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FDIC Banking Review
A Unified Federal Charter for Banks and Savings Associations
This article addresses the issues concerning the proposal to establish a single federal charter for banks and savings associations. It is an FDIC staff study and was originally published by the FDIC in October of 1996. Following the introduction, the differences in the powers of banking organizations and thrift organizations are summarized, and data are presented on the various categories of organizations. The next section reviews the arguments and evidence for and against a unification of the federal charters for depository institutions. The final section assumes the decision is to unify the charters and considers the issues that would then have to be resolved. It should be noted from the start, this review does not include the possible expansion of powers beyond those currently exercised by either the banking or thrift industries. Rather, the review is limited to powers that one or the other of the two industries currently possess.
The analysis contained in this study flowed from seven broad principles. Any prospective change needed to:
Federally chartered depository institutions insured by the Federal Deposit Insurance Corporation (FDIC) consist of federal savings associations,1 which are regulated by the Office of Thrift Supervision (OTS), and national banks, which are regulated by the Office of the Comptroller of the Currency (OCC). Their respective holding companies are savings-and-loan holding companies, which are under the jurisdiction of the OTS, and bank holding companies, which are regulated by the Federal Reserve Board (FRB).
Federal savings associations have historically enjoyed four distinct advantages not accorded national banks. These advantages were: (1) preferential taxation; (2) the most liberal branching rights of all federal depository institutions; (3) expanded subsidiary powers; and (4) virtually unlimited holding company activities. However, the magnitude of these thrift advantages has dissipated over time, and with enactment of the Small Business Job Protection Act on August 20, 1996, the preferential tax treatment for thrifts has been eliminated.
Balanced against the historical benefits accruing to federal savings associations, national banks have enjoyed the ability to engage in a much wider range of lending activities. National banks were subject neither to an enforced orientation toward a particular area, such as real-estate financing, nor to specific asset-type lending constraints. National banks may focus on a particular area of lending and investment if they desire, but they are not forced to.
This section explores the major areas where savings associations and national banks are treated differently. (For a more detailed comparison of their differences, a table prepared by the OCC and the OTS can be made available upon request from the Division of Research and Statistics of the FDIC).
Federal savings associations2 perform a similar financial intermediation function to that of commercial banks. However, savings-and-loan associations have a distinct focus from that of banks—the provision of home mortgage credit. The laws promulgated by Congress for the industry in the 1930s were motivated by a national policy to encourage home ownership, and this has remained the special focus of the thrift industry since that time.3
Federal savings associations are subject to several specific lending constraints. These constraints were also relaxed by the recent legislation. In general, loans secured by nonresidential real estate may not exceed 400 percent of capital. Commercial loans may not exceed 20 percent of assets, and amounts in excess of 10 percent must be used for small-business loans. Unsecured residential construction loans may not exceed the greater of 5 percent of assets or 100 percent of capital. In combination, consumer loans, commercial paper and corporate debt securities may not exceed 35 percent of assets.
In order to receive many of the special benefits of a thrift, an institution must pass the qualified thrift lender (QTL) test, which requires that at least 65 percent of an institution’s portfolio assets be qualified thrift investments, primarily residential mortgages and related investments. The Economic Growth and Regulatory Paper Reduction Act of 1996, enacted on September 30, 1996, somewhat relaxed the QTL test by expanding the list of qualified investments to include small-business-loans, and by increasing the amount of consumer-oriented loans that can be counted as qualifying assets. It also provided that an institution that qualifies as a domestic building-and-loan under the Internal Revenue Code is considered a qualified thrift lender. (See footnote four.)
Failure to meet the QTL test has several consequences. Probably the most significant is that a holding company owning a nonqualifying savings institution is required to register as a bank holding company. The activities of bank holding companies are significantly more limited than are the activities of most savings-and-loan holding companies. A later section of this report summarizes the differences in powers of bank and savings-and-loan holding companies. Other consequences of failure to meet the QTL test are restricted access to Federal Home Loan Bank (FHLB) financing and accelerated repayment of outstanding FHLB advances.
At the end of 1995, 98 percent of 1,437 savings associations met the QTL test. (As stated above, the test has since been relaxed.) The greatest level of profitability of institutions meeting the test, an ROA of 1.22 percent for the group, was achieved by institutions with QTL assets in the range of 65 to 75 percent of portfolio assets (see Table 1). Six percent of commercial banks appeared to have asset portfolios that would meet the QTL test. The ROA of the 410 banks with QTL assets in the range of 65 to 75 percent of portfolio assets was 1.16 percent, which was almost the same as the ROA for all banks, 1.17 percent.
Data as of December 31, 1995
QTL Test Compliance Distribution
Data as of December 31, 1995
QTL Test Compliance Distribution
As mentioned previously, the repeal of the thrift tax advantage became law on August 20, 1996. Prior to this date, Section 593 of the Internal Revenue Code (IRC) of 1986 permitted thrifts that met the definition of a domestic building-and-loan association4 to claim deductions for additions to a bad-debt reserve, and to use either the percentage-of-income method or the experience method in calculating such additions.5 Those thrifts electing to use the percentage-of-income method for additions to their bad-debt reserve were allowed to deduct against their taxable income additions to the reserve equal to 8 percent of taxable income.6
Public Law 104-188, the Small Business Job Protection Act, which was signed by the President on August 20, 1996, repealed the special bad-debt reserve provisions for thrifts. According to this law, thrifts are now treated the same as banks for federal income tax purposes. Banks are not permitted to use the percentage-of-income method for accounting for bad debt. Large banks (those with aggregate assets over $500 million) may not use any reserve method of accounting for bad debt, but must deduct bad debts as they occur (specific charge-off method); small banks are allowed to use the experience method or the specific charge-off method. These rules now apply to thrifts.
The Small Business Job Protection Act also waived recapture of bad-debt reserves for the years prior to 1988. According to the Act, thrifts need only to recapture reserves set aside after January 1, 1988, rather than their entire bad-debt reserves. Congressional estimates are that there are approximately $14.7 billion in bad-debt reserves in the industry, and that approximately $10.3 billion are pre-1988 reserves and thus exempt from taxation.
Liberal Branching Rights
The federal thrift charter confers the broadest geographic expansion authority of any federally insured depository institution charter. Federally chartered savings-and-loan associations that meet either the QTL test or the building-and-loan test can branch nationally with no “opting in” or “opting out” requirement. They also are not subject to any intrastate branching restrictions whereas banks are subject to a range of restrictions on their statewide branching. Figure 1 provides a graphic representation of state branching laws for commercial banks.
However, once again, the advantage that thrifts enjoyed relative to banks has changed. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 reduced much of the historical branching advantage of savings institutions. Under the terms of the Riegle-Neal legislation, adequately capitalized and managed bank holding companies may acquire a bank in any state beginning on September 29, 1995. As of June l, 1997, banks will be permitted to merge and consolidate their operations in the various states under one corporate structure, unless the state has “opted out” of interstate branching. As of May 1996, 24 states and Puerto Rico had accelerated the process by permitting interstate branching before June 1997, and an additional 11 states had “opted in” with interstate branching to begin on June 1, 1997. Only one state, Texas, had “opted out.” Of the states that have “opted in,” however, only Indiana and Puerto Rico allow immediate interstate branching by de novo institutions on a nonreciprocal basis and without other restrictions. In regards to intrastate branching, as depicted by the chart on state branching laws, most states have eliminated restrictions on intrastate branching for commercial banks, with much of this liberalization having occurred since 1985. Forty-one states now allow statewide branching and three additional states, Colorado, Georgia, and Arkansas, will permit statewide branching in 1997, 1998, and 1999, respectively. Of the remaining six, all allow statewide branching through acquisition.
State Branching Laws*
Expanded Service Corporation Activities
Federal savings associations may invest up to 3 percent of their assets in service corporations.7 Service corporations of federal savings associations may “engage in such activities reasonably related to the activities of Federal savings associations as the Office [of Thrift Supervision] may determine and approve” (12 C.F.R. §545.74(c)). Under this “reasonably related” standard the OTS has occasionally, on a case by case basis, approved service corporation activities that would not be permitted to a national bank such as insurance underwriting. In addition, the OTS has approved by regulation a long list of permissible activities for thrift service corporations, for which no prior approval is required. Most of the pre-approved activities are also permissible for national banks. Major activities permissible for service corporations of federal savings associations but not for national banks are (1) real-estate development and real-estate management for third parties and (2) selling many types of insurance on an agency basis.8
As of year-end 1995, 1,437 reporting savings associations had investments in a total of 2,035 service corporations. The total reported investments in service corporations were $5.4 billion, which represented less than 1 percent of the assets of the savings associations. The consolidated assets of the service corporations were $18.9 billion, or approximately 2.5 percent of the assets of the savings associations. Table 2 gives a breakdown of the service corporations by major type of activity.
As shown in Table 2, the greatest number of service corporations were in the business of real-estate development and sales (481 service corporations); followed by insurance brokerages and agencies (347 service corporations); acquiring improved real estate for sale or rental (254 service corporations); property management and maintenance (117 service corporations); and mortgage lending (99 service corporations). Of these top five thrift service corporation activities, only mortgage lending and, to a limited extent, insurance sales are activities also permissible for national banks.
Active Thrift Subsidiaries as of December 31, 19951
1 Includes service corporations, their subsidiaries and joint ventures; excludes "operating subsidiaries."
2 Data are from Thrift Financial Report, Schedule CSS, Item 120.
3 Data are from Thrift Financial Report, Schedule CSS, Item 100.
4 Activities that are also generally permissible for national banks.
5 Activities that are also permissible under certain circumstances for national banks.
Ten thrifts accounted for 75 percent of the industry’s investments, with two thrifts accounting for approximately 57 percent of the industry’s total investment in service corporations at December 31, 1995. These two thrifts are Household Bank FSB of Prospect Heights, Illinois, and Home Savings of America FSB of Irwindale, California.
Few Limitations on Holding Companies
In considering a unification of the federal charters for depository institutions, questions arise not only from the differences between the powers of federally chartered depository institutions but also from the differences between the powers of their holding company owners. Corporate owners of savings associations and banks are holding companies: savings-and-loan holding companies for savings associations and bank holding companies for banks. Savings-and-loan holding companies can be further subdivided into two categories: those in which non-thrift activities are essentially unrestricted9 and those in which non-thrift activities are restricted. The vast majority of savings-and-loan holding companies fall in the first, or unrestricted, category.
A savings-and-loan holding company in the unrestricted category is either a unitary holding company — one that controls only one savings association subsidiary, which meets the QTL test — or a multiple holding company, all of whose savings association subsidiaries meet the QTL test and where no more than one subsidiary was not acquired in a qualifying supervisory transaction.10 A savings-and-loan holding company in the restricted category has one or more savings association subsidiaries that do not meet the QTL test. A savings-and-loan holding company that has two or more savings association subsidiaries that were acquired in other than qualifying supervisory transactions would also be in the restricted category.
Unrestricted savings-and-loan holding companies may engage, directly or through their non-thrift subsidiaries, in any activities that do not threaten the safety and soundness of their subsidiary savings associations or that do not have the effect of enabling a savings association to evade applicable laws or regulations. Beyond these generalities, there are no limitations on the scope of permissible activities of savings-and-loan holding companies in the unrestricted category. Thus, savings-and-loan holding companies in the unrestricted category are generally permitted to engage in activities closely related to banking, general securities underwriting and dealing, other financial services, real-estate investment and development, and commercial and industrial enterprises. The latter categories allow activities as diverse as manufacturing (cigarettes, containers, furniture) to retail operations (hotels, drug stores and cosmetics) and services (refuse collection, utilities and advertising). In the submission to Congress last year, the OTS indicated that nearly all savings-and-loan holding companies in existence fell into the unrestricted category.
Another savings-and-loan holding company classification is between diversified and non-diversified. A diversified savings-and-loan holding company is defined by statute as one in which the subsidiary savings association and certain other financial activities represent less than 50 percent of consolidated net worth and consolidated net earnings. One of the few legal consequences flowing from classification as a diversified savings-and-loan holding company is that an exception to the Management Interlocks Act may be triggered.11 The major affiliations between savings associations and non-banking organizations are found in diversified holding companies.
The counting of savings-and-loan holding companies is complicated by the existence of a number of multi-tiered organizations with a variety of ownership arrangements. As of July 9, 1996, the OTS reported the following number of first-tier thrift holding companies: 28 diversified unitary holding companies; 650 non-diversified unitary holding companies; no diversified multiple holding companies; and 44 non-diversified multiple holding companies. The total number of savings-and-loan first-tier holding companies by this count was 722.
In contrast to most savings-and-loan holding companies, bank holding companies are limited to “nonbank” activities the FRB has found, by regulation or order, to be “closely related to banking and a proper incident thereto.” The broad categories of activities the FRB has found to meet these criteria are securities brokerage; to a limited extent securities underwriting; mortgage banking; commercial finance; consumer finance; leasing; small-business investment companies; insurance underwriting; and insurance agency. The insurance activities are severely constricted by statute and are principally limited to credit-related and grandfathered activities.
As of June 1996, the number of bank holding companies was 5,293. These holding companies held almost 80.3 percent of the assets of all FDIC-insured U.S. banks and thrifts. Bank holding company nonbank activities are concentrated in the larger bank holding companies, which are required to report financial data on these activities. According to the latest data available from the FRB, in 1994, 238 holding companies reported nonbank activities to the FRB. Total nonbank assets for these reporting companies were $270.2 billion, and the ratio of nonbank assets to total assets of the organizations was 8.40 percent.
Nonbank net income was $2.9 billion, and the ratio of nonbank net income to total net income was 8.29 percent. For the period 1986 to 1994, the ratio of nonbank assets to total assets for reporting companies ranged from a low of 6.91 percent in 1991, to the high of 8.40 percent in 1994. Over the same period, the ratio of nonbank net income to total net income ranged from a low of 1.22 percent in 1991, to a high of 14.35 percent in 1989.
Pros and Cons of Charter Unification
The recently enacted Deposit Insurance Funds Act of 1996 requires the Secretary of the Treasury to submit a report to the Congress by March 31, 1997, on the issues surrounding the development of a common charter for all insured depository institutions and the abolition of separate and distinct charters for banks and savings associations. The Act further requires that the BIF and the SAIF be unified on January 1, 1999, provided no insured depository institution remains as a savings association at that time.
This section discusses the major arguments for and against abolishing the current two-charter federal system for depository institutions and replacing it with a one-charter system. Because it makes little sense to unify the charters without also unifying the BIF and the SAIF, it assumes that if the charters are unified, the BIF and the SAIF will be merged by January 1, 1999.12
The arguments for a unified charter are not clear-cut — conflicting arguments and evidence can be advanced to either support or oppose a position. The major argument for a unified charter is that there is no longer a need for a thrift industry due to structural changes in housing finance: the thrift industry is no longer necessary to satisfy the societal need for which it was established, and therefore the thrift charter should be abolished. This argument is often buttressed with arguments that the long-term viability of the thrift industry is in question, and that the current restrictions on thrift activities hamper the ability of thrift institutions to respond to changes in the marketplace. Replacement of the current federal two-charter system for depository institutions with a one-charter system would “level the playing field” between thrifts and banks and allow them to compete head-on.
These latter arguments for a unified charter, with a few twists, can also be used to support the major opposing position—that there is no need for charter unification, but easier entry and exit between banks and thrifts. This position argues that what is needed are certain adjustments to current law, short of charter unification, that will enable banks and thrifts to switch charter types easily. These changes will “level the playing field,” and allow the market to decide of its own accord whether the thrift industry is viable and should survive.
The major arguments are examined below.
Arguments for Unification of Charters. According to proponents of this viewpoint, due to structural changes in housing finance, a separate legal status for a class of institutions to ensure availability of housing finance has become unnecessary. As Federal Reserve Board Chairman Greenspan stated in his September 21, 1995, testimony to the Banking Subcommittee on Financial Institutions and Consumer Credit . . . “The nexus between thrifts and housing largely has been broken without any evident detriment to housing finance availability.”
Statistics would appear to bear this out. Over a period of two decades, the thrift industry has seen the gradual erosion of its share of the market that the industry’s separate status was designed to foster. Between 1975 and 1994, the market share held by savings institutions dropped from 45 percent of total mortgages to 13 percent; from 56 percent of home mortgages to 14 percent; and from 39 percent of multifamily residential mortgages to 22 percent.13 Concerning originations, in 1975, thrifts originated 58 percent of home mortgages. By 1994, home mortgage originations by thrifts were down to 20 percent of the total.14
Thus, the housing market — the support and development of which has provided the rationale for a legally distinct thrift industry — has come to be less dependent on the thrift industry. Much of the thrift industry’s lost share of mortgages it held has gone to federally related mortgage pools—mortgage-backed securities guaranteed or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Farmers Home Administration. Much of the thrift industry’s lost share of mortgages that it originated has gone to mortgage banking companies.
It might be argued that though the thrift industry today appears to be less important to the health of the housing industry than in the past, the housing industry would still be harmed if the forced orientation of thrifts to housing were removed. However, this is not clear. The threshold for the QTL test is 65 percent of portfolio assets invested in specified assets largely related to housing finance. Yet as shown in Table 1, as of year-end 1995, 80 percent of thrifts held 75 percent or more of their portfolio assets in assets that qualified for the QTL test — substantially more than was necessary to meet the test. Therefore, as the QTL constraints appear to be non-binding, one would not expect that removing these constraints would result in a significant shift in thrift behavior. Moreover, as noted earlier, the QTL test has just been relaxed; thus, to the extent thrifts want to make incremental changes in their portfolios, they will be able to do so.
In addition, thrifts have not demonstrated a desire to expand into other fields by making full use of the asset powers now available to them. For example, federal savings associations can invest up to 10 percent of their assets in commercial loans, but as of year-end 1995, their commercial loans amounted to only 1 percent of assets.15 At that same date, only 89 institutions had more than 5 percent of their assets in commercial loans. Consequently, any shifts of institutions from or to a focus on housing finance is likely to be over an extended period and in response to market forces.
Indeed, lack of flexibility in responding to changing market forces caused by savings associations’ mandatory orientation toward housing is another reason often advanced for eliminating the federal savings association charter. If savings associations cannot redeploy their assets in response to the market, there will be excess capacity in the thrift industry. This in turn will lead to lower profitability, difficulty in attracting new capital, and a tendency to invest in riskier assets in order to maintain earnings. According to this view, it is better to eliminate the savings association charter than risk the losses — especially in light of federal deposit insurance—resulting from an inflexible charter.
Arguments against Unification of Charters. According to proponents of this viewpoint, the market — not the government — should decide whether a charter is obsolete. Thus, while the status quo is not desirable because it impedes the workings of the market, if certain adjustments were made to current law to enable banks and thrifts to switch charter types more easily, the institutions themselves could choose their future organizations based upon their individual situations. If thrifts could become banks without penalty and without adverse consequences for themselves or their owners, many, perhaps most, might do so. Removal of many of the barriers to entry and exit would allow the thrifts themselves to decide their future. If housing finance were profitable, then many thrifts — those that are operated with the proper attention to controlling costs and to prudent practices — would likely choose to remain as thrifts. But if housing finance entered a period of doldrums, particularly for an extended period of time, they would be free to reorient their efforts, and the industry would not become burdened with excess capacity.
The current impediments to thrifts switching to banks were described earlier. The major financial penalty — the recapture of bad-debt reserves for thrifts that became banks — has been addressed by legislation. Another restriction — imposition of the banking industry’s remaining geographic restrictions upon converting thrifts — has been whittled away over time by activity of the states, and, as discussed earlier, has been addressed by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Two major impediments remain to switching charters. They are the prohibition against banks owning service corporations engaged in many insurance activities and real-estate development activities;16 and the different requirements for thrift and bank holding companies — some corporate owners of thrifts could not qualify as bank holding companies. Short of changing the laws governing banks and bank holding companies, one way to ease these impediments would be to allow a number of years for a thrift or holding company to divest of the impermissible activity.
Charter Unification Implementation Issues
If a decision were made to unify the federal bank and thrift charters, implementation issues would arise at both the institution and holding company level. Many of these issues, such as the sale of insurance products by depository institutions or the separation between banking and commerce, are legitimate public-policy concerns in their own right. The prospect of charter unification brings them to the fore.
This section discusses these implementation issues and presents options for dealing with them. Again, as stated in the introduction, the options it examines concern only those powers that either banks or savings associations currently have. It does not broach financial modernization in its broader sense.
This section also reviews the impact that charter unification would have in several related areas: the QTL test, state-chartered thrift institutions, mutual savings associations, and the Federal Home Loan Bank System. Grandfathering is one option to deal with some of the implementation issues that would arise from charter unification. An appendix contains an historical overview of grandfathering within the context of financial industry legislation.
Issues at the Depository Institution Level
At the depository institution level, implementation issues arise in three areas: the asset powers of the depository institution; the powers of thrift service corporations; and branching restrictions.
Asset Powers. At the institution level, commercial banks have more extensive asset powers than savings associations whose investment in certain types of loans is restricted. As discussed in the previous section, the major argument for unifying the federal bank and thrift charters is that there is no longer a need for a special-purpose charter focused on the housing industry. In addition, broader asset powers allow for greater diversification and more competition, while not precluding the possibility of an institution specializing if that is its business strategy. Given the above, if the federal bank and thrift charters were to be merged, the only plausible alternative is to give the resultant institution the asset powers of a national bank.
Savings Association Service Corporations. One of the more difficult questions about charter unification at the institution level concerns the service corporations of federal savings associations. As discussed earlier, federal savings associations can invest up to 3 percent of their assets in service corporations. Also, while national banks can perform most of the pre-approved activities permissible for thrift service corporations, both directly and through operating subsidiaries, they are not permitted to engage in real-estate development and the management of real estate for third parties, or to sell most types of insurance without restriction (although recent judicial decisions have expanded the insurance agency powers of national banks).
As of year-end 1995, there were 255 savings associations with insurance subsidiaries. Most of these were at relatively small institutions, 207 of the 255 had under $1 billion in assets. Although no data are available on the activities of these insurance subsidiaries, anecdotal evidence indicates that many are restricted to the sale of credit-related insurance products, an activity permissible to subsidiaries of national banks.
Insurance brokerage and agency are basically sales-oriented activities and do not present safety-and-soundness issues. The sale of insurance by banks would provide customers with greater choice, and promote greater efficiency in the marketplace. Therefore, if federal bank and thrift charters were merged, a reasonable course of action would be to extend full insurance agency powers to national banks. However, as a practical matter, such a move might encounter significant political opposition.
Unlike insurance, real-estate activities, especially real-estate development, do raise safety-and-soundness issues.17 FIRREA required that equity investments and loans to service corporations engaged in activities not permissible for national banks be deducted from capital. As a result, federal savings associations no longer engage in real-estate activities on a large-scale basis. Savings associations reported $77.7 billion in real-estate service corporation assets at year-end 1989.18 By year-end 1995, this figure had fallen to $3.4 billion.
Despite the current low level of real-estate investment by savings associations, the divergent real-estate powers of federal savings associations and banks would need to be addressed if the federal charters were merged. One way to deal with those risks would be to require that any real-estate development or management activities be conducted in a bona fide subsidiary, with the bank’s investment (both equity and loans) deducted from capital, and with the subsidiary subject to Section 23 of the Bank Holding Company Act type restrictions. With the exception of the Section 23 requirements, these conditions already apply to thrift service corporations.19
Branching Restrictions. As discussed earlier, bank branching powers are in some cases more restrictive than federal savings association branching powers, although they have come much closer together over time. Full interstate and intrastate branching provides for the greatest diversification of risk, the greatest convenience for customers, and the greatest market efficiencies. Given these facts, the near universality today of statewide branching, and the clear momentum to interstate branching, a reasonable course of action should the federal charters be unified would be to allow full interstate and intrastate branching.
Issues at the Holding Company Level
The most difficult issue regarding the single federal charter concerns holding companies. Except for possible grandfathered situations (and ignoring the complication that would result if thrift charters were continued at the state level), the distinctions between savings-and-loan holding companies and bank holding companies would have to be eliminated. Table 3 contains a list of unitary diversified savings-and-loan holding companies, the type of savings-and-loan holding company most likely to contain significant nonfinancial businesses. As can be seen from the table, as of June 1996, there were only 28 such companies.
Four approaches to eliminating the prospective differences between savings-and-loan holding companies and bank holding companies could be taken (existing affiliations are discussed below): (1) holding companies could be allowed to engage in virtually any activity, the approach taken with unrestricted savings-and-loan holding companies; (2) holding companies could be restricted to a limited number of financially related activities, the approach currently taken with bank holding companies; (3) holding companies could be allowed to engage in most financially related activities, including, with proper safeguards, investment banking and the insurance business, but prohibited from nonfinancial activities; or (4) holding companies whose depository institutions met the QTL test (or similar test) could be allowed to engage in any activity that did not threaten the safety and soundness of the institution.
28 Thrift Diversified Holding Companies*
as of June 1996
Source: The Office of Thrift Supervision
Of these four options, the third option — permitting bank holding companies to expand into most financially related activities but with a continued prohibition against nonfinancial activities — would appear to be the most desirable. While the elimination of the separation between banking and commerce may be worth considering in the long run, a more cautious policy of bank expansion into other financial activities is probably a more prudent short-term course.
Banking organizations have expertise in managing certain financial risks. They should leverage this expertise before branching out into commercial ventures. In addition, bank regulators should develop a body of experience to evaluate the safety-and-soundness implications of any new financial affiliations before allowing broader affiliations with firms exposed to a different range of risks. On the other hand, compared to the status quo, allowing banks to expand into other financially related activities — perhaps through either holding companies or direct subsidiaries — would strengthen banking organizations by allowing diversification of income sources and better service to customers, and would promote an efficient and competitive evolution of U.S. financial markets.
With respect to using the QTL test, or some variant thereof, to determine holding company powers, in order for such an approach to make sense, some nexus would have to be established between the test and broader holding company powers. Absent such a nexus there would be no reason to distinguish between the powers of a holding company of a depository institution that met the test and powers of one that did not.
As to existing affiliations, commercial companies have not historically been a source of risk to the thrift industry. The OTS reports that unitary thrift holding companies, rather than having caused harm to their subsidiaries in the past, have in fact provided a source of strength to them during times of need. Additionally, affiliations between thrifts and commercial organizations do not appear to be extensive.20 Thus, the grandfathering of existing relationships might be feasible. In fact, some affiliations between commercial companies and bank holding companies were already grandfathered by the 1970 Amendments to the Bank Holding Company Act (see appendix). On the other hand, given the limited number of affiliations, divestiture would not require widespread restructuring of the thrift industry.
Charter unification raises issues in addition to the powers of depository institutions, their affiliates, and their holding companies. The topics in the following discussion concern the QTL test, state-chartered savings associations, mutual savings associations, and the Federal Home Loan Bank System.
QTL Test. If the charters are merged, the QTL test would basically be moot with two possible exceptions. First, as noted earlier, the QTL test could be used to exempt a holding company from the strictures of the Bank Holding Company Act. However, also as noted earlier, such a distinction would only make sense if there was a nexus between the QTL test and holding company powers. Second, the QTL test — or more accurately the percentage of QTL assets — is used to establish the amount of FHLB stock a non-savings association FHLB member must hold for a given amount of advances (the higher the ratio, the less stock). The role of the FHLBs and what characteristics, if any, their members should have is beyond the scope of this study. Depending on the mission of the FHLB System, requiring some continued portfolio orientation (although not necessarily the current QTL assets) in order to enjoy the benefits of FHLB advances may make sense.
State-Chartered Savings Associations.If the federal savings association charter were eliminated, a major question is whether state-chartered savings associations should be eliminated as well. As noted earlier, the Deposit Insurance Funds Act of 1996 requires that the BIF and the SAIF be merged on January 1, 1999, provided no institution remains as a savings association at that time.
Eliminating state-chartered thrifts might prove difficult. In order to eliminate state-chartered thrifts effectively, such a ban would have to include state-chartered savings banks as well as state-chartered savings-and-loan associations. As a general matter, states are allowed to issue limited-purpose charters. In addition to chartering savings-and-loan associations and savings banks, the states issue charters for trust companies, cooperative banks, and industrial banks. To force them to eliminate a specific type of limited charter would be a blow to the dual banking system. It would also be difficult to prevent a state from reincarnating a charter that looked very much like a savings association charter with a different name.
Short of mandating the elimination of the state thrift charter, state-chartered savings associations could be subjected to Section 24 of the FDI Act, which would require that they not engage in any activity not permissible for a national bank without FDIC approval.21 They could also be made subject to the Bank Holding Company Act with whatever grandfathering or other provisions that would apply to federal savings associations.22 Under such circumstances, state-chartered savings associations would probably lose their attractiveness. Many state-chartered savings associations might choose to convert to banks and some states might eliminate their thrift charters, but this would be accomplished without tampering with the dual banking system.
Mutual Savings Associations. At June 30, 1996, there were 410 mutual federal savings associations and 714 stock federal savings banks. While in number mutuals represent 36 percent of federal savings associations, they accounted for only 10 percent of the assets held by such institutions ($72 billion out of a total of $717 billion in assets). Including state-chartered savings and loans and savings banks there were a total of 943 mutual thrifts and 1,038 stock institutions. Mutual institutions hold a total of 17 percent of thrift assets ($179 billion out of a total of $1,023 billion). Commercial banks all take stock form.
The FDIC Division of Research and Statistics has looked at recently chartered de novo savings associations to determine whether the mutual form of organization has proven to be attractive to new industry entrants. According to a preliminary review, only a handful of savings associations over the past ten years have chosen the mutual form of organization. At least two were credit unions converting to savings associations. It is not clear that any of the new mutual charters over this period were true de novo mutual savings associations.
Given the large number of mutual thrifts, it does not make sense to change the status quo and require conversion. The other options are to grandfather existing mutuals but not grant new mutual charters, or to continue to grant new mutual charters, effectively extending the possibility of the mutual form to commercial banks. Historically, the mutual form of organization has not raised safety-and-soundness concerns. As such, there does not appear to be any reason not to follow this latter course.
Federal Home Loan Bank System (FHLBS). Replacement of the two-charter federal system with a single charter would have an impact on the Federal Home Loan Bank System (FHLBS). Federal savings associations are currently required to be members of the FHLBS. Elimination of the federal thrift charter could result in a voluntary FHLBS that would not have the automatic capital support of the current system. However, it should be noted that as of August 1996, federal savings associations accounted for only 19 percent of FHLBS members (commercial banks accounted for 65 percent, state-chartered thrifts 13 percent, and others 3 percent). Moreover, according to the Federal Housing Finance Board, since April 1995, when FHLBS membership was made voluntary for OTS-regulated state-chartered thrifts, no such thrift has left the system.23 It is likely that many federal savings associations would also choose to retain their FHLBS membership if such membership were to become voluntary. The FHLBS is therefore unlikely to face crisis if the federal thrift charter were eliminated.
Grandfathering in Banking Legislation
This appendix outlines how past legislation mandating changes in the banking industry dealt with the problem of existing activities and ownership arrangements. The approaches taken fall into two general categories: (1) requiring that existing activities and arrangements be ceased or divested; and (2) permitting the continuation of existing activities and arrangements. The second approach is often termed "grandfathering" and itself encompasses a range of controls. At one end of the spectrum, the continuation of existing activities and arrangements has been tightly circumscribed, even "frozen" as they were on a grandfather date. At the other end of the spectrum, few controls have been placed on the continuation, and the activities have thus enjoyed room for growth. An accompanying table summarizes the prohibition, divestiture, and grandfather provisions of the major laws covered in the discussion.
Glass-Steagall. Four provisions of the Banking Act of 1933 largely required the divestiture and continued separation of the investment banking and commercial banking businesses. The divestiture period was one year. The Glass-Steagall Act is still the law, but judicial and regulatory interpretations and developments in financing and investment techniques have eroded many of the distinctions between the two businesses.
Bank Holding Company Act of 1956 — Nonbanking Activities. The Bank Holding Company Act of 1956 generally required multibank holding companies to divest themselves of businesses extraneous to banking. The divestiture period was two years, which the Federal Reserve Board (FRB) could extend in individual cases to a maximum of five years.
Bank Holding Company Act of 1956 — Interstate Banking. The Bank Holding Company Act of 1956 provided that the FRB could not approve an application by a bank holding company to acquire voting shares on substantially all assets of a bank outside of its home state unless the acquisition was expressly permitted by the law of the target state. Twelve existing interstate holding companies were grandfathered. In the late 1970s and throughout the 1980s, states relaxed their laws to permit various degrees of interstate expansion by bank holding companies. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 authorized interstate expansion by bank holding companies beginning one year after its enactment. The Act also authorized interstate branching by banks beginning on June 1, 1997, unless a state either accelerates the effective date or opts out of interstate branching.
Bank Holding Company Act Amendments of 1970. The Bank Holding Company Act Amendments of 1970 brought single-bank holding companies within the jurisdiction of the Act and gave the FRB leeway to expand the nonbanking activities permitted bank holding companies. Companies that became bank holding companies as a result of the Amendments were given a ten-year period to divest impermissible activities they were directly or indirectly engaging in. Two primary grandfathered situations were provided for, the $60-million limitation and the hardship exemption.1
$60-Million Limitation. Under Section 4(a)(2) of the Bank Holding Company Act (12 U.S.C. §1843(a)(2)), a company that became a bank holding company as a result of the Amendments and that was engaged in activities on June 30, 1968, that became impermissible because of the Amendments could continue to engage in the activities unless the FRB determined termination was necessary to prevent undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. The FRB was required to make such a determination within two years if a company's bank had assets of over $60 million or within two years of the reaching of that level by a bank. The divestiture period after such a determination by the FRB was ten years. Under the $60-million limitation, a bank holding company could only continue existing impermissible nonbanking activities and not engage in new impermissible ones.
Hardship Exemption. Under Section 4(d) of the Bank Holding Company Act (12 U.S.C. §1843(d)), the FRB could grant exemptions from the Act for a company that became a bank holding company as a result of the Amendments, that controlled a single bank on July 1, 1968, and that did not subsequently acquire another bank. The exemptions could be subject to such conditions as the FRB considered necessary to protect the public interest. Unlike the grandfather privileges under the Section 4(a)(2) $60-million exemption, an exemption under Section 4(d) permitted a bank holding company to expand into new nonbanking activities. An exemption had to be based on one of three grounds: (1) to avoid disrupting business relationships that had existed over a long period of years without adversely affecting the banks or communities involved; (2) to avoid forced sales of small locally owned banks to purchasers not similarly representative of community interests; or (3) to allow retention of a bank so small in relation to the holding company's total interest and so small in relation to the banking market as to minimize the likelihood that the bank's powers to grant or deny credit would be influenced by a desire to further the holding company's other interests.
Selected banking industry legislation containing prohibition, divestiture, and grandfathering provisions are listed in this table. The provisions are described in greater detail in the accompanying text, which also covers additional legislation.
Altogether, the FRB granted approximately 12 hardship exemptions. Among the companies that received exemptions were The Goodyear Tire & Rubber Company, Olin Corporation, Minnesota Mining and Manufacturing Company, and Beneficial Corporation. Data on the hardship exemptions are presented in an accompanying table.
Foreign Banks — Nonbanking Activities. Among other things, the International Banking Act of 1978 made the restrictions on nonbanking activities contained in the Bank Holding Company Act applicable to a foreign bank that maintained a branch, agency, or commercial lending company in the United States (12 U.S.C. §3106(a)). Foreign banks could retain any nonbank investment or continue any nonbank activity until December 31, 1985. Grandfather privileges were granted beyond that date for direct or affiliate activities conducted on or applied for by July 26, 1978. In addition, foreign banks engaged since July 26, 1978, in underwriting, distributing, or selling securities in the United States through "domestically controlled affiliates" were permitted to engage in new activities through the affiliates or acquire the assets of going concerns through the affiliates. Under an FRB interpretation that was codified into the International Banking Act in 1987, a foreign bank that acquires a bank in the United States loses its grandfather rights.
Bank Holding Company Insurance Activities. In 1982, the Garn-St Germain Act, among other things, amended Section 4(c)(8) of the Bank Holding Company Act (12 U.S.C. §1843(c)(8)) to restrict the insurance activities of bank holding companies. Two grandfather situations were provided for. First, insurance agency activities conducted by a bank holding company on May 1, 1982, or approved for the company by the FRB on or before that date, could be continued. Further, the activities could be expanded to new locations in the state of the bank holding company's principal place of business, in adjacent states, and in other states where the activities were conducted on the grandfather date. And the agency activities could be expanded to include new types of insurance insuring against the same types of risk. Second, the FRB could approve new insurance activities for a bank holding company engaged in insurance agency activities prior to January 1, 1971, pursuant to FRB approval prior to that day. Insurance activities permitted under this second grandfather provision were not limited to those conducted in 1971. The Garn-St Germain amendment also provided for the growth of a $10,000 ceiling it imposed on extensions of credit for which finance company subsidiaries of bank holding companies could sell credit-related insurance. The ceiling increased annually to match the increase in the Consumer Price Index.
Competitive Equality Banking Act — Nonbank Banks. The Competitive Equality Banking Act of 1987 (CEBA) was signed into law on August 10, 1987. The cut-off date used in the grandfather provisions of this legislation was March 5, 1987. Among other things, CEBA closed the "nonbank bank" loophole in the Bank Holding Company Act by broadening the definition of "bank" in that Act to cover any institution that either met the then-existing definition or was insured by the FDIC (12 U.S.C. §1841). Several grandfather situations were provided for:
Section 4(d) Approvals
Nonbank Holding Company Owners. A company that controlled a nonbank bank on March 5, 1987, and was not a bank holding company before the enactment of CEBA would not be treated as a bank holding company solely by virtue of its control of the nonbank bank (12 U.S.C. §1843(f)). Within 60 days after enactment, such companies had to identify themselves to the FRB. In general, grandfather rights would be lost if the company otherwise became a bank holding company or if the nonbank bank did one or more of several things: (1) began to engage in activities in which it was not lawfully engaged on March 5, 1987; (2) offered or marketed products or services of affiliates that were not permitted for bank holding companies, or permitted its products or services to be offered or marketed by affiliates whose activities were broader than those permitted for bank holding companies, unless the products or services were offered or marketed as of March 5, 1987, and then only in the same manner; (3) permitted any overdraft on behalf of an affiliate or incurred any overdraft in its account at a Federal Reserve Bank on behalf of an affiliate (with exceptions regarding inadvertent overdrafts and affiliates that were primary dealers); or (4) increased its assets by more than 7 percent in any one 12-month period beginning one year after enactment of CEBA. A company losing its grandfather exemption would have 180 days after loss of the exemption to either divest each bank it controlled or come into compliance with the Bank Holding Company Act. A list of nonbank banks and their parents is given in an accompanying table.
Bank Holding Company Owners. Notwithstanding most other provisions of Section 4 of the Bank Holding Company Act—the then-limitations on interstate banking operations being the main concern—a bank holding company controlling an institution that became a bank by virtue of CEBA generally could retain control of the bank if the bank: (1) did not engage after enactment in any activity that would have caused it to be a bank pre-CEBA (that is, it did not begin both accepting demand deposits and making commercial loans); or (2) did not increase the number of locations from which it conducted business after March 5, 1987 (12 U.S.C. §1843(g)).
Explicit Exemptions. CEBA exempted certain special-purpose banks from the Bank Holding Company Act's new, broader definition of a bank. These exemptions included limited-purpose trust companies, credit-card banks, certain industrial loan companies, and the U.S. branches of foreign banks.
Competitive Equality Banking Act — Savings Banks. CEBA created a grandfathered entity called a "qualified savings bank," which was defined as a state savings bank organized on or before March 5, 1987. Under Section 3(f) of the Bank Holding Company Act (12 U.S.C. §1842(f)) as amended by CEBA, a "qualified savings bank" controlled by a bank holding company was permitted to engage in any activities allowed by the law of its state, other than certain insurance activities. The grandfather right would be lost if the savings bank was acquired by a company that was not a savings bank or a savings bank holding company, which was defined as a company whose qualified savings bank subsidiaries constituted at least 70 percent of its assets.
Competitive Equality Banking Act — Savings-and-Loan Holding Companies. CEBA grandfathered rights for certain savings-and-loan holding companies that would otherwise cease to qualify as unrestricted savings-and-loan holding companies because of a failure of their savings-and-loan subsidiaries to satisfy a new QTL test. Without grandfather protection, the period to bring savings-and-loan subsidiaries into compliance with the new QTL test was two years. A grandfathered savings-and-loan holding company was one that had received permission prior to March 5, 1987, to acquire control of a savings-and-loan association. Such a grandfathered company was permitted to engage in any activity in which it was lawfully engaged on that date. This grandfather right could be lost for a number of reasons: (1) the holding company acquired control of a bank or another savings-and-loan association (except in a qualified supervisory transaction); (2) any savings-and-loan subsidiary of the holding company failed to qualify under the Internal Revenue Code thrift test; (3) the holding company engaged in any business activity in which it was not engaged on March 5, 1987, and which was not otherwise permissible for savings-and-loan holding companies; (4) any savings-and-loan subsidiary of the holding company increased its number of business locations after March 5, 1987, except by means of a qualified supervisory transaction; and (5) any savings-and-loan subsidiary of the holding company permitted an overdraft on behalf of an affiliate or incurred an overdraft in its account at a Federal Reserve Bank on behalf of an affiliate, except an inadvertent overdraft. CEBA also grandfathered cross-marketing arrangements involving a savings-and-loan subsidiary of a diversified savings-and-loan holding company—a company whose savings-and-loan subsidiary and related activities represented less than 50 percent of its consolidated net worth and consolidated net earnings-—and an affiliate to the extent they engaged in such arrangements on March 5, 1987.
FIRREA — Savings Association Activities and Investments. Section 222 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) created Section 28 of the FDI Act. Section 28 prohibits any state savings association from engaging in any type of activity, or in an activity in any amount, that is not permissible for a federal savings association unless the FDIC determines the activity would pose no significant risk to the affected insurance fund and the savings association is and continues to be in compliance with certain capital standards (12 U.S.C. §1831e).2 The compliance date was January 1, 1990, less than four months from the enactment of FIRREA, but divestiture of existing non-conforming assets was not required. State savings associations also cannot make equity investments impermissible for federal associations, except that certain investments in service corporations are permissible. Impermissible investments had to be divested by July 1, 1994.
FDICIA — State Bank Activities. Section 303 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) created Section 24 of the FDI Act, which restricted the charter powers of insured state banks (12U.S.C.§1831a). Section 24 prohibits insured state banks from engaging directly or through subsidiaries in any activities not permissible for a national bank unless the FDIC determines that an activity poses no significant risk to the deposit insurance fund and the bank is in compliance with applicable capital standards. The compliance period was one year from the date of FDICIA's enactment. Certain very limited insurance activities provided through subsidiaries were grandfathered. State banks also cannot make equity investments that are not permissible for a national bank, with certain exceptions and subject to the grandfathering of limited state-permitted investments in listed securities. Impermissible equity investments had to be divested in five years, except a three-year period was provided for compliance with the limitation on state-permitted investments in securities.
Conclusion. Generalizations about Congressional selections between divestiture on the one hand and a grandfather scheme on the other are difficult to make. Each situation had its own unique circumstances. The relative political power of the defenders of the status quo and of those who sought change varied considerably from situation to situation, as did the degree of the apparent "evil" that was the subject of the legislation. Nevertheless, it seems reasonable to conclude that the selection was often influenced by magnitude, that is, by the relative scope of the activities concerned. Grandfather solutions appear to have been used more often in situations when the relative impact would not be large.
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