Office of the Comptroller of the Currency's Recent Regulatory Actions

SUMMARY STATEMENT OF EUGENE A. LUDWIG

COMPTROLLER OF THE CURRENCY

MAY 1, 1997

I welcome the opportunity to describe the OCC's recent regulatory actions, which are designed to maintain a safe and sound National Banking System that serves America's communities, businesses, and consumers within the context of a continually evolving economy.

Through the years, the banking industry has faced numerous, increasingly rapid, changes, each resulting in new challenges to the long-term health of the industry. Recently, competition within the industry increasingly has been augmented by competition from new participants that are able to target selectively segments of markets traditionally served by banks. Competition is not merely regional or national, but global. Underlying all this, rapid advances in technology are fundamentally changing the nature of how information is created, processed, and delivered-the heart of what banks do. Banks can meet these challenges, remain safe and sound, and profitably serve the needs of consumers and businesses only if lawmakers and regulators take a flexible and adaptable view of both the business and the supervision and regulation of banking.

The basic authority under which the OCC and the National Banking System operate is the National Currency Act of 1863, revised and renamed the National Banking Act in 1864. It was based on the belief that a safe, stable system of national banks was indispensable to our country's economic future. But Congress intended that the particulars of what national banks could do would evolve with a changing environment. The law also endowed the Comptroller with a large measure of independence and discretion in regulating the system under his care. Four unanimous Supreme Court decisions have recently reaffirmed the OCC's interpretation of the scope and evolutionary nature of the national bank charter.

As the banking industry evolves to meet the changing needs of the economy, so too must bank supervision evolve, and in my term as Comptroller we have taken many steps to do just that. We all remember that the industry was going through difficult times when I took office 4 years ago. There were numerous bank failures, complaints from small businesses and consumers about a credit crunch, and concerns in the banking industry and Congress about excessive regulatory burden. Community organizations were concerned about fair lending compliance, and both community organizations and banks agreed that the Community Reinvestment Act (CRA) regulations were not as effective as they should be.

We have worked hard to address these issues and to refocus and retool OCC supervision, adopting a risk-based approach to supervision and incorporating new analytical techniques. The results of the changes and innovations we have made to our approach to supervision are evident in the performance of the National Banking System. Today, we find a banking system that is not only highly profitable and healthy, but also one that is far better capitalized. Bank failures in 1996 were at a 20-year low. The OCC has also increased its enforcement of fair lending laws, completing over 3,000 exams with revised, state-of-the-art procedures. Since 1993, we have referred 23 cases to the Department of Justice for further investigation. Credit is flowing smoothly. Small business loans, which are reported every June, increased 31 percent over the 3 years ending June 1996.

We have increased supervisory and regulatory efficiency in numerous ways, for example, by reviewing all of our rules and creating an Ombudsman program. We have revised the CRA regulations, and one result has been that mortgage lending to low- and moderate-income individuals has increased dramatically. Since CRA became law in 1977, we have witnessed over $140 billion of loan commitments for community development. Remarkably, $100 billion-a full 70 percent of the totalwas made in the past 3 years alone. Also, before I became Comptroller in 1993, national banks had invested less than $1 billion in community development projects; but since then, national banks and their community development partners have made targeted investments of over $4 billion.

A dwindling core business, increased competition, changing consumer needs, and-most significantly-a dynamic environment in terms of technological change and globalization means that banking cannot stand still. If we deny banks the opportunity to evolve and pursue opportunities in new financially-related activities

they can undertake safely, banks will be pressed to squeeze more profit out of their dwindling traditional activities, either by moving further out on the risk limb or by shortchanging basic risk management systems and internal control mechanisms as they seek to cut costs without losing revenue. Indeed, it is this dynamic, the lack of opportunity to evolve and resulting increase in risk, that led to bank losses in lending to lesser-developed countries and highly-leveraged transactions within the past decade.

By contrast, creating a process through which banks can prudently respond to new marketplace demands for products and services will enable them to achieve balance and offset downturns in their traditional lines of business. The OCC's revised Part 5 regulation details a process by which banks can apply to engage in activities that are part of or incidental to the business of banking through operating subsidiaries, which, structurally, have been permitted for many years. It is a procedural rule that does not authorize any new activity; rather, it provides a framework within which the OCC will consider applications case-by-case, and it provides explicit safeguards to maintain the highest safety and soundness standards and protect the interests of America's consumers and communities. It does not breach any division between banking and commerce. And, it protects the interests of America's taxpayers by providing a framework upon which to build a stronger banking system that is better-positioned to meet the challenges of the next century.

In these respects, the rule provides many benefits. Bank earnings diversification from operating subsidiary activities would help reduce bank failures and any subsequent need to tap the Bank Insurance Fund. Stronger institutions with increased profits and asset growth will be better positioned to meet the credit needs in their communities and in the economy as a whole. As FDIC Chairman Helfer stated in recent testimony before the House Banking Committee's Subcommittee on Capital Markets, allowing a bank to put new activities in a bank subsidiary “lowers the probability of failure and provides greater protection to the insurance funds."

Part 5 contains important, explicit corporate and supervisory safeguards to ensure that any new activities are conducted safely and soundly. The safeguards in the rule will apply regardless of the particular activity undertaken by the special operating subsidiary. Also, in many cases, activities will be regulated on a functional basis by another regulator. Furthermore, the OCC will impose additional safeguards application-by-application as warranted by the particular activities the subsidiary proposes to conduct. These provisions have been carefully thought out in order to protect the bank, the safety and soundness of the National Banking System, consumers, and the taxpayer.

Some have expressed concern that banks could potentially benefit from a safety net subsidy that can be transmitted to an operating subsidiary and is best contained by the bank holding company structure. An attachment to my full written statement addresses these concerns in detail. To summarize, there simply is no evidence of a net subsidy. Any benefit banks receive from the safety net is more than offset by regulatory costs. Evidence cited as proof of a subsidy is readily attributed to other factors. Most important, banks do not behave as if they enjoy a subsidy. Even if there were a subsidy, the appropriate response would be to contain it with carefully constructed regulations-similar to those safeguards we have developed for operating subsidiaries rather than to impose organizational constraints on banking companies. The bank holding company structure is not superior to the bank subsidiary structure in containing any alleged subsidy; the bank subsidiary structure is actually the superior structure for containing any alleged subsidy.

In March 1993, when I stood before the full Senate Banking Committee at my confirmation hearing, I stated that I wanted to focus particular attention on the structure and function of the banking system from a long-term perspective. My actions taken to date as Comptroller, including promulgation of the revised Part 5, demonstrate my commitment to those statements I made 4 years ago. My goal for the remainder of my term is to continue to make certain that our supervision and our policies meet any new challenges that the future will bring so that the National Banking System remains healthy, stable, and able to serve the diverse needs of American consumers and communities.

PREPARED STATEMENT OF EUGENE A. LUDWIG

COMPTROLLER OF THE CURRENCY

MAY 1, 1997

Mr. Chairman and Members of the Subcommittee, I appreciate this opportunity to testify, as you requested, on recent regulatory actions by the Office of the Comptroller of the Currency (OCC). You have expressed particular interest in the OCC's recent revisions to Part 5, our regulation that governs corporate applications. I welcome the opportunity to describe our actions, which are designed to maintain a safe and sound National Banking System that serves America's communities and consumers within the context of a continually evolving economy.

The basic authority under which the OCC and the National Banking System operate is the National Currency Act of 1863.1 It was based on the belief that a safe, stable system of national banks was indispensable to our country's economic future. But Congress intended that the particulars of the law, specifying what the national banks could and could not do, would evolve with the demands of experience. The national banking laws also endowed the Comptroller with a large measure of independence and discretion in regulating the system under his care. Four unanimous Supreme Court decisions have recently reaffirmed the OCC's interpretation of the scope and evolutionary nature of the national bank charter.

The laws and regulations governing the National Banking System have changed dramatically over the years, as the drafters of the National Bank Act envisioned. In making these changes, Congress and the OCC have always been guided by the belief that national banks have a critical role to play in fostering the economic health of our Nation. That banks today do not look or act like they did 134 years ago would be a source of satisfaction to those who created the system to endure and adapt to changing times.

As the banking industry evolves to meet the changing needs of the economy, so too must bank supervision evolve, and in my term as Comptroller we have taken many steps to do just that. Just as a failure to change would make banking less relevant to the needs of the economy, a failure to change would make bank supervision less effective in assuring safety and soundness. Banking supervision must therefore be a dynamic process.

We all remember that the industry was going through difficult times when I took office 4 years ago. There were numerous bank failures, complaints from small businesses and consumers about a credit crunch, and concerns in the banking industry and Congress about excessive regulatory burden. Community organizations were concerned about fair lending compliance, and both community organizations and banks agreed that the Community Reinvestment Act (CRA) regulations were not as effective as they should be.

We have worked hard to address these issues and to refocus and retool OCC supervision. The results of the changes and innovations we have made to our approach to supervision are evident in the performance of the National Banking System. Today, we find a banking system that is not only highly profitable and healthy, but also one that is far better capitalized. Bank failures in 1996 were at a 20-year low. The OCC has also increased its enforcement of fair lending laws. Before my arrival at the OCC, the OCC had referred only one fair lending case to the Department of Justice. Since 1993, we have referred 23 cases. Credit is flowing smoothly-small business loans, which are reported every June, increased 31 percent over the 3 years ending June 1996.

We have increased supervisory and regulatory efficiency in numerous ways, for example, by reviewing all of our rules and creating an Ombudsman program. We

Statement required by 12 U.S.C. §250: The views expressed herein are those of the Office of the Comptroller of the Currency and do not necessarily represent the views of the President. 1 The National Currency Act of 1863 was revised in 1864 and renamed the National Bank Act.

have revised the CRA regulations, and one result has been that mortgage lending to low- to moderate-income individuals has increased dramatically. Since CRA became law in 1977, we have witnessed over $140 billion of loan commitments for community development. Remarkably, $100 billion-a full 70 percent of the totalwas made in the past 3 years alone. Also, before I became Comptroller in 1993, banks had invested less than $1 billion in community development projects; but since then, national banks and their community development partners have made targeted investments of over $4 billion.

While we are proud of our accomplishments, we are not complacent. Now, while the industry is strong, we must keep a vigilant watch for emerging risks, and we must make productive use of the time to reflect on what banking is, how the industry is changing, and what we as regulators must do to maintain safety and soundness. The mission of the OCC, however, remains constant: to charter, regulate, and supervise national banks to ensure a safe, sound, and competitive National Banking System that supports the citizens, communities, and economy of the United States. To this end, early in my term I outlined four basic principles, or pillars, that have guided the actions we have taken to ensure both the industry and our supervision keep pace with a changing environment:

• Ensure bank safety and soundness to support a strong national economy;

• Foster competition by allowing banks to offer new products and services to their customers as long as banks have the expertise to manage the risks effectively and to provide the necessary consumer protections;

• Improve the efficiency of bank supervision and reduce burdens by streamlining supervisory procedures and regulations; and

• Assure fair access to financial services for all Americans by enforcing CRA and fair lending laws, and by encouraging national bank involvement in community development activities.

The remainder of my statement will begin by elaborating further about the nature of changes currently affecting the banking industry and why I am concerned about the impact of these trends on the safety and soundness of the industry. Next, I will describe highlights of the regulatory and supervisory actions that the OCC has undertaken over the past 4 years in accordance with the four principles I just outlined. As you requested in your letter of invitation, I will focus on recent OCC actions, and in a separate section, I will describe the OCC's revised Part 5 regulation. Finally, I will summarize some of the efforts currently underway to prepare the agency for what I believe are the formidable challenges of the future.2

Ensuring Safety and Soundness in a Changing Environment
Competitive Challenges Through History

In prescribing a framework for bank powers and a rigorous program of Federal supervision, the founders of national banking law were reacting to the instability and lack of uniformity in American banking before the Civil War. In their world, public confidence in banking was synonymous with liquidity. Therefore, the law required national banks to hold large reserves against deposits and restricted national banks to loans that could be readily turned into cash. Accordingly, most real estate loans were forbidden by law, and OCC examiners were quick to criticize commercial loans that extended for more than the customary 30 or 60 days. Consistent with the intent of Congress, the OCC moved decisively to curb banking practices which, in the conservative context of the times, it viewed as dangerously venturesome. In 1873, Comptroller John Jay Knox deplored the payment of interest on deposits which, in his view, had "done more than any other to demoralize the practice of banking." By the same token, the OCC would have criticized national banks for making retail loans for consumer durable goods or home improvements had national banks been making any such loans.

Today, no one would deny that sound mortgage lending, consumer lending, competition for deposits, and many other activities that would once have been frowned upon are necessary and proper activities for commercial banks. Had national banks been unable to respond to the legitimate demands of our people and to the competitive challenges of other financial providers, they would not exist today, and American businesses and consumers would be the worse for banking's demise. But because the laws and regulations have been amenable to change, national banks have

2 Attachment 1 contains a detailed listing of our actions to improve access to credit and enhance safety and soundness. Attachment 2 contains an analysis of the OCC's legal authority to undertake revisions to Part 5, and Attachment 3 contains a paper analyzing and refuting the recently advanced argument that bank subsidiaries have an inherent advantage over bank holding company affiliates and nonbank competitors by virtue of a safety net subsidy.

been able to continue making important contributions to the growth of our communities and our Nation.

Current Competitive Factors

As I have mentioned, the banking industry of the 21st century is being shaped by an unprecedented combination of pressures. Although we cannot know precisely how the business of banking will change, we can be confident that change will occur and that banks will have to adjust to new competitive challenges. To underscore the importance of providing banks with opportunities to meet new competitive challenges, let me cite four examples that demonstrate that we, as regulators and legislators, must continue to re-think what a bank is in today's environment.

First, commercial banking, in essence, is an information business. In the course of servicing depositors and financing borrowers, banks have access to consumer and business information unavailable to would-be competitors. But this competitive edge is dwindling in today's information-driven economy. The information needed to make prudent and profitable loans is now more easily available, and less costly to access, than ever before. Increasingly, competition comes from companies that have not been traditional financial services providers, such as telecommunications companies and software development firms, as technological changes impact the production, packaging, and delivery of financial services, and these new competitors are transforming the banking industry in a number of profound ways.

As part of this transformation, banks now outsource a growing portion of the tasks necessary to produce and distribute financial services, and perform fewer of these tasks internally. This stands in direct contrast to the production methods used by commercial banks for decades. Today, banks are:

purchasing short-term funds in the open market rather than financing loans with core deposits;

• securitizing loans rather than holding loans in portfolio;

contracting with others to service loans because of scale economies rather than servicing them at the bank; and

using automated teller machines (ATM's) owned by nonbanks, networks of electronic switches owned by nonbanks,3 the Internet, and home banking software developed and maintained by nonbanks, rather than simply owning ATM's and operating a distribution network of branch facilities.

Technological advancements have allowed banks to move away from vertically integrated production and distribution methods. Some predict that this nexus of ATM's, electronic switches, and home computers will radically transform the financial services industry, with today's commercial banks becoming "contract banks" that produce very little themselves. These "virtual banks" would add value by accessing information about suppliers of various financial inputs and delivering this information to end users through electronic interfaces.4

Of course, we must be careful not to overstate the extent of change in the short term. Traditional strengths and methods of banking will not change overnight. For example, it is unlikely that the swift pace of technological change and access to information will completely erase the informational advantages fundamental to banking. In addition, banks may soon be able to combine technological advances with their customer relationships to retain the informational and competitive advantage in some lines of business. Moreover, loan securitization has its limits-some loans are simply so specialized and heterogeneous that securitization is not economical. Nevertheless, it is essential to appreciate that technological change is profoundly changing the financial services industry, and in particular, banking.

Second, even without significant legal or regulatory change, economic globalization has made financial services markets increasingly competitive. A 1994 OCC study of foreign banks operating in the United States reported that foreign banks' share of the U.S. commercial and industrial loan market grew from 16 percent in 1983 to 39 percent in 1993.5

Third, the mix of products and services that consumers of financial services want and need has changed and will continue to change in the future. Changing demographics affect the business of banking. For example, today, 12 million American households, many of which are minority families, do not even have deposit accounts with a financial institution. According to some projections, by the year 2010, one

3 For example, VISA, MasterCard, EDS, and ADP.

*See David Llewellyn, "Banking in the 21st Century: The Transformation of an Industry," presented at the 49th International Banking Summer School, Sorrento, Italy, June 4, 1996.

5 Nolle, Daniel E. "Are Foreign Banks Out-Competing U.S. Banks in the U.S. Market?" Economics and Policy Analysis Working Paper 94-95, May 1994.

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