The Comptroller of the Currency's office and the Securities and Exchange Commission announced last month that they would soon start working together on examinations of bank mutual fund operations. This innovative joint exam agreement was in large part the work of SEC Commissioner Steven Wallman. Mr. Wallman, a former partner at the Washington law firm of Covington & Burling, was appointed to the SEC in 1994 by President Clinton. In a recent interview at his Washington office with American Banker staff writer Justin Fox, Mr. Wallman said joint examinations with the Comptroller's office are just the beginning as the financial services industry and its regulators change with the times.

Q.: What was the genesis of the joint exam idea?

WALLMAN: With the banking regulators' interest in ensuring integrity and quality, and with our interest in ensuring this as well, and our expertise, the thought was that we could work together better than either of us could alone.

You combine that with the fact that the industry itself would be greatly benefited by not having redundant inspections, and hopefully over time will have just one set of regulators and inspectors as opposed to two or more, and you find that the industry should get tremendous savings as well.

So I thought it was something that was too obvious to pass on. I talked to the OCC about it, suggested strongly that they should have an interest in doing this. They agreed, and we decided to set out the template for a model of how we want to engage in joint investment adviser inspections and examinations, without attempting at the moment to bring in everybody else. But we hope that this will be the template for arrangements with other regulators as well.

Q.: Are there other areas of overlap between the SEC and banking agencies?

WALLMAN: There are. There are areas that relate to transactions and broker-dealers. Increasingly we're getting overlaps with regard to, for example, activities in connection with derivatives.

My view is that the various financial industries that currently exist - the securities industry, the banking industry in terms of both investment banking and commercial banking, merchant banking, broker-dealer-type activities, even to some degree perhaps other actions such as venture capital - are all starting to merge.

Many of the distinctions we used to think of in terms of a brick-and- mortar company you could look at and say, "This company does nothing but broker-dealer securities activities; this company does nothing but commercial banking," are simply evaporating. The lines are disappearing before our eyes.

The market understands that. The public understands it. And now regulators are beginning to understand that and deal with it. We need changes in our laws to reflect that. We need changes in our regulatory procedures to reflect that. I think that this kind of cooperation is a beginning step in that direction.

Q.: As the industries grow together, what should the regulatory structure look like?

WALLMAN: The only vision I would have is one of maintaining flexibility and adaptability and ensuring that the regulators do not inadvertently constrain competition or restrain opportunities that market participants might otherwise have just because of a desire to maintain their own regulatory jurisdiction over particular areas.

That means much more interagency cooperation, much more interagency coordination, and a much greater move toward functional regulation.

Q.: What do you mean by functional regulation?

WALLMAN: If somebody is going to maintain a bank with deposit insurance, so you have the federal government guaranteeing the deposits, that requires the operation of in essence an insurance fund, which implies safety-and- soundness concerns and ensuring adequate capital.

But one could have a very narrow core bank and say that, provided it is protected the same as one would functionally protect any kind of insured entity, to the extent that there are other operations that can be undertaken by affiliates or other entities related to that core bank, those other entities can engage in those other activities under whatever rules and regulations would apply to their actions.

So, functionally you regulate with regard to each of the actions that an entity might engage in.

Q.: Should market discipline and public disclosure be allowed to play a bigger role in the regulation of financial institutions - such as in the Federal Reserve's recent proposal to let banks set their own capital cushions for trading activities?

WALLMAN: The idea is, instead of having regulators set what the right amount of capital is, let the market decide.

People have proposed that for a long, long time. And the question that people keep having is whether the markets will establish the right amount of capital from a systemic risk standpoint, from the perspective of the depositors. Because depositors still have insurance behind them, they may care less about what the capital cushion is, so you don't necessarily have the market discipline built in.

When market discipline is built into the system, it works well. Market discipline works less well if you have regulatory constraints, if you have insurance that's guaranteed by the government, or if you have other measures that superimpose biases that stop market discipline from working.

There are also other problems. If you have banks that may start to be perceived as weak, and people start to feel that they can't just go to whatever bank is on the corner, do you start to raise the transaction cost for every bank customer in trying to figure out if this is a good bank?

Right now you've built up a whole infrastructure where people can rely on government regulation and government protection to provide very significant benefits. The question is whether you can simply remove that infrastructure and allow market participants to exceed prudent constraints.

If, on the other hand, what you're talking about is a system where you still have deposit insurance and you maintain full protections as currently provided, then what you're really talking about is allowing the market to discipline activities engaged in by banks or other financial services intermediaries with regard to nondeposit matters - derivatives, counterparty relationships. That clearly is a much different story, and that's what we have today.

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