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					                                                                                                                                     September 15, 2005




                                                                  Federal Reserve Bank of Cleveland




                 Umbrella Supervision
                 by Joseph G. Haubrich and James B. Thomson



                 S   even Blind Mice, a children’s book
                 based on an old Indian parable, tells the
                                                                  new and diverse financial services firms.
                                                                  Instead, GLBA has created a new type of
                 story of blind mice who visit an elephant.       bank holding company—the financial           Deregulation and financial consoli-
                 The first six explore the part of the ele-       holding company, where activities such       dation have led to the development of
                 phant they happen upon first and each            as merchant banking and insurance            financial holding companies—allow-
                 declares that he has discovered either a         underwriting, which previously were not      ing commercial banking, insurance,
                 pillar, a snake, a cliff, a spear, a fan, or a   permissible for banking firms, are now       investment banking, and other finan-
                 rope. Only the seventh mouse, who                allowed—and named the Federal                cial activities to be conducted under
                 explores the whole of the animal,                Reserve, the seventh mouse if you will,      the same corporate umbrella—and
                 deduces that it is an elephant. The lesson       as umbrella supervisor. (Thrift holding      the Federal Reserve has been named
                 of this parable for policymakers and             companies remain regulated by the
                                                                                                               supervisor of the consolidated enter-
                 financial regulators is that only by             Office of Thrift Supervision and invest-
                                                                                                               prise. This Commentary explains the
                 assessing the activities of a company as a       ment bank holding companies by the
                 whole can its true risk be acknowledged.         Securities and Exchange Commission.)         increasing importance of an
                                                                                                               umbrella supervisor amid the sea of
                 In 1933, the Glass-Steagall Act was              ■    Financial Holding                       regulatory agencies, and why the Fed
                 passed, shaping the evolution of the                  Companies                               may be the best natural choice, both
                 United States’ financial system through          There are several ways of conducting         practically and conceptually, to
                 a legislative blueprint that compartmen-         different financial services in the same     assume the role.
                 talized commercial banking, investment           organization: the universal bank as
                 banking, and insurance. Not surpris-             currently practiced in Germany, where
                 ingly, separate agencies were created to         all financial services are done within the
                 supervise these different areas, resulting                                                    holding company—the Fed—would
                                                                  bank; the bank subsidiary model, where
                 in a patchwork quilt of functional regu-                                                      examine a bank or thrift subsidiary of
                                                                  nonbanking activities are done in sepa-
                 lators at both the federal and state                                                          the holding company only under exigent
                                                                  rately chartered subsidiaries of the bank;
                 governmental levels.                                                                          circumstances, relying on the supervi-
                                                                  and the bank holding company model,
                                                                                                               sory judgment of the primary supervisor
                                                                  where nonbanking activities are done in
                 In the past several years, however, the                                                       to the greatest extent possible.
                                                                  firms owned by a parent company that
                 lines between commercial banking and
                                                                  also owns the bank. The United States        After GLBA was passed and the finan-
                 other financial services have become
                                                                  has used the bank holding company            cial holding company was created, the
                 increasingly blurred. Deregulation, most
                                                                  form since the mid-1950s.                    framework was set for the consolidation
                 recently in the form of the Gramm-
                 Leach-Bliley Act of 1999 (GLBA), and                                                          of the financial services industry. How-
                                                                  Prior to GLBA, bank holding companies
                 earlier in the form of the Reigle-Neal                                                        ever, GLBA did little in the way of
                                                                  could own banks, thrifts, and other firms
                 Act of 1994, has lifted interstate branch-                                                    regulatory consolidation. Even consoli-
                                                                  engaged in activities deemed closely
                 ing restrictions and dismantled many                                                          dating the Office of Thrift Supervision
                                                                  related to banking by the Federal
                 of the statutory limits on financial con-                                                     into the Office of the Comptroller of
                                                                  Reserve Board. However, supervision of
                 solidation that were the heart of Glass-                                                      the Currency was not actively under
                                                                  banks and thrifts owned by a parent
                 Steagall. This legal sea change, along                                                        consideration, despite both agencies
                                                                  holding company fell to the company’s
                 with technological innovations and                                                            being housed within the U.S. Treasury
                                                                  primary federal or state regulatory
                 financial engineering, make increased                                                         Department. Congress instead chose to
                                                                  agency—its functional regulator—and
                 integration of financial markets and                                                          adopt a functional-regulator approach
                                                                  supervision of nonbank subsidiaries of
                 more competition among financial firms                                                        for the new activities now allowed under
                                                                  bank holding companies and the consoli-
                 seem likely. However, consolidation                                                           GLBA. For instance, the Securities and
                                                                  dated holding company fell to the Fed-
                 does not seem as imminent for the regu-                                                       Exchange Commission would regulate
                                                                  eral Reserve. Under this regulatory
                 latory agencies that will supervise these                                                     investment banking subsidiaries of a
                                                                  model, the “umbrella supervisor” of the
ISSN 0428-1276
financial holding company, and the            consider the Butcher banks. The two            when this function is housed in the
appropriate state agency (insurance           Butcher brothers, Jake and C.H., Jr.,          parent company. This can only be done
commissioner or regulatory body in            owned or controlled approximately              effectively by a supervisor with the
the state where the subsidiary is incor-      40 depository institutions between them.       authority to look at the consolidated
porated) would regulate insurance             Through what was known as chain bank-          organization.
subsidiaries. Using these specialized         ing, the Butchers’ holdings included
industry regulators echoed the approach       depository institutions in two of the          Finally, choosing the financial holding
used to supervise banks and thrifts in        Federal Deposit Insurance Corporation’s        company form as the model for consoli-
traditional bank holding companies. It        (FDIC) jurisdictions and three Federal         dation stems from a desire to insulate
may not be a surprise, therefore, that the    Reserve Districts. Unlike a bank holding       bank and thrift subsidiaries from risks
Federal Reserve was chosen to be the          company, this chain of commonly held           posed by the new activities. By exten-
“umbrella supervisor” for the consoli-        institutions was not supervised on a           sion, Congress sought to limit the fed-
dated financial holding company,              consolidated basis. Depending on               eral financial safety net to the insured
because Congress viewed this role as an       location, charter, and Federal Reserve         depository institution subsidiaries and
extension of the Federal Reserve’s role       membership status, examination of each         thereby protect the federal deposit
as the regulator of bank holding compa-       separate chain-banking unit fell to one        insurance funds (and by implication,
nies. In fact, this sentiment is explicitly   of the seven bank or thrift regulatory         taxpayers) from the same risks. In
stated in the Conference Report on the        agencies involved, making it difficult         GLBA, Congress charged the umbrella
Gramm-Leach Bliley Act released               for any single examination agency to           supervisor with protecting the insured
November 1, 1999:                             detect systemwide problems. The lack           bank and thrift subsidiaries of financial
                                              of a comprehensive examination of their        holding companies, as well as the
    Reflected in the legislation is the       entire empire allowed the Butcher banks        domestic and international payments
    determination made by both Houses         to hide asset-quality problems by shift-       systems, from risks associated with
    to preserve the role of the Board of      ing problem loans from one bank to             the functionally regulated nonbank
    Governors of the Federal Reserve          another. Only after the FDIC conducted         subsidiaries of holding companies.
    System… as the umbrella supervi-          simultaneous examinations of all the           Therefore, while the Federal Reserve is
    sor for holding companies, but to         major Butcher-affiliated banks were            to rely mostly on the functional regula-
    incorporate a system of functional        the problems detected, leading to the          tor for information on the condition of a
    regulation designed to utilize the        closing of eight Butcher-affiliated banks      subsidiary of a nonbank financial hold-
    strengths of the various Federal          in 1983, with losses to the FDIC of            ing company, as umbrella supervisor
    and State financial supervisors.1         nearly $383 million.                           the Fed has broad authority to examine
                                                                                             any holding company subsidiary that is
Moreover, to minimize the regulatory          In addition to the need for comprehen-         seen as a possible material risk to the
burden associated with this layered           sive examinations, umbrella supervision        health of the insured banking (or thrift)
approach to the supervision of financial      is also necessary because the legal sepa-      subsidiaries or to the payments system.
holding companies, the GLBA limits            rateness afforded by the holding com-
the Federal Reserve’s ability to de facto     pany structure is less and less an eco-        ■    Umbrella Supervision and
regulate functionally regulated sub-          nomic reality. Senior management and                the Fed
sidiaries of financial holding companies.     boards of directors are increasingly           As with any supervisor of financial
                                              adopting enterprisewide risk manage-           services firms, the umbrella supervisor
■     Role of the Umbrella                    ment—aggregating risk at the corporate         is required to be independent of partisan
      Supervisor                              level in order to effectively establish risk   politics and the congressional appropria-
The parable of the blind mice illumi-         limits and controls. New regulations,          tions process. Moreover, the umbrella
nates how a functional regulator’s            such as the Basel II capital requirements      supervisor must have sufficient stature
assessment of a subsidiary may not            and Federal Reserve Board letter               in financial markets in order to attract
reflect the true risk in the context of the   SR99-18, have further nudged banks             and retain qualified staff. It is unlikely
entire company. The role of the               and their parent holding companies             that a stand-alone agency, even in the
umbrella supervisor is to piece together      toward organizing their risk-manage-           broad and deep financial markets of the
a consolidated picture of the financial       ment and economic capital allocation           United States, would meet both of the
holding company’s risks—including             plans according to lines of business,          above conditions, for how would such
management’s ability to understand and        not legal entities. Hence, the need for        an entity be funded other than by con-
manage those risks. In other words, the       aggregated risk information, coupled           gressional appropriations? After all, by
umbrella supervisor is charged with           with economies of scale in information         design, the umbrella supervisor would
producing a comprehensive picture             storage, retrieval, and processing, have       conduct few, if any, examinations, so
of an institution as the collection of its    reinforced the trend toward enterprise-        there would be no exam fees to rely on
parts, leaving the regulation and exami-      wide risk management by diversified            and, unlike the Fed and the FDIC, there
nation of each holding-company sub-           financial firms, including financial           would be no portfolio of government
sidiary to its functional regulator. It is    holding companies. Functional regula-          securities from which earnings could be
not just the parts but how they fit           tors provide an important level of review      used to support its operation. Hence, the
together that gives us the true profile       of risk-management systems at the legal        umbrella supervisory function would
of a financial holding company.               entity level, but they cannot, by design,      need to be housed in an existing agency,
                                              adequately assess the enterprise-wide,         a new financial regulatory agency, or the
To further stress the importance of
                                              risk-management efforts, particularly          central bank.
producing a comprehensive picture,
Why might the Federal Reserve be a           with Complex Risk Profiles, instructs
natural choice to be the umbrella super-     banks to allocate capital on an eco-
visor? The short answer—because              nomic basis, that is, to assign capital to
Congress delegated the role to the Fed       business lines according to the risks
in GLBA and it is a natural extension        they pose to the company. Available at
of the Fed’s role as regulator of bank       <http://www.federalreserve.gov/board
holding companies—is an unsatisfying         docs/SRLETTERS/1999/SR9918.HT>.
response, providing no explanation as
to why the central bank is a better          For more details on the Butcher
choice for this role than a federal bank     banks, see:
regulatory agency or even the SEC.           Federal Deposit Insurance Corporation.
However, an economic case can be             (FDIC) 1998. “Managing the Crisis:
made for housing the umbrella supervi-       The FDIC and RTC Experience:
sory function at the Fed. First, the Fed’s   Chronological Overview.” Available at
responsibility to manage macropruden-        <http://www.fdic.gov/bank/historical/
tial risks—including concerns for finan-     managing/Chron/index.html> (accessed
cial stability and the integrity of the      01/04/05).
payments system—suggests that there
may be economies of scope between            For more on the pros and cons of
central banking functions and umbrella       regulatory consolidation, including
supervision. In other words, the types of    comparisons with other countries, see:
information the Fed needs to carry out
                                             Charles A.E. Goodhart. 2000. “The
its mission include financial market and
                                             Organisational Structure of Banking
financial firm information that an
                                             Supervision,” FSI Occasional Papers,
umbrella supervisor would collect and
                                             No. 1, November.
consolidate. In addition, the existence
of the Federal Reserve is not contingent     Charles A.E. Goodhart, and
on its role as a functional supervisor.      D. Schoenmaker. 1992. “Institutional
Consequently, any conflicts of interest      Separation between Supervisory and
between an agency’s role as a func-          Monetary Agencies,” Giorn. Econ.,
tional supervisor and its role as            pp. 9–12, 353–439.
umbrella supervisor should be less at
the central bank. This, in turn, should      Alan Greenspan. 1994. “The Views of
facilitate the cooperation between the       the Board of Governors of the Federal
umbrella supervisory agency and func-        Reserve on the Consolidation of Bank
tional regulators so important to the        Supervision and Regulation.” Banking
success of financial holding companies.      Industry Regulatory Consolidation Hear-
                                             ings before the Committee on Banking,
■    Recommended Readings                    Housing, and Urban Affairs. U.S. Senate,
Ed Young. 1993. Seven Blind Mice,            S. Hrg. 103–692, pp. 130–56.
New York, N.Y.: Philomel Books.
                                             Joseph G. Haubrich. 1996. “Combining
For a discussion of enterprise-wide risk     Bank Supervision and Monetary Policy,”
management in banking companies, see:        Federal Reserve Bank of Cleveland,
Susan Schmidt Bies. 2004a. “Enterprise       Economic Commentary (November).
Perspectives in Financial Institution        Joao A. C. Santos. 1998. “Securities
Supervision.” Remarks at the Univer-         Activities of Banking Conglomerates:
sity of Connecticut School of Law,           Should They Be Regulated?” Cato Jour-
Connecticut Law Review Symposium,            nal 98, Spring/Summer, pp. 93–08.
Hartford, Connecticut, October 21.
                                             United States General Accounting
Susan Schmidt Bies. 2004b. “Using            Office. 2004. “Financial Regulation:
Enterprise-Wide Risk Management to           Industry Changes Prompt Need to
Effectively Execute Business Strate-         Reconsider U.S. Regulatory Structure.”
gies.” Remarks at the Risk Management        Report to the Chairman, Committee on
Association and Consumer Bankers             Banking, Housing, and Urban Affairs,
Association Retail Risk Conference,          U.S. Senate, October.
Chicago, Illinois, July 16.
                                             Footnotes
Federal Reserve Board letter SR 99-18,
                                             1. See http://banking.senate.gov/conf/
formally titled Assessing Capital
                                             somfinal.htm.
Adequacy in Relation to Risk at Large
Banking Organizations and Others
Joseph G. Haubrich is a consultant and
economist at the Federal Reserve Bank of
Cleveland, and James B. Thomson is a vice
president and economist at the Bank.

The views expressed here are those of the
authors and not necessarily those of the
Federal Reserve Bank of Cleveland, the Board
of Governors of the Federal Reserve System,
or its staff.

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We invite comments, questions, and sugges-
tions. E-mail us at editor@clev.frb.org.




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