Clearing the Hurdles

By Melanie Fein

Now that charters have been modernized for financial services providers, it is time to overhaul the regulatory framework in which these companies operate.

The passage of federal reform legislation in November 1999 opened a new era in financial services, but lingering regulatory entanglements threaten to offset many of the new law's advantages. Though federal legislators are understandably exhausted after crafting the historic Gramm-Leach-Bliley Act, they must step up to the challenge of regulatory modernization. Until they do, the vision of a truly modern and globally competitive U.S. financial services industry cannot be fully realized.

The situation reflects the incomplete nature of the work done last fall. By removing cross-sector merger restrictions and other limits on permissible activities, the new law freed financial services firms to offer every type of financial product and service. A major drawback, however, is that providers still must operate within a labyrinthine regulatory structure – one fraught with prickly jurisdictional issues and complicated by a strong tradition of dual federal and state oversight.

Excitement about the possibilities opened up by the new law is quickly tempered once a banking company realizes the regulatory implications of offering broker-dealer and insurance services in all 50 states. To do so, it must enter into at least 100 separate licensing arrangements and deal with a swarm of state regulatory agencies. This is in addition to the headaches of dealing with the overlapping jurisdictions and conflicting dictates of the federal agencies. Such entanglements defeat the new law's intent.

One step in rectifying this situation is to develop standardized regulations governing how retail products are delivered to consumers. After all, many customer protection issues are identical across product lines. There should be one overarching set of standards for information disclosure, sales training and conduct, the suitability of products and recommendations, privacy, conflicts of interest and record accuracy. Waste, confusion and conflict result when multiple regulatory bodies police these issues.

Further reductions in regulatory burdens associated with multiple product lines could be achieved by establishing "coordinating regulators" for nonbank activities. These entities would range from state regulators to the Securities and Exchange Commission and the National Association of Securities Dealers, depending on the type and size of institution. They would provide a single interface for each provider in the regulation of securities and insurance activities. Banking regulators would cede authority in these areas.

Another step is to develop a uniform licensing process for the retail delivery of investment products and insurance. That way, personnel could be licensed in all 50 states through a single process. A fourth measure is to eliminate discriminatory state laws and regulations that prevent banks from competing in certain markets.

The principal goal of these recommendations is to develop a simplified, uniform national regulatory framework. This arrangement will allow financial organizations to offer investment and insurance products in all 50 states – unencumbered by the existing patchwork of duplicative, inconsistent and discriminatory regulatory and supervisory requirements.

In an age when artificial distinctions based on product lines and geography have become irrelevant to so much of American commerce, perpetuating the anachronistic U.S. regulatory framework for financial services can be seen as one of modern government's great failures.

Stark Contrast

These insights spring from Regulating Convergence, a study commissioned by the Bank Administration Institute, Chicago. The goal of the BAI research project was to clarify the kind of regulatory framework needed to facilitate the convergence of banking, investments and insurance, and to develop specific recommendations on how to forge the new construct.

Other countries have come a long way in streamlining financial regulation. Great Britain, for example, in 1998 collapsed nine different regulatory bodies into a single Financial Services Authority that will oversee the banking, insurance and investments industries in that country. The FSA's purview includes safety and soundness, consumer protection and market conduct. Traditional boundaries between regulators "simply no longer reflect the economic reality of the industry," says Clive Briault, the FSA's director of central policy.

The FSA model probably cannot be applied to this market, given the strong U.S. system of dual federal and state regulation and the entrenched jurisdictions of the separate agencies that regulate banking, investment services and insurance. But it does illuminate the encumbrances imposed by the U.S. regulatory framework.

Consider, for example, the challenges a major American bank faces in taking advantage of the Gramm-Leach-Bliley Act to offer investment and insurance services nationwide. After the parent company satisfies bank regulatory and NASD requirements to form a broker-dealer subsidiary, the new unit then must register in every state where it intends to sell securities. SEC registration will be required if the broker-dealer provides investment advice for a fee and manages more than $25 million of assets; the advisory operations must be registered state-by-state if managing less than $25 million.

The bank also must create an insurance agency subsidiary and register the unit in every state where it intends to sell insurance. In some states, the agency must obtain multiple licenses to sell multiple types of products. Further complicating the picture, some states only license entities that they themselves charter, requiring the agency to form multiple state subsidiaries.

Moreover, all of the investment and insurance reps must be licensed in each state where they sell. People who sell annuities must have both a securities and an insurance license. Supervision and training is required for compliance with varying state laws and federal securities and banking laws. A separate compliance program is needed for each of the 50 states. And all of these requirements hold for transactions conducted by mail and over the Internet.

Even when a national system is finally assembled, additional regulatory obstacles will prevent the parent banking company from taking full advantage of it. Federal and state privacy laws limit the bank's ability to share customer information with affiliates, crimping the exchange of information that could facilitate service and sales.

Regulatory inconsistencies on privacy also pose problems. Each of the federal financial regulatory agencies must adopt regulations to implement the new law's privacy provisions. So too must the 50 state insurance commissioners. There is no requirement that the rules be uniform, however, and there is a strong possibility that a plethora of different privacy regulations will emerge.

There are also questions as to whether employees can be given adequate incentives to cross-sell. Why? The payment of referral fees in connection with the sale of investment and insurance products must be limited to a nominal, non-transaction-based fixed-dollar amount. This restriction stems from NASD rules and a federal interagency statement on retail sales of non-depository investment products.

Insurance referral activities face obstacles as well. Loan officers ostensibly could refer home mortgage and auto loan customers to an affiliate insurance rep for homeowners' or property and casualty insurance as part of the application process. But that's unlawful in some states, which only allow referrals after loan commitments are approved. At that stage, many customers already have found alternatives.

Selling loans that could be secured by customers' investment portfolios is another problem. When clients attempt to borrow against investments held in a mutual funds complex operated by the bank, the institution runs afoul of section 23A of the Federal Reserve Act, which limits transactions between a bank and its affiliates.

Meanwhile, a separate customer service plan must be developed for each state. Laws may vary, for example, as to the physical setting and circumstances of sales activities. State requirements also vary with respect to advertising and solicitation, commission-sharing and arrangements with affiliates. Further concerns revolve around diverse regulatory reporting burdens.

New Approach

Obviously, the current regulatory framework does not provide the best foundation for a thriving financial services industry. It needs to be streamlined and reformulated to facilitate national competition. The guiding principles for this transformation include: the eradication of artificial market entry barriers; nationwide operability; regulatory uniformity; flexibility of organizational structure and product offerings; and coordination by a single regulator for each institution.

Although customers and providers are progressively less concerned with geographic and product boundaries, the regulatory system still revolves around them. Individual state licensing requirements still frustrate access to regional markets in many instances. The 50-state licensing process poses an entry barrier to the national market. These restrictions no longer have any regulatory justification.

The absence of a single licensing process in the United States curtails the ability of financial institutions to operate nationally. Establishing an umbrella license – one that would qualify a provider to offer investment products and insurance in all 50 states – is essential for full nationwide operability.

Substantial uniformity must be introduced into the regulatory system if it is to become efficient. And the retail sale of investment products and insurance lends itself to uniform regulation. A multi-jurisdictional system wastes government and industry resources and causes conflict and confusion when agencies collide.

The system must be rationalized in a way that preserves flexibility, however, leaving plenty of room for innovation among providers. Each institution should be allowed to structure its operations and product offerings in accordance with the needs of its customers and its own business plan.

Ideally, each financial institution should be able to maintain its primary supervisory relationship with a single regulator. The unified regime should be based on a rational division of supervisory responsibility and designed to minimize regulatory redundancy, complexity and inconsistency.

The various agencies in the multi-jurisdictional U.S. system will have to cede certain powers to each other. Even then, care must be taken not to perpetuate tripartite federal regulatory approaches – banking vs. investments vs. insurance – which pose their own set of problems. As the three main arms of financial services converge, so too must the agencies that regulate them.

The current regulatory framework divvies up the financial services market along the three major product lines. Within each area, a separate agency (or set of agencies) tends to the five functionally distinct components of any financial services business, namely, products, providers, the marketplace, exchange mechanisms and delivery.

One reason this approach falls short is that the three major product lines in financial services no longer are sharply distinct from each other. Banks, securities firms and insurance companies are replicating each other's offerings and also blending features in ways that defy neat regulatory demarcations. A checking account that sweeps the customer's money into mutual funds may be viewed as both a banking and a securities product. A variable annuity may be viewed as both a securities and an insurance product.

Product-based regulation ignores these realities. It is an especially artificial (and inefficient) construct for the regulation of highly integrated organizations that seek to deliver a variety of financial products and services on a seamless basis. Progressive institutions are striving to intermingle the delivery of financial products for the convenience of their customers. But the government insists on deconstructing the exercise for regulatory purposes. In some cases, this forces institutions to restructure their operations just to facilitate a regulatory theory.

A Focus on Delivery

Especially in retail financial services, regulation could be sharply improved by building a common set of standards for the way products are delivered. The basic elements of delivery are essentially the same regardless of product type. Yet there are multiple regulators in every state applying different oversight of the delivery process at different types of financial institutions. The results are regulatory overkill, customer confusion and unnecessary compliance costs.

We suggest a new focus, one we refer to as "uniform retail financial services delivery regulation." This would encompass the conduct and qualification of retail sales personnel; advertising and marketing; advising customers; and product recommendations. It would also include handling customer information; maintaining customer accounts and records; providing statements of accounts; and protecting customer privacy.

This orientation would be embodied in uniform licensing standards and sales practice rules, administered in a coordinated supervisory and enforcement program designed to facilitate 50-state operability for banks and other financial services firms. The guidelines would be developed by a broad-based council of financial services regulators. But they would be implemented under the direction of a single coordinating regulator for each institution.

Behind the scenes, which is to say in areas not connected with the delivery of the product to the customer, the various agencies would continue their traditional oversight in areas such as institutional safety and soundness, the competitive structure of the marketplace, and market mechanisms such as payments systems, securities exchanges and reinsurance facilities.

The reformulated regulatory framework for the retail delivery of financial services will require a level of cooperation and coordination among federal and state regulators not heretofore attained. Achieving this degree of interagency cooperation will require the establishment of a "National Council on Uniform Financial Services Regulation," modeled on an expanded version of the Federal Financial Institutions Examination Council.

This new council would consist of representatives from each of the federal banking agencies, the Treasury, the SEC, the NASD, and state securities and insurance regulators. Its mandate would be to develop a system of uniform standards and rules applicable to the delivery of investment products and insurance by banking organizations without regard to product distinctions. The only exceptions would be for fundamental distinctions that ensure accuracy of disclosures and product descriptions, and suitability to customer needs.

A principal responsibility of the new council would be the development of a uniform licensing process for the retail delivery of investment products and insurance. Such a process would include qualification standards, procedures and forms. It would be available for the licensing of individual sales agents and supervisory personnel, as well as financial services firms.

The uniform licensing process would have an institutional component and a sales representative component. Under the institutional component, a financial services firm could be licensed to sell investment and insurance products and services in all 50 states through a single licensing procedure, subject to oversight by its product regulator. Under the uniform agent licensing process, sales personnel similarly could be licensed in all 50 states through a single process.

The qualification standards for a single uniform license would vary depending on the types of products the license holder intends to sell. The process for acquiring licensure to sell additional products would be simplified. A duly licensed financial product rep in good standing would simply be required to take a qualifying examination and, absent conduct violations, would not need a new license.

Developing uniform sales practice rules would be another priority. The rules would cover the adequacy of disclosures on product features, risks, and fees; advertising and sales literature; suitability standards; avoidance of conflicts of interest; and restrictions on tying of products. They would also address the training and qualifications of salespersons; supervision of the sales program and sales personnel; the setting and circumstances of sales activities; and privacy of customer information. These factors would be treated as uniformly as possible, giving due regard to the type of product being sold and the potential for customers to be misled.

In establishing uniform sales practice rules, the new council would be required to provide maximum flexibility for banking organizations. Providers should be free to offer investment and insurance services in whatever manner is most convenient and efficient for their customers – including integrating these offerings with banking products and services. Preferably, the council also would be empowered to adjudicate claims made by a given provider that discriminatory state laws obstruct its entrance into a given market.

Coordinating Regulator

A realignment of licensing and supervisory responsibility among the existing financial services regulators also is needed. Each institution should have a "financial services coordinating regulator." Such an entity would be responsible for coordinating all regulatory contact with respect to the institution's securities, investment advisory and insurance activities, including licensing, supervision, and enforcement.

A banking organization's affiliates would be subject to supervision and examination by the coordinating regulator, or by a local regulator acting on its behalf, in each state where they maintain offices open to the public. The coordinating regulator for an organization's investment and insurance retail sales activities would issue a single examination report. Any enforcement action would be taken by the coordinating regulator, or by a local regulator acting on its behalf.

Ideally, each banking company should have only one financial services coordinating regulator. Given the current division of regulatory jurisdiction along product lines, however, it may be more practical to assign one coordinating regulator for investment products and another one for insurance. The coordinating regulator would be the relevant product regulator for an entity, taking the place of the current multiplicity of product regulators.

To make this work, various regulators must be willing to accept a reduced supervisory role. Banking regulators would not have jurisdiction over securities brokerage, investment advisory or insurance activities conducted by "functionally regulated" affiliates of banks, for example, except to the extent that such activities are deemed to threaten banking safety and soundness, consistent with the Gramm-Leach-Bliley Act.

Until meaningful reform is effected on a national scale, the Comptroller of the Currency should consider a new concept of preemption of state law. The OCC is vested with broad preemptive powers under the National Bank Act to ensure that state laws furthering parochial interests do not frustrate the goals of the national banking system. The OCC should consider whether these powers should be invoked not only when an individual state law is deemed to significantly interfere with the exercise of national bank powers, but also when multiple state laws pose a significant cumulative interference.

Obviously, all of these proposals sum up to a sweeping effort, but that's reflective of the situation. The Gramm-Leach-Bliley Act did much to modernize the commercial structure of the financial services industry, but little to renovate the antiquated regulatory framework that governs it. Indeed, in some ways, the regulatory structure is more disjointed than before.

Even a modernized financial services industry cannot function efficiently under the convoluted U.S. regulatory regime. Banks, other financial services firms, their customers, shareholders, and the nation's economy as a whole will be deprived of the full benefits of financial modernization until the existing regulatory framework is revamped.

Ms. Fein is the author of the BAI study, Regulating Convergence. A former partner at Arnold & Porter, she works as an attorney and academic in the field of banking and financial services law.

Click here for more information on BAI's study Regulating Convergence.

Copyright © 2003 by Banking Strategies, published by BAI.

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