FRB: Testimony, Greenspan -- H.R. 10, the Financial Services Act of 1998 -- June 17, 1998 The Federal Reserve Board eagle logo links to home page

Testimony of Chairman Alan Greenspan
H.R. 10, the Financial Services Act of 1998
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
June 17, 1998

It is a pleasure to appear before this Committee to present the views of the Federal Reserve on the need to enact legislation to modernize the U.S. financial system and to express the Board's strong support for H.R. 10, which achieves this objective.

I. The Need for Financial Reform
U.S. financial institutions are today among the most innovative and efficient providers of financial services in the world. They compete, however, in a marketplace that is undergoing major and fundamental changes driven by a revolution in technology, by dramatic innovations in the capital markets, and by the globalization of the financial markets and the financial services industry.

The Federal Reserve believes that it is essential that the nation act promptly to modernize the rules that govern our financial institutions in order to ensure their continued competitiveness and to foster their ability to innovate, to operate efficiently and to provide the best and broadest possible services to consumers as well as to maintain this nation's role as the preeminent world financial center. We believe that it is important for Congress to set the rules for this industry, which is so important to our nation's health and prosperity. Only Congress has the ability to fashion rules that are comprehensive and equitable to all participants and that guard the public interest.

That is why the Federal Reserve strongly supports H.R. 10 and urges the Senate to consider and pass this legislation as soon as feasible.

The market will continue to force change whether or not Congress acts. The strength and viability of our financial institutions, the effectiveness of our regulatory structure, and the role and status of our financial services industry in the international system are in play as a result of the aforementioned market forces as well as regulatory actions. Without Congressional action, changes will occur through exploitation of loopholes and marginal interpretations of the law that courts feel obliged to sanction. This type of response to market forces leads to inefficiencies, expansion of the federal safety net, potentially increased risk exposure to the federal deposit insurance funds, and a system that will undermine the competitiveness and innovative edge of major segments of the financial services industry. Delay in acting on financial modernization legislation would only limit Congress's options as these developments proliferate and complicate, increase the difficulty of enacting protections included in H.R. 10 to protect safety and soundness and the public interest, and deny to consumers the benefits that immediate changes in our outdated banking laws will surely bring.

Of course, financial modernization involves complicated and sometimes divisive issues because it requires easing rules and opening options for some while increasing competition for others, redrawing lines that create new limits, and applying some pre-existing regulatory structures to new institutions. However, these issues are not new to the Senate.

The Senate Banking Committee has on three previous occasions led the way in developing financial modernization legislation, and the full Senate has twice followed this Committee's recommendation in adopting such legislation. (A summary of these financial modernization proposals is provided at Attachment 1.) In 1991, the Committee passed S. 543, which repealed the Glass-Steagall Act and allowed banks to affiliate with securities firms using the holding company structure to ensure safety and soundness, a level competitive playing field, and protection of the taxpayer. H.R. 10 uses that same holding company framework from S. 543, but expands the range of permissible financial affiliations to include insurance underwriting and merchant banking. Senate action at this time to enact H.R. 10 would be an historic achievement that would establish a sound and much-needed framework for launching our financial services industry into the 21st century.

There has been much--perhaps too much--arguing over details contained in H.R. 10. H.R. 10 is a comprehensive approach to the issues of financial modernization, and it is fundamentally a sound bill. No legislation that endeavors to address financial modernization will be considered ideal by all, but time will allow its rough spots to be worked out.

What is most important is that for the first time there is an extraordinary amount of agreement on nearly all of the key principles in the bill. There is no disagreement--and there has been no disagreement for many years--that the Glass-Steagall Act must be repealed. There is now finally no disagreement that insurance companies and banks should be permitted to affiliate, and virtual unanimity that banks should be permitted to sell insurance. There is no disagreement that financial holding companies should be permitted to engage in a broad range of other activities that are financial in nature, including merchant banking. And, there is no disagreement that new affiliations must be permitted on a level playing field and in a manner that permits a realistic two-way street between banking organizations that seek to affiliate with insurance and securities firms, and between insurance and securities firms that seek to acquire banks. Moreover, there is no disagreement that financial modernization must not place insurance and securities firms that choose to remain independent at a disadvantage in competing against those firms that choose to affiliate with banks.

In addition, there is strong agreement that new affiliations must be permitted within a framework that maintains the safety and soundness of our financial system in general and the banking system in particular without imposing unnecessary regulatory burden or intrusion. That means strong functional regulation and reasonable, but not bank-like, umbrella oversight of financial holding companies.

A consensus has also developed that banking and commerce should not be mixed at this time beyond the limited level needed to allow a realistic two-way street for financial firms that are predominantly securities and insurance companies to acquire banks. There is also agreement that the new law must provide regulators with adequate means to protect the consumer and assure that consumers are carefully informed about the differences between products that are backed by federal deposit insurance and those that are not.

These are the fundamental principles embodied in H.R. 10, save one. There are some details surrounding these aforementioned principles that are still under discussion. These surrounding details are important, but not so important that they should be allowed to defeat the consensus that has developed around these principles themselves. It would be a disservice to the public and the nation if, in the fruitless search for a bill that pleases everyone, the benefits of this vital legislation are lost or delayed.

There is, however, as I indicated, one fundamental principle embodied in H.R. 10 upon which there is disagreement between the Federal Reserve and the current Treasury Department, although there is agreement among the Federal Reserve and many in the affected industries as well as earlier Treasury Departments. That is the considered decision of the House to use the holding company structure, and not the universal bank, as the appropriate structure to allow the new securities and insurance affiliations. That decision, which is fundamental to the way in which the financial services industry will develop, is critical because it provides better protection for our banking and financial system without damaging the national or state bank charters or limiting in any way the benefits of financial modernization. Importantly, that decision also prevents the spread of the safety net and the accompanying moral hazard to the securities and insurance industries and assures a level playing field within the financial services industry and thus full, open and fair competition as we enter the next century. The other route towards universal banking for national banks will, in our view, lead to greater risk for the deposit insurance funds and the taxpayer. It will also inevitably lead to a weakening of the competitive strength of our financial services industry as independent securities, insurance and other financial services providers operate at a disadvantage to those owned by banks. It is for these reasons that the Federal Reserve, SEC, many state functional regulators and many in the affected industries support the holding company framework and have opposed the universal bank approach.

In virtually every other industry, Congress would not be asked to address issues such as these, which are associated with technological and market developments; the market would force the necessary institutional adjustments. Why is it so different for the financial system? I believe the difference reflects the painful experience that has taught us that developments in our financial system--especially, but not solely in our banking system--can have profound effects on the stability of our whole economy, rather than the limited impact we perceive from difficulties in individual nonfinancial industries.

Moreover, as a society we have made the choice to create a safety net for depository institutions, not only to protect the public's deposits, but also to minimize the impact of adverse developments in financial markets on our economy. Although we have clearly been successful in doing so, the safety net has predictably created a moral hazard: the banks determine the level of risk-taking and receive the gains therefrom, but do not bear the full cost of that risk; the remainder is borne by the government. Since the sovereign credit of the United States ultimately guarantees the stability of the banking system and the claims of insured depositors, bank creditors do not apply the same self-interest monitoring of banks to protect their own position as they would without discount window access and deposit insurance. Instead, this moral hazard requires that the guarantor, the U.S. government, supervise and regulate entities with access to the safety net to protect its own, that is the taxpayers' interest--the cost of making good on the guarantee.

Put another way, the safety net requires that the government replace with law, regulation, and supervision much of the disciplinary role that the market plays for other businesses. Our experience in the 1980's with insured thrift institutions illustrates the necessity of avoiding expanding risks to the deposit insurance funds and lax supervisory policies and rules. But this necessity has an obvious downside: these same rules limit innovative responses and the ability to take the risks so necessary for economic growth. The last thing we should want, therefore, is to widen or spread this unintended, but nevertheless corrosive dimension of the safety net to other financial and business entities and markets. It is clear that to do so would not only spread a subsidy to new forms of risk-taking, but ultimately require the expansion of bank-like supervision as well.

In our judgment, the holding company approach upon which H.R. 10 is premised avoids this pitfall; the universal bank approach does not.

While financial modernization represents a much needed reform, we should not forget that this modernization will, by itself, introduce dramatic changes in our financial services industry. We feel confident that the risks of this type of reform are manageable within the holding company framework set out in H.R. 10. We believe that the magnitude of the reform to our financial system represented by allowing new and broad affiliations counsels that this is not the time to experiment with these broad new affiliations through operating subsidiaries, an approach that has failed the taxpayer in other contexts and has other serious consequences. Instead, we believe the Congress is best advised to retain the existing holding company structure, which achieves the full benefits sought by financial modernization and has a proven track record of protecting safety and soundness, insulating the federal safety net, and providing competitive equality among companies that choose to affiliate with banks and those that choose to remain independent.

There are two final points I want to make since they appear to drive Treasury's opposition to H.R. 10. First, as I will discuss in more detail later, H.R. 10 would not diminish--but would in fact enhance--the national bank charter.

Second, H.R. 10 would not diminish the ability of the Executive Branch to continue to play its meaningful role in the development of banking or economic policy. Currently, the Executive Branch influences such policy primarily through its supervision of national banks and federal savings associations. H.R. 10 would not alter the Executive Branch's supervisory authority for national banks or federal savings associations, nor would it result in any reduction in the predominant and growing share of this nation's banking assets controlled by national banks and federal savings associations.

Furthermore, Congress for sound public policy reasons has purposefully apportioned responsibility for this nation's financial institutions among the elected Executive Branch and independent regulatory agencies. H.R. 10 retains this balance and the Federal Reserve does not believe it would be appropriate to alter this balance in favor of increased Executive control of financial institution policy. Such action would be contrary to the deliberate steps that Congress has taken to ensure independence in the regulation of this nation's financial institutions, both banking and nonbanking.

II. The Financial Services Act of 1998 (H.R. 10)
Although H.R. 10 is almost 300 pages in length, its objective is simple and can be stated concisely--H.R. 10 removes outdated restrictions that currently limit the ability of U.S. financial service providers, including banks, insurance companies and securities firms, to affiliate with each other and enter each other's markets.1 This objective--permitting the affiliation of financial service providers and thereby allowing open and free competition in the financial services industry--is supported by the banking, insurance, and securities industries as well as the three federal banking agencies, the Treasury Department, and the Securities and Exchange Commission.

For the most part, the remaining provisions of H.R. 10 are designed to implement and complement this change and to ensure that these new affiliations occur in a manner that is consistent with the safety and soundness of the banking and financial system and the protection of investors and other consumers of financial services. H.R. 10 requires that these new affiliations occur within a holding company structure, which the Federal Reserve believes is sound policy because it best protects the federal deposit insurance funds by limiting the additional risks permitted to insured depository institutions. Arguably of even greater importance, the holding company structure limits the spread of the federal safety net and its related subsidy and moral hazard to entities or activities beyond the insured depository institutions it was intended originally to support. H.R. 10 builds on the protection afforded by the holding company structure by relying on strong functional regulation of the securities, insurance, and banking components of the holding company. It also provides flexibility to authorize restrictions on transactions between depository institutions and their newly authorized affiliates when necessary to protect the safety and soundness of affiliated depository institutions and the Federal deposit insurance funds. H.R. 10 grants access to these new affiliations only to those organizations that have and maintain well-capitalized and well-managed subsidiary depository institutions.

H.R. 10 also includes provisions designed to ensure that these new affiliations occur in a manner that is consistent with the protection of consumers. For example, the bill requires that the federal banking agencies issue consumer protection regulations governing the retail sale of securities and insurance products by depository institutions. And, H.R. 10 emphasizes the obligation of depository institutions to help meet the credit needs of their entire community by limiting the new affiliations to only depository institutions that have at least a satisfactory performance record under the Community Reinvestment Act.

1. Umbrella Supervision and Functionally Regulated Entities
H.R. 10 for the first time would permit broad affiliations among financial service providers that are currently supervised by different agencies. As a result, H.R. 10 builds on the principle of functional regulation and includes important provisions that encourage and facilitate cooperation among the functional regulators. It also reduces overlap between the various regulators and clearly allocates responsibility and accountability for supervising the different parts of new financial holding companies. At the same time, H.R. 10 retains a meaningful, albeit streamlined, level of umbrella oversight of the entire organization to assure that some agency has a complete view of, and accountability for, new financial holding companies and can serve a facilitating role in relationships among functional regulators.

The Federal Reserve believes that H.R. 10 has constructed a good balance that provides the various regulators, including the umbrella supervisor, with the tools needed to supervise financial holding companies adequately. In addition, H.R. 10 is helpful in enhancing the ability of the relevant state and federal supervisory agencies to share information on a confidential basis.

The focus of H.R. 10 on functional regulation is perhaps best illustrated through an example. Under H.R. 10, responsibility would be allocated for supervising a new financial holding company comprised of an insurance company, a securities firm, several financial companies such as a mortgage lender and a financial data processing company, and an insured bank. H.R. 10 contemplates that responsibility for supervising and regulating the insurance company, securities firm and insured bank would, as under current law, rest, respectively, with the relevant state insurance authorities, with the Securities and Exchange Commission and the securities self-regulating organizations, and with the appropriate state and federal bank supervisory agencies. Each of these agencies would retain the full authority that it currently has to examine firms under its jurisdiction and to interpret and enforce the law applicable to the type of company that the agency is charged with supervising.

The Federal Reserve, as umbrella supervisor, would be required to the fullest extent possible to rely on regulatory reports required and examinations conducted by, using our example, the state insurance commissioner, the SEC (and appropriate securities self regulatory agencies) and the appropriate state or federal banking agency. In a problem bank situation, the Federal Reserve also would be prohibited from requiring that the insurance company or securities firm provide financial resources to the bank if the functional regulator determines that such action would have a materially adverse effect on the financial condition of the insurance company or securities firm. Instead, the Federal Reserve could order divestiture of the bank or affiliate in order to recapitalize the bank.

At the same time, H.R. 10 preserves the important authority of the umbrella supervisor to apply consolidated capital standards to the financial holding company, to examine the holding company and--under specified circumstances--any subsidiary that poses a material risk to the insured bank, and to enforce compliance by the organization with the Federal banking laws. This assures that, while the functional regulators are supervising various parts of the organization, someone is overseeing the organization as a whole as well as subsidiaries that are not subject to other functional regulation.

2. Enhanced Functional Regulation of Financial Products
Consistent with the bill's emphasis on functional regulation, H.R. 10 also would repeal the blanket exemptions provided banks from the definitions of "broker" and "dealer" in the Securities Exchange Act of 1934, requiring banks to register with the SEC if their securities activities fall outside specified categories of transactions. These categories are broad and would permit banks to continue engaging in securities activities in connection with their traditional trust, custody, safekeeping and derivatives operations and in a limited amount of retail securities transactions without registering as a broker or dealer.

The bill also establishes procedures for determining which functional regulator would have primary responsibility for supervising the provision of new or hybrid financial products that may be developed in the future. In the securities area, for example, H.R. 10 would authorize banks, to the extent consistent with applicable banking law, to offer and sell new or hybrid products that are developed in the future unless the SEC determines, after a formal rulemaking process and after consultation with the Federal banking agencies, that the new or hybrid product is a security for purposes of the securities laws. If the SEC makes such a determination, the bill would require that the product be sold by an SEC-registered entity, such as a subsidiary of the bank, subject to functional regulation as a security product.

The bill establishes a similar, although more complex, procedure for determining whether future products that are classified as insurance by a state may be underwritten by a bank within the framework of bank regulation or only by a functionally regulated insurance underwriting affiliate. This process seeks to ensure that banks will continue to have the ability to provide any product banks are providing today. In addition, it assures that banks may, as principal, provide any new form of a traditional banking product that may in the future be characterized as insurance by state law unless the product is treated as insurance for purposes of the federal Internal Revenue Code. There is also a procedure to resolve disputes between insurance and banking regulators over future products with final decisions by the courts "without unequal deference" to either the relevant Federal or State regulators and after reviewing the history of the regulation of the product.

Although any attempt to devise rules for the classification and regulation of future products is bound to encounter difficulties, and improvements could be made in some marginal provisions, the substantive provisions of H.R. 10 governing the division of regulatory responsibility for future products are carefully balanced in our judgment.

3. Competitive Flexibility
Importantly, H.R. 10 provides banking organizations--both large and small--substantial flexibility in determining how to respond to the market forces so rapidly changing the industry. Many large banking organizations that meet applicable criteria may elect to affiliate with full-service insurance and securities underwriting firms and thereby become comprehensive providers or "manufacturers" of financial products. Similarly, small banking organizations would remain free to engage in currently authorized activities or to expand into newly authorized principal activities at the pace most consistent with the organization's competitive strategy. Small banking organizations also would be free to focus their efforts in an area where they have a demonstrable competitive advantage--the sale of any type of financial product as agent.

One of the areas of great interest to banks--and one likely to increase consumer options and benefits greatly--is insurance sales. Importantly, H.R. 10 would expand the insurance sales opportunities for banks by authorizing subsidiaries of national banks to sell virtually any type of insurance product, whether underwritten by an affiliate or a third party, from any location on a nationwide basis. National banks also would retain their current ability to sell insurance as agent in any place with a population of 5,000 or less. One detail in this area that we do not support is the provision in H.R. 10 that requires a national bank, for the next 5 years, to expand its insurance activities in additional states only by buying an existing insurance agency.

H.R. 10 would also provide depository institutions important protections against state laws that might conflict with the ability of these institutions to sell financial products as authorized by Federal law. Some confusion and controversy, however, have arisen in this area, particularly as to whether H.R. 10 would scale back the Supreme Court's decision in the Barnett case concerning the ability of states to regulate the sale by national banks of insurance as agent. It is my understanding that H.R. 10, in fact, seeks to codify the Barnett decision by incorporating the phraseology used by the Supreme Court and a specific citation to the Supreme Court's opinion in Barnett into a new Federal statute that would preempt any state law that "prevents or significantly interferes" with the ability of any national bank or other depository institution to engage in insurance sales activities authorized by Federal law.

H.R. 10 does provide that a state law will not be preempted under the Barnett standard if the law is no more restrictive than an existing Illinois statute that governs insurance sales by banks. This statute, among other things, requires the licensing of agents and the disclosure that insurance products sold by the bank are not guaranteed or insured by the FDIC. This provision also prohibits the tying of insurance products to credit products, the payment of commissions to unlicensed persons, and the unauthorized disclosure of customer information. The statute's requirements are not onerous and the Comptroller of the Currency has recognized that the statute's requirements do not on their face conflict with the Barnett decision.

In short, the controversy in this area appears to stem largely from confusion concerning the bill's intent, which can be addressed through clarifying amendments designed to make plain that the bill does not scale back, and is fully consistent with, the Barnett decision.

III. Enhancements to the National Bank Charter
There has been some concern that H.R. 10 may damage the national bank charter. The Federal Reserve believes that it is important that the national bank charter not be impaired or diminished in view of its significance to the nation's financial system. On the other hand, we do not believe the national bank charter should be fundamentally transformed and enlarged into a universal bank charter by allowing national banks directly or indirectly to engage in underwriting life and property and casualty insurance, underwriting and dealing in securities, merchant banking and direct equity investing, or real estate investment and development. For the reasons laid out in this testimony, we believe such an expansion of the national bank charter would be a mistake for bank safety and soundness, the deposit insurance funds and safety net, the financial services industry (consumers and businesses alike) and the taxpayer.

In the Federal Reserve's view, the concern about H.R. 10's effect on the national bank charter appears based on a misunderstanding of the bill. Our review of H.R. 10 indicates that it preserves the existing benefits of the national bank charter and includes significant provisions that actually enhance the powers of national banks. First, H.R. 10 does not reduce the current powers of national banks to conduct banking activities or indeed limit the present activities conducted by national banks. In fact, H.R. 10 contains several provisions that specifically preserve these powers. Moreover, there is nothing in H.R. 10 that limits the authority of the OCC to authorize new powers for national banks as within the business of banking or incidental to a banking business under the National Bank Act other than those activities prohibited for national banks and future, as yet unauthorized, insurance underwriting activities.

As I mentioned earlier, H.R. 10 contains, as has every prior version of financial modernization legislation for the past 15 years including the recent Treasury proposal, provisions that encourage all banks to conduct securities activities through an affiliate or, where authorized, a subsidiary of the bank, rather than in the bank. These provisions, however, include significant exceptions that allow banks to continue to conduct in the bank securities activities that are part of or incidental to traditional banking services or that are conducted in limited numbers. And, as in the Treasury's recent modernization proposal, the provisions of H.R. 10 apply equally to all national and state banks.

Second, H.R. 10 improves the national bank charter. H.R. 10 empowers national banks to conduct any financial activity as agent through an operating subsidiary. Under this provision, national banks may, through a subsidiary, sell any type of insurance at any location (including in cities with a population over 5,000). This provision also allows a subsidiary of a national bank to sell any financial product as agent, and to engage in any financial agency activity that is permitted for a financial holding company. Such activity, as best we can judge, because it is rarely asset intensive and hence requires minimal equity, transfers little subsidy to the bank subsidiary.

H.R. 10 also authorizes national banks for the first time to underwrite any type of municipal security, including municipal revenue bonds, directly or through a subsidiary. At the same time, H.R. 10 removes the current advantage that state banks have over national banks in the securities area. H.R. 10 prohibits state banks from engaging in underwriting or dealing in securities, either directly or through an operating subsidiary, to the same extent that a national bank is prohibited from underwriting and dealing in securities.

H.R. 10 would clarify that national banks should not in the future underwrite life or property and casualty insurance beyond that currently permissible for national banks. State banks are already prohibited by the Federal Deposit Insurance Corporation Improvement Act of 1991 from commencing insurance underwriting activities or making equity investments. Thus, under H.R. 10, the only financial activity of which we are aware that state banks in some states could conduct, either directly or in an operating subsidiary, that national banks cannot is real estate investment and development. Treasury's recent bill, however, would wisely, in our view, also have prohibited that activity to national banks and their subsidiaries.

As I explained earlier, H.R. 10 also includes provisions that guarantee national banks the right to affiliate--through holding companies--with securities firms, insurance companies and other financial services providers, and to sell and market the products of those affiliates notwithstanding any state law. In addition, H.R. 10 preserves the rule of law established in Barnett.

Together, these provisions allow national banks to remain strong and vibrant competitors. H.R. 10 also does nothing to encourage national banks to convert to state charters. Nor does H.R. 10 tarnish in any way the appeal that many see in the national bank charter, particularly as a vehicle for conducting interstate branching. Indeed, nearly 90 percent of all interstate branches are operated by national banks, which operate under one set of rules and with one regulator at all their locations--the OCC.

The heart of the concern about H.R. 10's applicability to national banks does not appear to be that it fails to enhance the national bank charter, but that it fails to enhance the national bank charter enough for some. However, the record does not demonstrate that the national bank charter is in decline. In fact, the opposite is true. In the postwar years, national banks have controlled more than 50 percent of total bank assets. In fact, the share of assets controlled by national banks rose sharply last year and early in 1998, reflecting the increased attractiveness of the national charter as interstate branching has been authorized, and assets held by national banks are at the highest level this decade and near the postwar high relative to state banks. Attachment 3 provides additional data on the relative strength of the national bank charter.

In any event, the issue that is facing Congress is not whether we need to provide an edge to a particular type of bank charter. The record is replete with evidence that what is really needed is reform of the laws that prevent the affiliation of banks of all types with securities firms, insurance companies and other financial services providers, and thereby allow the financial services industry to adjust to a rapidly changing market. That is the deficiency that H.R. 10 is designed to address and does address very well. If the future finds, contrary to the past and present, that further adjustments are needed to the national bank charter to allow it to remain competitive and viable, those concerns can and should be addressed more clearly once an actual deficiency is shown.

IV. Operating Subsidiaries vs. Holding Companies
One area where some have argued that H.R. 10 does not go far enough is in authorizing national banks to own so-called operating subsidiaries, which are subsidiaries of the bank that engage in activities that national banks are forbidden by Federal law to conduct directly. This is not a detail or a technical issue, but one that we believe is critical to determining the shape, soundness and competitive fairness of our financial system as it develops into the 21st century, and will have profound ramifications for our Federal safety net.

There are two reasons why the Board believes that it is not wise or necessary to expand the ability of banks to engage in new principal activities through operating subsidiaries that are prohibited to the bank. These are (1) extension of the safety net subsidy to activities beyond what Congress originally intended and resultant harm to the vibrancy of competition in our financial services industry, and (2) the safety and soundness implications for banks and risk exposure of the deposit insurance funds.

Extension of the Safety Net. In my introductory remarks, I noted that a major reason the Congress is called upon to involve itself in a legislative response to technical innovation in financial markets is the safety net. Institutions covered by it receive a subsidy because insured depositors correctly perceive their risk exposure as virtually zero. These depositors--and other creditors who benefit from the stability brought to the banking system by the safety net--are willing therefore to provide funds to banks at much lower rates than are available to competing institutions. Moreover, the insured creditors--and many of the uninsured ones as well--do not feel the necessity to monitor their credit exposure because of the government guarantee and the other implications of the safety net. As a result, the government is required to monitor the risk-taking--to put itself in the shoes of the creditors--in order to protect the taxpayers and maintain financial market stability.

The existence of this subsidy is clear in debt ratings--which are virtually always higher at banks than at their parent holding company. It is clear in the higher capital ratios required of nonbanking financial firms, even those that receive the same debt rating as banks. It is clear in the tendency for banking organizations, when geographic restrictions were eased, to shift back to the bank and its subsidiaries those activities that, while authorized for banks, had been conducted in holding companies. Bank holding companies, the owners of most banks, have no doubt also gained by the higher debt ratings and lower cost of capital that comes from having as their major asset an entity--the bank--with access to the safety net. But holding companies also own nonsubsidized entities that have no direct access to the safety net. Accordingly, both bank holding companies and their non-bank subsidiaries have a higher cost of capital than banks that cannot be credibly explained by the holding companies' responsibilities to their insured depository institutions. Moreover, any benefit that holding companies might currently be experiencing from ownership of an insured bank can be expected to decline as the holding company's ability to expand its affiliations causes the insured bank to become a smaller part of the total organization.

Virtually all nonbank subsidiaries of bank holding companies, with the exception of Section 20 securities affiliates, were historically put in the holding company, not because the holding company could conduct broader activities than the bank, but for other reasons, such as geographic restrictions on the bank. As these restrictions have been eased over the last decade, the share of consolidated assets of bank holding companies associated with nonbank activities--other than Section 20s, whose purpose is to conduct a business that is not permissible for the bank itself--has declined by about 50 percent. Bank holding companies tell us that the primary reason for shifting back to banks those operations that can be shifted is to obtain cheaper funding and avoid limitations on funding transactions contained in sections 23A and B of the Federal Reserve Act. Activities that have stayed in holding company subsidiaries, we are told, remain there for tax reasons, inertia, and established names separate from the bank. In time, inertia will fade.

It is critical that the subsidy implicit in the federal safety net be limited to those activities that a bank can conduct directly. The Federal Reserve is concerned that operating subsidiaries would be a funnel for transferring the sovereign credit subsidy directly from the bank to finance any new principal activities authorized by either the Congress or by OCC regulatory action--imparting a competitive advantage to such entities. We approve of new principal activities, but we believe they should be financed competitively in the marketplace. Moreover, we do not believe that it is possible to bring to bear the separation of an operating subsidiary from its parent bank that one can introduce between a bank and its sister affiliates.

Rules can be devised to limit the aggregate equity investment made by banks in their subsidiaries. But one cannot eliminate the fact that the equity invested in subsidiaries is funded by the sum of insured deposits and other bank borrowings that directly benefit from the subsidy of the safety net. Thus, inevitably, a bank subsidiary must have lower costs of capital than an independent entity and even a subsidiary of the bank's parent. Indeed, one would expect that a rational banking organization would, as much as possible, shift its nonbank activity from the bank holding company structure to the bank subsidiary structure. Such a shift from affiliates to bank subsidiaries would increase the subsidy and the competitive advantage of the entire banking organization relative to its nonbank competitors.

I am aware that these are often viewed as only highly technical issues, and hence ones that are in the end, of lesser significance. I do not think so. The issue of the use of the sovereign credit is central to how our financial system will allocate credit, and hence real resources, the kinds of risk it takes, and the degree of supervision it requires. If the use of the sovereign credit is to be extended, that decision ought to be made by Congress in full recognition of the consequences of the subsidy on the financial system. But, it should not, in the name of some technical change, or in search of some minor efficiency, inadvertently expand significantly the use of the sovereign credit.

This issue would not be so important were we not in the process of addressing what must surely be a watershed in the revamping of our financial structure. But we are at such a watershed, and the Federal Reserve believes that we must avoid inadvertently extending the safety net and its associated subsidy without a thorough understanding of the implications of such an extension on the competitive balance and systemic risks of our financial system.

The safety net subsidy is difficult to measure and several observers have doubted its existence net of regulatory costs. Subsidy values--net or gross--vary from bank to bank; riskier banks clearly get a larger subsidy from the safety net than safer banks. In addition, the value of the subsidy varies over time. In good times, such as now, markets demand a low risk premium and it is difficult to discern the safety net subsidy. But, when markets turn weak, financial asset holders demand to be compensated by higher yields for holding claims on riskier entities. It is at this time that subsidy values are the most noticeable, as spreads open up between bank and nonbank claims. What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure.

The Federal Reserve has no doubt that the costs of regulation are large, too large in our judgment and we wish to reduce the degree of regulatory burden. But no bank has turned in its charter in order to operate without the cost of banking regulation, which would require that it operate also without deposit insurance or access to the discount window or payments system. To do so would require both higher deposit and other funding costs and higher capital. It is also instructive that there are no private deposit insurers competing with the FDIC. For the same product offered by the FDIC, private insurers would have to charge premiums far higher than those of government insurance, and still not be able to match the certainty of unlimited payments in the event of default, the hallmark of a government insurer backed by the sovereign credit of the United States.

The Federal Reserve has a similar status with respect to the availability of the discount window and riskless final settlement during a period of national economic stress. Providing such services is out of the reach of all private institutions. The markets place substantial values on these safety net subsidies, clearly in excess of the cost of regulation. To repeat, were it otherwise, some banks would be dropping their charters.

Safety and Soundness. Even if there were no subsidy issue, engaging in principal activities in an operating subsidiary exposes the bank--and hence the safety net--to greater risks. I am not arguing that the new financial activities that financial modernization would permit to banking organizations are unusually risky. But they do present additional risk as principal and any losses associated with these activities would have to be absorbed. If such losses were suffered by a bank holding company subsidiary, the loss would be consolidated into the holding company parent--an entity without direct access to the safety net. In contrast, if the loss occurred at a subsidiary of a bank, the loss would fall directly on the bank parent, increasing the risk exposure of the deposit insurance funds and the safety net. This difference is neither small nor technical. It lies at the heart of the matter.

The Treasury, as you know, has proposed and supported new principal activities in the operating subsidiary. It argues that potential losses in the operating subsidiary could be capped in such a way as to eliminate the exposure of the safety net. Under the Treasury plan, investment by a bank in its operating sub must be deducted from the regulatory capital of the bank, after which the bank's regulatory capital position must still be deemed "well-capitalized." Moreover, the bank would be prohibited from making good any of the debts of the failed subsidiary.

I should note that it is necessary that all of these prohibitions be statutory, since generally accepted accounting principles--GAAP--require that the subsidiaries' operations be consolidated with its parent and that courts determine if a parent is responsible for the claims on its failed subsidiaries. I should further note that what may be viewed as a regulatory matter as excess capital--the maximum amount that is to be invested in the subsidiary under this proposal--may or may not be excess in an economic or real sense. Regulatory accounting principles--RAP--are not often designed to reflect economic realities, as we saw last in the S&L crisis of the 1980s. Moreover, as I understand it, the RAP capital deduction for purposes of computing the level of a bank's investment in its operating subsidiaries would not be mirrored by a capital deduction for other regulatory purposes--like loans-to- one-borrower or dividend limit purposes.

And, I can assure you it will not be deducted for the GAAP bank statements that uninsured creditors and large loan customers will insist on reviewing before they conduct business with the bank. Thus, a capital deduction may matter for the regulators for some purposes, but it is not the way the market will view the organization.

In addition to being inconsistent with sound accounting standards (GAAP), the proposed deduction treatment also runs counter to the way that banks manage their subsidiaries, the way regulators have supervised subsidiaries and the way financial markets are likely to perceive the bank as a whole. Historically, both bank management and supervisors have considered subsidiaries of the bank to be an integral part of the bank (in fact they have been treated as departments of the bank) whose operations, if material, could have a significant impact on the bank's risk profile. Bank managers have invariably sought to support their subsidiaries in the past, and supervisors have carefully examined the operations of material subsidiaries in view of the difficulty in insulating the parent bank from problems in its subsidiaries.

Even if statutory barriers are erected that attempt to limit the impact of subsidiary losses on the parent bank, substantial losses in a subsidiary will likely erode the market's confidence in the management and health of the bank. This would be a critical development in the case of a bank whose stability--and whose level of risk to the federal deposit insurance funds--depends in large measure on its reputation and standing in the financial markets. A law may endeavor to mandate accounting and regulatory treatment, but it is not so easy to alter perceptions of counter-parties or the reality of financial markets.

It is worth noting that a dividend payment by a bank to its holding company results in a real decline in bank capital. This is a genuine constraint on the subsidy transfer from banks to their holding company affiliates and helps explain the reality that bank dividends historically have not chronically exceeded the dividends paid out by holding company parents plus debt service. The use of bank dividends to fund holding company expansion would, of course, incorporate a modest safety net subsidy since bank earnings are higher than they otherwise would be because of the safety net. But the capital constraint--plus the supervisor's natural tendency to guard against significant capital reductions--has limited such transfers. It is unlikely that a capital adjustment for regulatory purposes that is in conflict with GAAP would be as effective a constraint on the investments that a bank may make in its subsidiary.

Moreover, losses in, for example, securities dealing or fire and casualty insurance underwriting conducted in an operating subsidiary could occur so rapidly that they could overwhelm the bank parent before actions could be taken by the regulator. Put differently, losses in an operating subsidiary can easily far exceed a bank's original equity investment long before the supervisor has any such knowledge. The resulting bank safety and soundness concerns are only deepened by the extent to which past retained earnings of the operating subsidiary would have strengthened the capital of the parent bank--an ostensible reason for operating subsidiaries. Such a buildup in capital could be used to support other bank activities, and then eliminated by subsequent losses in the operating subsidiary, leaving the bank in an undercapitalized position.

The argument that operating subsidiaries are desirable because of the organizational flexibility they provide to bank management seems less than compelling. Having two options is better than one. But there is no real choice here. From the purview of banking organization profitability, the operating subsidiary is far superior to a holding company affiliate because of the funding advantage gained from access to the safety net. Hence, if profitability is the gauge, there is no increase in managerial flexibility. Rational management will always select the operating subsidiary.

Some observers have argued that operating subsidiaries should be allowed to conduct broad activities as principal in the U.S. because Edge Corporations, which are Congressionally authorized corporations chartered to conduct a banking business outside the U.S. and are largely owned by banks, have conducted a broader range of activities as principal outside the U.S. without damage to banks. As an initial matter, it is important to realize that there are only a handful of banks that engage to any significant extent through Edge Corporations in activities not permissible to their parent bank, and these engage primarily in various securities activities. Importantly, Congress authorized the Edge Corporation as a means to allow our banks to be competitive abroad. In order to do so, Edge Corporations had to be able to conduct outside the U.S. activities that are somewhat broader than those permitted domestically, provided the activities are usual in connection with the conduct of banking in the country in which the Edge Corporation operated. The Edge Corporation, therefore, conducts broader activities not because Congress believed that it was, as a general matter, prudent to permit subsidiaries of banks to conduct broad powers. Instead, Edge Corporations may conduct broader activities because they must be allowed to be as competitive as possible in the arena in which they compete--which is in foreign markets where the rules governing the activities of banks and other financial service providers differ from the rules in the U.S.

This same principle--allowing competitive equity--argues against authorizing operating subsidiaries to conduct broad activities within the U.S. As discussed above, the universal bank approach would allow banks and their subsidiaries a competitive advantage over U.S. securities and insurance firms that remain independent of banks--thereby inevitably impairing their competitive strength. Thus, given the structure of the financial services industry inside the U.S., the principle of competitive equity that gave rise to the Edge Corporation as a vehicle for conducting a banking business outside the U.S. argues against a similar vehicle within the U.S.

Others have concluded that the Federal Reserve's objection to operating subsidiaries is solely jurisdictional--solely turf. If by such comments, these critics believe that our concern is simply to maintain our status or prerogatives, they are mistaken. This has certainly not been our approach to bank powers. The Board was an early and strong supporter of interstate banking, knowing that it would induce shifts from state to national bank charters, reducing the Federal Reserve's supervisory role. Interstate banking was right for the economy, and we supported it. Operating subsidiaries are not, and that is why we oppose them.

V. H.R. 10 and the Community Reinvestment Act
It has also been argued that H.R. 10 damages the Community Reinvestment Act. The Board believes that this argument is incorrect. In fact, enactment of H.R. 10 would strengthen the CRA in very material ways.

The Board believes that the CRA has played an important role in encouraging banks to identify lending markets that may be underserved and to develop credit products and services in response to identified needs of their communities. H.R. 10 provides a compelling incentive for financial holding companies to continue these efforts by requiring as a prerequisite to the expanded powers and affiliations authorized by the bill that all of the subsidiary depository institutions have at least a "satisfactory" CRA rating.

Moreover, H.R. 10 adds teeth to the CRA. Currently, the CRA is enforced through the application process. But there is no current requirement that a depository institution divest a bank once a merger is approved if the bank fails to maintain adequate CRA performance levels after the merger. H.R. 10, however, requires that satisfactory CRA ratings be maintained as a condition for continued affiliation with companies authorized under the bill. Thus, a financial holding company has a strong incentive to assure that its depository institution subsidiaries continue to meet their CRA obligations. H.R. 10 also would expand the CRA to wholesale financial institutions, a new form of depository institution authorized by the bill.

There exists some confusion, however, as to whether the CRA would be further benefitted if banks were permitted to engage, either directly or through a subsidiary, in securities and insurance activities as principal. The CRA by its terms requires that the Federal banking agencies assess the record of depository institutions in meeting the credit needs of their entire community, including low- and moderate-income communities. While the CRA relates to the lending activities of depository institutions, it does not apply to securities or insurance underwriting activities--whether conducted by a bank, a subsidiary of a bank, or an affiliate of a bank. Accordingly, authorizing a bank to directly or indirectly conduct the securities and insurance underwriting activities authorized by H.R. 10 for financial holding companies would not increase a bank's obligations under the CRA, although it would expose the bank and its CRA-related lending activities to the earnings fluctuations and possible losses associated with such principal activities.

Under H.R. 10, banks would remain free to develop and offer the type of innovative or targeted lending products, either directly or through a subsidiary, that are designed to meet the identified credit needs of their communities and that are relevant to the bank's CRA assessment. Moreover, if a banking organization elected to engage in CRA-related activities through a holding company subsidiary, the organization would remain free under the CRA regulations issued by all of the Federal banking agencies to have the activities of the holding company subsidiary count towards the CRA performance of an affiliated bank.

VI. Commerce and Banking
Last year, the Board, in testimony before the House Banking and Commerce Committees, recommended caution about authorizing banking and commerce affiliations. We noted that technology was already in the process of eroding any bright line between commerce and banking. Nonetheless, we concluded that the free and open legal association of banking and commerce would be a profound and surely irreversible structural change that should best wait while we absorbed the significant changes called for by financial modernization.

Recent events have, if anything, strengthened our view on the desirability for caution in this area. The Asia crisis has highlighted some of the risks that can arise if relationships between banks and commercial firms are too close. It is not so much that U.S. entities would face structures like those in Indonesia, Thailand, or Korea. Rather it is the experience that interactions of complex structures can make it extremely difficult to monitor, analyze, and manage financial exposures. In short, the Board would prefer more experience with financial change as a prelude to considering further and more profound structural changes. We thus support the H.R. 10 provisions on commerce and banking.

H.R. 10, as passed by the House, prohibits the affiliation of banking and commerce, with three exceptions. Companies, such as securities and insurance firms, that engage predominantly in financial activities and that acquire an insured depository institution may continue to own commercial firms but must divest them within ten years (with the possibility of a further five year extension.) Financial holding companies that own only uninsured wholesale financial institutions also are permitted to retain limited grandfathered investments made as of the date of enactment of the bill, but are not required to divest them at the end of a specified period.

Unitary thrift holding companies--holding companies with only one thrift subsidiary--now may be affiliated with commercial entities. Only a few are, but H.R. 10 would grandfather the ability of all unitary thrift holding companies to establish commercial affiliations. For securities firms and insurance companies that acquire banks, however, H.R. 10 would not permit new commercial affiliations.

In light of the dangers of mixing banking and commerce, the Board supports elimination of the unitary thrift loophole, which currently allows any type of commercial firm to control a federally insured depository institution. Failure to close this loophole now would allow the conflicts inherent in banking and commerce combinations to further develop in our economy and complicate efforts to create a fair and level playing field for all financial service providers.

Accordingly, the Federal Reserve strongly supports the provisions of H.R. 10 that would prohibit new unitary thrift holding companies from having nonfinancial affiliations on a prospective basis. However, H.R. 10 would also permit existing unitary thrift holding companies to retain their current commercial affiliations, to expand those commercial affiliations, and to sell those rights to do so. Equity and fairness do not justify providing these grandfathered organizations such unique economic benefits. The Board, therefore, strongly supports an amendment to H.R. 10 that would at least prohibit or significantly restrict the ability of grandfathered unitary thrift holding companies to transfer their legislatively created grandfather rights to another commercial organization through mergers or acquisitions.

VII. Conclusion
The markets are demanding that we change outdated statutory limitations that stand in the way of more efficiently and effectively delivering financial services to the public. Many of these changes will occur even if Congress does not act, but only Congress can establish the ground rules designed to assure the maximum net public benefits and a fair and level playing field for all participants and to assure the continued primacy of U.S. financial markets.

The Senate has an historic opportunity to modernize our financial system by passing a bill that creates an unusually desirable framework. The Federal Reserve urges the Committee to establish a wider scope for the delivery of financial services through the holding company vehicle. This is the best way to minimize the spread of the safety net subsidy and its resulting competitive inequities, to minimize risks for depository entities and their insurance funds, and to facilitate a safe and sound banking and financial system that is able to serve the American public and maintain the leadership role of the American financial system in the global economy.


Attachment 1: Summaries of Prior Financial Modernization Legislation Considered and Passed by the Senate Banking Committee Since 1984

Attachment 2: Executive Summary of H.R. 10

Attachment 3: National Bank Market Shares


1 For the Committee's assistance, Attachment 2 to this testimony provides an executive summary of H.R. 10.

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1998 Testimony