NASAA Testimony on H.R. 268

Testimony of Denise Voigt Crawford
Texas Securities Commissioner
President-Elect, North American Securities Administrators Association
on behalf of the
North American Securities Administrators Association
Before the
of the

February 25, 1997

Madam Chairwoman and Members of the Subcommittee:

On behalf of the North American Securities Administrators Association (“NASAA”), I appreciate the opportunity to submit written testimony on several of the important issues associated with financial modernization. As the national voice of the state securities agencies responsible for investor protection and the efficient functioning of the capital markets on the local level, we commend Congress for its efforts to evaluate the existing structure of our financial institutions and reconcile conflicting views in order to bring comprehensive reform to the industry. NASAA believes that it is the responsibility of Congress to direct any financial services reform and, to that end, NASAA has appeared before the Congress on a number of occasions to reiterate our strong support for congressionally directed financial services reform that will continue to provide essential investor protection and faith in the integrity of our securities markets.

NASAA is disturbed by the trend toward federal regulators and agencies dictating policy that impacts existing law without Congressional oversight. This ad hoc manner of restructuring the financial services industry without coordination needs examination. State securities regulators view Congressional analysis of the current system and Congressional action to modernize regulation as the key to meaningful reform.

Moreover, NASAA strongly supports and upholds the ideals of functional regulation. As you are well aware, until recently the Glass-Steagall Act prohibited banks from engaging in most securities activities. That no longer holds true in today’s marketplace. Today, banks engage in a broad range of broker-dealer and investment advisory activities that are parallel to and competitive with the services of registered securities firms and registered investment advisers. However, it appears that H.R. 268 retains provisions for banks to be excluded from securities regulatory oversight, and as such, they would be governed by bank laws that have very little relevance to our securities market regulatory structure.

Madam Chairwoman, for the reasons set forth in our written testimony, NASAA believes that the Securities and Exchange Commission and state securities regulators should be the only primary regulators of securities activities regardless of the legal structure of the entity engaging in such activities.

As you know, traditional bank examinations have only focused on the financial viability, or so-called “safety and soundness” of the financial institution. This form of examination concentrates on the oversight and review of the actual health of the institution. Securities broker-dealer reviews encompass much of the same type of risk assessment as the traditional bank examination, but also includes customer-based transactions. This type of review includes a thorough examination of customer new account forms, customer account activity and customer asset allocation to insure that the party who bears the risk (the customer) has been treated fairly. Thus, sales practices that contribute substantially to the broker-dealer’s overall financial health, or safety and soundness, may nonetheless be subject to disciplinary action. This type of oversight is essential if investors, especially small investors, are to have the degree of confidence in our capital markets to encourage their participation.

With the current banking regulatory scheme it appears that investors are receiving a lower standard of protection than investors who conduct securities business through broker-dealers. This is evidenced by complaints received by state securities regulators concerning inadequate suitability/risk disclosure; misleading references to Federal Deposit Insurance Corporation (“FDIC”) and Securities Investor Protection Corporation (“SIPC”) coverage; a blurring of the distinctions between bank and brokerage activities; and agents who are inadequately trained and supervised. Investors deserve the same protections regardless of where and how they choose to invest in our capital markets.

In the most simple terms, modernization of the financial services system is a matter of permitting all financial service providers to compete on the same playing field. The competition, however, must not be impacted by regulatory advantage or disadvantage. From NASAA’s perspective, it is essential that all financial service providers be subject to the same securities regulatory standards. Alarmingly, it appears that H.R. 268 would permit certain broker-dealer subsidiaries (or affiliates) to operate outside the established state and federal securities regulation framework. This would have an untoward effect on the integrity of the securities markets, and of course, on investor protection. While H.R. 268 expresses concern about putting deposit insurance funds at risk there appears to be no parallel concern about the risk to securities markets and securities investors even though in the U.S. mutual fund assets now exceed bank deposits.

In addition to the lack of a two-way street that disadvantages securities firms vis-a-vis banks, securities markets and securities investors are put at risk by H.R. 268. This risk results from the Bill’s suggestion that certain broker-dealer activities, when conducted by a bank, would not be subject to the established state and federal securities regulatory framework. Thus the activity would take place without regard to essential securities law regulations, governing such fundamental issues as securities salesperson licensing and disqualification, oversight of broker-dealer operations, conduct standards and enforcement provisions. Permitting securities to be sold under two different regulatory systems directly and detrimentally impacts market integrity and investor protection. For example, standard market conduct requirements, such as the T+3 delivery rule and rules governing clearing arrangements, would not apply, impairing the integrity and uniformity of the securities marketplace. On the investor protection side, disregard of state securities licensing standards is the disregard of a vital consumer safeguard.

As noted previously, NASAA believes that the Securities and Exchange Commission and state securities regulators should be the only primary regulators of the securities activities of banks yet H.R. 268 appears to ignore the seminal role of state securities regulators in the overall regulation of financial institutions. It is the state securities administrator that is the closest to the investing public, that serves as the local cop on the beat. It is the state securities administrator who reviews the local securities offerings and oversees the integrity of the local securities marketplace. It is the state securities administrator that is the necessary jurisdictional and substantive complement to the Securities and Exchange Commission. To disregard state securities regulation in connection with the modernization of the financial services system is to upset the delicate and well-reasoned regulatory balance that has resulted in the unprecedented success of the United States securities markets. Further, if state securities law is disregarded, to what extent may other state laws, such as state corporate and commercial codes, be disregarded to the detriment of market integrity and consumer protection?

NASAA whole-heartedly supports financial services modernization, but only to the extent the financial service providers are on the same plane. There must be true functional regulation. Further, NASAA does not object to “risk assessment” supervisory principles. However, with respect to broker-dealer activities, a risk assessment must consist of the traditional securities oversight, which focuses on discreet operational functions, such as supervision, suitability, sales practices and record-keeping. Securities regulators have found this to be the only way to effectively monitor broker-dealer activities. Such oversight assesses risk, but on a much more specific level. Thus, NASAA would urge that existing state and federal securities regulatory system, including this system of specific examination and oversight, be applicable to all financial service providers. To hold otherwise would create an unlevel playing field, impairing market integrity and investor protection, and skewing competition based on regulatory advantages and disadvantages.

Section 114 of H.R. 268 would create a National Financial Services Committee (“NFSC”) composed of three national banking regulators (the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Federal Deposit Insurance Corporation and the Comptroller of the Currency), the Secretary of the Treasury, the Chairman of the Securities and Exchange Commission and one state insurance regulator, but no state securities regulator. The NFSC would determine the standards applicable to notices, reports, examinations and supervision of financial services holding companies and, more importantly, to the financial services institution subsidiaries of those holding companies. NASAA believes that the NFSC’s composition and function presents several problems that would undermine its effectiveness.

First, the lack of a state securities regulator is difficult to understand given that U.S. securities regulation, both federal and state, provides oversight of the richest, most liquid and successful capital marketplace in the world. We possess great experience and expertise and we do not duplicate each other’s regulation. Therefore, it seems unwise to exclude one of these expert parties. The absence of a state securities regulator on the NFSC is short-sighted and ill advised. Although representation of the Securities and Exchange Commission will provide valuable insight into some of the global issues facing our financial markets, it will not provide much insight as to how regulatory policies affect individual investors. According to the Wall Street Journal (January 29, 1997), the SEC closed or solved 345 cases in 1996. State securities regulators solved or closed over 6,740 cases during that period. These statistics reflect the differing enforcement emphasis of the state and federal securities regulators. State securities regulators handle the majority of individual investor complaints and are thus in a much better position to observe the effects of regulatory policies on the individual investor, as such investors become an increasingly larger portion of the investing public.

Second, the heavy representation of federal banking regulators compared to all other financial services regulators would tend to skew the NFSC’s policies towards the banking “safety and soundness” style of regulation. While this type of regulation is entirely appropriate for traditional banking activities where the FDIC and the government have assumed the risk for insured deposits, it is not appropriate for other financial services regulation. Securities regulation recognizes that the customer assumes most of the risk and the style of regulation reflects this different emphasis. This is why securities regulation stresses accurate disclosure of risk, suitability of investment recommendations and appropriate sales practices.

The proponents of H.R. 268 have recognized that the subtle differences in the views of the three federal banking regulators require that each of those three be represented on the NFSC, yet they have ignored the far more substantial differences in the regulatory approach of the state and federal securities regulators. If the bill is not amended to include a representative of state securities regulators on the NFSC, then it will have succeeded in creating yet another element of the federal bureaucracy that is out of touch with the individuals whose interests are supposed to be protected.

NASAA strongly recommends that H.R. 268 be amended to provide for state securities regulatory representation on the NFSC.

NASAA believes that regulation of each financial entity should be focused on the specific functions being performed, not solely on the corporate structure. This approach would help assure the proper balance between the twin goals of expanded opportunities related to the provision of banking, securities and insurance services and the provision of important institutional and individual protections. Clearly, great care must be taken to avoid duplicative regulations and oversight that waste resources.

It is interesting to note that statistics collected by Prophet Market Research & Consulting indicate that there are statistically significant differences between the effectiveness of Section 20 subsidiaries’ disclosure regarding the lack of FDIC insurance and parent guarantees insuring securities investments, and that given by bank subsidiaries. (See Prophet 1996 National Bank Securities Service Audit released last April.) NASAA would urge Congress to require banks to organize in a manner that will provide the most protection to investors and the FDIC. If banks believe that the regulation of certain existing entities is too restrictive, Congress should seek to eliminate the overly restrictive rules and regulations, rather than encourage banks to organize in a way that produces more risk to the bank and the investor. While ease of entry and increased competition are important goals, financial services reform efforts should not ignore the goals of maintaining protection of investors and the federal deposit insurance fund. If investors lose faith in the system, it will not matter how easy it is to enter.

Madam Chairwoman, NASAA commends the subcommittee for tackling the daunting task of financial modernization to recreate the regulatory structure for the financial services industry. We strongly believe that any new or amended regulatory system should create functional regulation with roles for each regulator based on the particular services provided by the financial institution. Such an approach will create a level regulatory playing field for both the securities and the banking industry, effectively utilize existing regulatory expertise, and, at the same time, eliminate the disparities caused by regulators with differing objectives reviewing identical services being provided in different financial institutions. This coordinated approach, most importantly, will provide continued investor protection by mandating a role for federal and state securities regulators in the financial institution’s securities activities, while allowing the banking regulators to ensure the safety and soundness of the banking functions of the financial institution.

NASAA cautions, however, that even in taking steps towards an ideal system of functional regulation, careful attention must be paid so as not to move precipitously. Changes to such complex regulatory structures must be made slowly with an abundance of caution to prevent hasty decisions that could lead to undesirable outcomes. Because little empirical data exists to validate (or dispute) the effectiveness of the proposed system or a system more closely modeled to effect functional regulation, wholesale modifications to the existing system should be made only after careful study and evaluation of all the potential collateral effects of such changes. NASAA, while strongly supporting a move toward functional regulation, fears that modifications made without appropriate reflection could have dire consequences both for the financial services industry and their customers.

The division of safety and soundness and investor protection responsibilities between banking regulators on the one hand and securities regulators on the other has served the public well for many decades. This division should continue after the abolition of the barriers the Glass-Steagall Act imposed on bank activities. If banks or their affiliates venture into the securities arena, they should have to play by the same rules as securities firms, and be subject to the same regulatory scheme administered by the same regulators.

Thank you again for the opportunity to provide our views on these important matters. NASAA is available to provide any requested input or assistance you desire as the Congress continues its efforts at financial services modernization.

February 25, 1997

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