FROM THE OFFICE OF PUBLIC AFFAIRS

Real Financial Modernization

During the course of this session, we may hear a lot about "financial modernization." Let's keep in mind what financial modernization really is.

Financial modernization is the process by which our financial system evolves in response to competition, innovation, and consumer preferences. Real financial modernization is a business process, not a political process. It occurs in the marketplace, not in the halls of Congress. The question for policymakers is how to respond to the financial modernization that is already occurring in this country and around the world.

Yet some people, including some here in Washington, lose sight of this point. They equate "financial modernization" with the legislative process -- as though the whole exercise were a gigantic game of "Simon Says," in which market participants couldn't move forward without Simon's say-so. Fortunately, that is not the case.

I say "fortunately" because over the years the progress of legislation intended to facilitate financial modernization has been torturously slow. Like a game of "Simon Says," it has often involved two steps forward and one step back, two steps forward and three steps back. Unlike a game of "Simon Says," it has also involved a lot of self-defeating behavior -- the equivalent of shooting yourself in the foot or holding your breath till you're blue in the face.

The Circular Firing Squad

And that brings me to my topic this morning: "Business Freedom and the Circular Firing Squad." Let's start with the firing squad.

The federal laws governing what companies can affiliate with banks -- notably the Glass-Steagall Act and the Bank Holding Company Act -- are badly outdated. They permit only limited affiliations between banks and other financial services firms. But changing these laws has proved difficult. Congress tried to do so in 1984, 1988, 1991, 1995, and 1997-98. Each time the process came to grief. And each time saw a great deal of self-defeating behavior.

I've often likened the process to a circular firing squad -- in which everyone hits the target but no one comes out ahead.

Business Freedom: The Subsidiary Option

A broad consensus has emerged in favor of allowing banks to affiliate with companies engaged in the full range of financial activities. But disagreement remains over what freedom a financial services firm that includes a bank should have in organizing itself. Indeed, when the past Congress debated H.R. 10, this proved to be one of the most divisive issues in a divisive process. I'm now going to examine that controversy more closely as a case study in business freedom and the dynamics of H.R. 10. I would note that it happens to be an issue in which the Administration has a strong interest.

The Administration believes that financial services firms should have a choice about where to conduct financial activities like securities underwriting, merchant banking, and insurance underwriting -- activities that banks, and companies affiliated with banks, have generally not been allowed to conduct in the past. The Administration proposed allowing financial services firms to conduct such activities through holding company affiliates or through subsidiaries of banks. This approach received support from the FDIC, the banking industry, the New York Times, the Washington Post and most independent economists who considered the issue.

But some participants in the debate took a different view. They insisted that Congress allow such new activities only in holding company affiliates. They evidently felt so strongly about this that they preferred to have no legislation at all rather than legislation that permitted the subsidiary approach. And they did this even though they had much to gain from H.R. 10, and much to lose if there were no legislation.

So let's look at the merits of the subsidiary approach. In particular, let's look at the arguments raised against it.

Opponents of the subsidiary approach raise six basic objections. First, they characterize it as an untried experiment -- a radical leap into the dark. Second, they brand it as overly risky. Third, they conjure up the specter of the thrift debacle and suggest that the subsidiary approach would produce a similar catastrophe. Fourth, they stress some possible accounting consequences of the subsidiary approach. Fifth, they assert that a subsidiary, because of its association with a federally insured bank, would receive a subsidy that is not available to an affiliate of that same bank. And sixth, they suggest that the subsidiary approach would somehow thwart functional regulation of securities and insurance activities.

Let's take a quick look at each of these objections.

1. Radical, Untried Experiment?

The first objection depicts the subsidiary as a radical, untried experiment.

But if you survey the financial systems of other developed countries, you'll find that organizational flexibility is the norm rather than the exception. No other country in the Group of Ten, and no country in the European Union, forces securities underwriting and dealing into a holding company affiliate. And virtually every such country that permits affiliations between banks and insurance underwriters allows subsidiaries of banks to underwrite insurance.

Nor is the subsidiary form a radical new experiment for U.S. banks. U.S. banks have had several decades of experience conducting nonbanking activities through subsidiaries. Such subsidiaries have for years engaged overseas in investment banking -- including underwriting and dealing in corporate debt and equity securities -- and merchant banking. All told, securities and merchant banking subsidiaries of U.S. banks have over $250 billion in assets, and insurance underwriting subsidiaries have some $4 billion in assets. So we should have a healthy skepticism about the doomsaying to which I will now turn.

2. Overly Risky?

The second objection is that the subsidiary approach would pose excessive risk to the parent bank and the federal deposit insurance funds.

In making this argument, critics ignore a fundamental, longstanding, and uniform rule of corporate law: that a parent corporation is generally not liable for the obligations of a separately incorporated subsidiary. If the subsidiary fails, the parent stands to lose no more than its investment in the subsidiary. The parent can be held liable for obligations of the subsidiary only under extraordinary circumstances, such as fraud by the parent.

We would reinforce this corporate separateness with rigorous safeguards on a bank's exposure to a subsidiary. For a subsidiary to engage in new financial activities, the bank would have to remain well capitalized and well managed. Every dollar of the bank's equity investment in the subsidiary would be deducted from the bank's capital -- and the bank would have to remain well capitalized even after the deduction.

These and other safeguards we propose would help assure that conducting an activity in a subsidiary posed no greater risk than conducting it in an affiliate. The rules governing extensions of credit, guarantees, and asset purchases would be exactly the same. The rules governing equity investments would be equivalent. A bank could invest in a subsidiary only the amount that it could pay as a dividend (e.g., to its parent holding company). And the bank would have to deduct from its own regulatory capital the entire amount of the investment. Thus, if the bank made an equity investment in a subsidiary, the effect on capital would be the same as if the bank had paid a dividend to its parent holding company and the holding company had invested the proceeds in an affiliate. In either case, the amount invested would no longer count as part of the bank's capital.

The current Chair of the FDIC and three of her predecessors all agree that the subsidiary approach is fully consistent with safety and soundness and the protection of the deposit insurance funds. Indeed, they believe that the subsidiary approach is, if anything, superior to the affiliate approach. A subsidiary's earnings accrue directly to the benefit of the parent bank, and help diversify the bank's earnings. If the bank ever gets into trouble, the bank's ownership interest in the subsidiary is among the assets available to the bank and the FDIC. By contrast, forcing assets out of the bank and into a holding company affiliate generally puts those assets beyond the reach of the FDIC and deprives the bank of the earnings from those assets.

Moreover, the notion that banks conduct safe "banking" activities whereas other financial service providers conduct dangerous "nonbanking" activities is antiquated, as Chairman Greenspan has explained:

"[T]he pressures unleashed by technology, globalization, and deregulation have inexorably eroded the traditional institutional differences among financial firms. . . . On the bank side, the economics of a typical bank loan syndication do not differ essentially from the economics of a best-efforts securities underwriting. Indeed, investment banks are themselves becoming increasingly important in the syndicated loan market. With regard to derivatives instruments, the expertise required to manage prudently the writing of over-the-counter derivatives, a business dominated by banks, is similar to that required for using exchange-traded futures and options, instruments used extensively by both commercial and investment banks. The writing of a put option by a bank is economically indistinguishable from the issuance of an insurance policy. The list could go on. It is sufficient to say that a strong case can be made that the evolution of financial technology alone has changed forever our ability to place commercial banking, investment banking, insurance underwriting, and insurance sales into neat separate boxes."

3. Another Thrift Debacle?

The third objection is that the subsidiary option would lead to a financial catastrophe like the thrift debacle. This argument is heavy on emotion but light on logic.

The thrift debacle had multiple causes, and resulted in part from allowing insolvent or weakly capitalized thrift institutions to expand rapidly into risky new activities for which they had little or no experience. Far from having to remain well-capitalized, thrifts faced no effective capital discipline. No capital deduction requirement applied. Since the thrifts in question had little or no real capital of their own, they essentially funded their investments with federally insured deposits. And far from being well-managed, these thrifts were ill-equipped to manage the risks involved.

By contrast, under the Treasury's proposal, a bank would in effect have to fund every dollar invested in a subsidiary with money that could otherwise go to the bank's own shareholders. The bank would have to remain not only well capitalized but well managed, which would include having internal controls adequate for the risks it faces.

Regulators exacerbated the thrift debacle by devising regulatory accounting rules for thrifts far less stringent than generally accepted accounting principles in order to mask problems for which they lacked the will and the financial resources to correct. Under our approach, by contrast, standards much stricter than GAAP would apply to the computation of regulatory capital whenever a bank engaged in new financial activities through a subsidiary.

4. Accounting as Reality?

The fourth objection to our approach points to generally accepted accounting principles that require consolidated reporting by the bank and any subsidiary. Thus, critics argue, because a subsidiary's losses would appear on the bank's books, the bank would feel pressure to prop up the subsidiary.

But accounting does not dictate liability. Consolidated accounting does not change the rule against holding a parent corporation liable for a subsidiary's obligations. The fact is that bank holding companies -- not banks -- issue the most heavily relied upon, publicly reported GAAP-based financial statements. And the fact is that those financial statements consolidate the bank with all of its affiliates as well as with all of its subsidiaries. So poor performance by an affiliate could concern investors and depositors just as easily as poor performance by a subsidiary. Thus, if a bank has a GAAP-induced incentive to prop up a subsidiary, it has the same incentive to prop up an affiliate. And under the Treasury's proposed safeguards on capital, lending, and investments, a bank would have no greater ability to support a troubled subsidiary than to support a troubled affiliate.

5. Imparting Subsidy Not Available to Affiliate?

The fifth objection is that a subsidiary, because of its association with a federally insured bank, would receive a subsidy that is not available to an affiliate of that same bank.

Now if subsidiaries have a significant subsidy advantage over affiliates, you would expect subsidiaries to dominate the lines of business in which both engage -- such as mortgage banking. In fact, that is not the case: affiliates hold their own in this area.

In any event, if any significant subsidy does exist, our proposed safeguards would prevent it from being transmitted to a subsidiary any more readily than it could be transmitted to an affiliate. Every dollar that the bank could invest in a subsidiary could just as readily be paid out as dividends to the holding company in order to capitalize an affiliate. And the limits on a bank's loans, guarantees, and the like would be exactly the same for a subsidiary as for an affiliate.

6. Thwarting Functional Regulation?

The sixth objection involves functional regulation of securities and insurance activities. Critics assert that allowing such activities in subsidiaries of banks would somehow undercut functional regulation and prevent securities and insurance regulators from carrying out their duties.

This is no reason whatsoever why this need be the case. Congress can specify that securities and insurance regulators would have exactly the same authority over a subsidiary as they do over an affiliate.

Conclusion

Our legal system gives businesses considerable flexibility in organizing themselves. That business freedom should be limited only to the extent demonstrably necessary to further the public interest.

The opponents of the subsidiary approach have failed to make a coherent -- much less a compelling -- case for denying financial services firms the option of that approach. On the contrary, U.S. banks have considerable experience conducting financial activities through subsidiaries. As we have proposed it, the subsidiary approach poses no greater risk than the affiliate approach, involves no greater potential for transmitting subsidies, gives banks the benefits of diversification, provides greater protection to the FDIC, and is fully consistent with functional regulation.

Thus one could quite reasonably view the subsidiary as superior to the affiliate from the standpoint of the public interest. Yet the Treasury has not sought to turn the subsidiary approach into a governmental mandate. We have been content to let financial services firms choose the structure that they believe makes the best business sense. But during Congressional consideration of H.R. 10, the partisans of the affiliate approach insisted on the affiliate as the only permissible vehicle for new activities. Not only did they persist in opposing the subsidiary option, but they evidently preferred to have no bill at all rather than include such a choice in H.R. 10.

Once again, the circular firing squad went about its work with gusto. Once again, its members hit the target. And once again, there were few winners.