Industrial Loan Corporations
Recent Asset Growth and Commercial Interest Highlight Differences in Regulatory Authority Gao ID: GAO-06-961T July 12, 2006Since their origin in the early 1900s, industrial loan corporations (ILCs) have grown significantly in size, and some have expressed concern that ILCs may have expanded beyond the original scope and purpose intended by Congress. Others have questioned whether the current regulatory structure for overseeing ILCs is adequate. This testimony is based on our September 2005 report that, among other things, (1) described the growth and permissible activities of the ILC industry, (2) compared the supervisory authority of the FDI--the current federal regulator for ILCs--with consolidated supervisors, and (3) described the extent to which ILC parents could mix banking and commerce. In this testimony GAO is reiterating that Congress should (1) consider options for strengthening the regulatory oversight of ILCs and (2) more broadly consider whether allowing ILCs a greater degree of mixing banking and commerce is warranted or whether other entities should be permitted to engage in this level of activity.
The ILC industry has experienced significant asset growth and has evolved from once small, limited-purpose institutions to a diverse industry that includes some of the nation's largest and more complex financial institutions. Between 1987 and 2006, ILC assets grew over 3,900 percent from $3.8 billion to over $155 billion. In most respects, ILCs may engage in the same activities as other depository institutions insured by the FDIC and are subject to the same federal safety and soundness safeguards and consumer protection laws. Therefore, from an operations standpoint, ILCs pose similar risks to the bank insurance fund as other types of insured depository institutions. Parents of insured depository institutions that present similar risks to the bank insurance fund are not, however, being overseen by bank supervisors that possess similar powers. ILCs typically are owned or controlled by a holding company that may also own or control other entities. Although FDIC has supervisory authority over an insured ILC, this authority does not explicitly extend to ILC holding companies and, therefore, is less extensive than the authority consolidated supervisors have over bank and thrift holding companies. Therefore, from a regulatory standpoint, these ILCs may pose more risk of loss to the bank insurance fund than other insured depository institutions operating in a holding company. For example, FDIC's authority to examine ILC affiliates is more limited than a consolidated supervisor. While FDIC asserted that its authority may achieve many of the same results as consolidated supervision, and that its supervisory model has mitigated losses to the bank insurance fund in some instances, FDIC's authority is limited to a particular set of circumstances and may not be used at all times. Further, FDIC's authority has not been tested by a large ILC parent during times of economic stress. Because of an exception in federal banking law, ILC holding companies can mix banking and commerce more than the holding companies of most other depository institutions. In addition, there are a number of pending applications for deposit insurance with FDIC involving commercial firms, including one of the largest retail firms. While some industry participants assert that mixing banking and commerce may offer benefits from operational efficiencies, empirical evidence documenting these benefits is mixed. Federal policy separating banking and commerce focuses on the potential risks from integrating these functions, such as the potential expansion of the federal safety net provided for banks to their commercial entities. GAO finds it unusual that a limited ILC exemption would be the primary means for mixing banking and commerce on a broader scale and sees merits in Congress taking a look at whether ILCs or other entities should be allowed to engage in this level of activity.
GAO-06-961T, Industrial Loan Corporations: Recent Asset Growth and Commercial Interest Highlight Differences in Regulatory Authority
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Testimony:
Before the Subcommittee on Financial Institutions and Consumer Credit,
Committee on Financial Services, House of Representatives:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Wednesday, July 12, 2006:
Industrial Loan Corporations:
Recent Asset Growth and Commercial Interest Highlight Differences in
Regulatory Authority:
Statement of Richard J. Hillman, Managing Director:
Financial Markets and Community Investment:
GAO-06-961T:
GAO Highlights:
Highlights of GAO-06-961T, testimony before the Subcommittee on
Financial Institutions and Consumer Credit, Committee on Financial
Services, House of Representatives
Why GAO Did This Study:
Since their origin in the early 1900s, industrial loan corporations
(ILCs) have grown significantly in size, and some have expressed
concern that ILCs may have expanded beyond the original scope and
purpose intended by Congress. Others have questioned whether the
current regulatory structure for overseeing ILCs is adequate.
This testimony is based on our September 2005 report that, among other
things, (1) described the growth and permissible activities of the ILC
industry, (2) compared the supervisory authority of the FDIC”the
current federal regulator for ILCs”with consolidated supervisors, and
(3) described the extent to which ILC parents could mix banking and
commerce.
In this testimony GAO is reiterating that Congress should (1) consider
options for strengthening the regulatory oversight of ILCs and (2) more
broadly consider whether allowing ILCs a greater degree of mixing
banking and commerce is warranted or whether other entities should be
permitted to engage in this level of activity.
What GAO Found:
The ILC industry has experienced significant asset growth and has
evolved from once small, limited-purpose institutions to a diverse
industry that includes some of the nation‘s largest and more complex
financial institutions. Between 1987 and 2006, ILC assets grew over
3,900 percent from $3.8 billion to over $155 billion. In most respects,
ILCs may engage in the same activities as other depository institutions
insured by the FDIC and are subject to the same federal safety and
soundness safeguards and consumer protection laws. Therefore, from an
operations standpoint, ILCs pose similar risks to the bank insurance
fund as other types of insured depository institutions.
Parents of insured depository institutions that present similar risks
to the bank insurance fund are not, however, being overseen by bank
supervisors that possess similar powers. ILCs typically are owned or
controlled by a holding company that may also own or control other
entities. Although FDIC has supervisory authority over an insured ILC,
this authority does not explicitly extend to ILC holding companies and,
therefore, is less extensive than the authority consolidated
supervisors have over bank and thrift holding companies. Therefore,
from a regulatory standpoint, these ILCs may pose more risk of loss to
the bank insurance fund than other insured depository institutions
operating in a holding company. For example, FDIC‘s authority to
examine ILC affiliates is more limited than a consolidated supervisor.
While FDIC asserted that its authority may achieve many of the same
results as consolidated supervision, and that its supervisory model has
mitigated losses to the bank insurance fund in some instances, FDIC‘s
authority is limited to a particular set of circumstances and may not
be used at all times. Further, FDIC‘s authority has not been tested by
a large ILC parent during times of economic stress.
Because of an exception in federal banking law, ILC holding companies
can mix banking and commerce more than the holding companies of most
other depository institutions. In addition, there are a number of
pending applications for deposit insurance with FDIC involving
commercial firms, including one of the largest retail firms. While some
industry participants assert that mixing banking and commerce may offer
benefits from operational efficiencies, empirical evidence documenting
these benefits is mixed. Federal policy separating banking and commerce
focuses on the potential risks from integrating these functions, such
as the potential expansion of the federal safety net provided for banks
to their commercial entities. GAO finds it unusual that a limited ILC
exemption would be the primary means for mixing banking and commerce on
a broader scale and sees merits in Congress taking a look at whether
ILCs or other entities should be allowed to engage in this level of
activity.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-961T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Richard J. Hillman at
(202) 512-8678 or hillmanr@gao.gov.
[End of Section]
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss the results of our 2005 report
on industrial loan corporations (ILCs).[Footnote 1] Over the past 10
years, ILCs, particularly when included as part of a holding company
structure, have experienced significant growth, now having over $155
billion in assets; these once small niche lenders have evolved into a
diverse industry that includes some large, complex financial
institutions. As a result, some have expressed concerns that ILCs may
be expanding beyond the original scope and purpose intended by
Congress.
The potential entry into banking services by some of the nation's
largest retailers has also raised concerns. In 2005, one of the world's
largest retailer, Wal-Mart, submitted an application with the Federal
Deposit Insurance Corporation (FDIC) to provide federal insurance of
deposits in a subsidiary ILC. In May, Home Depot, the nation's largest
home improvement retailer, submitted an application for FDIC to approve
the purchase of an existing ILC. Proponents assert that these
operations will benefit consumers through lower prices or increased
access to financial services. Critics, however, say that nonfinancial
operations of this size owning an insured ILC pose unnecessary risks to
the deposit insurance funds that cannot be adequately addressed under
the current regulatory authorities.
My remarks today are primarily based on our 2005 report and focus on
three of the report's objectives: the growth and permissible activities
of the ILC industry, how FDIC's supervisory authority over ILC holding
companies and affiliates compares with a consolidated supervisors'
authority; and, the extent to which the ILC charter enables commercial
holding companies to mix banking and commerce.[Footnote 2]
In summary:
ILCs began in the early 1900s as small, state-chartered, loan companies
that primarily served the borrowing needs of industrial workers unable
to obtain noncollateralized loans from banks. Since then, the ILC
industry has experienced significant asset growth and has evolved from
small, limited-purpose institutions to a diverse industry that includes
some of the nation's largest and more complex financial institutions
with extensive access to the capital markets. For example, from 1987 to
March 31, 2006, ILC assets have grown over 3,900 percent from $3.8
billion to over $155 billion. With one exception contained in federal
and one state's banking laws, federally insured ILCs in a holding
company structure may generally engage in the same activities as other
FDIC-insured depository institutions. Like other FDIC-insured
depository institutions, ILCs may offer a full range of loans such as
consumer, commercial and residential real estate, and small business
loans. As a result, from an operations standpoint, ILCs in a holding
company structure pose risks to the Deposit Insurance Fund (the Fund)
similar to those posed by other FDIC-insured institutions in holding
company structures.[Footnote 3]
ILCs are state chartered depository institutions. Concerns about them
presently exist because of a provision in the Bank Holding Company Act
(BHC Act). Under that act, a company that owns or controls a federally
insured ILC can conduct banking activities through the ILC without
becoming subject to the federal supervisory regime that applies to
companies that own or control banks or thrifts. Because these ILCs have
federally insured deposits, they are subject to supervision by FDIC as
well as their respective state regulators.[Footnote 4] However, FDIC
lacks the explicit authority to regulate ILC parent companies and their
activities. Under the BHC Act, the Board of Governors of the Federal
Reserve (Board) is responsible for supervising bank holding companies
and has established a consolidated supervisory framework for assessing
the risks to a depository institution that could arise because of their
affiliation with other entities in a holding company
structure.[Footnote 5] The Office of Thrift Supervision has similar
authority under the Home Owners Loan Act with respect to savings and
loan holding companies. The Board and OTS each take a systemic approach
to supervising depository institution holding companies and their
nonbank subsidiaries and may look across lines of business at
operations such as risk management, information technology, or internal
audit in order to determine the risk these operations may pose to the
insured institution. However, because of an exception under the BHC
Act, holding companies of ILCs are not subject to consolidated
supervision. Unlike the Board, FDIC does not have specific consolidated
supervisory authority over holding companies that conduct banking
activities only through ILCs. FDIC has, however, employed what some
term a "bank-centric" supervisory approach that primarily focuses on
isolating the insured institution from potential risks posed by holding
companies and affiliates, rather than assessing these potential risks
systemically across the consolidated holding company structure. While
FDIC's cooperative working relationships with state supervisors and ILC
holding company organizations, combined with its other bank regulatory
powers, has allowed FDIC, under certain circumstances, to assess and
address the risks to the insured institution and to achieve other
results to protect the insurance fund against ILC-related risks,
questions remain about the extent to which FDIC's supervisory approach
and authority address all risks posed to an ILC from its parent holding
company and nonbank affiliates and how well FDIC's approach would fare
for large, troubled ILCs during times of stress.
Another area of potential concern about ILCs is the extent to which
they can mix banking and commerce through the holding company
structure. The BHC Act maintains the historical separation of banking
from commerce by generally restricting bank holding companies to
banking-related or financial activities. [Footnote 6] However, because
of the ILC exemption in the BHC Act, ILC holding companies, including
nonfinancial institutions such as retailers and manufacturers, and
other institutions are not subject to federal activities restrictions.
Consequently, they have greater latitude to mix banking and commerce
than most other financial institutions. While some industry
participants have stated that mixing banking and commerce may offer
benefits from operational efficiencies, the policy of separating
banking and commerce was based primarily on reducing the potential
adverse consequences that combining these activities may pose. These
include the potential expansion of the federal safety net provided for
depository institutions to their commercial holding companies or
affiliates, increased conflicts of interest within a mixed banking and
commercial conglomerate, and increased economic power exercised by
large conglomerate enterprises. We found divergent views about the
competitive implications of mixing banking and commerce and were unable
to identify conclusive empirical evidence that documented efficiencies
attributable to mixing banking and commerce. In addition, we found it
unusual that use of the ILC exemption under the BHC Act would be the
primary means for mixing banking and commerce across a broader scale
than afforded to the holding companies of other federally insured
depository institutions.
Our report included matters for congressional consideration designed to
better ensure that insured institutions providing similar risks to the
Fund are subject to federal supervision overseen by banking supervisors
that possess similar powers. In this regard, we determined that it
would be useful for Congress to consider several options such as
eliminating the current BHC Act exception for ILCs and their holding
companies from consolidated supervision, granting FDIC similar
examination and enforcement authority as a consolidated supervisor, or
leaving the oversight responsibility of small, less complex ILCs with
the FDIC, and transferring oversight of large, more complex ILCs to a
consolidated supervisor. In addition, we concluded that it would also
be beneficial for Congress to more broadly consider the advantages and
disadvantages of mixing banking and commerce to determine whether
allowing ILC holding companies to engage in this activity more than the
holding companies of other types of financial institutions is warranted
or whether other financial or bank holding companies should be
permitted to engage in this level of activity.
Before discussing the results of our work more fully, I would like to
provide a brief overview of the growth of ILCs and compare their
permissible activities with those of a state nonmember commercial bank.
ILCs Have Grown Significantly and Are No Longer Small, Limited-Purpose
Institutions:
First, I would like to highlight the significant growth and
transformation that has taken place in the ILC industry since 1987.
ILCs began in the early 1900s as small, state-chartered loan companies,
serving the borrowing needs of industrial workers unable to obtain
noncollateralized loans from commercial banks. Since then, the ILC
industry has experienced significant asset growth and evolved from
small, limited-purpose institutions to a diverse group of insured
financial institutions with a variety of business models. Most notably,
as shown in figure 1, from 1987 to March 31, 2006, ILC assets have
grown over 3,900 percent, from $3.8 billion to over $155 billion, while
the number of ILCs declined about 42 percent from 106 to 61. In March
2006, 9 ILCs were among the 271 largest financial institutions in the
nation with $3 billion or more in total assets, and one institution had
over $62 billion in total assets. As of March 31, 2006, 6 ILCs owned
over 80 percent of the total assets for the ILC industry with aggregate
assets totaling over $125 billion and collectively controlled about $68
billion in FDIC-insured deposits. During this time period, most of the
growth occurred in the state of Utah while the portion of ILC assets in
other states declined--especially in California. According to Utah
officials, among the reasons ILCs grew in that state was because its
laws are "business friendly," and the state offers a large, well-
educated workforce for the financial services industry.
Figure 1: Number and Total Assets of ILCs, 1987 to March 31, 2006:
[See PDF for image]
Source: GAO analysis of FDIC Call Report data.
[End of figure]
Financial services firms, such as the ILCs owned by Merrill Lynch, USAA
Savings Bank, and American Express own and operate the majority of the
61 active ILCs.[Footnote 7] These ILCs are parts of complex financial
institutions with extensive access to capital markets. Other ILCs are
part of a business organization that conducts activities within the
financial arm of a larger corporate organization not necessarily
financial in nature. In addition, other ILCs directly support the
holding company organizations' commercial activities, such as the ILCs
owned by BMW and Volkswagen. Finally, some ILCs are smaller, community-
focused, stand-alone institutions such as Golden Security Bank and
Tustin Community Bank.
Although the total amount of estimated insured deposits in the ILC
industry has grown by over 600 percent since 1999, as shown in figure
2, these deposits represent less than 3 percent of the total estimated
insured deposits in the bank insurance fund for all banks. The
significant increase in estimated insured deposits since 1999 was
related to the growth of a few ILCs owned by financial services firms.
For example, as of March 31, 2006, the largest ILC, owned by Merrill
Lynch, held over $43 billion in estimated FDIC insured deposits.
Figure 2: Percentage of Estimated FDIC Insured Deposits Held by ILCs,
1987 - March 31, 2006:
[See PDF for image]
Source: GAO analysis of FDIC Call Report data.
[End of figure]
ILC Business Lines and Regulatory Safeguards Are Similar to Other
Insured Financial Institutions:
Next, I would like to briefly compare the permissible activities of
ILCs with other insured financial institutions.[Footnote 8] Federal
banking law permits FDIC-insured ILCs to engage in the same activities
as other insured depository institutions. However, in order to qualify
for the ILC exception in the BHC Act, (and also, we found, because of
restrictions in California state law) most ILCs, which are owned by non-
BHC Act holding companies, may not accept demand deposits. Other than
this exception, banking laws in California, Nevada, and Utah have
undergone changes that generally place ILCs on par with traditional
banks in terms of services provided. Thus, as shown in Table 1, like
other FDIC-insured depository institutions, ILCs may offer a full range
of loans such as consumer, commercial and residential real estate, and
small business loans. Further, like a bank, ILCs may "export" their
home-state's interest rates to customers residing elsewhere. [Footnote
9] In effect, this permits ILCs offering credit cards to charge their
state's maximum allowable interest rates in other states. [Footnote 10]
In addition, ILCs generally are subject to the same federal regulatory
safeguards that apply to commercial banks and thrifts. For example,
ILCs are subject to restrictions on transactions between an insured
institution and its affiliates under sections 23A and 23B of the
Federal Reserve Act that are designed to protect the insured depository
institution from adverse transactions with holding companies and
affiliates. [Footnote 11] Sections 23A and 23B generally limit the
dollar amount of loans to affiliates and require transactions to be
done on an "arms-length" basis.[Footnote 12] ILCs must also comply with
Bank Secrecy Act, Anti-Money Laundering, and Community Reinvestment Act
requirements and like other insured depository institutions comply with
consumer protection laws.
During our review, we did not identify any banking activities that were
unique to ILCs that other insured depository institutions were not
permitted to do. The primary difference, as shown in table 1, between
ILCs and other FDIC-insured depository institutions is that, to remain
outside of the BHC Act, an ILCs must be chartered in the states
described in the the ILC exemption and may not accept demand deposits
if its total assets are $100 million or more.[Footnote 13]
Table 1: Comparison of Permissible Activities Between State Nonmember
Commercial Banks and ILCs in a Holding Company Structure:
Permissible Activities: Ability to offer full range of loans,
including:
consumer, commercial real estate, residential real estate, small
business, and subprime;
State Non-member Commercial Bank: Yes;
Industrial Loan Corporation: Yes.
Permissible Activities: Ability to export interest rates;
State Non- member Commercial Bank: Yes;
Industrial Loan Corporation: Yes.
Permissible Activities: Ability to offer full range of deposits
including demand deposits;
State Non-member Commercial Bank: Yes;
Industrial Loan Corporation: Yes, except in California; However, BHC
Act-exempt ILCs may offer demand deposits if either the ILC's assets
are less than $100 million or the ILC has not been acquired after
August 10, 1987.[A].
Source: FDIC.
[AI] ILCs can accept NOW accounts which are insured deposits that, in
practice, are similar to demand deposits.
Note: This table was adapted from FDIC's Supervisory Insights, Summer
2004. According to the FDIC officials, Supervisory Insights was
published in June 2004, by FDIC to provide a forum to discuss how bank
regulation and policy is put into practice in the field, share best
practices, and communicate emerging issues that bank supervisors are
facing. This inaugural issue described a number of areas of current
supervisory focus at the FDIC, including the ILC charter. According to
FDIC officials, Supervisory Insights should not be construed as
regulatory or supervisory guidance.
[End of table]
Based on an analysis of the permissible activities of ILCs and other
insured depository institutions, we and FDIC's Inspector General found
that, from an operations standpoint, ILCs do not appear to have a
greater risk of failure than other types of insured depository
institutions. FDIC officials have reported that, like other insured
depository institutions, the risk of failure and loss to the Fund from
ILCs is not related to the type of charter the institution has. Rather,
these officials stated that this risk depends on the institution's
business plan and the type of business that the entity is involved in,
management's competency to run the bank, and the quality of the
institution's risk-management process. Further, FDIC officials stated
that their experience does not indicate that the overall risk profile
of ILCs is different from that of other types of insured depository
institutions, and ILCs do not engage in more complex transactions than
other institutions.
FDIC's Supervisory Authority Over ILC Holding Companies and Affiliates
Is Not Equivalent to Consolidated Supervisors' Authority:
In our 2005 report we compared the supervisory approaches of FDIC and
consolidated supervisors, such as the Board and the Office of Thrift
Supervision (OTS), and described in detail several differences between
FDIC's supervisory authority over ILC holding companies and affiliates
and the authority of these consolidated supervisors. Today, I will
highlight a few of these differences to illustrate how FDIC's authority
over holding companies and affiliates is not as extensive as the
authority that these consolidated supervisors have over holding
companies and affiliates of banks and thrifts.
FDIC and Consolidated Supervisors Use Different Supervisory Approaches:
With some exceptions, companies that own or control FDIC insured
depository institutions are subject to a consolidated--or top-down--
supervisory approach that is aimed at assessing the financial and
operations risks within the holding company structure that may pose a
threat to the safety and soundness of the depository institution.
Organizations in countries throughout the world recognize consolidated
supervision as an accepted approach to supervising organizations that
own or control financial institutions and their affiliates. The
European Union generally requires consolidated supervision for
financial institutions operating in its member states, and the Basel
Committee recognizes this approach as an essential element of banking
supervision.[Footnote 14] According to this committee, consolidated
supervision "includes the ability to review both banking and nonbanking
activities conducted by the banking organization, either directly or
indirectly (through subsidiaries and affiliates), and activities
conducted at both domestic and foreign offices. Supervisors need to
take into account that nonfinancial activities of a bank or group may
pose risks to the bank. In all cases, the banking supervisors should be
aware of the overall structure of the banking organization or group
when applying their supervisory methods."
In contrast to the top-down approach of bank consolidated supervision,
which focuses on depository institution holding companies, FDIC's
supervision focuses on depository institutions. FDIC's authority
extends to affiliates of depository institutions under certain
circumstances. Thus, FDIC describes its approach to examining and
taking supervisory actions concerning depository institutions and their
affiliates (including holding companies), as bank-centric or bottom-up.
According to FDIC officials, the objective of this approach is to
ensure that the depository institution is insulated and isolated from
risks that may be posed by a holding company or its subsidiaries. This
objective is similar to the objectives of consolidated supervision.
While FDIC officials assert that the agency's bank-centric approach can
go beyond the insured institution, as discussed later in this
testimony, this approach is not as extensive as the consolidated
supervisory approach in assessing the risks a depository institution
faces in a holding company structure.
Consolidated Supervisors Have More Explicit Supervisory Authority Over
Holding Company Affiliates than FDIC:
Because most ILCs exist in a holding company structure, they are
subject to risks from the holding company and its subsidiaries,
including adverse intercompany transactions, operations risk, and
reputation risk, similar to those faced by banks and thrifts existing
in a holding company structure. However, FDIC's authority over the
holding companies and affiliates of ILCs is not as extensive as the
authority that consolidated supervisors have over the holding companies
and affiliates of banks and thrifts. In our 2005 report, we described
in detail various ways that consolidated supervision offered more
explicit authority over holding company affiliates than FDIC's bank
centric approach. Today, I will summarize two of these points to
illustrate some of the differences in supervisory authority between the
FDIC and consolidated supervisors. These two points describe
differences in FDIC's and the Board's authority to examine holding
companies and their nonbank subsidiaries to assess potential risks to
the insured depository institution; and the importance of consolidated
supervision standards designed to ensure that the holding company
serves as a source of strength to the insured depository institution.
As consolidated supervisors, the Board and OTS have broad authority to
examine bank and thrift holding companies (including their nonbank
subsidiaries), respectively, in order to assess risks to the depository
institutions that could arise because of their affiliation with other
entities in a consolidated structure.[Footnote 15] The Board and OTS
have general authority to examine holding companies and their nonbank
subsidiaries, subject to some limitations, to assess, among other
things, the nature of the operations and financial condition of the
holding company and its subsidiaries; the financial and operations
risks within the holding company system that may pose a threat to the
safety and soundness of any depository institution subsidiary of such
holding company; and the systems for monitoring and controlling such
risks[Footnote 16]. This authority is limited with respect to certain
types of subsidiaries, such as those regulated by the Securities and
Exchange Commission or state insurance regulators, but even those
subsidiaries may be examined by the Board under appropriate
circumstances where the Board "has reasonable cause to believe that
such subsidiary is engaged in activities that pose a material risk to
an affiliated depository institution" or the Board has determined that
examination of the subsidiary is necessary to inform the Board of the
systems the company has to monitor and control the financial and
operational risks within the holding company system that may threaten
the safety and soundness of an affiliated depository institution
[Footnote 17]. Also, under the BHC Act, a Board examination of a
holding company must, to the fullest extent possible, focus on
subsidiaries that could have a materially adverse effect on the safety
and soundness of the affiliated depository institution due to the
subsidiary's size, condition or activities or the nature and size of
transactions between the subsidiary and the depository institution.
OTS' examination authority with respect to holding companies is subject
to the same limitation[Footnote 18]. Even with these limitations, both
the Board and OTS have direct authority to examine a subsidiary - based
solely on characteristics of the subsidiary - in order to assess the
condition of an affiliated bank.
In contrast to the consolidated supervisory approaches of the Board and
OTS, FDIC's supervisory authority is more limited and does not
specifically address the circumstances of an ILC holding company or its
nonbank subsidiaries except in the context of a relationship between
the ILC and an entity affiliated with it through the holding company
structure. Specifically, FDIC's authority to examine state nonmember
banks, including ILCs, includes the authority to examine some, but not
all, affiliates in a holding company structure. Under section 10(b) of
the FDI Act, FDIC, in the course of examining an institution, may
examine "the affairs of any affiliate of (the) institution as may be
necessary to disclose fully--( i) the relationship between such
depository institution and any such affiliate; and (ii) the effect of
such relationship on the depository institution."[Footnote 19]
According to FDIC officials, FDIC can use its subpoena and other
investigative authorities to obtain information from any affiliate, as
well as any nonaffiliate, to determine compliance with applicable law
and with respect to any matter concerning the affairs or ownership of
an insured institution or any of its affiliates.[Footnote 20] According
to FDIC officials, such an investigation would be triggered by concerns
about the insured institution.
Consolidated supervisors have also instituted standards designed to
ensure that the holding company serves as a "source of strength" for
its insured depository institution subsidiaries. For example, the
Board's regulations for bank holding companies include consolidated
capital requirements that, among other things, can help protect against
a bank's exposure to risks associated with its membership in the
holding company.[Footnote 21]
Because FDIC does not supervise institutions affiliated with depository
institutions on a consolidated basis, it has no direct authority to
impose consolidated supervision requirements, such as capital levels on
ILC holding companies. However, FDIC does have authorities that it can
use for certain purposes to address risk to depository institutions in
a holding company structure. For example, FDIC indicated that it can
initiate an enforcement action against an insured ILC and, under
appropriate circumstances, an affiliate that qualifies as an
institution-affiliated party (IAP) of the ILC if the ILC engages in or
is about to engage in an unsafe or unsound practice.[Footnote 22] An
ILC affiliate is an IAP if, among other things, it is a controlling
stockholder (other than a bank holding company), a shareholder who
participates in the conduct of the affairs of the institution, or an
independent contractor who knowingly or recklessly participates in any
unsafe or unsound practices.[Footnote 23] However, FDIC's ability to
use this authority to, for example, hold an ILC holding company
responsible for the financial safety and soundness of the ILC is less
extensive than application of the source of strength doctrine by the
Board or OTS under consolidated supervision.
Figure 3 compares some of the differences in explicit supervisory
authority between FDIC and consolidated supervisors, specifically the
Board and OTS. This figure shows that in two of the eight areas FDIC
has examination authority with respect to ILC affiliates that have a
relationship with the ILC, as do the Board and OTS. However, we
identified six areas where FDIC's explicit authority with respect to
ILC holding company affiliates is not as extensive as the explicit
authorities of consolidated supervisors to examine, impose capital-
related requirements on, or take enforcement actions against holding
companies and affiliates of an insured institution. In general, FDIC's
supervisory authority over holding companies and affiliates of insured
institutions depends on the agency's authority to examine relationships
between the institution and its affiliates and FDIC's ability to
enforce conditions of insurance and written agreements, to coerce
conduct based on the prospect of terminating insurance, and to take
enforcement actions against a holding company or affiliate that
qualifies as an IAP.[Footnote 24]
Figure 3: Comparison of Explicit Supervisory Authorities of the FDIC,
Board, and OTS:
[See PDF for image]
Source: GAO analysis of supervisory authorities of the FDIC, Board, and
OTS.
[A] FDIC may examine an insured institution for interaffiliate
transactions at any time and can examine the affiliate when necessary
to disclose the transaction and its effect on the insured institution.
[B] The authority that each agency may have regarding functionally
regulated affiliates of an insured depository institution is limited in
some respects. For example, each agency, to the extent it has the
authority to examine or obtain reports from a functionally regulated
affiliate, is generally required to accept examinations and reports by
the affiliates' primary supervisors unless the affiliate poses a
material risk to the depository institution or the examination or
report is necessary to assess the affiliate's compliance with a law the
agency has specific jurisdiction for enforcing with respect to the
affiliate (e.g., the Bank Holding Company Act in the case of the
Board). These limits do not apply to the Board with respect to a
company that is itself a bank holding company. These restrictions also
do not limit the FDIC's authority to examine the relationships between
an institution and an affiliate if the FDIC determines that the
examination is necessary to determine the condition of the insured
institution for insurance purposes.
[C] FDIC may take enforcement actions against institution-affiliated
parties of an ILC. A typical ILC holding company qualifies as an
institution-affiliated party. FDIC's ability to require an ILC holding
company to provide a capital infusion to the ILC is limited. In
addition, FDIC may take enforcement action against the holding company
of an ILC to address unsafe or unsound practices only if the holding
company engages in an unsafe or unsound practice in conducting the
affairs of the depository institution.
[D] FDIC maintains that it can achieve this result by imposing an
obligation on an ILC holding company as a condition of insuring the
ILC. FDIC also maintains it can achieve this result as an alternative
to terminating insurance. FDIC officials also stated that the prospect
of terminating insurance may compel the holding company to take
affirmative action to correct violations in order to protect the
insured institution. According to FDIC officials, there are no examples
where FDIC has imposed this condition on a holding company as a
condition of insurance.
[E] In addition to an enforcement action against the holding company of
an ILC in certain circumstances (see note b), as part of prompt
corrective action the FDIC may require any company having control over
the ILC to (1) divest itself of the ILC if divestiture would improve
the institution's financial condition and future prospects, or (2)
divest a nonbank affiliate if the affiliate is in danger of becoming
insolvent and poses a significant risk to the institution or is likely
to cause a significant dissipation of the institution's assets or
earnings. However, the FDIC generally may take such actions only if the
ILC is already significantly undercapitalized.
[End of figure]
Further, in our report we described various areas where FDIC officials
asserted that their supervisory approach could achieve similar results
to those of consolidated supervision. However, we found that FDIC's
authority in each of these areas was less extensive than consolidated
supervision because these authorities can only be used under specific
circumstances and they do not provide FDIC with a comprehensive
supervisory approach designed to detect and address the ILC's exposure
to all risks arising from its affiliations in the holding company, such
as reputation risk from an affiliate that has no relationship with the
ILC. Table 2 provides a summary of what FDIC officials told us about
their authority over holding companies and affiliates of insured
depository institutions and our analysis of the limitations of these
authorities. Today, I will highlight two of these areas: the ability to
examine certain ILC affiliates and the ability to terminate deposit
insurance to illustrate how FDIC's authority is not equivalent to
consolidated supervision of the holding company.
Table 2: The Extent of Selected FDIC Authorities:
FDIC authority: Examine certain ILC affiliates.[A];
Extent of authorities: Only to determine whether the affiliate has a
relationship with the ILC and, if so, to disclose the effect of the
relationship on the ILC. The authority does not extend to determining
how the affiliate's involvement in the holding company alone might
threaten the safety and soundness of the ILC.
FDIC authority: Impose conditions on or enter agreement with an ILC
holding company in connection with an application for deposit
insurance;
Extent of authorities: Only in connection with an application for
deposit insurance and cannot be used to unilaterally impose conditions
on an ILC holding company after the application has been approved.
FDIC authority: Terminate deposit insurance;
Extent of authorities: Only if certain notice and procedural
requirements (including a hearing on the record before the FDIC Board
of Directors) are followed after FDIC determines that;
* the institution, its directors or trustees have engaged in unsafe or
unsound practices;;
* the institution is in an unsafe or unsound condition; or;
* the institution, its directors or trustees have violated an
applicable legal requirement, condition of insurance, or written
agreement between the institution and FDIC.
FDIC authority: Obtain written agreements from the acquiring entity in
connection with a proceeding to acquire an ILC.[B];
Extent of authorities: Could be used if grounds for disapproval exist
with respect to the acquirer.
FDIC authority: Take enforcement actions against ILC affiliates.[C];
Extent of authorities: Only if an affiliate is an IAP; and; Only if the
IAP engages in an unsafe or unsound practice in conducting the business
of the ILC or has violated a legal requirement. If the IAP is
functionally regulated, FDIC's enforcement grounds are further limited.
Source: GAO analysis of the supervisory authorities stated by FDIC
officials.
[A] FDIC's ability to examine ILC affiliates is limited by the meaning
of the term "relationship," which is unclear in situations where the
ILC and the affiliate do not engage in transactions or share
operations. In this respect, FDIC's authority is less extensive than
consolidated supervision because (1) the examination authority of
consolidated supervisors does not depend on the existence of a
relationship and (2) without a relationship, FDIC generally needs the
consent of the affiliate to conduct an examination of its operations.
[B] FDIC's ability to obtain written agreements from the acquiring
entity in connection with a proceeding to acquire an ILC is limited
because certain types of risks, such as reputation risk, could be
unrelated to any of the grounds for disapproval of a Change In Bank
Control Act notice. Moreover, this ability would not be related to
concerns arising after the acquisition is made. Further, some experts
stated that it is unlikely that FDIC could require capital-related
commitments from a financially strong, well managed commercial
enterprise that seeks to acquire an ILC.
[C] In accordance with 12 U.S.C. §§1848a, 1831v(a), FDIC's authority to
take action against a functionally regulated IAP is limited to where
the action is necessary to prevent or redress an unsafe or unsound
practice or breach of fiduciary duty that poses a material risk to the
insured institution and the protection is not reasonably possible
through action against the institution.
[End of table]
FDIC's Examination Authority Is Less Extensive Than a Consolidated
Supervisor:
FDIC officials stated that its examination authority is sufficient to
address any significant risk to ILCs from holding companies and
entities affiliated with the ILC through the holding company structure.
For example, FDIC officials told us that it has established effective
working relationships with ILC holding companies and has conducted
periodic targeted examinations of some ILC holding companies and
material affiliates that have relationships with the ILC, which
includes those affiliates that are providing services to or engaging in
transactions with the ILC. FDIC officials also told us that these
targeted reviews of holding companies and affiliates help to assess
potential risks to the ILC.
We agree that the scope of FDIC's general examination authority may be
sufficient to identify and address many of the risks that holding
company and affiliate entities may pose to the insured ILC. However,
FDIC's general examination authority is less extensive than a
consolidated supervisor's. Because FDIC can examine an ILC affiliate
only to determine whether it has a relationship with the ILC and, if
so, to disclose the effect of the relationship on the financial
institution, FDIC cannot examine ILC affiliates in a holding company
specifically to determine how their involvement in the holding company
alone might threaten the safety and soundness of the ILC. When there is
no relationship between the ILC and the affiliate, FDIC generally would
need the consent of the affiliate to conduct an examination of its
operations. According to its officials, FDIC could use its subpoena
powers and other authorities under section 10(c) of the FDI Act to
obtain information, but the use of these powers appears to be limited
to examinations or investigations relating to the insured depository
institution.[Footnote 25] In contrast, the examination authorities of
the Board and OTS focus on the operations and financial condition of
the holding company and its nonbank subsidiaries and specifically on
financial and operations risks within the holding company system that
can threaten the safety and soundness of a bank subsidiary.[Footnote
26] To the extent that an affiliate's size, condition, or activities
could expose the depository institution to some type of risk, such as
reputation risk, where no direct relationship with the bank exists, the
consolidated supervisory approach is more able to detect the
exposure.[Footnote 27] FDIC's authority does not permit it to examine
an affiliate based solely on its size, condition, or activities. While
the most serious risk to an ILC would come from holding companies or
affiliates that have a relationship with the ILC, the possibility that
risks could come from affiliates with no relationship with the ILC
should not be overlooked. While no recent bank failures may have
resulted from reputation risk, it continues to attract the attention of
the FDIC and the Board. Moreover, consolidated supervision requirements
can address risks that might not be discernible at a particular point
in time, whereas FDIC can exercise its authorities only under certain
circumstances, such as when an application for insurance is granted.
FDIC's Authority to Terminate Insurance Can Be Exercised in Certain
Circumstances:
FDIC officials stated that, even if conditions or agreements were not
established in connection with the issuance of an ILC's insurance, the
prospect of terminating an institution's insurance can serve to compel
the holding company to take measures to enhance the safety and
soundness of the ILC. Under the FDI Act, FDIC can initiate an insurance
termination proceeding only if certain notice and procedural
requirements are followed after a determination by the FDIC that (1) an
institution, its directors, or trustees have engaged in or are engaging
in an unsafe or unsound practice; (2) an institution is in an unsafe or
unsound condition; or (3) the institution, its directors, or trustees
have violated an applicable legal requirement, a condition imposed in
connection with an application by the depository institution, or a
written agreement between the institution and FDIC.[Footnote 28] In
addition, termination proceedings must be conducted in a hearing on the
record, documented by written findings in support of FDIC's
determination, and are subject to judicial review.[Footnote 29] FDIC
officials told us that if the grounds for termination exist, FDIC can
provide the holding company of a troubled ILC with an opportunity to
avoid termination by agreeing to measures that would eliminate the
grounds for termination. These measures could include an agreement to
infuse capital into the ILC or provide reports about the holding
company and its affiliates. According to FDIC officials, the prospect
of terminating insurance is usually sufficient to secure voluntary
corrective action by a holding company to preclude the occurrence of an
unsafe or unsound practice or condition or restore the institution to a
safe and sound financial condition. FDIC officials stated that FDIC has
notified insured institutions that it intended to terminate deposit
insurance 184 times. Between 1989 and 2004, FDIC initiated formal
proceedings to terminate deposit insurance in 115 of these cases
because necessary corrections were not immediately achieved and
terminated deposit insurance in 21 of these cases. In 94 of these 115
instances, corrective actions were taken, and the deposit insurance was
not terminated.
As demonstrated by the number of institutions that took measures to
enhance the safety and soundness of the insured depository institution,
the threat of insurance termination has been an effective supervisory
measure in many instances. However, FDIC's ability to use the
possibility of insurance termination to compel the holding company to
enhance the safety and soundness of the insured institution is limited.
For example, because the statutory grounds for termination relate to
the condition of the institution and practices of its directors or
trustees, the prospect of termination would not be based solely on the
condition or operations of an institution's affiliate. While conditions
could exist in the holding company that might threaten the holding
company and thereby indirectly threaten an ILC, these conditions would
not serve as grounds for termination of insurance unless they caused
the institution to be in an unsafe or unsound condition. Further,
unlike the consolidated supervision approach, FDIC insurance
termination authority does not give it power to require a holding
company or any of its nonbank affiliates to change their operations or
conditions in order to rehabilitate the ILC. The extent to which FDIC
could enter into an agreement with a holding company would depend on
whether the holding company has an incentive to retain the
institution's insured status and/or the resources to take the action
FDIC seeks.
FDIC Actions May Help Mitigate Potential Risks:
FDIC's bank-centric, supervisory approach has undergone various
modifications to its examination, monitoring, and application
processes, designed to help mitigate the potential risks that FDIC-
examined institutions, including ILCs in a holding company structure,
can be exposed to by their holding companies and affiliates. For
example, FDIC revised the guidance for its risk-focused examinations
to, among other things, provide additional factors that might be
considered in assessing a holding company's potential impact on an
insured depository institution affiliate. These changes may further
enhance FDIC's ability to supervise the potential risks that holding
companies and affiliates can pose to insured institutions in a holding
company structure, including ILCs. In addition, FDIC's application
process may also help to mitigate risks to ILCs with foreign holding
companies and affiliates. While FDIC has provided some examples where
its supervisory approach effectively protected the insured institution
and mitigated losses to the bank insurance fund, questions remain about
whether FDIC's supervisory approach and authority over BHC Act-exempt
holding companies and affiliates addresses all risks to the ILC from
these entities.
FDIC's Supervisory Model and Authority Over BHC Act-Exempt Holding
Companies and Nonbank Affiliates Has Been Tested on a Limited Basis in
Relatively Good Economic Times:
Although there have been material losses to the bank insurance fund
resulting from two ILC failures in the past 7 years, the remaining 19
ILC failures occurred during the banking crisis in the late 1980s and
early 1990s. Most of these ILCs were small California Thrift and
Savings and Loan companies that, according to FDIC, had above-average
risk profiles. FDIC's analysis of bank failures during this time period
indicates that California experienced deteriorating economic conditions
and a severe decline in the real estate industry, which contributed to
the failure of 15 ILCs in that state. As previously discussed, FDIC has
since implemented changes to its supervisory approach and has told us
about some recent examples where, according to FDIC, its supervisory
approach--including its influence and authority as the provider of
deposit insurance--has effectively protected the insured institution
and prevented losses to the Fund. However, all of the ILCs that failed
since the late 1980s, as well as those ILCs that became troubled and
FDIC took corrective action, were relatively small in size compared
with some of the large ILCs that currently dominate the industry. FDIC
has no experience using its supervisory approach to mitigate potential
losses from troubled ILCs that would qualify for supervision under its
Large Bank program.[Footnote 30]
FDIC's supervisory model and authority over BHC Act-exempt ILC holding
companies and affiliates has emerged during a time when the banking
industry has experienced relatively good times. Former FDIC Chairman
Donald Powell described the past decade as a "golden age" of banking.
The past 10 years can be characterized by stable economic growth, which
has contributed to strong industry profitability and capital positions.
During the past 8 years, only 35 financial institutions protected by
the Fund have failed, and FDIC has reported that insured institutions'
earnings for 2004 set a new record for the fifth consecutive year and
that the industry's equity capital ratio is at its highest level since
1938.[Footnote 31] In contrast, 1,373 financial institutions protected
by the Fund failed between 1985 and 1992 due to, among other things,
poor management and poor lending practices.
How FDIC's supervisory approach would fare for large, troubled ILCs
during an adverse external environment is not clear and the test of
supervision is its effectiveness during periods of stress. We have long
advocated comprehensive regulation of financial services holding
companies on both a functional and consolidated basis in order to
assess how risks in other components of the holding company may affect
the insured bank. We have stated that capital standards for both
insured banks and their holding companies should adequately reflect all
major risks. Our belief in the importance of consolidated supervision
and consolidated capital standards is partly based on the fact that
most bank holding companies are managed on a consolidated basis, with
the risks and returns of various components being used to offset and
enhance one another. In addition, past experience has shown that,
regardless of whether regulatory safeguards--such as sections 23A and
23B limitations--are set properly, even periodic examinations cannot
ensure that regulatory safeguards can be maintained in times of stress.
ILCs May Offer Commercial Holding Companies a Greater Ability to Mix
Banking and Commerce than Other Insured Depository Institutions, but
Views on Competitive Implications Are Mixed:
ILC holding companies and their affiliates may be able to mix banking
and commerce more than other insured depository institutions because
the holding companies and affiliates of ILCs are not subject to
business activity limitations that generally apply to insured
depository institution holding companies. Except for a limited category
of firms, such as grandfathered unitary thrift holding companies and
companies that own limited purpose credit card banks (CEBA credit card
banks), entities that own or control insured depository institutions
generally may engage, directly or through subsidiaries, only in
activities that are financial in nature.[Footnote 32] Because of a
provision in the ILC exception in the BHC Act, an entity can own or
control a qualifying ILC without facing the activities restrictions
imposed on bank holding companies and nonexempt thrift holding
companies. As a result, the holding companies and affiliates of some
ILCs and other subsidiaries are allowed to engage in nonfinancial,
commercial activities.
Today, nonfinancial, commercial firms in the automobile, retail, and
energy industries, among others, own ILCs. As of March 31, 2006, 10
ILCs with total assets of about $ 3.6 billion directly support their
parent's commercial activities. However, these figures may understate
the total number of ILCs that mix banking and commerce because 5 other
ILCs are owned by commercial firms that were not necessarily financial
in nature. Because these corporations, on a consolidated basis, include
manufacturing and other commercial lines of business with the financial
operations of their ILC, we determined that these entities also mixed
banking and commerce. Thus, we found that, as of March 31, 2006,
approximately 15 of the 61 active ILCs were owned or affiliated with
commercial entities, representing about $13.2 billion, (about 8.5
percent) and $8.2 billion (about 9.7 percent) of total ILC industry
assets and estimated insured deposits, respectively.[Footnote 33] In
addition, there are a number of pending applications for deposit
insurance with FDIC involving commercial firms, including one of the
largest retail firms.
Regulators and practitioners with whom we spoke with also noted,
however, that several other major industrial nations do allow a greater
mixing of banking and commerce than does the United States. For
example, in Europe there are generally no limits on a nonfinancial,
commercial firm's ownership of a bank. However, the European Union has
mandated consolidated supervision. Japan has also allowed cross-
ownership of financial services firms, including banks and commercial
firms, permitting development of industrial groups or keiretsu that
have dominated the Japanese economy. These groups generally included a
major or "lead" bank that was owned by other members of the group,
including commercial firms, and that provided banking services to the
other members. The experience of these nations provides some empirical
evidence of the effects of increased affiliation of banking and
commercial businesses, particularly pointing to the importance of
maintaining adequate credit underwriting standards for loans to
affiliated commercial businesses. Problems in Japan's financial sector,
notably including nonperforming loans, often to commercial affiliates
of the banks, have contributed in part to the persistent stagnation of
the Japanese economy beginning in the 1990s. However, important
differences between the financial and regulatory systems of these
nations and the United States, and limitations in research into the
effects of these affiliations, limit many direct comparisons.
Mixing Banking and Commerce Presents Both Potential Risks and Benefits:
The policy generally separating banking and commerce is based primarily
on limiting the potential risks that may result to the financial
system, the deposit insurance fund, and taxpayers. We have previously
reported that the potential risks that may result from greater mixing
of banking and commerce[Footnote 34] include the (1) expansion of the
federal safety net provided for banks to their commercial entities, (2)
increased conflicts of interest within a mixed banking and commercial
conglomerate, and (3) increased economic power exercised by large
conglomerate enterprises. However, generally the magnitudes of these
risks are uncertain and may depend, in part, upon existing regulatory
safeguards and how effectively banking regulators monitor and enforce
these safeguards.
The federal government provides a safety net to the banking system that
includes federal deposit insurance, access to the Federal Reserve's
discount window, and final riskless settlement of payment system
transactions. According to Federal Reserve officials, the federal
safety net in effect provides a subsidy to commercial banks and other
depository institutions by allowing them to obtain low-cost funds
because the system of federal deposit insurance shifts part of the risk
of bank failure from bank owners and their affiliates to the federal
bank insurance fund and, if necessary, to taxpayers. The system of
federal deposit insurance can also create incentives for commercial
firms affiliated with insured banks to shift risk from commercial
entities that are not covered by federal deposit insurance to their
FDIC-insured banking affiliates. As a result, mixing banking and
commerce may increase the risk of extending the safety net, and any
associated subsidy, may be transferred to commercial entities. This
risk, however, may be mitigated by statutory and regulatory safeguards
between the bank and their commercial affiliates such as requirements
for arms-length transactions and restrictions on the size of affiliate
transactions under section 23A and 23B of the Federal Reserve Act.
However, during times of stress, these safeguards may not work
effectively--especially if managers are determined to evade them.
The mixing of banking and commerce could also add to the potential for
increased conflicts of interest and raise the risk that insured
institutions may engage in anticompetitive or unsound practices. For
example, some have stated that, to foster the prospects of their
commercial affiliates, banks may restrict credit to their affiliates'
competitors, or tie the provision of credit to the sale of products by
their commercial affiliates. Commercially affiliated banks may also
extend credit to their commercial affiliates or affiliate partners,
when they would not have done so otherwise. Additionally, some have
also stated that mixing banking and commerce could promote the
formation of very large conglomerate enterprises with substantial
amounts of economic power. If these institutions were able to dominate
some markets, such as the banking market in a particular local area,
they could impact the access to bank services and credit for customers
in those markets.
Other industry observers envision potential benefits from mixed banking
and commerce, including allowing banks, their holding companies, and
customers to benefit from potential increases in the scale of
operations, which lowers the average costs of production, known as
economies of scale, or from potential reductions in the cost of
producing goods that share common inputs, known as economies of scope,
and enhanced product and geographic diversification. Because banks
incur large fixed costs when setting up branches, computer networks,
and raising capital, these institutions may benefit from the selected
economies of scale and scope that could result from affiliations with
commercial entities. Mixed banking and commercial entities may also
benefit from product synergies that result from affiliation. For
example, firms engaged in both the manufacturing and financing of
automobiles may be able to increase sales and reduce customer
acquisition costs by combining manufacturing and financing. Enhanced
product and geographic diversification could also reduce risk to the
combined entity.
However, during our search of academic and other literature, we were
unable to identify any conclusive empirical evidence that documented
operational efficiencies from mixing banking and commerce. One primary
factor in the lack of empirical evidence may be that, because of the
policy generally separating banking and commerce, few institutions are
available for study.
Because GLBA removed several restrictions on the extent to which
conglomerates could engage in banking and nonbanking financial
activities, such as insurance and securities brokerage, some analysts
had expected that conglomeration would intensify in the financial
services industry after GLBA. However, as yet, this does not seem to
have happened. The reasons vary. Many banks may not see any synergies
with insurance underwriting. Additionally, it may be that many mergers
are not economically efficient, the regulatory structure set up under
GLBA may not be advantageous to these mergers, or, it is simply too
soon to tell what the impact will be. Further, a general slowdown
occurred in merger and acquisition activity across the economy in the
early 2000s, which may also be a contributing factor to the pace of
industry conglomeration post GLBA.
Concluding Remarks:
As we stated in our 2005 report, ILCs have significantly evolved from
the small, limited purpose institutions that existed in the early
1900s. Because of the significant recent growth and complexity of some
ILCs, the industry has changed since being granted an exemption from
consolidated supervision in 1987, and some have expressed concerns that
ILCs may have expanded beyond the original scope and purpose intended
by Congress. The vast majority of ILCs have corporate holding companies
and affiliates and, as a result, are subject to similar risks from
holding company and affiliate operations as banks and thrifts and their
holding companies. However, unlike bank and thrift holding companies,
most ILC holding companies are not subject to federal supervision on a
consolidated basis. While FDIC has supervisory authority over an
insured ILC, it does not have the same authority to supervise ILC
holding companies and affiliates as a consolidated supervisor. While
the FDIC's authority to assess the nature and effect of relationships
between an ILC and its holding company and affiliates does not directly
provide for the same range of examination authority, its cooperative
working relationships with state supervisors and ILC holding company
organizations, combined with its other bank regulatory powers, has
allowed the FDIC, under limited circumstances, to assess and address
the risks to the insured institution and to achieve other results to
protect the insurance fund against ILC-related risks. However, FDIC's
supervisory approach over ILC holding companies and affiliates has not
been tested by a large ILC parent during periods of economic stress.
Moreover, we are concerned that insured institutions posing similar
risks to the Deposit Insurance Fund are not being overseen by bank
supervisors that possess similar powers. Because of these differences
in supervision, we found that, from a regulatory standpoint, ILCs in a
holding company structure may pose more risk of loss to the Fund than
other types of insured depository institutions in a holding company
structure. To better ensure that supervisors of institutions with
similar risks have similar authorities, Congress should consider
various options such as eliminating the current exclusion for ILCs and
their holding companies from consolidated supervision, granting FDIC
similar examination and enforcement authority as a consolidated
supervisor, or leaving the oversight responsibility of small, less
complex ILCs with the FDIC, and transferring oversight of large, more
complex ILCs to a consolidated supervisor.
In addition, although federal banking law may allow ILC holding
companies to mix banking and commerce to a greater extent than holding
companies of other types of depository institutions, we were unable to
identify any conclusive empirical evidence that documented operational
efficiencies from mixing banking and commerce, and the views of bank
regulators and practitioners were mixed. Nevertheless, the potential
risks from combining banking and commercial operations remain. These
include the potential expansion of the federal safety net provided for
banks to their commercial entities, increased conflicts of interest
within a mixed banking and commercial conglomerate, and increased
economic power exercised by large conglomerate enterprises. In
addition, we find it unusual that this limited exemption for ILCs would
be the primary means for expanding the mixing of banking and commerce
than afforded to the holding companies of other financial institutions.
Because it has been a long time since Congress has focused on the
potential advantages and disadvantages of mixing banking and commerce
and given the rapid growth of ILC assets and a potential for increased
attractiveness of the ILC charter, we concluded in our 2005 report that
Congress should more broadly consider the advantages and disadvantages
of mixing banking and commerce to determine whether continuing to allow
ILC holding companies to engage in this activity more than the holding
companies of other types of financial institutions is warranted or
whether other financial or bank holding companies should be permitted
to engage in this level of activity.
Mr. Chairman, this concludes my prepared statement. I would be pleased
to answer any questions you or other Members may have at the
appropriate time.
GAO Contacts and Staff Acknowledgments:
For further information on this testimony, please contact Richard
Hillman at (202) 512-8678 or hillmanr@gao.gov. Contact points for our
Office of Congressional Relations and Public Affairs may be found on
the last page of this statement. Individuals making key contributions
to this testimony included Dan Blair, Tiffani Humble, James McDermott,
Dave Pittman, and Paul Thompson.
FOOTNOTES
[1] GAO, Industrial Loan Corporations: Recent Asset Growth and
Commercial Interest Highlight Differences in Regulatory Authority, GAO-
05-621 (Washington, D.C.: September 15, 2005).
[2] In preparation for this hearing, we updated our September 2005
report to provide information on the number and total assets of ILCs
through March 31, 2006.
[3] Under 12 U.S.C. 1831a(a), FDIC-insured state banks, a group that
includes ILCs, may not engage as principal in any activity that is not
permissible for a national bank unless the FDIC has determined that any
additional activity would pose no significant risk to the deposit
insurance fund and the bank is in compliance with applicable federal
capital standards.
[4] Since ILCs are state-chartered financial institutions, they are
subject to supervision and regulation by both FDIC and the chartering
state's financial regulator.
[5] The Securities and Exchange Commission has approved the
applications of five investment banks, including the parent companies
of several large ILCs, to be subject to consolidated supervision.
[6] As amended by the Gramm-Leach-Bliley Act (GLBA), the BHC Act
restricts the activities of bank holding companies to activities
"closely related to banking" that were permitted by the Federal Reserve
Board as of November 11, 1999. However, bank holding companies that
qualify as financial holding companies can engage in additional
activities defined in GLBA as activities that are "financial in
nature," as well as activities that are incidental to or complementary
to financial activity. Pub. L. No. 106-102 §§ 102, 103, codified at 12
U.S.C. § 1843(c)(8), (k) (2000 & Supp. 2004).
[7] As of March 31, 2006.
[8] A full comparison is beyond the scope of this testimony. See our
2005 report for a more detailed and comprehensive discussion of ILC
lines of business and the regulatory safeguards that apply to ILCs and
other insured depository institutions.
[9] See 12 U.S.C. § 1831d(a); see also, FDIC General Counsel's Opinion
No. 11, Interest Charges by Interstate State Banks, 63 Fed. Reg. 27282
(May 18, 1998).
[10] Nevada and Utah do not cap the interest rates credit card
companies can charge. Their usury laws, similar to Delaware and South
Dakota, are considered desirable for credit card entities.
[11] Covered transactions are specifically described in section 23A
(b)(7)(A) through (E) but generally consist of making loans to an
affiliate; purchasing securities issued by an affiliate; purchasing
nonexempt assets from an affiliate; accepting securities issued by an
affiliated company as collateral for any loan; and issuing a guarantee,
acceptance, or letter of credit on behalf of (for the account of) an
affiliate. Section 23A also lists several types of transactions that
are specifically exempted from its provisions. Under the BHC Act, as
amended by GLBA, a depository institution controlled by a financial
holding company is prohibited from engaging in covered transactions
with any affiliate that engages in nonfinancial activities under the
special 10-year grandfather provisions in the GLBA. 12 U.S.C. § 1843
(n)(6).
[12] Section 18(j) of the FDI Act extends the provisions of sections
23A and 23B of the Federal Reserve Act to state nonmember banks. 12
U.S.C. § 1828(j).
[13] The Competitive Equity Banking Act (CEBA) contains the ILC
exemption allowing entities that own or control ILCs to avoid Board
regulations as a bank holding company. This exemption applies to ILCs
chartered in states that as of March 5, 1987, had in effect or under
consideration a statute requiring ILCs to be FDIC insured. According to
the FDIC, at the time of the CEBA exemption, six states - California,
Colorado, Hawaii, Minnesota, Nevada, and Utah met this requirement.
Only ILCs chartered in these "grandfathered" states are eligible for
the ILC exemption from the BHC Act.
[14] The Basel Committee on Banking Supervision, established in 1974,
is composed of representatives from the central banks or supervisory
authorities of major industrial countries in Europe, North America, and
Asia, including the United States. This committee has no formal
authority but seeks to develop broad supervisory standards and promote
best practices in the expectation that each country will implement the
standards in ways most appropriate to its circumstances. Implementation
is left to each nation's regulatory authorities.
[15] As noted above, the Securities and Exchange Commission has
approved the applications of five investment banks, including the
parent companies of several large ILCs, to be subject to consolidated
supervision. This prudential supervision regime entails SEC oversight
of the risk management and control systems and SEC examination of
unregulated entities within the holding companies.
[16] See 12 U.S.C. §§ 1844(c)(2)(A), 1467a., and 12 U.S.C. § 1831v(b).
[17] See 12 U.S.C. § 1844(c)(2)(B).
[18] See 12 U.S.C. §§ 1467a(b)(4), 1831(a).
[19] See 12 U.S.C. 1820(b)(4)(A).
[20] See 12 U.S.C. § 1820(c).
[21] 12 C.F.R. Part 225, Appendices B & C.
[22] FDIC has no authority to take action against an ILC affiliate
whose activities weaken the holding company, and potentially the ILC,
unless the affiliate is an IAP and the IAP participated in conducting
the ILC's business in an unsafe or unsound manner, violated a legal
requirement or written condition of insurance, or otherwise engaged in
conduct subject to enforcement. See 12 U.S.C. § 1818(b).
[23] See 12 U.S.C. § 1813(u).
[24] In addition to these authorities, we note that measures under the
prompt corrective action provisions of the FDI Act based on an
institution's undercapitalized status include a parental capital
maintenance guarantee and the possibility of divestiture of a
significantly undercapitalized depository institution or any affiliate.
See 12 U.S.C. § 1831o. These measures apply equally to all FDIC insured
institutions and their respective regulators.
[25] See 12 U.S.C. § 1820(c).
[26] See, for example, the focus of bank holding company examinations
as prescribed in the BHC Act. 12 U.S.C. § 1844(c)(2).
[27] See 12 U.S.C. 1844(c)(1)(C) Board examinations, to fullest extent
possible, are to be limited to examinations of holding company
subsidiaries whose "size, condition, or activities" could adversely
affect the affiliated bank's safety and soundness or where the nature
and size of transactions between the affiliate and the bank could have
that effect.
[28] The procedural requirements include notifying the appropriate
federal or state banking supervisor of FDIC's determination for the
purpose of securing a correction by the institution. 12 U.S.C. §
1818(a)(2)(A).
[29] See 12 U.S.C. § 1818(a)(3),(5).
[30] FDIC's large bank program provides an on-site presence at
depository institutions with total assets greater than $10 billion or
because of their size, complexity, and risk profile.
[31] Equity capital or financing is money raised by a business in
exchange for a share of ownership in the company. Financing through
equity capital allows a business to obtain funds without incurring debt
or without having to repay a specific amount of money at a particular
time. The equity capital ratio is calculated by dividing total equity
capital by total assets.
[32] See 12 U.S.C. §§ 1843, 1467a(c). As previously discussed,
grandfathered unitary thrift holding companies are not subject to these
activities restrictions. Limited purpose credit card banks also are
exempt from the BHC Act. See 12 U.S.C. § 1841(c)(2)(F).
[33] When determining the current levels of mixed banking and commerce
within the ILC industry, we considered only ILCs owned or affiliated
with explicitly nonfinancial, commercial firms. Because some owners and
operators of ILCs are engaged in business activities that are generally
financial in nature, but still may not meet the statutory requirements
of a qualified bank or financial holding company, officials from the
Federal Reserve Board noted that they interpret the level of mixed
banking and commerce among ILCs may be greater than 8.5 percent of
industry assets and 9.7 percent of industry estimated insured deposits.
[34] GAO, Separation of Banking and Commerce, GAO/OCE/GGD-97-16R
(Washington, D.C.: Mar. 17, 1997).
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