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EXAMINATION OF FINANCIAL
MODERNIZATION WITHIN THE JURISDICTION
OF THE COMMITTEE ON BANKING AND
FINANCIAL SERVICES
WEDNESDAY, MARCH 12, 1997
House of Representatives,
Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises,
Committee on Banking and Financial Services,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:10 a.m., in room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
Present: Chairman Baker, Representatives Lazio, Cook, Hill, Sessions, LaFalce, Vento, Kanjorski, and Gutierrez.
Also present: Representative Leach.
Chairman BAKER. I'd like to call our hearing of the subcommittee on Capital Markets to order and welcome Members who are participating.
This morning we have, I think, an extraordinary opportunity to gain further insights into the principal differences as to how financial modernization should proceed.
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In my own case, I have contemplated the effects of commerce and finance being merged and have proposed a plan which, I believe, is reflective of current market conditions. But, I am contemplating, based on what we learn here today and from additional hearings that are planned, to perhaps incorporate concepts that have already been enumerated by the Comptroller, the Fed, as well as by important perspectives of Members from this subcommittee.
Suffice it to say the subcommittee is indeed privileged this morning to have with us the Chairman of the Full Banking Committee, who I am very pleased to say, has outlined a protocol for dealing with this very difficult issue to subcommittee chairs, to give full support and opportunity for every subcommittee chair to forward their own particular perspectives and to ultimately lead to a subcommittee markup later in the spring, which will be based principally on the Chairman's underlying mark. For that reason, I think, it very important and very helpful for the subcommittee to have this opportunity to hear from the Chairman his perspectives, and to ascertain what direction might be ahead of us in regard to this issue.
I have a written statement which I will submit for the record and would recognize Mr. Kanjorski.
[The prepared statement of Hon. Richard Baker can be found on page 260 in the appendix.]
Mr. KANJORSKI. Thank you very much, Mr. Chairman.
Mr. Chairman, I certainly welcome the presence of Chairman Leach to testify as our lead-off witness today, and I recall with great pleasure, that the Chairman took the opportunity in this Congress to address the Democratic Caucus of this committee and I think that the show of bipartisanship on this particular piece of legislation is refreshing.
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Today's testimony seems to direct itself again to some of the reasons we should open up commerce and banking, and I have heard a great deal of testimony and have read many articles as to why it would benefit the banking institutions of the country--and sometimes the insurance companies, sometimes the investment banking community--but to date we have heard little testimony as to how it is going to really affect consumers, average consumers, average Americans, small businessmen, entrepreneurs.
I think in reading over the testimony of Professor Kaufman, he does put his finger on the most important single question, whether combining banking and commerce improves aggregate economic efficiency and benefits consumers. I think that is the question.
However, he answers his own question with the fact that there is little evidence that with correct public policies we would significantly increase conflicts of interest, reduce competition, encourage excessive concentration, or reduce the safety and soundness of banks and increase the potential burden on taxpayers.
He concludes that when there is little likelihood of damage, there is a gain for permitting the activity. It's sort of ''proving the affirmative by stating that there is no negative.'' This is not very reassuring to me.
I think the burden on changing the law or broadening the scope of banking activities requires us to come to some conclusion that there's some clear and convincing evidence that consumers, small businesspeople, college students, and average Americans will benefit from significant change and broadening of the policy of banking and commerce and allowing them to exist together.
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If it will just benefit banking institutions alone--or other large industries of our economy--without commensurate benefit to consumers, taxpayers, and average people, I see little compelling reason as to why we would change.
However, I wish to state that I come to this hearing today with an open mind and I have not, in my own mind, resolved the issue of expanding banking and commerce activities in one institution--or group of institutions--in the country.
I hope, however, that as a result of the testimony we receive today and over the next several weeks, we will hear more evidence as to what the effect will be on entrepreneurs, small businessmen, average families, children who want to finance college education, and to see whether there really, truly is a benefit to the average taxpayers of America by the significant financial modernization that we are about to undertake.
I look forward to Chairman Leach's testimony.
[The prepared statement of Hon. Paul Kanjorski can be found on page 264 in the appendix.]
Chairman BAKER. Thank you, Mr. Kanjorski.
Mr. Cook.
Mr. COOK. No. Thank you.
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Chairman BAKER. Mr. LaFalce.
Anyone care to----
[No response.]
Chairman BAKER. No further Member desiring to be recognized, it is my pleasure to introduce for this first comment this morning, the distinguished Chairman of the Full House Banking Committee, Hon. James A. Leach.
Mr. Chairman.
STATEMENT OF HON. JAMES A. LEACH, CHAIRMAN, COMMITTEE ON BANKING AND FINANCIAL SERVICES
Mr. LEACH. Well, thank you very much, Mr. Chairman, and I have a rather lengthy statement with a number of addendums, and I would like to ask unanimous consent that they be placed in the record.
Chairman BAKER. Without objection.
Mr. LEACH. And what I would like to do is summarize part of it, and then read the concluding part, if that makes----
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Chairman BAKER. Absolutely, sir.
Mr. LEACH. I am honored to be invited to speak before the Chair and Mr. Kanjorski, and other distinguished members of the panel, and I would say that it's very important for the subcommittee to consider a broad range of alternative positions.
The subcommittee Chair's position is one of the most intellectually-attractive and cohesive approaches on the table. In fact, in many ways, the most cohesive approach on the table. I fundamentally believe that it is not compelling, but, I think, it is something that everyone should think through to the most serious degree possible.
Let me suggest first that the case for bank modernization is overwhelming in terms of rationalizing the market, and integrating banking, securities, and insurance services.
There is a separate and important issue that relates to the question of banking and commerce itself--that is, whether financial services companies should become fundamentally integrated with commercial enterprise. That issue should be addressed separately.
It is my belief that there are fundamental flaws to this the approach, based upon both history and current models, and also based upon lack of public consensus. For example, I have never held a town meeting, in 20 years in public life, when a constituent has come up to me and said, ''What ails America should be corrected by allowing CitiCorp to merge with GM.'' There is a great deal of angst in this country about things getting too big and out of control, and people want more manageable size.
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Now, that is popular feeling. The question is, is bigness economically rational?
We do have examples of commerce and banking in other countries. The oft-cited one is Germany, where, up till a decade ago, it was pointed to rather approvingly. Today, the Bundestag debates on this subject reflect a great public angst, and there's a movement to try to make the German system more like the American one, with its separation of powers in the private sector system.
In Japan, as recently as this week, there's an article in the Washington Post about how the public is objecting to the so-called ''Japan, Inc.'' model, and there are a lot of people who have concluded that the too-cozy relationship between banking and commercial enterprise in Japan has caused not only great losses to the public treasury, but certain stultification of the Japanese economy.
If we look to the American experience, the closest thing to commerce and banking that we have approved was during the S&L problem-building period, when certain State legislatures--with the approval of the Reagan Administration--endorsed a direct investment guideline for S&Ls. There is no one I know who doesn't think that giving that kind of power didn't deepen and lengthen the S&L dilemma.
And so, we have experience abroad that is imperfect, we have experience at home that's imperfect, and we have--in my judgment--no great public desire for the precept, although we do have certain enterprises that would like to advance the precept.
As a kind of middle-ground, an approach has been presented by a group called the Alliance, which envisions banks being allowed a 25 percent basket of non-financial business activities, the definition of ''basket'' being left to a government commission, which will be tasked to measure business activity.
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Well, as part of the addendum that I am releasing today in Tables A—1 through A—5, we are showing the ramifications of various definitions, measuring business activity by assets, book equity, market value, gross revenues, and that income for financial services holding companies in the purchase of non-financial firms.
Tables B—1 through B—5 show the ramifications of these definitions for non-financial firms acquiring banks.
There are many nuances to each definitional approach, but the following examples may be of relevance.
Based on a 25-percent-of-assets-test, a hypothetical combination of Chase and Salomon Brothers could purchase Exxon, the fourth largest Fortune 500 company in terms of assets. Based on a 25-percent-of-book-equity test, the combined firm could purchase Public Service Enterprises, the 61st largest company. Based on a 25-percent-of-market-value-test, the combined firm could purchase Sun Microsystems, the 96th largest company. Based on a 25-percent-of-gross-revenue-test, the combined firm could purchase CSX, the 98th largest firm; and based on a 25-percent-of-net-income-test, the firm could purchase Micron Technology, the 67th largest firm.
Likewise, various basket tests make clear that our largest, as well as smallest, banks remain vulnerable to takeover by various commercial enterprises, depending on what business activity definition is used and what percentage is applied to such definitions.
Here it is important that this subcommittee understand the importance of definitions. Historically, at least with regard to most of this century, conceptualizations of bank investments in commerce, whether sanctioned in the holding company or operating subsidiary, have related to a percentage of capital, rather than a business activity.
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The business activity definition has a number of perplexing ramifications related to magnitude, lack of precision, and inherent incentives provided to affected institutions to over-leverage and conglomerate.
It would be an exaggeration to suggest that a business activity test would incentivize Ponzi-like asset growth, but it would not be misleading to note that the introduction of a business activity definitional stricture would appear, in certain circumstances, to impel buyout efforts unrelated to the intrinsic business worth a prospective suitor might place on an enterprise. The rights which might be gained from a particular purchase to make other purchases or, conversely, the added capacities of a company to block another party from purchasing its own assets, would become front and center considerations.
For instance, in a race to have the most flexibility to invest in non-financial assets, various banks may wish to move quickly to merge with other financial services providers, or for defensive reasons, financial services providers may make a series of acquisitions of non-financial companies.
For example, under some business activity definitions, Ford--with a fractional increase in its, or Chase's financial business--would be qualified to merge with our largest bank. To block such a move, Chase might decrease its financial business, or purchase a non-financial company, to bollux up the possibility of a 75—25 financial-commercial mix which a Ford-Chase merger might otherwise make possible.
Perversely, under the business activity definition, the greater the integration of financial services businesses, the greater the vulnerability of a financial services company to takeover by larger commercial concerns. Likewise, the greater the integration of a financial services company with non-financial businesses, the greater its ability to maintain its independence and, in an unintended side effect, any non-financial enterprise facing an unfriendly non-financial takeover, could have a new poison pill deterrent strategy in its quiver of options. You could simply merge with a financial business in such a way as to throw akilter the necessary 75—25 formula.
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Some in government and the private sector have argued that a maximal business activity basket is the way to go, because it makes it easiest for securities companies with commercial ownerships, or major commercial investments, to affiliate with banks. Likewise, some insurance companies controlled by commercial parties may have more flexibility to affiliate with banks if the 25-percent-business-activity definition is adopted.
But questions demand answers. Is the kind of leveraging flexibility sought by a few, generally the largest, a compelling public concern? Aren't there many others, smaller banks, regional securities firms, insurance companies--particularly mutuals--which wish to maintain State regulation of insurance, financial firms of any size or type that want to remain independent, who may have doubts? Does the public have a vested interest in government-incentivized conglomeration or greater market competition?
Is not the most proper public goal rationalization of the financial services industry, rather than ensconcement of a new financial industrial ownership system?
What is at issue with full-blown commerce and banking, or for that matter, big baskets, as contrasted with more restrained reform, is differing versions for America: the question of whether American enterprise should be lean, efficient, and decentrally-owned, or whether conglomeration should become the norm.
Glass-Steagall reform and bank modernization are about making the financial markets more efficient and competitive.
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The mixing of commerce and banking is a related--but fundamentally separate--issue.
It is about ownership of America.
It is about transforming the nature of banking from an industry serving entrepreneurial America, to an industry making entrepreneurial investments.
If it seems that modest investment experimentation should be granted banks, a basket that relates to capital--rather than business activity--might, at least initially, be more prudential and less market-distorting.
Here it should be stressed that such a conceptual framework would not be insignificant if combined with the flexibility that H.R. 10, one of the principal bills on the table, provides. After all, H.R. 10 allows for an affiliate of a bank to engage in merchant banking; it allows for an insurance affiliate to invest in commercial enterprises, if these investments are part of the business of insurance underwriting. It also allows bank holding companies to engage in activities financial-in-nature, an expansion of present law which could be expected to be interpreted to include technology.
Americans have been well-served by an independent financial services industry, one which is competitive, innovative, and hallmarked by a customer-oriented approach to business. Unlike many societies, the strength of our financial system is its integrity and the paucity of conflicts of interest it engenders. Modernization that allows increased competition within the banking, securities, and insurance industries makes sense. More radical change that jeopardizes this independence should be looked upon with great wariness.
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I thank the Chair.
[The prepared statement of Hon. James A. Leach can be found on page 266 in the appendix.]
Chairman BAKER. Thank you, Mr. Chairman.
Let me start by, perhaps, outlining what I understand the conceptual differences to be. First, from a short historical perspective, in my own State there was, in the late portion of the 19th Century, the Atchafalaya Railroad and Banking Company that was created, and there were two other very large public projects that were, in fact, a blending of commerce and finance, and they survived until the 1930's or so, and in some cases divestitures were the decisions of ownership, rather than market pressure. But from the statistics of the 1930's, it appears that the Congress took the failures of the investment banking community and utilized that as the reason to inhibit further commercial and finance activities, without regard to the fact that it appears that single-line-of-activity banks failed in greater number than those with diversified interests.
Moving forward from the 1956 Act, to the 1970 Act, to the current day, Congress has attempted to limit further those activities, but, seemingly, the result has always been the creation of a new loophole, whether the non-bank bank, CEBA banks, unitaries--whatever they might have been. So, throughout the course of our financial marketplace history, there has been either a broad exception to the prohibition or a limited exception, and from my view, without untoward result. It appears as if the Congress has cast itself in the position of a rancher who says, ''I've got the big green valley and have made 10-, 20-, and 30-acre plots, some in the bottom of the valley where the good land is, and some up on the mountainside,'' and we determine whether you get 10 acres and whether it is farmable or whether you are up on the rocks, rather than letting those fences be taken down and letting people make business decisions based on their own risk-taking.
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Be that as it may, it appears that in recent weeks, regulators from various perspectives have said commerce and finance, in itself, may not be the bad thing that we fear. But rather, the question is how we regulate that blending. I believe Chairman Greenspan has talked about the appropriateness of whether the revenue limit, for example, is an appropriate measure of protection. Whether it would be at a 25-percent level of mix or not, of revenue to the holding company, to the financial institution's interest, if the non-related entity is very large, has a weak balance sheet, is providing less than 25 percent revenue to the financial institution, and fails, it does not seem that that limit on revenue really isolates the financial entity from the asset size of that failing institution. And what I am having trouble coming to grips with is whether it is a small amount, a moderate amount, or in the case of some, a whole lot. How do we really isolate the financial institution from the risk that is created by the large third-party entity, even if it is a securities company? It does not really matter if it is a hardware store securities, if it is going to put in jeopardy that finance institution. And I think the various proposals all are, perhaps, defective in that regard.
Could you comment as to that concern?
Mr. LEACH. Well, you have covered a lot of ground, and you certainly underscored the blurring that has occurred in the financial landscape. Your particular proposal is, without doubt, the cleanest. I might have a personal preference for a perfectly pristine, clean counterproposal that would allow almost no blending, but that is fairly unrealistic, and it is also politically unpalatable. So, the counterproposal that I have placed on the table is one with lots of inconsistencies.
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In terms of the safety net, however, which is of fundamental significance, the larger the amount of commerce that is blended with financial business, the greater the taxpayer liabilities in terms of deposit insurance, as well as rescues that might have to occur vis-a-vis the payment system or discount window, and the larger the number of the participants in an internationalized system, who may be making decisions from abroad. And it is one of the reasons in a regulatory environment that great concern has to be exhibited on both the locus and the level of regulation.
As this panel understands, I have a little bit of a preference, in some areas, for maintenance of a role for the Federal Reserve for a series of reasons, not the least of which is that only the Fed has a deep pocket. That is, there is no part of the Executive Branch that can bail out anyone on a timely basis. Only the Fed has that discretion. And this becomes exceptionally important if you look at a model, for example, in Japan. The Japanese economy would be in desperately awful shape today if the Bank of Japan, which is their equivalent of the Fed, had not been able to step in and stabilize the banking system. We need that capacity in this country, and, in my judgment, the Fed's role should be real.
Now, in terms of any other locus of regulation, I have attempted to modify approaches put on the table last year to involve a little greater role for the OCC, out of deference to the OCC, by allowing certain greater discretion to occur in activities within operating subsidiaries of banks, where the OCC has primacy of regulation. But I would say, and I'll just conclude with this, to move in the direction of no regulation or oversight would be, I think, very imprudent for this subcommittee, and I would point to the testimony of the Administration witness, Ricki Helfer, on behalf of the FDIC, before Mrs. Roukema's subcommittee several weeks ago, when she warned of the dangers of not having any prudential regulation.
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Chairman BAKER. On that point, Mr. Chairman, I wholeheartedly agree, and what, I think, I am suggesting is different regulation, not less regulation.
Mr. LEACH. Sure. And now coming to your question more precisely, I think Chairman Greenspan was very thoughtful in his observations if a particular enterprise had a very small aspect of its business being that related to commercial banking, it should not be heavily regulated with regard to its other activities.
Now, here is what I thought was one of the most interesting conundrums put before our subcommittee, and this was to Mrs. Roukema's subcommittee. Paul Volcker articulated the dilemma that, in his view, it would be very improper for a regulator, such as the Fed, not to look at the full activities of a major company that had a big commercial banking enterprise. On the other hand, he said, it would be very imprudential for the Fed to think it had much relevance in looking intrusively at the non-banking activities of such a conglomerated company, and his way out of what was, obviously, a Catch—22, was to suggest that, to the maximum degree possible, one should not integrate commerce and banking. So, the former Chairman of the Fed presented a very stark description of no integration. The view of the current Chairman of the Fed was close, but not identical, to Mr. Volcker's. He suggested that there is room for a greater fertilization, but in very modest quantity. So, those two gentlemen show some differentiation.
Chairman BAKER. Thank you, Mr. Chairman.
In deference to other Members, we will move along to Mr. Kanjorski.
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Mr. KANJORSKI. Mr. Chairman, will you briefly outline for me what you think the compelling reasons would be to combine banking and commerce?
Mr. LEACH. Well, the argument that I think all of us should have to respect, is that anytime you put a constraint, you have to make a case for a constraint. So when you argue for separation, which I generally support, I have to recognize that that is an extra burden to argue for, but it is my view that: (a) the public safety net is at issue; (b) that this country has had a fine modern history of efficiency and effectiveness with an independent financial services industry, in this case--in parts--and that the experimentations with integration of commerce and banking in this century have not been particularly happy, both for the taxpayer as well, more importantly, for economies at large. And in my judgment, integrating commerce and banking simply doesn't fit the American system.
I will make one analogy. Most Americans historically have liked local schools, and they have talked about neighborhood schools, and that is kind of an instinct. When people have been given rights in parts of America, in my home town for example, anyone can enroll a student in any school anywhere in our county, but, by choice, virtually everyone goes to the neighborhood school. In my view the instinct of America against terrific conglomeration is proven to be correct, and the experiment with conglomeration in American business of non-similar enterprises, has not worked real well. Economies of scale if two financial institutions combine can be there, but there are very few economies of scale of allowing, for example, Citicorp to merge with General Dynamics. It is simply a power structure, not an economically-rational structure.
Mr. KANJORSKI. The Chairman of the subcommittee made the analogy of the ''valley and the green acres,'' and it brought to my mind that very often in the middle of the valley a flood occurs. You know, though it may be more fertile land, it is not always the safest land to be in. In going back to the historical analogy that was made, how is it that we have forgotten the Progressive Era in America, and the existence of cartels and trusts, and how in structuring a completely open system are we ever going to have the capacity to prevent that from happening without getting so heavily involved in both commerce and banking as a government entity. Where literally, equity decisions on the commerce side will have to pass through the Justice Department, and other entities of the Federal Government, and why would this be healthy?
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Mr. LEACH. Well, if you are talking commerce and banking, I see no unhealthiness to it, and certainly we do have an antitrust tradition, symbolized by Teddy Roosevelt, that is deep in both political parties, but there is also a populist instinct in all of America that has a particular lack of comfort with concentration of economic and financial power.
Chairman BAKER. Thank you.
Mr. Cook.
Mr. COOK. Yes, I wanted to compliment both Chairman Leach and Chairman Baker on some very well written articles that appeared yesterday as a supplement in Roll Call. They were certainly very informative to me on some important things that helped me understand the issues involved a lot more. But, I have to admit, left me, as I finished reading those side-by-side articles, even more undecided as to what the best--or the better--course is.
But, Chairman Leach, I did want to ask you if you do not believe that the Federal antitrust laws that exist--the multitude of State banking laws that really will not be affected by anything that happens in terms of Glass-Steagall reform--if those laws are not really adequate to protect against the concentration of power that you have been describing--that you are concerned about--that a lot of us are concerned about, and the chance of monopolization?
Mr. LEACH. Well, I think, on your first premise, having read Richard Baker's article, I will tell you, I thought it was an exceptionally finely-reasoned piece, and anyone who can speak with total certitude about these subjects, I think, is making a major mistake. These are judgmental issues in which there are good arguments on virtually every side.
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As far as the antitrust laws, let me make two distinctions. One relates to Glass-Steagall reform. The case for merging securities activities, insurance activities, and banking activities, which is the traditional Glass-Steagall reform visualization, although it is principally securities and commercial banking, is procompetitive, in that it provides more consumers more options, and I would argue--particularly in rural areas--will bring securities options to smaller and smaller business through the local bank, and that is very healthy.
In terms of merging commerce and banking itself, in one sense there are certain things that the antitrust laws might apply to, and others that they would not. But I am not absolutely convinced that, unrelated to antitrust, there are not a series of issues that relate to expansion of the safety net, for example, of Federal liabilities if you have a downturn in the economy or a major mistake in business enterprise activity. We, for a long time, talked about banks too big to fail, and whether that is wise or not. Now, all of a sudden, you would have mega-financial institutions--or mega-financial commercial institutions--that may be way too big to fail. You also have, and here Ricki Helfer warned very precisely, the extraordinary political power that mega-financial commercial institutions would come to hold. That may be unrelated to an antitrust concern where, in each area of activity of a huge umbrella company, there might be no market dominance. But when you combine them all together, there could be rather extraordinary power ramifications that might be unhealthy for society.
Mr. COOK. If I could just ask quickly if financial institutions are not granted expanded opportunities in insurance and in securities, what are the ramifications for the American banking industry, especially, vis-a-vis, what has happened in the world banking industry--particularly Japan--and the other things that have happened rather dramatically in the last generation?
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Mr. LEACH. Well, I think that is the truly most important question on the table. I believe that if you do not have reform allowing banks to mix more fully with the securities and insurance industry, you will have a shrinking industry base at home, and you will also have a much weaker American competitive position in financial services abroad.
The second issue is also important. It is impressive to me how a number of our banks have excellent footholds abroad, but they do not have the capacity to offer full panoplies of services based upon great activity at home. The history of commerce is that very few individual companies can market much abroad if they do not also have a market at home. So, I think it will strengthen America's competitive position dramatically to move in the direction of bank modernization.
Mr. COOK. Thank you.
Chairman BAKER. Mr. Gutierrez.
Mr. GUTIERREZ. Yes, Mr. Chairman, I just want to say that I express my thanks to you as the Chairman of this subcommittee for putting together this hearing, and to Chairman Leach, and because I would much rather listen to the two of you speak about the issue than listen to my own voice ask questions, that--obviously, I have a lot of them--but I would rather continue to hear this rich discussion. So today I am going to pass on any questions, and so I'll learn a lot more. I am learning a lot more from listening to the two of you than any question I could possibly ask.
Chairman BAKER. Well, thank you very much. I will try to talk more.
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[Laughter.]
Chairman BAKER. Mr. Hill.
Mr. HILL. Thank you, Mr. Chairman, and thank you, Mr. Chairman, for testifying today.
It seems to me as though the argument the integration of financial services is essential for our financial services industry to compete in the international economy, and I accept that, and also the argument that for community banks to continue to thrive they have to be able to provide diverse services--or ought to be able to provide--diverse services.
But the integration then with commerce, do those arguments carry over that community banks need to be in commerce in order to survive? That our large international financial institutions need to be associated in other areas of commerce in order to compete in the international marketplace?
Mr. LEACH. I think they are totally separable issues.
Actually, what you think about at the big bank level is also what you think about at the small bank level. Let me give an example.
Let's say you come from a small rural town that has a single bank and the bank is allowed to invest in commerce. One the first things a bank would think about is real estate.
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Now, let's say you are the banker and Mr. Sessions is a real estate developer. He comes to you for a loan and you say, ''Gosh, that is a pretty good idea, I think I'll do it. By the way, my cost of money is 3 percent. Mr. Sessions, I'll make a loan at 10 or 11 percent.'' Who is in the more advantageous position, and is that fair in a competitive equity circumstance?
Beyond that, if Mr. Sessions comes to you with this great idea, are you, kind of, stealing his idea? Do you have an almost immediate conflict of interest?
Or, let's say that there are two drug stores in this town and you have half-ownership of one, and Mr. Sessions is an independent drug store owner. Are you going to give him a loan at the same rate? Are you going to learn about his business plan?
I mean, do you not have almost immediate conflicts of interest?
It strikes me often at the smaller institution level that conflicts are more immediately relevant than they are at the larger institution level, and that is why there is almost no appetite in rural America for combining commerce and banking.
Smaller banks have no desire for it and for varying reasons.
One of the more interesting reasons is--and I have had bankers from my State come up to me and talk about in their town--there are a number of enterprises owned by somewhat-elderly people, who are soon going to be passing them on, that are not particularly viable, and they are under a lot of pressure to invest in those businesses to save the town. Well, these are non-financial investments.
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I mean, they don't want to invest in them, but all of a sudden you have coercive pressure of kind of an odd type that you wouldn't expect to develop. So I just believe that the more you can keep financial services separate from commerce the better, recognizing--and here the Chairman didn't make the point, but if he did, it would be a very powerful one, at least at this hearing--that some of the non-bank banks, some of the commercial enterprises that have come to control financial institutions, have been very innovative and provided a lot of new competition into the American market and have done it--in more than a few cases--with great success. I must tell you that there are examples to the contrary of every example I give of one kind.
Mr. HILL. Is there any--obviously, the sense is that by integrating financial services we can increase competition, or reduce costs and benefit consumers.
Does that apply to other areas of commerce? I mean, did you see that opening to other areas of commerce is going to increase competition for either?
Mr. LEACH. That is an exceptional question. There can be economies of scale in combinations of like-enterprises--finance-to-finance, widget-making to widget-making.
Are there economies of scale when a bank invests in a widget-making company? They are pretty hard to see, and so I don't think the economies come into play.
Mr. HILL. Thank you, Mr. Chairman.
Chairman BAKER. Mr. Vento.
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Mr. VENTO. Thanks, and it is good to see the Chairman. In fact, this is a role that, I think, we should do more often in terms of individuals advocating ideas.
I want to admire you for your courage and for the yeoman service, Mr. Chairman, that you have performed trying to hold our feet to the fire in terms of dealing with this issue in the last session and in this one.
In fact, I think the intensity of the issue in this session will give us an opportunity to act on this measure, and I think, you are raising some very important questions. I think it is a very thoughtful statement and it invites us all to keep thinking and obviously you are much in that mode yourself.
As I listened, I thought about what are the right bend-points--in terms of where we regulate and control--of the issues? I think, the evolution in terms--and the convergence in terms of the financial institutions and of commerce--are inextricable. I think, as we look at the Internet and many other activities that are going on, that we have a responsibility to, in fact, respond as best we can in law--rather than simply in the regulatory mode--which has, of course, dictated the policy path for decades with regard to bank powers and activities, and realize that what we write may not be the last ink on the page with regard to this issue.
But, along those lines, you know the supposition--in terms of concentration that I have been concerned about with regard to banking, as were you--and I think, what we found, of course, is that the greater financial marketplace is taking a greater and greater percentage of what had, henceforth, been banking assets and credit powers and so forth, and they are shifting.
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I mean, this is an evolution which is not one because of the aforementioned comments that we can control, that there is indeed a global--not just a U.S. free market--and that that has a certain discipline, and it's a question how we approach it. If our antitrust laws are inadequate, if we need to modify those.
I would agree with someone who said we are, sort of, still in the 19th Century right now with regard to where antitrust has been, but there have been some exceptions in terms of AT&T and a few others.
But, in any case, I don't know that concentration per se, in these areas--in any type of an example--would have, and does demonstrate, for instance, the demise of competition. In fact, I think that the diversity in terms of what some commerce activities have been, versus some credit-making or financial institution activity, is not--I don't think that there is a track record--that, in other words, there has been the demise of competition.
As you implied, there's been some innovation, but, I think, insofar as we are looking at this in terms of setting rules as regard banking itself, we have seen that while we may have been concerned about branching and merging of banks, that again, I think, there is some concern about that. But, I think at the end of the day that there are some alternatives that do provide for competition and have resulted in that.
So, I think, that we have to reconcile it. Now, I admit that the 25 percent measure that we put in the bill is a safeguard, in terms of trying to reconcile it. I think that the documentation and research done here by the Federal Reserve, I take it--I don't know if I completely understand it yet--but I am sure that I will before we act on this. But it itself says anything that is--I mean, what we are trying to demonstrate here is it doesn't have to be the absolute integration. It practically doesn't have an effect in terms of commerce and banking and so, I think, in a sense from my perspective, because I think that that is happening and that the marketplace will actually discipline those types of arrangements in the context of antitrust and whatever regulation we find effective.
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Now, I just wanted to mention--the time is about to run out, I note, and I want to give you some chance to respond--but that, I mean, talking about the Fed's role or the FDIC, I understand that they have to have the ability--they have deep pockets. Those deep pockets can be used in the context--you don't have to be the principal regulator, or the ultimate regulator to use those deep pockets.
I mean, it can be--and we can accord that--they do have to have the information. In fact, today we are looking at ways of trying to take them off the hook, in terms of foreign corporations, in terms of efforts, because we found that we had them doing too much work with regard to foreign-owned holding companies, as you recall, with Mr. Campbell's bill.
So, I don't think that is the per se situation in terms of regulation. But, I think we have to find the right bend-points in terms of the regulatory scheme for the Fed, for the FDIC, and for others, because I think that this, as I said, this commerce-banking relationship, the electronic banking, the Internet, is inextricable, and we are in a state of denial here--or are trying to put a bright line around these aspects, Mr. Chairman--and in my view that is not going to get us very far down the road.
Two years ago, I think I would have said, ''Well, this is more careful, this bank holding company structure, this limit in terms of commerce and banking.'' But, as I have reviewed it, I have become convinced that this particular step is necessary at this time if we are going to have a policy path that is going to last, or persist for beyond the moment, and I would appreciate--briefly--your comment.
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My time has expired, Mr. Chairman.
Mr. LEACH. Well, I appreciate those exceptionally thoughtful observations. Let me just first, stress that legislation seldom changes the market. It mostly reflects changes that have occurred in the market and then someone sets the ground rules for future change.
Second, in my view, competition isn't as serious an issue as simple power is. I think the new power relationships would have a lot of ramifications for society.
One of those relates to taxpayer liabilities as people now and again make mistakes, and the biggest sometimes make the largest mistakes, because we do have a safety net that has taxpayer funding behind it.
Finally, your point about the Fed is true, that it is not absolutely essential that the Fed be integral. On the other hand, if one thinks it through, part of the reason that the Fed has such influence is its pockets--and particularly as we relate internationally, partly the respect it commands--more than the Congress, more than any Executive Branch. So, as we look at the import of counter-party regulatory supervision around the world, I think personally, the Fed is a better inter-reactor than any other conceivable United States governmental entity could be, both in terms of its prestige and also the fact that it does have those pockets.
Finally, it seems to me irrational to think that the governmental body that is posited with responsibility for the payment system for the discount window, should not have a role in the oversight of the payment system in the discount window.
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Now there is, as this subcommittee knows, some philosophical, as well as power, conflicts between the Executive Branch and Congress, the Executive Branch vis-a-vis the independent regulatory system. I have found those a little bit uncomfortable, but, putting all of them aside, I have tried in our most recent reproach to be as deferential to the Treasury as possible and to give more power to operating subsidiaries, which the OCC regulates. But to knock the Fed entirely out of its position would probably be a mistake.
Then one of the issues is how heavy its oversight should be, as our distinguished Committee Chairman indicated. Should it really look at a commercial party's business activities deeply if it has very little inter-reaction with the payment system?
Mr. VENTO. Thank you, Mr. Chairman.
Mr. Chairman.
Chairman BAKER. Thank you, Mr. Vento.
Mr. Sessions.
Mr. SESSIONS. Thank you, Mr. Chairman. Mr. Chairman, it's good to see you this morning. I must confess that your thoughtful wisdom and judicious advice to us is the way I have taken your testimony this morning--almost professorial and philosophical in nature--and I must confess sitting here, I find myself, kind of, in a mid-life crisis. That is that I find that thoughtful advice comes to me often, and yet then I go home and I have a 7-year-old.
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I used to be taught that infinity was as far as you can go, and now my son tells me from ''here to infinity and beyond,'' and so that causes some concern for me, as to how I approach this issue also.
Mr. Chairman, I really want to boil down my questions two ways and I will ask them one at a time.
On page one of your testimony, you talk about the ''. . . financial service industry as evolving at a rapid pace and legislation is needed,'' and then I hear the conversation about ''. . . expansion of a safety net,'' and then I hear about a ''. . . reality check as to what can happen,'' so to me it seems like yes, we should go do these things, and yet it is the percentage of assets and resources of these conglomerations.
Do we increase it over time? Do we start small and get big, which is what I hear you saying? Or, where I come from, I see this expansion of a safety net as being sometimes the philosophy, ''bigger is better,'' or at least the in marketplace. So I must confess that is where I sit, probably, in this argument.
I think my son has won--from here to infinity and beyond--because I, as a 42-year-old in two weeks from now, have seen that the things that we were aiming at, we have gone well past them. So I hope I have balanced that.
The question, one, is: what is the percentage? Do we get bigger? Do we get smaller? Is this safety net that we are talking about to keep us that way?
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I hope I have expressed this properly. I want to do the right thing, but I think expanding the safety net means getting bigger, letting the marketplace win.
Mr. LEACH. Well, by preface, I have a son too. He doesn't understand the precept of infinity, but he has informed me that I come from a different planet.
[Laughter.]
Mr. LEACH. In terms of professorialism, I am going to be followed by a panel that consists of a very distinguished lawyer and economist, who lay out a different case from the one than I have laid out, and so you are going to hear the best of the opposition to my point of view, and everyone is going to have to measure that pretty carefully. There is no one judgment, but it does relate to the safety net.
We do have a safety net. Some of it is involved in the Federal Deposit Insurance, some of it is involved in access to a payment system, some of it to the discount window in the event of difficulties--either in the economy or in the payment system.
It looks inevitable, whether we do nothing or we do something, some of that protection gets expanded. One of the questions is: If we do a whole lot, does it get expanded terrifyingly or prudentially? So, people have to apply their own individual judgments.
I would be--obviously--a little bit more on the cautionary side, but I think, it is clear it is being expanded every day, and part of that occurs simply with the growth in international trade, the growth in the size of the economy, and part of it comes from a little bit of an integration of industrial basis.
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Mr. SESSIONS. Thank you. One more question, Mr. Chairman.
I have, within the Fifth District of Texas, Dallas, which is an expanding market. Things happen more rapidly than slowly, and yet I have many rural areas and areas which you talked about.
Could you talk about what impact you see on community banks?
We talked about people aren't asking for this, but would the impact side be if we went, let's say, further than perhaps--further out toward past infinity than just there--of what the impacts could be, sir?
Mr. LEACH. Well, let me just talk a little bit about Texas.
First, the most important question is: What is the impact on consumers? I think consumers, if we move to bank modernization, will have more options in more places--and consumers are exerting preferences for single-stop shopping--and a bank will be able to offer more products, an insurance company more products, a securities firm more products.
From a commercial banking perspective, most of the approaches on the table would have the effect of pre-empting Texas law, to some extent, with regard to anti-affiliations, and the commercial banks would be able to sell insurance.
There's some community bank angst that too much new competition will be brought in. There's also community bank support that each community bank will be able to offer more products and so as a general rule, the more competitive bankers are leaning in favor of these approaches.
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The more old-line operating banks are more questioning. There has been polling data within the community banking industry in the country--although I haven't seen anything on Texas--that indicate that about 30 percent favor bank modernization; about 50 percent--a little less than that--have doubts; and about 20 percent are unknown--don't know or haven't decided. So you have a split industry.
But the intriguing aspect of this is that every industry grouping is split. There is no perfect consensus within each one, and each kind of company has different strategies for itself, and that is one of the reasons that, I think, the most important thing for Congress is to have as the overwhelming concern: What is in the public interest?
If we move in a direction of the public interest, doing our best we can to balance fairness and equity issues in a competitive way, we have a chance to achieve consensus.
Mr. SESSIONS. Mr. Chairman, thank you for your comments. I yield the rest of my time that isn't remaining.
Chairman BAKER. I thank you for that generous gift.
[Laughter.]
Mr. SESSIONS. Thank you, sir.
Chairman BAKER. Mr. Chairman, would you intend to return after this vote, or is your schedule permitting you to come back just briefly?
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Mr. LEACH. I will do--I am at your discretion.
Chairman BAKER. Well, I'll take just 30 seconds and make just a couple of quick points.
Mr. LEACH. Yes, please.
Chairman BAKER. With regard to two issues--the concentration question.
Mr. LEACH. Yes.
Chairman BAKER. And then the local economic interest, as in the case of Mr. Sessions, with the associates in Dallas who are part of Ford Motor, which also has Ford Motor Credit.
What is happening today is that situation where they are competing directly with the hometown banker, providing financing for that new car purchase, so that that kind of activity occurs, and it has a broad financial structure.
In fact, it wouldn't be improbable today that a Microsoft might acquire a Morgan Stanley Dean Witter, and so in the private sector, if we are worried about concentrations of economic wealth, that ought to scare us to death, and we can't stop that unless the FTC does. So the issue of concentration is already an issue, in my view, and the question of local competition already exists.
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John Deere--commercial paper, local tractor farmer, local community--those entities, commercial-in-nature, are providing better assets at a better price than the hometown banker can, because of all of the regulation and so what we must do is find a way for the hometown banker to have diversified opportunities to stay alive, because in my end result, the insured depository institution is critical to consumer confidence and, I think, that is what we are really looking at in the big picture. I hate to be so brief, and I know we are about out of time here.
Mr. Chairman, will you make any closing remark?
Mr. LEACH. Only to piggyback on that observation, which, I think, is exactly correct, that if a bank can't offer a panoply of financial services, bank customers are not going to return to the bank. So unless we fully empower banks at the community level, they will lose out--either to national banks or to every other non-bank kind of competitor.
Chairman BAKER. Let the record reflect we have reached agreement.
Mr. LEACH. OK, thank you.
[Laughter.]
Chairman BAKER. Thank you. Thank you, Mr. Chairman.
Mr. LEACH. Thank you, sir.
Chairman BAKER. We will stand in recess while we conduct this vote.
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[Recess.]
Chairman BAKER. If I may, I would like to call the hearing back to order. As everyone knows, we had a vote. I do believe it will be a few minutes before another is expected. In that light, I wanted to proceed. I know that our witnesses for the next panel do have some time constraints, and we wish to give them the courtesy of being able to make their presentation in a timely manner, and then make flights as necessary.
Our first witness is a partner of Gibson, Dunn & Crutcher and former General Counsel of the Treasury. It is a pleasure to have you here, Mr. Peter Wallison. Please proceed, sir.
STATEMENT OF MR. PETER J. WALLISON, PARTNER,
GIBSON, DUNN & CRUTCHER, FORMER GENERAL COUNSEL OF THE TREASURY
Mr. WALLISON. Thank you, Mr. Chairman.
First, I would like to thank the subcommittee and staff for inviting me to join this panel. The question we are going to address today--whether the continued separation of banking and commerce continues to make sense as a policy--is as important as any in banking, and I am pleased to have the opportunity to offer my views.
Although I am a banking lawyer practicing here in Washington, I am not appearing today as a representative of any client. The views I will express are my own, formed over many years since I served as General Counsel of the Treasury during the Reagan Administration.
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In the statement that follows, I would like to address directly a question that seems to have encapsulated the debate over the D'Amato-Baker Bill, the legislation before this subcommittee, and the legislation which most directly raises the question of the separation of banking and commerce. The question is this: Do you want Microsoft or IBM or AMOCO to acquire Citibank? Under the D'Amato-Baker proposal, such an acquisition would be possible, and I suppose for those who oppose the bill, the most effective nightmare scenario to throw at Congress is the image of a dominant and acquisitive corporate giant acquiring a dominant and aggressive bank.
The beginning of the analysis is to determine what it is exactly that we do not like about this idea. If the question were whether IBM or Microsoft could acquire General Motors, we would probably all have the same negative reaction, but we would recognize that the acquisition would not be prohibited by law.
As Americans we are not receptive to the idea of bigness in general. However, despite our hostility to size, we recognize that we should not prohibit big organizations from forming through acquisitions unless we can point to some specific economic harm. Bigness itself is not prohibited even if it is undesirable. In the case of across-industry--or conglomerate mergers such as IBM-GM--we cannot identify a specific harm, so we allow mergers of this kind to occur, even though they are between giant companies and create even larger conglomerates.
Thus, we should not be frightened or stampeded by the notion that Microsoft or IBM might acquire Citicorp or Citibank unless we can identify a specific harm.
Those who favor the separation of banking and commerce do, indeed, argue that combinations between commercial firms and banks will result in some specific harm. However, analysis reveals that these concerns are illusory. In fact, they seem to be based on an outdated and invalid picture of the role banks now play in today's economy. Many years ago, perhaps as late as the 1970's, banks were in a position to grant or withhold credit in their discretion. Individuals and corporations applied to banks for personal or commercial loans, and the bank's decision was awaited with anxiety. Under these circumstances banks had what antitrust experts would call ''market power''--the ability to discriminate among borrowers on a basis other than their creditworthiness.
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That world does not exist today. On the individual or consumer level the change should be obvious to anyone who gets mail. Day after day the offers pour in from banks all over the country for credit cards, personal loans, mortgage financing, debt consolidation loans, and home equity loans. Clearly, the banks that are aggressively soliciting this business are not in a position to, and would not deny, credit to any creditworthy individual they are fortunate enough to attract.
The change may even be more dramatic in commercial banking and lending. Today's financial market includes multitudinous sources of commercial credit--U.S. banks, foreign banks, commercial finance companies such as the General Electric Credit Corporation, insurance companies, leasing companies--a vast worldwide market for commercial paper, and a huge securitization business in which assets of all kinds are turned into securities and sold to global investors.
Anyone who observes the banking business on a day-to-day basis today cannot fail to notice that the banks are fighting like cats and dogs among themselves and with other commercial credit sources for every good lending opportunity. For years it has been noted and reported that in this highly-competitive environment, U.S. banks are steadily losing market share. Nor is it true that banks are losing market share only in lending to large corporations that have access to the securities markets. A Federal Reserve study published in November, 1996, showed a furiously-competitive market for small-business credit. Between 1987 and 1993, the period of the study, depository institutions--including banks and thrifts--continued their downward slide, losing an additional 5.4 percent of the small-business commercial credit market. Banks now provide only 60 percent of total credit used by small business. Even more disturbing was the fact that the percentage of small-business firms that used bank commercial credit of all kinds declined from 44 percent to 36 percent during this period, while credit from non-bank sources held steady.
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In other words, the financial world today is not one in which banks can write their own ticket. They face powerful, aggressive, and successful competition, and cannot afford to let a single creditworthy customer slip away.
With this background, I would like the subcommittee to consider three objections recently advanced by former Fed Chairman Paul Volcker in testimony before this subcommittee: First, the bank with a commercial affiliate will lend preferentially to its affiliates; Second, the bank will not lend to competitors of its commercial affiliates; and third, if the bank's commercial affiliates got into trouble, the bank's resources will be marshaled to bail out those affiliates.
Before beginning to deal with these objections to affiliation between a bank and a commercial firm, I would like to make a general point. If these objections are valid, they are not limited to the situation in which a bank might be affiliated with a commercial firm. Under existing law, a bank holding company is permitted to engage through subsidiaries in a large number of activities such as commercial lending, or mortgage banking, that compete with companies which are not affiliated with banks. If banks preferentially lend to these companies, or effectively deny credit to the competitors of their affiliates, an unfair and anticompetitive situation exists today. Nothing is changed if the affiliate happens to be a commercial firm rather than a firm we arbitrarily categorize as ''financial.''
The fact that we do not hear anything about such abuses should tell you something about whether these nightmare scenarios, focused on competition between banks and commercial firms, truly reflect reality.
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Turning then to the nightmare scenario of the Microsoft-Citibank combination, we should first consider the possibility that Citibank will preferentially make loans to Microsoft, transferring to Microsoft the lower cost of funds that the bank presumably enjoys by virtue of its ability to issue a government-insured deposit instrument. I should mention here, Mr. Chairman, that the Chairman of the Federal Deposit Insurance Corporation came before this subcommittee recently and made what I thought was a very persuasive argument that banks do not have a lower cost of funds that they can transfer to affiliates, but my testimony does not deal with that issue. I am presuming that there is a lower cost of funds, and then taking it from there.
For purposes of analysis, we will leave aside the fact that this kind of financial assistance is severely limited by the current law. Sections 23(A) and 23(B) of the Federal Reserve Act require all such loans to be fully collateralized, limits them in the aggregate to 20 percent of the bank's capital, and requires that loans be made on an arm's-length basis. This means that Citibank cannot legally lend to Microsoft at below-market rates.
However, again for purposes of analysis, we will assume that Microsoft is willing to collateralize the loan, so Citibank bears no significant risk, and that a way is found to charge Microsoft a lower interest rate than that charged to arm's-length borrowers. If all this is done, what is achieved by the combined entity? Microsoft gets a lower rate on its loan, but Citibank gets a lower return than it would get if it lent the same funds to an unrelated borrower. The parent's profit is the bank's loss. The result is a wash. The combined entity would have done just as well by collateralizing a loan from some independent third-party lender.
Well, then, let us assume that Microsoft could not get a loan from any other bank. Perhaps the advantage to Microsoft is that it can now get credit from its affiliates that it could not get elsewhere. This is difficult to imagine, since Microsoft will need adequate collateral in order to borrow from its affiliate, Citibank, and if it has all this collateral, it could presumably borrow from anyone. It is important to keep in mind that in today's financial world there are legions of banks and non-bank lenders out there willing to lend to anyone--from Microsoft to the corner shoe store--if the borrower has either the requisite financial strength, or the requisite collateral. Thus, if there is some advantage to Microsoft in owning Citibank, it does not come from preferential access to Citibank's lending.
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Perhaps then the advantage comes in the fact that the affiliated bank will not lend to competitors of Microsoft. By denying them credit, it gives Microsoft a major advantage. This scenario is probably the basis for claims that combinations between commercial firms and banks will create some kind of giant financial conglomerate or some dangerous concentration of economic power. But is this credible? Is it possible to believe that Microsoft's competitors would have only one source of credit? Again, the answer is no. In the competitive commercial lending world of today, if Citibank refused to lend to a creditworthy competitor of Microsoft, some other bank, or non-bank, lender would be delighted to do so. Owning Citibank would give Microsoft no advantage in denying credit to its competitors, and if it should be so foolish as to try such a course, it would only make Citibank less profitable.
These facts make clear that fear-mongering about giant financial conglomerates, or concentrations of financial and economic power, are wholly misplaced. They are based on an outdated picture of the importance of banks in today's competitive financial system. Perhaps at one time in the past the ability to control a bank could bring a commercial firm real financial and market clout, but today commercial credit is available everywhere, and controlling a bank would probably bring only headaches.
In fact, there was much talk this morning in the Members' questions of Chairman Leach, about combinations between commercial companies and banks--as though commercial companies are eager to get into the banking business. I see no evidence of this. I would be curious about why people think that a bank is such an attractive acquisition, other than for another bank which is attempting to expand its market.
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There is still the question of whether the resources of a subsidiary bank would be--or could be--marshaled to support a failing commercial affiliate, no matter what the laws and regulations say. This, too, is a fallacious argument.
First, as noted earlier, there is nothing special about a commercial affiliate that enhances the danger that the bank will be overreached to support a failing affiliate. Banks have all kinds of holding company affiliates today that are engaged in activities--leasing, securities brokerage, mortgage banking, and dealing in derivatives of various kinds--which can readily fail. If there is any truth to the argument that the bank's resources will be marshaled to assist such a subsidiary, then that will occur whether or not affiliation with a commercial firm is permitted. I know of no study which demonstrates that commercial activities are more likely to fail than financial activities.
Second, it is simply not true that managements in general will violate the law in order to save an affiliate from bankruptcy, and glib statements that they will do so should be rejected. As evidence, I offer the experience of the securities industry, which has been permitted for almost 60 years to have affiliates that control mutual funds. It is hard to think of a more direct conflict of interest than this. Securities firms hold portfolios of securities for trading purposes. Mutual funds buy and sell securities. A securities firm that is failing because of an inability to liquidate its portfolio would have a ready source of salvation in an affiliated mutual fund. Yet, in almost 60 years since the Investment Company Act of 1940 permitted securities firms to control mutual funds, there have been very few cases of this kind of overreaching. Why? Because it is illegal. I know of no reason to believe that bank managements are any more likely to violate the law than the managements of securities firms and mutual funds.
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Thus, the arguments advanced against affiliations between banks and commercial firms are without substance and should be rejected by this subcommittee and by Congress. Like the question: ''Do you want Microsoft, IBM, or AMOCO to acquire Citibank?''--their purpose is largely to frighten and shock, but they do not stand up to analysis.
It is significant that Chairman Greenspan in his testimony on February 11, 1997, to the Subcommittee on Financial Institutions and Consumer Credit, did not cite any of these reasons as the basis for his position. These are the arguments of the past, based on a world that no longer exists, and Chairman Greenspan's silence acknowledges as much.
It bears repeating that we do not prohibit economic combinations simply because the result is bigness. Some specific harm must be shown. The advocates of continued separation of banking and commerce have failed to meet this test. This in itself should be a reason for the subcommittee to proceed with the D'Amato-Baker proposal. Time and again it has been demonstrated that unwarranted government restrictions on private-sector activity bring unpleasant real-world results. Unnecessary regulations and restrictions should be eliminated. Since no specific harm can be shown for continuing to maintain the separation of banking and commerce, the restriction should disappear.
However, there is also an affirmative reason for eliminating the restriction on affiliations between banks and commercial firms. As all the data shows, banks are gradually losing market share to other providers of financial services. Indeed there is some question whether the very business of banking--that is, borrowing and lending as principal--has any future viability in a world where information on the financial condition of borrowers is freely available on the Internet and through many private informal information channels.
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The principal problem for policymakers in the future may be to find a way for the banking industry to downsize in an orderly way, to avoid the bankruptcies that would normally accompany the decline of an industry that no longer offers services the market needs or wants.
The subcommittee should consider how the banking industry is going to downsize if it is locked into a limited area of activity--whether it be banking, closely related to banking, or financial in nature. All of these formulations place some restriction on the kinds of businesses into which banking organization managements might want to move in looking for areas of profitable activity. For this reason, they increase the chances that some banks will not be able to find their way out of the banking industry by employing their capital and management skills elsewhere.
A good example of what I am talking about is the cigarette industry. Many years ago, cigarette manufacturers began to realize that their product, although highly-profitable, could have a limited future. As a result, they began to diversify into related areas, particularly foods. If and when government and societal pressure finally snuffs out the last cigarette, RJR and Philip Morris will be processing and packaging foods and beverages. If government restrictions had required these companies to remain in the business of cigarette manufacturing, they would eventually fail, with attendant losses to shareholders and creditors.
In much the same way, banking organizations, seeing problems for banking in the future, should be able to move into other activities wherever the management of a bank holding company sees the opportunity to employ the firm's capital profitably.
That is why restrictions on commercial activities of bank holding companies should be removed--to permit bank holding company managements gradually to reduce the amount of capital the organization as a whole devotes to banking activities, and to move the organization's capital into new and profitable areas of endeavor. These could include telecommunications, retailing or computer services, perhaps even competing with Microsoft.
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Accordingly, Mr. Chairman, while there are no sound reasons to continue the separation of banking and commerce, there is a very strong reason to eliminate it. If this subcommittee--and Congress, ultimately--take this action, a future crisis in the banking industry, one far more serious than the crisis the industry recently passed through, can be avoided.
That concludes my testimony. I would be pleased to answer any questions you may have.
[The prepared statement of Peter Wallison can be found on page 294 in the appendix.]
Chairman BAKER. Thank you very much, Mr. Wallison, for an excellent statement.
I would now recognize Dr. George Kaufman, Professor of Finance and Economics at the College of Business, Loyola University of Chicago.
We certainly welcome you and look forward to your remarks, sir.
STATEMENT OF DR. GEORGE G. KAUFMAN, JOHN F. SMITH PROFESSOR OF FINANCE AND ECONOMICS AT THE COLLEGE OF BUSINESS, LOYOLA UNIVERSITY, AND CO-CHAIRMAN, SHADOW FINANCIAL REGULATING COMMITTEE
Dr. KAUFMAN. Thank you, Mr. Chairman. I am happy to testify today on one of the perennial and more heated issues in banking through much of U.S. history, the issue of mixing banking and commerce in universal banks.
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I will summarize my longer written statement, which I submit for the record.
Analyzing proposals to combine banking and commerce is more difficult than analyzing many of the other issues related to banking reform, because both the theory and the empirical evidence are weaker. Synergies between banking and commerce are more difficult to conceptualize than those between banking and other financial services, and because of the existing ban, historical evidence has been scarce in recent years.
Although throughout most of U.S. history, commercial banks have generally been precluded from engaging directly in non-financial activities and non-financial firms in banking, until the enactment of the Bank Holding Company Act of 1956, combination of the two within a bank holding company structure has been more common.
Indeed, breaking up such holding company combinations was one of the objectives of the Act and its extension from multi-bank to one-bank holding companies in 1970.
In addition, multi-association S&L holding companies were permitted to combine depository and non-financial activities through 1967, and unitary S&L holding companies may do so today. Although holding company banking and commerce combinations were permitted in banking before 1956, and on a more limited scale through 1970, relatively few existed.
Moreover, documented abuses from the combination of banking and commerce did not appear to have motivated either the 1956 or the 1970 Acts. The fear was potential abuses. The 1956 Act appears to have been motivated primarily by a fear of interstate banking leading to the domination of deposits and credit by a few giant bank holding companies, and by the Federal Reserve's longstanding and obsessive drive to separate the Bank of America from the other activities operated by its parent, TransAmerica Corporation.
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The 1970 Amendments to the Bank Holding Company Act were motivated by a desire both to prevent large commercial banks from financing their expansion by bypassing Regulation Q deposit ceilings then in effect and to protect the economy against potential Japanese-style Zaibatsu combinations.
Although there were nearly 1000 one-bank holding companies in 1969 and most large banks were part of a holding company structure, most conglomerate or commerce-oriented holding companies were smaller, family-type operations. In the early 1980's commercial firms, as well as non-bank financial firms, could own non-bank commercial banks, which were banks that could not both accept demand deposits and make commercial loans, and therefore were not subject to the limitations of the Bank Holding Company Act.
However, only a few non-financial firms bought or organized such banks and none have grown to a significant size.
Among unitary S&L holding companies, Ford Motors owned First Nationwide, one of the largest S&Ls in the country, and Sears owned a medium-sized retail savings and loan association in California, but neither combination appeared very successful and they--as many others--have ended in divestiture. Nor have many non-financial firms combined with insurance companies or other financial firms except with their own captive finance companies.
Thus, there is little evidence supporting significant efficiency gains from extending commercial bank powers to non-financial activities.
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Besides potential synergies, combining banking and commerce raises questions of conflicts of interest, competition and concentration, safety and soundness, and regulatory capture. I have reviewed some of the evidence on these issues in a recent paper with Professor Randy Kroszner of the University of Chicago.
In brief, exploiting conflicts of interest in ways costly to consumers should be no greater in banking than in other industry, and best protected against by fostering competition. Likewise, fostering competition and avoiding excessive concentration in banking should be no more difficult than elsewhere.
In addition, the United States is starting with both a narrow and relatively fragmented banking structure, and strong competing bond and equity markets.
Last, exploiting the bank safety net should be unaffected by whether or not banks can enter into new asset activities, and any resulting misallocation of resources in these areas, no costlier.
Moreover, the enactment of FDICIA by Congress in 1991, has made exploiting the safety net more difficult and less costly to taxpayers, as long as the bank regulatory agencies enforce the letter and spirit of the Act.
In sum, it should be remembered that the bottom line in this analysis is whether combining banking and commerce improves aggregate economic efficiency and benefits consumers. Where there is little likelihood that permitting new activities will produce serious damage, there is a gain from permitting the activity and allowing individual economic agents to decide the optimal structure for their operations.
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Thus, I favor repeal of the Bank Holding Company Act that largely prohibits the combination of banking and commerce and the enactment of legislation permitting ownership of banks by non-financial firms, and bank ownership of non-financial activities on a limited and phased-in basis.
Thank you, Mr. Chairman.
[The prepared statement of Dr. George Kaufman can be found on page 305 in the appendix.]
Chairman BAKER. And thank you, Dr. Kaufman. I appreciate both of you being willing to testify today. Since I have the luxury of, or the opportunity to question, I would just want to proceed rather informally and ask you both to respond to points along the way.
First, I think, there is great danger in simply doing nothing. As I understand the bank market today, many of the prime customers who early on had the capability, went to Wall Street. Later, smaller and smaller business entities accessed other non-traditional financial sources, even commercial paper sources, to finance their needs. At the same time, credit card issuers were taking the bottom end of the market away from the banking product opportunity line, so you have a shrinking of the opportunities of where you can market your product.
At the same time, the non-regulated fellow has a broad array of stuff, from insurance to securities to money market funds--frankly, all the banking services--so you can't directly compete with the non-regulated fellow, because you don't have the array of products the other fellow has.
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Although we have very well-capitalized institutions today, and many with high liquidity, I am very much concerned that, given those constraints, unless we act, the very people many folks are most concerned about in the new approach are the community-based institutions who also have limited geographic resources.
They seem to be the ones most at risk if we fail to act. Do you have a comment on that?
Mr. WALLISON. I agree certainly with the analysis of where the market is going. The question of whether community-based banks are going to be adversely affected by the changes in the market relates very much to the kinds of services that they are going to be able to offer in the future.
Interestingly, over time, the community-based banks have been able to withstand a lot of the competition that they were afraid of when larger institutions were trying to get changes in the law to permit interstate banking. They offer a kind of service to the local community that has enabled them to survive by offering small business loans and personal loans to individuals, largely on the basis of the fact that they are a local institution.
Over time, it is probably likely that these community-based banks will be acquired by larger institutions and we will have a smaller number of banks in the industry as a whole. It is unlikely that any change in the laws relating to the separation of banking and commerce will harm community banks, but the opportunity for those institutions--if their managements want to expand out into other areas of activity in their local communities or to join with larger institutions elsewhere--will be enhanced dramatically, and that will give the managers and the shareholders of those institutions much greater resources and flexibility for the future.
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It can only help community-based institutions to break down some of the barriers to other activities they might want to engage in.
Chairman BAKER. Let me suggest that I didn't expect the next vote to come so quickly, so I am going to move, Dr. Kaufman, to the next question to try to get through this with the time available.
If I am hearing individuals talk about the potential for a commerce and finance blend, there is then the question of how far one goes.
The Comptroller wants a soft line. We don't know where the line is. The Secretary of the Treasury hasn't decided if we need a line. Mr. Greenspan says we need a line, but it needs to be very-narrowly-constricted, and perhaps limits on revenue aren't the appropriate way to constrain it.
I am worried about revenue limits. Revenue has little relationship to the soundness of the enterprise with which you affiliate.
The fact that you have less than 7.5 percent income from that source may mean it's in trouble to begin with. My concern is if we allow it in any form, whether a little or a lot, should we not look through some stress test analysis, some sort of formula that looks at the investment strategy of the financial institution, to determine its financial health and whether it can adequately take on the risk of the affiliation, notwithstanding whether it is a hardware store or an insurance company?
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Dr. KAUFMAN. I have a great deal of sympathy with what you say.
The problem is, how do we get from here to there? What is the transition process, if we all agree that in the longer run allowing the banks to have greater freedom, allowing the banks to move into commerce and commerce into banking, which, I think, is the way markets are going, and markets do not wait for legislation, so legislation is constantly catching up with what the market is doing. What should be the transition process and how do we manage this? Should the test, as you say, be a revenue test, or should it be the size of the firm?
I am not quite sure and, I think, that this is more of a technical question as to how you move over time to the new structure. I would probably not prefer a revenue test. I think a stress test--whether the institution has enough capital given the nature of the safety net--is one way of looking at it. Percent of total assets is another way of looking at it. But I differ with my colleague here, Peter Wallison. I do not think that all banks, and especially community banks, are going to be rushing into this.
As I have pointed out, there is very little evidence there are any synergies. When I talk to my students and the general public about what will the banking industry look like X years in the future, I say, ''Let's look at the grocery store industry, which has not been regulated.''
We have national supermarkets, and regional supermarkets, and ma-and-pa stores, and franchise stores, and the national supermarkets have not dominated the industry. In fact, the largest supermarket of 20 years ago, the A&P, almost went out of business. The rapid growth has been in small franchise stores and ma-and-pa specialty stores.
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Chairman BAKER. But on that point, wouldn't it be true that the distinction between the delivery of a grocery product and the delivery of a financial-in-nature product is that you can't E-mail groceries, and that the ability of someone to move into new markets that are now untapped no longer relates to one's asset size? It only relates to your innovative ability, and therein is the risk, I think.
Dr. KAUFMAN. But that's exactly the point. I think smaller community banks have an expertise in certain areas and they are going to stay in that area, and the profitable ones, as you know, the profitability of small banks has been greater than the profitability of large banks because----
Chairman BAKER. But ironically the staying in that, quote, ''line of business,'' doesn't mean geographically. It means in that special ''niche'' of the market, and they may be banking nationwide.
Dr. KAUFMAN. Right. It should be voluntary, I think, is the important thing. We should not limit that and all I was saying, that if it is done on a voluntary basis, which I favor, permitting them to do so, I think we'll find a lot of banks are not going to go into the commerce area. They are going to find that they have a niche and their area of expertise is in finance, and that is where they are going to stay.
Otherwise, everybody is going to look alike. I think, especially for the small banks, their success is being a niche player. Community banks are successful because they relate personally with their customers, which is something that large banks cannot do. If you look at the evidence on small business lending, as the larger banks consolidate, they lose their drive and their expertise in small business lending, leaving a wide open niche for the community banks.
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Again, all I am saying is that if we permit this, every community bank is not going to grab it. Some will and some won't, and what I favor is permitting institutions to do so. We'll see a whole range of different types of institutions, some doing it, some not doing it, some doing it partially, some moving in, failing, moving out, just like we see in the grocery store industry.
Chairman BAKER. Like any other business.
My last point that I think we need to address, although both of you have spoken to it to some degree, is the concentration question.
It appears to me that within the commercial marketplace today, significant concentrations of wealth could occur in any event, and it doesn't seem to be appearing in any greater or any lesser rate than it has in the past.
Isn't that, in your opinion, a legitimate concern in view of the competitive forces in today's market? I can understand it at the end of the 19th Century, when there were a handful of institutions and not very many creative alternative financial instruments to help fund business activities.
It wasn't that long ago, if you wanted to borrow $2500 to buy a used car, you had to go to the bank. Today, very few people who are going to use $2500 of credit do it through a banking institution. The marketplace has changed, therefore the risk of concentration, I think, has changed rather dramatically.
Can you comment?
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Mr. WALLISON. Yes. Well, my testimony was directed very much to that question.
The market for commercial and individual consumer lending is so competitive today that the risks of concentration are nonexistent.
There are so many ways that consumers and businesses can get the necessary financing that they need, that to worry about concentration--even if it could be demonstrated that there ever was a danger of concentration--is no longer a significant issue.
I want to, if I may, just address one of the points that Professor Kaufman mentioned, and that is that I do believe it is very important that all of our banks and similarly-situated organizations have the opportunity to go into other businesses, but this is a management decision. This is not a decision for the regulators, and there is no reason to believe that regulators themselves are any smarter about what would be right for a bank to do through a subsidiary, or through a holding company, than the managements of those institutions are themselves.
So, what this subcommittee ought to be looking for is a wide open market where managements can make these kinds of decisions based on what kinds of investments they can attract, what kinds of signals they get from the market, and not on the basis of what regulators think is appropriate for them.
Chairman BAKER. Isn't there so much diversity, and so many sources of financial activity, it's very difficult for regulators in the current system to keep up with, say, a new derivatives product, to even know what it is, much less how to regulate it?
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Should we be looking more toward a self-certification standard--that we set the rules and say, you must look like this in order to engage in new enterprise with the right of regulators to drop in unannounced and check the condition based on that formula--and if we find that you have represented things improperly, there is a death penalty associated with that inability to live by the rules?
Is that a better system than being cast in the role we are today, where we have an artificial capital limit which really has no reflection as to the risk-taking the institution may be absorbing, and early intervention abilities when there is trouble?
That, to me. does not seem to be responsive to what is happening today, much less tomorrow.
Dr. KAUFMAN. Well, let me answer that question first, then go to the other question.
I believe that we should follow a pattern--such as you say--that we should have a capital test and then if they miss the capital test, then they drop dead, but that is basically what FDICIA does.
It sets capital standards which, by the way, I think, are too low. Why do I say it's too low? Because if we take a look at the capital ratios of bank competitors--finance companies, or insurance companies, which are not insured, not covered by the safety net, therefore the capital ratio is set by the market--they are higher. Early intervention occurs as the performance of the bank deteriorates, as capital is dissipated. I think, given that we have a safety net, the Government does have an interest in trying to turn the bank around, but, if they use up all their capital, then we have a drop-dead rule.
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Chairman BAKER. Let me suggest, if I may, my vote has been called. I have got about 3 minutes left on this vote.
If I could ask both of you, if you choose to do so, to advance further responses on any of these issues to the subcommittee in writing. It would be most helpful, but I know your schedule is pressed and I really must get to the House floor and, with your understanding, we will just adjourn our hearing, and we do appreciate the courtesy of your participation here today.
Mr. WALLISON. Thank you.
Dr. KAUFMAN. Thank you.
Chairman BAKER. We will have follow-up questions as well. Thank you.
[Mr. Wallison's written responses to Chairman Baker's questions can be found on page 301 in the appendix.]
[Dr. Kaufman's written responses to Chairman Baker's questions can be found on page 315 in the appendix.]
Chairman BAKER. The hearing is adjourned. Thank you.
[Whereupon, at 12:10 p.m., the hearing was adjourned.]
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