Industrial Loan Corporations: Recent Asset Growth and Commercial Interest Highlight Differences in Regulatory Authority (07/12/2006, GAO-06-961T}

-------------------------Indexing Terms-------------------------
REPORTNUM:   GAO-06-961T
    TITLE:   Industrial Loan Corporations: Recent Asset Growth and Commercial Interest Highlight Differences in Regulatory Authority
     DATE:   07/12/2006



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Testimony: 

Before the Subcommittee on Financial Institutions and Consumer Credit, 
Committee on Financial Services, House of Representatives: 

United States Government Accountability Office: 

GAO: 

For Release on Delivery Expected at 10:00 a.m. EDT: 

Wednesday, July 12, 2006: 

Industrial Loan Corporations: 

Recent Asset Growth and Commercial Interest Highlight Differences in 
Regulatory Authority: 

Statement of Richard J. Hillman, Managing Director: 
Financial Markets and Community Investment: 

GAO-06-961T: 

GAO Highlights: 

Highlights of GAO-06-961T, testimony before the Subcommittee on 
Financial Institutions and Consumer Credit, Committee on Financial 
Services, House of Representatives 

Why GAO Did This Study: 

Since their origin in the early 1900s, industrial loan corporations 
(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 testimony is based on our September 2005 report that, among other 
things, (1) described the growth and permissible activities of the ILC 
industry, (2) compared the supervisory authority of the FDICï¿½the 
current federal regulator for ILCsï¿½with consolidated supervisors, and 
(3) described the extent to which ILC parents could mix banking and 
commerce. 

In this testimony GAO is reiterating that Congress should (1) consider 
options for strengthening the regulatory oversight of ILCs and (2) more 
broadly consider whether allowing ILCs a greater degree of mixing 
banking and commerce is warranted or whether other entities should be 
permitted to engage in this level of activity. 

What GAO Found: 

The ILC industry has experienced significant asset growth and has 
evolved from once small, limited-purpose institutions to a diverse 
industry that includes some of the nationï¿½s largest and more complex 
financial institutions. Between 1987 and 2006, ILC assets grew over 
3,900 percent from $3.8 billion to over $155 billion. In most respects, 
ILCs may engage in the same activities as other depository institutions 
insured by the FDIC and are subject to the same federal safety and 
soundness safeguards and consumer protection laws. 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 present 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 or control other 
entities. Although FDIC has supervisory authority over an insured ILC, 
this authority does not explicitly extend to ILC holding companies and, 
therefore, is less extensive than the authority consolidated 
supervisors have over 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, FDICï¿½s authority to 
examine ILC affiliates 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, FDICï¿½s 
authority is limited to a particular set of circumstances and may not 
be used at all times. Further, FDICï¿½s authority has not been tested by 
a large ILC parent during times of economic stress. 

Because of an exception in federal banking law, ILC holding companies 
can mix banking and commerce more than the holding companies of most 
other depository institutions. In addition, there are a number of 
pending applications for deposit insurance with FDIC involving 
commercial firms, including one of the largest retail firms. 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 merits in Congress taking a look at whether 
ILCs or other entities should be allowed to engage in this level of 
activity. 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-961T]. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Richard J. Hillman at 
(202) 512-8678 or [email protected]. 

[End of Section] 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss the results of our 2005 report 
on industrial loan corporations (ILCs).[Footnote 1] Over the past 10 
years, ILCs, particularly when included as part of a holding company 
structure, have experienced significant growth, now having over $155 
billion in assets; these once small niche lenders have evolved into a 
diverse industry that includes some large, complex financial 
institutions. As a result, some have expressed concerns that ILCs may 
be expanding beyond the original scope and purpose intended by 
Congress. 

The potential entry into banking services by some of the nation's 
largest retailers has also raised concerns. In 2005, one of the world's 
largest retailer, Wal-Mart, submitted an application with the Federal 
Deposit Insurance Corporation (FDIC) to provide federal insurance of 
deposits in a subsidiary ILC. In May, Home Depot, the nation's largest 
home improvement retailer, submitted an application for FDIC to approve 
the purchase of an existing ILC. Proponents assert that these 
operations will benefit consumers through lower prices or increased 
access to financial services. Critics, however, say that nonfinancial 
operations of this size owning an insured ILC pose unnecessary risks to 
the deposit insurance funds that cannot be adequately addressed under 
the current regulatory authorities. 

My remarks today are primarily based on our 2005 report and focus on 
three of the report's objectives: the growth and permissible activities 
of the ILC industry, how FDIC's supervisory authority over ILC holding 
companies and affiliates compares with a consolidated supervisors' 
authority; and, the extent to which the ILC charter enables commercial 
holding companies to mix banking and commerce.[Footnote 2] 

In summary: 

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. For example, from 1987 to 
March 31, 2006, ILC assets have grown over 3,900 percent from $3.8 
billion to over $155 billion. With one exception contained in federal 
and one state's banking laws, federally insured ILCs in a holding 
company structure may generally engage in the same activities as other 
FDIC-insured depository institutions. 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. As a result, from an operations standpoint, ILCs in a holding 
company structure pose risks to the Deposit Insurance Fund (the Fund) 
similar to those posed by other FDIC-insured institutions in holding 
company structures.[Footnote 3] 

ILCs are state chartered depository institutions. Concerns about them 
presently exist because of a provision in the Bank Holding Company Act 
(BHC Act). Under that act, a company that owns or controls a federally 
insured ILC can conduct banking activities through the ILC without 
becoming subject to the federal supervisory regime that applies to 
companies that own or control banks or thrifts. Because these ILCs have 
federally insured deposits, they are subject to supervision by FDIC as 
well as their respective state regulators.[Footnote 4] However, FDIC 
lacks the explicit authority to regulate ILC parent companies and their 
activities. Under the BHC Act, the Board of Governors of the Federal 
Reserve (Board) is responsible for supervising 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.[Footnote 5] The Office of Thrift Supervision has similar 
authority under the Home Owners Loan Act with respect to savings and 
loan holding companies. The Board and OTS each take a systemic approach 
to supervising depository institution holding companies and their 
nonbank subsidiaries and may look across lines of business at 
operations such as risk management, information technology, or internal 
audit in order to determine the risk these operations may pose to the 
insured institution. However, because of an exception under the BHC 
Act, holding companies of ILCs are not subject to consolidated 
supervision. Unlike the Board, FDIC does not have specific consolidated 
supervisory authority over holding companies that conduct banking 
activities only through ILCs. FDIC has, however, employed what some 
term 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. While 
FDIC's cooperative working relationships with state supervisors and ILC 
holding company organizations, combined with its other bank regulatory 
powers, has allowed FDIC, under certain circumstances, to assess and 
address the risks to the insured institution and to achieve other 
results to protect the insurance fund against ILC-related risks, 
questions remain about the extent to which FDIC's supervisory approach 
and authority address all risks posed to an ILC from its parent holding 
company and nonbank affiliates and how well FDIC's approach would fare 
for large, troubled ILCs during times of stress. 

Another area of potential concern about ILCs is the extent to which 
they can mix banking and commerce through the holding company 
structure. The BHC Act maintains the historical separation of banking 
from commerce by generally restricting bank holding companies to 
banking-related or financial activities. [Footnote 6] However, because 
of the ILC exemption in the BHC Act, ILC holding companies, including 
nonfinancial institutions such as retailers and manufacturers, and 
other institutions are not subject to federal activities restrictions. 
Consequently, they have greater latitude to mix banking and commerce 
than most other financial institutions. 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 reducing the potential 
adverse consequences that combining these activities may pose. These 
include the potential expansion of the federal safety net provided for 
depository institutions to their commercial holding companies or 
affiliates, increased conflicts of interest within a mixed banking and 
commercial conglomerate, and increased economic power exercised by 
large conglomerate enterprises. We found divergent views about the 
competitive implications of mixing banking and commerce and were unable 
to identify conclusive empirical evidence that documented efficiencies 
attributable to mixing banking and commerce. In addition, we found it 
unusual that use of the ILC exemption under the BHC Act would be the 
primary means for mixing banking and commerce across a broader scale 
than afforded to the holding companies of other federally insured 
depository institutions. 

Our report included matters for congressional consideration designed to 
better ensure that insured institutions providing similar risks to the 
Fund are subject to federal supervision overseen by banking supervisors 
that possess similar powers. In this regard, we determined that it 
would be useful for Congress to consider several options such as 
eliminating the current BHC Act exception 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 concluded that it would also 
be beneficial for Congress to more broadly consider the advantages and 
disadvantages of mixing banking and commerce to determine whether 
allowing 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. 

Before discussing the results of our work more fully, I would like to 
provide a brief overview of the growth of ILCs and compare their 
permissible activities with those of a state nonmember commercial bank. 

ILCs Have Grown Significantly and Are No Longer Small, Limited-Purpose 
Institutions: 

First, I would like to highlight the significant growth and 
transformation that has taken place in the ILC industry since 1987. 
ILCs began in the early 1900s as small, state-chartered loan companies, 
serving the borrowing needs of industrial workers unable to obtain 
noncollateralized loans from commercial banks. Since then, the ILC 
industry has experienced significant asset growth and evolved from 
small, limited-purpose institutions to a diverse group of insured 
financial institutions with a variety of business models. Most notably, 
as shown in figure 1, from 1987 to March 31, 2006, ILC assets have 
grown over 3,900 percent, from $3.8 billion to over $155 billion, while 
the number of ILCs declined about 42 percent from 106 to 61. In March 
2006, 9 ILCs were among the 271 largest financial institutions in the 
nation with $3 billion or more in total assets, and one institution had 
over $62 billion in total assets. As of March 31, 2006, 6 ILCs owned 
over 80 percent of the total assets for the ILC industry with aggregate 
assets totaling over $125 billion and collectively controlled about $68 
billion in FDIC-insured deposits. 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, among the reasons ILCs grew in that state was because its 
laws are "business friendly," and the state offers a large, well- 
educated workforce for the financial services industry. 

Figure 1: Number and Total Assets of ILCs, 1987 to March 31, 2006: 

[See PDF for image] 

Source: GAO analysis of FDIC Call Report data. 

[End of figure] 

Financial services firms, such as the ILCs owned by Merrill Lynch, USAA 
Savings Bank, and American Express own and operate the majority of the 
61 active ILCs.[Footnote 7] These ILCs are parts of complex financial 
institutions with extensive access to capital markets. Other ILCs are 
part of a business organization that conducts activities within the 
financial arm of a larger corporate organization not necessarily 
financial in nature. In addition, other ILCs directly support the 
holding company organizations' commercial activities, such as the ILCs 
owned by BMW and Volkswagen. Finally, some ILCs are smaller, community- 
focused, stand-alone institutions such as Golden Security Bank and 
Tustin Community Bank. 

Although the total amount of estimated insured deposits in the ILC 
industry has grown by over 600 percent since 1999, as shown in figure 
2, 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, as of March 31, 2006, the largest ILC, owned by Merrill 
Lynch, held over $43 billion in estimated FDIC insured deposits. 

Figure 2: Percentage of Estimated FDIC Insured Deposits Held by ILCs, 
1987 - March 31, 2006: 

[See PDF for image] 

Source: GAO analysis of FDIC Call Report data. 

[End of figure] 

ILC Business Lines and Regulatory Safeguards Are Similar to Other 
Insured Financial Institutions: 

Next, I would like to briefly compare the permissible activities of 
ILCs with other insured financial institutions.[Footnote 8] Federal 
banking law permits FDIC-insured ILCs to engage in the same activities 
as other insured depository institutions. However, in order to qualify 
for the ILC exception in the BHC Act, (and also, we found, because of 
restrictions in California state law) most ILCs, which are owned by non-
BHC Act holding companies, may not accept demand deposits. Other than 
this exception, banking laws in California, Nevada, and Utah have 
undergone changes that generally place ILCs on par with traditional 
banks in terms of services provided. Thus, as shown in Table 1, 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. [Footnote 
9] In effect, this permits ILCs offering credit cards to charge their 
state's maximum allowable interest rates in other states. [Footnote 10] 
In addition, ILCs generally are subject to the same federal regulatory 
safeguards that apply to commercial banks and thrifts. For example, 
ILCs are subject to 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. [Footnote 11] Sections 23A and 23B generally limit the 
dollar amount of loans to affiliates and require transactions to be 
done on an "arms-length" basis.[Footnote 12] ILCs must also comply with 
Bank Secrecy Act, Anti-Money Laundering, and Community Reinvestment Act 
requirements and like other insured depository institutions comply with 
consumer protection laws. 

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. The primary difference, as shown in table 1, between 
ILCs and other FDIC-insured depository institutions is that, to remain 
outside of the BHC Act, an ILCs must be chartered in the states 
described in the the ILC exemption and may not accept demand deposits 
if its total assets are $100 million or more.[Footnote 13] 

Table 1: Comparison of Permissible Activities Between State Nonmember 
Commercial Banks and ILCs in a Holding Company Structure: 

Permissible Activities: Ability to offer full range of loans, 
including: 
consumer, commercial real estate, residential real estate, small 
business, and subprime; 
State Non-member Commercial Bank: Yes; 
Industrial Loan Corporation: Yes. 

Permissible Activities: Ability to export interest rates; 
State Non- member Commercial Bank: Yes; 
Industrial Loan Corporation: Yes. 

Permissible Activities: Ability to offer full range of deposits 
including demand deposits; 
State Non-member Commercial Bank: Yes; 
Industrial Loan Corporation: Yes, except in California; However, BHC 
Act-exempt ILCs 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.[A]. 

Source: FDIC. 

[AI] ILCs can accept NOW accounts which are insured deposits that, in 
practice, are similar to demand deposits. 

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. 

[End of table] 

Based on an analysis of the permissible activities of ILCs and other 
insured depository institutions, we and FDIC's Inspector General 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 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 their 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. 

FDIC's Supervisory Authority Over ILC Holding Companies and Affiliates 
Is Not Equivalent to Consolidated Supervisors' Authority: 

In our 2005 report we compared the supervisory approaches of FDIC and 
consolidated supervisors, such as the Board and the Office of Thrift 
Supervision (OTS), and described in detail several differences between 
FDIC's supervisory authority over ILC holding companies and affiliates 
and the authority of these consolidated supervisors. Today, I will 
highlight a few of these differences to illustrate how FDIC's authority 
over holding companies and affiliates is not as extensive as the 
authority that these consolidated supervisors have over holding 
companies and affiliates of banks and thrifts. 

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. 
Organizations in countries throughout the world recognize consolidated 
supervision as an accepted approach to supervising organizations that 
own or control financial institutions and their affiliates. The 
European Union generally requires consolidated supervision for 
financial institutions operating in its member states, and the Basel 
Committee recognizes this approach as an essential element of banking 
supervision.[Footnote 14] 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 
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 
testimony, 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: 

Because most ILCs exist in a holding company structure, they are 
subject to risks from the holding company and its subsidiaries, 
including adverse intercompany transactions, operations risk, 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. In our 2005 report, we described 
in detail various ways that consolidated supervision offered more 
explicit authority over holding company affiliates than FDIC's bank 
centric approach. Today, I will summarize two of these points to 
illustrate some of the differences in supervisory authority between the 
FDIC and consolidated supervisors. These two points describe 
differences in FDIC's and the Board's authority to examine holding 
companies and their nonbank subsidiaries to assess potential risks to 
the insured depository institution; and the importance of consolidated 
supervision standards designed to ensure that the holding company 
serves as a source of strength to the insured depository institution. 

As consolidated supervisors, the Board and OTS have broad authority to 
examine bank and thrift holding companies (including their nonbank 
subsidiaries), respectively, in order to assess risks to the depository 
institutions that could arise because of their affiliation with other 
entities in a consolidated structure.[Footnote 15] The Board and OTS 
have general authority to 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[Footnote 16]. This authority is limited with respect to certain 
types of subsidiaries, such as those regulated by the Securities and 
Exchange Commission or state insurance regulators, but even those 
subsidiaries may be examined by the Board under appropriate 
circumstances 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 depository institution 
[Footnote 17]. Also, under the BHC Act, a Board examination of a 
holding company must, to the fullest extent possible, focus on 
subsidiaries that could have a materially adverse effect on the safety 
and soundness of the affiliated depository institution due to the 
subsidiary's size, condition or activities or the nature and size of 
transactions between the subsidiary and the depository institution. 
OTS' examination authority with respect to holding companies is subject 
to the same limitation[Footnote 18]. Even with these limitations, both 
the Board and OTS have direct authority to examine a subsidiary - based 
solely on characteristics of the subsidiary - in order to assess the 
condition of an affiliated bank. 

In contrast to the consolidated supervisory approaches of the Board and 
OTS, FDIC's supervisory authority is more limited and 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 in a holding company structure. Under section 10(b) of 
the FDI Act, FDIC, in the course of examining an institution, may 
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."[Footnote 19] 
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 ownership of 
an insured institution or any of its affiliates.[Footnote 20] According 
to FDIC officials, such an investigation would be triggered by concerns 
about the insured institution. 

Consolidated supervisors have also instituted standards designed to 
ensure that the holding company serves as a "source of strength" for 
its insured depository institution subsidiaries. For example, 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.[Footnote 21] 

Because FDIC does not supervise institutions affiliated with depository 
institutions on a consolidated basis, it has no direct authority to 
impose consolidated supervision requirements, such as capital levels 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 indicated that it 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.[Footnote 22] 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.[Footnote 23] 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. 

Figure 3 compares some of the differences in explicit supervisory 
authority between FDIC and consolidated supervisors, specifically the 
Board and OTS. This figure 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 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 relationships 
between the institution and its affiliates and FDIC's 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.[Footnote 24] 

Figure 3: Comparison of Explicit Supervisory Authorities of the FDIC, 
Board, and OTS: 

[See PDF for image] 

Source: GAO analysis of supervisory authorities of the FDIC, Board, and 
OTS. 

[A] FDIC 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. 

[B] The 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. 

[C] FDIC 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. 

[D] FDIC 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. 

[E] In addition to an enforcement action against the holding company of 
an ILC in certain circumstances (see note 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. 

[End of figure] 

Further, in our report we described various areas where FDIC officials 
asserted that their supervisory approach could achieve similar results 
to those of consolidated supervision. However, we found that FDIC's 
authority in each of these areas was less extensive than consolidated 
supervision because these authorities can only be used under specific 
circumstances and 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. 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. Today, I will highlight two of these areas: the ability to 
examine certain ILC affiliates and the ability to terminate deposit 
insurance to illustrate how FDIC's authority is not equivalent to 
consolidated supervision of the holding company. 

Table 2: The Extent of Selected FDIC Authorities: 

FDIC authority: Examine certain ILC affiliates.[A]; 
Extent of authorities: 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. 

FDIC authority: Impose conditions on or enter agreement with an ILC 
holding company in connection with an application for deposit 
insurance; 
Extent of authorities: Only in connection with an application for 
deposit insurance and cannot be used to unilaterally impose conditions 
on an ILC holding company after the application has been approved. 

FDIC authority: Terminate deposit insurance; 
Extent of authorities: 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; 
* the institution, its directors or trustees have engaged in unsafe or 
unsound practices;; 
* the institution is in an unsafe or unsound condition; or; 
* the institution, its directors or trustees have violated an 
applicable legal requirement, condition of insurance, or written 
agreement between the institution and FDIC. 

FDIC authority: Obtain written agreements from the acquiring entity in 
connection with a proceeding to acquire an ILC.[B]; 
Extent of authorities: Could be used if grounds for disapproval exist 
with respect to the acquirer. 

FDIC authority: Take enforcement actions against ILC affiliates.[C]; 
Extent of authorities: Only if an affiliate is an IAP; and; 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. 

[A] FDIC'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. 

[B] FDIC'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 Change In Bank 
Control Act 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. 

[C] In accordance with 12 U.S.C. ï¿½ï¿½1848a, 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. 

[End of table] 

FDIC's Examination Authority Is Less Extensive Than a Consolidated 
Supervisor: 

FDIC officials stated that its examination authority is sufficient to 
address any significant risk to ILCs from holding companies and 
entities affiliated 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. 

We agree that 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 information, but the use of these powers appears to be limited 
to examinations or investigations relating to the insured depository 
institution.[Footnote 25] 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.[Footnote 
26] 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.[Footnote 27] FDIC's authority does not permit it to examine 
an affiliate based solely on its size, condition, or activities. While 
the most serious risk to an ILC would come from holding companies or 
affiliates that have a relationship with the ILC, the possibility that 
risks could come from affiliates with no relationship with the ILC 
should not 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. 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's Authority to Terminate Insurance Can Be Exercised in Certain 
Circumstances: 

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.[Footnote 28] 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.[Footnote 29] 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 and 
terminated deposit insurance in 21 of these cases. In 94 of these 115 
instances, corrective actions were taken, and the deposit insurance was 
not terminated. 

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 Actions May Help Mitigate Potential Risks: 

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. 

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 7 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 no experience using its supervisory approach to mitigate potential 
losses from troubled ILCs that would qualify for supervision under its 
Large Bank program.[Footnote 30] 

FDIC's supervisory model and authority over BHC Act-exempt ILC holding 
companies and affiliates has emerged during a time when the banking 
industry has experienced relatively good times. Former FDIC Chairman 
Donald Powell 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 8 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 fifth consecutive year and 
that the industry's equity capital ratio is at its highest level since 
1938.[Footnote 31] 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 and the test of 
supervision is its effectiveness during periods of stress. We have long 
advocated comprehensive regulation of financial services holding 
companies on both a functional and consolidated basis in order to 
assess how risks in other components of the holding company may affect 
the insured bank. We have stated that capital standards for both 
insured banks and their holding companies should adequately reflect all 
major risks. 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. 

ILCs May Offer Commercial Holding Companies a Greater Ability to Mix 
Banking and Commerce than Other Insured Depository Institutions, but 
Views on Competitive Implications Are Mixed: 

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.[Footnote 32] Because of a 
provision in the ILC exception in the BHC Act, 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. As of March 31, 2006, 10 
ILCs with total assets of about $ 3.6 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 March 31, 2006, 
approximately 15 of the 61 active ILCs were owned or affiliated with 
commercial entities, representing about $13.2 billion, (about 8.5 
percent) and $8.2 billion (about 9.7 percent) of total ILC industry 
assets and estimated insured deposits, respectively.[Footnote 33] In 
addition, there are a number of pending applications for deposit 
insurance with FDIC involving commercial firms, including one of the 
largest retail firms. 

Regulators and practitioners with whom we spoke with also noted, 
however, that several other major industrial nations do allow a greater 
mixing of banking and commerce than does the United States. For 
example, in Europe 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 also 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 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 Potential Risks and Benefits: 

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. We have previously 
reported that the potential risks that may result from greater mixing 
of banking and commerce[Footnote 34] 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 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 of extending the safety net, and any 
associated subsidy, may be transferred to commercial entities. This 
risk, however, may be mitigated by statutory and regulatory safeguards 
between the bank and their commercial affiliates such as requirements 
for arms-length transactions and restrictions on the size of affiliate 
transactions under section 23A and 23B of the Federal Reserve Act. 
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. 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 envision 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. 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. Enhanced 
product and geographic diversification could also reduce risk to the 
combined entity. 

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. 

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. 

Concluding Remarks: 

As we stated in our 2005 report, ILCs have significantly evolved from 
the small, limited purpose institutions that existed in the early 
1900s. 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. While 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 insurance fund against ILC-related risks. However, FDIC's 
supervisory approach over ILC holding companies and affiliates has not 
been tested by a large ILC parent during periods of economic stress. 
Moreover, we are concerned that insured institutions posing similar 
risks to the Deposit Insurance Fund are not being overseen by bank 
supervisors that possess similar powers. Because of these differences 
in supervision, we 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. 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. 

In addition, 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. Nevertheless, the potential 
risks from combining banking and commercial operations remain. These 
include 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 expanding the mixing of banking and commerce 
than afforded to the holding companies of other financial institutions. 
Because it has been a long time since Congress has focused on the 
potential advantages and disadvantages of mixing banking and commerce 
and given the rapid growth of ILC assets and a potential for increased 
attractiveness of the ILC charter, we concluded in our 2005 report that 
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. 

Mr. Chairman, this concludes my prepared statement. I would be pleased 
to answer any questions you or other Members may have at the 
appropriate time. 

GAO Contacts and Staff Acknowledgments: 

For further information on this testimony, please contact Richard 
Hillman at (202) 512-8678 or [email protected]. Contact points for our 
Office of Congressional Relations and Public Affairs may be found on 
the last page of this statement. Individuals making key contributions 
to this testimony included Dan Blair, Tiffani Humble, James McDermott, 
Dave Pittman, and Paul Thompson. 

FOOTNOTES 

[1] GAO, Industrial Loan Corporations: Recent Asset Growth and 
Commercial Interest Highlight Differences in Regulatory Authority, GAO-
05-621 (Washington, D.C.: September 15, 2005). 

[2] In preparation for this hearing, we updated our September 2005 
report to provide information on the number and total assets of ILCs 
through March 31, 2006. 

[3] Under 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. 

[4] Since ILCs are state-chartered financial institutions, they are 
subject to supervision and regulation by both FDIC and the chartering 
state's financial regulator. 

[5] The Securities and Exchange Commission has approved the 
applications of five investment banks, including the parent companies 
of several large ILCs, to be subject to consolidated supervision. 

[6] As 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 ï¿½ï¿½ 102, 103, codified at 12 
U.S.C. ï¿½ 1843(c)(8), (k) (2000 & Supp. 2004). 

[7] As of March 31, 2006. 

[8] A full comparison is beyond the scope of this testimony. See our 
2005 report for a more detailed and comprehensive discussion of ILC 
lines of business and the regulatory safeguards that apply to ILCs and 
other insured depository institutions. 

[9] See 12 U.S.C. ï¿½ 1831d(a); see also, FDIC General Counsel's Opinion 
No. 11, Interest Charges by Interstate State Banks, 63 Fed. Reg. 27282 
(May 18, 1998). 

[10] Nevada 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. 

[11] Covered 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. ï¿½ 1843 
(n)(6). 

[12] Section 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. ï¿½ 1828(j). 

[13] The Competitive Equity Banking Act (CEBA) contains the ILC 
exemption allowing entities that own or control ILCs to avoid Board 
regulations as a bank holding company. This exemption applies to ILCs 
chartered in states that as of March 5, 1987, had in effect or under 
consideration a statute requiring ILCs to be FDIC insured. According to 
the FDIC, at the time of the CEBA exemption, six states - California, 
Colorado, Hawaii, Minnesota, Nevada, and Utah met this requirement. 
Only ILCs chartered in these "grandfathered" states are eligible for 
the ILC exemption from the BHC Act. 

[14] The Basel Committee on Banking Supervision, established in 1974, 
is composed of representatives from the central banks or supervisory 
authorities of major industrial countries in Europe, North America, and 
Asia, including the United States. 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. 

[15] As noted above, the Securities and Exchange Commission has 
approved the applications of five investment banks, including the 
parent companies of several large ILCs, to be subject to consolidated 
supervision. This prudential supervision regime entails SEC oversight 
of the risk management and control systems and SEC examination of 
unregulated entities within the holding companies. 

[16] See 12 U.S.C. ï¿½ï¿½ 1844(c)(2)(A), 1467a., and 12 U.S.C. ï¿½ 1831v(b). 

[17] See 12 U.S.C. ï¿½ 1844(c)(2)(B). 

[18] See 12 U.S.C. ï¿½ï¿½ 1467a(b)(4), 1831(a). 

[19] See 12 U.S.C. 1820(b)(4)(A). 

[20] See 12 U.S.C. ï¿½ 1820(c). 

[21] 12 C.F.R. Part 225, Appendices B & C. 

[22] 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 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. ï¿½ 1818(b). 

[23] See 12 U.S.C. ï¿½ 1813(u). 

[24] In 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. ï¿½ 1831o. These measures apply equally to all FDIC insured 
institutions and their respective regulators. 

[25] See 12 U.S.C. ï¿½ 1820(c). 

[26] See, for example, the focus of bank holding company examinations 
as prescribed in the BHC Act. 12 U.S.C. ï¿½ 1844(c)(2). 

[27] See 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. 

[28] The 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. ï¿½ 
1818(a)(2)(A). 

[29] See 12 U.S.C. ï¿½ 1818(a)(3),(5). 

[30] FDIC's large bank program provides an on-site presence at 
depository institutions with total assets greater than $10 billion or 
because of their size, complexity, and risk profile. 

[31] Equity 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. 

[32] See 12 U.S.C. ï¿½ï¿½ 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. ï¿½ 1841(c)(2)(F). 

[33] When 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 8.5 percent of 
industry assets and 9.7 percent of industry estimated insured deposits. 

[34] GAO, Separation of Banking and Commerce, GAO/OCE/GGD-97-16R 
(Washington, D.C.: Mar. 17, 1997). 

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