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					                                                                            LECTURE 5
Economic Rationale for Market Regulation
Identifying the public interest
   READ: Special Policy Report 12: Economic Rationale for Market Regulation
            http://www.financialpolicy.org/dscreports.htm

The market, the magic of the market, the infamous ―invisible hand,‖ is so highly regarded
these days that its limits are often overlooked, forgotten or otherwise misunderstood. The
market can do some things very well: generally setting prices that function as signals and
disciplining incentives to allocate resources between competing uses in an efficient manner.

There are also things that the market does not do well, or perfectly or sometimes not at all.
These things are called market failures, incomplete markets, or market imperfections. They
are often analyzed in economics as externalities, economies of scale, non-competitive
behavior, destructive competition, monopolistic or oligopolistic competition.

These analytical categories are often not as well studied as others in economics. In order to
bring greater rigor to this discussion, let‘s delve into these ideas more carefully.

First consider some illustrative examples of market imperfections in the area of corporate
governance.
       Executive manipulate earning reports in order to boost stock prices so as to capture
        gains on stock options. Not only are investors ultimately cheated, but also investors
        in other firms that compete for resources with the cheating firm. It distorts prices in
        securities markets, thereby reducing their efficiency, and it threatens integrity of
        capital markets and thus the viability of overall economy. This imposes costs on
        people both inside and outside the firm, and market incentives do not adequately
        discourage but sometime encourage this activity.
       A firm, or rogue traders within a firm, manipulates market prices. They
        have incentives to manipulate because it maximizes their profits. (For a
        brief description of market manipulation strategies read, "Learning Our
        Lessons: A Short History of Market Manipulation And The Public Interest”
        at http://www.financialpolicy.org/dscbriefs.htm) This price distortion,
        however, causes losses for others in the market and economic inefficiencies
        in the overall economy as resources are misdirected and the integrity of the
        marketplace is undermined.
       A CEO of a financial institution pressures the firm‘s research staff to
        produce overly optimistic assessment of another companies stock because
        the financial institution is acting a underwriter of its debt and securities.
        This generates profits for the financial institution and in turn for the CEO
        but it cheats investors and others in the market.
       Consider a more general point about investors‘ need for all relevant market
        information. Firms have an incentive to hoard information and not disclose
        to the markets any thing but good information about their activities, and
        even then they may not disclose good information on a timely basis but
                                               2


       instead when it is advantageous for them. Individual firm incentives are in
       this way inconsistent for overall market efficiency.

The Banking Sector
Today, there are 8,832 banks and thrifts (savings and loan associations and savings banks) at
the end of 2005, down from 12,000 in 1995. There are 8,700 credit unions with 70 million
members (and another 40 that qualify as members).

The term banks can be used to refer to a properly chartered bank, but today other depository
institutions function roughly the same as chartered banks. These depository institutions
include thrifts (savings and loans, savings bank, savings associations), credit unions, and
industrial loan companies. In addition, there are ‗special‘ credit card banks that have many
bank functions but are largely limited to the purpose of handling credit card operations.

And while there are some non-banks that function like banks, there are some banks that
engage in a range of financial activities that we do not think of as banking proper.
       According to FDIC, end 2005,
      1818 federal banks
      5709 state chartered banks
      772 federal thrifts
      533 state thrifts

Commercial banks have $9.53 trillion in assets, while thrifts have $1.83 trillion and credit
unions have $703 billion. Of a total of $41.7 trillion in credit market assets: $12.3 trillion in
mortgages, $3.3 in loans, $10.5 trillion in private bonds and commercial paper, and $13.5
trillion in government and GSE bonds. Checkable deposits and cash amount to $1.5 trillion,
savings and small time deposits are $4.7 trillion and money market funds are $2 trillion.
Total corporate equity shares are valued at $19 trillion.

Commercial banks hold $5.5 trillion in loans amongst their $9.5 trillion in all assets. And
$1.4 trillion in government and agency bonds.

History of banks, thrifts, and credit unions

Economic Function of Banking System
      Payments and settlements: provide liquidity and safe and sound payments system
      Savings vehicle: collect together savings from diverse customers
      Mobilize savings: mobilize additional savings from float and delays in payments
      Capital and Credit supplier:
      raise capital
      finance commerce and trade
      consumer finance
      finance governments
      Underwriters of some securities
                                            3


      Market makers of FX, derivatives and some securiti

How banks make profit
    maturity conversion: borrow short, lend long along yield curve
    hold credit risk:
    charge credit risk spread to borrowers, require collateral, and diversify to manage risk
    underwrite loans and securities
    act as dealer or market maker in securities
    funds management
    transactions fees

The market for banking services: various institutions and transactions
        commercial
        merchant banks
        wholesale financial institutions
        major, money center banks
        super regional
        independent banks
        federal versus state
        bank holding company
        foreign bank
        Edge Act bank
        agent bank

Public Interest Conce rns
       safety and soundness:
        - timely and safe and dependable payments
        - dependable savings institution
       non-discrimination in lending and financial services
       stable credit supply
       liquidity supply (elastic money supply to provide transactions services across
        business cycle)
 Bank run – consumer panic, whether warranted or not, removes liquidity from banks and
   in turn the economy
 Operations risk – clearing and checking services fail. This happened with technical
   failures or with external disasters such as North East blackout and terrorist attack.
 Insolvency – losses to creditors and shareholders. This leads to failures in derivatives
   markets (trading freezes up and price discovery ceases).
 Transmission of price shocks
                 change in interest rates                   balance sheet and derivatives
                 change in foreign exchange rates           ditto
                 change in equity prices                    derivatives
                 change in commodity prices                 derivatives
                                              4


Miskin, AEI and Other Free-Market Approach
Asymmetric information

Adve rse selection
       Those whose are most apt to abuse insurance are those most like ly to take out such
insurance.

Moral Hazard
        Deposit insurance creates moral hazard for banks who can take large risks without
fear that depositors will desert them. This leads to more than efficient levels of risk taking.

Too Big To Fail
         Banks know that government views them as too big to fail, and thus they take greater
risks knowing they will be not be allowed to fail.
         [However even Miskin admits that government ―purchase and assumption‖ followed
by its sale, the shareholders lose everything and the management is fired. The fate of non-
depositor creditors is not well defined. In some instances they were protected. This is not
necessarily so. One reason to keep them whole is that they are other banks who would in
turn suffer – create contagion – if they were allowed to fail.]

Create signaling device through required issuance of subordinated debt


Regulatory Response
Regulatory Agencies
      Fed (1913)
      OCC (1863)
      FDIC (1933)
      OTS (1933 as FSLIC)
      NCUA
      FFIEC
      State governments – beginning of republic

Three pillars of prudential regulation:
       1. Registration and Reporting
       2. Capital and collateral requirements
       3. Orderly market rules

REGISTRATION: Acquiring a Bank Charter – state or federal
     This is a registration process to prevent fraud, recklessness and inadequate
     capitalization
              anti- fraud
              stabilize market – no fools rushing in
              can also reduce competition or excess competition
                                             5


REPORTING: Disclosure or Reporting Requirements
      This provides information to the markets so that they can make more informed
      investment decisions
      This also provides info to government regulators and supervisions. Some of this
      information is collected through Call Reports. Other is gathered from onsite
      examinations of the institution.
Examinations and Supervision
      – some information must be treated as proprietary or of such heterogeneous nature
      that it does not lend itself to useful disclosure. Examiners evaluate loans and other
      assets to evaluate than ‗quality.‘

       Examination guidelines and objectives
       CAMEL standards
                   1. Capital
                   2. Assets
                   3. Management
                   4. Earnings
                   5. Liquidity
       Risk Management
                   1. Oversight by Board of Directors
                   2. Controls of risk taking (position limits)
                   3. Risk measurement and monitoring
                   4. Internal Controls – prevent fraud and unauthorized trading
Capital Requirements
       8%, risk based on assets – both on balance sheet and off
       Applies to credit exposure and sometimes ―potential credit exposure‖
       - may be not an effective forecasting measure.
               - Buffer
               - Risk governor
Collateral re quirements
       Loans – no regulations but operating standards
       Derivatives – no regulations and little in the way of standards
Other measures to govern risk-taking
       Asset restrictions

Orde rly Market Rules
       Consumer protection
              Truth in lending: use of APR, credit card box
              Deposit Insurance – avoids bank runs
              CRA
              Anti-predatory lending
              Anti- usury laws


REGULATORY INSTITUTIONS
Federal Reserve Board of Governors (Fed)
                                               6


       Created in 1913 to conduct monetary policy, supervise banking institutions, maintain
       the stability of the financial system, and provide financial services to the government.
       Oversees 5,863 Bank Holding Companies
       Oversees 919 State chartered banks that are members of Federal Reserve system
       Federal Reserve Banks (12)
       The Federal Reserve System (FRS), established in 1913, supervises bank
       holding companies, state-chartered banks that are members of FRS, and the
       U.S. operations of foreign banking organizations; it also regulates foreign
       activities and investments of FRS member banks (both national and state
       chartered), and Edge Act corporations.

Office of Comptroller of the Currency (OCC)
       Handles nationally chartered banks (it issues their charters). Created by National
       Bank Act of 1864 to charter, supervise, and regulate banks as well as be responsible
       for national currency. Conflict with Fed after its creation in 1913 because of
       overlapping authority. Today, the OCC: 1) charters national banks; 2) supervises
       member (national + state member) banks and enforces McFadden Act (interstate
       banking); 3) approves mergers and branches. Has permanent offices in London to
       oversee foreign banks.
       The Office of the Comptroller of the Currency ( OCC), established in 1864, charters and
       supervises national banks and federal branches and agencies of foreign banks.

Office of Thrift Supervision (OTS, formerly FSLIC)
       Created by FIRREA. A bureau of Treasury. Regulation and supervision successor to
       Fed. Home Loan Bank Board (FHLBB) over state and federal thrifts, and their
       holding companies. The Regulatory and supervisory component of former FSLIC.
       The Office of Thrift Supervision (OT S) charters and supervises national
       thrifts and also supervises state-chartered thrifts and thrift holding
       companies. OT S assumed these functions in 1989 from the Federal Home
       Loan Bank Board, which was established in 1932.
National Credit Union Administration (NCUA)
       An independent federal agency that charters and supervises federal credit unions, and
       it operates the federal credit union share insurance fund.
       Regulates and supervises 9,128 credit unions.
Federal Deposit Insurance Corporation (FDIC)
       Created as an independent agency in 1933 by Glass-Steagall Act.
       It insures deposits, monitors risk to bank insurance fund, and limits the effects on
       overall economy when a depository institution fails.
       It also handles state chartered banks that are not members of the Federal Reserve
       system.
       The FDIC has taken over FSLIC‘s role as provider of deposit insurance to thrifts. In
       doing so it administers two deposit insurance funds: the Band Insurance Fund (BIF)
       and Savings Association Insurance Fund (SAIF).
       Presently, the FDIC oversees 5,272 institutions – about half of all banking
       institutions, and provides deposit insurance to 8,854 banks.
       The Federal Deposit Insurance Corporation (FDIC), established in 1933, is
       the federal supervisor of federally insured, state-chartered banks that are
                                             7


      not FRS members.
FFIEC – Congress created the Federal Financial Institutions Examination Council
      (FFIEC) in 1979—comprising OCC, FDIC, FRS, OTS, and the National Credit
      Union Administration representatives—to promote consistency among
      these regulatory agencies, primarily in the area of financial examinations.

REGULATORY STATUTES IN THE USA
        [See GAO Report on US Bank Regulatory Structures, 1997.]
1908.
        Aldrich Vreeland Act of 1908.
        Response to currency shortage by allowing other securities to back up currency.
        Expired in 1915.

1913.
        The Federal Reserve Act of 1913 enacted on December 23, 1913.
        Response to great panic in 1907. Created the Federal Reserve System. Designed to
        be able to create an elastic currency or monetary or credit supply, and to improve the
        supervision of banking. Also empowered to enforce against fraud against consumers
        and discrimination in lending practices.

        The System is comprised principally of the Board of Governors, 12 Federal Reserve
        Banks (privately owned), and the Federal Open Market Committee (key policy
        committee). The 12 Federal Reserve Banks are each owned by its members and
        supervised by the Board of Governors. The Board is an independent government
        agency whose 7 Governors serve staggered 14 year terms. The President, with advice
        and consent of the Senate, appoints the 7, one as a Chair and one as Vice-Chair for 4-
        year terms. The Banks are governed by a board of 9 directors serving 3- year terms.
        Member banks elect 6 of the directors and the other 3 are appointed by the BOG. The
        FOMC consists of the 7 Governors plus 5 of the Bank Presidents – one of which is
        always from the New York FRB. The Advisory Council is appointed by the Board of
        Governors to represent consumers and creditors.

        The BOG supervises activities of Banks in open market and discount window
        operations, it regulates check clearing and collections, and the issuance of Federal
        Reserve notes. It is the primary federal regulator of state chartered banks, and a
        secondary role behind the OCC in federal chartered banks, and a primary role in bank
        holding companies. The BOG also set margin requirements on securities transactions
        and derivatives on equities. It implements consumer credit protection legislation. It
        regulates Edge Act banks, and the non-banking activities of foreign banks operating
        in the U.S. The BOG sets reserve requirements for banks.
        Established the FRS to provide an outside source of reserves for the banking system.
        Banks that were members of FRS could borrow from FRS reserves to obtain funds
        needed to meet a temporary cash drain or a rapid increase in the demand for credit.
        All national banks were required join FRS, and state banks were given the option to
        join. Also gave FRS the authority to hold a portion of its member banks‘ deposits in
        reserve and to make open-market purchases and sales of government securities. The
                                             8


        act provided that OCC was to examine each member bank at least twice a year. But it
        also authorized the Fed Board to examine member banks at its discretion, and another
        provision gave further authority to the 12 Federal Reserve Banks to make special
        examinations of member banks.

1927 - McFadden-Act of 1927
       Prohibited interstate banking. Initially, the act limited branching by national banks to
       their home city and later extended the limit to allow them to branch throughout their
       home state. Douglas Amendment to Bank Holding company Act of 1956 barred the
       purchase of banks across state lines unless the other state permitted.

1932 -- Federal Home Loan Bank Act
       Established Federal Home Loan Bank System (FHLBS) as a regulatory and support
       structure for the savings and loan associations. FHLBB was empowered to charter
       and regulate federal savings and loan associations. Previously, all savings and loan
       associations were chartered by the states. Also to act as central credit system for
       savings and loans institutions. The purposes of FHLBS were in some ways parallel to
       those of FRS. Its primary objectives were to (1) provide secondary liquidity to
       mortgage lending institutions that had temporary cash flow problems, (2) transfer
       loanable funds from areas where there was excess saving and little demand for loans
       to areas where the demand for loans was higher than the funds available, and (3)
       attempt to stabilize the residential construction and financing industries. Federal
       deposit insurance for savings and loan associations was created in 1934 when the
       Federal Savings and Loan Insurance Corporation (FSLIC) was established under
       FHLBB.

1933.
        Glass-Steagall Banking Act of 1933.
        Separates commercial from investment banking activities. Created FDIC to
        administer the deposit insurance program. It prohibited paying interest on demand
        deposits. Amended McFadden Act to permit national banks to branch within a state
        to the same extent that state chartered banks are permitted. (Carter Glass had his
        picture on the currency at some point.)

1934 - S&L deposits become insured by FSLIC.

1935.
        Banking Act of 1935
        Required state banks with $1 million in assets to join Federal Reserve System.
        Broadened powers of the Fed to regulate banks, created FOMC at Fed, established
        Board of Governors at Fed (which excluded the Comptroller of the Currency and the
        Secretary of Treasury).

        Together, the banking acts of 1933 and 1935 also (1) prohibited banks from paying
        interest on demand deposits; (2) provided for limitations on the interest banks could
        pay on time deposits; (3) prohibited investment banks from receiving deposits; (4)
                                               9


        restricted banks to a limited range of investment banking activities, including a
        prohibition on bank underwriting of corporate securities; (5) required federal banking
        agencies to consider capital adequacy, earnings prospects, managerial character, and
        community needs before chartering a bank; (6) gave the Federal Reserve Board the
        authority to change the reserve requirements for member banks; and (7) allowed
        national banks to form branch offices to the same extent as state banks.

        These banking acts gave FDIC the authority to examine all ins ured banks. The acts
        also required that insured banks ultimately become members of FRS, and
        membership implied that FRS would have oversight responsibility. But legislative
        pressures of nonmember banks led to the removal of the membership requirement in
        1939. To avoid regulatory duplication, OCC, FRS, and FDIC agreed to a formal
        division of responsibility for the bank examination function that still exists today:
        OCC would be responsible for national banks, FRS for state- member banks, and
        FDIC for state- nonmember banks.

1956.
        Bank Holding Company Act of 1956 (and 1970).
        Douglas Amendment prevented bank holding companies from holding banks across
        state lines. (The Act was aimed at Bank of America.) Applies to holding companies
        with controlling interest in two or more banks. It prevented holding companies from
        controlling any other business than banks, and put these holding companies under the
        regulation/ supervision of the Fed. The 1970 amendment redefined holding company
        to that with controlling interest in only one bank, to stop Citibank from owning
        related non-bank businesses. Fed has since issued a list of non-banking activities that
        the holding can operate: mortgage lending, tax preparation, other financial services.

1966(?).
       Thrift (and CU) deposits hit with interest rate ceiling, but one that is 25bp above that
       of banks.

1977.
        Community Reinvestment Act. The CRA mandates that each bank be evaluated to
        determine if it has met the credit needs of its entire community. That record is taken
        into account when the regulators considers a bank‘s application for deposit facilities,
        including mergers and acquisitions. The CRA is enforced by the financial regulators
        (FDIC, OCC, OTS, and FRB). In 1995, the implementing regulations for the CRA
        were strengthened by focusing the financial regulators' attention on institutions'
        performance in helping to meet community credit needs. These changes were very
        controversial and as a result, the regulators agreed to revisit the rule after it had been
        fully implemented for five years. Thus in 2002, the regulators opened up the
        regulation for review and potential revision. The 1995 revisions were credited with
        helping to substantially increase the amount of loans to small businesses and to low-
        and moderate-income borrowers for home loans. Part of the increase in the latter type
        of lending was no doubt due to increased efficiency in the secondary market for
        mortgage loans.
                                              10



1978.
        International Banking Act of 1978. This act made foreign bank holding companies
        subject to the Banking Holding Company Act and the Federal Reserve Act.

1980.
        Depository Institutions Deregulation and Monetary Control Act of 1980 DIDMCA.
        Ends prohibition of paying interest on demand deposits, and phases out Regulation Q
        as of March, 1986. S&Ls given new consumer lending powers & increased size of
        mortgage loans they are able to make to offset loss of 0.25% interest rate advantage.
        Raised deposit insurance coverage from $40,000 to $100,000. The intention was to
        help thrifts compete with banks and mutual funds and Eurodollar deposits.

1981.
        Regulation: OCC authorized banks to originate ARMs.

1982.
        "Garn-St Germain" or Depository Institutions Act of 1982. Geared towards banks
        and thrifts. Provided greater flexibility to federal bank regulators in dealing with
        troubled banks and thrifts. Expanded the ability of thrifts to offer a wider array of
        liabilities such as federally insured NOW and Super-NOW accounts. Also allowed
        them new powers to make more commercial loans in new areas. It allowed banks to
        merge with troubled thrifts across state lines.

                Together DIDMCA and DIA acts gave federally chartered thrifts a wider
        range of investments (assets) and financial products (transactions accounts). They
        gained more powers to determine the interest rates on their deposits. (Rates were
        finally deregulated by March 1986.) The gave the Depository Institutions
        Deregulation Committee the authority to create money market deposit accounts
        (OCDs). In order to assure them positive yield spreads the FHLBB permitted them to
        make, purchase, and participate in ARMs, make greater use of futures and options,
        invest in below-investment-grade bonds (JUNK BONDS), and borrow from sources
        outside the FHLB System. Thus greater flexibility and diversification of portfolios.

1986.
        Reagan‘s TAX REFORM ACT of 1986. Reduced incentives for thrifts to hold
        mortgage assets. These provisions decreased from 82% to 60% of total assets needed
        to qualify as a thrift. It also reduced the percentage of income that co uld be sheltered
        as bad-debt reserves. (Thus reducing incentives to hold reserves.)

1987.
        Competitive Equality in Banking Act
        This bill, amongst other things, exempted the parent holding corporation of an
        industrial loan banks (industrial loan companies) from consolidated supervision and
        regulation under the Bank Holding Company Act.
                                              11


1987.
        FSLIC Recapitalization. In order to pay for rising costs of losses of failing thrifts, the
        bill set up FICO to issue bonds to supplement insurance premiums, asset sales, and
        asset income. Interest on bonds would be paid back with insurance premiums from
        FSLIC and later SAIF, and the principle would be guaranteed by purchases of zero
        coupon Treasury bonds. Funded new capital for the Federal Savings and Loan
        Insurance Corporation‘s deposit insurance fund. In order to pay for rising costs of
        losses of closing thrifts, bill set up FICO to issue bonds to supplement insurance
        premiums, asset sales, and asset income. Interest on bonds would be paid back with
        insurance premiums from FSLIC and later SAIF, and the principle would be covered
        with purchases of zero coupon Treasury bonds. [Act also specified that ARMs must
        specify a maximum interest rate or cap can be charged on the ARM.]

1987.
        Expedited Funds Availability Act of 1987. United States Congress for the purpose of
        standardizing hold periods on deposits made to commercial banks and to regulate
        institutions' use of deposit holds

1989 – Financial Institutions Reform, Recovery, and Enforcement Act of 1989
       FIRREA promoted the acquisition of thrifts by bank holding companies. Exempted
       bank holding companies from limits on branching in enable these purchases.
       Abolished the FHLBB (Federal Home Loan Bank Board) and created the Resolution
       Trust Corporation (RTC), O ffice of Thrift Supervision (OTS) and new deposit
       insurance funds for thrifts and savings associations (SAIF). Allowed thrifts to offer
       demand deposits to businesses. Limited commercial real estate lending to 400% of
       capital. Applied national bank regulations on limits to loans to one borrower to
       thrifts. Appropriated $18.8 billion from Treasury, plus given $1.2 billion from FHLB
       system, and raised $30 billion through REFCORP bond issuances. Also mandated
       real estate appraisal standards.

1991.
        FIDICIA – Federal Deposit Insurance Corporation Improvement Act of 1991. $30
        billion for RTC approved March 23, 1991. Some specific rules on bank investment in
        real estate.

1993
        RTC Completion Act of 1993. Terminates RTC in 1995, provides final funding for
        RTC and additional funding for SAIF. Also contained reforms of RTC management
        practices.

1994
        Interstate Banking and Branching Efficiency Act of 1994 (Interstate Banking Act).
        Permitted interstate bank holding companies and interstate branching, thus largely
        overturning the McFadden Act and its subsequent amendments. Previously the
        degree of inter- and intrastate branching and banking allowable was largely
        determined by state laws. Under the McFadden Act of 1927 and the Banking Act of
                                             12


       1933, state laws determined how banks, including national banks, could branch
       within each state. The McFadden Act also prohibited interstate branching for all
       banks except state-chartered, nonmember banks. State laws governed the ability of
       these banks to branch interstate, but few states took advantage of this provision to
       permit interstate branching. However, as of June 1, 1997, the Interstate Banking Act
       will allow interstate branching through consolidation of existing banks or branches.
       The act gives states the ability to ―opt-out,‖ or choose not to allow branching, before
       June 1, 1997. They can also ―opt- in,‖ or authorize branching earlier. De novo
       branching—branching other than by merger with an existing bank—must be
       specifically authorized by individual states.

1999 – Gramm- Leach-Bliley Act
       Rolled back, in part, Glass-Steagall Act to allow bank holding companies and
       financial holding companies to own both commercial banking firms and securities
       firms (as well as insurance companies). Maintained the regulation of bank holding
       companies by the Fed, and created financial holding companies and made the SEC
       their regulator. Formalized functional regulation whereby federal financial
       regulators‘ authority not defined simply by type of institution but the type of activities
       within the institution. Reaffirmed the McCarran-Ferguson Act preventing the
       federal regulation of insurance and setting state licensing of insurance activities.
       Prohibits national banks and their subsidiaries from underwriting insurance –
       with some exceptions. Prohibits national banks from offering title insurance or
       annuities.

2000.
Commodity Futures Modernization Act of 2000. Largely deregulated exchange traded
futures and options and entirely deregulated the OTC market in derivatives. Also allowed
futures on singe stocks to be traded on exchange.
                                           13



                                                                         LECTURE 6
BANKING
Case Study: Wal-Mart applies for a bank charter
What is an ILB?
      ILBs are chartered by state governments under state law and are subsequently
      supervised by state bank authorities. Some of them issue deposits that are
      federally insured by the Federal Deposit Insurance Corporation (FDIC).
      Those that receive federal deposit insurance are also regulated at the federal
      level by the FDIC.

       Nearly all ILBs are owned by a holding company and thus are not stand-alone
       banks. Stand-alone banks are independent, unaffiliated with other financial
       institutions, and owned outright by a company that owns just the bank. In
       contrast, nearly all are owned through a holding company structure. These
       holding companies are often a major commercial or industrial company such
       as Toyota or BMW, or a major financial institution such as American Express
       or Citigroup.

       An ILB can serve any client, individual or business entity, and can offer most
       of the array of financial products available from normal commercial banks.
       These similar services include:
                  Credit cards
                  Consumer loans including those for vehicles, RVs, and home
                   improvements
                  Loans secured by brokerage accounts
                  Commercial lending
                  Real estate construction
                  Equipment financing and leasing
                  Subprime lending
                  ILBs with less than $100 million in assets can issue demand
                   deposits, while other can offer checkable ―NOW‖ accounts
                  Access to the Fed wire, automated clearing house (ACH) and
                   check clearing services of the Federal Reserve


What public interest issues are raised?
      - Conflict of interest between commercial/industrial and bank institution. The public
      interest concern is that a commercial entity will drain capital from financial
      institution, or otherwise distort the prudential investment decisions of the financial
      institution. [Note that two ILB failures due to mismanagement from pressure from
      commercial owners.]
                      exposing it to a variety of risks
                                            14


                     trouble at parent or affiliate can severely impair the ability of
                      an ILB to raise capital, acquire credit or otherwise gain access
                      to other services in the financial sector
                     lead to inappropriate inter-company transactions, such as drain
                      bank of capital or profits, through
                     paying excess dividends
                     charging above market prices or interest rates
                     paying below market prices or interest rates
                     increasing lending
                     Raising reputational risks
                     exposing it to operations risk from information technology
                      services shared with parent or affiliate

       - BIF: expose bank insurance fund to greater credit risk, put otherwise, anytime there
       is FDIC insurance there is a public interest concern
       - Competition
               1. Will Wal-Mart increase competition in banking services market and result
               in lower priced banking services?
               2. Will Wal-Mart chase independent banks out of business and become the
               new local monopoly and then refuse to extend create to local retailers who
               compete with Wal- mart?
       - Safety and Soundness concerns with commercial owned bank that lacks holding
       company oversight and operates with major conflicts of interest.

Regulatory issues
       - no holding company oversight (i.e. not subject to BHCA)
       - no penalties to holding company if bank fails to maintain capital or has an
       impairment of capital
       - not subject to penalties under BHCA for unsatisfactory CRA score, and no
       subsequent restrictions on activities of the parent company
       - FDIC regulation and oversight is limited and not yet tested regarding supervision of
       ILBs (according to GAO)
       - create or expand loophole that leads to uneven playing field. Federal Reserve
       Board‘s long-time staffers and now newest board member put it very well in a recent
       interview.
               "Industrial loan companies are a loophole that would be greatly expanded by
               this legislation," Federal Reserve Board governor Donald L. Kohn said in a
               recent interview. "If they want parity with banks, they should have parity in
               every respect, and that means their parent companies would be subject to the
               same rules and regulations the parents of other federally insured banks are
               subject to. If they were granted the powers they are trying to obtain, they
               would be treated differently and preferentially relative to other federally
               insured banks."
       - Exemptions under the Competitive Equality Banking Act of 1987 (CEBA) to the
       Bank Holding Company Act.
                                            15


                1. No federal oversight of parent company as a bank holding company. Thus
                    ILBs are not subject to penalties imposed on a financial holding company
                    if a subsidiary bank has an impairment of capital.
                2. ILBs are not subject to penalties under the BHCA for receiving less than a
                    satisfactory score under the Community Reinvestment Act (CRA) rating.
                    If an Industrial bank had to face any kind of CRA problems, it would not
                    result in any legal restrictions on operations of the holding company or
                    affiliates.
       In a recent report to Congress, the GAO concluded that, ―Therefore, from a regulatory
       standpoint, these ILCs may pose more risk of loss to the bank insurance fund than
       other insured depository institutions operating in a holding company. For example,
       FDIC‘s authority to examine ILC affiliates and take certain enforcement actions
       against them is more limited than a consolidated supervisor. While FDIC asserted that
       its authority may achieve many of the same results as consolidated supervision, and
       that its supervisory model has mitigated losses to the bank insurance fund in some
       instances, FDIC‘s authority is limited to a particular set of circumstances and may not
       be used at all times. Further, FDIC‘s authority has not been tested by a large ILC
       parent during times of economic stress.‖

How Are ILBs currently regulated?
STATE LAW
        ILBs are state chartered financial institutions that are subject to state laws and
supervised by the banking authority of their home state. State charters for ILBs are not very
limiting as to the type of activities undertaken by ILBs.1[15] A recent GAO report put it
clearly and succinctly, ―Banking laws in California, Nevada, and Utah have undergone
changes that generally place ILCs on par with traditional banks. Thus, like other FDIC-
insured depository institutions, ILCs may offer a full range of loans… [and] may ―export‖
their home-state‘s interest rates to customers residing elsewhere.‖ 2[16]

        Although ILBS can engage in a similar range of financial activities, these state
chartered financial institutions face some differences from state to state. For example,
California and Colorado prohibit non- financial firms, such as General Motors or Wal-Mart,
from owning ILBs. Also, California law prohibits ILBs from accepting checking or demand
deposits. Some states require IBLs to obtain deposit insurance from the FDIC as a condition
for issuing deposits.

        Despite being state-chartered, ILBs are allowed to ―export‖ their home state‘s interest
rates for transactions in other states. This allows an ILB to charge the up to the maximum
interest rate allowed by the state in which it is chartered irrespective of which state the
                                             16


customer is located. This means that any interest rate ceiling in the chartered-state applies
for transactions nationwide. Neither Utah nor Nevada – which together make up 89% of all
ILB assets – place a cap on interest rates, and so the ILBs located in those states face no anti-
usury limits on the interest rates they charge borrowers.

         The variation in law from state to state can lead to a lowering of prudential regulatory
standards. According to David Poulsen, President of the American Express Centurion Bank,
ILBs grew in popularity in specific states partially because of the states‘ ―low cost of
operation, simple and clear consumer credit code, and generally business friendly state
legislature.‖3[17] A story in Credit Card Management Magazine expressed this more
precisely, ―In the days immediately preceding the enactment of CEBA [Competitive Equality
Banking Act of 1987], when it became apparent that ILBs were to be preserved as a vehicle
for non-bank owners, several well-known financial-services companies feverishly sought out
the available ILC charters in Utah. The California and Colorado ILC do not appear as
attractive as those in Utah. That is because Utah has fewer restrictions to impede the growth
and potential usefulness of ILBs as vehicles with which to conduct nationwide lending and
deposit taking.‖4[18]

        Hence the uneven distribution of ILBs across the country. Today, 82% of FDIC
insured ILB assets are in Utah, 10% in California, 7% in Nevada and the remaining 1% in
Colorado, Hawaii and Minnesota.5[19]

FEDERAL LAW
        Federal banking laws address ILB regulation in three major ways. First, federal law
treats ILBs in much the same way as banks and thrifts. If ILBs issue deposits guaranteed by
the Federal Deposit Insurance Corporation, they are then subject to supervision by the FDIC
and are generally covered by the federal banking laws governing depository institutions.
Federal law allows ILBs to engage in nearly all types of financial transactions as state and
federally chartered banks and thrifts. One exception is their ability to offer normal checking
or demand accounts. Federal restricts their ability to do so if they want to remain exempt
from the Bank Holding Company Act (see discussion below). Nonetheless, ILBS can and do
offer similar ―NOW‖ checking accounts – these Negotiable Order Withdrawal accounts give
the financial institution the right to delay the payment of funds for seven days, but in
practice, they are usually made on demand.

       The FDIC began insuring the deposits of a few ILBs as early as 1958, although it did
not become general policy until passage of the Garn-St.Germain Act, P.L. 97-320
                                              17


(Depository Institutions Act) in 1982. This act authorized federal deposit insurance for thrift
certificates, a funding source used by industrial loan banks.

         Under federal banking law, ILBs are subject to the same safety and soundness
regulations and consumer protection laws. These include restrictions on transactions
between the ILB and its affiliates – in general requiring them to be conducted at ―arms-
length.‖ Specifically, the law limits loans or ―covered transactions‖ to any one affiliate to
10% of the bank‘s capital and to 20% of its capital for the combined amount of loans to all
affiliates. The term ―covered transaction‖ means loans plus securities, letters of credit, credit
guarantees and other such obligations from the affiliate. Federal law also requires that those
transactions be conducted on ‗normal or usual‘ terms, that advertising not imply that the
depository institution is responsible for obligations of its affiliates, and imposes limitations
on securities transactions between affiliates.

         Federal banking law addresses ILBs in a second way by providing a unique
exemption from the prohibition of non-financial holding companies owning a depository
institution and in the subsequent exemption of those holding companies from consolidated
holding company supervision and regulation.

        ILBs charters allow commercial and industrial firms, such as Sears, GM or Wal-Mart,
to own an ILB even though federal bank law would otherwise prohibit such firms from
owning and operating a normal state or federally chartered bank or thrift.6[20] It is
important to note that Gramm- Leach-Bliley eliminated a similar loophole for ―unitary thrifts‖
in 1999. Today the only two loopholes by which a non- financial commercial company can
own a financial institution is to obtain an ILC or a limited ‗credit card only‘ bank. In this
way Gramm- Leach-Bliley – contrary to some perceptions – actually strengthened the Glass-
Steagall principal of separating the ownership of banking institutions from commercial and
industrial enterprises.

        Combining banking and commercial firms creates several types of dangers. It creates
conflicts of interest that reduce the safety and soundness of the financial system, and
potentially increases the market power of large conglomerate corporate goliaths. The
implications for these conflicts of interest is for transfers of risk and returns between an ILB
and their parent (or with its other affiliates) to result in imprudent risk-taking, distortion of
public financial reporting, inefficient allocation of resources or unfair competitive advantages
for firms benefiting from this regulatory loophole.

        One particular concern that is raised by the Wal-Mart application is the potential for
the Wal-Mart bank to drive many independent banks and thrifts out of business and thus
leave many small towns and cities with only a Wal-Mart branch bank. Whereas the
independent banks and thrifts made their business by lending to all sorts of businesses, their
displacement by a Wal-Mart bank might result in a loss of credit and other financial services
                                              18


to local businesses that compete with Wal-Mart. This non-competitive behavior would lead
to greater economic inefficiencies.

        Although ILBs are regulated by the FDIC, their parent companies are not subject to
consolidated federal oversight as bank holding companies under the Bank Holding Company
Act (BHCA). The BHCA includes activity restrictions and supervisory provisions that apply
to bank holding companies, i.e. any company that controls a ―bank‖. As a general matter, the
Act defines ―bank‖ as a financial institution that issues checkable (demand) deposits insured
by the FDIC and makes commercial loans. Consolidated bank or financial holding company
regulation and supervision is carried out by the Federal Reserve Board and the Securities and
Exchange Commission, respectively.

        The Competitive Equality Banking Act of 19877[21] (CEBA) amended the BHCA so
as to provide exemptions, under certain conditions, for ILB holding companies to avoid
consolidated holding company regulation and supervision. The conditions for obtaining
exemption from the BHCA are the following:
       the ILB does not accept demand deposits (withdrawals by checks payable to a third
        party, i.e. normal checking accounts)
       total assets of the ILB are less than $100 million
       the ILB was not acquired after August 10, 1987

        As a result of this exemption, ILBs, as well as their parent holding company, are not
subject to the same capital requirements as other banks and thrifts. According to the
Congressional Research Service, ―ILCs and, especially their parent owners, need not always
carry as much capital as banks and their holding companies.‖8[22]

        The FDIC does have authority to examine any affiliate, including a parent company,
of a regulated financial institution for the purpose of fully disclosing the relationship with the
ILB. In contrast, a consolidated bank holding company regulator, i.e. the Fed or SEC, has
the power to examine the holding company and any subsidiary even though they may not
have any relationship to the insured ILB. However the FDIC does not have the enforcement
authority to exercise these responsibilities in all circumstances. A recent GAO report states
that, ―questions remain about whether FDIC‘s supervisory approach and authority over BHC
Act-exempt holding companies and their non-bank subsidiaries address all risks to the ILC
from these entities.‖9[23]

      The BHCA, as amended by the Gramm- Leach-Bliley Act, requires a bank holding
company that seeks to become a financial holding company, or a financial holding company
                                              19


seeking to expand its activities, to maintain all its depository institutions as ―well capitalized‖
and well managed. In contrast, FDIC enforcement action begins only after a bank fails to be
―adequately capitalized.‖

        The FDIC claims that it can enhance its authority by threatening to withdraw deposit
insurance. However this is a dangerously destabilizing ploy for dealing with a troubled
financial institution. It is akin to enforcing fire safety standards on a landlord by cutting off
water to the building.

As to why the CEBA carved out this exemption for ILBs while closing the loophole for near-
bank banks, former Federal Reserve Board Chair Alan Greenspan wrote in a letter to
Congressman Jim Leach on January 20, 2006 that when CEBA was passed in 1987 the
number of ILBs was small, their total assets were small (the largest had assets of less then
$400 million) and that many states – including Utah – were either not chartering or had a
moratorium on the chartering of ILBs. Greenspan went on to point out that actual market
conditions have changed considerably since that time.

The third issue for ILBs and federal banking law concerns ongoing Congressional efforts to
expand ILB powers. One of these would allow ILBs to offer interest bearing demand
deposits, and another would allow the offering of interest bearing business NOW accounts to
corporate clients. If allowed to do so, ILBs could greatly expand their deposit base. Another
of these provisions would expand powers of ILBs to branch interstate – even if this would
involve the creation of new branches – called de novo branching – and even if the branching
extended into states that otherwise passed laws prohibiting such de novo branching.10[24]
Allowing unrestricted interstate expansion through de novo branching would greatly increase
the size of ILBs and the demand for ILB charters.

				
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