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FINANCIAL SERVICES MODERNIZATION
THURSDAY, FEBRUARY 13, 1997
House of Representatives,
Subcommittee on Financial Institutions and
Consumer Credit,
Committee on Banking and Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. Marge Roukema [chairwoman of the subcommittee] presiding.
Present: Chairwoman Roukema, Representatives McCollum, Bereuter, King, Campbell, Royce, Metcalf, Ehrlich, Barr, Kelly, Paul, Weldon, Ryun, Vento, LaFalce, Schumer, Maloney, Barrett, Watt, Roybal-Allard, Ackerman, Bentsen, McKinney and Kilpatrick.
Also Present: Representatives Leach and Baker.
Chairwoman ROUKEMA. Please, the hearing will come to order. We are here to welcome our panelists, and certainly our Chairman of the Federal Reserve Board, and the other panelists.
As is too frequently the case, there are lots of conflicting schedules this morning; but we would expect more Members to arrive shortly. Of course, I do want to acknowledge that our chairman, Chairman Leach, is here today, as always thorough and diligent.
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We welcome you, Mr. Chairman. Thank you for being here.
Mr. LEACH. Thank you.
Chairwoman ROUKEMA. This is the second in our series of hearings here at the subcommittee level; and, as many of you know, it is our intention, both the subcommittee's and the full committee, to expedite consideration of reform this year. I fully expect that our subcommittee hearings are going to play an integral and constructive role in the development of that legislation.
This, as I have stated, is the second in the hearings. I see this as a relevant and important chapter in the search for a procedure so that we can pass landmark legislation in this Congress. Glass-Steagall did its job from the 1930's on to protect the safety and the soundness and economic concentration of power in a principled way, and it did protect consumers and businesses and the taxpayers of the Nation.
However, it is out of date, and we have to address the problems and modernize our financial institutions. But I will say, and many of you have heard me say this, almost like a broken record, we do not want another savings and loan debacle, that goes without saying, and we do not want another Depression where the savings of people are gambled away by either ignorant financiers or unscrupulous people, but we must have a financial system to compete in the modern world.
As we proceed with these hearings, our common goal is to provide for defined and principled legislation that will benefit the consumer by increasing competition in the financial service sector and preserving the safety and soundness of our system.
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Technology and market forces have broken down the barriers between banking, securities and insurance. Our parent statutory framework, as I said, is stuck in the 1930's; and it has led to an inability of our financial institutions to compete in a market that is most correctly defined as global.
In the absence of Congressional action, Federal agencies, and I hope no one here takes it very personally, but the Federal agencies have found loopholes and novel interpretation to allow financial institutions to adapt to this ever changing marketplace.
The actions of the Office of the Comptroller of the Currency are well known, and they authorize bank subsidiaries to engage in activities previously prohibited from doing so, and the Federal Reserve has proposed to eliminate firewalls as it applies to Section 20 affiliates. Unfortunately, in my opinion, this has resulted in a piecemeal regulatory reform that may not be in the best interest of the U.S. system.
I would expect that the regulators here today would confront these issues directly, and I look forward to their candor and intelligence and professionalism on those subjects.
Without exception, the Representatives of Congress have a responsibility, and it is our duty to make the important policy decisions giving statutory authority regarding the structure of financial markets. It is not in the best interest of the system to continue to let regulators make these decisions in a piecemeal or arbitrary fashion. For Congress not to act, and here I am speaking to our membership, not so much the regulators as I am speaking to our membership, for Congress not to act would be a serious abdication of responsibility.
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For those of us who are on the Banking Committee, we are fully aware of how controversial these issues are; and, to say the least, various sectors in the financial services industry have had different and often conflicting views on how to best go about modernization. Over a number of years, particularly the last two, the coalition known as the Alliance for Financial Modernization was formed to build a common framework for that modernization.
I believe you know the members. I won't go through the list. But there is an expanded list, beginning with the American Bankers Association; and more recently included is the American Council of Life Insurance who has come to the table. Indeed, in the hearing on Tuesday, the independent insurance agents expressed an interest in coming to the table, although not officially part of that Alliance. This Alliance, through a good deal of good faith negotiation and compromise, has come to agreement on reform, if not in every detail at least in a comprehensive way and an overriding way, an umbrella way.
But I, while recognizing that not everybody is in 100 percent agreement on everything in that legislation, I have, along with my colleague and Ranking Member here, introduced the legislation because it occurs to me that there are certain portions of it that are excellent. While we do not agree with every detail, we do believe that it is the most appropriate vehicle to bring everyone to the table and to be successful this year in accelerating consideration of reform.
I would say that conventional wisdom, without going into all the details of the legislation and going over it here today, I do want to point out two areas, at least, in which we have seen concern expressed. We will hear more concern expressed here, but we have also seen progress.
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The conventional wisdom suggests mixing banking and commerce would be detrimental to the overall vitality of the system because of potential conflicts of interest and potential for concentration of economic power. However, in today's world, the lines between banking and commerce are far less clear than they have been previously.
Various proposals recommend full banking in commerce. I do not support that, but there can be no doubt that full banking in commerce does have a constituency, but it has also far reaching ramifications, and the Alliance proposal, H.R. 268, takes an incremental approach and defines it as a ''25 percent basket.''
Clearly, it is time for reform. The Alliance bill repeals Section 20 and incorporates functional regulation, which is the second important controversial part of our consideration here, one: commerce; two: regulation, incorporates functional regulation which will ensure that all participants are playing on a level playing field.
Finally, the bill includes provisions that will close the last chapter, I hope, of the savings and loan debacle and the bill, that portion of the bill is very similar to, very close to, what I introduced last year, the Fifth Charter Conversion Bill, and also similar to the provision in the Leach bill.
Again, not to belabor the issue, this legislation, H.R. 268, is, to use the vernacular, ''a work in progress.'' I, along with other Members here, are willing to put our necks on the line in order to get a full and comprehensive debate on these complex issues. We want reform, but we do not want to compromise the basic soundness of our financial system.
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We want that bridge to the 21st Century, but it has to be on a firm foundation, and for that reason we are welcoming the regulators here today. I hope that their testimony, and I do not expect their testimony to be limited to H.R. 268. I want them to address in whichever way they are comfortable with, the overarching principles, the need, the imperative need for reform.
I have to say that I welcome all of those, certainly the Chairman of the Fed and the others here, who have gone out of their way and rearranged schedules.
Mr. Chairman, I don't want to embarrass you by referring to your jet lag. I refer to it only because you have gone well out of your way in your schedule to be here today, and others have as well.
Unfortunately, unfortunately, Treasury is not here. I have discussed at length their intentions. They did not feel that they were prepared, or far enough along in the consideration of their legislation, to be here today, and I deeply regret that. I think we could have greatly benefited by their testimony, but they are not here. I would hope that as soon as possible they will consent to come before this subcommittee and give us the benefit of their proposals, because they are wrestling with the same issues that we are wrestling with here today.
With that introduction, Mr. Ranking Member, do you have a statement to make?
Mr. VENTO. Well, thank you, Madam Chairwoman.
We had opening statements on Tuesday. I would just say that in our mixed economy the regulators and witnesses that are testifying today are at the interface of dealing with the market forces and our public policy initiatives in terms of guiding our economy. I think that is, you know, no better epitomized than the Chairman of the Board of Governors, Mr. Greenspan's presence this morning.
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I regret, too that the Treasury was not prepared, but I would say that this agenda is a very full agenda in terms of the testimony and information in that a member of the administration, Mr. Ludwig, also a regulator, will be testifying and will have views and guidance for us with regards to the banking modernization.
We face a problem of dealing with the convergence of financial institution activities, the opportunity to get out in front of that and to provide the needed regulatory flexibility and involvement, and the necessary safeguards to achieve a consequence of extending credit, of keeping these financial institutions and the financial related activities in a profitable mode in terms of serving our economy and importantly and ultimately serving the consumers in this Nation.
I think much has been done. I think the regulators have attempted to do this to the limits of what the current law provide, some would say in excess of what the current law provides. At times, I know I have made that observation; but, in reality, I think we have come around to the recognition that the franchises and powers that we here tried to extend to banks and to other entities now have been eclipsed by the marketplace activities.
So coming to grips with this in this legislation, I don't know how prescriptive we can be with it. I think we have to be cautious and realize that we need to give the opportunity for the regulators and for the market forces to continue to shape this. I think the wisdom, if Glass-Steagall was the right thing to do, I note that some are involved in rewriting the history of why Glass-Steagall existed and what the consequences were in the 1920's and 1930's. I must say it leaves me a little cold. I am more interested in looking ahead than thinking too much about it.
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But the fact is that we need to--I think the reason that it functioned for so many years is because it did capture the necessary mix and relationship between financial institutions at that time and put it in a working format.
We have to change that format today. And the question is how we do it. In a way, of course, there is a question of regulation, a question of corporate structure. There are many questions that we need to resolve.
I think the measure we have before us goes a long way to try to take some of the best ideas which have been developed, not all unique and original, with the, if I might say, with the chief sponsor and myself. But, in the business of legislating, plagiarism is not necessarily considered a prosecutable activity. In fact, we thrive on it, taking good ideas.
We look forward to, as the Chairwoman has said, we are working with a work in progress, so we look forward to the testimony today. I think we are very much in the formative stage with regards to this. So there have been many contributors to this process, and I know that there will be at this hearing, as we look at these structures. Hopefully, we will be able to come up with consensus legislation in this session that will have as lasting effects as that which was written during the 1930's.
Thank you, Madam Chairwoman. I look forward and welcome our witnesses. Thank you.
Chairwoman ROUKEMA. Thank you.
I think, without further ado, we will turn the panel over to our chairman, Mr. Greenspan, the Fed Chairman, and welcome you here most enthusiastically. Thank you, Mr. Chairman.
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STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, FEDERAL RESERVE BOARD
Mr. GREENSPAN. Thank you very much, Madam Chairwoman. I have submitted a statement for the record but would like to summarize it, if I may.
It is a pleasure to appear before this subcommittee here today to present the views of the Federal Reserve Board on some broad issues associated with reform.
We continue to support reform because we believe it would provide improved financial services for our citizens. Moreover, both our experience and analysis suggests that the additional risks of new financial products are modest and manageable. However, we urge that care be taken to assure that these newly permitted activities are financed at non-subsidized market rates. While a level playing field requires broader powers, it does not require subsidized ones.
The issue is relevant because the Congress in this century delegated the use of the sovereign credit to protect bank depositories, stem bank runs and lower the level of risk to the financial system from the insolvency of individual institutions. By sovereign credit, I mean the power to create money and borrow unlimited funds at the lowest possible cost.
In insuring depositors, the government, through the FDIC, substituted its unsurpassable credit rating for those of banks. Similarly, using the Federal Reserve's discount window, banks can convert illiquid assets, such as loans, into riskless assets; and banks can complete payments using Federal Reserve credits. All these uses of the sovereign credit have dramatically improved the soundness of our banking system and the public's confidence in it.
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In the process, it has also profoundly altered the risks and returns in banking. For example, sovereign credit guarantees have significantly reduced the amount of capital banks and other depositories need to hold, since creditors demand less of a buffer to protect themselves from the failure of institutions that are the beneficiaries of such guarantees.
In addition, depositories have been able to take greater risk in their portfolios than would otherwise be the case, because private creditors, depositors and others, are less affected by the illiquidity of or losses on the bank's portfolios. The end result has been a higher risk adjusted rate of return on depository institution equity.
The enhanced ability to take risk has contributed to economic growth, while the discount window and deposit insurance have contributed to our macroeconomic stability. But all good things have their price. The use of the sovereign credit in banking, even its potential use, creates a moral hazard that distorts the incentives for banks: the banks determine the level of risk taking and receive the gains therefrom but do not bear the full costs of that risk. The remainder of the risk is transferred to the government. This then creates the necessity for the government to limit the degree of risk it absorbs by supervising and regulating banks.
The subsidy is an undesirable but unavoidable consequence of creating a safety net. The United States Government has been remarkably successful in containing the value of most of the subsidy within depository institutions, I believe in large part because of the bank holding company organizational structure.
To be sure, bank holding companies have indirectly benefited from the subsidy because their major assets are subsidiary banks. The value of the subsidy given to the subsidiary banks has no doubt been capitalized in part into the share prices of holding companies and has improved their debt ratings, lowering their cost of capital. But holding companies also own non-subsidized 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.
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This is clear in the debt ratings of bank subsidiaries of bank holding companies, which are virtually always higher than those of their parent holding companies. Moreover, existing law and regulation under Sections 23(A) and 23(B) of the Federal Reserve Act require that any credit extended by a bank to its parents or affiliate not only be totally collateralized and subject to quantitative limits, but also be extended at arm's length and at market rates, making a direct transfer of the safety net subsidy difficult.
It is true that a bank could pay dividends from its earnings, earnings which have been enhanced by the safety net subsidy, to fund its parent's non-bank affiliates. However, the evidence appears to be that such transfers generally do not occur. The result is highly desirable since, as I noted, safety net subsidies have costs in terms of distorted incentives and misallocated resources. That is why the Congress must be cautious in how the sovereign credit is used.
It has been suggested that the bank holding company structure imposes inefficiencies on banking organizations and that these organizations should, thus, be given the option of conducting expanded financial activities in a direct subsidiary of the bank. The bank subsidiary might be a marginally more efficient way of delivering such services, but we believe it cannot avoid being a funnel for transferring the sovereign credit subsidy directly from the bank to finance the new powers, thereby imparting a subsidized competitive advantage to the subsidiary of the bank.
One can devise rules, such as Sections 23(A) and 23(B), to assure that loans from the bank to its own subsidiaries are limited and at market rates. One can even devise rules to limit the aggregate equity investment made by banks to 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.
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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 non-bank activity from the bank holding company structure to the bank subsidiary structure. Such a shift would increase the subsidy and the competitive advantage of the entire banking organization relative to its non-bank competitors.
I am aware that these are often viewed as only highly technical issues and, hence, ones that are, in the end, of little 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 risks it takes and the degree of supervision it requires.
If the Congress wants to expand the use of the sovereign credit further, to achieve a wider range over which the benefits of doing so can accrue, it ought to make that decision explicitly and accept the consequences of the subsidy on the financial system that come with it. But it should not, in the name of some technical change or in search of some minor efficiency, inadvertently expand 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 regulatory structure. We must avoid inadvertently extending the safety net and its associated subsidy.
If banks were permitted to engage in new activities in their own subsidiaries, inevitably virtually all holding companies would shift those activities now conducted in holding company affiliates to bank subsidiaries, eviscerating the holding company structure. Were such shifts to happen solely as the result of operational efficiencies, no one, including the Board, should mourn the demise of the holding company. But if, as I suspect, such shifts occurred because of the attraction of a government subsidy, we should be concerned because the insidious effects of such subsidies would have spread.
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As new activities hopefully expand for banking organizations, we believe that it is essential that we assure that they are financed at market rates, not subsidized ones. This will not always be easy, but the bank subsidiary vehicle strikes me as one that will surely extend the subsidy.
At bank holding companies, containment of subsidies is often implemented through firewalls and other devices which could also inhibit the very synergies which the expansion of activities is meant to achieve. But we have dealt with these tradeoffs before and should be able to in the future as well.
Madam Chairwoman, whether new activities are authorized in bank subsidiaries, bank holding companies, or both, Congress in its review of financial modernization must consider legal entity supervision versus umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit.
The bank holding company organization is increasingly being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such, especially their risk postures.
To understand the risk controls of the bank, we have first to come to grips with the fact that the organization is interested in risk and its control, not by instrument or legal entity, but for the entire business. This type of control is being adopted by more and more organizations each year and can only increase as more activities are authorized by the regulators and the Congress.
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Regulatory policies and operating procedures have had to respond to these realities, to focus on the process of decisionmaking for the total organization. The process, if not everything, is critical; and that process is determined increasingly at the parent holding company for all of the units of the organization on a consolidated basis.
One could argue, as several witnesses appearing before this subcommittee did on Tuesday, that regulators should only be interested in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors.
Indeed, our experience has been that a problem in one legal entity can have a contagion effect in other entities. If a bank affiliate begins to have difficulty, the market evaluates the problem as the consolidated entity's problem and can bring pressure on all units. These pressures usually take the form of funding or liquidity difficulties as creditors seek to reduce their exposure to all units of an organization that seem to be having trouble. Better safe than sorry.
Indeed, it is in the cauldron of the payments and settlements system, where decisions involving large sums must be made in short periods, that this contagion effect might first be seen as participants understandably seek to protect themselves from the uncertainty that accompanies this contagion effect; and that is how crises often begin.
We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect the shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focused on the key risk management processes, it would sharply reduce routine supervising umbrella presence in holding companies.
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We would hope that Congress recognizes that a bank which is a minor part of a broad based financial organization can be protected through adequate bank capital requirements and the application of Sections 23(A) and 23(B) of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company which, because it owns only a small bank, does not have material access to the safety net.
As I noted when discussing the safety net and bank subsidiaries, attached to all uses of the sovereign credit come efforts by the government to protect the taxpayer. Those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the non-safety net activities of banks without acquiring a bank.
If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies that own more than a small bank, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy.
Finally, let me turn to an issue that has bedeviled supervisory regulatory discussions for years, the potential separation of commerce and banking.
Just as the lines between banking and other financial institutions are often already difficult to discern, the boundaries between finance and non-finance are likely to become increasingly indistinct as we move into the 21st Century.
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Newer technologies will make it highly unlikely that the walling off of any ownership of financial institutions by non-financial businesses and vice versa can be continued very far into the 21st Century. Nonetheless, the Board has concluded that it would be wise to move with caution in addressing the removal of the current legal barriers between commerce and banking.
Were we fully confident of how the structure would evolve, we could presumably construct today the regulations which would foster that revolution. But we cannot be certain. If under such circumstances we change the rules now about banking and commerce, we might end up doing more harm than good.
Excessive delay, however, would doubtless produce some inequities. Expanded financial activities for banking organizations requires, the Board believes, that those firms operating in markets that banks can enter should, in turn, be authorized to engage in banking. A complete commerce and banking prohibition would thus require the divestiture of all non-financial activities by those organizations that wanted to acquire or establish banks.
The principle of caution suggests an approach which may prove useful. Perhaps those organizations that either have or establish well capitalized and well managed bank subsidiaries should be permitted a small basket of non-financial assets, a certain percentage of either consolidated assets or capital. A small permissible basket would establish, in effect, a pilot program to evaluate the efficacy of further breaching of the banking and commerce wall. We found that such a slow and deliberate policy worked well with Section 20 security affiliates.
Of course, some non-banking firms would find that their non-financial activities would exceed a small basket exemption. Such excess nonconforming assets might be addressed on a case-by-case basis with a scheduled longer term divestiture to avoid the worst short term inequities. A basket clause plus case-by-case review of individual situations might also provide a way to make available a common bank and thrift charter to those unitary thrifts that are affiliated with non-financial businesses.
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Madam Chairwoman, the Board has no firm opinion on just exactly how such tradeoffs might be made, constrained only by the general concerns I summarized earlier.
Thank you very much.
Chairwoman ROUKEMA. Thank you, Mr. Chairman. As always, you have given a conceptually comprehensive exposition of the values of the services of the Fed. Of course, you have given us the benefit of your experience. A lot in your testimony.
[The prepared statement of Hon. Alan Greenspan can be found on page 433 in the appendix.]
Chairwoman ROUKEMA. Let me present just two short, well, two questions. I don't know how short they are. And then I will let my colleagues have a go at it.
Now, you address this question of the safety net subsidy, but let me ask the question my way, recognizing that some of your answer will be redundant, but I think it is important to go over this again. You warn in your testimony that we must not inadvertently extend what you reference as the ''Federal safety net, without a thorough understanding of its implications, and such an extension would be a risk to the competitive balance and the systemic risk of our system.''
To what degree would you think the systemic risk would be increased by permitting banks, and I know you address this, but I want you to go over it again, by permitting banks' operating subsidiaries to engage in these non-bank activities? Go over it again in relationship to the safety net subsidy, because I have another question on the definition of that subsidy.
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Mr. GREENSPAN. OK. The first thing that I think is important to recognize is that the subsidy exists. There is concern amongst a number of analysts and commentators about whether, in fact, we do actually have a subsidy in the sense that a number of bankers argue that the cost of regulation, deposit insurance, when it is other than zero and a number of other elements that are involved in banking, exceed the benefits to whatever extent they are of such a subsidy.
The answer to that is twofold: first, that the subsidy exists is very clearly demonstrated by comparing finance companies or other types of intermediaries of a comparable credit rating with banks, in other words, getting the same credit rating of the finance company and the bank with essentially the same sort of assets.
What you find is that, in today's market, that finance companies require 6 or 7 percentage points higher capital/asset ratios than do banks; and the reason for that is the market requires that they have more capital because the bank, through its availability of the discount window and deposit insurance, is able to have a far more flexible system and an insured system than are nonsubsidized finance companies. So that the subsidy exists and that it has a significant effect on earnings of the banks strikes me as not an open question.
The key question with respect to the subsidiary of the bank is whether that subsidy which exists in the bank itself more easily can be transferred as equity from the bank to the sub of the bank than from the bank to the holding company.
I don't want to get into the details because we will be here all today.
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Chairwoman ROUKEMA. Why is that important to us in terms of our statutory definition? Why is that important?
Mr. GREENSPAN. It is very important because if you create a sub of the bank and allow it full powers that exist in the type of expansion of powers that we are contemplating in a number of the legislations, I am reasonably certain that the affiliates of the bank with the subsidized equity credit will have lower costs of capital than competitors in other areas of the economy and that what you will do is create an unlevel playing field in which the banking organization, because it concentrates its competitive activities within the bank sub, has competitive advantages because of the government subsidy not available to other players in our economy.
Chairwoman ROUKEMA. I said I had two questions. I think you have answered the second question, but let me make reference to it in any case.
Later, one of our panelists, Mr. Ludwig, will take issue with that by saying that there is no ''net'' subsidy. I think you have addressed that from your perspective. He will have the opportunity to refute it. But is there anything more that you want to say, with respect to that no ''net'' subsidy, in the context of observations? I don't know whether or not you have seen that testimony.
Mr. GREENSPAN. Yes, I did, and I hesitate to argue with Gene Ludwig, who is one of my regular golf partners and I am worried----
Chairwoman ROUKEMA. Well, this is the time to get back.
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Mr. GREENSPAN.----That if I am too unfriendly he won't give me five-foot putts like he tends to do.
But I have read his arguments, and I must say I do not agree with them. He raises questions, as I recall, as to whether there is a subsidy; and then, like a good lawyer, he says, if there is not, then such and such.
But if the subsidy weren't there and it wasn't more valuable to have deposit insurance and access to the discount window, it strikes me that there would be an awful lot of banks who, burdened with all of the excess stuff we put on them, and we do, would abandon their bank charters and go do their own thing without that.
Most importantly, this is visible when you take a look at deposit insurance. Deposit insurance is very clearly a much higher value than the price that is paid. I refer to Federal deposit insurance. If that were not the case, we would have a lot of private deposit insurance competitors and what is very evidently the case, that you will look far and wide for people who are willing to abandon the Federal deposit insurance for private insurance. So that clearly is evidence that the benefits far exceed the costs as perceived by the banks.
I don't want to get into a number of the details that Gene Ludwig raises, but he does raise the question with respect to the question that the holding company debentures, as I mentioned in my prepared remarks, have a lower credit rating than the parent. And he argues--the parent bank--I am sorry. They have a lower credit rating than the bank, and he argues that that is evidence that subsidy, that since the gap is very small between the interest rates on the debentures of the holding company and the bank, that the subsidy is small.
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What that reflects at this particular time is the relative degree to which the subsidy spills over from the bank into the holding company. It says nothing about the level of the total subsidy that exists within the holding company itself. Even there, I might say that he quotes, as I recall, 4 to 7 basis points difference. Usually, it is a much higher number, and the reason it is different today is that all yield spreads have converged very sharply. This is unusual and won't exist very long.
He raises a number of other issues that perhaps I better insert my remarks for the record rather than take up the time.
Chairwoman ROUKEMA. Please. I would appreciate that, and I can assure you that Members of this subcommittee will be going over in detail the testimony, both yours and Mr. Ludwig's. I think this is a very educational indication of how complex the issues are that this subcommittee is going to have to deal with this year, but we must confront them head on. I appreciate your testimony.
Mr. Vento.
Mr. VENTO. Thank you. Thank you, Madam Chairwoman.
I think the sovereign credit, that is to say, the issue of deposit insurance Fed window and wire issues, there is obviously this debate about the magnitude to which and how they carry through in terms of corporate structure; and, of course, the question is how do you limit, you know, this risk.
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I mean, I don't think any of us, I mean, everyone talks a lot about free enterprise. It is just they only like one side of it. That is where they make money. They don't like the side about losing money. So they want to get as many of their assets under the protection that they can.
I guess that is human nature. And I guess the question for us is, you know, your conclusion is that the bank holding company structure somehow gives an advantage in terms of limiting this particular structure. But that, as I mentioned earlier in our informal conversation, has only been around for 26 years or so; and I think the challenge for us is to, obviously in modernization, to try to prevent risk.
I mean, I think there has been an expansion of the deposit insurance in terms of the fact that some of the instruments and the convergence of financial activities inside banks begins to take on many aspects. After all, it is during this same 26 years that we had the problems with the thrifts and the problems with the banks. So it isn't obviously something that is completely--we have had some serious problems in spite of the fact that we have had this type of structure in terms of the expansion.
So our question is, is this type of holding company structure the only way? Do we have to, or does the marketplace have to, reflect some specific type of legislated corporate structure in order to actually provide regulation? In other words, can we effectively deal with preventing that basic subsidy insofar as it does exist? I will leave that between you and others. I have read this, but isn't there other ways that we can do it?
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Mr. GREENSPAN. I don't think you can fully prevent some leakages, because it is a very powerful force which moves around a bit. But what you can do is significantly limit its expansion so as not to corrode the overall incentive structure in the financial system.
Having looked at this issue in some detail, and it is a very complex question, we have concluded at the Federal Reserve Board that the holding company structure is by far the superior means by which you can contain the effect of the sovereign credit subsidy moving out of the bank where it is located into any other series of entities.
The issue is how one structures the system; and while you can theoretically impart similar barriers in the bank sub and in the affiliates for bank holding companies, in our judgment you never can make them equal. In other words, there is no way to avoid the fact, no matter what you do, that if you have expanded activities in a sub of a bank, that equity will flow into that sub at subsidized competitive rates. There is no way to avoid that.
The only thing that can be done is to find a structure for these expanded activities, which we all support, which delimits the expansion of the safety net and delimits the subsidies thereof. Because it is only under those conditions that you can get the true advantages of market incentive forces and the type of viable economic structure which we have developed in this country to function effectively, and it is that issue which I think is at the cutting edge of determining what type of structure we have.
Mr. VENTO. All that talks about is what firewalls. Obviously, if you have a holding company, it doesn't lend itself to the profitability or the ability of banks to respond to the marketplace and other financial entities. We end up with, in essence, no net gain. But I know that that is not the intent. That is why you are asking for streamlining of the holding company structure and activity in the statement that you made.
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One of the questions, of course, that we should address is the acquisition merger and the shape of the financial marketplace tomorrow in terms of the size of entities. In some views, it is reported that if, in fact, modernization will lead to merger acquisition of larger entities made up of both commerce and banking type of entities. In fact, even international, there is some, you know, suggestion that if we, in fact, write this legislation, don't prevent it, we could be owned by other entities on a global basis.
It seems to me, Mr. Chairman, that much of this business is becoming more global; and it is quite likely that we are going to have significant ownership on a global basis of financial entities in any case. The question is: Are there some words of wisdom briefly that you could offer that would guide us in terms of this merger acquisition concentration, even something as terrible as, in some folks' minds, as foreign ownership?
Mr. GREENSPAN. I don't know whether I can offer words of wisdom, but I will try to tell you how what I know. I don't know how you would characterize that.
Let's first remember that we are moving increasingly into a global environment. This is characterized by the fact that total trade is expanding far faster than the domestic, gross domestic products of the individual countries in the world, which means of necessity that, on average, imports are rising as a share of domestic demand and inevitably so is finance.
I don't think this should be something we should be concerned about. It is the inevitable way in which standards of living rise, and so long as there is a level playing field constructed in the United States I don't think that we should in any way be concerned about foreign holdings of U.S. institutions.
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With respect to the concentration question, I think that I am not terribly concerned about it; and I would be if I thought that it would somehow impact on our community banking structure, which I think is a very important and crucial element in our society and the dual banking system with which it is related. I think it has been a very effective mechanism for economic growth in this country and were I concerned that the issue of globalization would somehow impact on that, I would be a bit worried.
I don't believe so. My view of the way our small banking system functions, especially when you view it in the context of some of the larger banks trying to get into the markets of those community banks, is that you cannot substitute for the personal contact that community banks can offer, which larger banks can never compliment.
The consequence of this is that no matter how complex technology becomes, now matter how much the system increasingly gets structured with different types of various risk management systems, you will never get away from the issue of what I call ''character banking.''
And ''character banking'' is essentially what we mean by community banking. I think that has got a very strong, competitive edge in this country, and I do not believe it is subject to pressure.
Mr. VENTO. Thank you. I note your statement also has a special reference to provide some liberal treatment of community banks.
Thank you, Madam Chairwoman.
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Chairwoman ROUKEMA. Chairman Leach.
Mr. LEACH. Thank you, Madam Chairwoman.
Mr. Chairman, you have defined access to the discount window and the payment system as, effectively, government subsidies. Is it conceivable to you that it is prudential to allow parties access, particularly to the payment system, without any Fed oversight?
Mr. GREENSPAN. I would say one should be quite careful about that. Specifically it is most relevant in the issue of the payment system, and the reason I suggest you have to be careful is that as we run, for example, so-called ''Fed wire,'' which is a major system which has got a fund of risk free final settlements associated with it, which means we have a competitive edge which we have to be careful of because of that, in that system when we get individual institutions which are poorly rated, we make certain that they do not have access to significant amounts, or any, for that matter, of so-called ''daylight overdrafts,'' which is what occurs during the day. It is the type of credit which the central bank extends during the day as a system engenders these huge amounts of payments.
What happens if there is a failure is that we are required either to allow the failure to exist, meaning not a failure of payment, but an insolvency, which has very major consequences in the payment system; or we give a loan to the institution at the end of the day through the discount window.
When we know how risky an individual institution is, we can contain our extent of ''daylight overdraft'' and discount window privilege so as not to risk taxpayer funds in bailing out individuals who are less than creditworthy.
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If there are organizations which gain access to that system and we do not know whether they are creditworthy or not, we don't know how to handle the ''daylight overdraft'' cap problem, as we call it, nor whether there should be access to the discount window. As a consequence, we think it is important that a certain minimum amount of evaluation be available to the Federal Reserve if institutions want to move funds for final settlement through the Fed payment system.
Mr. LEACH. I appreciate that. One of the debates that is going to be occurring in the development of this legislation is the question of functional regulation. Virtually everyone supports functional regulation, but then the question is, ''Is there going to be only functional regulation?''
It strikes me if you postulate good actors and good times and not particular convergence of decisionmaking, only functional regulation is relatively persuasive. But if you postulate the possibility of bad times, the possibility of bad actors, and the possibility of convergence of economic decisionmaking within multifaceted corporations, you almost have to have a Fed oversight role.
Now, does that strike you as valid or invalid?
Mr. GREENSPAN. No, I think it is valid, Mr. Chairman.
I used to be a strong supporter of functional regulation about 10 years ago. The reason I was, was that it was not clear at that time that there would be any quick evolution of consolidated activities within holding company institutions, and that, therefore, it was perfectly adequate to have individual entities within a holding company separately examined and not be terribly concerned about what the state of the parent was.
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What has happened is a much more rapid degree of movement toward consolidated entities, where the decisionmaking process has increasingly moved from the subsidiaries, the individual activities, to the total, to the consolidated unit. So that now what happens is, in all of the major institutions, risk management is accomplished at the holding company level for all of the entities. That is where the crucial business decision is made.
If you do not have oversight of that particular decisionmaking process, then you are missing a very crucial part of supervision and regulation.
One may argue that you don't need to do very much, and I agree with that; I think that often we do far more regulation than is required and, indeed, as I mentioned in my prepared remarks, since it has become obvious to us how this structure has occurred, we are moving rapidly to a new paradigm of regulation. We have been moving for the last couple of years, and we hopefully will arrive at a point where the degree of supervision, regulation, examination, and the whole panoply of structure we are involved with is very significantly reduced.
But at the end of the day, it is very difficult to get around the fact that we cannot subject the taxpayer to the types of losses which would exist if we did not have the full type of evaluation structure that is necessary with umbrella supervision.
Mr. LEACH. I thank the Chairman.
Chairwoman ROUKEMA. Congressman LaFalce.
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Mr. LAFALCE. Thank you very much, Madam Chairwoman.
Dr. Greenspan, first I want to thank you and praise your staff. In December, you extended the courtesy of providing briefings by your staff on the various issues that are confronting our subcommittee, and you have undoubtedly the finest staff in the world, and you should be commended on that.
Mr. GREENSPAN. Thank you.
Mr. LAFALCE. Second, this year I begin my 23rd year on the committee and in Congress, and for the first time in that entire tenure, I am rationally exuberant about the prospects for financial modernization legislation passing. I was irrationally exuberant in the past, but this year I think I am rationally exuberant. So I hope it happens.
In the past, you and the other regulators, though, have not listened to the calls of some individuals in Congress for inaction in trying to bring Depression Era legislation to the marketplace realities of a cyberspace economy. You have been creative and the courts have ruled, invariably unanimously, that you have been correct in doing that. I commend you and the other regulators for doing that, but I encourage you to keep doing that, because it is always possible that even rational exuberance could turn into incorrect or inappropriate exuberance.
My first question is, having said all of this: Do I buy or sell on the Dow Jones today? No, you don't have to answer that question, since everybody is following your word so closely. Let me get serious for a second. This has little to do with financial modernization, but I always want to ask you the questions that are uppermost in my mind when I have the opportunity.
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Lately there have been a lot of writings--something was just put out by an author under the auspices of the Institute for International Economics, George Soros just came out with a book, and so forth, and they have to do with the serious, serious problems of global capitalism.
We have been talking about the tremendously increasing global economy, and in your comments, you talked about how that is necessary to raise standards of living.
Those certainly do that, for some, and perhaps it does this in the aggregate, but it could also leave an awful lot of individuals much further behind.
Are you familiar with the writings and statements of Soros on this issue, the recent work that was done at the Institute for International Economics? Is somebody at the Federal Reserve Board looking into this?
Mr. GREENSPAN. Well, I think we obviously function in an international context, and since the dollar is the major reserve currency of the world, it is incumbent upon us, if we care about the interaction of the rest of the world on dollar holdings, which affects us, that we be very knowledgeable about what is evolving, at least as much as that is feasible.
I don't want to comment on individual notions, unless you want me to, but I would just say generally that what is driving this tremendous globalization is technology, largely, and the ability to create an ever smaller per unit weight of the gross domestic product, if I may put it that way. In other words, we are downsizing all various different types of products, so everything is very small.
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Mr. LAFALCE. Maybe I didn't make my point clearly enough, so I would ask you to respond in writing. I am not looking at the overall, the macro. I am looking now at the micro, and there could be an awful lot of winners in this. It is the losers that we have.
Mr. GREENSPAN. I am addressing that subject.
Mr. LAFALCE. OK.
Mr. GREENSPAN. What I am saying is, as you get to increasing technology, which means that globalization is reflecting the expansion around the world of smaller and smaller physical things, which is the reason they are able to be moved, intellectual products are becoming of ever increasing importance everywhere.
What that means is that we are getting, as we have in recent years, a significant spread between those who have the type of knowledge that is required to deal in that society and those that do not. And this is reflected in the growing gap between the earnings of those who are college educated and those who are high school educated. And if you go from high school to high school dropout, the gap moves even more apparently.
What this suggests is, and one of the reasons why the income distribution in the United States has begun to spread is, it is an education problem that we are dealing with, and that is a problem that exists all around the world. It is not a function of any defect of capitalism, per se.
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Mr. LAFALCE. I have heard you give that explanation before. I encourage you to read the most recent documents on it, because while I think your answer is partially correct, I think it is only partially correct, and I think there are a great many other causes that we must examine and look into.
So I do not dispute what you are saying, but I think that is only a piece of the pie. How large a piece, we could debate, but only a piece of it. Therefore, I find it inadequate.
Madam Chairwoman, let me ask unanimous consent to, number one, introduce into the record my opening statement. Number two, I have approximately a dozen questions dealing with two basic subjects: A, functional regulation; and B, banking and commerce, and I would like to submit them to all the regulators and ask for their written responses.
Chairwoman ROUKEMA. So moved.
[The prepared statement of Hon. John J. LaFalce can be found on page 430 in the appendix.]
Chairwoman ROUKEMA. Dr. Paul.
Dr. PAUL. Thank you, Madam Chairwoman.
Welcome, Mr. Chairman.
It has been reported in the media on occasion that sometimes your words are confusing.
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Mr. GREENSPAN. I seem to work at that.
Dr. PAUL. But in reading over your testimony, there were a few items that I thought were very clear and very interesting. For instance, this concept of sovereign credit and your attack, or criticisms, of the expansion of subsidies. You say, ''The use of sovereign credits in banking, even its potential use, creates a moral hazard that distorts the incentives for banks.''
I find that very interesting and very pertinent.
Likewise, you also indicate some caution about the unsurpassable sovereign credit as an undesirable consequence of the system. I share your concern about the spreading of this subsidy, because this could be an undue burden placed on the taxpayer. Yet my question and my concerns are more directed toward the whole concept itself.
If there are moral hazards and there are concerns and undesirable consequences, shouldn't we rather not be just having a holding action, but questioning whether or not the system is a good system?
The system has been created, it is not created out of thin air as credit is. It is a creature of the Congress, and in many ways a creature of the courts. Yet if one were inclined to look at some guidelines that we are supposed to occasionally look at, and that is in the Constitution, there is very restrictive language there about what we can do with sovereign credit.
We don't read about sovereign credit in the Constitution. Article I and Sections 8 and 10 are very specific and limited as to what we can do. But we are at that point today where we are concerned about the spreading of the subsidy.
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And I am delighted you used that word, because that is what it is, and I will be certainly on the side of preventing the spread of a subsidy.
But my question really in a way is philosophic to you. Can you conceive of a system that might be entirely different than the one we have where we don't grant the subsidy and we don't grant this ability for banks to have the wrong type of incentives, and maybe prevent the financial bubbles that have occurred continuously over the last 70 or 80 years? And yet today there are many concerned about some of the financial bubbles, the trillion dollar foreign debt we have. The amount of debt that our foreign central banks hold now is well over $600 billion, and we have a stock market that is soaring. This is a reflex, I believe, of this sovereign credit notion.
So is there another system that, instead of going in the direction of trying to hold back the spread of the subsidy, saying, ''Is this subsidy proper? Is it moral? Is it correct? Is it Constitutional?''
Mr. GREENSPAN. Well, I think you are correct, Congressman, in stipulating that the concept of the sovereign credit does not exist in the Constitution, and the reason is that it never entered anybody's mind at that time, because what the sovereign credit implies is fiat money. That is, we had no sovereign credit in this country in the early years because we were effectively on a gold and silver standard for a very significant part of the history of this country.
It is only when we chose to move off the gold standard and to a fiat money system that the concept of sovereign credit emerged.
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The issue is a debate between two major different forms of financial systems. The earlier system, which was essentially constrained by the existence of the gold standard, made the issuance of significant amounts of government debt rather difficult because they were convertible into gold, and obviously the amount of debt that you could issue would be a function of the gold reserves which the government had.
Therefore, you could not create the types of government deficits which we and other nations can, as well.
A judgment has been made in this country that the cost of the restraints of the gold standard was such that many, in fact, the vast majority of the Congress eventually concluded in the 1930's that that was an undue constraint on the system, and choices were made at that point to move to another system.
You cannot, however, look at a financial system independently of the values of the society, and you cannot separate the financial system from the economic structure itself. So it is a value judgment that a society makes, and the judgment that this country has made since the abandonment of the gold standard in 1933 is that a fiat money, sovereign credit system is a superior mechanism for finance.
Dr. PAUL. Do you agree that that judgment was correct?
Mr. GREENSPAN. Well, I think that there are pluses and there are minuses. As I have said over the years, I have always had perhaps a nostalgic view for how the markets worked in those earlier years, but I would be naive to fail to recognize that that was a view that is held by the vast majority of my colleagues.
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Dr. PAUL. Madam Chairwoman, may I follow up later on with written questions?
Chairwoman ROUKEMA. Yes. That is appropriate.
I was about to make the announcement that the Chairman has been very generous with his time, and we will go through the first round of questions, but further questions will have to be deferred, not only for those who were able to stay, but for those who have had to leave because of conflicts with other committee hearings.
So I make a motion that everyone will be able to submit their further questions for written responses from the Chairman. He has been very, very generous with his time.
Without provoking my colleague, Dr. Paul, I just want to make one comment. You may be nostalgic, Mr. Chairman, but I am hardly nostalgic for what led to the crash of 1929 and the financiers' activities in that. We will have that debate.
Dr. PAUL. Madam Chairwoman, I might remind you that occurred after 1913.
Chairwoman ROUKEMA. But I was responding to the Chairman----
Mr. GREENSPAN. 1913 is when the income tax was put in place.
Dr. PAUL. And the Federal Reserve.
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Chairwoman ROUKEMA. I have got it, but that is a debate that we might want to have some other time. There are various wide differences of opinion on that subject.
Again, I apologize to Ms. Kilpatrick. It is my custom to take people in the order in which they arrived. I inadvertently called on Mr. LaFalce.
Ms. Kilpatrick is next.
Ms. KILPATRICK. Thank you, Madam Chairwoman, for the opportunity.
As relates to commerce and banking, the firewalls, the blurring of the lines, I think in your testimony you urged caution, and I am not quite sure if you felt that it should be regulated and not legislated, and what was your preference. You said a bit about the delay and what impact it may have. Could you speak to both, please?
Mr. GREENSPAN. Yes. I think that it has to be legislated. There is very little that we as regulators can, or in fact should, do with respect to that question. That is a very important fundamental watershed issue that I think that almost certainly requires fairly explicit guidelines from the Congress to the regulators.
So I would suggest that that issue, as I indicated in my testimony, is something which is really a short term question, because I suspect by the year, say, 2015 or so, you will not be able to tell easily the distinction between what is a financial institution, what is a bank, what is a non-financial institution.
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So we should recognize that whatever it is that we do, we should not hold back what is in the inevitable technological changes that are going to blur the lines of all of the various aspects of what types of institutions we have.
As I say in my formal remarks, in the detailed remarks, we have to be careful, however, because we do not have any reasonable ability to forecast what that structure will look like; and if we try to put in place a supervisory structure which we think will be consistent for the year 2015, we are almost sure to be wrong. So I am arguing that we should go step by step, recognizing where we ultimately have to end up, but do it with some degree of caution.
Ms. KILPATRICK. Thank you, Madam Chairwoman.
Chairwoman ROUKEMA. Thank you.
Mr. Royce.
Mr. ROYCE. Thank you, Madam Chairwoman.
Chairman Greenspan, in your testimony today you state in your words that ''. . . newer technologies will make it highly unlikely that the walling off of any ownership of financial institutions by non-financial businesses and vice versa can be continued very far into the 21st Century.'' At the same time, you advocate a cautious approach.
Is the 25 percent commercial basket contained in H.R. 268, too high, in your opinion, or is that right?
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Mr. GREENSPAN. It sounds a bit high, but I can't give you an alternate number. The reason is that you have to, instead of just arbitrarily picking a number out of the air, you have got to have a sense of what types of organizations we are thinking of that may move in certain directions.
So I think that in order to come up with what would be an appropriate number, you need far more analytical detail than one has at the moment. So I would be hesitant to suggest a number, but that a basket of some form be created strikes me as a pretty good idea.
Mr. ROYCE. Could you maybe elaborate, when you say we should ''. . . obtain additional analytical detail.'' How would you suggest to our subcommittee that we go about that?
Mr. GREENSPAN. I would say what you want to find out is knowing what the structure of our financial institutions are, what their size is, having some judgment as to what type of non-financial institution may wish to merge or purchase or sell, we have some sense of what relative sizes are. You will get an idea of what, say, a 25 percent basket would mean--or a lesser basket would mean--relevant to individual realistic situations. In other words, you will be able to put names down, various different corporate names in boxes to get an idea of what you are talking about.
But merely to choose a number without fully understanding what the implications are, I think, would be a mistake.
Mr. ROYCE. Chairman Greenspan, as we talk about financial modernization, one of the critical issues we must consider is that of regulation. Of course, in your testimony today you argue very strongly in favor of umbrella supervision and not functional regulation.
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At the same time you caution that ''. . . We must be careful that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual'', in your words.
Further you suggest that the Federal Reserve Board is considering changes that would sharply reduce routine supervisorial umbrella presence in holding companies.
Could you elaborate? What do you believe are the necessary elements of umbrella supervision?
Mr. GREENSPAN. Well, it is important that we understand that as part of this changing technology, the nature of what constitutes a ''bank'' or a ''financial institution'' is undergoing a very major change. We have been focusing on the question of how to address the increasing complexity of risk management, and indeed I have testified before this subcommittee, and the full committee, on many occasions on this changing regulatory structure, which means we have got to move more toward process and away from old fashioned evaluation of end-of-year, or end-of-quarter, or whatever statements.
This means that rather than micromanage the specific elements within the system, we should be looking at only the modular structures that are set up for risk management, and try to understand essentially how they are going to be used by management for the allocation of cap.
So it is a much lower degree of supervision than we have been doing in the past. It is a gradual process that will continue. It will accelerate. It also implies that there are less on-site types of review of non-bank facilities, because you no longer need to have that full sort of detail.
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You take more in the way of reports of other types of regulators to fill in, whereas in the past we used to think it was necessary when you did the balance sheet evaluation, to go into non-bank affiliates of holding companies, to verify everything. We think that is increasingly less relevant and very substantially counterproductive were we to continue to do it.
Finally, we have argued before this subcommittee on many occasions that what we need is legislation to significantly reduce the applications that are implicit in holding company regulation. We have done a lot of the streamlining ourselves, and, indeed, we will be discussing final rules on Regulation Y at a meeting next Wednesday of the Board, which is directed toward what we can do under existing statutes. But we believe that it would be very helpful if the Congress instructed us to contain this activity far more significantly than we do.
Mr. ROYCE. Thank you, Chairman Greenspan.
Chairwoman ROUKEMA. Mr. Bentsen.
Mr. BENTSEN. Thank you, Madam Chairwoman.
Mr. Greenspan, first of all I want to thank you for vindicating my comments the other day at our organizational meeting that the discount window and deposit insurance are a form of a subsidy. We had a discussion about that regarding a ridiculous disclosure rule that the House and committee has.
I also garnered from your testimony and discussion with Dr. Paul that we have traded, in your opinion, efficiency for stability and security in the banking system; and perhaps we traded it at some premium, but nonetheless that is what we have received. You seem to argue that we move fairly slowly as we go forward.
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I also notice that you seem to endorse a two way street, at least in terms of banking and securities, in your statement. You don't elaborate on it a great deal, but you do seem to endorse it.
I guess I have a couple of questions. One is, do you believe that the bills we are discussing today, as well as H.R. 10, the Chairman's bill; One: will bring us to a two way street in that area?
Second, I would ask with respect to your comments on credit and the subsidy that exists, could you elaborate on why you believe, and I think you believe, that an affiliation structure under a holding company really is that much more secure than a subsidiary structure? I don't know myself, and we may be talking about a legal question more than an economic question, but I would be interested in that.
The third is, if we go beyond banking and investment banking, are Sections 23(A) and 23(B)--or some subsequent Sections 23(A) and 23(B)--adequate if we are looking at commercial ventures? Or do we, and insurance for that matter, need to consider some other structure?
An example I would give, even if we had an arm's length market rate transaction involving derivatives between one affiliate and another within a holding company structure, if that were allowed, or could be structured to be allowed, would that indeed be secure under the existing structure of Sections 23(A) and 23(B)?
Mr. GREENSPAN. Well, Congressman, I think that, as I have indicated, the specific bill before you in this discussion today, I think falls short largely because of the lack of umbrella supervision.
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I might add that there is another aspect of umbrella supervision, which, if you wouldn't mind, I would like to bring in at this particular point, because it is not an irrelevant consideration; and it is the fact that while it is not a necessary condition, it is a sufficient condition for the Federal Reserve in its role as lender-of-last-resort to contain systemic risk and to act at the time of crisis.
Because we have supervision at the holding company level amongst all of the major banks or bank holding companies in this country, we have the capability, because we know what is going on and we know the people, to be able to function as the container of credit in the event of a credit crisis.
If the holding company structure is eliminated, it is conceivable that we could obtain those functions through another vehicle, but it certainly doesn't exist in the current bill, and I am very dubious that a mechanism can be constructed which would enable the central bank to oversee the total system as effectively as we can do under the current structure.
I emphasize that that is not an issue that is related to financial efficiency. I am merely saying it is an aspect of the holding company which serves another purpose, which in my judgment cannot be served as well in another configuration.
But coming directly to your specific questions, I fully support a two way street. I think equity clearly requires that.
With respect to the bank holding company structure, we have found that for a number of reasons, and unfortunately it is a very complex question, that it is far easier to contain the subsidies that we think are very strongly evident within the bank through other than a bank holding company structure. That is, the individual flows are inhibited so far as loans are concerned by Sections 23(A) and 23(B), and the equity flows seem to be far more difficult to move from the bank to the holding company affiliates than to downstream them through the subs.
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Sections 23(A) and 23(B) are a very effective mechanism which can be used in other constructions, but only for loans. It requires essentially that these loans be at market rates and competitive, and restricts the amount of capital that can be employed in doing that, which is probably a wise thing, even as we move beyond. That is part of Section 23(A).
The issue of subsidies is largely the movement of equity, not a debtor loan credit, and it is there where I think the question of how one constructs the system is very crucial.
Chairwoman ROUKEMA. Thank you. I would note that I appreciated Mr. Bentsen's question with respect to the umbrella regulation and its relationship to the holding company and your response, Mr. Chairman. I just want to observe that this is an issue that we must clearly work on together and work through.
I don't know whether we can come to complete agreement, but it is the crux of a problem that has to be resolved among these competing pieces of legislation before we get to consensus, if indeed we are able to reach consensus. But I would like to work with you.
I don't see an apparent resolution here. But I have listened very closely to your response, and we should continue working cooperatively, if possible.
Mr. Watt.
Mr. WATT. Thank you, Madam Chairwoman. I want to thank Chairman Greenspan for being here. I always find that I have to listen very intently to what you say. You are kind of like lawyers, you talk in code and express these things in code. But if I concentrate and listen intently, I always, at the end of the discussion, come away with a better understanding of what the issues are. For that, I am very grateful.
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I want to direct your attention, quickly, to one question that I wanted to clear up. On page 2 at the top of your statement you say ''. . . the Board believes that the changes we adopt should be consistent,'' with four factors that you list there.
One of those factors is ''. . . limiting the spread of both the moral hazard and the subsidy implicit in the safety net.'' I think I understand the subsidy. What I don't understand is what the ''moral hazard'' is.
Can you quickly give me an example or two that would help to educate me? I don't want to spend a lot of time on that, but I am just trying to get a clearer understanding.
Mr. GREENSPAN. ''Moral hazard'' exists when an institution creates a degree of risk to the overall system without paying the price, or cost, involved in it. Therefore, you have a situation in which, for example, as we had in the savings and loan crisis, where people had various differing types of authorities which they used to create potential, very large rewards to themselves if they survived; and if they failed, the taxpayer footed the bill.
Mr. WATT. That is very helpful to me. I think I understand, you are using ''moral'' in a banking sense. I am with you on that. OK.
Let me go beyond where Mr. Bentsen went. It seems to me that on page 6 of your statement you seem to be going well beyond what Mr. Bentsen said to conclude that you really can't do this effectively in a subsidiary system; you have come to grips with the holding company concept. But it doesn't seem to me that you can get the kind of controls and security that you are seeking in a subsidiary as opposed to a holding company.
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Mr. GREENSPAN. A subsidiary of a bank?
Mr. WATT. A subsidiary of a bank. Am I mischaracterizing what I think you are saying here?
Mr. GREENSPAN. No, on the contrary, Mr. Watt, I think that is the conclusion we have come to after a very thorough analysis of the pros and cons. And while we acknowledge that there are other sides of the argument, we have looked at them in very considerable detail and have found them not persuasive.
Mr. WATT. OK. Then on page 7 of your statement, it does seem to me that you come back and leave open that option of going, thereby saying, ''. . . if the Congress wants to extend the use of the sovereign credit further, for example, to a subsidiary kind of arrangement''; I assume you would be talking about that as one of those possibilities--''. . . it ought to make that decision explicitly and accept the consequences of the subsidy on the financial system that come with making that decision.''
Could you talk about some of those ''consequences'' as you see them?
Mr. GREENSPAN. Yes, Congressman. The extreme form of the use of the sovereign credit perhaps clarifies what it is we are concerned about at the end of the day.
We can theoretically in this country guarantee everybody's liabilities. In other words, the Federal Government can by law just basically say all deposits, for example, are insured, all liabilities of major corporations are insured.
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The consequence of that extreme case is an ultimate breakdown in the incentive structure of the way our system would work, and indeed we would find that the economy would not only not grow, but probably shrink. That is the ultimate ''moral hazard'', if I may put it that way.
What our concern is, is obviously not going all the way in that direction, but even if you go piecemeal in that direction, you do pick up at the margin increased inefficiencies.
One of the things that has made this country extraordinarily productive is the flexibility and the willingness to take risk which is not supported by government. What that has done is induced an entrepreneurial culture which has created a very high standard of living, on average.
My concern is that if we move increasingly toward Federal subsidization, especially inadvertently because there are many that don't think that subsidy really exists, I think we undercut the effectiveness of this economy. The more we do of it, the more we undercut the effectiveness.
Mr. WATT. I have a couple of other questions, but I am out of time.
Chairwoman ROUKEMA. You can submit those questions in writing.
Mrs. Maloney.
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Mrs. MALONEY. Thank you very much. First of all, Madam Chairwoman, I would like to welcome a former New Yorker and congratulate him on his approaching marriage.
Mr. GREENSPAN. Thank you.
Mrs. MALONEY. In our hearings Tuesday Mr. Greenspan, industry representatives denied any increased risk to taxpayers and the insurance funds from insured institutions expanding into new business ventures. They said that higher capital standards and the regulatory authority that we provided in 1991 through early intervention and prompt corrective measure requirements are sufficient.
As a regulator, can you suggest any new, or enhanced, authorities that Congress should consider to give this Member and the taxpayers greater confidence that failures can be managed and pose minimal risks to the insurance funds as banks and thrifts expand into new business ventures?
Mr. GREENSPAN. Well, Congresswoman, I think one way of looking at the issue is in the context of the Chairwoman's bill. Aside from the umbrella supervision issue, which is a rather important question, to say the least, the way the system is structured, except in the extreme case where safety and soundness would be involved, and I don't think that is a relevant consideration, we don't envisage any significant problem in the degree of subsidization in the way it is currently put in place.
Our concerns are essentially altering the holding company structure to something other than that. If you have a holding company structure, with or without the umbrella supervision, in and of itself it has the capability, in my judgment, of containing the degree of subsidy.
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My problem with the existing bill is not what your constituents are raising; it is the umbrella supervision question.
Mrs. MALONEY. Well, going back to the Alliance bill, the Alliance bill provides a mechanism for the Federal regulators to waive any or all of the requirements of Sections 23(A) and 23(B) if they see fit. Isn't this in direct contradiction to one of the major reasons for modernization that Congress, not the regulators, should be responsible for decisions about safety and soundness? We have a complete waiver system.
Mr. GREENSPAN. I don't want to comment on the specifics of the bill, as such, because I have not read the legislative detail, and not having done that, I feel not quite adequate to be as responsive as I think you would like me to be.
Mrs. MALONEY. But if they can waive the oversight requirements----
Mr. GREENSPAN. I grant you, if you start to waive certain of Sections 23(A) and 23(B) restrictions, that you do open up the possibilities of problems.
Mrs. MALONEY. OK. In the new structure of the holding company, with the holding company affiliate transaction, firewalls and Sections 23(A) and 23(B) of the Federal Reserve Act, are they still appropriate; or is there more that could be added and changed in statute to this bill?
Mr. GREENSPAN. Again, I don't want to comment on the bill, because unfortunately I just haven't had time to read it. My awareness of partial reading of bills is it is always a mistake, because lawyers have the wonderful ability to stick in Section 47(a), (b) or (c), something which is relevant to Section 2. Unless you have read it all, you don't understand it.
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How they understand it sometimes is beyond me, but apparently it is terribly important to do that, and I have not had the time to do it and feel that it is inappropriate.
Mrs. MALONEY. The Sections 23(A) and 23(B) are easy to understand.
To another point, I have written you several times about the Fed's suggestion to expand the allowable local check hold from 2 to 3 days, possibly 5, if you count Saturday and Sunday.
As you know, Mr. Greenspan, the banks are taking advantage of all kinds of new technology to increase the speed of check clearing and wire transfers. In New York, clearance is within 24 hours in our check clearing. Yet you are going in the opposite direction, asking for more time to hold on to consumers' checks, which is going to cause all kinds of problems with consumers, and it is unfair. Why are you suggesting this?
Everywhere I look, at the home and office, everything is taking less time. Here you are asking for more time for simple check clearance.
Mr. GREENSPAN. There are technical reasons why the staff evaluation came up with the conclusion. What I suggest I do is put in the record the reasons or perhaps respond to you by mail and give you the full detail of the specific issues that are involved.
I found very quickly, holding the same view that you do, that when I got into it, it got far more complex than I thought; and I would like to convey what the nature of some of the problems are that induced the staff to recommend to the Board and induced the Board to agree on that particular recommendation.
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Mrs. MALONEY. My time is up.
Chairwoman ROUKEMA. Thank you very much.
Chairman Greenspan, I think the whole subcommittee will benefit by your written response on that question. We really appreciate it.
Dr. Weldon.
Dr. WELDON. I thank the Chairwoman.
Mr. Greenspan, after the BCCI fiasco, the U.S. amended its laws to require that any foreign bank entering the United States be subjected to consolidated comprehensive supervision. Similarly, I believe it is the BASL supervisor's committee, established minimum standards for supervision for banking groups that includes consolidated supervision.
My question is, can we prevent future BCCIs if no one is looking at the entire picture?
Mr. GREENSPAN. There is no doubt that BCCI was the model of evasion on trying to play one supervisory regulator off against another, country by country.
I think that the change in regulations and the act, which has created authorities for the Federal Reserve to do far more in the area of foreign organizations with banking affiliates in the United States, I think pretty much enables us to reduce the types of problems which BCCI created.
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You never can eliminate all probabilities of things of that nature. All you can do is reduce the risks and the probability that it will occur.
I think that the legislation which was passed subsequent to that has been very effective relative to the types of problems which we envisaged could be occurring.
Dr. WELDON. So you don't see at this time the need for any further action on the part of the subcommittee?
Mr. GREENSPAN. I do not, Congressman. I think we have adequate authorities at this stage to handle that type of problem.
Dr. WELDON. Can you describe what the views are of the European Union on consolidated holding company supervision?
Mr. GREENSPAN. Their views are really quite simple, in that they have mainly the universal banking system. Britain does not, but the others do, and so the issue does not arise in the sense that it arises here.
The universal bank model, for example in Germany, dominates the financial structure of Germany, and the mechanisms that they have there to examine and regulate it are far simpler than would be required if you have separate organizations for securities and insurance and banking, the type of system which we have in the United States.
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So the model of Europe for us, in my judgment, is really not quite appropriate. They don't have the community banking system that we have, they don't have the dual banking system that we have, and they don't have the types of financial structures which we have, so that having looked at their system in great detail, I don't think that there is terribly much that we can learn from the consolidated supervisory procedures that they have employed there.
Dr. WELDON. It is just not applicable?
Mr. GREENSPAN. I think not. I think the structures are so different. One can take a look at their system and say, ''Does it work better overall than ours?'', and there are numbers of people that think that it does. It is not terribly obvious to me that that is, in fact, the case.
Dr. WELDON. Thank you. Let me say as a newcomer to the Banking Committee who does not have a finance background, I am a physician, I very much enjoyed your opening testimony. It was, I thought, very lucid and I want to just thank you for that.
Mr. GREENSPAN. Thank you very much, Doctor.
Dr. WELDON. I yield back the balance of my time.
Chairwoman ROUKEMA. Thank you.
Mr. Barrett.
Mr. BARRETT. Thank you, Madam Chairwoman.
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Welcome, Mr. Greenspan. I want to join my colleague, Mrs. Maloney, and congratulate you on the forthcoming personal event in your life. It seems to me to be a great sign of rational exuberance. I am happy to see that.
I want to follow up on some of the questions, or the line of thought, that my friend Mr. Watt was talking about here when he was talking about the use of the sovereign credit and the subsidy. My mind doesn't work in a particularly esoteric way. So I guess what I am looking to you for is, what are the traps that I have to look for--or others have to look for--when we do expand the powers? Or if we do expand the powers, and you specifically state that we should accept the consequences and explicitly make our decision.
For someone like myself, what are the traps, specifically, that we have to make sure we don't fall into?
Mr. GREENSPAN. I think the principle that I try to posit in my prepared testimony is that: One, in order to get a competitive playing field for banks and banking organizations, increased power strikes us as essential. But those increased powers should not be financed by government subsidies.
In other words, if the purpose is a market-based level playing field, to then bring in government subsidies to finance that strikes me as contradicting the base of the argument.
It is quite another thing to figure out when a certain activity is indeed dipping into the subsidies of the safety net. It is not self evident and indeed it is a very complex question, and in many cases it is hard to tell whether, in fact, a certain activity actually is being subsidized indirectly or not.
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The only thing that I could suggest is to ask the question, as the evidence suggests that the way a new activity is being set up or a new power is being defined, that it indeed does expand the competitive capabilities of the banking organization, which I hope is what we would be trying to do, but that it be market-based funded. And if one concludes that that is indeed the case and the costs of the net funding to finance that power are the same as one sees in the marketplace generally, I think one can conclude that the subsidy was not a factor.
Mr. BARRETT. What new powers, or potential new powers, are the ones in your mind that create the greatest potential for a cross subsidization?
Mr. GREENSPAN. I don't think the powers, per se, are as relevant as the structure on which it is financed. That is the reason why for part of my testimony I emphasized the distinction between financing new powers through an affiliate of the holding company and through a subsidiary of the bank.
It is our judgment that the probability that you will get significant subsidization occurs mainly through the bank subsidiary, rather than through the affiliate of the holding company.
There is no way to avoid some subsidization of an affiliate of a holding company, but there is a significant difference in our minds and our evaluations between the size of the subsidies that get leaked from the bank into the affiliate of the holding company and to the subsidiary of the bank.
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As I said before, it is not government policy, or should not be, to create the subsidies. It is an indirect consequence of the creation of the benefits of the safety net.
So what you are doing is recognizing that in increasing the values of the financial system by improving the competitiveness of banking organizations, that carries with it some inevitable subsidization. The question is, can it be kept de minimis in that process so that the tradeoff is very clearly positive?
Our concerns are that when you go through the sub of the bank, even as you endeavor to constrain that by various different efforts of firewall or capital reductions and a variety of other things, that you cannot effectively contain the subsidy in an adequate way, in our judgment.
Mr. BARRETT. Thank you.
Chairwoman ROUKEMA. Thank you.
We acknowledge the presence of Mr. Baker here, Congressman Baker, a Member of the full committee and the Chairman of the Capital Markets Subcommittee.
We appreciate your attendance here. I believe you have some inquiries.
Mr. BAKER. Madam Chairwoman, I appreciate your courtesy in allowing me to pose a question.
Mr. Chairman, it is always a pleasure to hear your thoughts, particularly in your response to Mr. Barrett, where you indicated powers, per se, are not as important as the structure in a regulatory sense to control the flow of the subsidy or perhaps to concern oneself about systemic risk, depending on the size of the entity.
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In both the Chairman's remarks and the Chairwoman's proposal there is a limit on percentage of revenue earned from the non-bank activity, 7 1/2 and 25, and then also a definition of what constitutes the powers and products which one may offer.
Is it really as important to concern ourselves with the nature of the business associations, the size of the revenue dependency of the holding company on those non-bank related activities, or the structure in which one engages in these?
My point being, I don't see, based on the unitary thrift model, the association of broad financial activities inherently a risk, either systematically or to deposit holders, if in fact there is sufficient regulatory oversight or limitation in total revenue.
Do you agree with that general view?
Mr. GREENSPAN. As I said earlier, I don't want to comment explicitly on the bill, because I have not yet had a chance to read it in detail.
Let me say with the unitary thrift, there is an interesting issue that does not necessarily apply to the broader global banking organization issues in the sense that the size of the industry, as you know, is smaller and, quite importantly, that the type of assets which thrifts hold, at least historically, have been quite a good deal different; and one of the concerns that lots of people have that doesn't strike me as overwhelming is that the ability of a bank to lend to its non-financial parent, I think that clearly does not exist in the unitary thrift system, so it is not really particularly relevant.
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My main concern is in the structure of the system as distinct from powers.
Mr. BAKER. Correct. That really is my point.
As the committee proceeds, not with regard to a particular legislative instrument, but as to Congressional policy, that diversity of powers is not inherently where our controversy should be centered.
Mr. GREENSPAN. That is correct.
Mr. BAKER. But rather only how we structure the constraints in which those diversified powers may operate with an insured depository institution.
Mr. GREENSPAN. Yes, Congressman.
Mr. BAKER. Further, with regard to the role of the Fed in the supervision of these entities, assuming we have a non-bank holding company with an insurance company, a securities company, which is perhaps a $5-, $10-billion asset size, would not that institution, in itself, present similar systemic risk concerns to a bank holding company which might have a car dealership and a hardware store in its $5 billion? What separates the two in their constraints as a matter of economic concern?
Mr. GREENSPAN. Well, remember that as we have constructed, if the subsidy is located within the bank. If in some organization, let's take an example where you have, say, the major institution is an insurance company which does not have that subsidy, it is very easy to, if that insurance company buys a modest bank or smaller bank, small relative to the size of the holding company, it is pretty clear that you would not want umbrella supervision of that holding company because the purpose of the umbrella supervision is to contain the subsidy, and it is easy to contain the subsidy within the bank by various means without going to examination of the big holding company.
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Mr. BAKER. If I may, the last element of this is, though, as to the concern for systemic risk as separated from the issue of deposit insurance. I recognize the concern is deposit insurance laws, and it might be minimal in that case, but if it is a large enough economic entity, without regard to whether it has a depository institution, does the Fed have a concern about a diversified financial services related activity, securities, insurance, anything other than a deposit taking institution, is that an issue which causes the Fed to have concern?
Mr. GREENSPAN. Not really, because in effect there is regulation of those institutions mainly by their counterparts.
That is, we talk about regulation as though only the Federal Government is the vehicle that can do that, but a goodly part of the time the most effective regulation is that people or institutions will not lend you money if they do not like what they see with respect to the safety and soundness of the institution. So in many cases, an investment house or insurance company or something of that nature which has no access to the safety net is essentially regulated by the people with whom they deal, and that can be very effective.
Our concern is not with that type of structure.
Mr. BAKER. Thank you very much, sir.
Mr. GREENSPAN. We look at it, but it doesn't create concerns on our part.
Chairwoman ROUKEMA. Thank you, Mr. Chairman. You have been very patient, but my colleague, the Ranking Member, does have a specific observation with respect to a statement that was made. It will be brief.
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Mr. VENTO. The exception here to Sections 23(A) and 23(B) is, I believe, on page 25 of the bill that I have sponsored. It applies to institutions that are neither located nor doing business in the United States, that is, the waiver of Sections 23(A) or 23(B).
Explicitly, in the law, under the Federal Reserve Act, there are provisions for waiver of Sections 23(A) and 23(B) today?
Mr. GREENSPAN. Yes.
Mr. VENTO. This, of course, would be exercised by the national financial committee.
I would say, too, with regards to activities, and we didn't get into it here, but with the wholesale financial institutions, they would have the Fed window and wire available, the Fed today has to differentiate in terms of how it responds to the law. The law allows for the Fed to act under crisis, which I don't think has been used by manufacturers and industries and we extended that, Madam Chairwoman, in the FDICIA, I believe, to investment banking, so there are some differentiations.
I think the issue, the gist of what I am trying to say, the issue for intervention and involvement and indirectly acting in providing credit for, for instance, stock market variations, which, we didn't ask you about the stock market, Mr. Chairman, but in any case, maybe John was going to. He wouldn't answer. Pardon me.
In any case, I am just trying to point out, we see a role. I don't know the structure role----
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Mr. GREENSPAN. Let me say, you are referring to the amendments to Section 13 of the Federal Reserve Act which clarified the issues as to how the Federal Reserve could offer credit to any institution with a supermajority of five votes on the Federal Reserve Board.
That is important. But what is far more important, so far as we are concerned for the purposes of maintaining the safety and soundness of the overall financial system, is our ability to interface with that system on a day-by-day basis, which we do in a variety of ways.
Through our holding company activities, we clearly examine the structure of all of the major institutions in this country which have potential systemic characteristics. That is, if they run into trouble, they can create a lot of problems for the system.
We have found that that degree of capability of examination and our interfacing with the various people within those organizations, whom we obviously get to know and deal with on a day-by-day basis, having that, having a significant presence as supervisor and regulator of several of the large State member banks, which gives us a sense of how the system is working, and a very large and significant presence among smaller banks, enables us to have practical applications to understand what to do if a crisis occurs and how to respond.
It is one thing to have legislative authority. It is quite another to know how and when to use it. And it is that issue which concerns us relevant to the potential elimination of the holding company structure.
We grant that it is capable of being reconstituted in another means, but we are concerned that that will not be sufficiently effective as the one we now have.
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Chairwoman ROUKEMA. I am going to have to exercise my prerogative as the Chairwoman of this subcommittee.
Mr. VENTO. I just want the record to show the Chairman agreed to me with regards to the waiver of Sections 23(A) and 23(B).
Chairwoman ROUKEMA. Mrs. Maloney is going to get her response in writing, I believe, to the related question that she has, and I have other questions, too. But we will submit them in writing, Mr. Chairman. You have been very generous.
I am going to restrain myself on the 7,000 points in the stock market we are now approaching. Or do you want to insist on making a comment? You will make news. You will make news.
Mr. GREENSPAN. I will restrain myself.
Chairwoman ROUKEMA. You will restrain yourself. In recognition of your being our guest, we will respect your restraint. Thank you very much.
I will say a 5-minute recess while the second panel is coming to the floor--5 minutes--no longer.
[Recess.]
Chairwoman ROUKEMA. Will the Members come to the hearing, please? The 5 minutes is over.
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I am not saying that to the panel members. You have been courteous and patient. That message is for the Members.
The 5 minutes is over. Staff will get their Members here. We shall proceed. Again, I hope staff will convey this message to Members as they come in, I am going to have to be very precise about the time periods for this panel, both for the individual panel members--5 minutes each--but specifically for the Members.
I know this has been particularly useful for all of us, and I expect to have the same useful and constructive contribution from this panel, but we are going to have to restrain ourselves and contain ourselves and discipline ourselves. I guess that is the word if we are going to get through this today before the voting begins and is disruptive to the whole procedure.
So if the staff will please inform the Members as they come in that I am going to use the gavel.
Mr. LAFALCE. A brief comment. It is solely within the prerogative of the Chairwoman as to how to structure the hearings, but I recommend for your consideration in future hearings a slightly different format.
We had an opportunity to hear from Chairman Greenspan for 2 hours and 20 minutes of prime time. He was able to go on fully and at great length in his initial presentation and in response to our questions. Now we will have four other regulators limited to 5 minutes. Few of our Members are here, we will be interrupted by the bells, and we will be able to have some interchange of ideas among the four who are here. What will be absent will be a direct interchange such as that with Chairman Greenspan.
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We have given primacy to the Federal Reserve Board. I think when it comes to financial modernization issues and issues of that nature, we ought to have all the regulators at the table at the same time with the same conditions and the same rules. I commend that for your future consideration.
Chairwoman ROUKEMA. I am hearing you, but as with all these things, it seems so simple, there are certain protocols that one understands.
But I will say this: I would have liked to have had more extended hearings, but this subcommittee was somewhat constrained by the judgments and the schedule of the full committee. But we shall try to give all the time absolutely necessary today and in the future when we have to.
I will take that under consideration, but with respect to these particular regulators, let me just observe that Mr. Greenspan did us a favor by coming to this subcommittee.
Mr. LAFALCE. That is his job.
Chairwoman ROUKEMA. I am sorry, my colleague, but I have had some other attitudes expressed by the Treasury Department, and we are just going to have to deal with them on a case-by-case basis, and there are other designs on this room. So we have had to satisfy a lot of different schedules here and different protocols.
With that, we will recognize our panel members in the order in which I see them, in the order in which they will testify. Eugene Ludwig, Comptroller of the Currency, well known.
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Your name has already been used, not in vain, but used as a reference in terms of your activities relevant to the actions of this subcommittee. We welcome you here today Mr. Ludwig.
STATEMENT OF HON. EUGENE A. LUDWIG, COMPTROLLER, OFFICE OF THE COMPTROLLER OF THE CURRENCY
Mr. LUDWIG. Thank you very much, Madam Chairwoman.
Chairman Greenspan referred to ''putting.'' I will grant him the ''putt'', but I will disagree with him on the substance.
Madam Chairwoman, Members of the subcommittee, I commend you for fostering a dialogue on the important issue of financial modernization. I thank you.
Mr. WATT. Mr. Ludwig, could you pull the microphone closer to you? I am having trouble hearing you.
Mr. LUDWIG. I want to thank the Chairwoman for fostering this dialogue on modernization. I think this is an important topic. I want to thank Mr. LaFalce, you, Mr. Watt, and Mr. Barrett. These are important issues, and I am honored to be here to discuss them today.
The pace of change in the financial sector of our economy accelerates almost daily, but our Nation's banks continue to be constrained by an antiquated legal and regulatory framework. H.R. 268, the Depository Institution Affiliation and Thrift Conversion Act, raises many of the central issues that the Congress must consider in order to modernize that framework.
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While it is unquestionably in the public interest to modernize this framework, there will naturally be differences of opinion on how that should be done. This morning, I will suggest five basic principles that I believe should reform the financial modernization effort.
First and foremost, any proposal for reform must ensure the safety and soundness of the banking system. Bank supervisors must understand the risks that banks are taking and must ensure that banks are managing those risks effectively.
As you know, we have taken a number of steps to modernize our own supervisory mechanism. We have adopted a supervision by risk program, created a new Deputy Comptroller for Risk Evaluation position, and included economists in our supervision effort. This is a very important element of the future, and we must be prepared to adapt. I think we have changed our supervision in a way that is more adaptable to the future.
But effective supervision by itself is not enough to ensure a safe and sound banking system. Banks must also have the flexibility to adapt to changes in the marketplace. Limiting banks' activities in the face of a changing marketplace poses long term threats to safety and soundness in two critical ways. First, it deprives banks of the benefits of diversification. Second, limiting bank activities pressures banks to squeeze more profit out of their dwindling traditional activities, either by moving further out on the risk curve or shortchanging basic risk management systems and internal controls through excessive cost cutting measures.
I strongly favor an approach that permits new financial activities for banks because I believe that expanding bank activities enhances, rather than threatens, safety and soundness. The empirical evidence supports that conclusion.
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For example, U.S. banks through foreign branches and subsidiaries, that is, our own banks through their branches and their subsidiaries, as well as holding company affiliates, have successfully engaged in a variety of nontraditional financial services abroad for many years. In fact, they engage in virtually all the activities that are the subject of the Chairwoman's and Mr. Vento's bill. Moreover, foreign bank supervisors have told me that income from nontraditional activities has been a key support to the safety and soundness of certain banks during periods of financial stress.
The second principle for financial modernization is that reform should promote broader access to financial services for all consumers, rich and poor alike.
Banks play a special and vital role in the development and prosperity of all communities, particularly those encompassing lower and middle income Americans. In recent years, the banking industry has made significant progress in expanding access to financial services for low- and moderate income consumers and communities. Any financial modernization proposal must build on this success.
The structural alternatives that financial modernization provides are extremely important in this regard. For example, allowing banks to conduct new activities in a subsidiary provides the opportunity to enhance the resources available for Community Reinvestment Act activities. Earnings from a bank's subsidiary flow up to the bank and, therefore, increase the bank's ability to undertake CRA activities. The earnings of a holding company subsidiary, on the other hand, flow to the parent holding company and are not available to directly support the bank's CRA obligations.
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Financial modernization must ensure, in addition, the protection of all consumers who use bank services. For example, proper disclosures must be made so that customers understand that some products are not FDIC insured and can appreciate the risks that uninsured products entail.
The third principle is that financial modernization should promote competition and increase efficiency within the financial services industry. The increased competition provided by banks in new markets should both lower costs to consumers and increase, or perhaps create, access to the capital markets for businesses.
Fourth, financial modernization must not impede community banks from competing in a changing financial services landscape. We are blessed, as Chairman Greenspan noted, with a fine community banking structure in the United States. Community banks profitably serve the financial needs of America's small businesses and farmers. Reform should not impose requirements that work for large institutions but are unnecessary and expensive when applied to small banks. I think the structural questions are very important to the viability of these smaller entities.
The fifth and last principle I suggest today is that any reform must ensure that financial services providers have the flexibility to choose, consistent with safety and soundness, the organizational form that best suits their business plans.
Today, banking companies have two structural options: the holding company affiliate approach and the bank subsidiary approach. Financial modernization should not dictate a particular organizational form just for the purpose of supervisory convenience. Instead, it must offer banks and other financial services providers the flexibility to adapt their organizational structures in any way that is consistent with safety and soundness so that they can best serve an evolving economy and changing consumer needs.
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Chairwoman ROUKEMA. Mr. Ludwig, I am sorry, but you have gone over the time. Could you summarize, please, and then we will get back? I am afraid the votes will start and I would like to have each member of the panel have their 5 minutes at least. Then we will come back and pick up during the questioning. I am afraid we will lose Members.
Mr. LUDWIG. Let me summarize quickly. I want to address the subsidy question head-on.
Some banking industry observers contend that allowing banks to participate in financial activities could lead to some expansion of the Federal safety net. Number one, whether or not there is a subsidy at all is a debatable question. It is not clear that, in fact, there is a subsidy. If there is a gross subsidy, it is probably in the 4 basis point area. But that is not the question. The question should be whether there is a net subsidy, a real subsidy, after you take into account the costs of bank supervision, reserve requirements, compliance costs and other costs imposed on the banking industry.
We believe, based on empirical work on the subject, there may well not be a net subsidy. But, much more importantly, whether or not there is a net subsidy, there is a question of whether or not any subsidy is transferred from the bank to an affiliate.
Our own view, very strongly, is that if the right mechanisms are in place, the same mechanisms for the affiliate and for the subsidiary, either a subsidy is transferred to both or no subsidy is transferred at all. I believe that the Sections 23(A) and 23(B) mechanism, with the capital deductions, results in essentially no transference of any subsidy, if a subsidy exists at all.
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Let me give you one bit of anecdotal but very important evidence. Banks are currently able to engage in a number of activities in either a bank subsidiary, the bank itself or a bank holding company subsidiary. Mortgage banking is a good example. If there was a subsidy, you would expect to see all mortgage banking conducted in the bank subsidiary or in the bank. That is not the case. You find really quite a varied pattern. Some banks, including some of the biggest banks, choose to engage in the activity in a holding company subsidiary; some choose to engage in mortgage banking in a bank subsidiary; and some choose to engage in it in a mix. If there were a subsidy, you would not expect to see this pattern.
I hope the principles I have outlined are useful measures for evaluating proposals for financial modernization.
I do have additional comments, Madam Chairwoman, on the subsidy and other questions. Hopefully, with additional time, I will be able to express those. But in any case, I will be happy to submit them for the record.
I appreciate your indulgence in my going a bit over my time.
Chairwoman ROUKEMA. Thank you. Thank you very much.
[The prepared statement of Hon. Eugene A. Ludwig can be found on page 451 in the appendix.]
Chairwoman ROUKEMA. Ricki Helfer, Chairman of the Federal Deposit Insurance Corporation, we welcome you today.
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STATEMENT OF HON. RICKI HELFER, CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION
Ms. HELFER. Thank you very much. Madam Chairwoman, Members of the subcommittee, I appreciate this opportunity to present the views of the Federal Deposit Insurance Corporation on financial modernization, on H.R. 268, the ''Depository Institution Affiliation and Thrift Charter Conversion Act,'' and on related issues.
I commend you, Madam Chairwoman and Congressman Vento, for placing a high priority on the need to modernize the Nation's banking and financial system. H.R. 268 represents a thoughtful approach toward meaningful reform that will serve us well in developing balanced, constructive legislation.
Before turning to those topics, I want to express our gratitude to you and to other Members of the Congress for passing legislation providing immediate financial stability for the Savings Association Insurance Fund (SAIF). The legislation solved the immediate problems of the SAIF. The SAIF, however, has longer term structural problems because it insures the deposits of far fewer, and more geographically concentrated, institutions.
A merger of the SAIF and the Bank Insurance Fund (BIF) would address these problems and create a single, highly diversified, well capitalized insurance fund. The FDIC strongly supports a merger of the two funds as soon as possible. The legislation capitalizing the SAIF made the merger of the BIF and the SAIF contingent upon the creation of a common bank charter that would include Federal savings associations, and I hope these issues can be addressed expeditiously.
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I have written testimony that examines in more detail financial modernization issues, and I would like to submit it for the record.
This morning, I will discuss four important points:
Point Number One: Experience has shown us that product and geographic constraints on insured institutions have resulted in inadequate diversification of sources of income and have prevented the institutions from responding to changing market conditions. In the 1970's and 1980's, such restrictions became increasingly harmful. Product restrictions on savings and loan associations created the inherently unstable situation of these institutions, borrowing short term deposits to fund long term mortgages, which helped lead to the collapse of the savings and loan industry.
Commercial banks faced new competition, in the commercial paper market and elsewhere, that drove them into the riskier activities, such as commercial real estate lending, that led to increased bank failures in the 1980's and early 1990's.
Point Number Two: Experience has also shown us that rapid expansion of insured institutions into unfamiliar activities, without adequate supervision and monitoring by the regulators, can have undesirable consequences. When many banks and thrifts aggressively expanded commercial real estate lending in the 1980's, insufficient attention was paid to safeguards against risky behavior.
Point Number Three: Because the record earnings and favorable economic conditions that banks and thrifts now enjoy may not last forever, as no one has repealed the business cycle, any financial modernization proposal must be examined and evaluated for its effects when financial institutions are under stress.
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Our current experience is extraordinary. In terms of profits, annual earnings for commercial banks last year probably surpassed $50 billion for the first time. Moreover, the number and aggregate assets of problem institutions are only a fraction of what they were only 6 years ago. Nevertheless, we should be concerned about what would happen in times of stress.
Point Number Four: Any financial modernization proposal should balance a number of public policy goals. These goals include: the safety and soundness of insured institutions; the integrity of the deposit insurance funds; and the need for depository institutions to generate returns sufficient to attract capital.
Moreover, the proposal must be examined for its effect on small communities, isolated markets, the dual banking system, and the customers of depository institutions.
We believe that the following principles are critical components for a financial modernization proposal that balances public policy goals and safety and soundness concerns:
First, with limited exceptions discussed in my written testimony, financial organizations should be permitted to engage in any type of financial activity consistent with safety and soundness.
Second, the financial institution should have flexibility to choose the corporate or organizational structure that best suits its needs, provided safeguards exist to protect the insurance funds and prevent expansion of the safety net.
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Third, safeguards should prohibit inappropriate transactions between insured institutions and their subsidiaries and affiliates, and should assure that capital levels remain strong after investments in non-banking activities.
Fourth, regulation should be commensurate with risk--no less, no more--and should be along functional lines with no gaps between the functional lines.
Fifth, easing the broad range of restrictions on activities of banking organizations beyond those that are financial in nature should proceed cautiously.
In conclusion, it is imperative that we learn from the past as we contemplate a substantial expansion of powers available to banking organizations in the future. I applaud this subcommittee for its substantial attention to these issues, and we stand ready to work with the subcommittee on this very important effort.
I look forward to answering your questions.
Chairwoman ROUKEMA. Thank you.
[The prepared statement of Hon. Ricki Helfer can be found on page 470 in the appendix.]
Chairwoman ROUKEMA. Chairman Levitt of the Securities and Exchange Commission.
STATEMENT OF ARTHUR LEVITT, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION
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Mr. LEVITT. Madam Chairwoman, Members of the subcommittee, I commend the Chairwoman and the Ranking Member for raising the important issue of financial services reform so early in this session.
My colleagues on this panel have described how Glass-Steagall reform could permit greater competition and efficiency in the banking industry. As the Nation's chief securities regulator and someone who has spent the better part of a lifetime in the securities industry, I approach the issue with somewhat different concerns.
Our markets are the envy of the world, and American securities firms are the unquestioned leaders of those markets. Last year alone, our firms raised more than $1 trillion. This capital was raised from investors, through the entrepreneurial and risk taking efforts of security firms without the benefit of Federal Deposit Insurance.
These markets are the engine of American capitalism. That engine is, and for many years has been, performing at a truly extraordinary level. From my vantage point, it is as if our engine gets 200 miles per gallon, while the rest of the world struggles to reach 50.
While we should never be complacent and never assume we can't do better, we change the means by which we fuel this engine at our peril.
The continuing success of our capital markets requires that we preserve the securities industry's ability to assume risks. It also requires that we maintain a strong system of investor protection that establishes, by both word and deed, that our markets are fair and honest and that public confidence in them is justified. If reform is to succeed, an appropriate balance must be struck between preserving bank safety and soundness and serving the needs of investors in the market as a whole.
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Although we agree with some aspects of H.R. 268, we feel it still has to go some distance to strike that balance. Most notably, it does not yet set forth a workable approach to functional regulation, and it seems to perpetuate inconsistencies in the so-called ''two way street.'' I will describe each in turn.
As we modernize financial services, we must also modernize their regulation. Investors should benefit if they can choose from a wider array of products and providers, but they should not be expected to give up basic safeguards in the process. The SEC continues to believe that the best way to ensure investor protection is through a system of functional regulation under which all securities activities are overseen by an expert securities regulator and all banking activities are overseen by an expert bank regulator.
The unprecedented number of investors in our markets today deserve protections that apply without regard to whether they bought their investment from a bank or from a securities firm.
Our second concern with H.R. 268 has to do with the so-called ''two way street.'' To the extent banks are allowed to own securities firms, those firms should be allowed to own banks. Alternatively, if they choose, securities firms should have access to banking functions such as the payments system through limited purpose entities that are fully subject to banking regulation, but without also being forced to shoulder intrusive holding company regulation. Without such competitive equality, there is a roadblock on one side of the two way street.
At the same time, the Commission believes that safety and soundness restrictions should not be applied to an entire organization made up of securities firms, insurance companies, and other financial services providers. Rather, these restrictions should focus solely on the discrete banking functions within that organization. Securities firms must be able to continue to engage in entrepreneurial risk taking activities.
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The Commission acknowledges the increased risks of a more concentrated financial system, but believes they can be managed through the use of segregated entities having solid capital requirements, strong firewalls, and a clear regulatory structure. For this reason, the Commission supports the thrust of the risk assessment provisions of H.R. 268. But we believe that more could be done to isolate bank oriented regulation to the insured bank, leaving affiliates to more market style regulation.
Finally, as deliberations on financial service modernization advance, I urge you to be mindful of the fact that the philosophies and cultures of the securities and banking industries and their respective regulators are dramatically different. These differences are quite intentional; the architects who constructed them were seeking to serve distinct public policy goals.
Bank regulation is oriented around the concept of maintaining safety and soundness. The theory is that by promoting the banking system as a whole, you serve the interests of the individuals and entities that use it and the taxpayers who underwrite it.
Securities regulation is entirely different. In part because the industry does not expose taxpayers to the risk of massive losses and in part because we are much smaller than the banking agencies, our regulatory programs are founded on the principle of protecting investors. The theory is that an unwavering commitment to protecting individuals serves to enhance the fairness and integrity of the system as a whole.
A problem at a mutual fund not long ago illustrates the profound importance of these differences. The case involved an investment adviser whose employees had engaged in illegal self dealing that was costly to the fund.
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The Commission required the adviser to compensate the fund for losses of more than $9 million. If the adviser had been a modestly, or weakly capitalized bank, however, would its banking regulator have ordered this remedy? Or, instead, would they have concluded that the fund's shareholders were out of luck because such compensation would weaken the bank and increase the risk to the deposit insurance fund?
Meaningful reform must reconcile these different approaches, and we urge the subcommittee to work toward a regulatory framework that fits today's marketplace without compromising our historic commitment to protecting investors.
Chairwoman ROUKEMA. Thank you, Mr. Levitt.
[The prepared statement of Mr. Arthur A. Levitt can be found on page 513 in the appendix.]
Chairwoman ROUKEMA. Mr. Downey, I am afraid we will have to leave now for that vote, but we will be returning in no longer than 15 minutes.
I will gavel us together, and Mr. Downey will begin in 15 minutes.
[Recess.]
Chairwoman ROUKEMA. Will the panelists please take their places? I know Members have not yet returned, but we have already gone over the stated 15-minute recess, and I am going to call the hearing to order. I am sure that others will be arriving shortly, although I see Mr. Watt is here. Hopefully, Mr. Vento will be returning.
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Mr. Downey, let's hear your testimony, and then we will get on with the questions.
STATEMENT OF JOHN DOWNEY, EXECUTIVE DIRECTOR, OFFICE OF THRIFT SUPERVISION
Mr. DOWNEY. Madam Chairwoman, subcommittee Members, I am John Downey, Executive Director of the Office of Thrift Supervision. I am here in place of Director Nick Retsinas, who was called away this morning due to a family health problem. I would ask that his prepared testimony be entered into the record, and Director Retsinas has asked me to make a few brief comments regarding OTS experience with the issues being discussed today.
In many ways, the thrift industry has served as a laboratory for exploring the effects, permutations and affiliations between various sectors of the financial services industry and between those sectors and other commercial firms.
The way these various affiliations are structured and regulated is by no means the only framework for our financial services system. However, our limited experience in regulating and observing how insured institutions manage their various business interests, both at the holding company and subsidiary level, is helpful in reaching an understanding of how the system can be structured to accommodate interlocking financial service companies, while preserving the safety and soundness of the insured institutions.
Insured savings associations have for years been affiliated with, and been owned by, a myriad of commercial entities. Our experience has been that affiliations between commercial firms and insured thrift institutions do not involve any greater risk than affiliations between thrifts and more traditional financial services companies.
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There are currently over 700 unitary thrift holding companies. The majority of these companies are predominantly financial service companies, but some engage in enterprises as diverse as paper and wood products and integrated food services. Although not all these relationships have been productive, affiliations between thrifts and companies engaged in financial, commercial and industrial activities, have raised neither systemic safety and soundness nor public policy concerns. Indeed, many of these affiliations have proved particularly beneficial to their subsidiary thrifts.
The thrift holding company model is useful because it demonstrates how the system can accommodate the intermingling of banking and commerce. Although savings and loan holding companies are not generally subject to activity restrictions or capital requirements, the interaction between the subsidiary thrift institutions, the holding companies, and its affiliates, is closely monitored. In this manner, we attempt to ensure that a holding company and its affiliates do not adversely impact a subsidiary thrift.
This is accomplished by the imposition of FIRREA's stringent restrictions on a thrift's transactions with its holding companies and affiliates, FDICIA's prompt corrective action sanctions, and limitations on capital distributions by a thrift to its parent, coupled with risk based capital requirements and risk focused examinations.
There is also concern that allowing insured institutions to operate a variety of non-banking businesses through operating subsidiaries and service corporations could adversely affect the health of the parent insured institution. Our limited experience suggests that with the proper safeguards in place, insured institutions can operate these subsidiaries without threatening the health of the insured parent.
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For example, a thrift's exposure to activities engaged in by a service corporation is limited. A thrift can only invest 3 percent of its total assets in service corporations. Furthermore, a thrift's equity investments in service corporations that engage in activities not permissible for a national bank are deducted dollar-for-dollar in calculating the thrift's capital.
This separate capitalization requirement means that a thrift must maintain additional capital if it wants to pursue nontraditional banking activities in a service corporation.
As I have described, our supervisory experience at OTS suggests that there are ways we can proceed to implement financial modernization reform without jeopardizing the safety and soundness of our insured institutions. Although a certain amount of disruption is inevitable when attempting to implement changes of the magnitude we are now discussing, financial modernization should not undermine the very objective it was intended to achieve, making insured institutions more competitive.
For example, we should avoid statutory changes that require institutions and their holding companies to divest existing profitable business activities. Similarly, we should avoid charter application requirements that are not necessary to complete the process of rechartering an organization. The joint efforts of the OTS and the other Federal banking agencies over the past 5 years to implement streamlined and uniform regulatory requirements as directed by Congress in various statutory provisions gives solid support for an automated rechartering process.
Any plan to modernize our financial services industry should also nourish the vitality and strength of America's community-based lending institutions. We cannot overlook the invaluable services that local lending institutions provide to our communities. We must preserve and extend, where possible, the ability of institutions to deliver personal and timely financial services to local communities.
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Finally, any proposal to modernize financial services must ensure that institutions are not discouraged or precluded from continuing to concentrate in mortgage lending. We should not force institutions that focus on housing finance to abandon a business that has not only been profitable, but also fulfills a very important public purpose.
Thank you.
[The prepared statement of Mr. Downey can be found on page 544 in the appendix.]
Chairwoman ROUKEMA. Well, we don't have other Members here, so I will use my time, but I will not abuse you, the Minority here, Mr. Watt. I do appreciate your being here.
Let me recognize the fact that Mr. Ludwig, I think, has had some opportunity to respond to some of the questions that were asked, that I asked specifically of Mr. Greenspan.
Let me give you the opportunity to broach the subject again if you feel it was not adequately covered by the time restraints on you, particularly on the subsidy question and perhaps on some of the other differentials there are with respect to regulatory matters, differences between yourself and the Fed. Because I think not only with respect to you, but certainly with respect to the other regulators here, and particularly the Securities Commission, to me, this is the heart of the matter, how we are going to get to the regulatory question. There are still wide differences.
Mr. Ludwig, whether you want to address yourself to amplifying the subsidy issue between you and Mr. Greenspan, or the overall regulatory differences, the questions you have in your mind.
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Mr. LUDWIG. That is very gracious of you, Madam Chairwoman. I will try to be brief because I realize that we have to leave time for the other panelists. I do want to make three points on the subsidy question.
First, even if you assume there is a net subsidy, which I think is not borne out by the research, the critical question is whether the subsidy inures more to a holding company subsidiary than a bank subsidiary. That question depends on what the rules are separating the bank subsidiary and the holding company subsidiary from the bank. We proposed in our Part 5 a strict separation, using Sections 23(A) and 23(B) of the Federal Reserve Act, capital deduction requirements for the subsidiary, and an insistence on separate operation of the subsidiary. Indeed, the restrictions we imposed are at least as severe and, on a case-by-case basis, can be much more severe, than the restrictions between the bank and the holding company subsidiary.
Second, there is no evidence that the bank subsidiary versus the holding company subsidiary model is more effective in restricting transference of any subsidy. If you look at mortgage banking, which can be conducted anywhere within the banking organization, you find no pattern. Of the top 20 bank holding companies, six conduct mortgage banking operations in a holding company subsidiary; nine conduct mortgage banking activities in the bank or bank subsidiaries; and five conduct mortgage banking through a combination of the bank and holding company. Moreover, there are mortgage banking companies that have nothing to do with banks that are extremely successful. If there were a meaningful subsidy of any sort, you would expect to see all the activity in the bank or bank subsidiary. If there was transference to the subsidiary that was meaningful at all, you would expect to see the activity there. You don't see that pattern, which strongly suggests that there is no transference.
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The third point I want to make is that for a considerable period of time, State banks have had subsidiaries that engage in a variety of these activities, so there is nothing really new here. Also, United States banks operating abroad for a generation have conducted the activities you are talking about in this bill. Nobody has ever questioned whether there is a subsidy.
In other words, this question is not new, and, indeed, one doesn't see historically this kind of subsidization matter.
Finally, there are costs to using a holding company versus a subsidiary approach. The costs, one of the significant costs of using the holding company structure as distinct from the subsidiary structure, which makes the holding company, I think, structure something one has to think about, is the CRA point. In other words, it does not cost less to transfer all of the activities out of a bank or out of a subsidiary into the holding company and into a holding company subsidiary from a public policy perspective. What it will mean is a shrinking of the bank, a shrinking of the assets that are available for CRA, at very considerable cost, in my view, to our low-, and moderate-income Americans.
In addition, it has been the bank that has for generations supported middle income Americans by providing a safe place to save at a decent return. To the extent that the bank has shrunk, shrunk, shrunk, the ability to provide that benefit to middle Americans shrink, shrink, shrinks, in my view, as well.
Finally I might mention, just so there is no confusion, operating subsidiaries are fully subject to SEC jurisdiction or other functional regulators. In other words, putting them in an operating subsidiary does not mean that the OCC or the FDIC or the State regulators are the only supervisors. They are fully subject to the SEC and functional regulation generally.
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Thank you very much, Madam Chairwoman, for the time. It is very gracious of you.
Chairwoman ROUKEMA. Thank you. Mr. Vento, with your agreement, may I ask a second question, because before you arrived, I allowed Mr. Ludwig more time to extend his remarks particularly because the subject was raised on the subsidy, and he had not had adequate time to respond.
With your approval, may I have one more general question to address?
Mr. VENTO. Fine.
Chairwoman ROUKEMA. That is particularly to Mr. Levitt, but to anyone----
Mr. WATT. Madam Chairwoman, I don't mean to disturb you, but I thought you were going pretty stringently according to time limits, the last time I heard.
Chairwoman ROUKEMA. Perhaps then you weren't here when I introduced the subject to Mr. Ludwig.
Mr. WATT. I was here. I thought he was responding to a question.
Chairwoman ROUKEMA. You are objecting?
Mr. WATT. I am not objecting. If you are going to apply the rules, I thought you said you were going to be religious in the application of the rules.
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Chairwoman ROUKEMA. I made an exception for Mr. Ludwig.
Mr. WATT. I would think you would apply the same rules to yourself.
Mr. VENTO. If the gentleman would yield to me, I think the Chairwoman was extending more time to Mr. Ludwig to extend his testimony rather than taking questioning time on her part.
Chairwoman ROUKEMA. I will concede to Mr. Vento. Go ahead, Mr. Vento.
Mr. VENTO. Fine. I think it is important that all of the regulators have ample time. I think the Fed, obviously, has an important role as regulator, but each of those before us right now have at least as significant a role, and maybe a greater role, depending on what we determine. So it is unfortunate. I think obviously having been in the role you play, trying to keep the Members here so they are active and engaged, is always difficult, as you can see with all the absences at this point.
But I think what is being established here is, I don't know. I mean, what I am hearing is this sovereign credit, maybe that the king doesn't have quite as many clothes as what was indicated earlier with regards to what this credit really means. I am not trying to take anything away. I guess I have sold it in a variety of ways to encourage banks, because of the franchise and other roles that they play, that we have extended activities to them.
So I am not going to continue this particular debate, but I think it is important to understand on the part of the regulators, not extending, for instance, I am especially concerned, incidentally, not so much about whether the window is open or there is access or potential of access as in the case of these industrial firms and the mortgage brokers, but whether or not we are going to actually get into an insurance scenario, because that is where we get into problems.
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Chairwoman Helfer, do you have any concerns about the structure of this bill that would in other words somehow qualify the ability of the FDIC to, in fact, protect the deposit insurance funds and draw on the Treasury, or draw on the Federal Government, that that would represent?
Ms. HELFER. We have raised some very specific comments in a letter to Chairwoman Roukema. Let me say our concerns are very much that we assure that the insured bank is protected, and that we have sufficient protections around the insured bank. I know the legislation looks to the question of applying Sections 23 (A) and (B) of the Federal Reserve Act, which govern transactions between the insured bank and affiliates. But, I also think it is very important that we assure adequate capital levels in the insured bank after an investment is made in a subsidiary of the insured bank.
I am not sure the bill addresses those issues quite as directly as we perhaps might like to see. Certainly our staff will continue to talk with the subcommittee staff on those issues.
Our view is that we have to assure that the insured bank will be well capitalized after that investment is made, and then, to make certain that we can limit any potential net subsidy impact, that is, the spreading of the safety net beyond the insured institution.
We would not permit the consolidation of the capital of the subsidiary with the insured bank for regulatory capital purposes. In addition, of course, applying Sections 23(A) and 23(B) to the dealings between the bank and its subsidiary, should that be the option chosen by a financial institution for engaging in these activities, would also have the impact of limiting any spread of the safety net.
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We are obviously concerned that the deposit insurance funds will be adequate to meet any problems in the future and that there never be an occasion in which taxpayers are called upon to meet those needs.
Mr. VENTO. Well, I think it is important. I notice that both the testimony of Mr. Ludwig and Chairwoman Helfer has been that they feel that structure isn't so important as is the actions and the powers of the regulators to, in fact, be involved. There isn't a holding company model in and of itself that has nothing explicitly that will offer or afford any greater degree of protection with regards to the regulatory regime that you have put in place. Is that your testimony?
Ms. HELFER. Yes. Basically, what we found during the failure period was that in times of stress, unfortunately, banking organizations are just as likely to turn to the insured institution for financial help from above, the holding company parent, as from below, the subsidiary of the bank. We don't see that either form works any better from a safety and soundness perspective. The real issues are assuring that the protections are in place and the insistence that regulators actually make certain those protections are conformed with between the insured institution and the affiliated entities.
Mr. VENTO. Mr. Ludwig, you concur?
Mr. LUDWIG. I share that view Congressman Vento, entirely. I think what really adds to safety and soundness is not the structure. In fact, in some ways focusing on the structure creates a completely false sense of security. What really adds to safety and soundness, this is both a historical experience and it is certainly in my experience as a regulator and has been the experience abroad, is serious supervision, the kinds of rules and firewalls that are necessary, the kind of separation in operation that I am sure Chairwoman Helfer and I both concur in. That is what really makes the entity safer, not a structure in and of itself.
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Mr. VENTO. My time has expired. I just think that Chairman Greenspan referred to systemic risk and referred to macroeconomics concerns that he had with regards to modernization. From my part, I don't see that these are directly related to the holding company structure or directly related to the issues that we are talking about with regard to regulation.
In fact, those types of functions are present and seldom used, as I indicated in other areas. I hope we can get back to question Mr. Levitt, Madam Chairwoman. Thank you.
Chairwoman ROUKEMA. Mr. Barr.
Mr. BARR. Thank you, Madam Chairwoman. I apologize for getting here a little bit late. We had some other hearings that I participated in on another subcommittee.
I have had the opportunity, Mr. Ludwig, to briefly review your testimony, and I don't know whether you read the entire thing into the record, but I presume it is consistent with what you stated.
Mr. LUDWIG. Yes, sir.
Mr. BARR. There is a big red flag that sort of jumped out at me, and I don't know whether you can make me feel any better about this or not. On page 7, I see ''community reinvestment'' appears several times, and I am wondering, is some move afoot to expand the entities to which CRA mandates apply? Also, what is the basis, because it seems to be your conclusion that profits from a bank subsidiary would actually be applied to CRA activities. You use terms like ''enhanced resources'' and so forth. Where would those come from, why would those apply to CRA?
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Does this reflect a notion or plan to expand CRA, which worries me a great deal?
Mr. LUDWIG. No, sir. The direction that I have taken in the testimony is that we should not do anything to reduce CRA's coverage. Indeed, the subsidiary holding company issue, I think, is very significant in that regard.
You see, if a subsidiary earns money and it dividends it up to the bank, that money is available for CRA. That is the way the law works now.
Mr. BARR. The activities of the subsidiary are not controlled. The requirements of CRA don't apply to the subsidiary?
Mr. LUDWIG. Not directly, but they do apply more indirectly in this regard.
When we do an assessment context, that is assess what the banks' responsibility is, we take into account the bank and its subsidiary as a whole, look at what the bank's response is. That is how the rules work today.
I am trying to be clear in my written and oral testimony here today that I don't think we ought to make changes that diminish that, if you will, safety net for low- and moderate-income Americans.
Mr. BARR. Isn't the best safety net having viable financial institutions in the communities that extend credit and make loans to people based on financial solvency? Isn't that really the best safety net?
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Mr. LUDWIG. That is extraordinarily important. I am proud to say we have seen a period of the most profitable period in American banking history in the last several years, and coincident with that era of profitability has been a dramatic increase in banks' lending to low- and moderate-income Americans. I think we have a win/win here for all Americans: Strong financial institutions making good healthy profits and supporting their communities as the law provides.
What I don't want to see is any diminution of those opportunities. Indeed, I think it would be very unfortunate if we saw any diminution of those opportunities.
Sir, remember the Community Reinvestment Act, and specifically the regulations under it, make clear that these are not to be losses, these are not to be bad loans. They are supposed to be profitable activities, indeed not just safe, but profitable activities.
Mr. BARR. Looking at it, we talked about subsidiaries, looking at bank holding companies, are you making any suggestion that we establish a CRA establishment for a bank holding company?
Mr. LUDWIG. Well, I didn't in my written testimony. I must say that if you completely take away low- and moderate-income opportunities through the subsidiary and the bank, you narrow it down to nothing. I think it does raise that issue, because this would be a substantial reduction in the availability of credit.
Mr. BARR. In your experience, and I know it is very, very extensive, won't banks--aren't they eager to lend to people wherever they are, if there is a promise of a rate of return and if they meet the sound fiscal requirements? I don't know that we would be taking anything away.
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Mr. LUDWIG. I am very proud of the American banks' focus and historic focus on their communities, including smaller institutions which have historically been high integrity on average, providing financial services to their entire communities.
Having said that, the Community Reinvestment Act and enforcement of the fair lending laws has demonstrably increased lending to low- and moderate-income Americans, for whatever reason, maybe just a focus on the issue.
We have seen in the last 3 years an increase in most American cities. If you look at the Home Mortgage Disclosure Act data of lending to low- and moderate-income Americans, it is in the neighborhood of from 117 to 130 percent to minorities. They are very significant increases. I believe they are attributable to changes in the regulations and other emphasis here. They are safe loans and they are profitable loans. This is an innovative area, part of what I would like to call the ''democratization'' of credit. I think a withdrawal of CRA would have an adverse impact on that.
Mr. BARR. My direct question is, can I read anything into your testimony here that indicates that there is an effort to expand CRA? I am not talking about withdrawing it. I may feel that way, but that is not what I am asking about. Is there any effort being made, is there any policy under contemplation at this time, in the context of the banking reform legislation that we are talking about, to expand the asset base of CRA or to expand the requirements on lending institutions for CRA's beyond those now covered?
Mr. LUDWIG. The purpose of the point I made in this testimony, the written testimony and orally, is sort of two points: One, I think considering the impact of financial services reform on low- and moderate-income Americans, on all Americans, is extremely important, because this has real rubber-meets-the-road impact on these people's lives.
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In that regard, I feel that strongly, that if one does not have the bank subsidiary option as it exists today and as it can exist in financial services reform, one will see a significant diminution in the availability of banking services, including credit services for low- and moderate-income Americans under the CRA.
Mr. BARR. I think I understand. Thank you. Thank you, Madam Chairwoman.
Chairwoman ROUKEMA. Thank you.
Mr. Watt.
Mr. WATT. Madam Chairwoman, I think Mr. Bentsen is actually next in order.
Chairwoman ROUKEMA. All right, whichever.
Mr. Bentsen.
Mr. BENTSEN. I thank my colleague, and I thank you all for testifying. First of all, Mr. Ludwig, obviously you and Mr. Greenspan have some differences of opinion, but I think there probably is a little bit of a subsidy that exists. I think that you conceivably could argue that having access to the discount window and being able to move money around, and I know traders always used to insist that banks were going to the discount window and reinvesting other procedures, that is all fungible in the Treasury market, and living off the spread. So I think there is some subsidy, and there might be subsidy through Section 23(A), where you can cover your position with a lower cost of funds than maybe a securities firm.
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But anyway, I don't want to get into a debate about that. What I thought was interesting was your conversation about ''structure'', and structure maybe not being as important. I have a question about that as well.
It seems to me that whether you have a subsidiary structure or an affiliation structure under a holding company, the risk, which is what our real concern should be, to the being able to access the taxpayer backed deposit insurance fund, is equal, unless we set up some substructure that precludes the holding company, or the parent company, from moving funds around or moving equity around.
Wouldn't that be correct? Not necessarily from your position as Comptroller, but maybe from your previous life as an attorney? What is the real difference between an ''affiliate'' and a ''subsidiary'', absent some other rules like Sections 23(A) and 23(B)?
Mr. LUDWIG. Actually, that is a very good question, Congressman Bentsen. The issue of corporate separateness actually reads on how the affiliate is governed and treated. So what these firewalls are and how the governance of these affiliates, be they in the holding coat or the subsidiary, matter a great deal. I think they are crucially important.
Similarly, it seems to me the issue is not where it is in the chain, as Chairwoman Helfer, I think, made very clear. It is really how the entity is treated. So my examiners go into banks every day. Many of the examiners in larger institutions, that is where they go to work. They are examining 360 days a year, or however many business days there are.
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Those are the things, the firewalls, the capitalization, the separation, how these entities are treated, that really matter from a safety and soundness, and I believe also, if there is any subsidy, subsidy transference, point of view, not where it exists in the corporate family.
Mr. BENTSEN. Isn't it possible, whether you have a subsidiary or an affiliate, that you can upstream capital or downstream capital without the appropriate firewalls in place? So it doesn't really make a difference whether it is an affiliate or subsidiary, as much as what the legal structure is in between the two entities?
Mr. LUDWIG. I think that is exactly right. It doesn't matter where it is in the corporate family. It matters where the firewalls are and how it is enforced.
Mr. BENTSEN. Obviously, Congress and the regulators can set them, and somebody else will come around and say. ''Let's find a neat way to get around that until Congress, or the regulators discover that, or until we have a problem'', which I think leads us into the commercial aspect of this. Does that open the door to more problems where you expand investments, or expand powers, beyond financial in nature?
I think insurance is probably financial in nature. I don't think making cars is necessarily financial in nature, although most of the car companies run credit operations.
So that is where our concern is and I think our concern probably needs to be more focused on that.
Let me ask Mr. Levitt, you talked about the regulatory structure and you talked about the need for functional regulation, and I agree, I think the SEC is more able to view a broker deal than the Comptroller is or the Fed is. I think H.R. 268 has that functional regulation component in it. But also, if I understand correctly, it has a committee component as well, and committees are worrisome.
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But the Chairman of the Fed was here earlier and he argued very strongly in favor of umbrella regulatory structure, presumably with the Fed at the top. But don't you need that at some point? Don't we need to have a functional regulatory structure that doesn't ultimately have one final regulator who can say, ''Yes, we have looked at what the SEC has said, what the FDIC has said, or the CSTC has said, and take that into consideration?'' Or do we have the problem where we might have regulator shopping on the part of a multifaceted financial institution?
Mr. LEVITT. The question is, could we have regulatory arbitrage? After years of being regulated and now some years regulating, I have come to the conclusion that flexibility is a factor that has got to be introduced into this process. As good as it may seem on paper, if you have to have every ''i'' dotted and every ''t'' crossed, that probably works against the system as it should be.
While I see some wisdom to an overseer, I want to be certain that the overseer has experience and expertise in terms of the entity that he or she is overseeing.
I have reservations about a committee structure. Again, my experience tells me when you get a group together like that, you don't get a very efficient decisionmaking process. This is a group that is made up largely of banking regulators. We already have a rather well functioning working group that meets on a regular basis and can do many of the things that are intended by this kind of super supervisory group.
I think the key here again is seeing to it that we don't impose the safety and soundness mantra, which I admit is extremely important and about which we have heard so much this morning. On the culture of entrepreneurship that is so characteristic of the securities end of the business.
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So while I certainly commend the Chairwoman and Congressman Vento for coming up with a bill that makes real progress, I think that the functional regulation provisions can certainly be more effective. They can be tightened in a number of respects which I could outline for you, and that would make me feel much more comfortable about it.
But I think the fact you have gone with a risk assessment model is constructive. I think that is a good way to go and adds to the flexibility that is becoming part of modern day regulation.
Mr. BENTSEN. I appreciate that. My time is up. I think it would be helpful if you could outline that in more detail, because I think we are sort of caught in between the middle of this, whether we create a super dominant regulator or regulate by committee, neither of which may be the way we want to go.
Mr. LEVITT. If I get more questions on it, I will be glad to amplify.
Chairwoman ROUKEMA. Mr. Watt.
Mr. WATT. Thank you, Madam Chairwoman.
Mr. Ludwig, I am going to go somewhere near where Mr. Barr went, but from a different perspective. I don't start with the assumption that the market will make adequate provisions for low- and moderate-income borrowers and that CRA is not necessary. I start from the other end of that perspective based on experience, and his experience is probably different than mine. But we have seen that in a number of areas, so that doesn't surprise me nor alarm me.
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Leaving aside the question of whether CRA ought to be applicable to a holding company, I want to go to the other end where you are talking about a subsidiary and find out from you, I am not clear that what you are saying is if a bank has a subsidiary, CRA ought to be applicable to that subsidiary?
Mr. LUDWIG. Yes, that is the current rules in this respect. They bite on it in two ways. Number one, subsidiaries earn profits, often, not always, but those profits are available for CRA. If it is not in a subsidiary, if it is a holding company affiliate, those profits are not available for CRA.
Second, when we assess what the bank ought to be doing for CRA purposes, as I said to Congressman Barr, we look at the entire entity, bank and subsidiary, that is part of the performance context. So when we assess ''Is the bank doing enough?'', we are looking at what the subsidiary activity is as well, how big it is, how much money they are making, and so forth. If you don't do that, if you go to a model where the bank shrinks, there are no subsidiary activities----
Mr. WATT. I got that point. Mr. Downey, you have a bunch of unitary thrifts that you say have all these assets and subsidiaries. Are they subject to CRA?
Mr. DOWNEY. Yes.
Mr. WATT. And you are comfortable with that aspect in the subsidiary arrangement?
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Mr. DOWNEY. I echo the Comptroller's words, yes.
Mr. WATT. I am not leaving anybody exempt from this line. If we get to the point where Mr. Levitt was talking about, where banks own securities companies, securities companies own banks, if they hold them in subsidiaries, I take it the logical extension of that would be regardless of which way you are going on the street, whether it is a securities owning the bank as a subsidiary or a bank owning a securities company as a subsidiary, all of those assets and all of those profits are going to be subjected to CRA?
Mr. LUDWIG. No, sir, not exactly.
Mr. WATT. Clarify for me then.
Mr. LUDWIG. If a securities company owns a bank, the bank, under current law, the bank and anything under the bank is, you might say, in the CRA family. If the bank owns a securities company, the profits of the securities company underneath the bank are available for CRA, and in assessing how much the bank on top ought to be doing for CRA, looking at the performance context, one would take into account the securities subsidiary.
Mr. WATT. All right. And under this new regime that is being proposed under the bills that we are talking about for modernization purposes, that is the question I am getting to. If there is a subsidiary, then am I clear that CRA will apply to all of what is under the bank?
Mr. LUDWIG. If it is under the bank, there is CRA applicability. If it is not under the bank, there is not.
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Mr. WATT. So what if, as Mr. Levitt postulated, you open the road to run both ways and the bank is under the securities company?
Mr. LUDWIG. Then if the bank is under the securities company, then the only part of that corporate family that would be covered by CRA under current law is the bank.
Mr. WATT. Well, I guess my question is, is a price that should be exacted for the privilege of doing that an equivalent set of rules that does, in fact, remove all these roadblocks in both directions?
Mr. LUDWIG. Well, as I indicated, this has, I think, profound impact, potentially these bills, on CRA and its coverage, and I think one has to look very hard at what really is going to be available under all these different schemes. I think it can have very profound effects.
Mr. WATT. Thank you, Madam Chairwoman.
Chairwoman ROUKEMA. Thank you. I want to go back to a question following up on this whole question of the structure of the firewalls and what kind of functional regulation we have. I guess I want to direct it to Mr. Levitt, because Mr. Levitt said to Mr. Bentsen that you wanted to amplify. I don't know if this is going to give you the opportunity to amplify, but let me put the question in the context of the example of Barings in Great Britain. I think there is a question here that is related.
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If we are speaking about the subsidiaries and the regulatory structure, we do know Barings showed how quickly an operating subsidy can break down. What is your reaction to this as a paralegal, and how does the lesson of Barings apply to what we are looking at here? And particularly keeping in mind something I am convinced of, but with our panel the other day, the subject kept coming up, although Mr. Greenspan didn't say it explicitly in his words today, we all know that under stress, firewalls melt.
I am sympathetic and supportive of the securities question here, whether it is from the Commission's point of view or whether it is from the securities industry's point of view. But I want you to amplify. I am concerned about those firewalls melting, and how does that relate to the supervision, whether it is umbrella or functional or whatever? Amplify, please. I think it is a follow-up to Mr. Bentsen's implications here.
Mr. LEVITT. I think, first of all, this bill, as progressive as it is, or any other bill I think, probably could not have prevented a Barings episode, which was a management failure, an oversight failure. This episode opens the question of no matter what we do in the United States, if we don't develop a better international coordination of globalized markets, our problems will be much more severe.
Leaving that for a moment, with respect to why I suggested to Mr. Bentsen that the functional regulation provisions presented in H.R. 268 simply are not strong enough. I can outline three areas, and then amplify in writing later on.
In the first place, the functional regulations provisions do not appear to cover existing banks. The provision that does cover banks engaged in new activities has many, many exceptions in terms of bank securities activities that either can come in or come out, with the banking regulators making the ultimate decision, rather than the SEC. I think that these areas have to be attended to as the bill moves forward.
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I cannot overemphasize the importance of distinguishing between the kind of safety and soundness regulation characteristic of banking examiners and the kind of regulation that securities firms have prospered and flourished under in terms of nurturing entrepreneurship and risk.
Mr. BENTSEN. Madam Chairwoman, if you will yield, in the case of Barings, which is under a different structure, I think, it was a different structure institution, it was a different regulatory structure. Maybe the question ought to be could Barings happen here, under this bill, or some hybrid of this bill?
Mr. LEVITT. After years of dealing with the unexpected, I would be very hesitant to say that a Barings-like event couldn't happen any place at any time. I think the question is whether it is less likely to happen with a bill that is more responsive to the needs of today's financial products and today's financial markets, and my answer to that would be in the affirmative, and that is why I feel some bill is necessary.
Chairwoman ROUKEMA. Reclaiming my time, I would also observe we are talking with Barings. It was about operating subsidies, and Mr. Ludwig and others of us have been talking about expanding the activities of operating subsidies. So I think it is relevant, not exactly parallel, but it is very relevant.
But I would say for both Mr. Levitt and anybody else, and particularly Mr. Ludwig, that we would invite further comment on the essence of this subject in writing, please. We don't have time right now, but perhaps you can add a PS or two. But do put it in writing in any case.
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Mr. Ludwig, I have another minute. Do you want to add anything at this point, I mean on this subject, on the question as I raised it?
Mr. LUDWIG. That is very gracious of you. On the Barings issue, we have a----
Chairwoman ROUKEMA. The subsidiary question, yes.
Mr. LUDWIG.----We have a very different structure in terms of our supervisory mechanism which would prohibit the kind of operations that the Barings entity was engaged in. We require strict separation of the back room, that is the operational side, and the sales side of any entity engaged in these or other activities.
Mr. LUDWIG. Those requirements, not only do they exist in our rules very explicitly, that is, the United States, but in addition, we are hands-on supervising, which is a very different supervisory mechanism than the British have. The British have a quite----
Chairwoman ROUKEMA. Excuse me. I really only want to inquire as to what the lessons are in terms of our own proposed structure in H.R. 268 or one of the other alternatives.
Mr. LUDWIG. I think the lesson, in terms of our own structure, is that supervision and proper rules in respect to the operation of the corporate entity are critical; that any corporate form, and there are as many cases of holding company affiliates and similar sort of thing as there are any other affiliates, the key thing is quality supervision and strict rules in terms of internal control mechanisms, which I have, and Chairwoman Helfer has as well, spoken out on repeatedly.
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Chairwoman ROUKEMA. All right. Thank you.
Mr. Vento.
Mr. VENTO. I thought maybe we were going to talk about Daiwa for a minute, which is, of course, regulated by the proposed--the sovereign--credit.
But I don't really know if it was a holding company that lost its grip or if it was a subsidiary, but I think the issue isn't so much the structure as it is that regulation. You know, we have obviously had the Fed over the coals on that particular issue. And well, BCCI was mentioned. They also had some responsibility there. But there was a little split between the State and themselves at that point.
But my question, Mr. Levitt, is in dealing with the lead regulator, where, I appreciate very much your comments. I think they are very constructive with regard to this legislation and some of the imperfections in it, we will certainly admit to, and whether we will write a perfect bill, I don't know.
I think your admonition with regard to flexibility is one that we really need to pay close attention to. I mean, the real concern most of us would have is that we are legislating beyond the ability of regulators to, in fact, and imposing responsibilities which are unrealistic in terms of their being able to deal with the issue. And that is, I think that your comments about culture and differences here are very important, because we are dealing really with the essence of our economy in terms of its ability to respond.
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And so I think your comments are quite helpful and those of the other witnesses are quite helpful with regard to getting this right, or at least leaving it to others. But the lead regulator issue is one, obviously, I suppose we tend to fall down toward the bank and giving the bank the role.
In your testimony, you might want to amplify a little on the fact that your thoughts were that if there was a greater preference or a greater concentration of investment in the investment banking side, that then the point would be that the lead regulator ought to remain, for instance, with the SEC or whatever its derivative is.
Mr. LEVITT. Yes. I think that to assume that, under this scheme, with the affiliation of a securities firm and a bank, with a securities firm being a substantially larger participant and the bank a substantially smaller participant, to have the lead regulator be a banking regulator leads to the kinds of problems that were outlined in my testimony. It makes me feel less comfortable with the vision of functional regulation as described in this bill, than would be the case if the lead regulator was assigned to the regulator with the greatest percentage of the overall entity, then you would have a regulator that was accustomed to dealing with the sorts of problems in the culture of that particular enterprise.
Mr. VENTO. It may be somewhat fluid, but, I mean, obviously, I note that the capitalization, the necessary structure of banks, tend to reflect that they have a higher asset value than investment banks.
Mr. LEVITT. I think that is very much on the point.
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Mr. VENTO. Yes.
Mr. LEVITT. Investment banks use capital very aggressively.
Mr. VENTO. Yes.
Mr. LEVITT. Because safety and soundness is not their program.
And I certainly understand where different considerations are important for banks, and it is for that very reason that I think there should be a distinction.
Mr. VENTO. I wanted to get the indices that were used--can't necessarily be sort of--asset value, that would be your point; is it not?
Mr. LEVITT. Yes.
Mr. VENTO. In looking at the magnitude of what Merrill Lynch does versus a large thrift or something may actually have more assets than the thrift.
Mr. LEVITT. They do very different things.
Mr. VENTO. Yes. And I just think the issue in terms of the importance of who is a lead regulator, that it may be much more important in that instance maybe for the SEC to be the lead regulator even though the assets side may not be reflective of that. That is not the proper indices to use is your point?
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Mr. LEVITT. That is correct.
Mr. VENTO. I wanted to make sure that that was understood.
I note that you point out that there are certain consumer protections that might be missing. I was a little confused by that. Is that your concern, that the safety and soundness would not take into consideration that, or is there some measure in the bill where we say, ''You don't have to have a prospectus, you don't have to have other types of warrants and assurances that are normal in the sale and securitization in underwriting''?
Mr. LEVITT. We have heard so many times today about the issue of safety and soundness. I want to be absolutely certain that we recognize that the beauty of our system is being able to accompany the protections and the safety of deposits in U.S. banks with the nurturing of entrepreneurship that takes place with respect to investment banks. It is the confusion of those roles, it is the handcuffing of one or the unleashing of the other, that I think represents a danger to the system.
Mr. VENTO. I might say, Madam Chairwoman, just briefly. I appreciate your indulgence in recognizing me for an additional question. I think it is an opportunity that we have here, where we see there has been discussion about, for instance, CRA. And almost everyone starts out with the predicate of this legislation: we are going to all help consumers. That is one of the major goals, I think, almost all of you, including the Chairman of the Fed, had mentioned this.
But, I mean, it is an opportunity for us not to, you know, superimpose CRA where it doesn't fit, but I think there are some securitization activities where it does fit. In fact, we have done so for Fannie and Freddie. And so we might want to look at mortgage banking or look at other activities where securitization does take place and see where that fits. And especially since we are looking at if we are changing the roles and structures, to really see a change in terms of where capital is to, in fact, look at other areas where it would logically fit in terms of trying to be certain that, in fact, consumers end up being a beneficiary of this particular process. And I----
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Mr. LEVITT. May I address that point for a moment?
Mr. VENTO. Yes.
Mr. LEVITT. I think that CRA is a very valuable and important remedial concept. It is a banking concept, and I think it is appropriate, having served on the board of a bank, for loans to go to that community.
The difference, and I think this goes to other areas of the bill. And my whole point about perception and about the culture of the industries, the different culture, is that our securities markets are national. Our mutual funds which now have more money in them than all the bank deposits in the United States, are national, and they seek national investment opportunities. So I think we have to be very cautious about imposing some of the same requirements on them as we might the banks.
Mr. VENTO. You tell me how to do it so it can serve consumers, and I will try to accommodate it.
Mr. LEVITT. All right.
Mr. VENTO. I think it is going to be a major issue in terms of it is an element that is missing from this bill.
Thank you, Madam Chairwoman.
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Chairwoman ROUKEMA. Mr. Barr, have we focused on the issue that is closest to your concern?
Mr. BARR. Well, we have. And I must say in all candidness, my concern remains.
If I could just put a couple of final questions, Mr. Ludwig.
In your written testimony, and your testimony in this particular paragraph on page 7, is predicated, as you say here, that ''. . . authorizing new activities can be conducted in a subsidiary bank in addition to an affiliate.'' And then just a little bit further down, you say, ''. . . first, earnings from a bank subsidiary flow up to the bank and thus increase the ability of the bank to undertake CRA activities.''
Would the reverse be true, if there is a loss?
Mr. LUDWIG. The way we have structured Part 5 of our rules in terms of operating subsidiaries is to wall off the sub from the bank so that when there is a loss situation, there is an asymmetry here. That is, the subsidiary is in a sense on its own. And indeed the capital, we have acquired a capital deduction, such that the capital of the bank has to survive on its own.
In other words, there has to be enough bank capital under bank rules, irrespective of how much capital the subsidiary has. That is an abundance of caution. In some cases, one could argue that that amount of capital, double capital, you might say, is not necessary.
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But we have tried to take an abundance of caution margin.
Mr. BARR. I am just talking about for purposes of CRA here. Is then what you are saying in here, and what you are just saying, that if there are earnings from a bank subsidiary, they do flow up to the bank for purposes of CRA, but you are saying that if there is a loss in that subsidiary, the bank does not similarly--be treated similarly--you wouldn't take that into account?
Mr. LUDWIG. Well, that is a very interesting point, Congressman Barr. In one sense, you would. That is, if the subsidiary were losing money, there would not be money available because it is a loss, not gain, for CRA purposes.
In addition, if a subsidiary were shrinking or losing money or whatever, the entire entity, bank and subsidiary, would be smaller and so in terms of the performance context that we analyze to determine what the bank ought to be doing, that would be taken into account.
Mr. BARR. In precisely the same way that it would be taken into account if a subsidiary has earnings?
Mr. LUDWIG. Not precisely the same way, no.
Mr. BARR. Is that fair?
Mr. LUDWIG. There are really two, if you might say, CRA attaches in this area in two respects. One: is just the earnings are available; and two: is the entire context of the entity.
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If the earnings aren't available, we put it this way: I think it is fair in the sense that we would not be requiring monies be used when monies aren't available, but we would be taking into account the strength and financial wherewithal of the entire banking entity for purposes of determining whether or not there is a good faith effort being made in terms of fulfilling CRA obligations. But it is an interesting comment.
Mr. BARR. There is a real concern out there, Madam Chairwoman. I presume that we will probably be exploring this further.
Mr. LUDWIG. Congressman Barr, if I might say, the one thing I would mention is that we are not proposing, in our Part 5, and I would not propose, that the subsidiary be an exclusive tool, so that if a bank felt burdened by the use of a subsidiary, it could use a holding company affiliate and not have a CRA obligation under current law and under our own proposal, if you see what I mean. So that if this were so burdensome or so asymmetrical that it created a problem, there would be other options for the entity under current law.
My own view, very strongly, is this is a win/win for everybody. As I said, we have seen the highest level of profitability in banking ever, and I think that the burdens here are not so great that they would negate the benefits one can derive. And so I really do think this is a win/win for everybody. It is an option.
Mr. BARR. We can have a fairly lengthy debate over a number of--the way you look at those and the way other folks do. But I do appreciate your candor, and appreciate the opportunity, Madam Chairwoman.
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Mr. LUDWIG. Thank you, sir.
Chairwoman ROUKEMA. I appreciate the fact that the gentleman from Georgia has raised this subject. It was quite extensively debated in the context of reform last year, and we never really came to a bipartisan agreement, necessarily. There are still differences.
But in the context of this legislation, it bears further analysis. It is the first time that we have really discussed it with Mr. Watt and Mr. Barr here today. It is the first time that this subcommittee is addressing that component of the reform. So we appreciate your contribution and we will be looking for more intensive analysis.
Mr. Vento, shall we recognize Mr. Bentsen, for the last question? Our panel has been very, very cooperative here.
Mr. Bentsen.
Mr. BENTSEN. Thank you, Madam Chairwoman.
I first have to say, I think at this point I tend to agree with Mr. Levitt with regard to the distinction between investment banking and commercial banking as it applies to CRA, but when and if we get into the discussion of the wholesale financial institutions, I think that may raise another issue that needs to be looked at.
But I want to talk about a different distinction. In all of your testimonies, and I didn't get a chance to hear all of it, but I looked through it. All of you all sort of tiptoed around the question of commercial investment or the banking and commerce distinction.
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You raised the issue of the unitary thrift and the experience with that and the fact that it brought more capital, although I think that was a unique situation where you were looking for capital, or the regulators were looking for capital and Congress was looking for capital.
Mr. Levitt brings up the discussions of entities that do have credit operations in banks, but then, again, you also talked about the difference between investment banking and commercial banking, and assets and assets that you put to work and the whole risk concern. Investment banks are more inclined to take risk than commercial banks, because that is what they are doing for their clients.
I would like you all to expand a little bit on that, particularly as it relates to direct investment up to 25 percent, as this bill, I think, would allow or at what level that should be, because we have seen instances where investment banks have made direct investment only to see the value drop dramatically and it has a tremendous impact on their balance sheet.
So I would appreciate all of you to comment on your views as to where you see what basket, if any, there should be, in a blending of commerce and banking.
Mr. LEVITT. Well, again, with respect to banks, I am inclined to agree with Chairman Greenspan when he said that the existing artificial separation between banking and commerce probably won't last into the 21st Century, and I think his caution is understandable with respect to investment banks.
As you point out, those relationships have existed for some time. Many of them haven't worked as well as they would have hoped. Others have worked extremely well, and I think relationships contemplated today would be better engineered than they would have been, as a result of the experience of the past 15 years.
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So I have much less caution with respect to investment banks that have had the experience and the culture and the need to have this kind of affiliation. I would prefer to leave the banking question to my colleagues, however.
Ms. HELFER. Well, Congressman Bentsen, let me say, we did have a very negative experience from 1982 on, when financial institutions were permitted a broader range of powers, which they proved to be unable to deal with effectively for lack of experience and expertise and lots of other things.
It is true that at a time when Congress and the country was desperate for capital to essentially prevent some thrifts from failing, industrial firms, commercial firms, stepped in and provided much needed capital and that, on the other hand it has been, as Mr. Downey pointed out, a positive experience but a limited example, as you say.
My concern is that commercial banks do not have the range of experience and expertise that Mr. Levitt says that investment banks may have. And more to the point, as Chairman Greenspan said, although not in these words, ''Once you let the genie out of the bottle, you can't put it back in.''
Now, there are examples, however, in our banking laws, where limited investments in commercial enterprises have been successful. For example, under the laws that apply to the foreign activities of U.S. banks, U.S. banks have been permitted to invest in up to 20 percent of the shares of any company engaged in any activity, as long as it was a passive investment.
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Moreover, in the debt-for-equity swap area, U.S. banks have been permitted to invest in up to 40 percent of the shares of a company engaged in any kind of business, using debt to make the investment, admittedly in partial response to the sovereign debt crisis, with a bit more involvement permitted than just passivity in the conduct of the investment.
Neither of those have proven to be problem areas for investment for U.S. banks. And, in fact, some of them have proven to be quite successful. So there may be a limited range of experience, which can prove to be a basis for making a judgment about a deliberate cautious approach, which would, in fact, identify a level of investment that could be permitted as a kind of test case, as Chairman Greenspan said, for how we would deal with the issue in the future.
Mr. LUDWIG. Congressman Bentsen, this is really a very interesting area and a particular area to commend Chairwoman Roukema and Congressman Vento in the bill for, you know, addressing these issues, because this is an area that deserves attention, for a couple of reasons.
First of all, although I have not made up my own mind as to banking and commerce and exactly the right line here, I will say several things about it which I believe are important. One, historically in this country we had not prohibited banking and commerce affiliation until 1970. This prohibition is of fairly recent vintage.
Second, we don't prohibit it in the thrift area. So we have some experience. We don't have, historically, tremendously negative experience, either in the thrift context or in--or prior to 1970. And we have some experience abroad. Similarly, that experience has not been overwhelmingly negative.
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On the other hand, it is a very serious matter and it is one that, as I say, I haven't come to rest on myself.
But the second point I would want to make is this: Whereas commerce is a moving target to some important degree, and where we have to be very careful and thoughtful is walling the banks away from--or any financial entity--areas of activity which become, over time, central to those businesses.
Let me give you an example. Back in the 1950's, 1960's, it was viewed that data processing, I think there is a Fed ruling on this, was not a part of banking. That was not financial, data processing. Today, technology, as we all know, is the core of what is becoming modern banking.
I think banks, frankly, lost an opportunity to be at the forefront of technology, and I think that hurt them from a safety and soundness perspective by not being able to get into this emerging area as aggressively as they might.
Now that we are in era of profound change, technologically, we have to be very cautious as to what they are prevented from doing in what we might perceive initially as a commerce area, but, in fact, can turn out to be intimately linked with their core business.
Mr. DOWNEY. As I testified, we have some experience, albeit limited, with the unitary holding company model. In that regard, we have found the mixing of banking and commerce to be very beneficial to the thrifts themselves. Again, our experience is very limited. If you take a look at the participants that have entered the thrift industry, including Ford, Sears and others, and infused capital, all worked well from our perspective, and protected the insurance fund.
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Again, I don't think there is any magic number on the amount of commerce that should be permitted to be combined with banking. I think the safeguards, at least that we have experience with and that we have had in place, including Sections 23(A) and 23(B), and the fact that thrifts can't lend to affiliated commercial companies. You can't lend to your parent if it is involved in commerce, and other types of safeguards, have worked very well. Although the thrift industry experience is limited, it has largely been beneficial to the affected thrift institutions.
Chairwoman ROUKEMA. Thank you.
Let me use my prerogative here and just make one observation based on that last question. I am a battle scarred veteran of the savings and loan wars of the 1980's, and I remember it. So whether it is a 25 percent basket or not, I certainly am with the incremental approach that Mr. Greenspan articulated, and certainly I am with Ms. Helfer, once that genie is out of the bottle, you can't get it back. We need experience and understanding. And I think opening the door, as some legislation would have us do, I think, would be very ill advised and show that we haven't learned much in the last 15 years. But that is my own particular bias.
Thank you very much. I greatly appreciate your contributions to this debate. And we will be submitting, as you have heard, questions in writing for you, of course. We hope you will feel free and take the time to further amplify in writing on your statements and the issues as we focused on them today.
Chairwoman ROUKEMA. Thank you very much.
The hearing is adjourned.
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[Whereupon, at 2:30 p.m., the hearing was adjourned.]
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