States Government Accountability Office Washington, D.C. 20548
September 15, 2005
The Honorable James A. Leach House of Representatives
Dear Mr. Leach:
Industrial loan corporations (ILC), also known as industrial banks, are
state-chartered financial institutions that emerged in the twentieth
century to provide consumer credit to low and moderate income workers who
were generally unable to obtain consumer loans from commercial banks. Over
the past 10 years, ILCs have experienced significant asset growth, and
these one-time, small niche lenders have evolved into a diverse industry
that includes some large, complex financial institutions. In addition,
some commercial entities are increasingly interested in owning ILCs. For
example, three large commercial entities were granted approval to open
ILCs in 2004, and one of the largest retail enterprises recently applied
for an ILC charter. As a result, some have expressed concerns that ILCs
may be expanding beyond the original scope and purpose intended by
Congress.
ILCs are typically owned or controlled by a holding company that may also
own other entities, and concerns have also been expressed that the current
regulatory structure for overseeing ILCs in holding companies may not
provide adequate protection against the potential risks that holding
companies and nonbank affiliates may pose to an ILC. The regulation of the
safety and soundness of ILCs rests with the Federal Deposit Insurance
Corporation (FDIC) and the ILC's respective state regulator. Under the
Bank Holding Company Act (BHC Act), the Board of Governors of the Federal
Reserve System (Board) generally supervises bank holding companies and has
established a consolidated supervisory framework for assessing the risks
to a depository institution that could arise because of their affiliation
with other entities in a holding company structure. For example, the Board
may generally examine holding companies and their nonbank subsidiaries,
subject to some limitations, to assess, among other things, the nature of
the operations and financial condition of the holding company and its
subsidiaries; the financial and operations risks within the holding
company system that may pose a threat to the safety and soundness of any
depository institution subsidiary of such holding company; and the systems
for monitoring and controlling such risks. Thus, consolidated supervisors
take a systemic approach to supervising holding companies and nonbank
subsidiaries of depository institutions. However, holding companies of
ILCs operate under an exception to the BHC Act, and
most are not subject to Board oversight. Moreover, FDIC has not been given
consolidated supervisory authority over ILC holding companies. FDIC has,
however, employed what some term as a "bank-centric" supervisory approach
that primarily focuses on isolating the insured institution from potential
risks posed by holding companies and affiliates, rather than assessing
these potential risks systemically across the consolidated holding company
structure.
Another area of concern about ILCs is the extent to which they can mix
banking and commerce through the holding company structure. The policy
separating banking and commercial activity was largely a reaction to the
perception that banks, especially those in a larger conglomerate
organization, had a disproportionate amount of economic power in the
period leading up to the stock market crash of 1929. The BHC Act maintains
the historical separation of banking from commerce by generally
restricting bank holding companies to banking-related or financial
activities.1 The BHC Act also allows ILC holding companies, including
nonfinancial institutions such as retailers and manufacturers, and other
institutions to avoid consolidated supervision and activities
restrictions. While some industry participants have stated that mixing
banking and commerce may offer benefits from operational efficiencies, the
policy of separating banking and commerce was based primarily on the
potential risks that combining these activities may pose to the federal
safety net for insured depository institutions, as well as the potential
for more conflicts of interest and the potential increase in economic
power exercised by large conglomerate enterprises. Currently ILC holding
companies and companies that own or control other types of insured
depository institutions and other nondepository institutions, such as
unitary thrifts, are permitted to mix banking and commerce to varying
degrees. However, some believe that ILCs may be the entities that offer
the greatest ability to mix these activities.
Currently, FDIC-insured banks, including ILCs, are not permitted to offer
interest-bearing business checking accounts. Over the past several years,
1As amended by the Gramm-Leach-Bliley Act (GLBA), the BHC Act restricts
the activities of bank holding companies to activities "closely related to
banking" that were permitted by the Federal Reserve Board as of November
11, 1999. However, bank holding companies that qualify as financial
holding companies can engage in additional activities defined in GLBA as
activities that are "financial in nature," as well as activities that are
incidental to or complementary to financial activity. Pub. L. No. 106-102
S:S: 102, 103, codified at 12 U.S.C. S: 1843(c)(8), (k) (2000 & Supp.
2004).
there have been repeated legislative proposals to repeal this prohibition
and some have stated that this prohibition is unnecessary and outdated.
Recent legislative proposals would grant insured depository institutions,
including many ILCs, the ability to pay interest on business checking
accounts and branch into other states through establishing new branches-
known as de novo branching. Some have questioned whether these proposals
would give ILCs a competitive advantage in the marketplace or essentially
place ILCs on par with commercial banks.
This report responds to your March 4, 2004, request for a review of
several issues related to ILCs. Specifically you asked us to (1) describe
the history and growth of the ILC industry; (2) describe the permissible
activities and regulatory safeguards for ILCs as compared with other
insured financial institutions; (3) compare FDIC's supervisory authority
over ILC holding companies and affiliates with the consolidated
supervisors' authority over holding companies and affiliates; (4) describe
recent changes FDIC made to its supervisory approach of the risks that
holding companies and affiliates could pose to ILCs and determine whether
FDIC's bank-centric supervisory approach protects the ILC from all the
risks that holding companies and nonbank affiliates may pose to the ILC;
(5) determine whether the ILC charter allows for a greater mixing of
banking and commerce than other types of insured depository institutions,
and whether this possibility has any competitive implications for the
banking industry; and (6) determine the potential implications of granting
ILCs the ability to pay interest on business checking accounts and operate
de novo branches nationwide.
To describe the history and growth of the ILC industry, we analyzed data,
including information on ILC assets and estimated insured deposits for the
time period 1987-2004. To describe the permissible activities of and
regulatory safeguards for ILCs, we reviewed federal and state legislation,
regulations, and guidance regarding ILCs and banks. We also interviewed
management from various ILCs and spoke with officials from FDIC; the
Board; and state supervisory officials from California, Nevada, and Utah
that are responsible for the safety and soundness of insured institutions.
We focused on ILCs and bank supervisors in these three states because they
comprise over 99 percent of the ILC industry assets. We also analyzed FDIC
data on ILCs from 1987-2004. To compare FDIC's supervisory authority over
ILC holding companies and affiliates with the consolidated supervisors'
authority over holding companies and affiliates, we reviewed and analyzed
legislation and regulations that govern the supervision of insured
depository institutions, including ILCs and their holding
companies, banks and their holding companies, and thrifts and their
holding companies. We also compared agency examination manuals and
guidance, interviewed officials regarding the FDIC's, the Board's, and the
Office of Thrift Supervision's (OTS) supervisory approaches and
supervisory authorities, and spoke with state and FDIC regional staff
responsible for conducting examinations. We focused our comparison
primarily on the Board's authorities relating to the consolidated
supervision of bank holding companies and the FDIC's supervision of ILCs,
their holding companies, and affiliates from a safety and soundness
perspective. However, because OTS also supervises similar institutions
with similar risks, we also reviewed OTS' supervisory authority with
respect to thrifts and savings and loan holding companies. To describe
what recent changes FDIC has made to its supervisory approach of the risks
that holding companies and their nonbank subsidiaries could pose to ILCs
and determine whether FDIC's bank-centric supervisory approach protects
the ILC from all the risks that holding companies and those subsidiaries
may pose to the ILC, we reviewed and synthesized relevant supporting
documents and the information from the two FDIC-Inspector General
(FDIC-IG) material loss reviews related to ILCs. Where appropriate, after
conducting our own due diligence review, we also relied upon the work of
the FDIC-IG's September 30, 2004, report on limited charter depository
institutions, including ILCs, that provided information on FDIC's guidance
and procedures for supervising limited-charter depository institutions,
including ILCs, and summarized recent actions regarding these
institutions.2 To determine whether the ILC charter allows for a greater
mixing of banking and commerce than other types of insured depository
institutions, and whether this possibility has any competitive
implications for the banking industry and to determine the potential
implications of granting ILCs the ability to pay interest on business
checking accounts and operate de novo branches nationwide, we reviewed
academic and other studies, relevant laws, and other documents,
interviewed management from several ILCs, and hosted a panel of experts
made up of academics, economists, industry practitioners, and independent
consultants. See appendix I for additional details on our objectives,
scope, and methodology.
2The Division of Supervision and Consumer Protection's Approach for
Supervising Limited-Charter Depository Institutions (FDIC Office of
Inspector General Report No. 2004-048, Sept. 30, 2004).
During this review, we did not assess the extent to which regulators
effectively implemented consolidated supervision or any other type of
supervision. Rather, we focused on the respective federal regulators'
authorities to determine whether there were any inherent limitations in
these authorities. We conducted our work in Washington, D.C.; Los Angeles,
California; San Francisco, California; Las Vegas, Nevada; and Salt Lake
City, Utah; between May 2004 and August 2005 in accordance with generally
accepted government auditing standards.
Results in Brief ILCs began in the early 1900s as small, state-chartered,
loan companies that primarily served the borrowing needs of industrial
workers unable to obtain noncollateralized loans from banks. Since then,
the ILC industry has experienced significant asset growth and has evolved
from small, limited purpose institutions to a diverse industry that
includes some of the nation's largest and more complex financial
institutions with extensive access to the capital markets. Most notably,
between 1987 and 2004, ILC assets grew over 3,500 percent from $3.8
billion to over $140 billion, while the number of ILCs declined about 46
percent from 106 to 57. The amount of estimated insured deposits in the
ILC industry has also grown significantly; however, these deposits
represent less than 3 percent of the total estimated insured deposits in
the Fund for all banks. This growth in the ILC industry has been
concentrated in three states-California, Nevada, and Utah. In 2004, 6 ILCs
were among the 180 largest financial institutions in the nation with $3
billion or more in total assets, and one institution had over $66 billion
in total assets.
With one exception contained in federal and one state's banking laws, ILCs
in a holding company structure may generally engage in the same activities
as FDIC-insured depository institutions. Also, FDIC-insured ILCs must
comply with the same federal requirements as other FDIC-insured depository
institutions. For these two reasons, ILCs pose risks to the Fund similar
to those posed by other FDIC-insured institutions from an operations
standpoint.3 Like other FDIC-insured depository institutions, ILCs may
offer a full range of loans such as consumer, commercial and residential
real estate, and small business loans. Further, like a bank, an
3Under 12 U.S.C 1831a(a), FDIC-insured state banks, a group that includes
ILCs, may not engage as principal in any activity that is not permissible
for a national bank unless the FDIC has determined that any additional
activity would pose no significant risk to the deposit insurance fund and
the bank is in compliance with applicable federal capital standards.
ILC may also "export" its home-state's interest rates to customers
residing elsewhere. However, because of restrictions in federal and
California state banking law, most ILCs do not accept demand deposits.4 As
a result, many ILCs offer Negotiable Order of Withdrawal (NOW)
accounts-similar in some respects to demand deposits and are, therefore,
able to offer a service similar to demand deposits without their holding
companies being subject to supervision under the BHC Act.5 While most ILC
holding companies are not subject to supervision under the BHC Act, ILCs
generally are subject to the same federal regulatory safeguards that apply
to commercial banks and thrifts, such as federal restrictions governing
transactions with affiliates and laws addressing terrorism financing,
money laundering, and other criminal activities by bank customers.
FDIC's supervisory authority over the holding companies and affiliates of
ILCs is more limited than the authority that consolidated supervisors have
over the holding companies and affiliates of banks and thrifts. For
example, FDIC's authority to examine an affiliate of an insured depository
institution is limited to examinations necessary to disclose fully the
relationship between the institution and any affiliate and the effect of
the relationship on the institution. Relationships generally include
arrangements involving some level of interaction, interdependence, or
mutual reliance between the ILC and the affiliate, such as a contract,
transaction, or the sharing of operations. When a relationship does not
exist, any reputation or other risk presented by an affiliate that could
impact the institution may not be detected. In contrast, consolidated
supervisors, subject to functional regulation restrictions, generally are
able to examine the holding company
4California law prohibits industrial banks from accepting demand deposits.
Cal. Financial Code S: 105.7 (Deering 2002). Section 2c(2)(H) of the BHC
Act exempts ILCs that satisfy certain criteria from the act. The exemption
applies to ILCs organized under the laws of states which, on March 5,
1987, had or were considering laws to require FDIC insurance for ILCs and
includes ILCs with assets of $100 million or more that do not accept
demand deposits that may be withdrawn by check or similar means for
payment to third parties. 12 U.S.C. S: 1841(c)(2)(H). The vast majority of
ILCs exist in a holding company structure, and these ILCs' assets account
for 99 percent of total ILC industry assets.
5NOW accounts are deposit accounts that give the depository institution
the right to require at least 7 days written notice prior to withdrawal
and have other characteristics set forth in Federal Reserve Regulation D.
12 C.F.R. S: 204.2(b)(3) (2004). Under the Federal Deposit Insurance Act,
NOW accounts may be offered to individuals and nonprofit organizations and
for the deposit of public funds. 12 U.S.C. S: 1832 (2000).
and any nonbank subsidiary regardless of whether the subsidiary has a
relationship with the affiliated insured bank.6 FDIC officials told us
that with its examination authority, as well as its abilities to impose
conditions on or enter into agreements with an ILC holding company in
connection with an application for federal deposit insurance, terminate an
ILC's deposit insurance, enter into agreements during the acquisition of
an insured entity, and take enforcement measures, FDIC can protect an ILC
from the risks arising from being in a holding company as effectively as
the consolidated supervision approach. However, with respect to the
holding company, these authorities are limited to particular sets of
circumstances and are less extensive than those possessed by consolidated
supervisors of bank and thrift holding companies.
While FDIC's bank-centric supervisory approach has undergone various
enhancements designed to help mitigate the potential risks that
FDICexamined institutions, including ILCs in a holding company structure,
can be exposed to by their holding companies and affiliates, questions
remain about whether FDIC's supervisory approach and authority over BHC
Actexempt holding companies and their nonbank subsidiaries address all
risks to the ILC from these entities. FDIC revised the guidance for its
riskfocused examinations to, among other things, provide additional
factors that might be considered in assessing a parent company's potential
impact on an insured depository institution affiliate. In addition, FDIC's
monitoring and application processes may also help to mitigate risks to
ILCs with foreign holding companies and affiliates. FDIC has provided some
examples where its supervisory approach effectively protected the insured
institution and mitigated losses to the Fund. However, FDIC's supervision
of large rapidly growing ILCs and FDIC's authority over ILC holding
companies and nonbank subsidiaries, including the risks that these
entities could pose to the ILC, has been refined during a period of time
described as the "golden age of banking" and has not been tested during a
time of significant economic stress or by a large, troubled ILC.
Because most ILC holding companies and their subsidiaries are exempt from
business activity limitations that generally apply to the holding
companies and affiliates of other types of insured depository
institutions, ILCs may provide a means for mixing banking and commerce
more than
6For purposes of this report, the term "bank" refers to insured depository
institutions, including ILCs and thrifts. The Federal Deposit Insurance
Act defines the term "bank" to include ILCs. 12 U.S.C. S: 1813(a).
ownership or affiliation with other insured depository institutions.
During our review, we identified other instances where the mixing of
banking and commerce previously existed, or currently exists on a limited
basis, such as unitary thrift holding companies, certain "nonbank banks"
in a holding company, and activities permitted under GLBA, such as
merchant banking and grandfathered, limited nonfinancial activities by
securities and insurance affiliates of financial holding companies.7
However, federal law significantly limits the operations and product mixes
of these entities and activities as compared with ILC holding companies.
Additionally, with the exception of a limited, credit-card-only bank
charter, ownership or affiliation with an ILC is today the only option
available to nonfinancial, commercial firms wanting to enter the insured
banking business. Three of the six new ILC charters approved by FDIC
during 2004 are owned by nonfinancial, commercial firms, and one of the
nation's largest retailers recently filed an application to own an ILC.
The policy generally separating banking and commerce is based primarily on
potential risks that integrating these functions may pose such as the
potential expansion of the federal safety net provided for banks to their
commercial holding companies or affiliates, potential increase in
conflicts of interest, and the potential increase in economic power
exercised by large conglomerate enterprises. While some industry
participants state that mixing banking and commerce may offer benefits
from operational efficiencies, empirical evidence documenting these
benefits is mixed.
Recent legislative proposals to allow insured depository institutions,
including certain ILCs, to offer NOW accounts to business customers and
the ability to de novo branch will expand the availability of products and
services that insured depository institutions, including ILCs, could offer
and may make the ownership of ILCs increasingly attractive, particularly
to commercial entities. FDIC-insured depository institutions, including
ILCs, are currently prohibited from offering interest-bearing business
checking accounts. Recent legislative proposals would remove the current
prohibition on paying interest on demand deposits and allow insured
depository institutions, including all or some ILCs, to offer
interest-bearing business NOW checking accounts. This would, in effect,
expand the
7Unitary thrift holding companies are generally any company that owns a
single thrift. Merchant banking refers to the practice where a financial
institution makes a passive equity investment in a corporation with a view
toward working with company management and operating partners to enhance
the value of the equity investment over time. Federal banking law contains
several provisions that are designed to distinguish merchant banking
investments from the more general mixing of banking and commerce.
availability of products and services that insured depository
institutions, including most ILCs, could offer. ILC advocates we spoke
with stated that including ILCs in these legislative proposals maintains
the current relative parity between ILC permissible activities and those
of other insured bank charters. However, Board officials, as well as some
industry observers we spoke with, told us that granting grandfathered ILCs
the ability to pay interest on business NOW accounts represents an
expansion of powers for ILCs, which, they stated, could further blur the
distinction between ILCs and traditional banks. Another recent legislative
proposal would allow banks and most ILCs (those included in a grandfather
provision) to de novo branch by removing states' authority to prevent them
from doing so. Board officials we spoke with told us that, if enacted,
these proposals could increase the attractiveness of owning an ILC,
especially by private sector financial or commercial holding companies
that already operate existing retail distribution networks.
To better ensure that supervisors of institutions with similar risks have
similar authorities, we are asking Congress to consider various options
such as eliminating the current exclusion for ILCs and their holding
companies from consolidated supervision, granting FDIC similar examination
and enforcement authority as a consolidated supervisor, or leaving the
oversight responsibility of small, less complex ILCs with the FDIC, and
transferring oversight of large, more complex ILCs to a consolidated
supervisor. In addition, we are asking Congress to more broadly consider
the advantages and disadvantages of mixing banking and commerce to
determine whether continuing to allow ILC holding companies to engage in
this activity significantly more than the holding companies of other types
of financial institutions is warranted or whether other entities should be
permitted to engage in this level of activity.
We provided a draft of this report to the Board, FDIC, OTS, and SEC for
review and comment. Each of these agencies provided technical comments
that were incorporated as appropriate. In written comments, the Chairman
of the Board of Governors of the Federal Reserve System (see app. II)
concurred with the report's findings and conclusions and stated that
"consolidated supervision provides important protections to the insured
banks that are part of a larger organization, as well as the federal
safety net that supports those banks" and that the report "properly
highlights the broad policy implications that ILCs raise with respect to
maintaining the separation of banking and commerce." In written comments
from the Chairman of the Federal Deposit Insurance Corporation (see app.
III), FDIC concurred that from an operations standpoint, ILCs do not
appear to
have a greater risk of failure than other types of insured depository
institutions but generally believed that no changes were needed in its
supervisory approach over ILCs and their holding companies and disagreed
with the matters for congressional consideration. Specifically, FDIC's
disagreements generally focused on three primary areas-whether
consolidated supervision of ILC holding companies is necessary to ensure
the safety and soundness of the ILC; that FDIC's supervisory authority may
not be sufficient to effectively supervise ILCs and insulate insured
institutions against undue risks presented by external parties; and the
impact that consolidated supervision of ILCs and their holding companies
would have on the marketplace and the federal safety net. However, we
believe that consolidated supervision offers broader examination and
enforcement authorities that may be used to understand, monitor, and when
appropriate, restrain the risks associated with insured depository
institutions in a holding company structure. We continue to be concerned
that FDIC's bank-centric approach has only been tested on a limited basis
in relatively good economic times, and our report identifies additional
tools that consolidated supervisors may use to help ensure the safety and
soundness of insured depository institutions. Further, the report does not
advocate an expansion of the federal safety net. Rather, this report
advocates that ILCs and their holding companies be regulated in a similar
manner as other insured depository institutions and their holding
companies.
Background Today, five federal agencies oversee federally insured
depository institutions and consolidated supervised entities: Office of
the Comptroller of the Currency, Board of Governors of the Federal
Reserve, Federal Deposit Insurance Corporation, Office of Thrift
Supervision, and the National Credit Union Association. Many of those
institutions are state chartered and are subject to state regulation. The
specific regulatory configuration depends on the type of charter the
banking institution chooses-commercial bank, thrift, credit union, or
industrial loan company. To achieve their safety and soundness goals, bank
regulators establish capital requirements, conduct on-site examinations
and off-site monitoring to assess a bank's financial condition, and
monitor compliance with banking laws. Regulators also issue regulations,
take enforcement actions, and close banks they determine to be insolvent.
In addition, federal regulators oversee compliance with and enforce
consumer protection laws such as those requiring fair access to banking
services and privacy protection.
The FDIC was created as an independent agency in 1933 to preserve and
promote public confidence in the financial system by (1) insuring deposits
in banks and thrift institutions for up to certain amounts (currently
$100,000); (2) identifying, monitoring, and addressing risks to the Fund;
and (3) limiting the effect on the economy and the financial system when a
bank or thrift institution fails. Today, FDIC directly examines and
supervises 5,272 insured, state-chartered banks, which, according to FDIC,
is more than half of all institutions in the banking system. FDIC is the
primary federal supervisor of state-chartered institutions that do not
join the Federal Reserve System, including ILCs. In addition, FDIC is the
backup supervisor for the remaining insured banks and thrift institutions.
As of December 31, 2004, 3 of the top 16 largest insured institutions
supervised by FDIC were ILCs. ILCs are also monitored at the state level
and are subject to state and federal supervision in the same manner as
state nonmember banks.
The Board was founded by Congress in 1913 and currently has the following
four general areas of responsibility: (1) conducting the nation's monetary
policy by influencing the money and credit conditions in the economy in
pursuit of full employment and stable prices; (2) supervising and
regulating banking institutions to ensure the safety and soundness of the
nation's banking and financial system and to protect the credit rights of
consumers; (3) maintaining the stability of the financial system and
containing systemic risk that may arise in financial markets; and (4)
providing certain financial services to the government, the public,
financial institutions, and foreign official institutions, including
playing a major role in operating the nation's payments system. Today, the
Board is the primary supervisor of 919 state-chartered member banks and
5,863 bank holding companies, and has direct oversight of bank holding
companies and their affiliates.
The Office of the Comptroller of the Currency (OCC), established in 1863
as a bureau of the Department of the Treasury (Treasury), is responsible
for chartering, supervising, and regulating all national banks. OCC's
mission is to ensure a stable and competitive national banking system
through (1) ensuring the safety and soundness of the national banking
system; (2) fostering competition by allowing banks to offer new products
and services; (3) improving the efficiency and effectiveness of OCC
supervision, including reducing regulatory burden; and (4) ensuring fair
and equal access to financial services for all Americans. OCC also
supervises the federal branches and agencies of foreign banks. Currently,
OCC supervises 1,906 national banks.
OTS was established as a bureau of the Treasury in 1989. Its mission is to
supervise savings associations and their holding companies in order to
maintain their safety and soundness and compliance with consumer laws and
to encourage a competitive industry that meets America's financial
services needs. OTS is the primary federal supervisor of all federally
chartered and many state-chartered thrift institutions, which includes
savings banks and savings and loan associations. Currently, OTS regulates
and supervises 886 thrifts8-some of which, like ILCs, are owned by a
commercial holding company-and has direct oversight of the thrift, the
thrift holding company and its subsidiaries, and its affiliates.
The National Credit Union Administration (NCUA) is an independent federal
agency that charters and supervises federal credit unions and operates the
National Credit Union Share Insurance Fund, which insures the savings in
all federal and many state-chartered credit unions. Currently, NCUA
regulates and supervises 9,128 credit unions.
In addition, the Securities and Exchange Commission has consolidated
supervisory oversight of certain financial conglomerates, known as
consolidated supervised entities, which are large, internationally active
securities firms. Certain of these consolidated supervised entities own
one or more large ILCs, although their primary line of business is the
global securities market.
Bank Holding Companies The BHC Act of 1956, as amended, contains a
comprehensive framework for the supervision of bank holding companies and
their nonbank subsidiaries. Bank holding companies are companies that own
or control an FDIC-insured bank or other depository institution that meets
the definition of "bank" in the BHC Act. Generally, any company that
acquires control of an insured bank or bank holding company is required to
register with the Board as a bank holding company. Regulation under the
BHC Act
8We use the term thrift to refer to savings and loan associations.
According to OTS, these institutions provide various financial services to
consumers and small to mid-sized businesses in their communities and offer
an array of deposit instruments including checking, savings, money market,
and time deposits. Thrifts' lending activities are primarily focused on
residential lending, including first mortgage loans, home equity loans,
and loans secured by multifamily residences. They also provide loans for
other consumer needs such as for autos, education, and home improvements.
In addition, thrifts provide community businesses with working capital
loans, loans secured by commercial property, and construction loans.
entails, among other things, consolidated supervision of the holding
company by the Board, as well as restrictions on the activities of the
holding company and its affiliates to those activities that are closely
related to banking or, for qualified financial holding companies,
activities that are financial in nature. The BHC Act defines "control" of
an insured bank flexibly to include ownership or control of blocs of
stock, the ability to elect a board majority, or other management
control.9 The Board's bank holding company supervision manual states that
a bank holding company structure may offer advantages. For example, a bank
holding company structure allows entities to avoid some regulatory
constraints such as limitations on geographic areas they can serve. In
addition, a bank holding company structure may increase an organization's
financial flexibility by allowing the combined firm to avoid selected
restrictions on the types of assets acquired, and types of liabilities
that can be issued by the combined entity.
The Board's bank holding company supervision manual states that the
holding company structure can adversely affect the financial condition of
a bank subsidiary through exposing the bank to various types of risk. The
reasons these risks occur cover a variety of circumstances, including poor
risk management, poor bank management, and poor asset quality. For
example, a holding company or its subsidiary with poor risk management
procedures may take on excessive investment or market risks and fail. This
failure of the holding company or affiliate can impair the insured
institution's access to financial markets. In another example, a holding
company with a poorly managed bank can initiate adverse intercompany
transactions with the insured bank or impose excessive dividends on the
insured bank.10 Adverse intercompany transactions may include charging
9Any one of the following circumstances will trigger coverage by the BHC
Act: (1) Stock ownership -- Where the company owns, controls or has the
power to vote 25 percent or more of any class of the voting securities of
a bank or bank holding company (either directly or indirectly or acting
through one or more other persons); (2) Ability to elect a board
majority--Where the company controls the election of a majority of the
directors or trustees of a bank or bank holding company; or (3) Effective
control of management-Where the Board determines, after notice and
opportunity for hearing, that the company directly or indirectly exercises
a controlling influence over the management or policies of a bank or bank
holding company. For purposes of this last provision, Congress expressly
presumed that any company that directly or indirectly owns, controls, or
has power to vote fewer than 5 percent of any class of voting securities
of a specific bank or bank holding company does not have the requisite
control. See 12 U.S.C. S: 1841(a).
10As discussed more fully later in this report, federal law restricts
transactions between an insured depository institution and its bank
holding company affiliates.
above market prices for products or services, such as information
technology (IT) services, provided to the insured institution by an
affiliate or requiring the insured institution to purchase poor quality
loans at above market prices from an affiliate. Such loans may place the
insured institution at higher risk of loss. Other types of risk that
holding companies and affiliates can pose to insured institutions include
operations or reputation risks. Operations risk is the potential that
inadequate information systems, operations problems, breaches in internal
controls, or fraud will result in unexpected losses. From a practical
standpoint, insured depository institutions, including ILCs, may be
susceptible to operations risk when they are dependent on or share in the
products or services of a holding company or its subsidiaries, such as IT
services or credit card account servicing. If these entities ceased their
operations, there could be an adverse impact on the insured institution.
Reputation risk is the potential that negative publicity regarding an
institution's or affiliate's business practices, whether true or not,
could cause a decline in the customer base, costly litigation, or revenue
reductions. Operations or reputation risks that impact the holding company
can also affect affiliates throughout the corporate structure.
The Board's Regulation Y contains a provision stating that a bank holding
company shall serve as a source of strength to its subsidiary banks and
shall not conduct its operations in an unsafe and unsound manner.11
According to the Board, as part of this policy, a bank holding company
should stand ready to use its available resources to provide adequate
funds to its subsidiary bank during periods of financial stress or
adversity and should maintain the financial flexibility and capital
raising capacity to obtain additional resources for assisting its
affiliate. According to this doctrine, a bank holding company should not
withhold financial support from an affiliate bank in a weakened or failing
position when it is in a position to provide the support. According to the
Board, a bank holding company's failure to assist a troubled or failing
subsidiary bank would generally be considered an unsafe and unsound
practice and may result in a violation of Regulation Y. Consequently, such
a failure would generally result in a cease and desist order or other
enforcement action as authorized under banking law.
1112 C.F.R. S: 225.4 (2004).
Historical Policies Governing Separation of Banking and Commerce
The policy separating banking and commercial activity was first codified
in provisions of the Banking Act of 1933 that generally are referred to as
the Glass-Steagall Act. Glass-Steagall was largely a reaction to the
perception that banks, and in particular banks that were part of larger
conglomerate organizations, such as the J. P. Morgan and John D.
Rockefeller entities of the era, wielded a disproportionate amount of
economic power in the period leading up to the stock market crash of 1929.
Among other things, Glass-Steagall generally prohibited banks from owning
corporate stock for their own accounts and also limited affiliations
between banks and securities firms. An immediate outcome of Glass-Steagall
was that the Morgan, Rockefeller, and other complex business combinations
with financial firms of the period were split into separate banking and
nonbanking parts. Since then, Congress and banking supervisors have
generally reaffirmed the long-standing policy of separating banking and
commerce. For example, the BHC Act of 1956 generally prohibited bank
holding companies from owning or controlling entities that were not banks
unless, among other things, the Board determined that the entity's
activities were "so closely related to the business of banking . . . as to
be a proper incident thereto...."12 In 1970, Congress amended the BHC Act
to broaden the Board's authority to determine when an activity is
sufficiently related to banking but restricted bank holding companies to
the business of banking remained a controlling principle of the act.13 In
1999, the GLBA amended the BHC Act by, among other things, relaxing the
distinction between separating banking and commerce to permit qualified
bank holding companies-known as financial holding companies-to engage in a
wider range of financial activities, such as insurance underwriting and
securities brokerage. By restricting bank holding companies to activities
that are financial in nature, GLBA generally reaffirmed the separation of
banking from nonfinancial, commercial industries. In addition, in the
GLBA, Congress also ended the unitary thrift provision that allowed
commercial firms to acquire control of a single savings association.
12Bank Holding Company Act of 1956, Pub. L. No. 84-511 S: 4.
13See Board of Governors of the Federal Reserve System v. Investment
Company Institute, 450 U.S. 46, 72, n. 51 (1980).
ILCs Have Grown Significantly and Are No Longer Small, Limited Purpose
Institutions
ILCs began in the early 1900s as small, state-chartered loan companies
that served the borrowing needs of industrial workers that were unable to
obtain noncollateralized loans from commercial banks. Since then, the ILC
industry has experienced significant asset growth and has evolved from
small, limited purpose institutions to a diverse group of insured
financial institutions with a variety of business models. Most notably,
from 1987 to 2004, ILC assets have grown over 3,500 percent from $3.8
billion to over $140 billion, while the number of ILCs declined about 46
percent from 106 to 57. In 2004, 6 ILCs were among the 180 largest
financial institutions in the nation with $3 billion or more in total
assets, and one institution had over $66 billion in total assets. During
this time period, most of the growth occurred in the state of Utah while
the portion of ILC assets in other states declined-especially in
California. According to Utah officials, ILCs grew in that state because
its laws are "business friendly," and the state offers a large,
well-educated workforce for the financial services industry. Some ILCs
have evolved into large, complex financial institutions with extensive
access to capital markets.
ILCs Have Evolved Over Time
ILCs, also known as industrial banks, are state-chartered financial
institutions that emerged from the Morris Plan banks of the early 20th
century to provide consumer credit to low and moderate income workers.
Generally, these workers were unable to obtain noncollateralized consumer
loans from commercial banks. Since many state laws prevented these banks
from accepting deposits, the banks issued certificates of investment or
indebtedness often referred to as thrift certificates and avoided using
the term "deposit." Initially, the FDIC determined that ILCs were not
eligible to be insured.
Over time, FDIC policy regarding ILC's eligibility for deposit insurance
changed. Insurance was initially granted on a case by case basis. However,
the Garn-St. Germain Depository Institutions Act of 1982 made all ILCs
eligible for federal deposit insurance.14 This act also authorized federal
deposit insurance for thrift certificates, a primary funding source for
ILCs at the time.15 Subsequently, some states required ILCs to obtain FDIC
insurance as a condition of keeping their charters. As a result, FDIC
14Depository Institutions Act of 1982, Pub. L. No. 97-320 S: 703. 15Id.
insured most ILCs, and they were subject to safety and soundness
supervision by the FDIC in addition to the supervision they received from
their respective states.
In 1987, Congress passed the Competitive Equality Banking Act (CEBA),
which also impacted the ILC industry.16 One purpose of CEBA was to close a
provision in the BHC Act under which commercial firms were able to own
"nonbank banks." These institutions had some characteristics of banks but
did not meet the BHC Act's definition of a bank. Prior to CEBA, the BHC
Act defined "bank" to mean an institution that both accepted demand
deposits and engaged in the business of making commercial loans. Nonbank
banks generally were limited purpose institutions that did not both accept
demand deposits and make commercial loans. By avoiding the BHC Act
definition of a bank, commercial firms that owned or controlled those
institutions were able to provide certain banking services across state
lines. Additionally, these firms were not subject to supervision by the
Board as a bank holding company. CEBA prohibited new nonbank banks and
more stringently defined "banks" under the BHC Act to include institutions
insured by the FDIC. This new definition of a "bank" contained exceptions
that allow entities that own or control certain types of insured
institutions to avoid Board regulation as a bank holding company. One of
these exceptions applies to ILCs chartered in states that on March 5,
1987, had in effect or under consideration a statute requiring ILCs to be
FDIC insured. An ILC chartered in those states is exempt from the
definition of "bank" in the BHC Act if it satisfies one or more of the
following conditions:17
o The ILC does not accept demand deposits that may be withdrawn by check
or similar means for payment to third parties.
o The ILC has total assets of less than $100 million.
16Pub. L. No. 100-86.
1712 U.S.C. S: 1841(c)(2)(H). According to the FDIC, at the time of the
1987 CEBA exemption six states-California, Colorado, Hawaii, Minnesota,
Nevada, and Utah-had statutes in effect or under consideration requiring
their ILCs to have federal deposit insurance. However, because the
exemption for ILCs is in the BHC Act, the Board has primary responsibility
for determining which states are grandfathered by the BHC Act. Only ILCs
chartered in "grandfathered" states are eligible for the ILC exemption
from the BHC Act.
o Control of the ILC was not acquired by any company after August 10,
1987.
Since the passage of CEBA, the ILC industry has changed significantly and
is currently a diverse group of insured financial institutions with a
variety of business models. The majority of the 57 active ILCs, as of
December 31, 2004, are owned and operated by financial services firms,
such as the ILCs owned by Merrill Lynch, USAA Savings Bank, and American
Express. These ILCs are complex financial institutions with extensive
access to capital markets. Other ILCs are part of a business organization
whose activities are conducted within the financial arm of a larger
corporate organization that is not necessarily financial in nature, such
as the ILCs owned by GE Capital Financial and GMAC Commercial Mortgage
Bank. In addition, other ILCs directly support the holding company
organizations' commercial activities, such as the ILCs owned by BMW and
Volkswagen. Additionally, some ILCs are smaller, community-focused,
stand-alone institutions such as Golden Security Bank and Tustin Community
Bank.
ILCs Have Experienced Significant Asset Growth
The total assets of the ILC industry have increased significantly since
1987. As shown in figure 1, although the total number of ILCs has
decreased by nearly half, from 106 to 57, as of December 31, 2004, the
total assets in the ILC industry have grown by over 3,500 percent,
increasing from $3.8 billion in 1987 to over $140 billion in 2004. In
2004, 6 ILCs were among the 180 largest financial institutions in the
nation with $3 billion or more in total assets, and one institution had
over $66 billion in assets. This significant growth in ILC assets was
primarily concentrated in a few large ILCs owned by financial services
firms. For example, as of December 31, 2004, 6 ILCs owned 85 percent of
the total assets for the ILC industry with aggregate assets totaling over
$119 billion and collectively controlled about $64 billion in FDIC-insured
deposits.
Figure 1: Number and Total Assets of ILCs 120 156
Number of ILCs
Assets (Dollars in billions)
100 130
80 104
60 78
40 52
20 26
00
1987 Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
2001 2002 2003 2004
ILCs
Assets
Source: GAO analysis of FDIC Call Report data.
Today, the vast majority of ILC assets are located in California, Nevada,
and Utah. Although seven states have active ILCs, three states charter
more than half, or 49, of the active ILCs that own over 99 percent of the
ILC industry's assets, as shown by figure 2. The state of Utah has
experienced the largest amount of ILC asset growth. As of December 31,
2004, there were 29 ILCs, representing 82 percent of the ILC industry
assets, with headquarters in Utah. According to officials at the Utah
Department of Financial Institutions, ILC growth in Utah occurred because
other state laws are not as "business friendly" as Utah. These officials
also stated that Utah has state usury laws that are more desirable than
many other states, and the state offers a large well-educated workforce
for the financial institutions industry.
Figure 2 also shows that the portion of ILC assets in states other than
Utah declined significantly. Moreover, California had the largest decline
in the number of ILCs during this time period. According to state banking
regulators in California, the decline in the number of ILCs was partially
due to a state law passed in 1985 requiring all thrifts and loans,
including ILCs, to obtain federal insurance in order to accept deposits.
Because many ILCs were unable to get approval from FDIC, they were
liquidated. Another reason these officials gave for the decline in ILCs in
California was that the ILC industry in California experienced similar
failures as the banking and savings and loan industries in the late 1980s
and early 1990s. While these failures and law changes accounted for much
of the decline in the assets held by California ILCs, these officials also
stated that California's laws are less favorable to business, which may
also have restricted the growth of the ILC industry in that state.
Figure 2: Percentage of ILC Assets Held by Individual States
1987 2004
1%
Othera Nevada
California
Utah
Source: GAO analysis of FDIC Call Report data.
aThe other category may consist of as many as nine states in some years.
In 1987, states in this category included Arizona, Colorado, Florida,
Hawaii, Minnesota, Nebraska and West Virginia. In 2004, this category
included Colorado, Hawaii, and Minnesota.
Figure 3 shows that, although the total amount of estimated insured
deposits in the ILC industry has grown by over 500 percent since 1999,
these deposits represent less than 3 percent of the total estimated
insured
deposits in the bank insurance fund for all banks. The significant
increase in estimated insured deposits since 1999 was related to the
growth of a few ILCs owned by financial services firms. For example, at
the end of 2004, the largest ILC, owned by an investment bank, had over
$40 billion in FDIC insured deposits.
Figure 3: Percentage of Estimated FDIC Insured Deposits Held by ILCs
Percentage
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
2003 2004
Year
Source: GAO analysis of FDIC Call Report data.
ILC Business Lines and Regulatory Safeguards Are Similar to Other Insured
Financial Institutions
Federal banking law permits FDIC-insured ILCs to engage in the same
activities as other insured depository institutions. However, because of
restrictions in California state law and in order to qualify for exemption
from the BHC Act, most ILCs, which are owned by non-BHC Act holding
companies, may not accept demand deposits. Banking laws in California,
Nevada, and Utah have undergone changes that generally place ILCs on par
with traditional banks. Thus, like other FDIC-insured depository
institutions, ILCs may offer a full range of loans such as consumer,
commercial and residential real estate, and small business loans. Further,
like a bank, ILCs may "export" their home-state's interest rates to
customers residing elsewhere. In addition, ILCs generally are subject to
the
same federal regulatory safeguards that apply to commercial banks and
thrifts, such as federal restrictions governing transactions with
affiliates and laws addressing terrorism, money laundering, and other
criminal activities by bank customers.
ILCs Are Permitted to Engage in Most Banking Activities
Under the Federal Deposit Insurance Act (FDI Act), FDIC insured
institutions, including ILCs, generally are permitted to engage only in
activities as principal that are permissible for a national bank, although
the FDIC may approve of an additional activity if it determines that the
activity would pose no significant risk to the bank insurance fund (Fund),
and the institution complies with applicable federal capital standards.
During our review, we did not identify any banking activities that were
unique to ILCs that other insured depository institutions were not
permitted to do. Table 1 shows that, like other insured depository
institutions, ILCs are permitted to offer a wide variety of loans
including consumer, commercial and residential real estate, small
business, and subprime.18 Like other FDICinsured state charters, an ILC
may charge its customers the interest rates allowed by the laws of the
state where the ILC is located, no matter where the customers reside.19 In
effect, this permits ILCs offering credit cards to charge their state's
maximum allowable interest rates in other states.20 A primary difference
between ILCs and other FDIC-insured depository institutions is that, to
remain exempt from the BHC Act, ILCs must be chartered in the
grandfathered states and generally do not accept demand deposits if their
total assets are $100 million or more.
18Subprime loans are a type of lending that relies on risk-based pricing
to serve borrowers who cannot obtain credit in the prime market.
19See 12 U.S.C. S: 1831d(a); see also, FDIC General Counsel's Opinion No.
11, Interest Charges by Interstate State Banks, 63 Fed. Reg. 27282 (May
18, 1998).
20Nevada and Utah do not cap the interest rates credit card companies can
charge. Their usury laws, similar to Delaware and South Dakota, are
considered desirable for credit card entities.
Table 1: Comparison of Permissible Activities Between State Nonmember
Commercial Banks and ILCs in a Holding Company Structure
State nonmember Permissible activities commercial bank Industrial loan
corporation
Ability to offer full range of Yes Yes
loans, including:
consumer,
commercial real estate,
residential real estate,
small business, and
subprime.
Ability to export interest Yes Yes rates.
Ability to offer full range of Yes Yes, except in California.
deposits including demand However, BHC Act-exempt ILCs
deposits. may offer demand deposits if
either the ILC's assets are less
than $100 million or the ILC has
not been acquired after August
10, 1987.
Source: FDIC.
Note: This table was adapted from FDIC's Supervisory Insights, Summer
2004. According to the FDIC officials, Supervisory Insights was published
in June 2004, by FDIC to provide a forum to discuss how bank regulation
and policy is put into practice in the field, share best practices, and
communicate emerging issues that bank supervisors are facing. This
inaugural issue described a number of areas of current supervisory focus
at the FDIC, including the ILC charter. According to FDIC officials,
Supervisory Insights should not be construed as regulatory or supervisory
guidance.
As discussed previously, in order to maintain an exemption from the BHC
Act, most ILCs with assets of $100 million or more may not accept demand
deposits that the depositor may withdraw by check or similar means for
payment to third parties. Representatives from some ILCs told us that
because demand deposits are an important, often primary source of
costeffective funding for some depository institutions, restrictions on
ILCs' ability to accept demand deposits is a limitation of the ILC
charter. However, federal regulation does not restrict ILCs' use of NOW
accounts. NOW accounts are similar to demand deposits but give the
depository institution the right to require at least 7 days written notice
prior to withdrawal. In addition, NOW accounts can be FDIC insured. Some
ILCs use NOW accounts as a source of funding, particularly those
institutions owned by investment banking/brokerage firms. Further, some
ILCs finance
their operations through sources other than FDIC insured deposits and use
commercial paper, brokered deposits.21
Based on an analysis of the permissible activities of ILCs and other
insured depository institutions, we and the FDIC-IG found that, from an
operations standpoint, ILCs do not appear to have a greater risk of
failure than other types of insured depository institutions. FDIC
officials have reported that, like other insured depository institutions,
the risk of failure and loss to the deposit insurance fund from ILCs is
not related to the type of charter the institution has. Rather, these
officials stated that this risk depends on the institution's business plan
and the type of business that the entity is involved in, management's
competency to run the bank, and the quality of the institution's
risk-management process. Further, FDIC officials stated that FDIC's
experience does not indicate that the overall risk profile of ILCs is
different from that of other types of insured depository institutions, and
ILCs do not engage in more complex transactions than other institutions.
Some State Banking Laws Have Evolved to Make ILCs More Like Banks
Despite initial state limitations on certain permissible activities of ILC
charters, the laws of the states we reviewed have essentially placed ILCs
on par with other FDIC-insured state banks. For example, officials in
California told us that ILCs originally were chartered to serve various
niche lending markets. However, these officials stated that, over time,
changes were made to California laws governing ILCs because these entities
sought to be more competitive with other financial institutions and engage
in different types of lending activities not specified in the charter law.
According to these officials, in October of 2000, the California
legislature revised the ILC charter law that contained a variety of
outdated and artificial lending restrictions. California officials also
stated that, at that time, ILCs were brought under the state banking laws
and, with the exception of the restriction against accepting demand
deposits, ILCs became subject to the same laws and regulations, as well as
standards for safe and sound lending practices, as commercial banks.
According to these officials, the laws that were no longer applicable to
ILCs contained restrictions on, among other things, the
21Commercial paper generally is a short-term, unsecured promissory note
issued primarily by highly rated corporations. Many companies use
commercial paper to raise cash needed for current transactions and find it
to be a lower-cost alternative to bank loans. Brokered deposits are
generally deposits obtained by a deposit broker and are considered
ratesensitive because consumers are able to withdraw them quickly and
without notice.
o type of security for an ILC loan,
o amount of loans that could be made out-of-state,
o loan-to-value ratios on loans,22 and
o amount of loans that had to be collateralized by real estate.
Officials at the Utah Department of Financial Institutions (Utah DFI) told
us that, since 1985, ILCs chartered in Utah have generally been able to
conduct the same permissible activities as state chartered commercial
banks. In addition, since at least 1997, Utah ILCs have been permitted to
use the term "bank" in their name.
ILCs Must Comply with Federal Requirements Applicable to Other Insured
Institutions
ILCs are subject to federal safety and soundness safeguards and consumer
protection laws that apply generally to FDIC-insured institutions. These
include restrictions on transactions between an insured institution and
its affiliates under sections 23A and 23B of the Federal Reserve Act that
are designed to protect the insured depository institution from adverse
transactions with holding companies and affiliates. Sections 23A and 23B
generally limit the dollar amount of loans to affiliates and require
transactions to be done on an "arms-length" basis.23 Specifically, section
23A regulates "covered transactions" between a bank and its affiliates and
permits an institution to conduct these transactions with its affiliates
so long as the institution limits the aggregate amount of covered
transactions with a particular affiliate to not more than 10 percent of
the bank's capital stock and surplus and, with all of its affiliates, to
20 percent of the
22Loan-to-value ratios are a lending risk ratio calculated by dividing the
total amount of the mortgage loan by the appraised value of the property
or the purchase price of the property.
23Section 18(j) of the FDI Act extends the provisions of sections 23A and
23B of the Federal Reserve Act to state nonmember banks. 12 U.S.C. S:
1828(j).
institution's capital stock and surplus.24 Section 23B essentially imposes
the following four restrictions: (1) a requirement that the terms of
affiliate transactions be comparable to terms of similar nonaffiliate
transactions; (2) a restriction on the extent that a bank may, as a
fiduciary, purchase securities and other assets from an affiliate; (3) a
restriction on the purchase of securities where an affiliate is the
principal underwriter; and (4) a prohibition on agreements and advertising
providing or suggesting that a bank is responsible for the obligations of
its affiliates.
Examples of other regulatory safeguards that ILCs must comply with include
provisions of the following Board regulations:
o Regulation O, which governs the extension of credit by a depository
institution to an executive officer, director, or principal shareholder of
the institution;25
o Regulation D, which sets reserves a depository institution must hold
against deposits;26
o Regulation Q, which generally prohibits the payment of interest on
demand deposits;27 and
o Regulation F, which requires that banks establish policies and
procedures to prevent excessive exposure to any individual correspondent
bank.28
24Covered transactions are specifically described in section 23A (b)(7)(A)
through (E) but generally consist of making loans to an affiliate;
purchasing securities issued by an affiliate; purchasing nonexempt assets
from an affiliate; accepting securities issued by an affiliated company as
collateral for any loan; and issuing a guarantee, acceptance, or letter of
credit on behalf of (for the account of) an affiliate. Section 23A also
lists several types of transactions that are specifically exempted from
its provisions. Under the BHC Act, as amended by GLBA, a depository
institution controlled by a financial holding company is prohibited from
engaging in covered transactions with any affiliate that engages in
nonfinancial activities under the special 10-year grandfather provisions
in the GLBA. 12 U.S.C. S: 1843 (n)(6).
25See 12 C.F.R. S: 337.3 (2005).
26See 12 C.F.R. Part 204.
27See 12 C.F.R. Part 329.
28See 12 C.F.R. Part 206.
In addition to these safeguards, ILCs must also comply with Bank Secrecy
Act, Anti-Money Laundering, and Community Reinvestment Act requirements.
Further, ILCs, like other insured depository institutions, are subject to
consumer protection laws and must comply with federal regulations such as
the Board's
o Regulation B, which implements the Equal Credit Opportunity Act's
antidiscrimination provisions;29
o Regulation Z, which implements the Truth in Lending Act requirements
relating to disclosures and other consumer protections;30 and
o Regulation CC, which implements the Expedited Funds Availability Act,
including the Act's requirements regarding the limits on the length of
time that a hold may be placed on funds deposited into an account,
including a NOW account.31
FDIC's Supervisory Authority Over ILC Holding Companies and Affiliates Is
Not Equivalent to Consolidated Supervisors' Authority
Because most ILCs exist in a holding company structure, they are subjected
to risks from the holding company and its subsidiaries, including adverse
intercompany transactions, operations, and reputation risk, similar to
those faced by banks and thrifts existing in a holding company structure.
However, FDIC's authority over the holding companies and affiliates of
ILCs is not as extensive as the authority that consolidated supervisors
have over the holding companies and affiliates of banks and thrifts. For
example, FDIC's authority to examine an affiliate of an insured depository
institution exists only to disclose the relationship between the
depository institution and the affiliate and the effect of that
relationship on the depository institution. Therefore, any reputation or
other risk from an affiliate that has no relationship with the ILC could
go undetected. In contrast, consolidated supervisors, subject to
functional regulation restrictions, generally are able to examine a
nonbank affiliate of a bank or thrift in a holding company regardless of
whether the affiliate has a relationship with the bank. FDIC officials
told us that with its examination authority, as well as its abilities to
impose conditions on or enter into agreements with an ILC holding
29See 12 C.F.R. Part 202. 30See 12 C.F.R. Part 226. 31See 12 C.F.R. Part
229.
company in connection with an application for federal deposit insurance,
terminate an ILC's deposit insurance, enter into agreements during the
acquisition of an insured entity, and take enforcement measures, FDIC can
protect an ILC from the risks arising from being in a holding company as
effectively as with the consolidated supervision approach. However, we
found that, with respect to the holding company, these authorities are
limited to particular sets of circumstances and are less extensive than
those possessed by consolidated supervisors of bank and thrift holding
companies. As a result, FDIC's authority is not equivalent to consolidated
supervision of the holding company.
FDIC and Consolidated Supervisors Use Different Supervisory Approaches
With some exceptions, companies that own or control FDIC insured
depository institutions are subject to a consolidated-or top-down-
supervisory approach that is aimed at assessing the financial and
operations risks within the holding company structure that may pose a
threat to the safety and soundness of the depository institution.
Consolidated supervision is widely recognized throughout the world,
including Asia, Europe, and in North America, as an accepted approach to
supervising organizations that own or control financial institutions and
their affiliates. The European Union also requires consolidated
supervision for financial institutions operating in its member states, and
this approach is recognized by the Basel Committee as an essential element
of banking supervision.32 According to this committee, consolidated
supervision "includes the ability to review both banking and nonbanking
activities conducted by the banking organization, either directly or
indirectly (through subsidiaries and affiliates), and activities conducted
at both domestic and foreign offices. Supervisors need to take into
account that nonfinancial activities of a bank or group may pose risks to
the bank. In all cases, the banking supervisors should be aware of the
overall structure of the banking organization or group when applying their
supervisory methods."
In contrast to the top-down approach of bank consolidated supervision,
which focuses on depository institution holding companies, FDIC's
32The Basel Committee on Banking Supervision, established in 1974, is
composed of representatives from the central banks or supervisory
authorities of various countries in Europe, North America, and Asia. This
committee has no formal authority but seeks to develop broad supervisory
standards and promote best practices in the expectation that each country
will implement the standards in ways most appropriate to its
circumstances. Implementation is left to each nation's regulatory
authorities.
supervision focuses on depository institutions. FDIC's authority extends
to affiliates of depository institutions under certain circumstances, thus
FDIC describes its approach to examining and taking supervisory actions
concerning depository institutions and their affiliates (including holding
companies), as bank-centric or bottom-up. According to FDIC officials, the
objective of this approach is to ensure that the depository institution is
insulated and isolated from risks that may be posed by a holding company
or its subsidiaries. This objective is similar to the objectives of
consolidated supervision. While FDIC officials assert that the agency's
bank-centric approach can go beyond the insured institution, as discussed
later in this report, this approach is not as extensive as the
consolidated supervisory approach in assessing the risks a depository
institution faces in a holding company structure.
Consolidated Supervisors Have More Explicit Supervisory Authority Over
Holding Company Affiliates than FDIC
As consolidated supervisors, the Board and OTS have authority to examine
bank and thrift holding companies and their nonbank subsidiaries in order
to assess risks to the depository institutions that could arise because of
their affiliation with other entities in a consolidated structure. The
Board and OTS may examine holding companies and their nonbank
subsidiaries, subject to some limitations,33 to assess, among other
things, the nature of the operations and financial condition of the
holding company and its subsidiaries; the financial and operations risks
within the holding company system that may pose a threat to the safety and
soundness of any depository institution subsidiary of such a holding
company; and the systems for monitoring and controlling such risks.34 The
Board's examination authority is limited to certain circumstances, such as
where the Board "has reasonable cause to believe that such subsidiary is
engaged in activities that pose a material risk to an affiliated
depository institution" or the Board has determined that examination of
the subsidiary is necessary to inform the Board of the systems the company
has to monitor and control the financial and operational risks within the
holding company system that may threaten the safety and soundness of an
affiliated
33See 12 U.S.C. S: 1831v(b). 34See 12 U.S.C. S:S: 1844(c)(2)(A), 1467a.
depository institution.35 OTS's examination authority with respect to
holding companies is subject to the same limitation.36 Also, the focus of
Board and OTS examinations of all holding company nonbank subsidiaries
must, to the fullest extent possible, be limited to subsidiaries that
could have a materially adverse effect on the safety and soundness of a
depository institution affiliate due to either the size, condition, or
activities of the subsidiary or the nature or size of transactions between
the subsidiary and any affiliated depository institution.37 FDIC
examinations of affiliates having a relationship with an institution are
not subject to the same limitations where the examination is to determine
the condition of the institution for insurance purposes.38
As a result of their authority, consolidated supervisors take a systemic
approach to supervising depository institution holding companies and their
nonbank subsidiaries. Consolidated supervisors may assess lines of
business, such as risk management, internal control, IT, and internal
audit across the holding company structure in order to determine the risk
these operations may pose to the insured institution. These authorities
enable consolidated supervisors to determine whether holding companies
that own or control insured depository institutions, as well as holding
company nonbank subsidiaries, are operating in a safe and sound manner so
that their financial condition does not threaten the viability of their
affiliated depository institutions.39 Thus, consolidated supervisors can
examine a holding company subsidiary to determine whether its size,
condition, or activities could have a materially adverse effect on the
safety and soundness of the bank even if there is no direct relationship
between the two entities. Although the Board's and OTS's examination
authorities are subject to some limitations, as previously noted, both the
Board and OTS maintained that these limitations do not restrict the
supervisors' ability to detect and assess risks to an insured depository
institution's safety and
35See 12 U.S.C. S: 1844(c)(2)(B).
36See 12 U.S.C. S:S: 1467a(b)(4), 1831(a).
37See 12 U.S.C. S:S: 1844(c)(2)(C), 1831v(a).
38See 12 U.S.C. S: 1831v(b).
39See "Framework for Financial Holding Company Supervision," Letter from
the Division of Banking Supervision and Regulation, Board of Governors of
the Federal Reserve System, to the Officer in Charge of Supervision and
Appropriate Supervisory Staff at Each Federal Reserve Bank and to
Financial Holding Companies (August 15, 2000).
soundness that could arise solely because of its affiliations within the
holding company.
The Board's and OTS' consolidated supervisory authorities also include the
ability to require holding companies and their nonbank subsidiaries to
provide reports in order to keep the agencies informed about matters that
include the holding company's or affiliate's financial condition, systems
for monitoring and controlling financial and operations risks, and
transactions with affiliated depository institutions.40 These authorities
are subject to restrictions designed to encourage the agency to rely on
reports made to other supervisors, publicly available information, and
externally audited financial statements. The Board requires that bank
holding companies provide annual reports of the company's operations for
each year that it remains a bank holding company; OTS has the authority to
require an independent audit of, among other things, the financial
statements of a holding company, at any time.41 According to Board's and
OTS' examination manuals, examiners may also use additional reports of
holding company and affiliate activities that are not publicly available,
such as the holding company's financial statements, budgets and operation
plans, various risk management reports, and internal audit reports.
In addition to examination authority, as consolidated supervisors, the
Board and OTS have instituted standards designed to ensure that the
holding company serves as a source of strength for its insured depository
institution subsidiaries. The Board's regulations for bank holding
companies include consolidated capital requirements that, among other
things, can help protect against a bank's exposure to risks associated
with its membership in the holding company.42 The OTS does not impose
consolidated regulatory capital requirements on thrift holding companies.
Although there is no specific numerical requirement (ratio), OTS's policy
is that regulated holding companies should have an adequate level of
capital to support their risk profile. OTS examiners are instructed to
consider all aspects of an organization's risk profile, on a case by case
basis, to determine if capital is adequate with respect to both the
holding company and its affiliate thrift.
40See 12 U.S.C. S:S: 1844(c)(1), 1467a(b)(2), 1844(c)(1)(B), 1831v(a)(1).
4112 C.F.R. S: 225.5(b) (Board); 12 C.F.R. S: 562.4(a) (OTS).
4212 C.F.R. Part 225, Appendices B & C.
In addition to consolidated capital requirements, the Board has, by
regulation, instituted the "source of strength" doctrine, which states
that a bank holding company shall serve as a source of financial and
managerial strength to its subsidiary banks.43 According to Board
officials, the source of strength doctrine can be invoked to require a
bank holding company to take affirmative action, for example, by providing
capital infusions to an affiliate depository institution in financial
distress, in order to enhance the safety and soundness of the institution.
Some banking experts have expressed concern that the Board's authority to
require a transfer of assets from the holding company to a troubled
affiliate bank is unclear.44 In amendments to the BHC Act and FDI Act
enacted as part of GLBA, Congress indicated its understanding that the
Board has such authority. These amendments refer to (1) limiting the
Board's authority to require the transfer of funds or other assets to a
subsidiary bank by bank holding companies or affiliates that are insurance
companies or are registered as brokers, dealers, investment companies or
investment advisers; (2) granting the Board authority to require a
functionally regulated subsidiary of a holding company to provide capital
or other funds or assets to a depository institution affiliate of the
holding company; and (3) prohibiting a bank holding company from engaging
in expanded activities as a financial holding company unless, among other
things, all of its depository institutions are well capitalized.45 The
third of these provisions suggests that the Board has authority to order
the holding company to maintain the bank's capital as a condition of its
status as a financial holding company. OTS officials stated that OTS has
the same authority as the Board with respect to requiring a capital
infusion.
43See 12 C.F.R. S: 225.4(a).
44The concern is based upon differing views about the effect of the
Supreme Court's ruling in Board of Governors v. MCorp. Financial, Inc.,
502. U.S. 32 (1991). In MCorp, the Court reversed a federal circuit
court's holding that federal courts had jurisdiction to consider and
enjoin an administrative action by the Board alleging MCorp's violation of
the Board's source of strength regulation. The Court observed that MCorp
ultimately could seek judicial review of the validity of the source of
strength regulation and its application "if and when the Board finds that
MCorp has violated that regulation." 502 U.S. at 43-44. The judicial
action subsequently was dismissed for lack of jurisdiction. MCorp.
Financial v. Board of Governors, 958 F.2d 615 (5th Cir. 1992). Questions
about the validity and enforcement of the regulation were unresolved.
45See, e.g., 12 U.S.C. S:S: 1844(g), 1831v(a)(2), and 1843(l),
respectively.
The Board and OTS also have enforcement authority over holding companies
and their nonbank subsidiaries which, among other things, allows the
agencies to order the termination of any activity, or ownership, or
control of any noninsured subsidiary, if there is reasonable cause to
believe that the continuation of the activity or ownership or control of
the uninsured affiliate constitutes a serious risk to the financial
safety, soundness, or stability of an affiliated insured depository
institution. For example, if a subsidiary exposed the holding company to
reputation risk that constituted a serious risk to the financial safety
and soundness of an affiliated bank, these authorities could be used to
force the holding company to divest of the subsidiary in order to prevent
any negative impact from spreading to the insured institution.46
In contrast to the consolidated supervisory approaches of the Board and
OTS, FDIC's authority does not specifically address the circumstances of
an ILC holding company or its nonbank subsidiaries except in the context
of a relationship between the ILC and an entity affiliated with it through
the holding company structure. Specifically, FDIC's authority to examine
state nonmember banks, including ILCs, includes the authority to examine
some, but not all, affiliates of the ILC in a holding company structure.
Under section 10(b) of the FDI Act, FDIC may, in the course of examining
an institution, examine "the affairs of any affiliate of (the) institution
as may be necessary to disclose fully-( i) the relationship between such
depository institution and any such affiliate; and (ii) the effect of such
relationship on the depository institution."47 FDIC's use of this
authority to determine the condition of an institution for insurance
purposes is not limited by the functional regulation restrictions that
apply to examinations by the Board and OTS.48 Also, according to FDIC
officials, FDIC can use its subpoena and other investigative authorities
to obtain information from any affiliate, as well as any nonaffiliate, to
determine compliance with applicable law and with respect to any matter
concerning the affairs or
46See 12 U.S.C. S: 1818(b)(3) (enforcement authority regarding nonbank
subsidiaries includes authority to impose cease and desist orders for
unsafe or unsound practices); see also, 12 U.S.C. S: 1467(g) (OTS
enforcement authority regarding thrift holding companies); 12 C.F.R. S:
225.4(b) (Board regulation providing for divestiture of holding company
affiliates); 12 U.S.C. S: 1467a(g)(5) (OTS divestiture authority).
47See 12 U.S.C. 1820(b)(4)(A).
48See 12 U.S.C. 1831v(b).
ownership of an insured institution or any of its affiliates.49 According
to FDIC officials, such an investigation would be triggered by concerns
about the insured institution.
Because FDIC does not regulate institutions affiliated with depository
institutions on a consolidated basis, it has no direct authority to impose
consolidated supervision requirements, such as capital levels and
reporting obligations, on ILC holding companies. However, FDIC does have
authorities that it can use for certain purposes to address risk to
depository institutions in a holding company structure. For example, FDIC
can initiate an enforcement action against an insured ILC and, under
appropriate circumstances, an affiliate that qualifies as an
institution-affiliated party (IAP) of the ILC if the ILC engages in or is
about to engage in an unsafe or unsound practice.50 An ILC affiliate is an
IAP if, among other things, it is a controlling stockholder (other than a
bank holding company), a shareholder who participates in the conduct of
the affairs of the institution, or an independent contractor who knowingly
or recklessly participates in any unsafe or unsound practices.51 However,
FDIC's ability to use this authority to, for example, hold an ILC holding
company responsible for the financial safety and soundness of the ILC is
less extensive than application of the source of strength doctrine by the
Board or OTS under consolidated supervision. As we will discuss later,
FDIC officials assert that FDIC can use its supervisory power over an ILC
under certain circumstances to achieve similar results as under
consolidated supervision.
Figure 4 compares some of the differences in explicit supervisory
authority between FDIC and consolidated supervisors, specifically the
Board and OTS. The table shows that in two of the eight areas FDIC has
examination authority with respect to ILC affiliates that have a
relationship with the ILC, as do the Board and OTS. However, we identified
six areas where FDIC's explicit authority with respect to ILC holding
company affiliates is not as extensive as the explicit authorities of
consolidated supervisors to examine, impose capital-related requirements
on, or take enforcement
49See 12 U.S.C. S: 1820(c).
50FDIC has no authority to take action against an ILC affiliate whose
activities weaken the holding company, and potentially the ILC, unless the
affiliate is an IAP and the IAP participated in conducting the ILC's
business in an unsafe or unsound manner, violated a legal requirement or
written condition of insurance, or otherwise engaged in conduct subject to
enforcement. See 12 U.S.C. S: 1818(b).
51See 12 U.S.C. S: 1813(u).
actions against holding companies and affiliates of an insured
institution. In general, FDIC's supervisory authority over holding
companies and affiliates of insured institutions depends on the agency's
authority to examine certain affiliates and its ability to enforce
conditions of insurance and written agreements, to coerce conduct based on
the prospect of terminating insurance, and to take enforcement actions
against a holding company or affiliate that qualifies as an IAP.52
Figure 4: Comparison of Explicit Supervisory Authorities of the FDIC, Board, and
OTS
Explicit authority
Less extensive authority
No authority
Sources: GAO analysis of the supervisory authorities of the FDIC, Board,
and OTS.
aFDIC may examine an insured institution for interaffiliate transactions
at any time and can examine the affiliate when necessary to disclose the
transaction and its effect on the insured institution.
52In addition to these authorities, we note that measures under the prompt
corrective action provisions of the FDI Act based on an institution's
undercapitalized status include a parental capital maintenance guarantee
and the possibility of divestiture of a significantly undercapitalized
depository institution or any affiliate. See 12 U.S.C. S: 1831o. These
measures apply equally to all FDIC insured institutions and their
respective regulators.
bThe authority that each agency may have regarding functionally regulated
affiliates of an insured depository institution is limited in some
respects. For example, each agency, to the extent it has the authority to
examine or obtain reports from a functionally regulated affiliate, is
generally required to accept examinations and reports by the affiliates'
primary supervisors unless the affiliate poses a material risk to the
depository institution or the examination or report is necessary to assess
the affiliate's compliance with a law the agency has specific jurisdiction
for enforcing with respect to the affiliate (e.g., the Bank Holding
Company Act in the case of the Board). These limits do not apply to the
Board with respect to a company that is itself a bank holding company.
These restrictions also do not limit the FDIC's authority to examine the
relationships between an institution and an affiliate if the FDIC
determines that the examination is necessary to determine the condition of
the insured institution for insurance purposes.
cFDIC may take enforcement actions against institution-affiliated parties
of an ILC. A typical ILC holding company qualifies as an
institution-affiliated party. FDIC's ability to require an ILC holding
company to provide a capital infusion to the ILC is limited. In addition,
FDIC may take enforcement action against the holding company of an ILC to
address unsafe or unsound practices only if the holding company engages in
an unsafe or unsound practice in conducting the affairs of the depository
institution.
dFDIC maintains that it can achieve this result by imposing an obligation
on an ILC holding company as a condition of insuring the ILC. FDIC also
maintains it can achieve this result as an alternative to terminating
insurance. FDIC officials also stated that the prospect of terminating
insurance may compel the holding company to take affirmative action to
correct violations in order to protect the insured institution. According
to FDIC officials, there are no examples where FDIC has imposed this
condition on a holding company as a condition of insurance.
eIn addition to an enforcement action against the holding company of an
ILC in certain circumstances (see footnote b), as part of prompt
corrective action the FDIC may require any company having control over the
ILC to (1) divest itself of the ILC if divestiture would improve the
institution's financial condition and future prospects, or (2) divest a
nonbank affiliate if the affiliate is in danger of becoming insolvent and
poses a significant risk to the institution or is likely to cause a
significant dissipation of the institution's assets or earnings. However,
the FDIC generally may take such actions only if the ILC is already
significantly undercapitalized.
While FDIC's Authority is Less Extensive Than Consolidated Supervision,
FDIC Officials Assert Its Authority Could Achieve Similar Results
Although FDIC's authority over an insured ILC permits FDIC to take certain
measures with respect to some ILC holding company affiliates under certain
circumstances, this authority is not equivalent to consolidated
supervision of the holding company. However, FDIC officials stated that it
can adequately protect an ILC from the risks arising from being in a
holding company without adopting a consolidated supervision approach. The
officials stated that FDIC has various authorities, including the
following:
o examining certain ILC affiliates that have a relationship with the ILC;
o imposing requirements on an ILC holding company in connection with an
application for deposit insurance, as a condition of insuring the ILC;
o terminating deposit insurance or entering into written agreements with
the holding company to correct conditions that would warrant termination
of the ILC's insurance;
o obtaining written agreements from the acquiring entity in connection
with a proceeding to acquire an ILC; and
o taking enforcement measures against ILCs and certain ILC affiliates.
FDIC may be able to use these authorities in many instances to supervise
ILCs and their holding company and affiliates. However, because these
authorities can be used in connection with concerns about a particular ILC
only under specific circumstances, they do not provide FDIC with a
comprehensive supervisory approach designed to detect and address the
ILC's exposure to all risks arising from its affiliations in the holding
company, such as reputation risk from an affiliate that has no
relationship with the ILC. These limitations are most significant with
respect to existing ILC holding companies that are not subject to
conditions or written agreements made in connection with the ILC's
application for insurance and whose ILCs are not currently financially
troubled or exposed to risks from relationships with their affiliates.
Table 2 provides a summary of what FDIC officials told us about their
authority over holding companies and affiliates of insured depository
institutions and our analysis of the limitations of these authorities.
Table 2: The Extent of Selected FDIC Authorities
FDIC authority Extent of authorities
a
Examine certain ILC affiliates. Only to determine whether the affiliate
has a relationship with the ILC and, if so, to disclose the effect of the
relationship on the ILC. The authority does not extend to determining how
the affiliate's involvement in the holding company alone might threaten
the safety and soundness of the ILC.
Impose conditions on or enter into Only in connection with an application
for deposit insurance and cannot be used to unilaterally agreement with an
ILC holding company in connection with an application for deposit
insurance.
impose conditions on an ILC holding company after the application has been
approved.
Terminate deposit insurance. Only if certain notice and procedural
requirements (including a hearing on the record before the FDIC Board of
Directors) are followed after FDIC determines that
o the institution, its directors or trustees have engaged in unsafe or
unsound practices;
o the institution is in an unsafe or unsound condition; or
o the institution, its directors or trustees have violated an applicable
legal requirement, condition of insurance, or written agreement between
the institution and FDIC.
Obtain written agreements from the Could be used if grounds for
disapproval exist with respect to the acquirer.
acquiring entity in connection with a
proceeding to acquire an ILC.b
Take enforcement actions against ILC Only if an affiliate is an IAP; and
c
affiliates. Only if the IAP engages in an unsafe or unsound practice in
conducting the business of the ILC or has violated a legal requirement. If
the IAP is functionally regulated, FDIC's enforcement grounds are further
limited.
Source: GAO analysis of the supervisory authorities stated by FDIC
officials.
aFDIC's ability to examine ILC affiliates is limited by the meaning of the
term "relationship," which is unclear in situations where the ILC and the
affiliate do not engage in transactions or share operations. In this
respect, FDIC's authority is less extensive than consolidated supervision
because (1) the examination authority of consolidated supervisors does not
depend on the existence of a relationship and (2) without a relationship,
FDIC generally needs the consent of the affiliate to conduct an
examination of its operations.
bFDIC's ability to obtain written agreements from the acquiring entity in
connection with a proceeding to acquire an ILC is limited because certain
types of risks, such as reputation risk, could be unrelated to any of the
grounds for disapproval of a CIBA notice. Moreover, this ability would not
be related to concerns arising after the acquisition is made. Further,
some experts stated that it is unlikely that FDIC could require
capital-related commitments from a financially strong, well managed
commercial enterprise that seeks to acquire an ILC.
cIn accordance with 12 U.S.C. S:S:1848a, 1831v(a), FDIC's authority to
take action against a functionally regulated IAP is limited to where the
action is necessary to prevent or redress an unsafe or unsound practice or
breach of fiduciary duty that poses a material risk to the insured
institution and the protection is not reasonably possible through action
against the institution.
FDIC's Examination Authority Is FDIC officials stated that its examination
authority is sufficient to address
Less Extensive Than a any significant risk to ILCs from holding companies
and entities affiliated
Consolidated Supervisor with the ILC through the holding company
structure. For example, FDIC officials told us that it has established
effective working relationships with ILC holding companies and has
conducted periodic targeted examinations
of some ILC holding companies and material affiliates that have
relationships with the ILC, which includes those affiliates that are
providing services to or engaging in transactions with the ILC. FDIC
officials also told us that these targeted reviews of holding companies
and affiliates help to assess potential risks to the ILC and include the
following:
o assessing the holding company's value-at-risk model used at its
affiliate banks;53
o assessing the internal control and review processes developed at the
holding company level and understanding how those processes are applied to
the bank, including how the holding company's internal audit function is
designed, scoped, and implemented with respect to the bank;
o reviewing information about the holding company's asset quality and its
processes for analyzing risk such as: stress testing, review of
commercial, industrial, and international loans and country risk ratings,
and loan underwriting procedures developed at the holding company level
and implemented at the bank; and
o assessing IT systems and controls related to the bank.
The scope of FDIC's general examination authority may be sufficient to
identify and address many of the risks that holding company and affiliate
entities may pose to the insured ILC. However, FDIC's general examination
authority is less extensive than a consolidated supervisor's. Because FDIC
can examine an ILC affiliate only to determine whether it has a
relationship with the ILC and, if so, to disclose the effect of the
relationship on the financial institution, FDIC cannot examine ILC
affiliates in a holding company specifically to determine how their
involvement in the holding company alone might threaten the safety and
soundness of the ILC. When there is no relationship between the ILC and
the affiliate, FDIC generally would need the consent of the affiliate to
conduct an examination of its operations. According to its officials, FDIC
could use its subpoena powers and other authorities under section 10(c) of
the FDI Act to obtain
53Value-at-risk is an estimate of the potential losses that might occur in
a portfolio due to changes in market rates, based on a specified period of
time during which the rates change, and at a specified probability level.
For example, a firm may generate a value at risk estimate for a 10-day
period at 99 percent probability and arrive at a figure of $1 million.
This means that 99 percent of the time it would expect its losses during a
10-day move of rates to be less than $1 million.
information, but the use of these powers appears to be limited to
examinations or investigations relating to the insured depository
institution.54 In contrast, the examination authorities of the Board and
OTS focus on the operations and financial condition of the holding company
and its nonbank subsidiaries and specifically on financial and operations
risks within the holding company system that can threaten the safety and
soundness of a bank subsidiary.55 To the extent that an affiliate's size,
condition, or activities could expose the depository institution to some
type of risk, such as reputation risk, where no direct relationship with
the bank exists, the consolidated supervisory approach is more able to
detect the exposure.56 FDIC's authority does not permit it to examine an
affiliate based solely on its size, condition, or activities. However,
FDIC officials told us that it is unlikely that any serious risk could
come from an affiliate that does not have a relationship with the insured
institution. According to these officials, there have been no bank
failures in the United States from reputation risk in the past 20 years.
We agree that the most serious risk to an ILC would come from holding
companies or affiliates that have a relationship with the ILC. However,
the possibility that risks could come from affiliates with no relationship
with the ILC cannot be overlooked. While no recent bank failures may have
resulted from reputation risk, it continues to attract the attention of
the FDIC and the Board.
Unlike the specific examination authority of the Board, the full extent of
FDIC's examination authority over affiliates is unclear because there is
no established definition of the term "relationship" in the context of
FDIC's examination authority. Further, we are not aware of any judicial or
legislative clarification of this term as it relates to FDIC examinations.
According to FDIC officials, determining whether a relationship exists can
be routine in cases where an insured institution and an affiliate engage
in a transaction or share operations. However, in less obvious cases, the
determination might involve circumstances that may be unique or
unprecedented.
54See 12 U.S.C. S: 1820(c).
55See, for example, the focus of bank holding company examinations as
prescribed in the BHC Act. 12 U.S.C. S: 1844(c)(2).
56See 12 U.S.C. 1844(c)(1)(C) (Board examinations, to fullest extent
possible, are to be limited to examinations of holding company
subsidiaries whose "size, condition, or activities" could adversely affect
the affiliated bank's safety and soundness or where the nature and size of
transactions between the affiliate and the bank could have that effect.)
However, both the Board and FDIC officials, as well as an expert we
interviewed, generally agreed that the term connotes an arrangement in
which there exists some level of interaction, interdependence or mutual
reliance between the ILC and the affiliate, such as a contract,
transaction, or the sharing of operations. Board officials expressed the
view that the term has a limiting effect on affiliate examinations. FDIC
officials told us that its use of this authority to examine ILC holding
companies or entities affiliated with an insured institution in a holding
company has never been challenged.
FDIC's Authority to Impose FDIC officials also stated that it can use its
authority to approve Conditions or Written applications for deposit
insurance as a means of requiring an ILC holding Agreements Can Be Used in
company to adopt commitments, operations and procedures that enhance
Certain Circumstances the safety and soundness of the ILC. When reviewing
an application for
insurance, FDIC must consider the following seven statutory factors:57
o financial history and condition of the depository institution,
o adequacy of the institution's capital structure,
o future earnings prospects of the institution,
o general character and fitness of the institution's management,
o risk the institution presents to the deposit insurance fund,
o convenience and needs of the community to be served by the institution,
and
o whether the institution's corporate powers are consistent with the FDI
Act.
57See 12 U.S.C. S:S: 1815(a)(4), 1816.
FDIC officials stated that because its primary mission is to protect the
bank insurance fund, the FDIC's incidental powers and other authorities
under the FDI Act authorize the FDIC to impose conditions on insurance
where those conditions are warranted by the statutory factors.58 Under its
enforcement authority, FDIC can initiate proceedings against an IAP for
violation of a condition imposed in writing by FDIC in connection with the
granting of any application or request by the depository institution or
any written agreement with the agency.59 In March 2004, FDIC issued
guidance that identified nonstandard conditions that might be imposed when
approving applications for deposit insurance involving financial
institutions to be owned by or significantly involved in transactions with
commercial or financial companies. For example, among other things, FDIC
can require that the majority of ILC management be independent of its
holding company and affiliates, and that all arrangements to share
management staff, personnel, or resources with the holding company or any
affiliate be governed by written contracts giving the bank authority to
govern its own affairs. FDIC officials told us that the approval of
insurance could be conditioned upon the holding company's adhering to
prescribed capital levels, adopting a capital maintenance plan for the
ILC, and/or other measures such as submitting reports about affiliates to
FDIC. For example, FDIC's policy is to favor capital commitments from
holding companies of applicants for insurance.60 However, FDIC officials
were unable to provide examples where FDIC has imposed conditions on an
application for insurance that required the holding company to provide
specific reports of
58FDIC's incidental powers are set forth at 12 U.S.C. 1819(a)(Seventh).
59See 12 U.S.C. S: 1818(b)(1).
60FDIC's Policy Statement on Applications for Deposit Insurance provides,
in pertinent part, that: Where the proposed depository institution will be
a subsidiary of an existing bank or thrift holding company, the FDIC will
consider the financial and managerial resources of the parent organization
in assessing the overall proposal and in evaluating the statutory factors
prescribed in section 6 of the Act. . . . If the applicant (for deposit
insurance) is being established as a wholly owned subsidiary of an
eligible holding company, . . . the FDIC will consider the financial
resources of the parent organization as a factor in assessing the adequacy
of the proposed initial capital injection. In such cases, the FDIC may
find favorably with respect to the adequacy of capital factor, when the
initial capital injection is sufficient to provide for a Tier 1 leverage
capital ratio of at least 8 percent at the end of the first year of
operation, based on a realistic business plan, or the initial capital
injection meets the $2 million minimum capital standard set forth in this
Statement of Policy, or any minimum standards established by the
chartering authority, whichever is greater. The holding company shall also
provide a written commitment to maintain the proposed institution's Tier 1
leverage capital ratio at no less than 8 percent throughout the first 3
years of operation. See 67 Fed. Reg. 79276-79278 (Dec. 27, 2002).
operations, financial condition, and systems of monitoring risk at the
holding company and affiliates. Although FDIC officials and examiners told
us that no ILC holding company has refused to provide all of the reports
and supporting documents that the examiners needed, our review found that
FDIC examiners rely upon information about holding company and affiliate
operations that is voluntarily provided by ILC holding companies during
the course of an examination to assess the various types of risk from the
holding company and affiliate operations, including various types of
nonpublic information such as asset quality and loan underwriting.
Further, FDIC officials told us that it has never imposed capital
requirements on a holding company; rather, officials gave an example where
a legally enforceable agreement to maintain a certain level of capital was
obtained from the holding company. In addition to imposing conditions,
FDIC could, according to its officials, enter into a written agreement
with the holding company of an institution to establish a supervisory
system similar to consolidated supervision. For example, the agreement
could call for the holding company to correct conditions at the affiliate
that presents risks to the ILC, provide reports about affiliates, or even
a capital infusion into the ILC. According to FDIC officials, whether to
impose capital and reporting requirements as conditions on insurance or
achieve the same result through agreements with the holding company
depends upon the circumstances of the application for insurance.
FDIC's authority does not permit it to impose conditions on an ILC holding
company after the application has been approved. Should the ILC face risks
from the holding company that are not adequately covered by insurance
conditions or a written agreement with the holding company and do not
arise from any relationship that the ILC has with an affiliate, FDIC would
have to resort to some other means to achieve corrective action by the
holding company, such as persuading the holding company to take action to
avoid termination of the depository institution's insurance. FDIC
officials also referred to procedures under the prompt corrective action
(PCA) provisions of the FDI Act for undercapitalized institutions that can
require action by a holding company, such as a guarantee to maintain the
depository institution's capital at prescribed levels and divestiture of a
significantly undercapitalized institution or any affiliate.61 FDIC's PCA
authority cannot be used unless the institution violates capital standards
and is triggered only by a bank's capital deficiency. In contrast, under
consolidated supervision, capital and reporting requirements are imposed
61See 12 U.S.C. S: 1831o(e)(2)(C), (f)(I)(ii).
FDIC's Authority to Terminate Insurance Can Be Exercised in Certain
Circumstances
on holding companies of depository institutions to address the potential
for risks arising from the holding company system. Moreover, consolidated
supervision requirements can address risks that might not be discernible
at a particular point in time, whereas FDIC can exercise its authorities
only under certain circumstances, such as when an application for
insurance is granted.
FDIC officials stated that, even if conditions or agreements were not
established in connection with the issuance of an ILC's insurance, the
prospect of terminating an institution's insurance can serve to compel the
holding company to take measures to enhance the safety and soundness of
the ILC. Under the FDI Act, FDIC can initiate an insurance termination
proceeding only if certain notice and procedural requirements are followed
after a determination by the FDIC that (1) an institution, its directors,
or trustees have engaged in or are engaging in an unsafe or unsound
practice; (2) an institution is in an unsafe or unsound condition; or (3)
the institution, its directors, or trustees have violated an applicable
legal requirement, a condition imposed in connection with an application
by the depository institution, or a written agreement between the
institution and FDIC.62 In addition, termination proceedings must be
conducted in a hearing on the record, documented by written findings in
support of FDIC's determination, and are subject to judicial review.63
FDIC officials told us that if the grounds for termination exist, FDIC can
provide the holding company of a troubled ILC with an opportunity to avoid
termination by agreeing to measures that would eliminate the grounds for
termination. These measures could include an agreement to infuse capital
into the ILC or provide reports about the holding company and its
affiliates. According to FDIC officials, the prospect of terminating
insurance is usually sufficient to secure voluntary corrective action by a
holding company to preclude the occurrence of an unsafe or unsound
practice or condition or restore the institution to a safe and sound
financial condition. FDIC officials stated that FDIC has notified insured
institutions that it intended to terminate deposit insurance 184 times.
Between 1989 and 2004, FDIC initiated formal proceedings to terminate
deposit insurance in 115 of these cases because necessary corrections were
not immediately achieved. In 94 of these 115
62The procedural requirements include notifying the appropriate federal or
state banking supervisor of FDIC's determination for the purpose of
securing a correction by the institution. 12 U.S.C. S: 1818(a)(2)(A).
63See 12 U.S.C. S: 1818(a)(3),(5).
In Certain Circumstances, FDIC May Enter Into Agreements in Connection
with the Acquisition of an Insured Institution
instances, corrective actions were taken, and the deposit insurance was
not terminated. For the remaining 21 of the 115 cases, FDIC terminated
deposit insurance. FDIC officials told us that, after terminating deposit
insurance, 17 of these institutions implemented appropriate corrective
actions, and the insurance was subsequently reinstated.
As demonstrated by the number of institutions that took measures to
enhance the safety and soundness of the insured depository institution,
the threat of insurance termination has been an effective supervisory
measure in many instances. However, FDIC's ability to use the possibility
of insurance termination to compel the holding company to enhance the
safety and soundness of the insured institution is limited. For example,
because the statutory grounds for termination relate to the condition of
the institution and practices of its directors or trustees, the prospect
of termination would not be based solely on the condition or operations of
an institution's affiliate. While conditions could exist in the holding
company that might threaten the holding company and thereby indirectly
threaten an ILC, these conditions would not serve as grounds for
termination of insurance unless they caused the institution to be in an
unsafe or unsound condition. Further, unlike the consolidated supervision
approach, FDIC insurance termination authority does not give it power to
require a holding company or any of its nonbank affiliates to change their
operations or conditions in order to rehabilitate the ILC. The extent to
which FDIC could enter into an agreement with a holding company would
depend on whether the holding company has an incentive to retain the
institution's insured status and/or the resources to take the action FDIC
seeks.
FDIC officials also stated that if an entity sought to acquire an ILC, the
regulatory process for such a transaction could afford FDIC an opportunity
to seek an agreement from the prospective acquirer relating to matters
such as capital maintenance, examinations, and reporting. Provisions of
the Change In Bank Control Act (CIBA) set forth the reasons for which FDIC
can disapprove the proposed acquisition of an insured ILC.64 These include
proposed acquisitions where (1) the financial condition of the acquiring
company might jeopardize the financial stability of the depository
institution; (2) the competence, experience, or integrity of the acquirer
or proposed management personnel do not satisfy statutory standards; and
where (3) FDIC determines that the acquisition would have an adverse
64FDIC's authority in connection with the acquisition of an insured
institution is set forth at 12 U.S.C. S:S: 1817(j).
FDIC's Authority to Take Enforcement Actions Is Less Extensive Than a
Consolidated Regulator
effect on the deposit insurance fund. According to FDIC officials, it
could use the prospects of disapproval on these or other grounds to force
a potential acquirer to enter agreements that would address potential
risks to an ILC arising from its presence in a holding company. FDIC
officials described an instance where officials obtained an agreement from
an acquirer to correct potential problems even before issuing disapproval
of the CIBA notice to address the acquirer's request to avoid negative
publicity.
FDIC's ability to reach an agreement in connection with an acquisition
appears to be helpful in mitigating some of the risks that could arise at
this time. However, FDIC's ability to obtain agreements in connection with
a CIBA notice is limited when a prospective acquirer of an ILC does not
trigger the statutory concerns described above. For example, some experts
we talked with said it is unlikely that FDIC could use its CIBA authority
to require capital-related commitments from a financially strong,
wellmanaged commercial enterprise that seeks to acquire an ILC. Moreover,
certain types of risk to a depository institution that can arise from its
affiliations in a holding company, such as reputation risk arising from an
affiliate of the acquirer, could be unrelated to any of the grounds for
disapproval set forth in CIBA or could arise after the acquisition has
been approved.
FDIC officials also stated that it can use its enforcement authority to
compel certain institution affiliated parties of ILCs (a group that
typically would include the ILC's holding company) to take measures
relating to the safety and soundness of the ILC. However, FDIC has no
enforcement authority over ILC affiliates that are not IAPs, and its
ability to require an IAP to infuse capital into a troubled ILC appears to
be limited. As discussed previously, FDIC has no authority to take action
against an ILC affiliate whose activities weaken the holding company, and
potentially the ILC, unless the affiliate is an IAP. If grounds for an
enforcement action exist, FDIC can initiate an action against the insured
institution or an IAP to obtain, among other things, a cease and desist
order or civil money penalties.65
65Grounds for an enforcement action against an IAP include the occurrence
or potential occurrence of an unsafe or unsound practice by the insured
institution caused by the IAP's conducting the business of the institution
or the violation of a law, regulation or other regulatory requirements by
the institution or IAP. See 12 U.S.C. S: 1818(b)(1).
FDIC officials told us that it could use its enforcement authority, under
appropriate circumstances, to require an ILC holding company to take
action necessary to protect or restore the safety and soundness of its
affiliate insured institution, which action could include transferring
capital into the institution or making a guarantee to do so. However,
FDIC's ability to impose such requirements against a functionally
regulated affiliate is limited.66 Moreover, FDIC's authority to require an
asset transfer in an administrative enforcement action may be limited. In
a decision interpreting OTS' authority to require a holding company to
comply with a written condition requiring the company to maintain the net
worth of a savings bank affiliate, the District of Columbia Circuit Court
(Court) held that OTS had no authority to require an asset transfer absent
proof of the holding company's unjust enrichment or reckless disregard of
its legal obligations.67 In that decision, the Court observed that this
same provision governs enforcement actions by other federal banking
agencies, including FDIC. According to this decision, FDIC has no
authority to require an ILC holding company to transfer assets to a
troubled ILC solely because of the ILC's unsafe or unsound condition,
unless the condition is the result of the holding company's use of the ILC
for unjust enrichment or reckless disregard of a legal obligation to make
the transfer. The Court's decisions in these cases also may limit the
authority of the Board and OTS to require an asset transfer without
proving unjust enrichment or reckless disregard of a legal requirement. In
this regard, a bank holding company's reckless disregard of its obligation
to maintain the financial safety and soundness of a subsidiary bank might
satisfy the Court's requirements for a capital infusion.
66See 12 U.S.C. S:S: 1831v, 1848a.
67Wachtel v.Office of Thrift Supervision, 982 F.2d 581 (D. Cir. 1993) (OTS
lacks authority to require majority shareholder of a savings and loan to
inject capital into the institution pursuant to a written agreement where
OTS failed to prove unjust enrichment.); see also, Rapaport v. Office of
Thrift Supervision, 59 F.3d 212 (1995).
FDIC Actions May Help Mitigate Potential Risks, but Supervision of ILC
Holding Companies and Affiliates Has Only Been Tested on a Limited Basis
in Relatively Good Economic Times
FDIC's bank-centric, supervisory approach has undergone various
modifications to its examination, monitoring, and application processes,
designed to help mitigate the potential risks that FDIC-examined
institutions, including ILCs in a holding company structure, can be
exposed to by their holding companies and affiliates. For example, FDIC
revised the guidance for its risk-focused examinations to, among other
things, provide additional factors that might be considered in assessing a
holding company's potential impact on an insured depository institution
affiliate. These changes may further enhance FDIC's ability to supervise
the potential risks that holding companies and affiliates can pose to
insured institutions in a holding company structure, including ILCs. In
addition, FDIC's application process may also help to mitigate risks to
ILCs with foreign holding companies and affiliates. While FDIC has
provided some examples where its supervisory approach effectively
protected the insured institution and mitigated losses to the bank
insurance fund, questions remain about whether FDIC's supervisory approach
and authority over BHC Act-exempt holding companies and affiliates
addresses all risks to the ILC from these entities. Further, FDIC's
supervision of large, rapidly growing ILCs and authority over BHC
Act-exempt holding companies and nonbank affiliates has been refined
during a period of time described as the "golden age of banking" and has
not been tested during a time of significant economic stress or by a
large, troubled ILC.
FDIC Examination and Monitoring Procedures May Help to Mitigate Risks to
ILCs from Holding Companies and Affiliates
According to FDIC, its process for conducting safety and soundness
examinations for ILCs is risk-focused and generally the same as for other
banks under its oversight. These officials believed that an examiner's
ability to exercise judgment to determine the depth of review in each
functional area is crucial to the success of the risk-focused supervisory
process. FDIC officials and examiners told us that, at every examination,
FDIC reviews an institution's relationships with affiliated entities.
According to FDIC's Supervisory Insights, in an examination of a
depository institution with affiliates, including an ILC, FDIC examiners
assess the bank's corporate structure, the bank's interactions with
affiliates-which include a review of intercompany transactions and
interdependencies-as well as the financial risks that may be inherent in
the affiliate relationship. Once each on-site examination is initiated,
the FDIC requests information from bank management to obtain items that
serve as the starting point for reviewing the institution's relationships
with affiliated entities. The requested information may include items such
as the following:
o a list of officers and directors of affiliates, including
organizational chart, if available;
o a list of affiliated organizations and their financial statements as of
the financial statement date, or most recent date available;
o the most recent annual report, SEC 10-K report, and/or SEC 10-Q report
(annual and quarterly financial filings to the SEC);
o a tax allocation agreement with the holding company;
o contracts for all business relationships with affiliates that provide
services to the ILC; and
o the fee structure of transactions with the holding company and/or
affiliates.
FDIC's examination manual notes that an institution's relationship with
its affiliates is an important part of the analysis of the condition of
the bank itself. The manual further states that, because of common
ownership or management, transactions with affiliates may not be subject
to the same sort of objective analysis by bank management that is used to
analyze transactions between independent parties and that affiliates offer
an opportunity to engage in types of business endeavors that are
prohibited for the bank itself, yet may impact the condition of the bank.
In March 2004, the FDIC updated the Related Organizations section of its
examination manual to, among other things, expand the discussion of
management's fiduciary responsibilities to ensure that an insured
depository institution maintains a separate corporate existence from its
affiliates; to provide additional factors that might be considered in
assessing a holding company's potential impact on an insured depository
institution affiliate, such as the independence of the bank's management
from the holding company; and to emphasize examiners' authority under
Section 10(b) and (c) of the FDI Act to examine affiliates of state
nonmember banks, if deemed warranted.
Table 3 lists some of the examination procedures performed during a review
of an institution with affiliates, including ILCs.
Table 3: Affiliate Related Examination Procedures
Assessing the bank's corporate structure.
Reviewing intercompany transactions to determine how the bank interacts
with the affiliates.
Reviewing the interdependencies of the bank and affiliates.
Evaluating any financial risks that may be inherent in the relationship.
Reviewing the current written business plan and evaluating any changes.
Reviewing any arrangements of shared management or employees.
Reviewing services provided to an affiliate to determine whether the same
terms and conditions are in place as would be for nonaffiliated entities.
Reviewing the services purchased from an affiliate to determine whether
the same terms and conditions are similar to those that would be applied
to a nonaffiliated entity.
Assessing whether written agreements are in place for all service
relationships.
Reviewing relevant documents to determine whether the bank has a
contingency plan for all critical business functions performed by
affiliated companies.
Source: FDIC.
Note: Adapted from Supervisory Insights, June 2004.
While the FDIC lacks specific authority to require that holding companies
serve as a source of strength to affiliate financial institutions, FDIC
officials told us that examination activities to assess the holding
company's source of strength to the insured institution are performed at
each examination. The examination manual also states that a sound,
well-managed holding company can be a source of strength for unit banks
and provide strong financial support because of its greater ability to
attract and shift funds from excess capital areas to capital deficient
areas. Moreover, the examination manual states that, when the financial
condition of the holding company or its nonbanking affiliates is tenuous,
pressures can be exerted on the affiliate bank by payment of excessive
dividends, investing in high risk assets, purchase and/or trade of high
quality assets for affiliates lower quality assets, purchase of
unnecessary services, or payment of excessive management or other fees.
In its recent report on FDIC's approach to supervising limited-charter
institutions, including ILCs, the FDIC-IG recommended that FDIC further
revise its examination manual and policies to expand the discussion of the
source of strength provided to an affiliate bank by the managerial and
financial capabilities of the holding company and provide guidance and
procedures to examiners for analyzing the holding company's source of
strength. FDIC officials told us that, in December 2004, FDIC further
revised its manual to include more specific suggestions for analyzing
whether a holding company, including a holding company of an ILC, may
serve as a potential "source of strength." Currently, FDIC's manual
provides specific guidance to examiners on: (1) measuring the ability of
the holding company to cover its interest expense; (2) testing the holding
company's cash availability to meet not only interest expenses, but also
operating expenses, taxes, shareholders dividends, and debt maturities;
and (3) assessing the risk to a bank through the use of dual-employee
arrangements. FDIC officials told us that if the management or financial
capacity of the holding company provides a significant source of strength
to the ILC, this finding would typically be incorporated into the summary
examination report. The FDIC-IG's report also stated that establishing
uniform and complete policies and procedures for assessing a bank's
corporate structure or relationships with affiliated entities, including
the holding company, should help ensure that examiners adequately identify
risks that may be inherent in the ILC-holding company relationship. The
FDIC-IG concluded that FDIC could further improve its examination policies
and procedures by (1) including specific procedures for examiners to
follow in assessing dual-manager and dual-employee arrangements; (2)
clarifying procedures with respect to reviewing business plans, operating
budgets, or strategic planning documents to ensure that procedures are
consistently applied; and (3) requiring examiners to calculate and provide
financial ratios in the summary examination report, especially for ILCs.
The report further states that, in the absence of Board holding company
reports, these ratios could provide examiners with important insights
about the impact that affiliates are having on the ILC.
Other aspects of FDIC's examination approach also help mitigate the risk
that holding companies and affiliates may pose to insured institutions,
including ILCs. For example, some ILCs are included in FDIC's Large State
Nonmember Bank Onsite Supervision or "Large Bank" and Dedicated Examiner
programs and receive continuous supervision. The Large Bank program
provides an on-site presence at depository institutions through
visitations and targeted reviews throughout the year as opposed to the
traditional annual point-in-time examination. State nonmember banks with
total assets of $10 billion or more are eligible. Institutions that do not
meet the asset threshold can qualify for the Large Bank program based upon
their size, complexity, and risk profile. Some of the major areas covered
in the targeted reviews can include: capital markets activities, lending,
risk management, operations, internal controls and audit, management
supervision, capital, earnings, and liquidity. Three ILCs that represent
nearly 75% of total ILC assets are currently part of the Large Bank
program.
In addition, according to the FDIC-IG report, the FDIC established the
Dedicated Examiner program in 2002 to appoint eight dedicated examiners to
work closely with the primary federal supervisors of the eight largest
insured depository institutions in the United States. Currently there are
three holding companies that are monitored as part of the Dedicated
Examiner program and, together, they own a total of four ILCs. These
dedicated examiners work with examination staff from the Board, OTS, and
OCC to obtain real-time access to information about the risk and trends in
these organizations. According to FDIC officials, currently dedicated
examiners for two of the three holding companies had not been assigned.
Examiners also use Call Report68 data to monitor the condition of
financial institutions and assist in prioritizing on-site safety and
soundness examination efforts. In addition, according to FDIC officials
and examiners we spoke with, examiners often obtain information, including
holding company financial reports and monthly board of directors' meeting
minutes, voluntarily provided by ILC management that can assist an
examiner's ability to assess risks to the ILC. This documentation can
include information regarding existing and planned transactions and
contracts with its holding company and affiliates and can further assist
in an examiner's ability to identify and assess potential risks to the ILC
stemming from these relationships.
FDIC also works with state banking supervisors to examine ILCs, including
assessing the risks that ILC holding companies and affiliates may pose to
the insured institution. In May 2004, FDIC jointly developed recommended
practices for state and federal supervisors to communicate and coordinate
the planning and execution of supervisory activities.69 Recommendations
included: involving both the state and federal banking supervisors in
meetings with bank management and directors; sharing reports produced
through off-site monitoring or targeted supervisory activities; discussing
and preparing supervisory plans at least once during the examination
cycle,
68All commercial banks insured by the FDIC and all FDIC-supervised savings
banks are required to submit quarterly Call Reports. The Call Report
contains a variety of financial information that shows a bank's condition
and income and is used for multiple purposes including assessing the
financial health and risk of the institution.
69FDIC jointly developed the recommended practices as documented by the
State Federal Working Group Supervisory Agreement together with the Board
and the Conference of State Banking Supervisors.
or more frequently, as appropriate; and jointly discussing, coordinating,
and executing all corrective action plans such as memoranda of
understanding and cease and desist orders.
In addition, FDIC established a goal, as part of its 2004 Performance
Plan, to develop an on-site examination program for nonbank holding
companies. The program would establish procedures for examination of a
nonbank or commercial holding company that owns an insured institution,
beyond what is currently done to determine the holding company's potential
effect on the insured institution. According to FDIC officials, a
preliminary draft outline of the examination program had been provided to
FDIC's legal and management divisions for comment in September 2004. FDIC
officials also told us that proposals for the program are still being
drafted. At this time, it is too early to determine how this program will
enhance FDIC's ability to protect an insured depository institution from
the potential risks that holding company and affiliate entities may pose.
FDIC's Application Process May Help to Mitigate Risks to ILCs from Foreign
Holding Companies and Affiliates
As previously discussed, FDIC's authority to impose conditions on a
holding company is limited to the circumstances previously discussed.
However, its application process may help mitigate potential risks to ILCs
from foreign holding companies. For example, deposit insurance
applications from foreign owners are subject to the same approval and
review processes as all other applications. While foreign banking
organizations chartered in the European Union are already subject to
consolidated supervision, FDIC officials told us that not all
foreign-owned ILC holding companies are designated as foreign banking
organizations (as defined by the Board) and, therefore, are not subject to
consolidated supervision in their home country. According to FDIC,
currently, only one of the five foreign-owned ILCs is owned by a foreign
banking organization that is subject to comprehensive consolidated
supervision in its home country. We reviewed an order approving an
application for insurance from a foreign holding company of an ILC in
which FDIC indicated that the proposed ownership structure presented some
concerns because it had potential to present supervisory concerns similar
to those posed by chain
banking organizations70 and because part of the "chain" was located in
another country and not subject to U.S. supervision. According to FDIC,
chain banks present opportunities to shift low-quality assets and other
funds between banks to avoid being detected by supervisors and auditors.
FDIC's concerns were mitigated, in part, because of its ability to review
publicly available information about the publicly traded holding company
and the foreign bank affiliates' location in countries that appeared to
have adequate supervisory regimes.
In addition, FDIC may impose conditions in foreign applications for
deposit insurance when it is deemed necessary to insulate the ILC. For
example, we reviewed an order approving an application for deposit
insurance from a foreign holding company of an ILC in which FDIC imposed
several conditions, including the following:
o requiring the holding company to establish a designated agent in the
United States, prior to receiving deposit insurance;
o entering into a written agreement with FDIC whereby the holding company
agrees to be subject to United States Court jurisdiction on domestic
banking issues;
o prohibiting the bank from engaging in any transactions with non-U.S.
affiliates without the prior written approval of the regional Director of
the FDIC; and
o requiring the holding company to obtain and maintain current financial
information on any non-U.S. financial affiliate prior and subsequent to
entering into any transactions with the non-U.S. financial affiliate and
making the information available for examiner review at the holding
company's main office in the United States.
70According to FDIC, a chain banking organization is a group of two or
more banks or savings and loan associations and/or their holding companies
that are controlled directly or indirectly by an individual or company
acting alone or through or in concert with any other individual or
company. The linkage of several banks or holding companies into a chain
creates a concentration of banking resources that can be susceptible to
common risks including poor loan participation practices, common
deficiencies in lending and/or investment policies, domineering or
absentee ownership, insider abuses, or other selfserving practices.
Further, FDIC has noted that chain banking organizations do not have to
report financial information on a consolidated basis, thereby making
offsite monitoring difficult.
State Supervisors Contribute to ILC Supervision, but Resources Vary
The state chartering authorities also play a role in supervising ILCs and
their holding companies and affiliates. The states of California, Nevada,
and Utah collectively supervise 49 of the 57 active, FDIC-insured ILCs.
Like FDIC, they examine transactions and agreements that the ILCs may have
with their holding companies and affiliates for compliance with sections
23A and 23B of the Federal Reserve Act. In addition, according to these
state banking supervisors, they have authority to conduct examinations of
holding companies and affiliates, although the scope of these authorities
varies.71 Utah officials also maintain that the Commissioner of Financial
Institutions can, under general supervisory authority over financial
institution holding companies, impose capital requirements on the holding
company in order to protect the insured institution.72 We also found that
FDIC has written, formal information sharing agreements with all three
states and has an agreement to accept examination reports prepared by
California on alternate examination years and to conduct examinations
jointly with Nevada and Utah.
Table 4 compares the examination resources and organizational structure of
the state banking supervisory offices in all three states. As shown in the
table, more than half of the institutions supervised by the state of Utah
are ILCs while this percentage is significantly less in California and
Nevada.
71Under Nevada Law, the Commissioner of Financial Institutions has
authority to examine ILC affiliates for limited purposes. Nev. Rev. Stat.
S: 677.440 (2004). The laws of Utah and California provide for full
examinations of ILC affiliates. Utah Code Ann. S:S: 7-1-314, 7-1-510
(2004); Cal. Fin. Code S: 3704 (2004).
72See Utah Code Ann. S: 7-1-510.
Table 4: Comparison of Examination Resources and Organizational Structure of
State Banking Supervisory Office
(Dollars in billions)
Total number
of
insured
institutions Number of Number of
State banking ILCs Organizational
supervisory Total examination
office supervised supervised ILC staff structure
assets
California 190 15 $13.7 120 Reports directly
to the
Department of state Business,
Financial Transportation
Institutions and
Housing Agency
Nevada 29 5 $10.2 12 Reports directly
to the
Division of state Department
Financial of
Institutions Business and
Industry
Utah 56 29 $115.0 33 Reports directly
to the
Department of Governor of Utah
Financial
Institutions
Sources: GAO and FDIC data.
Note: All data reported are as of December 31, 2004.
Table 4 also demonstrates that the supervisory resources available in each
state and the organizational structure of each banking supervisory office
vary. Further, the number of examination staff per regulated entity is
similar for California and Utah while Nevada has fewer examiners per
institution supervised. Additionally, Utah has supervisory oversight over
almost half of the active ILCs, 29 out of the 57, and employs 33 examiners
that are responsible for examining 56 state-supervised banking
institutions, including ILCs. The Utah DFI reports directly to the state
Governor. The Utah DFI recently provided ILCs in its jurisdiction the
opportunity to voluntarily submit to continuous supervision by FDIC and
Utah state supervisors, as part of FDIC's Large Bank program.73 As a
result, according to Utah officials, 4 ILCs have volunteered to
participate.74 California has supervisory oversight over 190
state-supervised banking institutions, including 15 ILCs and employs 120
examiners. The California Department
73FDIC's Large Bank program provides an onsite presence at depository
institutions through visitations and targeted reviews throughout the year
as opposed to the traditional annual point-in-time examination. FDIC
Regional Directors or their designees are to determine which institutions
qualify for the program, however FDIC guidance indicates that all state
nonmember banks with total assets of $10 billion or more should be
considered.
74Four Utah ILCs are eligible to participate in the Large Bank program. As
of the date of this report, FDIC has approved three of these ILCs and the
fourth is awaiting approval to participate.
of Financial Institutions reports directly to the state Business,
Transportation and Housing Agency. Nevada has supervisory oversight over
29 state-supervised banking institutions, including 5 ILCs, and currently
employs 12 examiners. As of the time of our review, the Nevada Division of
Financial Institutions (Nevada DFI) was not accredited, largely due to
limited staff resources. As a result, the Nevada DFI is unable to examine
insured depository institutions without partnership with FDIC or other
federal supervisors.75 The Nevada DFI reports directly to the state
Department of Business and Industry.
Questions Exist Regarding Whether the Bank-Centric Approach Addresses All
Risks to the ILC
Officials from the FDIC and the Board disagree over whether the
bankcentric approach to supervision, without the added components of the
consolidated supervisory approach, effectively identifies all of the
potential risks that holding companies and ILC may pose to the ILC. FDIC
officials told us that its current supervisory approach focuses not only
on the insured institution but also on the risks that holding companies
and affiliates could pose to an insured institution in a holding company
structure. FDIC notes in Supervisory Insights that its experience with
ILCs reinforces the agency's position that effective bank-level
supervision is essential in safeguarding institutions from risk posed by
holding companies. However, officials from the Board told us that the
bank-centric approach alone was not sufficient to protect banks from all
the risks that holding company and affiliate entities could pose. These
officials stated that consolidated supervision of holding companies is
essential to ensuring the safety and soundness of institutions, like ILCs,
that exist in a holding company structure.
According to FDIC officials, consolidated supervision of the holding
company is not a superior method for protecting the insured entity;
rather, these officials stated that the primary source of strength for the
holding
75In June 1995, the Federal Financial Institutions Examination Council
(FFIEC) issued guidelines for federal supervisors to use to determine
whether to rely upon state examinations. The guidelines stipulate that the
federal banking agencies will "accept and rely on State reports of
examination in all cases in which it is determined that State examinations
enable the Federal banking agencies to effectively carry out their
supervisory responsibilities." According to FFIEC and FDIC criteria, the
FDIC should consider the adequacy of state budgeting and examiner staffing
in determining reliance placed on state examinations. In addition to FFIEC
criteria, FDIC uses a number of other factors, including the state bank
supervisor's accreditation through the Conference of State Bank
Supervisors (CSBS). CSBS is the professional association of state banking
departments responsible for chartering, regulating, and supervising the
nation's state chartered banks.
company is usually the insured institution. FDIC officials told us that
its bank-centric approach is not limited in its focus and that examiners
have access to whatever they need in order to assess potential risks to
the insured institution. As noted previously, FDIC officials provided
examples of where examiners conducted targeted reviews of selected
operations of the holding company and material affiliates of several ILCs.
In addition, officials stated that the bank-centric approach has
effectively mitigated losses to the bank insurance fund stemming from
troubled banks. For example, FDIC officials told us about its efforts to
protect Conseco Bank- an insured ILC whose assets, at one point, totaled
$3 billion-from operations and reputation risk from its parent company
that eventually filed for bankruptcy after experiencing financial
difficulty from acquiring a business with a poor loan portfolio. In this
instance, FDIC, the state supervisor, and the bank developed a mutually
agreed upon plan to protect Conseco Bank by implementing policies that
placed more control in the hands of bank management. For example, the plan
prohibited the bank from paying dividends to any affiliate, including the
parent, and required Conseco Bank to sell its problem loans to the parent.
Also, since loan servicing for Conseco Bank was provided by an affiliate
of the parent, the agreement required the parent to sell the loan
servicing affiliate to Conseco Bank to improve the independence and
continuity of the bank's operations. The FDIC and state supervisor closely
monitored Conseco Bank throughout the parent's bankruptcy proceedings.
Eventually, Conseco Bank was marketed and ultimately sold for full value
with no loss to the Fund.
FDIC told us of three other examples where its bank-centric approach
effectively managed the risks being posed by holding companies and their
subsidiaries to ILCs that were troubled. In one example, the FDIC
established a written agreement with the ILC prohibiting it from paying
dividends to its holding company or its affiliates without FDIC approval
or engaging in transactions covered under the limitations set forth in
sections 23A and 23B of the Federal Reserve Act. In two other examples,
FDIC enforced corrective actions that were applicable to the ILC, as well
as the holding company and the ILC's affiliates. Specifically, in one
instance, a cease and desist order to end unsafe and unsound banking
practices and enforce sections 23A and 23B transaction limits were
applicable to the ILC, as well as the holding company and its subsidiary
organizations. In the other example, FDIC entered into a written agreement
with the ILC because of declines in its asset quality, as well as a
capital and liquidity assurance agreement with the holding company. As a
result, the holding company provided the ILC with a capital infusion and
purchased its low
quality assets. None of these troubled ILCs failed and no losses were
incurred by the Fund.
According to the FDIC-IG, two recent ILC failures, Pacific Thrift and Loan
in 1999 and Southern Pacific Bank in 2003, resulted in material losses to
the Fund totaling more than $105 million.76 As a result of the failures,
the FDIC-IG made several recommendations to revise FDIC's supervisory
approach, which FDIC implemented. According to FDIC officials, other
conditions in the banking industry that occurred at the same time of the
ILC failures were also contributing factors to the changes that FDIC made
to its supervisory approach. Specifically, since 1999, FDIC has, among
other things, modified its risk focused examination procedures; issued
guidance to examiners on topics such as risk from examining subprime
lending programs and real estate lending standards; and hosted a symposium
to discuss the lessons learned from these failures. According to FDIC,
both failures were generally the result of ineffective risk management and
poor credit quality. Table 5 provides a summary of the causes of the ILC
failures and a description of the various corrective actions that FDIC
officials told us were taken in response to the failures and other
conditions in the banking industry that occurred during the same time
period.
76From 1985 through year-end 2003, a total of 21 ILCs failed, including
those discussed above. The other 19 failures did not result in material
losses to the bank insurance fund; therefore, the FDIC-IG did not conduct
a review. A material loss review by the Inspector General of the principal
federal regulator of a failed institution is required when the estimated
loss to the bank or savings association insurance funds exceeds the
greater of $25 million or 2 percent of the institution's total assets at
the time the FDIC was appointed receiver. These 19 ILCs were operated as
finance companies, and their average total assets were $23 million.
According to FDIC, most of the failures were small California ILCs that
failed during the banking crisis of the late 1980s and early 1990s.
Table 5: Causes of Material ILC Failures and FDIC's Response to Failures and
Other Industry Conditions
Name of ILC(year of failure) Amount of loss to assets at closing Cause of
failure the fund FDIC's response
Pacific Thrift & Loan; Woodland Hills, Calif. (1999)
Total assets: $117.6 million at closing Poor corporate governance.
Poor risk management.
Lack of risk diversification.
Annual financial statement audit did not identify the actual financial
condition of the bank.
Inappropriate accounting for estimated future revenue from high risk
assets.
Auditors did not provide a written report of internal control weaknesses
to the bank audit committee and examiners.
Auditors did not provide examiners access to workpapers and supporting
documentation.
$42 million (as of 01/01/02)
Modified risk focused examination procedures.
Issued internal guidance on:
o subprime lending programs, and
o real estate lending standards.
Modified guidance for examining high-risk residual assets (e.g.,
Modifications to Capital Markets Examination handbook, specifically
mortgage derivative securities, asset-backed securities, structured notes,
and
a
securitization).
Issued a proposed rule to revise risk-based capital requirements (e.g.,
Financial Institution
Southern Poor corporate $63.4 Letter, Capital Treatment
Pacific Bank; governance. million of Residual Interest
Torrance, (as of in Asset Securitizations,
Calif. (2003) 12/31/04) issued 9/2000).
Poor risk management.
Total assets: Hosted a symposium for
FDIC regional
$1.1 billion Lack of risk management on "Lessons
at closing diversification. Learned" from
bank failures.
Annual financial
statement audit did
not
identify the actual Required that contracts
financial condition of with third parties
the bank. providing audit services
include a provision to
provide examiners access
to audit
Auditors did not workpapers and supporting
provide a written materials.
report
of internal control
weaknesses to the
bank audit committee
and examiners.
Sources: GAO, FDIC, and FDIC-IG.
Note: This table is based on information from FDIC-IG's material loss
reviews and interviews with and documentation from FDIC.
aMortgage derivative and asset backed securities refer to securities
created from securitized assets. Structured notes are debt securities
whose principal and interest payments vary according to specific formulas
or as a result of changes in exchange rates or equity and commodity
prices, they may also contain derivatives or financial contracts based on,
or derived from, an underlying market, such as stocks, bonds, or
currencies.
Board officials told us that they had a different view of the FDIC-IG
reports concerning the two ILC failures that resulted in material losses
to the bank insurance fund. According to Board officials, the lack of
consolidated supervision at the holding company level contributed to the
problems that impacted the ILCs. For example, these officials stated that
the failure of Pacific Thrift and Loan was, in part, due to problems at
the holding company level that were affecting the bank. To support their
view, Board officials highlighted that the FDIC-IG reported that the
holding company accumulated more debt than could be supported by the
dividends it received from the ILC, thereby allowing the ILC to generate
loans without reliable and stable funding sources. Officials from the
Board stated that, as a result, the holding company implemented an
aggressive high-risk strategy to boost profitability and pay these debt
instruments, which resulted in significant losses and the holding
company's inability to raise enough capital to help the ILC. Board
officials told us that, because the holding company of Pacific Thrift and
Loan was exempt from the BHC Act, no federal supervisor had examined the
holding company, and the regulatory capital requirements that would have
limited the borrowings of the holding company did not apply. While the
lack of federal supervision of the holding company was not explicitly
stated as a cause of failure in the FDIC-IG's material loss review of
Pacific Thrift and Loan, the FDIC-IG's review discusses this matter in
detail. Board officials told us that the ability to see a broader picture
of, and take enforcement action against, the holding company would have
enabled FDIC to identify and correct problems at the holding company
before the ILC failed. Further, the FDIC-IG's material loss review
recommended that FDIC remind its examiners of the agency's authority to
examine holding companies and affiliates. Subsequently, FDIC examiners
performed two on-site visitations of the holding company of Southern
Pacific Bank, before it failed in 2003, to determine the overall condition
of the holding company and its ability to support the ILC.
Board officials told us that the bank-centric approach alone is not
sufficient to assess all the risks that a holding company and affiliates
can pose to an insured financial institution. Board officials also stated
that consolidated supervision has a long, successful history of assessing
the potential risks that holding company and affiliate organizations may
pose to insured depository institutions. According to Board officials, in
order to understand the risks within a holding company structure and how
they are dispersed, bank supervisors must assess risks across business
lines, by legal entity, and on a consolidated basis. Board officials note
that consolidated supervision provides its examiners with both the ability
to understand the financial strength and risks of the overall holding
company-especially
operations and reputation risk-and the authority to address significant
management, operations, capital, and other deficiencies throughout the
organization before these deficiencies pose a danger to affiliate insured
banks and the bank insurance fund.
Further, Board officials stated that focusing supervisory efforts on
transactions covered by sections 23A and 23B will not cover the full range
of risks that insured institutions are exposed to from holding companies
and their subsidiaries. Board officials told us that sections 23A and 23B
violations most often occur in smaller organizations, and the risks posed
by large organizations are more often related to other issues such as
internal controls and computer systems problems. These officials stated
that FDIC would likely not be able to detect these problems in a large
holding company unless it was able to supervise the entire organization on
a consolidated basis. In addition, Board officials stated that operations
and reputation risk cannot be effectively assessed by focusing on sections
23A and 23B limitations. Board officials told us, for example, that these
risks could come from a lending affiliate in the holding company that has
loans outstanding to the same borrower as the ILC, but the affiliate does
not do any business with the ILC. If this lending affiliate engaged in
improper lending practices, it could impact the reputation of the holding
company and ultimately affect the ILC. Further, the lending limits of both
the ILC and the affiliate could be within an acceptable range, based upon
a review of each individual organization's financial statements. However,
based upon a consolidated view of the holding company's financial
statement, the amount of loans from the ILC and the affiliate to the
borrower could expose the consolidated entity to risk from a concentration
of credit, which could ultimately impact the ILC. According to Board
officials, it is unclear whether the FDIC's bank-centric approach would be
able to detect either condition given that the ILC does not do business or
otherwise have a relationship with the lending affiliate.
In our 1995 testimony to the House Committee on Banking and Financial
Services, we presented our views on the need for consolidated supervision
of bank holding companies. Based upon our work evaluating the
effectiveness of bank supervision and examination during the 1980s and
1990s, we discussed specific safeguards that are necessary to protect
against undue risks.77 These safeguards included a comprehensive
regulation of financial services holding companies on both a functional
and consolidated basis. We stated that an umbrella supervisory authority
needs to exist to adequately assess how risks to insured banks may be
affected by risks in the other components of the holding company
structure. In addition, we also stated that capital standards for both
insured banks and financial services holding companies that adequately
reflect all major risks, including market and operations risk, were a
necessary safeguard. Because our past work on failed banks and thrifts
found that capital can erode quickly in times of stress, we stated that
supervisors should also be required to conduct periodic assessments of
risk management systems for all the major components of the holding
company, as well as for the holding company itself.
Our belief in the importance of consolidated supervision and consolidated
capital standards is partly based on the fact that most bank holding
companies are managed on a consolidated basis, with the risks and returns
of various components being used to offset and enhance one another. In
addition, past experience has shown that, regardless of whether regulatory
safeguards-such as sections 23A and 23B limitations-are set properly, even
periodic examinations cannot ensure that regulatory safeguards can be
maintained in times of stress. However, the consolidated supervisory
approach is flexible enough to account for and recognize the contagion or
systemic risks inherent in a holding company structure. Further, it
appears that, in some instances, FDIC also embraces this concept. For
example, in an order approving a foreign organization's application for
deposit insurance in January 2004, FDIC expressed concerns over the
difficulty of monitoring foreign affiliates that were not subject to U.S.
supervision.78 The order states that FDIC has embraced the concept of
effective, comprehensive, consolidated supervision.
77For the 1995 testimony, see Financial Regulation: Modernization of the
Financial Services Regulatory System (GAO/T-GGD-95-121, Mar. 15, 1995). In
addition to this testimony, other GAO products present similar views on
consolidated supervision. See, for example, Separation of Banking and
Commerce (GAO/OCE/GGD-97-61R); the U.S. Bank Oversight: Fundamental
Principles for Modernizing Structure (GAO/T-GGD-96-117, May 2, 1996); Bank
Oversight Structure: U.S. and Foreign Experience May Offer Lessons for
Modernizing U.S. Structure (GAO/GGD-97-23, Nov. 20, 1996); Bank Powers:
Issues Related to Repeal of the Glass-Steagall Act (GAO/GGD-88-37, Jan.
22, 1988).
78In Re: Toyota Financial Savings Bank Henderson, Nevada, Application for
Federal Deposit Insurance, Federal Deposit Insurance Corporation, January
2004.
FDIC's Supervisory Model and Authority Over BHC Act-Exempt Holding
Companies and Nonbank Affiliates Has Been Tested on a Limited Basis in
Relatively Good Economic Times
Although there have been material losses to the bank insurance fund
resulting from two ILC failures in the past 6 years, the remaining 19 ILC
failures occurred during the banking crisis in the late 1980s and early
1990s. Most of these ILCs were small California Thrift and Savings and
Loan companies that, according to FDIC, had above-average risk profiles.
FDIC's analysis of bank failures during this time period indicates that
California experienced deteriorating economic conditions and a severe
decline in the real estate industry, which contributed to the failure of
15 ILCs in that state. As previously discussed, FDIC has since implemented
changes to its supervisory approach and has told us about some recent
examples where, according to FDIC, its supervisory approach-including its
influence and authority as the provider of deposit insurance-has
effectively protected the insured institution and prevented losses to the
Fund. However, all of the ILCs that failed since the late 1980s, as well
as those ILCs that became troubled and FDIC took corrective action, were
relatively small in size compared with some of the large ILCs that
currently dominate the industry. FDIC has not provided any examples where
its supervisory approach was used to mitigate potential losses from
troubled ILCs that would qualify for supervision under its Large Bank
program.
As previously discussed, because FDIC has established positive working
relationships with ILC holding companies, examiners are able to obtain
information about holding company and affiliate operations, supplied by
ILC holding companies on a voluntary basis, from large, complex ILCs.
According to examiners we spoke with, this information enhances FDIC's
ability to monitor the potential risks posed by holding companies and
affiliates to the insured ILC and, in some instances, this information is
not publicly available. Further, according to FDIC, its requests for
information about holding company and affiliate organizations have not
been challenged in court. Therefore, it is not clear whether FDIC would be
able to successfully obtain needed information about holding company and
affiliate organizations in the absence of consent by the holding company
or affiliate.
FDIC's supervisory model and authority over BHC Act-exempt ILC holding
companies and affiliates has emerged during a time when banking has not
confronted an adverse external environment. FDIC Chairman Donald Powell
has described the past decade as a "golden age" of banking. The past 10
years can be characterized by stable economic growth, which has
contributed to strong industry profitability and capital positions. During
the past 7 years, only 35 financial institutions protected by the Fund
have failed, and FDIC has reported that insured institutions' earnings for
2004
set a new record for the fourth consecutive year and that the industry's
equity capital ratio is at its highest level since 1938.79 In contrast,
1,373 financial institutions protected by the Fund failed between 1985 and
1992 due to, among other things, poor management and poor lending
practices. How FDIC's supervisory approach would fare for large, troubled
ILCs during an adverse external environment is not clear.
ILCs May Offer Commercial Holding Companies a Greater Ability to Mix
Banking and Commerce Than Other Insured Depository Institution, but Views
on Competitive Implications Are Mixed
Because most ILC holding companies and their subsidiaries are exempt from
business activity limitations that generally apply to the holding
companies and affiliates of other FDIC-insured depository institutions,
ILCs may provide a greater means for mixing banking and commerce than
ownership or affiliation with other insured depository institutions.
During our review, we found other more limited instances where the mixing
of banking and commerce previously existed or currently exists, such as
unitary thrift holding companies, certain "nonbank banks," and certain
activities permitted under GLBA, such as merchant banking and
grandfathered, limited nonfinancial activities by securities and insurance
affiliates of financial holding companies. However, federal law
significantly limits the operations and product mixes of these entities
and activities as compared with ILCs. Additionally, with the exception of
a limited creditcard-only bank charter, ownership or affiliation with an
ILC is today the only option available to nonfinancial, commercial firms
wanting to enter the insured banking business. The policy generally
separating banking and commerce is based primarily on potential risks that
integrating these functions may pose, such as the potential expansion of
the federal safety net provided for banks to their commercial entities,
potential increased conflicts of interest, and the potential increase in
economic power exercised by large conglomerate enterprises. While some
industry participants state that mixing banking and commerce may offer
benefits from operational efficiencies, empirical evidence documenting
these benefits is mixed.
79Equity capital or financing is money raised by a business in exchange
for a share of ownership in the company. Financing through equity capital
allows a business to obtain funds without incurring debt or without having
to repay a specific amount of money at a particular time. The equity
capital ratio is calculated by dividing total equity capital by total
assets.
ILC Charter May Offer Commercial Holding Companies More Opportunity to Mix
Banking and Commerce Than Other Insured Depository Institution Charters
ILC holding companies and their affiliates may be able to mix banking and
commerce more than other insured depository institutions because the
holding companies and affiliates of ILCs are not subject to business
activity limitations that generally apply to insured depository
institution holding companies. Except for a limited category of firms,
such as grandfathered unitary thrift holding companies and companies that
own limited purpose credit card banks (CEBA credit card banks), entities
that own or control insured depository institutions generally may engage,
directly or through subsidiaries, only in activities that are financial in
nature.80 Because of a provision in the BHC Act excluding certain ILCs
from the act's coverage, an entity can own or control a qualifying ILC
without facing the activities restrictions imposed on bank holding
companies and nonexempt thrift holding companies. As a result, the holding
companies and affiliates of some ILCs and other subsidiaries are allowed
to engage in nonfinancial, commercial activities. Today, nonfinancial,
commercial firms in the automobile, retail, and energy industries, among
others, own ILCs. According to the FDIC officials, as of December 31,
2004, 9 ILCs with total assets of about $3 billion directly support their
parent's commercial activities. However, these figures may understate the
total number of ILCs that mix banking and commerce because 5 other ILCs
are owned by commercial firms that were not necessarily financial in
nature. Because these corporations, on a consolidated basis, include
manufacturing and other commercial lines of business with the financial
operations of their ILC, we determined that these entities also mixed
banking and commerce. Thus, we found that, as of December 31, 2004,
approximately 14 of the 57 active ILCs were owned or affiliated with
commercial entities, representing about $9.0 billion, (about 6.4 percent)
and $4.6 billion (about 6.2 percent) of total ILC industry assets and
estimated insured deposits, respectively.81
80See 12 U.S.C. S:S: 1843, 1467a(c). As previously discussed,
grandfathered unitary thrift holding companies are not subject to these
activities restrictions. Limited purpose credit card banks also are exempt
from the BHC Act. See 12 U.S.C. S: 1841(c)(2)(F).
81When determining the current levels of mixed banking and commerce within
the ILC industry, we considered only ILCs owned or affiliated with
explicitly nonfinancial, commercial firms. Because some owners and
operators of ILCs are engaged in business activities that are generally
financial in nature, but still may not meet the statutory requirements of
a qualified bank or financial holding company, officials from the Federal
Reserve Board noted that they interpret the level of mixed banking and
commerce among ILCs may be greater than 6.4 percent of industry assets and
6.2 percent of industry estimated insured deposits.
During our review, regulators and practitioners we spoke with highlighted
other, more limited, historical exceptions to the policy generally
separating banking and commerce, such as unitary thrift holding companies
and "nonbank banks"-both of which at one time allowed for instances where
insured banks could be owned by or affiliated with nonfinancial,
commercial firms. Regulators also provided us with other current examples
of limited mixed banking and commerce in the financial system, such as the
merchant banking operations of financial holding companies and CEBA credit
card banks, which offer limited opportunities to attract insured deposits
and no commercial lending opportunities, but are permitted to be owned by
or affiliated with commercial firms. However, because of the wide variety
of products and services that ILCs offer and the continued availability of
this charter type in certain states,82 ILCs may offer commercial holding
companies a greater opportunity to mix banking and commerce than these
other exempted insured depository institutions and currently more limited
situations of mixed banking and commerce. Additionally, with the exception
of the more limited CEBA credit card only bank charter, ownership or
affiliation with an ILC is today the only option available to
nonfinancial, commercial firms wanting to enter the insured banking
business.
Unitary thrift holding companies or unitary savings and loan holding
companies are firms that own or control a single FDIC-insured thrift or
savings and loan and typically own or control other subsidiaries. The
Savings and Loan Holding Company Act of 1967 (HOLA) established the
regulatory framework for unitary thrift holding companies. Unitary thrift
holding companies were at one time permitted to own one thrift association
and engage, without limitation, in other activities, including commercial
activities, as long as the thrift complied with requirements intended to
maintain its function as a thrift.83 In 1999, as previously discussed,
GLBA prohibited new unitary thrift holding companies from being chartered
after May 4, 1999.84 GLBA also "grandfathered" existing unitary thrift
holding companies and limited the existing commercial
82In 2003, California and Colorado enacted laws restricting ownership or
control of ILCs to financial firms. As a result, greater mixed banking and
commerce for the holding company's affiliates of ILCs is not available to
owners of California and Colorado ILCs.
83In 1967, Congress enacted the current version of the Savings and Loan
Holding Company Act, Pub. L. No. 90-255, 82 Stat. 5 (1968). In that
legislation, Congress permitted unitary thrift holding companies to engage
in nonthrift business.
84Pub. L. No. 106-102 S: 401 (1999).
powers of a unitary thrift holding company to the owners at that time.
Thus, after this date, new owners of a unitary thrift would be unable to
engage in commercial, nonfinancial activities. While many of the original
commercial owners of unitary thrift holding companies have since sold
their insured thrifts, several "grandfathered" commercially owned or
affiliated unitary thrift holding companies remain active. As of December
31, 2004, there were 17 commercially owned or affiliated unitary thrift
holding companies representing $38.7 billion in assets and $15.0 billion
in estimated insured deposits.
Officials from the OTS highlighted several limitations of unitary thrift
holding companies that made this charter more restrictive in its ability
to mix banking and commerce than ILCs. These limitations for unitary
thrift holding companies include the following:
o prohibitions on lending to commercial affiliates of the insured
thrift;85
o restrictions on commercial lending to 20 percent of assets, provided
any amount over 10 percent is in small business lending;86 and
o restrictions under the qualified thrift lender test (QTL), including
holding at least 65 percent of its assets in qualified thrift investments,
which are primarily mortgage related assets.87
OTS officials told us that the restrictions on extending credit to
commercial affiliates in the unitary thrift holding company structure
prevents a unitary thrift holding company from using the insured thrift to
fund nonbanking activities of the holding company. Unlike qualified
thrifts, ILCs are not subject to restrictions on extending credit to
commercial affiliates, limitations on the amount of commercial lending
activity they can engage in, or restrictions on the mix of assets in their
loan portfolios.
A similar, but even more limited, historical exception to the policy
generally separating banking and commerce was, at one time, granted to
"nonbank banks"-generally financial institutions that either accepted
demand deposits or made commercial loans but did not engage in both
85See 12 U.S.C. S: 1468(a). 86See 12 U.S.C. S: 1464(c)(2)(A). 87See 12
U.S.C. S: 1467a(m).
activities. Because the BHC Act defined a bank as a firm that did both of
these activities, a company could own or control a "nonbank bank" and
avoid federal supervision as a bank holding company. Similar to ILCs, the
owners and affiliates of "nonbank banks" were able to mix banking and
commerce prior to 1987 when CEBA was enacted. In effect, CEBA ended the
ability to mix banking and commerce through the "nonbank bank" charter,
because activity limitations on bank holding companies limit the holding
companies' ability to own a bank and commercial affiliates. CEBA
grandfathered the organizations that acquired a nonbank bank prior to
March 5, 1987, provided that the organization did not undergo a change in
control after that date and the organization and its nonbank bank abide by
various restrictions contained in the BHC Act. Currently, only eight
grandfathered nonbank banks remain in existence.
In addition to these historical exemptions, other more limited
opportunities to mix banking and commerce currently exist, such as
merchant banking and portfolio investing by the securities and insurance
affiliates of financial holding companies and CEBA credit card only banks.
Merchant banking refers to the practice where a financial institution
makes a passive equity investment in a corporation with a view toward
working with company management and operating partners to enhance the
value of the equity investment over time. Merchant banking can result in
ownership of significant portions of a firm's equity. GLBA relaxed
long-standing restrictions on the merchant banking activities of banking
organizations by permitting qualified financial holding companies to own
and operate merchant banking entities. However, GLBA contains several
provisions that are designed to distinguish merchant banking investments
from the more general mixing of banking and commerce.88 For example,
merchant banking investments may only be held for a period of time to
enable the resale of the investment, and the investing financial holding
company may not routinely manage or operate the commercial firm except as
necessary or required to obtain a reasonable return on the investment on
resale.89 Similarly, CEBA credit card banks, which are exempt from the BHC
Act, offer limited opportunities to mix banking and commerce because they
can
88In the GLBA, Congress authorized FHCs to engage in merchant banking
activities through nondepository institution subsidiaries under specific
conditions, thus allowing an FHC to acquire or control, directly or
indirectly, any kind of ownership interest in any entity engaged in any
kind of trade or business, subject to rules to be promulgated by the FRB
and the Secretary of the Treasury. See H. Rep. No. 106-434 at 154.
89See 12 U.S.C. S: 1843(k)(4)(H).
be owned by or affiliated with nonfinancial, commercial firms but, because
of the nature of their charter, are limited scope banking entities. CEBA
credit card banks are FDIC-insured institutions whose only business is
credit cards. A CEBA credit card bank is not allowed to offer demand
deposits or NOW accounts, can accept only "jumbo deposits" ($100,000
minimum), may have only one office that accepts deposits, and cannot make
any commercial loans.90
Industry practitioners we spoke with also highlighted examples of
commercial firms providing bank-like services through finance
subsidiaries, such as the credit card operations of selected retailers or
the financing subsidiaries of manufacturing firms-often referred to as
captive finance subsidiaries because their business operations generally
focus on providing credit to support the sale of a holding company or
affiliate's products. For example, selected manufacturers of furniture,
tractors, boats, and automobiles may offer credit through financing
subsidiaries. However, banking regulators told us that captive financing
subsidiaries are generally limited scope operations that must rely on the
capital markets, their commercial holding companies, or banks for funding,
and may not offer insured deposits. Banking regulators also stated that
insured depository institutions generally can offer a broader range of
banking services and can attract insured deposits as an attractive source
of funding. Because the noninsured finance subsidiaries of commercial
firms are not permitted to offer insured deposits, noninsured finance
subsidiaries do not represent risk to the federal bank insurance fund.
Additionally, several developed countries allow greater mixing of banking
and commerce than the United States. For example, in European countries
there are generally no limits on a nonfinancial, commercial firm's
ownership of a bank. However, the European Union has mandated consolidated
supervision. Japan has allowed cross-ownership of financial services
firms, including banks and commercial firms, permitting development of
industrial groups or keiretsu that have dominated the Japanese economy.
These groups generally included a major or "lead" bank that was owned by
other members of the group, including commercial firms, and that provided
banking services to the other members. The experience of these nations
provides some empirical evidence of the effects of increased affiliation
of banking and commercial businesses, particularly pointing to the
importance of maintaining adequate credit
90See 12 U.S.C. S: 1841(c)(2)(F).
underwriting standards for loans to affiliated commercial businesses.
Problems in Japan's financial sector, notably including nonperforming
loans, often to commercial affiliates of the banks, have contributed in
part to the persistent stagnation of the Japanese economy beginning in the
1990s. However, important differences between the financial and regulatory
systems of these nations and the United States, and limitations in
research into the effects of these affiliations, limit many direct
comparisons.
Mixing Banking and Commerce Presents Both Risks and Potential Benefits
The mixing of banking and commerce can potentially come about in many
different forms. For example, banks may want to enter nonfinancial
activities, and commercial firms may want to enter banking. A bank may
also want to take an equity stake in a commercial firm, or a commercial
firm may want to make an ownership investment in a bank. The forms of
mixing banking and commerce differ depending on the firms' and banks'
motivations. In the ILC industry, mixing banking and commerce has
primarily been in the form of commercial, nonfinancial firms owning and
operating insured banks.
The policy generally separating banking and commerce is based primarily on
limiting the potential risks that may result to the financial system, the
deposit insurance fund, and taxpayers. As discussed more fully below, we
have previously reported that the potential risks that may result from
greater mixing of banking and commerce91 include the (1) expansion of the
federal safety net provided for banks to their commercial entities, (2)
increased conflicts of interest within a mixed banking and commercial
conglomerate, and (3) increased economic power exercised by large
conglomerate enterprises. However, generally the magnitudes of these risks
are uncertain and may depend, in part, upon existing regulatory safeguards
and how effectively banking regulators monitor and enforce these
safeguards.
The federal government provides a safety net to the banking system that
includes federal deposit insurance, access to the Federal Reserve's
discount window, and final riskless settlement of payment system
transactions. According to Federal Reserve officials, the federal safety
net in effect provides a subsidy to commercial banks and other depository
91GAO, Separation of Banking and Commerce, GAO/OCE/GGD-97-16R (Washington,
D.C.: Mar. 17, 1997).
institutions by allowing them to obtain low-cost funds because the system
of federal deposit insurance shifts part of the risk of bank failure from
bank owners and their affiliates to the federal bank insurance fund and,
if necessary, to taxpayers. The system of federal deposit insurance can
also create incentives for commercial firms affiliated with insured banks
to shift risk from commercial entities that are not covered by federal
deposit insurance to their FDIC-insured banking affiliates. As a result,
mixing banking and commerce may increase the risk that the safety net, and
any associated subsidy, may be transferred to commercial entities. The
potential transfer of risks among insured banks and uninsured commercial
affiliates could result in inappropriate risk-taking, misallocation of
resources, and uneven competitive playing fields in other industries. As
noted by regulators and practitioners we spoke with, these risks may be
mitigated by regulatory safeguards between the bank and their commercial
affiliates. For example, requirements for arms-length transactions and
restrictions on the size of affiliate transactions under sections 23A and
23B of the Federal Reserve Act are a regulatory safeguard designed to
protect an insured institution from adverse intercompany transactions.
However, during times of stress, these safeguards may not work
effectively- especially if managers are determined to evade them.
The mixing of banking and commerce could also add to the potential for
increased conflicts of interest and raise the risk that insured
institutions may engage in anticompetitive or unsound practices. For
example, some have stated that, to foster the prospects of their
commercial affiliates, banks may restrict credit to their affiliates'
competitors, or tie the provision of credit to the sale of products by
their commercial affiliates. Commercially affiliated banks may also extend
credit to their commercial affiliates or affiliate partners, when they
would not have done so otherwise. For example, when a bank extends credit
to an affiliate, customers, or suppliers of an affiliate, the credit
judgment could be influenced by that relationship. While current
regulatory safeguards are designed to mitigate this possibility, advocates
of continued separation highlight that the potential for more frequent
misallocation of credit opportunities is greater in a merged banking and
commercial environment. These advocates have stated that increased
conflicts of interest could result in greater numbers of loans to
commercial affiliates with favorable terms, relaxed underwriting
standards, preferential lending to suppliers and customers of commercial
affiliates, and ultimately increased risk exposure to the federal bank
insurance fund. Additionally, some have also stated that mixing banking
and commerce could promote the formation of very large conglomerate
enterprises with substantial amounts of economic power. If these
institutions were able to dominate some markets, such as the banking
market in a particular local area, they could impact the access to bank
services and credit for customers in those markets.
Other industry observers have stated that there are potential benefits
from mixed banking and commerce, including allowing banks, their holding
companies, and customers to benefit from potential increases in the scale
of operations, which lowers the average costs of production known as
economies of scale, or from potential reductions in the cost of producing
goods that share common inputs, known as economies of scope, and enhanced
product and geographic diversification. Because banks incur large fixed
costs when setting up branches, computer networks, and raising capital,
these institutions may benefit from the selected economies of scale and
scope that could result from affiliations with commercial entities. For
example, we were told combined entities may be able to generate operating
efficiencies by sharing computer systems or accounting functions. Mixed
banking and commercial entities may also benefit from product synergies
that result from affiliation. For example, firms engaged in both the
manufacturing and financing of automobiles may be able to increase sales
and reduce customer acquisition costs by combining manufacturing and
financing. Other incentives for affiliations between banking and
commercial firms include enhanced product and geographic diversification,
which could contribute to reduced risk to the combined entity.
Additionally, one FDIC staff wrote that increased mixing of banking and
commerce may help U.S. banks with regard to global competition with
several other countries that have fewer restrictions than the United
States. Advocates have also stated that some of these potential revenue
and cost synergies may be passed on to consumers through lower prices for
banking or commercial services.
Divergent Views Exist About the Competitive Implications of Mixed Banking
and Commerce
Continued market interest by commercial firms in mixed banking and
commerce may indicate that at least some participants believe that
operational efficiencies and cost synergies may be realized from mixing
banking and commerce. For example, three of the six new ILC charters
approved by FDIC after June 30, 2004, are owned by nonfinancial,
commercial firms. Additionally, recent press reports and conversations we
had with federal banking regulators indicate one of the nation's largest
retailers has expressed continuing interest in owning an insured
depository institution. However, during our search of academic and other
literature, we were unable to identify any conclusive empirical evidence
that documented operational efficiencies from mixing banking and commerce.
One primary factor in the lack of empirical evidence may be that, because
of the policy generally separating banking and commerce, few institutions
are available for study.
However, product synergies between banking and commercial firms may exist
in certain industries. For example, several automobile manufacturers own
or operate captive financing affiliates that generally provide credit to
borrowers at competitive rates to facilitate the commercial holding
company's efforts to sell automobiles. Some of these affiliates are
insured depository institutions while others rely on the capital markets,
their commercial holding companies, or banks for funding. Additionally,
other regulators and practitioners noted that commercially affiliated
insured depository institutions might benefit from access to existing
commercial holding company or affiliate customers. For example, insured
banks owned or affiliated with commercial firms may be able to attract
deposits or potential credit card customers through targeted marketing to
the commercial holding company or affiliate customers. Industry observers
we spoke with also told us that commercially affiliated banks might
benefit from stronger brand recognition and, in instances where banks are
owned by retailers, the banks may benefit from being located in stores
that keep longer hours of operation. Furthermore, as discussed previously,
combined firms may generate efficiencies from the sharing of fixed costs,
such as computer systems or accounting functions.
One OTS official and industry practitioners we talked with were less
convinced of potential economic efficiencies from mixing banking and
commerce and suggested that these firms might not have a competitive
advantage over other businesses. For example, an OTS official we talked
with provided us with instances where the commercial owners of insured
banks operating under the "nonbank bank" exemption had subsequently sold
their insured banking subsidiaries because these firms may not have been
able to realize expected operational efficiencies from mixed banking and
commerce. For instance, a published study we reviewed noted that, in the
late 1980s, a large retailer's efforts to cross market its traditional
product line and financial services failed to generate expected synergies.
The study highlighted the management challenges associated with linking
the conglomerate's insurance, securities, real estate, retail, and catalog
businesses. The study also mentioned difficulties managing accurate
customer information and division management concerns about other
divisions pursuing their customers as reasons for the conglomerate's
inability to capture expected synergies. Further, the study noted the
financial services centers operating inside the traditional retailer's
stores
generally proved unprofitable. Eventually, the retailer cited in the study
abandoned its diversification strategy and sold its financial services
business. Similarly, a practitioner we spoke with stated that success in
the banking industry may require skill sets that are different from the
expertise and business practices in commercial sectors of the economy.
While there is little direct research assessing the competitive effects of
mixing banking and commerce, the incentives to mix banking and commerce
may in some way be linked to research indicating that operational
efficiencies may result from merging two banks. According to this
research, there is a general expectation that operational efficiencies may
be realized from scale and scope economies within the banking industry.
For example, merging two banks can result in gains from the closing of
redundant branches, consolidating systems and back offices, and marketing
products, such as credit cards, to broader customer bases. Some of these
same operational efficiencies-such as the marketing of credit cards to a
broader customer base-would presumably be available to mixed banking and
commercial firms as well. However, empirical studies have not found clear
evidence that bigger is necessarily better in banking. For example one
study noted that while large banking operations were regarded as
advantageous, the conclusions in academic literature on economies of scale
and scope within merged banks are mixed. Our own independent review of
academic literature reached similar conclusions. Some studies documented
economies of scale and scope in banking, but others were less conclusive.
Additionally, while some recent studies we reviewed suggested that recent
advances in information technology may be contributing to greater
opportunities for economies of scale and scope within the banking
industry, these studies do not provide conclusive evidence on the
competitive implications of mixing banking and commerce.
The mixed findings on scale and scope economies within academic literature
we reviewed are in many ways consistent with market activity post GLBA.
Because GLBA removed several restrictions on the extent to which
conglomerates could engage in banking and nonbanking financial activities,
such as insurance and securities brokerage, some analysts had expected
that conglomeration would intensify in the financial services industry
after GLBA. However, as yet, this does not seem to have happened. The
reasons vary. Many banks may not see any synergies with insurance
underwriting. Additionally, it may be that many mergers are not
economically efficient, the regulatory structure set up under GLBA may not
be advantageous to these mergers, or, it is simply too soon to tell what
the
impact will be. Further, a general slowdown occurred in merger and
acquisition activity across the economy in the early 2000s, which may also
be a contributing factor to the pace of industry conglomeration post GLBA.
Recent Legislative Proposals May Increase the Attractiveness of Operating
an ILC
FDIC-insured banks, including ILCs, are currently not permitted to offer
interest-bearing business checking accounts. Recent legislative proposals
would remove the current prohibition on paying interest on demand deposits
and, separately, authorize insured depository institutions, including most
ILCs, to offer interest-bearing business NOW accounts.92 This would, in
effect, expand the availability of products and services that insured
depository institutions, including those ILCs, could offer. ILC advocates
we spoke with highlighted that including ILCs in these legislative
proposals maintains the current relative parity between ILC permissible
activities and those of other insured bank charters. However, Board
officials and some industry observers we spoke with told us that granting
grandfathered ILCs the ability to offer business NOW accounts represents
an expansion of powers for ILCs, which could further blur the distinction
between ILCs and traditional banks. Another legislative proposal,
introduced but not passed in the last congressional session, would allow
banks and most ILCs (those included in a grandfathered provision) to
branch into other states through establishing new branches-known as de
novo branching-by removing states' authority to prevent them from doing
so.93 Board officials we spoke with told us that, if enacted, these
proposals could increase the attractiveness of owning an ILC, especially
by private sector financial or commercial holding companies that already
operate existing retail distribution networks.
As previously discussed, in order to remain exempt from the definition of
a bank under the BHC Act, most ILCs may not accept demand deposits, if
their total assets are $100 million or more. However, ILCs are not
restricted from offering NOW accounts, which are insured deposits that, in
practice, are similar to demand deposits. Current federal banking law
prohibits insured depository institutions from paying interest on demand
deposits and does not authorize insured depository institutions to offer
NOW
92See H.R. 1224, 109th Cong. S: 3 (2005).
93H.R. 1375 108th Cong. S: 401(b) (2004). This bill would permit de novo
interstate branching by ILCs subject to the grandfathering provisions
described later in our discussion of legislative proposals to permit
interest-bearing business checking accounts.
business checking accounts. According to a Treasury official, the
prohibition on paying interest on demand deposits, including those
maintained by businesses, was enacted in the 1930s because of concerns
about the solvency of the nation's banks and the belief that limiting
competition among banks would reduce bank failures. This ban was designed
to protect small rural banks from having to compete for deposits with
larger institutions that could offer higher interest rates and use the
deposits to make loans to stock market speculators and deprive rural areas
of financing.
There have been repeated legislative proposals to repeal this prohibition.
Supporters of these efforts have stated that the prohibition on paying
interest on demand deposits, including those maintained by businesses, is
an unnecessary and outdated law that unfairly affects small businesses.
According to these supporters, small businesses tend to bank at smaller
institutions that do not offer sweep accounts which, in effect, circumvent
the ban on interest bearing demand accounts, because their deposit
balances may not qualify for these accounts at larger institutions.94 The
most recent legislative proposals would repeal section 19(i) of the
Federal Reserve Act and section 18(g) of the FDI Act, which, together with
other federal laws, effectively prohibit the payment of interest on demand
deposits, including business checking accounts.95 This would allow insured
depository institutions to pay interest on their demand deposits,
including those maintained by businesses, although it would not remove the
BHC Act provision exempting larger ILCs from the definition of a bank on
the condition, among others, that they do not accept demand deposits.
Separate provisions of this legislative proposal would allow qualified
ILCs (which would include ILCs owned or controlled by a commercial firm
where the ILC obtained deposit insurance prior to October 1, 2003, and did
not undergo a change in control after September 30, 2003) to offer
business NOW accounts. Going forward, other ILCs could offer business NOW
accounts, provided that their state supervisors determine that at least
85% of their holding company and affiliated entities' gross revenues were
from activities that were financial in nature or incidental to a financial
activity in at least three of the prior four calendar quarters. In effect,
this amendment would make it difficult for nongrandfathered ILCs owned by
commercial
94Generally, sweep accounts use computers to analyze customer accounts and
automatically transfer funds at the end of each day to higher-interest
earning money market accounts.
95H.R. 1224 S: 3. See 12 U.S.C. S:S: 371a, 1828(g), 1832.
enterprises to offer interest bearing business NOW accounts. ILC advocates
we spoke with highlighted that if other insured banks are permitted to
offer interest bearing demand deposit accounts to businesses, granting
ILCs the ability to offer interest bearing business NOW accounts maintains
the current relative parity between ILC permissible activities and those
of other insured bank charters. Officials at the Board have opposed ILCs
being able to offer interest bearing business NOW accounts, unless ILC
holding companies were subjected to consolidated supervision and the same
activity restrictions applied to the holding companies of most other
insured depository institutions, because doing so would further enable
ILCs to become the functional equivalent of full-service banks and expand
their operations beyond the historical function of ILCs and the terms of
their exemption in current banking law.
Federal banking law permits insured state banks and ILCs to expand on an
interstate basis by acquiring another institution, provided that state law
does not expressly prohibit an interstate merger.96 However, banks and
ILCs are not permitted to branch in another state without having an
established charter in that state and without acquiring another bank-known
as de novo branching-unless the host state enacted legislation that
expressly permitted this practice.97 Currently, only 17 states have
enacted this legislation. According to proponents of de novo branching,
current restrictions make it difficult for small banks seeking to operate
across state lines and puts banks at a disadvantage compared with savings
associations, which are permitted to establish interstate de novo
branches. A proponent also stated that de novo branching would benefit
small banks near state borders to better serve customers by establishing
new branches across state lines and would increase competition by
providing banks with a less costly method for offering their services in
new locations.
According to a Utah state bank supervisory official we spoke with, ILCs in
some states have the ability to establish branches in certain other states
through reciprocal branching agreements. For example, this official stated
that ILCs in Utah have reciprocity agreements with 17 other states and are
able to branch, without federal de novo branching authority, into these 17
states. However, this Utah state supervisory official and industry
practitioners told us that many ILC business models do not rely on retail
96See 12 U.S.C. S:S: 1831u. 97See 12 U.S.C. S: 1828(d).
branching to conduct their business operations. For example, currently
only two Utah ILCs have branches, and they have only two branches each.
According to Board officials, granting ILCs unrestricted de novo branching
authority in other states may increase the relative attractiveness of ILCs
as compared with other financial institution charters. These officials
highlighted that reduced restrictions on nationwide branching may increase
private sector interest in ILC ownership by financial or commercial
holding companies that operate retail distribution networks. However,
according to at least one industry expert we spoke with, the effects of
the consequences of de novo branching may be overstated and not likely to
result in major changes in the ILC industry.
Conclusions ILCs have significantly evolved from the small, limited
purpose institutions that existed in the early 1900s. In particular, the
ILC industry has grown rapidly since 1999 and, in 2004, six ILCs were
among the 180 largest financial institutions with $3 billion or more in
total assets, and one institution had over $66 billion in assets. Because
of the significant recent growth and complexity of some ILCs, the industry
has changed since being granted an exemption from consolidated supervision
in 1987, and some have expressed concerns that ILCs may have expanded
beyond the original scope and purpose intended by Congress.
The vast majority of ILCs have corporate holding companies and affiliates
and, as a result, are subject to similar risks from holding company and
affiliate operations as banks and thrifts and their holding companies.
However, unlike bank and thrift holding companies, most ILC holding
companies are not subject to federal supervision on a consolidated basis.
Although FDIC has supervisory authority over an insured ILC, it does not
have the same authority to supervise ILC holding companies and affiliates
as a consolidated supervisor. While the FDIC's authority to assess the
nature and effect of relationships between an ILC and its holding company
and affiliates does not directly provide for the same range of examination
authority, its cooperative working relationships with state supervisors
and ILC holding company organizations, combined with its other bank
regulatory powers, has allowed the FDIC, under limited circumstances, to
assess and address the risks to the insured institution and to achieve
other results to protect the Fund against ILC-related risks. However, we
are concerned that insured institutions providing similar risks to the
Fund are not being overseen by bank supervisors that possess similar
powers.
FDIC has responded appropriately to the challenges it faces supervising
the ILC industry by implementing significant enhancements to its examiner
guidance designed to mitigate the risks that could be posed to insured
depository institutions, including ILCs, from various sources, such as
holding companies and affiliates. Within the scope of its authority, FDIC
has demonstrated that its supervisory approach has, in some instances,
effectively mitigated losses to the Fund. Some have even stated that, from
a safety and soundness perspective, FDIC's approach is an effective
alternative to the Board's bank holding company supervision, given that
FDIC has successfully mitigated losses to the Fund posed by some troubled
institutions. However, the Board disagrees and stated that FDIC's
approach, without the aid of consolidated supervision, cannot effectively
assess all the risks to a depository institution posed by the holding
company and affiliates of an ILC. Moreover, the extent of some of FDIC's
authorities over ILC holding companies and affiliates is not clear. For
example, it is unclear under what circumstances FDIC could compel ILC
affiliates to provide information about their operations when these
affiliates do not have a relationship with an ILC. As a result, absent a
cooperative working relationship, FDIC's supervisory approach may not be
able to identify or address all potential risks to the insured
institution. It is also unclear how effective the FDIC's approach would be
if the ILC industry incurred widespread and significant losses or if a
large complex ILC were to become troubled. As a result of differences in
supervision, we and the FDIC-IG have found that, from a regulatory
standpoint, ILCs in a holding company structure may pose more risk of loss
to the Fund than other types of insured depository institutions in a
holding company structure.
Although federal banking law may allow ILC holding companies to mix
banking and commerce to a greater extent than holding companies of other
types of depository institutions, we were unable to identify any
conclusive empirical evidence that documented operational efficiencies
from mixing banking and commerce, and the views of bank regulators and
practitioners were mixed. Including ILCs in recent legislative proposals
to offer business checking accounts and operate de novo branches
nationwide maintains the current relative parity between ILC permissible
activities and those of other insured bank charters. These legislative
proposals may make the ILC charter more attractive and encourage future
growth. However, the potential risks from combining banking and commercial
operations remain, including the potential expansion of the federal safety
net provided for banks to their commercial entities, increased conflicts
of interest within a mixed banking and commercial conglomerate, and
increased economic
power exercised by large conglomerate enterprises. In addition, we find it
unusual that this limited exemption for ILCs would be the primary means
for mixing banking and commerce on a broader scale than afforded to the
holding companies of other financial institutions. Because it has been a
long time since Congress has broadly considered the potential advantages
and disadvantages of mixing banking and commerce and given the rapid
growth of ILC assets and the potential for increased attractiveness of the
ILC charter, it would be useful for Congress to review the ILC holding
company's ability to mix banking and commerce more than other types of
financial institutions and whether the holding companies of other
financial institutions should be permitted to engage in this level of
activity.
Matters for Congressional Consideration
Consolidated supervision is a recognized method of supervising an insured
institution, its holding company, and affiliates. While FDIC has developed
an alternative approach that it claims has mitigated losses to the bank
insurance fund, it does not have some of the explicit authorities that
other consolidated supervisors possess, and its oversight over nonbank
holding companies may be disadvantaged by its lack of explicit authority
to supervise these entities, including companies that own large and
complex ILCs. To better ensure that supervisors of institutions with
similar risks have similar authorities, Congress should consider various
options such as eliminating the current exclusion for ILCs and their
holding companies from consolidated supervision, granting FDIC similar
examination and enforcement authority as a consolidated supervisor, or
leaving the oversight responsibility of small, less complex ILCs with the
FDIC, and transferring oversight of large, more complex ILCs to a
consolidated supervisor.
The long-standing policy of separating banking and commerce has been based
primarily on mitigating the potential risk that combining these operations
may pose to the Fund and the taxpayers. GLBA reaffirmed the general
separation of banking from commerce and providing financial services from
nonfinancial commercial firms. However, under federal banking law, the ILC
charter offers commercial holding companies more opportunity to mix
banking and commerce than other insured depository institution charters.
Congress should also be aware of the potential for continued expansion of
large commercial firms into the ILC industry- especially if ILCs are
granted the ability to de novo branch and offer interest bearing business
checking accounts. In recent years, this policy issue has been addressed
primarily through exemptions and provisions to existing laws rather than
assessed on a comprehensive basis. Thus,
Congress should more broadly consider the advantages and disadvantages of
mixing banking and commerce to determine whether continuing to allow ILC
holding companies to engage in this activity more than the holding
companies of other types of financial institutions is warranted or whether
other financial or bank holding companies should be permitted to engage in
this level of activity.
Agency Comments and Our Evaluation
We provided a draft of this report to the Board, FDIC, OTS, and SEC for
review and comment. Each of these agencies provided technical comments
that were incorporated as appropriate. In written comments, the Chairman
of the Board of Governors of the Federal Reserve System (see app. II)
concurred with the report's findings and conclusions. Specifically, the
Chairman stated that "consolidated supervision provides important
protections to the insured banks that are part of a larger organization,
as well as the federal safety net that supports those banks." The Chairman
also wrote that our report "properly highlights the broad policy
implications that ILCs raise with respect to maintaining the separation of
banking and commerce."
In written comments from the Chairman of the Federal Deposit Insurance
Corporation (see app. III), FDIC concurred with one of the report's
findings but generally believed that no changes were needed in its
supervisory approach over ILCs and their holding companies and disagreed
with the matters for congressional consideration. Specifically, the FDIC
concurred that from an operations standpoint, ILCs do not appear to have a
greater risk of failure than other types of insured depository
institutions. However, FDIC's disagreements generally focused on three
primary areas-whether consolidated supervision of ILC holding companies is
necessary to ensure the safety and soundness of the ILC; that FDIC's
supervisory authority may not be sufficient to effectively supervise ILCs
and insulate insured institutions against undue risks presented by
external parties; and the impact that consolidated supervision of ILCs and
their holding companies would have on the marketplace and the federal
safety net.
First, in its comments about consolidated supervision for ILCs and their
holding companies, FDIC stated that its bank-centric supervision, enhanced
by sections 23A and 23B of the Federal Reserve Act and the Prompt
Corrective Action provisions of the FDIC Improvement Act, is a proven
model for protecting the deposit insurance funds, and no additional layer
of consolidated federal supervision of ILC holding companies is necessary.
As stated in our report, we agree that FDIC's approach has
effectively mitigated the risk of loss to the Fund in some instances.
However, FDIC's approach has only been tested on a limited basis in
relatively good economic times. FDIC also expressed concern that our
report did not include a comparison of the effectiveness and cost of
FDIC's bank-centric approach with the effectiveness and cost of
consolidated supervision. As stated in our report, the scope of this
review did not include an assessment of the extent to which regulators
effectively implemented consolidated supervision or any other type of
supervision. Rather, we focused on the respective regulators' authorities
to determine whether there were any inherent limitations in these
authorities. Consolidated supervision is widely recognized nationally and
throughout the world as an accepted approach to supervising organizations
that own or control financial institutions and their affiliates, and we
are not aware of any empirical evidence, or a reliable method of gathering
such evidence, that could be used to draw meaningful conclusions about the
costs and benefits of either supervisory approach. Further, during our
review we did not become aware of any significant concerns over the cost
of consolidated supervision. While we recognize that consolidated
supervision would likely pose some additional cost to ILC holding
companies, determining the extent of this cost would be speculative,
depending on the scope of coverage of consolidated supervision (including
whether current ILC parents would be grandfathered or whether ILCs below
some size threshold would be exempt). Further, we believe that as one
considers any additional costs, consideration should also be given to the
benefits obtained from the enhanced supervisory tools and authorities that
ILC regulators could use to better protect the Fund.
Further, FDIC believes that no additional layer of consolidated federal
supervision of ILC holding companies is necessary and asserts that the
report inappropriately repeated assertions by the Board which speculated
that excessive debt at the parent of Pacific Thrift and Loan (PTL), an
ILC, caused PTL to engage in higher-risk strategies that resulted in the
ILC's failure. FDIC further stated that these assertions were not
supported by the FDIC-IG's material loss review. We disagree that the
information presented in the report is not supported by the FDIC-IG's
review of PTL. As we report, the IG did not specifically identify PTL's
excessive debt as a cause of failure. The IG found that inappropriate
valuation of PTL's residual assets (i.e., the assets that PTL retained
after it packaged and sold loans) ultimately caused the collapse of the
bank. As FDIC notes, it and the other bank regulators have subsequently
tightened rules for this valuation. However, the collapse of PTL was not
purely an issue of inappropriate accounting. The IG found that while PTL's
parent "was incurring
monumental amounts of debt, no federal agency was present to regulate
these activities. The major problem with the borrowing arrangement was
whether or not [the parent] had the financial wherewithal to repay the
debt on a stand-alone basis without relying on PTL for financial support."
The IG's report also stated that PTL's new "management team immediately
implemented an expansionary program of originating and selling subprime
mortgage loans...without regard to adequate policies, programs, and
controls [which] resulted in serious shortcomings." We believe that one of
the significant benefits of consolidated supervision is that it may better
position a regulator to obtain an earlier awareness of possible problems
within a holding company structure that could have an impact on the
insured bank than does the FDIC's bank-centric approach. Had there been a
greater regulatory presence at the holding company, potentially, problems
at PTL may have been identified earlier or averted. Further, the Board's
view of all of the contributing factors to PTL's failure is necessary to
have a balanced discussion of this event.
Second, FDIC commented that it does not need any additional supervisory
authority and has an excellent track record of identifying potential
problems at nonbank subsidiaries and taking appropriate corrective action.
FDIC further stated that the report too narrowly interpreted its
examination authority. We agree that within the scope of its authority,
FDIC has demonstrated that its supervisory approach has, in some
instances, effectively mitigated losses to the Fund. However, we disagree
that the report narrowly interprets FDIC's various authorities and
continue to believe that consolidated supervision offers broader
examination and enforcement authorities that may be used to understand,
monitor, and, when appropriate, restrain the risks associated with insured
depository institutions in a holding company structure. Further, as stated
in the report, consolidated supervisors can compel holding companies and
nonbank subsidiaries to provide key financial and operational reports and
can impose consolidated or parent-only capital requirements that are
important tools used to help ensure the safety and soundness of an insured
depository institution. We continue to be concerned that FDIC's
bank-centric approach relies on voluntary participation by regulated and
unregulated entities to provide this key information, and that this
approach has only been tested during a favorable economic environment. The
ILC industry is growing rapidly and some ILCs are becoming increasingly
complex. Thus, we believe it is important for the Congress to consider
whether insured institutions providing similar risks to the Fund should
also be overseen by bank supervisors that uniformly possess similar
powers.
Third, in its comments, FDIC also stated that consolidated supervision of
ILCs and their holding companies would result in greater federal
involvement with commercial parents and nonbank subsidiaries. While we
agree that more commercial entities would be subject to federal oversight,
we disagree with FDIC's comment that such oversight "would represent a new
level of government intrusion in the marketplace" and would "radically
restructure" the federal government's role relative to commercial firms.
Subjecting commercial ILC holding companies to consolidated supervision
currently would affect a relatively small number of firms that chose to
own and operate ILCs and provide them with a similar level of oversight
afforded to other firms owning insured depository institutions. In so
doing, consolidated supervision could better ensure that there is
sufficient regulatory authority to effectively supervise these entities.
Our report, however, raises oversight concerns with not only commercial
holding company ownership of ILCs, but also discusses the development of a
small number of more complex ILCs owned by financial-oriented holding
companies that are currently exempt from consolidated supervision. At this
time, it is more so because of the advent of these larger institutions-
which increases the potential risk to the Fund-rather than commercial
ownership of ILCs, that we believe this lack of consolidated supervision
merits additional congressional scrutiny.
FDIC further stated that such supervision may call into question the
individual accountability of insured institutions owned by large
organizations to manage their own capital and could lead to an unintended
expansion of the federal safety net to these entities. We disagree that
consolidated supervision would have this effect since many institutions
currently manage their capital, and regulators assess its adequacy on a
consolidated basis. Further, the report does not advocate an expansion of
the federal safety net. Rather, this report advocates that ILCs and their
holding companies be regulated in a similar manner as other insured
depository institutions and their holding companies.
Historically, limited charter entities such as ILCs and nonbank banks were
exempt from consolidated supervision. However, ILCs have evolved from
small, limited purpose institutions and are exempt from business activity
limitations that generally apply to the holding companies and affiliates
of other FDIC-insured depository institutions offering similar services.
Further, ILCs may provide a greater means for mixing banking and commerce
than ownership of or affiliation with other insured depository
institutions. Given the changes and growth in the ILC industry, we see
less distinction now between ILC holding companies and other holding
companies owning insured depository institutions, and it is unclear why a
different regulatory approach would be used to supervise ILCs. As a
result, we continue to believe that Congress should consider various
options such as eliminating the current exclusion for ILCs and their
holding companies from consolidated supervision, granting FDIC similar
examination and enforcement authority as a consolidated supervisor, or
leaving the oversight responsibility of small, less complex ILCs with the
FDIC, and transferring oversight of large, more complex ILCs to a
consolidated supervisor.
As agreed with your office, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 30 days from
the report date. At that time we will send copies of this report to the
Chairman and Ranking Minority Member of the Senate Committee on Banking,
Housing, and Urban Affairs; Chairman and Ranking Minority Member of the
House Committee on Banking, Housing, and Urban Affairs; and other
congressional committees. We also will send copies to the Federal Deposit
Insurance Corporation, the Board of Governors of the Federal Reserve, the
Office of the Comptroller of the Currency, the Office of Thrift
Supervision, the Securities and Exchange Commission, and make copies
available to others upon request. In addition, the report will be
available at no charge on the GAO Web site at http://www.gao.gov.
This report was prepared under the direction of Dan Blair, Assistant
Director. If you or your staff have any questions regarding this report,
please contact me at (202) 512-8678 or [email protected]. Contact points
for our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. Key contributors are acknowledged in
appendix IV.
Sincerely yours,
Richard J. Hillman Managing Director, Financial Markets
and Community Investment
Appendix I
Objectives, Scope, and Methodology
To describe the history and growth of the industrial loan corporation
(ILC) industry, we analyzed Federal Deposit Insurance Corporation (FDIC)
Call Report and Statistics on Depository Institutions (SDI) data on ILCs
including total assets and estimated insured deposits from 1987 through
2004 to determine the (1) number of ILCs by year and by state, (2) total
ILC industry assets by year and by state, and (3) ILC industry estimated
insured deposits as a percentage of total estimated insured deposits by
year. Prior to using the Call Report and SDI data, we assessed its
reliability by (1) reviewing existing information about both data systems
(2) interviewing agency officials knowledgeable of both data systems to
discuss the sources of the data variables and the controls in place to
ensure the accuracy and integrity of the data, and (3) performing various
electronic tests of the required data elements. Based on our work, we
determined that the data from both the Call Report and SDI systems were
sufficiently reliable for the purposes of this report.
To describe the permissible activities and regulatory safeguards for ILCs
as compared with state nonmember banks, we reviewed federal and state
legislation, regulations, and other guidance regarding ILCs and banks. We
interviewed state bank regulators from the Utah Department of Financial
Institutions, the California Department of Financial Institutions, and the
Nevada Financial Institutions Division. We focused on ILCs and regulators
in these three states because over 99 percent of the ILC industry assets
exist in these states. We also interviewed key management officials of
various ILCs in these states that were representative of the various sizes
and business strategies, including: large businesses with activities that
were predominantly within the financial services sector; businesses that
were primarily credit card operations; captive financing arms of
commercial holding companies; and a small, community-oriented banking
institution. In addition, we interviewed management officials from the
headquarters of FDIC, as well as field staff from FDIC's San Francisco
Regional Office and the FDIC Salt Lake City Field Office that are
responsible for the supervision of ILCs located in California, Nevada,
Utah, and other states. We also interviewed officials from the Board of
Governors of the Federal Reserve (Board).
To compare FDIC's supervisory authority over ILC holding companies and
affiliates with the consolidated supervisors' authority over holding
companies and affiliates, we analyzed legislation and regulations that
govern the supervision of insured depository institutions, including ILCs
and their holding companies, banks and their holding companies, and
thrifts and their holding companies. We focused our comparison from a
Appendix I
Objectives, Scope, and Methodology
safety and soundness perspective primarily on the Board's consolidated
supervision of bank holding companies and their affiliates because these
entities may pose similar risks to insured depository institutions as ILCs
that exist in a holding company structure. However, because the Office of
Thrift Supervision (OTS) also supervises similar entities that pose
similar risks to insured depository institutions, we also reviewed OTS'
supervisory authority. We also interviewed state banking regulators in
California, Nevada, and Utah, as well as officials headquartered in the
offices of the FDIC, the Board, and OTS who are knowledgeable of the
supervisory approach and authorities of these agencies.
To determine recent changes FDIC has made to its supervisory approach for
the risks that holding companies and affiliates could pose to ILCs and
whether differences in supervision and regulatory authorities pose
additional risk to the Fund, we interviewed knowledgeable FDIC officials
and obtained documentation regarding revised agency guidance on safety and
soundness examination procedures. We also compared agency examination
manuals and other guidance; interviewed agency officials regarding the
supervisory approach and supervisory authority of FDIC, the Board and OTS;
and spoke with state and FDIC regional staff responsible for conducting
examinations. Additionally, we synthesized and relied, as appropriate,
upon information from the FDIC Inspector General (FDIC-IG) September 30,
2004, report entitled, The Division of Supervision and Consumer
Protection's Approach for Supervising Limited-Charter Depository
Institutions because this report provided information on FDIC's guidance
and procedures for supervising limited charter depository institutions,
including ILCs, and summarized various recent actions that FDIC had taken.
Prior to relying on the FDIC-IG's report, we performed various due
diligence procedures that provided a sufficient basis for relying upon
their work including obtaining information about the other auditors'
qualifications and independence; reviewing the other auditors' external
quality control review report; and determining the sufficiency, relevance,
and competence of the other auditors' evidence by reviewing the audit
report, audit program and documentation. We also reviewed and synthesized
information from the FDIC-IG's material loss reviews of Pacific Thrift and
Loan and Southern Pacific Bank, two failed ILCs. To determine what actions
FDIC had taken as a result of these material loss reviews and any other
conditions existing in the banking industry at that time, we interviewed
FDIC management about the status of recommendations made by the FDIC-IG in
the material loss reviews.
Appendix I
Objectives, Scope, and Methodology
To determine whether ILCs allow for greater mixing of banking and commerce
than other insured depository institutions and whether this possibility
has any competitive implications, as well as to determine the implications
of granting ILCs the ability to pay interest on business checking accounts
and operate de novo branches nationwide, we reviewed and synthesized
academic, bank regulator, and other studies and literature about the
historic policy of mixing banking and commerce, potential economies of
scale and scope in the banking industry, and academic literature on mixed
banking and commerce in other countries. We also interviewed and reviewed
studies from academics who have published on the subject of regulatory and
competitive issues in the banking industry. Additionally, we reviewed
applicable laws and legislative proposals, press reports, and other
documents. Furthermore, we assessed the degree to which other depository
institutions are able to mix banking and commerce, such as unitary
thrifts, "nonbank banks," merchant banks, and captive finance
subsidiaries. In addition, we reviewed applicable laws and regulations and
interviewed federal banking regulators from the FDIC, Federal Reserve, and
OTS. We also interviewed state banking regulators in Utah, California, and
Nevada and key management officials from several ILCs in California,
Nevada, and Utah, as well as representatives from the Independent
Community Bankers Association.
Finally, to more fully understand (1) the significance of the differences
between consolidated supervision of bank and thrift holding companies and
FDIC's supervision of ILCs and the potential risks that their holding
company and affiliate organizations may pose to the ILC, (2) the potential
for greater mixing of banking and commerce by ILC holding companies as
compared with other types of depository institutions, and (3) the
potential advantages and disadvantages of granting ILCs the ability to pay
interest on business checking accounts and open de novo branches
nationwide, we hosted a panel of experts. The panel members were selected
from a list of well-known and knowledgeable officials from the FDIC and
the Board, academics, economists, industry practitioners, and independent
consultants. The panel participants were selected to ensure a robust
discussion of divergent views on issues facing the ILC industry and bank
regulators.
Appendix II
Comments from the Board of Governors of the Federal Reserve System
Appendix II
Comments from the Board of Governors of
the Federal Reserve System
Appendix III
Comments from the Federal Deposit Insurance Corporation
Appendix III
Comments from the Federal Deposit
Insurance Corporation
Appendix III
Comments from the Federal Deposit
Insurance Corporation
Appendix III
Comments from the Federal Deposit
Insurance Corporation
Appendix III
Comments from the Federal Deposit
Insurance Corporation
Appendix III
Comments from the Federal Deposit
Insurance Corporation
Appendix IV
GAO Contact and Staff Acknowledgments
GAO Contact Richard J. Hillman (202) 512-8678
Staff Acknowledgments
(250202)
The following individuals made key contributions to this report:
Dan Blair, Assistant Director
Heather Atkins
Rudy Chatlos
Jordan Corey
Tiffani Humble
James McDermott
Marc Molino
David Pittman
Rhonda Rose
Paul Thompson.
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