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- ICI Comment Letters
"Financial Services Act of 1999," H.R. 10
Committee on Banking and Financial Services
U.S. House of Representatives
Matthew P. Fink
Investment Company Institute
February 10, 1999
Table of Contents
I. Oral Statement of Matthew P. Fink
IV. The Elements of Successful Financial Services Reform
V. The Appropriate Role of the Bank Regulatory Agencies
VI. Nonfinancial Activities
VII. Grandfathered Unitary Savings and Loan Holding Companies
Mr. Chairman and Members of the Committee, my name is Matthew Fink. I am President of the Investment Company Institute, which is the national association of the American mutual fund industry.
I am pleased to be here today to testify in support of H.R. 10, the "Financial Services Act of 1999." As an initial matter, I would like to commend the Committee, and note your leadership in particular, Mr. Chairman, in spearheading the effort for financial services reform legislation. Last year, you joined with leaders of the House Commerce Committee and reached historic compromises on issues that had long been divisive. That unprecedented action spoke powerfully. It is now abundantly clear that the laws that separate mutual funds, commercial banks, broker-dealers, insurance companies and other financial services firms are obsolete in the face of technological advances, fierce competition, and dynamic and evolving markets.
We believe that H.R. 10 represents a sound framework for financial services reform.
First, it would permit affiliations among all types of financial services companies.
Second, it would grant banks full mutual fund powers.
Third, it would modernize the federal securities laws to address bank mutual fund activities.
Fourth, it would generally implement an oversight system based on the sound principle of functional regulation.
For all of these reasons, the Institute supports passage of this legislation.
In the spirit of that support, we would take this opportunity to ask that you consider our additional comments. In particular, there is one issue whose importance became more apparent in the closing days of the last Congress. That is the need to ensure that the principle of functional regulation applies to all—and not just some—of the bank regulatory agencies. More specifically, the appropriate standards that are set forth in the bill for the Federal Reserve Board and the FDIC should also apply to the Comptroller of the Currency and the Office of Thrift Supervision.
Why is functional regulation so important? One obvious reason is that it reduces overlap between the various regulators. Even more important is that it avoids regulatory concepts designed for one type of institution being applied to different types of institution for which they are inappropriate.
For example, our securities markets are based on transparency, strict market discipline, creativity and risk-taking. As the SEC has repeatedly testified, placing entrepreneurial and risk-taking securities firms, like mutual funds, under bank-type regulation, which is premised on safety and soundness concerns, would be a serious mistake. It would threaten the continued successful operation of the existing securities regulatory system and even the health of our capital markets.
In general, H.R 10 implements a carefully crafted mechanism designed to ensure that the principle of functional regulation is not undermined. For example, while H.R. 10 assigns to the Federal Reserve Board oversight responsibility over financial holding companies, it carefully prescribes the Board’s authority over regulated non-bank subsidiaries, such as mutual fund companies, to only those situations where necessary to prevent a material risk to the safety and soundness of an affiliated bank or to the payments system. H.R. 10 applies these same sound standards to the FDIC.
These standards were developed late in the prior Congress. It is our belief that there just was not enough time to incorporate provisions to apply them to the Comptroller of the Currency and to the Office of Thrift Supervision. But given the overall intent of the functional regulation provisions, this is a serious loophole. Congress should now take the opportunity to fill in these gaps and amend H.R. 10 to apply the principle of functional regulation to these agencies as well. Otherwise, these agencies could inappropriately apply bank-type regulation to mutual fund companies and other non-bank subsidiaries. This would make no sense; obviously the OCC and the OTS should not have broader authority than that which is assigned to the Federal Reserve, in its capacity as umbrella regulator of financial holding companies, and the FDIC, which safeguards the deposit insurance fund.
In addition, we recommend two other changes.
First, we believe the bill should be amended to accommodate a limited degree of nonfinancial activities for diversified financial services organizations. Mutual fund companies and other nonbanking financial services firms have never been subject to activities restrictions like those contained in H.R. 10. They should not be penalized if they are to become subject to its provisions.
Second, we support changing the "grandfather date" for unitary thrift status from October 7, 1998, to the effective date of H.R. 10. Institutions that have become, or that have applied to become, unitary thrift holding companies subsequent to last October 7 have acted in full compliance with existing law. They should not be denied an equal opportunity to take advantage of legitimate business opportunities.
Mr. Chairman, I thank you for the opportunity to present our views. We look forward to working with you and the Congress as this legislation moves toward enactment.
My name is Matthew P. Fink. I am President of the Investment Company Institute, the national association of the American investment company industry. The Institute’s membership includes 7,408 open-end investment companies ("mutual funds"), 449 closed-end investment companies, and 8 sponsors of unit investment trusts. The Institute’s mutual fund members have assets of about $5.468 trillion, accounting for approximately 95 percent of total industry assets, and have over 62 million individual shareholders. The Institute’s members include mutual funds advised by investment counseling firms, broker-dealers, insurance companies, bank holding companies, banks, savings associations, and affiliates of commercial firms.
Mr. Chairman and Members of the Committee, I am pleased to be here today on behalf of the Institute to testify in support of H.R. 10, the "Financial Services Act of 1999" and thank you for the opportunity to express our views on this legislation. The Institute has been an active participant in the debate on financial services reform and has testified before Congress on subjects directly related to financial services reform numerous times over the last twenty-three years.
Initially, we would like to commend your leadership in spearheading the effort for financial services reform legislation. To most observers, it is now abundantly clear that the laws that separate mutual funds, banks, broker-dealers, insurance companies, and other financial services firms are obsolete in the face of technological advances, fierce competition, and dynamic and evolving capital and financial markets.
In light of the evolution of H.R. 10 since its initial introduction, the legislation now reflects a sound framework for reform of the financial services industry. Thus, we would urge Congress to enact H.R. 10. As is discussed further below, we also believe that certain changes should be made to the bill as the process moves forward. The Institute anticipates that these matters will be satisfactorily resolved through reasonable compromise, and we fully support passage of this legislation.
A. Regulation of the Mutual Fund Industry.
Since 1940, when Congress enacted the Investment Company Act, the mutual fund industry has grown steadily from 68 funds to over 7,000 funds today, and from assets of $448 million in 1940 to over $5 trillion today. In our view, the most important factor contributing to the mutual fund industry’s growth and success is that mutual funds are subject to stringent regulation by the Securities and Exchange Commission under the Investment Company Act. The core objectives of the Act are to: (1) ensure that investors receive adequate, accurate information about mutual funds in which they invest; (2) protect the integrity of the fund’s assets; (3) prohibit abusive forms of self-dealing; (4) restrict unfair and unsound capital structures; and (5) ensure the fair valuation of investor purchases and redemptions. These requirements—and the industry’s commitment to complying with their letter and spirit—have produced widespread public confidence in the mutual fund industry. In our judgment, this investor confidence has been and continues to be the foundation for the success that the industry enjoys.
Our opinion concerning the efficacy of the mutual fund regulatory system has been corroborated by the General Accounting Office. In its report on mutual fund regulation, it found that "the SEC has responded to the challenges presented by growth in the mutual fund industry." It also noted that the "SEC’s oversight focuses on protecting mutual fund investors by minimizing the risk to investors from fraud, mismanagement, conflicts of interest, and misleading or incomplete disclosure." To carry out its oversight goal, the SEC performs on- site inspections, reviews disclosure documents, engages in regulatory activities, and takes enforcement actions. The SEC is also buttressed by "industry support for strict compliance with securities laws."1
The mutual fund industry has always spoken out against developments that would impair this effective and time-tested regulatory system, such as would occur if the supervisory approaches applied to banks were imposed on the mutual fund industry.
B. Differences Between Bank Regulation and Mutual Fund Regulation.
H.R. 10 recognizes that if financial services reform is to succeed in producing more vibrant and competitive financial services companies, it must provide a regulatory structure that respects and is carefully tailored to the divergent requirements of each of the business sectors that comprise the financial services marketplace. The mutual fund, broker-dealer, banking, and insurance industries all historically have been and presently are subject to extensive governmental oversight. But for reasons that continue to make good sense even in this era of consolidation and conglomeration, the regulations governing each of these businesses rest on different premises, have different public policy objectives, and respond to distinct governmental and societal concerns.
Our securities markets are based on transparency, strict market discipline, creativity and risk-taking. The federal securities laws, including the Investment Company Act, reflect the nature of this marketplace and, accordingly, do not seek to limit risk-taking nor do they extend any governmental guarantee. Rather, the securities laws require full and fair disclosure of all material information, focus on protecting investors and maintaining fair and orderly markets, and prohibit fraudulent and deceptive practices. Securities regulators strictly enforce the securities laws by bringing enforcement actions and imposing substantial penalties in a process that by design is fully disclosed to the markets and the American public.
Banks, by contrast, are supported by federal deposit insurance, access to the discount window and the payments system, and the overall federal safety net. For these reasons, banking regulation imposes significant restraints and requirements on the operation of banks.
It may well be that this regulatory approach is prudent and appropriate when it comes to the government’s interest in overseeing banks. But it would be fundamentally inconsistent with the very nature of the securities markets to impose bank-like regulation on mutual fund companies and other securities firms. To do so could profoundly impair the ability of mutual funds and securities firms to serve their customers and compete effectively. More worrisome, it could compromise the continued successful operation of the existing securities regulatory system.
Finally—and perhaps most importantly—imposing bank-like regulation on an industry for which it was not designed could even jeopardize the functioning of our broad capital markets. This would risk the loss of a priceless and valuable national asset. As SEC Chairman Arthur Levitt has stated [in remarks to the Conference Board], "[o]ur capital markets must remain among our nation’s most spectacular achievements . . . . Those markets, and investors’ confidence in them, are a rich legacy we have inherited, but do not own. They are a national asset we hold in trust for our children, and for generations of Americans to come."2 This Committee is wise to ensure that otherwise well-intended efforts to modernize financial services law and regulation do not compromise our capital formation system.
By permitting affiliations among all types of financial companies, H.R. 10 represents a major step forward in the effort to modernize the nation’s financial laws and to realign the financial services industry in a manner that should benefit the economy and the public. It also includes three important principles that underlie successful financial services reform: (1) it would grant banking organizations full mutual fund powers; (2) it would modernize the federal securities laws to address bank-mutual fund activities; and (3) it would establish an oversight system based on functional regulation.
In light of our support of H.R. 10, we would like to take this opportunity to call to your attention certain changes we believe should be made to the bill as it moves forward. These changes pertain to: (1) the appropriate role of the bank regulatory agencies; (2) nonfinancial activities for diversified financial services organizations; and (3) the grandfather date for unitary savings and loan holding companies.
A. Federal Reserve Board.
Under H.R. 10, the Federal Reserve Board would be assigned regulatory responsibility over all financial holding companies, including any financial services organization that owns a bank. The Institute has testified previously regarding our belief that it is unnecessary to assign to the Federal Reserve this type of "umbrella regulator" role, but we acknowledge that H.R. 10 would address many of our concerns as it would limit any authority the Board otherwise might have over the operations of the holding company’s regulated subsidiaries. In particular, the Board could only exercise such authority if necessary to prevent a material risk to the financial safety and stability of an affiliated bank or the payments system.
In adopting this approach, H.R. 10 recognizes the need to adjust the present statutory authority of the banking agencies. This adjustment is needed because the statutory schemes applicable to these agencies did not envision that a supervised bank might be affiliated with several functionally regulated, non-bank entities like mutual fund companies, broker-dealers, or insurance companies. Accordingly, laws that provide for banking agency supervisory authority over bank affiliates in general have not taken the role and responsibility of other functional regulators into account.
The Board has indicated [in previous testimony] that the standards imposed under H.R. 10 would be sufficient to maintain the safety and soundness of our financial system in general and the banking system in particular3 and that they would provide a method for the Board "to enforce compliance by the organization with the Federal banking laws."4 For example, they would not affect the applicability of H.R. 10’s specific provisions that require adoption of consumer regulations for banks and their subsidiaries. Thus, in general, with respect to the role of the Board, H.R. 10 strikes an appropriate balance between preserving the Board’s authority to protect the safety and soundness of the banking, financial and payments systems and avoiding the potential for supervisory intervention into a regulated non-bank entity’s day-to-day affairs.
B. Role of Bank Primary Supervisors.
Similar to the Federal Reserve, the other banking agencies are responsible for supervising banks to protect the deposit insurance funds and to enforce the banking laws. For the very same reasons discussed above, these agencies should have no greater authority than, and should be subject to the same standards as, the Federal Reserve Board with respect to the ability to exercise supervisory discretion over a functionally regulated, non-bank entity.
H.R. 10 applies these same functional regulation standards to the FDIC, with an exception for examinations where necessary to protect the deposit insurance funds.5 However, H.R. 10 currently does not apply these standards to the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS). Thus, as presently constituted, H.R. 10 would not preclude these agencies from asserting that they have broad authority over bank affiliates—even those, like securities firms, that are subject to comprehensive regulation under a separate statutory scheme. Ironically, this could result in these banking agencies asserting that their authority is broader than that considered necessary by the Federal Reserve, the consolidated supervisor of financial holding companies, and the FDIC, the protector of the deposit insurance funds.
This is simply illogical, untenable and, we believe, unintended. The provisions in H.R. 10 that clarify the Federal Reserve’s and the FDIC’s authority with respect to functionally regulated non-bank entities should also apply to the other banking agencies. In fact, the failure to do so is inconsistent with the otherwise carefully balanced structure and approach taken in H.R. 10. And this is not just an issue for mutual funds—it affects any functionally regulated affiliate, including broker-dealers, investment advisers, and insurance companies.
Let me give an example of how the failure to subject the OCC and the OTS to appropriate standards could result in duplicative or inconsistent regulation being imposed on bank affiliates. If information disclosed in a mutual fund prospectus was alleged to be misleading and some of the fund’s shareholders were customers of affiliated banks, the banking agencies might attempt to argue that—in addition to the SEC—they should be empowered to take supervisory action against the mutual fund in order to prevent the harm to the mutual fund’s reputation from spilling over and harming the reputation of the bank.
As a result, the mutual fund could be faced with a multitude of regulators asserting jurisdiction over the same event to prevent the spread of such a "risk" to its bank affiliates, on top of any potential action by the SEC under the securities laws to protect the fund and its shareholders. This is incompatible with the concept of functional regulation and would result in conflicting, inconsistent, and overly burdensome regulation. It would also allow a banking agency to set aside the SEC’s supervisory approach as well as its sense of judgment and materiality.
A simple reversal of the scenario reveals the absurdity of this approach. If a bank were allegedly not in compliance with consumer lending laws, would it make sense for the SEC to be able to take supervisory action against the bank? Would the SEC be justified in taking such action to ward off the contagion effect from the bank’s "reputational risk" to its affiliated mutual fund? The questions answer themselves.
Unfortunately, scenarios like the one I posited are not merely theoretical concerns. History demonstrates that, pursuant to their statutes and regulations, the bank regulators have asserted authority over securities affiliates or subsidiaries of banks and have imposed requirements that are inconsistent with fundamental tenets of securities regulation. For example, under the FDIC’s rules related to state nonmember bank securities affiliates, the mix of securities that such a securities firm may underwrite have been restricted.6 The FDIC rule’s accompanying release indicated that its purpose was to address the risk associated with the proposed securities activities. It also indicated that, on a case-by-case basis, the FDIC would take action to prohibit particular practices, acts or conduct of the securities firm that it considered risky or unsafe or unsound. Likewise, if the OCC determines that a national bank may be affected by the risky nature of the operations of a subsidiary such as a securities firm, the OCC may direct the securities firm to discontinue specified activities or to be liquidated or divested.7
The concern also exists that a banking agency might be tempted to stifle innovation and preclude new product developments by a securities firm affiliated with a bank on the grounds that such developments may compromise the competitive standing of banks. For example, Professor John C. Coffee, Jr. observed that a single financial services regulator might have barred or restricted the growth of money market mutual funds in the 1970s because of the competition these funds posed to bank accounts. Such an outcome not only would have been anticompetitive, but also a notable disservice to consumers and to our capital markets.
If the banking agencies are permitted, without limitation, to take a discretionary supervisory action based on their judgment about business risk, they will be able to apply a bank-like regulatory approach and/or impose activity or operational restrictions on mutual fund complexes in particular or the securities markets generally. This could profoundly impair the continued successful operation of the existing securities regulatory system and damage our capital markets. Accordingly, we believe it is critical that the standards stipulated for the Federal Reserve Board and the FDIC in H.R. 10 be applied to all banking agencies, including the OCC and the OTS.
An important objective of any financial services reform legislation is to create competitive equality among banks, mutual funds, broker-dealers, and insurance companies. Unfortunately, H.R. 10 retains a strict separation between "banking" and "commerce." Specifically, a diversified financial services company that becomes a financial holding company would be required to divest its nonfinancial activities within 10-15 years. This approach would introduce competitive inequities: all bank holding companies could enter the securities and insurance businesses, but mutual fund companies, broker-dealers, and insurance companies with limited nonfinancial activities would be forced to alter their operations and structure (after some period) in order to enter commercial banking.
Mutual fund companies and other nonbanking financial services firms have never been subject to activities restrictions like those contained in H.R. 10, and should not be penalized if they now become subject to its provisions. Thus, in order to provide a fair and balanced competitive environment, the Institute recommends that H.R. 10 be amended to allow a financial holding company to engage to a limited degree in nonfinancial activities, for example, the amount specified in discussion drafts of Representative LaFalce’s "Financial Services Modernization Act" or in the version of H.R. 10 that was passed by this Committee last year. This would create a financial services holding company that reflects the realities of today’s marketplace in which financial companies often engage in limited commercial activities.
Under the Home Owners’ Loan Act, in general, any company may control a single savings association and become a so-called unitary savings and loan holding company. Such a company may engage in any kind of commercial or financial activity if its savings association subsidiary complies with the qualified thrift lender test. H.R. 10 would bar a company engaged in any commercial or nonfinancial activities from being a unitary savings and loan holding company, subject to a grandfather provision. Under the grandfather provision, a company that was a unitary savings and loan holding company as of October 7, 1998, or had an application pending before the OTS to become one on or before that date, could retain this status.
As a general matter, the Institute believes that an entity that is engaged in or that has applied to engage in a lawful activity should be eligible for any grandfather provision that is available if the activity becomes prohibited. This approach provides all entities with an equal opportunity to take advantage of an available business opportunity. Moreover, we are unaware of any identifiable risk to the banking system from extending the date. Accordingly, we support changing the applicable date for the grandfather provision to the effective date of H.R. 10.
The Institute continues to support efforts by Congress to modernize the nation’s financial laws. H.R. 10 represents a significant milestone in that endeavor, in particular, by permitting affiliations among all types of financial companies, by giving banks full mutual fund powers, by modernizing the federal securities laws to address bank-mutual fund activities, and by establishing a system of functional regulation.
We support H.R. 10 and are taking this opportunity to suggest and respectfully recommend for your consideration the following: (1) that the same functional regulation standard applied to the FRB and the FDIC be extended to the OTS and the OCC so that regulatory principles of the banking agencies are not inappropriately applied to mutual fund organizations, to the detriment of the investing public and our capital markets; (2) that all financial companies engaged to a limited extent in nonfinancial activities be permitted to affiliate with banks; and (3) that the applicable date for the unitary savings and loan grandfather provision be changed to the effective date of H.R. 10.
We thank you for the opportunity to present our views and look forward to working with the Congress as H.R. 10 moves forward.
1Mutual Funds: SEC Adjusted its Oversight in Response to Rapid Industry Growth (GAO/GGD-97-67, May 28, 1997) at pages 28, 5 & 29, respectively.
2"A Declaration of (Accounting) Independence," Remarks by Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, before The Conference Board, New York, New York (Oct. 8, 1997).
3See generally Hearings before the Senate Committee on Banking, Housing and Urban Affairs on H.R. 10, the Financial Services Act of 1998, Written Statement of Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System on H.R. 10 at 5 & 13-15.
4Id. at 15.
5See Section 118 of H.R. 10.
6See 12 C.F.R. 337.4.
7See 12 C.F.R. 5.34.