15

notice, the written conditions the OCC, at a minimum, would likely impose would cover the voluntary commitments set forth in the Policy Statement.

Under previous Comptrollers, the OCC has not generally provided for formal public notice and comment on operating subsidiary filings, reasoning that any activity that would be judged permissible in an operating subsidiary would by definition be permitted without prior notice in the bank itself. I believe, however, that public comment may be appropriate in cases where the nature of the activities to be carried out in the operating subsidiary, the size of the transaction, or other unusual factors raise special legal or policy issues. I have therefore initiated a review of the OCC's policies in this area, and I plan to request comment on a proposed rule that would require publication of notice in the Federal Register of operating subsidiary notifications that raise novel questions of law or policy.

In light of the novel and complex issues raised by the Mellon proposal--and also by First Union National Bank's similar proposal to acquire Lieber and Company and the Evergreen Asset Management Corporation--we have decided to publish these two proposals for public comment. The comment notice appeared in the Federal Register on February 23, 1994. We look forward with great interest to the comments that we will receive, and we are confident they will improve the quality of our decisionmaking process.

The OCC is currently reviewing Mellon's proposal to ensure that all of the proposed activities are, in fact, permitted by law. We will not approve the proposal unless this is the case. We are also evaluating the management controls proposed for both Mellon and its operating subsidiary, including the adequacy and independence of management and board oversight and other control systems, the business plans and strategies of both Mellon and Dreyfus, and their written policies and procedures, audit programs, and compliance programs. Our review places particular emphasis on the controls governing the relationship between Mellon and Dreyfus, and on the safeguards that will help to ensure that customers understand which products offered by the combined entity are federally insured and which are not.

Because bank operating subsidiaries involved in mutual fund activities are also regulated by the Securities and Exchange Commission, we are coordinating our review of the Mellon proposal with the SEC. We have met with senior SEC staff to discuss the SEC's general procedures for supervising mutual fund companies such as Dreyfus. We also inquired specifically about the SEC's experience regulating Dreyfus, and asked whether the SEC had any particular concerns that we should be aware of as we process Mellon's proposal.

After the OCC concludes its review of the proposal, we will decide whether to approve the proposal, and--if the decision is to approve--what special conditions should be placed on Mellon or Dreyfus beyond those offered in the proposal.

Safety and Soundness Issues. The OCC is carefully evaluating the safety and soundness implications of the proposed acquisition, including the fact that Mellon is proposing to operate Dreyfus as an operating subsidiary. The safety and soundness issues raised by this proposal are

16

similar to those involved in other operating subsidiary proposals involving mutual funds that the OCC has approved. Nevertheless, the volume of business that Dreyfus would bring to Mellon makes this proposal unique.

The principal financial risks posed by mutual fund operations include liquidity risk (the risk that a bank will cover losses arising from a fund's inability to meet redemption requests), operational risk (the risk that a bank will suffer losses because it lacks necessary expertise or operational infrastructure), and legal risk (the risk of losses due to lawsuits brought by customers or enforcement action brought by the bank's regulators). These and other risks are not unique to mutual funds; they arise in other banking activities as well. Whenever the OCC evaluates a proposal for a bank to set up an operating subsidiary, we consider the adequacy of the controls to deal with these risks. Risk management is also a central focus of OCC examinations, for mutual fund activities carried out in banks, in operating subsidiaries, and through third-party vendors.

From the perspective of bank safety and soundness, the most serious concern raised by a proposal such as Mellon's is the possibility of exposure to operational or fiduciary losses in its mutual funds subsidiary. Bank managers might feel strong pressure to reimburse an affiliated mutual fund or its customers for market losses, particularly if a money-market mutual fund managed by the bank would otherwise fail to maintain a constant net asset value. Bank managers might also feel pressure to provide emergency credit to or investments in a mutual fund subsidiary to cover an unexpected surge in redemptions.

We are looking closely at the Mellon/Dreyfus proposal to determine whether it contains adequate safeguards against any such depletion of bank capital. In cases where operating subsidiaries would otherwise pose an unacceptable risk to bank capital, the OCC has limited, as a condition of approval, the amount that a bank may invest in its operating subsidiary. If circumstances warrant, we can place similar limits on Mellon.

But it is important to keep this risk in perspective. The possibility of loss to the parent bank is not unique to mutual fund subsidiaries: it exists with respect to activities conducted in a division of the bank itself. Mutual fund sales pose less risk to banks than many more traditional banking activities, since the risk that the mutual fund's holdings could decline in value is borne by the customer rather than the bank; although a sharp decline in the market could increase mutual funds' liquidity risk.

We also need to ensure that the operations of the parent bank do not endanger its mutual fund subsidiary. In particular, the Dreyfus Corporation currently holds far more capital than is required by the SEC's capital requirements. This capital for the most part reflects direct investments by Dreyfus, by virtue of which Dreyfus shareholders benefit from the firm's investment management capabilities. The surplus capital cushion also provides an extra margin of protection to Dreyfus customers.

17

If the OCC decides to allow Mellon to acquire Dreyfus as an operating subsidiary, Dreyfus's excess capital will strengthen the balance sheet of the combined entity. This improvement in Mellon's capital position will not come at the expense of Dreyfus customers, as long as Mellon is adequately capitalized in light of all the risks faced by the combined entity. The OCC is currently reviewing Mellon's proposal to determine what effect the consolidation of Mellon and Dreyfus would have on Dreyfus's net capital ratio. If the OCC approves the transaction, we will insist as a condition of approval that Dreyfus remain in compliance with all financial responsibility standards, including the capital requirements established by securities laws.

Conflict of Interest Issues. In addition to posing risks to the bank, and to customers who misunderstand the risks of their mutual fund investments, mutual fund sales and other mutual fund activities can give rise to potential conflicts of interest. For example, a bank could be open to charges of conflict of interest if it lent to a company whose securities were held by a bankmanaged mutual fund, if the mutual fund made off-market purchases of securities from the bank's investment account (or from bank customers or creditors), if the mutual fund invested funds in securities which assisted a bank customer in paying off bad debts to the bank, or if a fund manager traded on his own account in advance of a trade of the same securities on the fund's account. The absence of strong controls could result in charges of self-dealing and possible financial liability. In reviewing Mellon's proposal to acquire the Dreyfus Corporation, the OCC is considering the potential for conflicts of interest and the policies and procedures that Mellon would use to identify and avoid possible conflicts.

Here too, however, it is important to put the issue in context. The same kinds of issues arise when banking firms have securities subsidiaries--or, indeed, trust departments. Both the banking industry and its regulators have a long history of experience in this area. Banking and securities laws, rules, and regulations include a broad range of conflict of interest restrictions designed to ensure that bank customers and mutual fund customers are not placed at a disadvantage by insiders. These restrictions cover banks acting in their fiduciary capacity as well as banks serving as broker-dealers for their customers. Banks providing investment advice to mutual funds are also subject to a host of disclosure requirements and prohibitions against self-dealing.

Because a breach of a bank's obligations to its customers can expose the bank to significant legal liability, banks generally adhere to internal conflict of interest policies above and beyond the regulatory requirements. One of the primary functions of the OCC as regulator is to ensure that these internal systems and controls meet or exceed legal requirements and are enforced. Our examination experience in this areas indicates that bank managers and directors share our concern for implementation and enforcement of strict conflict of interest policies.

18

Conclusion

Our nation needs a strong banking system--not for the sake of having a strong banking system--but for the sake of the public. We need a banking system that can foster economic growth, and enable disadvantaged people to participate in that growth. For our banking system to remain strong, banks must be able to respond to changes in the market for financial services. To prohibit banks from responding to change would reduce both competitiveness and safety and soundness. To reduce the range of products and services from which consumers may choose would impoverish our marketplace and our economy.

One of the clearest changes in the past decade has been the growing role of mutual funds in the financial services industry. With appropriate protections for consumers and safeguards aimed at maintaining safety and soundness, banks can take part in that change. Banks are well positioned to meet customer needs in the mutual fund market, due to their extensive network of branches, which reaches into virtually every community in the nation; their long-standing tradition of fulfilling the fiduciary needs of their customers; and their established relationships with most of the nation's households. Bank sales of mutual funds, whether through an operating subsidiary or directly from the bank, can be fundamentally beneficial to the banking public. They offer customers greater convenience and greater choice in shopping for mutual fund services, and permit banks to compete on an equal footing with other providers of financial services.

But the rapid growth in bank sales of mutual funds also raises a number of serious policy issues that regulators and the banking industry need to address. Bank mutual fund operations must incorporate adequate customer protections and safeguards against potential conflicts of interest. They must not endanger the financial soundness of banks or their mutual fund subsidiaries. They must observe legal limitations on permissible banking activities, and they must be adequately supervised. We are weighing these issues, as well as the specific circumstances of Mellon Bank, as we consider Mellon's proposal to acquire the Dreyfus Corporation.

Mr. DINGELL. The Chair thanks you very much for your statement.

Ms. Broadman, do you have any comments you would like to make?

Ms. BROADMAN. I do not.

Mr. DINGELL. Very well.

The Chair recognizes the gentleman from Colorado for questions. Mr. SCHAEFER. Thank you, Mr. Chairman.

Thank you, Mr. Ludwig and Ms. Broadman for being here today. Yesterday's and today's hearings have been so focused on the actual and potential problems of sales of securities at banks that some people may be wondering why it was ever contemplated in the first place. What are the advantages of permitting customers to buy securities at banks?

Mr. LUDWIG. Well, I think there are genuine advantages. Banks offer competition, they offer consumer choice. The very fact that consumers are buying mutual funds from banks in record numbers, to a considerable degree, testifies to consumer desires. So I think there are genuine benefits to banks' being involved in this activity. Mr. SCHAEFER. Well, you have mentioned competition, what are the competitive advantages? I mean, if somebody wants to buy securities, what is the difference?

Mr. LUDWIG. There are a couple of points worth making here. In any market, the fact that you have more market participants increases the level of competition, and drives down price, and increases choice. Moreover, banks are located in areas that are often underserved by other players. There are thousands of bank branches, and banks have community responsibilities, CRA responsibilities, that other participants in this market do not.

Mr. SCHAEFER. So, in other words, a bank merger with securities then is going to be advantageous to the consumer?

Mr. LUDWIG. There are serious consumer issues here, there is no doubt, and we take those very seriously. But I believe that in judging whether or not banks ought to be in mutual funds that, in fact, they should and that the consumer benefits outweigh the negatives.

There are serious questions here, to be sure, and we are going to address them as vigorously as is necessary but, at the same time, it seems to me that there are a variety of different reasons why this kind of activity is an appropriate activity for a banking organization.

Mr. SCHAEFER. As long as we steer away from problems such as occurred with Keating and Continental?

Mr. LUDWIG. Absolutely.

Mr. SCHAEFER. We had AARP in here saying that, gosh, you have to look at the fine print on the last page to see whether or not you are FDIC insured.

Mr. LUDWIG. We have to be very vigorous in those areas, and I believe we have a quality examination team properly focused and we are giving it proper focus to achieve the necessary consumer protections.

Mr. SCHAEFER. What is OCC's examination process for banks' sales of nondeposit investment products?