Banks' Securities Activities: Oversight Differs Depending on Activity and
Regulator (Chapter Report, 09/21/95, GAO/GGD-95-214).
Pursuant to a congressional request, GAO reviewed federal bank
regulators' oversight of banks' securities activities, focusing on the:
(1) extent to which banks provide and regulate securities brokerage
services; (2) results of Federal Reserve inspections of bank holding
company subsidiaries authorized to underwrite and deal in securities;
and (3) Federal Deposit Insurance Corporation's (FDIC) regulation of
bank subsidiaries that can underwrite and deal in securities.
GAO found that: (1) about 22 percent of U.S. banks offered securities
brokerage services to their customers in 1994; (2) the Securities and
Exchange Commission (SEC) and the National Association of Securities
Dealers (NASD) regulated the securities activities of 88 percent of
these 2,400 banks by providing these services through broker dealers,
while 287 banks provided bank-direct brokerage services; (3) federal
bank regulators did not always review bank-direct brokerage operations
routinely, but the regulators jointly issued new guidance and
examination procedures in 1994 that emphasized these reviews; (4)
securities activities can be overseen by different regulators depending
on how the banks organize their securities activities, creating the
potential for inconsistent oversight; (5) although Federal Reserve
examiners usually met their inspection schedules, addressed inspection
procedures, and tested securities subsidiaries for compliance with
applicable firewalls, there were a few cases of insufficient
documentation; and (6) FDIC had no centralized program to oversee the
activities of the bona fide securities subsidiaries and had not fully
prepared its examiners to examine securities activities, posing risks to
affiliated banks.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-95-214
TITLE: Banks' Securities Activities: Oversight Differs Depending
on Activity and Regulator
DATE: 09/21/95
SUBJECT: Securities regulation
Financial institutions
Compliance
Internal audits
Brokerage industry
Documentation
Bank holding companies
Banking law
Internal controls
Bank examination
IDENTIFIER: BIF
Bank Insurance Fund
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Cover
================================================================ COVER
Report to Congressional Requesters
September 1995
BANKS' SECURITIES ACTIVITIES -
OVERSIGHT DIFFERS DEPENDING ON
ACTIVITY AND REGULATOR
GAO/GGD-95-214
Banks' Securities Activities
(233408)
Abbreviations
=============================================================== ABBREV
BIF - Bank Insurance Fund
CRD - Central Registration Depository
FDIC - Federal Deposit Insurance Corporation
FDICIA - Federal Deposit Insurance Corporation Improvement Act
FRS - Federal Reserve System
NASD - National Association of Securities Dealers
OCC - Office of the Comptroller of the Currency
SEC - Securities and Exchange Commission
SIPC - Securities Investor Protection Corporation
SRO - self-regulatory organization
Letter
=============================================================== LETTER
B-259498
September 21, 1995
The Honorable John D. Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives
The Honorable Edward J. Markey
Ranking Minority Member
Subcommittee on Telecommunications
and Finance
Committee on Commerce
House of Representatives
This report presents the results of our review of federal banking
regulators' oversight of banks' securities activities. You requested
that we report on the extent to which banks have expanded into
securities activities. You also asked us to evaluate the status of
federal banking regulators' programs for examining and enforcing
compliance with regulatory safeguards intended to separate insured
banking activities from securities activities and protect securities
investors from unfair practices. This report recommends actions to
improve bank regulators' oversight of bank securities activities.
As agreed with you, unless you publicly release its contents earlier,
we plan no further distribution of this report until 5 days from its
issue date. At that time, we will provide copies to interested
Members of Congress, appropriate committees, the Board of Governors
of the Federal Reserve System, the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, the Securities
and Exchange Commission, the National Association of Securities
Dealers, other interested parties, and the public.
Major contributors to this report are listed in appendix X. If you
have any questions, please call me at (202) 512-8678.
James L. Bothwell
Director, Financial Institutions
and Markets Issues
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
Numerous U.S. banks and bank holding companies are expanding into
securities activities, including retail securities brokerage services
(acting as an agent for buyers and sellers of securities), securities
underwriting (publicly distributing new issues of securities), and
securities dealing (trading securities as a principal in the
secondary market). These securities activities can provide greater
diversification and additional income for banks, a more competitive
securities industry, and added convenience for bank customers. They
may also pose additional risks to banks and new challenges to
regulators.
The adequacy of regulatory oversight of banks' securities activities
concerned the Ranking Minority Member of the House Committee on
Commerce and the Ranking Minority Member of the Subcommittee on
Telecommunications and Finance, House Committee on Commerce. They
asked GAO to
determine the extent to which banks provide securities brokerage
services and how these services are regulated;
evaluate the completeness and results of Federal Reserve
inspections of bank holding company subsidiaries that the agency
authorizes to underwrite and deal in securities; and
evaluate the Federal Deposit Insurance Corporation's (FDIC)
regulation of bank subsidiaries that can underwrite and deal in
securities.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
Congress passed the Glass-Steagall Act in 1933 in reaction to the
banking crisis of the Great Depression. The act generally prohibits
banks from underwriting and dealing in securities, except for
"bank-eligible" securities. These are limited to securities offered
and backed by the federal government and federally sponsored
agencies, and certain state and local government securities. As
banks have sought to expand their product lines, federal regulators
have provided banks, through affiliated firms, limited authority to
underwrite and deal in "bank-ineligible" securities. Banks subject
to Glass-Steagall provisions may be chartered and regulated by one or
more federal and state regulators. National banks are chartered and
regulated by the Office of the Comptroller of the Currency (OCC).
State-chartered and regulated banks are also regulated federally by
the Federal Reserve if they choose to join the Federal Reserve System
(FRS). If they do not join FRS, they are regulated by FDIC because
they are federally insured. The Federal Reserve also regulates all
bank holding companies.
In addition to restricting activities within banks, Section 20 of the
Glass-Steagall Act prohibits FRS-member banks, including all national
banks, from affiliating with firms "principally engaged" in
underwriting ineligible securities. The Federal Reserve interprets
Section 20 of the act to allow bank holding companies to establish
subsidiaries engaged in securities underwriting and dealing, as long
as the subsidiary generates no more than 10 percent of its gross
revenue from ineligible securities. The subsidiary's activities must
also be considered closely related to banking. Bank holding
companies must obtain Federal Reserve approval to establish
underwriting and dealing subsidiaries, which are known as "Section 20
subsidiaries."
In November 1994, OCC proposed to revise its rules so that
subsidiaries of approved national banks could engage in activities
impermissible for the parent bank, possibly including underwriting
and dealing in ineligible securities. OCC is considering comments on
the proposal.
The Glass-Steagall Act does not prohibit subsidiaries of
state-chartered non-FRS-member banks from engaging in securities
activities. In 1984, FDIC issued regulations setting out conditions
under which "bona fide subsidiaries" of these banks may underwrite
ineligible securities.
The Glass-Steagall Act also does not restrict bank securities
brokerage activities, which may take place either within a bank or an
affiliate. Generally, a firm that provides securities brokerage
services (known as a broker-dealer) must register with and be
regulated by the Securities and Exchange Commission (SEC). Banks,
however, are exempted from SEC registration. Consequently, brokerage
services provided directly by a bank are not subject to scrutiny by
federal securities regulators. The bank exemption does not apply to
separately incorporated bank affiliates.
Generally, bank regulators supervise banking organizations to ensure
their safety and soundness and compliance with banking laws. As part
of their supervision, the regulators are to ensure that the banking
organizations, including banks' securities affiliates, are adequately
capitalized and comply with certain operating conditions and
restrictions called "firewalls." Among other things, firewalls help
insulate banks from credit relationships and intercompany
transactions that pose risks to bank safety and soundness or
potential conflicts of interest.
Securities regulators examine and monitor the activities of
broker-dealers for compliance with securities laws and regulations,
including net capital rules. Much of this regulation is done through
self-regulatory organizations (SROs) such as the National Association
of Securities Dealers (NASD), which enforce rules of fair practice
among their members. SEC evaluates the quality of SRO oversight in
enforcing compliance with federal securities laws, including
provisions related to preventing fraudulent and manipulative
practices and protecting investors from such practices.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
About 22 percent of U.S. banks offered securities brokerage services
to their customers in 1994. SEC and NASD regulated the securities
activities of 88 percent of these 2,400 banks because they provided
these services through registered broker-dealers or through
third-party arrangements with registered broker-dealers. However,
287 banks provided these services on bank premises exclusively
through bank employees. These bank-direct brokerage operations were
subject to regulation by federal bank regulators and were exempted
from regulation by SEC and NASD. GAO found that federal bank
regulators did not always review bank-direct brokerage operations as
part of routine bank examinations. However, in 1994 bank regulators
jointly issued new guidance and examination procedures that placed
increased emphasis on such reviews.
Because some bank securities activities are overseen by securities
regulators while others are overseen by bank regulators, the
potential exists for inconsistent oversight of these activities.
This potential for inconsistent oversight has not been much of a
problem so far, because most banks provide securities services in
affiliates that are regulated primarily by securities regulators.
While the regulators have coordinated their exams, among other
things, providing consistent securities oversight, no matter where in
an organization these activities are done, would be enhanced by
increased cooperation, coordination, and sharing of regulatory
expertise among bank and securities regulators.
As of November 1994, the Federal Reserve had 35 Section 20 securities
subsidiaries to examine for compliance with firewall requirements.
GAO found that FRS examiners usually met their inspection schedules,
addressed the inspection objectives and procedures outlined in FRS
guidance, and, in general, comprehensively reviewed or tested for
compliance with applicable firewalls. However, GAO found a few cases
where full compliance with all firewalls could not be assured or was
not documented. Specifically, for 2 of the 14 subsidiary
examinations that GAO reviewed, neither Federal Reserve examiners nor
the bank internal auditors, whose work the examiners can rely upon,
had reviewed or tested all applicable firewall procedures. Also, in
two of the four FRS districts GAO visited, examiners had not always
provided sufficient documentation to determine whether they had
reviewed or tested applicable firewall procedures, especially when
examiners relied on internal auditors.
Unlike the Federal Reserve, FDIC had no centralized program to
oversee the activities of the bona fide securities subsidiaries of
state-chartered banks, and did not know how many such subsidiaries
were actually operating. FDIC also had not fully prepared its
examiners to examine securities activities because it had not
provided training and had no examination guidelines. In some cases,
FDIC examiners were confused about when subsidiaries needed to obtain
the bona fide designation. As a result, FDIC had little assurance
about the risks these subsidiaries' activities pose to affiliated
banks.
GAO'S ANALYSIS
---------------------------------------------------------- Chapter 0:4
BANK SECURITIES BROKERAGE
ACTIVITIES RAISE REGULATORY
ISSUES
-------------------------------------------------------- Chapter 0:4.1
About 2,400 banks--22 percent of nearly 11,100 banks
nationwide--offered retail securities brokerage services, according
to the results of GAO's survey of banks. Of those 2,400 banks, most
(88 percent) provided the services through registered brokerage
subsidiaries or through arrangements with nonaffiliated registered
securities broker-dealers. The remaining 287 banks, about 12
percent, provided direct brokerage services. According to survey
responses, these banks had limited their services to discount
brokerage, in which the employees of these banks took customers'
orders but did not make buy and sell recommendations.
Because the securities laws exempt banks from SEC registration and
regulation, the securities activities of the 287 banks that GAO
estimated provide direct brokerage services are regulated by bank
regulators. GAO's review of regulatory examinations of 40 of these
banks, completed during 1992 through mid-1994, showed that bank
regulators had not reviewed the brokerage operations of 29, or 72
percent, of the sampled banks.
Bank regulators have since taken steps intended to improve the
oversight of banks' direct brokerage operations. In 1994, bank
regulators issued a joint policy statement to banks on the sale of
nondeposit investment products, such as mutual funds, stocks, and
bonds. Each regulator also issued examination guidance for reviews
of bank-direct brokerage operations.
Bank and securities regulators have also acted to coordinate
examinations of most bank brokerage activities, but other regulatory
issues need to be addressed to ensure consistent regulation of all
bank brokerage activities. In January 1995, all three banking
regulators and NASD reached a formal agreement to coordinate
examinations of bank-affiliated broker-dealers and share examination
findings and workpapers. However, this agreement did not address
bank-direct brokerage operations because they are not subject to SEC
and NASD regulation. Also, bank and securities regulators' guidance
and proposed rules under which bank brokerages are expected to
operate are not consistent, and not all regulatory procedures used by
securities regulators are available to bank regulators. The lack of
consistent regulatory standards for bank-related and nonbank-related
brokerages could result in confused investors, ambiguous sales
practice standards, and inconsistent oversight of sales
representatives.
Bank regulators have provided new guidance and examination procedures
and are working to improve their oversight of bank-direct brokerage
operations. Nevertheless, providing consistent securities oversight,
no matter where in an organization these activities are done, would
be enhanced by ongoing cooperation, coordination, and sharing of
regulatory expertise among bank and securities regulators.
FEDERAL RESERVE INSPECTIONS
USUALLY ASSESS COMPLIANCE
WITH ALL APPLICABLE
FIREWALLS
-------------------------------------------------------- Chapter 0:4.2
The Federal Reserve's policy is to inspect the firewall procedures of
underwriting subsidiaries either before approving their underwriting
and dealing activities or during initial inspections after approval,
depending upon the type of underwriting powers sought. Approved
subsidiaries underwrote $59 billion of securities in 1993. As of
November 1994, 35 subsidiaries were operating with Federal Reserve
approval to underwrite and deal in certain bank-ineligible
securities.
Federal Reserve examiners may rely upon annual reviews by the bank
holding company internal auditors to assess subsidiaries' compliance
with firewall requirements. The examiners may also do their own
annual evaluations of firewall compliance by subsidiaries during bank
holding company inspections. The Federal Reserve is also to
routinely monitor the activities and financial status of the
subsidiaries.
Although the Federal Reserve's inspections GAO reviewed usually
addressed all applicable firewalls, in two instances Federal Reserve
examiners and bank holding company internal auditors did not review
all applicable firewalls. For example, in a 1993 inspection of a
large underwriting subsidiary, neither Federal Reserve examiners nor
internal auditors reviewed firewalls that restricted credit
extensions to the underwriting subsidiary and its clients and
customers or that prohibited intercompany transactions and transfers
of assets between the subsidiary and affiliated insured banks. The
Federal Reserve inspections also did not always document the extent
to which examiners or internal auditors had tested firewalls. For
example, in GAO's review of the annual inspections of six
subsidiaries, examiners said they relied on the internal auditors'
review and tests and did some selective review and tests themselves,
but the review and testing was not always documented in workpapers.
In these instances, inspection supervisors' reviews would have been
needed to ensure that all firewalls were examined and work was
properly documented in work papers.
The Federal Reserve has imposed few sanctions for firewall
noncompliance. However, it has acted to correct identified
compliance-related deficiencies through inspection close-out meetings
with bank officials and required correspondence from the banks on
actions taken to correct deficiencies.
FDIC HAD NO PROGRAM TO
ASSESS RISKS POSED BY
SECURITIES ACTIVITIES
-------------------------------------------------------- Chapter 0:4.3
FDIC requires state-chartered non-FRS-member banks that establish or
acquire bona fide subsidiaries to underwrite and deal in securities
to file notices with FDIC regional directors. FDIC then is to
examine the parent banking organizations and the subsidiaries for
compliance with FDIC regulations.
Unlike the Federal Reserve, FDIC has no centralized system to oversee
the securities activities of bank subsidiaries. Such a system could
help FDIC to identify banks that own operating subsidiaries and
assess the subsidiaries' financial condition, compliance with
firewall restrictions, and the overall risks the subsidiaries might
pose to insured banks and the Bank Insurance Fund. FDIC could not
provide accurate data on the number of banks that were using
authority granted under FDIC regulations.
FDIC officials said that underwriting and dealing in securities were
more common among larger banking organizations than among the
state-chartered nonmember banks it supervises. FDIC officials said
that examiners could identify any bona fide subsidiaries that should
be subject to its regulatory provisions through the examination
process. However, in 3 of 13 examinations GAO reviewed, FDIC
examiners were confused about the applicability of these provisions
and had to seek a legal determination from the FDIC regional
headquarters about a subsidiary's status. As of September 1994, FDIC
had no formal examiner training program that focused on oversight of
securities activities of state nonmember banks and their
subsidiaries.
Without a program to identify and routinely review the securities
activities and the financial condition and performance of bank
securities subsidiaries that are under FDIC's jurisdiction, FDIC
cannot fully assess the risks the underwriting and dealing activities
of bank subsidiaries pose to insured banks and the Bank Insurance
Fund.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5
GAO is making the following recommendations:
The Federal Reserve, FDIC, OCC, SEC, and NASD should work together
to develop and implement an approach for regulating bank-direct
securities activities that provides consistent and effective
standards for investor protection, while ensuring bank safety
and soundness.
The Chairman of the Board of Governors of the Federal Reserve
System should ensure that either Federal Reserve examiners or
internal auditors review and test all applicable firewalls at
least once annually and appropriately document the work
performed.
The Chairman of FDIC should establish a program to identify and
routinely review the securities activities and the financial
condition and performance of bona fide subsidiaries under FDIC's
jurisdiction to assess the overall risks posed by the activities
on federally insured banks and ensure compliance with firewalls.
The program should provide FDIC examiners guidance and training
on how to examine bank and bank subsidiary securities
activities.
AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6
The Federal Reserve, FDIC, OCC, SEC, and NASD provided written
comments on a draft of this report. These comments are presented and
evaluated in chapters 2, 3, and 4. The bank regulators commented
that they have already begun efforts to coordinate regulation of bank
brokerage activities with securities regulators. The securities
regulators agreed to participate in cooperative efforts but believe
that a system of functional regulation, in which each entity is
regulated according to the particular activities that it undertakes,
would provide a more effective and efficient regulatory structure.
The Federal Reserve commented that it would promptly address GAO's
findings on firewall compliance. It intends to reiterate to
examiners the need to fully inspect and document Section 20
companies' compliance with firewalls.
FDIC disagreed with GAO over the benefits of centralized monitoring
of the securities activities and financial performance of bona fide
subsidiaries of insured banks. FDIC commented that a centralized
program would create a burdensome reporting process while supervision
of those institutions would still fall on regional personnel. FDIC
said that it is considering the scope and type of examiner training
necessary for bank securities activities.
FDIC also disagreed with GAO over the need for a program to assess
the risks securities activities of bona fide subsidiaries may pose to
insured banks and ensure compliance with regulatory firewalls. It
said that such a program would create a burdensome reporting process.
GAO disagrees with FDIC's views. GAO believes that as a regulator of
federally insured banks, FDIC is responsible for knowing of and
supervising activities that may pose risks to those banks. A program
to identify and monitor the securities activities of those banks'
securities subsidiaries could improve FDIC's oversight immediately at
little extra cost. Also, because FDIC already requires banks to
notify it of subsidiaries' securities activities and has regional
supervision programs in place and because securities subsidiaries'
financial data are available from reports required by securities
SROs, a centralized program should not impose added regulatory or
reporting burden on banks.
INTRODUCTION
============================================================ Chapter 1
Since the mid-1980s, banks have been expanding into securities
activities by providing retail brokerage services--buying and selling
securities for customers, which may involve making buy and sell
recommendations--and underwriting and dealing in securities.\1 These
securities activities can provide additional income for banks and
convenience for bank customers, and they can foster a more
competitive securities industry. However, without proper management,
including internal controls, and appropriate regulatory oversight,
banking organizations that conduct such securities activities may be
subject to a heightened risk of financial losses that, if large
enough, could undermine public trust in the banking system. Also,
without proper oversight of the securities activities, investors may
not be adequately protected from fraudulent and unfair sales
practices. As a result of concerns of and issues raised by the
Ranking Minority Member of the House Committee on Commerce and the
Ranking Minority Member of the Subcommittee on Telecommunications and
Finance, House Committee on Commerce, about the expansion of banks
into securities activities, we reviewed federal bank regulators'
procedures and processes for examination and supervision of bank
securities activities.
--------------------
\1 Underwriting is the public distribution of new issues of
securities; dealing refers to the business of holding oneself out to
the public as being willing to make a secondary market in a security
by offering to buy and sell securities as principal.
BACKGROUND
---------------------------------------------------------- Chapter 1:1
Banks' expansion into securities activities presents legal and
financial risks to federally insured banks. How these risks are
managed and overseen depends on how the banks are chartered and
regulated and on how they are organized to do business. It also
depends on the securities activities the banks undertake, which may
be limited by federal law and regulation.
SECURITIES ACTIVITIES CAN
POSE LEGAL AND FINANCIAL
RISKS TO INSURED BANKS
-------------------------------------------------------- Chapter 1:1.1
Generally, the types and degree of risk that securities activities
present to banking organizations vary by type of activity. Discount
brokerage activities, in which the broker only takes orders and
executes trades for customers who make their own investment
decisions, pose little risk. Full-service brokerage activities, in
which the broker also provides investment recommendations, can pose
legal and financial risk, because the broker--including, for example,
a federally insured bank whose employees provide investment
advice--can be held liable for a customer's financial losses if those
losses result from fraudulent or unsuitable investment
recommendations. Underwriting and dealing activities generally pose
greater financial risk because the underwriter or dealer may incur
losses in the principal amount (face value) of securities being
underwritten or held.
BANKS ARE CHARTERED AND
REGULATED BY FEDERAL AND
STATE AUTHORITIES
-------------------------------------------------------- Chapter 1:1.2
A bank's power to engage in securities activities comes from the
government authority that charters the bank. In the case of a
national bank, the chartering authority is the Office of the
Comptroller of the Currency (OCC). OCC, as the primary regulator,
establishes the regulations under which national banks operate.
State authorities charter state banks. A state bank's authority to
engage in securities activities is established by the state banking
agency and governed by state law.
Two other federal agencies also have bank regulatory
responsibilities.\2 The Board of Governors of the Federal Reserve
System is the primary federal regulator of bank holding companies\3
and those state-chartered banks that choose to become members of the
Federal Reserve System (FRS). The Federal Deposit Insurance
Corporation (FDIC) is the primary federal regulator of
state-chartered banks that have federally insured deposits and are
not members of the Federal Reserve System. FDIC also administers the
Bank Insurance Fund (BIF), which provides deposit insurance for
banks. Because of this role, FDIC has back-up regulatory authority
over all insured banks.
The primary goal of federal bank regulators is to work toward
improving and maintaining the safety and soundness of banks to help
safeguard the financial system and protect depositors and other
customers. Regulators adopt policies and regulations and examine the
banks under their jurisdiction for soundness and compliance with
these policies and regulations. The Federal Reserve also inspects
bank holding companies to ascertain their financial strength and to
determine the consequences of transactions between the parent bank
holding company, its nonbanking subsidiaries, and the subsidiary
banks.
--------------------
\2 The Office of Thrift Supervision and the National Credit Union
Administration also regulate depository institutions, respectively,
thrifts and credit unions. Their activities were not within the
scope of our work because it was limited to securities activities of
commercial banks.
\3 A bank holding company is a company that controls one or more
banks. A company controls a bank if it owns, controls, or has power
to vote 25 percent or more of the voting stock of a bank, controls
the election of a majority of the bank's directors, or exercises a
controlling influence over the bank's management or policies. A bank
holding company structure allows nonbank subsidiaries to engage in a
variety of nonbanking activities that are considered closely related
to banking functions.
The largest bank in a bank holding company is typically referred to
as the lead bank and often holds most of the company's assets.
Although the Federal Reserve is responsible for inspecting all bank
holding companies, OCC or FDIC, respectively, would be responsible
for regulating the lead bank if it is a nationally chartered bank or
a state-chartered bank that is not a member of the Federal Reserve
System.
BANK AND SECURITIES
REGULATORS OVERSEE VARIOUS
BANK SECURITIES ACTIVITIES
-------------------------------------------------------- Chapter 1:1.3
Bank regulators and securities regulators both play a role in
regulating the securities activities of banks; the specific roles
they play depend on both the activities and the way banks organize
those activities. Brokerage services, for example, may be regulated
by bank or securities regulators depending upon the method the bank
uses to provide these services. Also, both bank regulators and
securities regulators are responsible for overseeing various aspects
of the underwriting and dealing activities of banking organization
subsidiaries.
The Securities Act of 1933 and the Securities Exchange Act of 1934
are the basis for securities regulation in the United States. Under
the 1934 act, firms engaged in brokering or dealing securities,
including bank securities affiliates, must register as
broker-dealers.\4 The Securities and Exchange Commission (SEC) is the
federal agency responsible for securities regulation. SEC achieves
its mission, in part, through self-regulatory organizations (SROs)
like the National Association of Securities Dealers (NASD) and the
New York Stock Exchange.\5
Basically, SEC and SROs adopt rules and regulations that the
broker-dealers must follow to protect securities investors and
provide for the maintenance of fair and orderly markets. Securities
rules and regulations require companies providing brokerage services
to have adequate capital to protect investors from the losses of
broker-dealers. Such companies are also required to implement
procedures to protect investors from unfair sales practices. The
inability of registered broker-dealers to meet obligations to retail
customers--that is, to restore the funds in retail customers'
accounts if the broker-dealers go out of business--is insured against
by the Securities Investor Protection Corporation (SIPC).\6
Securities regulators examine and monitor the broker-dealers'
activities for compliance with securities laws and regulations. SEC
also evaluates the quality of SRO oversight in enforcing compliance
with federal securities laws and SRO rules, including provisions
related to preventing fraudulent and manipulative practices and
protecting investors from such practices.
--------------------
\4 Broker-dealers combine the function of brokers and dealers.
Brokers are agents who handle public orders to buy and sell
securities. Dealers are principals who buy and sell securities for
their own accounts and at their own risk.
\5 We have reported in the past on SEC and SRO regulation of the
securities industry and broker-dealers in general, which include
registered securities affiliates of banking organizations. In those
reports we recommended various actions needed to improve regulatory
oversight of securities markets and broker-dealers and better protect
investors. See, for example, Securities Industry: Strengthening
Sales Practice Oversight (GAO/GGD-91-52, Apr. 25, 1991); Securities
Investor Protection: The Regulatory Framework Has Minimized SIPC's
Losses (GAO/GGD-92-109, Sep. 28, 1992); Penny Stocks: Regulatory
Actions to Reduce Potential for Fraud and Abuse (GAO/GGD-93-59, Feb.
3, 1993); and Securities Markets: Actions Needed to Better Protect
Investors Against Unscrupulous Brokers (GAO/GGD-94-208, Sep. 14,
1994).
\6 SIPC, a private, nonprofit membership corporation established by
Congress in 1970, provides certain financial protections to the
customers of failed U.S. broker-dealers. In 1992 we reported that
SIPC had been successful at protecting investors and noted that
SIPC's success was derived from SEC's and SROs' diligent oversight of
the securities industry. See Securities Investor Protection: The
Regulatory Framework Has Minimized SIPC's Losses (GAO/GGD-92-109,
Sep. 28, 1992).
BROKERAGE ACTIVITIES MAY
BE REGULATED BY
SECURITIES OR BANK
REGULATORS
------------------------------------------------------ Chapter 1:1.3.1
As shown in table 1.1, securities regulators are responsible for
regulating a bank's brokerage services when a bank provides these
services to its customers through (1) a registered securities
brokerage affiliate; or (2) an arrangement with an unaffiliated
registered third-party broker-dealer, whether the services are
provided on or off bank premises. When these services are provided
on the bank's premises by bank employees or through a bank affiliate,
bank regulators may examine the brokerage activities. Bank
regulators have no direct authority over unaffiliated, third-party
broker-dealers, even when they operate on bank premises. However,
the federal banking agencies' "Interagency Statement on Retail Sales
of Nondeposit Investment Products," February 15, 1994, requires that
a bank's agreement with a third-party broker-dealer authorize the
appropriate banking agency to have access to all records of the
third-party broker as are necessary or appropriate to evaluate
whether the third-party broker is complying with the terms of its
agreement. Bank regulators generally address safety and soundness
concerns and compliance with applicable laws, regulations, and
supervisory guidance, while securities regulators generally address
investor protection concerns and compliance with securities laws and
regulations.
Banks that exclusively use their own employees, rather than an
affiliated company, to provide securities brokerage services to
retail customers are exempt from registration and regulation as
broker-dealers under the 1934 securities exchange act. The exemption
means that these activities are outside the normal securities
regulatory framework. However, the antifraud provisions of the
federal securities laws still apply. Further, banking regulations
require banks providing such direct securities brokerage services to
keep records and provide customers confirmations of securities
transactions. Also, the securities brokerage activities of these
banks are not SIPC-insured, unless the bank customers are also
identified as customers of an SEC-registered broker-dealer through
which the bank places customers' orders for execution.
Table 1.1
Bank Methods of Providing Retail
Brokerage Services and Resulting
Regulatory Responsibilities
Method Regulatory responsibility
---------------------------------- ----------------------------------
Off bank premises, either through Securities regulators. Bank
registered securities brokerage regulators also can examine
affiliate or an arrangement with activities of bank affiliates.
an unaffiliated registered third-
party broker-dealer.
On bank premises through a Bank and securities regulators.
registered securities brokerage
affiliate.
On bank premises through a third- Securities regulators. Bank
party arrangement with an regulators have no direct
unaffiliated registered broker- authority over unaffiliated
dealer. broker-dealers. A bank's agreement
with an unaffiliated broker-
dealer is required to provide
regulators access to records of
the unaffiliated broker-dealer.
On bank premises through bank's Bank regulators.
own employees.
----------------------------------------------------------------------
Source: GAO Analysis
AFFILIATES THAT
UNDERWRITE AND DEAL IN
SECURITIES ARE REGULATED
BY BOTH BANK AND
SECURITIES REGULATORS
------------------------------------------------------ Chapter 1:1.3.2
Banking organizations' securities underwriting and dealing activities
are subject to regulation by both bank and securities regulators.
Bank regulations require that a bank holding company and its
subsidiaries that underwrite and deal in securities meet certain
financial conditions and have regulatory limitations called firewalls
in place and functioning to protect insured banks and bank customers
from any possible losses of an underwriting affiliate. Bank
regulators examine the underwriting subsidiaries for both their
overall financial condition and compliance with firewalls.
Securities regulators oversee and examine the same subsidiaries for
compliance with securities laws and SEC and SRO regulations and
rules.
Firewalls are policies and procedures that separate the activities of
banks from their affiliated companies that underwrite and deal in
securities. These devices are meant to insulate insured banks from
any possible losses of the underwriting affiliate. Firewalls also
serve to minimize conflicts of interest.
BANKS ARE NOT PROHIBITED
FROM PROVIDING RETAIL
BROKERAGE SERVICES
-------------------------------------------------------- Chapter 1:1.4
Banks have never been prohibited by federal law or regulation from
providing customers with retail securities brokerage services and
associated investment advisory services. Nevertheless, bank retail
brokerages did not become common until after the mid-1980s, when OCC
issued a statement that generally granted national banks approval to
provide retail brokerage services. The Federal Reserve also issued a
statement approving bank holding companies' provision of retail
brokerage services.
After these statements were issued, banks began to request and
receive approval from the regulators to provide retail brokerage
services. At the time of our review, banks' retail securities
brokerage services included the buying and selling of securities,
such as stocks, bonds, and mutual funds, which bank regulators refer
to as "nondeposit investment products."
BANKING ORGANIZATIONS CAN
UNDERWRITE AND DEAL IN
SECURITIES ONLY UNDER
CERTAIN CONDITIONS
-------------------------------------------------------- Chapter 1:1.5
The Banking Act of 1933, commonly known as the Glass-Steagall Act,
restricts banks and bank-affiliated companies in many underwriting
and dealing activities. The act allows banks and companies
affiliated with a bank\7 to underwrite and deal in certain types of
securities known as bank-eligible securities. These include U.S.
government and federally sponsored agency securities and general
obligation bonds of states and municipalities. Underwriting and
dealing in other types of securities--known as bank-ineligible
securities--are subject to specific restrictions.
The Glass-Steagall Act was enacted in reaction to the banking crisis
of the Great Depression, during which many banks failed and customers
lost confidence in the banking system. Basically, the act separates
commercial and investment banking in an effort to enhance the safety
and soundness of commercial banking and protect bank customers from
potential conflict-of-interest abuses and other inequities.\8 The
Glass-Steagall Act prohibits banks from underwriting and dealing in
bank-ineligible securities--that is, municipal revenue bonds, private
mortgage-backed securities, commercial paper, asset-backed
securities, and corporate equity and debt securities (stocks and
bonds). More specifically:
Section 16 of the act prohibits a national bank from underwriting
and dealing in bank-ineligible securities.
Section 20 of the act prohibits a Federal Reserve member bank from
becoming affiliated with any company that is "principally
engaged" in the underwriting, sale, or distribution of
bank-ineligible securities.
Section 21 of the act prohibits any person or company engaged in
the business of underwriting, selling, and distributing
bank-ineligible securities from engaging in the business of
receiving deposits.
Section 32 of the act governs interlocking relationships by
prohibiting directors, officers, or employees of member banks
from serving as directors, officers, or employees of any
institution primarily engaged in underwriting and dealing in
securities.
The Federal Reserve Act subjects state-chartered banks that belong to
the Federal Reserve System to the same underwriting and dealing
restrictions as national banks. Although Section 21 of the
Glass-Steagall Act in effect prohibits state-chartered banks that are
not FRS members from directly underwriting and dealing, they are not
subject to Glass-Steagall restrictions on affiliations and, if not
prohibited by state law, may affiliate with securities firms.
However, bank holding companies that own state nonmember banks must
obtain the Federal Reserve's approval under the Bank Holding Company
Act before acquiring any underwriting subsidiary.
Until recently, OCC interpreted the restrictions on national bank
securities activities to apply to both banks and any subsidiary of
the bank. OCC, however, changed this interpretation in November
1994, when it submitted a proposal to revise its rules governing
corporate applications. The proposal would set up a process for OCC
to consider applications from individual national banks to pursue new
activities, including securities underwriting, through establishment
of operating subsidiaries. OCC formerly prohibited bank subsidiaries
from activities impermissible for the parent banks. According to
OCC, applications would be considered on a case-by-case basis. OCC
is considering comments on the proposal.
--------------------
\7 A bank becomes affiliated with a securities underwriting firm when
(1) the company that owns the bank also owns the securities firm, (2)
the securities firm owns the bank, or (3) the securities firm is a
subsidiary of the bank.
\8 An example of an inequity that could result if banks were allowed
unrestricted securities activities would be banks' favoring loan
requests of customers and clients of their securities business over
those of other bank customers.
SECTION 20 SUBSIDIARIES
------------------------------------------------------ Chapter 1:1.5.1
In addition to restricting activities within banks, Section 20 of the
Glass-Steagall Act prohibits Federal Reserve member banks--all
national banks and state banks that choose to become members--from
affiliating with an institution principally engaged in underwriting
securities. The Federal Reserve interprets the prohibition to allow
banks owned by holding companies to affiliate with institutions
engaged in securities underwriting and dealing so long as the
activity involving bank-ineligible securities generates 10 percent or
less of the affiliate's gross revenue. The 10-percent threshold
signifies that the bank-ineligible activity is not a principal
activity of the institution. The companies that the Federal Reserve
has approved to underwrite and deal in bank-ineligible securities are
known as Section 20 subsidiaries. Generally, the principal business
of these subsidiaries is underwriting and dealing in bank-eligible
securities.
Other financial and operating conditions must also be met before a
Section 20 subsidiary may be established by a bank holding company.
As described in further detail in chapter 3, the company must meet
the following criteria:
It must be adequately capitalized.
It must be approved for such activities by the Federal Reserve
Board.
It must register with SEC as a broker-dealer and be a member in
good standing of NASD.
It must comply with certain operating conditions and firewalls.
BONA FIDE SUBSIDIARIES
------------------------------------------------------ Chapter 1:1.5.2
Although Section 21 of the Glass-Steagall Act has the effect of
prohibiting a state-chartered non-FRS-member bank from underwriting
securities, the prohibition does not extend to the bank's
subsidiaries. In 1984, FDIC issued regulations\9 setting out
conditions under which insured state banks that are not Federal
Reserve members can establish subsidiaries to engage in the sale,
distribution, and underwriting of bank-ineligible securities. These
subsidiaries are known as bona fide subsidiaries.
Unlike the Federal Reserve, FDIC does not require non-FRS-member
banks to obtain advance approval from FDIC headquarters to establish
bona fide subsidiaries. However, any nonmember bank that wants to
establish such subsidiaries is required to notify the Regional FDIC
director of its intentions. Otherwise, bona fide subsidiaries must
meet conditions similar to those required of Section 20 subsidiaries.
As discussed in further detail in chapter 4, the company must meet
the following criteria:
It must be adequately capitalized.
It must register with SEC as a broker-dealer and be a member in
good standing of NASD.
It must comply with operating conditions and restrictions that are
similar to the firewalls that the Federal Reserve requires of
bank holding company subsidiaries.
--------------------
\9 12 CFR Section 337.4.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:2
As a result of the requesters' concerns and issues raised about the
regulation of banking organizations' expansion into securities
brokerage, underwriting, and dealing activities, we reviewed (1) bank
regulators' procedures and processes for examining and supervising
banks that provide brokerage services directly by bank employees and
(2) banking organizations' securities underwriting and dealing
activities. Our objectives were to assess
the extent to which banks provide securities brokerage services and
how these services are regulated;
the Federal Reserve's supervision of bank holding company
subsidiaries that the agency authorizes to underwrite and deal
in securities, including the completeness and results of its
inspections; and
FDIC's regulation of bona fide subsidiaries that underwrite and
deal in securities.
We also sought to provide information on training available to bank
examiners on brokerage and other securities activities.
The scope of our work was limited to banking organizations'
securities activities that are subject to Federal Reserve, OCC, and
FDIC regulation. We have reported in the past on SEC and SROs'
regulation of the securities industry and broker-dealers in general,
which include registered securities subsidiaries of banking
organizations. This report does not address other bank securities
activities, including banks' holding securities as proprietary
investments, which they can trade; banks' management of trusts or
serving as investment advisers to mutual funds; and banks' activities
as registered government and municipal securities dealers. Also, it
was not within the scope of our work to determine comparative degrees
of risk associated with different types of investment products or the
various banking and nonbanking activities that banks might engage in.
We obtained information on regulatory programs from officials of
federal bank regulatory agencies, reviewed agency documents and
examination files, and surveyed a sample of banks. To evaluate bank
regulators' oversight of bank-direct brokerage operations we obtained
from OCC, the Federal Reserve, and FDIC, respectively, guidance for
examining brokerage operations and nonbanking activities of national,
state FRS-member and state non-FRS-member banks and bank
subsidiaries. We reviewed regulatory examinations of banks
identified as having bank-direct brokerage operations to determine if
the brokerage operations were examined as directed by the guidance.
We identified banks that provided brokerage services directly by the
bank from our survey of banks' securities and mutual fund activities
(see ch. 2).
We obtained information on the Federal Reserve's supervision of
underwriting subsidiaries of bank holding companies from Federal
Reserve officials. We reviewed the two most recently completed
inspections, usually from 1992 and 1993, of the underwriting
subsidiaries in four Federal Reserve Districts--Chicago, New York,
Richmond, and San Francisco--to determine if the inspections were
conducted as directed by Federal Reserve guidance on the inspection
of nonbank subsidiaries engaged in underwriting and dealing. The
four districts were selected because they provided a mix of banking
organizations and subsidiaries, including money center banks, large
regional organizations, and foreign-owned subsidiaries. They also
were located near our headquarters and regional offices.
We obtained information on regulation of securities activities
conducted by national banks and their securities affiliates from OCC
officials. We also reviewed examinations and interviewed examiners
of national banks affiliated with underwriting subsidiaries to
determine if their examinations included procedures to review
prohibited interaffiliate transactions between a national bank and an
underwriting affiliate.
We obtained information on regulation of nonmember state-chartered
banks' securities activities from FDIC officials. In addition to our
review of bank-direct brokerage operations, we also reviewed and
selected recent examinations of banks identified by FDIC as having
bona fide subsidiaries meeting the criteria for underwriting and
dealing in securities.
The three bank regulators also provided us information related to the
training of bank examiners on banks' securities activities.
To develop information on the extent to which banks are providing
brokerage services to retail customers and how those services are
being provided, we surveyed a stratified random sample of 2,233 banks
that is projectable to a nationwide universe of about 11,100
commercial banks. Our survey sample, described in appendix VIII,
included Federal Reserve member, nationally chartered, and
state-chartered banks of varying sizes. We conducted the survey
because data on banks' securities activities that are compiled by
bank regulators and industry groups did not capture the information
we sought on banks' involvement in securities brokerage and mutual
fund activities.
Our work was performed at the Board of Governors of the Federal
Reserve System, OCC, and FDIC in Washington, D.C.; in the Federal
Reserve's Chicago, New York, Richmond, and San Francisco districts;
and in OCC's and FDIC's Atlanta, Chicago, New York, and San Francisco
regions. We conducted our audit work between May 1993 and September
1994 in accordance with generally accepted government audit
standards. We obtained comments on a draft of the report from the
Federal Reserve, FDIC, OCC, SEC, and NASD. Their comments are
presented and evaluated in chapters 2, 3, and 4 and are reprinted in
appendixes III, IV, V, VI, and VII.
BANKS' SECURITIES BROKERAGE
ACTIVITIES RAISE REGULATORY ISSUES
============================================================ Chapter 2
Our survey of banks showed that the securities activities of most
banks are regulated by SEC. The survey also showed that an estimated
287, about 12 percent, of the estimated 2,400 banks that provide
securities brokerage services provide those services on bank
premises, exclusively through bank employees. We refer to these as
bank-direct brokerage operations. Because banks are exempt from
securities regulation, as noted in chapter 1, the securities
brokerage activities of these banks are regulated by bank regulators.
In the past, bank regulators did not always review the bank-direct
brokerage operations as part of bank examinations, but they issued
new guidance and examination procedures in 1994 that have increased
emphasis on such reviews. Nevertheless, exempting the securities
activities of these banks from securities regulation results in
parallel, though different, regulatory systems for the same activity.
MANY BANKS PROVIDE RETAIL
SECURITIES BROKERAGE SERVICES
---------------------------------------------------------- Chapter 2:1
To determine the number of banks providing bank-direct and other
brokerage services and to gather data about the nature of services
provided, we surveyed a sample of over 2,200 banks nationwide.
Appendixes VIII and IX provide technical information about the survey
and the questionnaire we used.
On the basis of the results of our survey, we estimate that about
2,400 banks offered retail securities brokerage services as of June
1994. This represents about 22 percent of the 11,084 banks that we
estimated were in the United States at the time of our survey.\1
Figures 2.1 through 2.3 show by size, type, and region the percent of
all banks that offered brokerage services. For example, figure 2.1
shows that the larger the bank, the greater the likelihood that it
provided securities brokerage services to retail customers.
Figure 2.1: Estimated Percent
of All Banks and Banks in Each
Size Category Offering Retail
Securities Brokerage Services
(See figure in printed
edition.)
Source: GAO survey.
Figures 2.2 and 2.3 show the percentages of banks by type and region
of the United States that provide securities brokerage services.
Figure 2.2: Estimated Percent
of All Banks and Banks of Each
Type Offering Retail Securities
Brokerage Service
(See figure in printed
edition.)
Source: GAO survey.
Figure 2.3: Estimated Percent
of All Banks and Banks in Each
Region Offering Retail
Securities Brokerage Services
(See figure in printed
edition.)
Source: GAO survey.
Of the estimated 2,400 banks that offered retail securities brokerage
services, 27 percent provided full-service brokerage services, 52
percent provided discount brokerage services, and 21 percent provided
accommodation brokerage services.\2 Except for banks operating in the
West, we found similar patterns in the type of securities brokerage
services banks offered by size, type of bank, and regional location,
as shown in figures 2.4 through 2.6. We also found that larger banks
and banks operating in the West were more likely to offer
full-service retail brokerage services.
Figure 2.4: Type of Brokerage
Services Offered by Banks That
Provide Securities Services in
Each Size Category
(See figure in printed
edition.)
Note: Percentages may not add to 100 percent bacause of rounding.
Source: GAO survey.
Figure 2.5: Type of Brokerage
Services Offered by Banks That
Provide Securities Services by
Type of Bank
(See figure in printed
edition.)
Source: GAO survey.
Figure 2.6: Type of Brokerage
Services Offered by Banks That
Provide Securities Services by
Region
(See figure in printed
edition.)
Source: GAO survey.
--------------------
\1 The sampling errors for the weighted estimates from our survey are
no more than plus or minus 5 percent unless otherwise noted. The
number of banks shown differs from the number, 11,210, shown in app.
VIII, table VIII.1, because we estimated 126 banks in the original
population were ineligible for our survey because they had ceased to
operate as financial institutions.
\2 In our survey of banks, we defined full-service brokerage as
offering investment advice and/or buy and sell recommendations in
conjunction with executing customer buy and sell orders, discount
brokerage as acting solely as an agent in executing customer buy and
sell orders, and accommodation brokerage as placing buy and sell
orders as a service only when requested by a customer or to
facilitate other transactions.
MOST BANK BROKERAGE SERVICES
WERE PROVIDED THROUGH
SUBSIDIARIES AND THIRD-PARTY
ARRANGEMENTS
---------------------------------------------------------- Chapter 2:2
As table 2.1 shows, 12 percent of the banks that offered securities
brokerage services (287 banks, or about 3 percent of banks
nationwide) provided only bank-direct brokerage services. The
remaining 88 percent of banks that provided securities brokerage
services did so through an SEC-registered securities broker-dealer.
Securities brokerage services at some of these banks were provided in
a variety of ways. As a result, some banks responding to our survey
provided multiple responses to describe securities brokerage
services. Table 2.1 shows the various ways in which banks provide
securities brokerage services to retail customers.
Table 2.1
How Banks Provide Retail Securities
Brokerage Services to Their Customers
(Multiple responses allowed)
Bank
response
s
(percent
Services provided )
------------------------------------------------------------ --------
Customer orders taken directly by employees of the bank only 12
Through a leasing or networking agreement\a with a 35
registered broker-dealer
Bank employee referral of customers to registered broker- 39
dealers and/or other arrangements involving a registered
broker-dealer
Through registered affiliate or subsidiary broker-dealer 42
Using dual employees\b of the bank and a registered broker- 44
dealer
----------------------------------------------------------------------
\a A leasing or networking agreement is an arrangement between a bank
and a registered broker-dealer to offer brokerage services to
customers on bank premises. These arrangements can involve either
affiliated or unaffiliated broker-dealer firms.
\b An arrangement in which a registered broker-dealer uses bank
employees and premises to sell securities and in return makes a
monthly payment to the bank. The dual employees can be paid
incentive bonuses in addition to a fixed salary.
Source: GAO survey.
To validate questionnaire responses and determine how banks handle
brokerage transactions, we contacted all 46 banks that responded to
our survey by April 15, 1994, indicating that they provided
bank-direct brokerage services. Officials of six banks said their
employees either referred customers directly to an unaffiliated
registered broker-dealer or provided brokerage services through a
registered broker-dealer subsidiary. Officials of the remaining 40
banks confirmed that they provided bank-direct brokerage
services--that is, services at the bank premises and exclusively
through bank employees. According to officials from these 40 banks,
designated bank employees take customer-initiated orders to buy or
sell investment products, which the bank refers to unaffiliated
registered broker-dealers for execution and confirmation.
After April 15, 1994, 25 additional banks responded to our survey and
indicated that they provided bank-direct brokerage services. The
size, type, and location of these additional banks appeared similar
to the characteristics of the 40 banks we had identified earlier as
providing bank-direct brokerage services. We did not gather
additional information on how these 25 additional banks handled their
retail securities brokerage operations because we had no reason to
expect their responses would be different from the responses we
received from the initial 46.
Follow-up discussions with the 40 banks that provided bank-direct
brokerage services indicated that most were not handling large
volumes of brokerage transactions. Officials of 16 of those banks
said that they processed fewer than 10 transactions per month, 14
said 10 to 25 per month, and 10 said more than 25 per month. An
official from 1 of the 40 banks said the bank also offered investment
advice to retail customers. However, the investment advice was
offered only to retail customers interested in the bank's mutual fund
sales program. The official from this particular bank said the bank
also operated a separate brokerage unit to provide discount brokerage
services to customers interested in buying or selling other
securities products, such as stocks, bonds, and U.S. Treasury
securities.
BANK REGULATORS ARE WORKING TO
IMPROVE REVIEWS OF BANK-DIRECT
BROKERAGE OPERATIONS
---------------------------------------------------------- Chapter 2:3
Bank regulators' responsibilities for examining bank-direct brokerage
operations are defined by regulations and supervisory guidance.
Before 1994, under the old guidance, bank regulators did few
examinations of bank-direct brokerage operations. In 1994, federal
bank regulators issued new joint guidance and examination procedures
for brokerage operations on bank premises. It is too early too tell
how frequently examinations will be done or how effective bank
examiners will be at examining brokerage operations under the new
guidance and examination procedures. Examination of brokerages
traditionally has been the responsibility of securities regulators.
Further, not all bank examiners are trained to examine bank
securities activities.
BEFORE 1994, BANK REGULATORS
DID FEW EXAMINATIONS OF
BANK-DIRECT BROKERAGE
OPERATIONS
-------------------------------------------------------- Chapter 2:3.1
Bank regulators' responsibilities to monitor banks activities,
including bank-direct brokerage activities, although not explicitly
stated, are defined generally by the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA) (P.L. 102-242). The
act, as amended in 1994, requires federal bank regulatory agencies to
perform a full-scope, on-site examination at least once a year for
each insured depository institution with assets greater than $250
million.\3 The purpose of these examinations is to ensure that
effective internal controls are in place and operating as intended to
protect the safety and soundness of the bank. The examinations are
to cover all factors relevant to the safe and sound operation of the
bank--including nonbanking activities conducted on bank premises,
such as bank-direct brokerage services. However, federal securities
regulators told us that bank regulatory oversight is not equivalent
to oversight by securities regulators because federal banking
statutes and regulations do not comprehensively address sales
practice issues, nor do they impose an explicit duty to supervise
bank securities sales personnel. In addition, they said bank
securities customers have no formal avenue of redress for complaints.
Regulatory responsibilities related to bank-direct brokerage
activities are further defined by guidance that each bank regulator
has issued on nonbanking activities, including securities brokerage
activities. During 1993, each of the three bank regulators
individually issued agency guidance that instructed examiners to
focus on the sale of nondeposit investment products on bank premises
as part of routine bank examinations.\4
Despite the requirements of FDICIA and existing agency guidance, many
bank-direct brokerages were not reviewed during on-site examinations
completed in the period 1992 through mid-1994. The results of our
review of examinations completed in that period showed that 28 (72
percent) of 39 bank-direct brokerages that should have been reviewed
were not. (We excluded one FDIC-regulated bank from this analysis
because it responded that it provided minimal accommodation brokerage
services.) Because these bank-direct brokerages are exempt from SEC
and NASD regulation and they were not reviewed by bank regulators,
they were operating without any federal oversight. Table 2.2 shows
the number of bank-direct brokerages, out of the 40 we reviewed, that
bank regulators have examined.
Table 2.2
Bank-Direct Brokerage Operations
Examined by Bank Regulators in the
Period 1992 Through Mid-1994
Banks with
examinations that
included a review
Banks with bank- of bank-direct
direct brokerage brokerage
Bank regulators operations operations
------------------------------ ------------------ ------------------
FDIC 18 3
Federal Reserve 4 1
OCC 17 8
======================================================================
Total 39 12
----------------------------------------------------------------------
Source: GAO analysis.
--------------------
\3 State regulatory examinations can be substituted in alternate
years for state-chartered banks, and longer examination periods--18
months--can be used for banks with less than $250 million in assets
that previous examinations have shown to be well-capitalized and
well-managed.
\4 FRB notice to Officers-in-Charge of Supervision at each federal
reserve bank on the separation of mutual fund sales activities from
insured deposit-taking activities (June 17, 1993) (SR 93-35 (FIS));
OCC Banking Circular 274, issued July 19, 1993 (NR 93-77); FDIC
Statement on State Nonmember Bank Sales of Mutual Funds and
Annuities, issued October 8, 1993 (FIL-71-93).
BANK REGULATORS HAVE ISSUED
NEW GUIDANCE ON BANK-DIRECT
BROKERAGE OPERATIONS
-------------------------------------------------------- Chapter 2:3.2
Banking regulators recently took steps to improve their oversight of
bank-direct brokerage operations. On February 15, 1994, federal bank
regulators issued a joint policy statement on the sale of nondeposit
investment products on the premises of insured banking institutions.
This new guidance addresses investor protection issues, such as sales
practices and suitability,\5 use of information about customers, and
consumer disclosure and advertising requirements for the retail sale
of mutual funds and other securities products on bank premises. The
new guidance applies to retail recommendations and sales of
nondeposit investment products made by (1) employees of a banking
organization, (2) employees of an affiliated or unaffiliated third
party operating on the premises of the banking organization, and (3)
sales resulting from a referral of retail customers by the
institution to a third party when the depository institution receives
a benefit for the referral. The purpose of the guidance is to
minimize the possibility of customer confusion and to safeguard the
institution from liability under antifraud provisions of the federal
securities laws.
The Federal Reserve, FDIC, and OCC have taken steps to review for
compliance with this guidance as part of their routine
safety-and-soundness examinations. Although the new guidance does
not have the same force as a federal statute or bank regulation,
federal bank regulators have informed the various banking
organizations under their jurisdiction that, as appropriate, a review
for compliance with the joint agency guidance will be included in
routine bank examinations. For example, OCC said that it directed
examiners to include a review of nondeposit investment product sales
activities in all bank safety and soundness examinations. All three
bank regulators have developed detailed examination procedures for
their examiners to use in reviewing securities sales activities of
banks during routine examinations. The examination procedures
address investor protection concerns, such as advertising,
suitability of investments recommended, and sales practices.
--------------------
\5 Suitability refers to the matching of customer financial means and
investment objectives with a suitable product.
INFORMATION ON TRAINING
PROVIDED TO BANK EXAMINERS
FOR OVERSIGHT OF BANK
SECURITIES ACTIVITIES
-------------------------------------------------------- Chapter 2:3.3
FDICIA requires federal bank agencies to periodically review and
provide training to their examiners to ensure frequent, objective,
and thorough examinations of federally insured banking institutions.
The Federal Reserve, FDIC, and OCC provide bank examiners with
guidance on overseeing bank securities activities. Bank examiners at
the Federal Reserve and OCC also receive formal training that
addresses oversight of bank and bank subsidiaries' securities
activities, including the joint agency guidance. However, as of
September 1994, FDIC had no formal examiner training program that
focused on oversight of securities activities of state nonmember
banks and their subsidiaries.
THE FEDERAL RESERVE AND
OCC PROVIDE EXAMINER
TRAINING ON BANK
SECURITIES ACTIVITIES
------------------------------------------------------ Chapter 2:3.3.1
Federal Reserve examiners may receive training related to bank
securities activities through specialized seminars and training
courses. For example, Federal Reserve examiners can attend a
securities market seminar. This 2- to 3-day seminar covers relevant
securities and banking laws governing bank securities activities as
well as retail securities brokerage activities within the bank.
Seminar topics include inequitable and unfair sales practices,
insider trading, customer account recordkeeping and confirmation
requirements, firewall requirements (discussed in chapters 3 and 4),
SEC and SRO oversight functions, and other related topics. In
addition, the Federal Reserve recently developed an examiner training
course on the joint regulatory guidance on retail sale of nondeposit
investment products in the bank.
OCC examiners receive specialized training through conferences,
seminars, and courses. In December 1992, OCC offered examiners a
conference that included a session on risks banks take in selling
mutual funds and annuities. This conference included a discussion of
suitability issues.\6 In September 1993, OCC offered examiners a
3-day seminar on bank sales of mutual funds and nondeposit investment
products. In addition, OCC's 1993 course catalog also lists various
examiner training opportunities related to bank securities
activities. An OCC Capital Markets Expert Seminar covered a range of
capital markets topics, including bank dealer, trading, and retail
brokerage activities. Another OCC course covered fundamental
concepts and terminology of the securities business. It explained
the processes and procedures used in issuing, transferring, and
regulating securities and presented an overview of securities
industry operations and the basic industry components. A course
entitled "Bank Securities Dealers" was designed to enable OCC
examiners to identify potentially unsafe and unsound practices for
sales of municipal securities. Another OCC examiner course focused
on the potential effects of transactions between banks and affiliates
and related organizations. According to OCC, training relevant to
examining bank securities activities was also provided in each of its
six district offices and those examiners, in turn, provided the
training to examiners in other offices across the country.
--------------------
\6 Consistent with NASD's Rules of Fair Practice, bank regulators
expect banks to determine whether a product being recommended is an
appropriate investment for the customer. Banks are instructed to
ensure that any salesperson involved in bank-related sales obtains
sufficient information from a customer to enable the salesperson to
make a judgment about the suitability of any recommendations to the
customer.
FDIC PROVIDES NO FORMAL
EXAMINER TRAINING ON BANK
SECURITIES ACTIVITIES
------------------------------------------------------ Chapter 2:3.3.2
FDIC provided no extended formal training to its examiners on
oversight of bank securities brokerage and underwriting activities.
FDIC's examiner training on these subjects was limited to briefings
on changes in regulations, a lecture on bank relationships with
broker-dealers, and on-the-job examiner training. FDIC officials
said that FDIC's primary focus is to oversee the safety and soundness
of banks--not the sales practices of bank securities subsidiaries,
which are subject to oversight by securities industry regulators.
However, FDIC is responsible for regulatory oversight of bank-direct
brokerage activities of banks under FDIC's jurisdiction. Such
brokerages are exempt from oversight of securities regulators.
In April 1994, FDIC provided examiners with specific examination
procedures for examinations of bank-direct brokerage activities;
however, the agency provides no similar guidance for examinations
related to securities underwriting activities. In the absence of
such aids and a formal training program, FDIC examiners are
instructed to use FDIC's regulation for bona fide subsidiaries as
guidance, along with their professional judgment, in examining
banking organizations for compliance with the FDIC firewall
provisions that apply to bank securities underwriting activities.
FDIC officials said that despite the lack of formal training programs
to address bank securities underwriting and brokerage activities,
they were confident that their examiners could assess the impact of
banks' securities activities on the safety and soundness of state
nonmember banks.
BANK AND SECURITIES REGULATORS
CAN COOPERATE TO MAKE OVERSIGHT
OF BANK-DIRECT BROKERAGE
OPERATIONS MORE CONSISTENT
---------------------------------------------------------- Chapter 2:4
Under the current regulatory structure, either bank or securities
regulators may oversee the securities activities of banks, depending
on how banks organize the activities. Therefore, to ensure that
customers who invest in securities are treated fairly, bank and
securities regulators must work closely together to share
information, coordinate rules, and provide consistent examinations.
Otherwise, securities investors can be exposed to inconsistent sales
practices by sales representatives having different levels of
training and experience. Although bank and securities regulators
have cooperated well on some activities, other opportunities for
cooperation exist that could provide more consistent regulation of
bank securities activities.
On occasion bank and securities regulators have worked together. For
example, during 1994 bank regulators sought the assistance of SEC and
NASD officials and examiners in developing new guidance and in
developing and pilot-testing examination procedures. Also during
1994, the Federal Reserve and NASD agreed to coordinate examinations
of bank brokerage affiliates. In January 1995, all three banking
regulators and NASD reached a formal agreement to coordinate
examination schedules of bank-affiliated broker-dealers and share
examination findings and workpapers. Further, securities regulators
and bank regulators told us that they are discussing various
proposals to extend securities industry qualifications testing and
registration to bank employees who are engaged in bank-direct
securities activities. The testing and registration process is to be
backed by examination, enforcement, and disciplinary functions
designed to be identical to those in place for the securities
industry. Bank and securities regulators expect to resolve this
issue within the next several months. SEC has also contacted the
bank regulators to propose development of a common approach to
eliminating the payment of referral fees to nonregistered employees
of financial institutions.
Despite such cooperative efforts, differences in approaches to and
procedures for regulating bank brokerage operations persist. For
example, the interagency guidance sets forth standards for registered
broker-dealers that differ, in some respects, from federal securities
laws and regulations. These differences were highlighted when, in
December 1994, NASD released for comment proposed rules governing
securities broker-dealers operating on bank premises. The proposed
NASD rules prohibit the payment of referral fees by the broker-dealer
to nonregistered bank employees. Referral fees are permitted by the
interagency guidance, provided that they are one-time nominal fees of
a fixed-dollar amount and not contingent on the referral resulting in
a transaction. The proposed rules also place stricter controls than
the interagency guidance on the broker's use of confidential bank
customer financial information, such as certificate of deposit
maturity dates and balances, for soliciting sales of securities.
Also, the proposed NASD rules place stricter limits on the use of
bank logos in advertising materials for securities than the
interagency guidance.
NASD's proposed rules have generated controversy in the banking
industry. According to the financial press, some bankers have
complained that the rules hold bank brokerages to standards that are
higher than for nonbank brokerages. For example, they note that,
unlike bank brokerages, nonbank brokerages are not required to
disclose that mutual funds are not federally insured. An NASD
official responded that when a customer deals with a brokerage in a
bank, that brokerage has a higher responsibility to ensure that the
customer understands the risk involved in investing in securities as
compared to savings accounts or certificates of deposit. According
to NASD, its proposed rules\7 seek consistent treatment of affiliated
and networking (third-party) broker-dealers. Further, NASD said the
banking guidelines established by the Interagency Statement do not
have the force and effect of law and cannot support disciplinary
actions against broker-dealers. Both the Interagency Statement and
the proposed NASD rules, however, require written acknowledgement of
the disclosure of risks associated with investment products sold in
banks. The Interagency Statement is more comprehensive in that it
also requires oral disclosure at any sales presentation or offering
of investment advice.
Additional cooperative efforts among bank and securities regulators
could help make regulation more uniform and consistent by making
information and regulatory procedures used by securities regulators
available to bank regulators. For example, NASD and state securities
regulators maintain the Central Registration Depository (CRD), a
database containing background and disciplinary information on
broker-dealers and individual sales representatives.\8 In our
September 1994 report and testimony before the congressional
oversight committee\9 we recognized that the CRD information, after
system design limitations are corrected, could be a useful regulatory
tool for controlling the migration of unscrupulous persons among
sectors of the financial services industry. We recommended that SEC,
the Treasury Department, and other regulators work together to
increase disclosure of the CRD information among the various
regulators of financial services. Those regulators have begun
actions to increase disclosure.\10 According to the Federal Reserve,
banking and securities regulators are developing a proposal that
would include developing a CRD recordkeeping system for bank sales
personnel.
--------------------
\7 NASD's proposed rules will be held open for further notice and
comment when they are submitted to SEC for approval.
\8 Originally established as a centralized broker licensing and SRO
registration system, CRD is now also used by regulators and the
industry to help oversee brokers' activities.
\9 Securities Markets: Actions Needed To Better Protect Investors
Against Unscrupulous Brokers (GAO/GGD-94-208, Sep. 14, 1994); and
Securities Markets: Actions Needed To Better Protect Investors
Against Unscrupulous Brokers (GAO/T-GGD-94-190, Sep. 14, 1994).
\10 Bank regulators currently have access to CRD but as currently
structured, CRD does not include bank employees engaged in
bank-direct sales of securities.
BANK AND SECURITIES REGULATORS
HAVE DIFFERING VIEWS ON HOW
BANKS' SECURITIES ACTIVITIES
SHOULD BE REGULATED
---------------------------------------------------------- Chapter 2:5
Although bank and securities regulators have cooperated to develop
guidance and related examination procedures for banks offering
brokerage services, the same regulators have been at odds about
whether the current regulatory structure is adequate to protect
investors. Securities regulators are concerned that the current
regulatory structure for oversight of bank securities activities has
not kept pace with changes in the market and may not be adequate to
protect investors. In particular, the securities regulators have
questioned the continued exemption of banks from SEC registration and
regulation. They argue that the exemptions subject banks to weaker
regulatory standards than broker-dealers. For example, in
congressional hearings SEC officials stated that banking regulation
has traditionally focused on the safety and soundness of the banking
system and the protection of depositors as opposed to protection of
securities investors. The securities regulators and securities
industry representatives have stated that Congress should reassess
the current regulatory structure in light of banks' expansion into
securities activities and develop a system of functional regulation
in which the securities regulators would be responsible for
regulating all securities activities, including those of banks.\11
In contrast, bank regulators and banking industry representatives
have stated that measures that they have taken to strengthen
oversight of securities activities provide adequate protection to
customers who choose to invest through their banks. They also said
that reforming the regulatory structure as advocated by SEC would
create a duplicative and burdensome regulatory environment for banks.
Banking industry representatives have testified that functional
regulation should be considered only in connection with comprehensive
reform of banking regulation, including repeal of Glass-Steagall Act
provisions that limit banks' securities activities.
--------------------
\11 The concept of functional regulation calls for regulation
according to function rather than according to the entity performing
the function. Hence, under functional regulation SEC would be
responsible for regulation and oversight of all securities
broker-dealer and related activities of banks, and banking regulators
would be precluded from examining these activities.
CONCLUSIONS
---------------------------------------------------------- Chapter 2:6
Clearly, banking and securities activities are no longer separate as
envisioned by 1930s legislation because banks have become more
involved in providing their customers with securities services. The
regulatory system, which was also designed in the 1930s, has not been
adjusted to reflect the changed activities. Because banks are exempt
from SEC registration and regulation, banking organizations can chose
how to organize their securities brokerage activities, and depending
on that organization, how they are regulated. For example, banks can
choose to sell securities directly and be subject to oversight by
banking regulators but not by securities regulators. If these
activities are to be regulated, then bank regulators must include
them in their regulatory scheme and examinations. Under the current
regulatory structure the same type of securities activities can be
overseen by different regulators depending on how banks organize
their securities activities.
The potential for inconsistent oversight has not been much of a
problem so far because most banks provide securities services in
subsidiaries that are regulated primarily by securities regulators.
Further, for the 3 percent of banks nationwide that offer brokerage
services that are exempt from regulation by securities regulators,
bank regulators have provided new guidance and examination procedures
and are working to improve their oversight. Nevertheless, providing
consistent securities oversight, no matter where in an organization
these activities are done, would be enhanced by increased
cooperation, coordination, and sharing of regulatory expertise among
bank and securities regulators. Although bank and securities
regulators have shown that they can cooperate on oversight of
securities sales on bank premises, as we have indicated, issues
requiring further coordination remain. By working more closely
together bank and securities regulators could help ensure that both
safety and soundness and investor protection concerns are
appropriately addressed in regulatory requirements and examinations
of bank-direct brokerage activities, but without added regulatory
burden.
RECOMMENDATION
---------------------------------------------------------- Chapter 2:7
We recommend that the heads of the Federal Reserve, FDIC, OCC, SEC,
and NASD require their respective staffs to work together to develop
and implement an approach for regulating bank-direct securities
activities that provides consistent and effective standards for
investor protection while ensuring bank safety and soundness.
AGENCY COMMENTS AND OUR
EVALUATION
---------------------------------------------------------- Chapter 2:8
FDIC
-------------------------------------------------------- Chapter 2:8.1
FDIC commented that although its procedures were not flawless in the
period covered by our review, the results shown in table 2.2 on
bank-direct brokerages examined by bank regulators may be misleading.
In preparing detailed comments, FDIC reviewed our analysis and said
it found a different picture of its regulatory oversight from that
indicated by the numbers presented. FDIC polled its regions and
found that three, rather than two, of the banks' brokerage activities
were examined. This additional examination was completed after the
period of our survey. We now include it in table 2.2 as being
examined. FDIC stated that many of the banks are not involved in
retail sales of nondeposit investment products except to accommodate
customer requests. FDIC also said that the remainder of those banks
conduct a brokerage activity only through a third-party vendor.
We cannot explain why the securities brokerage activities of banks as
reported by FDIC would differ from information we obtained directly
from the banks we surveyed, unless the banks changed how they
provided brokerage services between the time of our survey and the
time they were last contacted by FDIC examiners. Nineteen
FDIC-regulated banks responded to our survey that they provided
brokerage services to customers directly by bank employees. We later
called each of those banks to validate their responses. Eighteen of
those banks responded that they provide discount brokerages services
by bank employees. One bank responded that it provided minimal
accommodation brokerage services. We have dropped it from the table
2.2 analysis in our final report.
FDIC commented that its efforts have been directed at eliminating
customer confusion concerning investment products sold by banks. It
said it is working closely with other federal regulators to develop
and implement an improved and coordinated approach to supervising
securities activities and would continue to work with SEC and NASD to
harmonize rules.
FDIC commented that it has supervisory responsibility over few
banking organizations with securities activities that would require
extensive specialized examiner training. However, it is considering
the type and scope of examiner training necessary.
FEDERAL RESERVE
-------------------------------------------------------- Chapter 2:8.2
The Federal Reserve agreed with our recommendation that bank and
securities regulators work together to develop and implement an
approach for regulating bank-direct securities activities. The
Federal Reserve said that it has been pursuing a number of efforts to
coordinate supervision of bank securities activities with securities
regulators. It also said that its joint efforts with securities
regulators are resulting in a supervisory program for bank-direct
sales activities that is analogous to, and consistent with,
broker-dealer regulation. Among these, the Federal Reserve noted
banking regulators' efforts to make securities regulators'
professional qualification examinations available to bank sales
personnel. The Federal Reserve also noted that the banking
regulators have proposed coordinated rulemaking by the banking
regulators, including developing a comprehensive central registration
depository type recordkeeping system for bank sales personnel.
OCC
-------------------------------------------------------- Chapter 2:8.3
OCC commented that our recommendation is consistent with actions it
has already undertaken to improve oversight of banks' securities
brokerage activities through better coordination and cooperation with
securities regulators.
OCC disagreed with our discussion of the additional risks to banks
that are associated with securities activities. We did not study the
comparative risks of various banking and nonbanking activities.
Nevertheless, securities activities can pose risks to banking
organizations, just as they can to securities firms. When federally
insured banks can be affected by such risks, measures should be taken
to insulate those banks from losses incurred by the securities
activities.
OCC stated that it directed examiners to include a review of
nondeposit investment product sales activities in all bank safety and
soundness examinations. The examinations are to be done with
statutory frequency--every 12 to 18 months, depending on bank size
and condition. OCC expects that by the end of 1995, all national
banks that are engaged in bank-direct brokerage operations will have
had at least one such examination.
SEC
-------------------------------------------------------- Chapter 2:8.4
SEC commented that it, the federal banking regulators, and NASD have
worked hard together but that interagency cooperation to regulate
banks' securities activities is not enough. It advocated a system of
functional regulation, in which each entity is regulated according to
the particular activity that it undertakes. SEC stated that
functional regulation would be a more efficient and responsible use
of both taxpayer dollars and bank capital. SEC emphasized the
importance of ensuring that the applicable regulatory scheme provides
equal protection for all investors and reduces regulatory costs.
This, SEC commented, in turn, would ensure that competition is based
on market performance, rather than on arbitrary differences in
regulation. SEC commented that our report appears to encourage a
system of duplicative regulation, which it strongly disagrees with.
We believe that in the present regulatory environment, in which
bank-affiliated securities activities are regulated primarily by
securities regulators and bank-direct activities are regulated by
bank regulators, cooperation and coordination by regulators is a
practical means of sharing regulatory expertise and achieving
consistent investor protection. Without financial system reform and
restructuring, which could include both functional and consolidated
regulatory systems as a means to efficient and comprehensive
regulation, cooperation and coordination is the only way to achieve
consistent investor protection. Under a system of functional
regulation, cooperation and coordination among regulators would still
be needed to avoid duplication and coverage gaps and share
information and examination results.
NASD
-------------------------------------------------------- Chapter 2:8.5
NASD commented that it is a strong advocate of functional regulation
as the long-term solution to establishing an effective regulatory
structure that spans the securities activities of banks and
broker-dealers. However, NASD stated that it was willing to support
our recommendation that the regulators cooperate by sharing its
advertising and sales practice policies and procedures and experience
and expertise in securities examinations with the bank regulators and
assisting in bank examiner training.
FEDERAL RESERVE INSPECTIONS
USUALLY ASSESS COMPLIANCE WITH ALL
APPLICABLE FIREWALLS
============================================================ Chapter 3
As of November 1994, the number of Section 20 subsidiaries in
operation was 35. The total gross revenues of all Section 20
subsidiaries was about $10 billion in 1993, which was about 8 percent
of total 1993 gross revenues for the securities industry. The
Federal Reserve has prescribed firewalls to protect insured
affiliated banks from risks associated with the Section 20
subsidiaries' securities activities. Federal Reserve examiners are
to inspect those Section 20 subsidiaries that seek to underwrite and
deal in corporate securities before they begin operations to ensure
that they are capable of complying with prescribed firewalls. For
all other Section 20 subsidiaries, the first annual inspection is to
include a detailed examination of compliance with applicable
firewalls. All subsidiaries are then to be inspected annually to
assess their financial condition and to determine their compliance
with firewalls and the limits on the amount of their business in
bank-ineligible securities.
We found that the Federal Reserve has generally maintained its annual
inspection cycle during the last 2 years and that the Federal Reserve
has taken steps to correct deficiencies identified by the
inspections. However, we also found that some firewalls were not
examined, and documentation available in some examination files was
inadequate for determining whether appropriate firewall inspections
had occurred. Thus, although the Federal Reserve in general
comprehensively reviewed or tested for compliance with all firewalls,
there were a few cases in which full compliance with all firewalls
could not be assured.
SECTION 20 SUBSIDIARIES'
SECURITIES ACTIVITIES HAVE
GROWN
---------------------------------------------------------- Chapter 3:1
As mentioned in chapter 1, the Federal Reserve allows bank holding
companies to establish Section 20 subsidiaries, which engage in
limited amounts of underwriting and dealing in bank-ineligible
securities (no more than 10 percent of the subsidiary's gross revenue
can be derived from such activities). The Federal Reserve has
approved bank-ineligible securities for Section 20 activities over
time, starting in 1987. The initial Federal Reserve order of April
30, 1987, approved applications of Citicorp, J.P. Morgan & Co., and
Bankers Trust New York Corp. to engage in limited underwriting and
dealing in municipal revenue bonds, mortgage-related securities, and
commercial paper. Later that year, the Federal Reserve issued an
order approving the underwriting of asset-backed securities.\1 The
activities approved in 1987 are referred to as "1987 powers" of
Section 20 subsidiaries. In 1989, the Federal Reserve extended the
powers for certain Section 20 subsidiaries to underwriting and
dealing in corporate debt and equity securities--referred to as "1989
powers."
As of November 1994, 35 Section 20 subsidiaries were operating under
Federal Reserve approval. As shown in table 3.1, 17 of those
subsidiaries operated under 1987 powers, 14 operated under both 1987
and 1989 powers, and 4 had 1987 and 1989 corporate-debt- only powers.
Twelve of the 35 Section 20 subsidiaries were foreign-owned.
The volume of activity among Section 20 subsidiaries in
bank-ineligible securities has grown rapidly in recent years even
though their share of revenues in the securities industry has
declined. In 1990, the volume of bank-ineligible securities
underwritten by Section 20 subsidiaries was about $27.8 billion.\2
According to Federal Reserve records, the volume of bank-ineligible
securities underwritten by Section 20 subsidiaries in 1993 was about
$58.6 billion, a 110-percent increase over 1990's volume. The total
gross revenues of the Section 20 subsidiaries increased by 57 percent
from about $6.4 billion for 1990 to about $10.0 billion for 1993.
However, according to SEC data, the total gross revenues of Section
20 subsidiaries as a percent of the total for the securities industry
declined from 10.1 percent for 1990 to 7.8 percent for 1993. As of
the end of 1993, Section 20 subsidiaries held 13.6 percent of the
total securities industry assets.
The top 10 Section 20 subsidiaries in terms of revenue production
during 1993 included J.P. Morgan Securities, Greenwich Capital
Markets, BT Securities, Citicorp Securities, Barclays Capital, Chase
Manhattan Securities, Sanwa-BGK Securities, Chemical Securities,
Deutsche Bank Securities, and NationsBanc Capital Markets. The
Section 20 subsidiaries and their parent organizations are also shown
in table 3.1.
Table 3.1
Section 20 Subsidiaries' Securities
Powers and Parent Organizations as of
November 1994
Section 20 subsidiary Parent organization
---------------------------------- ----------------------------------
1987 and 1989 Corporate debt and equity powers
----------------------------------------------------------------------
BA Securities, Inc. BankAmerica Corp.
BT Securities Corp. Bankers Trust N.Y. Corp.
Chase Securities Inc. Chase Manhattan Corp.
Chemical Securities Inc. Chemical Banking Corp.
Deutsche Bank Securities Corp. Deutsche Bank AG\a
Harris Nesbitt Thomson Securities, Bankmont Financial Corp.\a
Inc.
Hopper Soliday and Co., Inc. Dauphin Deposit Corp.
J.P. Morgan Securities Inc. J.P. Morgan and Co., Inc.
NationsBanc Capital Markets, Inc NationsBanc Corp.
RBC Dominion Securities Corp. Royal Bank of Canada\a
Republic N.Y. Securities Corp. Republic New York Corp.\a
ScotiaMcleod (USA) Inc. The Bank of Nova Scotia\a
Toronto Dominion Securities (USA) Toronto-Dominion Bank\a
Inc.
Woody Gundy Corp. The Canadian Imperial Bank of
Commerce\a
1987 and 1989 Corporate debt powers
----------------------------------------------------------------------
Barclays Capital Corp. Barclays Bank PLC\a
Citicorp Securities Inc. Citicorp
First of America Securities, Inc. First of America Bank Corp.
First Chicago Capital Markets, First Chicago Corp.
Inc.
1987 Powers
----------------------------------------------------------------------
ABN AMRO Securities (USA) Inc. ABN AMRO North America, Inc.\a
Banc One Capital Corp. Bank One Corp.
Bank South Securities Corp. Bank South Corp.
Barnett Securities, Inc. Barnett Banks Inc.
DKB Securities Corp. The Dai-Ichi Kangyo Bank, Ltd.\a
First Union Securities, Inc. First Union Corp.
Fleet Securities, Inc. Fleet Financial Group, Inc.
Greenwich Capital Markets, Inc. The Long-Term Credit Bank of
Japan\a
Huntington Capital Corp. Huntington Bancshares, Inc.
Liberty Investment Services, Inc. Liberty National Bancorp, Inc.
National City Investments Corp. National City Corp.
Norwest Investment Services Norwest Corp.
PNC Securities Corp. PNC Bank Corp.
Sanwa-BGK Securities Co., L.P. The Sanwa Bank Ltd.\a
SouthTrust Securities Inc. SouthTrust Corp.
SunTrust Capital Markets SunTrust Banks, Inc.
Synovus Securities, Inc. Synovus Financial Corp.
----------------------------------------------------------------------
\a Foreign-owned corporation.
Source: Federal Reserve Board.
--------------------
\1 These are bonds or notes backed by loans or accounts receivable
originated by banks, credit card companies, or other providers of
credit. Typically, the originator of the loan or account receivable
paper, such as for automobile loans and credit card receivables,
sells the paper to a special trust, which repackages it as
securities. The securities are then underwritten by brokerage firms,
which reoffer them to the public.
\2 Our report, Bank Powers: Bank Holding Company Securities
Subsidiaries' Market Activities Update (GAO/GGD-91-131, Sep. 20,
1991), provided information on the market activities of Section 20
subsidiaries. From the amount shown for the value of securities
underwritten we excluded the amount of commercial paper underwritten
by the Section 20 subsidiaries in 1990 to make the total amount
consistent with data reported to the Board for 1993. The Board did
not include commercial paper, because issues are frequently rolled
over and reissued several times during a year.
THE FEDERAL RESERVE HAS
PRESCRIBED FIREWALLS TO PROTECT
BANKS AND REQUIRES SECTION 20
SUBSIDIARIES TO HAVE INTERNAL
CONTROLS
---------------------------------------------------------- Chapter 3:2
Both the Federal Reserve and banking organizations that seek to
establish Section 20 subsidiaries are to provide safeguards to
insulate banks from subsidiaries' securities activities. To protect
affiliated insured banks and the parent banking organization from
risks associated with Section 20 subsidiaries' underwriting and
dealing activities, the Federal Reserve has prescribed various
firewalls. The banking organizations that establish Section 20
subsidiaries are also to have internal controls in place to ensure
compliance with the firewalls and to manage attendant business risks.
FIREWALLS PROVIDE IMPORTANT
PROTECTION FOR INSURED BANK
AFFILIATES
-------------------------------------------------------- Chapter 3:2.1
As discussed briefly in chapter 1, Section 20 subsidiaries are
subject to various limitations on their activities and operating
conditions, which are called firewalls. These limitations and
operating conditions are intended to insulate affiliated banks from
risks associated with the ineligible securities underwriting and
dealing activities and minimize conflicts of interest. The firewalls
define the method a banking organization with a Section 20
subsidiary should use to calculate its capital so that
investments and loans to the subsidiary are not counted toward
the consolidated capital of the bank holding company;
limit credit extensions that the bank affiliate may make to the
Section 20 subsidiary and its clients and customers;
require separate offices for the Section 20 subsidiary and limit
employees, officers, and directors from serving in the same
capacity for both the Section 20 subsidiary and an affiliated
bank.
require disclosures of the nature of the Section 20 subsidiary's
business and its relationship with the banking affiliates,
including disclosing to customers that the subsidiary is an
organization separate from any affiliated bank and that
securities recommended, offered, or sold by the subsidiary are
not bank deposits and are not insured by FDIC;
restrict a banking affiliate from offering investment advice
regarding securities underwritten or dealt in by the Section 20
subsidiary unless the customer is notified of the affiliate's
involvement;
restrict extensions of credit and purchases of assets that would
shift risk to insured institutions and prevent any unfair
competitive advantage to bank-affiliated securities firms; and
restrict the exchange of nonpublic customer information between
banking affiliates and the Section 20 subsidiary.
For each Section 20 subsidiary, the specific firewalls that apply
vary according to the powers of the subsidiary and whether the
subsidiary is foreign-owned. All of the firewalls are published in
the Federal Reserve's Bank Holding Company Supervision Manual. (See
app. I for a list of the Federal Reserves's detailed firewall
conditions.) In addition to meeting the firewall conditions,
applicants seeking expanded 1989 powers to underwrite and deal in
corporate debt and equity securities are required to establish the
necessary managerial and operational infrastructure before receiving
Federal Reserve approval for these activities.
The original Federal Reserve orders giving banks approval to
underwrite and deal in securities document the rationale and
importance of the establishment and operations of firewalls. The
firewalls that prohibit extensions of credit, for example, are
considered important for the following reasons:
They preclude banking affiliates from making loans to depositors to
purchase securities underwritten by a Section 20 subsidiary and
thus seek to ensure that affiliates grant credit in a sound and
impartial manner.
They restrict banking subsidiaries from making unwise loans to
improve the financial condition of the companies or
organizations whose securities are underwritten or dealt in by
an affiliated underwriting subsidiary, either to assist in
marketing the securities or to prevent the customers of the
underwriting subsidiary from incurring losses on securities sold
by the subsidiary.
They prohibit loans or other transactions between banking
subsidiaries and underwriting subsidiaries to cover any
financial losses sustained by the underwriting subsidiaries.
They prohibit banks from purchasing low-quality assets from the
underwriting subsidiary or providing the underwriting subsidiary
with credit on preferential terms. (Such transactions are
prohibited by Sections 23A and 23B of the Federal Reserve Act.)
Firewalls that insulate the underwriting subsidiaries from banking
subsidiaries by requiring separate operations--including separate
officers, directors, and employees--are important to avoid any
conflicts of interest and prevent loss of public trust in the banking
subsidiary should the underwriting subsidiary sustain financial
losses.
SUBSIDIARIES ARE DIRECTED TO
ESTABLISH INTERNAL CONTROLS
FOR COMPLIANCE WITH
FIREWALLS AND OTHER
REQUIREMENTS
-------------------------------------------------------- Chapter 3:2.2
The Federal Reserve generally requires Section 20 subsidiaries to
have internal controls in place. For example, Federal Reserve
inspection guidance for Section 20 subsidiaries seeking 1989 powers
directs examiners to confirm that the subsidiaries have (1) internal
control procedures to ensure compliance with the Federal Reserve's
firewalls; (2) written underwriting and trading position limits; (3)
procedures for managing syndicate (group) underwritings; and (4)
procedures for segregation of duties, control over data entry, and
hiring competent employees.
The banking organizations we met with use a variety of such policies,
procedures, and control mechanisms. According to information we
obtained from three banking organizations, the controls used
generally were in the form of written policies and procedures, staff
training and awareness activities, and internal audit functions.
Also, procedures to ensure compliance with regulations included
compliance manuals, routine memoranda on securities underwritten and
associated restrictions on credit relationships, separation of
duties, supervision of employees, surveillance systems, compliance
reviews, and internal audits. Those Section 20 subsidiaries also had
policies and procedures to prevent insider trading and prevent
affiliates from engaging in impermissible credit or investment
activities and "tie-in" arrangements. (Tie-in or tying arrangements
involve an agreement to provide a customer one service on the
condition that he or she also obtain other services. This practice
is considered anticompetitive and is generally prohibited by the Bank
Holding Company Act, section 106(b).) To restrict insider trading and
impermissible credit or investment activities, the subsidiaries
issued "watch lists" and "restricted lists." To make employees aware
of regulatory provisions prohibiting tie-in arrangements and the
banks' antitying policies, the subsidiaries used compliance
guidelines, memoranda, and training.
Officials of the three banking organizations also said that they had
employee training programs that included reviews of regulatory
compliance requirements. Officials of one banking organization said
that the organization's compliance manual is reviewed with employees,
and insider trading and antitying policies are highlighted.
Officials of another bank holding company said that all new hires
were trained on securities laws and regulations as well as provisions
on firewalls and antitying. Officials of another banking
organization said it provided employees ongoing regulatory compliance
training, and it required all employees to read compliance
regulations annually and certify that they are familiar with and will
comply with controls and provisions governing the bank's securities
activities. According to Federal Reserve officials, such internal
controls and training programs are common among the bank holding
companies that the Federal Reserve has approved to underwrite and
deal in bank-ineligible securities. However, a detailed review of
private sector banking organizations' internal control systems was
beyond the scope of our work, and we cannot comment on the
effectiveness of those controls.
BOTH FEDERAL RESERVE AND
SECURITIES REGULATORS ARE TO
EXAMINE SECTION 20 SUBSIDIARIES
---------------------------------------------------------- Chapter 3:3
Section 20 subsidiaries are to be examined by both the Federal
Reserve and by securities regulators, but for different purposes.
The Federal Reserve focuses on compliance with the firewalls and with
the 10-percent limit on the subsidiaries' business in bank-ineligible
securities. Securities regulators examine the subsidiaries for
compliance with securities laws and SEC and SRO regulations and
rules. Both the Federal Reserve and securities regulators examine
the Section 20 subsidiaries' financial condition; however, according
to Federal Reserve officials, the scope and objectives of the
examinations differ. The officials said that securities regulators
examine financial records to check for compliance with net capital
requirements for broker-dealers.\3 They said Federal Reserve
examiners verify data reported to the Federal Reserve on the
subsidiaries' financial performance\4 and focus on any adverse
effects of the subsidiaries' operations on the consolidated bank
holding company and its depository institution affiliates.
--------------------
\3 Net capital requirements are set forth in SEC Rule 15c3-1.
\4 Section 20 subsidiaries report quarterly on Form FR Y-20,
Financial Statements for a Bank Holding Company Subsidiary Engaged in
Ineligible Securities Underwriting and Dealing. The FR Y-20 data are
considered as confidential pursuant to section (b)(4) of the Freedom
of Information Act, 5 U.S.C. 552(b)(4).
FEDERAL RESERVE INSPECTIONS
FOCUS ON COMPLIANCE WITH
FIREWALLS AND OPERATING
CONDITIONS
-------------------------------------------------------- Chapter 3:3.1
The Federal Reserve's guidance on inspections of Section 20
subsidiaries outlines four types of inspections of the subsidiaries:
firewall condition inspections, infrastructure reviews, annual
inspections, and supplemental inspections. The timing and purposes
of these inspections are described in table 3.2.
Table 3.2
Federal Reserve Inspections of Section
20 Subsidiaries
Type of Time of
inspection inspection Scope of inspection
------------- ------------- ----------------------------------------
Firewall Initial All of the Section 20 subsidiary's
condition inspection policies and operating procedures.
inspection for
compliance
with
firewalls and
operating
conditions
applicable to
1987 powers.
Infrastructur Before Reviews of management, SRO examination
e review approval for results, internal controls, computer and
1989 powers, accounting systems, and internal audit
regardless of and other areas. Examiners are to (1)
whether the review and confirm that management is
applicant is qualified to direct and supervise
seeking securities underwriting and dealing
initial activities and knowledgeable about
powers or has associated risks and marketing
been approved techniques; (2) review the latest SRO
for 1987 examination to determine compliance with
powers. securities laws and regulations; (3)
review internal controls to ensure that
appropriate controls are in place; (4)
review computer and accounting systems
to determine whether the systems can
process and account for the relevant
securities activities; and (5) evaluate
the internal audit program and auditors'
qualifications and determine the
adequacy of the internal audit function,
recordkeeping, and accounting and
computer systems.
Annual Annual. Evaluations of compliance with the
inspection applicable firewalls and the 10 percent
revenue limitation, and assessments of
the subsidiaries' financial condition.
In conducting annual inspections,
Federal Reserve examiners rely on the
work of the subsidiary's internal
auditor and focus on
(1) assessing changes in subsidiary
operations that may have affected
applicable firewalls and
(2) verifying that deficiencies found by
internal and any external audits have
been corrected.
The annual inspection procedures
emphasize that a strong internal audit
department will ordinarily review and
test internal controls. This minimizes
the need for Federal Reserve examiners
to engage in extensive review and
testing of controls.
Supplemental Random or Testing of the firewalls in instances
inspections targeted. where a Section 20 subsidiary has a poor
compliance record or has not been
subject to substantial internal audits.
----------------------------------------------------------------------
Source: GAO Analysis of the Federal Reserve's Inspection Guidance.
Additional controls over Section 20 subsidiaries are provided by
mandatory financial reporting, the Federal Reserve's centralized
monitoring of inspection results and the underwriting activities of
the subsidiaries, and regulation by securities industry regulators.
In 1990, the Federal Reserve instituted a program requiring Section
20 subsidiaries to file quarterly reports on balance sheet, income,
stockholders' equity, and other data on their underwriting
activities. These data are to be submitted on reporting Form FR
Y-20. The Federal Reserve uses these data to monitor compliance with
the Federal Reserve's 10 percent revenue test and the financial
status and underwriting activities of the Section 20 subsidiaries.
Before FR Y-20 reporting was started, the Federal Reserve used copies
of FOCUS Reports (Financial and Operational Combined Uniform Single
Report) filed with securities industry Self-Regulatory Organizations
(SROs) and other quarterly reports to monitor compliance with the 10
percent revenue test and the financial condition of Section 20
subsidiaries. Staff at Federal Reserve headquarters also monitor the
results of the Federal Reserve districts' inspections of the Section
20 subsidiaries.
SECURITIES REGULATORS
EXAMINE FOR COMPLIANCE WITH
SECURITIES LAWS AND
REGULATIONS
-------------------------------------------------------- Chapter 3:3.2
Section 20 subsidiaries are also required to register with SEC and
join an SRO. The currently approved Section 20 subsidiaries are
members of NASD or the New York Stock Exchange. The SROs regulate
and examine the Section 20 subsidiaries' compliance with securities
laws and regulations, SRO rules of fair practice, and their
implementation of procedures designed to restrict opportunities for
insider trading.\5 While banking organizations should have controls
in place to prohibit the sharing of confidential information, the
Section 20 subsidiaries' compliance with the insider trading
provisions is primarily under SEC, NASD, and other SRO oversight,
rather than the bank regulators.\6
--------------------
\5 These procedures, required by the Insider Trading and Securities
Fraud Enforcement Act of 1988, P.L. 100-704, are intended to prevent
nonpublic information acquired in one capacity from being used in
another--for example, between a financial organization's varied
activities, such as underwriting and trading and investment research
and advice. NASD and NYSE have jointly developed guidelines for the
securities industry to restrict insider trading.
\6 We reported on SROs' adoption of insider trading provisions in
Securities Markets: Clearly Defined "Chinese Wall" Standards Have
Been Issued (GAO/GGD-91-115, Aug. 21, 1991).
SUBSIDIARIES GENERALLY WERE
INSPECTED ANNUALLY
---------------------------------------------------------- Chapter 3:4
Information on the timing of the Federal Reserve's inspections of
Section 20 subsidiaries showed that Federal Reserve examiners
generally inspected the Section 20 subsidiaries annually. The
information provided to us by Federal Reserve officials showed that
the Federal Reserve annually inspected 30 of the 31 Section 20
subsidiaries that were active at the end of 1992 and 1993. One
subsidiary was not inspected; although Federal Reserve officials
could not provide a reason for this, they said they had made the
district bank aware that the Section 20 subsidiary should be
inspected annually.
However, in the period from 1989 through 1993, a total of nine of the
Section 20 firms were not examined annually as required. According
to Federal Reserve officials, annual inspections were delayed for a
variety of reasons. The officials said delays in inspections of
foreign-owned subsidiaries occurred due to a 1991 reorganization of
the Federal Reserve's New York District inspection staff. In that
reorganization, the officials said, two separate units were
formed--one to inspect domestic firms and the other to inspect
foreign-owned firms. According to the officials, as a result of the
reorganization, no foreign-owned subsidiaries were inspected in 1991,
but such scheduling delays have not been repeated. According to the
Federal Reserve officials, other inspections were delayed because
some districts were slow in implementing Section 20 inspection
programs. One Section 20 subsidiary initially was not inspected
because, although approved in 1990 for 1989 powers, it had not
completed an internal audit program and was not actually allowed to
begin underwriting and dealing activities until 1991.
We also interviewed bank examiners with OCC, the primary regulator of
national banks. These examiners are responsible for examining
national banks that are subsidiaries of the same parent bank holding
company as a Section 20 subsidiary. The national bank examiners said
that their examinations consider the operations of Section 20
subsidiaries only to the extent that they might affect the safety and
soundness of the national banks. The examiners said they are
concerned with the bank's overall risk exposure and the bank's
efforts to measure and manage risk levels, and they leave the
detailed reviews of the Section 20 subsidiaries to the Federal
Reserve and securities regulators.
SOME FEDERAL RESERVE
INSPECTIONS RELIED ON INTERNAL
AUDITS AND DID NOT ALWAYS
ASSESS COMPLIANCE WITH ALL
FIREWALLS
---------------------------------------------------------- Chapter 3:5
Our review of the Federal Reserve's inspections of 14 Section 20
subsidiaries located in the Chicago, New York, Richmond, and San
Francisco Federal Reserve districts showed that the Federal Reserve
usually conducted detailed reviews of the subsidiaries. The district
examiners conducted the required infrastructure reviews of
subsidiaries seeking powers to underwrite corporate equity and debt
securities. The results of our analysis of four infrastructure
reviews completed during 1993 showed that those reviews generally
were complete and addressed all conditions listed in the Federal
Reserve's guidance. As noted on page 55, the Federal Reserve also
completed annual firewall inspections of 30 of 31 approved
underwriting subsidiaries.
We also analyzed annual and special firewall inspections completed in
1992 and 1993 for all 14 Section 20 subsidiaries. The approach taken
on the annual inspections varied among districts. The Richmond and
San Francisco Federal Reserve Banks generally conducted independent
reviews and, as applicable, tested the firewall conditions. The
Chicago and New York Banks--especially the New York bank, in whose
district the largest number of Section 20 subsidiaries are
located--relied more on the banking organizations' internal auditors'
assessments of compliance with the firewall conditions. For example,
our review of the Federal Reserve's annual inspections of six Section
20 subsidiaries in the New York district found that the examiners
relied, in all six cases, on the internal auditors' review and
testing of the firewalls.
Although Federal Reserve examiners said that they did some selective
review of policies and procedures and testing of the firewalls, we
found that such review and testing were not always documented in the
inspection workpapers. In addition, the workpapers did not always
include documents showing the scope and methodology of the internal
auditors' review and testing of firewalls. In a 1993 report on the
Federal Reserve's bank holding company inspections, we noted that the
quality of Federal Reserve workpapers was inconsistent, and the
Federal Reserve Manual did not provide guidance on workpaper
preparation.\7 We also recommended that the Federal Reserve improve
workpaper documentation of its bank holding company inspections. In
response to those recommendations, the Federal Reserve said that
those workpapers would be subject to standards similar to the
agency's new standards for workpapers in commercial bank
examinations, which the Federal Reserve was testing as of September
1994. The Federal Reserve's standardized commercial bank work
documentation program is intended to provide a consistent format for
documenting the tasks performed on each examination. The Federal
Reserve's commercial bank examination standards also provide a format
for examiners to follow in reviewing the work of internal auditors,
including determining the adequacy of internal auditors' testing
methods.
In our review of the Federal Reserve's inspections of the Section 20
subsidiaries, we found two instances in which neither Federal Reserve
examiners nor the internal auditors reviewed for compliance with
certain firewalls. More specifically, we found the following:
In the 1993 inspection of one of the larger Section 20
subsidiaries, neither the Federal Reserve examiner nor the
internal auditors reviewed firewalls that restricted credit
extensions to the underwriting subsidiary and its clients and
customers, prohibited interlocking directorates, required
disclosure of the subsidiary's relationship to the parent
organization, and prohibited intercompany transactions and
transfers of assets between the Section 20 subsidiary and
affiliated insured banks. In this case, the examiner said that
he relied on an internal audit that was the same one he relied
on in the prior year's inspection. The Federal Reserve
examiners said that they used spot-checks and walk-throughs to
review these items, and those reviews may not have been
documented in workpapers.
In another inspection, neither the Federal Reserve examiner nor the
internal auditor reviewed firewalls that restrict the sale of
securities underwritten by the Section 20 subsidiary to other
subsidiaries of the same bank holding company and restrict any
asset sales to affiliated banks.
It is important that these firewalls be checked to ensure that they
are in place and functioning properly to restrict conflicts of
interest, risky credit relationships, and illegal intercompany
transactions\8 and reciprocal arrangements. In these instances,
inspection supervisors' reviews would have been needed to ensure that
all firewalls were examined and work was properly documented in
workpapers.
Federal Reserve officials said that it allowed the districts to use
their own discretion in deciding how much to rely on the work of
internal auditors. Such discretion is allowed because it is a
practical approach to covering all Section 20 subsidiaries.
Otherwise, the districts would not be able to cover all of the bank
holding companies and their subsidiaries if Federal Reserve examiners
themselves did extensive testing of every regulatory requirement.
This would be especially true for the New York district, which has
the highest number of Section 20 subsidiaries (13).
--------------------
\7 Bank Examination Quality: FRB Examinations and Inspections Do Not
Fully Assess Bank Safety and Soundness (GAO/AFMD-93-13, Feb. 16,
1993).
\8 We earlier reported that during bank holding company inspections
Federal Reserve examiners did not adequately assess risks from
intercompany transactions. See GAO/AFMD-93-13, Feb. 16, 1993, pp.
45-46.
FEDERAL RESERVE INSPECTIONS
SEEK TO CORRECT DEFICIENCIES
AND AVERT PROBLEMS
---------------------------------------------------------- Chapter 3:6
The Federal Reserve, as well as the other federal bank regulators,
can impose any of several informal and formal enforcement actions on
banks that operate in an unsafe or unsound manner or fail to comply
with laws and regulations. Informal enforcement actions include
meeting with bank officers and boards of directors to obtain
agreement on improvements needed,
requiring banks to issue commitment letters to the regulators
specifying corrective actions that need to be taken,
requiring bank boards of directors to issue resolutions specifying
corrective actions, and
requiring a memorandum of understanding between regulators and bank
officers on actions that will be taken.
Formal enforcement actions include formal written agreements; orders
to cease and desist; assessments of civil money penalties; and orders
for removal, prohibition, or suspension of individuals from bank
operations.\9
According to Federal Reserve officials, the Federal Reserve has taken
few enforcement actions against Section 20 subsidiaries for firewall
noncompliance. Since the 1987 order that first approved Section 20
subsidiaries, two enforcement actions have been taken, one formal and
one informal, both during 1994. On December 5, 1994, the Federal
Reserve Bank of New York executed a Written Agreement with a bank
holding company, its affiliated bank, and its Section 20 subsidiary
not to engage in any violation of Section 23A of the Federal Reserve
Act or any of the Federal Reserve's firewalls. As a result of a 1994
inspection, at the Federal Reserve's request a Section 20 subsidiary
adopted a board of directors resolution that restricted the
subsidiary's underwriting and dealing in ineligible securities and
required various corrective measures.
According to Federal Reserve officials, the Federal Reserve has taken
few enforcement actions because the Federal Reserve emphasizes
corrective measures, rather than enforcement actions, to ensure that
Section 20 firms have appropriately functioning internal control and
internal audit procedures in place. Under this approach, Federal
Reserve officials said, potential problems are discovered and
corrected as part of the inspection process before they become
serious enough to warrant an enforcement action. However, Federal
Reserve officials said they will take enforcement actions if their
examiners discover (1) an incidence of serious noncompliance with
laws, regulations, or supervisory guidance relative to a Section 20
subsidiary; (2) repeat offenses; or (3) an unwillingness to correct
voluntarily noted deficiencies or violations.
Even though the Federal Reserve's inspections have not resulted in
many enforcement actions, our review of Federal Reserve inspection
reports showed that the Federal Reserve's annual firewall inspection
efforts have identified deficiencies and potential problems. In 15
out of 31 of the most recent inspections completed during 1992 or
1993, Federal Reserve examiners noted deficiencies. These
deficiencies included, among others, a lack of internal audits for a
newly established Section 20 subsidiary and failure to account for
and adhere to technical rules related to calculation of the amounts
of ineligible versus eligible revenues. According to Federal Reserve
officials, such deficiencies are discussed with bank officials in
inspection close-out meetings. Following these meetings, Federal
Reserve officials said they require the subsidiaries' management to
respond in writing within 60 days about the actions that the
subsidiary will take to correct such deficiencies. The officials
also said that the Federal Reserve would consider taking a formal or
informal enforcement action, as appropriate, if no response were
received or the next inspection showed that the subsidiary had failed
to correct the deficiency.
--------------------
\9 The bank regulatory enforcement process is described in detail in
our report Bank Supervision: Prompt and Forceful Regulatory Actions
Needed (GAO/GGD-91-69, April 15, 1991, pp.17-19).
CONCLUSIONS
---------------------------------------------------------- Chapter 3:7
The Federal Reserve's inspections of Section 20 subsidiaries were
usually done on schedule and assessed compliance with applicable
firewalls. Federal Reserve examiners or bank holding company
internal auditors usually reviewed and tested for compliance with all
applicable firewalls. However, the Federal Reserve's monitoring for
firewall compliance is not complete unless Federal Reserve examiners
or internal auditors review all applicable firewalls and unless
Federal Reserve examiners review the completeness of the internal
audit and document the audit's scope, methodology, and results.
Reliable monitoring of and compliance with firewalls help ensure that
banking organizations--including federally insured banks--are not
engaging in unwise or unduly risky transactions with the underwriting
subsidiaries, their clients, or their customers.
In cases where documentation of the work performed by examiners and
internal auditors is not sufficient, the Federal Reserve cannot
attest to the completeness of its firewall inspections or to the
general level of compliance with firewalls. Also, without sufficient
documentation we cannot fully conclude that the Federal Reserve's
inspections are complete and effective, that the Federal Reserve has
a basis for reliance on bank holding company internal auditors, or
comment on the general level of compliance with the Federal Reserve's
firewalls. The Federal Reserve's proposed development of a
standardized workpaper format for bank holding company inspections
that is similar to the format that it has developed and is testing
for commercial bank examinations could provide adequate documentation
of the work performed by Federal Reserve examiners and internal
auditors if applied to the Section 20 subsidiary segments of the bank
holding company inspections. However, those instances where firewall
reviews are not being performed will not be remedied by
implementation of documentation procedures.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 3:8
We recommend that the Chairman of the Board of Governors of the
Federal Reserve System ensure that either Federal Reserve examiners
or internal auditors review and test all applicable firewalls at
least once annually and document in inspection workpapers the work
performed by Federal Reserve examiners or bank holding company
internal auditors. Federal Reserve workpapers should document
Federal Reserve examiners' testing of the work of internal auditors
as a basis for reliance on internal audit.
AGENCY COMMENTS AND OUR
EVALUATION
---------------------------------------------------------- Chapter 3:9
The Federal Reserve said that it would promptly address our findings
related to firewall compliance. It intends to reiterate for
examiners the Federal Reserve's long-standing policy to inspect and
fully document Section 20 companies' compliance with all applicable
firewall conditions. In addition, it will instruct examiners that
when they rely on the reports of internal auditors, their workpapers
must explicitly cross-reference the auditors' documentation of
testing for compliance with each firewall.
The Federal Reserve also noted that in recent months additional
enhancements have been made to its supervisory program to facilitate
oversight of Section 20 companies' regulatory compliance. According
to the Federal Reserve these include (1) the addition of another
full-time, experienced staff member to its Section 20 oversight
group; and (2) the preparation of a quarterly profile of the
operations of each Section 20 company, including any violations of,
or weaknesses in, controls relative to firewall conditions and the
status of any supervisory follow-up actions and corrective measures.
The Federal Reserve also commented on three instances that we cited
in the draft report of examiners or internal auditors failing to
review for compliance with certain firewalls and instances where
examiners' review and testing of firewalls were not always
documented. The Federal Reserve said that those instances were
either minor or not completely accurate. Federal Reserve staff
reviewed each of the instances cited to provide additional detail.
In the first instance, Federal Reserve staff found that the
examiners felt justified in their reliance on the same internal
audit for two consecutive inspections. This was because of the
examiners' confidence in the company's strong program of
quarterly firewall testing, history of consistent compliance,
and the high quality of its internal audit programs. We could
not review private banking organizations' compliance and
internal audit programs and cannot comment on their quality.
However, we believe that relying on the same internal audit for
two consecutive inspections of firewall compliance does not
provide continued assurance of compliance with firewalls.
In the second instance, Federal Reserve staff found that internal
auditors failed to review compliance with a firewall restricting
sales of securities underwritten by the Section 20 company to
affiliates because of a recent merger. In that case Federal
Reserve staff found that the examiners verified compliance with
this firewall. However, we did not see this work and the
results documented in the inspection workpaper files that we
reviewed. The Federal Reserve staff also noted that the Section
20 company in question, at the time of the inspection, was
operating under the Federal Reserve Board's 1987 Order and was
not subject to the firewall governing asset sales. According to
our reading of the Federal Reserve's Bank Holding Company
Supervision Manual, Section 2185.0, page 28, the 1987 Order did
contain a firewall governing asset sales.
In the third instance, Federal Reserve staff found that a firewall
prohibiting reciprocal arrangements was not tested because the
Section 20 company in question did about 98 percent of its
business in government securities, which are not subject to
firewalls. This company was involved only as a minor
participant in underwritings of ineligible securities. This
information was not apparent from inspection workpapers and was
not provided to us at the time of our review. We have dropped
this example from the final report.
FDIC WAS UNABLE TO ASSESS RISKS TO
FEDERALLY INSURED BANKS POSED BY
SECURITIES ACTIVITIES OF BANK
SUBSIDIARIES
============================================================ Chapter 4
Under FDIC regulation and supervision federally insured
state-chartered nonmember banks under its jurisdiction can establish
or acquire bona fide subsidiaries to underwrite and deal in
securities--activities not permissible for banks. However, the
agency has not fully prepared its examiners to examine these
activities and does not have other procedures for monitoring the
subsidiaries' activities. As a result, FDIC has no systematic way of
knowing the extent to which bank subsidiaries are engaged in
securities activities that pose risks to nonmember banks or ensuring
that any such risks are minimized.
BONA FIDE AND SECTION 20
SUBSIDIARY FIREWALLS SHARE THE
SAME PURPOSE
---------------------------------------------------------- Chapter 4:1
As discussed in chapter 1, bona fide subsidiaries are subject to
operating conditions and firewalls required under FDIC Rules and
Regulations, Section 337.4. The purpose of these requirements, like
the requirements that Section 20 subsidiaries must meet, is to ensure
the safety and soundness of bank affiliates of the bona fide
subsidiaries and protect consumers from conflict-of-interest abuses
and other inequities. Generally, Section 337.4 contains the
following provisions:
The bona fide subsidiary must be adequately capitalized.
The bona fide subsidiary must be physically separate from the bank
with separate offices, separate accounting and other records,
and separate employees and officers.
Bona fide subsidiaries' underwriting and dealing activities are
limited to (1) "investment quality" debt and equity securities
that are rated in the top four rating categories by a nationally
recognized rating service or have equivalent characteristics, or
(2) underwriting of investment companies whose holdings are
primarily investment quality securities or obligations of the
U.S. government and its agencies or money market instruments.\1
The nature of the bona fide subsidiary's business and its
relationship with the banking affiliates, including that the
subsidiary is a separate organization from the bank and that
investments recommended, offered, or sold by the subsidiary are
not bank deposits and are not insured by FDIC, must be disclosed
to customers.
Credit extensions that the bank affiliate may make to the bona fide
subsidiary and its clients and customers are limited.
Banks are prohibited from purchasing as fiduciary any securities
underwritten or dealt by the bona fide subsidiary.
Banks are prohibited from transacting business through a trust
department with a bona fide subsidiary on terms that appear
preferential when compared to similar transactions with
unaffiliated securities companies.
Banks are prohibited from conditioning any loan or extension of
credit on the requirement that the bona fide subsidiary
underwrite or distribute a company's securities.
Like the Federal Reserve, FDIC seeks to ensure that subsidiaries
engaged in underwriting and dealing in bank-ineligible securities are
insulated from bank affiliates by mandating separate
operations--including separate officers and employees. Also similar
to the Federal Reserve, the FDIC Regulation requires that an insured
nonmember bank's direct investment in a securities subsidiary not be
counted toward the bank's capital. FDIC expects bona fide
subsidiaries to establish the necessary managerial and operational
infrastructure before beginning operations. A more detailed account
of the Section 337.4 provisions that apply to bona fide subsidiaries
is presented in appendix II.
--------------------
\1 This restriction does not apply to subsidiaries that are members
in good standing with NASD and have been in continuous operation for
at least 5 years.
FDIC REQUIRES NOTIFICATION OF
BANKS' AFFILIATION WITH BONA
FIDE SUBSIDIARIES
---------------------------------------------------------- Chapter 4:2
The Federal Reserve examines a Section 20 subsidiary before it is
approved to underwrite and deal in corporate equity and debt
securities. In contrast, FDIC requires only that a nonmember bank
notify the agency when it establishes or acquires a bona fide
subsidiary. Section 337.4, rather than an FDIC action of approval,
authorizes bona fide subsidiaries to underwrite and deal in certain
corporate equity and debt securities. A nonmember bank is to notify
the FDIC regional director of its intention to establish a bona fide
subsidiary 60 days before the subsidiary is to begin operations and
again within 10 days after it begins operations.
FDIC makes no effort to ensure through an on-site examination that
bona fide subsidiaries commence securities underwriting and dealing
activities in compliance with Section 337.4 operating conditions and
firewalls. FDIC requires compliance with the Section 337.4
provisions at the time that a bona fide subsidiary begins operations.
However, as a matter of policy, after receiving the notification FDIC
reviews the bank's compliance at the next scheduled FDIC examination
of the bank. Under certain conditions, this policy could allow a
bona fide subsidiary to operate for many months before it is examined
for compliance with Section 337.4 requirements. For banks subject
only to FDIC examinations, a newly established bona fide subsidiary
could operate for nearly a year before an examination. For banks
that are subject to annual examinations alternating between FDIC and
state regulators, such subsidiaries might operate without FDIC
oversight for a longer period.\2 According to FDIC officials, FDIC
has not established any procedure for approving state nonmember
banks' establishment of bona fide subsidiaries because doing so would
be burdensome on the banks.
--------------------
\2 The FDIC Improvement Act allows examination requirements to be met
by state examinations in alternating years if the federal regulator
deems this appropriate.
FDIC DOES NOT KNOW HOW MANY
BANKS HAVE ESTABLISHED BONA
FIDE SUBSIDIARIES
---------------------------------------------------------- Chapter 4:3
From among the more than 6,000 banks the agency supervised, FDIC
could neither provide an accurate count of the number of banks that
had established or acquired bona fide subsidiaries nor identify all
such subsidiaries. In response to our request for a list of banks
with bona fide subsidiaries, FDIC polled its regions and identified
80 such banks. In our review of examination files for 13 of these
banks, we found that none were engaged in underwriting and dealing in
bank-ineligible securities.\3 In fact, only 5 of the 13 banks had
actually established or acquired bona fide subsidiaries. Of those
five subsidiaries, three provided full-service brokerage services;
the remaining two provided only discount brokerage services (which
did not require bona fide subsidiary status). Of the remaining eight
banks that had not established bona fide subsidiaries, one provided
full-service brokerage services (so it should have obtained bona fide
subsidiary status), five provided only discount brokerage services,
and two provided no brokerage services.\4
FDIC officials later told us that the initial listing of 80 banks was
inaccurate, and they were unable to provide us with any other data on
banks with bona fide subsidiaries engaged in underwriting and dealing
in bank-ineligible securities. The officials said that examiners
have several ways of identifying banks and subsidiaries that should
be examined for compliance with Section 337.4: (1) through the
notices filed by banks to FDIC regional directors, (2) from
information obtained from the banks in response to a preexamination
entry letter, (3) from survey questionnaires responded to by bank
officers, (4) from listings of bank affiliates and subsidiaries, and
(5) from examiners' own visual examination of the banking
organizations' activities. According to the officials, very few
nonmember banks have established bona fide subsidiaries for the
purpose of underwriting and dealing in bank-ineligible securities.
The FDIC officials said that underwriting and dealing in securities
are more common among larger banking organizations than the
state-chartered nonmember banks FDIC supervises.
--------------------
\3 The 13 banks were located in FDIC's Atlanta, Chicago, New York,
and San Francisco regions.
\4 As noted in chapter 1, the Glass-Steagall Act does not prohibit
banks from providing discount and full-service brokerage services.
SOME EXAMINERS WERE UNCERTAIN
ABOUT EXAMINING BONA FIDE
SUBSIDIARIES
---------------------------------------------------------- Chapter 4:4
FDIC examination guidance directs examiners to review the activities
of bank subsidiaries and their compliance with firewalls.\5 During
examinations of nonmember banks, FDIC examiners are also to determine
that the activities of bank subsidiaries do not endanger the safety
and soundness of the parent institution. When applicable, FDIC
examiners are to review for compliance with Section 337.4 provisions.
Although such subsidiaries are also subject to SEC and NASD
examination, possible impacts on the safety and soundness of
affiliated banks and compliance with firewalls to protect those banks
are not within the scope of the SEC and NASD examinations.
In our review of FDIC examinations, we found instances of uncertainty
among examiners about whether the Section 337.4 provisions applied to
the subsidiary being examined. On two examinations--one in FDIC's
Atlanta region and one in the San Francisco region--examiners did not
know if the Section 337.4 provisions applied to the organization
being examined and had to obtain determinations from FDIC regional
legal counsels of whether the regulation applied. In another
instance--in the Chicago region--a bank subsidiary that was providing
full-service brokerage services was not examined for compliance with
the regulation because the examiners believed that it did not apply
to full-service brokerage activities.
The uncertainty examiners experienced regarding the applicability of
Section 337.4 provisions is understandable. FDIC has no process for
approving the securities activities of individual banks; thus, going
into examinations FDIC examiners do not know which banks should be
examined for compliance with Section 337.4. Further, FDIC's
requirement that full-service brokerage subsidiaries be bona fide
subsidiaries and comply with Section 337.4 provisions does not appear
in FDIC's examination guidance. Section 337.4 requires only that
activities prohibited by the Glass-Steagall Act, namely underwriting
and dealing, be conducted in a bona fide subsidiary. The uncertainty
that follows from this condition might be minimized by additional
examiner guidance. As noted in chapter 2, FDIC examiners are not
provided formal training on bank securities activities. Also, FDIC
has no detailed examination procedures for examiners to follow in
examining for compliance with Section 337.4. According to FDIC
officials, no specific examination procedures are needed because
Section 337.4 "speaks for itself" and serves as adequate examination
guidance.
FDIC relies on the examination process as a means of monitoring the
activities of bona fide subsidiaries. However, FDIC has no reliable
means of knowing which banks and subsidiaries should be examined for
compliance with Section 337.4, nor has it provided clear examination
guidance or specialized training to enable FDIC examiners to conduct
efficient and effective compliance examinations of bona fide
subsidiaries.
--------------------
\5 Securities subsidiaries of nonmember banks, including bona fide
subsidiaries, are also subject to NASD examinations, which focus on
investor protection issues, such as net capital position, trading
practices, and sales practices, rather than on any effect that the
subsidiary might have on the safety and soundness of the parent
banking institution.
FDIC HAS NO RELIABLE WAY TO
MONITOR SECURITIES ACTIVITIES
OF NON-FEDERAL RESERVE MEMBER
BANKS
---------------------------------------------------------- Chapter 4:5
FDIC delegates all oversight of the bona fide subsidiaries to its
regions. FDIC does not maintain centralized data on nonmember banks
that have established or acquired bona fide subsidiaries, the volume
of bank subsidiaries underwriting and dealing activities, the
financial condition of the subsidiaries, or the subsidiaries'
compliance with FDIC firewalls. This information would be relevant
to monitoring possible risks to federally insured banks and any
possible effect on the FDIC-administered Bank Insurance Fund.
The effects of FDIC's lack of centralized oversight of the securities
activities of nonmember banks were exemplified by the results of our
effort to obtain information about those activities. FDIC could not
provide a count of banks that had established bona fide subsidiaries
or even identify any such subsidiaries. This inability to provide
information is most troublesome, as it bears on FDIC's ability to
monitor the safety and soundness of banks under its jurisdiction that
operate bona fide subsidiaries.
CONCLUSIONS
---------------------------------------------------------- Chapter 4:6
Federal banking regulators with supervisory responsibility for bank
subsidiaries that engage in securities underwriting and dealing
activities have a clear responsibility to adequately monitor the
subsidiaries' activities in order to assess and minimize risks such
activities may pose to federally insured banks. FDIC's policies on
compliance monitoring and examination guidance and training, and the
lack of systematic oversight, do not enable the agency to fulfill its
responsibility to ensure that risks securities activities pose to
nonmember banks are minimized.
Perhaps FDIC officials are correct in their perception that very few
nonmember banks have engaged in underwriting and dealing in
securities as permitted by FDIC regulations. If so, FDIC probably
does not need to establish a program to monitor bona fide
subsidiaries of the same magnitude as the program the Federal Reserve
uses to monitor Section 20 subsidiaries. However, to ensure the
safety and soundness of insured parent banks, FDIC at least should be
capable of (1) identifying which of the banks it supervises have
established bona fide subsidiaries, (2) monitoring and maintaining
information on the size of those subsidiaries' underwriting and
dealing activities and their capital adequacy positions, and (3)
ensuring that the subsidiaries have controls in place and functioning
to ensure compliance with firewalls.
RECOMMENDATION
---------------------------------------------------------- Chapter 4:7
We recommend that the Chairman, FDIC, establish a program to identify
and routinely review the securities activities and the financial
condition and performance of bona fide subsidiaries under FDIC's
jurisdiction to assess the overall risks posed by the activities on
federally insured banks and ensure compliance with firewalls. The
program should provide FDIC examiners guidance and training on how to
examine bank and bank subsidiary securities activities.
AGENCY COMMENTS AND OUR
EVALUATION
---------------------------------------------------------- Chapter 4:8
FDIC disagreed with our recommendation that it establish a program to
identify and routinely review the financial condition and performance
of bona fide subsidiaries, assess risks posed by the subsidiaries'
securities activities, and ensure compliance with firewalls. It
believes that its decentralized approach has provided effective
supervision and minimized risks to insured banks. It commented that
because the range of permissible bank securities activities is
subject to change over time, centralized reporting would only
identify which banks had a bona fide subsidiary at some point in
time. FDIC also said that supervision of those institutions would
still fall to regional personnel. FDIC noted that bank securities
subsidiaries also fall under the supervisory umbrella of SEC and
NASD. FDIC said that rather than create a burdensome reporting
process, it prefers to deal with bank subsidiaries' securities
activities on a case-by-case basis. However, FDIC also commented
that as the number of banks engaged in securities activities and the
variety of such activities increase, it is considering various ways
to improve its oversight of institution and systemic developments and
issues.
We disagree with FDIC's view that changes in the range of permissible
bank securities activities make monitoring those activities difficult
and thereby justify its not systematically monitoring those
activities. We believe that as a regulator of federally insured
banks, FDIC is responsible for knowing of and supervising activities
that may pose risks to those banks. We believe a centrally
administered program to identify and monitor the securities
activities and financial performance of institutions could improve
FDIC's oversight of nonmember banks' securities activities
immediately at little extra cost. For example, the centrally
administered Federal Reserve program requires minimal staff
resources--until recently, it required only one full-time analyst.
With FDIC having few banking organizations with securities activities
to oversee, a centrally administered program would likely require
only a part-time responsibility for one headquarters staff position.
Also, because FDIC already requires banks to notify it of
subsidiaries' securities activities and has regional supervision
programs in place, a centralized program should not require added
regulatory burden on nonmember banks. Such a program, through
regional examiners, would rely on the results of securities
regulators' examinations to alert FDIC of conditions that might
affect bank safety and soundness and not encourage duplicative
examinations. Additional reporting burden would also not be a
concern because securities subsidiaries' financial data are available
from the FOCUS reports required by securities SROs.
FEDERAL RESERVE BOARD FIREWALLS
=========================================================== Appendix I
This appendix lists (1) the firewall
requirements the Federal Reserve
established in its 1987 and 1989 orders
approving bank holding company
subsidiaries to underwrite and deal in
bank-ineligible securities and (2)
firewall requirements the Federal
Reserve modified for underwriting
subsidiaries of foreign banks.
Foreig
1987 1989 n-
Firewall category/firewall description Powers Powers owned
-------------------------------------------------------- ------ ------ ------
Types of securities to be underwritten
--------------------------------------------------------------------------------
1. Section 20 subsidiary may underwrite and deal only in
the following four ineligible securities: municipal
revenue bonds, mortgage-related securities, commercial
paper, and consumer-receivable-related (asset-backed)
securities.
2. Section 20 subsidiary may underwrite and deal in
corporate debt and equity.
Capital investment and adequacy
--------------------------------------------------------------------------------
3(a). Parent is required to deduct from its consolidated
capital any investment it makes in the Section 20
subsidiary that is treated as capital in the Section 20
subsidiary.
3(b). Foreign parent bank should meet Basle Accord
risk-based capital standards.
4. Parent will also deduct from its regulatory capital
any credit it or a nonbank subsidiary extends directly
or indirectly to the Section 20 subsidiary unless the
extension of credit is fully secured by U.S. Treasury
Securities or other marketable securities and is
collateralized in the same manner and to the same
extent as would be required under Section 23A(c) of the
Federal Reserve Act if the credit extension was made by
a member bank.
5(a). Parent and its nonbank subsidiaries will not,
directly or indirectly, provide any funds to, or for
the benefit of, the Section 20 subsidiary, whether in
the form of capital, secured or unsecured extensions of
credit, or transfer of assets, without prior notice to
and approval by the Board.
5(b). A Section 20 subsidiary may not be funded by an
applicant's U.S. bank, thrift, branch, or agency. A
foreign bank may invest in or lend to a Section 20
subsidiary as though foreign bank was a bank holding
company.
6. Before commencing new activities, parent must submit
to the Board acceptable plans to raise additional
capital or demonstrate that it is strongly capitalized
and will remain so after making the capital adjustments
authorized or required by the Board's order.
7. Section 20 subsidiary will maintain at all times
capital adequate to support its activity and cover
reasonably expected expenses and losses.
Credit extensions to customers of underwriting subsidiary
--------------------------------------------------------------------------------
8(a). Parent and its subsidiaries will not extend credit
that may be viewed as enhancing credit worthiness or
marketability of an ineligible security issue
underwritten by the Section 20 subsidiary.
8(b). Section 20 subsidiary will not underwrite or
distribute ineligible securities if it knows that an
affiliate, foreign or domestic, is providing credit
enhancements.
9. Parent and its non-Section 20 subsidiaries will not
knowingly extend to a customer credit directly or
indirectly secured by, or for the purpose of
purchasing, any ineligible security that the Section 20
subsidiary underwrites during the underwriting period
or for 30 days thereafter; or to purchase from the
Section 20 subsidiary any ineligible security in which
it makes a market.
10(a). Parent and its subsidiaries may not make loans to
issuers of ineligible securities underwritten by the
Section 20 subsidiary for purpose of payment of
principal, interest, or dividends on such securities.
To ensure compliance, any credit lines extended to an
issuer by a bank affiliate shall provide for different
timing, terms, conditions, and maturities from
ineligible securities being underwritten.
11. Parent will adopt appropriate procedures to assure
that any credit extensions by it or any of its
subsidiaries to issuers of ineligible securities
underwritten or dealt in by the Section 20 are on an
arm's length basis for purposes other than payment of
principal, interest, or dividends on such securities.
12. In any transaction involving the Section 20
subsidiary, thrift subsidiaries will observe the \a
limitations of Sections 23A and 23B of the Federal
Reserve Act as if the thrifts were banks.
13. Requirements relating to credit extensions to
issuers noted in items 8-12 above will also apply to
extensions of credit to parties that are major users of
projects that are financed by industrial revenue bonds.
14. Parent will cause its U.S. bank subsidiaries to
adopt policies and procedures, including appropriate
limits on exposure, to govern their participation in
financing transactions underwritten or arranged by the
Section 20 subsidiary.
15. Parent and its U.S. subsidiaries will establish
appropriate policies, procedures, and limitations
regarding exposure of the holding company on a
consolidated basis to any single customer whose
securities are underwritten or dealt in by the Section
20 subsidiary.
Limitations to maintain separateness of underwriting affiliate's activity
--------------------------------------------------------------------------------
16(a). No officer, director, or employee interlocks are
permitted between the Section 20 and any bank
subsidiaries of the holding company. Section 20 will
have separate offices from any affiliated bank.
16(b). No interlocks except one officer of branch may
act as a director of section 20 subsidiary. The Section
20 will have offices separate from any affiliated bank.
Disclosure by underwriting subsidiary
--------------------------------------------------------------------------------
17(a). Section 20 subsidiary will provide special
disclosure statement describing difference between the
Section 20 subsidiary and its U.S. bank affiliates,
pointing out that an affiliated bank could be a lender
to an issuer and referring the customer to the
disclosure document for details.
Statement will state that securities sold, offered, or
recommended by the Section 20 subsidiary are not
deposits, are not insured by FDIC or FSLIC, are not
guaranteed by bank affiliate, and are not an obligation
or responsibility of the bank. Section 20 will disclose
any material lending relationship between issuer and
bank affiliate, and in every case whether the proceeds
of the issue will be used to repay outstanding
indebtedness to affiliates.
Marketing activities on behalf of underwriting subsidiary
--------------------------------------------------------------------------------
18. Section 20 subsidiary and affiliated U.S. bank will
not engage in advertising or enter into an agreement
stating or suggesting that an affiliated bank is
responsible in any way for the Section 20's
obligations.
19(a). U.S. bank affiliates of the Section 20 will not
act as agent for, or engage in marketing activities on
behalf of, the Section 20. In this regard, prospectuses
and sales literature relating to securities being
underwritten or dealt in by the Section 20 subsidiary
may not be distributed by bank and may not be made
available to the public at bank affiliate office,
unless specifically requested by a customer.
Investment advice by bank and thrift affiliates and conflicts of interest
--------------------------------------------------------------------------------
20. U.S. bank affiliates may not express opinion on the
value or the advisability of purchase or sale of
ineligible securities underwritten or dealt in by the
Section 20 subsidiary unless the bank affiliate
notifies the customer that the Section 20 subsidiary is
underwriting, making a market, distributing, or dealing
in the security.
21. Parent and its U.S. bank, thrift, trust, or
investment advisory subsidiary will not purchase, as a
trustee or in any other fiduciary capacity, for
accounts over which they have investment discretion
ineligible securities (a) under-written by the Section
20 subsidiary as lead underwriter or syndicate member
during period of underwriting or selling syndicate, and
for 60-day period after termination; (b) from the
Section 20 if it makes a market in that security,
unless such purchase is specifically authorized.
Extensions of credit and purchases and sales of assets/conflicts of interest
--------------------------------------------------------------------------------
22. Parent and its non-Section 20 subsidiaries will not:
(a) purchase, as principal, ineligible securities that
are underwritten by the Section 20 subsidiary during
underwriting period and for 60 days after close of
underwriting period or (b) purchase from the Section 20
subsidiary any ineligible securities in which the
Section 20 subsidiary makes a market.
23. Section 20 subsidiary may not underwrite or deal in
ineligible securities issued by its affiliates or
representing interests in, or secured by, obligations
originated or sponsored by its affiliate, except for:
(a) securities of affiliates if rated by a
nonaffiliated, nationally recognized rating
organization or are issued or guaranteed by FNMA, FHLMC
or GNMA\,\b or represent interests in such obligations;
and (b) grantor trusts or special purpose corporations
created to facilitate underwriting of securities backed
by residential mortgages originated by a nonaffiliated
lender.
24(a). Parent will ensure that no U.S. bank subsidiary
will, directly or indirectly, extend credit in any
manner to the Section 20 subsidiary; or issue a
guarantee, acceptance, or letter of credit, including
an endorsement or standby letter of credit, for the
benefit of the Section 20 subsidiary.
24(b). This prohibition does not apply to an extension
of credit by a bank to the Section 20 subsidiary that
is incidental to the provision of clearing services by
the bank to the Section 20 subsidiary with respect to
securities of the U.S. or its agencies, if the credit
extension is fully secured by such securities, is on
market terms, and is repaid on the same calendar day.
25(a). All purchases and sales of assets between U.S.
bank affiliates and Section 20 subsidiary (or third
parties in which the Section 20 is participant, or has
financial interest, or acts as an agent or broker or
receives a fee for its services) will be at arm's
length and on terms no less stringent than those
applicable to unrelated third parties and will not
involve low-quality securities, as defined in Section
23A of the Federal Reserve Act.
25(b). U.S. bank subsidiary will not, directly or
indirectly, for its own account, purchase or sell
financial assets of the Section 20 subsidiary. This
limitation does not apply to the purchase and sale of
U.S. Treasury securities that are not subject to
repurchase or reverse repurchase agreements between the
Section 20 subsidiary and bank affiliate.
Limitations on transfers of information to address possible unfair competition
--------------------------------------------------------------------------------
26. U.S. bank affiliates may not disclose to the Section
20 subsidiary, and vice versa, any nonpublic customer
information, including an evaluation of credit
worthiness of an issuer or other customer of that bank
or Section 20 subsidiary, without customer consent.
Reports
--------------------------------------------------------------------------------
27. Parent will submit quarterly to the Federal Reserve
FOCUS reports filed with NASD or other SROs and
detailed information on the Section 20's underwriting
activity broken out by eligible and ineligible
securities.
Transfer of activities and formation of subsidiaries of an underwriting
subsidiary to engage in underwriting and dealing
--------------------------------------------------------------------------------
28. Pursuant to Regulation Y, corporate reorganization
of the Section 20 subsidiary may not be consummated
without prior Board approval.
Limitations on reciprocal arrangements and discriminatory treatment
--------------------------------------------------------------------------------
29(a). Parent and its subsidiaries may not, directly or
indirectly, enter into any reciprocal arrangement with
another holding company for purposes of evading Board
requirements.
29(b). U.S. bank affiliates of Section 20 subsidiary \c
will not, directly or indirectly, (a) acting alone or
with others, extend or deny credit or services, or vary
terms or conditions, if the effect would be to treat an
unaffiliated securities firm less favorably than the
Section 20, unless the extension or denial is based on
objective criteria and is consistent with sound
business practices; (b) extend or deny credit or
services or vary terms or conditions with intent of
creating a competitive advantage for the Section 20.
Requirement for supervisory review before commencement of activities
--------------------------------------------------------------------------------
30. Parent may not commence proposed debt and equity
securities underwriting and dealing activities until
the Board has determined that policies and procedures
have been established to ensure compliance with this
Order's requirements, including computer, audit, and
accounting systems, internal risk management controls,
and operational and managerial infrastructure.
--------------------------------------------------------------------------------
Legend
= Firewall applicable
\a Sections 23A and 23B of the Federal Reserve Act were made
applicable to thrifts in 1989 by the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989.
\b FNMA refers to Federal National Mortgage Association; FHLMC refers
to Federal Home Loan Mortgage Corporation; GNMA refers to Government
National Mortgage Association.
\c Although 1987 firewalls did not include tying restrictions,
Section 20 subsidiaries operating with 1987 powers are not exempt
from tying prohibitions contained in section 106(b) of the Bank
Holding Company Act Amendments of 1970 and Federal Reserve Regulation
Y (12 C.F.R. 225.7).
Source: GAO analysis of Federal Reserve information.
FDIC BONA FIDE SUBSIDIARY
PROVISIONS AND FIREWALLS
========================================================== Appendix II
FDIC regulation 337.4 requires that a subsidiary of an insured
nonmember bank that conducts securities activities not authorized for
a bank under sections 16 and 21 of the Glass-Steagall Act
(1) is adequately capitalized;
(2) is physically separate and distinct in its operations from the
operation of the bank;
(3) maintains separate accounting and other corporate records;
(4) observes separate formalities, such as board of directors'
meetings;
(5) maintains separate employees who are compensated by the
subsidiary;
(6) shares no common officers with the bank;
(7) has a board of directors that is composed of a majority of
persons who are neither directors nor officers of the bank; and
(8) conducts business pursuant to independent policies and procedures
designed to inform customers and prospective customers of the
subsidiary that the subsidiary is an organization separate from the
bank and that investments recommended, offered, or sold by the
subsidiary are not bank deposits, are not insured by FDIC, and are
not guaranteed by the bank nor are otherwise obligations of the bank.
Bona fide subsidiaries are required to register with the Securities
and Exchange Commission as broker-dealers and be members in good
standing of the National Association of Securities Dealers.
Bona fide subsidiaries' underwriting activities are limited to
underwriting of investment quality debt and equity securities and
underwriting of investment companies with not more than 25 percent of
their investments in other than investment quality securities or
obligations of the United States Government and its agencies, bank
certificates of deposit, bankers acceptances, and other bank money
instruments, short-term corporate debt instruments, and other similar
investments normally associated with a money market fund.
An insured nonmember bank that has a subsidiary or affiliate that
engages in the sale, distribution, or underwriting of stocks, bonds,
debentures, notes, or other securities, or acts as an investment
advisor to any investment company shall not:
(1) Purchase in its discretion as fiduciary, cofiduciary, or managing
agent any security currently distributed, currently underwritten, or
issued by its "bona fide" subsidiary or an investment company advised
by that subsidiary, unless where allowed by regulation.
(2) Transact business through its trust department with its
subsidiary unless the transactions are at least comparable to
transactions with an unaffiliated securities company or a securities
company that is not a subsidiary of the bank.
(3) Extend credit or make any loan directly or indirectly to any
company the stocks, bonds, debentures, notes, or other securities of
which are currently underwritten or distributed by its subsidiary or
affiliate of the bank unless the company's stocks, bonds, debentures,
notes, or other securities that are underwritten or distributed
qualify as investment quality debt or equity securities.
(4) Extend credit or make any loan directly or indirectly to any
investment company whose shares are currently underwritten or
distributed by the "bona fide" subsidiary of the bank.
(5) Extend credit or make any loan where the purpose of the extension
of credit or loan is to acquire any stock, bond, debenture, note, or
other security underwritten by the bank's subsidiary or an investment
company advised by the subsidiary, unless as allowed by regulation.
(6) Make any loan or extension of credit to the "bona fide"
subsidiary unless the loan or extension of credit is within limits
imposed by Section 23A of the Federal Reserve Act.
(7) Make any loan or extension of credit to an investment company for
which the bank's subsidiary acts as an investment advisor unless the
loan or extension of credit is within limits imposed by Section 23A
of the Federal Reserve Act.
(8) Directly or indirectly condition any loan or extension of credit
to any company on the requirement that the company contract with, or
agree to contract with, the bank's subsidiary to underwrite or
distribute the company's securities or directly or indirectly
condition any loan or extension of credit to any person on the
requirement that the person purchase any security currently
underwritten or distributed by the bank's subsidiary or affiliate.
(See figure in printed edition.)Appendix III
COMMENTS FROM THE BOARD OF
GOVERNORS OF THE FEDERAL RESERVE
SYSTEM
========================================================== Appendix II
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following is GAO's comment on the Federal Reserve's May 18, 1995,
letter.
GAO COMMENT
-------------------------------------------------------- Appendix II:1
1. The caption in the executive summary, the title of chapter 3, and
our conclusion on the effectiveness of the Federal Reserve's program
in the final report were modified. These changes were made in
response to the Federal Reserve's noting the few problems we found
after reviewing inspections of numerous individual firewall
conditions.
(See figure in printed edition.)Appendix IV
COMMENTS FROM THE FEDERAL DEPOSIT
INSURANCE CORPORATION
========================================================== Appendix II
(See figure in printed edition.)
Now on p. 36.
(See figure in printed edition.)
(See figure in printed edition.)
See comment 3.
(See figure in printed edition.)
See comment 5.
See comment 7.
(See figure in printed edition.)
The following are GAO's comments on FDIC's May 18, 1995, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix II:2
1. The draft of this report referred to securities activities that
FDIC "allows." Because FDIC pointed out that it did not have the
authority to convey authority to banks, the text in this report was
modified to delete the word "allows."
2. The analysis of table 2.2 and related text were modified, in
part, in response to information provided by FDIC.
3. Table 1.1 was modified to reflect FDIC's comment that bank direct
brokerages are not subject to regulation by SEC and NASD. The text
was modified to include this information.
4. The text and table 1.1 were modified to indicate that bank
regulators have no authority over third-party broker-dealers
operating on bank premises.
5. As FDIC pointed, out the text was modified to indicate that bank
and securities regulators are already cooperating on developing
testing requirements for bank personnel.
6. FDIC pointed out that a statement in the draft was inconsistent
with a provision in the Federal Deposit Act and the statement was
deleted from the text.
7. FDIC pointed out that a statement in the draft about its
regulatory requirements concerning bank capital was incorrect. The
statement was revised to indicate that its regulations require that
an insured nonmember bank's direct investment in a securities
subsidiary not be counted toward the bank's capital.
8. FDIC pointed out that a statement in the draft about which
subsidiaries must meet the definition of a bona fide subsidiary was
incorrect and the statement was deleted from the text.
(See figure in printed edition.)Appendix V
COMMENTS FROM THE COMPTROLLER OF
THE CURRENCY
========================================================== Appendix II
(See figure in printed edition.)
See comment 1.
See comment 2.
(See figure in printed edition.)
Now on p. 41.
Now on pp. 34 and 35.
Now on pp. 37 and 38.
(See figure in printed edition.)
The following are GAO's comments on OCC's June 8, 1995, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix II:3
1. OCC said the introductory section incorrectly concludes that bank
underwriting activities necessarily increase bank risk. It said that
diversification into securities activities can actually reduce risk.
In the Objective, Scope, and Methodology section we note that it was
not in the scope of our review to determine comparative degrees of
risk associated with different banking and nonbanking activities that
banks might engage in. However, banks that engage in securities
underwriting and dealing would be subject to risks of financial
losses just as securities firms that underwrite and deal in
securities are.
2. OCC said that the draft misrepresented its proposed rule
governing corporate applications. The text was modified to
incorporate OCC's interpretation of the proposal.
3. OCC said the draft incorrectly implied that the banking agencies
permitted referral fees in a manner inconsistent with a NASD proposed
rule. The text was modified to indicate that the Interagency
Statement permits one-time fixed-dollar amount referral fees. OCC
states that the NASD proposal also permits, or does not prohibit,
such fees. However, fees paid by the bank to bank employees are
beyond NASD's authority.
4. As OCC suggested, the text was modified to note that the
Interagency Statement also requires oral disclosure at any sales
presentation or offering of investment advice.
5. OCC said that banking agency access to CRD information should not
be highlighted as a new initiative because they have had direct
access to that information for years. A footnote was added to note
limitation of the regulators access to CRD information.
6. In response to OCC's comments, information about the cooperative
effort to make securities industry qualification examinations
available to the banking industry is now characterized as an ongoing
effort rather than a proposal.
7. The text was modified to include the additional training that OCC
said was provided to examiners.
8. As OCC suggested, the text was modified to indicate that the
antifraud provisions of federal securities law apply to banks in the
same manner as registered broker-dealers.
9. The statement that banking regulators try to minimize their
disclosure of enforcement actions against banks was deleted from the
text.
(See figure in printed edition.)Appendix VI
COMMENTS FROM THE SECURITIES AND
EXCHANGE COMMISSION
========================================================== Appendix II
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on SEC's May 19, 1995, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix II:4
1. As SEC suggested, the text was modified to compare the number of
bank-direct brokerages to the total number of banks that provide
securities services.
2. Brokerage services that are provided through registered
broker-dealers, including bank affiliates and independent third-party
broker-dealers, were not included in the scope of this report, as SEC
suggested, because they are subject to SEC and NASD regulation. See
p. 22.
(See figure in printed edition.)Appendix VII
COMMENTS FROM THE NATIONAL
ASSOCIATION OF SECURITIES DEALERS
========================================================== Appendix II
(See figure in printed edition.)
See comment 1.
(See figure in printed edition.)
See comment 3.
See comment 4.
See comment 5.
(See figure in printed edition.)
The following are GAO's comments on NASD's May 17, 1995, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix II:5
1. The clarification to table 1.1 that NASD suggested was made by
providing separate categories for bank affiliates and third-party
broker-dealers.
2. NASD said the bank regulators did not discuss their Joint Policy
Statement with NASD as the draft stated. The phrase was deleted from
the text.
3. The text was modified to special "financial" information as NASD
recommended.
4. The text was modified to include NASD's views on regulation of
banks' securities brokerage activities.
5. As NASD indicated, information about the cooperative effort to
make securities industry qualification examinations available to the
banking industry is now characterized as an ongoing effort rather
than a proposal.
TECHNICAL APPENDIX: SURVEY OF
BANKS
======================================================== Appendix VIII
Ranking Minority Members of congressional committees asked us to
determine whether bank examiners check for compliance with retail
securities brokerage safeguards and whether sanctions are imposed on
banks that breach those safeguards. To accomplish this, we needed to
select for evaluation banks whose own employees were involved in the
brokerage services offered by the bank. We also set out to describe
the nature and extent of retail securities activities conducted by
banks.
To help meet this request, we mailed questionnaires to a random
sample of 2,233 banks. The results of that survey are representative
of the entire banking industry.
Our questionnaire gathered data on the different types of retail
securities brokerage services offered and through what arrangements
with employees, subsidiaries, affiliates, or third parties the
services were being offered. In addition, we included a number of
questions on the related subject of bank mutual fund sales programs.
The fieldwork for the survey was conducted from February through June
of 1994.
SURVEY SAMPLE PLAN
---------------------------------------------------- Appendix VIII:0.1
We developed the survey frame (a listing, without duplicates or
omissions, of each element in the population of U.S. banks) from a
file containing the June 1993 Call Report data. This database listed
13,360 banks. After removing International Banking Associations and
New York Investment Companies (which we felt were mostly commercial
institutions unlikely to have retail brokerage programs), our frame
contained 11,769 banks. Later, we excluded 559 mutual savings banks
from the analysis, because they fell outside the scope of our work.
Our total survey population, or universe, consisted of 11,210 banks.
From this frame, we randomly sampled 2,233 banks. We divided the
institutions in the frame into 12 strata (see table VIII.1) and
distributed our sample across those strata so that survey estimates
from each stratum would be likely to have sampling errors for the
most important questions of no more than � 5 percent at the
95-percent level of confidence. Unless otherwise noted, the survey
statistics in this report have sampling errors within that range.
Because we surveyed only one of a large number of possible samples of
the bank population to develop the statistics used in this report,
each of the estimates made from this sample has a sampling error,
which is a measure of the precision with which the estimate
approximates the population value. The sampling error is the maximum
amount by which estimates derived from our sample could differ from
estimates from any other sample of the same size and design and is
stated at a certain confidence level, usually 95 percent. This means
that if all possible samples were selected, the interval defined by
their sampling errors would include the true population value 95
percent of the time. In addition to sampling error, all sample
surveys may also be subject to error from a number of other sources,
as described in the section on survey error and data quality below.
QUESTIONNAIRE DESIGN AND
ADMINISTRATION
---------------------------------------------------- Appendix VIII:0.2
We developed our questionnaires in consultation with experts in the
finance industry and at regulatory agencies, and we conducted six
pretests with banks that represented a range of sizes and regulators.
We made revisions to the questionnaire on the basis of the comments
we received. See appendix IX for a copy of the pages from the
questionnaire used in our analysis.
We addressed each questionnaire to the office of the President or CEO
at each institution, using the mailing address information listed in
the Call Report file.
We mailed questionnaires to all 2,233 sampled banks in early February
of 1994. To the institutions not responding to our survey by the end
of March 1994, we sent a follow-up questionnaire on April 1, 1994.
We ended the fieldwork for this survey on June 16, 1994, discarding
any questionnaire returned after that date.
SURVEY RESPONSE
---------------------------------------------------- Appendix VIII:0.3
By the end of the survey fieldwork period, we had received 1,508
completed questionnaires, accounting for 68 percent of the banks in
our sample. Table VIII.1 displays, by strata, the dispositions of
the questionnaires we sent out. Because banks in different strata
were sampled at different rates, and because institutions responded
at different rates across the strata, the survey estimates made in
this report were weighted, or statistically adjusted, so that the
answers given by institutions in different strata were represented in
proportion to their actual numbers in the entire population.
There was a slight tendency for the smaller institutions (in terms of
asset size) to respond at higher rates than larger institutions.
Also, those responding early in the survey period tended to be the
banks not offering brokerage services (such questionnaires required
little work on the part of our respondents, making it easier to fill
out the questionnaire). We have no reason to believe that these
patterns of response had any impact on the accuracy of the survey
estimates. However, we conducted no follow-up contacts with any of
the nonrespondents to determine if their answers were significantly
different from the answers of those who did respond.
Table VIII.1
Survey Dispositions of Sampled Banks
Strata
(institution Returned Returned
type and asset Original Initial Ineligible\b Adjusted undeliverable by unusable Returned usable
size) population\a sample from sample sample\c Post Office\d questionnaire\e questionnaire Response rate\f
---------------- ------------ ------------ ------------ ---------------- ---------------- ---------------- ---------------- ----------------
FRS national 2,514 350 2 348 12 2 265 0.76%
banks up to
$150 million
$150-$250 348 174 4 170 6 0 122 0.72
million
$250 MM-$1 388 194 5 189 10 0 98 0.52
billion
$1 billion and 202 150 4 146 4 2 75 0.51
up
FRS state banks 749 270 1 269 8 1 207 0.77
up to
$150 million
$150-$250 76 76 2 74 4 0 47 0.64
million
$250 million-$1 84 84 0 84 3 0 55 0.65
billion
$1 billion and 63 63 1 62 5 0 33 0.53
up
FDIC state banks 5,900 375 4 371 9 2 284 0.77
up to
$150 million
$150-$250 428 214 2 212 7 0 143 0.67
million
$250 million-$1 350 175 4 171 13 1 120 0.70
billion
$1 billion and 108 108 2 106 10 1 59 0.56
up
====================================================================================================================================================
Totals 11,210 2,233 31 2,202 91 9 1,508.00 0.68
----------------------------------------------------------------------------------------------------------------------------------------------------
\a All banks identified in the June 1993 Call Report, except mutual
savings banks, international bank associations, and New York
investment companies.
\b Sampled elements outside the survey population due to no existing
address, merger, receivership, or other cessation of operations as a
depository institution.
\c Number in original sample minus number ineligible.
\d Sampled elements in the survey population, but questionnaire
returned undeliverable due to insufficient address, or unknown
address and forwarding order expiration.
\e Blank, incomplete, or refused questionnaire returned, or returned
after cut-off date.
\f Response rate calculated as the number of banks completing usable
questionnaires divided by the number of eligible banks in the
adjusted sample.
SURVEY ERROR AND DATA
QUALITY
---------------------------------------------------- Appendix VIII:0.4
In addition to the presence of sampling errors, as discussed above,
the practical difficulties of conducting any survey may introduce
other types of errors, commonly referred to as nonsampling errors.
For example, differences in how a particular question is interpreted,
in the sources of information that are available to respondents, or
in the types of people who do not respond can introduce unwanted
variability into the survey results.
We included steps in both the data collection and data analysis
stages for the purpose of minimizing such nonsampling errors. We
selected our sample from the most complete and up-to-date listing of
banks available, and we attempted to increase the response rate by
conducting a follow-up mailing accompanied by cover letters stressing
the importance of the survey. To minimize errors in measurement, we
pretested the questionnaire thoroughly and obtained reviews from
industry experts and agency officials.
To ensure data processing integrity, all data were double-keyed and
verified during data entry. Computer analyses were performed to
identify inconsistencies or other indication of errors, and all
computer analyses were checked by a second independent analyst.
Finally, we performed limited validation of a number of returned
questionnaires through contacts with respondents or review of other
agency records.
(See figure in printed edition.)Appendix IX
SURVEY OF BANKS AND THRIFTS ON
MUTUAL FUND AND SECURITIES
ACTIVITIES
======================================================== Appendix VIII
(See figure in printed edition.)
(See figure in printed edition.)
MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix X
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
--------------------------------------------------------- Appendix X:1
Michael A. Burnett, Project Director
David P. Tarosky, Project Manager
Charles Michael Johnson, Deputy Project Manager
Desiree W. Whipple, Reports Analyst
Carl Ramirez, Social Science Analyst
CHICAGO REGIONAL OFFICE
--------------------------------------------------------- Appendix X:2
Roger E. Kolar, Senior Evaluator
Daniel K. Lee, Evaluator
NEW YORK REGIONAL OFFICE
--------------------------------------------------------- Appendix X:3
Susan Chan, Evaluator
Phillip F. Merryman, Evaluator
SAN FRANCISCO REGIONAL OFFICE
--------------------------------------------------------- Appendix X:4
Susan J. Kramer, Senior Evaluator
Donald Y. Yamada, Senior Evaluator